CBO

TESTIMONY

Statement of

Peter R. Orszag

Director

Economic Volatility

before the

Joint Economic Committee

United States Congress

February 28, 2007

CONGRESSIONAL BUDGET OFFICE

SECOND AND D STREETS, S.W.

WASHINGTON, D.C. 20515

This document is embargoed until it is delivered

at 9:30 a.m. (EST) on Wednesday, February 28,

2007. The contents may not be published, transmitted, or otherwise communicated by any print,

broadcast, or electronic media before that time.
Notes

Some of the figures in this testimony use shaded vertical bars to indicate periods of

recession. (A recession extends from the peak of a business cycle to its trough.)

Numbers in the text and tables may not add up to totals because of rounding.
Chairman Schumer, Vice-Chair Maloney, Congressman Saxton, and Members of

the Committee, I appreciate the invitation to participate in today’s hearing. My

testimony makes four main points:

B First, macroeconomic volatility—the ups and downs of overall economic

growth and inflation—has declined and is now relatively low. In particular,

year-to-year fluctuations in the economy have become smaller than in the past.

B Second, despite the relatively modest volatility in the overall economy, workers

and households still experience substantial variability in their earnings and

income from year to year. The Congressional Budget Office’s (CBO’s) analysis

shows, for example, that between 2001 and 2002, one in four workers saw his

or her earnings increase by at least 25 percent, while one in five saw his or her

earnings decline by at least 25 percent. Some of that variability stems from

voluntary actions, such as a decision to stay home and rear children, and some

stems from involuntary events, such as the loss of a job. Earnings volatility is

somewhat higher for people with less education.

B Third, although earnings and income volatility is substantial, more research is

required to determine how and when that variability has changed over the past

few decades. The existing evidence suggests that annual earnings have tended

to fluctuate more, on a percentage basis, over the past 25 years than they did

during the 1970s. The number of studies on the topic is limited, however, and

they have somewhat different results. Therefore, it is too early to reach firm

conclusions about the precise timing or magnitude of any increase. Given their

importance, trends in earnings and income volatility seem to warrant significant

research attention.

B Fourth, many observers are accustomed to thinking about the federal tax

system as an “automatic stabilizer” that helps to reduce variations in national

income. The tax system, though, also helps to smooth out variability at the

level of households by reducing year-to-year fluctuations in their after-tax

income. That insurance effect of the tax system is potentially significant, given

the substantial variation in households’ earnings and income. At the same time,

however, the tax system levies higher average rates on households whose

income is more variable and imposes costs on the economy by distorting the

decisions that households make about how much to work, how much to save,

and how to receive their compensation for doing so. In evaluating different tax

structures, policymakers need to weigh the role of the tax system in smoothing

income against its other effects on households and the economy.
2

Figure 1.

Macroeconomic Volatility

(Percent)

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

a. Inflation as measured by the growth of the chained price index for personal consumption 

expenditures. 

           

















'ROWTHOF2EALPER#APITA'ROSS$OMESTIC0RODUCT

           















)NFLATIONA
3

Table 1.

Changes in Macroeconomic Volatility

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis.

Note: Volatility is measured as the standard deviation of the change from the previous year in 

gross domestic product (GDP) per capita (for GDP growth) and in the chained price index for 

personal consumption expenditures (for inflation), in each case using quarterly data.

Macroeconomic Volatility

Macroeconomic volatility has been significantly lower during the past 20 years

than in preceding decades. Although recessions can still be quite painful for

particular sectors and workers, recessions have been less severe overall—in

duration, frequency, and magnitude—than they were between 1950 and the mid1980s. The quarter-to-quarter fluctuations in real (inflation-adjusted) gross

domestic product (GDP) have also become smaller (see the top panel of Figure 1).

In addition, the level and volatility of inflation over the past 20 years have also

been relatively low (see the bottom panel of Figure 1). Volatility in more recent

years has been less than half that of the previous period (see Table 1). The

corresponding reduction in people’s uncertainty about prices allows them to plan

better for the future. Volatility has declined not only in the growth of overall GDP

and inflation but also in virtually all of the major components of GDP and in

aggregate unemployment, wages, and income.

Although there is no conclusive explanation for the decline in the volatility of

GDP growth and inflation, numerous reasons have been advanced, many of which

are closely interrelated. The proposed explanations fall into four broad categories.

B A More “Flexible” Economy. Improvements in production processes and investments in information technologies (such as those that facilitate just-in-time

inventory management), increases in temporary and flexible work arrangements, and the deregulation of many industries (especially in the transportation

sector) have made it possible for the economy to adjust much more smoothly to

changes in the availability of, or demand for, goods and services. The economy

an more easily adapt to shocks, such as the energy price shock of 2004 and

2005, without large changes in output or large jumps in inflation.1

1. See Congressional Budget Office, The Economic Effects of Recent Increases in Energy Prices

(July 2006). See also Lawrence F. Katz and Alan B. Krueger, “The High Pressure U.S. Labor

Market of the 1990s,” Brookings Papers on Economic Activity, no. 1 (1999).

1950–1984 1985–2005

GDP Growth 3.1 1.4

Inflation 2.9 1.0

Volatility
4

B Improvements in Financial Markets and Institutions. Financial innovations

since the 1970s have enhanced businesses’ and households’ access to credit and

thereby enabled them to borrow more readily when their income turns down.

Those innovations include improved assessment and pricing of risk (including

the development of credit derivatives and interest rate swaps) and the greater

use of financial markets in supplying credit (through securitization, for example).2 In addition, changes in government regulations have allowed more diversification in banking and made housing financing more stable. Even though

those changes in capital markets seem esoteric, they appear to have broadened

and deepened access to credit for both businesses and households and to have

improved the resiliency of the financial system by spreading the risk of default

more widely and efficiently.

B Management of Monetary Policy. During the past two decades, the Federal

Reserve has shown a strong commitment to keeping inflation low and stable. Its

actions to reduce and contain inflationary pressures seem, in turn, to have stabilized firms’ and households’ expectations of future inflation. As a result, the

Federal Reserve has not needed to respond as forcefully as in the past to

dampen swings in expectations of inflation or to bring inflation down from a

high level. The result may be reduced macroeconomic volatility.

B Fewer Shocks to the Economy. This explanation—that fewer shocks to the

economy, particularly the worldwide economy, have occurred—was proposed

before the rapid rise in oil prices from 2004 to mid-2006. Given the mild effect

of that oil price shock on economies worldwide, the explanation now seems less

persuasive. Moreover, overall U.S. economic growth was little affected by other

major shocks during the past 20 years, such as the Asian currency crisis of

1997, the Russian debt crisis of 1998, and the terrorist attacks of September 11,

2001.

Workers’ Earnings and Households’ Income

The story at the level of the individual worker or household is different from the

story at the macroeconomic level. Individual earnings tend to rise over time, but

the data suggest that workers and families experience substantial volatility year to

year around that underlying trend.

To examine earnings and income volatility, CBO analyzed recent data from the

Survey of Income and Program Participation (a data set collected by the U.S. Census Bureau). The analysis focused on workers who were 25 to 55 years old and not

2. Securitization involves the conversion of cash flows into securities; credit derivatives are financial instruments designed to transfer credit risk from one party to another; and interest rate

swaps are exchanges of two series of payments based on different interest rates, which entities

undertake to manage their exposure to changes in rates.
5

Figure 2.

Distribution of Changes in Workers’ Annual

Earnings from 2001 to 2002

(Percent)

Source: Congressional Budget Office based on data from the 2001 panel of the Bureau of the 

Census’s Survey of Income and Program Participation. 

Note: The sample consists of individuals ages 25 to 55 who had positive earnings in 2001 and were 

not enrolled in school that year or in 2002. Earnings are inflated to 2002 dollars using the 

research series of the consumer price index for urban consumers. 

in school, so it therefore does not capture changes in earnings associated with

graduating from school or leaving work for school.3 Even so, the analysis shows

substantial variation in workers’ before-tax earnings from 2001 to 2002. After an

adjustment for inflation, one in four workers saw his or her earnings increase by at

least 25 percent, while one in five saw his or her earnings decline by at least 25

percent. A substantial portion of workers, 11 percent, saw their earnings decline by

at least half (see Figure 2).

Workers with less education tend to experience more volatility in their earnings

than do workers with more education (see Table 2). For example, from 2001 to

2002, 16 percent of workers without a high school education had their earnings

3. For a discussion of wage trends in low-wage labor markets, see Congressional Budget Office,

Changes in Low-Wage Labor Markets Between 1979 and 2005 (December 2006).

0

10

20

30

40

50

60

70

Decrease

of at Least

50 Percent

Decrease

of at Least

25 Percent

Change

of Less Than

25 Percent

Increase

of at Least

25 Percent

Increase

of at Least

50 Percent
6

Table 2.

Distribution of Changes in Workers’ Annual

Earnings from 2001 to 2002, by Educational

Attainment and Age

(Percent)

Source: Congressional Budget Office based on data from the 2001 panel of the Bureau of the 

Census’s Survey of Income and Program Participation. 

Note: The sample consists of individuals ages 25 to 55 in 2001 who had positive earnings in 2001 

and were not enrolled in school that year or in 2002. Earnings are inflated to 2002 dollars 

using the research series of the consumer price index for urban consumers.

decline by 50 percent or more, compared with 10 percent of workers with more

than a high school education.

Such fluctuations in earnings can result from many sources, including job changes,

job losses, job gains, voluntary exits from the labor force to care for children or

other family members, changes in the number of hours worked per year, or

changes in the wage rate received by workers. Among workers who experienced at

least a 50 percent drop in earnings, most did not work at least a month and typically did not work eight months in 2002. When asked why they were not working,

the most common responses were that they were caring for a child or other family

member or were pregnant; were not able to find work or had been laid off; were

unable to work because of disability, illness, or injury; or were not interested in

working or were retired.4 The responses appear to be split evenly between those

suggesting that the departure from the labor force was voluntary and those suggesting that it was not.

Total household income consists not only of the earnings of household members

but also other sources of cash income such as unemployment insurance, retirement

4. Only those individuals who had at least four consecutive months without a job responded to the

question.

All Workers 10.7 19.8 55.5 24.7 14.2

Educational Attainment

Less than high school 15.6 26.0 47.9 26.0 16.4

High school 11.6 19.8 55.0 25.2 14.8

More than high school 9.5 18.8 57.0 24.2 13.6

Age

25 to 30 11.4 20.0 53.8 26.2 14.6

31 to 40 10.7 19.8 54.5 25.7 14.9

41 to 55 10.5 19.7 56.7 23.6 13.7

50 Percent 25 Percent

Earnings of at Least

Increases in 

25 Percent 50 Percent

Changes in 

25 Percent

Earnings of at Least Earnings of Less Than

Decrease in 
7

income, dividends, and interest. Compared with earnings, it thus represents a

broader measure of the economic resources available to individuals.5 Like workers’ earnings, household income can vary from year to year, though it tends to be

less variable than individual earnings. First, if an individual worker in a household

with multiple earners loses a job, the earnings of the other members may partially

mitigate the consequences of the job loss. Second, a loss in earned income may be

alleviated by an increase in other sources of income, like unemployment insurance, payments from a retirement plan, or disability insurance. Neither the mitigating effects of the presence of other earners in the household nor the potential for

increases in nonlabor income is captured in the more narrow measure of individual

earnings.

To be sure, household income can vary from changes in the composition of

households. Households are not fixed entities: They often evolve, as couples

marry, separate, or divorce and working children move out of or into the house.

According to CBO’s analysis, the growth of before-tax income varied substantially

among households between 2001 and 2002 (see Figure 3). Nearly one in four

households experienced an increase in income of at least 25 percent, virtually

identical to the number of individuals who experienced a similar percentage

increase in earnings. Fewer households, one in seven, experienced a decrease in

income of at least 25 percent. And one in 25 households experienced a decrease

in income of at least 50 percent—compared with one in nine individuals who

experienced such a decline in earnings. Unlike the variability of earnings, however, the variability of household income seems similar across education levels

(see Table 3).

For another point of comparison, CBO conducted a similar analysis using data

from 1997 to 1998—a period of relatively rapid economic growth, in contrast to

the relatively slow growth from 2001 to 2002—and found similar results.6 Thus,

substantial variability in workers’ earnings and income can occur in periods of

both strong and weak economic growth.

Using surveys to measure the year-to-year variability in earnings and income is

complicated by the fact that individuals’ responses are often in error (which

could either overstate or understate the actual changes in earnings or income).7 In

5. Household income, as reported here, is before-tax income and excludes capital gains and

losses.

6. The data are from the 1996 and 2001 panels of the Survey of Income and Program Participation, conducted by the U.S. Census Bureau.

7. See John Bound and Alan B. Krueger, “The Extent of Measurement Error in Longitudinal Surveys: Do Two Wrongs Make a Right?” Journal of Labor Economics, vol. 9, no. 1 (January

1991), pp. 1–24.
8

Figure 3.

Distribution of Changes in Households’ Annual

Income from 2001 to 2002

(Percent)

Source: Congressional Budget Office based on data from the 2001 panel of the Bureau of the 

Census’s Survey of Income and Program Participation.

Note: The sample consists of households in January 2001 that were surveyed for all of that year 

and 2002. Income, which is before taxes, includes earnings, unemployment compensation, 

workers’ compensation, Social Security benefits, Supplemental Security Income, public 

assistance, veterans’ payments, survivors’ benefits, disability benefits, pension or retirement 

income, interest, dividends, rents, royalties, income from estates or trusts, alimony, child 

support, financial assistance from outside the household, and other cash income. Income 

is inflated to 2002 dollars using the research series of the consumer price index for urban 

consumers. 

addition, while the surveys are intended to be nationally representative, they may

not include undocumented workers and can be subject to biases because some

people either refuse to respond at all or drop out of the surveys before their

completion. An important question, then, is whether, over longer periods of time,

earnings and income volatility has increased. According to most studies on the

topic, earnings have tended to fluctuate more, on a percentage basis, over the past

0

10

20

30

40

50

60

70

Decrease

of at Least

50 Percent

Decrease

of at Least

25 Percent

Change

of Less Than

25 Percent

Increase

of at Least

25 Percent

Increase

of at Least

50 Percent
9

Table 3.

Distribution of Changes in Households’ Annual

Income from 2001 to 2002, by Educational

Attainment and Age of the Head of the Household

(Percent)

Source: Congressional Budget Office based on data from the 2001 panel of the Bureau of the 

Census’s Survey of Income and Program Participation. 

Note: The sample consists of households in January 2001 that were surveyed for all of that year 

and 2002. Income, which is before taxes, includes earnings, unemployment compensation, 

workers’ compensation, Social Security benefits, Supplemental Security Income, public 

assistance, veterans’ payments, survivors’ benefits, disability benefits, pension or retirement 

income, interest, dividends, rents, royalties, income from estates or trusts, alimony, child 

support, financial assistance from outside the household, and other cash income. Income 

is inflated to 2002 dollars using the research series of the consumer price index for urban 

consumers.

25 years than they did during the 1970s.8 Relative to other questions about income

and earnings, however, the trend in their volatility has received relatively little research attention. More research is therefore needed before firm conclusions about

the precise time trend in earnings and income volatility can be reached.

8. See, for example, Peter Gottschalk and Robert Moffitt, “The Growth of Earnings Instability in

the U.S. Labor Market,” Brookings Papers on Economic Activity, no. 2 (1994); Costas Meghir

and Luigi Pistaferri, “Income Variance Dynamics and Heterogeneity,” Econometrica, vol. 72,

no. 1 (2004), pp. 1–32; Maury Gittleman and Mary Joyce, “Earnings Mobility in the United

States, 1967–91,” Monthly Labor Review, vol. 118, no. 9 (September 1995), pp. 3–13; and Peter

Gottschalk and Robert Moffitt, “Trends in the Transitory Variance of Earnings in the United

States,” Economic Journal, vol. 112, no. 478 (2002), pp. 68–73.

Changes in 

Income of Less Than

50 Percent 25 Percent 25 Percent 25 Percent 50 Percent

All Households 4.3 14.2 62.2 23.6 12.5

Educational Attainment 

of the Head of the Household

Less than high school 4.3 14.6 62.1 23.3 12.6

High school 4.2 13.8 61.9 24.2 12.6

More than high school 4.3 14.3 62.3 23.3 12.4

Age of the Head 

of the Household

25 to 30 4.2 14.8 59.3 26.0 13.8

31 to 40 4.3 14.7 59.6 25.7 13.6

41 to 55 4.8 15.1 61.2 23.7 12.1

Income of at Least Income of at Least

Decrease in Increases in 
10

To the extent that variability in earnings and income has increased, the phenomenon may be consistent with—and indeed perhaps part of the explanation of—the

decreased macroeconomic volatility described earlier. For example, more-flexible

labor markets could enable the economy to adjust to changes in the economic

environment more quickly but also could mean that individuals change jobs and

have their wages change more frequently.

Risk Sharing, Income Fluctuations, and Taxation

Economists have long noted that the tax system serves as an automatic stabilizer

that offsets at least part of demand shocks to the economy.9 A decline in aggregate

before-tax income of one dollar generates a decline in aggregate after-tax income

of less than one dollar. As a result, the tax system helps to stabilize demand for

goods and services, which in turn helps to reduce fluctuations in the overall

economy.10

In addition to its well-recognized role as a macroeconomic automatic stabilizer,

the tax system can serve as a microeconomic automatic stabilizer by helping to

smooth out variability at the level of workers’ earnings and households’ income.11

The tax system automatically reduces the tax burden when before-tax income declines and automatically raises the burden when before-tax income rises. After-tax

income therefore tends to vary less than before-tax income.12 In that way, the tax

system provides a form of after-tax earnings or income insurance, which complements the social insurance provided through a variety of government programs.

9. See Alan J. Auerbach and Daniel Feenberg, “The Significance of Federal Taxes as Automatic

Stabilizers,” Journal of Economic Perspectives, vol. 14, no. 3 (Summer 2000), pp. 37–56; and

Thomas J. Kniesner and James P. Ziliak, “Tax Reform and Automatic Stabilization,” American

Economic Review, vol. 92, no. 3 (June 2002), pp. 590–612

10. The stabilizing effect of the tax system on the overall economy reached a peak around 1980 and

by 1995 had declined to about the same level as in the 1960s. Since 1995, according to CBO’s

estimates, there has been relatively little change. Those movements mirror the increase and then

the decline in effective tax rates. See Auerbach and Feenberg, “The Significance of Federal

Taxes as Automatic Stablizers.”

11. See Hal R. Varian, “Redistributive Taxation as Social Insurance,” Journal of Public Economics,

vol. 14, no. 1 (August 1980), pp. 49–68; Jonathan Eaton and Harvey S. Rosen, “Labor Supply,

Uncertainty, and Efficient Taxation,” Journal of Public Economics, vol. 14, no. 3 (December

1980), pp. 365–374; Jonathan Eaton and Harvey S. Rosen, “Taxation, Human Capital, and

Uncertainty,” American Economic Review, vol. 70, no. 4 (September 1980), pp. 705–715;

Jonathan Eaton and Harvey S. Rosen, “Optimal Redistributive Taxation and Uncertainty,”

Quarterly Journal of Economics, vol. 95, no. 2 (September 1980), pp. 357–364.

12. Variability of income can be measured in different ways. Some analysts measure it as the

change in dollar income; other analysts measure it as the percentage change in income. A pure

proportional tax system can reduce the dollar amount of variability but does not affect the variability in percentage terms; a progressive tax system can reduce variability by both measures.
11

Table 4.

Effect of Taxes on the Variability of Income:

An Example

(Dollars)

Source: Congressional Budget Office.

Note: Based on the tax schedule for a single worker in 2006.

(Although the federal tax system generally works to smooth out fluctuations in

income, that attribute does not apply for each and every taxpayer.13)

The risk-sharing features of the tax system can be illustrated in a simple example

(see Table 4). Consider a single worker earning $45,000 in 2006 with no other

sources of income. At that level of income, the worker would owe $5,695 in federal income taxes and $3,443 in payroll taxes and would therefore have $35,863 in

after-tax income. If the worker’s earnings fell by 20 percent, to $36,000, after-tax

earnings would decline to $29,491. Although before-tax earnings fell by $9,000

(20 percent), after-tax earnings declined by only $6,372 (18 percent).

The predictability of households’ income will affect how much value they place

on the insurance provided through the tax system. To the extent that swings in

earnings or income are unpredictable, households will tend to value the insurance

more. However, the value of that insurance will be smaller for households whose

earning or income swings are largely expected or stem from intentional decisions

about how much and when to work.

The insurance provided by the progressive tax system to households with variable

income comes at a price: it can reduce average after-tax income for such households. Consider two people who have the same amount of lifetime earnings; one

has steady earnings and the other, large swings in earnings. Under a progressive

tax system based on annual income, the steady earner pays less in taxes over a

13. See Robert Moffitt and Michael Rothschild, “Variable Earnings and Nonlinear Taxation,” Journal of Human Resources, vol. 22, no. 3 (Summer 1987), pp. 405–421. For example, the payroll

tax for the Old-Age, Survivors, and Disability Insurance program does not apply to earnings

above the taxable maximum ($97,500 in 2007). As a result, when earnings fluctuate across that

threshold, after-tax earnings can be more variable in percentage terms than before-tax earnings.

Before-Tax Wages 45,000 36,000 -9,000 -20

Income Taxes 5,695 3,755

Payroll Taxes 3,443 2,754 _____ _____

Total taxes 9,138 6,509

After-Tax Wages 35,863 29,491 -6,372 -18

Initial Wages

Change in Wages

Lower Wages Dollars Percent
12

lifetime even though both people have the same total amount of earnings. Thus,

progressive taxation combined with an annual accounting period fails to treat

people in similar circumstances in the same way. Various options for changing the

tax system would alter the trade-off between the income smoothing insurance provided and the average cost imposed on households with variable income.

In addition to that trade-off between the insurance provided to and the price paid

by households with variable income, any risk-sharing benefits that the tax system

generates must be weighed against the potential costs that it imposes on the economy at large. Marginal tax rates affect households’ decisions about how much to

work and save, as well as the form in which to receive compensation for doing so,

and those distortions reduce the efficient operation of the economy. The implicit

insurance that the government provides through the tax system may have other

effects, such as changing the types and forms of insurance products offered by the

private markets or encouraging people to take risks they would not take in the

absence of that implicit insurance.14

Comparing the various costs and benefits is difficult, and a complete accounting of

all of those effects has not yet been achieved. Nonetheless, some recent studies

have found that, compared with some alternatives, the current tax system may provide insurance benefits that are larger than the costs that it imposes on the economy by distorting decisions about working and saving.15 However, those analyses

depend on many assumptions, and alternative assumptions could yield different

estimates, so the studies should be viewed with caution. Despite those caveats, a

reasonable conclusion from this new research is that the income-smoothing insurance provided through the tax system could be quantitatively important and should

be taken into account in any analysis of the relative costs and benefits of different

tax systems.

Finally, it is important to note that the benefits of risk sharing and the costs of distortions are not captured by changes in GDP. Although GDP is a useful summary

measure that may be related to households’ well-being, it does not measure the

value that households place on smoother incomes or the cost of distorted decisionmaking. Instead, GDP is merely a measure of how much output the market economy produces using its capital, labor, and technology. It does not measure what

ultimately matters and what needs to be measured: changes in the well-being of

households.

14. See Dirk Krueger and Fabrizio Perri, “Public Versus Private Risk Sharing” (working paper,

December 2005).

15. See Shinichi Nishiyama and Kent Smetters, “Consumption Taxes and Economic Efficiency

with Idiosyncratic Wage Shocks,” Journal of Political Economy, vol. 113, no. 5 (October

2005), pp. 1088–1111; Juan Carlos Conesa and Dirk Krueger, “On the Optimal Progressivity

of the Income Tax Code,” Journal of Monetary Economics, vol. 53, no. 7 (October 2006),

pp. 1425–1450.
13

Conclusion

The U.S. economy has become less volatile: Macroeconomic fluctuations are now

much milder than they were in the past. At the same time, however, households

continue to experience substantial variability in their earnings and income, and

that variability may now be greater than in the past—perhaps contributing to anxiety among workers and families. The tax system can help to smooth fluctuations in

income not only at the macroeconomic level but also at the level of workers and

households. The income insurance provided as a result may be quite valuable but

needs to be weighed against the other effects of the tax system.