CONGRESSIONAL BUDGET OFFICE

The Macroeconomic and 

Budgetary Effects of an 

Illustrative Policy for Reducing the 

Federal Budget Deficit

July 14, 2011

The federal government’s debt has increased dramatically in the past few years, and 

large annual budget deficits will probably continue indefinitely under current laws or 

policies. If current laws remain unchanged, deficits will total roughly $7 trillion over 

the next 10 years, the Congressional Budget Office (CBO) projects; if certain policies 

that are scheduled to expire under current law were extended instead, deficits would 

be much larger. Beyond the coming decade, the aging of the U.S. population and rising health care costs will put increasing pressure on the federal budget. If debt held by 

the public continues to expand faster than the economy—as it has since 2007—the 

growth of people’s incomes will slow, the share of federal spending devoted to paying 

interest on the debt will rise more quickly, and the risk of a fiscal crisis will increase.1

At the same time, the recovery from the recent recession has been anemic, and the 

economy remains in a severe slump. CBO and many private forecasters expect that 

the unemployment rate will remain high, and that output will remain well below the 

economy’s potential, for a number of years.

This analysis describes the economic and budgetary effects of an illustrative policy 

that would reduce primary deficits—that is, total budget deficits excluding net 

interest payments—by a cumulative $2.0 trillion between 2012 and 2021 relative to 

CBO’s baseline projections, before taking into account any economic effects of the 

policy.2

 The reduction in primary deficits under that policy, excluding economic 

effects, was assumed to equal $100 billion in 2012 and to increase gradually until it 

1. See Congressional Budget Office, CBO’s 2011 Long-Term Budget Outlook (June 2011); and Federal 

Debt and the Risk of a Fiscal Crisis, Issue Brief (July 27, 2010).

2. CBO last issued baseline projections in March 2011 and is scheduled to publish an updated baseline in August 2011. CBO’s baseline is a neutral reference point for measuring the budgetary 

effects of proposed changes to federal revenues or spending. It consists of projections of budget 

authority, outlays, revenues, and the deficit or surplus over 10 years. Those projections, which are 

calculated according to rules originally set forth in the Balanced Budget and Emergency Deficit 

Control Act of 1985, are not intended to be predictions of future budgetary outcomes; rather, they 

represent CBO’s best judgment of how economic and other factors would affect federal revenues 

and spending if current laws did not change. 
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Figure 1.

Cumulative Reduction in Deficits Under an Illustrative 

Policy, With and Without Its Macroeconomic Effects

(Billions of dollars)

Source: Congressional Budget Office.

Notes: The primary deficit is the total budget deficit excluding net interest.

All of the years in this figure are federal fiscal years, which run from October 1 to 

September 30.

CBO provides a range of estimates of the possible effects of the illustrative policy on output 

(see Table 1). The assumptions that generate medium-sized effects on output are discussed 

in the text.

reaches $300 billion in 2021. That illustrative policy does not incorporate any 

assumptions about the particular mix of spending or revenue changes and is not 

meant to correspond to any specific legislative proposal. Such a reduction in future 

deficits would result in lower federal debt than is currently projected, thus reducing 

the government’s interest costs. Taking into account those savings in interest, CBO 

estimates that the illustrative policy would lower deficits by a total of $2.4 trillion over 

the 2012–2021 period, under an assumption that those budgetary changes would 

have no effect on the economy (see Figure 1).

But, in fact, budgetary changes would affect the economy—in differing ways in the 

short term and over the medium term and long term:3

3. For a discussion of the effects of budget deficits on the economy over different time horizons, see 

Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for Fiscal Year 2012

(April 2011), pp. 21–22.

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

0

500

1,000

1,500

2,000

2,500

3,000

0

500

1,000

1,500

2,000

2,500

3,000

Reduction in

Primary Deficits Without

Macroeconomic Effects

Reduction in

Total Deficits Without

Macroeconomic Effects

Reduction in Total Deficits

With Medium-Sized

Effects on Output
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B In the short term, while the economy is relatively weak and economic growth is 

restrained primarily by a shortfall in demand for goods and services, the reduction 

in federal spending or increases in taxes that would produce smaller deficits would 

decrease the demand for goods and services even further and thus reduce economic 

output and income. In addition, long-term interest rates would be lower than if the 

deficit reduction did not occur.

B Over the medium term and long term, when economic output is determined by 

the supply of labor and capital and the productivity of those inputs, the reduction 

in federal borrowing that would result from smaller deficits would induce greater 

national saving and investment and thereby increase output and income. Longterm interest rates would continue to be lower than if the deficit reduction did 

not occur.

CBO used two approaches to estimate the effects of the illustrative policy on the 

economy. Those approaches focus on somewhat different aspects of the economy: 

One approach is used to estimate short-term effects only; the other addresses 

medium-term and long-term effects. Because considerable uncertainty surrounds 

many of the economic relationships that are fundamental to this analysis, CBO used 

a range of assumptions about the short-term effects on output of changes in federal 

spending and taxes and about the effects on national saving and investment of 

changes in deficits—and reports results corresponding to smaller, medium-sized, and 

larger effects on output. Even so, the macroeconomic impact of a reduction in primary budget deficits of $2.0 trillion could lie outside the range of estimates reported 

here, depending on the specific policies chosen, the future state of the economy, and 

numerous other factors. The magnitude of the impact of future deficit reduction on 

interest rates is especially uncertain.

CBO estimated the effects of the illustrative policy relative to the current-law assumptions underlying CBO’s baseline projections. According to those estimates, lower 

demand resulting from the illustrative policy would decrease real (inflation-adjusted) 

gross national product (GNP) in 2012, 2013, and 2014 by amounts ranging from 

roughly 0.1 percent to 0.6 percent depending on the year and the assumptions used.4

In addition, long-term interest rates would be reduced by about 0.1 to 0.4 percentage 

points during those years. Beyond 2014, the estimates show that the illustrative policy 

would lead to gains in GNP that increased over time. Near the end of the decade, in 

the years from 2019 through 2021, GNP would increase by roughly 0.5 percent 

4. For this analysis, all references to gross national product are expressed in real terms (that is, the 

estimates have been adjusted to exclude the effects of inflation). CBO used GNP—the total market value of goods and services produced in a given period by the labor and capital supplied by the 

country’s residents, regardless of where the labor and capital are located—as its measure of output 

instead of the more commonly cited gross domestic product. Changes in GNP exclude foreigners’ 

earnings on investments in the domestic economy but include U.S. residents’ earnings overseas 

and are therefore a better measure of the effects on U.S. residents’ income than are changes in gross 

domestic product. CBO’s budget calculations for this analysis reflect the fact that features of U.S. 

tax laws result in some foreign income of U.S. residents effectively being untaxed.
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to 1.4 percent, again depending on the year and the assumptions used. Long-term 

interest rates would be reduced by about 0.1 to 0.2 percentage points. 

The changes in the economy would in turn affect the federal budget—through 

changes in such factors as taxable income (which affects the amount of revenues collected) and interest rates (which affect the government’s borrowing costs). Specifically, 

CBO’s analysis indicates the following:

B The macroeconomic effects of the illustrative policy would increase primary deficits by small amounts in the first part of the coming decade and reduce them by 

small amounts in the latter part of the decade. Because the gains in GNP generated 

by the policy would increase further beyond the decade, the reduction in primary 

deficits would continue to grow as well. 

B The macroeconomic effects would reduce federal interest payments—over and 

above the reduction attributable to the lower levels of debt that would result from 

the policy—because the policy would lead to lower interest rates (relative to those 

underlying CBO’s baseline projections) in every year. Those savings would be 

much larger than the net savings arising from the changes in primary deficits 

induced by the macroeconomic effects of the policy and would also continue to 

grow beyond the end of the decade. 

B Under the set of assumptions that imply medium-sized effects of the illustrative 

policy on output, the macroeconomic effects of the policy would reduce deficits 

by about $185 billion over and above the $2.4 trillion reduction in primary deficits 

and interest costs estimated before accounting for the macroeconomic effects. 

Therefore, the illustrative $2.0 trillion reduction in primary deficits (relative to 

CBO’s baseline projections) would yield a total reduction in deficits of about 

$2.6 trillion from 2012 through 2021 (see Figure 1 on page 2). 

Alternative scenarios for deficit reduction would generate different macroeconomic 

effects and resulting budgetary effects. For example, a policy that had a different 

amount of cumulative reduction in primary deficits but that reduced deficits on the 

same gradual time path as the policy analyzed here would have macroeconomic and 

budgetary effects that differed by roughly the same percentage as did the cumulative 

amount of deficit reduction. Thus, for example, a reduction in primary deficits that 

followed the same gradual time path but was twice as large would produce macroeconomic effects that were roughly twice as large as those shown here.

A different policy that had the same amount of cumulative reduction in primary deficits but that reduced deficits more slowly than the policy analyzed here would have 

more favorable macroeconomic effects in the next few years but less favorable ones 

later in the decade. The total budgetary impact of slower deficit reduction would be 

smaller, for two reasons. First, the policy’s impact on interest rates would be smaller. 
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Second, because the reduction in debt would occur more slowly, the resulting savings 

in interest costs would have less time to compound. 

A related question concerns the effects of the same illustrative $2.0 trillion reduction 

in primary deficits on the same timetable analyzed here, but assuming that those 

reductions were relative to a scenario other than the circumstances under current law. 

In that case, the macroeconomic and resulting budgetary effects of the policy would 

probably be similar, but not identical, to the effects described here. For example, compared with an alternative fiscal scenario that led to significantly greater amounts of 

debt than in CBO’s baseline, the illustrative policy would reduce interest rates slightly 

more than presented here, and the larger amount of debt under the alternative fiscal 

scenario would imply that a given reduction in interest rates would lead to a larger 

reduction in interest payments.5 As a result, relative to such a scenario, the budgetary 

implications of the macroeconomic effects of this illustrative policy would be modestly larger.

An Illustrative Policy of Deficit Reduction

For its analysis, CBO constructed an illustrative policy of deficit reduction with the 

following characteristics:

B Current-law policies would be changed to reduce primary deficits by a cumulative 

$2.0 trillion between 2012 and 2021, with no specification about the mix of 

spending and revenue changes that would make up that total;

B Deficit reduction would total $100 billion in 2012 and grow by about $22 billion 

per year until it reached $300 billion in 2021;

B No net changes would be made to benefit programs or tax policies that would 

directly affect households’ incentives to work and save or businesses’ incentives to 

hire and invest. For example, CBO assumed that no changes to marginal tax rates, 

unemployment insurance, or tax rules for depreciation would occur.6

To put that amount of deficit reduction in context, CBO projects that, under current 

law, federal budget deficits will total $6.7 trillion over the 2012–2021 period. Under 

an alternative fiscal scenario that incorporated several changes to current law that are 

widely expected to occur or that modified some provisions of law that might be difficult to sustain for a long period, budget deficits would total $12.8 trillion during 

5. Other economic responses would be somewhat different as well. For an example of such an alternative scenario and its economic consequences, see Congressional Budget Office, CBO’s 2011 

Long-Term Budget Outlook, Chapter 2.

6. When analyzing specific policies, CBO incorporates the effects of changes in such incentives. See, 

for example, Congressional Budget Office, An Analysis of the President’s Budgetary Proposals for 

Fiscal Year 2012 and CBO’s 2011 Long-Term Budget Outlook, Chapter 2. 
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those years, CBO projects.7 In order to keep the ratio of debt held by the public to 

gross domestic product (GDP) in 2021 from rising above the 69 percent figure 

projected for the end of fiscal year 2011, cumulative deficits over the next decade 

would need to be roughly $1.6 trillion less than is indicated in CBO’s current-law 

projections and roughly $7.6 trillion less than would be the case in the alternative 

fiscal scenario. 

Types of Macroeconomic Effects 

CBO used two approaches to estimate the effects of the illustrative policy on the 

economy relative to the agency’s baseline projections. Those approaches focus on 

somewhat different aspects of the economy and reflect distinct ways of thinking about 

it. One approach addresses short-term effects that stem largely from variations in 

aggregate demand; the other addresses medium-term and long-term effects on the 

economy’s potential output.8

 Each approach represents people’s economic decisions in 

a simplified way while capturing some important aspects of actual behavior. 

In CBO’s judgment, the macroeconomic effects of the illustrative policy would be 

determined primarily by effects on the demand for goods and services in 2012 and 

2013, by effects on the nation’s capital stock (such as factories and computers) in the 

years 2017 through 2021, and by a combination of those factors from 2014 through 

2016.9

Short-Term Effects. The path of deficit reduction in the illustrative policy could be 

achieved through many possible combinations of decreases in government spending 

and increases in revenues. Such combinations would affect economic output in the 

short term both directly and indirectly. Direct effects consist of immediate effects on 

economic activity from a decrease in demand for goods and services. For example, in 

the case of lower government spending on goods and services, output would fall 

directly on a dollar-for-dollar basis. In the cases of tax increases, reductions in transfer 

payments, and decreases in aid to state and local governments, the direct effects on 

output would occur as the parties affected by the changes reduced their spending.10

7. See Congressional Budget Office, CBO’s 2011 Long-Term Budget Outlook.

8. For examples of recent CBO analyses using the same approaches, see Congressional Budget Office, 

An Analysis of the President’s Budgetary Proposals for Fiscal Year 2012, Chapter 2; and Statement of 

Douglas W. Elmendorf, Director, Congressional Budget Office, before the Senate Committee on 

the Budget, The Economic Outlook and Fiscal Policy Choices (September 28, 2010).

9. Specifically, CBO combines results from the modeling approaches as follows: estimates for 2012 

and 2013 are based on effects on demand; estimates for 2014, 2015, and 2016 place weights of 

0.75, 0.50, and 0.25, respectively, on the effects on demand and the remaining weights on the 

effects on the capital stock; and estimates for 2017 through 2021 are based on effects on the 

capital stock. 

10. For the purpose of this analysis, CBO assumed that 75 percent of the overall direct effect would 

occur in the quarter when the deficit reduction occurs and 25 percent would occur in the following quarter.
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Reductions in spending or increases in taxes would also have indirect effects on 

economic output. For example, the immediate reductions in demand for goods and 

services from private firms would prompt those firms to cut back on hiring and 

reduce capital investment because of scaled-back production plans. Those reductions, 

in turn, would lead to additional reductions in demand and output. At the same 

time, the lower path of expected future budget deficits would reduce interest rates, 

which would spur spending and output. The enactment of a significant deficit reduction policy would probably also reduce uncertainty about future policy actions and 

enhance business and consumer confidence. However, CBO did not incorporate such 

effects into its analysis because they are quite difficult to quantify. 

CBO’s analysis allows the illustrative policy to have a range of possible short-term 

effects on output. The medium-sized response reflects the assumption that each onedollar reduction in the deficit would cause economic output to decline by a dollar in 

the short term excluding the effects from changes in interest rates. At one end of the 

range, each one-dollar cut in the deficit was assumed to cause cumulative economic 

output to decline by $0.60 over several quarters. At the opposite end of the range, 

each one-dollar cut in the deficit was assumed to cause economic output to decline by 

a cumulative $1.40.11

In the near term, weaker demand for goods and services would increase unemployment and slow the rate of inflation, which would typically lead monetary 

policymakers to lower short-term interest rates. However, with short-term interest 

rates already near zero and expected to stay low for some time, the Federal Reserve 

might be constrained from reducing those rates as much as it would under other 

circumstances. Still, short-term interest rates would be somewhat lower during the 

next few years than they would be in the absence of the illustrative policy.12

The illustrative policy would also lead to lower long-term interest rates than would 

occur in the absence of the policy, even during the period when short-term rates are 

constrained from falling as much as they would otherwise. Long-term interest rates 

reflect, to at least some extent, the expectations that participants in financial markets 

11. The dollar-for-dollar response lies within the ranges of estimated effects on GDP for many policies 

examined in CBO’s analysis of the macroeconomic effects of the American Recovery and Reinvestment Act of 2009 (ARRA); the percentage range of possible effects on GDP used in this analysis 

is about the same as that assumed for the effects on GDP of particular policies in the analysis 

of ARRA. See Congressional Budget Office, Estimated Impact of the American Recovery and 

Reinvestment Act on Employment and Economic Output from January 2011 Through March 2011

(May 2011).

12. In this analysis, CBO assumed that, apart from the lower bound of zero on interest rates, monetary policy would follow a so-called Taylor rule with: (a) some forward-looking behavior based 

on projected inflation and unemployment; and (b) a slowly adjusting view of the interest rate 

that will prevail when the economy is operating at its potential and a desired level of inflation is 

reached. In addition, CBO assumed that the proximity of interest rates to the lower bound of zero 

would affect the Federal Reserve’s interest-rate decisions.
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have about future short-term rates. Further, long-term interest rates tend to move 

contemporaneously and in the same direction as short-term rates. Thus, long-term 

interest rates would be expected to decline once the policy was enacted. However, the 

magnitude of that decline is especially uncertain, in part because it would depend on 

the credibility of the deficit reduction plan.13

In this analysis, CBO estimated the effect on interest rates of an illustrative deficit 

reduction plan relative to the interest rates that would prevail if no such plan was 

adopted and participants in the financial markets concluded that no such plan would 

be adopted. Thus, this analysis also shows that interest rates would increase if a deficit 

reduction plan that participants in financial markets had been expecting failed to be 

enacted and those participants no longer expected one to be enacted. 

The Federal Reserve’s inability in the near term to respond to the illustrative policy 

by lowering interest rates as much as it would under better economic conditions 

would tend to increase the negative short-term effects of that policy on economic output. In light of the recent evidence of continued weakness in output and employment, 

the Federal Reserve might keep interest rates near zero for a longer period of time—

under current-law fiscal policy—than CBO projected in January 2011.14 Under those 

circumstances, the illustrative policy considered here would reduce short-term interest 

rates by less and reduce output by more in the next few years than shown in this 

analysis. 

Medium-Term and Long-Term Effects. Over the medium term and long term, a 

reduction in primary budget deficits would boost economic output and lower both 

short-term and long-term interest rates relative to what would occur without such 

deficit reduction. In estimating the effects of deficit reduction beyond the next few 

years, CBO used an enhanced version of a widely used model developed by Robert 

Solow. In that model, output depends on the size and composition of the capital 

stock, the quantity and quality of the labor force, and the nation’s technological 

progress.15 This analysis focused on how the illustrative policy would affect output 

and income by changing the nation’s capital stock. 

13. Even if the plan itself was fully credible, if its enactment caused financial market participants to 

expect future policy changes that offset some of the changes in the illustrative policy, then the 

effect on interest rates would be smaller than what is shown here.

14. See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2011 to 2021

(January 2011).

15. For details of that model and a discussion of alternative assumptions about the effects of budget 

deficits on saving and investment, see Congressional Budget Office, An Analysis of the President’s 

Budgetary Proposals for Fiscal Year 2012, Appendix A. Unlike in that earlier analysis, the results 

reported here are not sensitive to the response of labor supply because CBO assumed that this 

illustrative policy would have no net effect on incentives to work.
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The capital stock owned by residents of the United States depends on national saving, 

which is the sum of personal saving, business saving (that is, after-tax corporate profits 

not paid as dividends), and saving or dissaving (as reflected in budget surpluses or 

deficits) by the federal government and state and local governments. Federal budget 

deficits reduce national saving, so all other things being equal, a decrease in those 

deficits would increase that saving—resulting in a larger capital stock owned by U.S. 

residents over time from an increase in domestic investment, a decrease in net borrowing from abroad, or both. To illustrate a range of possible effects, CBO assumed that 

each dollar of deficit reduction would increase domestic investment by 20, 36, or 

50 cents (reflecting different assumptions about the effects of deficits on both national 

saving and net borrowing from abroad). Those alternative responses would cause the 

reduction in budget deficits to have small, medium-sized, and large effects on output, 

respectively. 

The larger capital stock from greater investment would increase economic output 

(because the labor force would use the additional capital to be more productive) and 

decrease interest rates (because the greater availability of capital would drive down the 

cost of using it). In this analysis, the resulting change in interest rates was projected to 

be the same for both short-term and long-term rates.

Estimates of Macroeconomic Effects

On the basis of CBO’s assumptions that would lead to medium-sized effects on output—specifically, that each one-dollar cut in the deficit causes economic output to 

decline by a dollar in the short term and increases domestic investment by 36 cents—

CBO projects that the illustrative policy would decrease GNP by amounts ranging 

from 0.4 percent in 2012 to 0.2 percent in 2014, but gradually increase GNP in 

later years relative to the level projected under current law (see Table 1). In 2012, with 

short-term interest rates still close to zero and monetary policy therefore constrained, 

the decrease in GNP of 0.4 percent would be the largest in any year over the 10-year 

period. As monetary policy became less constrained over the following few years, 

the negative effects on GNP would diminish. By 2015, GNP would be about what 

it would have been without the policy. Between 2016 and 2021, GNP would be 

increasingly above CBO’s baseline projections because the policy would boost savings 

and the capital stock by increasing amounts each year. By 2021, GNP would be 

1.0 percent higher than CBO projects under current law (and the positive impact of 

the policy would continue beyond that). During the next 10 years, long-term interest 

rates would decrease by between 0.08 and 0.29 percentage points relative to the rates 

projected under current law.

Under the set of assumptions that imply the budgetary changes would have smaller 

effects on output—that is, each one-dollar cut in the deficit causes economic output 

to decline by 60 cents in the short term and increases domestic investment by 

20 cents—the illustrative policy would decrease GNP by amounts ranging from 

0.3 percent in 2012 to 0.1 percent in 2014, relative to CBO’s baseline projections; it 
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Table 1.

The Macroeconomic Effects of an Illustrative Policy Under 

Three Sets of Assumptions

Source: Congressional Budget Office.

Notes: Gross national product (GNP) is expressed in real terms; that is, it has been adjusted to 

exclude the effects of inflation.

Changes are measured relative to the economic projections that underlie CBO’s March 2011 

baseline. Those projections are summarized in Chapter 2 of The Budget and Economic 

Outlook: Fiscal Years 2011 to 2021 (January 2011). All of the years in this table are federal 

fiscal years, which run from October 1 to September 30.

CBO provides a range of estimates of the illustrative policy’s possible effects on output. The 

assumptions that generate smaller, medium-sized, and larger effects on output are discussed 

in the text.

would increase GNP thereafter, for example, by 0.6 percent in 2021. Long-term 

interest rates would be 0.05 to 0.19 percentage points lower throughout those 

10 years.

Under the set of assumptions that imply larger effects on output, in which each onedollar cut in the deficit causes economic output to decline by $1.40 in the short term 

and increases domestic investment by 50 cents, the illustrative policy would decrease 

GNP by amounts ranging from 0.6 percent in 2012 to 0.3 percent in 2014, relative 

to CBO’s baseline projections. It would increase GNP in subsequent years; by 2021, 

GNP would be 1.4 percent higher than CBO projects under current law. The 

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Real GNP (Percent) -0.3 -0.2 -0.1 0.0 0.2 0.3 0.4 0.4 0.5 0.6

Interest Rates

(Percentage points)

Three-month Treasury bill -0.27 -0.25 -0.18 -0.16 -0.10 -0.05 -0.05 -0.06 -0.07 -0.08

Ten-year Treasury note -0.19 -0.17 -0.12 -0.10 -0.07 -0.05 -0.05 -0.06 -0.07 -0.08

Real GNP (Percent) -0.4 -0.3 -0.2 0.0 0.3 0.5 0.6 0.8 0.9 1.0

Interest Rates

(Percentage points)

Three-month Treasury bill -0.41 -0.39 -0.30 -0.27 -0.18 -0.08 -0.10 -0.12 -0.14 -0.16

Ten-year Treasury note -0.29 -0.28 -0.20 -0.18 -0.13 -0.08 -0.10 -0.12 -0.14 -0.16

Real GNP (Percent) -0.6 -0.5 -0.3 0.0 0.3 0.7 0.9 1.0 1.2 1.4

Interest Rates

(Percentage points)

Three-month Treasury bill -0.55 -0.54 -0.41 -0.38 -0.25 -0.12 -0.14 -0.17 -0.20 -0.22

Ten-year Treasury note -0.40 -0.38 -0.28 -0.25 -0.18 -0.12 -0.14 -0.17 -0.20 -0.22

Smaller Effects on Output

Larger Effects on Output

Medium-Sized Effects on Output
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reductions in interest rates would be larger throughout that period than under the 

other sets of assumptions: Specifically, long-term interest rates would be 0.12 to 0.40 

percentage points lower over those 10 years.

The Implications for Deficits of the Policy’s Macroeconomic Effects

CBO estimated the budgetary implications of the illustrative policy’s macroeconomic 

effects using an approach that takes into account changes in GNP, interest rates, and 

other factors.16 Over the period from 2012 through 2021, CBO estimates, those 

effects would reduce deficits by an additional $185 billion under the set of assumptions that imply medium-sized effects on output (see Table 2). The additional 

reduction in deficits would be about $100 billion or $280 billion, respectively, 

under the sets of assumptions that imply smaller or larger effects on output.17

Under all of the assumptions analyzed here, most of those additional amounts of 

deficit reduction would stem from lower interest rates than those projected in CBO’s 

current-law baseline and correspondingly lower interest costs. The results based on 

assumptions that lead to larger effects of the illustrative policy on output show a 

greater reduction in deficits over 10 years through their bigger reductions in interest 

rates, even though they also show larger negative effects on GNP in the first few years, 

which would boost primary deficits in those years. Similarly, under the assumptions 

16. CBO has previously used this same approach to estimate the budgetary implications of macroeconomic effects of fiscal policies. See, for example, Congressional Budget Office, An Analysis of 

the President’s Budgetary Proposals for Fiscal Year 2012. Chapter 2 of that report describes the budgetary implications of the proposals’ macroeconomic effects; Chapter 1 presents a more detailed 

program-by-program analysis of the proposals that does not incorporate such macroeconomic 

feedback.

17. A previous analysis by CBO (The Economic and Budget Outlook: Fiscal Years 1998-2007, January 

1997, Chapter 4) of the macroeconomic effects and resulting budgetary effects of deficit reduction 

showed larger effects per dollar of deficit reduction than those presented here. The principal reason for the difference in estimated effects is that the previous analysis assumed that long-term 

interest rates would fall to a greater extent than the current analysis projects. The magnitude of the 

interest rate responses in this analysis derives from the macroeconomic models that CBO uses in 

all of its current analyses of the economic effects of fiscal policy. Those models are grounded in 

both theory and data, and the response of long-term interest rates to fiscal policy in the models is 

within the range of the statistical relationships examined in recent research. (For a review of the 

empirical literature, see Eric M. Engen and R. Glenn Hubbard, “Federal Government Debt and 

Interest Rates,” NBER Macroeconomics Annual, 2004.) The relationship between long-term and 

short-term interest rates in this analysis reflects the expectations hypothesis, a theory that links 

long-term rates to the expected path of short-term rates, as well as the historical statistical relationship between long-term and short-term rates. (The current analysis also differs from the previous 

one by incorporating short-term effects on output from the reduction in demand for goods and 

services that would result from increases in taxes or decreases in government spending. The previous analysis assumed that the reduction in demand would be fully offset by monetary policy, 

which, as explained earlier in the text, would be much more difficult under current economic 

circumstances.)
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Table 2.

Reductions in Deficits Under an Illustrative Policy, 

With and Without Its Macroeconomic Effects

(Billions of dollars)

Source: Congressional Budget Office.

Notes: The primary deficit is the total budget deficit excluding net interest. 

Positive numbers indicate a decrease in the primary deficit, interest costs, or total deficit; 

negative numbers indicate an increase in those items. 

Changes are measured relative to CBO’s March 2011 baseline projections, which are 

summarized in Table 1-5 of An Analysis of the President’s Budgetary Proposals for 

Fiscal Year 2012 (April 2011). All of the years in this table are federal fiscal years, which run 

from October 1 to September 30.

CBO provides a range of estimates of the possible effects of the illustrative policy on output. 

The assumptions that generate medium-sized effects on output are discussed in the text.

that generate smaller effects on output, the effects on interest rates and the total 

amount of deficit reduction would be smaller. 

The economic effects on primary deficits—which result from changes in both 

spending and revenues—would be much smaller on net than those on interest costs, 

raising those deficits slightly in the early years and reducing them slightly later on. 

Initially, when the illustrative policy reduced GNP, government revenues would be 

2012- 2017- 2012-

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2016 2021 2021

Deficit Reductions Without 

Macroeconomic Effects

Primary deficit 100 122 144 167 189 211 233 256 278 300 722 1,278 2,000

Interest costs 1 5 10 18 28 40 54 70 87 106 62 357 419 ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ____ ____

Subtotal 101 127 154 185 217 252 288 325 365 406 784 1,635 2,419

Additional Deficit Reductions

With Medium-Sized Effects on 

Output

Primary deficit -10 -15 -12 -7 0 6 9 12 16 21 -45 65 20

Interest costs 7 19 20 20 18 15 16 16 17 19 82 83 165 __ __ __ __ __ __ __ __ __ __ __ ___ ___

Subtotal -4 3 7 12 18 21 25 28 33 40 37 148 185

Total Reductions

in Deficits 97 130 162 197 235 272 312 354 398 446 821 1,783 2,604

Memorandum: 

Total Deficit as Projected in

CBO's March 2011 Baseline -1,081 -692 -513 -538 -635 -590 -585 -665 -710 -729 -3,459 -3,278 -6,737

Total
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reduced and government spending (excluding interest costs) would increase as more 

households qualified for government assistance, such as unemployment insurance. 

However, by 2014, that effect on spending would be outweighed by a decline in pricesensitive spending, such as Social Security benefits, reflecting lower inflation in those 

early years. In the latter part of the 10-year period, primary deficits would decrease as 

a result of lower spending and higher revenues generated by higher GNP.18

Caveats About This Analysis

CBO’s findings depend critically on the assumptions made to construct the illustrative policy and estimate its effects on the economy. A legislative plan with the same 

effects on primary budget deficits (apart from the economic impact) as that illustrative policy but that differed from that policy in any of three ways would have different 

effects on the economy. Those possible differences relate to the plan’s timing (that is, 

how quickly or gradually the deficit reduction occurred); its composition of tax and 

spending changes, including the effects of those changes on people’s incentives to 

work and invest and their impact on productive government investments; and its 

credibility. In addition, for this analysis CBO assumed the continuation of current 

laws, aside from any changes included in the illustrative policy; if the same policy was 

evaluated relative to some other scenario, the macroeconomic and budgetary effects 

could also be different. 

Timing. Relative to the illustrative policy, reducing deficits more quickly—while monetary policy is constrained by the low level of short-term interest rates—would lead to 

a greater loss in economic output in the short run. However, a faster reduction in deficits would also lead to greater increases in output in the second half of the decade, for 

several reasons. The total cumulative impact on deficits would be greater, because 

interest savings would have more time to compound and because reductions in both 

short- and long-term rates would be larger. Also, when earlier additions to the capital 

stock increase output, some of that additional output goes toward investment, which 

further increases the capital stock. Conversely, reducing deficits more slowly than was 

assumed in this analysis would result in smaller negative effects on output in the short 

term and smaller positive effects on output in the second half of the decade.

Composition of Tax and Spending Changes, Including Their Effect on Incentives and on 

Productive Government Investments. The illustrative policy was assumed to have no 

direct effects on households’ incentives to work and save or on businesses’ incentives 

to hire and invest. For example, CBO assumed that the policy would include no 

changes to marginal tax rates, the unemployment insurance program, or tax rules for 

depreciation. In addition, the illustrative policy was assumed to have no impact on 

productive government investments. For example, CBO assumed that the policy 

18. The increase in revenues is slowed a little by the lower level of prices—reflecting lower inflation in 

the early years—as well as by other technical factors.
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CBO

would include no changes in infrastructure investment or funding for educational 

programs that might affect the economy’s productivity in the long run. Moreover, the 

estimates of medium-sized effects on output are based on the assumption that the 

illustrative policy would change taxes and government spending in such a way that 

each dollar of deficit reduction would reduce real GDP in the short term by a cumulative total of one dollar. 

A legislated deficit reduction plan might not have those characteristics. For example, 

such a plan might include higher marginal income tax rates that would decrease 

households’ incentives to supply labor. Also, a deficit reduction plan might reduce 

productive government investments; a plan that cut such spending but was otherwise 

similar to the illustrative policy would have less positive long-run effects on the economy. Further, changes in policies that have a greater short-term impact per dollar on 

GDP would increase the negative effects of deficit reduction on GDP in the next few 

years, while changing policies that have a smaller short-term impact would decrease 

the negative effects.19

Credibility. A policy’s credibility—the extent to which people are confident that it will 

be carried out and be effective—can have a significant impact on its economic effects. 

In this analysis, the credibility of the deficit reduction policy matters most for the estimated impact of future short-term interest rates (which depend on the ultimate 

amount of deficit reduction achieved) on current long-term rates. For example, an 

analysis that assumed a deficit reduction policy had less credibility would imply a 

smaller reduction in long-term interest rates in the early years of the policy—and, 

hence, a slightly larger decline in output in the first few years, smaller savings in interest costs, and less deficit reduction. 

Comparisons with Other Scenarios. Applying the illustrative deficit reduction policy to 

a scenario in which deficits were assumed to be larger or smaller than those in CBO’s 

current-law baseline would yield different estimates of the policy’s macroeconomic 

and budgetary effects. For example, if the starting point involved greater amounts 

of debt than are projected in CBO’s baseline, as is the case in the alternative fiscal 

scenario described in CBO’s 2011 Long-Term Budget Outlook, a given reduction in 

interest rates under the illustrative policy would result in a modestly larger reduction 

in interest costs.20

Moreover, relative to the alternative fiscal scenario, the illustrative policy’s effects on 

interest rates would differ slightly from those estimated in this analysis. Under the 

assumptions of the alternative fiscal scenario, deficits would be larger than those in the 

baseline and the Federal Reserve would probably raise interest rates more rapidly than 

19. For a discussion of how CBO estimated the effects on the economy of an assortment of different 

policies, see Congressional Budget Office, Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from January 2011 Through March 2011 (May 

2011).
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CBO

it would under current law. Therefore, in analyzing a deficit reduction plan that took 

the alternative fiscal scenario as its starting point instead of current law, CBO would 

assume that the Federal Reserve would be able to respond by reducing short-term 

interest rates by a larger amount. That greater responsiveness of monetary policy 

would cause long-term interest rates to fall by more when the policy was enacted, and 

it would also attenuate the policy’s negative short-run effects on output. Overall, the 

budgetary implications of the macroeconomic effects would be modestly larger in 

total.

20. The alternative fiscal scenario incorporates several changes to current law that are widely expected 

to occur or that would modify some provisions of law that might be difficult to sustain for a long 

period. Most important are the assumptions about revenues: that the tax cuts enacted since 2001 

and extended most recently in 2010 will be permanently extended and that the reach of the alternative minimum tax will be restrained to stay close to its historical extent. This scenario also incorporates the assumption that Medicare’s payment rates for physicians will remain at current levels 

(rather than declining by about a third, as under current law).