CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

An Analysis of the President’s Budgetary

Proposals for Fiscal Year 2005

MARCH 2004

The Congress of the United States O Congressional Budget Office

CBO

An Analysis of the President’s Budgetary 

Proposals for Fiscal Year 2005

March 2004
Notes

Unless otherwise indicated, the years referred to in this report are fiscal years.

Numbers in the text and tables may not add up to totals because of rounding.
Preface

This Congressional Budget Office (CBO) analysis of the President’s budgetary proposals 

for fiscal year 2005 was prepared at the request of the Senate Committee on Appropriations. 

The report updates CBO’s preliminary analysis, which was released on February 27, 2004. 

That analysis incorporated estimates from the Joint Committee on Taxation that subsequently 

have been slightly revised. Those updated revenue estimates as well as other minor corrections 

are reflected in this report.

The analysis was produced by the staffs of CBO’s Budget Analysis, Macroeconomic Analysis, 

and Tax Analysis Divisions under the supervision of Robert Sunshine, Robert Dennis, and 

Thomas Woodward, respectively. The baseline revenue estimates and the estimates of certain 

revenue proposals were prepared by CBO; most of the estimates of the President’s revenue 

proposals were prepared by the Joint Committee on Taxation.

Barry Blom of CBO’s Projections Unit wrote Chapter 1 under the supervision of Jeff Holland, 

with assistance from Mark Booth, John Peterson, David Weiner, and the staff of the State and 

Local Government Cost Estimates Unit. Ben Page of the Macroeconomic Analysis Division 

wrote Chapter 2 and Appendixes A and B with assistance from Bob Arnold, Paul Burnham, 

Ufuk Demiroglu, Tracy Foertsch, Mark Lasky, Shinichi Nishiyama, Larry Ozanne, and Frank 

Russek.

Leah Mazade edited the report, and Christian Spoor proofread it. Maureen Costantino prepared the report for publication. Lenny Skutnik printed the initial copies, and Annette Kalicki 

produced the electronic versions for CBO’s Web site (www.cbo.gov).

Douglas Holtz-Eakin

Director

March 2004

1 CBO’s Estimate of the President’s Budget for Fiscal Year 2005 1

The President’s Budgetary Policies 4

CBO’s and the Administration’s

Economic Assumptions 14

Differences Between CBO’s and the Administration’s

Policy Estimates 15

Changes to CBO’s Baseline 16

Differences Between CBO’s Baseline and the

Administration’s Current-Services Baseline 18

2 The Economy Under the President’s Budget and Under

CBO’s Baseline Policy Assumptions 25

How Fiscal Policy Affects the Economy 28

A Description of CBO’s Models

and Their Results 32

A The Potential Economic Effects of Selected Proposals

in the President’s 2005 Budget 39

Extend the Reductions in Dividend and Capital Gains Taxes 39

Expand Tax-Free Savings Accounts 40

Extend the Repeal of the Estate Tax 41

B The Models Used to Analyze the Macroeconomic Effects of the 

President’s Budget Over the Next Decade 43

CONTENTS
vi AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Tables

1-1. Comparison of Projected Deficits and Surpluses in CBO’s Estimate

of the President’s Budget and CBO’s March Baseline 2

1-2. CBO’s Estimate of the President’s Budget 3

1-3. Sources of Differences Between CBO’s and the Administration’s

Estimates of the President’s Budget 5

1-4. Discretionary Spending Under the President’s Budget and CBO’s

March Baseline 6

1-5. Comparison of Discretionary Budget Authority Enacted for 2004

and Requested by the President for 2005, by Budget Function 8

1-6. CBO’s Estimate of the Effect of the President’s Budget on

Baseline Deficits 11

1-7. Comparison of CBO’s, the Administration’s, and Private-Sector

Economic Projections for Calendar Years 2004 Through 2009 16

1-8. Changes in CBO’s Baseline Projections of the Deficit or Surplus

Since January 2004 18

1-9. CBO’s March Baseline Projections 20

1-10. Comparison of CBO’s March Baseline and the Administration’s

Published February Baseline 22

2-1. CBO’s Estimates of How the President’s Budget Would Affect

the Deficit After Accounting for Economic Effects 27

2-2. CBO’s Estimates of Effective Marginal Federal Tax Rates

on Labor Income 29

2-3. CBO’s Estimates of Effective Marginal Federal Tax Rates

on Capital Income 31

2-4. CBO’s Estimates of How the President’s Budget Would Affect

Real Gross Domestic Product 34

2-5. CBO’s Year-by-Year Forecast and Projections for Fiscal Years

2004 Through 2014 35

2-6. The Budgetary Implications of the Macroeconomic Effects 37
CONTENTS vii

Figures

2-1. CBO’s Estimates, Using Various Models, of How the President’s

Budget Would Affect the Deficit After Accounting

for Economic Effects 26

2-2. Selected Inputs Used for CBO’s Estimates 33

Boxes

1-1. Grants-in-Aid 10

1

CBO’s Estimate of the President’s Budget

for Fiscal Year 2005

At the request of the Senate Committee on Appropriations, the Congressional Budget Office (CBO), 

with contributions from the Joint Committee on Taxation (JCT), has analyzed the President’s budget submission for fiscal year 2005. According to CBO’s estimates, 

which use the agency’s own economic assumptions and 

estimating techniques, the deficit under the President’s 

budgetary proposals would be $478 billion in fiscal year 

2004 and $358 billion in 2005 (see Table 1-1).1

 As a 

share of the economy, the deficit would total 4.2 percent 

of gross domestic product (GDP) this year, then fall to 

3.0 percent next year. Under the President’s policies, the 

deficit would decline further—to 2.1 percent of GDP—

in 2006 and then remain between 1.6 percent and 1.8 

percent of GDP through 2014. Those figures do not include possible future costs for ongoing operations in Iraq 

and Afghanistan, which the Administration did not include in its budget for 2005 and subsequent years.

Over the 10-year budget projection period, from 2005 

through 2014, deficits would total more than $2.7 trillion under the President’s policies—$726 billion higher 

than CBO’s baseline projection of the cumulative deficit.2

 Debt held by the public would rise from 36 percent 

of GDP at the end of 2003 to about 40 percent during 

the years 2006 through 2014.

Under the President’s budgetary proposals, outlays would 

total slightly less than 20 percent of GDP from 2005 

through 2014 (see Table 1-2). Over that same period, 

spending for entitlements and other mandatory programs 

under the President’s budget would grow faster than 

nominal GDP (by 5.7 percent annually versus 4.7 percent); in contrast, discretionary outlays would rise at an 

average annual rate of only 1.8 percent. Revenues as a 

share of GDP would grow from 15.8 percent this year to 

16.8 percent in 2005—slightly below CBO’s baseline 

level of 17 percent. By 2007, revenues would reach nearly 

18 percent of GDP and remain around that level through 

2014. 

Relative to CBO’s baseline projections, the President’s 

budget would decrease outlays (excluding debt service) by 

$597 billion from 2005 through 2014, CBO estimates. 

Outlays for programs funded by discretionary appropriations (which CBO extrapolated beyond 2009) would be 

$706 billion below the baseline level over that period, 

mainly because CBO’s baseline, as required by law, extends the 2004 supplemental appropriations for activities 

in Iraq and Afghanistan throughout the period.3

 That extension is equivalent to an assumption that discretionary 

spending on activities in Iraq and Afghanistan will conCHAPTER

1. This report incorporates small revisions to some of the results that 

CBO released in its preliminary analysis on February 27, 2004. In 

total, the revisions reduce CBO’s estimate of the cumulative deficit under the President’s budgetary proposals by $12 billion over 

the 2005-2014 period.

2. The President’s budget does not provide year-by-year estimates of 

spending and revenues after 2009. It does, however, specify a total 

budgetary effect from changes in tax and mandatory spending 

laws for the entire 10-year period and proposes annual levels of 

discretionary spending through 2009. To estimate discretionary 

outlays for the 2010-2014 period, CBO projected the discretionary budget authority recommended by the President for 2009, 

adjusted for inflation.

3. The Balanced Budget and Emergency Deficit Control Act of 1985 

states that discretionary spending should be projected by adjusting 

the current year’s budget authority to reflect inflation.
2 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Table 1-1.

Comparison of Projected Deficits and Surpluses in CBO’s Estimate

of the President’s Budget and CBO’s March Baseline

(Billions of dollars)

Sources: Congressional Budget Office; Joint Committee on Taxation.

Note: * = between -$500 million and $500 million; n.a. = not applicable.

tinue at 2004 levels, adjusted for inflation, for the next 10 

years. By contrast, the President’s budget includes no 

funding for reconstruction and military operations in 

those countries beyond 2004. If those supplemental appropriations were excluded from the baseline projection, 

defense discretionary outlays over the next 10 years under 

the President’s proposals would exceed that projection by 

$451 billion, or about 10 percent, CBO estimates; nondefense discretionary outlays would fall below that adjusted projection by $277 billion, or about 6 percent. 

The President’s proposals would increase mandatory 

spending (excluding debt service) through 2014 by $109 

billion compared with CBO’s baseline; most of that additional spending would come from proposals relating to 

refundable tax credits.4

 Debt-service costs on additional 

Total, Total,

Actual 2005- 2005-

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2009 2014

On-Budget Deficit -536 -639 -531 -464 -450 -476 -496 -498 -553 -532 -558 -572 -2,418 -5,132

Off-Budget Surplus 161 161 174 193 208 224 238 251 264 273 281 288 1,037 2,394 ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ____ ____

Total Deficit -375 -478 -358 -271 -242 -252 -258 -247 -289 -259 -278 -284 -1,381 -2,738

On-Budget Deficit -536 -638 -537 -466 -482 -509 -519 -523 -439 -310 -314 -302 -2,513 -4,402

Off-Budget Surplus 161 161 174 193 208 224 238 250 263 273 280 287 1,036 2,390 ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ____ ____

Total Deficit -375 -477 -363 -273 -274 -286 -281 -272 -176 -38 -34 -15 -1,477 -2,012

On-Budget Deficit 0 -1 6 1 32 33 22 25 -114 -222 -244 -270 95 -730

Off-Budget Surplus 0 0 * * * * 1 1 1 1 1 1 1 4 ___ _ __ __ __ __ ___ ___ ___ ___ __ ___

Total Deficit 0 -1 6 1 32 34 23 26 -114 -221 -243 -269 96 -726

Memorandum:

Total Deficit as a

Percentage of GDP

CBO's estimate of the

President's budget -3.5 -4.2 -3.0 -2.1 -1.8 -1.8 -1.8 -1.6 -1.8 -1.6 -1.6 -1.6 -2.1 -1.8

CBO's baseline -3.5 -4.2 -3.0 -2.1 -2.1 -2.1 -1.9 -1.8 -1.1 -0.2 -0.2 -0.1 -2.2 -1.3

Debt Held by the Public

as a Percentage of GDP

CBO's estimate of the

President's budget 36.1 38.2 39.4 39.8 40.0 40.1 40.2 40.1 40.3 40.2 40.2 40.1 n.a. n.a.

CBO's baseline 36.1 38.2 39.4 39.8 40.3 40.6 40.8 40.9 40.3 38.9 37.6 36.1 n.a. n.a.

Difference (President's budget minus baseline)

CBO's Estimate of the President's Budget

CBO's March Baseline

4. Taxpayers who have no tax liability and income below a certain 

level can receive earned income and child tax credits in the form 

of government payments, which are classified as outlays in the federal budget.
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 3

Table 1-2.

CBO’s Estimate of the President’s Budget

Source: Congressional Budget Office.

Note: n.a. = not applicable.

Total, Total,

Actual 2005- 2005-

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2009 2014

On-budget 1,258 1,272 1,454 1,610 1,722 1,811 1,905 2,016 2,093 2,210 2,330 2,458 8,502 19,609

Off-budget 524 545 572 601 629 659 690 721 753 786 821 858 3,152 7,091 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ _____ _____

1,782 1,816 2,027 2,211 2,351 2,470 2,595 2,738 2,847 2,996 3,151 3,315 11,654 26,701

825 895 906 894 901 921 944 969 998 1,014 1,043 1,068 4,565 9,658

1,179 1,245 1,298 1,368 1,437 1,522 1,612 1,702 1,810 1,897 2,028 2,158 7,237 16,833

153 155 180 220 256 279 298 313 328 344 358 374 1,232 2,948 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ _____ _____

2,158 2,295 2,384 2,482 2,593 2,722 2,853 2,984 3,136 3,256 3,429 3,600 13,034 29,439

On-budget 1,795 1,911 1,986 2,074 2,172 2,287 2,401 2,514 2,647 2,743 2,888 3,030 10,920 24,741

Off-budget 363 384 399 408 421 435 451 470 489 513 540 570 2,114 4,697

-375 -478 -358 -271 -242 -252 -258 -247 -289 -259 -278 -284 -1,381 -2,738

-536 -639 -531 -464 -450 -476 -496 -498 -553 -532 -558 -572 -2,418 -5,132

161 161 174 193 208 224 238 251 264 273 281 288 1,037 2,394

3,914 4,387 4,758 5,043 5,298 5,563 5,834 6,092 6,393 6,664 6,954 7,251 n.a. n.a.

10,829 11,469 12,091 12,682 13,236 13,862 14,519 15,187 15,862 16,562 17,301 18,070 66,389 149,371

On-budget 11.6 11.1 12.0 12.7 13.0 13.1 13.1 13.3 13.2 13.3 13.5 13.6 12.8 13.1

Off-budget 4.8 4.7 4.7 4.7 4.8 4.8 4.8 4.7 4.7 4.7 4.7 4.7 4.7 4.7 ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___

16.5 15.8 16.8 17.4 17.8 17.8 17.9 18.0 17.9 18.1 18.2 18.3 17.6 17.9

7.6 7.8 7.5 7.0 6.8 6.6 6.5 6.4 6.3 6.1 6.0 5.9 6.9 6.5

10.9 10.9 10.7 10.8 10.9 11.0 11.1 11.2 11.4 11.5 11.7 11.9 10.9 11.3

1.4 1.4 1.5 1.7 1.9 2.0 2.0 2.1 2.1 2.1 2.1 2.1 1.9 2.0 ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___

19.9 20.0 19.7 19.6 19.6 19.6 19.6 19.6 19.8 19.7 19.8 19.9 19.6 19.7

On-budget 16.6 16.7 16.4 16.4 16.4 16.5 16.5 16.6 16.7 16.6 16.7 16.8 16.4 16.6

Off-budget 3.4 3.3 3.3 3.2 3.2 3.1 3.1 3.1 3.1 3.1 3.1 3.2 3.2 3.1

-3.5 -4.2 -3.0 -2.1 -1.8 -1.8 -1.8 -1.6 -1.8 -1.6 -1.6 -1.6 -2.1 -1.8

-4.9 -5.6 -4.4 -3.7 -3.4 -3.4 -3.4 -3.3 -3.5 -3.2 -3.2 -3.2 -3.6 -3.4

1.5 1.4 1.4 1.5 1.6 1.6 1.6 1.7 1.7 1.6 1.6 1.6 1.6 1.6

36.1 38.2 39.4 39.8 40.0 40.1 40.2 40.1 40.3 40.2 40.2 40.1 n.a. n.a.

Outlays

In Billions of Dollars

Revenues

Discretionary spending

Total

Mandatory spending

Net interest

Total

Deficit (-) or Surplus

Deficit (-) or Surplus

On-budget 

Outlays

Discretionary spending

Mandatory spending

Total

Net interest

Total

On-budget 

Off-budget

Debt Held by the Public

Memorandum:

Gross Domestic Product

As a Percentage of GDP

Revenues

Off-budget

Debt Held by the Public
4 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

borrowing would add another $37 billion to the cumulative deficit.

The President’s proposed tax policies would lower receipts relative to CBO’s baseline projection by about $1.3 

trillion between 2005 and 2014.5 Roughly $1.1 trillion 

(85 percent) of that difference stems from the President’s 

proposal to permanently extend provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 

(EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Because most of those 

provisions are slated to expire at the end of 2010, nearly 

87 percent ($949 billion) of the decrease in revenues attributable to their extension would be seen during the 

2011-2014 period. The remaining portion of the overall 

reduction in revenues (relative to CBO’s baseline) would 

come from a variety of proposals either to extend current 

tax laws that are set to expire over the next 10 years or to 

introduce new tax provisions.

The preceding paragraphs summarize the results—presented in detail later in this chapter—of CBO’s analysis 

of the President’s budgetary proposals using methods that 

do not include the proposals’ potential impact on the 

economy. Because any such impact could in turn influence how the proposals affected the deficit, CBO has prepared a macroeconomic analysis of the Administration’s 

proposals. That assessment, which is discussed in Chapter 

2, uses various models and assumptions to indicate the 

range of potential economic and budgetary impacts of 

the President’s proposed policies. CBO has concluded 

that the macroeconomic effects and their resulting budgetary impact are likely to be modest.

Overall, CBO’s and the Administration’s estimates of the 

President’s budget are similar (see Table 1-3). In their 

outlook for the next several years, both agencies expect 

the deficit to peak in 2004: CBO projects a deficit of 

$478 billion for this year; the Administration, a shortfall 

of $521 billion. For 2005, CBO estimates that the deficit 

will total $358 billion, $6 billion less than the Administration anticipates. (Neither figure includes costs for operations in Iraq and Afghanistan.) For the 2005-2009 period (the Administration did not provide estimates 

beyond 2009), CBO’s cumulative deficit projection of 

$1.38 trillion is only $32 billion more than the Administration’s estimate.

For 2004, CBO estimates that outlays will be $24 billion 

below the Administration’s estimate; for the 2005-2009 

period, CBO’s estimates total just $9 billion less than 

those of the Administration. On the revenue side of the 

budget, the story is much the same—CBO’s estimates 

under the President’s budgetary proposals are similar to 

the Administration’s. For 2004, CBO anticipates that total revenues under the President’s budget will be $18 billion higher than the Administration expects; however, 

CBO’s revenue estimate for the 2005-2009 period is $41 

billion (about 0.3 percent) lower than the Administration’s. Most of that variance can be traced to differing 

projections of revenues under current law.

In conjunction with its analysis of the President’s budget, 

CBO has updated its baseline projections to take into account new information from the budget and other 

sources. Those changes are almost exclusively technical 

(that is, not related to legislation or to economic factors); 

revised estimates of spending for Medicaid and for Parts 

A and B of Medicare account for most of them. CBO 

now projects that the cumulative deficit for the 2005-

2014 period will total a little more than $2 trillion if current policies remain unchanged—an increase of $119 billion from the baseline projections that CBO published in 

January 2004.

The President’s Budgetary Policies

The President’s policies would increase the projected deficit by $1 billion in 2004 and $726 billion between 2005 

and 2014, CBO estimates. Outlays would be below the 

level in CBO’s baseline by $559 billion over that 10-year 

period, largely because the President’s budget does not assume further funding for activities in Iraq and Afghanistan, whereas CBO’s baseline assumes continued spending for those activities at the 2004 level adjusted for 

inflation. Over the 10 years, revenues under the President’s policies would be nearly $1.3 trillion lower than in 

the baseline—mostly because of the proposed extension 

and acceleration of provisions in EGTRRA and 

JGTRRA.

5. For proposals that would amend the Internal Revenue Code, 

CBO is required by law to use estimates provided by the Joint 

Committee on Taxation. For estimates related to the 2005 budget, 

see Joint Committee on Taxation, Estimated Budget Effects of the 

Revenue Provisions Contained in the President’s Fiscal Year 2005 

Budget Proposal, JCX-14-04R (March 3, 2004). 
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 5

Table 1-3.

Sources of Differences Between CBO’s and the Administration’s Estimates

of the President’s Budget

(Billions of dollars)

Sources: Congressional Budget Office; Joint Committee on Taxation.

Note * = between -$500 million and $500 million.

a. Positive numbers denote that the Administration’s estimate of the deficit is higher than CBO’s; negative numbers denote that its estimate 

of the deficit is lower than CBO’s.

Total,

2005-

2004 2005 2006 2007 2008 2009 2009

-521 -364 -268 -241 -239 -237 -1,349

26 1 14 4 -18 -35 -33

-8 -11 -9 -4 3 13 -8

__ __ __ __ __ __ __

18 -10 5 * -16 -21 -41

-13 -8 2 -4 -2 1 -11

-9 -12 -13 -7 -13 -13 -58

* 3 14 3 8 12 40

_ __ __ __ __ __ __

-9 -10 1 -5 -5 * -19

-1 2 7 9 5 -2 21

__ __ _ _ _ _ __

-24 -15 9 1 -2 -1 -9

Total, All Differencesa 42 6 -4 -1 -13 -21 -32

-478 -358 -271 -242 -252 -258 -1,381

-1 2 6 -8 -26 -44 -70

5 9 14 20 20 18 81

_ _ __ __ __ __ ___

-6 -7 -8 -28 -46 -62 -151

19 -11 * 8 10 23 29

-29 -25 -5 -19 -23 -19 -90

__ __ _ __ __ __ ___

48 13 4 27 33 41 119

Deficit Under the President's Budget

Memorandum:

Technical Differences

Revenues

Subtotal

Subtotal

Revenues

Outlays

Mandatory

Baseline

Policy

Subtotal, outlays

Baseline

Policy

Totala

Net interest

CBO's Estimate

Totala

Outlays

Outlay Differences

Discretionary

Economic Differences

Deficit Under the President's Budget

Revenue Differences

Sources of Differences Between CBO and the Administration

Administration's Estimate
6 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Table 1-4.

Discretionary Spending Under the President’s Budget and CBO’s March Baseline

(Billions of dollars)

Continued

Policy Proposals That Affect Discretionary Spending

By CBO’s estimate, the President’s budget proposes 

nearly $823 billion in discretionary budget authority for 

2005 (including $2.5 billion previously enacted for 

Project Bioshield, a program to develop biodefense countermeasures) and $44 billion in obligational authority for 

transportation programs—for total discretionary funding of $867 billion (see Table 1-4).6 (The advance appropriations for Project Bioshield are not part of the Administration’s discretionary funding total. In addition, for a 

number of reasons, including different projections of offsetting collections and the effect of changes to mandatory 

programs proposed in appropriation bills, the AdminisTotal, Total,

Actual 2005- 2005-

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2009 2014

455 459 421 443 463 484 507 519 532 545 558 572 2,317 5,043

Homeland securityb 28 27 31 30 32 33 37 35 36 37 38 39 163 349

Otherb 407 433 415 416 419 422 423 433 442 453 463 474 2,095 4,361

___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ____ ____

Subtotal, nondefense 435 460 446 447 451 455 459 469 479 490 501 513 2,258 4,710

Total 890 919 867 889 914 939 966 987 1,010 1,034 1,060 1,086 4,575 9,752

405 452 447 439 445 464 485 505 525 531 549 564 2,281 4,955

Homeland security 23 23 27 30 32 33 35 35 36 37 38 39 157 343

Other 397 420 431 425 423 423 424 429 437 446 456 466 2,127 4,360 ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ____ ____

Subtotal, nondefense 420 443 459 455 455 456 458 464 473 483 493 505 2,284 4,703

Total 825 895 906 894 901 921 944 969 998 1,014 1,043 1,068 4,565 9,658

455 459 472 480 491 503 516 529 542 556 570 585 2,462 5,244

Homeland securityb 28 27 29 27 28 29 32 30 31 32 33 34 146 306

Otherb 407 433 447 454 464 475 487 498 510 522 535 548 2,327 4,939

___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ____ ____

Subtotal, nondefense 435 460 476 482 492 504 518 529 541 554 568 581 2,472 5,246

Total 890 919 948 962 984 1,007 1,035 1,057 1,083 1,110 1,138 1,166 4,935 10,490

405 452 469 476 482 497 509 522 540 544 563 578 2,433 5,180

Homeland security 23 23 26 28 29 30 30 31 31 32 33 33 142 302

Other 397 420 441 452 462 471 481 492 503 514 526 539 2,307 4,882 ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ___ ____ ____

Subtotal, nondefense 420 443 467 480 491 501 512 523 534 547 559 572 2,450 5,184

Total 825 895 936 956 973 998 1,021 1,045 1,074 1,091 1,122 1,150 4,882 10,364

Defense

Nondefense

CBO's Baseline for Discretionary Spending

Defense

Nondefense

Outlays

Defense

Nondefense

CBO's Estimate of Discretionary Spending Under the President's Budgeta

Outlays

Funding

Funding

Defense

Nondefense

6. Spending from the Highway Trust Fund and the Airport and Airway Trust Fund is subject to obligation limitations. Budget 

authority for those programs is provided in authorizing legislation 

and is not considered discretionary.
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 7

Table 1-4.

Continued

(Billions of dollars)

Source: Congressional Budget Office.

a. The President’s budget specifies discretionary spending only through 2009. The numbers shown here for discretionary spending after 

2009 under the President’s budget are projections by CBO using its baseline rates of inflation.

b. Funding comprises both budget authority and obligation limitations. Spending from the Highway Trust Fund and the Airport and Airway 

Trust Fund is subject to such limitations. Budget authority for those programs is provided in authorizing legislation and is not considered 

discretionary.

tration’s estimate of budget authority is about $2 billion 

lower than CBO’s figure.)

By comparison, discretionary funding for 2004 (including $43 billion in obligational authority for transportation programs and $0.9 billion for Project Bioshield) totals $919 billion. That sum includes $87 billion in 

supplemental budget authority mostly for reconstruction 

and military operations in Iraq and Afghanistan.

If the supplemental appropriations for 2004 were excluded from the comparison, the growth of discretionary 

funding (including obligational authority) in 2005 under 

the President’s proposed budget would equal 4.2 percent, 

or $35 billion. Defense spending would grow by about 7 

percent, and nondefense spending for homeland security 

would rise by roughly 15 percent.7 Other nondefense 

funding, by contrast, would grow by 1 percent (see Table 

1-5). 

For 2005, the President’s budget would add $27 billion 

in discretionary budget authority for defense programs, 

compared with the funding level for 2004 excluding supplemental appropriations. The budget would increase 

funding for operations and maintenance (by $13 billion), 

for pay and other benefits for service members (by $6.5 

billion), and for the research and development of new 

weapon systems (by $4.6 billion).

The category of homeland security is also slated for an increase in funding—of $4 billion—in 2005 under the 

President’s budget. Health-related programs would receive the largest portion of that increase ($1.8 billion), although most of that amount has already been provided 

Total, Total,

Actual 2005- 2005-

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2009 2014

0 0 -51 -38 -28 -19 -10 -10 -11 -11 -12 -13 -145 -202

Homeland securityb 0 0 2 3 3 4 5 5 5 5 5 5 17 43

Otherb 0 0 -32 -38 -45 -53 -64 -65 -68 -70 -72 -73 -232 -579

_ _ __ __ __ __ __ __ __ __ __ __ ___ ___

Subtotal, nondefense 0 0 -30 -35 -42 -49 -59 -60 -63 -64 -66 -68 -215 -536

Total 0 0 -81 -73 -70 -68 -69 -70 -73 -76 -78 -81 -360 -738

0 0 -22 -37 -37 -33 -24 -17 -15 -13 -14 -14 -152 -225

Homeland security 0 0 1 2 3 4 4 5 5 5 5 5 15 40

Other 0 0 -9 -27 -39 -48 -58 -63 -66 -69 -71 -73 -180 -521 ___ __ __ __ __ __ __ __ __ __ ___ ___

Subtotal, nondefense 0 0 -8 -25 -35 -44 -53 -58 -61 -63 -65 -67 -166 -481

Total 0 0 -30 -62 -72 -77 -77 -76 -76 -77 -79 -81 -318 -706

Outlays

Defense

Nondefense

Defense

Nondefense

Difference (President's budget minus baseline)

Funding

7. Funding for homeland security in the President’s budget for 2005 

includes about $700 million for programs that were not classified 

in that category for 2004.
8 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Table 1-5.

Comparison of Discretionary Budget Authority Enacted for 2004 and Requested 

by the President for 2005, by Budget Function

(Billions of dollars)

Source: Congressional Budget Office.

Note: n.a. = not applicable.

a. Includes certain receipts (such as those from loan guarantees made by the Federal Housing Administration’s Mutual Mortgage Insurance 

programs) and other collections (such as those from the Securities and Exchange Commission) that are recorded as negative budget 

authority and outlays.

459.1 420.8 -38.3 -8.3

48.7 31.6 -17.1 -35.1

23.3 24.4 1.1 4.7

3.6 3.5 -0.1 -2.2

30.3 28.4 -1.9 -6.2

5.6 5.5 -0.1 -2.0

-0.8 -1.2 -0.4 49.0

23.7 23.9 0.2 0.9

15.6 14.0 -1.6 -10.2

78.0 80.4 2.3 3.0

51.8 53.2 1.3 2.5

3.8 3.9 0.1 1.5

44.6 45.2 0.6 1.2

4.1 4.5 0.4 9.4

29.3 29.8 0.5 1.8

37.1 37.9 0.9 2.3

17.6 17.2 -0.4 -2.3

0 -0.2 -0.2 n.a. ____ ____ ___

Subtotal, nondefense discretionary 416.4 402.1 -14.3 -3.4

Total Discretionary 875.5 822.9 -52.6 -6.0

43.5 44.1 0.6 1.4

394.0 420.8 26.8 6.8

27.1 31.2 4.1 15.2

367.2 370.9 3.8 1.0

____ ____ ___

Subtotal, nondefense discretionary 394.2 402.1 7.9 2.0

Total Budget Authority Excluding

Supplemental Appropriations 788.2 822.9 34.7 4.4

Percent

Increase or Decrease (-)

Allowances for emergencies and

Defense Discretionary

Social Security (Administrative costs)

Veterans' benefits and services

Administration of justice

General government

social services

other needs

Memorandum:

Transportation Obligation Limitations

Defense

Nondefense

Homeland security

Other

Discretionary Budget Authority Excluding

Supplemental Appropriations

Health

Medicare (Administrative costs)

Income security

Commerce and housing credita

Transportation 

Community and regional development 

Education, training, employment, and

General science, space, and technology

Energy

Natural resources and environment

Agriculture

Nondefense Discretionary

International affairs

2004

Enacted

2005

Request

Billions

of Dollars
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 9

through advance appropriations for Project Bioshield. 

Funding for law enforcement activities would also grow, 

by $1 billion. (Such activities include customs, border 

protection, and certain duties performed by the Federal 

Bureau of Investigation.) In addition, the Transportation 

Security Administration would receive a net increase of 

nearly $600 million.

For 2005, nondefense discretionary funding unrelated to 

homeland security would rise under the President’s budget by about $4 billion (relative to the 2004 level excluding supplemental appropriations). From that small overall 

increase, however, some budget functions would receive 

relatively large boosts in funding, and others would have 

their funding reduced.8 International affairs programs 

would see the biggest increase ($4.7 billion), with substantial additional funding allocated to the Millennium 

Challenge Corporation ($1.5 billion) and to international security assistance ($1.3 billion). Funding for education grants, social services, and related activities would 

also rise, by $2.1 billion. (Grants-in-aid to state, local, 

and tribal governments are discussed in Box 1-1.) Spending on general science, space, and technology would grow 

as well, by $1.0 billion, mostly because of larger appropriations for the National Aeronautics and Space Administration.

By contrast with those increases, other budget functions 

would experience cuts in non-homeland-security funding 

for 2005. For example, funding for natural resources under the President’s budget would drop by $1.8 billion; the 

largest cuts would apply to the Environmental Protection 

Agency’s state and tribal assistance grants and the Army 

Corps of Engineers. (In each case, funding for 2005 

would fall by about $600 million.)

For the years 2006 through 2009, the President has proposed average annual increases of 4.8 percent in defense 

funding, 4.0 percent in homeland security funding, and 

0.5 percent in all other nondefense discretionary funding.

Policy Proposals That Affect Mandatory Spending

The President’s proposals would add $109 billion to 

mandatory spending over the 2005-2014 period, CBO 

estimates. Most of that budgetary impact stems from proposals that involve refundable tax credits (see Table 1-6).

Refundable Tax Credits. Outlays over the 2005-2014 period would rise—by an estimated $123 billion—under 

the Administration’s tax proposals because some of the 

tax credits that those policies address are refundable. In 

particular, the President’s proposal to extend tax creditrelated provisions in EGTRRA and JGTRRA would increase outlays by $64 billion through 2014. The President also proposes to create a refundable tax credit for the 

cost of health insurance, which would add $54 billion in 

outlays over the 10-year period, by CBO’s and JCT’s estimates. A further $4 billion in outlays over that period 

would result from the President’s proposal to simplify tax 

laws for families.

Customs User Fees. Under current law, the provisions relating to customs user fees expire on March 1, 2005. One 

such provision requires individuals to pay a processing 

fee—based on the value of an item—for merchandise 

brought into the United States. Another fee is charged for 

the entry of certain vehicles, vessels, and individuals. The 

President’s budget would extend those fees, which in turn 

would increase offsetting receipts (a credit against mandatory spending) by an estimated $19 billion from 2005 

through 2014.9

Other Proposals. The President’s budget proposes a variety of other changes that would affect mandatory spending (and offsetting receipts) related to the federal student 

loan programs, auctions of licenses to use the electromagnetic spectrum, spending from tariffs on certain foreign 

goods, drilling leases in Alaska, and the federal government’s debt-recovery efforts.

Student Loan Programs. Some of the President’s proposals 

affecting the federal student loan programs (which could 

be incorporated in the upcoming reauthorization of the 

Higher Education Act of 1965) would reduce the federal 

government’s costs, and some would raise them. For example:

B New student loans made after June 2006 are scheduled to carry a fixed interest rate of 6.8 percent. The 

President’s proposal to continue the existing interest 

rate formulas for borrowers would save the government money because, under those formulas, borrowers would typically pay a rate higher than 6.8 percent.

8. Budgetary resources are grouped into 20 broad categories, called 

budget functions, so that all budget authority and outlays can be 

presented according to the national interests being addressed.

9. Spending from the fees related to the entry of certain vehicles, vessels, and individuals is included in CBO’s baseline even though 

the law enabling collection of the fees is scheduled to expire.
10 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

B A more favorable formula for special-allowance payments to lenders who make loans funded with the 

proceeds of tax-exempt securities is slated to begin 

with loans newly acquired or disbursed after September 2004. Eliminating that change, which the President’s budget proposes, would also reduce the 

government’s costs.

B In contrast, the Administration’s proposals to provide 

extended repayment terms in the guaranteed loan program and to increase loan limits for first-year students 

would raise the program’s costs. An additional increase 

would come from the proposal designating $3.1 billion for new benefits for borrowers—although those 

benefits are as yet unspecified.

In total, student loan proposals affecting mandatory 

spending would increase the government’s costs by $2.3 

billion over the next 10 years, CBO projects. (In addition, the Administration is proposing to shift administrative costs that are currently classified as mandatory to the 

discretionary side of the budget.)

Auctions of Spectrum Licenses. The Federal Communications Commission (FCC) conducts periodic auctions to 

award licenses for use of the electromagnetic spectrum. 

The President’s budget includes four legislative proposals 

that would affect offsetting receipts from such license 

awards. The President would impose new fees on licenses 

used for analog television broadcasts and on licenses 

awarded by methods other than auctions, allow certain 

agencies to spend some auction receipts without further 

appropriations, and extend the FCC’s authority to conduct auctions beyond 2007. Overall, implementing those 

proposals would reduce receipts from auctions by an estimated $400 million over the next five years. Over the following five years, however, receipts would increase by almost $6.5 billion. 

Box 1-1.

Grants-in-Aid

Grants to state, local, and tribal governments now 

make up about 40 percent of nondefense discretionary funding. The grants are concentrated largely in 

three areas: education, training, employment, and 

social services; transportation; and income security. 

Excluding one-time appropriations for election reform assistance ($1.5 billion) and for temporary state 

fiscal assistance ($5 billion), funding for such grants 

totaled $166 billion in fiscal year 2004.1

 The discretionary funding requested in the President’s 2005 

budget includes slightly less than that amount for 

grants-in-aid—about $165 billion, CBO estimates.

Grants in three areas—administration of justice, 

community and regional development, and natural 

resources and the environment—would decline significantly under the President’s proposed policies. 

Budget authority for various law enforcement assistance grants would drop by more than $800 million, 

or approximately 35 percent. The Administration 

also proposes to reduce spending authority for community and regional development grants by a total of 

$1.4 billion, or 12 percent, with the reductions 

spread out over a number of programs. The largest 

cut would occur in state and local programs of the 

Department of Homeland Security—primarily 

among grants for firefighters and so-called first responders, which would fall by almost $800 million, 

or over 20 percent. (However, substantial funds have 

been appropriated in previous years for those programs, and unobligated balances in the programs’ accounts total about $3.5 billion.) The President 

would also significantly reduce—by about 17 percent—discretionary grant programs of the Environmental Protection Agency. In contrast, under the 

2005 budget, grants for education for the disadvantaged and special education would increase by about 

$2.1 billion, or 8 percent.

1. That amount includes obligation limitations for transportation trust fund programs.
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 11

Table 1-6.

CBO’s Estimate of the Effect of the President’s Budget on Baseline Deficits

(Billions of dollars)

Sources: Congressional Budget Office, Joint Committee on Taxation.

Note: EGTRRA = Economic Growth and Tax Relief Reconciliation Act of 2001; JGTRRA = Jobs and Growth Tax Relief Reconciliation Act of 

2003; AMT = alternative minimum tax; * = between -$500 million and $500 million.

Total, Total,

2005- 2005,

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2009 2014

-477 -363 -273 -274 -286 -281 -272 -176 -38 -34 -15 -1,477 -2,012

0 -12 -20 -19 -15 -11 -7 -100 -157 -161 -166 -77 -669

0 -1 -1 -2 -2 -2 -2 -29 -51 -55 -61 -7 -206

0 0 0 0 -2 -13 -14 -29 -31 -33 -35 -16 -157

0 0 -4 -7 -5 -4 -3 -3 -3 -3 -3 -19 -34

0 0 0 0 0 0 * -4 -7 -8 -10 0 -30

_ __ __ __ __ __ __ ___ ___ ___ ___ ___ ____

0 -13 -25 -27 -24 -30 -27 -165 -249 -260 -274 -119 -1,095

* -3 -4 -5 -5 -6 -6 -7 -7 -7 -8 -23 -58

0 * -1 -1 -2 -3 -3 -4 -4 -5 -5 -6 -27

0 * -2 -2 -2 -3 -3 -3 -3 -3 -4 -9 -25

0 * * * -1 -1 -1 -1 -1 -1 -1 -2 -7

* -9 -14 0 0 0 0 0 0 0 0 -23 -23

0 4 6 4 2 * -1 -2 -3 -4 -5 15 -1

* 1 2 2 3 3 3 4 4 4 5 11 31

-1 -2 -6 -5 -6 -8 -10 -10 -10 -11 -12 -26 -80

_ __ __ __ __ __ __ ___ ___ ___ ___ ___ ____

-1 -23 -44 -33 -35 -48 -47 -188 -274 -288 -304 -183 -1,285

0 -22 -37 -37 -33 -24 -17 -15 -13 -14 -14 -152 -225

0 -8 -25 -35 -44 -53 -58 -61 -63 -65 -67 -166 -481

_ __ __ __ __ __ __ __ __ __ __ ___ ___

0 -30 -62 -72 -77 -77 -76 -76 -77 -79 -81 -318 -706

0 * 5 4 4 4 3 * 15 15 14 18 64

0 0 6 7 6 6 6 6 6 6 5 25 54

0 -1 -2 -2 -2 -2 -2 -2 -2 -2 -2 -8 -19

* 2 7 -2 2 2 1 * -1 -1 -1 12 9

_ __ __ __ __ __ __ __ __ __ __ __ ___

* 1 16 7 12 11 8 4 17 17 16 47 109

* * * -1 -3 -4 -6 -2 6 18 30 -9 37

_ __ __ __ __ __ __ __ __ __ __ ___ ___

* -28 -46 -66 -69 -71 -73 -74 -53 -45 -35 -279 -559

Total Impact on the Deficit -1 6 1 32 34 23 26 -114 -221 -243 -269 96 -726

-478 -358 -271 -242 -252 -258 -247 -289 -259 -278 -284 -1,381 -2,738

Nondefense

Deficit in CBO's March 2004 Baseline 

Extension of expiring EGTRRA

Defense

Deduction for high-deductible health insurance 

AMT for individuals

Discretionary

Outlays

Effect of the President's Proposals

Revenues

Tax rates on dividends and capital gains

Other proposals

and JGTRRA provisions

General tax rates, child credits, and brackets

Estate and gift taxes

Refundable health insurance credit

Expansion of tax-free savings

Tax shelters and compliance

Research and experimentation credit

Deduction for long-term care insurance

Customs user fees

and JGTRRA provisions

Other proposals

 Net interest

Deficit Under the President's Proposals

Subtotal, discretionary

Subtotal, mandatory

Subtotal, outlays

Expensing for small businesses

Education, retirement, and other provisions

Subtotal, proposed extensions

Subtotal, revenues

Mandatory

Extension of expiring EGTRRA

Refundable health insurance credit
12 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Spending from Tariff Proceeds. Currently, the federal government assesses tariffs on foreign goods that are sold below cost. The Continued Dumping and Subsidy Offset 

Act of 2000 provides that those collections be paid out to 

the affected domestic industries. The President proposes 

to repeal that law, saving $2.4 billion from 2005 through 

2009, CBO estimates.

Alaskan Leasing Sales. Another of the President’s proposed 

policies would open a portion of the coastal plain of the 

Arctic National Wildlife Refuge to oil and gas leasing and 

development. By CBO’s estimate, leasing sales from such 

a program would generate receipts (net of payments to 

Alaska) totaling $2 billion over the 2007-2009 period.

Federal Debt Recovery. The President has proposed three 

methods to help recover debts owed to the government: 

eliminate the current 10-year limit on collection of nontax debts; use the National Directory for New Hires to locate delinquent debtors; and allow the government to 

withhold federal income tax refunds to recover outstanding overpayments of state unemployment insurance benefits. Overall, those proposals would reduce outlays by 

$1.4 billion and decrease revenues by $348 million over 

the 2005-2009 period, CBO estimates.

Policy Proposals That Affect Revenues

The President’s budget proposes several changes to tax 

law that would significantly reduce revenues, relative to 

the level in CBO’s baseline, over the next decade. Such 

proposals include the extension of a number of expiring 

tax provisions and a variety of new tax incentives. CBO 

and the Joint Committee on Taxation estimate that the 

proposals will reduce revenues by $23 billion in 2005. 

Over the 2005-2014 period, revenues would be reduced 

by $1.3 trillion (and outlays from proposals that affected 

revenues would be increased by $123 billion), according 

to Congressional estimates. (As noted earlier, the increase 

in outlays arises from the proposals’ effects on refundable 

credits.) The most significant proposals include those involving provisions in EGTRRA and JGTRRA, the research and experimentation tax credit, deductions for 

long-term care insurance premiums and for high deductibles on health care plan reimbursement, the alternative 

minimum tax, tax-free savings plans, treatment of tax 

shelters, and tax compliance.

Permanently Extend Provisions of EGTRRA and JGTRRA. 

The President proposes to permanently extend certain 

provisions of EGTRRA and JGTRRA that are scheduled 

to expire, or “sunset.” The provisions in EGTRRA that 

were scheduled to sunset at the end of 2010 would be extended permanently; they include changes in income tax 

rates, relief from the so-called marriage penalty, the implementation of child tax credits and of policies related to 

education and retirement, and repeal of the estate tax. In 

addition to making the provisions permanent, the President proposes to maintain the timing of the implementation of some of them (including the 10 percent tax 

bracket, the child credit, and marriage penalty relief). 

Their implementation was accelerated by JGTRRA, 

which directed that they take effect earlier than they 

would have under EGTRRA. However, the acceleration 

is due to expire at the end of 2004; the President’s proposal would make the speedup permanent beginning in 

2005. 

Those extensions and accelerations would reduce revenues by $904 billion from 2005 through 2014, JCT and 

CBO estimate. They would also increase outlays for refundable tax credits by $64 billion over the same period.

Other proposals in the President’s budget to permanently 

extend provisions of JGTRRA that are scheduled to expire would also result in a decline in revenues. JGTRRA’s 

reduction—to 15 percent—of the maximum tax rate on 

long-term capital gains and dividend income is scheduled 

to expire in 2008. Making that cut permanent would reduce revenues by an additional $157 billion between 

2005 and 2014, CBO and JCT project. Another provision of JGTRRA liberalized rules governing depreciation 

for small businesses from 2003 through 2005, increasing 

the amount of investment that such businesses could “expense” (immediately deduct from their taxable income 

rather than deduct over time) from $25,000 to $100,000. 

The President’s proposal would make those expensing 

changes permanent, at a cost of about $34 billion between 2005 and 2014. 

In total, making permanent all of the extensions and accelerations proposed in the 2005 budget would reduce 

revenues by an estimated $1.1 trillion over the 2005-

2014 period.

Permanently Extend the Research and Experimentation 

Tax Credit. Under current law, corporations may obtain a 

tax credit of 20 percent on certain research expenditures 

above a base amount. The credit is scheduled to expire on 

June 30, 2004, but the President is proposing to make it 

permanent. The resulting revenue loss, according to 

CBO’s and JCT’s estimates, would total $58 billion over 

the next 10 years.
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 13

Allow an “Above-the-Line” Deduction for Long-Term 

Care Insurance. The tax code currently treats the costs of 

insurance for long-term health care as it does other medical expenses: taxpayers can take a deduction from their 

taxable income if they itemize deductions and have total 

medical expenditures that exceed 7.5 percent of their adjusted gross income (AGI). The President’s proposal 

would permit taxpayers to deduct premiums for longterm health care insurance (up to current annual limits) 

regardless of whether they itemized deductions and without requiring that their medical expenditures exceed a 

prescribed limit. The provision would be phased in 

through 2008 and would cost, by CBO’s calculation, $27 

billion over the 2005-2014 period.

Allow an “Above-the-Line” Deduction for HighDeductible Health Insurance. Taxpayers who carry individual (not employment-based) health insurance plans 

with a high deductible amount that must be met before 

reimbursement occurs may contribute to health savings 

accounts (HSAs) that can be used to pay health care costs 

for themselves and their dependents.10 Medical expenses 

exceeding 7.5 percent of AGI are currently deductible 

from taxable income for taxpayers who itemize. This proposal would allow people who contributed to HSAs to 

deduct the premiums they paid on individually purchased, high-deductible plans from their taxable income. 

The deduction would be used in calculating AGI and 

would be allowed even if the taxpayer did not itemize. 

With an effective date of January 1, 2005, the proposal 

would cost an estimated $25 billion from 2005 through 

2014.

Establish a Refundable Tax Credit for Health

Insurance. The creation of a refundable income tax credit 

for the cost of health insurance is another of the President’s proposed policies for 2005. The credit, which 

would become effective on January 1 of that year, would 

be worth as much as $1,000 per adult and $500 per child 

(for up to two children). It could cover a maximum of 90 

percent of the cost of insurance for individual taxpayers 

with a maximum modified AGI of $15,000; those with 

higher income would receive less, and the credit would 

phase out completely for taxpayers with a modified AGI 

of $30,000. Over the 2005-2014 period, the proposal 

would reduce revenues by a total of $7 billion and increase outlays by $54 billion.

Provide AMT Relief for Individuals. The alternative minimum tax (AMT) is a parallel income tax system with 

fewer exemptions, deductions, and rates than the regular 

income tax has; taxpayers pay a tax equal to the greater of 

the regular tax or the AMT. Previous legislation gave temporary relief to taxpayers who would otherwise have been 

subject to the AMT. Permitting the use of certain nonrefundable personal credits that would otherwise have been 

disallowed by the AMT was one feature of that legislation, as was raising the amount of income that was exempt from tax under the AMT rates. The President proposes to extend taxpayers’ ability to use nonrefundable 

credits against the AMT for two years (the credits could 

be applied to tax years 2004 and 2005) and to extend the 

higher AMT exemption amounts enacted in JGTRRA 

through tax year 2005. After that, the AMT would revert 

to the same rules that existed before the recent years’ tax 

cuts. The cost of extending the temporary relief is estimated to total $23 billion from 2005 through 2006.

Expand Tax-Free Savings Plans. The tax code comprises a 

variety of individual retirement accounts (IRAs) that can 

be used not only for retirement but also for other purposes (such as education). The President proposes to 

unify many of those accounts into two tax-free savings

vehicles—retirement savings accounts (RSAs) and lifetime savings accounts (LSAs)—and to expand their applicability.

For RSAs, individuals could contribute up to $5,000 annually, and no income limits would apply. Contributions 

would be taxable, but all earnings on the accounts would 

accumulate tax free. Withdrawals without penalty could 

occur after age 58 or because of death or disability. Accounts currently held as Roth IRAs would become RSAs. 

Moreover, traditional IRAs and nondeductible IRAs 

could be converted into RSAs in the same way that they 

can now be converted into Roth IRAs. Another difference distinguishing RSAs from traditional IRAs is that 

even someone who was already covered by another retirement plan could open an RSA. 

Individuals could also contribute up to $5,000 annually 

to lifetime savings accounts, which would face the same 

tax treatment as RSAs and, like them, have no income restrictions on participation. In contrast to the treatment 

that applies to IRA withdrawals, however, withdrawals 

from LSAs could be made for any purpose and at any age. 

Balances currently held in Coverdell education savings 

accounts and qualified state tuition plans could be converted into balances in LSAs.

10. The Administration did not provide specific information on what 

kinds of plans would qualify as high-deductible health insurance.
14 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Over the 2005-2014 period, the net revenue loss attributable to the expansion of tax-free savings plans would be 

$1 billion, CBO projects. Gains in revenue would initially occur (from 2005 through 2008) because contributions to many current savings vehicles that receive favorable tax treatment are made on a pretax basis, whereas the 

new vehicles’ contributions would be made after taxes. In 

addition to redirecting their contributions, some taxpayers would convert their existing traditional IRAs to RSAs. 

As a result, the proposals would increase federal revenues 

when the contributions were made and the balances converted but reduce revenues later, when withdrawals went 

untaxed. From 2009 through 2014, the net budgetary effect of the proposals would be losses in revenue.

Change the Treatment of Tax Shelters and Improve Tax 

Compliance. The President proposes a number of measures to address tax shelters, abusive transactions, and tax 

compliance. Altogether, the proposals would raise revenues by an estimated $31 billion over the 2005-2014

period. About $21 billion of that amount would be generated by reducing the advantages of certain leasing transactions, generally with tax-exempt parties, that are often 

referred to as sale-in/lease-out (SILO) transactions. Other 

proposals would modify the rules for tax deductions that 

apply to donations of patents and other intellectual property (increasing revenues by $4 billion) and limit interest 

deductions by corporations that result from the debt of 

their related foreign entities (for a revenue gain of $3 billion).

Other Proposals. The President’s 2005 budget also contains a number of other tax changes, such as incentives related to charitable giving, health care, education, energy, 

and the environment. Included as well are various 

changes in taxes related to pensions and other retirement 

saving; an effort to simplify the tax code by establishing a 

uniform definition of a child and implementing other 

changes that would affect taxpayers with children; a new 

tax credit for developers of affordable single-family housing; and reinstatement of a number of provisions that expired at the end of 2003. Those proposed changes would 

combine over the 2005-2014 period to reduce revenues 

by an estimated $80 billion and increase outlays by $4 

billion.

CBO’s and the Administration’s

Economic Assumptions

Although CBO and the Administration forecast similar 

values for the underlying economic variables used to estimate revenues and outlays, the Administration’s projections imply a more favorable outlook for the budget than 

do CBO’s, particularly for fiscal years 2007 through 

2009.

The Administration’s projections of the level of wages and 

salaries—the income category that has the biggest effect 

on revenue projections—are larger than CBO’s for 2004 

through 2009 (see Table 1-7 on page 16). The difference 

derives in part from the Administration’s higher estimates 

of wages and salaries as a percentage of GDP. In the later 

years of that period, the slightly higher level of GDP that 

the Administration projects also tends to keep the estimated level of wages and salaries above that in CBO’s 

projection.

Profits, another income category that influences revenue 

estimates, are lower in the Administration’s projections 

than in CBO’s after 2005, both in dollars and as a share 

of GDP. Because the projections of profits do not affect 

revenue estimates as much as projections of wages and 

salaries do, however, the net effect of the differences in income categories is higher revenues after 2006 under the 

Administration’s projections.

CBO assumes that the growth of real GDP will be 

slightly faster than the Administration estimates in 2004 

and 2005; by contrast, the Administration anticipates 

faster growth in the remaining years (2006 to 2009). 

Over the entire period, however, average real GDP 

growth is almost the same in the two forecasts.

The Administration projects lower inflation through 

2007 (as measured by the consumer price index for all urban consumers) and generally lower interest rates than 

does CBO. (However, the Administration’s estimates of 

10-year interest rates are higher than CBO’s beginning in 

2007.) Lower inflation and interest rates produce lower 

outlays under the President’s budget, in large part for two 

reasons. First, the inflation measures used to determine 

cost-of-living adjustments for programs such as Social Security and Food Stamps grow less rapidly under the Administration’s lower inflation outlook than under CBO’s 

through 2007. Second, the Administration’s projection 

through 2007 of lower short- and long-term interest rates 

has a substantial effect on debt-service costs, particularly 

in fiscal years 2006 through 2008.
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 15

A comparison of the two agencies’ forecasts to a recent 

survey of 50 private-sector forecasts, the Blue Chip Economic Indicators, shows that the average of private-sector 

views for the next two years does not differ much from 

that of either the Administration or of CBO. 

Differences Between CBO’s and the 

Administration’s Policy Estimates

Overall, CBO’s estimates of the budgetary impact of the 

President’s proposals for revenues and mandatory spending do not differ much from those of the Administration. 

However, some notable differences are apparent in estimates of specific proposals (see Table 1-3 on page 5).

Outlay Differences

On the outlay side of the budget, there are several significant differences between CBO’s and the Administration’s 

estimates. For mandatory outlays, CBO projects that the 

President’s proposals will increase spending by more than 

$47 billion over the 2005-2009 period—$40 billion 

more than the Administration estimates. About 55 percent of that difference is attributable to the proposal to 

create a refundable tax credit for the cost of health insurance. According to the budget, the Administration expects to make offsetting cuts elsewhere and has included 

savings from such reductions in its estimates. But the 

President’s budget does not specify where the cuts are to 

be made, and as a result, CBO did not incorporate any 

savings into its five-year projections. Those unspecified 

savings in the Administration’s budget amounted to $22 

billion over the 2005-2009 period.

The President’s budget also includes savings of almost 

$10 billion over the next five years from legislation involving Medicaid. The proposed legislation would limit 

Medicaid’s cost reimbursements to government-operated 

providers (such as county hospitals) and curb states’ use 

of intergovernmental transfers to claim additional federal 

Medicaid funds without a corresponding increase in state 

spending. CBO did not estimate any savings for those 

proposals because the Administration did not provide 

specific details about how the legislation would achieve 

them.

Another major difference between the Administration’s 

and CBO’s estimates involves tax proposals that affect the 

amount of the refundable child credit and the earned income credit. JCT and CBO expect that the President’s 

proposals, if enacted, will increase outlays by over $4 billion more than the Administration has projected. 

CBO and the Administration also differ in their assessment of the impact of the proposals related to student 

loans: in the Administration’s estimates, the policies reduce outlays by $1 billion over the next five years; in 

CBO’s, they increase spending by about $0.5 billion. 

Those differences occur mainly because CBO expects 

smaller effects than the Administration does from provisions to reduce costs. In addition, CBO estimates that the 

proposal relating to borrowers’ interest rates will decrease 

federal costs; the Administration estimates that it will increase them. 

Revenue Differences

The President’s proposals in combination would reduce 

revenues over the 2005-2009 period by a total of $183 

billion, CBO estimates—or $8 billion (5 percent) more 

than the Administration’s estimated reduction of $175 

billion. CBO and JCT project larger revenue losses than 

the Administration does in each year from 2005 through 

2007; it projects smaller losses in 2008 and 2009. 

The $8 billion more in net revenue losses in CBO’s projections for the five-year period results from lower estimates of the gains in revenue from certain provisions—

specifically, those that would alter the interest rates used 

to determine required pension contributions ($9 billion 

less revenue gain); address certain issues regarding tax 

compliance and tax shelters, especially SILO transactions 

($8 billion); and expand tax-free savings plans ($6 billion).

Partially offsetting those effects in CBO’s estimates is a 

lower amount of lost revenue as a consequence of certain 

revenue-reducing provisions. Most significantly, by 

CBO’s estimate, extending the reduced tax rates on dividends and capital gains would cut revenues by $12 billion 

less through 2009 than the Administration projects. That 

difference applies mainly to 2008 and 2009, around the 

time of the proposed extension of the rate reduction. 

With the exception of their estimates of the effect of the 

dividend/capital gains rate reduction, CBO’s and the Administration’s projections of the reductions in revenues 

from the proposals that extend and accelerate provisions 

of EGTRRA and JGTRRA are very similar.

For 2004, CBO forecasts a potential net revenue decline 

of $1 billion from those proposals, whereas the Administration forecasts a potential net revenue increase of $7 bil-
16 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Table 1-7.

Comparison of CBO’s, the Administration’s, and Private-Sector Economic

Projections for Calendar Years 2004 Through 2009

Continued

lion. The $8 billion difference stems mostly from CBO’s 

lower estimate of the gain in revenues from the proposal 

to alter the interest rates used for pension calculations. 

CBO also projects more revenue losses from certain tax 

incentives than the Administration does.

Changes to CBO’s Baseline

In conjunction with its annual analysis of the President’s 

budget, CBO has updated the 10-year baseline projections that it published in January.11 Constructed according to rules specified in law and intended to serve as a 

neutral benchmark, CBO’s baseline projections estimate 

the future path of spending and revenues if current laws 

remain unchanged.

Technical revisions to the baseline (changes attributable 

to factors other than legislation or economic variables) 

have increased projected outlays over the 2005-2014 period by $102 billion and reduced projected revenues by 

$18 billion (see Table 1-8 on page 18). Technical revisions make up almost all of the changes to CBO’s baseline; revisions resulting from legislation since January 

have been minimal, and CBO saw no need to update the 

baseline’s underlying economic assumptions. All told, 

CBO now projects that deficits will total $2.0 trillion 

over the next 10 years if current policies remain in place 

(see Table 1-9 on page 20). Deficits as a percentage of 

GDP are projected to decline from 4.2 percent in 2004 

to 3.0 percent in 2005 and 1.8 percent in 2010. After 

2011, if the tax cuts enacted in EGTRRA expired as 

scheduled, if growth in discretionary spending continued 

to be limited to the rate of inflation, and if other policies 

stayed the same, the budget would essentially be in balance.

Nominal GDP (Billions of dollars)

10,980 11,629 12,243 13,728

10,984 11,612 12,187 13,822

10,988 11,651 12,280 n.a.

Nominal GDP (Percentage change)

4.8 5.9 5.3 4.7

4.8 5.7 4.9 5.1

4.8 6.0 5.4 n.a.

Real GDP (Percentage change)

3.2 4.8 4.2 2.8

3.1 4.4 3.6 3.3

3.1 4.6 3.7 n.a.

GDP Price Index (Percentage change)

1.6 1.1 1.1 1.8

1.6 1.2 1.3 1.8

1.6 1.4 1.6 n.a.

Consumer Price Indexa

 (Percentage change)

2.3 1.6 1.7 2.2

2.3 1.4 1.5 2.2

2.3 1.6 2.0 n.a.

Projected 

Annual Average,

2006-2009

CBO

Administration

Forecast

2004 2005

February Blue Chip

CBO

Administration

February Blue Chip

February Blue Chip

CBO

CBO

Administration

February Blue Chip

CBO

February Blue Chip

Administration

Administration

Estimated

2003

11. See Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2005-2014 (January 2004).
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 17

Table 1-7.

Continued

Sources: Congressional Budget Office; Office of Management and Budget; Aspen Publishers, Inc., Blue Chip Economic Indicators (February 

10, 2004); Department of Commerce, Bureau of Economic Analysis; Federal Reserve Board; Department of Labor, Bureau of Labor 

Statistics.

Note: Percentage changes are year over year; n.a. = not available.

a. The consumer price index for all urban consumers.

b. The Blue Chip survey does not include projections of tax bases.

Increases in projected spending for Medicare ($48 billion 

from 2005 through 2014) and Medicaid ($32 billion 

over those 10 years) represent the largest changes to the 

baseline. Revisions to Medicaid outlays were driven by 

new information on the growth of caseloads in the feefor-service and managed care sectors of the program and 

on spending for prescription drugs for beneficiaries not 

covered by the newly enacted prescription drug plan under Medicare (Part D). New data on Parts A and B of 

Medicare (Hospital Insurance and Supplementary Medical Insurance, respectively), together with improvements 

in CBO’s modeling of Medicare benefits for those programs, explain most of the increases in projected outlays 

for Medicare. (CBO’s estimate of the cost of Part D is unchanged.)

The most significant change to projected revenues in the 

baseline affects corporate income tax receipts—the revision reduces such revenues by about $12 billion over the 

2005-2014 period. That adjustment was based on new 

information about the growing use of certain corporate 

tax shelters.

Unemployment Rate (Percent)

6.0 5.8 5.3 5.1

6.0 5.6 5.4 5.1

6.0 5.7 5.4 n.a.

4.0 4.6 5.4 5.5

4.0 4.6 5.0 5.7

4.0 4.6 5.3 n.a.

CBO 7.7 8.1 10.8 9.9

Administration 7.7 8.5 10.8 9.4

CBO 46.3 45.9 46.1 46.4

Administration 46.4 46.1 46.6 47.1

Tax Basesb

 (Billions of dollars)

CBO 844 948 1,319 1,357

Administration 845 992 1,313 1,297

CBO 5,087 5,333 5,639 6,367

Administration 5,092 5,352 5,682 6,513

2004 2005 2006-2009

Projected 

Estimated Forecast Annual Average,

Administration

2003

Ten-Year Treasury Note Rate (Percent)

Wage and salaries

Tax Basesb

 (Percentage of GDP)

Corporate book profits

CBO

Wages and salaries

Corporate book profits

CBO

Administration

February Blue Chip

February Blue Chip
18 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Table 1-8.

Changes in CBO’s Baseline Projections of the Deficit or Surplus

Since January 2004

(Billions of dollars)

Source: Congressional Budget Office.

Note: * = between -$500 million and $500 million.

Because of revisions that decrease projected revenues and 

increase projected outlays, CBO estimates that the Treasury will need to borrow more than it would have under 

the previous baseline. By CBO’s estimate, such additional 

borrowing will raise net interest payments by $15 billion 

over the decade.

Differences Between CBO’s Baseline 

and the Administration’s CurrentServices Baseline

In the past, the Administration and CBO constructed 

their baselines using similar concepts derived from the 

Balanced Budget and Emergency Deficit Control Act of 

1985. Consequently, discrepancies between the two sets 

of estimates derived from differences in technical or economic estimating assumptions. In its current baseline, 

however, the Administration has deviated from prior 

practices in three ways. First, its baseline assumes that 

EGTRRA and JGTRRA will be extended. Second, as 

noted earlier, the Administration has not extended into 

future years the $87 billion supplemental appropriation 

for 2004 (mostly for military and reconstruction activities 

in Iraq and Afghanistan). And third, it has made an adjustment to the way it accounts for increases in pay when 

projecting discretionary spending. Aside from the effects 

of those revised approaches, underlying differences between the Administration’s and CBO’s benchmark measures are small.

In its modified baseline, the Administration projects a 

deficit for 2004 of $527 billion, whereas CBO’s baseline 

Total, Total,

2005- 2005-

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2009 2014

-477 -362 -269 -267 -278 -268 -261 -162 -24 -16 13 -1,443 -1,893

Changes to Projections

*********** * 1

Revenues * 1 -1 -1 -1 -1 -1 -1 -2 -2 -9 -3 -18

Outlays

-1 * 1 * * * * * * * * 1 *

3 5 3 4 4 6 4 6 4 6 7 22 48

* 1 1 3 3 4 4 4 4 4 4 11 32

* * * * * 1 1 2 3 4 6 * 15

* -3 -1 * * 2 1 1 2 2 2 -2 7

_ _ _ _ _ __ __ __ __ __ __ __ ___

Subtotal, mandatory 2 3 3 6 8 12 10 13 12 16 19 31 102

Subtotal, technical * -2 -4 -8 -8 -13 -11 -14 -14 -18 -28 -35 -120

Total Impact on the

Deficit or Surplus * -2 -4 -8 -8 -13 -11 -14 -14 -18 -28 -34 -119

-477 -363 -273 -274 -286 -281 -272 -176 -38 -34 -15 -1,477 -2,012

Medicare

Medicaid

Debt service

Total Deficit (-) or Surplus

as Projected in January 2004

Discretionary

Mandatory

Total Deficit as

Projected in March 2004

Other

Legislative

Technical
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 19

shows a deficit of $477 billion (see Table 1-10 on page 

22). For the five years from 2005 through 2009, the Administration expects the deficit to decline each year, with 

the shortfall totaling about $1.3 trillion. Under CBO’s 

projections, the deficit continues to drop in both 2005 

and 2006 and stays relatively constant thereafter, producing a cumulative five-year deficit of $1.5 trillion. If the 

Administration’s projections were produced in a manner 

comparable with CBO’s, its projections would show a 

five-year deficit nearly equal to CBO’s estimate.

Outlay Differences

On the spending side of the budget, CBO’s estimate of 

outlays for 2004 is $24 billion lower than the Administration’s. Of that amount, differences in discretionary 

spending account for $13 billion. CBO believes that in 

many cases, agencies have overestimated the rate at which 

funds will be spent this year. The largest variations between the two agencies’ assessments involve international 

affairs, disaster relief and insurance, ground transportation, federal law enforcement activities, and education. In 

terms of mandatory spending, CBO’s estimate is lower 

than the Administration’s by about $9 billion, primarily 

because of differing judgments about outlays for Medicare and Medicaid.

For the 2005-2009 period, CBO’s estimate of total outlays exceeds that of the Administration by $306 billion. 

Discretionary outlays in CBO’s baseline exceed the Administration’s projections by $345 billion, with the bulk 

of that difference stemming from the Administration’s 

decision not to extend and inflate the $87 billion supplemental appropriation enacted in November 2003. If the 

two baselines were prepared on a comparable basis, the 

Administration would add $400 billion to its estimate of 

discretionary outlays—and the Administration’s and 

CBO’s figures for that category over the next five years 

would differ by about $54 billion, or about 1 percent. 

CBO’s projection of mandatory spending (excluding debt 

service) over the five-year period is about $75 billion below the Administration’s, with the largest differences 

stemming from the agencies’ divergent estimates for 

Medicare and Medicaid. Over the 2005-2009 period, 

CBO’s baseline projection of Medicare spending is $75 

billion less than the Administration’s, mostly because the 

Administration projects higher costs for the Medicare Advantage program and for Medicare’s new prescription 

drug benefit. CBO’s estimates of Medicaid spending, 

which are $56 billion below the Administration’s projections over the five-year period, anticipate smaller overall 

increases in enrollment and reflect different assumptions 

about per capita growth for a range of services. 

Another difference between the two baselines arises because CBO does not include the effects of proposed policy changes in its baseline. Consequently, unlike the Administration, it did not include the effects on outlays of 

permanently extending the child tax credit—which add 

$16 billion in outlays over the five-year period to the 

baseline published by the Administration. For 2005 

through 2009, CBO’s estimates of the outlays from refundable tax credits under current law are an additional 

$10 billion lower than those of the Administration.

In the other direction, CBO’s baseline estimates of outlays for Social Security are slightly higher than those of 

the Administration—by about $33 billion. CBO’s projections of outlays for all other mandatory programs over 

the 2005-2009 period are a total of $49 billion higher 

than the Administration’s.

By contrast, the Administration’s projections of net interest for 2005 through 2009 are lower than CBO’s by $35 

billion, mostly because CBO assumes that interest rates 

will be higher over that period than the Administration 

anticipates they will be.

Revenue Differences

CBO estimates that revenues for the current fiscal year 

will be $26 billion higher than the Administration expects—mainly because the Administration reduced its 

revenue projections by $20 billion to account for the element of uncertainty in making such projections. Nevertheless, CBO’s estimates of baseline revenues over the 

2005-2009 period are very similar to those of the Administration. In total, CBO’s estimates are higher than the 

Administration’s by $99 billion (about 0.8 percent) for 

that five-year period.

The major difference results from the Administration’s 

decision to include the effects of making permanent the 

tax cuts enacted in 2001 and 2003. Those proposals include the higher child credit, marriage penalty relief, the 

expanded 10 percent tax bracket for individuals, increased expensing of capital expenditures for small businesses, and reduced tax rates on dividends and capital 

gains. CBO’s baseline does not include those effects, 

which increases its estimates relative to the Administration’s by $132 billion over the 2005-2009 period. CBO’s 

baseline does include the effects of certain legislation en-
20 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Table 1-9.

CBO’s March Baseline Projections

Continued

acted since the beginning of calendar year 2004, which 

the Administration’s estimates do not, but the resulting 

difference in revenues is negligible.

The remaining differences between CBO’s and the Administration’s revenue projections are relatively small—

$33 billion over 10 years—and are explained by differences in the agencies’ projections of macroeconomic activity and their assumptions about how much revenue 

that activity will generate. CBO’s economic projection 

yields about $70 billion less in revenues over the 2005-

2009 period than the Administration’s does. Compared 

with the Administration, CBO projects a higher level of 

GDP through 2006, but it anticipates less income in the 

form of wages and salaries and generally more in corporate profits—and the effects on revenues from those differences roughly offset each other. From 2007 through 

2009, however, CBO projects that GDP will be slightly 

lower than the Administration expects and that less of 

GDP will be earned in the form of wages and salaries.

Partially offsetting the small difference related to economic assumptions are other, technical estimating differences. Such variations add about $38 billion over the 

2005-2009 period to CBO’s revenue projections relative 

to the Administration’s baseline. Of that total, $15 billion 

stems from the baseline adjustment that the Administration attributes to the uncertainty inherent in making revenue estimates.

Total, Total,

Actual 2005- 2005-

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2009 2014

794 762 885 997 1,074 1,146 1,237 1,335 1,528 1,684 1,786 1,896 5,339 13,569

132 161 223 264 272 274 275 277 285 295 306 318 1,308 2,789

713 747 789 830 868 906 946 988 1,031 1,076 1,123 1,173 4,340 9,732

144 148 152 164 170 178 185 184 190 215 224 234 849 1,896 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ _____ _____

1,782 1,817 2,050 2,255 2,384 2,505 2,643 2,785 3,035 3,271 3,439 3,620 11,837 27,986

On-budget 1,258 1,273 1,477 1,654 1,755 1,846 1,953 2,064 2,282 2,484 2,618 2,762 8,685 20,895

Off-budget 524 545 572 601 629 659 690 721 753 786 821 858 3,152 7,091

825 895 936 956 973 998 1,021 1,045 1,074 1,091 1,122 1,150 4,882 10,364

1,179 1,245 1,297 1,352 1,429 1,511 1,601 1,694 1,806 1,880 2,011 2,142 7,190 16,724

153 155 180 220 257 282 302 318 330 338 340 343 1,241 2,911 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ _____ _____

2,158 2,295 2,413 2,528 2,659 2,791 2,924 3,057 3,211 3,309 3,473 3,635 13,314 29,998

On-budget 1,795 1,911 2,014 2,120 2,237 2,355 2,472 2,586 2,721 2,795 2,932 3,064 11,199 25,297

Off-budget 363 384 398 408 421 435 452 471 490 514 541 571 2,115 4,702

-375 -477 -363 -273 -274 -286 -281 -272 -176 -38 -34 -15 -1,477 -2,012

-536 -638 -537 -466 -482 -509 -519 -523 -439 -310 -314 -302 -2,513 -4,402

161 161 174 193 208 224 238 250 263 273 280 287 1,036 2,390

3,914 4,385 4,762 5,048 5,335 5,633 5,927 6,212 6,400 6,450 6,496 6,525 n.a. n.a.

10,829 11,469 12,091 12,682 13,236 13,862 14,519 15,187 15,862 16,562 17,301 18,070 66,389 149,371

In Billions of Dollars

Off-budget

Debt Held by the Public

Memorandum:

Gross Domestic Product

Revenues

Individual income taxes

Corporate income taxes

Social insurance taxes

Other

Total

Outlays

Discretionary spending

Mandatory spending

Net interest

Total

Deficit (-) or Surplus

On-budget 
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 21

Table 1-9.

Continued

Source: Congressional Budget Office.

Note: n.a. = not applicable.

Total, Total,

Actual 2005- 2005-

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2009 2014

7.3 6.6 7.3 7.9 8.1 8.3 8.5 8.8 9.6 10.2 10.3 10.5 8.0 9.1

1.2 1.4 1.8 2.1 2.1 2.0 1.9 1.8 1.8 1.8 1.8 1.8 2.0 1.9

6.6 6.5 6.5 6.5 6.6 6.5 6.5 6.5 6.5 6.5 6.5 6.5 6.5 6.5

1.3 1.3 1.3 1.3 1.3 1.3 1.3 1.2 1.2 1.3 1.3 1.3 1.3 1.3 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

16.5 15.8 17.0 17.8 18.0 18.1 18.2 18.3 19.1 19.7 19.9 20.0 17.8 18.7

On-budget 11.6 11.1 12.2 13.0 13.3 13.3 13.5 13.6 14.4 15.0 15.1 15.3 13.1 14.0

Off-budget 4.8 4.7 4.7 4.7 4.8 4.8 4.8 4.7 4.7 4.7 4.7 4.7 4.7 4.7

7.6 7.8 7.7 7.5 7.3 7.2 7.0 6.9 6.8 6.6 6.5 6.4 7.4 6.9

10.9 10.9 10.7 10.7 10.8 10.9 11.0 11.2 11.4 11.4 11.6 11.9 10.8 11.2

1.4 1.4 1.5 1.7 1.9 2.0 2.1 2.1 2.1 2.0 2.0 1.9 1.9 1.9 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____

19.9 20.0 20.0 19.9 20.1 20.1 20.1 20.1 20.2 20.0 20.1 20.1 20.1 20.1

On-budget 16.6 16.7 16.7 16.7 16.9 17.0 17.0 17.0 17.2 16.9 16.9 17.0 16.9 16.9

Off-budget 3.4 3.3 3.3 3.2 3.2 3.1 3.1 3.1 3.1 3.1 3.1 3.2 3.2 3.1

-3.5 -4.2 -3.0 -2.1 -2.1 -2.1 -1.9 -1.8 -1.1 -0.2 -0.2 -0.1 -2.2 -1.3

-4.9 -5.6 -4.4 -3.7 -3.6 -3.7 -3.6 -3.4 -2.8 -1.9 -1.8 -1.7 -3.8 -2.9

1.5 1.4 1.4 1.5 1.6 1.6 1.6 1.6 1.7 1.6 1.6 1.6 1.6 1.6

36.1 38.2 39.4 39.8 40.3 40.6 40.8 40.9 40.3 38.9 37.6 36.1 n.a. n.a.

Individual income taxes

As a Percentage of GDP

Corporate income taxes

Debt Held by the Public

Off-budget

Other

Total

Total

Deficit (-) or Surplus

On-budget 

Outlays

Discretionary spending

Mandatory spending

Revenues

Net interest

Social insurance taxes
22 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Table 1-10.

Comparison of CBO’s March Baseline and the Administration’s

Published February Baseline

(Billions of dollars)

Continued

Total,

2005-

2004 2005 2006 2007 2008 2009 2009

1,817 2,050 2,255 2,384 2,505 2,643 11,837

1,273 1,477 1,654 1,755 1,846 1,953 8,685

545 572 601 629 659 690 3,152

895 936 956 973 998 1,021 4,882

1,245 1,297 1,352 1,429 1,511 1,601 7,190

155 180 220 257 282 302 1,241 ____ ____ ____ ____ ____ ____ _____

2,295 2,413 2,528 2,659 2,791 2,924 13,314

On-budget 1,911 2,014 2,120 2,237 2,355 2,472 11,199

Off-budget 384 398 408 421 435 452 2,115

-477 -363 -273 -274 -286 -281 -1,477

-638 -537 -466 -482 -509 -519 -2,513

161 174 193 208 224 238 1,036

1,791 2,037 2,215 2,354 2,497 2,636 11,738

1,257 1,462 1,612 1,717 1,830 1,937 8,557

534 575 603 636 668 699 3,181

908 910 885 896 914 933 4,537

1,254 1,309 1,370 1,441 1,528 1,618 7,265

156 178 213 245 273 296 1,206 ____ ____ ____ ____ ____ ____ _____

2,319 2,397 2,468 2,583 2,715 2,847 13,008

On-budget 1,939 2,000 2,067 2,171 2,294 2,410 10,942

Off-budget 380 396 401 412 420 436 2,066

-527 -360 -253 -229 -218 -211 -1,270

-682 -539 -455 -453 -465 -474 -2,385

154 179 202 224 247 263 1,115

Deficit (-) or Surplus

On-budget

Off-budget

Discretionary

Mandatory

Net interest

Total

Revenues

On-budget

Off-budget

Outlays

CBO's March Baseline

Outlays

Discretionary

Mandatory

Administration's Published February Baseline

Revenues

On-budget

Off-budget

Net interest

Total

Deficit (-) or Surplus

On-budget

Off-budget
CHAPTER ONE CBO’S ESTIMATE OF THE PRESIDENT’S BUDGET FOR FISCAL YEAR 2005 23

Table 1-10.

Continued

(Billions of dollars)

Sources: Congressional Budget Office; Office of Management and Budget.

a. Positive numbers denote that the Administration’s estimate of the deficit is higher than CBO’s; negative numbers denote that its estimate 

of the deficit is lower than CBO’s.

b. Baseline deficits calculated by the Administration according to the Balanced Budget and Emergency Deficit Control Act as amended.

Total,

2005-

2004 2005 2006 2007 2008 2009 2009

Difference (CBO minus Administration)

26 13 40 31 8 7 99

16 16 42 38 16 16 128

11 -3 -2 -7 -9 -9 -29

-13 26 71 76 84 88 345

-9 -12 -18 -12 -17 -17 -75

-1 2 7 11 9 5 35

__ __ __ __ __ __ ___

-24 16 60 76 76 77 306

On-budget -28 14 53 67 61 61 256

Off-budget 4 2 7 9 15 16 49

50 -3 -20 -45 -68 -70 -207

43 2 -11 -29 -45 -45 -128

7 -5 -9 -16 -24 -25 -79

-527 -393 -305 -292 -288 -271 -1,549

Administration's Budget

On-budget

Off-budget

Memorandum:

Deficit Under the 

Enforcement Act Baselineb

Deficit (-) or Surplusa

On-budget

Off-budget

Outlays

Discretionary

Mandatory

Net interest

Total

Revenues

2

The Economy Under the

President’s Budget and Under

CBO’s Baseline Policy Assumptions

The Congressional Budget Office’s analysis of the 

President’s budgetary proposals included a consideration 

of how those policies—in comparison with the policies 

assumed in CBO’s baseline—would affect the economy. 

That assessment produced the following main conclusions:

B Under the policies in the President’s budget, economic 

output could be either higher or lower, on average, 

over the 2005-2009 period and would probably be 

higher over the 2010-2014 period than it would be 

under the policies in CBO’s baseline. However, the 

differences are likely to be small, affecting output by 

less than one-half of one percentage point, on average.

B The small size of the effects on output stems in part 

from the small size—relative to the overall economy—

of the budgetary impact of the proposals. From 2005 

to 2009, CBO estimates, revenues under the President’s proposals—excluding economic effects—would 

be lower by 0.3 percent of cumulative gross domestic 

product than they would be under CBO’s baseline. 

Spending, including interest on government debt, 

would be lower by 0.4 percent of GDP. (Spending under the President’s proposals would be lower largely 

because CBO’s baseline extends supplemental appropriations for 2004, adjusted for inflation, to future 

years, and the President’s proposals do not.) 

B Another reason that the proposals’ effects on the economy are estimated to be small and to vary over time is 

that their changes in policy (relative to CBO’s baseline) have offsetting effects: some proposals tend to 

imply greater output, and some tend to imply less.

B The macroeconomic effects of the proposals could in 

turn alter their budgetary cost. Under the baseline’s 

economic assumptions, the President’s budgetary proposals would reduce the cumulative deficit for the 

2004-2009 period by $96 billion, CBO estimates, 

compared with the deficit under the baseline’s policy 

assumptions. When the budgetary effects of the economic changes resulting from those proposals are included in the estimate, the projected reduction in the 

cumulative deficit over that period ranges from as 

much as $130 billion to as little as $72 billion (see 

Figure 2-1 and Table 2-1).

B For the years 2010 to 2014, under the baseline’s economic assumptions, the President’s budgetary proposals would increase the cumulative deficit by $822 

billion. When the budgetary effects of the economic 

changes resulting from those proposals are also considered, the projected increase in the cumulative deficit 

over that period ranges from as much as $818 billion 

to as little as $716 billion.

CHAPTER
26 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Figure 2-1.

CBO’s Estimates, Using Various Models, of How the President’s Budget Would 

Affect the Deficit After Accounting for Economic Effects

(Cumulative change from CBO’s baseline, in billions of dollars)

Source: Congressional Budget Office.

Notes: The estimates in the figure reflect the proposals’ supply-side effects on the economy but exclude demand-side economic impacts. 

Positive changes reduce the deficit; negative changes increase it.

CBO’s analysis used the following models (which are described in the text): (A) “textbook” high model, (B) “textbook” low model, (C) 

closed-economy life-cycle model with lower government spending after 2014, (D) closed-economy life-cycle model with higher taxes 

after 2014, (E) open-economy life-cycle model with lower government spending after 2014, (F) open-economy life-cycle model with

higher taxes after 2014, (G) infinite-horizon model with lower government consumption after 2014, (H) infinite-horizon model with 

higher taxes after 2014, (I) Macroeconomic Advisers’ model, and (J) Global Insight’s model.

a. Because this model is designed primarily to capture business-cycle developments, which are hard to predict beyond a few years, CBO did 

not compute an estimate for the 2010-2014 period.

0

40

80

120

160

-1,000

-800

-600

-400

-200

0

AB C D E FG H I J

A BC DE FGH I J

2005 to 2009

2010 to 2014

Budget's Impact on the 2005-2009 Deficit

Assuming No Macroeconomic Feedbacks ($96

billion)

Budget's Impact on the 2010-2014 Deficit

Assuming No Macroeconomic Feedbacks (-$822 billion)

a a
CHAPTER TWO THE ECONOMY UNDER THE PRESIDENT’S BUDGET AND UNDER CBO’S BASELINE POLICY ASSUMPTIONS 27

Table 2-1.

CBO’s Estimates of How the President’s Budget Would Affect the Deficit After Accounting for Economic Effects

(Cumulative change from CBO’s baseline, in billions of dollars)

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

Numbers in this table reflect the positive or negative effects of the President’s proposals on the cumulative deficit relative to CBO’s 

baseline.

The “textbook” growth model is an enhanced version of a model developed by Robert Solow. The life-cycle growth model, developed

by CBO, is an overlapping-generations general-equilibrium model. The infinite-horizon growth model is an enhanced version of a 

model first developed by Frank Ramsey. The models by Macroeconomic Advisers and Global Insight, which are available commercially, 

are designed to forecast short-term economic developments. The various models reflect a wide range of assumptions about the 

extent to which people are forward-looking in their behavior: in the textbook model and those by Macroeconomic Advisers and Global 

Insight, people have the least foresight, whereas in the infinite-horizon model, foresight is perfect and extends infinitely to include a 

full consideration of effects on descendants.

In models with forward-looking behavior, CBO had to make assumptions about how the President’s budget would be financed after 

2014. CBO chose two alternatives—cutting government consumption and transfer payments or raising marginal tax rates.

High (Hours worked respond strongly to tax-rate changes) 104 -783

Low (Hours worked respond weakly to tax-rate changes) 100 -818

Lower government spending after 2014 82 -763

Higher taxes after 2014 79 -769

Lower government spending after 2014 77 -748

Higher taxes after 2014 72 -750

Lower government spending after 2014 77 -777

Higher taxes after 2014 95 -716

128 n.a.

130 n.a.

110 n.a.

82 n.a.

Memorandum:

President's Proposals Under Baseline Economic Assumptions 96 -822

Global Insight

CBO's Estimate of the Budgetary Effects of the

Growth Models

With Forward-Looking Behavior

Macroeconometric Models

Supply-Side and Demand-Side Contributions

Macroeconomic Advisers

Supply-Side Contribution

Global Insight

Without Forward-Looking Behavior

2005 to 2009 2010 to 2014

Macroeconomic Advisors

Textbook Growth Model

Closed-Economy Life-Cycle Growth Model

Open-Economy Life-Cycle Growth Model

Infinite-Horizon Growth Model
28 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

How Fiscal Policy Affects the Economy

Budgetary policies can affect the economy in a variety of 

ways. Changes in the tax rates that people face on their 

income can affect incentives to work and save; government spending on goods and services can reduce the resources available for investment; and spending and tax 

policies can influence the overall level of demand in the 

economy.1 Those impacts and other possible economic 

influences can be broadly divided into long-run supplyside effects and short-run demand-side effects. 

The economy’s underlying potential to produce goods 

and services depends on the size and quality of both the 

labor force and the stock of productive capital (such as 

factories and information systems), as well as on the level 

of technological know-how. Economists refer to longterm changes in those three determinants of potential 

output as “supply-side” changes because they alter the 

quantity of goods and services that the economy is capable of supplying on a sustainable basis. Supply-side 

changes have a lasting effect on the economy.

In the short run, however, economic output can deviate 

from its potential level, as the total demand for goods and 

services moves above and below that level, causing employment to rise and fall and the stock of capital to be 

used more or less intensively. Those movements are referred to as demand-side, or cyclical, variations. Unlike 

movements on the supply side of the economy, cyclical 

changes are temporary—built-in corrective forces usually 

tend to move the economy back toward the sustainable 

potential level determined by the supply side.

Both supply-side and demand-side economic developments depend on the choices of millions of individuals 

about what and how much to buy, how much to save and 

what assets to hold, and where and how much to work. 

The government plays a crucial role in establishing the legal and institutional framework within which the economy operates and an overall level of government spending and taxes. Once that general framework is in place, 

however, changes in government spending and tax policies influence individuals’ choices only to a limited degree. Decisions by businesses, personal circumstances, 

and preferences play a much larger role in economic performance than do modest changes in the federal government’s fiscal policies.

Supply-Side Effects

The supply-side effects of the policies in the President’s 

budget could include influences on the quantity and 

quality of labor, the size and composition of the capital 

stock, and technological progress. Changes in any or all 

of those factors are capable of permanently altering potential output.

The Quantity and Quality of Labor. The overall quantity 

and quality of labor is an important determinant of potential output. Put simply, a long-term increase in the 

overall number of hours worked in the economy raises its 

potential to generate output. Moreover, increases in 

workers’ educational attainment, level of training, and 

experience or degree of effort on the job raise the quality 

of each hour worked, which will also increase potential 

output. Some analysts argue that certain policies in the 

President’s budget, such as extending expiring tax cuts, 

will ultimately affect the quality of labor. However, the 

channels through which budgetary policies influence that 

supply-side variable and the pace at which the effects occur are not well understood. For that reason, CBO’s analysis concentrated on the hours of labor supplied, which 

the President’s proposals would affect in two main ways.

First, several provisions, such as the extension of the child 

tax credit and the exemption of some dividend and capital gains income from taxation, would increase people’s 

after-tax income but not significantly change the marginal tax rates on income resulting from labor. (In general, the marginal rate is the rate on the last dollar of income.) A rise in after-tax income without a change in 

those marginal rates tends to reduce the number of hours 

of labor that people supply because they can maintain the 

same standard of living with less work. 

Second, provisions in the President’s budget, such as the 

extension of the reductions in marginal tax rates enacted 

in the Economic Growth and Tax Relief Reconciliation 

Act of 2001, would both increase the compensation after 

taxes for each additional hour of work and boost after-tax 

income overall. Evaluating how such rate reductions affect the number of hours people work is complicated by 

the fact that the cuts have opposing effects: people earn 

more for each extra hour they work, which tends to en1. Economists refer to government outlays for current goods and services (as opposed to outlays for transfer payments, interest on government debt, or long-lasting investments such as highways or 

military equipment) as “government consumption” because it 

reduces the resources available for investment in much the same 

way that private consumption does.
CHAPTER TWO THE ECONOMY UNDER THE PRESIDENT’S BUDGET AND UNDER CBO’S BASELINE POLICY ASSUMPTIONS 29

Table 2-2.

CBO’s Estimates of Effective Marginal Federal Tax Rates on Labor Income

(Percent)

Source: Congressional Budget Office.

Note: The effective federal marginal tax rate on income from labor is the share of the last dollar of such income taken by taxes—specifically, 

federal individual income and payroll taxes.

courage work, but they can earn the same after-tax income working fewer hours, which tends to discourage 

work. Most studies find, however, that on balance, reductions in marginal tax rates such as those the President is 

proposing to extend will increase the hours of labor supplied, primarily because the cuts will draw secondary 

earners (for example, the spouse of a household’s primary 

breadwinner) into the labor force. 

To summarize as a single number the changes proposed 

by the President in the schedule of marginal tax rates, 

CBO estimated the impact those changes would have on 

the effective marginal tax rate on labor income—the rate 

at which the average additional dollar of compensation 

for labor is taxed (see Table 2-2). The largest changes in 

rates occur for the years 2011 to 2014, when the President proposes to extend various expiring tax cuts. For 

those years, the average effective marginal tax rate on labor income is about 5 percent lower under the President’s 

proposals than under the current-law policies assumed in 

CBO’s baseline.

The President’s proposals could also influence the level of 

the capital stock (as discussed in the next section), potentially affecting the hours of labor supplied by changing 

people’s productivity and wages. If the proposals reduced 

investment, the stock of productive capital would be 

smaller and wages would be lower, which would discourage work. (Increased investment would imply the opposite results.) 

Another way in which the President’s proposals could affect the hours worked in the economy would be by 

changing people’s expectations about future policies. Under the President’s budget, the cumulative federal budget 

deficit over the 2005-2014 period would grow. That rise 

could lead people to expect that at some time after that 

period, fiscal policy would have to change to finance the 

increase in the federal government’s interest payments on 

the money it borrowed to cover the bigger deficit. Either 

taxes would have to be raised or spending cut.2

 If people 

expected to have to pay more in taxes or receive less in 

services or transfer payments (such as Social Security benefits), they might try to work and save more now so as to 

have more resources to compensate for the larger burden 

in the future. In addition, if people expected to face 

higher tax rates on their income from labor in the future, 

they might try to work more before the rates went up and 

then work less when the rates were higher.

Calendar

Year

2004 27.8 27.8 0 0

2005 28.7 28.0 -0.6 -2.2

2006 28.7 28.7 -0.1 -0.3

2007 29.0 28.9 -0.1 -0.3

2008 29.2 29.2 0 0

2009 29.4 29.4 0 0

2010 29.7 29.7 0 0

2011 31.5 29.9 -1.6 -5.2

2012 31.8 30.2 -1.6 -4.9

2013 31.9 30.4 -1.5 -4.6

2014 32.1 30.7 -1.4 -4.4

Difference

Percent

Tax Rate Under the

President's Budget

Tax Rate Under

Current Law Percentage Points

2. For some time, the shortfall could be made up by running larger 

deficits. But the federal government could not follow such an 

approach indefinitely, because the interest costs would compound 

over time.
30 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

It is difficult to gauge, however, the degree to which such 

foresight influences people’s decisions. Also unclear is the 

time horizon that people consider in making plans and 

the future changes in policy they actually expect. To illustrate the importance of those factors, CBO used various 

assumptions in its analysis about the extent of people’s 

foresight and the expectations they might have about future policies. 

In sum, CBO estimates that the President’s budgetary 

proposals would have relatively small effects, on average, 

on the number of hours worked over the first five years of 

the 2005-2014 period, and those effects could be positive 

or negative. Over the second five years of that period, 

however—during which the reductions in marginal tax 

rates are largest relative to CBO’s baseline policy assumptions—the proposals would increase the hours of labor 

supplied.

The Size and Composition of the Capital Stock. The President’s budgetary policies would influence the size of the 

capital stock primarily by affecting consumption and 

therefore investment. The President’s proposals would directly lower government consumption of goods and services relative to the level assumed in CBO’s baseline. That 

reduction would tend to boost private investment in productive capital by increasing the resources available for 

that purpose.3

The President’s budgetary policies would also produce 

offsetting influences on private consumption. The reductions in taxes that the budget proposes would increase after-tax income, which would tend to increase consumption. Other things being equal, higher consumption 

could reduce investment and crowd out private capital. 

But some of the President’s tax proposals would tend to 

reduce consumption in the years they were in effect—

including proposals such as extending EGTRRA’s reductions in marginal income tax rates, extending the reductions in tax rates on dividends and capital gains enacted 

in the Jobs and Growth Tax Relief Reconciliation Act of 

2003, and expanding tax-free savings accounts. Those 

proposals would provide an incentive to save by lowering 

the effective marginal tax rates on capital income and 

thus increasing the after-tax rate of return on savings. 

(For a detailed analysis of the President’s proposals concerning dividend and capital gains taxation, savings accounts, and the estate tax, see Appendix A.)

Again, to summarize in one number the effects of the 

President’s proposals on the rate of return on savings, 

CBO calculated the average effective marginal tax rate on 

capital income. That calculation was performed under 

two sets of policy assumptions: one comprising the President’s policies and the other, the current-law policies in 

CBO’s baseline (see Table 2-3). In both instances, the estimated effective tax rates resulting from that analysis are 

below all but the lowest statutory marginal tax rate because some capital income (for example, the interest that 

flows into tax-free savings accounts or pension funds) is 

not taxed. According to CBO’s estimates, by 2014, the effective marginal tax rate on capital income would be almost 9 percent lower under the President’s proposals than 

under CBO’s baseline.

The proposed reductions in taxes on capital income 

would raise the rate of return on savings and affect consumption in two opposing ways (just as lowering the 

marginal tax rate on labor income would have opposing 

effects on the labor supply). The higher return on savings 

that the reductions would imply would increase the gain 

in savers’ future consumption for every dollar they saved, 

which would tend to increase saving and reduce current 

consumption. But the higher return would also increase 

savers’ wealth by boosting their after-tax income, both 

now and in the future, which would tend to push up 

their current consumption. On balance, the implications 

for consumption could be either positive or negative. The 

general conclusion by economists analyzing empirical 

data is that the return on savings has a relatively small effect on how much people spend. Nevertheless, to cover 

other possibilities, CBO included in its analysis a range of 

assumptions about the rate of return’s effect on consumption. Some of CBO’s estimates incorporate the assumption that the rate has little or no effect on how 

much people spend; others assume that increasing the 

rate of return on savings will reduce consumption—and 

increase saving—significantly.

Finally, as described earlier, the higher (relative to CBO’s 

baseline) cumulative 10-year deficit under the President’s 

budgetary proposals might lead some people to anticipate 

changes in policy in the future. If people expected higher 

3. Some of the supportive effect on investment of that lower government consumption would probably be offset by a decline in the 

amount of foreign capital flowing into the United States. However, because most of the returns on foreign investments accrue to 

foreigners, a decline in foreign capital flows would not commensurately reduce the resources available to U.S. firms and consumers in the long run.
CHAPTER TWO THE ECONOMY UNDER THE PRESIDENT’S BUDGET AND UNDER CBO’S BASELINE POLICY ASSUMPTIONS 31

Table 2-3.

CBO’s Estimates of Effective Marginal Federal Tax Rates on Capital Income

(Percent)

Source: Congressional Budget Office.

Note: The effective federal marginal tax rate on income from capital is the share of the last dollar of such income taken by taxes—specifically, federal individual income and corporate income taxes.

taxes, lower transfer payments, or fewer government services in the years to come, they might reduce their spending and build up their savings to compensate for those 

anticipated policies. CBO used a range of assumptions 

about those expectations in its analysis. Some of CBO’s 

estimates indicated that, on average, the capital stock 

would be larger under the policies in the President’s budget than under those in CBO’s baseline; others suggested 

that it would be smaller. Yet in most cases, the differences 

are modest. The most positive effects on the capital stock 

come under the most dramatic assumption about foresight—that people care just as much for future generations as they do for themselves. In effect, if people have a 

sufficiently long time horizon, they may recognize and 

counter the deleterious effects of fiscal policy on the formation of capital and thus on future standards of living. 

In addition to changes in the level of the capital stock, 

changes in the mix of different types of capital within 

that stock can affect potential output. Of the policies in 

the President’s budget, the proposal to extend the reduction in tax rates on corporate dividends and capital gains 

would probably have the largest effect on the stock’s composition because it would encourage a shift of capital 

from the noncorporate to the corporate sector by lessening the taxation of corporate income. Some corporate income is taxed once at the level of the firm, through the 

corporate income tax, and again at the personal level, 

through the individual income tax on dividends and capital gains. That tax treatment distorts the way that capital 

is allocated in the economy because it discourages investing in the corporate sector relative to investing in the 

housing and noncorporate business sectors. As a result, 

less capital is held in the corporate sector than is optimal 

for the economy’s efficient operation. 

The taxation of dividends and capital gains also encourages firms to finance investment by borrowing rather 

than by issuing stock. Interest payments on debt are deducted from taxable profits at the corporate level and so 

are taxed only once, at the individual level, when people 

receive them as income. That tax policy may influence 

firms’ decisions about financing and lead to economic inefficiencies. Reducing the tax on dividends and capital 

gains would lessen those inefficiencies and thereby 

increase overall economic output.

Technological Progress. The President’s budgetary policies might conceivably affect the economy by influencing 

the rate of technological progress—an important consideration because new and improved processes and products are the source of most long-term growth in productivity. Economists, however, lack a basis for estimating 

how fiscal policy influences technological innovation. Because so little is understood about the genesis of such inCalendar

Year

2004 13.5 13.3 -0.2 -1.5

2005 13.6 13.3 -0.2 -1.7

2006 13.6 13.3 -0.3 -2.0

2007 13.6 13.3 -0.3 -2.1

2008 13.6 13.3 -0.3 -2.4

2009 13.9 13.3 -0.6 -4.5

2010 14.0 13.3 -0.7 -4.9

2011 14.5 13.3 -1.3 -8.7

2012 14.6 13.3 -1.3 -8.7

2013 14.6 13.3 -1.3 -8.7

2014 14.6 13.3 -1.3 -8.7

Percent

Tax Rate Under the

President's Budget

Tax Rate Under

Current Law Percentage Points

Difference
32 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

novation, CBO has not incorporated in its analysis any 

effects on technological progress from the President’s proposals. 

Demand-Side (Cyclical) Effects 

The federal government’s policies also affect the economy 

by adding to or subtracting from the total demand for 

goods and services. Increases in demand can cause firms 

to temporarily gear up production and hire more workers; decreases in demand can have the opposite effects. 

From a demand-side perspective, budgetary policies that 

reduce consumption (and other purchases) might slow 

the pace of the current cyclical expansion of the U.S. 

economy. 

Demand-side effects, however, can only temporarily raise 

or lower output beyond what it would have been otherwise—with or without demand-side effects, built-in economic forces tend to move output toward its sustainable 

potential level. Moreover, policies that increase demand 

by raising government or private consumption are likely 

to lower output in the long run because they tend eventually to decrease investment and the size of the capital 

stock.

A Description of CBO’s Models

and Their Results

CBO estimated the economic effects of the President’s 

budget relative to CBO’s baseline assumptions by using 

several different models of the economy. Although similar 

in some respects, the models capture different features of 

the economy and reflect different ways of thinking about 

it.

Those models fall into two broad categories. Three estimate only supply-side effects. The other two are commercial macroeconometric models that emphasize the business-cycle aspects of the economy and are designed 

primarily to analyze demand-side effects, although they 

incorporate some supply-side influences as well. (For a 

year-by-year graphic presentation of some of the key inputs into CBO’s various models—the impact of the President’s proposals on effective tax rates on labor and capital 

and on the deficit—see Figure 2-2.)

Ten-Year Analysis of Supply-Side Effects 

CBO used three growth models—a life-cycle growth 

model, an infinite-horizon growth model, and a “textbook” growth model—to analyze the supply-side effects 

of the President’s proposals from 2005 through 2014 (the 

same period that the budget process requires CBO to 

cover in its baseline projections). The models differ in 

part in their assumptions about how far ahead people 

look in making their plans (see Appendix B). The lifecycle model incorporates the assumption that people 

make life-long plans for working and saving but do not 

care about events after their death. By contrast, the infinite-horizon model incorporates the assumption that 

people care as much about the welfare of their descendants as they do about their own. That assumption 

means that people behave as if they will live forever. The 

textbook growth model is not forward-looking—it assumes that people do not explicitly incorporate expected 

future policies into their current plans. 

It is important to note that the estimates CBO produced 

using the life-cycle and infinite-horizon growth models 

are based on the assumption that people behave as if they 

are certain that the assumed budgetary policies—those of 

the President or of CBO’s baseline—will be maintained 

over the 10-year modeling period. In reality, people 

would probably think it possible that the policies could 

change at some point during that time.

Another characteristic of the estimates produced by the 

life-cycle and infinite-horizon models is that they depend 

in part on how the President’s budgetary proposals affect 

people’s expectations about fiscal policy beyond 2014. 

The models both generated two sets of estimates, each of 

which was based on a different assumption about how the 

increased deficits under the President’s budget would 

eventually be financed (the models require such an 

assumption about financing because they are forwardlooking). Under one assumption, people believe that the 

proposals will be financed by gradually reducing government spending on goods and services and on transfer 

payments (as shares of GDP) over the 2015-2024 period. 

(The reductions in the two categories would be proportional to their shares of government spending in CBO’s 

baseline.) Under the other assumption, people believe 

that the proposals will be financed by gradually increasing 

marginal tax rates over the same period.4

Depending on which of the assumptions is used and on 

whether the economy is assumed to be open or closed to 

4. Those financing assumptions differ somewhat from those used in 

last year’s analysis of the President’s budget; see Appendix B for 

details.
CHAPTER TWO THE ECONOMY UNDER THE PRESIDENT’S BUDGET AND UNDER CBO’S BASELINE POLICY ASSUMPTIONS 33

Figure 2-2.

Selected Inputs Used for CBO’s Estimates

Source: Congressional Budget Office.

a. Positive changes reduce the deficit, and negative changes increase it.

b. Changes in the effective federal marginal tax rate on income from capital (in principle, the share of the last dollar of such income taken by 

federal individual income and corporate income taxes).

c. Changes in the effective federal marginal tax rate on income from labor (in principle, the share of the last dollar of such income taken by 

federal individual income and payroll taxes).

flows of foreign capital, the life-cycle model projects that 

under the President’s proposals, economic output will fall 

by between 0.1 percent and 0.2 percent over the 2005-

2009 period compared with CBO’s baseline and will rise 

by between 0.4 percent and 0.5 percent over the 2010- 

2014 period (see Table 2-4). The difference in the projected effects over the two periods stems partly from the 

assumption that people will shift some hours of work 

from the earlier to the later period, when tax rates are 

lower (relative to CBO’s baseline assumptions).

The infinite-horizon model projects that the President’s 

proposals will subtract between zero and 0.2 percent from 

GDP over the first five years but then raise output by between 0.3 percent and 0.7 percent (relative to CBO’s 

baseline) over the second five years. Again, the difference 

in projected effects arises partly because people are estimated to shift some of their hours of work from one period to another. (See Table 2-5 for details of CBO’s baseline projections of GDP and other economic variables.) 

In the infinite-horizon model, estimates produced under 

the assumption that taxes will eventually increase after 

2014 tend to suggest more positive effects on output over 

the next 10 years than do estimates that assume that government spending will be cut. The reason is that people—as the model represents them—will work and save 

more inside the 10-year projection period to prepare for a 

tax increase or cut in transfer payments, but they will not 

do so for a reduction in government spending on goods 

and services. (The models incorporate the assumption 

that people do not value such spending.)

The differing assumptions about funding have a greater 

effect on the infinite-horizon model than on the life-cycle 

model because people as represented in the infinite-horizon model know that they (or their descendants, whom 

they care about as much as they do themselves) are going 

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-2.0

-1.6

-1.2

-0.8

-0.4

0.0

0.4

0.8

-10

-8

-6

-4

-2

0

2

4

Percent

Budget's Impact on the Deficit Under CBO's Baseline

Economic Assumptions (Left scale)

Changes in the

Effective Tax Rate on

Labor Income

(Right scale)

Changes in the

Effective Tax Rate on

Capital Income

(Right scale)

Percentage of GDP

b

c

a
34 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Table 2-4.

CBO’s Estimates of How the President’s Budget

Would Affect Real Gross Domestic Product

(Average percentage change from CBO’s baseline)

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

The “textbook” growth model is an enhanced version of a model developed by Robert Solow. The life-cycle growth model, developed

by CBO, is an overlapping-generations general-equilibrium model. The infinite-horizon growth model is an enhanced version of a 

model first developed by Frank Ramsey. The models by Macroeconomic Advisers and Global Insight, which are available commercially, 

are designed to forecast short-term economic developments. The various models reflect a wide range of assumptions about the 

extent to which people are forward-looking in their behavior: in the textbook model and those by Macroeconomic Advisers and Global 

Insight, people have the least foresight, whereas in the infinite-horizon model, foresight is perfect and extends infinitely to include a 

full consideration of effects on descendants.

In models with forward-looking behavior, CBO had to make assumptions about how the President’s budget would be financed after 

2014. CBO chose two alternatives—cutting government consumption and transfer payments or raising marginal tax rates.

to bear the burden of any future increase in taxes. By contrast, people as represented in the life-cycle model face 

some probability of retiring or dying before the increase 

occurs. (An increase in marginal tax rates has less effect 

on retirees because they do not earn and pay taxes on labor income.)

CBO used the textbook growth model to produce estimates under two assumptions about the degree to which 

people alter their hours of labor in response to changes in 

marginal tax rates: a “low” assumption, in which there is 

little response, and a “high” assumption, in which the response is at the upper end of the consensus of economists’ 

High (Hours worked respond strongly to tax-rate changes) 0.1 0.2

Low (Hours worked respond weakly to tax-rate changes) 0 0

Lower government spending after 2014 -0.1 0.4

Higher taxes after 2014 -0.1 0.4

Lower government spending after 2014 -0.2 0.5

Higher taxes after 2014 -0.2 0.5

Lower government spending after 2014 -0.2 0.3

Higher taxes after 2014 0 0.7

0.3 n.a.

0.2 n.a.

0.1 n.a.

-0.3 n.a.

Supply-Side and Demand-Side Contributions

Macroeconomic Advisers

Global Insight

Growth Models

With Forward-Looking Behavior

Macroeconometric Models

Without Forward-Looking Behavior

Supply-Side Contribution

2005 to 2009 2010 to 2014

Macroeconomic Advisors

Global Insight

Closed-Economy Life-Cycle Growth Model

Open-Economy Life-Cycle Growth Model

Infinite-Horizon Growth Model

Textbook Growth Model
CHAPTER TWO THE ECONOMY UNDER THE PRESIDENT’S BUDGET AND UNDER CBO’S BASELINE POLICY ASSUMPTIONS 35

Table 2-5.

CBO’s Year-by-Year Forecast and Projections for Fiscal Years

2004 Through 2014

Sources: Congressional Budget Office; Department of Commerce, Bureau of Economic Analysis; Department of Labor, Bureau of Labor Statistics; Federal Reserve Board.

Note: Percentage change is year over year.

a. The consumer price index for all urban consumers.

b. The employment cost index for wages and salaries only, private-industry workers.

Estimated

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Nominal GDP 

(Billions of dollars) 10,829 11,469 12,091 12,682 13,236 13,862 14,519 15,187 15,862 16,562 17,301 18,070

Nominal GDP 

(Percentage change) 4.4 5.9 5.4 4.9 4.4 4.7 4.7 4.6 4.4 4.4 4.5 4.4

Real GDP

(Percentage change) 2.8 4.7 4.3 3.5 2.6 2.8 2.8 2.7 2.5 2.5 2.5 2.5

GDP Price Index

(Percentage change) 1.5 1.2 1.1 1.3 1.7 1.9 1.9 1.9 1.9 1.9 1.9 1.9

Consumer Price Indexa

(Percentage change) 2.4 1.7 1.6 2.0 2.2 2.2 2.2 2.2 2.2 2.2 2.2 2.2

Employment Cost Indexb

(Percentage change) 2.8 2.5 2.5 2.6 3.1 3.4 3.4 3.4 3.4 3.4 3.4 3.4

Unemployment Rate

(Percent) 6.0 5.9 5.4 5.0 5.1 5.2 5.2 5.2 5.2 5.2 5.2 5.2

Three-Month Treasury 

Bill Rate (Percent) 1.1 1.1 2.6 3.8 4.5 4.6 4.6 4.6 4.6 4.6 4.6 4.6

Ten-Year Treasury

Note Rate (Percent) 3.9 4.5 5.3 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5

Tax Bases

(Billions of dollars)

Corporate book profits 819 938 1,215 1,353 1,354 1,358 1,357 1,382 1,435 1,500 1,569 1,645

Wages and salaries 5,051 5,257 5,563 5,859 6,134 6,435 6,744 7,057 7,370 7,693 8,033 8,386

Tax Bases

(Percentage of GDP)

Corporate book profits 7.6 8.2 10.0 10.7 10.2 9.8 9.3 9.1 9.0 9.1 9.1 9.1

Wages and salaries 46.6 45.8 46 46.2 46.3 46.4 46.5 46.5 46.5 46.5 46.4 46.4

 Forecast Projected
36 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

empirical estimates.5 (The model makes no assumption 

about future financing because it is not forward-looking.) 

Under the low assumption, the President’s budgetary proposals would have little effect on GDP in either the 

2005-2009 or the 2010-2014 period. Under the high assumption, the proposals would raise GDP by about 0.1 

percent over the 2005-2009 period and by about 0.2 percent over the 2010-2014 period.

The textbook growth model’s results differ from those of 

the other two growth models largely because it does not 

incorporate forward-looking behavior: people, as represented by the model, do not shift hours of labor from the 

earlier to the later period and do not work and save more 

in anticipation of a tax increase after 2014. In addition, 

unlike the life-cycle and infinite-horizon models, the textbook growth model does not incorporate any direct effects on private consumption from lower marginal (as opposed to average) tax rates and higher pretax interest 

rates. 

The effects on the economy from the President’s proposed changes in fiscal policy would in turn affect the 

federal budget through 2014 (see Tables 2-1 and 2-6). 

The President’s proposals are projected to reduce the cumulative deficit over the 2005-2009 period by $96 billion under the economic assumptions incorporated in 

CBO’s baseline. Under the various assumptions used in 

the growth models that CBO employed in its analysis, 

the economic effects of the President’s proposals over that 

period could add as much as $8 billion to that reduction 

or subtract as much as $24 billion from it. 

For the 2010-2014 period, the President’s budgetary proposals are projected to increase the cumulative deficit by 

$822 billion under the baseline’s economic assumptions. 

The economic effects of the President’s proposals over 

that period, according to the models, could lessen that increase by as little as $4 billion or as much as $106 billion.

Five-Year Analysis Including Demand-Side Effects 

CBO turned to macroeconometric forecasting models 

created by two private forecasting firms, Macroeconomic 

Advisers (MA) and Global Insight (GI), to analyze both 

the demand-side and supply-side effects of the President’s 

budgetary proposals on the economy over the next five 

years. Although the MA and GI models include embedded growth models, their design concentrates on demand-side (cyclical) economic effects. Such effects are increasingly harder to estimate as the projection extends 

into the future. Therefore, CBO used those models to 

produce estimates only for the first five years of the 2005-

2014 projection period. 

Like the textbook growth model, the MA and GI models 

are not forward-looking—people as the models represent 

them do not behave as though they have specific expectations about future policies or economic developments. 

Instead, people respond to economic changes in the same 

way as they have in the past, regardless of the source of 

those changes. For example, they react to the tax proposals in the President’s budget (which would raise disposable income) by increasing their purchases to about the 

same degree as they have, on average, in the past when 

disposable income rose. However, in reality, people might 

increase their spending by a smaller amount in response 

to a tax cut than they would in response to some other 

change that raised income (such as an increase in productivity) because they might feel that the tax cut was more 

likely to be reversed in the future. 

The lack of forward-looking behavior in the macroeconometric models implies that specific policy changes 

scheduled to occur in the future do not affect the current 

behavior of people represented in the model unless special out-of-model adjustments are made to mimic such 

behavior. For example, the President’s proposal to extend 

EGTRRA’s tax cuts would reduce taxes from 2011 to 

2014 compared with the levels in CBO’s baseline. The reduced taxes would increase the amount of after-tax income that people expected in the future, which might 

cause them to boost their spending today (as the forwardlooking models imply). In the macroeconometric models, 

however, those tax cuts affect consumption only when 

they occur.

5. See Congressional Budget Office, Labor Supply and Taxes (January 

1996). 
CHAPTER TWO THE ECONOMY UNDER THE PRESIDENT’S BUDGET AND UNDER CBO’S BASELINE POLICY ASSUMPTIONS 37

Table 2-6.

The Budgetary Implications of the Macroeconomic Effects

(Cumulative change from CBO’s estimate of the President’s budget, in billions of dollars)

Source: Congressional Budget Office.

Notes: n.a. = not applicable.

Numbers in this table reflect the positive or negative effects on the deficit of the economic impacts shown in Table 2-4. They do not 

include the estimated cost of the President’s budgetary proposals under CBO’s baseline economic assumptions. The total impact of 

the proposals on the deficit, including both those direct costs and the secondary effects shown above, appear in Table 2-1.

The “textbook” growth model is an enhanced version of a model developed by Robert Solow. The life-cycle growth model, developed

by CBO, is an overlapping-generations general-equilibrium model. The infinite-horizon growth model is an enhanced version of a 

model first developed by Frank Ramsey. The models by Macroeconomic Advisers and Global Insight, which are available commercially, 

are designed to forecast short-term economic developments. The various models reflect a wide range of assumptions about the 

extent to which people are forward-looking in their behavior: in the textbook model and those by Macroeconomic Advisers and Global 

Insight, people have the least foresight, whereas in the infinite-horizon model, foresight is perfect and extends infinitely to include a 

full consideration of effects on descendants.

In models with forward-looking behavior, CBO had to make assumptions about how the President’s budget would be financed after 

2014. CBO chose two alternatives—cutting government consumption and transfers or raising marginal tax rates.

High (Hours worked respond strongly to tax-rate changes) 8 39

Low (Hours worked respond weakly to tax-rate changes) 4 4

Lower government spending after 2014 -14 59

Higher taxes after 2014 -17 53

Lower government spending after 2014 -19 74

Higher taxes after 2014 -24 72

Lower government spending after 2014 -19 45

Higher taxes after 2014 -1 106

31 n.a.

33 n.a.

14 n.a.

-14 n.a.

2005 to 2009 2010 to 2014

Macroeconomic Advisors

Global Insight

Closed-Economy Life-Cycle Growth Model

Open-Economy Life-Cycle Growth Model

Infinite-Horizon Growth Model

Textbook Growth Model

Macroeconomic Advisers

Global Insight

Growth Models

With Forward-Looking Behavior

Macroeconometric Models

Supply-Side and Demand-Side Contributions

Without Forward-Looking Behavior

Supply-Side Contribution
38 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

The projections by the MA and GI models also required 

an adjustment relating to the supply of labor. Those 

models, like the textbook growth model, do not incorporate the effects of taxes on the number of hours worked, 

so CBO adjusted the models’ equations to incorporate its 

own estimates of those effects.6

CBO produced two sets of estimates to illustrate the 

magnitude of demand-side effects in the models. For one 

set, CBO ran the models using the standard assumption 

that monetary policy would not allow both demand- and 

supply-side effects. For the second set, CBO attempted to 

isolate the supply-side effects by altering interest rates in 

such a way as to hold the unemployment rate at the level 

projected in CBO’s baseline. That approach produced an 

estimate of the implications of the proposals for potential 

(or noncyclical) GDP.7

 CBO took the difference between 

the two sets of projections as its estimate of the demandside effects of the President’s proposals on various economic variables.

The MA and GI models differed in their estimates of the 

effects of the policies in the President’s budget compared 

with the policies in CBO’s baseline (see Table 2-4). The 

GI model predicted that together, the demand- and supply side effects of those changes would subtract about 0.3 

percent from GDP, on average, between 2005 and 2009. 

The MA model projected that the changes would add 

about 0.1 percent to output. 

The results differ because of the divergence in the models’ 

estimates of the magnitude of the opposing effects on demand under the President’s proposals. The policies proposed in the 2005 budget would cut government spending, which would reduce demand. But the proposal to 

extend the reduction in capital gains and dividend taxation would lead to an increase in stock prices, which 

would increase people’s wealth and therefore consumption, boosting demand. In the GI model’s projections, the 

effect of lower government spending outweighs the effect 

of increased consumption. The MA model, however, incorporates a much stronger response by consumption to 

changes in wealth, and therefore its estimates show the 

proposal increasing demand on a net basis.

In contrast to the models’ diverging estimates of demandside effects, their estimates of the supply-side impacts 

were quite similar. The macroeconometric models projected that the supply-side effects of the President’s budgetary proposals would increase output by between 0.2 

percent and 0.3 percent.

The projected economic impacts of the proposals would 

in turn affect the budget. According to the GI model’s estimates, the supply-side and cyclical effects of the President’s proposals could subtract $14 billion from the $96 

billion reduction in the deficit projected for the 2005-

2009 period under the baseline’s economic assumptions 

(see Table 2-6). By the MA model’s projections, the proposals’ impacts on the economy could add $14 billion to 

deficit reduction over the same period.

6. Those estimates accounted for the effects of changes in both marginal tax rates and after-tax income under the President’s proposals, using data on a large sample of taxpayers and incorporating a 

larger response to changes in marginal tax rates among secondary 

earners than among primary earners.

7. Because the decrease in interest rates stems mostly from demandside effects and the Federal Reserve’s efforts to offset them, using 

those changes in interest rates to calculate budgetary effects 

ascribed to the supply side makes little sense. Instead, in its estimates of those effects in Tables 2-1 and 2-6, CBO used interest 

rate changes that reflected only the predicted changes in the marginal product of capital (the amount produced by one additional 

unit of capital)—the true supply-side effect.
A

The Potential Economic Effects of Selected

Proposals in the President’s 2005 Budget

Three provisions in the President’s 2005 budget—

the proposals to extend the reductions in dividend and 

capital gains taxes beyond 2008, to expand the availability of tax-free savings accounts, and to extend the repeal 

of the estate tax—have especially complex economic impacts. Discussed below are the factors that the Congressional Budget Office (CBO) considered and the methods 

it used in assessing those impacts. (CBO’s analysis of the 

overall economic effects of the President’s budgetary proposals is described in Chapter 2.)

Extend the Reductions in Dividend and 

Capital Gains Taxes

In 2003, the Jobs and Growth Tax Relief Reconciliation 

Act (JGTRRA) reduced the tax rates applicable to both 

dividends and capital gains to a bottom rate of 5 percent 

and a top rate of 15 percent. Previously, dividends would 

have been subject to the same tax rates as ordinary income—ranging from 15 percent to 35 percent—and 

most capital gains would have been subject to rates of 

8 percent, 10 percent, and 20 percent. However, 

JGTRRA’s lower rates expire in 2008, and the President, 

in his 2005 budget, is proposing to extend them permanently.

The rate reductions were enacted in part to reduce overall 

taxation of corporate profits. Some corporate profits are 

taxed once under the corporate income tax and then 

again, when people receive dividends and realize capital 

gains on stock sales—gains brought about by the firm’s 

reinvesting of its profits. Lowering the tax rates that individuals face on the two types of income reduces the total 

rate of taxation.

JGTRRA’s lower tax rates not only reduce the taxation of 

corporate income but also cut taxes on some income that 

is currently taxed only once. A substantial portion of taxable capital gains arises from investments whose earnings 

are not subject to the corporate income tax, such as gains 

on individually held real estate. The lower capital gains 

tax rate will lower the level of taxation on those investments as well. 

To some extent, the impacts on the economy of reducing 

the tax rates on dividends and capital gains are already being felt because the lower rates are currently in effect. 

However, the short duration of those rates lessens their effect on investment and the capital stock. Investments in 

productive capital take time to implement, and firms are 

unlikely to fully adjust their long-term investment plans 

in response to temporary changes in dividend and capital 

gains taxation. Thus, some portion of the impacts of the 

lower rates can be expected to occur only if the proposed 

extension of those rates takes effect. 

One such impact is that by reducing the overall taxation 

of capital income, a cut in taxes on dividends and capital 

gains might be expected to lower the cost of financing for 

businesses. (They could pay investors less before taxes to 

yield the same after-tax return.) But how much the cost 

of capital might drop is unclear. Some analysts argue that 

firms’ financial strategies imply that the reduction in the 

cost of capital will reflect only the cut in taxes on capital 

gains. Others hold that the reduction will reflect the cut 

in taxes on both gains and dividends.1

APPENDIX

1. George R. Zodrow, “On the ‘Traditional’ and ‘New’ Views of Dividend Taxation,” National Tax Journal, vol. 44, no. 4, part 2 

(December 1991), pp. 497-509.
40 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

Corresponding to the disagreement among analysts about 

the size of the drop in the cost of capital is a difference of 

opinion about how much the values of firms’ stock might 

rise. (Share values rise because the tax cuts increase the 

after-tax return to shareholders.)

2

 The view of corporate 

finance that predicts a relatively large increase in those 

values predicts a relatively small decrease in the cost of 

capital, and vice versa. 

In the absence of a consensus, CBO has adopted a middle-ground estimate of the effects of the President’s proposal on the cost of capital for firms and on share values.

High values for stock shares lead to more consumption 

among shareholders (the so-called wealth effect). Therefore, the President’s proposal will help boost overall demand in the short run. But the more it helps demand by 

raising consumption, the more it will hurt supply in the 

long run by lowering saving and investment.

Another impact of extending the tax cuts on capital gains 

and dividends is that it is likely to lessen the disadvantage 

that the corporate sector now faces in the competition for 

capital. For example, although under current law some 

income from the corporate sector is taxed twice, income 

from small businesses is taxed only once (at the personal 

level), and the value of housing services from owneroccupied housing is not taxed at all. That disparity in tax 

treatment leads to less investment in the corporate sector 

than may be optimal for economic output. Lowering 

taxes on firms would allow them to attract additional capital from the housing and small-business sectors and in 

general improve the economy’s efficiency. It might, however, conflict with other policy goals, such as support for 

owner occupancy of homes or for unincorporated businesses.

Yet another impact of the proposal is that it would affect 

firms’ financial behavior in two ways: it would make equity financing more attractive relative to debt financing, 

and it would make the payment of dividends more attractive relative to the retention of earnings. Currently, firms 

can deduct interest payments on debt from corporate income, so those payments are taxed only once, at the personal level. (That is, the individual who receives the payment pays the tax.) But if a firm finances a project by 

issuing stock (equity financing), some of the returns on 

the investment that the project generates are taxed at 

both the corporate and personal levels. The President’s 

proposal would narrow that disparity in tax treatment.

The proposed reduction in the taxation of dividends and 

capital gains would also interact with some of the President’s other proposals and with current law. For instance, 

the President’s proposal to boost the amount that people 

could deposit in tax-free savings accounts (discussed below) would increase the share of personal assets held in 

such accounts—duplicating some of the effect that the 

proposal to cut the tax on dividends and capital gains 

would have on the cost of capital and on its allocation 

among sectors of the economy. However, the expanded 

accounts would partly undo the impact that the dividend/capital gains proposal would have in bolstering equity financing because the interest earned on assets in the 

accounts would not be taxed at either the personal or the 

corporate level. That lessening of the proposal’s impact 

on equity financing would be intensified by the combined effect of the two policies in increasing the proportion of interest-bearing assets in tax-free accounts: the incentive to hold equities in such accounts would be 

weakened if their returns already faced lower tax rates. 

CBO incorporated the effects of the dividend/capital 

gains proposal in its analysis in two ways. For the macroeconometric models, CBO estimated the proposal’s effect 

on the cost of capital in different economic sectors and 

on the values of stock shares. It then incorporated those 

estimates into the models, and the models’ equations estimated the ultimate effect on the economy.

For the growth models, CBO estimated the proposal’s 

overall effect on the average cost of capital and incorporated that calculation. Those models, however, have no 

mechanism to incorporate the effect of the reallocation of 

capital. To take account of that impact, CBO reviewed 

research on how reallocation might influence output, determined a midrange estimate, and added that amount to 

the models’ underlying estimates of the effect on output. 

The procedure added an average of 0.07 percent to the 

proposal’s projected effect on gross domestic product over 

the 2005-2014 period in the growth models.

Expand Tax-Free Savings Accounts

The President's budget includes a proposal that is designed to both consolidate and expand the current system 

of tax-free savings accounts for retirement and other purposes, such as education. Two new kinds of accounts 

2. Over time, however, increased investment will enlarge the capital 

stock, in turn reducing the pretax rate of return and offsetting at 

least some of the impact of the reduction in taxes.
APPENDIX A THE POTENTIAL ECONOMIC EFFECTS OF SELECTED PROPOSALS IN THE PRESIDENT’S 2005 BUDGET 41

would be created: retirement savings accounts (RSAs) and 

lifetime savings accounts (LSAs). The RSA would function in some ways like a Roth individual retirement account (IRA)—that is, taxes would not be deferred on 

contributions, as they are for contributions to traditional 

IRAs, but the interest that the accounts earned would accrue tax-free. In contrast to Roth IRAs, however, RSAs 

would be available to all workers (and their spouses) regardless of income; they would also have higher limits on 

contributions and allow penalty-free withdrawals at a 

slightly earlier age. The proposal would eliminate further 

tax deferrals for IRA contributions.

Like the RSAs, the proposed lifetime savings accounts 

would face tax treatment similar to that governing Roth 

IRAs. However, unlike Roth IRAs or RSAs, LSAs would 

be open to everyone, regardless of age, income, or employment status, and participants could withdraw funds 

at any time for any reason. Taxpayers could also use LSAs 

to consolidate other savings plans, including Coverdell 

education savings accounts and qualified state tuition 

plans.

CBO estimates that the new savings accounts that the 

President has proposed would have little effect on the 

economy, on average, through 2014. Most taxpayers 

would simply save the same amount in one of the new accounts as they would have saved in one of their present 

tax-free accounts. One possible outcome of implementing the new accounts is that people who currently have 

assets in taxable accounts will reduce their tax liability by 

selling those assets and putting the cash from the sale into 

the new accounts. However, that action would create no 

new saving and thus would have no effect on the total 

amount of private saving. Most new saving would involve 

small amounts set aside by taxpayers with few taxable assets to shift.

Beyond 2014, the effects of the proposal could be greater 

than those just described. In those years, CBO estimates, 

the proposal would have a modestly positive impact on 

saving, an effect that would increase for some time.

Extend the Repeal of the Estate Tax 

The President’s proposal to extend the repeal of the estate 

and gift tax beyond 2010 (its scheduled expiration date) 

could have varying effects on consumption and saving, 

depending on people’s motives for leaving bequests. 

There is little consensus about the dominant form of 

those motives or even about whether bequests are typically the result of a deliberate saving plan. If they are not, 

the repeal of the estate tax will not encourage saving. 

Moreover, those who believe that estate taxes affect consumption and saving disagree about the direction of that 

effect. A lower estate tax makes it cheaper for people to 

leave money to their heirs, which could encourage people 

to save more to leave larger bequests. But a lower estate 

tax also means that people can leave the same after-tax bequest with a smaller amount of savings, which might induce them to save less. Moreover, to the extent that a 

lower estate tax increases the size of bequests after taxes, 

potential recipients might reduce their saving. Some opponents of the estate tax argue that it has a particularly 

negative effect on the creation of new small businesses, 

but there is little evidence available on that position.

Because so little is understood about how the permanent 

repeal of the estate tax would affect consumption, CBO’s 

estimates incorporated the assumption that people would 

alter their consumption and saving in the same way as 

they altered them, on average, in response to past spending or tax changes that affected the budget deficit. That 

assumption implies that people will spend some of their 

increased after-tax income, boosting total consumption.

B

The Models Used to Analyze the

Macroeconomic Effects of the 

President’s Budget Over the Next Decade

The Congressional Budget Office (CBO) used three 

models to estimate the supply-side effects of the President’s budget from 2005 to 2014: a “textbook” growth 

model, a life-cycle growth model, and an infinite-horizon 

growth model. (The estimates resulting from those models are presented in Chapter 2.) 

The textbook growth model, which CBO uses to project 

the economy’s potential output for the agency’s 10-year 

economic baseline, is an enhanced version of the model 

developed by Robert Solow, a pioneer in the theory of 

growth accounting.1

 The textbook growth model assumes that output is determined by the number of hours 

of labor supplied by workers, the size and composition of 

the capital stock (for example, factories and information 

systems), and total factor productivity—which represents 

the state of technological know-how. The model is not 

forward-looking—people base their decisions entirely on 

current economic conditions. In particular, they do not 

respond to expected future changes in government policy. 

Nor does the model incorporate effects from demandside, or cyclical, variations in the economy; rather, the 

model assumes that output is always at its potential level. 

The estimates that CBO developed using the textbook 

growth model incorporate the effects of the changes in 

marginal tax rates specified in the President’s budget on 

the number of hours worked. (CBO estimated the taxrate effects in a side calculation.) Those effects are greatest 

from 2011 through 2014, when lower marginal tax rates 

increase the supply of labor relative to the level in CBO’s 

baseline.

The estimated effect of the President’s budget on the capital stock differs over time in the textbook growth model. 

Initially, the reduction in the federal government’s consumption of goods and services makes more resources 

available for investment. However, the tax cuts that the 

President proposes to extend to the final four years of the 

2005-2014 period (and beyond) lead to increased private 

consumption, the model estimates, which eventually outweighs the earlier effect and crowds out investment. In 

the textbook growth model, changes in marginal tax rates 

on capital have no direct effect on spending by the private 

sector.

The positive effects on the capital stock are partially offset 

by two factors, for which the model includes assumptions 

based on past relationships. First, the decrease in government consumption is moderated by the assumption that 

people reduce their private saving by 40 cents for every 

dollar that the deficit declines. Second, for every dollar 

that national saving rises (national saving equals private 

plus government saving), the amount of foreign capital 

invested in the United States is assumed to fall by 40 

cents.

The life-cycle and infinite-horizon growth models that 

CBO also used in its supply-side analysis differ in fundaAPPENDIX

1. For a detailed description of the textbook growth model, see Congressional Budget Office, CBO’s Method for Estimating Potential 

Output: An Update (August 2001).
44 AN ANALYSIS OF THE PRESIDENT’S BUDGETARY PROPOSALS FOR FISCAL YEAR 2005

mental ways from the textbook growth model.2 The lifecycle and infinite-horizon models incorporate simulated 

people who make decisions about how much to work and 

save in order to make themselves as well off as possible 

over their lifetime. Their behavior is calibrated so that 

macroeconomic variables such as the total amount of labor supplied and the size of the capital stock match the 

levels occurring in the U.S. economy. In the life-cycle and 

infinite-horizon growth models, people’s consumption 

changes by a relatively large amount in response to 

changes in the after-tax rate of return on their saving. 

Like the textbook growth model, those models do not allow for any demand-side effects.

The people in the life-cycle and infinite-horizon models 

are assumed to be forward-looking—that is, they know 

future changes in economic conditions and policy and alter their behavior accordingly. In terms of the degree to 

which people incorporate future events into their current 

behavior, that “perfect foresight” is at the other end of the 

range of possible assumptions from the assumption used 

in the textbook growth model. Most people actually fall 

somewhere between those two extremes. However, in using those two somewhat extreme assumptions, CBO has 

tried to encompass as broad a range of possible responses 

to the President’s budgetary proposals as is feasible.

Because people’s behavior as represented in the life-cycle 

and infinite-horizon growth models depends in part on 

future policies, the use of those models requires analysts 

to make assumptions about budgetary policies beyond 

2014 (the end of the period covered by CBO’s current 

10-year baseline projections). Policies that increase deficits must be offset at some point in the future by taxes 

that are higher or spending that is lower than it would 

have been in the absence of the higher deficits.

The assumptions about how and when to offset the bill 

that comes due can influence the estimated economic effects of the President’s proposed policies over the 2005-

2014 period. That influence stems from the fact that in 

the models, people anticipate the offsetting policies and 

plan accordingly. In its analysis, CBO used two different 

assumptions about how the budget would be stabilized 

after 2014: either marginal tax rates would be increased, 

or government consumption of goods and services 

(which the models assume does not enhance people’s 

well-being) and transfer payments would be cut. The size 

of the cuts in those two categories that the models incorporate would be proportional to the relative size of transfer payments and government consumption in CBO’s 

baseline for 2014, an assumption that implies that they 

would be roughly equal.

CBO has made the assumptions about financing in the 

forward-looking models more realistic—relative to those 

that CBO used last year in analyzing the President’s budgetary policies—in two ways. First, as described above, 

the two assumptions now involve increases in marginal 

tax rates or a blend of cuts in government consumption 

and transfer payments; last year, they consisted of increases in lump-sum taxes (an equal dollar amount of 

taxes levied on everyone) or cuts in government consumption. Second, in this year’s analysis, those policy 

changes are assumed to be phased in over 10 years, 

whereas in last year’s assessment, they were assumed to 

occur all at once, in the year following the end of the 10-

year budget projection period.

The life-cycle and infinite-horizon growth models differ 

in what they assume about how far ahead people look in 

making their plans. The life-cycle model is calibrated so 

that the probability of death at a given age matches current U.S. mortality rates, and people are assumed to take 

account of the impact of future economic or policy 

changes only on themselves and not on their children. In 

the infinite-horizon model, people behave as though the 

well-being of their descendants is as important to them as 

their own well-being. That leads them to behave as if they 

expected to live forever. Although the possibility that 

such an assumption reflects actual behavior cannot be 

ruled out, there is some evidence against it.3

The difference in the models’ time horizons has an important effect on the resulting estimates. The people in 

2. For a detailed description of the life-cycle model, see Shinichi 

Nishiyama, Analyzing Tax Policy Changes Using a Stochastic OLG 

Model with Heterogeneous Households, Technical Paper 2003-12 

(December 2003), available from CBO’s Macroeconomic Analysis 

Division or at www.cbo.gov/tech.cfm. CBO plans to publish a full 

description of its infinite-horizon growth model sometime in the 

future.

3. See Joseph G. Altonji, Fumio Hayashi, and Laurence Kotlikoff, 

“Risk Sharing Between and Within Families,” Econometrica, vol. 

64, no. 2 (March 1996), pp. 261-294; Paul Evans, “Consumers 

Are Not Ricardian: Evidence from Nineteen Countries,” Economic 

Inquiry, vol. 31, no. 4 (October 1993), pp. 534-548; and T.D. 

Stanley, “New Wine in Old Bottles: A Meta-Analysis of Ricardian 

Equivalence,” Southern Economic Journal, vol. 64, no. 3 (January 

1998), pp. 713-727.
APPENDIX B THE MODELS USED TO ANALYZE THE MACROECONOMIC EFFECTS OF THE PRESIDENT’S BUDGET OVER THE NEXT DECADE 45

both models expect the increase in deficits under the 

President’s budgetary proposals to be offset at some point 

in the future. However, people as represented in the lifecycle model, especially older individuals, know that they 

may die before an offsetting policy change occurs. Consequently, they may be less willing to work or save more 

during the 10-year projection period to compensate for 

any future tax increases or cuts in transfer payments. 

By contrast, people in the infinite-horizon model act as 

though they (or, equivalently, their descendants, whom 

they care about as much as they do themselves) will be 

alive when the offsetting policy change is made. That expectation implies that a belief that taxes will increase in 

the future has a greater effect on their current work and 

saving than it does on the corresponding variables for 

people in the life-cycle model. For that reason, the infinite-horizon model using the assumption of future tax increases produces the most positive estimates of the effect 

of the President’s budget on the economy within the current budget window (2005 through 2014).

CBO used two different assumptions in the life-cycle 

model about how open the economy is to flows of capital 

to and from other countries. One assumption was that 

the economy is completely closed—no capital can flow 

into or out of the country. The other assumption was that 

the economy is completely open and cannot affect world 

interest rates—capital flows freely into and out of the 

country to keep the domestic interest rate equal to a constant world rate. The U.S. economy effectively operates 

somewhere between those two extremes, because although it is relatively open to investment, it is so large 

that it can influence world interest rates.