Interest Costs in CBO's Long-Term Projections

As part of our blog series on CBO's recent long-term budget and economic projections, we now turn our focus to the fastest growing part of the budget over the next several decades: interest payments on the national debt. CRFB recently released a policy paper on federal interest spending and the potential risks involved with the federal budget. This post, however, will look at the latest projections from CBO.

While health care, retirement, and tax expenditure costs generally receive most of the attention in budget discussions, it is actually interest payments on the debt that are the fastest growing element of CBO's budget projections. The reason is twofold: interest rates will rise as the economy recovers and as the Federal Reserve unwinds its extraordinary actions, and there is a rising stock of debt to pay interest on. The former assumption is a bigger factor in the near term, while the latter effect dominates in the long term.

According to CBO's latest projections, interest spending will grow from 1.3 percent of GDP this year to 3.1 percent by 2023 under current law and to over 5 percent by 2040. That's nearly a four-fold increase in just a few decades, much faster than spending growth in any other area of the budget. Under CBO's Alternative Fiscal Scenario (AFS) projections, though, interest payments would be much higher, rising to over 8 percent of GDP by 2040 due to the much higher debt projected.

The most recent projections from CBO show noticeable improvement compared to last year's long-term AFS projections, largely a result of the fiscal cliff deal in January, which will reduce deficits, debt, and interest spending going forward. While there has been notable improvement in budget projections over the past few years, it is clear that, like many other parts of the budget, the interest spending situation is still very unsustainable. 

Interest spending threatens to diminish the federal resources available to contribute to other important priorities -- be it education, infrastructure, retirement security, or a lower tax burden. Importantly, interest spending could turn out to be much higher than currently projected, potentially fueling more debt and, thus, interest payments.

CBO's long-term interest projections assume interest rates of slightly above 5 percent, as was assumed in last year's projections. In CRFB's recent interest rate analysis, however, even just slightly higher interest rate projections could have profound impacts on deficits and debt this decade. CRFB estimates that if interest rates were just 0.5 percentage points higher than current projections, across the board, the debt could be more than $600 billion higher by 2023. If interest rates rose just 1 percentage point above current projections, the debt could be $1.2 trillion higher by 2023 -- enough to wipe away all the savings from sequestration.

As CRFB recently stated, interest payments and overall debt payments take years to bring down to sustainable levels, but interest rates can change in a year, a month, and even overnight. And when they change rapidly, it is almost always for the worse. A comprehensive debt reduction plan can tackle our interest spending and debt risks head on.