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The following Special Report was written by our Washington Editor, Dr. Rudolph Penner. Dr. Penner is currently a resident scholar with the Urban Institute, a nonpartisan public policy research organization in Washington. He has been a pre-eminent and influential analyst of budget policy for the past two decades. He was also director of the Congressional Budget Office during the mid-1980s.

Dr. Penner analyses the Bush Administration's 2007 Budget, and reviews the long-term outlook for fiscal policy and the budget balance. The short-run budget outlook is fairly benign. The 2006 deficit will be much lower than the Administration's estimate of $423 billion. Fiscal policy will have a roughly neutral impact on real GDP growth this year, and could be slightly contractionary in FY2007.

The good news is that the budget deficit is likely to decline as a percent of GDP for the next few years, even if the President's tax cuts are made permanent. The bad news is that little progress will be made on reforming entitlements, which are set to explode in the next decade as the population ages. Congress is unlikely to tamper with Social Security and Medicare until it is forced to do so by voters or financial markets. It may take a riot in the bond market before politicians act.

The aging time bomb is ticking. Nonetheless, the bond market is sanguine at the moment, and a declining deficit/GDP ratio in the next few years reduces the risk that a riot point will erupt in the near term. Thus, we do not think that bond investors should position for a major increase in fiscal risk premiums within a one or two-year investment horizon.

Note: This report is available in its entirety in the Portable Document Format (PDF).

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

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