Estimating Effects of 4% Unemployment
on the Federal Deficit

(Adapted from the article A Twin Deficit Perspective on the Federal Budget.)

The Congressional Budget Office's (CBO) estimate of "potential" GDP is based on its estimate of the NAIRU -- the "Non-Accelerating-Inflation Rate of Unemployment.". This varies from a low 5.4% in 1955 to a high 6.3% in 1978 and back down to a projected 5.7% in 1999 -- mainly because of the changing labor-force composition (women and teenagers tend to have higher unemployment rates). This rate is now apparently the implicit policy target of the Fed and the Clinton Administration. But it seems a travesty to consider this rate our "full- employment potential" GDP.

Therefore, since NAIRU was 2.3 percentage points above 4% when the Humphrey/Hawkins "Full Employment and Balanced Growth Act of 1978" (FEBGA) was adopted in 1979, I adjusted the CBO's SE deficit to the FEBGA 4% rate, by the following empirical method..

For each year I calculated the excess of the actual unemployment rate over the NAIRU rate, and then did a scatter chart of this excess unemployment against the CBO's "cyclical" deficit as a ratio to GDP (to make them both "operating rate shortfalls").

scatter chart

As can be seen, most values are well-concentrated along a well-defined slope. This can be determined by a surprisingly powerful low-tech method -- the "black-thread method" -- to eliminate the outlier values:

scatter chart with black-thread line drawn through points

This disclosed that each 1% increase in unemployment increases the deficit by 0.693% of GDP -- a value referred to here as Due1.

(During severe recessions the deficit was significantly above this trend line, partly because only annual data was available, while "person" unemployment -- as distinguished from person-hour employment -- typically lags about one quarter behind incomes, tax receipts and unemployment benefits. More precise estimates might be derived from quarterly data and by taking account of specific changes in tax rates and spending programs.)

Thus, the chart values were calculated by these formulas:

HI-UE Deficit = CBO "cyclical" deficit + 2.3 * Due1 + .0017 GDP (scatter chart intercept).

Policy Deficit = CBO SE deficit + SSTF surplus - 2.3 * Due1


Written: December, 1994
Posted: July, 1998
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