    [Analytical Perspectives]
    [Economic and Accounting Analyses]
    [1. Economic Assumptions]
    [From the U.S. Government Printing Office, www.gpo.gov]

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                        ECONOMIC AND ACCOUNTING ANALYSES

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    [[Page 3]]

                           1.  ECONOMIC ASSUMPTIONS

                                   Introduction
      The economic expansion is about to enter its sixth year. Too often in
    the past when expansions have reached this point, or even sooner, the
    economy has begun to overheat, pushing up inflation and interest rates,
    and ultimately bringing on a recession. In contrast, the policy
    decisions of the last three years have enabled this expansion to attain
    an elusive goal--a ``soft landing'' in which economic growth has slowed
    to a sustainable rate without triggering an increase in unemployment.
      The ``soft landing'' of 1995 is the culmination of three years of very
    successful macroeconomic policy. Over this period, jobs have increased
    and unemployment has fallen, while at the same time, inflation has been
    low and relatively stable. Interest rates have fluctuated, but long-term
    rates are as low as at any time in recent memory. Looking ahead, the
    Administration expects economic growth to continue at a moderate rate
    for the foreseeable future.\1\ Employment is projected to expand
    sufficiently to absorb new workers, keeping the rate of unemployment
    stable. Meanwhile, the Administration expects inflation to continue at a
    low, relatively constant rate, and interest rates to decline further as
    the budget is brought into balance.
      \1\Beyond the next year or two, the Administration does not attempt to
    project the economy's cyclical patterns. The longer term economic
    projections used for the Budget and summarized here are best thought of
    as forecasts of average experience expected to be achieved over a period
    of several years.
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      The Omnibus Budget Reconciliation Act of 1993 put the Federal budget
    deficit on a downward track that helped to reduce long-term interest
    rates, which in turn helped spark the revival in the economy. The
    Administration's current budget proposals would build on that success
    and cap it with a balanced budget. The Federal Reserve has helped to
    support these needed fiscal actions by pursuing a policy to control
    inflation, while also showing that it is willing to reduce interest
    rates when that is appropriate.
      This chapter begins with a review of recent economic and policy
    developments. With this as background, it then presents the
    Administration's economic assumptions. The assumptions call for a
    continuation of trends already evident in the economy for most of the
    major economic variables. They offer a reasonable and prudent basis for
    making budget projections.
      Two important changes in the statistics on which this forecast is
    based are also described in this chapter. First, real gross domestic
    product (GDP) is now measured on a chain-weighted basis in the National
    Income and Product Accounts. This is reflected in the budget projections
    of real GDP and the aggregate measure of inflation. Second, anticipated
    changes in the calculation of the Consumer Price Index (CPI) will slow
    its growth, and that of related measures of price inflation.
      The chapter compares the Administration's economic assumptions with
    those of the Congressional Budget Office (CBO) prepared at about the
    same time (December 1995). Although there are some differences in the
    underlying policy assumptions on which the two forecasts are based, they
    are quite similar, and the differences between them are well within the
    normal range of forecasting error.
      The chapter also includes an analysis of the impact of changes in the
    economic assumptions since last year's budget on the projected deficit,
    and it concludes with estimates of the sensitivity of the budget to
    changes in economic assumptions.
                               Recent Developments

      1993--Enacting a Responsible Fiscal Policy: The passage of the Omnibus
    Budget Reconciliation Act of 1993 (OBRA93) put fiscal policy on a
    sounder footing and created the preconditions for a healthy expansion.
    The 1992 deficit was $290 billion. Since then, the deficit has fallen
    for three straight years, bringing it down to $164 billion in 1995. That
    is just 2.3 percent of GDP, less than half the level in 1992. The
    improvement in the deficit is traceable to both improvement in the
    economy and to policy changes, of which the President's economic program
    was far and away the most important. The Administration estimated that
    OBRA93 would reduce the deficit during the five years 1994-98 by a
    cumulative total of $505 billion. During the first two years alone, it
    cut deficits by about $130 billion. The economic program has also
    contributed indirectly to the reduction in the deficit by strengthening
    the pace of the economic recovery.
      Stabilizing Inflation: Most previous postwar expansions have ended
    because inflation accelerated, forcing a policy correction. The best way
    to avoid the need for such measures is to act before inflation becomes a
    problem. That is just what monetary policy did during 1994. Entering
    that year, inflation was under control; the CPI had only increased 2.7
    percent over the preceding 12 months. However, 1993 had seen
    unemployment fall by almost a full percentage point as real economic
    growth accelerated, and the economy's momentum was clearly pointing
    towards further large gains in 1994. Those gains were realized, as 1994
    became one of the best years for overall economic performance since the
    end of World War II. During 1994, 3.5 million new jobs were created, and
    the unemployment rate was pulled down by another full percentage point.
    These were welcome developments; but if the economy had continued to
    expand at that rate, shortages of labor
    [[Page 4]]
    and plant capacity would have
    been sure to emerge, carrying with them a high risk of accelerating
    price increase.
      To avoid that risk, the Federal Reserve raised short-term interest
    rates in several stages during 1994. The intention was to slow growth
    and stabilize unemployment at its new lower levels to avoid the
    inflation risks that faster growth would generate. While the Fed was
    acting to raise short-term rates, investors in the financial markets
    were pushing up long-term rates, anticipating future inflation and the
    possibility of further Fed tightening to choke it off.
      The effect of these developments was seen in 1995. The higher interest
    rates cooled off demand in the economy's interest-sensitive sectors,
    such as housing and consumer durables. In 1995, real GDP rose 1.4
    percent, down from a growth rate of 3.5 percent during the previous
    year.\2\ Although growth slowed, the economy continued to generate new
    jobs at a healthy rate, albeit less rapidly than in 1994; and the
    unemployment rate did not increase. Payroll employment rose by 1.7
    million in 1995 and the unemployment rate averaged 5.6 percent for the
    year, which was its lowest level since 1990.
      \2\These rates are based on the new chain-weighted definition of real
    GDP which is explained more fully below.
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      The slower growth of economic activity and employment was accompanied
    by continued moderation in wages and prices, exactly what the Fed had
    been hoping to achieve when it tightened policy in 1994. The most
    meaningful measure of overall labor compensation, the Employment Cost
    Index, rose 2.9 percent in 1995--virtually the same increase as in the
    previous year.
      Compensation costs were also held down by a significant deceleration
    in employee benefit costs. Health insurance premiums, which had been
    rising at double-digit rates earlier in the decade, were brought firmly
    under control. The spread of innovations in health care delivery helped
    to bring about this moderation. Although slower growth of employee
    health care costs shows up in the aggregate statistics as a decline in
    the rate of increase in compensation, the long-run effect is likely to
    be an increase in workers' take-home pay. Most studies reveal that
    employee benefits are paid for by workers through lower cash wages. A
    reversal of the trend towards increased benefit costs should strengthen
    cash wages in the long run.
      Moderation in labor markets was mirrored in the product markets. At
    the beginning of 1995, the capacity utilization rate in manufacturing
    had reached nearly 85 percent, a level that in the past had initiated an
    acceleration of price increases. By spring, slower growth caused the
    operating rate to return to a range of around 82 percent, a level
    associated in the past with stable price inflation.
      Reflecting this moderation, the CPI rose only 2.5 percent over the 12
    months of 1995, slightly less even than in 1994. The underlying rate of
    inflation, the CPI excluding food and energy, was also well-behaved,
    rising 3.0 percent during 1995. The inflation rate over the three years
    1993-1995 was the best since the mid-1960s.

      Sustaining the Momentum of the Expansion: As it became clear that
    inflation was under control and likely to remain so for some time, the
    Federal Reserve gradually relaxed its previous tightening. Having
    achieved the desired ``soft landing'', the Federal Reserve took steps to
    make sure the economy would not stall out. It reduced the Federal funds
    rate by one-quarter percentage point in July and in December of 1995,
    and again in January of 1996. Judging from the futures market, the
    financial community anticipates a further reduction of about one-quarter
    percentage point by this summer.
      While the Federal Reserve was lowering short-term rates last year, the
    financial markets were lowering long-term rates even more. The inflation
    fears that had troubled the markets in 1994 were succeeded in 1995 by
    the expectation that inflation would remain subdued. Moreover,
    bipartisan agreement that the budget should be balanced in the coming
    years helped further reduce long-term interest rates. From the end of
    1993 to the beginning of 1996, long-term interest rates fell more than
    two full percentage points. Except for a few months in 1993, the last
    time long-term interest rates were this low was in the 1960s. The drop
    in rates last year is expected to set the stage for a pickup in economic
    activity in 1996.
      Lower interest rates and a healthy economic outlook propelled the
    stock market to record levels. Last year, the Dow-Jones industrial
    average rose 36 percent, and other major indexes were up by similarly
    impressive amounts. In the opening months of this year, stock markets
    set a series of new highs. Financial markets fluctuate, and these gains
    will not continue unabated; but the rise in the stock market last year
    will contribute to the forward momentum in the economy in 1996 by
    lowering the cost of capital to business, which should stimulate
    investment, and by raising household wealth, which will boost consumer
    spending.
                              Economic Projections

                                           Table 1-1.  ECONOMIC ASSUMPTIONS\1\
                                      (Calendar years; dollar amounts in billions)
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                                                                            Projections
                                      Actual -----------------------------------------------------------------------
                                       1994     1995     1996     1997     1998     1999     2000     2001     2002
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    Gross Domestic Product (GDP):
      Levels, dollar amounts in
       billions:
        Current dollars............    6,931    7,254    7,621    8,008    8,417    8,848    9,295    9,772   10,268
        Real, chained (1992)
         dollars...................    6,604    6,742    6,888    7,047    7,212    7,380    7,553    7,730    7,911
        Chained price index
         (1992=100), annual average    105.0    107.6    110.6    113.6    116.7    119.9    123.1    126.4    129.8
      Percent change, fourth
       quarter over fourth quarter:
        Current dollars............      5.9      4.1      5.1      5.1      5.1      5.1      5.1      5.1      5.1
        Real, chained (1992)
         dollars...................      3.5      1.5      2.2      2.3      2.3      2.3      2.3      2.3      2.3
        Chained price index
         (1992=100), annual average      2.3      2.5      2.8      2.7      2.7      2.7      2.7      2.7      2.7
      Percent change, year over
       year:
        Current dollars............      5.8      4.7      5.1      5.1      5.1      5.1      5.1      5.1      5.1
        Real, chained (1992)
         dollars...................      3.5      2.1      2.2      2.3      2.3      2.3      2.3      2.3      2.3
        Chained price index
         (1992=100), annual average      2.3      2.5      2.8      2.7      2.7      2.7      2.7      2.7      2.7

    Incomes, billions of current
     dollars:
        Personal income............    5,750    6,104    6,416    6,716    7,025    7,337    7,664    8,031    8,434
        Wages and salaries.........    3,241    3,420    3,607    3,801    3,995    4,193    4,403    4,629    4,864
        Corporate profits before
         tax.......................      528      602      650      702      753      800      843      882      917

    Consumer Price Index (all
     urban):\2\
        Level (1982-84=100), annual
         average...................    148.2    152.4    156.6    161.3    165.9    170.5    175.3    180.2    185.2
        Percent change, fourth
         quarter over fourth
         quarter...................      2.6      2.7      3.1      2.9      2.8      2.8      2.8      2.8      2.8
        Percent change, year over
         year......................      2.6      2.8      2.8      3.0      2.8      2.8      2.8      2.8      2.8

    Unemployment rate, civilian,
     percent:
        Fourth quarter level.......      5.6      5.6      5.7      5.7      5.7      5.7      5.7      5.7      5.7
        Annual average.............      6.1      5.6      5.7      5.7      5.7      5.7      5.7      5.7      5.7

    Federal pay raises, January,
     percent:
        Military...................      2.2      2.2      2.6      3.0      3.1      3.1      3.1      3.1      3.1
        Civilian\3\................  .......      2.0      2.0      3.0       NA       NA       NA       NA       NA

    Interest rates, percent:
        91-day Treasury bills\4\...      4.3      5.5      4.9      4.5      4.3      4.2      4.0      4.0      4.0
        10-year Treasury notes.....      7.1      6.6      5.6      5.3      5.0      5.0      5.0      5.0      5.0

    Addendum: GDP and incomes, pre-
     revision basis:\5\

    Gross Domestic Product (GDP),
     current dollars:
        Levels, dollar amounts in
         billions..................    6,738    7,078    7,428    7,805    8,203    8,623    9,058    9,523   10,005
        Percent change, fourth
         quarter over fourth
         quarter...................      6.5      4.2      5.1      5.1      5.1      5.1      5.1      5.1      5.1
        Percent change, year over
         year......................      6.2      5.0      5.0      5.1      5.1      5.1      5.1      5.1      5.1

    Incomes, billions of current
     dollars:
        Personal income............    5,702    6,054    6,357    6,654    6,960    7,270    7,595    7,958    8,358
        Wages and salaries.........    3,279    3,450    3,631    3,826    4,020    4,220    4,431    4,658    4,895
        Corporate profits before
         tax.......................      525      572      608      657      706      749      790      826      859
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    NA=Not Available.
    \1\Based on information available as of mid-January 1996.
    \2\CPI for all urban consumers. Two versions of the CPI are published. The index shown here is that currently
      used, as required by law, in calculating automatic adjustments to individual income tax brackets. Projections
      reflect scheduled changes in methodology.
    \3\Percentages for 1994-1996 exclude locality pay adjustments. Percentages to be proposed for years after 1997
      have not yet been determined.
    \4\Average rate (bank discount basis) on new issues within period.
    \5\Because the comprehensive revision to the National Income and Product Accounts (which include GDP and
      incomes) was delayed due to furloughs of Government employees, some budget estimates are based, at least in
      part, on GDP and incomes data on the pre-revision basis shown in this addendum.

      Key assumptions: The economic projections underlying this budget are
    summarized in Table 1-1. They are based on several key assumptions.
    First and foremost, the projections assume that the Administration's
    budget will be adopted. The budget proposals are intended to reduce the
    deficit progressively and achieve a small surplus in 2002, according to
    Congressional Budget Office assumptions, and in 2001 according to
    Administration estimates. Such a policy would foster a continuation of
    the favorable macroeconomic trends that have emerged since 1992. Deficit
    restraint moderates inflationary pressures by restraining demand. It
    enables the Federal Reserve to continue its recent policy of easing
    short-term interest rates. The combination of easier monetary policy and
    fiscal restraint provides an environment in which financial markets can
    keep
    [[Page 5]]
    long-term interest rates on a downward path. A policy to balance
    the budget would thus encourage investment, and thereby raise the level
    of productivity and potential output in the long run.
      Real GDP: Economic growth was temporarily restrained in the fourth
    quarter of last year by two shutdowns of the Federal Government, and in
    the first quarter of this year by a record-breaking blizzard. According
    to preliminary estimates, real GDP grew at a 0.9 percent annual rate in
    the fourth quarter; based on partial information, first quarter growth
    may also be relatively weak.
      Growth is expected to pick up as the negative impact of the recent
    disruptions fades. Interest-sensitive sectors, such as consumer durables
    and business equipment spending, are likely to be at the leading edge of
    the acceleration in response to the fall in long-term interest rates
    during 1995 and the surge in the stock market. On average, real GDP is
    forecast to increase 2.2 percent over the four quarters of 1996.
      During 1997-2002, real GDP is projected to rise 2.3 percent annually
    (the Administration's estimate of the economy's potential growth rate).
    Lower interest rates and smaller deficits are projected to increase
    investment and raise the trend growth in output per hour. Productivity
    in the nonfarm business sector had been
    [[Page 6]]
    growing at 1.1 percent per year
    on average since 1973, but it is projected to increase 1.2 percent
    annually over the next six years.
      Potential GDP growth is also determined by growth of the labor force.
    Labor force participation trends of recent years are assumed to
    continue. The rise in the female participation rate is expected to be
    much less than during the 1970s and 1980s, while the male rate is
    expected to continue to decline. On balance, there is likely to be
    little overall change in labor force participation. During 1997-2002,
    the labor force is projected to grow 1.1 percent per year, about the
    same pace as during the past six years, but noticeably slower than the
    1.7 percent rate during the 1980s when female participation rates rose
    rapidly.

      Unemployment rate: The civilian unemployment rate, which averaged 5.6
    percent during the fourth quarter of 1995, is expected to average 5.7
    percent this year and hold at that level through the end of the
    projection period. With real GDP projected to rise at the rate of growth
    of potential output, the unemployment rate would remain stable.
      Inflation: The chain-weighted GDP price index is projected to rise 2.7
    percent a year over the projection horizon. That is just slightly faster
    than the 2.5 percent estimated for 1995. The Consumer Price Index is
    expected to rise 3.1 percent during 1996, about the same as the 3.0
    percent rise last year in the CPI excluding food and energy. The CPI is
    expected to rise 2.9 percent in 1997 and 2.8 percent per year during
    1998-2002. The deceleration is due to scheduled improvements in the
    methods used to calculate the CPI. These improvements are discussed
    later in this chapter.
      Interest rates: Short- and long-term rates are projected to fall as a
    result of the reduced borrowing needs of the government that result from
    the Administration's budget proposals. The 91-day Treasury bill rate is
    expected to fall to 4.0 percent by 2000 and hold at that level through
    2002; in the fourth quarter of 1995, the rate was 5.3 percent. The yield
    on the 10-year Treasury note is projected to decline to 5.0 percent by
    1998 and hold at that level; in the fourth quarter of last year, the
    yield was 5.9 percent. These projections, in combination with a forecast
    of stable inflation, imply a reduction in real interest rates to levels
    that prevailed when the Federal budget was close to balance. The sharper
    fall in short rates will cause the yield curve to steepen, which is a
    more typical pattern for an expansionary period.
      Incomes: As a result of the drop in interest rates, the share of
    nominal GDP accounted for by personal interest income, a component of
    personal income, is expected to decline. On the other hand, the
    corporate sector is a net borrower, so the profits share and the share
    of dividend income are likely to grow because of the reduction in
    interest costs. The projected share of wages and salaries in GDP is
    expected to remain about unchanged over the projection horizon. After
    adjustment for inflation, real wages and salaries are projected to
    increase 14 percent from 1996 to 2002.
                            Statistical Improvements
      The economic assumptions incorporate two important changes in the way
    economic activity is measured.

      Fixing Biases in Real GDP: For fifty years, the featured measure of
    real GDP was based on a fixed-weight price system, with an update every
    five to ten years to account for shifts in spending patterns. While
    convenient and familiar, that system introduced a ``substitution bias''
    into the estimate of real GDP and the GDP implicit price deflator. The
    bias was significant whenever relative prices changed rapidly--as for
    example in the 1970s, when oil prices jumped sharply. Until the recent
    revision, 1987 was the base year for the fixed-weight price system. The
    large drop in the quality-adjusted price of computers since 1987 caused
    a growing upward bias in the measurement of real GDP growth.
      To remove these biases, the Bureau of Economic Analysis changed to a
    chain-weighted system for estimating real GDP in January of 1996. The
    weights are now based on nearly contemporaneous spending patterns. Real
    GDP growth for 1993, for example, is calculated using average
    expenditure weights for 1992-1993, and the growth rate for 1994 is
    computed using an average of 1993-1994 spending. Thus, the weights are
    linked year-to-year, hence the term ``chain weights.''
      The substitution bias in the former fixed-weight system distorted the
    picture of real growth and aggregate inflation. The shift to chain
    weights lowered the measured rate of real GDP growth in 1993-94 by about
    \1/2\ percentage point yearly compared with the previous estimate, and
    raised the estimate of aggregate inflation by a similar amount. While
    converting to chain weights provides a more accurate measure of the
    Nation's economic performance, it does have one inconvenience. Real GDP
    no longer exactly equals the sum of real spending by households,
    businesses and governments--the familiar rule that GDP = C+I+G+net
    exports. Now there is a difference, known as ``the residual,'' that
    needs to be added to the components to sum to real GDP.

      Changing the CPI: The CPI is one of the most important statistics
    produced by the Federal Government. It is widely used to measure changes
    in the cost of living.\3\ The CPI's effect on the budget is pervasive;
    it is linked by formula to spending for social security, Federal
    pensions, and many smaller programs, and to the tax brackets and
    exemptions in the individual income tax. It is estimated that a
    reduction of 0.1 percentage point in the average yearly rate of change
    in
    [[Page 7]]
    the CPI would reduce the budget deficit by a total of about $20
    billion over the next seven years.
      \3\This is done even though the CPI is explicitly not a cost-of-living
    index. Rather, it measures changes in the average cost of a fixed market
    basket of goods and services. By design, the CPI does not allow for
    those changes in consumption patterns that people make routinely to
    maintain their standard of living when prices are changing.
    ---------------------------------------------------------------------------
      Given its importance, it is not surprising that the CPI has often been
    criticized. There is no perfect price index, but the Bureau of Labor
    Statistics (BLS), which computes the CPI, strives to eliminate potential
    biases from the index. Over the years, the BLS has been receptive to
    suggestions for improvements. BLS is the main source of the technical
    analysis needed to make such improvements, and it is often the first to
    highlight potential problems.
      Much recent criticism has suggested that the CPI may overstate
    inflation. Various possible causes have been examined. One major problem
    is how to separate quality changes from price increases for goods and
    services. For example, if the price of a visit to the doctor goes up,
    how much of this is due to better service due to improved diagnostic
    equipment and new testing procedures, and how much is a pure price
    increase? Such questions are hard to answer, but critics believe BLS too
    often treats quality improvements as price rises. Another problem area
    is the exclusion of new products or new outlets from the sample used to
    determine the CPI. There are good practical reasons why it takes time to
    incorporate new items into that sample, but the effect may be to miss
    some important price declines that occur as new products and services
    enter the market.
      Finally, there are some technical issues concerning how the CPI is
    measured and put together. BLS has announced that it will introduce two
    methodological improvements in the CPI over the next three years that
    should make the index more accurate. These changes are expected to
    reduce the annual rate of growth of the index by about 0.3 percentage
    points.
      The announced improvements (along with recent revisions to GDP) will
    also narrow the wedge between the rates of change in the CPI, on the one
    hand, and the price indexes for consumer expenditures and for GDP in the
    National Income and Product Accounts on the other. During 1998-2002, the
    annual growth in the CPI is assumed to be 2.8 percent, almost the same
    as the 2.7 percent assumed for the chain-weighted price index for GDP.
      By January 1997, BLS plans to institute new estimation procedures to
    correct what has sometimes been called ``formula bias,'' but which might
    be more accurately described as ``sample rotation bias.'' These new
    procedures are estimated to reduce the growth of the CPI by about 0.2
    percentage point per year. The bias arises because of the need to update
    the sample of items entering the CPI. New brands and varieties of goods
    are continually being introduced in the marketplace, and if the CPI is
    to remain current, it must be based on the current brands of cereals,
    toothpaste, automobiles, et cetera. When new goods are introduced,
    however, the usual BLS procedures can generate inappropriate weights for
    those that are temporarily selling at either abnormally low or
    abnormally high prices. The problem is greatest for items with prices
    that fluctuate around a trend, such as fruits and vegetables.
    Recognizing this, BLS instituted a correction for some components of the
    index in January 1995. One possible course is to apply the same type of
    correction throughout the index.
      Correcting the sample rotation bias in the CPI will also reduce the
    rate of change in the price indexes used to determine real personal
    consumption expenditures in the national income and product accounts,
    which are based on detailed data from the CPI. The effect of a slower
    rise in consumer prices is expected to hold down the growth of the
    overall GDP price index by about 0.1 percentage point yearly. Consumer
    expenditures account for about two-thirds of GDP, and the rest is not
    affected by the change. Measured real GDP growth will, of course,
    increase by a similar magnitude (because total nominal spending growth
    is a datum that is not affected by this change).
      The second scheduled improvement in the CPI is an updating of the
    fixed market basket that is expected to occur in January 1998.
    Currently, the CPI market basket is based on 1982-1984 consumption
    patterns; in 1998, the market basket will be updated to reflect 1993-
    1995 spending patterns. This ``rebasing'' of the index occurs about
    every 10 years. Rebasing tends to reduce the measured inflation rate in
    subsequent years by reducing the substitution bias that builds up over
    time as the economy moves away from the base period prices. The new
    weights tend to give more emphasis in the index to goods whose prices
    have been rising relatively less rapidly (because consumers tend to
    shift their consumption toward those items). The budget assumes that the
    change in the CPI market basket will slow the growth of the CPI by about
    0.1 percentage point per year beginning in 1998. This improvement will
    not affect real GDP or the price indexes associated with it.
      These improvements in the CPI will go some way towards correcting its
    apparent tendency to overstate inflation. The largest potential biases--
    quality measurement and adjustments for new goods--will not be addressed
    by these changes. Continued research in these areas by BLS and outside
    experts is needed to improve this vital economic statistic.
                               Comparison with CBO
      The Congressional Budget Office (CBO) prepares forecasts of the
    economy that are used by Congress in formulating budget policy. Thus, it
    performs a similar function to that of OMB, the Council of Economic
    Advisers and Treasury for the Executive Branch. While outside observers
    have often compared the CBO forecast with that of the Administration,
    the budget is usually prepared well before the current CBO forecast is
    made public, so a timely forecast comparison is generally impossible.
      Over the past year, however, there has been heightened interest in the
    economic assumptions used for the budget and in the differences between
    Administration and CBO forecasts. That is because the fiscal policy
    [[Page 8]]
    objective is now to achieve a balanced budget, rather than a specific
    amount of deficit reduction. Even small differences in economic
    assumptions can matter for the size of policy changes needed to achieve
    budget balance. When the goal is a specific amount of deficit reduction,
    differences in economic assumptions usually have little bearing on the
    size of policy changes needed to achieve a specific amount of budgetary
    savings.

      Post-Policy vs Pre-Policy: One important difference between CBO and
    the Administration concerns the policy assumptions on which the forecast
    is based. The Administration projections always assume that the
    President's budget proposals will be enacted as proposed; the economic
    projections are ``post-policy.'' CBO normally assumes that current law
    will continue; it is a ``pre-policy'' projection.
      This difference often is immaterial in determining the major
    macroeconomic variables. Important as budget policy is, especially in
    the long run, even large dollar changes in programs will often have only
    a modest effect on real GDP or inflation. Therefore, a specific budget
    proposal may make little difference to the macroeconomic outlook. Thus,
    comparisons of CBO and Administration economic projections can be
    meaningful even when the policy assumptions are not identical. Sometimes
    the difference is crucial, however, and that was the case in 1995.

      The Fiscal Bonus: The Administration's policy is to balance the budget
    over the next seven years. The decision to seek a balanced budget has
    major implications for the economic outlook. Such a significant change
    in policy, if enacted, would be likely to cause noticeable changes in
    several macroeconomic variables, especially interest rates and income
    shares. However, CBO's initial forecast for the 1996 budget (and the
    Administration's) assumed that the deficit would not be eliminated over
    this time period.
      In April, CBO presented its estimates of the fiscal bonus that would
    result from balancing the budget following the policies in the
    congressional budget resolution. This bonus took account of the more
    favorable interest rate outlook that would result from a balanced
    budget. It did not, however, reflect the likely shifts in income among
    sectors of the economy that would follow from the lower interest rates
    generated by a balanced budget. This was corrected in December, when a
    revised CBO forecast was prepared that took into account the full range
    of macroeconomic effects that a balanced budget would produce.

      The Treatment of Statistical Biases: The statistical biases in the
    measurement of real GDP and inflation described above posed problems for
    forecasters. Neither CBO nor the Administration was completely
    consistent in dealing with these issues. In some cases, projected
    economic variables reflected the bias that was built into their
    measurement; in other cases, the projections assumed that the bias would
    be corrected somehow during the course of the forecast. In any case, the
    revisions to GDP that were made in January and the planned modifications
    to the CPI go a long way toward removing this source of past difference
    in the forecasts.
      Projection Comparison: The main outlines of the Administration's
    current forecast were determined in December at about the time that CBO
    made public its economic projections. A comparison of the two forecasts
    (including the CBO fiscal bonus to put them on the same policy basis)
    reveals a convergence of views summarized in Table 1-7.