    [Budget of the U.S. Government]
    [III. Putting the Building Blocks in Place]
    [From the U.S. Government Publishing Office, www.gpo.gov]

                   III.  PUTTING THE BUILDING BLOCKS IN PLACE

      ----------------------------------------------------------------------

      To reclaim our future, we must strive to close both the budget deficit and the investment gap.

                                          Governor Bill Clinton
                                          Senator Al Gore
                                          Putting People First
                                          1992

      With regard to Congress, if I could do one thing, I would pass a balanced budget that would open the doors of
    college to all Americans and continue the incremental progress we've made in health care reform.
                                          President Clinton
                                          November 10, 1996

      ----------------------------------------------------------------------
      President Clinton has pursued a disciplined but fair budget policy,
    working with Congress to make the tough choices that have dramatically
    cut the deficit while protecting the values that Americans share. He has
    cut wasteful and lower-priority spending while protecting safety net
    programs and investing in the future.
      The results are clear: The deficit has fallen by a whopping 63
    percent--from $290 billion in 1992, the year before the President took
    office, to $107 billion last year. Now, with this budget, the President
    proposes to build on that progress by balancing the budget for the first
    time since 1969.
      Why must we finish the job?

    What the Administration Inherited

      Large budget deficits damage the economy, hurting taxpayers and
    discouraging businesses. The sharply higher deficits that began in 1981
    have been a serious drag on the Nation's economic performance ever
    since.

      The Debt and What It Means for the Average Citizen: The budget deficit
    is the annual amount that the Government spends in excess of what it
    receives in revenues. The Federal debt, by contrast, is the total of the
    accumulated deficits that have not been offset by surpluses over the
    years.
      At first blush, deficits may appear painless; they allow the Nation's
    leaders to avoid the hard choices needed to bring spending in line with
    revenues. But the Government must finance the debt that it accumulates,
    and the cost of doing so prevents the Nation from meeting future
    spending needs or cutting taxes.
      The Government finances the deficit mainly by borrowing from the
    public, including foreign investors. The large deficits of the 1980s and
    early 1990s quadrupled the Federal debt. At the end of 1980, Federal
    debt held by the public was $710 billion. By the end of 1992, it had
    grown by $2.289 trillion--to $2.999 trillion.\1\ Because the deficit has
    fallen under this Administration, the debt has risen more slowly, and,
    in fact, the ratio of the debt to our Gross Domestic Product (GDP) has
    declined. But until we balance the budget, the debt will keep growing.
    ---------------------------------------------------------------------------
      \1\ This measure excludes the debt held in Federal trust funds. It
    counts only the debt held directly by private investors and the Federal
    Reserve System.
    ---------------------------------------------------------------------------
      In a sense, today's deficits are the legacy of the much larger
    deficits of the years from 1981 to 1992. The budget would be

    [[Page 22]]

    balanced today if not for the interest that we pay on the deficits accumulated in those 12 years.
      The Federal Government paid $241 billion in interest last year--$241
    billion that it could have spent in far more productive ways. If the
    Government were not paying interest at all, it could have used those
    funds to have a balanced budget and still have $134 billion left over--
    which equals half of the military budget, or about 40 percent of Social
    Security payments, or about 20 percent of income taxes.

      How Deficits Have Damaged the Economy: The economy did not perform as
    well from 1980-1992 as before, partly due to the rise in Federal debt
    that marked the period. As this experience shows, persistent deficits
    reduce saving, raise interest rates, stifle investment, and cut the
    growth of productivity, output, and incomes.
      During recessions, when private consumption and investment declines,
    Government borrowing to finance unemployment and other benefits and to
    make up for reduced income taxes maintains demand and helps to turn the
    economy around. But if deficits become ``structural''--that is, they
    persist even in good times--they can cause harm. That's what happened in
    the 1980s.
      A structural deficit--especially when sustained for a long time, as in
    the 1980s--depletes the Nation's pool of saving. Saving provides the
    resources to build the new factories and machinery that generate
    tomorrow's incomes. National saving has two components:
      private saving (by individuals and businesses--the net result
              of millions of savings decisions); and
       public saving (by Federal, State, and local governments,
              which save when they run surpluses and dis-save when they run
              deficits). \2\
    ---------------------------------------------------------------------------
      \2\ Recently, the Commerce Department's Bureau of Economic Analysis
    modified the national income accounts to measure more accurately how
    government at all levels contributes to saving.
    ---------------------------------------------------------------------------
      If the Government taps the savings pool to finance its deficit, that
    borrowed saving is not available to make productive private investments.
    With its massive deficits in the 1980s, the Government drained much of
    the pool. Worse, as Federal deficits were rising, private saving was
    falling, exacerbating the overall saving problem.
      In each year of the 1960s, net national saving \3\ totaled at least 10
    percent of GDP (see Chart III-1). Since then, net saving has fallen
    substantially. After averaging about eight percent of GDP in the 1970s,
    the net national saving rate fell to five percent of GDP in the 1980s,
    and hit a low point of just 2.4 percent of GDP in 1992.
    ---------------------------------------------------------------------------
      \3\ That is, gross saving minus depreciation of the Nation's capital
    stock.

      With less saving, interest rates remained high in the 1980s, choking
    off demand for private investment. Why? Because lower saving shrinks the
    pool of available funds. The Federal Government taps the pool first by
    selling its bills, notes, and bonds at auction, leaving private
    borrowers to compete for what's left. With so many would-be borrowers,
    and so little left to borrow, the competition forces interest rates
    higher.
      Real interest rates--that is, the portion of the rate that exceeds
    inflation--were markedly higher in the 1980s than in the prior three
    decades. In real terms, short-term rates had actually been negative for
    much of the 1970s, but they averaged almost four percent in the 1980s;
    long-term real interest rates were as much as much as two to three
    percentage points higher than in the prior three decades (see Chart III-
    2).

      Under this Administration, saving has rebounded, mainly due to lower
    deficits. In the first three quarters of calendar 1996, net national
    saving averaged 5.4 percent of GDP. In fact, over 90 percent of the
    improvement in the net saving rate in the last four years is
    attributable to lower deficits.
      Higher real interest rates in the early 1980s attracted foreign
    capital into the United States, driving up the dollar in foreign
    exchange markets. The foreign capital helped offset some of the fall in
    domestic saving and helped to cushion U.S. investment. But it came at a
    price. The higher dollar pushed up the U.S. trade deficit significantly,
    causing competitive problems for American manufac-

    [[Page 24]]

    turers and industrial workers. The Nation entered the 1980s as the world's largest creditor; it left as the largest debtor.
      Thus, big deficits unsettle potential investors--they raise interest
    rates, increase the risk of ballooning future Government credit demands
    and higher inflation, and create uncertainty in the currency markets. In
    response, business decision makers and other investors will likely buy
    safer, shorter-term securities rather than risk their money in long-term
    commitments for new factories, machines, and other productive
    investments. As a result, investment declines, and the economy is poorer
    for the foreseeable future.
      And, in fact, despite the increase in borrowing from abroad, net
    investment \4\ fell in the 1980s. The share of net private domestic
    investment (including residential and nonresidential spending) fell from
    over seven percent to five percent of GDP (see Chart III-3). By 1992,
    the ratio of net investment to GDP had dropped to just 2.5 percent.
    ---------------------------------------------------------------------------
      \4\ That is, gross investment minus depreciation of the Nation's
    capital stock.
    ---------------------------------------------------------------------------
      With the rise in net saving since then, net investment has rebounded.
    Equipment investment, which includes computer purchases, has risen
    especially rapidly--with the increases averaging 11 percent a year in
    inflation-adjusted terms.

      The economy grew much slower in the 1980s than in prior decades,
    partly due to the fall in saving and investment. From the business cycle
    peak in 1960 to the peak in 1980, real economic growth averaged 3.7
    percent a year--compared to 2.6 percent during the business cycle of the
    1980s. By reducing national saving, the 1980s-era deficits held down
    capital formation enough to cut real potential GDP at the end of the
    decade by an estimated 2.5 to 3.5 percent. If incomes had been three
    percent higher in 1996, the average person would have had $600 more in
    disposable income to spend.

    [[Page 25]]

      Growth has improved in the past four years, compared to 1988-1992. In
    fact, private-sector GDP has grown since 1992 faster than in either of
    the two previous Administrations. Because the government component of
    GDP is shrinking now, whereas it rose rapidly in the 1980s, the overall
    numbers do not fully reflect this strength.
      Still, several factors continue to hold the economy back. First, the
    stagnant saving and low investment of the 1980s and early 1990s are
    still having an effect. Only years of higher investment will offset the
    capital that was not put in place over the preceding 12 years. Second,
    the labor force is growing more slowly. And third, the recent slow
    growth of the major European economies and Japan has constrained the
    exports of even the newly revitalized and competitive U.S. economy.

    What the Administration Has Accomplished

      When the President took office, the deficit was high and rising. It
    had reached almost five percent of GDP in 1992, and projections
    suggested that it would not fall below four percent of GDP even during
    the anticipated economic recovery over the following four years. Then,
    according to the projections, the deficit would rise again, and continue
    rising without limit in the future.
      The President took action.

      The Omnibus Budget Reconciliation Act of 1993 (OBRA 1993): Upon taking
    office, the President proposed a five-year deficit reduction program
    that was largely enacted later that year as OBRA 1993.
      The law was designed to cut projected deficits from 1994 to 1998 by a
    total of $505 billion, cutting spending and raising revenues about
    equally. Of the spending cuts, about $100 billion came in entitlement
    programs, mostly in health care programs (although expanded health
    coverage offset some of the savings); other cuts came in discretionary
    spending and interest costs. All income tax rate increases fell on the
    top 1.2 percent of families. At the same time, the plan cut taxes for 15
    million working families by expanding the Earned Income Tax Credit.
      But, largely because the economy has performed better than expected,
    the Administration now projects that the plan will cut the 1994-98
    deficits by $924 billion (see Chart III-4). Specifically, the plan
    helped cut interest rates and spur growth, thereby generating more
    Federal revenues and less spending on unemployment compensation and
    other social benefits. Lower interest rates also helped to cut Federal
    costs for deposit insurance and for servicing the debt. Meanwhile, the
    Administration's push for health care reform helped to slow the rise in
    health care inflation, thus helping to slow the growth in Medicare and
    Medicaid.

      While cutting the deficit, the President's plan also shifted resources
    toward Administration priorities in education and training, the
    environment, science and technology, and law enforcement. These
    investments were intended to raise living standards and the quality of
    life, both now and in the future.

      Budget Cuts Since OBRA 1993: The President has continued to cut the
    budget the right way--eliminating wasteful and lower-priority spending
    while preserving key investments. The President and Congress have
    scrapped over 200 programs and projects entirely, while cutting hundreds
    more. Spurred by the Vice President's National Performance Review,
    departments and agencies also have cut their workforces, streamlined
    programs, reduced paperwork, and overhauled their procurement systems.
      The Economic Benefits: The President's success in cutting the deficit
    is paying huge dividends.
      Falling deficits enabled the Federal Reserve to hold short-term
    interest rates low in 1993. In addition, the markets also reacted
    favorably, cutting long-term rates. Just as rising deficits increase
    investor uncertainty about credit demands, inflation, and currency
    fluctuations, the prospect of continually falling deficits into the
    future eases uncertainty, prompting investors to risk their money on the
    new factories and equipment that enhance productivity and, thus, make
    the economy grow.
      Short-term rates stayed low through the President's first year in
    office. As for long-

    [[Page 26]]

    term rates, the yield on 10-year Treasury notes fell
    below six percent in 1993--the first time since 1972 that the rate was
    this low. Lower long-term rates helped to stimulate investment in
    housing and business equipment, spurring the recovery.
      Interest rates later rose somewhat as the economy expanded, but they
    remained at very low levels for a rapidly growing economy with such low
    unemployment. In fact, the last time the economy had unemployment as low
    as today, the rate on the 10-year Treasury bond was about two percentage
    points higher.
      Future interest rates likely will depend on the success of efforts to
    balance the budget over the next five years. A bipartisan agreement this
    year would greatly foster chances of further cuts in both short- and
    long-term rates.
      What have we learned? That, contrary to some views, deficit cutting
    can go hand-in-hand with economic growth--if the deficit cutting allows
    the Federal Reserve to maintain low interest rates, and if it's credible
    in the financial markets. In the months between the announcement and
    enactment of the President's 1993 economic plan, economic activity
    picked up. As shown in the monthly employment reports, job gains
    accelerated, and over the next four years, the economy created over 11
    million new jobs--about 93 percent of them in the private sector (see
    Chart III-5).

       The job gains occurred without an increase in inflation, which has
    been remarkably stable for several years. Although the Consumer Price
    Index (CPI) rose a bit more last year, the increase was due to faster
    increases in volatile food and energy prices, which experts do not
    expect to see again this year. If anything, the underlying rate of
    inflation has fallen (see Chart III-6).

    [[Page 28]]

      Family Incomes, Poverty, and Inequality: More jobs, low inflation, and
    steady growth can foster a widely shared rise in living standards, as
    witnessed by the last two years. After many years of, at best, modest
    gains in median family income, 1995 witnessed one of the largest real
    gains in two decades--1.8 percent. Moreover, people in all kinds of
    households gained. Poverty fell for the second straight year (see Chart
    III-7), and groups at the bottom of the income distribution actually
    enjoyed larger percentage gains than those at the top.

      The stronger investment climate also sent stocks much higher. The Dow-
    Jones Industrial Average has risen an average of 18 percent a year from
    December 1992 to December 1996--more than half again as fast as in the
    prior 12 years. Corporate profits, the underpinning for the value of
    stocks, also have soared. Just as important, the profit gains have not
    come at the expense of wages, which have risen in this period, but are
    mainly due to falling corporate interest payments and a slowdown in
    employers' health insurance costs.
      To be sure, the strong economy is not due to the President's budget
    policy alone. But just as surely, his policies have contributed to a
    stronger financial climate, enabled the Federal Reserve to maintain low
    interest rates, released extra saving for private investment, and showed
    skeptics that the Nation's leaders could cut the deficit. These
    successes have played their part in revitalizing the economy in the last
    four years.

    What Remains To Be Done

      The best way to preserve and strengthen the current economic expansion
    is to cut the deficit further. This budget reaches balance in 2002--a
    goal widely shared by Congress and the public. The President is
    committed to achieving it, and his previous success in cutting the
    deficit puts it well within reach.
      But the goal of reaching balance is not without controversy. Some
    observers would

    [[Page 29]]

    balance the budget every year--no matter what the
    circumstances; they even would enshrine the goal in the Constitution by
    passing an amendment to that effect. Others argue that further deficit
    cutting is unnecessary, if not economically harmful. Both of these
    visions are misguided.

      A Balanced Budget Requirement: A requirement to reach balance every
    year is potentially harmful. Virtually all taxes, and many spending
    programs, respond automatically to changing economic conditions. That
    is, when the economy is weak and incomes fall, income tax revenues fall
    as well; unemployment compensation and other benefits also cushion the
    effect of the downturn on consumer buying power. Without these
    ``automatic stabilizers,'' economic downturns would be much worse.
      Consider what could happen under a balanced budget amendment. A weak
    economy would mean fewer tax revenues and more spending on unemployment
    and other programs. As a result, a balanced budget requirement could
    force a tax increase or spending cuts--or both--in the middle of a
    recession. Those steps would make a weak economy even weaker.
      Nor are any ``escape hatches'' from the budget-balancing requirement--
    for times of economic distress--guaranteed to work. One reason is that
    economists are notoriously slow to recognize economic downturns.
    Consequently, by the time they saw the slowdown and Congress acted to
    ease the balanced-budget requirement, the economic damage would be done.
    The better practice is to aim for balance, but to adjust budget policy
    according to circumstances.

      A Reversal of Course: Allowing the deficit to begin rising again would
    be economically damaging. Admittedly, as some analysts argue, continued
    economic growth and low interest rates could keep Federal debt growing
    more slowly than the economy as a whole, and that would help to keep
    Federal interest costs under control. The problem is, the Nation faces
    some important challenges in the not-so-distant future for which we
    should begin to prepare. A balanced budget would be a good first step.
      Today, the Nation is benefitting from its demography. Its largest
    population group--the ``baby-boom'' generation, born between 1946 and
    1964--is entering its highest-earning years. They pay much more to the
    Government than they receive in direct benefits. But the situation will
    begin to change in about 12 years.
      At that point, the oldest baby-boomers will become eligible for early
    retirement under Social Security. Because the next generation of
    taxpayers is smaller in size, they will contribute relatively less to
    the Government in revenues, making it harder to support the baby-boomers
    in their retirement. The President has already called for a bipartisan
    process to address that problem. But if we don't balance the budget
    beforehand, the challenge of supporting the baby boomers will only grow
    larger.
      A balanced budget by 2002 will add a margin of safety into the budget
    to absorb the coming demographic burden--and any unforeseen problems
    before then. As illustrated in Chart III-8, if Congress enacts the
    President's budget and continues his proposed limits on Medicaid while
    controlling discretionary spending beyond 2002, the Government should be
    able to avoid an explosion of debt when the baby-boomers retire. (See
    Chapter 2 of Analytical Perspectives for a full discussion of the
    methodology underlying these projections.)

    The Administration's Economic Assumptions

      This budget, like the Administration's previous budgets, is based on
    prudent assumptions about economic growth, interest rates, inflation,
    and unemployment for the foreseeable future. As with the previous
    budgets, the assumptions are close to the consensus among private
    forecasters. While the Administration believes that, with sound
    policies, our economy can do even better, we also believe that we should
    use prudent, mainstream economic assumptions for budget planning.
      The Congressional Budget Office (CBO) also prepares economic
    assumptions with which to evaluate budget proposals. In the past four
    years, CBO's assumptions generally have

    [[Page 30]]

    been quite close to this Administration's, although small differences can generate large gaps in budget projections over five to seven years.
      In recent years, the economy generally has performed somewhat better
    than either the Administration or CBO had projected, showing faster
    growth and lower unemployment and inflation.
      The Administration's assumptions include the following:
      Growth: Real growth will dip slightly below the trend for the
              next two years, averaging two percent on a fourth quarter over
              fourth quarter basis. Later, real GDP growth will average 2.3
              percent per year--the Administration's estimate of its
              potential growth rate.
      Interest rates: If Congress enacts the President's budget
              plan, interest rates will fall as the budget approaches
              balance. The yield on 10-year Treasury notes, 6.3 percent at
              the end of 1996 and higher earlier in the year, will decline
              to 5.1 percent and then stabilize; on a discount-basis, the
              90-day Treasury bill rate will drop to four percent, from
              around 5.1 percent. The long-term real rate will be about 2.5
              percent, and the short-term real rate about 1.5 percent. These
              real interest rates are consistent with U.S. experience during
              past periods of steady growth and low inflation.
      Inflation: Inflation will remain fairly stable. The CPI will
              rise an average of 2.7 percent a year from 1997 through 2002,
              down slightly from the 3.3 percent increase in 1996 (which was
              aggravated by special factors). The price index for GDP
              (measured on a chain-weighted basis) will rise at a 2.6
              percent annual rate--somewhat faster than in 1996. The gap
              between these two measures of inflation, which has been large
              in the past, will narrow due to recent and forthcoming changes
              to the methodology underlying both indexes--including improved
              measures of health care

    [[Page 31]]

              inflation (due later this year) and an
              update of the CPI market basket (effective in 1998).
      Unemployment: Civilian unemployment will be 5.5 percent by the
              start of 1998, very near the current rate, and the average
              level will remain there.
      The Administration does not forecast the economy's cyclical pattern
    beyond the next few quarters; within that horizon, it sees no sign of an
    impending downturn. If the economy continues to grow for the entire
    forecasting period, the current expansion would become the longest in
    this century.
      In some years, growth may exceed 2.3 percent; in others, it may fall a
    bit short. But, the Administration's assumptions should be, on average,
    close to correct for this period, and should provide a sound basis for
    reaching balance by 2002.
      ----------------------------------------------------------------------

                                         Table III-1.  ECONOMIC ASSUMPTIONS \1\
                                      (Calendar years; dollar amounts in billions)
    ----------------------------------------------------------------------------------------------------------------
                                                                                Projections
                                               Actual --------------------------------------------------------------
                                                1995     1996     1997     1998     1999     2000     2001     2002
    ----------------------------------------------------------------------------------------------------------------
    Gross Domestic Product (GDP):
      Levels, dollar amounts in billions:
        Current dollars.....................    7,254    7,577    7,943    8,313    8,717    9,153    9,610   10,087
        Real, chained (1992) dollars........    6,743    6,901    7,056    7,197    7,355    7,525    7,699    7,877
        Chained price index (1992 = 100),
         annual average.....................    107.6    109.9    112.7    115.7    118.7    121.8    125.0    128.2
      Percent change, fourth quarter over
       fourth quarter:
        Current dollars.....................      3.8      5.0      4.6      4.7      5.0      5.0      5.0      5.0
        Real, chained (1992) dollars........      1.3      2.8      2.0      2.0      2.3      2.3      2.3      2.3
        Chained price index (1992 = 100)....      2.5      2.3      2.5      2.6      2.6      2.6      2.6      2.6
      Percent change, year over year:
        Current dollars.....................      4.6      4.5      4.8      4.7      4.9      5.0      5.0      5.0
        Real, chained (1992) dollars........      2.0      2.3      2.2      2.0      2.2      2.3      2.3      2.3
        Chained price index (1992 = 100)....      2.5      2.2      2.5      2.6      2.6      2.6      2.6      2.6

    Incomes, billions of current dollars:
        Corporate profits before tax........      599      652      676      714      757      796      816      849
        Wages and salaries..................    3,431    3,628    3,808    3,982    4,168    4,374    4,590    4,810
        Other taxable income \2\............    1,532    1,612    1,684    1,748    1,809    1,882    1,967    2,068

    Consumer Price Index (all urban): \3\
        Level (1982-84 = 100), annual
         average............................    152.5    156.9    161.2    165.5    170.0    174.6    179.3    184.1
        Percent change, fourth quarter over
         fourth quarter.....................      2.7      3.1      2.6      2.7      2.7      2.7      2.7      2.7
        Percent change, year over year......      2.8      2.9      2.7      2.7      2.7      2.7      2.7      2.7

    Unemployment rate, civilian, percent:
        Fourth quarter level................      5.5      5.3      5.4      5.6      5.5      5.5      5.5      5.5
        Annual average......................      5.6      5.4      5.3      5.5      5.5      5.5      5.5      5.5
    Federal pay raises, January, percent:
        Military............................      2.6      2.6      3.0      2.8      3.0      3.0      3.0      3.0
        Civilian \4\........................      2.6      2.4      3.0      2.8       NA       NA       NA       NA

    Interest rates, percent:
        91-day Treasury bills \5\...........      5.5      5.0      5.0      4.7      4.4      4.2      4.0      4.0
        10-year Treasury notes..............      6.6      6.5      6.1      5.9      5.5      5.3      5.1      5.1

    ----------------------------------------------------------------------------------------------------------------
    NA=Not Available.

    \1\ Based on information available as of mid-November 1996.

    \2\ Rent, interest, dividend and proprietor's components of personal income.

    \3\ CPI for all urban consumers. Two versions of the CPI are now 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.

    \4\ Overall average increase, including locality pay adjustments. Percentages to be proposed for years after
      1998 have not yet been determined.

    \5\ Average rate (bank discount basis) on new issues within period.

      ----------------------------------------------------------------------