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


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                          ECONOMIC ASSUMPTIONS

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                        1.  ECONOMIC ASSUMPTIONS

                               Introduction

  The economy is in excellent health. Not only are current conditions 
favorable, but they provide a solid foundation for continued economic 
progress. During the last two years, the economy achieved the often 
elusive ``soft landing.'' Real economic growth slowed from the 
unsustainable 3.5 percent of 1994 to an average of 2 percent per year--
close to the Administration's 2.3 percent estimate of the economy's 
potential growth rate. This occurred without an increase in the 
unemployment rate. Indeed, during this time, 4.8 million new jobs were 
created--enough new jobs to absorb all the new entrants into the labor 
force and raise the employment/population ratio to record levels. 
Inflation, meanwhile, has been low and relatively stable. In financial 
markets, interest rates at the end of 1996 were lower than two years 
ago, and the Dow Jones Industrial average gained 72 percent during 1995-
1996.
  The Administration projects real growth to continue during the next 
two years at the same rate as that of the past two years--2.0 percent. 
This will be enough growth to create millions more new jobs, while 
holding the unemployment rate close to its current level. Growth of 
demand is not projected to put in jeopardy the success achieved in the 
last four years in controlling inflation. Passage of the President's 
balanced budget plan is expected to bring interest rates down further.
  Beyond 1998, the economic assumptions represent anticipated trends 
rather than a precise cyclical pattern. Assuming that the deficit 
continues on a path toward balance in 2002, potential growth on average 
is expected to be slightly faster than in recent years, unemployment and 
inflation are expected to remain low, and interest rates are likely to 
continue to decline as the budget approaches balance.
  Most private forecasters also share a favorable view of the economic 
outlook. The most recent Blue Chip consensus forecast, an average of 50 
private forecasts, also calls for real GDP growth to average 2.0 percent 
through 1998 and to pick up a bit thereafter. The consensus expects 
inflation and unemployment to remain low through 2002. However, the 
consensus expects interest rates to hold at around current levels, 
rather than decline as in the Administration's projection. This 
difference is probably due to differences in fiscal policy assumptions. 
The Administration assumes that a credible balanced budget agreement 
will be reached this year and fully implemented in the coming years. If 
private sector forecasters based their projections on this fiscal policy 
assumption, they too would likely project a downward trend for interest 
rates. The broad similarity between these private sector forecasts and 
the Administration's assumptions indicates that the assumptions provide 
a reasonable, prudent basis for projecting the budget.
  The business cycle expansion that began in April 1991 has already 
outlasted all but three of the previous 20 expansions during this 
century. If the expansion continues through December 1998, it will 
become the century's longest peacetime expansion. If it continues 14 
months beyond that date, through February 2000, it will surpass even the 
record of 106 months set by the 1960s expansion. With inflation under 
control, incomes and employment on the rise, consumer and business 
confidence high, interest rates trending down, and fiscal and monetary 
policy supporting noninflationary growth, this expansion certainly has 
the potential to enter the record books.
  This chapter begins with a review of recent developments, followed by 
a discussion of two important statistical issues involving the 
measurement of real growth and inflation that are relevant to 
understanding recent trends. Next, the Administration's projections are 
presented and compared with those of the Congressional Budget Office 
(CBO). The chapter concludes with an analysis of the impact on the 
projected deficit of changes in economic assumptions since last year's 
budget, and with estimates of the sensitivity of the budget to changes 
in economic assumptions.

                       Fiscal and Monetary Policy

  The favorable economic environment currently prevailing and the 
buoyant outlook reflect the underlying strength of the American economy 
when it is supported by sound fiscal and monetary policies. The Omnibus 
Budget Reconciliation Act of 1993 (OBRA93) was intended to set the 
budget deficit on a sharp downward path. In 1992, prior to passage of 
OBRA93, the deficit hit a postwar record of $290 billion, 4.7 percent of 
gross domestic product (GDP). Since then, the deficit has shrunk in 
every year. In 1996, the deficit was only $107 billion, the lowest level 
in 15 years and just 1.4 percent of GDP. The last time the deficit share 
was this low was over two decades ago. Special factors added to the 
deficit's decline in 1996, and without those special factors in 1997, 
the deficit is expected to increase modestly. However, if the 
President's budget is adopted, the deficit will resume its downward 
trend in 1998.
  The Administration originally estimated that OBRA93 would reduce 
deficits during 1994-98 by a cumulative total of $505 billion. The 
budget and the economy have far outperformed the projections made in 
1993. It now seems likely that the cumulative deficit reduction through 
1998, even without the further deficit reductions proposed in this 
budget, will be around $924 billion.

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  The lower deficit path contributed greatly to the economy's soft 
landing in 1995-1996. It enabled interest rates to decline, rather than 
rise--as has often occurred at similar stages of past business cycles. 
Lower interest rates, in turn, have helped propel the stock market, 
thereby lowering businesses' cost of capital and boosting household 
wealth. Lower interest rates have stimulated business investment in new 
plant and equipment and household interest-sensitive purchases of 
durable goods and new homes. The ensuing boost to business and household 
demand created new jobs and raised incomes as the economy continued to 
grow neither too fast nor too slowly. It also increased the Nation's 
productive capacity, and helped productivity to grow faster--thereby 
providing protection against future inflation.
  Monetary policy helped to engineer the soft landing by acting 
preemptively to prevent inflation from picking up as the economy 
approached its potential output. In the past, when the economy 
approached capacity, excessive demands in labor and product markets 
often pushed it beyond the noninflationary limits. The ensuing strains 
caused inflation to accelerate, and forced the monetary authorities to 
tighten policy and precipitate a recession.
  In this expansion, however, monetary policy tightened in 1994 and 
early 1995, when the economy was growing rapidly but before inflationary 
pressures had yet appeared. During 1995 and early 1996, as the pace of 
economic activity slowed and incipient inflationary pressures waned, the 
Federal Reserve gradually relaxed monetary policy to support economic 
growth. The last move in this direction occurred in January 1996 when 
the Federal Open Market Committee reduced the federal funds rate \1/4\ 
percentage point to 5\1/4\ percent. During the past year, as the soft 
landing became evident, the Federal Reserve kept monetary policy 
unchanged.
  The stability of monetary policy since January 1996 helped maintain 
short-term interest rates at relatively stable levels. The 3-month 
Treasury bill rate has been on a plateau near 5 percent. Long-term rates 
have been more volatile, moving up as the pace of activity quickened in 
the spring and down as the economy slowed in the second half of the 
year. During the first six months of the year, the 10-year Treasury bond 
yield rose 1\1/4\ percentage points to 7 percent in June. By the end of 
the year, however, the rate was 6.3 percent. Although higher than at the 
end of 1995, that rate was still 1\1/2\ percentage points lower than two 
years earlier, and very low by historical standards for periods with 
similar unemployment and economic growth.

                           Recent Developments

  Real Growth: The economy expanded an estimated 2.8 percent over the 
four quarters of last year, up from the 1.3 percent pace of the prior 
year. Several important but transitory factors restrained growth around 
the start of 1996. The Federal Government was partially shut down twice 
by budgetary disputes between the Administration and Congress. In 
addition, a severe January blizzard paralyzed business activity on the 
East Coast; and in March, motor vehicle production was sharply curtailed 
by a strike at General Motors, the Nation's largest automaker. In the 
second quarter, however, the economy grew at nearly a 5 percent annual 
rate as it made up for the earlier losses of output and sales. In the 
second half of the year, the pace of economic activity moderated.
  The fastest-growing component of GDP last year was business fixed 
investment, which was up at a double-digit pace during the first three 
quarters of the year. Outsized advances in spending on computers and 
other information processing equipment continued to lead the way, but 
businesses also boosted their outlays for other types of equipment and 
structures. During the past two years, business investment has been 
propelled by a need to reduce costs in competitive world markets, and 
also to expand capacity as the economy operated close to its potential, 
leaving little excess capacity to exploit. During 1995-1996, industrial 
capacity grew by 4 percent annually, up from the 2\1/2\-percent average 
of the prior three years. Business inventory investment also contributed 
to GDP growth last year, especially in the third quarter. A pick-up in 
final sales in the fourth quarter kept inventories in line with sales.
  The expansion was also supported by the household sector's willingness 
and ability to purchase big-ticket durable goods and homes. Consumer 
confidence rose during the year, and by the second half was at its 
highest level in years. Expanding employment and income and a booming 
stock market provided consumers with the wherewithal to spend. Over the 
first three quarters of the year, consumer spending rose at a 2\1/2\-
percent annual rate, led by durable goods purchases. New home sales 
during the first 11 months of the year reached the highest level in 17 
years, helping to push housing starts to the highest level in eight 
years. The residential investment component of GDP increased at a 6 
percent annual rate over the first three quarters of the year.
  Even the government sector contributed modestly to growth last year. 
Over the first three quarters, Federal Government consumption and gross 
investment rose at a 4 percent annual rate. All of the growth, however, 
was attributable to a catch-up for the lost activity during the 
shutdowns in the fourth quarter of 1995. By the third quarter of 1996, 
the Federal component of GDP was lower than a year earlier. State and 
local governments' consumption and gross investment rose at a 2\1/4\ 
percent rate over the first three quarters of 1996, about the same pace 
as during 1995. State and local government finances have benefited from 
the long expansion, which has boosted revenues.
  The foreign sector was the main restraint on GDP growth last year. 
During the first three quarters, net exports of goods and services 
slowed growth by 1 percentage point. The wider trade deficit reflected 
the stronger growth of domestic demand in the U.S. than in several of 
our trading partners.

  Labor Markets: During 1996, nearly 2.6 million new jobs were created, 
bringing the total since this Adminis-

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tration came into office in January 
1993 to 11.2 million. Almost all the new jobs added last year were in 
the private sector, primarily in service industries. Manufacturing 
payrolls shrank for the second consecutive year. The availability of 
jobs throughout the country provided the incentive for more people to 
enter the labor force and to find work. By the fourth quarter of 1996, 
both the labor force participation rate and the employment/population 
ratio had reached their highest levels in the postwar period.
  The unemployment rate last year averaged 5.4 percent, the lowest level 
since 1989. By the end of the year, 32 States had unemployment rates of 
5 percent or less. Unemployment rates were 4 percent or less in States 
with the tightest labor markets. Even areas of the country that had 
lagged behind in job creation earlier in the recovery experienced 
favorable job markets and the lowest unemployment rates in years. By the 
end of 1996, almost all demographic groups enjoyed lower unemployment 
rates than a year earlier.

  Inflation: Despite the low unemployment rate last year, inflation 
remained under control. The broadest measure of inflation, the GDP 
chain-weighted price index, rose at just a 2.2 percent annual rate 
during the first three quarters, down from 2.5 percent during 1995. As 
for consumer prices, core inflation measured by the Consumer Price Index 
excluding food and energy increased only 2.6 percent during 1996, the 
slowest rise since 1965. The overall Consumer Price Index rose 3.3 
percent last year, mainly because of sharp increases in energy prices. 
These are not expected to be repeated in 1997.
  The low inflation rate was made possible by a moderate growth of labor 
compensation. The most comprehensive measure of labor compensation, the 
Employment Cost Index (ECI), rose just 2.8 percent during the most 
recent 12 months, virtually the same as it did during the previous year. 
This is the smallest rise since the series began in 1981. The ECI is 
composed of both benefits and wages. In recent years, benefit costs have 
slowed substantially. Firms have been able to rein in health insurance 
costs thanks to innovations in health care delivery, and have also been 
able to reduce their contributions to retirement programs because of 
booming equity markets. Cash wages, however, increased more rapidly in 
the past year. This is consistent with the results of most studies that 
reveal that there is a trade-off between benefits and cash wages. 
Savings in benefit costs eventually are passed on to workers in the form 
of higher cash wages.
  The favorable inflation performance last year sheds new light on the 
key question for monetary policy: What is the current threshold level of 
unemployment below which inflation tends to accelerate (and above which 
it decelerates)? This threshold has been called NAIRU--for 
``nonaccelerating inflation rate of unemployment.'' For much of the 
1980s, the consensus was that NAIRU was in the neighborhood of 6 
percent. This estimate proved to be consistent with the experience of 
1987-1990, when inflation increased as unemployment fell below 6 
percent.
  A 6 percent estimate of NAIRU, however, is not consistent with the 
experience since 1994. Last year, unemployment averaged 5.4 percent. If 
NAIRU was 6 percent, inflation should have risen; instead it declined, 
as measured by the GDP chain-weighted price index and by the core CPI. 
In light of recent experience, it is likely that NAIRU is now well below 
6 percent. In the 1997 Budget, the Administration had assumed NAIRU was 
5.7 percent; in this Budget, NAIRU is assumed to be 5.5 percent, in part 
because of the moderate inflation experienced last year.
  A decline in NAIRU in recent years can be attributed to three factors. 
First, the aging of the baby boomers has shifted the composition of the 
labor force towards groups that have lower unemployment rates. To 
achieve the same degree of labor market tightness in 1996 as a decade 
earlier would now require a lower overall unemployment rate. Second, 
heightened competition in product and labor markets may have made 
businesses less able to raise their prices, and workers more cautious in 
seeking wage gains. Finally, for much of the 1970s and early 1980s, wage 
demands appear to have been based on unrealistic expectations of 
productivity growth that did not incorporate the productivity slowdown 
that began in 1974. Because of these demands, the level of NAIRU 
consistent with stable inflation was higher. By 1996, however, the wage 
and productivity relationship was in better balance.

                           Statistical Issues

  Serious questions have been raised recently about whether real GDP 
accurately measures the economy's growth and whether the CPI accurately 
measures inflation.

  Real Growth: In the past two years, a wide and growing discrepancy has 
developed between growth measured by the change in output (the familiar 
real GDP) and growth measured by the increase in real income (real Gross 
Domestic Income). In the two years ending in the third quarter of 1996, 
the most recent data available, real GDP rose at an average annual rate 
of 2.1 percent. Growth measured by real Gross Domestic Income (GDI), 
however, was up at a more rapid 3.1 percent rate. In the third quarter 
of 1996, the discrepancy had widened to 2.1 percentage points: GDP was 
up at a 2.1 percent annual rate, but GDI was up at a 4.2 percent pace.
  In an ideal world, the two measures would be equal. In reality, they 
always differ because of inconsistencies and gaps in source data. The 
differences, however, have rarely been as large as they are now. The 
difference between the output and income measures is called the 
statistical discrepancy; it was nearly $100 billion in the third quarter 
of 1996--a record 1.3 percent of nominal GDP.
  The divergent readings during the last two years make it difficult to 
ascertain how fast the economy has grown and where the economy is with 
respect to 


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potential output. There are three reasons, however, for 
believing that the output measure of growth may be an underestimate.
    First, Treasury receipts during 1996 came in strong. While 
          some of this may be due to capital gains receipts spurred by 
          the booming stock market, which are not included in the 
          national accounts measures, some may also be from taxes levied 
          on economic activity that is not showing up on the output side 
          (that is, GDP). The receipts growth is less puzzling in light 
          of the higher income-side measure.
     Second, with GDP growth in the neighborhood of a 2.0 
          percent annual rate during the past two years, the 
          unemployment rate might have been expected to have held steady 
          or even risen slightly. Instead, it fell 0.3 percentage point, 
          which is more consistent with the growth rate measured from 
          the income side.
     Third, growth rates closer to the higher income-side 
          reading would mean that productivity growth was also stronger 
          than reported and unit labor cost growth less than reported. 
          That more favorable scenario fits better with the subdued 
          inflation experienced last year.
  The incorporation of new source data in the forthcoming July benchmark 
revisions to the National Income and Product Accounts may narrow the 
difference between the output and income sides. On the other hand, the 
difference is so large that even after the benchmark there may still be 
considerable uncertainty about the pace of economic activity in recent 
years.

  Inflation: In December, the Advisory Commission to Study the Consumer 
Price Index, appointed by the Senate Finance Committee and led by 
Michael Boskin, former Chairman of the Council of Economic Advisers, 
reported its finding that the Consumer Price Index for urban consumers 
(CPI-U), compiled by the Bureau of Labor Statistics (BLS), overestimates 
annual changes in the cost of living by 1.1 percentage points. The 
Commission's findings were controversial. Although there is a widely 
shared view that problems in calculating the CPI may give it an upward 
bias, there is far less agreement over the size of the bias and over the 
practical steps that should be taken to remedy it.
  The BLS continually tests the CPI and regularly makes improvements in 
it when problems are discovered. It has been unable to identify 
quantitatively more than a fraction of the bias reported by the 
Commission. Recently, BLS has proposed a number of changes in the way it 
computes the CPI that are expected to reduce measured inflation over the 
next several years.
  The CPI is a ``fixed-weight'' price index. The market basket on which 
it is based consists of about 200 categories of goods and services which 
are updated only once every 10 years or so. Within each of these 
categories, however, about one-fifth of the individual items are 
replaced each year, so the CPI can keep current with changing brands and 
other minor variations in consumption patterns. Essentially, the CPI 
measures how much this market basket costs each month. The CPI was last 
updated in 1987 to reflect consumption patterns in 1982-1984; the next 
rebasing is scheduled for January 1998 when 1993-1995 spending patterns 
will be used.
  The CPI has some long-recognized disadvantages which are highlighted 
in the Advisory Commission's report. In the first place, when relative 
prices change, people change their consumption patterns to reduce the 
effects of such changes on their living standards; because it is a 
fixed-weight index, the CPI misses these adjustments. And, because it is 
not based on current spending patterns, the CPI can miss the 
introduction of new products, which often have sharp price declines 
early in their life cycle. Also, when consumers switch from department 
stores to discount outlets to save money on name-brand merchandise, the 
BLS does not record this as a drop in consumer prices, because the 
discount outlets are assumed to provide less service.
  The single largest source of bias identified by the Advisory 
Commission is insufficient adjustment for quality changes. Sometimes 
goods rise in price because their quality improves; for example, the 
higher prices paid today for many medical services may reflect the 
higher quality of these services, including a better chance of survival 
and less pain or confinement during treatment. Quality can also decline, 
of course, and if such changes are missed then the CPI would understate 
inflation. The BLS attempts to capture the effects of quality changes 
where there are reliable measures. For example, beginning this year, the 
BLS revised the way it treats hospital costs to account better for 
quality improvements. Most experts acknowledge that the task of 
incorporating quality changes into the CPI is quite difficult.
  If the upward bias is as large as the Advisory Commission suggests, 
recent economic history would have to be rewritten to reflect the 
revised inflation estimate. For example, the decline in real weekly 
wages over the past three decades would be reversed if the CPI has 
really been overstated consistently by 1.1 percentage points per year 
since 1965. Real economic growth would also be raised by between 0.5 and 
1.0 percentage points per year. Productivity growth would show a 
comparable increase. These are large changes, and it is not yet clear 
whether there is other evidence to support such wholesale revisions to 
recent history. This is another reason why the Advisory Commission's 
findings have been controversial.
  Because many Federal benefit programs and tax provisions are indexed 
to the CPI, a lower rate of increase in the CPI would be helpful to the 
budget. Limiting the rate of change in the CPI by 1.1 percentage points 
per year compared with the current Administration forecast would lower 
the deficit projected in 2002 by $58 billion, and would reduce the 
cumulative deficit between 1997 and 2002 by $145 billion. These figures 
indicate how important the CPI is to the budget, but they are not 
necessarily a reason for changing the indexing formulas that rely on the 
CPI. Because the CPI 

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is important to the budget and to a wide variety of 
private contracts, any changes made to this index need to be studied 
carefully and justified thoroughly.
  While the Advisory Commission has recommended changes in technical 
practices at BLS that might be expected to reduce the bias in the CPI, 
the actual effects of these changes remain to be determined. Moreover, 
the recommended procedures would require data that are not currently 
available in time for the monthly production of the CPI. In preparing 
its report, the Advisory Commission relied heavily on retrospective data 
that are unavailable when the CPI is actually produced. Other gaps in 
the data were filled by the informed judgements of its authors. This is 
a common practice in academic studies, and it is appropriate in that 
context, but it would be questionable in a Federal statistical series 
that must be based on objective data.
  The technical experts at BLS, who have a long research tradition that 
has exposed weaknesses in the CPI in the past and provided remedies for 
them, will continue the scheduled sequence of improvements while 
continuing to refine the estimates of other possible biases. 
Improvements in procedures for hospital costs in January of 1997 will 
likely reduce measured inflation; and updating the CPI market basket in 
1998 can be expected to lower reported inflation by bringing the market 
basket weights more in line with current experience.
  All observers agree that the Nation needs the best possible measure 
for the cost of living. No change will be made to the CPI that is not 
technically appropriate for the better measurement of living costs.

                          Economic Projections

  Key assumptions: The economic projections underlying this budget are 
summarized in Table 1-1. They are based on the crucial assumption that 
the budget will be adopted. If it is, the deficit will be progressively 
reduced until the budget achieves a surplus by 2002. Deficit reduction 
is expected to continue to foster the favorable macroeconomic 
environment experienced in recent years. Interest rates would come down 
and private sector investment would continue to grow, without 

[[Page 8]]

any 
buildup of inflationary pressures. This would allow interest rates to 
decline without igniting inflation.

                                                          Table 1-1.  ECONOMIC ASSUMPTIONS \1\                                                          
                                                      (Calendar years; dollar amounts in billions)                                                      
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                                                                                                                    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.                                                                                     



  Real GDP and unemployment: Over the next two years, real GDP is 
expected to rise 2.0 percent annually, close to the rate of the past two 
years. During 1999-2002, the pace of growth is expected to quicken to 
2.3 percent annually--the Administration's estimate of the economy's 
potential growth rate. As in recent years, the fastest growing component 
of GDP is likely to be business fixed investment, stimulated by the fall 
in interest rates. Federal consumption and gross investment is projected 
to decline as the budget moves towards balance. The net export component 
of GDP is expected to move from deficit to surplus as the Federal 
deficit shrinks, and there is less need for capital from abroad to 
support domestic investment.
  The faster GDP growth in the outyears is due to an expected boost in 
trend productivity growth that is likely to accompany higher rates of 
investment. Productivity growth is projected to average 1.2 percent per 
year during the next seven years. By way of reference, from the last 
cyclical peak in the third quarter of 1990 to the third quarter of 1996, 
productivity growth was 0.9 percent per year measured from the output 
side and 1.2 percent measured from the income side.
  Potential GDP growth can be decomposed into the trend growth of 
productivity (1.2 percent) and the growth of the labor force. The 
Administration's projection assumes that the working age population will 
grow 1.0 percent annually during the next seven years, and the labor 
force participation rate will edge up 0.1 percent per year. This labor 
force projection assumes that the trends of the past six years will 
continue, which represents a significant break with experience in 1974-
1990 when both population and labor force participation were growing 
more rapidly. With the baby boom generation well into its working years, 
and both the labor force participation rate and the employment/
population ratio already at record levels, it is prudent to project 
continued but slower growth of the work force in the future.
  The real GDP growth projection of 2.0 percent during the next two 
years is consistent with a slight rise in the unemployment rate, edging 
up from the 5.4 percent average of last year to 5.5 percent by 1998. 
Thereafter, real growth is expected to be at the potential growth rate, 
implying that the unemployment rate would remain stable.

  Inflation: With projected unemployment close to or at NAIRU throughout 
the budget forecast, inflation is expected to remain steady. The GDP 
chain-weighted price index is projected to stay on a plateau of 2.6 
percent annual growth. The CPI is expected to grow 2.7 percent per year 
in almost every year, slightly slower than the 3.3 percent actual for 
1996. The CPI would continued to grow about 3.0 percent during 1997-1998 
if not for methodological improvements already instituted or planned by 
the Bureau of Labor Statistics. These are expected to trim the annual 
growth of the CPI by about 0.3 percentage point.
  Interest rates: Short- and long-term interest rates are expected to 
decline as a result of the passage of the Administration's budget 
proposals, which will reduce the Government's demands on credit markets. 
The 91-day Treasury bill rate is expected to decline steadily from 5.0 
percent at the end of 1996 to 4.0 percent by 2001 and then hold at that 
level. The 10-year Treasury bond yield, which was 6.3 percent at the end 
of last year, is projected to fall to 5.1 percent by 2001 and remain at 
that level. With inflation holding steady, these interest rate 
projections imply a reduction in real interest rates to levels seen 
previously when the Federal budget was closer to balance.
  Incomes: The decline in interest rates is expected to have important 
but largely offsetting impacts on the income of the household sector, a 
net lender in the economy, and the corporate sector, a net borrower. The 
share of personal interest income of the household sector in nominal GDP 
is expected to decline because of lower rates. On the other hand, the 
fall in rates will help keep the share of profits near the historically 
high levels that prevailed during 1996. During the first three quarters 
of last year, the share of corporate profits before tax in nominal GDP 
was the highest since 1979. The share of wages and salaries in nominal 
GDP is projected to remain close to the level of last year. Aggregate 
wages and salaries are projected to rise nearly 40 percent from 1996 to 
2002. After adjustment for inflation, real wages and salaries are 
expected to increase 15 percent.

                           Comparison with CBO

  The Congressional Budget Office (CBO) prepares the economic 
projections used by Congress in formulating budget policy. In the 
executive branch, this function is performed jointly by the Treasury, 
the Council of Economic Advisers (CEA), and OMB. It is natural that the 
two sets of economic projections be compared with one another, but there 
are several important differences, along with the similarities, that 
should be kept in mind:
     The Administration's projections always assume that the 
          President's policy proposals in the budget will be adopted in 
          full. Currently, that means the deficit will be progressively 
          reduced until the budget achieves a surplus in 2002. In 
          contrast, CBO normally assumes that current law will continue 
          to hold; thus, it makes a ``pre-policy'' projection. Both last 
          year and this, however, CBO also presented economic 
          projections based on a fiscal policy similar to the budget's.
     Both CBO and the Administration believe that balancing the 
          Federal budget by 2002 would have significant macroeconomic 
          effects, especially for interest rates and the distribution of 
          income. The Administration does not present an explicit 
          estimate of the fiscal dividend in this budget. CBO's 
          

[[Page 9]]

estimates of the dividend show that it is smaller now than it 
          was a year ago, partly because the budget is already closer to 
          balance.
    The two sets of projections are often prepared at different 
          times. The Administration's projections must be prepared 
          months ahead of the release of the budget. Some of the 
          differences in the Administration's and CBO's near-term 
          forecasts, therefore, may be due to the availability of more 
          recent data to CBO; a direct comparison with the CBO 
          projections is not always meaningful. Timing differences are 
          much less likely to play an important role in any differences 
          in outyear projections, however.
  Table 1-2 presents a summary comparison of the two sets of projections 
based on the common assumption that the deficit will be eliminated by 
2002.

                                     

                                 Table 1-2.  COMPARISON OF ECONOMIC ASSUMPTIONS                                 
                                                (Calendar years)                                                
----------------------------------------------------------------------------------------------------------------
                                                                                 Projections                    
                                                           -----------------------------------------------------
                                                              1997     1998     1999     2000     2001     2002 
----------------------------------------------------------------------------------------------------------------
Real GDP (chain-weighted) \1\:                                                                                  
  CBO January \2\.........................................      2.1      2.1      2.2      2.2      2.1      2.1
  1998 Budget.............................................      2.0      2.0      2.3      2.3      2.3      2.3
                                                                                                                
Chain-weighted GDP Price Index \1\:                                                                             
  CBO January \2\.........................................      2.4      2.6      2.6      2.6      2.6      2.6
  1998 Budget.............................................      2.5      2.6      2.6      2.6      2.6      2.6
                                                                                                                
Consumer Price Index (all-urban) \1\:                                                                           
  CBO January  \2\........................................      2.9      3.0      3.0      3.0      3.0      3.0
  1998 Budget.............................................      2.6      2.7      2.7      2.7      2.7      2.7
                                                                                                                
Unemployment rate \3\:                                                                                          
  CBO January \2\.........................................      5.3      5.6      5.8      5.9      6.0      6.0
  1998 Budget.............................................      5.3      5.5      5.5      5.5      5.5      5.5
                                                                                                                
Interest rates \3\:                                                                                             
  91-day Treasury bills:                                                                                        
    CBO January \2\.......................................      5.0      5.0      4.6      4.2      3.9      3.9
    1998 Budget...........................................      5.0      4.7      4.4      4.2      4.0      4.0
                                                                                                                
  10-year Treasury notes:                                                                                       
    CBO January \2\.......................................      6.2      6.1      5.8      5.5      5.5      5.5
    1998 Budget...........................................      6.1      5.9      5.5      5.3      5.1      5.1
----------------------------------------------------------------------------------------------------------------
\1\ Percent change, fourth quarter over fourth quarter.                                                         
\2\ Economic projections assuming balanced budget policy.                                                       
\3\ Annual averages, percent.                                                                                   

    Real GDP: The projections of real GDP growth are quite 
          similar. The Administration projects that real GDP will grow 
          at an average rate of 2.2 percent from 1997-2002; CBO projects 
          a 2.1 percent average growth rate.
     Inflation: Both the Administration and CBO expect inflation 
          to continue at a slow, steady rate over the next several 
          years. For the chain-weighted GDP price index, both predict 
          that inflation will be 2.6 percent yearly beginning in 1998; 
          CBO expects the annual rate of change in the CPI to be about 
          one-quarter percentage point higher than the Administration.
     Unemployment: CBO projects unemployment to rise from its 
          current level to around 6 percent. The Administration believes 
          unemployment can stabilize near its current level without 
          raising the rate of inflation.
     Interest rates: Both the Administration and CBO have a 
          similar decline in short-term interest rates. The 
          Administration, however, projects a slightly larger drop in 
          long-term rates than does CBO.
     Income distribution: Both CBO and the Administration expect 
          a shift of income from interest to corporate profits as a 
          result of the lower interest rates produced by a balanced 
          budget. The corporate sector is a net borrower and the profits 
          share of GDP benefits from lower interest rates. In part 
          because the Administration assumes a larger decline in long-
          term interest rates than does CBO, it projects a larger shift 
          into profits.
  CBO has a good economic forecasting record. During much of the 1980s 
its forecasts were more accurate than those of the Administration. The 
record over the last four years, however, has been more mixed. Since it 
took office in 1993, this Administration has placed the highest priority 
on careful and prudent economic forecasts. Partly because of its 
conservative approach to forecasting the deficit, the Administration has 
overestimated the deficit by about $50 billion on average in the budgets 
submitted for fiscal years 1994-1996. It is too early to tell whether 
this pattern will continue, but even the Mid-Session estimate of the 
1996 deficit proved to be an overestimate.
  It would be preferable to project the deficit without any error, but 
that is not possible. Still, the Administration's cautious approach has 
meant that the projection misses have helped and not hurt in the effort 
to reduce the deficit. There are a number of reasons why the 

[[Page 10]]

budget has 
performed better than expected. Some of these are technical shifts; for 
example, Medicaid spending has fallen short of expectations for 
technical reasons. In addition, however, the economy has performed as 
well as or better than the Administration has assumed, and even more in 
excess of CBO's expectations.
  Because of the revisions to GDP adopted in January of 1996 by the 
Commerce Department, it is impossible to show a consistent history of 
real growth projections for both last year and the earlier years of the 
Administration. Looking at the unrevised data through 1995, however, the 
Administration was more accurate than CBO in its initial forecast of 
real GDP growth, but still underpredicted the actual performance of the 
economy by 0.8 percentage point per year on average. In subsequent 
forecasts, the Administration has also been slightly more accurate in 
projecting real GDP. Over the last four years, the Administration has 
been more accurate than CBO in its forecast of unemployment, but still 
has consistently overestimated the unemployment rate. CBO has also 
tended to resist the mounting evidence for a significant increase in the 
GDP share of corporate profits as a result of lower interest rates and 
the greater competitiveness of U.S. business. The Administration's 
projections of the profits share were closer to the actual outcome.
  The differences in economic assumptions between the Administration and 
CBO have been small--smaller than they were under previous 
Administrations, and well within the usual range of error in such 
projections. However, even small differences in economic assumptions can 
yield sizable differences in budget projections when extended over 
several years. Given the positive economic outlook in the United 
States--strong and steady growth, robust job creation, and low inflation 
and interest rates with none of the excesses that suggest an economic 
downturn--there are sound reasons for believing that the 
Administration's projection is likely to be close to the actual outcome. 
In that case, the President's budget as presented in the document would 
continue in force through 2002, with no need to limit spending or 
suspend tax cuts to achieve a balanced budget.

                            Can We Do Better?

  The Administration's average projected rate of growth for real GDP 
over the budget period--2.2 percent per year--is about equal to the 
estimate of potential non-inflationary growth held by a broad consensus 
of the economics profession. It is natural to wonder if the economy is 
capable of doing better than this. The Administration is optimistic that 
it can, and has proposed the policies that are most likely to raise 
potential growth. However, it would not be prudent to base the budget on 
best-case assumptions, or even on assumptions much above the middle 
ground. Previous Administrations made that mistake, and one result was a 
sequence of large, unanticipated deficits.
  Statistical problems suggest that growth might already be faster than 
we think. The possible mismeasurement of GDP on the ``output'' side (as 
opposed to Gross Domestic Income, on the ``income'' side) may have 
reduced measured average growth over the past six years by as much as 
\1/4\ percentage point. The Administration assumes that the true rate of 
growth over this period was better approximated by the growth of 
incomes, and that assumption is reflected in the projected 2.3 percent 
growth rate for potential GDP.
  The possibility that the CPI is mismeasured also affects GDP. As 
indicated above, an overstatement of 1.1 percentage point per year in 
the measurement of the CPI would have cut measured real GDP growth by 
between 0.5 and 1.0 percentage point. Correcting for such an error would 
raise the Administration's projected real growth rate to around 3 
percent per year.
  Another factor affecting the current measured growth rate of real GDP 
should not be a cause for concern. The growth of total output is equal 
to the sum of the growth rate of labor productivity and the growth rate 
of hours worked. The Administration projects that hours worked will 
increase by less than in the past. There are two benign reasons for the 
expected slowdown:
     The working-age population is growing more slowly than it 
          did in earlier decades, purely because of lower historical 
          birth rates. Family incomes and individual well-being should 
          not be affected by such a slowdown.
     Both the rate of labor force participation and the 
          percentage of the population employed are already at record 
          levels, and accordingly are not expected to rise at the rates 
          of recent years. During the past two decades there was a 
          massive inflow of women into the paid labor force. That inflow 
          has slowed, and there are signs that the rate of female labor 
          force participation is stabilizing. This is not necessarily a 
          cause for alarm even though it means slower growth in total 
          hours worked and less real GDP growth. The voluntary decisions 
          of people to enter or leave the labor force ought to be 
          respected by Government, and incomes can rise on a per capita 
          or per family basis whether or not labor force participation 
          is increasing. If unemployment is low and jobs are plentiful, 
          as they are now, then those women (and men) who would like to 
          work have the best opportunity to do so.

                                Table 1-3.  SAVING, INVESTMENT, AND TRADE BALANCE                               
                                     (Fiscal years; in billions of dollars)                                     
----------------------------------------------------------------------------------------------------------------
                                                           1996 actual                1998 estimate             
----------------------------------------------------------------------------------------------------------------
Current account.........................................      -154            -180 to -140                      
Merchandise trade balance...............................      -181            -210 to -170                      
Net foreign investment..................................      -140            -175 to -135                      
Net domestic saving (excluding Federal saving) \1\......       460             440 to 480                       
Net private domestic investment.........................       393             415 to 455                       
----------------------------------------------------------------------------------------------------------------
\1\ Defined for purposes of Public Law 100-418 as the sum of private saving and the current surpluses of State  
  and local governments. All series are based on the National Income and Product Accounts (NIPA) measures except
  for the current account balance.                                                                              
                                                                                                                
                                                                                                                

  Because of these changes, the average growth rate of hours worked is 
expected to decline from an average of about 1.7 percent per year during 
the 1970s and 1980s to around 1.2 percent per year for the next six 
years. This decline will reduce real GDP growth by a corresponding 
amount.
  A further increase in productivity growth would be highly desirable, 
and Administration initiatives in education, technology, and regulatory 
reform are intended to improve productivity. But raising the trend rate 
of productivity growth has proved very difficult, however often 
policymakers have espoused that goal; therefore, a prudent assumption is 
to project a continuation in the prevailing productivity trend while 
working to ex-

[[Page 11]]

ceed that conservative forecast. If this course is 
successful, then inflation will be less than expected and the deficit 
will be smaller too. These surprises would be welcome.

                   Table 1-4.  COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 1997 AND 1998 BUDGETS                  
                                  (Calendar years; dollar amounts in billions)                                  
----------------------------------------------------------------------------------------------------------------
                                                     1996     1997     1998     1999     2000     2001     2002 
----------------------------------------------------------------------------------------------------------------
Nominal GDP:                                                                                                    
  1997 budget assumptions........................    7,621    8,008    8,417    8,848    9,295    9,772   10,268
  1998 budget assumptions........................    7,577    7,943    8,313    8,717    9,153    9,610   10,087
                                                                                                                
Real GDP (percent change): \1\                                                                                  
  1997 budget assumptions........................      2.2      2.3      2.3      2.3      2.3      2.3      2.3
  1998 budget assumptions........................      2.8      2.0      2.0      2.3      2.3      2.3      2.3
                                                                                                                
GDP price index (percent change): \1\                                                                           
  1997 budget assumptions........................      2.8      2.7      2.7      2.7      2.7      2.7      2.7
  1998 budget assumptions........................      2.3      2.5      2.6      2.6      2.6      2.6      2.6
                                                                                                                
Consumer Price Index (percent): \2\                                                                             
  1997 budget assumptions........................      3.1      2.9      2.8      2.8      2.8      2.8      2.8
  1998 budget assumptions........................      3.1      2.6      2.7      2.7      2.7      2.7      2.7
                                                                                                                
Civilian unemployment rate (percent): \2\                                                                       
  1997 budget assumptions........................      5.7      5.7      5.7      5.7      5.7      5.7      5.7
  1998 budget assumptions........................      5.4      5.3      5.5      5.5      5.5      5.5      5.5
                                                                                                                
91-day Treasury bill rate (percent): \2\                                                                        
  1997 budget assumptions........................      4.9      4.5      4.3      4.2      4.0      4.0      4.0
  1998 budget assumptions........................      5.0      5.0      4.7      4.4      4.2      4.0      4.0
                                                                                                                
10-year Treasury note rate (percent): \2\                                                                       
  1997 budget assumptions........................      5.6      5.3      5.0      5.0      5.0      5.0      5.0
  1998 budget assumptions........................      6.5      6.1      5.9      5.5      5.3      5.1      5.1
----------------------------------------------------------------------------------------------------------------
\1\ Fourth quarter-to-fourth quarter.                                                                           
\2\ Calendar year average.                                                                                      
                                                                                                                
                                                                                                                

              Omnibus Trade and Competitiveness Act of 1988

  As required by the Omnibus Trade and Competitiveness Act of 1988, 
Table 1-3 shows estimates for economic variables related to saving, 
investment, and foreign trade consistent with the economic assumptions.
  The merchandise trade and current account deficits deteriorated in 
fiscal year 1996 and are expected to stabilize near current levels 
through fiscal year 1998. Net private investment in the United States 
has expanded rapidly during this Administration, and it is expected to 
continue to increase as the economy expands. The sources for the 
increased private investment have been the decline in the Federal 
deficit and higher private saving, plus a larger inflow of foreign 
capital.
  The Act requires information on the amount of borrowing by the Federal 
Government in private credit markets. This is presented in Chapter 12, 
``Federal Borrowing and Debt.''
  It is difficult to gauge with precision the effect of Federal 
Government borrowing from the public on interest rates and exchange 
rates, as required by the Act. Both are influenced by many factors 
besides Government borrowing in a complicated process involving supply 
and demand for credit and perceptions of fiscal and monetary policy here 
and abroad.

              Impact of Changes in the Economic Assumptions

  The economic assumptions underlying this budget are similar to those 
of last year. Both budgets envisaged that achieving a balanced budget 
would result in a substantial decline in interest rates that would serve 
to extend the economic expansion at a moderate pace while helping to 
maintain low, steady rates of inflation and unemployment. A shift to a 
balanced budget and the ensuing lower interest rates were also expected 
to shift income from interest to profits. This would have favorable 
effects on budget receipts and the deficit, be-

[[Page 12]]

cause profits face a 
higher marginal tax rate than interest income.
  The changes in the economic outlook since last year's budget have been 
relatively modest. On the positive side, the differences are primarily 
the result of more favorable economic experience in 1996 than was 
anticipated in last year's assumptions; on the negative side, partly 
because of the failure to enact a balanced budget, interest rates did 
not decline as was anticipated in last year's assumptions. Indeed, 
interest rates increased during the first half of the year. Even so, 
inflation and unemployment continued to improve in 1996. Because of this 
favorable experience, the forecast average for the unemployment rate has 
been lowered by 0.2 percentage point, and inflation has been reduced by 
0.1 percentage point. Meanwhile, interest rates are again assumed to 
decline in this budget, but the descent begins a year later than 
previously assumed, and the decline is smaller in percentage points.
  The net effects on the budget of these modifications in the economic 
outlook are shown in Table 1-5. The last column in the table shows the 
effect in 2002. The largest effects come from lower receipts due to 
lower inflation and lower real GDP growth in 1997 and 1998, and from the 
shift in timing of the expected decline in interest rates. Because the 
decline starts a year later, interest rates are higher in this budget, 
which increases the deficit relative to last year's estimates. The 
budget surplus projected for 2002 would have been about $43 billion 
larger had last year's economic assumptions been used in place of this 
year's assumptions.

              Table 1-5.  EFFECTS ON THE BUDGET OF CHANGES IN ECONOMIC ASSUMPTIONS SINCE LAST YEAR              
                                            (In billions of dollars)                                            
----------------------------------------------------------------------------------------------------------------
                                                              1997     1998     1999     2000     2001     2002 
----------------------------------------------------------------------------------------------------------------
Budget totals under 1997 budget economic assumptions and                                                        
 1998 budget policies:                                                                                          
  Receipts................................................  1,517.3  1,585.4  1,668.8  1,754.4  1,839.6  1,932.4
  Outlays.................................................  1,630.3  1,677.9  1,748.4  1,802.9  1,834.8  1,872.1
                                                           -----------------------------------------------------
      Surplus or deficit (-)..............................   -113.0    -92.6    -79.7    -48.5      4.9     60.3
                                                                                                                
Changes due to economic assumptions:                                                                            
  Receipts................................................    -11.9    -18.5    -25.4    -27.1    -31.3    -35.7
  Outlays:                                                                                                      
    Inflation.............................................     -1.5     -2.2     -3.3     -4.2     -5.4     -6.6
    Unemployment..........................................     -3.3     -1.8     -1.4     -1.9     -2.0     -2.0
    Interest rates........................................      5.1     12.3     14.2     13.4     11.2      8.6
    Interest on changes in borrowing......................      0.3      1.2      2.7      4.2      5.8      7.6
                                                           -----------------------------------------------------
      Total, outlay increases (net).......................      0.7      9.5     12.3     11.5      9.7      7.6
                                                           -----------------------------------------------------
      Increase in deficit (-).............................    -12.6    -28.1    -37.7    -38.6    -41.0    -43.3
                                                                                                                
Budget totals under 1998 budget economic assumptions and                                                        
 policies:                                                                                                      
  Receipts................................................  1,505.4  1,566.8  1,643.3  1,727.3  1,808.3  1,896.7
  Outlays.................................................  1,631.0  1,687.5  1,760.7  1,814.4  1,844.5  1,879.7
                                                           -----------------------------------------------------
      Surplus or deficit (-)..............................   -125.6   -120.6   -117.4    -87.1    -36.1     17.0
----------------------------------------------------------------------------------------------------------------

                     Structural vs. Cyclical Deficit

  When there is slack in the economy, receipts are lower than they would 
be if resources were fully employed, and outlays for unemployment-
sensitive programs (such as unemployment compensation and food stamps) 
are higher. As a result, the deficit is higher than it would be if 
unemployment were at NAIRU. The portion of the deficit that can be 
traced to such factors is called the cyclical deficit. The remainder, 
the portion that would remain with unemployment at NAIRU (consistent 
with a 5.5 percent unemployment rate), is called the structural deficit.
  Changes in the structural deficit give a better picture of the impact 
of budget policy on the economy than does the unadjusted deficit. During 
a recession or the recovery from one, the structural deficit also gives 
a clearer picture of the deficit problem that fiscal policy must 
address, because this part of the deficit will persist even when the 
economy has fully recovered, unless policy changes.
  In the early 1990's, large swings in net outlays for deposit insurance 
(the S&L bailouts) had substantial impacts on deficits, but had little 
impact on economic performance. It therefore became customary to remove 
deposit insurance outlays as well as the cyclical component of the 
deficit from the actual deficit to compute the adjusted structural 
deficit. This is shown in Table 1-6.
  Because the economy is projected to be quite close to full employment 
over the forecast horizon, the cyclical component of deficits is small. 
Indeed, for 1996 and 1997, the unemployment rate is slightly below the 
full employment rate of 5.5 percent, resulting in negative cyclical 
components of the deficit (cyclical surpluses). Deposit insurance net 
outlays are relatively small and do not change greatly from year to 
year. Thus, rather unusually, the adjusted structural deficits in this 
budget display much the same pattern of year-to-year changes as the 
actual deficits. The most significant


[[Page 13]]

 point illustrated by this table, 
is the fact that of the $183 billion reduction in the actual budget 
deficit between 1992 and 1996 (from $290 billion to $107 billion), 41 
percent ($75 billion) resulted from cyclical improvement in the economy. 
The rest of the reduction stemmed primarily from policy actions--mainly 
those in the Omnibus Budget Reconciliation Act of 1993, early in 
President Clinton's first term, which reversed a projected continued 
steep rise in the deficit.

                                     

                                                         Table 1-6.  ADJUSTED STRUCTURAL DEFICIT                                                        
                                                                (In billions of dollars)                                                                
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   1992    1993    1994    1995    1996    1997    1998    1999    2000    2001    2002 
--------------------------------------------------------------------------------------------------------------------------------------------------------
Unadjusted surplus (-)/deficit..................................   290.4   255.0   203.1   163.9   107.3   125.6   120.6   117.4    87.1    36.1   -17.0
  Cyclical component............................................    68.7    52.6    24.2     2.3    -6.7   -10.3    -3.7     0.0     0.0     0.0     0.0
                                                                 ---------------------------------------------------------------------------------------
Structural deficit..............................................   221.7   202.6   178.9   161.6   114.0   135.9   124.4   117.4    87.1    36.1   -17.0
  Deposit insurance outlays.....................................    -2.4   -28.0    -7.6   -17.8    -8.4   -12.1    -4.0    -2.0    -1.1    -1.6    -1.5
                                                                 ---------------------------------------------------------------------------------------
Adjusted structural surplus(-)/deficit..........................   224.1   230.4   186.5   179.5   122.4   148.0   128.4   119.4    88.3    37.7   -15.5
--------------------------------------------------------------------------------------------------------------------------------------------------------

            Sensitivity of the Budget to Economic Assumptions

  Both receipts and outlays are affected by changes in economic 
conditions. This sensitivity seriously complicates budget planning, 
because errors in economic assumptions lead to errors in the budget 
projections. It is therefore useful to examine the implications of 
alternative economic assumptions.
  Many of the budgetary effects of changes in economic assumptions are 
fairly predictable, and a set of rules of thumb embodying these 
relationships can aid in estimating how changes in the economic 
assumptions would alter outlays, receipts, and the deficit.
  Economic variables that affect the budget do not usually change 
independently of one another. Output and employment tend to move 
together in the short run: a higher rate of real GDP growth is generally 
associated with a declining rate of unemployment, while weak or negative 
growth is usually accompanied by rising unemployment. In the long run, 
however, changes in the average rate of growth of real GDP are mainly 
due to changes in the rates of growth of productivity and labor supply, 
and are not necessarily associated with changes in the average rate of 
unemployment. Inflation and interest rates are also closely 
interrelated: a higher expected rate of inflation increases interest 
rates, while lower expected inflation reduces rates.
  Changes in real GDP growth or inflation have a much greater cumulative 
effect on the budget over time if they are sustained for several years 
than if they last for only one year.
  Highlights of the budget effects of the above rules of thumb are shown 
in Table 1-7.
  If real GDP growth is lower by one percentage point in calendar year 
1997 only and the unemployment rate rises by one-half percentage point, 
the fiscal 1997 deficit would increase by $8.6 billion; receipts in 1997 
would be lower by about $7.1 billion, and outlays would be higher by 
about $1.5 billion, primarily for unemployment-sensitive programs. In 
1998, the receipts shortfall would grow further to about $15.2 billion, 
and outlays would be increased by about $5.2 billion relative to the 
base, even though the growth rate in calendar 1998 follows the path 
originally assumed. This is because the level of real (and nominal) GDP 
and taxable incomes would be permanently lower and unemployment higher. 
The budget effects (including growing interest costs associated with the 
higher deficits) would continue to grow slightly in later years.
  The budget effects are much larger if the real growth rate is assumed 
to be one percentage point less in each year (1997-2002) and the 
unemployment rate to rise one-half percentage point in each year. With 
these assumptions, the levels of real and nominal GDP would be below the 
base case by a growing percentage. The deficit would be $143.0 billion 
higher than under the base case by 2002.
  The effects of slower productivity growth are shown in a third 
example, where real growth is one percentage point lower per year while 
the unemployment rate is unchanged. In this case, the estimated budget 
effects mount steadily over the years, but more slowly, reaching a 
$120.8 billion deficit add-on by 2002.
  Joint changes in interest rates and inflation have a smaller effect on 
the deficit than equal percentage point changes in real GDP growth 
because their effects on receipts and outlays are substantially 
offsetting. An example is the effect of a one percentage point higher 
rate of inflation and one percentage point higher interest rates during 
calendar year 1997 only. In subsequent years, the price level and 
nominal GDP would be one percent higher than in the base case, but 
interest rates are assumed to return to their base levels. Outlays for 
1997 rise by $6.3 billion and receipts by $8.1 billion, for a decrease 
of $1.8 billion in the 1997 deficit. In 1998, outlays would be above the 
base by $15.6 billion, due in part to lagged cost-of-living adjustments; 
receipts would rise $16.5 billion above the base, however, resulting in 
a $0.9 billion decrease in the deficit. In subsequent years, the amounts 
added to receipts would continue to be larger than the additions to 
outlays.
  If the rate of inflation and the level of interest rates are higher by 
one percentage point in all years, the price level and nominal GDP would 
rise by a cumulatively growing percentage above their base levels. In 
this case, the effects on receipts and outlays mount


[[Page 14]]

 steadily in successive years, adding $75.1 billion to outlays and $101.1 billion to 
receipts in 2002, for a net reduction in the deficit of $26.0 billion.
  The table also shows the interest rate and the inflation effects 
separately, and rules of thumb for the added interest cost associated 
with higher or lower deficits (increased or reduced borrowing). The 
effects of changes in economic assumptions in the opposite direction are 
approximately symmetric to those shown in the table. The impact of a one 
percentage point lower rate of inflation or higher real growth would 
have about the same magnitude as the effects shown in the table, but 
with the opposite sign.
  These rules of thumb are computed while holding the income share 
composition of GDP constant. Because different income components are 
subject to different taxes and tax rates, estimates of total receipts 
can be affected significantly by changing income shares. These 
relationships, however, have proved too complex to be reduced to simple 
rules.

                                     

                          Table 1-7.  SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS                         
                                            (In billions of dollars)                                            
----------------------------------------------------------------------------------------------------------------
                    Budget effect                       1997      1998      1999      2000      2001      2002  
----------------------------------------------------------------------------------------------------------------
             Real Growth and Employment                                                                         
                                                                                                                
Budgetary effects of 1 percent lower real GDP                                                                   
 growth:                                                                                                        
  For calendar year 1997 only: \1\                                                                              
    Receipts........................................      -7.1     -15.2     -17.4     -17.7     -18.2     -18.8
    Outlays.........................................       1.5       5.2       6.5       7.7       8.9      10.2
                                                     -----------------------------------------------------------
      Deficit increase (+)..........................       8.6      20.4      23.9      25.4      27.1      29.0
                                                                                                                
  Sustained during 1997-2002: \1\                                                                               
    Receipts........................................      -7.1     -22.4     -40.6     -59.8     -80.2    -101.9
    Outlays.........................................       1.5       6.8      13.3      21.2      30.2      41.1
                                                     -----------------------------------------------------------
      Deficit increase (+)..........................       8.6      29.2      53.9      81.0     110.4     143.0
                                                                                                                
  Sustained during 1997-2002, with no change in                                                                 
   unemployment:                                                                                                
    Receipts........................................      -7.1     -22.7     -41.6     -62.2     -84.2    -108.1
    Outlays.........................................       0.2       1.0       2.6       5.0       8.3      12.7
                                                     -----------------------------------------------------------
      Deficit increase (+)..........................       7.3      23.7      44.2      67.1      92.5     120.8
                                                                                                                
            Inflation and Interest Rates                                                                        
                                                                                                                
Budgetary effects of 1 percentage point higher rate                                                             
 of:                                                                                                            
  Inflation and interest rates during calendar year                                                             
   1997 only:                                                                                                   
    Receipts........................................       8.1      16.5      16.4      15.3      16.1      16.9
    Outlays.........................................       6.3      15.6      12.9      11.8      11.3      11.1
                                                     -----------------------------------------------------------
      Deficit increase (+)..........................      -1.8      -0.9      -3.4      -3.5      -4.8      -5.8
                                                                                                                
  Inflation and interest rates, sustained during                                                                
   1997-2002:                                                                                                   
    Receipts........................................       8.1      25.0      42.6      60.3      79.7     101.1
    Outlays.........................................       6.3      22.3      36.7      50.1      62.7      75.1
                                                     -----------------------------------------------------------
      Deficit increase (+)..........................      -1.8      -2.6      -5.9     -10.2     -17.0     -26.0
                                                                                                                
  Interest rates only, sustained during 1997-2002:                                                              
    Receipts........................................       1.1       2.8       3.6       3.9       4.2       4.5
    Outlays.........................................       5.8      17.6      25.4      31.1      35.7      39.3
                                                     -----------------------------------------------------------
      Deficit increase (+)..........................       4.7      14.8      21.8      27.2      31.5      34.8
                                                                                                                
  Inflation only, sustained during 1997-2002:                                                                   
    Receipts........................................       7.0      22.1      39.0      56.4      75.5      96.6
    Outlays.........................................       0.4       4.7      11.3      19.0      27.0      35.8
                                                     -----------------------------------------------------------
      Deficit increase (+)..........................      -6.6     -17.4     -27.7     -37.4     -48.5     -60.9
                                                                                                                
      Interest Cost of Higher Federal Borrowing                                                                 
                                                                                                                
Effect of $100 billion additional borrowing during                                                              
 1997...............................................       2.9       5.4       5.3       5.3       5.3       5.4
----------------------------------------------------------------------------------------------------------------
\1\ The unemployment rate is assumed to be 0.5 percentage point higher per 1.0 percent shortfall in the level of
  real GDP.