[Analytical Perspectives]
[Economic and Accounting Analyses]
[1. Economic Assumptions]
[From the U.S. Government Publishing Office, www.gpo.gov]
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ECONOMIC AND ACCOUNTING ANALYSES
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1. ECONOMIC ASSUMPTIONS
Introduction
The economy begins this year in excellent condition. Budget surpluses
have replaced soaring deficits; fiscal policy is now augmenting national
saving, investment and growth, rather than restraining them. Monetary
policy has successfully pursued the goals of supporting economic growth
while at the same time wringing out inflation.
These sound policies have contributed to another year of outstanding
economic achievement. Data for the first three quarters of 1998 and
partial data for the fourth indicate that real Gross Domestic Product
(GDP) rose about 4 percent over the four quarters of 1998, almost one
percentage point faster than the average pace set during the prior five
years. The Nation's payrolls increased by 2.9 million jobs during 1998,
bringing the total number of new jobs created since this Administration
took office to 17.7 million--93 percent of which were in the private
sector. Healthy job growth pulled the unemployment rate down further
last year. By December, the rate was 4.3 percent, the lowest level in
nearly three decades and 3.0 percentage points lower than in January
1993. The unemployment rate averaged 4.5 percent last year, the lowest
it has been since 1969.
Despite robust growth and low unemployment, inflation remained low.
The Consumer Price Index (CPI) rose just 1.6 percent last year, aided by
a sharp fall in energy prices. Even excluding the volatile food and
energy components, the CPI rose only 2.4 percent. The GDP chain-weighted
price index, the broadest measure of prices paid by consumers, business,
and government, rose by around 1 percent. Not since the early 1960s has
inflation been this low. The combination of a low unemployment rate and
a low inflation rate pulled the ``Misery Index''--the sum of the two
rates--to its lowest level since the 1960s.
Both households and businesses have prospered in this environment of
strong growth and low inflation. For the second year in a row, hourly
earnings after adjustment for inflation increased faster than at any
time in the past two decades, while the share of profits in GDP reached
10 percent during the last three years, the highest it has been since
1968.
Effective policy actions and the fundamental health of the American
economy have enabled it to weather an extraordinary buffeting from
economic turmoil abroad. Imports, adjusted for inflation, rose last
year, while exports shrank; but robust growth of domestic demand by
consumers and businesses more than offset this source of restraint. The
sound fiscal policies of this Administration, which produced the first
Federal budget surplus since 1969, lowered interest rates and reduced
the government's demands in credit markets, thereby providing needed
resources for private-sector spending. During the summer and fall,
financial crises in foreign lands sent tremors through stock and bond
markets. Beginning in September, the Federal Reserve responded by
cutting the Federal funds rate in three successive steps, actions that
restored confidence to financial markets. As 1999 began, financial and
nonfinancial market indicators were signaling that the economic outlook
remains healthy.
The economy has outperformed the consensus forecast during the past
six years, and the Administration believes that it can continue to do so
if sound fiscal policies are maintained. However, for purposes of budget
planning, it is prudent to rely on mainstream projections. The
Administration assumes that the economy will continue to expand, while
unemployment, inflation and interest rates will remain low. Real growth
in the next few years is expected to moderate to 2.0 percent per year,
followed by somewhat faster, but sustainable, growth thereafter
averaging 2.4 percent per year.
Even with more moderate growth than recently, the economy will
generate millions of new jobs. The unemployment rate, which by
mainstream estimates is below the level consistent with stable
inflation, is projected to edge up slightly until mid-2001. Thereafter,
it is projected to average a relatively low 5.3 percent, the middle of
the range that the Administration estimates is consistent with stable
inflation. Inflation is expected to rise slightly as the restraining
influence of temporary factors wanes, but then to average just above 2
percent per year. Short-term interest rates are expected to remain in
the neighborhood of levels reached at the end of 1998. Long-term rates
are projected to move up by about 0.6 percentage point, the same amount
as the rise in inflation, leaving inflation-adjusted long-term rates not
much different than in December.
Most private sector forecasts have a similarly favorable view of the
outlook. The most recent Blue Chip consensus, an average of 50 private
forecasts, calls for real growth of 2.1 percent this year, and 2.4
percent, on average, through 2004. Unemployment and inflation
projections are also close to the Administration's economic assumptions,
while interest rates are projected to be slightly higher in the outyears
of the budget horizon. The similarity with private-sector projections
indicates that the Administration's assumptions provide a reasonable,
prudent basis for projecting the budget.
In December, this business cycle expansion (which began in April 1991)
set the record for the longest period of continuous growth during
peacetime--surpassing the expansion of the 1980s. Last month marked the
94th consecutive month of growth. If the expansion continues through
February 2000, it will exceed the
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longevity record of 106 months set during the Vietnam War expansion of
the 1960s. The Administration expects, as do most private sector
forecasters, that this expansion will surpass that record.
This chapter begins with a review of recent developments, and then
discusses two statistical issues: the growing statistical discrepancy
(the difference between the aggregate measures of output and income);
and recent methodological improvements in the calculation of the
Consumer Price Index. The chapter then presents the Administration's
economic projections, followed by a comparison with the Congressional
Budget Office's projections. The following sections present the impact
of changes in economic assumptions since last year on the projected
budget surplus, and the cyclical and structural components of the
surplus. The chapter concludes with estimates of the sensitivity of the
budget to changes in economic assumptions.
Fiscal and Monetary Policy
Fiscal Policy: When this Administration took office in January 1993,
it vowed to restore sound fiscal discipline. That goal has been amply
achieved. In contrast to 1992, when the deficit reached a postwar record
of $290 billion, representing 4.7 percent of GDP, the budget last year
recorded a surplus of $69 billion, or 0.8 percent of GDP. The last time
the budget was in surplus was in 1969; the last time the surplus was a
larger share of GDP was in 1956. This year, the surplus is projected to
rise to $79 billion, or 0.9 percent of GDP. The dramatic shift in the
Nation's fiscal position in the last six years from huge deficits to
surpluses is unprecedented since the demobilization just after World War
II.
The historic improvement in the Nation's fiscal position during this
Administration is due to two landmark pieces of legislation, the Omnibus
Budget Reconciliation Act of 1993 (OBRA) and the Balanced Budget Act of
1997 (BBA). OBRA, based on proposals made by the Administration soon
after it came into office and signed into law in August of that year,
set budget deficits on a downward path. The deficit reductions following
OBRA have far exceeded predictions made at the time of its passage. OBRA
was projected to reduce pre-Act deficits by $505 billion over the five
years 1994-98. The total deficit reduction has been more than twice
this--$1.2 trillion. In other words, OBRA and subsequent developments
have enabled the Treasury to issue $1.2 trillion less debt than would
have been required under previous estimates.
While OBRA fundamentally altered the course of fiscal policy towards
lower deficits, it was not projected to eliminate the deficit. Without
further action, deficits were expected to begin to climb once again. To
prevent this and bring the budget into permanent surplus, the
Administration negotiated the Balanced Budget Act with the Congress in
the summer of 1997. The BBA was not expected to produce surpluses until
2002, but like OBRA, the results of pursuing a policy of fiscal
discipline far exceeded expectations. The budget moved into surplus in
1998, four years ahead of schedule. OBRA and the BBA together are
estimated to have improved the budget balance compared with the pre-OBRA
baseline by a cumulative total of $4.4 trillion over 1993-2002.
Like the budget, the economy in recent years has far outperformed
expectations. This is more than a coincidence. Lower deficits contribute
to a healthy, sustainable expansion by reducing interest rates and
boosting interest-sensitive spending in the economy. Rapid growth of
business capital spending expands industrial capacity and boosts
productivity growth. The additional capacity, in turn, prevents
shortages and bottlenecks that might otherwise threaten to ignite
inflation.
Lower interest rates also raise equity prices, which increases
household wealth, optimism, and spending. The added impetus to consumer
spending creates new jobs and business opportunities. While the benefits
of fiscal discipline have been widely recognized, the surprise in recent
years has been the magnitude of the positive impact on the economy.
Growth of production, jobs, income, and capital gains have all exceeded
expectations. Consequently, Federal revenues in the past three years
have been larger than projected--the so-called ``revenue surprise.''
Deficits have been smaller than expected and surpluses have occurred
sooner. The outstanding economic performance during this Administration
is proof positive of the lasting benefits of prudent fiscal policies.
Monetary Policy: Monetary policy shares the credit for the economy's
excellent performance. During this expansion, the Federal Reserve
appropriately tightened policy when inflation threatened to pick up, but
eased when the expansion risked stalling out. In 1994 and early 1995,
interest rates were raised when rapid growth threatened to cause
inflationary pressures. During 1995 and early 1996, however, the Federal
Reserve reduced interest rates because the expansion appeared to be
slowing unduly at a time when higher inflation no longer threatened.
From January 1996 until this past fall, monetary policy remained
essentially unchanged; the sole adjustment was a one-quarter percentage
point increase in the federal funds rate target in March 1997 to 5\1/2\
percent.
Last year, the spread of financial turmoil from foreign markets to our
own threatened to undermine the hard-won health of the U.S. economy. The
Russian government's default on its debt in August led to a near-panic
in credit markets and a sell-off of equities here and abroad. Almost
instantly there was a drastic revaluation of potential risks--not just
for foreign loans, but for domestic credit as well. At the height of the
flight to quality in early October, the spreads between yields on
Treasury and private sector bonds widened dramatically. Market
participants shunned all but the most liquid of credit instruments. The
drying up of normal credit channels intensified with the near-failure of
a large, highly leveraged U.S. hedge fund that had borrowed heavily from
major banks.
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In response to these challenges, the Federal Reserve quickly shifted
policy once more. It cut the Federal funds rate by one-quarter
percentage point in September, followed by a cut of similar magnitude in
both the funds rate and the discount rate in October and again in
November. The drop in the funds rate target from 5\1/2\ to 4\3/4\
percent in just seven weeks, accompanied by a one-half percentage point
cut in the discount rate to 4\1/2\ percent, was the swiftest easing
since 1991, when the economy was just emerging from recession.
Market sentiment responded quickly to these actions. U.S. stock
markets, which endured a short but sharp decline in late summer and
early fall, rallied during the winter, reaching record levels in
January, 1999. The S&P 500 was up 27 percent during 1998, a remarkable
achievement after having more than doubled during the prior three years.
Other market indexes staged impressive gains as well. During the last
four years, the S&P and the narrower Dow-Jones Industrial Average have
risen by 2\1/2\ times. This is the best four-year performance in the
postwar period.
By December, the Federal Reserve's actions had restored normal
relationships in most credit markets. Rates on short-term Treasury bills
and commercial paper were about 70 basis points lower than in December
1997. The yield on 30-year Treasury bonds was about 90 basis points
lower than a year earlier while yields on high-grade AAA-rated corporate
bonds were 55 basis points lower. New bond and equity issuance, which
had plummeted in the panic-ridden market atmosphere of October,
recovered--even for less credit-worthy companies.
Some signs of heightened risk aversion remained, however. Interest
rate spreads between highly rated instruments and more risky ones were
still unusually large, although not as large as in October. The yield
spread between below-investment grade corporate bonds and equivalent
maturity Treasury bonds, for example, finished the year three percentage
points higher than at the end of 1997.
Although there were still strains in some markets, credit, so
essential to a healthy economy, was generally widely available--and at
favorable interest rates by historical standards. Consequently, at its
December meeting, the Federal Reserve decided that no further easing was
needed. The actions taken during the prior three months had accomplished
its goal of restoring confidence.
Recent Developments
Real Growth: The economy expanded at a 3.7 percent annual rate over
the first three quarters of 1998, and is estimated to have grown at a
somewhat faster pace during the fourth quarter. This is the third year
in a row of robust growth of around 4 percent annually. In each of these
years, most forecasters had expected growth to slow to about 2\1/4\
percent per year, around the pace that the economy is generally believed
capable of sustaining on a long-run basis.
The fastest growing sector last year was again business spending on
new equipment: up at a 16 percent annual rate during the first three
quarters of the year, it is estimated to have risen at a double-digit
rate in the fourth quarter as well. The biggest gains continued to be
for information processing and related equipment, but businesses
invested heavily in other forms of equipment as well. Investment in new
structures, in contrast, edged down during 1998.
This exceptionally strong growth of spending for new equipment boosted
productivity and expanded industrial capacity to meet current and future
demands. Overall industrial capacity rose by more than 5 percent in each
of the past four years; the last time capacity grew this rapidly was in
the late 1960s. The extra capacity has helped keep inflation low by
easing the bottlenecks that might otherwise have developed. In the
fourth quarter of 1998, the manufacturing operating rate was below its
long-term average, even though labor markets were much tighter than
usual.
Growth last year was also supported by robust household spending. Low
unemployment, low interest rates, rising real incomes, extraordinary
capital gains, and record levels of consumer optimism have provided
households with the resources and willingness to spend heavily,
especially on discretionary, postponable purchases. Overall consumer
spending after adjustment for inflation rose at a 5.4 percent annual
rate during the first three quarters of the year, and continued at a
brisk pace in the fourth quarter. Growth of consumer spending last year
was the fastest in 15 years.
The surge in consumer spending last year outstripped even the robust
growth of disposable personal income. As a result, the saving rate edged
down during the year, and entered negative territory in the fourth
quarter. Not since the 1930s has the household saving rate been
negative. Then, however, it was sign of extreme stress: incomes were
shrinking faster than spending. Now, it is the result of economic
success: soaring stock market wealth has enabled households to feel
confident boosting spending knowing they have made unexpectedly large
capital gains.
The same factors spurring consumption pushed new and existing home
sales during 1998 to their highest level since record-keeping began. The
homeownership rate reached a record 66.8 percent in the third quarter.
Buoyant sales and low inventories of unsold homes provided a strong
incentive for builders to start new construction. Housing starts rose
last year to the highest level since 1987. Residential investment, after
adjustment for inflation, increased at a 13.5 percent annual rate during
the first three quarters of the year, and is estimated to have risen at
a double-digit pace in the fourth quarter. The growth of residential
investment last year was the strongest since 1992, when homebuilding was
just emerging from recession.
Government purchases, on balance, made very little contribution to GDP
growth last year. Federal government spending in GDP after adjustment
for inflation edged down at a 1.2 percent annual rate during the
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first three quarters, about the same contraction as during 1997. By the
third quarter of last year, Federal government spending in GDP was 12
percent lower than when the Administration took office. State and local
spending in GDP rose at a moderate 2.3 percent rate during the first
three quarters of 1998, offsetting the restraint on growth from the
Federal sector. In recent years, States and localities have increased
their spending only modestly, despite the availability of unexpectedly
large budget surpluses resulting from stronger-than-expected revenues.
The foreign sector was the primary restraint on growth last year, as
it was the year before. Exports of goods and services after adjustment
for inflation shrank last year (the first time that has occurred since
1985) as several economies abroad contracted--including Japan, the
world's second largest economy. In addition, the 21 percent rise in the
dollar from the end of 1996 to October 1998 stimulated imports into the
United States. The widening of the net export deficit during the first
three quarters of the year trimmed 1\3/4\ percentage point off of real
GDP growth. The negative contribution from the trade sector was less
pronounced during the second half of the year than the first, suggesting
that the worst of the adverse trade impact may be over.
Labor Markets: The performance of the labor market last year far
exceeded most predictions. At the start of the year, most forecasters
had expected growth to slow and the unemployment rate to rise slightly.
Instead, the economy expanded at about the same rapid pace as during
1997, driving the unemployment rate down to 4.3 percent by December.
When this Administration took office, the unemployment rate was 7.3
percent. All demographic groups, and especially minorities, have
experienced a large decline in unemployment. Forty states had
unemployment rates of 5.0 percent or less in November; only two had
rates above 6.0 percent.
The Nation's payrolls expanded by a sizeable 2.9 million jobs last
year. Unlike previous years, employment gains were not widespread across
industries. Mining and manufacturing, especially vulnerable to
developments in international trade, lost jobs. This was more than
offset numerically by job growth by the private service sector,
construction, state and local government, and even the Federal
Government (because of its temporary hiring in preparation for the
decennial census). The abundance of employment opportunities pushed the
labor force participation rate and employment/population ratio up the
highest levels on record.
Inflation: Despite rapid growth and the low unemployment rate,
inflation remained low last year, and even declined by some measures.
The Consumer Price Index (CPI) and the CPI excluding food and energy
increased about the same rate in 1998 as in 1997. The core CPI excluding
food and energy rose just 2.4 percent last year, nearly matching 1997's
2.2 percent, which was the slowest rise since 1965. Because of falling
energy prices, the total CPI rose even less, 1.6 percent, about the same
as the 1.7 percent of 1997.
Progress in reducing inflation is even more impressive measured by the
broadest indicator, the GDP chain-weighted price index. It rose just 0.9
percent at an annual rate during the first three quarters of 1998, 0.8
percentage point less than during the four quarters of 1997. The last
time aggregate inflation was this low was in 1961.
The favorable inflation performance was the result of several factors:
intense foreign competition, low unit labor costs, and perhaps
structural changes in the link between unemployment and inflation. The
rise in the dollar has reduced the costs of imported materials and
intensified price competition from imports. Non-oil import prices fell
3.1 percent last year, while imported oil prices tumbled 40 percent.
Export prices of goods (a component of the GDP price index) fell 3.5
percent, as American exporters trimmed prices to remain competitive
abroad.
Despite low unemployment, the increase in hourly earnings and the
broader measures of compensation were not much different during 1998
than the prior year. Moreover, robust investment in new equipment
contributed to unusually strong productivity growth for this stage of an
expansion, helping to restrain inflation by offsetting the gains in
labor compensation. Unit labor costs rose at only a 1.8 percent annual
rate during the first three quarters of 1998, down from 2.0 percent
during 1997.
The absence of inflationary pressures has implications for the
estimate of the level of unemployment that is consistent with stable
inflation. This threshold has been called the NAIRU, or
``nonaccelerating inflation rate of unemployment.'' Economists have been
lowering their estimates of NAIRU in recent years in keeping with the
accumulating experience that lower unemployment has not led to higher
inflation, even after taking into account the influence of temporary
factors. The economic projections for this Budget assume that NAIRU is
in a range centered on 5.3 percent. That is 0.1 percentage point less
than estimated in the 1999 Budget assumptions and 0.4 percentage point
less than in the 1997 Budget. Most private forecasters have also reduced
their estimates of NAIRU in recent years.
By the end of 1998, the unemployment rate was about one percentage
point below the current mainstream estimate of NAIRU. The Administration
forecast for real growth over the next three years implies that
unemployment will return to 5.3 percent by the middle of 2001.
Statistical Issues
The U.S. statistical agencies endeavor to measure accurately the
economy's performance, but the U.S. economy is a moving target;
statistical agencies must constantly improve their measurement tools
just to keep up with rapid structural changes. It is not surprising,
therefore, that concerns have been raised about possible
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mismeasurement in recent years, especially of real GDP growth and of
inflation.
Real Growth: In a perfect statistical world, the value of output would
equal the value of income generated in its production: GDP would match
Gross Domestic Income (GDI). However, because the series are estimated
from different source data, each with its own gaps and inconsistencies,
the two measures are hardly ever identical. What is particularly unusual
now is the wide and growing difference between product and income
measures.
This ``statistical discrepancy'' (defined as aggregate output minus
aggregate income) was -$102 billion in the third quarter of 1998, a
record -1.2 percent of nominal GDP. By comparison, in the first quarter
of 1995, the statistical discrepancy was nearly zero, and two years
earlier, in the first quarter of 1993, it was a positive $71 billion, or
1.1 percent of GDP. A swing of this magnitude means that during the past
five and a half years, the annual average real growth rate measured from
the familiar GDP output side has been about 0.4 percentage point less
than the growth rate measured from the income side. During the first
three quarters of last year, the divergence between the two measures of
real growth remained near this magnitude.
It is possible that the incorporation of more complete source data in
the annual and benchmark revisions to the national accounts will
eventually reduce the size of the statistical discrepancy. That is what
happened last July, but even after that revision, the discrepancy in the
third and fourth quarters of 1997 was still a sizeable -0.8 percent of
GDP.
The absence of a clear picture of the economy's actual growth
performance is a cause for some concern. Any estimate of potential
growth depends on an estimate of trend productivity growth, which itself
depends on recent data on actual growth. When there is a growing
divergence between product and income measures, there is a comparable
divergence in estimates of the productivity trend. For example, from the
last cyclical real GDP peak in the second quarter of 1990 to the third
quarter of 1998, labor productivity growth has increased at a 1.3
percent annual rate according to the official productivity statistics
which measure output growth from the product side. Productivity growth
measured from the income side, however, is at a 1.5 percent rate.
While faster growth of trend productivity and potential GDP of 0.2
percentage point per year may seem trivial, cumulated over the 10-year
budget horizon--or more significantly over the 75 years of the long-run
projections made in Chapter 2 of this Analytical Perspectives volume--
the additional output made possible by higher productivity growth can
imply tens or even hundreds of billions of dollars of additional income
in the economy.
It is unclear whether the product or the income side provides the more
accurate measure of growth. The Bureau of Economic Analysis (BEA)
recognizes the shortcomings of both measures but believes that GDP is a
more reliable measure than GDI (see the Survey of Current Business,
August 1997, page 19). Other experts believe that some figure between
the two measures may be more accurate.
There is circumstantial evidence to suggest that growth may be faster
than shown by the traditional GDP output measure. The recent combination
of low inflation and high profits suggests that productivity growth may
be stronger than reported from the output side. Moreover, the unexpected
strength of Treasury receipts in the last three years suggests that the
output measure, and even the income measure, may be too low. While some
of the higher receipts are from capital gains generated by the booming
stock market, which are not included in the national income accounts
(because they arise from asset price revaluations rather than from
current production), capital gains do not fully account for the surge.
The Administration's budget assumptions project trend productivity
growth of 1.3 percent per year, the average measured pace since GDP
reached its last peak in the second quarter of 1990. It is possible that
trend productivity growth may be somewhat faster, not only because of
the faster growth of gross domestic income than gross domestic product
in recent years, but also because the next benchmark GDP revision to the
national accounts may incorporate improvements to the measurement of
consumer prices that would lower GDP inflation slightly during the first
half of the 1990s and raise real GDP growth by a comparable amount.
In last July's annual revision covering the years 1995-1998, the
Bureau of Economic Analysis took a step in this direction by switching
to a geometric mean formula for the calculation of the consumer price
measures used to deflate personal consumption expenditures. This lowered
overall GDP inflation by almost 0.2 percentage points per year, and
thereby boosted measured nonfarm output and productivity growth by 0.2
percentage points annually. The next benchmark GDP revisions, which will
be published in October 1999, will incorporate this methodological
change going back at least to 1990. All other things equal, this would
be expected to raise slightly productivity growth measured from the last
cyclical peak. However, because the benchmark revisions will include
many other methodological and source data improvements, it is not
possible to know how much and in what direction the currently measured
productivity trend will be altered. Therefore, the budget projections
are based on the prudent course of assuming a continuation of the
productivity trend as measured by the statistics now available.
The uncertainty surrounding actual growth and its trend makes it more
difficult to determine appropriate monetary policy. From a budgetary
perspective, estimates of receipts and expenditures are more uncertain
because they are dependent on the forecast for growth. As shown in Table
1-6, ``Sensitivity of the Budget to Economic Assumptions,'' even small
errors in projecting real GDP growth can have a significant effect on
the budget balance cumulated over several years.
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Inflation: Accurate measurement of inflation has become increasingly
important in recent years, even as inflation has been brought under
control. Eliminating biases of even a few tenths of a percentage point a
year can be important relative to a goal of price stability when
inflation is low, while it may have less significance when inflation is
higher.
A few years ago, questions were raised about the magnitude of bias in
the Consumer Price Index (CPI). In December 1996, the Advisory
Commission to Study the Consumer Price Index, appointed by the Senate
Finance Committee, reported that the index overstated the actual cost of
living by 1.1 percentage points per year; other experts believed that
the magnitude of empirically demonstrated biases was less.
The Bureau of Labor Statistics (BLS) has made important methodological
improvements beginning in 1995 that have significantly reduced any
overstatement of inflation as measured by the CPI. Taken together, these
changes are estimated to result in a 0.7 percentage point slower annual
rise in the CPI by 1999 compared with the methodologies used in 1994.
The changes instituted from 1995-1998 are estimated to have slowed the
growth of the CPI by 0.5 percentage point per year. These improvements
include correction of a problem in rotating new stores into the survey,
a better measure of prices for hospital services and computers, and a
more accurate estimate of the equivalent rent attributed to owner-
occupied housing. In addition, the BLS updated the expenditure weights
used in the CPI from a 1982-84 basis to 1993-95 weights, introduced a
more accurate geographic sample based on the 1990 decennial census, and
redefined the groupings of items. (For a fuller description of these
changes, see pages 7-8 in last year's Analytical Perspectives.) The
changes introduced this year are expected to reduce CPI growth by
another 0.2 percentage point per year.
Two methodological improvements are being instituted this year.
Beginning with the January CPI, items will be sampled on a product
rather than a geographical basis. This switch will allow more frequent
sampling of categories with rapidly changing product lines, such as
consumer electronics.
An even more important change is the replacement of the fixed-weighted
Laspeyres formula that has been used in the CPI by a geometric mean
formula for combining individual price quotations within certain
components of the index. BLS is applying this improvement to categories
where there are deemed to be substantial possibilities for substitution
among items within the category--for example, different varieties of
apples. In total, the categories using geometric means account for about
60 percent of the overall weight of the CPI. A CPI calculated using
geometric means more closely approximates a cost-of-living index. Unlike
the fixed-weighted aggregation, the geometric mean formula allows for
some shifts in consumer spending patterns in response to changes in
relative prices within categories of goods and services.
Because the CPI is used to deflate some nominal spending components of
GDP, a slower rise in the CPI translates directly into a faster measured
rise in real GDP and productivity growth. As noted in the discussion of
real GDP in the prior section, the BEA recently applied the geometric
mean formula to the prices used to deflate nominal personal consumption
expenditures. As a result, measured productivity growth and real GDP
growth in recent years were raised by almost 0.2 percentage point per
year.
The improved measurement of inflation, both in the CPI and the
national income accounts, has important implications for the budget.
Slower growth of the CPI means that outlays for programs with cost-of-
living adjustments tied to this index or its components--such as Social
Security, Supplemental Security Income (SSI), retirement payments for
railroad and Federal employees, and Food Stamps--will rise at a slower
pace more in keeping with true inflation than they would have without
these improvements. In addition, slower growth of the CPI will raise the
growth of receipts: personal income tax brackets, the size of the
personal exemptions, and eligibility thresholds for the Earned Income
Tax Credit (EITC) will rise more slowly because they are also indexed to
the CPI. Hence, the methodological improvements made in recent years act
on both the outlays and receipts sides of the budget to increase the
size of budget surpluses.
Economic Projections
The economy's strong performance last year--and, indeed, over the last
six years--and the maintenance of sound fiscal and monetary policies
raise the possibility that actual economic developments may even be
better than assumed--as has been the case in recent years. Nonetheless,
it is prudent to base budget estimates on a conservative set of economic
assumptions close to the consensus of private-sector forecasts.
The economic assumptions summarized in Table 1-1 are predicated on the
adoption of the policies proposed in this budget. The swing in the
fiscal position from deficit to surplus is expected to contribute to
continued favorable economic performance. Federal Government surpluses
reduce interest rates, stimulate private sector investment in new plant
and equipment, and help keep inflation under control. The Federal
Reserve is assumed to continue to pursue successfully the twin goals of
keeping inflation low while promoting growth.
The economy is likely to continue to grow during the next few years,
although at a more moderate pace than during 1998. While job
opportunities are expected to remain plentiful, the unemployment rate is
likely to rise gradually to a level consistent with stable inflation
over the longer horizon. New job creation will boost incomes and
consumer spending and keep confidence at a high level. Continued low
inflation will enable monetary policy to support economic growth.
Growth, in turn, will further improve the budget balance.
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Table 1-1. ECONOMIC ASSUMPTIONS \1\
(Calendar years; dollar amounts in billions)
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Projections
Actual --------------------------------------------------------------
1997 1998 1999 2000 2001 2002 2003 2004
--------------------------------------------------------------------------------------------------------------------------------------------------------
Gross Domestic Product (GDP):
Levels, dollar amounts in billions:
Current dollars............................................................. 8,111 8,497 8,833 9,199 9,582 10,004 10,456 10,930
Real, chained (1992) dollars................................................ 7,270 7,539 7,717 7,872 8,029 8,208 8,404 8,606
Chained price index (1992 = 100), annual average............................ 111.6 112.7 114.4 116.8 119.3 121.8 124.4 127.0
Percent change, fourth quarter over fourth quarter:
Current dollars............................................................. 5.6 4.5 4.0 4.2 4.1 4.5 4.5 4.5
Real, chained (1992) dollars................................................ 3.8 3.5 2.0 2.0 2.0 2.4 2.4 2.4
Chained price index (1992 = 100)............................................ 1.7 0.9 1.9 2.1 2.1 2.1 2.1 2.1
Percent change, year over year:
Current dollars............................................................. 5.9 4.8 4.0 4.1 4.2 4.4 4.5 4.5
Real, chained (1992) dollars................................................ 3.9 3.7 2.4 2.0 2.0 2.2 2.4 2.4
Chained price index (1992 = 100)............................................ 1.9 1.0 1.5 2.1 2.1 2.1 2.1 2.1
Incomes, billions of current dollars:
Corporate profits before tax................................................ 734 721 724 739 765 787 826 867
Wages and salaries.......................................................... 3,890 4,146 4,349 4,526 4,701 4,892 5,106 5,331
Other taxable income \2\.................................................... 1,717 1,763 1,815 1,863 1,921 1,980 2,051 2,126
Consumer Price Index (all urban): \3\
Level (1982-84 = 100), annual average....................................... 160.6 163.1 166.7 170.6 174.5 178.5 182.6 186.8
Percent change, fourth quarter over fourth quarter.......................... 1.9 1.6 2.3 2.3 2.3 2.3 2.3 2.3
Percent change, year over year.............................................. 2.3 1.6 2.2 2.3 2.3 2.3 2.3 2.3
Unemployment rate, civilian, percent:
Fourth quarter level........................................................ 4.7 4.6 4.9 5.1 5.3 5.3 5.3 5.3
Annual average.............................................................. 5.0 4.6 4.8 5.0 5.3 5.3 5.3 5.3
Federal pay raises, January, percent:
Military \4\................................................................ 3.0 2.8 3.6 4.4 3.9 3.9 3.9 3.9
Civilian \5\................................................................ 3.0 2.8 3.6 4.4 3.9 3.9 3.9 3.9
Interest rates, percent:
91-day Treasury bills \6\................................................... 5.1 4.8 4.2 4.3 4.3 4.4 4.4 4.4
10-year Treasury notes...................................................... 6.4 5.3 4.9 5.0 5.2 5.3 5.4 5.4
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Based on information available as of early December 1998.
\2\ Rent, interest, dividend and proprietors components of personal income.
\3\ Seasonally adjusted 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\ Beginning with the 1999 increase, percentages apply to basic pay only; adjustments for housing and subsistence allowances will be determined by the
Secretary of Defense.
\5\ Overall average increase, including locality pay adjustments.
\6\ Average rate (bank discount basis) on new issues within period.
Real GDP, Potential GDP and Unemployment: Over the next three years,
real GDP is expected to rise 2.0 percent per year. This shift to more
moderate growth recognizes that by mainstream assumptions, growth has
exceeded the pace that can be maintained on a sustained basis, and that
this could eventually result in upward pressures on inflation. More
moderate growth has been expected for this reason. Also, recessions in
Asia and slow growth elsewhere are expected to restrain U.S. growth
again this year, albeit not as much as during 1998. From 2001-2007,
growth is expected to average a slightly faster 2.4 percent per year--
the Administration's estimate of the economy's potential growth rate. In
2008, potential growth is projected to slow to 2.3 percent to reflect
the foreseeable demographic trend toward slower growth of the workforce
as the baby-boomers begin to retire.
The net export component of GDP is expected to restrain real growth by
about half as much as during 1998. Exports are expected to rise, rather
than contract as they did in 1998, and import growth is likely to be
somewhat slower than last year as our domestic demand slows. Beginning
with 2000, the foreign sector is not expected to make a large
contribution, positive or negative, to overall growth.
As has been the case throughout this expansion, during the next six
years business fixed investment is expected to be the fastest growing
component of GDP. Although residential investment is also expected to
benefit from low mortgage rates and strong demand for second homes for
vacation or retirement, the high level of housing starts in recent years
and underlying demographic trends may tend to reduce future growth
somewhat. Consumer spending, especially on durable goods, is also likely
to moderate from the rapid pace of 1998. The fundamental factors
supporting consumer spending are likely to remain favorable, although
not quite to the same extent as during 1998. The government component of
GDP will grow slowly through 2004. A decline in Federal consumption and
gross investment is projected to be offset by moderate growth in State
and local spending.
Potential GDP growth of 2.4 percent on average through 2007 can be
decomposed into the trend growth
[[Page 10]]
of productivity, 1.3 percent per year, plus the growth of the labor
force, estimated at 1.1 percent annually. The Administration's labor
force projection assumes that the population of working age will grow
1.0 percent per year and that the labor force participation rate will
edge up 0.1 percent per year.
Both the labor force and participation rate assumptions are lower than
recent experience. The participation rate has risen 0.2 percent per year
since 1993, as falling unemployment and rapidly expanding job
opportunities have induced job-seeking. With the labor force
participation rate and employment/population ratio already at post-World
War II highs last year, it is prudent to project a slower rise in coming
years. In addition, the female participation rate, which had risen
sharply during much of the postwar period, grew much more slowly during
the 1990s, and this is forecast to be reflected in future growth rates.
The real GDP growth projection of 2.0 percent through 2001 is
consistent with a gradual rise in the unemployment rate to 5.3 percent.
Unemployment is then projected to average 5.3 percent from 2001 onward,
when real GDP growth reverts on average to the Administration's estimate
of the economy's potential growth rate.
Inflation: With unemployment expected to be slightly below the NAIRU
during the next three years, inflation is projected to creep up. The CPI
is projected to increase 2.3 percent during this and the subsequent
years of the forecast; the GDP chain-weighted price index is projected
to increase 2.1 percent annually beginning in 2000. The 0.2 percentage
point difference between the two inflation measures is narrower than the
0.5 percentage point of 1998, in part because BLS will introduce the
geometric means formula into the CPI this year, which will slow the
growth in the index by about 0.2 percentage point annually. As discussed
above, this change will not affect the GDP price index because BEA has
already incorporated this improvement.
Despite the relatively tight labor market in the next few years, the
inflation rate is projected to remain low, partly because of two
temporary factors. The rise in the dollar is expected to hold down
import prices and intensify price competition from imported goods and
services. In addition, wide profit margins provide a cushion that will
enable firms to absorb cost increases without having to pass them on
fully into higher prices. Moreover, the methodological improvements to
the CPI introduced this year also will slow the rise in the CPI.
Interest Rates: The assumptions, which were finalized in early
December, project stable short-term rates and a slight rise in long-term
interest rates. The rise at the long end of the maturity spectrum is
about the same as the increase in the CPI. By 2002, the 91-day Treasury
bill rate is expected to be 4.4 percent, close to December's average;
the yield on the 10-year Treasury bond is projected to be 5.3 percent,
compared with 4.7 percent in December.
Incomes: The moderating of real growth during the projection horizon
is expected to shift the distribution of national income slightly,
augmenting somewhat the share going to compensation, while trimming the
unusually high profits share in GDP. The personal interest income share
is also projected to decline as interest rates remain historically low
and as households hold less Federal government debt because of the
projected budget surpluses. On balance, total taxable income is
projected to decline gradually as a share of GDP.
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 the Office of Management and
Budget (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. In contrast, CBO
normally assumes that current law will continue to hold; thus, it makes
a ``pre-policy'' projection. In recent years, and currently, CBO has
made economic projections based on a fiscal policy similar to the
budget's.
Both CBO and the Administration assume that maintaining budget
surpluses would have significant macroeconomic effects, especially for
interest rates and the distribution of income.
The two sets of projections are often prepared at different times.
The Administration's projections must be prepared in early December,
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. 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. Briefly, the Administration and CBO projections are very
similar for all the major variables affecting the budget outlook:
Real GDP: The projections of real GDP growth are quite similar; both
the Administration and CBO project that real GDP will grow at an average
annual rate of 2.2 percent over the 1999-2004 period.
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 2.1
percent yearly; CBO expects the annual rate of change in the CPI to be
about 0.3 percentage point higher than the Administration.
Unemployment: CBO projects unemployment to rise from its current
level to 5.7 percent. The Administra
[[Page 11]]
Table 1-2. COMPARISON OF ADMINISTRATION AND CBO ECONOMIC ASSUMPTIONS
(Calendar years; percent)
----------------------------------------------------------------------------------------------------------------
Projections
-----------------------------------------------------
1999 2000 2001 2002 2003 2004
----------------------------------------------------------------------------------------------------------------
Real GDP (chain-weighted): \1\
CBO January............................................. 1.8 1.9 2.3 2.4 2.5 2.4
2000 Budget............................................. 2.0 2.0 2.0 2.4 2.4 2.4
Chain-weighted GDP Price Index: \1\
CBO January............................................. 2.1 2.0 2.2 2.1 2.1 2.1
2000 Budget............................................. 1.9 2.1 2.1 2.1 2.1 2.1
Consumer Price Index (all-urban): \1\
CBO January............................................. 2.7 2.6 2.6 2.6 2.6 2.6
2000 Budget............................................. 2.3 2.3 2.3 2.3 2.3 2.3
Unemployment rate: \2\
CBO January............................................. 4.6 5.1 5.4 5.6 5.7 5.7
2000 Budget............................................. 4.8 5.0 5.3 5.3 5.3 5.3
Interest rates: \2\
91-day Treasury bills:
CBO January........................................... 4.5 4.5 4.5 4.5 4.5 4.5
2000 Budget........................................... 4.2 4.3 4.3 4.4 4.4 4.4
10-year Treasury notes:
CBO January........................................... 5.1 5.3 5.4 5.4 5.4 5.4
2000 Budget........................................... 4.9 5.0 5.2 5.3 5.4 5.4
Taxable income (share of GDP): \3\
CBO January............................................. 77.8 77.1 76.9 76.6 76.5 76.3
2000 Budget............................................. 78.0 77.5 77.1 76.6 76.4 76.1
----------------------------------------------------------------------------------------------------------------
\1\ Percent change, fourth quarter over fourth quarter.
\2\ Annual averages, percent.
\3\ Taxable personal income plus corporate profits before tax.
tion projects that the unemployment rate will average a slightly lower
5.3 percent.
Interest rates: The Administration and CBO have very similar paths
for long- and short-term interest rates.
Income distribution: The Administration and CBO have similar
projections for total taxable income shares of GDP. Both CBO and the
Administration expect a shift of income from interest to corporate
profits as a result of the sustained lower interest rates resulting from
continued budget surpluses. Both project a similar secular decline in
the total taxable income share.
Impact of Changes in the Economic Assumptions
The economic assumptions underlying this budget are similar to those
of last year. Both budgets anticipated that achieving a fundamental
shift in fiscal posture from large deficits to surpluses would result in
a significant decline in interest rates, which would serve to extend the
economic expansion at a moderate pace while helping to maintain low,
steady rates of inflation and unemployment. The shift to budget
surpluses and the ensuing lower interest rates were also expected to
shift the composition of income from interest to profits. This would
have favorable effect on receipts and the budget balance, because
profits are on average taxed more heavily than interest income.
The changes in the economic assumptions since last year's budget have
been relatively modest, as Table 1-3 shows. The differences are
primarily the result of economic performance in 1998 that has, once
again, proven more favorable than was anticipated at the beginning of
last year. Economic growth was stronger than expected in 1998, while
inflation and unemployment were lower. Because of this favorable
performance, the projected annual averages for the unemployment rate and
GDP price index have again been reduced slightly this year. At the same
time, interest rates are assumed in this budget to remain near their
current low levels. Interest rates are already lower than the levels to
which they were assumed to decline eventually in last year's forecast.
[[Page 12]]
Table 1-3. COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 1999 AND 2000 BUDGETS
(Calendar years; dollar amounts in billions)
----------------------------------------------------------------------------------------------------------------
1998 1999 2000 2001 2002 2003 2004
----------------------------------------------------------------------------------------------------------------
Nominal GDP:
1999 Budget assumptions \1\.................... 8,473 8,818 9,189 9,596 10,045 10,508 10,999
2000 Budget assumptions........................ 8,497 8,833 9,199 9,582 10,004 10,456 10,930
Real GDP (percent change): \2\
1999 Budget assumptions........................ 2.0 2.0 2.0 2.3 2.4 2.4 2.4
2000 Budget assumptions........................ 3.5 2.0 2.0 2.0 2.4 2.4 2.4
GDP price index (percent change): \2\
1999 Budget assumptions........................ 2.0 2.1 2.2 2.2 2.2 2.2 2.2
2000 Budget assumptions........................ 0.9 1.9 2.1 2.1 2.1 2.1 2.1
Consumer Price Index (percent change): \2\
1999 Budget assumptions........................ 2.2 2.2 2.3 2.3 2.3 2.3 2.3
2000 Budget assumptions........................ 1.6 2.3 2.3 2.3 2.3 2.3 2.3
Civilian unemployment rate (percent): \3\
1999 Budget assumptions........................ 4.9 5.1 5.3 5.4 5.4 5.4 5.4
2000 Budget assumptions........................ 4.6 4.8 5.0 5.3 5.3 5.3 5.3
91-day Treasury bill rate (percent): \3\
1999 Budget assumptions........................ 5.0 4.9 4.8 4.7 4.7 4.7 4.7
2000 Budget assumptions........................ 4.8 4.2 4.3 4.3 4.4 4.4 4.4
10-year Treasury note rate (percent): \3\
1999 Budget assumptions........................ 5.9 5.8 5.8 5.7 5.7 5.7 5.7
2000 Budget assumptions........................ 5.3 4.9 5.0 5.2 5.3 5.4 5.4
----------------------------------------------------------------------------------------------------------------
\1\ Adjusted for July 1998 NIPA revisions.
\2\ Fourth quarter-to-fourth quarter.
\3\ Calendar year average.
The net effects of these modifications in the economic assumptions on
the budget are shown in Table 1-4. The largest effects come from higher
receipts during 1999-2004. In all years through 2004, there are lower
outlays for interest due to the unexpectedly large fall in interest
rates, and lower outlays for cost-of-living adjustments to Federal
programs due to lower 1998 inflation. The change in economic assumptions
since last year increases budget surpluses by $40 billion to $50 billion
a year.
Table 1-4. EFFECTS ON THE BUDGET OF CHANGES IN ECONOMIC ASSUMPTIONS SINCE LAST YEAR
(In billions of dollars)
----------------------------------------------------------------------------------------------------------------
1999 2000 2001 2002 2003 2004
----------------------------------------------------------------------------------------------------------------
Budget totals under 1999 Budget economic assumptions and
2000 Budget policies:
Receipts................................................ 1,778.4 1,857.0 1,909.0 1,988.9 2,060.2 2,154.5
Outlays................................................. 1,743.1 1,789.0 1,824.8 1,846.3 1,921.0 1,987.8
-----------------------------------------------------
Surplus............................................. 35.4 68.1 84.1 142.6 139.2 166.8
Changes due to economic assumptions:
Receipts................................................ 27.9 25.9 24.4 18.1 14.8 11.0
Outlays:
Inflation............................................. -4.9 -6.3 -6.6 -6.9 -7.3 -7.9
Unemployment.......................................... -3.5 -2.4 -1.6 -0.7 -0.9 -1.0
Interest rates........................................ -6.4 -11.0 --11.4 -10.0 -9.2 -8.3
Interest on changes in borrowing...................... -1.2 -3.6 -6.1 -8.4 -10.6 -12.7
-----------------------------------------------------
Total, outlay decreases (-)......................... -16.0 -23.3 -25.6 -26.0 -28.1 -29.9
-----------------------------------------------------
Increase in surplus................................. 43.9 49.2 50.0 44.1 42.9 40.9
Budget totals under 2000 Budget economic assumptions and
policies:
Receipts................................................ 1,806.3 1,883.0 1,933.3 2,007.1 2,075.0 2,165.5
Outlays................................................. 1,727.1 1,765.7 1,799.2 1,820.3 1,893.0 1,957.9
-----------------------------------------------------
Surplus............................................. 79.3 117.3 134.1 186.7 182.0 207.6
----------------------------------------------------------------------------------------------------------------
[[Page 13]]
Structural vs. Cyclical Balance
When the economy is operating above potential as it is currently
estimated to be, receipts are higher than they would be if resources
were less fully employed, and outlays for unemployment-sensitive
programs (such as unemployment compensation and food stamps) are lower.
As a result, the deficit is smaller or the surplus is larger than it
would be if unemployment were at the NAIRU. The portion of the surplus
or deficit that can be traced to this factor is called the cyclical
surplus or deficit. The remainder, the portion that would remain with
unemployment at the NAIRU (consistent with a 5.3 percent unemployment
rate), is called the structural surplus or deficit.
Table 1-5. ADJUSTED STRUCTURAL BALANCE
(In billions of dollars)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
--------------------------------------------------------------------------------------------------------------------------------------------------------
Unadjusted deficit (-) or surplus.......... -290.4 -255.0 -203.1 -163.9 -107.4 -21.9 69.2 79.3 117.3 134.1 186.7 182.0 207.6
Cyclical component....................... -75.0 -66.2 -38.1 -16.5 -7.8 12.4 34.3 29.4 16.7 6.6 0.3 ...... ......
------------------------------------------------------------------------------------------------------------
Structural deficit (-) or surplus.......... -215.4 -188.9 -165.0 -147.4 -99.6 -34.3 35.0 49.9 100.6 127.5 186.5 182.0 207.6
Deposit insurance outlays................ -2.3 -28.0 -7.6 -17.9 -8.4 -14.4 -4.4 -5.0 -2.3 -1.8 -1.3 -* 0.8
------------------------------------------------------------------------------------------------------------
Adjusted structural deficit (-) or surplus. -217.7 -216.9 -172.6 -165.3 -108.0 -48.7 30.6 44.8 98.3 125.7 185.1 182.0 208.5
--------------------------------------------------------------------------------------------------------------------------------------------------------
Changes in the structural balance give a better picture of the impact
of budget policy on the economy than does the unadjusted budget balance.
The level of the structural balance also gives a clearer picture of the
stance of fiscal policy, because this part of the surplus or deficit
will persist even when the economy achieves permanently sustainable
operating levels.
In the early 1990s, large swings in net outlays for deposit insurance
(the S&L bailouts) had substantial impacts on deficits, but had little
concurrent impact on economic performance. It therefore became customary
to remove deposit insurance outlays as well as the cyclical component of
the surplus or deficit from the actual surplus or deficit to compute the
adjusted structural balance. This is shown in Table 1-5.
For the period 1998 through mid-2001, the unemployment rate is
slightly below the estimated NAIRU of 5.3 percent, resulting in cyclical
surpluses. Thereafter, unemployment is projected to equal the NAIRU, so
the cyclical component of the surplus vanishes. Deposit insurance net
outlays are relatively small and do not change greatly from year to
year. The adjusted structural surplus or deficits in this budget display
much the same pattern of year-to-year changes as the actual deficits.
Two significant points are illustrated by this table. First, of the $360
billion swing in the actual budget balance between 1992 and 1998 (from a
$290 billion deficit to a $69 billion surplus), 30 percent ($109
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, which reversed a projected
continued steep rise in the deficit and set the stage for the remarkable
cyclical improvement that has occurred. Second, the structural surplus
is expected to rise substantially over the projection horizon--in part
due to the effects of the Balanced Budget Act of 1997.
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 surplus.
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 high rate of real GDP growth is generally
associated with a declining rate of unemployment, while moderate 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 1-6.
If real GDP growth is lower by one percentage point in calendar year
1999 only and the unemployment rate rises by one-half percentage point,
the fiscal 1999 surplus would decrease by $9.8 billion; receipts in 1999
would be lower by about $8.0 billion, and outlays would
[[Page 14]]
be higher by about $1.8 billion, primarily for unemployment-sensitive
programs. In fiscal year 2000, the receipts shortfall would grow further
to about $17.2 billion, and outlays would increase by about $6.1 billion
relative to the base, even though the growth rate in calendar 2000
equals the rate 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 higher deficits or smaller surpluses) 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 (1999-2004) 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 budget balance would be worsened
by $163.3 billion relative to the base case by 2004.
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, resulting in a
$133.3 billion worsening of the budget balance by 2004.
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 1999 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
1999 rise by $5.6 billion and receipts by $9.2 billion, for a increase
of $3.6 billion in the 1999 surplus. In 2000, outlays would be above the
base by $12.9 billion, due in part to lagged cost-of-living adjustments;
receipts would rise $18.4 billion above the base, however, resulting in
a $5.6 billion improvement in the budget balance. 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 steadily in
successive years, adding $54.0 billion to outlays and $109.0 billion to
receipts in 2004, for a net increase in the surplus of $55.0 billion.
The table shows the interest rate and the inflation effects
separately. These separate effects for interest rates and inflation
rates do not sum to the effects for simultaneous changes in both. This
occurs because, when the budget is in surplus and some debt is being
retired, the combined effects of two changes in assumptions affecting
debt financing patterns and interest costs may differ from the sum of
the separate effects, depending on assumptions about Treasury's
selection of debt maturities to retire and the interest rates they bear.
The last entry in the table shows rules of thumb for the added interest
cost associated with changes in the budget surplus.
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. However, the
relationships between changes in income shares and changes in growth,
inflation, and interest rates are too complex to be reduced to simple
rules.
[[Page 15]]
Table 1-6. SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
(In billions of dollars)
----------------------------------------------------------------------------------------------------------------
Budget effect 1999 2000 2001 2002 2003 2004
----------------------------------------------------------------------------------------------------------------
Real Growth and Employment
Budgetary effects of 1 percent lower real GDP
growth:
For calendar year 1999 only: \1\
Receipts........................................ -8.0 -17.2 -20.1 -20.9 -21.8 -22.7
Outlays......................................... 1.8 6.1 6.6 8.0 9.7 11.5
-----------------------------------------------------------
Decrease in surplus (-)....................... -9.8 -23.3 -26.7 -28.9 -31.5 -34.2
Sustained during 1999-2004: \1\
Receipts........................................ -8.0 -25.4 -46.1 -68.3 -92.0 -117.5
Outlays......................................... 1.8 8.0 14.7 23.1 33.3 45.7
-----------------------------------------------------------
Decrease in surplus (-)....................... -9.8 -33.4 -60.9 -91.4 -125.4 -163.3
Sustained during 1999-2004, with no change in
unemployment:
Receipts........................................ -8.0 -25.4 -46.2 -68.4 -92.1 -117.6
Outlays......................................... 0.2 1.0 2.8 5.7 10.0 15.7
-----------------------------------------------------------
Decrease in surplus (-)....................... -8.2 -26.4 -49.0 -74.2 -102.1 -133.3
Inflation and Interest Rates
Budgetary effects of 1 percentage point higher rate
of:
Inflation and interest rates during calendar year
1999 only:
Receipts........................................ 9.2 18.4 17.8 16.4 17.2 18.1
Outlays......................................... 5.6 12.9 10.3 9.2 9.0 8.3
-----------------------------------------------------------
Increase in surplus (+)....................... 3.6 5.6 7.5 7.2 8.2 9.7
Inflation and interest rates, sustained during
1999-2004:
Receipts........................................ 9.2 28.1 47.1 65.7 86.3 109.0
Outlays......................................... 5.6 18.6 29.3 38.1 46.4 54.0
-----------------------------------------------------------
Increase in surplus (+)....................... 3.6 9.5 17.8 27.6 39.9 55.0
Interest rates only, sustained during 1999-2004:
Receipts........................................ 1.3 3.3 4.1 4.4 4.8 5.1
Outlays......................................... 5.2 14.1 18.5 20.3 21.6 22.2
-----------------------------------------------------------
Decrease in surplus (-)....................... -3.9 -10.9 -14.4 -15.9 -16.9 -17.1
Inflation only, sustained during 1999-2004:
Receipts........................................ 8.0 24.8 43.0 61.3 81.6 103.9
Outlays......................................... 0.5 4.7 11.3 18.7 26.4 34.1
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Increase in surplus (+)....................... 7.5 20.2 31.7 42.6 55.2 69.7
Interest Cost of Higher Federal Borrowing
Outlay effect of a $50 billion reduction in the 1999
surplus............................................ 1.2 2.4 2.5 2.7 2.9 3.0
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* $50 million or less.
\1\ The unemployment rate is assumed to be 0.5 percentage point higher per 1.0 percent shortfall in the level of
real GDP.