[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 prudent macroeconomic policies pursued since 1993 have fostered 
the healthiest economy in over a generation. Budget surpluses have 
replaced soaring deficits. During this Administration, fiscal policy has 
been augmenting national saving, private investment, productivity, and 
economic growth, rather than restraining them. Monetary policy has 
helped reduce inflation while supporting economic growth, and minimizing 
the domestic effect of international financial dislocations.
  These sound policies have contributed to another year of outstanding 
economic achievement--and hold the promise of more successes to come. 
Real Gross Domestic Product (GDP) rose 4.2 percent during 1999, the 
fourth consecutive year that growth has been four percent or more. The 
last time growth was this strong for so long was in the mid-1960s.
  Strong and sustained growth has created abundant job opportunities and 
raised real wages. The Nation's payrolls expanded by 2.7 million jobs 
last year, bringing the total number of jobs created during this 
Administration to 20.4 million. The unemployment rate during the last 
three months of the year fell to 4.1 percent of the labor force, the 
lowest level since January 1970, and 3.2 percentage points lower than 
the rate in January 1993.
  Despite robust growth and very low unemployment, inflation has 
remained low. The Consumer Price Index excluding the volatile food and 
energy components rose only 1.9 percent last year, the smallest increase 
since 1965. The combination of low inflation and low unemployment pulled 
the ``Misery Index,'' defined as the sum of the inflation and 
unemployment rates, to the lowest level since 1965.
  Households, businesses and investors have prospered in this 
environment. Wage growth has outpaced inflation during each of the last 
four years, reversing a two-decade decline in real earnings. In 1998, 
the poverty rate fell to the lowest level since 1980. Although the 
poverty rate for 1999 will not be known until later this year, another 
decline is likely in light of the economy's strong job gains and 
declining unemployment. The healthy economy boosted consumer optimism 
last year to the highest level on record.
  Businesses' confidence in the future is evident in a willingness to 
invest heavily in new, capacity-enhancing plant, equipment and software. 
During the past seven years, equipment and software spending has risen 
at a double-digit pace, spurred by purchases of high-tech capital. Rapid 
growth of investment has helped return labor productivity growth to 
rates not seen since before the first oil crisis in 1973. Rapid 
productivity growth has enabled firms to achieve healthy increases in 
profits, and to raise real wages while still holding the line on prices.
  Forward-looking financial markets have responded to these 
developments. The bull market in equities that began in 1994 continued 
in 1999. These past five years have recorded the largest percentage 
gains in stock prices in the postwar period. From December 31, 1994 to 
December 31, 1999, the Dow Jones Industrial Average rose 200 percent; 
the S&P 500 gained 220 percent; and the technology-laden NASDAQ soared 
441 percent. During January, the Dow and the NASDAQ edged into record 
territory and the S&P 500 remained close to its record high.
  Short- and long-term interest rates rose during 1999 in response to 
the increased demand for credit that accompanied strong private-sector 
growth and the Federal Reserve's tightening of monetary policy. Even so, 
long-term interest rates during 1998 and 1999 were still lower than in 
any year during the prior three decades. The real long-term interest 
rate (the nominal rate minus expected inflation), an important 
determinant of investment decisions, was also lower in these two years 
than in any other two-year period since 1980. As 2000 began, financial 
and nonfinancial market indicators were signaling that the economic 
outlook remains healthy.
  The economy has outperformed the consensus forecast during the past 
seven years, and the Administration believes that it can continue to do 
so if sound fiscal policies are maintained. However, for purposes of 
budget planning, the Administration continues to choose projections that 
are close to the consensus of private forecasters. The Administration 
assumes that the economy will grow between 2.5 and 3.0 percent yearly 
through 2010, while unemployment, inflation and interest rates are 
projected to remain relatively low.
  Even with the moderation in growth, the economy is expected to 
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-2003. Thereafter, 
it is projected to average a relatively low 5.2 percent, the middle of 
the range that the Administration estimates is consistent with stable 
inflation in the long run. The Consumer Price Index (CPI), which rose 
2.7 percent during 1999 because of rapidly rising energy prices, is 
projected to slow slightly in the next two years and then increase 2.6 
percent per year on average through 2010. Short- and long-term interest 
rates are expected to remain in the neighborhood of the levels reached 
at the end of 1999.

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  As of December, this business cycle expansion had lasted 105 months 
since the trough in March 1991. If the expansion continues through 
February, as seems highly likely, it will exceed the previous longevity 
record of 106 months set by the Vietnam War expansion of the 1960s. If 
macroeconomic policies continue to foster high investment without 
engendering inflationary pressures, there is every reason to believe 
that this expansion will continue for many more years.
  This chapter begins with a review of recent developments, and then 
discusses two statistical issues: the recent methodological improvements 
in the calculation of the Consumer Price Index, which slowed its rise; 
and the October comprehensive revisions to the National Income and 
Product Accounts, which incorporated computer software as a component of 
investment, among other changes. 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.

                           Recent Developments

  The outstanding performance of the economy is due to a combination of 
several factors. First, macroeconomic policies have promoted strong 
growth with low inflation. Second, thanks in part to robust investment 
and new, high-tech means of communicating and doing business, labor 
productivity growth in the last four years has approached 3 percent per 
year--double the rate that prevailed during the prior two decades, and 
comparable to the high rates achieved during the first three decades 
following World War II. Third, inflation has been restrained by 
recession in much of the world and by the rising exchange value of the 
dollar. These forces together--plus intensified competition, including 
competition from foreign producers--have kept down commodity prices and 
prevented U.S. producers from raising prices. Finally, the labor market 
appears to have changed in ways that now permit the unemployment rate to 
fall to lower levels without triggering faster inflation.

   Fiscal Policy: In 1992, the deficit reached a postwar record of $290 
billion, representing 4.7 percent of GDP--and the prospects were for 
growing deficits for the foreseeable future. When this Administration 
took office in January 1993, it vowed to restore fiscal discipline. That 
goal has been amply achieved. By 1998, the budget moved into surplus for 
the first time since 1969; and in 1999 it recorded an even larger 
surplus of $124 billion. That is the largest surplus ever, and, at 1.4 
percent of GDP, it is the largest as a share of the overall economy 
since 1951. This fiscal year, the surplus is projected to rise to $167 
billion, or 1.7 percent of GDP. The dramatic shift from huge deficits to 
surpluses in the last seven years is unprecedented since the 
demobilization just after World War II.
  The historic improvement in the Nation's fiscal position during this 
Administration is due in large measure to two landmark pieces of 
legislation, the Omnibus Budget Reconciliation Act of 1993 (OBRA) and 
the Balanced Budget Act of 1997 (BBA). OBRA enacted budget proposals 
that the Administration made soon after it came into office, and set 
budget deficits on a downward path. The deficit reductions following 
OBRA have far exceeded the predictions made at the time of its passage. 
OBRA was projected to reduce deficits by $505 billion over 1994-1998. 
The actual total deficit reduction during those years was more than 
twice that--$1.2 trillion. In other words, OBRA and subsequent 
developments 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 unified 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, and achieved an even larger surplus 
in 1999. OBRA 1993 and BBA 1997, together with subsequent developments, 
are estimated to have improved the unified budget balance compared with 
the pre-OBRA baseline by a cumulative total of $6.7 trillion over 1993-
2005.
  The better-than-expected budget results in recent years have 
contributed to the better-than-expected economic performance. Lower 
deficits and bigger surpluses helped promote a healthy, sustainable 
expansion by reducing the cost of capital, through both downward 
pressure on interest rates and higher prices for corporate equities. A 
lower cost of capital stimulated business capital spending, which 
expanded industrial capacity, boosted productivity growth, and 
restrained inflation. Rising equity prices also increased household 
wealth, optimism, and spending. The added impetus to consumer spending 
created new jobs and business opportunities. The faster-growing economy, 
in turn, boosted incomes and profits, which fed back into an even 
healthier budget.
  Though 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, incomes, and capital 
gains have all exceeded expectations. The outstanding economic 
performance during this Administration is proof positive of the lasting 
benefits of prudent fiscal policies.

   Monetary Policy: During this expansion, the Federal Reserve tightened 
policy when inflation threatened to pick up, but eased when the 
expansion risked stalling out. In 1994 and early 1995, the monetary 
authority

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raised interest rates 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 
while higher inflation no longer threatened. From January 1996 until the 
fall of 1998, 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.
  During the second half of 1998, however, financial turmoil abroad 
threatened to spread to the United States. In addition, a large, highly 
leveraged U.S. hedge fund, which had borrowed heavily from major 
commercial and investment banks, nearly failed. In this environment, 
normal credit channels to even the most credit-worthy private businesses 
were disrupted. In response to these serious challenges to the financial 
system and the economy, the Federal Reserve quickly shifted policy by 
cutting the Federal funds rate by one-quarter percentage point on three 
occasions in just seven weeks--the swiftest easing since 1991, when the 
economy was just emerging from recession. By early 1999, those actions 
had restored normal credit flows and risk spreads among credit market 
instruments and returned the stock market to its upward trajectory.
  With the return of financial market stability and amidst an 
environment of strong growth and falling unemployment, the Federal 
Reserve raised the Federal funds rate by one-quarter percentage point on 
three separate occasions during 1999, returning the rate to the 5\1/2\ 
percent level that prevailed before the 1998 international financial 
dislocation.

   Real Growth: The economy expanded at a 3.7 percent annual rate over 
the first three quarters of 1999, and rose at an even faster 5.8 percent 
pace during the fourth quarter. Over the four quarters of the year, real 
GDP increased 4.2 percent, the fourth year in a row of robust growth 
exceeding 4.0 percent.
  The fastest growing sector last year was again business spending on 
new equipment and software, which rose 11.0 percent during 1999. The 
biggest gains continued to be for information processing and software, 
with added impetus from the need to upgrade systems to be Y2K compliant. 
Investment in new structures, in contrast, edged down during 1999.
  The exceptionally strong growth of spending for new equipment and 
software in recent years raised trend productivity growth. This helped 
to keep inflation in check by permitting firms to grant real wage 
increases without putting upward pressure on prices. The increase in 
productive capacity resulting from robust capital spending also eased 
the supply bottlenecks and strains that normally would accompany tight 
labor markets. In the fourth quarter of 1999, the manufacturing 
operating rate was below its long-term average, even though the 
unemployment rate was unusually low. Overall industrial capacity rose by 
more than 4 percent in each of the past six years--the fastest sustained 
increase in capacity in three decades.
  The consumer sector, which accounts for two-thirds of GDP, made a 
significant contribution to last year's rapid growth, as it did in the 
previous two years. Consumer spending after adjustment for inflation 
rose 5.4 percent over the four quarters of 1999, the largest increase in 
a quarter century. Thanks to low unemployment, rising real incomes, 
extraordinary capital gains from the booming stock market and record 
levels of consumer confidence, households have the resources and 
willingness to spend heavily, especially on discretionary, big-ticket 
purchases. For example, sales of cars, minivans and other light-weight 
trucks reached nearly 17 million units last year, a new record.
  In 1999, growth of consumer spending again outpaced even the strong 
growth of disposable personal income, pulling down the saving rate to 
2.4 percent, the lowest level in the postwar period. Because of the 
enormous increase in household wealth created by the soaring stock 
market, households felt confident enough to boost spending by reducing 
saving out of current income.
  Partly because of rising wealth, households took on considerably more 
debt. As a consequence, household debt service payments as a percent of 
disposable personal income rose from 11.7 percent at the end of 1992 to 
13.4 percent in the third quarter of 1999. However, the ratio of debt 
service to income was still \3/4\ percentage point below its prior peak, 
suggesting that the household sector on average was not overextended, 
especially considering the rapid rise in household equity wealth.
  The same factors spurring consumption pushed new and existing home 
sales during 1999 to their highest level since record-keeping began. The 
homeownership rate reached a record 66.8 percent last year. Buoyant 
sales and low inventories of unsold homes provided a strong incentive 
for new construction. Housing starts, which were already at a high level 
in 1998, increased further last year to the highest level since the mid-
1980s. Residential investment, after adjustment for inflation, increased 
during the first half of the year but edged down during the second half, 
reflecting the peak in housing starts early in the year.
  As a result of the healthier fiscal position of all levels of 
government, spending by the government sector rose more rapidly than it 
has in recent years. State and local consumption spending after 
adjustment for inflation rose 4.6 percent last year, while Federal 
Government spending increased 5.3 percent.
  The foreign sector was the primary restraint on GDP growth in 1999, as 
during the prior two years. Although the economic recovery of our 
trading partners boosted our exports, this positive contribution to GDP 
growth was more than offset by the very rapid rise of imports that 
accompanied the exceptionally strong growth of U.S. domestic demand. 
Over the year, exports of goods and services after adjustment for 
inflation rose 4.0 percent, while imports soared 13.1 percent. As a 
result, the net export balance widened considerably, and restrained real 
GDP growth by an average of 1.2 percentage points per quarter--a larger 
drag on growth than

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during the two previous years when recessions abroad dramatically 
curtailed U.S. exports. The trade-weighted value for the dollar, which 
had risen strongly in recent years, was little changed, on average, 
during 1999. However, the dollar depreciated 7 percent against the 
Japanese yen, while it appreciated 15 percent against the newly launched 
Euro.

   Labor Markets: At the start of the year, most forecasters had 
expected growth to slow significantly and the unemployment rate to rise. 
Instead, the economy continued to expanded at a rapid pace, pulling the 
unemployment rate down from 4.3 percent at the end of 1998 to 4.1 
percent during the last three months of 1999. When the Administration 
took office, the unemployment rate was 7.3 percent. In December, forty-
five States had unemployment rates of 5.0 percent or less; rates in the 
other five were between 5.1 and 6.1 percent. Significantly, all 
demographic groups have participated in the improved labor market. The 
unemployment rates for Hispanics and Blacks during 1999 were the lowest 
on record.
  The Nation's payrolls expanded by a sizeable 2.7 million jobs last 
year. As in 1998, employment did not increase in all industries; mining 
and manufacturing, which are especially vulnerable to adverse 
developments in international trade, lost jobs. However, a greater 
number of jobs were created in the private service sector, construction, 
and State and local government. The abundance of employment 
opportunities last year kept the labor force participation rate at the 
record-high level set in 1997 and 1998, and pulled up the employment/
population ratio to the highest level ever.

   Inflation: Despite continued rapid economic growth and the low 
unemployment rate, inflation remained low last year, and the ``core'' 
rate even slowed. The core CPI, which excludes the volatile food and 
energy components, rose just 1.9 percent over the 12 months of 1999, 
down from 2.4 percent during 1998. Last year's rise in the core rate was 
the smallest since 1965. However, because of a sharp rise in energy 
prices, driven to a considerable extent by international economic 
recovery, the total CPI rose 2.7 percent last year--up from 1.6 percent 
during 1998, when energy prices fell substantially.
  The broader GDP chain-weighted price index rose just 1.6 percent 
during 1999, not much higher than the 1.1 percent during the four 
quarters of 1998. This is the smallest two-year rise in overall prices 
since 1962-63. The favorable inflation performance was the result of 
intense competition, including from imports; very small increases in 
unit labor costs because of robust productivity growth; and perhaps 
structural changes in the link between unemployment and inflation.
  Last year, however, import and export prices exerted less of a 
restraint on inflation than in prior years. Because of the overall 
stability of the dollar last year, import prices other than petroleum 
were about unchanged during 1999; by contrast, import prices had been 
falling for several years in response to the dollar's rise. Moreover, 
the price of imported petroleum products doubled last year as a result 
of a recovery in world demand and a cutback in OPEC production. On the 
other side of the ledger, prices of exported goods (a component of the 
GDP price index) were about unchanged during 1999, after having fallen 
in 1998; the dollar's stability enabled U.S. firms to avoid having to 
cut prices to remain competitive.
  Real wages grew again in 1999; but even with the low unemployment, 
hourly earnings and the broader measures of compensation rose slightly 
less during 1999 than in the prior year. Robust investment in new 
equipment contributed to unusually strong productivity growth for this 
stage of an expansion, helping to restrain inflation by offsetting the 
nominal rise in labor compensation. Unit labor costs rose at only a 1.8 
percent annual rate during the first three quarters of 1998, down from 
2.1 percent during 1999.
  The absence of any signs of a buildup of inflationary pressures 
despite low and falling unemployment and rapid growth 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 of lower unemployment without 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 5.2 percent in the long run. That is the same rate as in the 
Mid-Session Review published last June, but 0.1 percentage point less 
than estimated in the 2000 Budget assumptions, and 0.5 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 1999, the unemployment rate was well below the current 
mainstream estimate of the long run NAIRU. The Administration's forecast 
for real growth over the next three years implies that unemployment will 
return to 5.2 percent by the middle of 2003.

                            Statistical Issues

  Statistical agencies must constantly improve their measurement tools 
to keep up with rapid structural changes in the U.S. economy. Last year, 
the Bureau of Labor Statistics (BLS) implemented the latest in a series 
of planned improvements to the Consumer Price Index; and the Bureau of 
Economic Analysis (BEA) made significant methodological and statistical 
changes to the National Income and Product Accounts. On balance, these 
changes revised real GDP growth and labor productivity growth 
significantly upward in recent years.

   Inflation: The CPI is not just another statistic. Perhaps more than 
any other statistic, it actually affects the incomes of governments, 
businesses and households via statutory and contractual cost-of-living 
adjustments.

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As such, recent improvements in measurement of the CPI--which, on 
balance, have slowed its increase--have significant impacts throughout 
the economy. Because the CPI is used to deflate some nominal spending 
components of GDP as well as household incomes, compensation, and wages, 
a slower rise in the CPI translates directly into a faster measured real 
growth of such key indicators as GDP, productivity, household incomes 
and wages.
  In recent years, considerable attention has been given to estimating 
the magnitude of the bias in the CPI and how best to reduce it. In 
December 1996, the Advisory Commission to Study the Consumer Price 
Index, appointed by the Senate Finance Committee, issued its 
recommendations on this subject.
  Beginning in 1995, the Bureau of Labor Statistics instituted a number 
of important methodological improvements to the CPI. Taken together, 
these changes are estimated to result in about a 0.6 percentage point 
slower annual increase in the index in 1999 and every year thereafter 
compared with the methodologies and market basket used in 1994. The most 
recent significant change, instituted beginning with the January 1999 
CPI release, replaced the fixed-weighted Laspeyres formula, which had 
been used to aggregate lower level components of the CPI, with a 
geometric mean formula for most such aggregates. A CPI calculated using 
geometric means more closely approximates a cost-of-living index. Unlike 
the fixed-weighted aggregation, the geometric mean formula assumes 
consumer spending patterns shift in response to changes in relative 
prices within categories of goods and services.
  Also in 1999, BLS instituted new rotation procedures in its sampling 
of retail outlets where it selects items for price collection. The new 
procedures focus on expenditure categories rather than geographic areas, 
thereby enabling the CPI to incorporate price information on new, high-
tech consumer products in a more timely fashion.
  The next scheduled improvement will be an updating of the consumption 
expenditure weights used in the CPI effective with the release of the 
CPI for January of 2002, when weights based on spending patterns in 
1999-2000 will replace the current 1993-95 market-basket weights. The 
BLS has announced that it will update expenditure weights every two 
years thereafter. It is expected that the shift to biennial updates of 
the weights will have little impact on measured inflation.
  For the Federal Government, slower increases in the CPI mean 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 tax receipts because personal 
income tax brackets, the size of the personal exemptions, and 
eligibility thresholds for the Earned Income Tax Credit (EITC) are 
indexed to the CPI. Thus, the methodological improvements made in recent 
years act on both the outlays and receipts sides of the budget to 
increase the budget surpluses.
  For the National Income and Product Accounts, the Bureau of Economic 
Analysis follows the convention that changes in concepts and methods of 
estimation are incorporated into the historical series whenever 
possible. In contrast, the Bureau of Labor Statistics (BLS) follows the 
convention that the historical CPI series is never revised. The 
reasoning is that the public is probably better served by having an 
unchanged CPI series for convenient use in contract escalation clauses 
rather than one that is revised historically and might trigger claims 
for payment adjustments with every revision.
  The BLS, however, has recently published a research CPI series (the 
CPI-RS) that backcasts the current methods to 1978. (See ``CPI Research 
Series Using Current Methods, 1978-98,'' Monthly Labor Review, June 
1999, for the series and an explanation of all the methodological 
improvements instituted since 1978.) This methodologically consistent 
series shows a slower rise in inflation, and therefore a faster rise in 
real measures, than the official CPI: during these 21 years, the CPI-RS 
increased 4.28 percent per year on average compared with 4.73 percent 
for the CPI, a difference of 0.45 percentage point per year.
  As discussed below, the National Income and Product Accounts had 
already incorporated many of the improvements in methods that have been 
made over the years in the CPI. The most recent significant improvement, 
the use of a geometric mean formula for combining lower level 
aggregates, was incorporated into the October benchmark national 
accounts for the period 1977-94; this change was already in the national 
accounts for the period since 1994.

   National Income and Product Accounts: In October, the BEA released a 
comprehensive revision of the National Income and Product Accounts 
(NIPA), also referred to as a ``benchmark'' revision. These periodic 
revisions differ from the usual annual revisions in that they are much 
wider in scope and include definitional, methodological and 
classification changes in addition to incorporation of new and revised 
source data. The latest comprehensive revision significantly changed the 
definition and estimates of nominal and real GDP, investment, and 
saving. (For details about the revision, see the August, October and 
December, 1999 issues of the Survey of Current Business.)
   Real and Nominal GDP: The most significant definitional change was 
the recognition of business and government expenditures on computer 
software (including the costs of in-house production of software) as 
investment, and therefore as a component of GDP and the Nation's capital 
stock. Until this revision, BEA had treated software, except that 
embedded in other equipment, as if it were an intermediate good, and had 
not counted it in GDP until it appeared as part of a final

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product. Intermediate goods do not add directly to GDP; capital goods 
do. (The Federal Government investment estimates presented in Chapter 6 
of this volume also treat software as investment.)
  The rapid growth of spending on software in recent years has made a 
significant contribution to the new, upwardly revised estimates of real 
GDP growth. Although real GDP growth was raised by 0.4 percentage point 
per year on average during 1987-93 and by a similar amount since then, 
the sources of the revision differ greatly between the two periods. 
During 1987-93, new definitions, notably the inclusion of spending on 
computer software as a component of investment, boosted growth by only 
0.1 percentage point. The downward revision to inflation estimates, 
notably the incorporation of the geometric mean formula to estimate 
consumer price inflation, contributed another 0.3 percentage point. New 
source data did not make any contribution to the upward revision of real 
growth. In contrast, during 1994-98, about 0.2 percentage point of the 
upward revision was due to the inclusion of computer software; and 
another 0.2 percentage point was due to revised source data. Revisions 
to inflation hardly affected the estimate of real GDP growth.
  The sources of the upward revision to nominal GDP provide another 
perspective on the importance of including software in the definition of 
GDP. For calendar year 1998, the benchmark revision in total raised 
nominal GDP by $249 billion, or 2.9 percent. Definitional sources, 
primarily the new classification of software, added $169 billion (2.0 
percentage points). Statistical sources (including new and revised 
source data, the incorporation of the more recent input-output accounts, 
and preliminary data from the 1997 economic census) accounted for $80 
billion (0.9 percentage point).

   Saving: By including computer software spending as investment, the 
comprehensive revisions boosted measured gross business saving (or 
undistributed profits and capital consumption) but increased gross 
national saving much more than net national saving. That is because 
including software as investment also increases capital consumption 
(depreciation) more than undistributed profits. In fact, most of the 
gross investment in software, as measured in NIPA, goes to replace the 
large amount of software that is annually ``used up'' or depreciated 
through technical obsolescence, as reflected in the short service lives. 
Therefore, net saving is only a slightly larger share of Net Domestic 
Product in recent years than it was in the previous data, and for some 
prior years, in which capital consumption increased more as a result of 
the revision than did gross saving, the revised net saving rate is 
smaller than it was previously. It is only net saving and its 
counterpart, net investment, that adds to the Nation's net capital 
stock.
  In addition to defining software spending as part of GDP, the 
comprehensive revisions made other changes in the NIPA definitions. 
These did not have a noticeable effect on nominal or real GDP or overall 
national saving; they did, however, affect measured saving of government 
and households. These definitional changes included:
     A shift in the classification of government employee 
          pensions from the public sector to the private sector, which 
          increased measured personal saving, and reduced the NIPA 
          government surplus by an equal amount. (For an explanation of 
          the differences between the NIPA definition of the Federal 
          Government surplus and the unified surplus referred to in the 
          Budget, see Chapter 16 of this volume.)
     Estate and gift taxes were reclassified as ``capital 
          transfers.'' This reduced government saving by reducing 
          current receipts, and increased personal saving by reducing 
          personal taxes.
     Federal investment grants were also reclassified as 
          ``capital transfers,'' which increased Federal saving by 
          eliminating a category previously counted as a NIPA Federal 
          government expenditure. As a counterpart, the reclassification 
          reduced State and local government revenues and, therefore, 
          the saving of that sector.
  These changes affected the composition of saving, shifting some saving 
from the government sector to the household sector. The new methodology 
treats government employee pensions the same as private employee 
pensions: the contributions to the pension programs are treated as 
saving of the household sector; the earnings on pension fund assets are 
treated as household income; and the benefits paid by the pension funds 
are defined as transfers within the household sector, not part of 
government transfer payments. The net effect of these changes is to 
raise the NIPA measures of personal saving while lowering the NIPA 
government surplus. The previously reported nonoperating surplus of 
State and local governments, which was composed in large part of the 
difference between pension fund receipts and payments, was nearly 
eliminated by this change.

   Productivity: The upward revisions to real GDP growth, and in 
particular, the even larger revisions to the growth of output in the 
Nation's nonfarm business sector, have significantly raised measured 
labor productivity growth--especially beginning in 1994, because of the 
inclusion of software spending and the revised source data.
  The Administration had already raised its projections of real GDP and 
productivity growth in last summer's Mid-Session Review. The further 
increase in trend growth of GDP and productivity in the 2001 assumptions 
presented below reflects the new information in the benchmark revision 
that revealed that underlying source data in recent years have been 
revised upward.
  Productivity growth, which had averaged 1.4 percent per year from 1994 
through 1998, was revised up to 1.9 percent per year. During the four 
years through the third quarter of 1999, the most recent quarter 
available, productivity growth averaged an even faster 2.7 percent per 
year. In other words, the recent growth of productivity is double the 
pace experienced from 1973 to 1995, and on a par with the rapid rates 
that pre

[[Page 9]]

vailed from the end of World War II until the first oil crisis in 1973.
  The growth of productivity would be even faster in recent years if 
nonfarm business output were measured from the income side of the 
national accounts (using Gross Domestic Income) rather than from the 
slower-growing GDP product side. Since the third quarter of 1995, gross 
domestic income in real terms has grown 0.4 percentage point per year 
faster than the growth of GDP. That is because the statistical 
discrepancy--the difference between the product and income sides of the 
accounts--has shifted from $3 billion to -$141 billion over these four 
years. In principle, the product and income sides of the accounts should 
be equal. In practice, this does not occur because the two measures are 
estimated from different source data. What is unique about recent years, 
however, is the extent of the difference and the magnitude of the swing. 
Although there is no perfect measure of productivity and real growth, 
the income side perspective provides some reason to believe that 
productivity and real growth recently may have been even stronger than 
the official series suggest.

                           Economic Projections

  The economy's outstanding performance last year--indeed, over the last 
seven years--and the maintenance of sound policies raise the possibility 
that future economic developments may continue even better than assumed. 
Nonetheless, it is prudent to base budget estimates on a conservative 
set of economic assumptions, close to the consensus of private-sector 
forecasts.

                                                                              Table 1-1.  ECONOMIC ASSUMPTIONS \1\
                                                                          (Calendar years; dollar amounts in billions)
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                      Projections
                                                                              Actual -----------------------------------------------------------------------------------------------------------
                                                                               1998     1999     2000     2001     2002     2003     2004     2005     2006     2007     2008     2009     2010
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Gross Domestic Product (GDP):
  Levels, dollar amounts in billions:
    Current dollars........................................................    8,760    9,232    9,685   10,156   10,621   11,105   11,644   12,236   12,847   13,477   14,118   14,777   15,471
    Real, chained (1996) dollars...........................................    8,516    8,850    9,142    9,393    9,629    9,870   10,146   10,451   10,758   11,064   11,360   11,655   11,958
    Chained price index (1996 = 100), annual average.......................    102.9    104.3    105.9    108.1    110.3    112.5    114.8    117.1    119.4    121.8    124.3    126.8    129.4
  Percent change, fourth quarter over fourth quarter:
    Current dollars........................................................      5.9      5.2      4.8      4.6      4.6      4.5      5.0      5.1      4.9      4.9      4.7      4.7      4.7
    Real, chained (1996) dollars...........................................      4.6      3.8      2.9      2.6      2.5      2.5      3.0      3.0      2.9      2.8      2.6      2.6      2.6
    Chained price index (1996 = 100).......................................      1.1      1.4      1.9      2.0      2.0      2.0      2.0      2.0      2.0      2.0      2.0      2.0      2.0
  Percent change, year over year:
    Current dollars........................................................      5.5      5.4      4.9      4.9      4.6      4.6      4.9      5.1      5.0      4.9      4.8      4.7      4.7
    Real, chained (1996) dollars...........................................      4.3      3.9      3.3      2.7      2.5      2.5      2.8      3.0      2.9      2.8      2.7      2.6      2.6
    Chained price index (1996 = 100).......................................      1.2      1.4      1.6      2.0      2.0      2.0      2.0      2.0      2.0      2.0      2.0      2.0      2.0

Incomes, billions of current dollars:
    Corporate profits before tax...........................................      782      845      842      828      827      824      852      892      933      971    1,001    1,034    1,062
    Wages and salaries.....................................................    4,186    4,470    4,711    4,942    5,161    5,388    5,629    5,892    6,176    6,458    6,747    7,039    7,342
    Other taxable income \2\...............................................    1,990    2,088    2,161    2,231    2,293    2,356    2,431    2,518    2,609    2,703    2,802    2,904    3,015

Consumer Price Index (all urban): \3\
    Level (1982-84 = 100), annual average..................................    163.1    166.7    171.0    175.1    179.6    184.3    189.1    194.0    199.0    204.2    209.5    215.0    220.6
    Percent change, fourth quarter over fourth quarter.....................      1.5      2.7      2.3      2.5      2.6      2.6      2.6      2.6      2.6      2.6      2.6      2.6      2.6
    Percent change, year over year.........................................      1.6      2.2      2.6      2.4      2.6      2.6      2.6      2.6      2.6      2.6      2.6      2.6      2.6

Unemployment rate, civilian, percent:
    Fourth quarter level...................................................      4.4      4.1      4.3      4.7      5.1      5.2      5.2      5.2      5.2      5.2      5.2      5.2      5.2
    Annual average.........................................................      4.5      4.2      4.2      4.5      5.0      5.2      5.2      5.2      5.2      5.2      5.2      5.2      5.2
Federal pay raises, January, percent:
    Military \4\...........................................................      2.8      3.6      4.8      3.7      3.7      3.2      3.2      3.2       NA       NA       NA       NA       NA
    Civilian \5\...........................................................      2.8      3.6      4.8      3.7      3.7      3.2      3.2      3.2       NA       NA       NA       NA       NA

Interest rates, percent:
    91-day Treasury bills \6\..............................................      4.8      4.7      5.2      5.2      5.2      5.2      5.2      5.2      5.2      5.2      5.2      5.2      5.2
    10-year Treasury notes.................................................      5.3      5.6      6.1      6.1      6.1      6.1      6.1      6.1      6.1      6.1      6.1      6.1      6.1
------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
NA = Not Available.

\1\ Based on information available as of late November 1999.

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

\3\ Seasonally adjusted CPI for all urban consumers.

\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.

  The economic assumptions summarized in Table 1-1 are predicated on the 
adoption of the policies proposed in this Budget. The maintenance of 
unified budget surpluses in the coming years is expected to contribute 
to continued favorable economic performance. Growing Federal Government 
surpluses reduce real interest rates, stimulate private-sector 
investment in new plant

[[Page 10]]

and equipment, boost productivity growth, and thereby raise real incomes 
and help keep inflation under control. The Federal Reserve is assumed to 
continue to pursue the goal 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 1999. While job 
opportunities are expected to remain plentiful, the unemployment rate is 
projected to rise gradually to the range that mainstream private-sector 
forecasters estimate is consistent with stable inflation. New job 
creation will boost incomes and consumer spending, and keep confidence 
at a high level. Continued low inflation will support economic growth. 
Growth, in turn, will further help the budget balance.

   Real GDP, Potential GDP and Unemployment: During 2000, real GDP is 
expected to rise 2.9 percent, then average 2.5 percent during the 
following three years. This shift to more moderate growth recognizes 
that by mainstream assumptions, growth must proceed at a pace below the 
Nation's potential GDP growth rate for a while; the unemployment rate 
would then rise somewhat, thereby avoiding a build-up of inflationary 
pressures. Beginning in 2004, real GDP growth is assumed to match the 
growth of potential GDP. Inflation-adjusted potential and actual growth 
are projected to moderate from 3.0 percent yearly during 2004-2005 to 
2.6 percent during 2008-2010.
  As has been the case throughout this expansion, business fixed 
investment is again expected to be the fastest-growing component of GDP, 
although capital spending is likely to slow from the double-digit pace 
of recent years. Consumer spending is also expected to moderate, as the 
stimulus from the soaring stock market of the last few years approaches 
its full effect. Although residential investment is also expected to 
benefit from relatively 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 from the pace of the last few years.
  The growth of the Federal and State/local government components of GDP 
is also projected to moderate from the pace of recent years. The net 
export balance is expected to be less of a restraint on growth this year 
than during 1998-99, because more moderate growth of domestic demand is 
expected to slow the growth of imports. After 2000, the foreign sector 
is projected to make a modest, positive contribution to GDP growth in 
each year, reflecting the fundamental competitiveness of U.S. business, 
and the increased demand for U.S. exports that is likely to accompany a 
sustained recovery of activity abroad.
  The real GDP growth projection is consistent with a gradual rise in 
the unemployment rate to 5.2 percent by mid-2003. The unemployment rate 
is then projected to remain at that level on average thereafter, as real 
GDP growth returns to the Administration's estimate of the economy's 
potential growth rate.
  Potential GDP growth depends largely on the trend growth of labor 
productivity in the nonfarm business sector and the growth of the labor 
force. Productivity growth is assumed to moderate gradually from the 
high rates of recent years. During 2000-2001, productivity is projected 
to rise 2.1 percent annually on average, then phase down to 1.8 percent 
(which is the average rate experienced during the 1990s after allowance 
is made for the procyclical behavior of productivity) from 2007 onwards. 
The productivity path in the projection is a conservative estimate that 
allows the near-term projection to rely more heavily on recent 
experience and the longer-term projection to rely on the productivity 
experience over a longer period.
  The labor force component of potential GDP growth is assumed to rise 
1.2 percent per year through 2007 and then slow to 1.0 percent yearly as 
the first of the baby-boomers begin to retire.

   Inflation: With the unemployment rate well below mainstream estimates 
of the NAIRU, inflation is projected to creep up. The CPI is projected 
to increase 2.3 percent during this year, rising to 2.6 percent in 2002 
and thereafter. The GDP chain-weighted price index is projected to 
increase 1.9 percent during 2000, and 2.0 percent thereafter.
  The 0.6 percentage point difference between the CPI and the GDP chain-
weighted price index matches the average difference between these two 
inflation measures during the past five years. The CPI tends to increase 
relatively faster than the GDP chain-weighted price index in part 
because sharply falling computer prices exert less of an impact on the 
CPI than on the GDP price measure.
  In the 2000 budget, this ``wedge'' between the two measures was 
projected to be 0.2 percentage point. The larger wedge assumed in this 
projection tends to reduce the Federal budget surplus because Social 
Security payments and other indexed programs increase with the faster-
rising CPI, while Federal revenues are expected to increase in step with 
the slower-rising GDP chain-weighted price index. In addition, a 
relatively faster-rising CPI reduces the rate of growth of Federal 
receipts because the CPI is used to index personal income tax brackets, 
the size of the personal exemptions, and the eligibility thresholds for 
the Earned Income Tax Credit.

   Interest Rates: The assumptions, which were based on information as 
of late November, project stable short- and long-term interest rates. 
The 91-day Treasury bill rate is expected to average 5.2 percent over 
the forecast horizon; the yield on the 10-year Treasury bond is 
projected to average 6.1 percent. Since the completion of the 
assumptions, market rates have edged up somewhat.
   Incomes: On balance, the share of total taxable income in nominal GDP 
is projected to decline gradually. This is primarily because the 
corporate profits share of GDP is expected to fall. That is a 
consequence of

[[Page 11]]

the expected rapid growth of depreciation, a component of business 
expenses. Robust growth of capital spending, especially on rapidly 
depreciating high-tech equipment and software, suggests that 
depreciation will account for an increasing share of GDP at the expense 
of the corporate profits share. The personal interest income share is 
also projected to decline, as interest rates remain relatively low and 
as households hold less Federal Government debt because of the projected 
unified budget surpluses. The share of labor compensation in GDP is 
expected to be little changed.

                           Comparison with CBO 

                                                     Table 1-2.  COMPARISON OF ECONOMIC ASSUMPTIONS
                                                                (Calendar years; percent)
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                        Projections
                                                                 ---------------------------------------------------------------------------------------
                                                                   2000    2001    2002    2003    2004    2005    2006    2007    2008    2009    2010
--------------------------------------------------------------------------------------------------------------------------------------------------------
Real GDP (chain-weighted): \1\
  CBO January...................................................     2.9     3.0     2.7     2.6     2.6     2.7     2.7     2.7     2.8     2.9     2.9
  2001 Budget...................................................     2.9     2.6     2.5     2.5     3.0     3.0     2.9     2.8     2.6     2.6     2.6

Chain-weighted GDP Price Index: \1\
  CBO January...................................................     1.7     1.6     1.7     1.7     1.7     1.7     1.7     1.7     1.7     1.7     1.7
  2001 Budget...................................................     1.9     2.0     2.0     2.0     2.0     2.0     2.0     2.0     2.0     2.0     2.0

Consumer Price Index (all-urban): \1\
  CBO January...................................................     2.3     2.5     2.5     2.5     2.5     2.5     2.5     2.5     2.5     2.5     2.5
  2001 Budget...................................................     2.3     2.5     2.6     2.6     2.6     2.6     2.6     2.6     2.6     2.6     2.6

Unemployment rate: \2\
  CBO January...................................................     4.1     4.2     4.4     4.7     4.8     5.0     5.0     5.1     5.2     5.2     5.2
  2001 Budget...................................................     4.2     4.5     5.0     5.2     5.2     5.2     5.2     5.2     5.2     5.2     5.2

Interest rates: \2\
  91-day Treasury bills:
    CBO January.................................................     5.4     5.6     5.3     4.9     4.8     4.8     4.8     4.8     4.8     4.8     4.8
    2001 Budget.................................................     5.2     5.2     5.2     5.2     5.2     5.2     5.2     5.2     5.2     5.2     5.2

  10-year Treasury notes:
    CBO January.................................................     6.3     6.4     6.1     5.8     5.7     5.7     5.7     5.7     5.7     5.7     5.7
    2001 Budget.................................................     6.1     6.1     6.1     6.1     6.1     6.1     6.1     6.1     6.1     6.1     6.1

Taxable income (share of GDP): \3\
  CBO January...................................................    79.9    79.3    78.6    78.0    77.5    77.1    76.8    76.4    76.1    75.8    75.4
  2001 Budget...................................................    79.6    78.8    78.0    77.2    76.5    76.0    75.6    75.2    74.7    74.3    73.8
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Percent change, fourth quarter over fourth quarter.

\2\ Annual averages, percent.

\3\ Taxable personal income plus corporate profits before tax.

  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. An additional source of difference is that CBO and 
Administration forecasts are finalized at somewhat different times.
  Table 1-2 presents a summary comparison of the Administration and CBO 
projections. Briefly, they are very similar for all the major variables 
affecting the budget outlook.

  Real growth and unemployment: Over the 10-year projection horizon, the 
average rates of real GDP growth projected by CBO and the Administration 
are quite close. However, CBO projects somewhat faster growth through 
2003 than does the Administration, while the Administration assumes 
somewhat faster growth than CBO during the following four years. During 
the last three years of the projection period, CBO projects a slight 
pickup in the growth rate to a faster pace than that projected by the 
Administration.
  These differences in real growth contribute to the differences in the 
unemployment rate paths. While both projections assume that the rate 
will gradually rise to, and level off at, 5.2 percent, the 
Administration's projection reaches this sustainable level in 2003 while 
CBO's projection reaches it in 2008.

  Inflation:  The Administration and CBO forecast the same moderate 
rates of increase for the CPI for 2000 and 2001, and differ by only 0.1 
percentage point thereafter, with the Administration higher. Over the 
same period, both project low and steady rates of increase

[[Page 12]]

for the GDP price index, with CBO's projection 0.3 percentage point 
lower in each year, 2000-2010.
  Interest rates: The Administration and CBO have very similar paths for 
long- and short-term interest rates. In 2000 and 2001, CBO's rates are 
slightly higher; from 2003 onward, CBO's are slightly lower.
  Income shares: Although both projections envision a decline in the 
total taxable income share of GDP, primarily because of a decline in the 
profits share, the CBO total taxable share is higher in every year, and 
declines more slowly, than the Administration's 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 unified budget deficits to moderate 
unified budget surpluses would result in a significant boost in 
investment, 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 unified budget surpluses and the ensuing 
stronger investment were also expected to continue to have favorable 
effects on receipts and the budget balance, because of stronger profits, 
capital gains, and high taxable incomes.
  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 1999 that has, once 
again, proven more favorable than was anticipated at the beginning of 
last year. Economic growth was stronger than expected in 1999, 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--but 
conservatively. At the same time, interest rates are assumed in this 
budget to remain near their current low levels. 

                   Table 1-3.  COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2000 AND 2001 BUDGETS
                                  (Calendar years; dollar amounts in billions)
----------------------------------------------------------------------------------------------------------------
                                                     1999     2000     2001     2002     2003     2004     2005
----------------------------------------------------------------------------------------------------------------
Nominal GDP:
  2000 Budget assumptions \1\....................    9,108    9,495    9,899   10,345   10,823   11,325   11,850
  2001 Budget assumptions........................    9,232    9,685   10,156   10,621   11,105   11,644   12,236

Real GDP (percent change): \2\
  2000 Budget assumptions........................      2.1      2.1      2.1      2.5      2.5      2.5      2.5
  2001 Budget assumptions........................      3.8      2.9      2.6      2.5      2.5      3.0      3.0

GDP price index (percent change): \2\
  2000 Budget assumptions........................      1.9      2.1      2.1      2.1      2.1      2.1      2.1
  2001 Budget assumptions........................      1.4      1.9      2.0      2.0      2.0      2.0      2.0

Consumer Price Index (percent change): \2\
  2000 Budget assumptions........................      2.3      2.3      2.3      2.3      2.3      2.3      2.3
  2001 Budget assumptions........................      2.7      2.3      2.5      2.6      2.6      2.6      2.6

Civilian unemployment rate (percent): \3\
  2000 Budget assumptions........................      4.8      5.0      5.2      5.3      5.3      5.3      5.3
  2001 Budget assumptions........................      4.2      4.2      4.5      5.0      5.2      5.2      5.2

91-day Treasury bill rate (percent): \3\
  2000 Budget assumptions........................      4.2      4.3      4.3      4.4      4.4      4.4      4.4
  2001 Budget assumptions........................      4.7      5.2      5.2      5.2      5.2      5.2      5.2

10-year Treasury note rate (percent): \3\
  2000 Budget assumptions........................      4.9      5.0      5.2      5.3      5.4      5.4      5.4
  2001 Budget assumptions........................      5.6      6.1      6.1      6.1      6.1      6.1      6.1
----------------------------------------------------------------------------------------------------------------
\1\ Adjusted for October 1999 NIPA revisions.

\2\ Fourth quarter-to-fourth quarter.

\3\ Calendar year average.

  The net effects on the budget of these modifications in the economic 
assumptions are shown in Table 1-4. By far the largest effects come from 
higher receipts during 2000-2005 resulting from higher nominal incomes. 
In all years through 2005, there are higher outlays for interest due to 
the higher interest rates in the 2001 Budget assumptions than in the 
2000 Budget assumptions, and, in most years, higher outlays for cost-of-
living adjustments to Federal programs due to higher CPI inflation 
assumptions. On net, the changes in economic assumptions since last year 
increase unified budget surpluses by $61 billion to $85 billion a year.

              Table 1-4.  EFFECTS ON THE BUDGET OF CHANGES IN ECONOMIC ASSUMPTIONS SINCE LAST YEAR
                                            (In billions of dollars)
----------------------------------------------------------------------------------------------------------------
                                                              2000     2001     2002     2003     2004     2005
----------------------------------------------------------------------------------------------------------------
Budget totals under 2000 Budget economic assumptions and
 2001 Budget policies:
  Receipts................................................  1,899.3  1,947.5  2,004.1  2,076.2  2,166.4  2,259.3
  Outlays.................................................  1,793.6  1,835.7  1,893.1  1,960.3  2,041.3  2,128.8
                                                           -----------------------------------------------------
      Unified budget surplus..............................    105.7    111.8    111.0    116.0    125.1    130.5

Changes due to economic assumptions:
  Receipts................................................     57.0     71.5     77.1     71.3     69.7     81.6
  Outlays:
    Inflation.............................................     -1.8     -0.9      0.3      2.0      3.7      5.8
    Unemployment..........................................     -7.8     -7.7     -3.5     -0.7     -0.9     -1.1
    Interest rates........................................      6.9     12.2     13.2     12.5     11.5      9.9
    Interest on changes in borrowing......................     -1.4     -4.4     -7.8    -11.2    -14.4    -17.9
                                                           -----------------------------------------------------
      Total, outlay changes (net).........................     -4.1     -0.7      2.2      2.6     -0.2     -3.4
                                                           -----------------------------------------------------
      Increase in surplus.................................     61.0     72.2     74.9     68.7     69.9     85.0

Budget totals under 2001 Budget economic assumptions and
 policies:
  Receipts................................................  1,956.3  2,019.0  2,081.2  2,147.5  2,236.1  2,340.9
  Outlays.................................................  1,789.6  1,835.0  1,895.3  1,962.9  2,041.1  2,125.5
                                                           -----------------------------------------------------
      Unified budget surplus..............................    166.7    184.0    185.9    184.6    195.0    215.4
----------------------------------------------------------------------------------------------------------------
Note: The surplus allocation for debt reduction is part of the President's overall budgetary framework to extend
  the solvency of Social Security and Medicare, and is shown in Tale S-1 in Part 6 of the 2001 Budget.

                     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

[[Page 13]]

is larger than it would be if unemployment were at the long-run 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 long-run NAIRU (consistent 
with a 5.2 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    2005
--------------------------------------------------------------------------------------------------------------------------------------------------------
Unadjusted deficit (-) or surplus..   -290.4   -255.0   -203.1   -163.9   -107.4   -21.9    69.2   124.4   166.7   184.0   185.9   184.6   195.0   215.4
  Cyclical component...............   -106.1   -106.1    -73.0    -30.9    -13.1    16.7    48.3    74.8    74.1    57.9    35.4    15.2     1.7  ......
                                    --------------------------------------------------------------------------------------------------------------------
Structural deficit (-) or surplus..   -184.3   -148.9   -130.1   -133.0    -94.3   -38.6    21.0    49.6    92.6   126.1   150.5   169.5   193.3   215.4
  Deposit insurance outlays........     -2.3    -28.0     -7.6    -17.9     -8.4   -14.4    -4.4    -5.3    -1.4    -1.6    -1.3    -1.0    -0.7     0.2
                                    --------------------------------------------------------------------------------------------------------------------
Adjusted structural deficit (-) or    -186.6   -176.9   -137.7   -150.9   -102.7   -53.0    16.6    44.3    91.2   124.5   149.2   168.5   192.5   215.7
 surplus...........................
--------------------------------------------------------------------------------------------------------------------------------------------------------

  Changes in the structural balance give a better picture of the impact 
of budget policy on the economy than do changes in 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 
(savings and loan and bank 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 1999 through 2002, the unemployment rate is slightly 
below the long-run NAIRU of 5.2 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 now relatively small and do not change greatly from year to 
year. Two significant points are illustrated by this table. First, of 
the $415 billion swing in the actual budget balance between 1992 and 
1999 (from a $290 billion deficit to a $124 billion surplus), 44 percent 
($181 billion) resulted from cyclical improvement in the economy. The 
rest of the reduction stemmed in major part from policy actions--mainly 
those in the Omnibus Budget Reconciliation Act of 1993, which reversed a 
projected continued steep rise in the unified budget deficit and set the 
stage for the remarkable cyclical improvement that has occurred. Second, 
the structural surplus is expected to rise sub

[[Page 14]]

stantially over the projection horizon--in part due to the effects of 
the Balanced Budget Act of 1997--even though the cyclical component of 
the surplus is projected to vanish by 2005.

            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 
2000 only, and the unemployment rate rises by one-half percentage point, 
the fiscal 2000 surplus would decrease by $10.5 billion; receipts in 
2000 would be lower by about $8.5 billion, and outlays, primarily for 
unemployment-sensitive programs, would be higher by about $2.0 billion. 
In fiscal year 2001, the receipts shortfall would grow further to about 
$18.3 billion, and outlays would increase by about $6.8 billion relative 
to the base, even though the growth rate in calendar 2001 equals the 
rate originally assumed. This effect grows 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 (2000-2005) 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 $179.3 billion relative to the base case by 2005.
  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 
$145.5 billion worsening of the budget balance by 2005.
  Joint changes in interest rates and inflation have a smaller effect on 
the budget balance 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 2000 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 
2000 rise by $5.8 billion and receipts by $9.9 billion, for an increase 
of $4.1 billion in the 2000 surplus. In 2001, outlays would be above the 
base by $11.9 billion, due in part to lagged cost-of-living adjustments; 
receipts would rise $19.8 billion above the base, however, resulting in 
a $7.8 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 $50.4 billion to outlays and $117.3 billion to 
receipts in 2005, for a net increase in the surplus of $66.9 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 unified 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. 
In any case, the sensitivity of the budget to interest rate changes has 
been greatly reduced since the budget shifted into unified surplus. The 
last entry in the table shows rules of thumb for the added interest cost 
associated with changes in the unified 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.

[[Page 15]]

  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.

                          Table 1-6.  SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
                                            (In billions of dollars)
----------------------------------------------------------------------------------------------------------------
                    Budget effect                       2000      2001      2002      2003      2004      2005
----------------------------------------------------------------------------------------------------------------
             Real Growth and Employment

Budgetary effects of 1 percent lower real GDP
 growth:
  For calendar year 2000 only: \1\
    Receipts........................................      -8.5     -18.3     -21.5     -22.4     -23.3     -24.3
    Outlays.........................................       2.0       6.8       7.6       9.4      11.4      13.5
                                                     -----------------------------------------------------------
      Decrease in surplus (-).......................     -10.5     -25.2     -29.1     -31.7     -34.6     -37.8

  Sustained during 2000-2005: \1\
    Receipts........................................      -8.5     -27.1     -49.5     -73.2     -98.7    -126.4
    Outlays.........................................       2.0       8.9      16.7      26.4      38.5      52.9
                                                     -----------------------------------------------------------
      Decrease in surplus (-).......................     -10.5     -36.0     -66.1     -99.7    -137.2    -179.3

  Sustained during 2000-2005, with no change in
   unemployment:
    Receipts........................................      -8.5     -27.1     -49.5     -73.2     -98.7    -126.4
    Outlays.........................................       0.2       1.2       3.4       7.1      12.3      19.1
                                                     -----------------------------------------------------------
      Decrease in surplus (-).......................      -8.7     -28.3     -52.9     -80.3    -110.9    -145.5

            Inflation and Interest Rates

Budgetary effects of 1 percentage point higher rate
 of:
  Inflation and interest rates during calendar year
   2000 only:
    Receipts........................................       9.9      19.8      19.2      17.6      18.3      19.3
    Outlays.........................................       5.8      11.9       9.5       8.3       7.9       7.7
                                                     -----------------------------------------------------------
      Increase in surplus (+).......................       4.1       7.8       9.8       9.3      10.4      11.6

  Inflation and interest rates, sustained during
   2000-2005:
    Receipts........................................       9.9      30.2      50.9      70.8      92.7     117.3
    Outlays.........................................       5.8      17.5      26.8      35.3      43.0      50.4
                                                     -----------------------------------------------------------
      Increase in surplus (+).......................       4.1      12.7      24.0      35.5      49.6      66.9

  Interest rates only, sustained during 2000-2005:
    Receipts........................................       1.4       3.5       4.4       4.8       5.1       5.5
    Outlays.........................................       4.7      12.0      15.1      16.5      16.9      16.6
                                                     -----------------------------------------------------------
      Decrease in surplus (-).......................      -3.4      -8.5     -10.7     -11.7     -11.8     -11.1

  Inflation only, sustained during 2000-2005:
    Receipts........................................       8.5      26.7      46.5      66.0      87.6     111.8
    Outlays.........................................       1.1       5.7      12.3      19.8      27.8      36.2
                                                     -----------------------------------------------------------
      Increase in surplus (+).......................       7.4      21.0      34.2      46.2      59.8      75.6

      Interest Cost of Higher Federal Borrowing

Outlay effect of $100 billion reduction in the 2000        2.8       5.7       6.0       6.4       6.7       7.1
 unified surplus....................................

----------------------------------------------------------------------------------------------------------------
* $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.

