    [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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    [[Page 3]]

                            1.  ECONOMIC ASSUMPTIONS

                                  Introduction

       Economic growth decelerated suddenly and sharply last year; by the
    end of the year, the record-long expansion was on the verge of stalling.
    The economy hardly expanded in the fourth quarter, and signs of weakness
    in the first months of this year were widespread. The stock market has
    plummeted, consumer and business confidence has dropped sharply,
    industrial production and capacity utilization rates have declined, and
    job growth has slackened. The unemployment rate, although low by
    historical standards, has begun to climb.
       Despite the sudden weakness, most forecasters, including the
    Administration, anticipate that an economic recovery will begin later
    this year. Forward-looking indicators have begun to strengthen recently,
    pointing to faster growth in the coming months. Monetary policy has
    shifted to stimulating demand. The Federal Reserve reduced the Federal
    funds rate twice in January, and it made another cut in March.
      Fiscal policy is poised to support a recovery. The Administration
    proposes to reduce individual income taxes, which will provide near-term
    fiscal stimulus and long-term economic incentives to encourage work and
    saving. Beyond the next year or two, the long-term outlook has never
    been brighter. There is accumulating evidence that the underlying
    productivity trend has improved markedly. This is welcome news for
    American workers and business. Enhanced productivity growth enables real
    wages to grow faster, profits to expand, and the stock market to rise.
    In the long run, productivity growth is the key to maintaining a strong
    economy and rising living standards.
      This chapter begins with a review of recent developments and then
    presents the Administration's economic assumptions, followed by a
    comparison with projections of the Congressional Budget Office and the
    consensus of private sector forecasters. The following section
    decomposes the surplus into its cyclical and structural components. The
    chapter concludes with estimates of the sensitivity of the budget to
    changes in economic assumptions.

                               Recent Developments

      Financial Markets: Beginning in 1999 and lasting through May 2000, the
    Federal Reserve tightened monetary policy to reduce the risk of higher
    inflation in a rapidly expanding economy. However, the ensuing
    deceleration of demand, the falloff in profits, and financial strains
    were unexpectedly sharp. As a result, the threat of higher inflation
    diminished while the risk that the expansion might end soon rose. In
    response to this shift in the balance of risks, the Federal Reserve
    eased monetary policy by cutting the Federal funds by a total of one
    percentage point in January and by another one-half percentage point in
    March to 5.0 percent. Judging by the futures market, investors expect
    additional cuts in the funds rate of one-half percentage point by the
    summer.
       The credit markets responded promptly to the monetary easing. In the
    Treasury market, the yield on 3-month bills fell by 1.5 percentage
    points from the end of 2000 to late March, bringing the rate down to 4.3
    percent. The decline in the yield on the 10-year Treasury note was less
    pronounced, from 5.1 percent to 4.8 percent. Together these changes
    restored an upward sloping yield curve, which in the past has often
    signaled faster economic growth ahead. In response to the shift in
    monetary policy, bond yields fell this year while new issuance rose
    significantly. The renewed access to capital enables firms to cope with
    the financial pressures from weaker sales and profits.
       The easing of monetary policy and lower interest rates, however, did
    not succeed in arresting the fall in the stock market. As of late March,
    the S&P 500 and the broad-based Wilshire 5000 were down almost 15
    percent since the end of last year, bringing the total decline from
    their peaks in March 2000 to over 25 percent. The technology-laden
    NASDAQ was hit even harder--off about 20 percent through late March, and
    about 60 percent from its year-earlier peak.
      Economic Activity: Economic growth decelerated significantly last
    year, sliding from a robust 5.2 percent annual rate of increase during
    the first half of the year to only a 1.1 percent advance in the fourth
    quarter. The decline in the growth rate reflected the effects of falling
    stock prices and rising interest rates. The deceleration was most
    pronounced in the sectors that are especially responsive to changes in
    financial market conditions: residential investment, business capital
    spending, and consumer durable goods purchases.
         Residential investment contracted in the third and fourth
              quarters, the first back-to-back declines in four years.
              Homebuilding was adversely affected by the rise in mortgage
              rates during 1999 and the first half of 2000. By May, the rate
              on 30-year mortgages reached 8.5 percent, the highest level in
              over five years. Since then, however, the mortgage rate has
              fallen to 7.0 percent, the lowest rate in three years, and
              there were signs of a pickup in the housing markets as the new
              year began.
         After adjusting for inflation, investment in new plant and
              equipment contracted slightly in the fourth quarter, a marked
              drop-off from the double-digit gains that prevailed since
              1995. Even demand for high-technology hardware and software,
              which had soared in recent years, slackened in

    [[Page 4]]

              the final quarter, growing at about one-third the pace of the
              first half of the year. Weakening capital spending reflected
              lackluster demand, growing excess capacity, and a rising cost
              of capital because of higher interest rates and falling equity
              values.
         Real consumer spending on durable goods fell in the fourth
              quarter, led by an unexpected drop in motor vehicle purchases,
              which, in turn, contributed to a buildup of unwanted
              inventories on dealers' lots and sizeable cutbacks in
              production in the first quarter. The drop in durable goods
              spending restrained the total growth of consumer spending in
              the fourth quarter to a 2.8 percent annual rate, the smallest
              advance in over three years. The slackening of consumer
              spending was influenced by falling equity wealth--a reversal
              from the prior five years when exceptional stock market gains
              boosted wealth and fueled consumer spending. From its peak in
              March 2000 to the end of the year, the decline in the stock
              market cut $3 trillion off the $18 trillion in market
              capitalization of U.S. equities.
      The foreign sector also restrained GDP growth in the fourth quarter,
    trimming about one-half percentage point off the growth rate. Imports of
    goods and services declined modestly at the end of the year, which
    bolstered growth slightly, but this was more than offset by a decline in
    exports, in part because of weakening demand in our trading partners.
      The economic news so far in 2001 has been mixed. On the downside,
    surveys of consumers' attitudes revealed a further loss of confidence,
    with especially heightened concerns about the future. The stock market,
    which is an indicator of investors' confidence, fell as well.
      On the upside, the Nation's total payrolls continued to expand in
    January and February, despite large job losses in manufacturing
    industries. The unemployment rate ticked up from 4.0 percent to 4.2
    percent in January and held there in February. This is still a very low
    rate, two percentage points below the average rate over the previous
    thirty years.
      Based on information for the first two months of the year, consumer
    spending after adjustment for inflation appears to have continued to
    expand in the first quarter at a moderate pace. Sales of motor vehicles,
    however, recovered sharply, which helped reduce the excess inventories
    that built up at the end of last year.
      In the housing market, starts, permits, existing home sales and
    refinancing all increased at the start of the year in response to the
    fall in mortgage rates during the second half of 2000. There were also
    signs that business investment was holding up. In January, nondefense
    capital goods orders and unfilled orders, excluding the volatile
    aircraft sector, rose sharply.
      Inflation: Price inflation accelerated last year, primarily because of
    a jump in crude oil prices, which rippled through to higher energy
    prices. The price of West Texas Intermediate crude oil doubled during
    1999 and rose by another third during the first 11 months of 2000. On a
    year-over-year basis, the total Consumer Price Index (CPI) rose 3.4
    percent in 2000, up from 2.2 percent in 1999. Since November, oil prices
    have fallen sharply, which can be expected to slow the growth of overall
    inflation this year. Excluding the volatile food and energy components,
    the acceleration in core CPI inflation last year was much less
    pronounced than the rise in the total. The core CPI rose just 2.4
    percent during 2000, which is not much more than the 2.1 percent rise in
    1999.
      The GDP chain-weighted price index, a broad gauge of inflation
    covering all the goods and services produced in the United States, rose
    just 2.1 percent in 2000 measured on a year-over-year basis. Although
    higher than the 1.5 percent advance in 1999, it is still a remarkably
    low rate of inflation. Looking at the prices paid by consumers,
    businesses, and governments, and excluding the food and energy
    components, inflation was only 1.8 percent in 2000, not much different
    than the 1.5 percent of 1999.

      Historically low unemployment last year contributed to strong growth
    of labor compensation, including benefits as well as cash wages.
    Nonetheless, core price inflation rose very little because of continued
    robust productivity growth, which provided an offset to the upward price
    pressures from rising labor costs.
      With the unemployment rate near 4 percent for the last two years and
    only a small step-up in the core rate of inflation, the economy appeared
    capable of maintaining stable inflation at a lower level of unemployment
    than previously envisaged. In light of this experience, the Budget
    assumes that NAIRU (the ``nonaccelerating inflation rate of
    unemployment'') is 4.6 percent in the long run. That is identical to the
    rate implied by the consensus of private sector forecasters. By
    contrast, two years ago the consensus implied a NAIRU just above 5
    percent.
      Productivity: Productivity growth during the past five years has
    averaged 2.9 percent per year, double the rate that prevailed from 1974
    through 1995. Increased capital investment and general improvements in
    business efficiency were responsible for the step up. The maintenance of
    this strong productivity growth, even as the expansion has aged and
    unemployment has declined to very low levels, provides evidence that the
    improvement is likely to be ongoing.

                              Economic Projections

       The Administration's economic projections, summarized in Table 1-1,
    assume the adoption of the policies proposed in the Budget: tax relief
    for American workers and their families, the maximum feasible reduction
    in Federal debt, Federal spending restraint, and the preservation of the
    Social Security surplus for Social Security. Enactment of this
    comprehensive program will provide both a needed near-term stimulus to
    the economy and promote an economic climate that fosters long-term
    growth. The Federal Reserve is assumed to continue

    [[Page 5]]

    Table 1-1.  ECONOMIC ASSUMPTIONS \1\
                                                                              (Calendar years; dollar amounts in billions)
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                          Projections
                                                                                  Actual -----------------------------------------------------------------------------------------------------------
                                                                                   1999     2000     2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
    Gross Domestic Product (GDP):
      Levels, dollar amounts in billions:
        Current dollars........................................................    9,299    9,974   10,434   11,004   11,596   12,217   12,866   13,550   14,269   15,023   15,817   16,649   17,524
        Real, chained (1996) dollars...........................................    8,876    9,325    9,551    9,867   10,184   10,509   10,840   11,180   11,532   11,894   12,264   12,642   13,031
        Chained price index (1996 = 100), annual average.......................    104.8    107.0    109.2    111.5    113.8    116.2    118.7    121.2    123.7    126.3    128.9    131.7    134.4
      Percent change, fourth quarter over fourth quarter:
        Current dollars........................................................      6.5      6.2      4.8      5.5      5.3      5.3      5.3      5.3      5.3      5.3      5.3      5.3      5.2
        Real, chained (1996) dollars...........................................      5.0      3.7      2.6      3.3      3.2      3.2      3.1      3.1      3.1      3.1      3.1      3.1      3.1
        Chained price index (1996 = 100).......................................      1.6      2.3      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1
      Percent change, year over year:
        Current dollars........................................................      5.8      7.3      4.6      5.5      5.4      5.4      5.3      5.3      5.3      5.3      5.3      5.3      5.3
        Real, chained (1996) dollars...........................................      4.2      5.1      2.4      3.3      3.2      3.2      3.1      3.1      3.1      3.1      3.1      3.1      3.1
        Chained price index (1996 = 100).......................................      1.5      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1

    Incomes, billions of current dollars:
        Corporate profits before tax...........................................      823      935      951      983    1,030    1,080    1,137    1,173    1,222    1,256    1,291    1,332    1,402
        Wages and salaries.....................................................    4,470    4,766    5,016    5,312    5,620    5,930    6,256    6,590    6,927    7,272    7,641    8,035    8,448
        Other taxable income \2\...............................................    2,141    2,285    2,348    2,431    2,505    2,590    2,677    2,770    2,872    2,979    3,092    3,206    3,324

    Consumer Price Index (all urban): \3\
        Level (1982-84 = 100), annual average..................................    166.7    172.3    176.9    181.4    186.1    190.8    195.6    200.4    205.5    210.6    215.9    221.3    226.8
        Percent change, fourth quarter over fourth quarter.....................      2.6      3.4      2.5      2.6      2.5      2.5      2.5      2.5      2.5      2.5      2.5      2.5      2.5
        Percent change, year over year.........................................      2.2      3.4      2.7      2.6      2.6      2.5      2.5      2.5      2.5      2.5      2.5      2.5      2.5

    Unemployment rate, civilian, percent:
        Fourth quarter level...................................................      4.1      4.0      4.6      4.6      4.5      4.5      4.5      4.5      4.5      4.6      4.6      4.6      4.6
        Annual average.........................................................      4.2      4.0      4.4      4.6      4.5      4.5      4.5      4.5      4.5      4.6      4.6      4.6      4.6
    Federal pay raises, January, percent:
        Military \4\...........................................................      3.6      4.8      3.7      4.6      3.9      3.9      3.9      3.9      3.9      3.9      3.9      3.9      3.9
        Civilian \5\...........................................................      3.6      4.8      3.7      3.6      3.9      3.9      3.9      3.9      3.9      3.9      3.9      3.9      3.9

    Interest rates, percent:
        91-day Treasury bills \6\..............................................      4.7      5.8      5.3      5.6      5.6      5.6      5.3      5.0      5.0      5.0      5.0      5.0      5.0
        10-year Treasury notes.................................................      5.6      6.0      5.4      5.6      5.7      5.7      5.7      5.7      5.7      5.7      5.7      5.7      5.7
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
    \1\ Based on information available as of January 20, 2001.
    \2\ Rent, interest, dividend and proprietor's components of personal income.
    \3\ Seasonally adjusted CPI for all urban consumers.
    \4\ 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.

    to pursue monetary policies that support economic activity while keeping
    inflation under control.
       The economic assumptions are conservative and are close to those of
    the Congressional Budget Office and mainstream private sector
    forecasters. The key assumption for the average real GDP growth over the
    next 10 years is even slightly below the private sector consensus. The
    economy may perform even better than assumed here. Nonetheless, for the
    purpose of planning fiscal policy, it is appropriate to base the Budget
    on prudent assumptions that do not over-estimate available resources.
      Real GDP, Potential GDP and Unemployment: Real GDP, which rose 5.0
    percent in 2000 on a calendar-year basis, is projected to increase 2.4
    percent this year. Economic activity is expected to gain momentum during
    the year as the easing of monetary policy stimulates interest-sensitive
    sectors. The restraint on production and GDP growth from the buildup of
    excess inventories evident early in the year is likely to diminish as
    inventories are brought in line with sales.
       Economic activity is expected to increase 3.3 percent during 2002.
    Faster economic growth over the next year and a half will add to the
    pace of job creation, household incomes, and corporate profits, which in
    turn will improve consumer confidence and equity markets. With actual
    GDP growth below the Nation's potential GDP growth during much of this
    year, the unemployment rate is projected to creep up to 4.6 percent by
    the fourth quarter. During 2002, the unemployment rate is projected to
    remain at that relatively low level.
       Beyond 2002, real GDP growth is projected to moderate gradually to a
    3.1 percent annual rate of increase beginning in 2005. Average GDP
    growth over the next ten years is expected to be close to potential
    growth, which would maintain the unemployment rate on a plateau of
    around 4.6 percent. Potential GDP growth depends largely on the growth
    of the labor force and the trend growth of labor productivity. The labor
    force is projected to increase 1.0 percent per year on average over the
    ten years 2002 to 2011.
       Nonfarm business sector productivity is projected to grow 3.0 percent
    in calendar year 2001, 2.6 percent in 2002-2003, slowing to a 2.2
    percent average annual increase from 2004 through 2011. Over the next
    ten years, productivity growth is assumed to average 2.3

    [[Page 6]]

    percent yearly, close to the very long-run average for the U.S. economy.
    This is well above the 1.4 percent average rate during 1974-1995,
    although it is a deceleration from the 2.9 percent average rate of the
    past five years. The assumption that productivity growth will taper off
    somewhat from its recent trend is a conservative one, appropriate for
    prudent budget planning.
      Inflation: The rate of inflation, measured by either the CPI or the
    GDP chain-weighted price index, is expected to slow this year as energy
    prices fall from the high levels at the end of last year. The CPI is
    projected to rise 2.7 percent in 2001 on a calendar year basis and slow
    to 2.5 percent yearly beginning in 2004. The GDP measure of inflation is
    forecast to increase 2.1 percent each year. The CPI tends to increase
    faster than the GDP chain-weighted price index in part because sharply
    falling computer prices, which are expected to continue, exert less of
    an impact on the CPI than on the GDP inflation measure.
      Interest Rates: The 91-day Treasury bill rate is projected to rise
    during 2001, leveling off at 5.6 percent during 2002-2004, then
    gradually decline to 5.0 percent in 2006 and thereafter. The yield on
    the 10-year Treasury note is assumed to rise to 5.7 percent in 2003 and
    remain at that level through 2011. The projected decline in the short-
    term rate after 2004 would restore an upward sloping yield curve, which
    is normal during periods of expansion.
      Incomes: The share of total taxable income in nominal GDP is projected
    to decline gradually, mainly because capital consumption is expected to
    claim a larger proportion of GDP. The investment boom of recent years
    and the projected rising share of investment in GDP imply a rapid growth
    of depreciation, a component of business expenses. As the share of
    depreciation in GDP rises, the share of corporate profits is projected
    to decline. The share of wages and salaries in GDP is projected to be
    relatively stable over the projection horizon.

                Comparison with CBO and Private-Sector Forecasts

      The Congressional Budget Office (CBO) and many private-sector
    forecasters also make 10-year projections. The CBO projection is used by
    Congress in formulating budget policy. In the executive branch, this
    function is performed jointly by the Treasury, the Council of Economic
    Advisers, and the Office of Management and Budget. The private sector
    forecasts are often used by businesses for long-term planning. Table 1-2
    compares the Budget assumptions with projections by the CBO and the Blue
    Chip consensus, an average of about 50 private forecasts

       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

                                                         Table 1-2.  COMPARISON OF ECONOMIC ASSUMPTIONS
                                                                    (Calendar years; percent)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                 Projections
                                                          ----------------------------------------------------------------------------------------  Average,
                                                            2001    2002    2003    2004    2005    2006    2007    2008    2009    2010    2011    2002-11
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Real GDP (chain-weighted): \1\
      CBO January........................................     2.4     3.4     3.3     3.0     3.0     3.0     3.0     3.0     3.0     3.1     3.1        3.1
      Blue Chip Consensus March..........................     1.9     3.4     3.5     3.4     3.4     3.4     3.3     3.3     3.3     3.3     3.3        3.4
      2002 Budget........................................     2.4     3.3     3.2     3.2     3.1     3.1     3.1     3.1     3.1     3.1     3.1        3.2

    Chain-weighted GDP Price Index: \1\
      CBO January........................................     2.3     2.1     2.0     1.9     1.9     1.9     1.9     1.9     1.9     1.9     1.9        1.9
      Blue Chip Consensus March..........................     2.1     2.0     2.1     2.1     2.1     2.2     2.2     2.2     2.2     2.2     2.2        2.2
      2002 Budget........................................     2.1     2.1     2.1     2.1     2.1     2.1     2.1     2.1     2.1     2.1     2.1        2.1

    Consumer Price Index (all-urban): \1\
      CBO January........................................     2.8     2.8     2.7     2.5     2.5     2.5     2.5     2.5     2.5     2.5     2.5        2.6
      Blue Chip Consensus March..........................     2.8     2.4     2.6     2.6     2.5     2.6     2.6     2.6     2.6     2.6     2.6        2.6
      2002 Budget........................................     2.7     2.6     2.6     2.5     2.5     2.5     2.5     2.5     2.5     2.5     2.5        2.5

    Unemployment rate: \2\
      CBO January........................................     4.4     4.5     4.5     4.7     4.8     4.9     5.0     5.1     5.2     5.2     5.2        4.9
      Blue Chip Consensus March..........................     4.5     4.6     4.6     4.6     4.6     4.6     4.6     4.6     4.6     4.6     4.6        4.6
      2002 Budget........................................     4.4     4.6     4.5     4.5     4.5     4.5     4.5     4.6     4.6     4.6     4.6        4.6

    Interest rates: \2\
      91-day Treasury bills:
        CBO January......................................     4.8     4.9     5.0     4.9     4.9     4.9     4.9     4.9     4.9     4.9     4.9        4.9
        Blue Chip Consensus March........................     4.6     4.8     5.2     5.3     5.3     5.2     5.2     5.2     5.2     5.2     5.2        5.2
        2002 Budget......................................     5.3     5.6     5.6     5.6     5.3     5.0     5.0     5.0     5.0     5.0     5.0        5.2

      10-year Treasury notes:
        CBO January......................................     4.9     5.3     5.5     5.6     5.7     5.8     5.8     5.8     5.8     5.8     5.8        5.7
        Blue Chip Consensus March........................     5.1     5.4     5.7     5.7     5.7     5.7     5.7     5.7     5.7     5.7     5.7        5.7
        2002 Budget......................................     5.4     5.6     5.7     5.7     5.7     5.7     5.7     5.7     5.7     5.7     5.7        5.7
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Sources: Congressional Budget Office; Aspen Publishers, Inc., Blue Chip Economic Indicators
    \1\ Year over year percent change.
    \2\ Annual averages, percent.

    [[Page 7]]

    a ``pre-policy'' projection. The private sector forecasts are based on
    an appraisal of ``the most-likely policy outcome,'' which would vary
    considerably among forecasters. Despite these differences in policy
    assumptions, the three sets of projections are currently quite close for
    almost all the key economic assumptions.
       For real GDP growth, the Blue Chip consensus is slightly lower than
    the public-sector forecasts in 2001. The private forecasts, made in
    early-March, were influenced in part by the weaker recent data. For
    2002, all three sets of forecasts anticipate a rebound of growth. Over
    the ten years 2002-2011, the Blue Chip consensus averages 3.4 percent
    GDP growth, two-tenths of a percentage point faster than the 3.2 percent
    in the Administration's conservative assumptions.
       The Administration's inflation projection is very similar to that of
    the Blue Chip consensus. CBO's GDP inflation projection is slightly
    below the Administration's assumptions in most years. The
    Administration's unemployment rate is nearly identical to the Blue
    Chip's, while the CBO's rate is well above either of the other two
    forecasts.
       The Administration's projection of the yield on the 10-year Treasury
    note is identical in most years to that of the Blue Chip consensus, and
    is close to that of CBO. The Administration's short-term interest rate
    projection is somewhat higher than that of the Blue Chip consensus over
    the next few years. Beyond 2005, the three short-term interest
    projections are quite close.

                         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 intensely employed, and outlays for unemployment-sensitive
    programs (such as unemployment compensation and food stamps) are lower.
    As a result, the surplus is larger than it would be if unemployment were
    at the sustainable long-run average. The portion of the surplus that can
    be traced to this factor is called the cyclical component. The balance,
    the portion that would remain with the unemployment rate at its long-run
    value, is called the structural surplus (or structural deficit).

       The structural balance 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.
    For this reason, changes in the structural balance give a better picture
    of the impact of budget policy on the economy than does the unadjusted
    budget balance.
       During 1992-1996, when the actual unemployment rate was above the 5.2
    percent estimate of NAIRU, the cyclical component was negative: the
    unadjusted deficit was larger than the structural deficit. From 1997 to
    2000, the consensus of private sector forecasters gradually reduced
    NAIRU to 4.6 percent. Nonetheless, the actual unemployment rate was
    below NAIRU, resulting in a positive cyclical component. By 2000, the
    actual surplus of $236 billion was $72 billion larger than the
    structural surplus.
       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 1-3.
       Two significant points are illustrated by this table. First, of the
    $527 billion swing in the actual budget balance between 1992 and 2000
    (from a $290 billion deficit to a $236 billion surplus), only 35 percent
    ($182 billion) resulted from cyclical improvement in the economy. The
    rest of the reduction stemmed from policy actions and an unusually
    strong rise in individual income tax receipts as a percentage of GDP.
    Second, in 2002 and thereafter, the cyclical component of the surplus is
    small because the projected unemployment rate is close to the assumed
    NAIRU of 4.6 percent. Deposit insurance net outlays are also projected
    to be very small in the coming years. Therefore, the adjusted structural
    surplus and the unadjusted surplus are nearly identical during the
    forecast horizon.

                Sensitivity of the Budget to Economic Assumptions

       Both receipts and outlays are affected by changes in economic
    conditions. This sensitivity 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

                                                             Table 1-3.  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   -255.1   -203.3   -164.0   -107.5   -22.0    69.2   124.6   236.4   280.7   231.2   242.0   262.1   269.0
      Cyclical component...............   -109.9   -104.0    -68.7    -29.5    -16.0     5.9    33.5    44.8    72.0    36.3     2.1     6.4     7.6     7.1
                                        --------------------------------------------------------------------------------------------------------------------
    Structural deficit (-) or surplus..   -180.5   -151.1   -134.6   -134.5    -91.5   -27.9    35.7    79.8   164.4   244.4   229.1   235.6   254.5   261.9
      Deposit insurance outlays........     -2.3    -28.0     -7.6    -17.9     -8.4   -14.4    -4.4    -5.3    -3.1    -1.0    -0.7     0.1     0.6     1.1
                                        --------------------------------------------------------------------------------------------------------------------
    Adjusted structural deficit (-) or    -182.8   -179.1   -142.2   -152.3    -99.9   -42.3    31.3    74.5   161.3   243.4   228.4   235.7   255.1   263.0
     surplus...........................
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    NOTE: The NAIRU is assumed to be 5.2% through calendar year 1998, 4.9% in 1999, and 4.6% thereafter.

    [[Page 8]]

    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
    force, 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 1-4.
       If real GDP growth is lower by one percentage point in calendar year
    2001 only and the unemployment rate rises by one-half percentage point
    more than in the budget assumptions, the fiscal year 2001 surplus is
    estimated to decrease by $11.7 billion; receipts in 2001 would be lower
    by $9.6 billion, and outlays would be higher by $2.1 billion, primarily
    for unemployment-sensitive programs. In fiscal year 2002, the estimated
    receipts shortfall would grow further to $20.9 billion, and outlays
    would increase by $7.3 billion relative to the base, even though the
    growth rate in calendar 2002 equaled 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 smaller surpluses)
    would continue to grow slightly in each successive year.
       The budget effects are much larger if the real growth rate is assumed
    to be one percentage point less in each year (2001-2011) and the
    unemployment rate to rise one-half percentage point in each year. In
    this case, the levels of real and nominal GDP would be below the base
    case by a growing percentage. The budget balance would be worsened by
    $545.0 billion relative to the base case by 2011.
       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
    $431.9 billion worsening of the budget balance by 2011.
       Joint changes in interest rates and inflation have a smaller effect
    on the surplus than equal percentage point changes in real GDP growth.
    An example is the effect of a one percentage point higher rate of
    inflation and one percentage point higher interest rates during calendar
    year 2001 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 2001 rise by
    $5.5 billion and receipts by $11.0 billion, for a increase of $5.5
    billion in the 2001 surplus. In 2002, outlays would be above the base by
    $11.4 billion, due in part to lagged cost-of-living adjustments;
    receipts would rise $22.4 billion above the base, however, resulting in
    an $11.0 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 $57.7 billion to outlays in 2011 and $341.1
    billion to receipts, for a net increase in the 2011 surplus of $283.4
    billion. This rule-of-thumb now shows a more positive net budget outcome
    than was estimated a few years ago, when the interest outlays were
    larger because of higher levels of public debt.
       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 in part because, when the budget is in surplus and 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.
       The outlay effects of a one percentage point increase in interest
    rates alone is now relatively small, and changes sign, that is, reduces
    outlays after 2006 when increased interest earnings on the Government's
    excess balances exceed increased interest payments on the outstanding
    debt held by the public. The receipts portion of this rule-of-thumb is
    due to the Federal Reserve's deposit of earnings on its securities
    portfolio.
       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.

    [[Page 9]]

       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 1-4.  SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
                                                                    (In billions of dollars)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                        Budget effect                        2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                  Real Growth and Employment

    Budgetary effects of 1 percent lower real GDP growth:
      For calendar year 2001 only: \1\
        Receipts.........................................     -9.6    -20.9    -24.8    -26.0    -27.3    -28.5    -29.8    -31.2    -32.7    -34.2    -35.9
        Outlays..........................................      2.1      7.3      8.6     10.8     13.0     15.1     17.5     20.2     23.0     26.2     29.7
                                                          --------------------------------------------------------------------------------------------------
          Decrease in surplus (-)........................    -11.7    -28.3    -33.3    -36.8    -40.3    -43.6    -47.3    -51.4    -55.8    -60.4    -65.6

      Sustained during 2001-2011: \1\
        Receipts.........................................     -9.6    -30.8    -56.7    -84.8   -115.2   -147.9   -183.0   -220.8   -261.6   -305.0   -353.0
        Outlays..........................................      2.1      9.5     18.5     30.1     43.8     59.6     78.4    101.0    126.6    157.1    192.0
                                                          --------------------------------------------------------------------------------------------------
          Decrease in surplus (-)........................    -11.7    -40.3    -75.2   -114.9   -159.1   -207.5   -261.4   -321.8   -388.2   -462.1   -545.0

      Sustained during 2001-2011, with no change in
       unemployment:
        Receipts.........................................     -9.6    -30.8    -56.7    -84.9   -115.3   -148.0   -183.1   -221.0   -261.9   -305.2   -353.3
        Outlays..........................................      0.2      1.1      3.3      7.1     12.2     18.2     25.9     35.8     47.6     61.9     78.6
                                                          --------------------------------------------------------------------------------------------------
          Decrease in surplus (-)........................     -9.8    -31.8    -60.1    -92.0   -127.5   -166.1   -209.0   -256.8   -309.5   -367.2   -431.9

                 Inflation and Interest Rates

    Budgetary effects of 1 percentage point higher rate
     of:
      Inflation and interest rates during calendar year
       2001 only:
        Receipts.........................................     11.0     22.4     22.1     20.7     21.9     23.1     24.5     25.8     27.1     28.7     30.6
        Outlays..........................................      5.5     11.4      9.8      9.0      8.4      7.2      6.5      6.1      5.6      5.2      4.6
                                                          --------------------------------------------------------------------------------------------------
          Increase in surplus (+)........................      5.5     11.0     12.3     11.7     13.4     15.9     18.0     19.7     21.5     23.5     26.0

      Inflation and interest rates, sustained during 2001-
       2011:
        Receipts.........................................     11.0     34.1     58.2     82.4    109.2    138.7    171.4    207.3    247.1    290.9    341.1
        Outlays..........................................      5.3     16.1     23.9     30.8     37.5     42.8     47.4     51.4     54.5     56.7     57.7
                                                          --------------------------------------------------------------------------------------------------
          Increase in surplus (+)........................      5.7     17.9     34.3     51.7     71.7     95.9    124.0    155.9    192.7    234.1    283.4

      Interest rates only, sustained during 2001-2011:
        Receipts.........................................      1.4      3.8      4.8      5.3      5.7      6.1      6.5      7.0      7.4      7.8      8.2
        Outlays..........................................      4.1      9.8     11.6     11.3     10.2      8.3      5.7      2.1     -2.1     -7.1    -13.4
                                                          --------------------------------------------------------------------------------------------------
          Decrease in surplus (-)........................     -2.7     -6.0     -6.8     -6.0     -4.6     -2.2      0.9      4.8      9.4     14.8     21.6

      Inflation only, sustained during 2001-2011:
        Receipts.........................................      9.6     30.3     53.4     77.2    103.5    132.6    164.8    200.3    239.7    283.1    332.9
        Outlays..........................................      1.2      6.6     12.8     20.6     29.2     37.4     46.0     55.2     64.5     74.3     84.7
                                                          --------------------------------------------------------------------------------------------------
          Increase in surplus (+)........................      8.4     23.7     40.5     56.6     74.4     95.2    118.9    145.1    175.3    208.8    248.2

          Interest Cost of Higher Federal Borrowing

    Outlay effect of $100 billion reduction in the 2001        2.8      5.9      6.3      6.7      6.9      7.0      7.2      7.6      8.0      8.4      8.9
     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.