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

    [[Page 17]]

      ======================================================================

                        ECONOMIC ASSUMPTIONS AND ANALYSES

    ========================================================================

    [[Page 19]]

                             2. ECONOMIC ASSUMPTIONS

                                  Introduction

      Beginning in mid-2000, economic growth decelerated sharply. Over the
    following half-year manufacturing production declined, the Nation's
    payrolls grew very little, and the unemployment rate rose. In response
    to the slowing economy, the Federal Reserve cut the federal funds rate
    by 2-\3/4\ percentage points during the first half of 2001, the largest
    reduction in such a short period since 1984. Fiscal policy also shifted
    to stimulate demand. In June, the President signed the Economic Growth
    and Tax Relief Reconciliation Act of 2001, which reduced personal income
    taxes by $44 billion during the second half of the year, the first
    installment in a multi-year permanent reduction in income tax
    liabilities.
      Under normal circumstances, the strong monetary and fiscal stimulus
    either in place or enacted by mid-2001 would have been more than
    sufficient to reinvigorate the stalled economy. In fact, last spring
    most forecasters, including the Administration, were predicting that the
    sluggish growth that began in 2000 would end by late 2001 and the
    economy would again be growing at a sustainable pace that would keep the
    unemployment rate from rising further.
      However, the normal channels of transmission linking economic policy
    and economic performance never had a chance to operate. The terrorist
    attacks of September 11th temporarily shattered consumer and business
    confidence. Faced with a highly uncertain and much more risky economic
    environment, consumers, businesses and investors for a brief time became
    much less willing to undertake the purchases and investments which are
    needed to achieve sustainable growth.
      According to the National Bureau of Economic Research (NBER), the
    business cycle expansion that began in March 1991 ended in March 2001,
    six months before the terrorist attacks. The expansion lasted exactly
    ten years, making it the longest period of continuous economic growth in
    the Nation's history. In the absence of the terrorist attacks, the
    longest-running expansion might have continued well into its second
    decade. As the NBER stated, ``Before the attacks, it is possible that
    the decline in the economy would have been too mild to qualify as a
    recession. The attacks clearly deepened the contraction and may have
    been an important factor in turning the episode into a recession.'' \1\
    ---------------------------------------------------------------------------
      \1\ National Bureau of Economic Research, ``The NBER's Business-Cycle
    Dating Procedure'', December 13, 2001, page 7.
    ---------------------------------------------------------------------------
      At the start of 2001, hardly any forecaster expected that the economy
    would slip into recession within a few months. None did, or could,
    anticipate the shock to the economy from the terrorist attacks later in
    the year. Consequently, forecasts of real GDP growth made in January
    2001 turned out to be well above the actual outcome.
      The forecasts made in January 2001 by the Administration, the
    Congressional Budget Office (CBO) and the Blue Chip consensus, an
    average of prominent private sector forecasts, projected real GDP growth
    in 2001 would be close to 2.5 percent. Although the official estimate of
    fourth quarter growth is not yet available, the consensus forecast
    anticipates that growth in 2001 will be close to 1 percent. The error
    was especially large for business capital spending. Most forecasters
    expected an increase in 2001; instead it fell sharply.
      The forecasts made in January 2001 by the Administration, the CBO and
    the Blue Chip consensus for GDP growth in 2002 were all close to 3.5
    percent. That is about 2-\1/2\ percentage points above the current
    projections for 2002, which are 0.7 percent in the economic assumptions
    used in this Budget; 0.8 percent in the January 2002 CBO projections;
    and 1.0 percent in the January 2002 Blue Chip consensus.
      The large over-estimate of real growth during 2001-2002 contributed to
    a large over-estimate of receipts in FY 2002. Receipts are now expected
    to be $177 billion lower than anticipated in the 2002 Budget published
    in April 2001 due to the weaker economy and related factors, and outlays
    are expected to be $20 billion higher. Thus, the budget balance for 2002
    has been reduced $197 billion due to the impacts from the unexpected
    weak economy. (For further details, see the section below ``Sources of
    Change in the Budget Since Last Year.'') Economic-driven misses in
    budget projections are not unusual, however. The budget balances for
    1998 through 2000 were boosted by $135 billion to $200 billion each year
    due to economic and technical factors, relative to the forecast made at
    the start of each budget year. (For further discussion of the historical
    record of misses in budget projections and their sources, see Chapter
    18, ``Comparison of Actual to Estimated Totals for 2001.'')
      Despite the setback caused by the terrorist attacks, the economy
    appears to be once again poised to resume sustainable growth in 2002.
    The Federal Reserve cut the Federal funds rate four times after
    September 11th, lowering it to just 1-\3/4\ percentage point in early
    December, the lowest it has been in 40 years. In total during 2001, the
    Federal Reserve reduced the funds rate by 4-\3/4\ percentage points,
    which helped support consumer durables spending and residential
    investment in 2001 and which will stimulate business investment during
    the recovery this year. Inflation remains low, which will allow the
    Federal Reserve to ease further if that appears necessary.
      Substantially lower energy prices will provide a boost to economic
    activity. Crude oil prices have fallen nearly

    [[Page 20]]

    50 percent since late 2000, with an especially sharp drop after mid-
    2001. Lower prices for gasoline, heating oil and natural gas act like a
    tax cut for energy-consuming households and businesses, although this is
    partly offset by lower incomes for domestic energy producers. The net
    impact is stimulative because the United States imports a substantial
    portion of the energy it consumes.
      Fiscal policy is also expected to boost growth. The bipartisan
    economic security package proposes lower personal taxes and increases
    incentives for business investment. These measures, along with the
    budget's ``automatic stabilizers'' such as lower income taxes and
    increased unemployment insurance payments, will provide additional
    purchasing power to households and businesses this year.
      During each quarter of 2001, businesses cut back on capital spending
    in response to a ``capital overhang'' that developed in 2000 following
    the Y2K surge in spending, the unanticipated slowing of demand here and
    abroad, and the decline in corporate cash flow. When the economy begins
    growing again, businesses will have the willingness and ability to
    invest more in new plant and equipment. Also, businesses liquidated
    inventories during 2001 to such an extent that they will soon have to
    step up orders to replenish stocks. For these reasons, the usual
    dynamics of the business cycle are likely soon to swing from restraining
    growth to boosting growth. Increased orders for capital equipment and
    stockbuilding will require increased production, which will require more
    workers on payrolls, which will generate more incomes, restore
    confidence, stimulate consumer spending, and, in turn, lead to further
    increases in business investment. This ``virtuous circle'' has been the
    regular sequence of events in past business cycles.
      Financial markets are already anticipating faster economic growth this
    year. The stock market is often a reliable leading signal of future
    economic activity, and it has risen sharply from its low point on
    September 21st. By mid-January, the Dow Jones Industrial Average had
    gained almost 20 percent and the technology-laden NASDAQ 40 percent. In
    every post-World War II recession, the economy has emerged from
    recession to expansion a few months after the start of a sustained stock
    market rally. Bond markets are sending a similar signal. The spread
    between short and long-term interest rates widened significantly in the
    final months of 2001, an indication that bond market investors also
    anticipate faster growth shortly.
      Despite the encouraging signals from financial and nonfinancial
    markets, a strong and sustained expansion is far from assured. The
    recovery of business investment may be delayed; consumers may yet
    curtail discretionary spending in the face of uncertain prospects for
    employment and income; and U.S. exports may be weaker than anticipated
    as a result of slow growth abroad. In light of these downside risks that
    might prolong the recession, the Administration endorses the bipartisan
    economic security package to insure a quick and successful transition
    from contraction to expansion.
      This chapter begins with a fuller review of recent economic
    developments and policy actions. The chapter goes on to present the
    Administration's economic assumptions that underpin the 2003 Budget
    projections and to compare these with the forecasts of the private
    sector and the Congressional Budget Office. The economic assumptions are
    conservative and close to those of the Congressional Budget Office and
    the consensus of private sector forecasters, both in the near-term and
    over the Budget horizon to 2012. As such, the Administration's
    assumptions provide a prudent basis for the budget balance projections.
    The following sections of the chapter describe how the economic
    assumptions have been revised since those of the 2002 Budget and how the
    changes in economic assumptions, policies and technical factors since
    last year have affected projected budget surpluses. The next section
    presents 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 2000-2001 Economic Slowdown: The slowdown in the economy's growth
    rate began in mid-2000, well before the onset of the recession in March
    2001. During the second half of 2000, the economy expanded at only a 1.6
    percent annual rate, and during the first half of 2001 growth slowed
    further to a mere 0.8 percent annual pace. A number of factors
    contributed to the deceleration of economic activity:
        First, from the end of 1995 through mid-2000 real GDP growth
              was at an unsustainably strong pace, averaging 4.3 percent per
              year. By mid-2000, it was clear to most observers that growth
              would have to slow for some period of time to permit the
              economy to return to its potential level.
        Second, the cost of credit rose during 1999 and the first
              half of 2000, as the Federal Reserve tightened monetary policy
              to avoid an acceleration of inflation.
        Third, the stock market fell after March 2000, with an
              especially pronounced drop for high-tech firms. The loss in
              equity wealth slowed the growth of consumer spending and
              raised the cost of capital to business. With the benefit of
              hindsight, it appears that the stock market at the end of the
              1990s had reached unsustainable heights, especially for high-
              tech firms.
        Fourth, energy prices spiked in 1999 and 2000. The higher
              energy prices acted like a tax on consumers, leaving them with
              less income to spend on non-energy goods and services. Profits
              of non-energy producing businesses were squeezed by the higher
              costs of production.
        Finally, by late 2000, businesses found themselves with
              excess fixed capital and unwanted inventories. In response,
              firms sharply reduced business fixed investment and
              inventories during 2001.

    [[Page 21]]

      Despite the equity losses, consumer spending continued to sustain the
    economy's growth after mid-2000. Consumer spending adjusted for
    inflation accounts for two-thirds of GDP and residential investment
    another 4 percent. With 70 percent of the economy growing, albeit at a
    somewhat slower pace, real GDP continued to expand slowly through the
    second quarter of 2001. Residential investment also expanded during the
    period of decelerating GDP growth, spurred by historically low mortgage
    interest rates. During 2001, the rate on 30-year mortgages averaged 7.0
    percent, the lowest level since the 1960s. Housing starts actually
    increased after mid-2000 and total home sales set a record high in 2001.
      The business sector was the major source of restraint responsible for
    the deceleration of GDP growth. After eight successive years of double-
    digit growth, real investment in equipment and software slowed sharply
    beginning in the third quarter of 2000, and declined in each of the next
    four quarters. The decrease in investment in high-technology equipment
    was especially pronounced, but spending on other types of equipment and
    structures also declined. As the economy's growth slowed, excess
    capacity emerged in many industries and reduced the immediate need for
    new capital investment to augment capacity. Businesses also sharply
    reduced their inventory investment during the second half of 2000 and
    continued to liquidate inventories in 2001 as they sought to bring
    stocks back in line with weakened sales. Although inventories are a
    relatively small component of GDP, they are subject to substantial
    swings that exert a disproportionately large impact on GDP growth around
    business cycle turning points. Since the middle of 2000, declining
    inventory investment has reduced real GDP growth by between one-half
    percentage point and 2-\1/2\ percentage points in each quarter. Although
    the official data are not yet available, inventory liquidation in the
    fourth quarter of last year appears to have again reduced real GDP
    growth substantially.
      Government purchases added a little less than one-half percentage
    point to real GDP growth after mid-2000. Virtually all of that modest
    contribution to growth came from State and local spending; Federal
    government spending hardly increased. Net exports also had only a small
    impact on GDP growth after mid-2000. Growth of U.S. exports was hurt by
    slow growth abroad, while the growth of U.S. imports was restrained by
    the deceleration of U.S. domestic demand. As a result, the net export
    balance, which had deteriorated sharply during the last half of the
    1990s, hardly changed after mid-2000. The unemployment rate began rising
    steadily after its cyclical low in October 2000 at 3.9 percent.
      Fiscal Policy: In keeping with his campaign pledge, soon after the
    President took office in January 2001 he proposed substantial tax relief
    for the American people. That goal was achieved with the passage of the
    Economic Growth and Tax Relief Reconciliation Act (EGTRRA) in June. The
    Act, which is projected to reduce taxes by $1.24 trillion over 11 years,
    will enable families to keep more of their income and will provide new
    incentives to work and save. The bill reduces marginal income tax rates;
    reduces the ``marriage penalty'' for most married couples; increases the
    child and adoption tax credit credits; eliminates the estate tax; and
    increases the annual contribution limits to IRAs, 401k retirement plans,
    and educational IRAs. Many of these tax reductions became effective
    starting in 2001 or 2002 and were phased in over several years.
      The tax reduction package was well timed to support a weakened
    economy. Beginning in July of 2001, 85 million taxpayers received rebate
    checks totaling $36 billion. These checks represented a full year's tax
    reduction from the creation of the new 10 percent tax bracket carved out
    of the beginning of the 15 percent tax bracket. In addition, beginning
    July 1st, payroll tax withholding schedules were reduced to reflect the
    phase-in of the lower marginal income tax rates for those in the 28
    percent tax bracket and higher. In January of this year, payroll
    withholding schedules were lowered to reflect the new 10 percent tax
    bracket that took the form of a rebate in 2001. All told, the rebate and
    other withholding changes are estimated to have reduced personal income
    tax liabilities by $44 billion in calendar year 2001 and are expected to
    lower them by $52 billion in 2002. The lower taxes enable households to
    increase spending and pay down debt. Adding in all the other major
    personal income tax reductions, EGTRRA is estimated to reduce taxpayers'
    2002 calendar year liabilities by about $70 billion.
      In this Budget, the Administration proposes an economic security
    package to insure that the economy recovers quickly from the recession.
    The package includes: speeding up the income tax reductions Congress
    passed last year as part of EGTRRA; tax refunds to lower- and moderate-
    income families who did not benefit from the income tax rebates in 2001;
    providing partial expensing of new investment and reforming the
    corporate alternative minimum tax. In addition, the Administration
    supports measures to provide immediate assistance to laid-off workers,
    both by extending their unemployment benefits and helping them retain
    their health insurance coverage.
      Monetary Policy: Beginning in early 2001, the Federal Reserve
    consistently pursued an easier monetary policy to reinvigorate the
    unexpectedly weak economy and to offset the shock to confidence from the
    terrorist attacks of September 11th. The Federal Reserve cut the Federal
    funds rate by one percentage point in January 2001 and by one-half
    percentage point in March. In the following months, and especially after
    September 11th, the Federal Reserve further reduced the Federal funds
    rate. All told, the funds rate was cut eleven times during 2001,
    reducing it from 6-\1/2\ percent to 1-\3/4\ percent by early December,
    the lowest it has been since the early 1960s.
      Credit markets responded to the monetary easing. Short-term interest
    rates matched the decline in the funds rate. At the long end of the
    maturity spectrum,

    [[Page 22]]

    yields had already declined substantially in late 2000 in anticipation
    of the Fed's shift in policy, and then fluctuated somewhat during 2001
    as prospects for recovery varied. On October 31st, the Treasury
    announced it was halting sales of the 30-year bond, and the yield on
    long-term Treasury notes dropped sharply, but within a month yields
    returned to pre-announcement levels. By January 2002, as the recovery in
    economic activity appeared close at hand, the yield on the 10-year
    Treasury note had risen to 5.1 percent, close to the level at which it
    began 2001. The steeply upward sloping yield curve at the start of 2002
    was another signal from credit markets that the economy was about to
    emerge from recession to recovery.
      The Recession and the Post-September 11th Economy: The terrorist
    attacks pushed a weak economy over the edge into an outright
    contraction. After September 11th, the forces that had been restraining
    growth since mid-2000 were augmented by temporary disruptions to
    business travel and tourism and by the temporary shock to confidence
    that the terrorist attacks had engendered. As a result, real GDP
    decreased at a 1.3 percent annual rate in the July-September quarter and
    probably contracted in the October-December quarter as well. \2\
    Consumer and business confidence plummeted immediately after September
    11th. The Conference Board's survey of consumer confidence dropped 26
    percent from August to October. When the financial markets reopened
    following the attacks, there were sharp declines in asset values. On
    September 21st, when the stock market hit its low point, the S&P 500 was
    off 12 percent from its close on September 10th; the NASDAQ was down 16
    percent.
    ---------------------------------------------------------------------------
      \2\  The first official estimate of fourth quarter GDP was released at
    the end of January, after this text was finalized.
    ---------------------------------------------------------------------------
      Clear signs that the recession was taking hold also appeared in the
    Nation's labor markets. Payrolls began to shrink after the March
    business cycle peak but the largest job losses followed the September
    11th attacks. All in all, 1.1 million jobs were lost last year, with
    over 943 thousand jobs lost in the last three months of the year.
    Manufacturing industries, and especially high-tech and other capital
    goods industries, experienced the largest job losses. But even the job-
    generating private service sector industries lost nearly 300,000 jobs
    last year. Initial claims for unemployment insurance surged during the
    second half of September and well into October. Layoffs accelerated,
    especially in industries directly affected by the attacks, such as the
    airlines, hotels, restaurants and car rentals. The unemployment rate
    jumped from 5.0 percent in September to 5.8 percent by December. For the
    year as a whole, the unemployment rate averaged 4.8 percent, the highest
    level since 1997. The weakening labor market last year was also evident
    in the declines in the labor force participation rate and in the
    employment-population ratio.
      The growing underutilization of physical capital, which began in late
    2000, became more pronounced in 2001, especially, after September 11th.
    By December, the manufacturing capacity utilization rate was only 73
    percent, well off the 82 percent of mid-2000. The operating rate in
    high-tech industries fell to 60 percent in December, the lowest level
    for those industries since record-keeping began in the 1960s.
      Signs of Recovery: In the closing months of 2001, there were tentative
    signs that the economy was about to emerge from the recession. After
    hitting bottom on September 21st, the stock market rose sharply and the
    yield curve steepened. Consumer confidence jumped 10 percent in
    December, and surveys revealed that consumers' expectations about the
    future had nearly returned to the levels attained in August.
      Despite the shocks to confidence, consumers were still willing to make
    big-ticket purchases in the fourth quarter. Motor vehicle sales set a
    record high in the quarter, spurred by zero-percent financing. In past
    recessions, housing activity contracted sharply while consumer spending
    usually declined at some point. That pattern was not repeated this time.
    The considerable stimulus provided by the tax reductions and lower
    interest rates, and the restoration of confidence following early
    successes in the war on terrorism, appear to have sustained the
    household sector through this turbulent period.

                                                                                  Table 2-1.  ECONOMIC ASSUMPTIONS \1\
                                                                              (Calendar years; dollar amounts in billions)
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                          Projections
                                                                                  Actual -----------------------------------------------------------------------------------------------------------
                                                                                   2000     2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011     2012
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
    Gross Domestic Product (GDP):
      Levels, dollar amounts in billions:
        Current dollars........................................................    9,873   10,197   10,481   11,073   11,681   12,321   12,962   13,614   14,299   15,020   15,775   16,569   17,404
        Real, chained (1996) dollars...........................................    9,224    9,313    9,382    9,739   10,101   10,462   10,802   11,136   11,482   11,838   12,204   12,583   12,973
        Chained price index (1996=100), annual average.........................    107.0    109.5    111.7    113.7    115.6    117.8    120.0    122.2    124.5    126.8    129.2    131.6    134.1
      Percent change, fourth quarter over fourth quarter:
        Current dollars........................................................      5.3      1.9      4.7      5.6      5.5      5.4      5.0      5.0      5.0      5.0      5.0      5.0      5.0
        Real, chained (1996) dollars...........................................      2.8     -0.5      2.7      3.8      3.7      3.5      3.1      3.1      3.1      3.1      3.1      3.1      3.1
        Chained price index (1996=100).........................................      2.4      2.4      1.9      1.7      1.7      1.9      1.9      1.9      1.9      1.9      1.9      1.9      1.9
      Percent change, year over year:
        Current dollars........................................................      6.5      3.3      2.8      5.6      5.5      5.5      5.2      5.0      5.0      5.0      5.0      5.0      5.0
        Real, chained (1996) dollars...........................................      4.1      1.0      0.7      3.8      3.7      3.6      3.2      3.1      3.1      3.1      3.1      3.1      3.1
        Chained price index (1996=100).........................................      2.3      2.3      2.0      1.8      1.7      1.8      1.9      1.9      1.9      1.9      1.9      1.9      1.9

    Incomes, billions of current dollars:
        Corporate profits before tax...........................................      845      706      733      848      931    1,023    1,090    1,136    1,188    1,251    1,312    1,354    1,419
        Wages and salaries.....................................................    4,837    5,100    5,246    5,519    5,818    6,115    6,415    6,730    7,058    7,401    7,763    8,147    8,549
        Other taxable income \2\...............................................    2,236    2,297    2,331    2,458    2,547    2,650    2,750    2,839    2,937    3,042    3,152    3,265    3,386

    Consumer Price Index (all urban): \3\
        Level (1982-84=100), annual average....................................    172.3    177.2    180.5    184.5    188.7    193.2    197.8    202.6    207.4    212.4    217.3    222.3    227.4
        Percent change, fourth quarter over fourth quarter.....................      3.4      2.0      2.4      2.2      2.3      2.4      2.4      2.4      2.4      2.3      2.3      2.3      2.3
        Percent change, year over year.........................................      3.4      2.9      1.8      2.2      2.3      2.4      2.4      2.4      2.4      2.4      2.3      2.3      2.3

    Unemployment rate, civilian, percent:
        Fourth quarter level...................................................      4.0      5.5      5.8      5.4      5.1      4.9      4.9      4.9      4.9      4.9      4.9      4.9      4.9
        Annual average.........................................................      4.0      4.8      5.9      5.5      5.2      5.0      4.9      4.9      4.9      4.9      4.9      4.9      4.9
    Federal pay raises, January, percent:
        Military \4\...........................................................      4.8      3.7      6.9      4.1      3.4      3.4      3.4      3.4      3.4      3.4      3.4      3.4      3.4
        Civilian \5\...........................................................      4.8      3.7      4.6      2.6      3.4      3.4      3.4      3.4      3.4      3.4      3.4      3.4      3.4

    Interest rates, percent:
        91-day Treasury bills \6\..............................................      5.8      3.4      2.2      3.5      4.0      4.3      4.3      4.3      4.3      4.3      4.3      4.3      4.3
        10-year Treasury notes.................................................      6.0      5.0      5.1      5.1      5.1      5.1      5.2      5.2      5.2      5.2      5.3      5.3      5.3
    ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
    \1\ Based on information available as of late November 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; 2002 figure is average of various rank- and longevity-specific adjustments; 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, secondary market (bank discount basis).

      Other signs of improvement could be seen in the labor markets, where
    the number of new claims for unemployment insurance tapered off sharply
    in November and again in December, while job losses in December were
    much less than in either October or November. Finally, business capital
    goods orders rose substantially in October and November, a signal that
    businesses were again beginning to undertake long-term investment
    commitments. As 2002 began, most forecasters were projecting that real
    GDP growth would resume in the first or second quarter of the year.
      Nonetheless, a resumption of strong growth later this year is far from
    assured. The recent recovery of business and consumer confidence is
    still fragile and could be shattered by any adverse shocks. Job losses
    in December, although less than a few months earlier, were substantial
    and the unemployment rate was still on the rise. Faced with
    uncertainties about job security, consumers may yet cut back on spending
    as has often occurred in recessions. Businesses may still be reluctant
    to invest heavily in new plant and equipment. Finally, it may prove
    difficult for the hard-hit manufacturing sector to pull out of recession
    given the continuing weakness in U.S. export markets.

                              Economic Projections

      The Administration's economic projections are summarized in Table 2-1.
    They assume that the policies proposed in the Budget will be adopted,
    notably the bipartisan economic security package to insure that the
    recovery does not falter. The Federal Reserve is assumed to pursue a
    monetary policy that supports a return to sustainable growth while
    continuing to keep inflation under control. These economic assumptions
    are conservative and close to those of the Congressional

    [[Page 23]]

    Budget Office and the consensus of private sector forecasters, as
    described in more detail below.
      There are both upside and downside risks to the assumptions. If the
    favorable productivity performance since 1995 is maintained in the years
    ahead real GDP growth may be stronger than assumed here. On the other
    hand, the recession might prove deeper than expected or the recovery
    weaker, risks that would increase if Congress again fails to pass the
    bipartisan economic security package. The Budget assumptions take a
    balanced view of these risks and are intended to avoid either over- or
    under-estimation of available budgetary resources.
      Real GDP: Assuming passage of the bipartisan economic security
    package, the recession is projected to end early in 2002 and the
    recovery is expected to be firmly established during the second half of
    the year. On a calendar year basis, real GDP is projected to rise 0.7
    percent in 2002, following a 1.0 percent gain in 2001. Because of the
    timing of the business cycle, the transition from recession to recovery
    can be seen more clearly in the fourth-quarter to fourth-quarter growth
    rates in Table 2-1, which are -0.5 percent during the recession year of
    2001 and 2.7 percent during the recovery year of 2002. Following the
    usual cyclical pattern, during the early stages of the economic
    expansion real growth is projected to exceed the long-run sustainable
    rate. During this period, the unemployment rate is projected to decline
    until it reaches a sustainable level of 4.9 percent in 2005. From 2006
    through 2012, real GDP is projected to increase 3.1 percent per year,
    and the unemployment rate is projected to remain at 4.9 percent.
      The largest contribution to GDP growth in the near-term is expected to
    come as massive inventory liquidation gives way to renewed accumulation
    during 2002 as businesses rebuild their depleted inventories. Beyond
    this year, inventories are likely to grow in line with sales and their
    contribution to GDP growth is likely to be quite small. After 2002, real
    growth is expected to be primarily supported by a return to strong
    growth of business investment, especially in productive high-tech
    capital, and by the moderate growth of consumer spending. Overall GDP
    growth, however, is not pro

    [[Page 24]]

    jected to return to the very rapid rates experienced in the last half of
    the 1990s. During those years, a stock market boom contributed to
    unsustainable growth rates of investment and consumer spending.
    Residential investment is expected to benefit from relatively low
    mortgage rates and growing demand for second homes for vacation and
    retirement. However, underlying demographic trends will make for a
    relatively moderate growth of homebuilding in the years ahead.
      The Federal, State and local government components of GDP are also
    expected to grow at a moderate pace. Faster growth of Federal spending
    on security requirements is expected to be coupled with more moderate
    growth in other spending. State and local government spending is
    projected to be restrained by lingering fiscal pressures that developed
    during the recession. During 2002, the foreign sector is likely to exert
    a drag on real GDP growth. The recovery of world economic growth is
    expected to be led by the United States, which will tend to increase our
    imports at a time when our exports will still be hurt by slow growth
    abroad. In subsequent years, growth in our major trading partners is
    projected to pick up again and the net export sector will no longer be a
    source of restraint, and may even make a small contribution to GDP
    growth.
      Potential GDP: The growth of potential GDP is assumed to be 3.1
    percent per year through 2012. Potential growth is approximately equal
    to the sum of the trend growth rates of the labor force and
    productivity. The labor force component is assumed to rise 1.0 percent
    per year on average.
      Potential productivity in the nonfarm business sector is assumed to
    grow 2.1 percent per year during 2002-2012, which is higher than the
    1973-1995 average of 1.4 percent but lower than the 1995-2001 average of
    2.4 percent. The assumed growth of potential productivity in the nonfarm
    business sector is close to the historical averages experienced both
    over the long-term of 1948-2001 and over the medium-term between the
    cyclical peaks in 1990 and 2001. The potential productivity trend is
    assumed to be somewhat below the average productivity growth of the last
    six years for two reasons:
        First, growth of business investment last year and in the
              next few years is likely to be somewhat less than experienced
              during the last half of the 1990s. As a result, there is
              likely to be a somewhat slower growth of capital per worker.
        Second, the fight against terrorism is likely to slow
              potential productivity growth as conventionally measured, at
              least temporarily. Businesses and governments will have to
              spend tens of billions of dollars to reduce the risks of
              terrorist attacks and to minimize the damage they might do if
              they occur. Although this spending will add to the Nation's
              well-being, much of this spending will not increase measured
              productivity growth, and could possibly diminish it. After a
              transition period, however, potential productivity growth is
              not likely to be significantly affected by the new security
              measures.
      Inflation and Unemployment: Price inflation slowed last year,
    restrained by falling energy prices and growing slack in labor and
    capital markets. On a year-over-year basis, the Consumer Price Index
    (CPI) increased just 2.8 percent in 2001, down from 3.4 percent in 2000.
    Excluding the volatile food and energy components, the ``core'' CPI rose
    2.7 percent last year, which was slightly higher than the 2.4 percent of
    2000.
      Over the past year, the consensus of private sector forecasters and
    the Administration have edged up their estimate of the unemployment rate
    that is consistent with stable inflation, from 4.6 percent to 4.9
    percent. Although there is a wide range of uncertainty surrounding any
    estimate of the ``NAIRU'' (the non-accelerating inflation rate of
    unemployment), the small increase in both the core CPI last year and in
    average hourly earnings suggest that the NAIRU may be slightly higher
    than last year's 4.8 percent average unemployment rate. Nonetheless, at
    4.9 percent, the NAIRU estimate is still well below the estimates that
    prevailed just a few years ago, reflecting the experience of recent
    years that demonstrated that the economy could operate at lower levels
    of unemployment without experiencing accelerating inflation.
      The considerable slack in labor and product markets created by the
    recession is expected to restrain the growth of wages and prices this
    year. The unemployment rate is projected to decline steadily beginning
    in 2002 but still remain above the 4.9 percent NAIRU estimate until
    2005, implying progressively lower inflation during these years. The CPI
    is expected to slow to 2.4 percent by 2006 and then remain at around
    that level. The GDP chain-weighted price index, which increased 2.3
    percent in 2001, is projected to slow to 1.9 percent by 2006 and then
    stay at that level.
      Increases in the CPI tend to be slightly larger than those of the GDP
    measure of inflation in part because sharply falling computer prices
    exert less of an impact on the CPI than on the GDP measure. In addition,
    the CPI uses a fixed market basket for its weights while overall GDP
    inflation uses a chain-weight system that reflects shifts in buying
    patterns, generally away from goods and services with increasing
    relative prices and towards those with decreasing relative prices.
      Interest Rates: The budget's interest-rate assumptions are based on
    information as of late November. They project a rise in short-term rates
    through 2005 because the transition from recession to expansion will
    increase short-term credit demand. The yield on the 10-year Treasury
    note is projected to remain at around the 5.1 percent level reached when
    the assumptions were finalized. This projection assumes that the market
    price as of that date incorporated all relevant information, including
    the consensus view that the economy was about to enter an extended
    period of sustained economic growth.
      Income Shares: The share of total taxable income in nominal GDP is
    projected to decline gradually. The

    [[Page 25]]

    share of wages and salaries is expected to trend lower as the share of
    nonwage benefits in compensation rises and as the labor compensation
    share of GDP declines to its longer-term average. The profits share,
    which fell sharply during the recession, is projected to rise in the
    initial recovery years, when a cyclical increase in productivity growth
    is likely to hold down unit costs and boost profit margins.

                Comparison with CBO and Private-Sector Forecasts

      The Congressional Budget Office (CBO) and many private-sector
    forecasters also make 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. Private-sector
    forecasts are often used by businesses for long-term planning. Table 2-2
    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 assume that the President's policy
    proposals in the Budget, including the economic stimulus package, will
    be adopted. CBO normally assumes that current law will continue to hold.
    The private sector forecasts are based on appraisals of the most-likely
    policy outcomes, which can vary considerably among forecasters. Despite
    these differences in policy assumptions, the three sets of projections
    are usually very close for the key economic assumptions. The differences
    among them are generally well within the normal margin of error for such
    forecasts. Currently, the three sets of projections agree on the timing
    of the recovery and envision similar economic conditions during the
    subsequent expansion.

                                                         Table 2-2.  COMPARISON OF ECONOMIC ASSUMPTIONS
                                                                        (Calendar years)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                      Projections
                                    --------------------------------------------------------------------------------------------------------------  Average,
                                       2002      2003      2004      2005      2006      2007      2008      2009      2010      2011      2012     2002-12
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Real GDP (billions of 1996
     dollars):
      CBO January..................   9,398     9,782    10,146    10,471    10,804    11,145    11,493    11,850    12,216    12,590    12,972    .........
      Blue Chip Consensus January     9,410     9,742    10,069    10,401    10,738    11,075    11,425    11,791    12,168    12,557    12,959    .........
       \2\.........................
      2003 Budget..................   9,382     9,739    10,101    10,462    10,802    11,136    11,482    11,838    12,204    12,583    12,973    .........

    Real GDP (chain-weighted): \1\
      CBO January..................       0.8       4.1       3.7       3.2       3.2       3.2       3.1       3.1       3.1       3.1       3.0        3.1
      Blue Chip Consensus January         1.0       3.4       3.4       3.3       3.2       3.1       3.2       3.2       3.2       3.2       3.2        3.1
       \2\.........................
      2003 Budget..................       0.7       3.8       3.7       3.6       3.2       3.1       3.1       3.1       3.1       3.1       3.1        3.1

    Chain-weighted GDP Price Index:
     \1\
      CBO January..................       1.4       2.0       2.0       2.0       2.0       2.0       2.0       2.0       2.0       2.0       2.0        1.9
      Blue Chip Consensus January         1.6       1.9       2.1       2.1       2.2       2.2       2.2       2.2       2.2       2.2       2.2        2.1
       \2\.........................
      2003 Budget..................       2.0       1.8       1.7       1.8       1.9       1.9       1.9       1.9       1.9       1.9       1.9        1.9

    Consumer Price Index (all-
     urban): \1\
      CBO January..................       1.8       2.5       2.5       2.5       2.5       2.5       2.5       2.5       2.5       2.5       2.5        2.4
      Blue Chip Consensus January         1.7       2.4       2.6       2.7       2.7       2.7       2.6       2.6       2.6       2.6       2.6        2.5
       \2\.........................
      2003 Budget..................       1.8       2.2       2.3       2.4       2.4       2.4       2.4       2.4       2.3       2.3       2.3        2.3

    Unemployment rate: \3\
      CBO January..................       6.1       5.9       5.4       5.2       5.2       5.2       5.2       5.2       5.2       5.2       5.2        5.4
      Blue Chip Consensus January         6.1       5.7       4.9       4.9       4.8       4.9       4.9       4.9       4.9       4.9       4.9        5.1
       \2\.........................
      2003 Budget..................       5.9       5.5       5.2       5.0       4.9       4.9       4.9       4.9       4.9       4.9       4.9        5.1

    Interest rates: \3\
      91-day Treasury bills:
        CBO January................       2.2       4.5       4.9       4.9       4.9       4.9       4.9       4.9       4.9       4.9       4.9        4.6
        Blue Chip Consensus January       2.1       3.4       4.5       4.7       4.8       4.8       4.7       4.7       4.7       4.7       4.7        4.3
         \2\.......................
        2003 Budget................       2.2       3.5       4.0       4.3       4.3       4.3       4.3       4.3       4.3       4.3       4.3        4.0

      10-year Treasury notes: \3\
        CBO January................       5.0       5.4       5.8       5.8       5.8       5.8       5.8       5.8       5.8       5.8       5.8        5.7
        Blue Chip Consensus January       5.1       5.6       5.7       5.7       5.7       5.8       5.8       5.8       5.8       5.8       5.8        5.7
         \2\.......................
        2003 Budget................       5.1       5.1       5.1       5.1       5.2       5.2       5.2       5.2       5.3       5.3       5.3        5.2
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Sources: Congressional Budget Office; Blue Chip Economic Indicators, Aspen Publishers, Inc.
    \1\ Year over year percent change.
    \2\ January 2002 Blue Chip Consensus forecast for 2002 and 2003; Blue Chip October 2001 long run extension for 2004-2012.
    \3\ Annual averages, percent.

      For real GDP growth, the Administration, CBO and the Blue Chip
    consensus anticipate that the economy will recover from the 2001
    recession in 2002 and grow even faster in 2003. The differences between
    the Administration's projections in each year and those of the CBO and
    Blue Chip are quite small. Over the eleven-year span 2002-2012, all
    three have an identical forecast average of 3.1 percent annual real GDP
    growth

    [[Page 26]]

    and the level of real GDP projected for 2012 is nearly the same in the
    three forecasts. \3\
    ---------------------------------------------------------------------------
      \3\ The Blue Chip consensus forecast for 2002-2003 is from January,
    2002 Blue Chip Economic Indicators; the 2004-2012 forecast is from
    October, 2001.
    ---------------------------------------------------------------------------
      All three forecasts anticipate low and stable GDP inflation in the
    neighborhood of 2 percent annually during the forecast period. The
    Administration's unemployment rate projection is very close to the Blue
    Chip's while CBO's projected unemployment rate is somewhat above the
    other two forecasts. In the outyears, the Administration and the Blue
    Chip project a 4.9 percent rate; CBO projects 5.2 percent. All three
    forecasts have similar interest rate projections for 2002, and foresee a
    rise in short-term interest rates in 2003 as the expansion gathers
    momentum. CBO projects a somewhat sharper rise in 2003 than the other
    two forecasts. During the outyears, the Blue Chip and CBO short-term
    projections are similar and slightly above those of the Administration.
    The Administration also projects somewhat less of an increase in long-
    term rates than the other two forecasts.

                         Changes in Economic Assumptions

      As shown in Table 2-3, the economic assumptions underlying this Budget
    have been revised from those of the 2002 Budget to reflect unanticipated
    cyclical developments and the implications of the terrorist attacks. The
    current projection of real GDP growth has a pronounced cyclical swing
    that takes into account the recession during 2001 and the likely pick-up
    in activity in the recovery and expansion phases of the business cycle.
    On a year-over-year basis, real GDP growth is considerably slower in
    2001 and 2002 than projected in the prior Budget assumptions and faster
    during 2003-2006. From 2007 onwards, however, real GDP growth in this
    and the prior Budget is projected to be 3.1 percent yearly, the same as
    the estimate of potential GDP growth during those years. Consistent with
    the near-term increase in unemployment and the lower level of interest
    rates at the end of 2001, inflation and interest rates are projected to
    be lower than in the previous Budget.

                                           Table 2-3.  COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2002 AND 2003 BUDGETS
                                                          (Calendar years; dollar amounts in billions)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Nominal GDP:
      2002 \1\...........................................   10,328   10,892   11,478   12,094   12,736   13,413   14,125   14,871   15,657   16,481   17,347
      2003...............................................   10,197   10,481   11,073   11,681   12,321   12,962   13,614   14,299   15,020   15,775   16,569

    Real GDP (1996 dollars):
      2002 \1\...........................................    9,440    9,752   10,065   10,387   10,714   11,050   11,397   11,756   12,121   12,494   12,879
      2003...............................................    9,313    9,382    9,739   10,101   10,462   10,802   11,136   11,482   11,838   12,204   12,583

    Real GDP (percent change): \2\
      2002...............................................      2.3      3.3      3.2      3.2      3.1      3.1      3.1      3.1      3.1      3.1      3.1
      2003...............................................      1.0      0.7      3.8      3.7      3.6      3.2      3.1      3.1      3.1      3.1      3.1

    GDP price index (percent change): \2\
      2002...............................................      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1      2.1
      2003...............................................      2.3      2.0      1.8      1.7      1.8      1.9      1.9      1.9      1.9      1.9      1.9

    Consumer Price Index (percent change): \2\
      2002...............................................      2.7      2.6      2.6      2.5      2.5      2.5      2.5      2.5      2.5      2.5      2.5
      2003...............................................      2.9      1.8      2.2      2.3      2.4      2.4      2.4      2.4      2.4      2.3      2.3

    Civilian unemployment rate (percent): \3\
      2002...............................................      4.4      4.6      4.5      4.5      4.5      4.5      4.5      4.6      4.6      4.6      4.6
      2003...............................................      4.8      5.9      5.5      5.2      5.0      4.9      4.9      4.9      4.9      4.9      4.9

    91-day Treasury bill rate (percent): \3\
      2002...............................................      5.3      5.6      5.6      5.6      5.3      5.0      5.0      5.0      5.0      5.0      5.0
      2003...............................................      3.4      2.2      3.5      4.0      4.3      4.3      4.3      4.3      4.3      4.3      4.3

    10-year Treasury note rate (percent): \3\
      2002...............................................      5.4      5.6      5.7      5.7      5.7      5.7      5.7      5.7      5.7      5.7      5.7
      2003...............................................      5.0      5.1      5.1      5.1      5.1      5.2      5.2      5.2      5.2      5.3      5.3
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    \1\ Adjusted for July 2001 NIPA revisions.
    \2\ Year over year.
    \3\ Calendar year average.

      Primarily because growth during the initial years of the expansion is
    not expected to be as high as the 4 percent or more rate that has
    occurred in past recoveries, during 2001-2005 real GDP growth is now
    expected to average 0.5 percentage point less per year than previously
    projected. Consequently, as shown in the table, the level of real GDP is
    projected to be lower in each year than forecast in last year's
    assumptions, and from 2006 onward the level of real GDP is now projected
    to be about 2 percent lower than envisaged in last year's Budget
    assumptions.
      Over the past year, the CBO and the Blue Chip have made similar
    reductions in their estimate of average growth during 2001-2011 and, as
    a result, have also lowered their estimate of the level of real GDP in
    2011 by an amount similar to that in the Budget assumptions. Thus, the
    consensus view is that this cycle of recession and expansion is likely
    to be different from those of the past when the level of real GDP
    eventually returned to the pre-recession trend. As explained below,

    [[Page 27]]

    the unusual nature of this business cycle implies substantially lower
    projected budget surpluses, even when the economy returns to its
    potential growth rate.
      The slower average real GDP growth rate for the forecast period, and
    the resulting lower level of real GDP, primarily reflects three factors:
        First, the overhang of capital that developed unexpectedly
              during 2001 has resulted in lower actual business investment
              during 2001 and slower growth of investment for the next few
              years than projected in the 2002 Budget assumptions. As a
              result, productivity growth for the next few years is
              projected to be somewhat slower because of the slower growth
              of capital per worker.
        Second, in the aftermath of the September 11th terrorist
              attacks, resources which might have been invested in expanding
              productive capacity will be diverted to enhance security. This
              diversion will slow productivity growth and real GDP growth
              slightly for the next few years.
        Finally, the Administration's estimate of the long-run
              sustainable level of the unemployment rate has been revised up
              modestly from 4.6 percent to 4.9 percent, as has the Blue
              Chip's, which implies a lower level of real GDP for the
              largely unchanged projected labor force.

                 Sources of Change in the Budget Since Last Year

      The sources of the change in the budget outlook from the 2002 Budget
    pre-policy baseline to the 2003 Budget policy projection are shown in
    Table 2-4. The second block shows that enacted legislation reduced the
    projected pre-policy surpluses of $5.6 trillion during 2002-2011 by $2.1
    trillion.
      The third and fourth blocks quantify the impact on the budget outlook
    from changes in the economic assumptions and technical factors.
    Technical factors are those changes that are not due to explicit
    economic assumptions or legislation, such as income from stock options
    and the effective tax rate on corporate profits. Because of the
    interaction of economic developments and technical factors, it is
    difficult to estimate accurately their separate budgetary impacts. Block
    5 shows that the combined changes due to economic and technical factors
    reduced projected surpluses by $1,345 billion. The Addendum shows that
    the lower projected level of real GDP in each year accounted for $851
    billion of the reduced surpluses. Block 6 shows that policies proposed
    in this Budget are expected to reduce cumulative surpluses by $1,556
    billion. Block 7 shows the resulting 2003 Budget policy surplus
    projection.

                                     Table 2-4.  SOURCES OF CHANGE IN BUDGET TOTALS
                                                (In billions of dollars)
    ----------------------------------------------------------------------------------------------------------------
                                            2002       2003       2004       2005       2006       2007    2002-2011
    ----------------------------------------------------------------------------------------------------------------
     (1) 2002 Budget baseline
        Receipts.......................      2,221      2,324      2,438      2,569      2,698      2,836
        Outlays........................      1,938      1,991      2,051      2,130      2,182      2,250
                                        ----------------------------------------------------------------------------
          Unified budget surplus.......        283        334        387        439        515        585      5,637

     (2) Changes due to enacted
     legislation:
        Receipts.......................        -33        -83       -104       -102       -126       -137     -1,127
        Outlays........................         61         62         70         76         86         95        943
                                        ----------------------------------------------------------------------------
          Surplus reduction (-),               -95       -145       -174       -179       -212       -232     -2,070
           enacted legislation.........

     (3) Changes due to economic
     assumptions:
        Receipts.......................        -82        -91        -81        -87       -100       -109     -1,077
        Outlays........................         -7        -15        -13        -12        -11         -8        -63
                                        ----------------------------------------------------------------------------
          Surplus reduction (-),               -76        -76        -67        -75        -89       -101     -1,014
           economic....................

     (4) Changes due to technical
     factors:
        Receipts.......................        -94        -29        -19        -14        -10         -9       -197
        Outlays........................         27         32         18          3          8          3        135
                                        ----------------------------------------------------------------------------
          Surplus reduction (-),              -121        -61        -37        -17        -19        -12       -331
           technical...................

     (5) Surplus reduction, economic          -197       -138       -104        -92       -108       -114     -1,345
     and technical subtotal............

     (6) Changes due to 2003 Budget
     policy:
        Receipts.......................        -65        -73        -59        -28         -6         -9       -414
        Outlays........................         32         59         63         80        103        126      1,143
                                        ----------------------------------------------------------------------------
          Surplus reduction (-), policy        -97       -132       -122       -108       -110       -136     -1,556

     (7) 2003 Budget totals (policy)
        Receipts.......................      1,946      2,048      2,175      2,338      2,455      2,572
        Outlays........................      2,052      2,128      2,189      2,277      2,369      2,468
                                        ----------------------------------------------------------------------------
          Unified budget surplus.......       -106        -80        -14         61         86        104        665

                 Addendum:
     Surplus Reduction due to Change in
     Economic Assumptions:
        Lower Real GDP.................        -70        -85        -79        -75        -75        -80       -851
        Higher Unemployment............        -16         -7         -4         -3         -4         -6        -64
        Lower Inflation................         -1         -1         -2         -6        -10        -15       -159
        All Other......................         11         16         18          9         -1         -1         60
                                        ----------------------------------------------------------------------------
          Surplus reduction (-),               -76        -76        -67        -75        -89       -101     -1,014
           economic....................

    ----------------------------------------------------------------------------------------------------------------
    Note: Changes in interest costs due to receipts changes included in outlay lines.

                        Structural and Cyclical Balances

      When the economy is operating below potential and the unemployment
    rate exceeds the long-run sustainable average, as is projected to be the
    case for the next few years, receipts are lower than they would be if
    resources were more fully employed, and outlays for unemployment-
    sensitive programs (such as unemployment compensation and food stamps)
    are higher. As a result, the surplus is smaller, (or the deficit larger)
    than would be the case if unemployment were at the sustainable long-run
    average. The portion of the surplus (or deficit) that can be traced to
    this factor is called the cyclical component. The balance is the portion
    that would remain if the unemployment rate were at its long-run value,
    which is called the structural surplus (or structural deficit).
      Compared to the actual, unadjusted surplus or 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
    is operating at the sustainable level of unemployment. For this reason,
    changes in the structural balance give a better picture of the
    independent impact of budget policy on the economy than does the
    unadjusted budget balance, which reflects the combined impact of policy
    and cyclical economic conditions on the budget.
      From 1997 to 2001, unemployment was lower than could be expected to
    persist in the long run. Therefore, as shown in Table 2-5, in 1997 the
    structural deficit exceeded the actual unadjusted deficit and in 1998-
    2001 the structural surplus was smaller than the actual unadjusted
    structural surplus. In 2002, when the unemployment rate is projected to
    be above the sustainable level, the actual deficit is projected to be
    $106 billion at a time when the structural deficit is expected to be $18
    billion. Beginning in 2006, the unadjusted and the structural surplus
    are about equal because the unemployment rate is projected to be at its
    sustainable level.
      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. Deposit insurance net outlays are projected
    to be very small in the coming years. Therefore, the adjusted structural
    surplus and the unadjusted structural 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 in the
    economic assumptions would alter outlays, receipts, and the surplus or
    deficit.
      Economic variables that affect the budget do not usually change
    independently of one another. Output and

    [[Page 28]]

    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.

                                                             Table 2-5.  ADJUSTED STRUCTURAL BALANCE
                                                                    (In billions of dollars)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                    1996     1997     1998     1999     2000     2001     2002     2003     2004     2005     2006     2007
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Unadjusted surplus or deficit (-)...........   -107.5    -22.0     69.2    124.6    236.4    127.1   -106.2    -80.2    -13.7     61.1     86.2    104.0
      Cyclical component........................    -13.7     15.5     45.3     64.3     81.9     42.1    -88.0    -77.5    -45.5    -17.5     -0.5      0.0
                                                 -----------------------------------------------------------------------------------------------------------
    Structural surplus or deficit (-)...........    -91.5    -27.9     35.7     79.8    164.4     85.0    -18.2     -2.7     31.7     78.7     86.7    104.0
      Deposit insurance outlays.................     -8.4    -14.4     -4.4     -5.3     -3.1     -1.4      0.2      1.4      0.4     -0.2     -0.3     -0.4
                                                 -----------------------------------------------------------------------------------------------------------
    Adjusted structural surplus or deficit (-)..    -99.9    -42.3     31.3     74.5    161.3     83.5    -17.9     -1.3     32.1     78.5     86.4    103.6
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    NOTE: The NAIRU is assumed to be 5.2% through calendar year 1998 and 4.9% thereafter.

      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 budgetary effects of the above rules of thumb are
    shown in Table 2-6.
      For real growth and employment:
        As shown in the first block, if real GDP growth is lower by
              one percentage point in calendar year 2002 only and the
              unemployment rate rises by one-half percentage point more than
              in the budget assumptions, the fiscal year 2002 deficit is
              estimated to increase by $11.5 billion; receipts in 2002 would
              be lower by $9.3 billion, and outlays would be higher by $2.1
              billion, primarily for unemployment-sensitive programs. In
              fiscal year 2003, the estimated receipts shortfall would grow
              further to $19.3 billion, and outlays would increase by $7.1
              billion relative to the base, even though the growth rate in
              calendar 2003 equaled the rate originally assumed. This is
              because the level of real (and nominal) GDP and taxable
              incomes would be permanently lower, and unemployment
              permanently higher. The budget effects (including

    [[Page 29]]

              growing interest costs associated with smaller surpluses)
              would continue to grow slightly in each successive year.
              During 2003-2012, the cumulative reduction in the budget
              surplus is estimated to be $394 billion.
        The budgetary effects are much larger if the real growth
              rate is one percentage point lower in each year than initially
              assumed and the unemployment rate is unchanged, as shown in
              the second block. This scenario might occur if trend
              productivity is permanently lower than initially assumed. In
              this case, the estimated reduction in the surplus is much
              larger than in the first scenario. In this example, during
              2003-2012, the cumulative reduction in the budget surplus is
              estimated to be $1.9 trillion.
      Joint changes in interest rates and inflation have a smaller effect on
    the surplus than equal percentage point changes in real GDP growth.
        The third block shows the effect of a one percentage point
              higher rate of inflation and one percentage point higher
              interest rates during calendar year 2002 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. In 2003, outlays would be
              above the base by $16.4 billion, due in part to lagged cost-
              of-living adjustments; receipts would rise $21.4 billion above
              the base, however, resulting in an $5.1 billion improvement in
              the budget balance. In subsequent years, the amounts added to
              receipts would continue to be larger than the additions to
              outlays. During 2003-2012, cumulative budget surpluses would
              be $106 billion larger than in the base case.
        In the fourth block example, the rate of inflation and the
              level of interest rates are higher by one percentage point in
              all years. As a result, the price level and nominal GDP 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 $775 billion to outlays
              over 2003-2012 and $1,559 billion to receipts, for a net
              increase in the 2003-2012 surpluses of $784 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 also 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 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, as shown in the
              fifth block. The receipts portion of this rule-of-thumb is due
              to the Federal Reserve's deposit of earnings on its securities
              portfolio.
        The sixth block shows that a sustained one percentage point
              increase in the GDP chain-weighted price index and in CPI
              inflation increase cumulative surpluses by a substantial $962
              billion during 2003-2012. This large effect is because the
              receipts from a higher tax base exceeds the combination of
              higher outlays from mandatory cost-of-living adjustments and
              lower receipts from CPI indexation of tax brackets.
      The last entry in the table shows rules of thumb for the added
    interest cost associated with changes in the budget surplus or deficit.
      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 30]]

                                                  Table 2-6.  SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
                                                                    (In billions of dollars)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                                                      2003-
                   Budget effect                   2002     2003     2004     2005     2006     2007     2008     2009     2010     2011     2012     2012
    --------------------------------------------------------------------------------------------------------------------------------------------------------
             Real Growth and Employment

    Budgetary effects of 1 percent lower real
     GDP growth:
      (1) For calendar year 2002 only: \1\
        Receipts...............................     -9.3    -19.3    -21.3    -22.3    -23.1    -24.1    -25.4    -26.7    -28.0    -29.3    -30.9    -250.4
        Outlays................................      2.1      7.1      7.4      9.1     11.0     13.0     14.9     16.8     19.0     21.4     24.0     143.7
                                                ------------------------------------------------------------------------------------------------------------
          Decrease in surplus (-)..............    -11.5    -26.5    -28.7    -31.4    -34.2    -37.1    -40.2    -43.5    -47.1    -50.7    -54.8    -394.1

      (2) Sustained during 2002-2012, with no
       change in unemployment:
        Receipts...............................     -9.4    -29.9    -54.7    -82.0   -110.4   -141.5   -175.1   -211.8   -251.1   -292.4   -338.2  -1,687.1
        Outlays................................       -*      0.3      1.9      4.6      8.4     13.4     19.4     26.4     35.3     45.9     58.4     214.0
                                                ------------------------------------------------------------------------------------------------------------
          Decrease in surplus (-)..............     -9.4    -30.2    -56.6    -86.6   -118.8   -154.9   -194.5   -238.2   -286.4   -338.3   -396.6  -1,901.1

            Inflation and Interest Rates

    Budgetary effects of 1 percentage point
     higher rate of:
      (3) Inflation and interest rates during
       calendar year 2002 only:
        Receipts...............................     10.6     21.4     20.9     19.3     20.1     21.1     22.3     23.6     24.9     26.3     28.1     228.0
        Outlays................................      8.4     16.4     14.4     12.2     11.8     11.3     11.0     11.1     11.2     11.4     11.2     121.8
                                                ------------------------------------------------------------------------------------------------------------
          Increase in surplus (+)..............      2.2      5.1      6.4      7.1      8.3      9.8     11.3     12.5     13.7     15.0     16.9     106.2

      (4) Inflation and interest rates,
       sustained during 2002-2012:
        Receipts...............................     10.6     32.7     55.4     77.9    101.8    128.5    158.2    191.6    228.3    268.6    315.6   1,558.7
        Outlays................................      8.3     24.4     37.9     49.9     61.0     71.8     83.0     94.4    106.0    118.3    128.2     774.8
                                                ------------------------------------------------------------------------------------------------------------
          Increase in surplus (+)..............      2.3      8.3     17.5     28.0     40.8     56.7     75.3     97.2    122.3    150.4    187.4     783.9

      (5) Interest rates only, sustained during
       2002-2012:
        Receipts...............................      1.4      3.7      4.7      5.2      5.6      6.0      6.4      6.8      7.2      7.6      8.0      61.1
        Outlays................................      6.8     17.0     22.9     26.1     28.1     29.6     30.5     31.2     31.5     31.4     30.8     279.1
                                                ------------------------------------------------------------------------------------------------------------
          Decrease in surplus (-)..............     -5.4    -13.3    -18.2    -20.9    -22.5    -23.6    -24.1    -24.3    -24.3    -23.9    -22.8    -217.9

      (6) Inflation only, sustained during 2002-
       2012:
        Receipts...............................      9.2     29.0     50.7     72.8     96.2    122.5    151.8    184.8    221.1    261.0    307.6   1,497.6
        Outlays................................      1.5      7.6     15.5     24.8     34.6     44.7     56.0     68.0     80.9     95.2    108.2     535.6
                                                ------------------------------------------------------------------------------------------------------------
          Increase in surplus (+)..............      7.7     21.4     35.2     47.9     61.6     77.8     95.8    116.8    140.2    165.8    199.4     962.0

     Interest Cost of Higher Federal Borrowing

    (7) Outlay effect of $100 billion increase       1.3      3.5      4.4      4.9      5.2      5.5      5.7      5.9      6.2      6.5      6.8      54.8
     in the 2002 unified deficit...............

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