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


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                    ECONOMIC ASSUMPTIONS AND ANALYSES

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[[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.