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






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                    ECONOMIC ASSUMPTIONS AND ANALYSES

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ANALYTICAL PERSPECTIVES

2. ECONOMIC ASSUMPTIONS


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                         2. ECONOMIC ASSUMPTIONS

                              Introduction

  The economy passed through nearly all the stages of a business cycle 
over the last three years. Growth slowed sharply in the second half of 
calendar year 2000 as the expansion that began in 1991 entered its final 
phase. That expansion finally gave way in 2001 to a mild recession 
lasting most of the year. An economic recovery began late in 2001, but 
it has proceeded unevenly and at an overall slower pace than the typical 
upturn, entailing rising unemployment and job losses.
  In a typical business expansion, the economy establishes a virtuous 
circle. An initial burst of growth generates employment gains, falling 
unemployment, and rising consumer confidence, in the process creating 
additional jobs and income. Businesses then boost capital spending to 
meet the rising demands, generating still more jobs and income. Restored 
investor confidence pushes up equity prices, helping to hold down the 
cost of capital and supporting increased investment. A stock market 
rally, in fact, usually precedes the business recovery in anticipation 
of the imminent upturn in activity and profits.
  This time, however, the stock market continued to fall even as the 
economy began to expand; consumer and investor confidence remained 
depressed; and job growth was lackluster, limiting the growth of income, 
spending, and investment. Although the actual fourth quarter growth rate 
will not be available until after the budget goes to press, it appears 
that growth in the final quarter of 2002 was well below the average for 
the first four quarters of the upturn. As 2002 ended, the expansion 
appeared to be losing momentum.
  In response, on January 7th, the President proposed a comprehensive 
growth and jobs creation package designed to strengthen the expansion 
and raise the potential for long-term growth. Thus as 2003 begins, the 
foundation for a sustained expansion is in place: inflation is low, 
productivity growth is high, and monetary and fiscal policies are 
focused on fostering faster growth of aggregate demand and supply. To be 
sure, a great deal of uncertainty remains about the economic outlook due 
to domestic and international concerns. Nonetheless, most private- and 
public-sector forecasters, including the Administration, expect these 
restraints on growth to be overcome by the favorable fundamental forces 
that will propel this expansion for years to come.
  This chapter begins with a review of recent fiscal and monetary policy 
actions and related economic developments. The chapter goes on to 
present the Administration's economic assumptions for the 2004 Budget 
and compares them with the projections of the Congressional Budget 
Office and private-sector economists. The Administration's assumptions 
are close to those of the other forecasters. Consequently, the 
assumptions provide a sound and prudent basis for the budget 
projections. The subsequent sections of the chapter describe the 
revisions to the economic assumptions since last year's Budget and how 
changes in the assumptions, policies and technical factors since last 
year have affected the budget outlook. The next section presents 
cyclical and structural components of the budget balance. The chapter 
concludes with estimates of the sensitivity of the budget to changes in 
economic assumptions.

                             Policy Actions

  Fiscal Policy: In June 2001 the President signed into law the Economic 
Growth and Tax Relief Reconciliation Act (EGTRRA). The Act was designed 
to provide long-term benefits to the economy. It provided for a phase-in 
of tax relief over several years, thereby reducing disincentives in the 
tax system and making it more conducive to work, saving, and investment. 
Although focused on the long-term, EGTRRA also turned out to be the 
appropriate policy from a cyclical perspective. By providing significant 
immediate tax relief to all income tax payers early on in the recession, 
EGTRRA helped minimize the depth and the duration of the downturn.
  Because of EGTRRA, beginning in July 2001, 86 million taxpayers were 
sent rebate checks totaling $36 billion. This sum reflected the creation 
of a new, lower 10 percent tax bracket. At the same time, income tax 
withholding schedules were reduced to incorporate the first stage of a 
multi-year lowering of marginal income tax rates for those in the 28 
percent tax bracket and higher. In January 2002, withholding schedules 
were lowered to incorporate the new 10 percent tax bracket.
  In addition to lowering income tax rates, EGTRRA phased in reductions 
in the marriage penalty, increased the Child Tax Credit, included 
measures to promote saving for education and retirement, and phased out 
the taxation of estates and gifts. All in all, EGTRRA lowered tax 
liabilities by about $56 billion in calendar year 2001, $78 billion in 
2002, and $80 billion in 2003. The next two stages of the phase-in of 
marginal tax rate reductions under EGTRRA were scheduled for January 
2004 and 2006.
  In March 2002, the President signed the Job Creation and Worker 
Assistance Act to support the nascent and still vulnerable recovery. The 
Act promoted business investment and assisted unemployed workers. The 
Act allows businesses to expense 30 percent of the value of qualified 
new capital assets, including equipment and software, for a limited time 
ending on September 11, 2004. The remaining 70 percent is depreciated 
according to existing schedules. The expensing provisions pro

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vide a temporary incentive for businesses to invest during the first 
fragile years of the expansion. The Act also provided up to 13 weeks of 
additional unemployment benefits for those who had exhausted their 
regular State unemployment insurance benefits.
  On January 7, 2003, the President proposed a substantial new growth 
and jobs creation package to strengthen the Nation's economic security 
by insuring that the economy quickly achieves strong, self-sustaining 
growth. The plan reduces income taxes and lowers the cost of capital to 
business. Combined, the components of the package will raise after-tax 
incomes of households, increase consumer spending, improve consumer and 
investor confidence, support the stock market, and stimulate business 
investment. Over fiscal years 2003-2013 inclusive, the package is 
estimated to provide $671 billion in tax relief. In addition, the 
package provides $3.6 billion during 2003-2004 to help unemployed 
workers find new jobs. The extension of unemployment insurance, called 
for by the President and passed by Congress in early January, provides 
unemployed workers who have exhausted their normal benefits about $7 
billion in additional benefits in 2003.
  The package accelerates to the beginning of 2003 tax relief that was 
scheduled to occur over the next several years under provisions of 
EGTRRA. These include: reductions in marginal income tax rates and the 
marriage tax penalty, an increase in the Child Tax Credit to $1,000 from 
$600 currently, and an increase in the upper income threshold for the 
lowest 10 percent tax rate so that some income would be subject to that 
low rate rather than at the next higher rate of 15 percent.
  In addition, the package excludes dividend income from individual 
taxable income, thereby eliminating the unfair and distortionary double 
taxation of dividend income that now occurs because dividends are taxed 
both at the corporate level and again at the individual taxpayer level. 
Also, the package increases the Alternative Minimum Tax (AMT) exemption 
amount for married joint filers by $8,000 and for single filers by 
$4,000. (The AMT is a parallel tax system using a broader tax base and 
lower tax rates than the regular income tax. Taxpayers pay the higher of 
their tax liability as determined in the regular income tax and the AMT 
calculations.) The AMT exclusion needs to be raised in tandem with the 
proposed tax relief in order to make sure that taxpayers do not lose 
some of their potential tax relief because they would become subject to 
the AMT. Finally, the proposal increases the amount of investment 
purchases a small business can deduct immediately from $25,000 to 
$75,000, thereby reducing the true cost of investment.
  All told, the tax relief would reduce calendar year 2003 tax 
liabilities by an estimated $98 billion. This would add directly to 
households' purchasing power this year. Soon after enactment of this 
legislation, the $400 increase in the Child Tax Credit for 2003 would be 
mailed out as checks to eligible families. Also, new payroll withholding 
schedules would take effect that incorporate the lower marginal tax 
rates, providing an immediate boost to employees' take-home pay.
  The benefits of the proposed tax relief would also add to purchasing 
power in the spring of 2004 when taxpayers file their 2003 income tax 
returns and receive their refunds or make any additional tax payments. 
The tax relief from the dividend exclusion will show up at that time. 
Similarly, some of the reduction in tax liability on wage income will 
take the form of bigger tax refunds or smaller tax payments when 2003 
income taxes are filed. That is because the new withholding schedules 
will only affect pay received after those schedules are put in effect, 
which may be well into 2003. Wages received earlier in 2003 will have 
been withheld based on the current higher tax rates, creating over-
withholding on some 2003 wages. While some wage earners may adjust their 
withholding later in the year so that their 2003 liabilities and 
withholdings more nearly balance out, for many taxpayers the correction 
for overwithholding will occur when they file their 2003 income taxes.
  In addition to creating growth and jobs, the President's package also 
assists unemployed workers in two ways. First, because the extension of 
unemployment insurance passed in March 2002 had expired, the President's 
plan included a call for Congress to extend Federal unemployment 
insurance (UI) benefits to those workers who exhausted their regular 
State benefits. In early January, Congress passed and the President 
signed legislation that will provide up to 13 weeks of additional 
benefits; for the unemployed in States with relatively high unemployment 
rates, the extension will cover up to 26 weeks.
  Second, the growth and jobs creation package includes Personal Re-
employment Accounts, a new form of job assistance. The package provides 
$3.6 billion to create individual accounts of up to $3,000 for each 
eligible individual. Recipients can use the funds to aid their job 
search or training and, significantly, recipients get to keep any funds 
not used if they get a job within 13 weeks. Thus, there is a new 
incentive for eligible UI beneficiaries to find work quickly and get off 
of the UI rolls sooner.
  Monetary Policy: As it became clear early in 2001 that the economy had 
begun to falter, the Federal Reserve reduced the federal funds rate 
sharply, from 6\1/2\ percent at the start of the year to 3\1/2\ percent 
by early September. After the terrorist attacks of September 11th, the 
Federal Reserve further cut the funds rate to 1\3/4\ percent by December 
2001 while making sure that there was enough financial liquidity to keep 
the economy going in the aftermath of September 11th. The 1\3/4\ funds 
rate was maintained for almost a year until November 2002, when it was 
reduced further to 1\1/4\ percent and held at that low level into 2003. 
Very low and falling inflation during the past two years has enabled the 
Federal Reserve to ease monetary policy substantially without fear of 
igniting inflation.
  Short-term interest rates fell sharply in response to the Federal 
Reserve's actions. At the end of 2002, the

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3-month Treasury bill rate was a mere 1.2 percent, down sharply from 5.7 
percent two years earlier. Short-term private sector rates fell in 
parallel. Adjusted for inflation, short-term interest rates during 2002 
were close to zero.
  As is usually the case, the change in rates at the longer-end of the 
maturity spectrum was not as large as at the short end; the declines, 
however, were still substantial and brought long-term rates to the 
lowest levels since the 1960s. At the end of 2002, the yield on the 10-
year Treasury note was 3.8 percent, down from 5.1 percent at the end of 
2000. This is the lowest level in four decades. The rate on conventional 
30-year mortgages ended the year under 6 percent, also the lowest level 
since the mid-1960s. Because of heightened uncertainties in the 
corporate sector, the yield on corporate bonds did not fall quite as far 
as Treasury and mortgage rates, but for well-rated companies they were 
still down to the lowest levels since the late 1960s. The yields on 
below-investment-grade bonds, however, were no lower at the end of 2002 
than they were two years earlier. The risk premium on lower quality debt 
increased substantially during 2002, in part because of the bankruptcy 
of several large, well-regarded companies; some, but not all of these, 
had been tainted by accounting scandals.

                       Slower-Than-Usual Recovery

  The contraction of real Gross Domestic Product (GDP) during the 2001 
recession was relatively mild. From its peak in the fourth quarter of 
2000 to its low point in the third quarter of 2001, real GDP fell by 
just 0.6 percent. By comparison, the average decline in real GDP during 
the prior seven recessions was 2.3 percent. During the first four 
quarters of this recovery, however, real GDP rose only 3.3 percent, 
about half the 6.0 percent average gain during the comparable periods of 
the prior seven recoveries. It is not unusual for mild recessions to be 
followed by subpar recoveries, but this recovery has also been held back 
by a number of extraordinary factors unique to this cycle.
  Stock Market Collapse: The stock market fell sharply during 2002, in 
marked contrast to the strong gains usually recorded in the first year 
of past economic recoveries. During 2002, the S&P 500 dropped 23 
percent, bringing its total fall since the March 2000 market peak to 42 
percent. The technology-laden NASDAQ fell by a similar amount in 2002, 
but its cumulative loss since March 2000 reached nearly 75 percent. 
Three consecutive years of falling markets is unprecedented in the post-
World War II experience, but so too were the record gains set in the 
prior five years. From the start of the bull market at the end of 1994 
to its peak in March 2000, the S&P 500 tripled and the NASDAQ increased 
six fold.
  In dollar terms, the collapse of equity values since March 2000 
reduced household wealth by about $6\3/4\ trillion, eliminating nearly 
two-thirds of the equity gain during the bull market of the last half of 
the 1990s. While the strong rise in the value of household-owned real 
estate last year supported household wealth and spending, it was not 
nearly enough to offset the restraint on consumer spending resulting 
from falling equities.
  In addition to the negative effect on consumer spending, the declining 
stock market restrained business investment by increasing the cost of 
capital. Federal and State government revenues were also hurt by the 
slumping stock market's effect on income and capital gains tax receipts. 
In response, States took a variety of measures to balance their budgets, 
including restraining spending growth.
  Based on past relationships between equity wealth and spending, the 
cumulative loss in equity wealth may have reduced real GDP growth during 
2002 by almost 2 percentage points. This estimate does not include the 
fiscal and monetary policy responses that were taken to stimulate the 
sluggish expansion.
  Falling Confidence: Usually, consumer and investor confidence 
strengthen as a recovery takes hold; during 2002, however, they 
weakened. By year-end, surveys revealed that the level of confidence was 
lower than at the start of the year. Confidence was shaken by a wide 
range of economic and non-economic factors. Consumers were especially 
concerned about the weak labor market as the expansion generated 
relatively few new jobs. Investors' confidence was shaken by their 
falling equity wealth and by accounting scandals at several major 
corporations that revealed huge over-statements of earnings.
  A number of large, once well-regarded firms filed for bankruptcy, some 
in the aftermath of accounting scandals. In related developments, 
serious questions were raised about conflicts of interest at several 
accounting and Wall Street brokerage firms that could have resulted in 
investors receiving inaccurate and misleading reports on businesses' 
financial condition. In response to the scandals, in July the President 
signed the Sarbanes-Oxley Act to make wide-ranging reforms of corporate 
governance; in August, the Securities and Exchange Commission required 
major firms to re-examine their financial statements and certify their 
accuracy; and in December ten major Wall Street firms paid a total of 
$1.4 billion to Federal, State and industry regulators and agreed to 
reform their stock advisory functions to avoid conflicts of interest 
with other activities of the firms.
  Among the non-economic factors depressing confidence and restraining 
economic activity were concerns about the possibility of further 
terrorist attacks. The leisure and airline industries were especially 
affected by such fears. Business investment in new structures, which 
fell throughout 2002, was depressed, in part by the difficulty of 
obtaining insurance against the risk of terrorist-caused damages. In 
November, the President signed both the Terrorism Risk Insurance Act to 
provide coverage for catastrophic losses from potential terrorist 
attacks and the Homeland Security Act. The Homeland Security Act 
reorganized 22 Federal agencies across the government into a single 
department to im

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prove the government's ability to deal more effectively with the threat 
of terrorism in the United States. Near the turn of the year, the 
possibility of armed conflict with Iraq and its possible consequences 
also raised concerns among consumers and investors.
  Worldwide Slowdown: In the past, recovery in the United States was 
often aided by concurrent expansions in other industrialized economies. 
That was not the case in 2002. Most of our major trading partners were 
either in recession or were suffering from very slow growth. As a 
result, U.S. exports were restrained by weak growth of demand abroad. 
The U.S. manufacturing sector is heavily dependent on export sales and 
was especially hard-hit by the overseas slowdown. According to forecasts 
by the Organization for Economic Cooperation and Development (OECD), in 
2002 real GDP grew only 1.1 percent in the member states of the OECD 
aside from the United States. Output in Japan, the world's second 
largest economy, fell for the second consecutive year. In the European 
Union, growth was forecast to be only 0.9 percent. Among the larger OECD 
countries, only Canada had faster growth than the U.S. last year. 
Although some nations took actions during the year to stimulate their 
flagging economies, it is likely that additional measures will be needed 
to restore healthy growth in our trading partners.
  U.S. export sales were also dampened, and imports fostered, by the 
lagged effects of the appreciation of the dollar during 2000-2001 when 
the trade-weighted value of the dollar rose 15 percent against major 
foreign currencies. During 2002, the dollar fell, returning it to the 
mid-2000 level. The decline in the dollar will help make U.S. producers 
more competitive here and abroad. Despite last year's slow growth here, 
falling U.S. stock market, and sliding dollar, the United States 
remained a relatively favorable outlet for foreign savings, especially 
in light of the weaker growth and sharply falling stock markets abroad.
  Leaders and Laggards: The subpar expansion reflected moderate growth 
in the economy's leading sectors and continued restraint on growth from 
the lagging sectors. Households were willing to spend, especially when 
they perceived a bargain, such as zero percent car financing and 
extensive sales at Christmas time. Nonetheless, the pace of consumer 
spending, a leading factor in this upturn, was less than usual for a 
recovery. During the first year of prior expansions, consumer spending 
adjusted for inflation rose 4.9 percent on average. By contrast, during 
the first four quarters of this expansion, from the fourth quarter of 
2001 through the third quarter of 2002, real consumer spending rose 3.8 
percent. Growth of consumer spending appears to have slowed considerably 
in the fourth quarter of last year judging by the partial information 
now at hand. (As of this writing, the official estimates of fourth 
quarter GDP and its components are not available.)
  Housing was also an important leading sector in the recovery last 
year, aided by the lowest mortgage rates since the mid-1960s. Housing 
starts for 2002 reached a 16-year high; new and existing home sales 
reached the highest level on record. The increase in demand pushed up 
prices significantly and reduced the inventory of unsold new homes to 
historically low levels.
  In contrast to consumption and housing, real business capital spending 
was a significant restraint on growth, falling 5.1 percent during the 
first four quarters of the recovery. In contrast, during the comparable 
period in the past seven expansions investment increased 5.8 percent on 
average. This time, investment in new structures declined in each 
quarter, while investment in equipment and software turned positive only 
by the third and fourth quarters of the expansion. It is not unusual for 
business investment to lag as the economy begins to recover. However, in 
this upturn, the turnaround in investment has been unusually delayed and 
weak.
  Business inventory investment swung from liquidation at the start of 
the expansion to moderate restocking by the fourth quarter of the 
recovery. Overall, inventory investment made a moderate contribution to 
GDP growth during the first year of the expansion. Businesses remained 
cautious in their inventory management, however, and the ratio of 
inventories to sales remained low by historical standards.
  The impetus to growth from increased inventory investment was just 
about offset by the deterioration in the foreign trade balance. Real 
exports of goods and services rose a moderate 2.8 percent while imports 
soared 6.7 percent. The surge in imports meant that a significant 
portion of the increase in U.S. demand last year was supplied by foreign 
producers. The widening trade deficit caused by slow growth abroad and 
the lagged effects of an earlier rise in the dollar pushed the current 
account deficit to a record of nearly 5 percent of GDP.
  Government purchases added a little less than one percentage point to 
GDP growth during the first year of the expansion. Federal spending, 
primarily on defense, accounted for about half of this. The contribution 
from State and local governments waned during the year as these 
governments, which are required to balance their budgets, cut back on 
spending growth in the face of an unanticipated decrease in receipts.
  Unemployment and Inflation: The weak expansion, combined with strong 
productivity growth, resulted in net job losses last year. There were 
180,000 fewer jobs at the end of 2002 than at the end of 2001; 
manufacturing employment was down by almost 600,000. The unemployment 
rate finished the year at 6.0 percent, compared with 5.8 percent at the 
end of 2001. The rise in the unemployment rate would have been greater 
except that it was limited by a very slow rise in the labor force as the 
weak job market caused some potential workers to leave the labor force.
  Virtually all of the increase in output during the first year of the 
expansion was accounted for by rising output per hour. Total hours 
worked in the economy barely increased. During this first year, output 
per hour in the nonfarm business sector rose 5.6 percent, the

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best four-quarter performance since 1973. In the long-run, strong 
productivity growth is a very healthy development for the economy 
because it increases the Nation's potential output and our standard of 
living. In the short-run, however, if GDP growth is subpar, then strong 
productivity growth results in little, if any, job growth.
  Inflation, which was already low at the end of the recession, slowed 
further last year as the subpar recovery created additional slack in 
labor and product markets. During the four quarters of 2002, the core 
Consumer Price Index (CPI), which excludes the volatile food and energy 
components, rose a mere 2.0 percent, down from 2.7 percent during 2001. 
The overall CPI rose 2.2 percent last year, slightly faster than the 
core CPI because of a pickup in energy prices, which more than offset 
slow growth of food prices. The GDP chain-weighted price index, a more 
comprehensive measure of overall inflation that includes purchases of 
businesses, governments, and consumers, rose between 1 and 2 percent at 
an annual rate in each quarter of 2002. Overall CPI inflation in the 
range of 1 to 2 percent is consistent with the goal of price stability. 
Low inflation has enabled the Federal Reserve to pursue a growth-
promoting monetary policy.

                          Economic Projections

  The Administration's economic projections are summarized in Table 2-1. 
These economic assumptions are prudent and close to those of the 
Congressional Budget Office and the consensus of private sector 
forecasters, as described in more detail below.
  The Budget assumptions strike a balance between upside and downside 
risks. On the upside, real GDP growth may be greater than projected if 
the response of consumers, businesses, and investors to the growth and 
jobs creation package quickly sets the economy onto a strong expansion 
path. In addition, if the favorable productivity performance of recent 
years continues unabated, then long-run growth may be stronger than 
assumed here. On the other hand, the restraining forces that contributed 
to weak growth near the end of last year may take longer than assumed to 
dissipate. The Budget assumptions take a cautious view of these risks to 
avoid an over-estimation of available budgetary resources. 

                                                          Table 2-1.  ECONOMIC ASSUMPTIONS \1\
                                                      (Calendar years; dollar amounts in billions)
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                                                                                                          Projections
                                                            Actual   -----------------------------------------------------------------------------------
                                                             2001        2002        2003        2004        2005        2006        2007        2008
--------------------------------------------------------------------------------------------------------------------------------------------------------
Gross Domestic Product (GDP):
  Levels, dollar amounts in billions:
    Current dollars.....................................      10,082      10,442      10,884      11,447      12,031      12,637      13,263      13,919
    Real, chained (1996) dollars........................       9,215       9,440       9,710      10,061      10,414      10,760      11,102      11,446
    Chained price index (1996=100), annual average......       109.4       110.6       112.1       113.8       115.5       117.4       119.4       121.6
  Percent change, fourth quarter over fourth quarter:
    Current dollars.....................................         2.0         4.2         4.8         5.2         5.0         5.0         4.9         5.0
    Real, chained (1996) dollars........................         0.1         2.9         3.4         3.6         3.4         3.3         3.1         3.1
    Chained price index (1996=100)......................         2.0         1.2         1.4         1.5         1.6         1.7         1.8         1.8
  Percent change, year over year:
    Current dollars.....................................         2.6         3.6         4.2         5.2         5.1         5.0         5.0         4.9
    Real, chained (1996) dollars........................         0.3         2.4         2.9         3.6         3.5         3.3         3.2         3.1
    Chained price index (1996=100)......................         2.4         1.1         1.3         1.5         1.5         1.7         1.7         1.8

Incomes, billions of current dollars:
    Corporate profits before tax........................         670         659         771         830       1,069       1,069       1,085       1,120
    Wages and salaries..................................       4,951       5,021       5,275       5,575       5,870       6,159       6,450       6,757
    Personal dividend income............................         409         434         450         470         477         497         526         567
    Other taxable income \2\............................       1,957       1,979       1,986       2,067       2,116       2,170       2,230       2,295

Consumer Price Index (all urban): \3\
    Level (1982-84=100), annual average.................       177.1       179.9       183.8       187.6       191.5       195.7       200.0       204.5
    Percent change, fourth quarter over fourth quarter..         1.9         2.3         2.0         2.1         2.1         2.2         2.2         2.3
    Percent change, year over year......................         2.8         1.6         2.2         2.1         2.1         2.2         2.2         2.3

Unemployment rate, civilian, percent:
    Fourth quarter level................................         5.6         5.8         5.6         5.3         5.1         5.1         5.1         5.1
    Annual average......................................         4.8         5.8         5.7         5.5         5.2         5.1         5.1         5.1

Federal pay raises, January, percent:
    Military \4\........................................         3.7         6.9         4.7           *          NA          NA          NA          NA
    Civilian \5\........................................         3.7         4.6         3.1           *          NA          NA          NA          NA

Interest rates, percent:
    91-day Treasury bills \6\...........................         3.4         1.6         1.6         3.3         4.0         4.2         4.2         4.3
    10-year Treasury notes..............................         5.0         4.6         4.2         5.0         5.3         5.4         5.5         5.6
--------------------------------------------------------------------------------------------------------------------------------------------------------
NA = Not Available; * = (see note below).
\1\ Based on information available as of late November 2002.
\2\ Rent, interest and proprietor's components of personal income.
\3\ Seasonally adjusted CPI for all urban consumers.
\4\ Percentages apply to basic pay only; 2002 and 2003 figures are averages of various rank- and longevity-specific adjustments; pay raises for 2004
  range from 2.0 to 6.25 percent, depending on rank and longevity; percentages to be proposed for years after 2004 have not yet been determined.
\5\ Overall average increase, including locality pay adjustments. The increase for 2004 (which would also apply also to uniformed services other than
  armed forces) would be 2.0 percent. Percentages to be proposed for years after 2004 have not yet been determined.
\6\ Average rate, secondary market (bank discount basis).

  Real GDP: The pace of economic activity is expected to gather momentum 
during 2003 with real GDP projected to rise 2.9 percent on a calendar 
year basis in 2003, up from 2.4 percent in 2002. During the next few 
years, real growth is projected to exceed the Nation's long-term 
potential, which is estimated at 3.1 percent. The unemployment rate is 
expected to decline until it reaches a sustainable level of 5.1 percent 
in the fourth quarter of 2005.
  The largest contributions to growth in the near-term are expected to 
come from consumer spending and business fixed investment. The 
President's growth package will increase after-tax incomes of families, 
and thereby boost spending, by accelerating reductions in marginal tax 
rates and the marriage tax penalty, increasing the Child Tax Credit, and 
raising the upper threshold of the 10 percent income bracket so that 
less income is taxed at the 15 percent rate. The exclusion of dividends 
from taxation will increase after-tax incomes and will likely support 
the stock market. Any resulting increase in equity wealth would 
contribute both to near-term spending and to saving available for 
retirement. The dividend exclusion will also lower the cost of capital 
to business and thereby raise business investment. As the expansion 
picks up speed, the usual virtuous circle of more jobs, more spending, 
and more capital investment will be firmly established.
  Residential investment, which was already at a very high level in 
2002, is unlikely to rise further. Consequently, its contribution to GDP 
growth may be quite small in the next few years. A positive contribution 
to growth from net exports may be delayed a few years until such time as 
there is stronger growth abroad.
  The Federal, State, and local government contribution to GDP growth is 
also likely to be quite modest in the next few years. At the Federal 
level, growth of spending on security requirements is expected to be 
accompanied by more moderate growth in other spending. At the State and 
local level, outlays will be restrained by the need to restore budget 
balance in the face of very weak receipts growth.
  Potential GDP: The growth of potential GDP is assumed to be 3.1 
percent per year. Potential growth is approximately equal to the sum of 
the trend growth rates of the labor force and of productivity. The labor 
force is projected to grow 1.0 percent per year on average; the trend 
growth of productivity is assumed to be 2.2 percent. This rate of 
productivity growth is equal to the average growth experienced from the 
business cycle peak in 1990 through the third quarter of 2002, but it is 
slower than the 2.6 percent rate achieved during the past seven years. 
The underlying trend of productivity growth, and therefore potential 
growth, may turn out to be higher than assumed, especially if business 
investment responds rapidly to the improving economy. In the interest of 
prudent budget forecasting, however, a more cautious assumption appears 
warranted.
  Inflation and Unemployment: Inflation is projected to remain low. The 
CPI is expected to increase 2.2 percent on a calendar year basis in 
2003, rising gradually to 2.3 percent in 2008. The GDP chain-weighted 
price index is projected to edge up 1.3 percent this year, rising to 1.8 
percent annually in 2008. The outyear inflation rates are slightly lower 
than the average rates of the past decade: 2.6 percent yearly for the 
CPI and 1.9 percent for the GDP inflation measure.
  The slower rise of prices projected during the next six years relative 
to the prior decade is the result of very low inflation at this stage of 
the expansion and the downward pressure on wages and prices that will 
remain until the excess slack in labor and capital resources is 
eliminated by the growing economy. The unemployment rate, which reached 
6.0 percent in Decem

[[Page 26]]

ber 2002, is projected to decline gradually to 5.1 percent. This rate is 
the center of the range around the unemployment rate that is consistent 
with stable inflation. Similarly, the low capacity utilization rate in 
manufacturing, at about 74 percent in the last quarter of 2002, will 
exert further downward pressure on prices and it will take a few years 
for this effect to abate.
  The one-half percentage point faster rise in the CPI than in the GDP 
inflation measure is consistent with historical experience. The CPI 
tends to rise faster than the GDP measure in part because computer 
prices, which have been falling sharply, have a larger weight in GDP 
inflation which includes computer purchases of government, business, and 
consumers. Also, the CPI uses a fixed market basket for its weights, 
while the GDP measure uses current, ``chain'' weights. As such, the CPI 
does not fully reflect the reallocation of purchases that occurs in 
response to changing relative prices that is reflected in the GDP 
inflation measure. This source of upward bias to the CPI has been 
eliminated in a new supplemental series, the Chained Consumer Price 
Index for All Urban Consumers, that uses chain weights. This alternative 
measure of consumer price inflation is likely to increase more in line 
with the GDP measure than the conventional CPI.
  Interest Rates: Interest rates are projected to rise with the 
resumption of strong, self-sustaining growth. The 3-month Treasury bill 
rate, at 1.2 percent at the end of last year, is expected to rise to 4.3 
percent over the next six years. As is usually the case when credit 
demands increase as growth accelerates, the increase at the longer end 
of the maturity spectrum is likely to be smaller than at the short end. 
The yield on the 10-year Treasury note, which was 3.8 percent at the end 
of 2002, is projected to rise to 5.6 percent by 2008. Adjusted for 
inflation, the outyear real interest rates are close to their historical 
averages.

[[Page 27]]

  Income Shares: The share of taxable income in nominal GDP is projected 
to rise through 2005 and decline thereafter. The wage and salary share 
is expected to rise through 2005 from its relatively low level in 2002 
as workers capture in higher wages more of the recent gains in 
productivity growth. During these years, ``other labor income,'' which 
includes employer-paid health insurance and pension contributions that 
are not part of the tax base, is likely to rise. After 2005, the wage 
share is projected to decline while an increasing proportion of labor 
compensation is accounted for by further increases in other labor 
income, essentially tax-exempt employee benefits.
  Two factors are likely to drive up the share of other labor income in 
GDP during the coming years. First, health insurance paid by employers 
is expected to continue to rise rapidly. During 2002, employer 
contributions to health insurance rose at a double-digit pace after 
increasing around nine percent in 2000 and 2001. Employers will shift 
some of the future cost increases on to employees by raising deductibles 
and co-pays; nonetheless, the increases in employers' contributions are 
likely to be significant. Second, employers' contributions to defined-
benefit pension plans are also likely to rise. The sharp fall in the 
stock market in the last three years has created underfunding in many 
plans that will have to be made up by larger contributions in the coming 
years. In addition, many plans, including those that are currently well-
funded, will have to raise contributions because of lower assumed rates 
of return on fund assets in light of the actual lower returns.
  The share of corporate profits before tax will be affected by the pace 
of economic activity and by the temporary expensing provisions of the 
Job Creation and Worker Assistance Act of 2002. The faster growth 
beginning this year is expected to increase the profits share from the 
low levels during the recession and the subpar recovery. The expensing 
provision lowers book profits through September 11, 2004 by allowing 
firms to write off more of their investment expense sooner. After the 
expiration of expensing on that date, book profits will be raised 
because the remaining depreciation on investments eligible for expensing 
will be lower. Taking these and other factors affecting book profits 
into consideration, the share of profits before tax in GDP is projected 
to rise from 6.3 percent in 2002 to a high of 8.9 percent in 2005, and 
then gradually decline to eight percent in at the end of the forecast 
horizon.
  Among the other components of taxable income, the share of personal 
interest income in GDP is projected to decline significantly, reflecting 
the lagged effects of past declines in interest rates on the average 
yield on interest-earning assets of the household sector. The shares of 
the remaining components (proprietors' income, rental income, and 
dividend income) are projected to remain stable at around their 2002 
levels. The President's growth and jobs creation package proposes to 
eliminate income taxes on dividends which have already been taxed at the 
corporate level.

            Comparison with CBO and Private-Sector Forecasts

  The Congressional Budget Office (CBO) and many private-sector 
forecasters also make projections. CBO develops its projections to aid 
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-sector forecasts.
  The three sets of economic assumptions are based on different 
underlying assumptions concerning economic policies. The private-sector 
forecasts are based on appraisals of the most likely policy outcomes, 
which vary among forecasters. The CBO baseline projection assumes that 
current law will remain unchanged. Despite their differing policy 
assumptions, the three sets of economic projections, shown in Table 2-2, 
are very close. The similarity of the Budget economic projection with 
the CBO baseline projection underscores the cautious nature of the 
Administration forecast.

                                                     Table 2-2.  COMPARISON OF ECONOMIC ASSUMPTIONS
                                                                    (Calendar years)
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                            Projections                                       Average,
                                                       -------------------------------------------------------------------------------------------------
                                                            2003          2004          2005          2006          2007          2008         2003-08
--------------------------------------------------------------------------------------------------------------------------------------------------------
Real GDP (billions of 1996 dollars):
  CBO January.........................................       9,673        10,018        10,358        10,697        11,037        11,380
  Blue Chip Consensus January \2\.....................       9,704        10,050        10,383        10,709        11,041        11,384
  2004 Budget.........................................       9,710        10,061        10,414        10,760        11,102        11,446

Real GDP (chain-weighted): \1\
  CBO January.........................................           2.5           3.6           3.4           3.3           3.2           3.1           3.2
  Blue Chip Consensus January \2\.....................           2.8           3.6           3.3           3.1           3.1           3.1           3.2
  2004 Budget.........................................           2.9           3.6           3.5           3.3           3.2           3.1           3.3

Chain-weighted GDP Price Index: \1\
  CBO January.........................................           1.6           1.7           2.0           2.1           2.1           2.2           2.0
  Blue Chip Consensus January \2\.....................           1.6           1.9           2.1           2.1           2.1           2.1           2.0
  2004 Budget.........................................           1.3           1.5           1.5           1.7           1.7           1.8           1.6

Consumer Price Index (all urban): \1\
  CBO January.........................................           2.1           2.2           2.5           2.5           2.5           2.5           2.4
  Blue Chip Consensus January \2\.....................           2.2           2.2           2.5           2.6           2.5           2.5           2.4
  2004 Budget.........................................           2.2           2.1           2.1           2.2           2.2           2.3           2.2

Unemployment rate: \3\
  CBO January.........................................           5.9           5.8           5.4           5.3           5.3           5.2           5.5
  Blue Chip Consensus January \2\.....................           5.9           5.5           5.1           5.1           5.1           5.1           5.3
  2004 Budget.........................................           5.7           5.5           5.2           5.1           5.1           5.1           5.3

Interest rates: \3\
  91-day Treasury bills:
    CBO January.......................................           1.4           3.5           4.8           4.9           4.9           4.9           4.1
    Blue Chip Consensus January \2\...................           1.6           2.9           4.2           4.4           4.6           4.4           3.7
    2004 Budget.......................................           1.6           3.3           4.0           4.2           4.2           4.3           3.6

  10-year Treasury notes: \3\
    CBO January.......................................           4.4           5.2           5.6           5.8           5.8           5.8           5.4
    Blue Chip Consensus January \2\...................           4.4           5.2           5.6           5.8           5.7           5.7           5.4
    2004 Budget.......................................           4.2           5.0           5.3           5.4           5.5           5.6           5.2
--------------------------------------------------------------------------------------------------------------------------------------------------------
Sources: Congressional Budget Office; Aspen Publishers, Inc., Blue Chip Economic Indicators
\1\ Year over year percent change.
\2\ January 2003 Blue Chip Consensus forecast for 2003 and 2004; Blue Chip October 2002 long run for 2005 - 2008.
\3\ Annual averages, percent.

  For real GDP growth, the Administration, CBO and the Blue Chip 
consensus anticipate that the pace of economic activity will accelerate 
during the next two years. For calendar year 2003, the three forecasts 
fall within the narrow range of 2.5 to 2.9 percent; for 2004, all three 
project 3.6 percent growth. The three forecasts have similar projections 
for 2005-2008.
  All three forecasts anticipate continued low inflation of around two 
percent as measured by the GDP chain-weighted price index and 2\1/2\ 
percent as measured by the CPI. The unemployment rate projections are 
also similar. All three forecasts envisage a similar path of rising 
interest rates during the next few years. For short-term rates, CBO's 
projection is slightly higher than the Blue Chip's, which is slightly 
higher than the Administration's. The three long-term interest rate 
projections are very close.

                     Changes in Economic Assumptions

  As shown in Table 2-3, the economic assumptions underlying this Budget 
have been revised significantly from those of the 2003 Budget, which 
were finalized just 2-1/2 months after the September 11th attacks. At 
that time it seemed that recovery from the attacks would be quite slow 
in coming and that it would not be until 2003 that a strong expansion 
would be well-established. In the event, the economy proved to be much 
more resilient than the Administration and other forecasters had 
anticipated.
  Real GDP growth during 2002, although relatively weak for a recovery, 
was still considerably stronger than projected in last year's Budget. 
However, by the end of last year, the current recovery appeared to be 
losing momentum, rather than gaining it as projected in last year's 
Budget. Consequently, projected real GDP growth during 2003 is now lower 
than anticipated in

[[Page 28]]

last year's Budget. From 2004 onwards, however, real GDP growth in this 
and the prior Budget are quite similar. Largely because of the better-
than-projected growth in 2002, the level of real GDP is now projected to 
be higher in each year than in last year's Budget (adjusted for 
historical revisions).
  The level of nominal GDP, however, is projected to be lower in each 
year than in last year's Budget. That is primarily because actual GDP 
inflation was lower in 2002, and is expected to be lower thereafter, 
than in last year's Budget. The unemployment rate is expected to be 
slightly higher than in last year's assumptions and ultimately to 
decline to 5.1 percent rather than 4.9 percent. Interest rates are 
projected to be lower during the next few years than was envisaged in 
last year's Budget, reflecting their current low levels. While the 
outyear short-term rate is about unchanged from last year's assumptions, 
outyear long-term rates are slightly higher. Adjusted for inflation, the 
real long-term rate is higher than in last year's Budget. 

                                       Table 2-3.  COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2003 AND 2004 BUDGETS
                                                      (Calendar years; dollar amounts in billions)
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                         2002        2003        2004        2005        2006        2007        2008
--------------------------------------------------------------------------------------------------------------------------------------------------------
Nominal GDP:
  2003 Budget assumptions \1\.......................................      10,346      10,930      11,530      12,162      12,794      13,438      14,114
  2004 Budget assumptions...........................................      10,442      10,884      11,447      12,031      12,637      13,263      13,919

Real GDP (1996 dollars):
  2003 Budget assumptions \1\.......................................       9,250       9,602       9,959      10,315      10,650      10,980      11,321
  2004 Budget assumptions...........................................       9,440       9,710      10,061      10,414      10,760      11,102      11,446

Real GDP (percent change): \2\
  2003 Budget assumptions...........................................         0.7         3.8         3.7         3.6         3.2         3.1         3.1
  2004 Budget assumptions...........................................         2.4         2.9         3.6         3.5         3.3         3.2         3.1

GDP price index (percent change): \2\
  2003 Budget assumptions...........................................         1.9         1.7         1.7         1.9         1.9         1.9         1.9
  2004 Budget assumptions...........................................         1.2         1.4         1.5         1.6         1.7         1.8         1.8

Consumer Price Index (percent change): \2\
  2003 Budget assumptions...........................................         2.4         2.2         2.3         2.4         2.4         2.4         2.4
  2004 Budget assumptions...........................................         2.3         2.0         2.1         2.1         2.2         2.2         2.3

Civilian unemployment rate (percent): \3\
  2003 Budget assumptions...........................................         5.9         5.5         5.2         5.0         4.9         4.9         4.9
  2004 Budget assumptions...........................................         5.8         5.7         5.5         5.2         5.1         5.1         5.1

91-day Treasury bill rate (percent): \3\
  2003 Budget assumptions...........................................         2.2         3.5         4.0         4.2         4.4         4.4         4.2
  2004 Budget assumptions...........................................         1.6         1.6         3.3         4.0         4.2         4.2         4.3

10-year Treasury note rate (percent): \3\
  2003 Budget assumptions...........................................         5.1         5.1         5.1         5.1         5.2         5.2         5.2
  2004 Budget assumptions...........................................         4.6         4.2         5.0         5.3         5.4         5.5         5.6
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Adjusted for July 2002 NIPA revisions.
\2\ Year over year.
\3\ Calendar year average.

             Sources of Change in the Budget since Last Year

  The sources of the change in the budget outlook from the 2003 Budget 
baseline (which excludes the effects of policy proposals) to the 2004 
Budget policy projection are shown in Table 2-4. The second block shows 
that enacted legislation reduced the pre-policy surplus of $109 billion 
for 2004 projected in the 2003 Budget by $79 billion.
  The third, fourth, and fifth blocks quantify the separate impacts on 
the budget outlook from changes in economic projections, technical 
factors, and revised historical data on GDP and taxable incomes.
  The third block shows the effects on receipts and outlays from changes 
in economic assumptions. These include the effects of changes in 
assumptions for real growth, inflation, interest rates, unemployment, 
and the growth rates of various taxable incomes.
  Technical factors (block 4) are all changes in budget estimates that 
are not due to explicit economic assumptions, revisions to historical 
economic data, or legislation. Examples of technical factors are changes 
in re

[[Page 29]]

ceipts and outlays from changes in estimating methodologies.
  Revisions in the level of historical income data affect receipts 
estimates. These effects are shown in the fifth block, which quantifies 
the impact on the budget of data revisions affecting tax bases. After 
the publication of the 2003 Budget in February 2002, the historical 
levels of profits and of wages and salaries for calendar year 2001 were 
revised down significantly. As a result of the lower historical starting 
point for the projection of incomes, the levels of the tax base in 2002 
and beyond that were assumed in the 2003 Budget were too high. The 
reduction in receipts estimates because of the lower initial level of 
the tax base (and the associated higher net interest outlays) account 
for $75 billion of the downward re-estimate of the budget baseline for 
2004.

                                 Table 2-4.  SOURCES OF CHANGE IN BUDGET TOTALS
                                            (In billions of dollars)
----------------------------------------------------------------------------------------------------------------
                                             2003        2004        2005        2006        2007        2008
----------------------------------------------------------------------------------------------------------------
 (1) 2003 Budget baseline
    Receipts............................       2,121       2,234       2,366       2,461       2,581       2,710
    Outlays.............................       2,070       2,126       2,197       2,266       2,341       2,435
                                         -----------------------------------------------------------------------
      Unified budget surplus............          51         109         169         196         240         274

 (2) Changes due to enacted legislation:
    Receipts............................         -37         -26          20          19          14          10
    Outlays.............................          64          53          49          49          54          54
                                         -----------------------------------------------------------------------
      Surplus reduction (-), enacted            -101         -79         -30         -30         -40         -44
       legislation......................

 (3) Changes due to economic
 assumptions:
    Receipts............................         -27         -30         -29         -34         -38         -36
    Outlays.............................         -26         -29         -16          -8          -3          -*
                                         -----------------------------------------------------------------------
      Surplus reduction (-), economic...          -1          -1         -13         -25         -35         -36

 (4) Changes due to technical factors:
    Receipts............................        -134         -77         -42         -11          -*           1
    Outlays.............................          21          35          35          27          29          28
                                         -----------------------------------------------------------------------
      Surplus reduction (-), technical..        -156        -112         -78         -39         -29         -27

 (5) Changes due to NIPA Revisions:\1\
    Receipts............................         -56         -70         -78         -83         -87         -92
    Outlays.............................           1           4          10          14          19          24
                                         -----------------------------------------------------------------------
      Surplus reduction (-), NIPA                -57         -75         -88         -97        -106        -116
       revisions........................

 (6) Surplus or deficit (-), 2004 Budget        -264        -158         -40           5          29          51
 baseline...............................

 (7) Changes due to 2004 Budget policy:
    Receipts............................         -31        -109        -100         -89         -71         -72
    Outlays.............................           9          40          68         116         136         169
                                         -----------------------------------------------------------------------
      Surplus reduction (-), policy.....         -40        -149        -168        -205        -207        -241

 (8) 2004 Budget totals (policy)
    Receipts............................       1,836       1,922       2,135       2,263       2,398       2,521
    Outlays.............................       2,140       2,229       2,343       2,464       2,576       2,711
                                         -----------------------------------------------------------------------
      Unified budget surplus or deficit         -304        -307        -208        -201        -178        -190
       (-)..............................
----------------------------------------------------------------------------------------------------------------
* Less than $500 million.
Note: Changes in interest costs due to receipts changes included in outlay lines.
\1\ Effect of changes in historical data on GDP and incomes in the National Income and Product Accounts (NIPA).

  Block 6 shows the 2004 Budget baseline, which is equal to block 1, 
plus all the changes in blocks 2 through 5.
  Block 7 of the table shows the budgetary effect of policies proposed 
in this Budget. These total -$149 billion in 2004.

                    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 deficit is larger (or the surplus is 
smaller) than would be the case if the unemployment rate were at the 
sustainable long-run average. The portion of the deficit (or surplus) 
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, and is called the structural deficit (or 
structural surplus).
  The structural balance can often provide a clearer understanding of 
the stance of fiscal policy than the unadjusted budget balance. That is 
because the unadjusted budget balance is affected by cyclical economic 
conditions. The structural balance, however, shows the surplus or 
deficit that 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 balance.
  The estimates of the structural balance are based on the relationship 
between changes in unemployment and real GDP growth on the one hand, and 
receipts and outlays on the other. As such, the relationships do not 
take into account other possible changes in the economy that might also 
be cyclically related. For example, the sharply rising stock market 
during the second half of the 1990s boosted capital gains-related 
receipts, and the subsequent fall in the stock market reduced receipts. 
Some of this rise and fall may have been cyclical in nature. It is not 
possible, however, to estimate

[[Page 30]]

this cyclical component accurately. As a result, both the unadjusted and 
structural balances are affected by cyclical stock market movements.
  From 1997 to 2001, the unemployment rate appears to have been lower 
than could be sustained in the long run. Therefore, as shown in Table 2-
5, in 1997 the structural deficit of $37 billion exceeded the actual 
deficit of $22 billion. Similarly, in 1998-2001, the structural surplus 
was smaller than the actual surplus, which was enlarged by the boost to 
receipts and the reduction in outlays associated with the low level of 
unemployment.
  On the other hand, in 2002, the unemployment rate was above what is 
currently thought to be the sustainable level and the actual deficit of 
$158 billion exceeded the structural deficit of $111 billion. Similarly 
in 2004, the actual deficit of $304 billion contains a cyclical 
component of about $36 billion. The structural deficit for that year is 
lower, at $272 billion. As the projected unemployment rate declines 
toward the sustainable level in the next few years, the projected 
unadjusted deficit is expected to decline to be about equal to the 
structural deficit in 2007 and thereafter.
  In the early 1990s, large swings in net outlays for deposit insurance 
(the saving and loan bailouts) had substantial impacts on deficits, but 
had little concurrent impact on economic performance. It therefore 
became customary to estimate an adjusted structural balance that removed 
deposit insurance outlays as well as the cyclical component of the 
budget balance from the actual balance. Deposit insurance net outlays 
are projected to be very small in the coming years. Therefore, the 
adjusted structural deficit and the structural deficit are nearly 
identical over 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 alter

[[Page 31]]

native 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 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)
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                1997     1998     1999     2000     2001     2002     2003     2004     2005     2006     2007     2008
--------------------------------------------------------------------------------------------------------------------------------------------------------
Unadjusted surplus or deficit (-)...........    -22.0     69.2    125.6    236.4    127.3   -157.8   -304.2   -307.4   -208.2   -200.5   -178.1   -189.6
  Cyclical component........................     15.1     47.6     69.9    106.2     49.6    -46.5    -53.9    -35.7    -18.2     -6.1     -0.5     -*.1
                                             -----------------------------------------------------------------------------------------------------------
Structural surplus or deficit (-)...........    -37.1     21.7     55.7    130.3     77.7   -111.3   -250.3   -271.7   -190.0   -194.4   -177.6   -189.6
  Deposit insurance outlays.................    -14.4     -4.4     -5.3     -3.1     -1.4  .......  .......  .......       -*  .......       -*  .......
                                             -----------------------------------------------------------------------------------------------------------
Adjusted structural surplus or deficit (-)..    -51.5     17.3     50.4    127.2     76.3   -111.3   -250.3   -271.7   -190.0   -194.4   -177.6   -189.6
--------------------------------------------------------------------------------------------------------------------------------------------------------
NOTE: The long-run sustainable unemployment rate is assumed to be 5.2% through calendar year 1998 and 5.1% 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 2003 only and the 
          unemployment rate rises by one-half percentage point more than 
          in the budget assumptions, the fiscal year 2003 deficit is 
          estimated to increase by $11.8 billion; receipts in 2003 would 
          be lower by $9.3 billion, and outlays would be higher by $2.5 
          billion, primarily for unemployment-sensitive programs. In 
          fiscal year 2004, the estimated receipts shortfall would grow 
          further to $19.4 billion, and outlays would increase by $7.3 
          billion relative to the base, even though the growth rate in 
          calendar 2004 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 growing 
          interest costs associated with larger deficits) would continue 
          to grow slightly in each successive year. During 2003-2008, 
          the cumulative increase in the budget deficit is estimated to 
          be $173 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 increase in the deficit is much 
          larger than in the first scenario. In this example, during 
          2003-2008, the cumulative increase in the budget deficit is 
          estimated to be $465 billion.
    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 2003 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 2004, outlays would be 
          above the base by $18.5 billion, due in part to lagged cost-
          of-living adjustments; receipts would rise $22.1 billion above 
          the base, however, resulting in an $3.6 billion improvement in 
          the budget balance. In subsequent years, the amounts added to 
          receipts would continue to be larger than the additions to 
          outlays. During 2003-2008, cumulative budget deficits would be 
          $38 billion smaller 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 $317 billion to outlays 
          over 2003-2008 and $428 billion to receipts, for a net 
          decrease in the 2003-2008 deficits of $111 billion. 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 largely because the gains in 
          budget receipts due to higher inflation result in higher debt 
          service savings when interest rates are assumed to be higher 
          as well (the combined case) than when interest rates are 
          assumed to be unchanged (the separate case).
    The outlay effects of a one percentage point increase in 
          interest rates alone is shown in the fifth

[[Page 32]]

          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 decrease cumulative deficits by a substantial $258 
          billion during 2003-2008. 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.

                          Table 2-6.  SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
                                            (In billions of dollars)
----------------------------------------------------------------------------------------------------------------
                                                                                                       Total of
        Budget effect            2003        2004        2005        2006        2007        2008      Effects,
                                                                                                       2003-2008
----------------------------------------------------------------------------------------------------------------
 Real Growth and Employment

Budgetary effects of 1
 percent lower real GDP
 growth:
  (1) For calendar year 2003
   only: \1\
    Receipts................        -9.3       -19.4       -21.6       -22.4       -23.2       -24.3      -120.4
    Outlays.................         2.5         7.3         7.9         9.6        11.4        13.5        52.1
                             -----------------------------------------------------------------------------------
      Increase in deficit (-       -11.8       -26.7       -29.5       -32.0       -34.6       -37.8      -172.5
       )....................

  (2) Sustained during 2003-
   2008, with no change in
   unemployment:
    Receipts................        -9.4       -30.3       -56.4       -83.6      -112.8      -144.5      -437.0
    Outlays.................        -0.1         0.2         1.9         4.6         8.3        13.5        28.4
                             -----------------------------------------------------------------------------------
      Increase in deficit (-        -9.3       -30.5       -58.3       -88.3      -121.1      -157.9      -465.4
       )....................

Inflation and Interest Rates

Budgetary effects of 1
 percentage point higher
 rate of:
  (3) Inflation and interest
   rates during calendar
   year 2003 only:
    Receipts................        11.1        22.1        22.3        20.9        21.6        22.6       120.6
    Outlays.................        10.5        18.5        16.1        13.3        12.5        12.1        83.0
                             -----------------------------------------------------------------------------------
      Decrease in deficit            0.6         3.6         6.3         7.6         9.1        10.5        37.6
       (+)..................

  (4) Inflation and interest
   rates, sustained during
   2003-2008:
    Receipts................        11.1        33.8        58.4        81.9       107.2       135.1       427.5
    Outlays.................        10.6        28.9        46.4        61.9        76.8        92.2       316.8
                             -----------------------------------------------------------------------------------
      Decrease in deficit            0.5         4.9        12.1        20.0        30.3        42.9       110.7
       (+)..................

  (5) Interest rates only,
   sustained during 2003-
   2008:
    Receipts................         1.7         4.0         5.3         5.9         6.6         7.2        30.7
    Outlays.................         8.7        21.0        30.5        36.4        41.8        47.2       185.6
                             -----------------------------------------------------------------------------------
      Increase in deficit (-        -7.0       -17.0       -25.2       -30.4       -35.3       -40.0      -154.9
       )....................

  (6) Inflation only,
   sustained during 2003-
   2008:
    Receipts................         9.4        29.7        53.0        75.7       100.2       127.5       395.5
    Outlays.................         1.9         8.1        16.4        26.6        36.7        47.6       137.4
                             -----------------------------------------------------------------------------------
      Decrease in deficit            7.5        21.6        36.6        49.1        63.5        79.8       258.1
       (+)..................

   Interest Cost of Higher
      Federal Borrowing

(7) Outlay effect of $100            0.8         2.8         4.4         4.8         5.1         5.5        23.4
 billion increase in the
 2003 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.