[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
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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
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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
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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.