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


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                        11. ECONOMIC ASSUMPTIONS

                              Introduction

  The economic outlook appears brighter now than at any time in recent 
years. Expansionary fiscal and monetary policies, combined with the 
inherent resilience of the American economy, have finally succeeded in 
overcoming the forces of restraint that have held growth back. Barring 
adverse shocks, over the near-term there is good reason to believe that 
a self-sustaining and on-going expansion is at hand, one that will 
create more jobs, more income, and more consumer spending and business 
investment.
  From a longer-term perspective, the expansion should proceed briskly 
in the years ahead due to strengthened productivity growth and 
improvements in the tax system that will make it easier for markets to 
reward work and investment. A healthy economy will raise living 
standards and shrink the budget deficit when combined with restraint in 
Federal spending.
  Economic growth began to slow in 2000 following the stock market 
downturn that began in March. The decline showed up first in 
manufacturing, where employment peaked in July 2000. The overall economy 
contracted in the third quarter of 2000, and the slowdown turned into a 
brief, mild recession in early 2001 that was over by the end of the 
year. Although the economy began to expand in the fourth quarter of 
2001, the pace of growth was initially well shy of that of a normal 
recovery and the labor market weakened further. In a typical business 
recovery, employment begins to rise soon after the recession ends, but 
in this instance payroll employment sagged for many months following the 
recession trough.
  Beginning in mid-2003, however, there were gathering signs of self-
reinforcing economic growth. In such a virtuous circle, rising 
employment adds to workers' incomes and supports consumer spending, 
which leads to additional increases in output and further gains in 
employment. Growing consumer confidence contributes to new spending and 
is further strengthened by continued growth and prosperity. Meanwhile, 
as businesses experience increased sales, orders, and profits, they are 
encouraged to boost capital spending, which creates still more jobs and 
income. Improved business conditions strengthen investor confidence in 
the economy's future, which drives up the stock market, boosting 
household wealth and reducing the cost of capital to business, which 
helps spur further growth.
  The process can continue as long as inflation and interest rates 
remain low and the economy does not bump up against supply constraints. 
With inflation and interest rates at their lowest levels in decades, 
there is good reason to expect that the strengthening economic forces 
now emerging will return the economy to high levels of labor and capital 
resource use.
  Productivity growth accelerated in the last half of the 1990s and has 
stepped up still further in the last three years. Some of the recent 
acceleration is very likely a temporary gain: cyclical pressures pushed 
firms to cut labor and other costs in the face of weak sales. Even 
taking such cyclical factors into account, however, the underlying pace 
of productivity growth appears to have improved significantly. If more 
rapid productivity growth is sustained, then future economic growth 
would be considerably stronger than most forecasters currently expect. 
Consistent with conservative forecasting, the Administration assumes 
productivity growth that is slower than recent experience and close to 
the average pace of the last four decades.
  The Administration's economic near- and medium-term projections 
reflect a reasonably sanguine view of the outlook, which is shared by 
most forecasters. The Administration's economic projections are similar 
to those of private sector forecasters and the Congressional Budget 
Office. However, after several years of generally disappointing economic 
news, it would not be surprising if the gathering positive cyclical 
forces propelled the economy forward even faster than is now generally 
anticipated.

                             Policy Actions

  Fiscal Policy: During the first three years of this Administration, 
the President proposed and Congress passed three important tax relief 
measures that have helped pull the economy out of recession and provide 
a foundation for future growth.
    In June 2001, the President signed the Economic Growth and 
          Tax Relief and Reconciliation Act (EGTRRA). It provided 
          significant income tax rate reductions including lower 
          marginal income tax rates; a reduction in the marriage tax 
          penalty; and a new, lower, 10 percent tax bracket. Beginning 
          in July 2001, 85 million taxpayers received rebate checks 
          totaling $36 billion reflecting the new 10 percent bracket. 
          The rebate and lower withholding rates bolstered consumer 
          spending at a critical juncture, helping to return the economy 
          to growth by the end of 2001.
    In March 2002, the President signed the Job Creation and 
          Worker Assistance Act (JCWAA). The main provision of JCWAA 
          reduced the tax disincentive for business to invest by 
          permitting expensing on 30 percent of the value of qualified 
          new capital assets, primarily equipment and software. This 
          expensing provision created a temporary period of lower 
          capital costs until the provision originally expired in 
          September 2004. JCWAA

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          was aimed directly at weak capital spending, a key reason why 
          the business cycle recovery was much slower than usual. The 
          Act also provided additional unemployment benefits for long-
          term unemployed workers who exhausted their regular 
          unemployment insurance benefits.
    In May 2003, the President signed another extension of 
          unemployment insurance benefits for individuals who had 
          exhausted their regular benefits. He also signed the Jobs and 
          Growth Tax Relief Reconciliation Act (JGTRRA) to provide 
          additional stimulus to the subpar recovery. This legislation:

            1) Advanced the date at which the 2001 tax bill's lower 
          marginal individual income tax rates were to take effect and 
          made them retroactive to January 2003; raised the child tax 
          credit for 2003 and 2004, with the 2003 increase given to 
          families in the form of rebate checks during the summer; 
          advanced the reduction in the marriage penalty; and raised the 
          exemption amount for the individual Alternative Minimum tax 
          (AMT) in 2003 and 2004. (Taxpayers pay the higher of their tax 
          liability as determined by the regular income tax and the AMT 
          calculation.)

            2) Reduced the individual income tax rates on dividend 
          income and capital gains. The tax bill reduced to 15 percent 
          the maximum tax rate on dividends which previously were taxed 
          at the taxpayer's marginal tax rate, and it reduced the 
          maximum tax rate on net capital gains (the excess of net long-
          term gains over net short-term losses) from 20 percent to 15 
          percent. Tax rates on capital income were also reduced for 
          those lower income families paying less than the maximum rate. 
          The reductions in the tax rates on capital gains and dividends 
          reduced a longstanding distortion in the tax code: the double 
          taxation of corporate earnings that had lowered business 
          investment and biased corporate financing against equity and 
          in favor of debt.

            3) Raised the expensing provision of the 2002 tax bill from 
          30 percent to 50 percent and extended the window for eligible 
          investments from September 11, 2004 to the end of the year. 
          Also, the maximum amount of new investment that a small 
          business can expense was raised from $25,000 to $100,000.
  All told, the three tax relief bills provided $68 billion in tax 
stimulus in fiscal year 2001, $89 billion in 2002, $159 billion in 2003, 
$272 billion in 2004, and $171 billion in 2005. The total stimulus, 
including assistance to States and long-term unemployed workers, was 
even larger.
  Tax relief played a crucial role in ending the 2001 recession and then 
invigorating the recovery. It took two years, but the stimulus in the 
tax bills is finally producing the rapid economic growth that the 
economy needs and that will eventually generate new jobs and higher 
incomes. In addition to the near-term stimulus, the 2001 and 2003 Acts 
also made fundamental improvements in the Nation's tax system that will 
raise the long-term level of economic activity by reducing the 
disincentives and distortions in the system.
    The reductions in marginal tax rates mean that individuals, 
          sole proprietorships, and partnerships will have more 
          incentive to produce more, earn more, save more, and invest 
          more.
    Lower tax rates on dividends and capital gains will lower 
          the after-tax cost of purchasing capital equipment and 
          software, thus raising the rate of investment. Lower tax rates 
          will also shift investment to more productive uses by reducing 
          distortions in the pattern of investment caused by the tax 
          system. By reducing the bias in favor of debt over equity 
          finance, lower tax rates on dividends and capital gains will 
          encourage corporations to maintain stronger balance sheets.
    The reduction in the individual capital gains tax rates will 
          encourage more high-risk, high-payoff investments essential to 
          maintaining a dynamic economy and ensuring U.S. 
          competitiveness in the world economy.
    Lower tax rates on capital income will help raise asset 
          values and thereby improve household and business balance 
          sheets.
  The short-term benefits of fiscal stimulus are already evident in the 
quick end to the recession in 2001 and the further surge in economic 
growth that occurred in the second half of 2003. The tax cuts have 
helped to transform an ailing economy into a healthier one. The longer-
term benefits from an improved tax system will be evident in the years 
ahead as new incentives alter the behavior of individuals and businesses 
in ways that augment economic growth.
  Monetary Policy: Since early 2001 the Federal Reserve has aggressively 
pursued a policy aimed at restoring strong, self-sustaining growth. As 
it became clear that the abrupt slowing of growth in late 2000 would 
likely turn into a recession in early 2001, the Federal Reserve cut the 
federal funds rate sharply. Eventually, it lowered this key interest 
rate eight times, bringing it down from 6\1/2\ percent at the start of 
2001 to 3\1/2\ percent by August. In the months following the terrorist 
attacks of September 11th, the Federal Reserve cut the rate four more 
times bringing it to just 1\3/4\ percent by the end of the year, the 
lowest level since the early 1960s.
  As the economy began to expand beginning in the fourth quarter of 
2001, the Federal Reserve held the federal funds rate constant, but as 
the pace of growth proved disappointing and payrolls continued to 
contract, the Federal Reserve reduced the funds rate to 1\1/4\ percent 
in November 2002 and to 1 percent in June 2003. Even as growth 
accelerated in the second half of 2003, the Federal Reserve indicated 
that it intended to maintain an accommodative monetary policy for a 
considerable period of time.
  At the longer end of the maturity spectrum, interest rates declined 
sharply in late 2000 as markets perceived the slowdown in the economy. 
They remained

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about unchanged during 2001, and then resumed their decline in 2002 and 
the first half of 2003. At its low point in June 2003, the yield on the 
10-year Treasury note fell to 3.1 percent, three percentage points below 
its level three years earlier and the lowest level since the late 1950s. 
The yield rose during the second half of 2003 and finished the year at 
4.3 percent. With the exception of the past year and a half, this is the 
lowest level for the 10-year note since 1965.
  The decline in long-term interest rates that continued until mid-2003 
reflected slack credit demand, a reduction in inflation and in inflation 
expectations, and the easing of monetary policy. The final phase of the 
decline in rates in May through June 2003 also reflected some apparent 
confusion in financial markets regarding the Federal Reserve's 
intentions. The rise in long-term rates during the second half of 2003 
reflected a better understanding by market participants of Federal 
Reserve policy, along with the pickup in economic activity, and the 
expectation of further strengthening of the expansion in 2004.
  The trend in yields on long-term private sector instruments was 
similar to that of Treasury notes, declining to very low levels by mid-
2003 and then rising to still relatively low levels by year's end. The 
yield on corporate AAA bonds closed the year at 5.6 percent, the lowest 
level since 1967. The rate on 30-year fixed rate mortgages finished the 
year at 5.8 percent, the lowest level since the early 1960s.

                           Recent Developments

  The economic expansion that began in late 2001 was restrained by a 
number of special factors. The stock market decline, which lasted from 
early 2000 until early 2003, was much longer--and much steeper--than in 
a typical business cycle. The market decline was prolonged by the 
corporate accounting scandals in 2002 that shook investor confidence. 
The erosion of consumer confidence was another negative factor that 
persisted until early 2003, well beyond the normal cyclical correction. 
Confidence was sapped not only by economic conditions in 2001-2002, but 
also by the terrorist attacks on September 11, 2001, and subsequent 
developments in the War on Terror which periodically heightened anxiety. 
Another factor holding back growth was the business capital stock 
overhang that had emerged in late 2000 and needed to be worked off. The 
overhang held down investment spending until mid-2003. Finally, slow 
growth, or even recession, in other leading industrial nations curtailed 
U.S. exports.
  These obstacles to growth had been overcome or greatly reduced by mid-
2003. The stock market was on the rise again as the uncertainties 
surrounding the 2002 accounting scandals subsided and new legislation 
passed in 2002 led to wide-ranging reforms of corporate governance. 
Consumers and investors became more optimistic as the Administration and 
the American people together successfully met the domestic and 
international threats to the Nation's security at home and overseas. 
Businesses had largely eliminated the excess capital stock by mid-2003, 
and investment began increasing again. Growth abroad also picked up 
modestly. The attenuation of these special factors permitted the highly 
stimulative fiscal and monetary policies put in place in 2001-2003 to 
operate to full effect, restoring the economy to a healthy growth rate.
  The economy surged in the third quarter of 2003 as real GDP growth 
soared to an 8.2 percent annual rate, the fastest quarterly advance 
since 1983. Growth in the fourth quarter undoubtedly moderated from this 
stellar pace, but it appears to have remained robust. (The official 
estimate of fourth quarter growth was not available until after the 
Budget had gone to press.)
  A telling indication that the expansion has become healthier and more 
self-sustaining is the more balanced mix of the growth of GDP 
components. Unlike the initial phase of the expansion, which was 
dominated by consumer and Government spending, growth is now being 
propelled by business and consumer spending as Government spending 
growth slows.
  Components of Aggregate Demand: Business investment in equipment and 
software, adjusted for inflation, increased at an 18 percent annual rate 
in the third quarter, the fastest growth in 5\1/2\ years. Rising 
shipments of nondefense capital goods in October and November suggest 
that equipment investment made a substantial contribution to GDP growth 
in the fourth quarter as well. Business investment in structures has 
leveled off instead of declining as it had earlier. Given the usual 
lags, an upturn in spending on structures is increasingly likely this 
year.
  The stalwart of the expansion has been consumer spending, and it 
continued to expand rapidly at nearly a 7 percent annual rate in the 
third quarter. Consumption probably remained strong in the fourth 
quarter, as well. Individuals' discretionary spending, such as for new 
cars, has been especially robust. Residential investment has been the 
other mainstay of the expansion so far, spurred by relatively low 
mortgage rates. Residential investment spending rose at over a 20 
percent rate in the third quarter, the fastest pace in a decade. Housing 
starts in November reached the highest level in almost twenty years, 
which suggests another double-digit rise in residential investment in 
the fourth quarter.
  Other Indications of Stronger Growth:
    The Nation's payrolls have begun increasing again, and 
          unemployment is on the decline. The unemployment rate fell 
          from 6.3 percent in June to 5.7 percent in December. From July 
          to December, employers added 278,000 workers to their 
          payrolls, reversing the trend of shrinking payrolls of the 
          prior months. However, the gain in December of only 1,000 jobs 
          suggests that job creation at the end of the year was still 
          well shy of the usual expansion pace. Further significant 
          payroll gains are likely in 2004, although recent experience 
          suggests that job growth may remain uneven through the early 
          part of the year.

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    Output in the hard-hit manufacturing sector turned around in 
          2003. Manufacturing production during September through 
          December rose at the fastest pace in nearly four years. The 
          Purchasing Managers' Index, a forward looking indicator of 
          manufacturing activity, reached 66 in December, the highest 
          level in 20 years. A reading above 50 indicates an expanding 
          manufacturing sector.
    Consumer and investor confidence has risen sharply. From 
          their low points in March 2003, the University of Michigan 
          Index of Consumer Sentiment increased nearly 20 percent 
          through December and the Conference Board measure advanced 
          almost 50 percent. A survey of investor confidence conducted 
          by UBS/Gallup rose from a low reading of 5 in March to 104 in 
          December.
    Corporate profit margins and overall profits expanded 
          briskly in 2003, which should help foster further increases in 
          business hiring and capital spending in 2004. In the third 
          quarter, the share of profits in GDP reached 10 percent, the 
          highest level since late 1997. Strong productivity growth, 
          well in excess of the growth of labor compensation, has 
          contributed to the growth of profits by lowering unit labor 
          costs and raising profit margins.
    Stock markets have soared since March 2003. The S&P 500 and 
          the Dow Jones Industrial average each gained about 30 percent 
          during the last nine months of 2003; the NASDAQ, with its 
          predominance of high-tech companies, rose 50 percent. The 
          increase in equity values added almost $3 billion to household 
          wealth from the end of March to the end of December and 
          reduced the cost of equity capital to businesses.
    At the same time that economic activity has been picking up, 
          inflation has been drifting lower. The core Consumer Price 
          Index, which excludes the volatile food and energy components, 
          increased a mere 1.1 percent in the 12 months ending in 
          December 2003. That is the lowest rate in 40 years and well 
          below the 2.7 percent increase at the recession's trough in 
          November 2001. The rise in the overall CPI was 1.9 percent 
          during the most recent 12 months. This was higher than the 
          core rate mainly because of a jump in energy prices. The GDP 
          price index increased 1.7 percent in the year ending in the 
          third quarter of 2003. The absence of any significant 
          inflationary pressures suggests that the Federal Reserve 
          should be able to maintain an accommodative monetary policy 
          for some time yet.
  Productivity and the Longer Run Outlook: Since the fourth quarter of 
2000, productivity in the nonfarm business sector has risen at a 4.4 
percent annual rate. That is much faster than the 1.4 percent average 
from 1974 to 1995 and faster even than the accelerated 2.5 percent pace 
during the latter half of the 1990s. While some of the recent step up is 
likely attributable to intense cost cutting during the recession and the 
subsequent slow recovery, and therefore transitory, a considerable part 
of the productivity improvement is likely to prove to be permanent. 
Strong productivity growth is the best foundation for continued economic 
growth.
  In summary, the accommodative stances of fiscal and monetary policy 
have combined to ignite a more vigorous expansion. Growth is likely to 
be above average this year, accompanied by further declines in 
unemployment and stronger employment gains. Beyond this year, solid 
productivity growth, low inflation, and an improved tax framework offer 
the prospect of a new, extended period of robust economic growth.

                          Economic Projections

  The Administration's economic projections are summarized in Table 11-
1. These assumptions are close to those of the Congressional Budget 
Office and the average of private sector forecasters, as described in 
more detail below. The assumptions were based on information available 
as of late November. In December, the Bureau of Economic Analysis 
released a comprehensive revision of the National Income and Product 
Accounts. The Addendum to Table 11-1 presents the assumptions on a basis 
comparable to the revised national accounts.
  As the foregoing discussion suggests, the Administration is projecting 
the economy to improve steadily. The major contributors to economic 
growth this year are likely to be business investment and consumer 
spending, spurred by stronger income growth, the tax relief legislation 
of the past three years, the rise in stock market, and increased housing 
wealth. Spending on equipment and software could surge later this year 
as firms take advantage of the expensing provision scheduled to expire 
at year's end. To the extent that the timing of investment is shifted 
forward from 2005 to 2004, capital spending in early 2005 may be 
temporarily weakened. Businesses are also likely to add to their 
inventories in 2004, which were lean at the end of 2003.
  The foreign sector may once again make at least a modest positive 
contribution to growth because of an expected pick up of economic 
activity abroad and the recent decline in the value of the dollar, both 
of which should help U.S. exports. From February 2002 to the end of 
2003, the dollar declined 23 percent against the currencies of the major 
U.S. trading partners.
  Residential investment may not maintain the exceptionally high levels 
reached in late 2003 and so may make little, if any, contribution to 
growth. The contribution to real GDP growth from Government spending is 
also likely to be at most modest. At the Federal level, growth in 
spending on security requirements will be partly offset by more moderate 
spending growth in areas of lower priority. At the State and local 
level, growth of outlays will continue to be restrained as these 
governments strive to achieve balanced budgets.

                                                          Table 11-1.  ECONOMIC ASSUMPTIONS \1\
                                                      (Calendar years; dollar amounts in billions)
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                      Projections
                                                  Actual 2002 ------------------------------------------------------------------------------------------
                                                                   2003         2004         2005         2006         2007         2008         2009
--------------------------------------------------------------------------------------------------------------------------------------------------------
Gross Domestic Product (GDP):
  Levels, dollar amounts in billions:
    Current dollars.............................     10,446       10,939       11,566       12,139       12,746       13,396       14,096       14,831
    Real, chained (1996) dollars................      9,440        9,730       10,163       10,528       10,886       11,248       11,607       11,969
    Chained price index (1996=100), annual            110.7        112.4        113.8        115.3        117.1        119.1        121.4        123.9
     average....................................
  Percent change, fourth quarter over fourth
   quarter:
    Current dollars.............................        4.3          5.8          5.2          4.9          5.0          5.2          5.2          5.2
    Real, chained (1996) dollars................        2.9          4.2          4.0          3.4          3.3          3.3          3.1          3.1
    Chained price index (1996=100)..............        1.3          1.5          1.2          1.4          1.6          1.8          2.0          2.0
  Percent change, year over year:
    Current dollars.............................        3.6          4.7          5.7          4.9          5.0          5.1          5.2          5.2
    Real, chained (1996) dollars................        2.4          3.1          4.4          3.6          3.4          3.3          3.2          3.1
    Chained price index (1996=100)..............        1.1          1.6          1.2          1.3          1.5          1.7          2.0          2.0
 
Incomes, billions of current dollars:
    Corporate profits before tax................        665          756          891        1,181        1,134        1,134        1,175        1,222
    Wages and salaries..........................      4,996        5,101        5,356        5,686        6,008        6,347        6,687        7,030
    Other taxable income \2\....................      2,411        2,487        2,609        2,681        2,727        2,791        2,888        3,016
 
Consumer Price Index: \3\
    Level (1982-84=100), annual average.........      179.9        184.0        186.6        189.4        192.8        196.8        201.5        206.6
    Percent change, fourth quarter over fourth          2.2          2.0          1.4          1.6          1.9          2.2          2.5          2.5
     quarter....................................
    Percent change, year over year..............        1.6          2.3          1.4          1.5          1.8          2.1          2.4          2.5
 
Unemployment rate, civilian, percent:
    Fourth quarter level........................        5.9          5.9          5.5          5.3          5.2          5.1          5.1          5.1
    Annual average..............................        5.8          6.0          5.6          5.4          5.2          5.1          5.1          5.1
 
Federal pay raises, January, percent:
    Military \4\................................        6.9          4.7         4.15          3.5           NA           NA           NA           NA
    Civilian \5\................................        4.6          4.1          4.1          1.5           NA           NA           NA           NA
 
Interest rates, percent:
    91-day Treasury bills \6\...................        1.6          1.0          1.3          2.4          3.3          4.0          4.3          4.4
    10-year Treasury notes......................        4.6          4.0          4.6          5.0          5.4          5.6          5.8          5.8
 
ADDENDUM: \7\
Gross Domestic Product (GDP), revised:
  Levels, dollar amounts in billions:
    Current dollars.............................     10,481       10,984       11,612       12,187       12,796       13,449       14,151       14,890
    Real, chained (2000) dollars................     10,083       10,397       10,858       11,248       11,630       12,017       12,401       12,788
    Chained price index (2000=100), annual            103.9        105.7        107.0        108.4        110.0        111.9        114.1        116.4
     average....................................
  Percent change, fourth quarter over fourth
   quarter:
    Current dollars.............................        4.2          5.9          5.2          4.9          5.0          5.2          5.2          5.2
    Real, chained (2000) dollars................        2.8          4.3          4.0          3.4          3.3          3.3          3.1          3.1
    Chained price index (2000=100)..............        1.4          1.5          1.2          1.4          1.6          1.8          2.0          2.0
  Percent change, year over year:
    Current dollars.............................        3.8          4.8          5.7          4.9          5.0          5.1          5.2          5.2
    Real, chained (2000) dollars................        2.2          3.1          4.4          3.6          3.4          3.3          3.2          3.1
    Chained price index (2000=100)..............        1.5          1.6          1.2          1.3          1.5          1.7          2.0          2.0
 
Incomes, billions of current dollars, revised:
    Corporate profits before tax................        745          845          992        1,313        1,261        1,262        1,307        1,359
    Wages and salaries..........................      4,975        5,092        5,352        5,682        6,004        6,342        6,682        7,025
    Other taxable income \2\....................      2,349        2,401        2,515        2,587        2,634        2,701        2,796        2,923
--------------------------------------------------------------------------------------------------------------------------------------------------------
NA = Not Available.
\1\ Based on information available as of late November 2003.
\2\ Dividends, rent, interest and proprietors' income components of personal income.
\3\ Seasonally adjusted CPI for all urban consumers.
\4\ Percentages apply to basic pay only; 2002, 2003, and 2004 figures are averages of various rank- and longevity- specific adjustments; percentages to
  be proposed for years after 2005 have not yet been determined.
\5\ Overall average increase, including locality pay adjustments. Percentages to be proposed for years after 2005 have not yet been determined.
\6\ Average rate, secondary market (bank discount basis).
\7\ Assumptions adjusted to reflect comprehensive revisions to GDP and incomes released by the Bureau of Economic Analysis in December 2003.

  Real GDP and Unemployment: The economy is projected to grow 4.4 
percent in 2004 measured on a calendar year-over-year basis, compared 
with 3.1 percent in 2003. During the next few years, real growth is

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expected to exceed the long-run potential growth rate. As a result, the 
unemployment rate is projected to decline gradually from its 5.7 percent 
level in December 2003 to 5.1 percent in 2007. This rate is in the 
center of the range that is thought to be consistent with stable 
inflation.
  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 about 1.0 percent per year on average, a 
combination of a 1.1 percent increase in the working-age population and 
a slight decline in the labor force participation rate. Trend 
productivity growth in the nonfarm business sector is assumed to average 
2.3 percent per year, about the average during the past four decades, an 
extended period that encompasses rapid and slow productivity growth 
trends. The productivity assumption is a cautious one, especially in 
light of the 4.4 percent average growth rate in nonfarm productivity 
since the fourth quarter of 2000.
  Inflation: Inflation is expected to edge up slightly from its low 
levels in 2003. The GDP chain-weighted price index is projected to 
increase 1.2 percent this year, rising to 2.0 percent in 2008 and 2009. 
The CPI is expected to increase 1.4 percent this calendar year, and then 
move up to 2.5 percent in 2009. The difference between inflation 
measured by the CPI and the GDP price index in the outyears is 
consistent with historical experience.
  The forecast for low inflation in the coming years reflects the 
current very low inflation, the absence of inflationary expectations, 
the additional downward pressure on wages and prices that will persist 
until stronger growth eventually eliminates excess slack in the economy, 
and the demonstrated ability of the Federal Reserve in recent years to 
assure a reasonable degree of price stability. Not since the mid-1960s 
has there been a 10-year period with average inflation as low as is 
projected for 2000-2009.
  Interest Rates: As is usual during an expansion, interest rates are 
projected to rise. The 3-month Treasury bill rate ended 2003 at 0.9 
percent. It is expected to increase to 4.4 percent by 2009. The yield on 
the 10-year Treasury note ended last year at 4.3 percent. It is 
projected to increase to 5.8 percent by 2009.
  The larger increase at the short end of the maturity spectrum than at 
the longer end is the usual cyclical experience and reflects an assumed 
less accommodative monetary policy as the expansion matures. Rates start 
from such a low level currently that, despite their projected increase, 
interest rates on average during 2003 through 2009 are likely to be 
lower than during any other seven-year period since the mid-1960s. 
Adjusted for inflation, the outyear real interest rates are close to 
their historical averages.
  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 projected to rise steadily through 2007 from a relatively low level 
in the third quarter of 2003. The share of the nontaxable component of 
labor compensation in GDP is expected to rise significantly over the 
forecast horizon. This component, called supplements to wages and 
salaries in the national income accounts, is composed of employer 
contributions for social insurance and employer-paid benefits, such as 
health insurance and pension contributions. Both health insurance and 
pension contributions are projected to rise more rapidly than taxable 
wages and salaries.
  The cost of health insurance purchased by employers rose at a double-
digit pace in both 2002 and 2003. Employers have shifted some of the 
rise in insurance costs on to employees, and are likely to continue to 
do so. Nonetheless, the upward pressure on the employers' share of 
insurance premiums is expected to be substantial. Also, employers' 
contributions to defined-benefit pension plans are expected to increase 
significantly over the next few years. Firms must reduce the large 
underfunding of plans created by the fall in the stock market between 
2000 and 2003, lower assumed rates of return on fund assets, and the 
ongoing obligations for their workforce.
  The share of corporate profits before tax will be affected by the 
strength of the economy and the end of the temporary expensing 
provisions for qualified capital by the end of 2004. Healthy economic 
growth will help sustain the corporate profits share. On the other hand, 
the expensing provision will lower profits before tax this year compared 
to what they otherwise would have been by allowing firms to write off 
more of their investment sooner. After 2004, however, corporate profits 
before tax will increase both because new investments will not qualify 
for the temporary expensing provision and because the remaining 
depreciation on expensed investments will be lower. Taking these various 
factors into account, the corporate profits share is expected to 
increase slightly this year, jump sharply in 2005 when the receipts 
payback for expensing will begin, and then decline gradually thereafter.
  Among the other components of the tax base, the share of personal 
interest income in GDP is projected to decline significantly reflecting 
the relatively low nominal interest rates during the next six years. The 
remaining shares of the tax base (proprietors' income, rental income, 
and dividend income) are projected to remain relatively stable at around 
their 2003 levels.
  Summary: The economic news since the assumptions were finalized has 
generally been favorable, although job growth in December fell well 
below expectations. On balance, at the start of 2004, the upside risks 
to the near-term forecast may exceed the downside risks. Moreover, if 
the strong productivity performance of recent years continues at even a 
somewhat more moderate pace, then long-run growth may also be stronger 
than assumed here. On the other hand, growth may also be weaker than 
forecast if, for example, the economy is subjected to additional and 
significant adverse shocks.

[[Page 175]]

            Comparison with CBO and Private-Sector Forecasts

  In addition to the Administration, the Congressional Budget Office 
(CBO) and many private-sector forecasters also make economic 
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 11-2 compares the 2005 
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 their appraisals of the most likely policy 
outcomes, which vary among the forecasters. The Administration forecast 
assumes that all Budget proposals will be enacted. The CBO baseline 
projection assumes that current law as of the time the estimates are 
made will remain forever unchanged. Despite their differing policy 
assumptions, the three sets of economic projections, shown in Table 11-
2, are very close. The similarity of the Budget economic projection to 
both the CBO baseline projection and the Consensus forecast underscores 
the cautious nature of the Administration forecast.

                                                     Table 11-2.  COMPARISON OF ECONOMIC ASSUMPTIONS
                                                                    (Calendar years)
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                Projections                                    Average,
                                                              ------------------------------------------------------------------------------------------
                                                                   2004         2005         2006         2007         2008         2009       2004-09
--------------------------------------------------------------------------------------------------------------------------------------------------------
GDP (billions of current dollars):
  CBO January................................................     11,629       12,243       12,814       13,389       14,023       14,686
  Blue Chip Consensus January \2\............................     11,660       12,291       12,929       13,588       14,292       15,045
  2005 Budget................................................     11,612       12,187       12,796       13,449       14,151       14,890
 
Real GDP (chain-weighted): \1\
  CBO January................................................        4.8          4.2          3.1          2.7          2.8          2.8          3.4
  Blue Chip Consensus January \2\............................        4.6          3.7          3.3          3.1          3.2          3.2          3.5
  2005 Budget................................................        4.4          3.6          3.4          3.3          3.2          3.1          3.5
 
Chain-weighted GDP Price Index: \1\
  CBO January................................................        1.1          1.1          1.5          1.8          1.9          1.9          1.5
  Blue Chip Consensus January \2\............................        1.4          1.6          1.8          1.9          2.0          2.0          1.8
  2005 Budget................................................        1.2          1.3          1.5          1.7          2.0          2.0          1.6
 
Consumer Price Index (all-urban): \1\
  CBO January................................................        1.6          1.7          2.0          2.2          2.2          2.2          2.0
  Blue Chip Consensus January \2\............................        1.7          2.1          2.3          2.4          2.4          2.4          2.2
  2005 Budget................................................        1.4          1.5          1.8          2.1          2.4          2.5          2.0
 
Unemployment rate: \3\
  CBO January................................................        5.8          5.3          5.0          5.1          5.2          5.2          5.3
  Blue Chip Consensus January \2\............................        5.8          5.4          5.4          5.3          5.3          5.2          5.4
  2005 Budget................................................        5.6          5.4          5.2          5.1          5.1          5.1          5.3
 
Interest rates: \3\
  91-day Treasury bills:
    CBO January..............................................        1.3          3.0          4.0          4.6          4.6          4.6          3.7
    Blue Chip Consensus January \2\..........................        1.3          2.6          3.7          3.9          4.1          4.1          3.3
    2005 Budget..............................................        1.3          2.4          3.3          4.0          4.3          4.4          3.3
 
  10-year Treasury notes: \3\
    CBO January..............................................        4.6          5.4          5.5          5.5          5.5          5.5          5.3
    Blue Chip Consensus January \2\..........................        4.7          5.4          5.5          5.6          5.6          5.6          5.4
    2005 Budget..............................................        4.6          5.0          5.4          5.6          5.8          5.8          5.4
--------------------------------------------------------------------------------------------------------------------------------------------------------
Sources: Congressional Budget Office; Aspen Publishers, Inc., Blue Chip Economic Indicators
All forecasts adjusted to reflect December 2003 comprehensive revisions to the National Income and Product Accounts.
\1\ Year over year percent change.
\2\ January 2004 Blue Chip Consensus forecast for 2004 and 2005; Blue Chip October 2003 long run extension for 2006 - 2009.
\3\ Annual averages, percent.

  For real GDP, the Administration, CBO, and the Blue Chip consensus 
anticipate strong growth this year. The Administration projects 4.4 
percent growth, slightly below the CBO and private sector consensus. For 
calendar year 2005, the Administration, at 3.6 percent, is again 
slightly below the Consensus (at 3.7 percent), and significantly less 
than CBO's 4.2 percent. Thereafter, the Administration's forecast 
remains close to the consensus growth rate. Over the six-year span as a 
whole, the Administration and the private sector consensus both project 
an average 3.5 percent annual growth rate, CBO 3.4 percent.
  All three forecasts anticipate continued low inflation of between 1 
and 2 percent as measured by the GDP chain-weighted price index, and 
between 1\1/2\ and 2\1/2\ percent as measured by the CPI. The 
unemployment rate projections are also similar. All three forecasts en

[[Page 176]]

visage slightly rising interest rates during the next few years. For 
short-term rates, the consensus forecast is slightly below the 
Administration's in the outyears, while CBO is higher. The three long-
term interest rate projections are very close.

                     Changes in Economic Assumptions

  As shown in Table 11-3, the economic assumptions underlying this 
Budget have been revised significantly from those of the 2004 Budget.
  Real GDP growth accelerated beyond expectation in the latter part of 
2003 and for the year as a whole was a bit stronger, overall, than 
projected in last year's Budget. A year ago, the economic recovery 
appeared to be losing momentum; now, it is gaining speed. Consequently, 
the level of real GDP projected for this year is now a full percentage 
point higher than anticipated in last year's Budget, and the year-over-
year growth rate is 0.8 percentage points higher. From 2005 onwards, 
moreover, real GDP growth in this budget is projected to be slightly 
above last year's projected rates.
  The level of nominal GDP is projected to be about one percentage point 
higher in each year, 2004-2009, than in last year's budget. That is 
primarily because actual real GDP was significantly higher in 2003, and 
is now expected to grow slightly faster during 2004-2008, than in last 
year's budget. The unemployment rate is expected to be somewhat higher 
than in last year's assumptions but ultimately to decline to 5.1 
percent, as before. 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. The short-term rate is expected to gradually 
approach last year's outyear assumptions, but long-term rates are now 
projected to be slightly higher. Adjusted for inflation, the real long-
term rate is the same as in last year's budget. 

                                      Table 11-3.  COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2004 AND 2005 BUDGETS
                                                      (Calendar years; dollar amounts in billions)
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                   2003         2004         2005         2006         2007         2008         2009
--------------------------------------------------------------------------------------------------------------------------------------------------------
Nominal GDP: \1\
  2004 Budget assumptions....................................     10,884       11,447       12,031       12,637       13,263       13,919       14,608
  2005 Budget assumptions....................................     10,939       11,566       12,139       12,746       13,396       14,096       14,831
 
Real GDP (1996 dollars): \1\
  2004 Budget assumptions....................................      9,710       10,061       10,414       10,760       11,102       11,446       11,801
  2005 Budget assumptions....................................      9,730       10,163       10,528       10,886       11,248       11,607       11,969
 
Real GDP (percent change): \2\
  2004 Budget assumptions....................................        2.9          3.6          3.5          3.3          3.2          3.1          3.1
  2005 Budget assumptions....................................        3.1          4.4          3.6          3.4          3.3          3.2          3.1
 
GDP price index (percent change): \2\
  2004 Budget assumptions....................................        1.3          1.5          1.5          1.7          1.7          1.8          1.8
  2005 Budget assumptions....................................        1.6          1.2          1.3          1.5          1.7          2.0          2.0
 
Consumer Price Index (percent change): \2\
  2004 Budget assumptions....................................        2.2          2.1          2.1          2.2          2.2          2.3          2.3
  2005 Budget assumptions....................................        2.3          1.4          1.5          1.8          2.1          2.4          2.5
 
Civilian unemployment rate (percent): \3\
  2004 Budget assumptions....................................        5.7          5.5          5.2          5.1          5.1          5.1          5.1
  2005 Budget assumptions....................................        6.0          5.6          5.4          5.2          5.1          5.1          5.1
 
91-day Treasury bill rate (percent): \3\
  2004 Budget assumptions....................................        2.0          3.6          4.3          4.4          4.4          4.5          4.5
  2005 Budget assumptions....................................        1.0          1.3          2.4          3.3          4.0          4.3          4.4
 
10-year Treasury note rate (percent): \3\
  2004 Budget assumptions....................................        4.2          5.0          5.3          5.4          5.5          5.6          5.6
  2005 Budget assumptions....................................        4.0          4.6          5.0          5.4          5.6          5.8          5.8
 
--------------------------------------------------------------------------------------------------------------------------------------------------------
\1\ Not adjusted for December 2003 comprehensive revisions to the National Income and Product Accounts.
\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 2004 Budget 
to the 2005 Budget are shown in Table 11-4. The second block shows that 
proposed and enacted legislation increases the deficit in 2004 and 2005 
but has little effect thereafter.
  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 various taxable incomes.

                                 Table 11-4.  SOURCES OF CHANGE IN BUDGET TOTALS
                                            (In billions of dollars)
----------------------------------------------------------------------------------------------------------------
                                        2004         2005         2006         2007         2008         2009
----------------------------------------------------------------------------------------------------------------
 (1) 2004 Budget
    Receipts......................      1,922        2,135        2,263        2,398        2,521        2,649
    Outlays.......................      2,229        2,343        2,464        2,576        2,711        2,843
                                   -----------------------------------------------------------------------------
      Unified budget deficit (-)..       -307         -208         -201         -178         -190         -194
 
 (2) Changes due to policy:
    Receipts......................        -17           15           38           33           23           19
    Outlays.......................         92           62           34           39           27           14
                                   -----------------------------------------------------------------------------
      Deficit increase (-), policy       -109          -48            4           -5           -5            4
 
 (3) Changes due to economic
 assumptions:
    Receipts......................        -39          -37          -41          -27          -10            4
    Outlays.......................        -22          -37          -33          -24          -14           -6
                                   -----------------------------------------------------------------------------
      Deficit increase (-),               -18            1           -8           -4            4           10
       economic...................
 
 (4) Changes due to technical
 factors:
    Receipts......................        -68          -77          -55          -53          -48          -56
    Outlays.......................         19           31            8           -1            1            2
                                   -----------------------------------------------------------------------------
      Deficit increase (-),               -87         -108          -63          -54          -48          -57
       technical..................
 
 (5) Total changes from 2004
 Budget:
    Receipts......................       -124          -99          -57          -47          -36          -33
    Outlays.......................         89           56           10           16           14           10
                                   -----------------------------------------------------------------------------
      Total deficit increase (-)..       -213         -155          -67          -63          -49          -43
 
 (6) 2005 Budget
    Receipts......................      1,798        2,036        2,206        2,351        2,485        2,616
    Outlays.......................      2,319        2,400        2,473        2,592        2,724        2,853
                                   -----------------------------------------------------------------------------
      Unified budget deficit (-)..       -521         -364         -268         -241         -239         -237
 
----------------------------------------------------------------------------------------------------------------
Note: Changes in interest costs due to receipts changes included in outlay lines.

  Technical factors (block 4) are all changes in budget estimates that 
are not due to changes in economic assumptions or legislation. Examples 
of technical factors are revised demographic data from the 2000 Census 
and changes in estimating methodologies, including changes in the 
relationship between economic variables, income reported on tax returns, 
and actual tax collections.

[[Page 177]]

                    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 
portion that would remain if the unemployment rate was at its long-run 
value 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 including 
the cyclical component. The structural balance shows the surplus or 
deficit that will persist even when the economy is operating at the 
sustainable level of unemployment.
  The estimates of the structural balance are based on the relationship 
between changes in the unemployment rate 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 was cyclical in nature. It is not possible, 
however, to estimate this cyclical component accurately. As a result, 
both the unadjusted and structural balances are affected by cyclical 
stock market movements.
  From 1998 to 2001, the unemployment rate appears to have been lower 
than could be sustained in the long run. Therefore, as shown in Table 
11-5, in 1998 the structural surplus of $22 billion was less than the 
actual surplus of $69 billion. Likewise, in 1999-2001, the structural 
surplus continued to be 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 $104 billion. Similarly 
in 2003, the actual deficit of $375 billion contained a cyclical 
component of about $74 billion. The structural deficit for that year was 
$302 billion. As the projected unemployment rate declines toward the 
sustainable level in the next few years, the projected unadjusted 
deficit is

[[Page 178]]

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 negative numbers in the coming years. 
Therefore, the adjusted structural deficit and the structural deficit 
are nearly identical over the forecast horizon.

                                                        Table 11-5.  ADJUSTED STRUCTURAL BALANCE
                                                                (In billions of dollars)
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                1998     1999     2000     2001     2002     2003     2004     2005     2006     2007     2008     2009
--------------------------------------------------------------------------------------------------------------------------------------------------------
Unadjusted surplus or deficit (-)...........     69.2    125.6    236.4    127.4   -157.8   -375.3   -520.7   -363.6   -267.6   -241.3   -239.0   -237.1
  Cyclical component........................     47.5     72.8    110.2     49.0    -53.4    -73.6    -39.1    -15.3     -5.1     -1.4      -.1  .......
                                             -----------------------------------------------------------------------------------------------------------
Structural surplus or deficit (-)...........     21.7     52.7    126.3     78.4   -104.4   -301.7   -481.6   -348.3   -262.6   -239.9   -239.0   -237.1
  Deposit insurance outlays.................     -4.4     -5.3     -3.1     -1.4     -1.0     -1.4     -1.5     -1.5     -1.0     -1.2     -1.9     -2.0
                                             -----------------------------------------------------------------------------------------------------------
Adjusted structural surplus or deficit (-)..     17.4     47.4    123.2     77.0   -105.5   -303.1   -483.1   -349.8   -263.6   -241.1   -240.8   -239.1
--------------------------------------------------------------------------------------------------------------------------------------------------------
Note: The NAIRU is assumed to be 5.2% through calendar year 1998 and 5.1% thereafter.

            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 possible changes in 
economic assumptions. Many of the budgetary effects of such changes 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. 
These rules of thumb should be understood as suggesting orders of 
magnitude; they ignore a long list of secondary effects that are not 
captured in the estimates.
  Economic variables that affect the budget do not usually change 
independently of one another. Output and employment tend to move 
together in the short run: a high rate of real GDP growth is generally 
associated with a declining rate of unemployment, while moderate or 
negative growth is usually accompanied by rising unemployment. In the 
long run, however, changes in the average rate of growth of real GDP are 
mainly due to changes in the rates of growth of productivity and labor 
force, and are not necessarily associated with changes in the average 
rate of unemployment. Inflation and interest rates are also closely 
interrelated: a higher expected rate of inflation increases interest 
rates, while lower expected inflation reduces rates.
  Changes in real GDP growth or inflation have a much greater cumulative 
effect on the budget over time if they are sustained for several years 
than if they last for only one year. Highlights of the budgetary effects 
of the above rules of thumb are shown in Table 11-6.
  For real growth and employment:
    As shown in the first block, if in 2004 for one year only, 
          real GDP growth is lower by one percentage point and the 
          unemployment rate permanently rises by one-half percentage 
          point relative to the budget assumptions, the fiscal year 2004 
          deficit is estimated to increase by $12.2 billion; receipts in 
          2004 would be lower by $9.3 billion, and outlays would be 
          higher by $2.9 billion, primarily for unemployment-sensitive 
          programs. In fiscal year 2005, the estimated receipts 
          shortfall would grow further to $20.8 billion, and outlays 
          would increase by $7.4 billion relative to the base, even 
          though the growth rate in calendar 2005 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 2004-2009, the cumulative increase in the budget 
          deficit is estimated to be $187 billion.
    The budgetary effects are much larger if the real growth 
          rate is permanently reduced by one percentage point and the 
          unemployment rate is unchanged, as shown in the second block. 
          This scenario might occur if trend productivity were 
          permanently lowered. In this example, during 2004-2009, the 
          cumulative increase in the budget deficit is estimated to be 
          $511 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 2004 only. In subsequent 
          years, the price level and nominal GDP would be one percent 
          higher than in the base case, but interest rates and future 
          inflation rates are assumed to return to their base levels. In 
          2005, outlays would be above the base by $22.2 billion, due in 
          part to lagged cost-of-living adjustments; receipts would rise 
          $22.3 billion above the base, however, resulting in a $0.1 
          billion improvement in the budget balance. In subsequent 
          years, the amounts added to receipts would continue to be 
          larger than the additions to outlays. During 2004-2009, 
          cumulative

[[Page 179]]

          budget deficits would be $23 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 $365 billion to outlays 
          over 2004-2009 and $442 billion to receipts, for a net 
          decrease in the 2004-2009 deficits of $78 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 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 $257 
          billion during 2004-2009. 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 deficit.
  The effects of changes in economic assumptions in the opposite 
direction are approximately symmetric to those shown in the table. The 
impact of a one percentage point lower rate of inflation or higher real 
growth would have about the same magnitude as the effects shown in the 
table, but with the opposite sign.

[[Page 180]]



                         Table 11-6.  SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
                                            (In billions of dollars)
----------------------------------------------------------------------------------------------------------------
                                                                                                       Total of
        Budget effect            2004        2005        2006        2007        2008        2009      Effects,
                                                                                                       2004-2009
----------------------------------------------------------------------------------------------------------------
 Real Growth and Employment
 
Budgetary effects of 1
 percent lower real GDP
 growth:
  (1) For calendar year 2004
   only: \1\
    Receipts................        -9.3       -20.8       -23.8       -24.9       -26.1       -27.5      -132.6
    Outlays.................         2.9         7.4         7.8         9.7        12.0        14.3        54.1
                             -----------------------------------------------------------------------------------
      Increase in deficit (-       -12.2       -28.3       -31.6       -34.6       -38.2       -41.8      -186.7
       )....................
 
  (2) Sustained during 2004-
   2009, with no change in
   unemployment:
    Receipts................        -9.5       -32.5       -61.1       -91.6      -124.7      -160.7      -480.1
    Outlays.................        -0.1         0.1         1.4         4.5         9.4        15.7        31.0
                             -----------------------------------------------------------------------------------
      Increase in deficit (-        -9.3       -32.6       -62.5       -96.0      -134.1      -176.5      -511.1
       )....................
 
 
Inflation and Interest Rates
 
Budgetary effects of 1
 percentage point higher
 rate of:
  (3) Inflation and interest
   rates during calendar
   year 2004 only:
    Receipts................        10.6        22.3        22.8        21.6        22.7        23.9       123.9
    Outlays.................        11.3        22.2        19.1        16.9        16.2        15.3       101.0
                             -----------------------------------------------------------------------------------
      Decrease in deficit           -0.6         0.1         3.7         4.7         6.5         8.6        22.9
       (+)..................
 
  (4) Inflation and interest
   rates, sustained during
   2004-2009:
    Receipts................        10.6        34.1        59.4        84.4       111.8       142.2       442.5
    Outlays.................        11.5        34.3        53.9        71.3        88.2       105.7       364.8
                             -----------------------------------------------------------------------------------
      Decrease in deficit           -0.9        -0.1         5.6        13.1        23.6        36.5        77.7
       (+)..................
 
  (5) Interest rates only,
   sustained during 2004-
   2009:
    Receipts................         1.8         4.4         5.7         6.4         7.0         7.7        33.0
    Outlays.................         9.4        25.1        35.3        42.9        49.8        56.9       219.4
                             -----------------------------------------------------------------------------------
      Increase in deficit (-        -7.6       -20.7       -29.7       -36.5       -42.8       -49.2      -186.5
       )....................
 
  (6) Inflation only,
   sustained during 2004-
   2009:
    Receipts................         8.8        29.6        53.6        77.7       104.4       134.0       408.2
    Outlays.................         2.1         9.4        19.1        29.4        40.1        51.4       151.4
                             -----------------------------------------------------------------------------------
      Decrease in deficit            6.7        20.2        34.5        48.3        64.3        82.7       256.7
       (+)..................
 
 
   Interest Cost of Higher
      Federal Borrowing
 
(7) Outlay effect of $100            0.6         2.2         3.4         4.3         5.1         5.5        21.2
 billion increase in the
 2004 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.