[Analytical Perspectives]
[Economic Assumptions and Analyses]
[12. Economic Assumptions]
[From the U.S. Government Printing Office, www.gpo.gov]
Five years ago, at the beginning of the new millennium, optimism about
the Nation's economic future abounded, but that period of optimism was
followed by a succession of shocks whose cumulative severity was as
great as any previous setback in the postwar period. Now, five years
later, the effects of these shocks have been overcome and faith in the
economy and the future are once again on the rise.
Negative Shocks
Six substantial shocks buffeted the economy starting in 2000.
The stock market bubble burst in March 2000; by October 2002, the
market had lost half its value. Household equity wealth fell by $7
trillion, wiping out two-thirds of the equity gain from the last half of
the 1990s.
Business investment slowed to a trickle beginning in mid-2000 as the
stock market decline mirrored a dramatic revision in business
expectations, and collapsed the following year as firms began to work
off a huge overhang of what was now perceived to be excess capital. The
over-investment was due in part to inflated expectations about the
return on new technology and to a surge in Y2K-related computer hardware
and software investment that ended abruptly in 2000. Not until 2003 did
capital spending turn up. This nearly three-year slump was one of the
longest and deepest in the postwar period.
The terrorist attacks of September 11th and the possibility of even
more dangerous attacks depressed consumer and business confidence for a
time, while substantially increasing the resources that governments,
families, and businesses needed to devote to security measures. The War
on Terror, especially as fought through the campaigns in Afghanistan and
Iraq, also contributed to heightened uncertainties. The increased
uncertainty hampered investment planning and contributed to the slump in
investment spending.
Corporate accounting scandals were uncovered throughout 2002-2003.
Although the scandals had been long in the making, their sudden
revelation came as a further shock to confidence. The subsequent
bankruptcy of some once-well-regarded corporations further shook
investor confidence, and the revelation of conflicts of interest at
several major accounting firms and Wall Street brokerage houses cast
doubt on the reliability of the information and advice provided by them,
again making investors leery of putting money at risk in the market. The
scandals and the reaction to them had the effect of prolonging the slump
in business investment.
Recession or slumping growth mired major U.S. trading partners for
most of this period which restrained U.S. exports, especially of
manufactured goods. Output in Japan and in the European Union grew only
1 percent per year on average during 2001-2003; outright declines
occurred in several countries during this period.
Oil prices doubled in 2003-2004. The benchmark price of West Texas
intermediate crude oil jumped from $28 per barrel in May, 2003, to $55
at its peak in late October, 2004. Prices moved down thereafter, closing
the year at $42. On balance, however, the rise in oil prices slowed U.S.
growth during 2004.
Timely Response
Policymakers responded quickly and appropriately to this series of
adverse shocks. Expansionary policies, both fiscal and monetary, were
adopted in a timely manner, and when combined with the inherent
resilience of the American economy, succeeded in overcoming the forces
of restraint and minimizing the actual downturn in 2001. From the peak
in the fourth quarter of 2000 to its low point in the third quarter of
2001, real Gross Domestic Product (GDP) edged down a mere 0.2 percent.
Partly because of quick policy action, both consumer spending and
housing investment held up much better during the 2001 slump than in
previous business downturns, which helped limit the decline in real
output. During the subsequent recovery through mid-2003, however, growth
was not as robust as usual, which is not surprising in light of the
shocks that continued to buffet the economy and the relatively mild
downturn that limited the likely size of the rebound.
Policymakers responded to the disappointing recovery by providing
additional fiscal and monetary stimulus. This renewed stimulus worked,
and as a result, the economy has achieved robust growth and an improved
labor market since mid-2003 without a significant increase in inflation
or interest rates. As 2005 begins, the near-term economic outlook is
promising. A wide range of indicators suggests that the economy will
continue to expand at faster than normal rates of growth. More than 100
thousand new jobs are being created monthly, adding to the purchasing
power of workers; consumer spending remains strong; businesses' capital
spending is growing at a rapid rate, and order books are lengthening;
home sales have reached record levels, boosting home prices and
household wealth; and manufacturing production and exports are again
expanding. The stock market finally bottomed in 2002, and it has risen
sharply since last August, adding to household wealth and reducing the
cost of capital to business. By early 2005, the major stock market
indices had reached their highest levels since mid-2001.
Looking beyond the next few years, the outlook is also encouraging.
Over the long-run, the growth of out
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put and the standard of living depend critically on productivity growth,
and there is reason to be optimistic here. Productivity growth
accelerated in the second half of the 1990s, and surprisingly in view of
the shocks of recent years, it stepped up again after 2000 to reach a
pace not seen in over fifty years. A slowdown from this torrid pace is
expected by the Administration and most other forecasters, but even with
a slowdown, productivity growth is expected to remain strong over the
next decade, and with it the rise in the standard of living.
The Administration's near- and medium-term economic projections assume
that the economy will not face exceptional disturbances in the coming
years, unlike the last five. With that provision, the Administration
anticipates strong, sustained growth, rising employment, and relatively
low inflation and interest rates. The economic assumptions underlying
the budget are close to those of the consensus of private-sector
forecasts, and for real growth below those of the Congressional Budget
Office. The prospects of a lengthy sustained expansion, exceptionally
high productivity growth, and the Administration's policies mean that
actual performance could exceed the official projections. In the
interest of sound, prudent budgeting, however, the Administration has
adopted a cautious economic forecast.
Policy Actions
Fiscal Policy: The Administration proposed, and Congress enacted,
significant tax relief in each of the past four years designed to
overcome the shocks that were restraining the economy and restore strong
growth of output, income, and jobs. In addition to providing much needed
near-term stimulus, the 2001 and 2003 Acts also were designed to raise
long-term growth by reducing the disincentives and distortions in the
tax system. These Acts reduced marginal tax rates on income, dividends,
and capital gains. Lower tax rates encourage individuals and businesses
to produce more, save more, and invest more. More saving and investment
create capital, add to economic growth, and raise the standard of
living. The combined tax relief from the four Acts totaled $68 billion
in fiscal year 2001, $89 billion in 2002, $159 billion in 2003, and $272
billion in 2004, moderating to $189 billion in 2005.
Economic Growth and Tax Relief and Reconciliation Act: This act
lowered marginal income tax rates; reduced the marriage tax penalty; and
created a new, lower 10 percent tax bracket, among other changes. In
July 2001, near the low point of the 2001 recession, taxpayers began
receiving rebate checks reflecting their lower liability with the new 10
percent bracket; lower withholding schedules also went into effect at
that time. With the benefit of hindsight, the fiscal stimulus from the
tax relief was exceptionally well-timed: economic growth during the
prior half-year had ground to a halt, yet it had resumed by year-end
despite the terrorist attacks on September 11th.
Job Creation and Worker Assistance Act: In March 2002, the President
signed this Act, which was designed to halt the ongoing slide in
business capital spending and to aid unemployed workers. The Act
permitted immediate depreciation of 30 percent of the value of qualified
new capital assets put in place during the three years ending in
September 11, 2004. Accelerated depreciation provided an incentive for
firms to invest. For a limited time, more of a qualified investment
could be written-off for tax purposes, thereby lowering the cost of
capital and providing an incentive for firms to speed up their capital
spending. The Act also extended unemployment insurance benefits to
workers who had exhausted their normal benefits.
Jobs and Growth Tax Relief Reconciliation Act: In May 2003, the
President signed both another extension of unemployment insurance
benefits and the 2003 jobs and growth tax cut, which was designed to
invigorate the lackluster recovery then underway. The Act lowered income
tax rates, reduced the marriage penalty, raised the child tax credit,
and raised the exemption amount for the individual Alternative Minimum
Tax. Significantly, the Act reduced income tax rates on dividend income
and capital gains, which reduced distortions in the tax code from the
double taxation of corporate earnings. To stimulate business capital
spending further, the Act raised the percentage of an asset's value that
could be expensed immediately from 30 to 50 percent and lengthened the
window of opportunity for businesses to take advantage of this benefit
from September 11, 2004 to the end of the year. The Act also improved
the outlook for small business investment and hiring by raising the
maximum amount that a small business could expense from $25,000 per year
to $100,000.
Working Families Tax Relief Act: In October 2004, the President signed
this Act, which extended parts of the President's tax relief plan that
were scheduled to expire at the end of 2004 and reinstated several
expired or expiring business-related tax incentives. In doing so, the
Act protected taxpayers from several scheduled tax increases. The Act
also provided tax relief to certain military personnel with families,
and simplified the tax code for many families by creating a uniform
definition of a qualifying child for tax purposes.
The short-term benefits of the substantial tax relief of the past four
years are evident in the strong expansion now underway. The longer-term
benefits will be apparent in a more efficient allocation of the Nation's
resources in coming years and a sustained increase in economic activity.
Monetary Policy: During the past four years, monetary policy has been
focused on overcoming negative shocks and restoring strong, sustained
growth. From the beginning of 2001 through mid-2003, the Federal Reserve
lowered the target Federal funds rate 13 times, from 6\1/2\ percent to 1
percent. That low rate was maintained until June 2004 when the Federal
Reserve began to increase the funds rate gradually. Over the course of
2004, it became increasingly evident that the economy was once again
growing strongly and labor mar
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kets were improving, which reduced the need for monetary stimulus.
By December 2004, the Federal Reserve had raised the funds rate to
2\1/4\ percent, a level that it believed was still accommodative. In its
statement accompanying the December increase, the Federal Reserve
indicated that it intended to move at a measured pace to reduce the
accommodative stance of monetary policy further. As of early January,
financial futures markets expected the funds rate to reach 3 percent by
the end of 2005.
As a result of the accommodative monetary policy along with low
expected inflation and sub-par growth, interest rates fell sharply from
mid-2000 to mid-2003. The 91-day Treasury bill rate tracked the path of
the funds rate, dropping by about 5 percentage points from its 2000 peak
to a plateau of about 1 percent from mid-2003 to mid-2004, then rising
to 2.2 percent by the end of 2004. As is usually the case, the swings in
the longer-term interest rates were less than those of short-term rates.
The yield on the 10-year Treasury note, for example, fell three
percentage points from mid-2000 to 3.2 percent by mid-2003. This was its
lowest level since the late 1950s. The yield fluctuated around a mild
upward trend from mid-2003 to the end of 2004, finishing the year at 4.2
percent, a level that is still relatively low.
Private-sector financial instruments followed a similar pattern to
U.S. Treasuries. The rate on 30-year fixed rate mortgages, for example,
fell to 5.2 percent in June 2003, which was its lowest level since the
early 1960s. The mortgage rate, like the long-term Treasury yield, then
fluctuated around an upward trend and by the end of December 2004 had
reached a level of 5.7 percent. Even so, the mortgage rate remained
below its level in any month from the mid-1960s to early-2003.
Low interest rates have spurred interest-sensitive spending on such
items as motor vehicles and housing. They have enabled homeowners to
refinance their mortgages, saving on mortgage payments and enabling
families to access some of their built-up home equity. Lower interest
rates have enabled consumers, businesses, and governments to reduce
their interest expenses. Finally, low rates have helped support the
stock market.
In late 2002, the stock market responded to the cumulative effects of
fiscal and monetary stimulus and the prospects of strong, sustained
growth. Equity prices rose rapidly from the end of the third quarter of
2002 through the end of 2003. After remaining about unchanged during the
first eight months of 2004, equity prices rose strongly once again. All
told, from the beginning of October 2002 to the end of 2004, the S&P 500
and the Dow Jones Industrial Average gained about 45 percent; the hard-
hit, technology-laden NASDAQ soared 85 percent. By the end of 2004, the
S&P, NASDAQ and the Dow were at their highest levels since June 2001.
Recent Developments
Economic Growth: Beginning in the second quarter of 2003, the
contractionary forces that had held back growth during the initial phase
of the recovery gave way to stronger forces of expansion. During the
year ending in the first quarter of 2004, inflation-adjusted Gross
Domestic Product (GDP) increased 5.0 percent, the fastest advance of any
four-quarter period in nearly two decades. Growth moderated to a 3.3
percent pace in the second quarter, but then picked up in the third
quarter to a substantial 4.0 percent rate. Growth in the fourth quarter
continued at a healthy pace. (Official estimates of fourth quarter
growth were not available at the time the Budget was printed.) Although
still relatively strong, growth in 2004 was hampered by the rise in oil
prices.
Labor Market: In response to this stronger growth of output, the labor
market also improved markedly. The Nation's payrolls began to increase
in September 2003; by December 2004, there were 2.5 million more jobs
than at the August low. (Based on preliminary indications from the
Bureau of Labor Statistics, this figure is likely to be revised up, to
at least 2.6 million, in the benchmark revision that will become
available in early February after the Budget is printed.) The
unemployment rate, which reached a peak of 6.3 percent in June 2003,
fell to 5.4 percent by December 2004. Although still above its long-run
sustainable rate, the level of the unemployment rate at the end of last
year was lower than the average for the decades of the 1970s, 1980s, and
1990s.
Components of Aggregate Demand: During the six quarters from the
second quarter of 2003 through the third quarter of 2004 (the latest
quarter available when the Budget went to press), real GDP grew at a
robust 4.6 percent annual average rate. That was a significant
improvement from the sub-par 2.1 percent average pace during the first
six quarters of the recovery. Faster growth of both consumer and
business spending were largely responsible for the shift.
Consumer spending accounts for 70 percent of GDP, so its faster growth
recently played a significant role in boosting overall growth. Consumer
confidence took an upturn in early 2003, and as labor markets began to
improve a few months later, consumers became increasingly willing and
able to spend. During the six quarters ending in the third quarter of
2004, real consumer spending increased at a 3.9 percent annual rate, up
from 3.3 percent during the prior six quarters. The saving rate, which
had already declined to a historically low 1.0 percent by early 2003,
fell even further to a mere 0.3 percent by November 2004. Underlying the
gains in consumer spending have been increasing household wealth, led by
higher home and stock prices, and rising after-tax incomes, supported by
an improving labor market and tax relief.
Low mortgage interest rates and growing incomes also contributed to an
exceptionally strong housing market. During the six quarters ending in
the third
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quarter of 2004, real residential investment rose at a 10.5 percent
average annual rate, a considerable step up from the 5.2 percent pace
during the initial six quarters of the expansion. Housing starts during
the six quarters through the third quarter of last year were at the
highest level in 25 years; home sales were at the highest level since
recordkeeping began in the 1960s. Housing starts, home sales, and real
residential investment eased during the second half of 2004, in part
because of the rise in mortgage rates from their 2003 lows and in part
because housing activity had risen to unsustainable levels. While the
level of housing investment is expected to remain strong, housing is not
projected to lead the expansion in 2005-2010.
The turnaround in business capital spending was even more dramatic
and it contributed significantly to the step-up in the pace of overall
economic activity. During the latest six quarters of available data,
real business fixed investment grew at an average annual rate of 11.3
percent. In contrast, investment fell at a 6.2 percent pace during the
prior six quarters. Underlying the recovery of capital spending has been
the acceleration of overall output, more favorable financial conditions
including low interest rates, a rising stock market, and the temporary
provision of accelerated depreciation that expired at the end of 2004.
Business investment is expected to continue at a rapid rate as the
expansion matures.
The foreign sector was a small drag on overall growth during the six
quarters through the third quarter of 2004, trimming about one-third of
a percentage point from GDP growth. That was an improvement over the
first six quarters of the expansion when net exports reduced growth by
about three-quarters of a percentage point on average. Throughout the
expansion, growth of U.S. exports was restrained by slow growth
overseas. The exchange value of the dollar peaked in February 2002,
declining 12 percent on a trade-weighted basis against the currencies of
our major trading partners by September 2004. During the last three
months of 2004, the dollar declined another six percent, which should
work to reduce the U.S. trade imbalance during 2005. Although this has
been a substantial decline, it has merely retraced an earlier run-up so
that by mid-January 2005 the dollar had returned to its level of 1997.
The government sector grew more slowly during the latest six quarters.
Real Federal purchases continued to grow strongly, at a 6.1 percent
annual rate, led by spending on the War on Terror, but real State and
local purchases increased at a slow 0.3 percent pace, down from 2.4
percent during the first six quarters of the expansion. State and local
governments restrained spending to cope with exceptionally large fiscal
deficits created by the sharp fall-off in revenues from mid-2001 to
early-2002. Although State and local government revenues are on the rise
again, their combined revenues had only returned to their level in early
2001 by the third quarter of 2004.
Productivity Growth: In contrast to the initial six quarters of the
expansion when output growth was entirely accounted for by strong
productivity growth, during the subsequent six quarters both increased
labor hours and productivity have contributed to increased output. Since
the official business cycle peak in the first quarter of 2001,
productivity has risen at a remarkable 4.2 percent average annual rate.
By way of contrast, during 1996 through 2000, productivity growth
averaged 2.5 percent per year, and during 1974 through 1995,
productivity growth was a mere 1.4 percent on average. Usually
productivity growth surges temporarily during the initial phase of a
recovery and then slows markedly. In the current expansion, productivity
growth during the six quarters ending in the third quarter of 2004 was
even faster than during the prior six quarters.
The exceptional productivity performance during the last four years
has helped keep inflation low and thereby enabled the Federal Reserve to
focus monetary policy on overcoming shocks and restoring sustainable
growth. Because of robust productivity growth, businesses have not had
to rely on labor input to the extent they otherwise might have, which
has hampered employment. Over the long term, however, the faster the
growth of productivity, the faster will be the growth of our output and
standard of living. In the long run, faster productivity growth will not
permanently restrain employment growth.
Inflation: The Consumer Price Index (CPI) rose 3.3 percent during
2004, up from 1.9 percent during 2003. Much of the pick up was due to a
surge in energy prices, which rose at a 17 percent annual rate, compared
with just 7 percent during 2003. Excluding the volatile food and energy
components, the core CPI rose 2.2 percent during 2004, compared with 1.1
percent during 2003.
Higher energy prices may have indirectly contributed to higher core
inflation as they fed through to the costs of non-energy goods and
services. Businesses also may have increased their markup of prices over
unit labor costs, which had been subdued by weak demand earlier in the
expansion. Reflecting the decline in crude oil prices in the closing
months of 2004, gasoline prices moved down in November and December,
suggesting that the energy-related upward push on the CPI was abating.
Summary: Entering 2005, the economy appears poised for continued
strong expansion. Overall growth, led by consumer and business spending,
is at a pace that suggests the steady creation of new jobs and a lower
unemployment rate. Core inflation, although higher than in 2003, is
still relatively low. Interest rates, too, are at historically low
levels.
Economic Projections
The Administration's economic projections, based on information
available as of early December, are summarized in Table 12-1. These
assumptions are close to those of the Congressional Budget Office and
the con
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sensus of private-sector forecasters, as described in more detail below
and shown in Table 12-2. In brief, the assumptions call for a
continuation of the recent trends of strong, sustained growth, improving
labor markets, low inflation, and, even allowing for a projected rise in
the next few years, relatively low interest rates.
Real GDP, Potential GDP, and Unemployment Rate: Real GDP, which is
estimated to have increased 4.4 percent in 2004 on a year-over-year
basis, is projected to increase 3.6 percent this year. During the next
few years, growth is likely to continue to exceed the long-run potential
growth rate. As a result, the unemployment rate, at 5.4 percent in
December, is projected to decline to 5.1 percent at the end of 2006 and
then remain at that level. That rate is the center of the range that is
thought to be consistent with stable inflation. The main sources of
growth in demand in coming years are likely to be business capital
spending, net exports, and to a lesser extent, consumer spending. The
contributions to overall growth from residential investment and the
government sector are expected to be small at best.
Table 12-1. ECONOMIC ASSUMPTIONS \1\
(Calendar years; dollar amounts in billions)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Projections
Actual 2003 ------------------------------------------------------------------------------------------
2004 2005 2006 2007 2008 2009 2010
--------------------------------------------------------------------------------------------------------------------------------------------------------
Gross Domestic Product (GDP):
Levels, dollar amounts in billions:
Current dollars......................... 11,004 11,731 12,392 13,083 13,797 14,537 15,306 16,112
Real, chained (2000) dollars............ 10,381 10,842 11,233 11,626 12,011 12,395 12,782 13,179
Chained price index (2000=100), annual 106.0 108.3 110.4 112.6 114.9 117.3 119.8 122.3
average................................
Percent change, fourth quarter over fourth
quarter:
Current dollars......................... 6.2 6.3 5.5 5.6 5.4 5.4 5.3 5.3
Real, chained (2000) dollars............ 4.4 3.9 3.5 3.4 3.2 3.2 3.1 3.1
Chained price index (2000=100).......... 1.7 2.3 1.9 2.0 2.1 2.1 2.1 2.1
Percent change, year over year:
Current dollars......................... 4.9 6.6 5.6 5.6 5.5 5.4 5.3 5.3
Real, chained (2000) dollars............ 3.0 4.4 3.6 3.5 3.3 3.2 3.1 3.1
Chained price index (2000=100).......... 1.8 2.1 1.9 2.0 2.1 2.1 2.1 2.1
Incomes, billions of current dollars:
Corporate profits before tax............ 874 998 1,307 1,276 1,265 1,266 1,270 1,292
Wages and salaries...................... 5,104 5,345 5,649 5,988 6,340 6,719 7,104 7,502
Other taxable income \2\................ 2,311 2,451 2,549 2,675 2,798 2,917 3,047 3,181
Consumer Price Index: \3\
Level (1982-84=100), annual average..... 184.0 188.9 193.4 197.8 202.5 207.4 212.4 217.5
Percent change, fourth quarter over 1.9 3.4 2.0 2.3 2.4 2.4 2.4 2.4
fourth quarter.........................
Percent change, year over year.......... 2.3 2.7 2.4 2.3 2.4 2.4 2.4 2.4
Unemployment rate, civilian, percent:
Fourth quarter level.................... 5.9 5.4 5.3 5.1 5.1 5.1 5.1 5.1
Annual average.......................... 6.0 5.5 5.3 5.2 5.1 5.1 5.1 5.1
Federal pay raises, January, percent:
Military \4\............................ 4.7 4.15 3.5 3.1 NA NA NA NA
Civilian \5\............................ 4.1 4.1 3.5 2.3 NA NA NA NA
Interest rates, percent:
91-day Treasury bills \6\............... 1.0 1.4 2.7 3.5 3.8 4.0 4.1 4.2
10-year Treasury notes.................. 4.0 4.3 4.6 5.2 5.4 5.5 5.6 5.7
--------------------------------------------------------------------------------------------------------------------------------------------------------
NA = Not Available.
\1\ Based on information available as of December 3, 2004.
\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; 2003 and 2004 figures are averages of various rank- and longevity- specific adjustments; percentages to be
proposed for years after 2006 have not yet been determined.
\5\ Overall average increase, including locality pay adjustments. Percentages to be proposed for years after 2006 have not yet been determined.
\6\ Average rate, secondary market (bank discount basis).
Potential growth is approximately equal to the sum of the trend rates
of growth of the labor force and of productivity. Potential GDP growth
is projected to be 3.2 percent through 2008, and then edge down to 3.1
percent during 2009-2010, primarily because of an assumed slowing in
labor force growth. The labor force is projected to grow about 1.2
percent per year through 2008 on average, slowing to about 0.8 percent
yearly on average during 2009-2010 as increasing numbers of baby boomers
enter retirement.
Trend productivity growth is assumed, conservatively, to be 2.6
percent per year. That pace is noticeably below the average since the
business cycle peak in the first quarter of 2001 (4.2 percent per year).
It is, however, close to the pace during 1996-2000 (2.5 percent) and not
far from the average since the official productivity series began in
1947 (2.3 percent).
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Inflation: Inflation increased in 2004, in large part because of the
surge in energy prices. With the recent easing of these prices,
inflation is likely to be lower in 2005. On a year-over-year basis, the
CPI is projected to increase 2.4 percent this year and remain close to
that level in each year through 2010. This inflation rate is lower than
the average during each decade of the 1970s, 1980s, and 1990s. The GDP
chain-weighted price index is projected to increase around 2.0 percent
in each year through 2010, slightly less than the CPI, which is the
usual pattern.
The forecast of low inflation reflects the current very low core
inflation rate, modest inflationary expectations, the additional
downward pressure on wages and prices that will persist until excess
labor and capital resources are fully re-employed, and the Federal
Reserve's focus on removing policy accommodation at a measured pace so
as to avoid an over-heated economy.
Interest Rates: As usually occurs during an expansion, interest rates
are projected to rise. The 3-month Treasury bill rate, which was 2.2
percent at the end of December, is expected to increase to 4.2 percent
by 2010. The yield on the 10-year Treasury note, 4.2 percent at the end
of last year, is projected to increase to 5.7 percent by 2010. The
larger increase at the shorter end of the maturity spectrum than at the
longer end is also typical of past cyclical experience.
The forecast rates are historically low: the projected averages for 3-
month and 10-year Treasuries during 2005-2010 are lower than the
averages for these instruments during each decade of the 1970s, 1980s,
and 1990s. The relatively low projected yields are due largely to the
relatively low projected inflation rate. Adjusted for inflation, the
projected real interest rates are close to their historical averages.
Income Shares: The share of labor compensation in GDP is projected to
rise from its low level in 2004 while the share of corporate profits is
projected to decline from the unusually high levels of 2004 and
anticipated for 2005. In recent years, growth of labor compensation
adjusted for inflation has not kept up with the growth of productivity.
During the projection period, however, labor compensation is expected to
catch up, which would raise the labor share in GDP back to its
historical average.
Among the components of labor compensation, the wage share in GDP is
expected to rise from its recent low level while the share of
supplements to wages and salaries is expected to remain at around the
high level reached in 2004. The supplement share in GDP has risen
because of rapidly growing health insurance contributions paid by
employers and by sharply higher employer contributions to defined-
benefit pension plans.
Corporate profits before tax as shown in Table 12.1 jumps sharply as a
share of GDP in 2005 because of the end of the accelerated depreciation
permitted by the 2002 and 2003 tax acts. Accelerated depreciation
lowered profits before tax compared with what they otherwise would have
been in 2003 and 2004 by allowing firms to write off more of their
investment sooner. After 2004, however, corporate profits before tax
will increase both because new investment will not qualify for the
temporary acceleration and because the remaining depreciation permitted
on investment that used this provision will be less.
Among the other income components, the share of personal interest
income in GDP is projected to decline reflecting the low nominal
interest rates of recent years. The remaining shares of the tax base
(dividends, rental income, and proprietors' income) are projected to
remain relatively stable at around their 2004 levels.
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 12-2 compares the 2006
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
generally assumes that the President's Budget proposals will be enacted.
The CBO baseline projection assumes that current law as of the time the
estimates are made remains forever unchanged. Despite their differing
policy assumptions, the three sets of economic projections, shown in
Table 12-2, 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 12-2. COMPARISON OF ECONOMIC ASSUMPTIONS
(Calendar years)
--------------------------------------------------------------------------------------------------------------------------------------------------------
Projections
------------------------------------------------------------------------------ Average,
2005 2006 2007 2008 2009 2010 2005-10
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GDP (billions of current dollars):
2006 Budget................................................ 12,392 13,083 13,797 14,537 15,306 16,112
CBO January................................................ 12,396 13,059 13,766 14,486 15,210 15,940
Blue Chip Consensus January \2\............................ 12,398 13,066 13,762 14,496 15,265 16,098
Real GDP (chain-weighted): \1\
2006 Budget................................................ 3.6 3.5 3.3 3.2 3.1 3.1 3.3
CBO January................................................ 3.8 3.7 3.7 3.4 3.1 2.9 3.5
Blue Chip Consensus January \2\............................ 3.6 3.4 3.2 3.2 3.1 3.3 3.3
Chain-weighted GDP Price Index: \1\
2006 Budget................................................ 1.9 2.0 2.1 2.1 2.1 2.1 2.0
CBO January................................................ 1.8 1.5 1.7 1.8 1.8 1.8 1.7
Blue Chip Consensus January \2\............................ 2.0 2.0 2.1 2.1 2.1 2.1 2.1
Consumer Price Index (all-urban): \1\
2006 Budget................................................ 2.4 2.3 2.4 2.4 2.4 2.4 2.4
CBO January................................................ 2.4 1.9 2.1 2.2 2.2 2.2 2.2
Blue Chip Consensus January \2\............................ 2.5 2.3 2.4 2.4 2.4 2.4 2.4
Unemployment rate: \3\
2006 Budget................................................ 5.3 5.2 5.1 5.1 5.1 5.1 5.2
CBO January................................................ 5.2 5.2 5.2 5.2 5.2 5.2 5.2
Blue Chip Consensus January \2\............................ 5.2 5.2 5.1 5.1 5.1 5.1 5.1
Interest rates: \3\
91-day Treasury bills:
2006 Budget.............................................. 2.7 3.5 3.8 4.0 4.1 4.2 3.7
CBO January.............................................. 2.8 4.0 4.6 4.6 4.6 4.6 4.2
Blue Chip Consensus January \2\.......................... 3.0 3.8 4.1 4.3 4.2 4.2 3.9
10-year Treasury notes:
2006 Budget.............................................. 4.6 5.2 5.4 5.5 5.6 5.6 5.3
CBO January.............................................. 4.8 5.4 5.5 5.5 5.5 5.5 5.4
Blue Chip Consensus January \2\.......................... 4.7 5.3 5.6 5.6 5.6 5.6 5.4
--------------------------------------------------------------------------------------------------------------------------------------------------------
Sources: Congressional Budget Office; Blue Chip Economic Indicators, Aspen Publishers, Inc.
\1\ Year-over-year percent change.
\2\ January 2005 Blue Chip Consensus forecast for 2005 and 2006; Blue Chip October 2004 long-run extension for 2007 - 2010.
\3\ Annual averages, percent.
For real GDP, the Administration, CBO, and the Blue Chip Consensus
anticipate strong growth this year. The Administration projects 3.6
percent growth on a year-over-year basis, about the same as the private
sector consensus and slightly below CBO's forecast. For calendar year
2006, the Administration, at 3.5 percent, is mid-way between the
consensus (at 3.4 percent), and CBO's 3.7 percent. Thereafter, the
Administration's projection is very close to the consensus growth rate
but generally below CBO's. Over the six-year span as a whole, the
Administration and the private sector consensus both project a 3.3
percent average annual growth rate, CBO 3.5 percent.
All three forecasts anticipate continued low inflation in the range of
1.5 to 2.1 percent as measured by the GDP chain-weighted price index,
and between 1.9 and 2.5 percent as measured by the CPI, with CBO lower
than the Administration and the private sector consensus, which are
close to each other. The three unem
[[Page 193]]
ployment rate projections are also similar with a projected rate just
above 5 percent in the later years of the forecast. All three project
slightly rising interest rates during the next few years, with CBO's
increase slightly larger than those of the Administration and the
private sector projection.
Changes in Economic Assumptions
The economic assumptions underlying this Budget are similar to those
of the 2005 Budget, as shown in Table 12-3.
As in last year's Budget, real GDP growth is expected to be 3.6
percent in 2005 on a year-over-year basis and moderate gradually to 3.1
percent in the outyears. Consequently, the levels of real GDP projected
this year are little changed from those of the 2005 Budget when
allowance is made for the Commerce Department's historical revisions to
the National Income and Product Accounts released in July 2004. The
level of nominal GDP is now projected to be higher than in the 2005
Budget because of a faster-than-expected rise in the GDP price index
last year and higher projected GDP inflation in the coming years.
The unemployment rate projection is virtually identical to last
year's. As in the 2005 Budget, the rate is expected to decline to 5.1
percent by 2007 and remain at that relatively low level. Interest rates
are expected to trend upward, as before. However, by 2009 the 3-month
Treasury bill rate is projected to be 0.3 percentage point lower than in
the 2005 Budget, and the yield on the 10-year Treasury note is expected
to be 0.2 percentage point lower.
Table 12-3. COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2005 AND 2006 BUDGETS
(Calendar years; dollar amounts in billions)
----------------------------------------------------------------------------------------------------------------
2004 2005 2006 2007 2008 2009 2010
----------------------------------------------------------------------------------------------------------------
Nominal GDP:
2005 Budget assumptions \1\.................... 11,622 12,197 12,807 13,460 14,163 14,902 15,671
2006 Budget assumptions........................ 11,731 12,392 13,083 13,797 14,537 15,306 16,112
Real GDP (2000 dollars):
2005 Budget assumptions \1\.................... 10,837 11,226 11,608 11,994 12,377 12,763 13,159
2006 Budget assumptions........................ 10,842 11,233 11,626 12,011 12,395 12,782 13,179
Real GDP (percent change): \2\
2005 Budget assumptions........................ 4.4 3.6 3.4 3.3 3.2 3.1 3.1
2006 Budget assumptions........................ 4.4 3.6 3.5 3.3 3.2 3.1 3.1
GDP price index (percent change): \2\
2005 Budget assumptions........................ 1.2 1.3 1.5 1.7 2.0 2.0 2.0
2006 Budget assumptions........................ 2.1 1.9 2.0 2.1 2.1 2.1 2.1
Consumer Price Index (percent change): \2\
2005 Budget assumptions........................ 1.4 1.5 1.8 2.1 2.4 2.5 2.5
2006 Budget assumptions........................ 2.7 2.4 2.3 2.4 2.4 2.4 2.4
Civilian unemployment rate (percent): \3\
2005 Budget assumptions........................ 5.6 5.4 5.2 5.1 5.1 5.1 5.1
2006 Budget assumptions........................ 5.5 5.3 5.2 5.1 5.1 5.1 5.1
91-day Treasury bill rate (percent): \3\
2005 Budget assumptions........................ 1.3 2.4 3.3 4.0 4.3 4.4 4.4
2006 Budget assumptions........................ 1.4 2.7 3.5 3.8 4.0 4.1 4.2
10-year Treasury note rate (percent): \3\
2005 Budget assumptions........................ 4.6 5.0 5.4 5.6 5.8 5.8 5.8
2006 Budget assumptions........................ 4.3 4.6 5.2 5.4 5.5 5.6 5.7
----------------------------------------------------------------------------------------------------------------
\1\ Adjusted for July 2004 NIPA revisions.
\2\ Year-over-year.
\3\ Calendar year average.
Table 12-4. ADJUSTED STRUCTURAL BALANCE
(In billions of dollars)
--------------------------------------------------------------------------------------------------------------------------------------------------------
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
--------------------------------------------------------------------------------------------------------------------------------------------------------
Unadjusted surplus or deficit (-)........... 125.5 236.2 128.2 -157.8 -377.6 -412.1 -426.6 -390.1 -312.1 -250.8 -232.9 -207.3
Cyclical component........................ 86.3 127.3 66.0 -62.8 -102.0 -60.2 -30.0 -13.4 -0.7 -0.2 ....... .......
-----------------------------------------------------------------------------------------------------------
Structural surplus or deficit (-)........... 39.2 108.8 62.1 -95.0 -275.6 -351.9 -396.6 -376.6 -311.4 -250.6 -232.9 -207.3
Deposit insurance outlays................. 5.3 3.1 1.6 1.0 1.4 2.0 0.3 1.0 2.3 2.3 2.2 1.8
-----------------------------------------------------------------------------------------------------------
Adjusted structural surplus or deficit (-).. 44.5 111.9 63.7 -94.0 -274.1 -350.0 -396.3 -375.7 -309.1 -248.3 -230.7 -205.5
--------------------------------------------------------------------------------------------------------------------------------------------------------
NOTE: The NAIRU is assumed to be 5.2% through calendar year 1998 and 5.1% thereafter.
Structural and Cyclical Balances
When the economy is operating below potential, as is projected to be
the case for the next few years, the unemployment rate exceeds the long-
run sustainable average consistent with price stability. As a result,
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; the deficit is
larger (or the surplus is smaller) than would be the case if the
unemployment rate were at its sustainable long-run average. The portion
of the deficit (or surplus) that can be traced to this factor can be
called the cyclical component. The portion that would remain if the unem
[[Page 194]]
ployment rate was at its long-run value is then called the structural
deficit (or structural surplus).
Historically, the structural balance has often provided a clearer
understanding of the stance of fiscal policy than has the unadjusted
budget balance which includes a cyclical component. In the typical post-
World War II business cycle, the structural balance has provided a
clearer gauge of the surplus or deficit that would persist in the long
run with the economy operating at the sustainable level of unemployment.
Conventional estimates of the structural balance are based on the
historical relationship between changes in the unemployment rate and
real GDP growth on the one hand, and receipts and outlays on the other.
For various reasons, these estimated relationships do not take into
account all of the cyclical changes in the economy. One example of a
cyclical phenomenon not captured in these estimates was the sharply
rising stock market during the second half of the 1990s. It boosted
capital gains-related receipts and pulled down the deficit. The
subsequent fall in the stock market reduced receipts and added to the
deficit. Some of this rise and fall was cyclical in nature. Receipts
would probably be higher today, if the cyclical component were removed
from the stock market, although recently the stock market has recovered
some of its earlier losses with a positive effect on receipts. It is not
possible, however, to estimate the cyclical component of the stock
market accurately, and for that reason, all of the stock market's
contribution to receipts is counted in the structural balance.
Other factors unique to the current economic cycle provide other
examples of less than complete cyclical adjustment. The extraordinary
fall-off in labor force participation, from 67.1 percent of the U.S.
population in 1997-2000, to 66.0 percent in 2004 appears to be
[[Page 195]]
at least partly cyclical in nature, and most forecasters are assuming
some rebound in labor force participation as the expansion continues.
Since the official unemployment rate does not include workers who have
left the labor force, the conventional measures of potential GDP,
incomes and Government receipts understate the extent to which potential
work hours have been under-utilized in the current expansion to date
because of the decline in labor force participation.
A third example is the fall-off in the wage and salary share of GDP,
from 49.2 percent in 2000 to 45.5 percent in the third quarter of 2004.
Again this change is widely suspected to be at least partly cyclical.
Since Federal taxes depend heavily on wage and salary income, the
larger-than-predicted decline in the wage share of GDP suggests that the
true cyclical component of the deficit is understated for this reason as
well.
There are also lags in the collection of tax revenue that can delay
the impact of cyclical effects beyond the year in which they occur. The
result is that even after the unemployment rate has fallen, receipts may
remain cyclically depressed for some time until these lagged effects
have dissipated.
For all these reasons, the current estimates of the cyclical deficit
are probably understated and perhaps by a large margin. The current
unemployment gap is only 0.3 percentage points, and the Administration
forecasts that the gap will be closed within two years, but in the
broader sense discussed above, the cyclical gap in receipts is likely to
be much larger than this and will not close as quickly.
From 1999 to 2001, the unemployment rate appears to have been lower
than could be sustained in the long run. Therefore, as shown in Table
12-4, in those years 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.
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 12-6.
For real growth and employment:
As shown in the first block, if in 2005 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 2005
deficit is estimated to increase by $13.0 billion; receipts in
2005 would be lower by $10.2 billion, and outlays would be
higher by $2.8 billion, primarily for unemployment-sensitive
programs. In fiscal year 2006, the estimated receipts
shortfall would grow further to $21.8 billion, and outlays
would increase by $8.1 billion relative to the base, even
though the growth rate in calendar year 2006 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 2005-2010, the cumulative increase in the budget
deficit is estimated to be $195 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 2005-2010, the
cumulative increase in the budget deficit is estimated to be
$529 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 2005 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 and 2006, outlays would be above the base by $11.0
billion and $19.1 billion, respectively, due in part to lagged
cost-of-living adjustments. Receipts would fall by $10.0
billion in 2005, due to the temporary effect of higher
interest rates on finanical corporations' profits and taxes,
but then would rise by $28.4 billion above the base in 2006
due to the sustained
[[Page 196]]
effects of inflation on the tax base, resulting in a $9.3
billion improvement in the 2006 budget balance. In subsequent
years, the amounts added to receipts would continue to be
larger than the additions to outlays. During 2005-2010,
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 $388 billion to outlays
over 2005-2010 and $492 billion to receipts, for a net
decrease in the 2005-2010 deficits of $104 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 are 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 and
the short-term effect of interest rate changes on financial
corporations' profits (and taxes).
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 2005-2010. 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 197]]
Table 12-5. SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
(In billions of dollars)
----------------------------------------------------------------------------------------------------------------
Total of
Budget effect 2005 2006 2007 2008 2009 2010 Effects,
2005-2010
----------------------------------------------------------------------------------------------------------------
Real Growth and Employment
Budgetary effects of 1
percent lower real GDP
growth:
(1) For calendar year 2005
only: \1\
Receipts................ -10.2 -21.8 -24.3 -25.6 -27.0 -28.4 -137.2
Outlays................. 2.8 8.1 8.8 10.6 12.5 14.7 57.4
-----------------------------------------------------------------------------------
Increase in deficit (- -13.0 -29.8 -33.0 -36.2 -39.5 -43.1 -194.6
)....................
(2) Sustained during 2005-
2010, with no change in
unemployment:
Receipts................ -10.4 -34.0 -62.9 -94.5 -129.0 -166.3 -497.1
Outlays................. * 0.5 2.1 5.0 9.3 15.3 32.2
-----------------------------------------------------------------------------------
Increase in deficit (- -10.4 -34.5 -65.0 -99.5 -138.4 -181.6 -529.3
)....................
Inflation and Interest Rates
Budgetary effects of 1
percentage point higher
rate of:
(3) Inflation and interest
rates during calendar
year 2005 only:
Receipts................ -10.0 28.4 37.1 24.7 26.0 27.4 133.6
Outlays................. 11.0 19.1 17.5 16.3 15.7 15.5 95.2
-----------------------------------------------------------------------------------
Decrease in deficit -21.0 9.3 19.6 8.3 10.3 11.9 38.4
(+)..................
(4) Inflation and interest
rates, sustained during
2005-2010:
Receipts................ -10.0 22.7 67.2 100.7 136.0 175.1 491.7
Outlays................. 11.4 34.5 56.9 76.8 95.0 113.3 387.8
-----------------------------------------------------------------------------------
Decrease in deficit -21.4 -11.8 10.4 24.0 41.0 61.8 103.9
(+)..................
(5) Interest rates only,
sustained during 2005-
2010:
Receipts................ -20.5 -11.4 6.3 11.8 16.0 20.9 23.1
Outlays................. 8.8 24.3 37.0 46.0 53.3 60.1 229.5
-----------------------------------------------------------------------------------
Increase in deficit (- -29.3 -35.7 -30.7 -34.1 -37.3 -39.2 -206.4
)....................
(6) Inflation only,
sustained during 2005-
2010:
Receipts................ 10.5 34.0 60.8 88.6 119.7 153.8 467.4
Outlays................. 2.7 10.5 20.5 32.0 43.7 56.2 165.5
-----------------------------------------------------------------------------------
Decrease in deficit 7.8 23.6 40.3 56.6 76.0 97.6 301.9
(+)..................
Interest Cost of Higher
Federal Borrowing
(7) Outlay effect of $100 1.3 3.5 4.2 4.7 5.0 5.4 24.2
billion increase in
borrowing in 2005........
----------------------------------------------------------------------------------------------------------------
* $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.