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

    [[Page 165]]

                            12. ECONOMIC ASSUMPTIONS

      By the end of 2005 the U.S. economy had entered its fifth year of
    expansion, exhibiting a sustained solid pace of economic growth, with
    low rates of unemployment and underlying inflation, rising payroll jobs,
    high homeownership rates, strong business investment, and a record level
    of real household wealth. This robust performance of the economy stands
    in marked contrast to the economic slowdown and recession of 2000-2001
    followed by the slow recovery in 2002-2003.\1\ The sluggish performance
    during those years resulted from a number of unanticipated shocks,
    including sharp declines in stock market valuations beginning in 2000;
    falling manufacturing production and business investment; and corporate
    accounting scandals. The terrorist attacks of September 11, 2001 were a
    further shock aimed at the heart of the U.S. economy and government. The
    renewed solid economic performance since mid-2003 is a testament to the
    resilience of the U.S. economy and the adoption of successful pro-growth
    policies, including tax relief, Federal Reserve monetary policy actions,
    and ongoing efforts to promote liberalized international trade and
    investment in innovative technologies.
    ---------------------------------------------------------------------------
      \1\ Economic performance is discussed in terms of calendar years.
    Budget figures are in terms of fiscal years.
    ---------------------------------------------------------------------------
      The performance of the economy over the past year provided further
    evidence for the robust nature of the expansion in the face of
    additional shocks. The economy continued its solid performance despite
    high energy prices and the substantial damage and disruptions from the
    worst hurricane season on record. Hurricanes Katrina, Rita, and Wilma
    resulted in significant loss of life, destruction of property and
    productive assets, disruption of local Gulf Coast populations and living
    conditions, and sharp increases in energy prices. Even so, during the
    very quarter of the year when the hurricanes hit, the economy still
    registered growth in real gross domestic product (GDP) in excess of 4
    percent at an annual rate. And by the final quarter of the year, most
    economic indicators that had shown short-lived adverse effects had
    returned to their pre-storm-season paths.
      As we move into 2006 and look forward to future years, the
    Administration and other public and private forecasters expect the
    expansion to continue for the foreseeable future, with sustained non-
    inflationary real growth, and the economy providing a solid foundation
    for the Federal budget outlook.

                           Recent Economic Performance

      At the time of the preparation of the 2007 Budget, real GDP in the
    U.S. economy has been increasing for 16 consecutive quarters, with the
    latest 10 consecutive quarters showing average growth rates of 4.1
    percent and no quarter during the period growing slower than 3.3
    percent. Over the 4 quarters of 2005, the economy was on track to
    register real GDP growth at about a 3.5 percent pace, following the 3.8
    percent growth rate during 2004 and the 4.0 percent rate of 2003. By
    virtually all signs, the expansion has entered a self-reinforcing phase,
    with growth widespread across various components and sectors.
      Increases in employment and ongoing strong gains in the efficiency of
    the U.S. workforce--that is, high growth in labor productivity--have
    combined to generate the sustained solid growth in real output.
        In labor markets, nonfarm payroll employment has increased
              by 4.6 million jobs since the post-recession low in May 2003,
              with 2 million of those job gains occurring during 2005--or
              about a 1.5 percent increase in payroll employment in the past
              year alone.
        Reflecting the improving labor situation, the unemployment
              rate declined to 4.9 percent in December 2005, down from a
              post-recession high of 6.3 percent in June 2003.
        Labor productivity gains--the increase in output per hour of
              labor--have been remarkably strong in recent years, providing
              a substantial boost to growth in real GDP. For example, output
              per hour in the nonfarm business sector was on track to rise
              by about 2.5 percent during 2005, following an increase of 2.6
              percent during 2004 and an especially robust increase of 5.0
              percent during 2003.
        The recent productivity gains reinforce the stronger trend
              productivity performance of the past decade. Since 1995, labor
              productivity in the nonfarm business sector has increased at
              about a 2.9 percent annual rate, compared to a 1.4 percent
              annual rate of gain in the period from 1973 to 1995.

    Stronger growth in labor productivity is a fundamental building block
    for the longer-term performance of the economy and represents the
    essential basis for increasing standards of living for American workers
    and families.

      At times in the past, after the economy had grown at a relatively
    strong pace with declining unemployment for an extended period--such as
    we have seen recently--there was an increase in inflationary pressures.
    That was the repeated experience in the 1960s and 1970s and early 1980s.
    Since 2003, however, strong gains in labor productivity have helped to
    keep the underlying rate of inflation low by historical standards
    despite the generally robust economic performance. Strong gains in
    productivity reduce production costs and keep down the pressures on
    output prices.

    [[Page 166]]

      Although rising productivity growth when supported by responsible
    monetary policy can keep inflation under control in the long run, other
    factors can affect the short-run behavior of prices and inflation:
        Primary commodity prices generally have been on a strong
              upward trend over the past 4 years reflecting increased demand
              associated with the stronger U.S. and international economies,
              and some depreciation of the U.S. dollar over this period.
        Energy prices--notably crude oil and natural gas prices--
              have increased sharply over the past 4 years. For example, the
              benchmark price for West Texas Intermediate crude oil
              increased from just under $20 a barrel in December 2001 to
              about $65 a barrel in August 2005. Over the same period, the
              national average retail gasoline price rose from $1.09 a
              gallon to more than $2.60 a gallon.
        The destruction of oil and natural gas facilities and the
              shutdown of gasoline refineries along the coast of the Gulf of
              Mexico from Hurricanes Katrina and Rita contributed to further
              volatility and increases in energy prices during August and
              September 2005. Crude oil prices initially rose sharply, with
              West Texas Intermediate crude oil reaching nearly $70 a barrel
              in early September, before falling back to hover around $60 a
              barrel over the final 2 months of the year. Gasoline prices
              initially rose above $3 a gallon and stayed near that level
              until beginning a gradual decline in mid-October, falling to
              about $2.25 by the end of the year.
        The rise in energy and gasoline prices contributed to a
              slight increase in the ``headline'' rate of inflation during
              2005: the consumer price index (CPI) rose 3.4 percent during
              2005 (December to December), up from a 3.3 percent rate during
              2004.
        Even so, abstracting from volatile food and energy items
              shows that ``core'' CPI inflation was 2.2 percent during 2005,
              a very low rate by historical standards. The price index for
              personal consumption expenditures excluding food and energy
              items from the National Income and Product Accounts (NIPAs)--
              which uses a method of calculation that eliminates one source
              of upward bias that exists in the CPI measures--was on track
              for an increase of less than 2 percent during 2005.

    The key point to recognize is that, despite rising commodity and energy
    prices that have led to a temporary increase and heightened volatility
    in the overall rate of inflation, underlying inflation remains subdued
    and inflation expectations do not appear to be adversely affecting
    business or household decisions.

      Indicators of real economic activity provide additional evidence for
    the strong, sustained growth performance of the U.S. economy in recent
    years and during 2005, and illustrate the broad-based nature of the
    expansion:
        Through the first 3 quarters of 2005, real consumer spending
              increased at a 3.6 percent annual rate, following increases at
              a 3.8 percent rate during both 2003 and 2004. In the fourth
              quarter, consumption spending slowed down, mainly because of a
              sharp drop in motor vehicle sales in the fall. Real
              consumption gains resumed in the last 2 months of the quarter,
              however, coinciding with a rebound in consumer confidence
              following temporary declines in sentiment following Hurricanes
              Katrina and Rita, and consumption spending does not appear to
              have suffered a permanent shock.
        Manufacturing activity and private investment spending have
              been strong in recent years, rebounding from the 2000-2001
              slowdown and recession. Manufacturing industrial production
              rose 2.8 percent during 2005, and has increased at more than a
              4.5 percent annual rate over the past 2\1/2\ years. Real
              business equipment and software spending rose at a 10 percent
              annual rate through the first 3 quarters of 2005 and has
              increased at an 11 percent annual rate over the past 2\1/4\
              years.
        Housing market activity continues to show its best sustained
              performance in more than a quarter century. There were 2.1
              million housing starts in 2005, following 1.95 million starts
              in 2004. Over the past 2 years, the national homeownership
              rate continued to run near record levels of about 69 percent.
              According to the National Association of Realtors, the median
              price of existing homes increased 13 percent over the most
              recent 12-month period. The housing boom is expected to
              moderate in 2006 and beyond, but without sharp declines in
              national housing prices or residential investment.
        Increasing housing wealth and higher stock market valuations
              have boosted real household wealth to record levels. At the
              end of the third quarter of 2005, household wealth reached $51
              trillion--or 5 times the level of annual personal income--up
              7.6 percent over the prior last quarters after adjusting for
              inflation. The real value of household real estate assets
              increased by 11 percent, and the real value of household
              holdings of corporate equities, mutual funds, and pension
              funds rose by 6 percent during the last 4 quarters.

    In general, economic performance during 2005 and the data and
    information from the past several years confirm that the U.S. economy is
    fundamentally strong, supporting the outlook for continued expansion
    with non-inflationary real growth.

                                Policy Background

      The fiscal and monetary policies of the past 5 years have successfully
    contributed to the current good economic performance. The general fiscal
    policy outlook--as presented in the President's Budget--continues to be
    consistent with the outlook for sustained expansion in the U.S. economy
    for the foreseeable future.

    [[Page 167]]

      The resilience of the U.S. economy in 2005 despite the economic and
    social disruptions caused by the hurricanes echoed the economic recovery
    from the variety of shocks that hit the economy over the 2000-2003
    period. Looking back, timely tax relief and reductions in interest rates
    promoted a rebound from the economic slowdown, helping our Nation
    overcome the adverse effects from these shocks, which included the
    bursting of the stock market bubble of the late 1990s; the terrorist
    attacks of September 11, 2001; problems with corporate malfeasance; and
    the uncertainty associated with an international war on terrorism and
    military conflicts in Afghanistan and Iraq. Those policies continue to
    provide a solid foundation for current and future economic performance.

                                 Policy Actions

      Fiscal Policy: Beginning in 2001, the Administration proposed, and
    Congress enacted, significant tax relief designed to overcome the shocks
    and recession--promoting recovery in the growth of output, income, and
    jobs--and to provide a strong basis for continued economic expansion in
    the long term.
         The Economic Growth and Tax Relief and Reconciliation Act
              of 2001 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.
         The Job Creation and Worker Assistance Act of 2002
              permitted immediate depreciation of 30 percent of the value of
              qualified new capital assets put in place during the three
              years ending 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.
         The Jobs and Growth Tax Relief Reconciliation Act of 2003
              lowered income tax rates, reduced the marriage penalty, raised
              the child tax credit, and raised the exemption amount for the
              individual Alternative Minimum Tax. The Act reduced tax rates
              on dividend income and capital gains, reducing 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
              raised the maximum amount that a small business could expense
              from $25,000 per year to $100,000.
         The Working Families Tax Relief Act of 2004 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.
      Efforts continue to preserve the favorable tax environment the
    President and the Congress have created. Maintaining a relatively low
    tax environment in the United States is a central element of the
    Administration's economic and budget policies. The Administration's
    budget proposals, including sustained lower taxes and significant
    spending restraint, will reduce the Federal budget deficit in coming
    years as a share of GDP, so that publicly held debt is projected to
    remain relatively stable, and eventually to decline, relative to the
    size of the economy.

      Monetary Policy and Interest Rates: As we enter 2006, Federal Reserve
    monetary policy continues to be oriented toward promoting sustained non-
    inflationary, real growth in the U.S. economy. Looking back, from early
    2001 through mid-2003 monetary policy was focused on overcoming negative
    shocks and restoring stronger real growth. The Federal Reserve lowered
    the target Federal funds rate--a key interbank overnight interest 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, reflecting the accumulating evidence of improved
    economic performance and the outlook for sustained future growth. By
    December 2005, the Federal Reserve had raised the funds rate to 4\1/4\
    percent. In its statement accompanying the December increase, the
    Federal Reserve stated that ``some further measured policy firming is
    likely to be needed to keep the risks to the attainment of both
    sustainable economic growth and price stability roughly in balance.''
    The Administration forecast for the 3-month Treasury bill rate,
    presented below, is consistent with market expectations reflecting the
    outlook for ``further measured policy firming.''
      Longer-term interest rates, notably the yield on 10-year Treasury
    notes, remained low by historical standards during 2005. The 10-year
    rate traded as low as 3.9 percent and as high as 4.6 percent during the
    year, but it ended the year at just under 4.4 percent, not much
    different from where it began the year. With the increases in the
    Federal funds rate during the year to 4\1/4\ percent, the low 10-year
    Treasury yield at the end of the year produced a very flat structure of
    interest rates across short- to long-term maturities. The low levels of
    longer-term interest rates--including those for corporate securities and
    for residential mortgages--

    [[Page 168]]

    have been key factors promoting the strong gains in business and
    residential investment.

                                   Challenges

      Even though the general outlook is for continued healthy expansion for
    the U.S. economy, a number of challenges remain, including:
        The strong performance of residential construction and the
              increases in housing prices and wealth of recent years have
              introduced concerns about the future performance of housing
              markets and the implications for general economic activity
              should the housing boom end precipitously. Most analysts
              anticipate that an orderly transition will occur to a more
              moderate pace of housing activity with stabilizing prices.
              Although risks remain, the general expectation is that
              household consumption spending and overall economic
              performance will not be significantly affected if the housing
              adjustment is moderate and gradual.
        The U.S. continues to run mounting international trade and
              current account deficits, and concerns persist about their
              sustainability. These international deficits are largely the
              result of the persistant strength of the U.S. economy relative
              to our foreign trading partners. Most forecasters expect that
              the pressures tending to raise international deficits will
              alleviate somewhat going forward reflecting changes in key
              determinants, including expected improvements in the growth
              rates of foreign economies. The general expectation is that
              the U.S. trade position will gradually improve in coming
              years, consistent with the outlook for ongoing sustained
              expansion in the U.S. economy.
        Strong consumption spending in recent years has resulted in
              a low measured rate of personal saving. The increases in
              household wealth from higher housing and stock market
              valuations, and the associated increases in consumption, can
              account for much of the lower saving rate. An orderly
              transition in residential housing markets, if coupled with
              ongoing solid corporate equity valuations and rising real
              incomes, will not dampen consumption spending.
        The Federal budget outlook presents potential challenges.
              During 2005, the worst hurricane season on record resulted in
              additional costs for the Federal Government for rebuilding and
              disaster relief efforts. Other special costs continue,
              including for the international War on Terror and ongoing
              efforts in Afghanistan and Iraq. The short-term increases in
              the budget deficit require further efforts for fiscal
              discipline. Over the next five years, the Administration's
              budget proposals call for reduction in the Federal budget
              deficit as a share of GDP, and the publicly held debt is
              projected to remain relatively stable, and then to decline,
              relative to the size of the economy. Those patterns for the
              deficit and the debt are consistent with a sustainable fiscal
              policy that will coincide with continued expansion. Beyond the
              five-year budget horizon, the effects of demographic changes
              and rising health care costs on entitlement programs make the
              long-term outlook for the deficit and the debt more
              problematic, as discussed in Chapter 13 of this volume,
              ``Stewardship.''
      Although these factors represent potential risks and challenges, the
    current outlook continues to be one of a gradual and orderly transition
    that will support the ongoing expansion in the U.S. economy.

                              Economic Projections

      The Administration's economic projections, based on information
    available as of mid-November 2005, are summarized in Table 12-1. These
    assumptions are close to those of the Congressional Budget Office and
    the consensus 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; solid
    jobs growth; low inflation; and, even allowing for a projected rise in
    the next few years, relatively low interest rates.

                                                              Table 12-1.  ECONOMIC ASSUMPTIONS \1\
                                                          (Calendar years; dollar amounts in billions)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                              Projections
                                                                Actual   -----------------------------------------------------------------------------------
                                                                 2004        2005        2006        2007        2008        2009        2010        2011
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Gross Domestic Product (GDP):
      Levels, dollar amounts in billions:
        Current dollars.....................................    11,734      12,482      13,210      13,949      14,713      15,493      16,310      17,177
        Real, chained (2000) dollars........................    10,756      11,139      11,514      11,896      12,284      12,669      13,062      13,467
        Chained price index (2000=100), annual average......     109.1       112.1       114.7       117.3       119.8       122.3       124.9       127.5
      Percent change, fourth quarter over fourth quarter:
        Current dollars.....................................       6.8         6.4         5.6         5.6         5.4         5.3         5.3         5.3
        Real, chained (2000) dollars........................       3.8         3.5         3.4         3.3         3.2         3.1         3.1         3.1
        Chained price index (2000=100)......................       2.9         2.8         2.2         2.2         2.1         2.1         2.1         2.2
      Percent change, year over year:
        Current dollars.....................................       7.0         6.4         5.8         5.6         5.5         5.3         5.3         5.3
        Real, chained (2000) dollars........................       4.2         3.6         3.4         3.3         3.3         3.1         3.1         3.1
        Chained price index (2000=100)......................       2.6         2.7         2.4         2.2         2.1         2.1         2.1         2.1

    Incomes, billions of current dollars:
        Corporate profits before tax........................     1,059       1,425       1,506       1,497       1,516       1,495       1,497       1,500
        Wages and salaries..................................     5,389       5,745       6,095       6,459       6,843       7,229       7,613       8,028
        Other taxable income \2\............................     2,420       2,495       2,618       2,717       2,877       2,974       3,105       3,231

    Consumer Price Index: \3\
        Level (1982-84=100), annual average.................     188.9       195.3       201.1       205.9       210.9       215.9       221.1       226.6
        Percent change, fourth quarter over fourth quarter..       3.4         3.8         2.4         2.4         2.4         2.4         2.4         2.5
        Percent change, year over year......................       2.7         3.4         3.0         2.4         2.4         2.4         2.4         2.5

    Unemployment rate, civilian, percent:
        Fourth quarter level................................       5.4         5.0         5.0         5.0         5.0         5.0         5.0         5.0
        Annual average......................................       5.5         5.1         5.0         5.0         5.0         5.0         5.0         5.0

    Federal pay raises, January, percent:
        Military \4\........................................      4.15         3.5         3.1         2.2          NA          NA          NA          NA
        Civilian \5\........................................       4.1         3.5         3.1         2.2          NA          NA          NA          NA

    Interest rates, percent:
        91-day Treasury bills \6\...........................       1.4         3.2         4.2         4.2         4.3         4.3         4.3         4.3
        10-year Treasury notes..............................       4.3         4.3         5.0         5.3         5.5         5.6         5.6         5.6
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    NA = Not Available.
    \1\ Based on information available as of November 15, 2005.
    \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; 2004 figure is average of various rank- and longevity-specific adjustments; percentages to be proposed for
      years after 2007 have not yet been determined.
    \5\ Overall average increase, including locality and special pay adjustments. Percentages to be proposed for years after 2007 have not yet been
      determined.
    \6\ Average rate, secondary market (bank discount basis).

       Real GDP, Potential GDP, and Unemployment Rate: Real GDP, which is
    estimated to have increased 3.6 percent in 2005 on a year-over-year
    basis, is projected to increase 3.4 percent this year. During the next
    few years, both actual and potential growth are likely to continue to
    moderate further to about 3.1 percent. As a result, the unemployment
    rate, fluctuating narrowly around 5.0 percent for the last nine months
    of 2005, is projected to 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.
      For the private business sector of the economy, potential growth is
    approximately equal to the sum of the trend rates of growth of the labor
    force and of productivity. Potential growth of total GDP (including
    government sectors) is projected to be about 3\1/4\ percent over the
    next two years, trending down to 3.1 percent after 2008, primarily
    because of an assumed slowing in labor force growth. The labor force is
    projected to grow about 1.3 percent per year through 2007 on average,
    slowing to about 0.9 percent yearly on average during 2008-2011 as
    increasing numbers of baby boomers enter retirement.
      Trend productivity growth in the nonfarm business sector \2\ is
    assumed to be 2.6 percent per year. The 2.6 percent trend pace is
    noticeably below the average since the business cycle peak in the first
    quarter of 2001 (3.6 percent per year). It is, however, close to

    [[Page 169]]

    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).
    ---------------------------------------------------------------------------
      \2\ The nonfarm business sector accounts for about three-fourths of
    the value of GDP, with households, institutions and government
    accounting for the remainder. The nonfarm business sector serves as the
    standard metric for productivity because of its reliable measurement.
    ---------------------------------------------------------------------------
       Inflation: Inflation increased in 2005, in large part because of
    surging energy prices. With the recent easing of these prices, inflation
    is likely to be lower in 2006. On a year-over-year basis, the CPI is
    projected to increase 3.0 percent this year with the increase moderating
    to 2.4 to 2.5 percent a year through 2011. This inflation rate is lower
    than the average during each decade of the 1970s, 1980s, and 1990s. The
    GDP price index is projected to increase 2.2 or 2.1 percent in each year
    through 2011, 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 downward pressure
    on wages and prices due to both domestic and global competition, and the
    Federal Reserve's focus on measured policy firming so as to avoid an
    over-heated economy.
       Interest Rates: Interest rates are projected to rise, as is the usual
    case during an expansion. The 3-month Treasury bill rate, which was 4.0
    percent at the end of December, is expected to increase to 4.3 percent
    by 2008. The yield on the 10-year Treasury note, 4.3 percent at the end
    of last year, is projected to increase to 5.6 percent by 2009.
      The forecast rates are historically low: the projected averages for 3-
    month and 10-year Treasuries during 2006-2016 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 2005, while the share of corporate profits is
    projected to decline from the unusually high levels of 2005 and those
    anticipated for 2006. In recent years, growth of labor

    [[Page 170]]

    compensation adjusted for inflation has lagged 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 about 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 2005. The supplement share in GDP has risen
    because of rapidly growing health insurance contributions paid by
    employers and sharply higher employer ``catch-up'' contributions to
    defined-benefit pension plans.
      Corporate profits before tax jumped sharply as a share of GDP in 2005
    primarily 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 be higher than
    normal 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 2005 levels.

                Comparison with CBO and Private-Sector Forecasts

                                     Table 12-2.  COMPARISON OF ECONOMIC ASSUMPTIONS
                                                    (Calendar years)
    ----------------------------------------------------------------------------------------------------------------
                                                                       Projections
                                              ------------------------------------------------------------  Average,
                                                 2006      2007      2008      2009      2010      2011     2006-11
    ----------------------------------------------------------------------------------------------------------------
    GDP (billions of current dollars):
      2007 Budget............................  13,210    13,949    14,713    15,493    16,310    17,177
      CBO January............................  13,263    13,960    14,696    15,455    16,208    16,954
      Blue Chip Consensus January \2\........  13,237    13,939    14,703    15,505    16,372    17,280

    Real GDP (chain-weighted): \1\
      2007 Budget............................       3.4       3.3       3.3       3.1       3.1       3.1       3.2
      CBO January............................       3.6       3.4       3.4       3.3       3.0       2.8       3.3
      Blue Chip Consensus January \2\........       3.4       3.1       3.2       3.1       3.3       3.2       3.2

    Chain-weighted GDP Price Index: \1\
      2007 Budget............................       2.4       2.2       2.1       2.1       2.1       2.1       2.2
      CBO January............................       2.4       1.8       1.8       1.8       1.8       1.8       1.9
      Blue Chip Consensus January \2\........       2.4       2.1       2.3       2.2       2.3       2.2       2.3

    Consumer Price Index (all-urban): \1\
      2007 Budget............................       3.0       2.4       2.4       2.4       2.4       2.5       2.5
      CBO January............................       2.8       2.1       2.2       2.2       2.2       2.2       2.3
      Blue Chip Consensus January \2\........       2.9       2.4       2.5       2.5       2.4       2.5       2.5

    Unemployment rate: \3\
      2007 Budget............................       5.0       5.0       5.0       5.0       5.0       5.0       5.0
      CBO January............................       5.0       5.0       5.1       5.2       5.2       5.2       5.1
      Blue Chip Consensus January \2\........       4.9       4.9       4.9       4.9       5.0       4.9       4.9

    Interest rates: \3\
      91-day Treasury bills:
        2007 Budget..........................       4.2       4.2       4.3       4.3       4.3       4.3       4.3
        CBO January..........................       4.5       4.5       4.4       4.4       4.4       4.4       4.4
        Blue Chip Consensus January \2\......       4.5       4.5       4.4       4.3       4.4       4.4       4.4

      10-year Treasury notes: \3\
        2007 Budget..........................       5.0       5.3       5.5       5.6       5.6       5.6       5.4
        CBO January..........................       5.1       5.2       5.2       5.2       5.2       5.2       5.2
        Blue Chip Consensus January \2\......       4.9       5.0       5.3       5.3       5.4       5.4       5.2
    ----------------------------------------------------------------------------------------------------------------
    Sources: Congressional Budget Office; Blue Chip Economic Indicators, Aspen Publishers, Inc.
    \1\ Year-over-year percent change.
    \2\ January 2006 Blue Chip Consensus forecast for 2006 and 2007; Blue Chip October 2005 long-run extension for
      2008-2011.
    \3\ Annual averages, percent.

      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 2007
    Budget assumptions with projections by CBO and by the Blue Chip
    Consensus, an average of about 50 private-sector forecasts.

    [[Page 171]]

      The three sets of economic assumptions are based on different
    underlying assumptions concerning economic policies. The Administration
    forecast generally assumes that the President's Budget proposals will be
    enacted. In contrast, the CBO baseline projection assumes that current
    law as of the time the estimates are made remains 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 conservative nature of the
    Administration forecast.
      For real GDP, the Administration, CBO, and the Blue Chip Consensus
    anticipate solid growth this year. The Administration projects 3.4
    percent growth on a year-over-year basis, the same as the private sector
    consensus and slightly below CBO's forecast. For calendar year 2007, the
    Administration, at 3.3 percent, is between the consensus (at 3.1
    percent), and CBO's 3.4 percent. Thereafter, the Administration's
    projection is very close to the consensus growth rate but below CBO's
    through 2009. Over the six-year span as a whole, the Administration, CBO
    and the private sector consensus all project 3.2 or 3.3 percent average
    annual growth rates.
      All three forecasts anticipate continued low inflation in the range of
    1.8 to 2.4 percent as measured by the GDP price index; and, after 2006,
    between 2.2 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 unemployment rate projections are also similar
    with a projected rate near 5 percent throughout the forecast. All three
    project slightly rising interest rates during the next few years, with
    the Administration's long term rates slightly above the Blue Chip's and
    CBO's slightly below, and the short term rate forecasts nearly
    identical.

                         Changes in Economic Assumptions

      The economic assumptions underlying this Budget are similar to those
    of the 2006 Budget, as shown in Table 12-3.
      Real GDP growth is now expected to be 3.4 percent in 2006 on a year-
    over-year basis compared to 3.5 percent forecast in last year's Budget,
    and to 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 2006 Budget when allowance is made for the Commerce Department's
    historical revisions to the National Income and Product Accounts
    released in July 2005. The level of nominal GDP is now projected to be
    higher than in the 2006 Budget because of a faster-than-expected rise in
    the GDP price index last year and slightly higher projected GDP
    inflation in the coming years.
      The unemployment rate projection is virtually identical to last
    year's. Where the 2006 Budget had the rate level at 5.1 percent in
    future years, the rate is now projected to remain at the relatively low
    average of 5.0 percent recorded for the last nine months of 2005.
    Interest rates are expected to trend upward, as before. The 3-month
    Treasury bill rate is now projected to rise to 4.3 percent by 2008,
    where before it reached that level only in 2011; and the yield on the
    10-year Treasury note is expected to rise only to 5.6 percent, not 5.7
    percent.

                                          Table 12-3.  COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2006 AND 2007 BUDGETS
                                                          (Calendar years; dollar amounts in billions)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                             2005        2006        2007        2008        2009        2010        2011
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Nominal GDP:
      2006 Budget assumptions \1\.......................................      12,401      13,093      13,808      14,548      15,318      16,124      16,976
      2007 Budget assumptions...........................................      12,482      13,210      13,949      14,713      15,493      16,310      17,177

    Real GDP (2000 dollars):
      2006 Budget assumptions \1\.......................................      11,149      11,540      11,922      12,303      12,688      13,081      13,487
      2007 Budget assumptions...........................................      11,139      11,514      11,896      12,284      12,669      13,062      13,467

    Real GDP (percent change): \2\
      2006 Budget assumptions...........................................         3.6         3.5         3.3         3.2         3.1         3.1         3.1
      2007 Budget assumptions...........................................         3.6         3.4         3.3         3.3         3.1         3.1         3.1

    GDP price index (percent change): \2\
      2006 Budget assumptions...........................................         2.0         2.0         2.1         2.1         2.1         2.1         2.1
      2007 Budget assumptions...........................................         2.7         2.4         2.2         2.1         2.1         2.1         2.1

    Consumer Price Index (percent change): \2\
      2006 Budget assumptions...........................................         2.0         2.3         2.4         2.4         2.4         2.4         2.5
      2007 Budget assumptions...........................................         3.4         3.0         2.4         2.4         2.4         2.4         2.5

    Civilian unemployment rate (percent): \3\
      2006 Budget assumptions...........................................         5.3         5.2         5.1         5.1         5.1         5.1         5.1
      2007 Budget assumptions...........................................         5.1         5.0         5.0         5.0         5.0         5.0         5.0

    91-day Treasury bill rate (percent): \3\
      2006 Budget assumptions...........................................         2.7         3.5         3.8         4.0         4.1         4.2         4.3
      2007 Budget assumptions...........................................         3.2         4.2         4.2         4.3         4.3         4.3         4.3

    10-year Treasury note rate (percent): \3\
      2006 Budget assumptions...........................................         4.6         5.2         5.4         5.5         5.6         5.6         5.7
      2007 Budget assumptions...........................................         4.3         5.0         5.3         5.5         5.6         5.6         5.6

    --------------------------------------------------------------------------------------------------------------------------------------------------------
    \1\ Adjusted for July 2005 NIPA revisions.
    \2\ Year-over-year.
    \3\ Calendar year average.

                        Structural and Cyclical Balances

      When the economy is operating below potential, 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 unemployment 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. 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 2004-2005, appears to be 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

    [[Page 172]]

    under-utilized in the current expansion to date because of the decline
    in labor force participation.

                                                            Table 12-4.  ADJUSTED STRUCTURAL BALANCE
                                                                    (In billions of dollars)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                    2000     2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Unadjusted surplus or deficit (-)...........    236.2    128.2   -157.8   -377.6   -412.7   -318.3   -423.2   -354.2   -223.3   -207.6   -182.7   -204.9
      Cyclical component........................    134.6     80.8    -47.0    -91.4    -51.6    -19.3     -5.0     -0.8  .......  .......  .......  .......
                                                 -----------------------------------------------------------------------------------------------------------
    Structural surplus or deficit (-)...........    101.6     47.5   -110.8   -286.2   -361.2   -299.0   -418.2   -353.4   -223.3   -207.6   -182.7   -204.9
      Deposit insurance outlays.................      3.1      1.6      1.0      1.4      2.0      1.4      1.3      1.8      1.8      1.7      2.8      3.7
                                                 -----------------------------------------------------------------------------------------------------------
    Adjusted structural surplus or deficit (-)..    104.7     49.0   -109.8   -284.8   -359.2   -297.6   -416.9   -351.6   -221.5   -205.8   -179.9   -201.2
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    NOTE: The NAIRU is assumed to be 5.0 percent

      A third example is the fall-off in the wage and salary share of GDP,
    from 49.2 percent in 2000 to 45.6 percent in the second quarter of 2004.
    Again, this change is widely suspected to be 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. The current unemployment gap is believed to be
    zero, and the Administration forecasts that it will remain so, but in
    the broader sense discussed above, the cyclical gap in receipts is
    likely to still be large and only slowly shrinking.
      During fiscal years 2000 and 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.

    [[Page 173]]

                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 slow 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 the 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 interest 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 12-5.
      For real growth and employment:
        As shown in the first block, if in 2006 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 2006
              deficit is estimated to increase by $15.8 billion; receipts in
              2006 would be lower by $12.6 billion, and outlays would be
              higher by $3.2 billion, primarily for unemployment-sensitive
              programs. In fiscal year 2007, the estimated receipts
              shortfall would grow further to $26.6 billion, and outlays
              would increase by $8.9 billion relative to the base, even
              though the growth rate in calendar year 2007 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 2006-2011, the cumulative increase in the budget
              deficit is estimated to be $236 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 2006-2011, the
              cumulative increase in the budget deficit is estimated to be
              $662 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 2006 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
              2006 and 2007, outlays would be above the base by $11.2
              billion and $19.3 billion, respectively, due in part to lagged
              cost-of-living adjustments. Receipts would rise by only $16.6
              billion in 2006, due to the temporary effect of higher
              interest rates on financial corporations' profits and taxes,
              but then would rise by $44.4 billion above the base in 2007
              due to the sustained effects of inflation on the tax base,
              resulting in a $25.1 billion improvement in the 2007 budget
              balance. In subsequent years, the amounts added to receipts
              would continue to be larger than the additions to outlays.
              During 2006-2011, cumulative budget deficits would be $123
              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 $362 billion to outlays
              over 2006-2011 and $783 billion to receipts, for a net
              decrease in the 2006-2011 deficits of $421 billion.
        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 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 price index and in CPI inflation decrease
              cumulative deficits by a substantial $429 billion during 2006-
              2011. This large effect is because the receipts from a higher
              tax base exceed the combination of higher outlays from
              mandatory cost-of-living adjustments and lower receipts from
              CPI indexation of tax brackets. The separate effects of higher
              inflation and higher interest rates in the fifth and sixth
              blocks do not sum to the effects for simultaneous changes in
              both in the fourth block. 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

    [[Page 174]]

              well (the combined case) than when interest rates are assumed
              to be unchanged (the separate case).
      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.

                             Table 12-5.  SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
                                         (Fiscal years; in billions of dollars)
    ----------------------------------------------------------------------------------------------------------------
                                                                                                            Total of
                  Budget effect                  2006      2007      2008      2009      2010      2011     Effects,
                                                                                                           2006-2011
    ----------------------------------------------------------------------------------------------------------------
            Real Growth and Employment

    Budgetary effects of 1 percent lower real
     GDP growth:
      (1) For calendar year 2006 only: \1\
        Receipts.............................     -12.6     -26.6     -30.2     -32.1     -34.2     -36.3     -172.1
        Outlays..............................       3.2       8.9       9.8      11.9      14.0      16.2       64.0
                                              ----------------------------------------------------------------------
          Increase in deficit (-)............     -15.8     -35.5     -39.9     -44.0     -48.3     -52.5     -236.0

      (2) Sustained during 2006-2011, with no
       change in unemployment:
        Receipts.............................     -12.8     -41.8     -77.7    -117.3    -161.5    -209.8     -620.8
        Outlays..............................       0.2       1.0       3.3       7.3      12.0      17.8       41.5
                                              ----------------------------------------------------------------------
          Increase in deficit (-)............     -12.9     -42.8     -80.9    -124.5    -173.5    -227.6     -662.3

           Inflation and Interest Rates

    Budgetary effects of 1 percentage point
     higher rate of:
      (3) Inflation and interest rates during
       calendar year 2006 only:
        Receipts.............................      16.6      44.4      40.2      32.8      35.0      37.1      206.1
        Outlays..............................      11.2      19.3      14.6      13.3      12.9      12.3       83.5
                                              ----------------------------------------------------------------------
          Decrease in deficit (+)............       5.4      25.1      25.7      19.6      22.1      24.8      122.6

      (4) Inflation and interest rates,
       sustained during 2006-2011:
        Receipts.............................      16.6      65.2     111.6     151.6     194.6     243.3      783.0
        Outlays..............................      11.7      35.2      54.0      70.4      86.9     103.8      361.9
                                              ----------------------------------------------------------------------
          Decrease in deficit (+)............       4.9      30.0      57.7      81.3     107.7     139.5      421.0

      (5) Interest rates only, sustained
       during 2006-2011:
        Receipts.............................       3.9      24.1      36.5      38.9      39.2      40.6      183.3
        Outlays..............................       8.6      24.4      34.2      40.3      45.4      49.7      202.8
                                              ----------------------------------------------------------------------
          Increase in deficit (-)............      -4.7      -0.3       2.2      -1.4      -6.2      -9.2      -19.5

      (6) Inflation only, sustained during
       2006-2011:
        Receipts.............................      12.6      41.0      74.9     112.4     154.9     202.2      598.2
        Outlays..............................       3.1      11.1      20.5      31.6      44.2      58.3      168.8
                                              ----------------------------------------------------------------------
          Decrease in deficit (+)............       9.5      29.9      54.4      80.8     110.8     143.9      429.4

    Interest Cost of Higher Federal Borrowing

    (7) Outlay effect of $100 billion               2.2       4.6       4.9       5.2       5.5       5.8       28.2
     increase in borrowing in 2006...........
    ----------------------------------------------------------------------------------------------------------------
    \1\ The unemployment rate is assumed to be 0.5 percentage point higher per 1.0 percent shortfall in the level of
      real GDP.