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



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                        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.

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  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.

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  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--

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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

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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

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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.