    [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 2006 the U.S. economy had entered its sixth year of
    expansion, with a moderate pace of economic growth, sustained increases
    in payroll jobs, relatively low levels of unemployment and underlying
    inflation, and good prospects for steady, sustained growth ahead. \1\
    The ongoing solid economic performance of recent years demonstrates the
    resilience of the U.S. economy and the beneficial effects of successful
    pro-growth policies, including tax relief, Federal Reserve monetary
    policy actions, and ongoing efforts to promote investment in innovative
    technologies and to liberalize international trade.
    ---------------------------------------------------------------------------
      \1\ Economic performance is discussed in terms of calendar years.
    Budget figures are in terms of fiscal years.
    ---------------------------------------------------------------------------
      The performance of the past five years reveals the robust nature of
    the U.S. economic expansion and the ability of the economy to overcome a
    series of shocks, including: sharp declines in the stock market and in
    investment in business equipment that led to the economic slowdown and
    recession of 2000-2001; the terrorist attacks of September 11, 2001; the
    onset of the Global War on Terror; high and increasing prices for crude
    oil and energy in recent years; and the substantial damage and
    disruptions from the 2005 hurricane season. Further, during 2006, the
    U.S. economy began to experience adverse effects from a housing market
    slowdown. Despite these unfavorable events, the U.S. economy has
    continued to expand, with solid productivity and income growth, low
    unemployment, and the generation of more than 7.2 million payroll jobs
    since August 2003 (including revisions).
      As 2007 begins, the Administration and other public and private
    forecasters expect the expansion to continue throughout the budget
    window, with sustained non-inflationary real growth providing a solid
    foundation for the Federal budget outlook.

                           Recent Economic Performance

      At the time of the preparation of the Budget, real gross domestic
    product (GDP) in the U.S. economy has been increasing for 20 consecutive
    quarters, averaging 3.0 percent growth at an annual rate during the
    expansion. Over the four quarters of 2006, real GDP growth was on track
    to register about a 3.1 percent growth rate, following the same pace
    during 2005 and a 3.4 percent rate during 2004.
      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 growth in real output in recent
    years.
        In labor markets, nonfarm payroll employment has increased
              by more than 7.2 million jobs since the post-recession low in
              August 2003, with about 2.0 million of those job gains
              occurring during 2006.
        Reflecting the improved labor situation, the unemployment
              rate was down to 4.5 percent in December 2006 from its post-
              recession high of 6.3 percent in June 2003--and recently has
              been at its lowest level in five years, and at levels below
              the averages of each of the past five decades.
        Labor productivity gains--the increase in output per hour of
              labor--have been remarkably strong during the expansion,
              providing a substantial boost to growth in real GDP. Output
              per hour in the nonfarm business sector has increased at a 3.0
              percent average annual rate over the past five years, although
              at a slower 2.5 percent pace since the spring of 2003,
              reflecting the return to stronger employment growth.
        The productivity gains during the expansion reinforce the
              stronger trend productivity performance of the past decade.
              Since 1995, labor productivity in the nonfarm business sector
              has increased at about a 2.8 percent annual rate, double the
              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 rising wages and increasing standards of living for
    American workers and families.

        Reflecting labor gains from stronger productivity growth,
              during 2006 real hourly earnings of production workers rose by
              1.7 percent, the strongest annual gain in five years.
        Through November, real disposable personal income had
              increased by 3.0 percent at an annual rate during 2006, and
              the real per capita increase was at a 2.0 percent rate. By way
              of comparison, during the current expansion real disposable
              personal income per capita is up 9.7 percent, compared with
              the 6.7 percent increase during the equivalent period of the
              prior expansion of the 1990s.
      Other economic indicators also provide evidence for the sustained
    growth performance of the U.S. economy in recent years and during 2006:
        Through the third quarter of 2006, real consumer spending
              had increased at a 3.4 percent annual rate, following
              increases at a 2.9 percent rate during 2005 and at a 4.0
              percent rate during 2004. In the fourth quarter, consumption
              spending growth continued, providing a strong base for final
              demand in the economy at the end of the year.

    [[Page 166]]

        Real fixed business investment in structures showed strong
              gains in 2006, rising at a 15 percent annual rate through the
              third quarter of the year, on track to being the strongest
              annual increase in more than two decades.
        Real business investment in durable equipment and software
              increased by 7.1 percent at an annual rate through the third
              quarter of 2006, following the increases of 7.0 percent during
              2005 and 8.3 percent during 2004.
        Real net exports improved during the year as real exports
              grew by 9.0 percent at an annual rate through the third
              quarter of 2006--on track to being the strongest performance
              in 10 years.
      Although the underlying trend performance of the U.S. economy has been
    good and the gains have translated into solid growth of output, incomes,
    wages, and accumulating wealth, the economy continues to face important
    challenges--some new, some ongoing including:
         The housing market and residential investment activity
              generally slowed sharply during 2006, subtracting
              significantly from real GDP growth as the year went on.
              Housing starts peaked at an annual rate of more than 2.2
              million units early in the year, but fell back to about a 1.5
              million to 1.6 million annual pace near the end of the year--
              the lowest in about 5 years. During 2006, real residential
              investment spending was on track to subtract about 0.7
              percentage point from overall real GDP growth.
         Manufacturing activity showed signs of slowing at the end
              of the summer and into the fall. Industrial production of
              consumer durables slipped in September and October, reflecting
              declines in production of motor vehicles, energy products, and
              residential appliances, furniture, and carpeting. Survey
              measures of manufacturing activity also showed slowing
              activity. Even so, manufacturing industrial production rose in
              December and was 3.3 percent higher than in December 2005.
         Energy prices--notably crude oil, natural gas, and gasoline
              prices--increased sharply over the past five years and
              continued at relatively high levels during much of 2006. For
              example, the benchmark price for West Texas Intermediate crude
              oil increased from under $20 a barrel in December 2001 to
              about $74 a barrel in July 2006. Over the same period, the
              national average retail gasoline price rose from $1.09 a
              gallon to $2.98 a gallon. Some relief occurred during the
              second half of 2006 as the price of crude oil fell back to
              below $61 a barrel by the end of the year, and the retail
              gasoline price fell to $2.34 a gallon.
         The lingering effects from hurricane damage presented
              challenges during 2006 as the economy worked through and
              rebounded from the adverse effects of the severe 2005
              hurricane season. Some of the persisting high energy prices in
              the first half of the year described above can be attributed
              to effects from hurricane damage to key oil, natural gas, and
              refining facilities.
         Inflation initially increased as the rise in energy and
              gasoline prices contributed to higher inflation rates during
              2005 and through the middle of 2006--but price increases began
              to moderate by the end of 2006. The consumer price index (CPI)
              rose 2.5 percent during 2006 (December to December), down from
              a 3.4 percent rate during 2005.
         Core inflation rose during the first half of 2006 and then
              began to subside. Abstracting from volatile food and energy
              items shows that ``core'' CPI inflation was 2.6 percent during
              2006, up from 2.2 percent during 2005. 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 up at a
              2.3 percent annual rate through November, compared to the 2.1
              percent rate during 2005.
         Imbalances in international accounts persisted during 2006
              with the trade deficit at about 6 percent of GDP and the
              current account deficit at nearly 7 percent of GDP. Even so,
              the international imbalances actually stabilized over the past
              year with little effect on real GDP growth--after having risen
              steadily over the past decade and subtracting 0.6 percentage
              point per year on average from GDP growth over that time.
      The economy continued to grow in the face of these challenges,
    although growth has slowed somewhat over the past year. Despite the
    volatility in the overall rate of inflation, underlying inflation
    remains relatively subdued and was lower during the last six months than
    earlier in 2006. Meanwhile, expectations of future inflation do not
    appear to be adversely affecting business or household decisions. In
    general, despite adverse events and slowing performance in specific
    sectors, economic performance as a whole during 2006 confirms that the
    U.S. economy is on track for continued expansion with non-inflationary
    real growth.

                                Policy Background

      The fiscal and monetary policies of the past five years have
    successfully contributed to the current good economic performance. The
    general fiscal policy outlook--as presented in the President's Budget--
    reflects the outlook for sustained expansion in the U.S. economy for the
    foreseeable future. Looking back, timely tax relief and reductions in
    interest rates promoted the economy's recovery from recession and helped
    the Nation overcome the adverse effects from the variety of shocks it
    faced. Those policies continue to provide a solid foundation for current
    and future economic performance.

      Fiscal Policy: Beginning in 2001, the Administration proposed, and the
    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

    [[Page 167]]

    economic expansion in the long term. Key tax relief legislation
    included:
         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.
         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 for three years. 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 also reduced tax
              rates on dividend income and capital gains and expanded bonus
              depreciation and small business expensing of equipment
              purchases.
      Additional legislation of recent years has extended tax relief,
    helping to ensure that key provisions would continue and not expire.

      Monetary Policy and Interest Rates: As 2007 begins, the Federal
    Reserve continues to orient monetary policy toward promoting sustained
    non-inflationary real growth in the U.S. economy. As the expansion
    strengthened, the Federal Reserve raised the Federal funds rate in a
    steady series of increases from 1 percent to 5.25 percent. The Federal
    funds rate remained at 5.25 percent over the second half of 2006. In a
    recent policy statement, the Federal Open Market Committee stated that
    ``the economy seems likely to expand at a moderate pace on balance over
    coming quarters... Nonetheless... some inflation risks remain.'' The
    Administration's forecast for the 3-month Treasury bill rate, presented
    below, was derived to be consistent with market expectations for the
    interest rate outlook at the time the forecast was completed.
      During 2006, longer-term interest rates, notably the yield on 10-year
    Treasury notes, remained low by historical standards. The 10-year rate
    traded as low as 4.3 percent in January and as high as 5.25 percent in
    June, but it ended the year at 4.7 percent. With the Federal funds rate
    exceeding 5 percent for most of the year, the low 10-year Treasury
    yields during the year produced a somewhat inverted structure of
    interest rates across short- to long-term maturities.

      Trade and Regulatory Policies and Competitiveness Initiatives: Beyond
    these budget and monetary policies, the Administration continues to work
    to advance a comprehensive set of policies to promote the short- and
    long-term performance of the U.S. economy, including trade and
    regulatory policies and initiatives aimed at boosting competitiveness in
    domestic and international markets. Expanding opportunities in
    international trade and investment is one of the Administration's top
    priorities. Efforts continue to negotiate and implement bilateral,
    regional, and multilateral agreements to promote international trade and
    investment with countries around the world. These policies create and
    expand markets for U.S. exports and strengthen the U.S. economy while
    also creating new economic opportunities for our trading partners--
    including helping to alleviate poverty in the developing world and
    promote democratic reform. The Administration's American Competitiveness
    Initiative is targeted at advancing U.S. competitiveness through
    promoting technological innovation, opening new markets, increasing
    research in the physical sciences and engineering, and protecting
    intellectual property. Efforts also continue to streamline and simplify
    Federal regulations that can hinder economic growth and job creation.

                              Economic Projections

      The Administration's economic projections, based on information
    available as of mid-November 2006, 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 sustained growth, solid jobs
    growth, low inflation, and relatively low interest rates.

                                                              Table 12-1.  ECONOMIC ASSUMPTIONS \1\
                                                          (Calendar years; dollar amounts in billions)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                          Projections
                                                         Actual   ------------------------------------------------------------------------------------------
                                                          2005         2006         2007         2008         2009         2010         2011         2012
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Gross Domestic Product (GDP):
      Levels, dollar amounts in billions:
        Current dollars.............................     12,456       13,248       13,946       14,711       15,507       16,316       17,148       18,003
        Real, chained (2000) dollars................     11,049       11,412       11,721       12,077       12,451       12,827       13,211       13,599
        Chained price index (2000=100), annual            112.7        116.1        119.0        121.8        124.6        127.2        129.8        132.4
         average....................................
      Percent change, fourth quarter over fourth
       quarter:
        Current dollars.............................        6.4          5.9          5.5          5.5          5.3          5.2          5.0          5.0
        Real, chained (2000) dollars................        3.1          3.1          2.9          3.1          3.1          3.0          3.0          2.9
        Chained price index (2000=100)..............        3.1          2.7          2.5          2.3          2.2          2.1          2.0          2.0
      Percent change, year over year:
        Current dollars.............................        6.3          6.4          5.3          5.5          5.4          5.2          5.1          5.0
        Real, chained (2000) dollars................        3.2          3.3          2.7          3.0          3.1          3.0          3.0          2.9
        Chained price index (2000=100)..............        3.0          3.0          2.5          2.4          2.2          2.1          2.0          2.0

    Incomes, billions of current dollars:
        Corporate profits before tax................      1,519        1,779        1,785        1,815        1,839        1,846        1,860        1,879
        Wages and salaries..........................      5,665        6,115        6,478        6,862        7,248        7,628        8,035        8,454
        Other taxable income \2\....................      2,563        2,754        2,949        3,112        3,261        3,404        3,579        3,756

    Consumer Price Index: \3\
        Level (1982--84=100), annual average........      195.3        201.7        206.0        211.4        216.8        222.0        227.2        232.5
        Percent change, fourth quarter over fourth          3.7          2.3          2.6          2.6          2.5          2.4          2.3          2.3
         quarter....................................
        Percent change, year over year..............        3.4          3.3          2.1          2.6          2.5          2.4          2.3          2.3

    Unemployment rate, civilian, percent:
        Fourth quarter level........................        5.0          4.5          4.7          4.8          4.8          4.8          4.8          4.8
        Annual average..............................        5.1          4.6          4.6          4.8          4.8          4.8          4.8          4.8

    Federal pay raises, January, percent:
        Military \4\................................        3.5          3.1          2.7          3.0           NA           NA           NA           NA
        Civilian \5\................................        3.5          3.1          2.2          3.0           NA           NA           NA           NA

    Interest rates, percent:
        91-day Treasury bills \6\...................        3.1          4.7          4.7          4.6          4.4          4.2          4.1          4.1
        10-year Treasury notes......................        4.3          4.8          5.0          5.1          5.2          5.3          5.3          5.3
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    NA = Not Available.
    \1\ Based on information available as of mid-November 2006.
    \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; percentages to be proposed for years after 2008 have not yet been determined.
    \5\ Overall average increase, including locality pay adjustments. Percentages to be proposed for years after 2008 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 3.1 percent in 2006 on a fourth quarter-
    over-fourth quarter basis, is projected to increase 2.9 percent this
    year. During the next few years, both actual and potential growth are
    projected to moderate slightly from 3.1 percent for 2008 to 2.9 percent
    by 2012. As a result, the unemployment rate, which dipped as low as 4.4
    percent late in 2006, is projected to edge up to its sustainable rate of
    4.8 percent and 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 most.
      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 percent over the next
    two years, trending down to 2.9 percent by 2012, primarily because of an
    assumed slowing in labor force growth. The labor force is projected to
    grow about 1.0 percent per year through 2008 on average, slowing to
    about 0.7 percent yearly on average during 2009-2012 as increasing
    numbers of baby boomers enter retirement.

    [[Page 168]]

       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 (3.1 percent per year). It is, however, close to the
    pace from 1995 through 2000 (2.5 percent) and not far from the 60-year
    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 sector of reference for productivity because of its reliable
    measurement.
    ---------------------------------------------------------------------------

      Inflation: Inflation moderated in 2006, in large part because of
    declining energy prices. With the recent easing of these prices,
    inflation is likely to be lower in 2007. On a year-over-year basis, the
    CPI is projected to increase 2.1 percent this year but to rebound to 2.6
    percent in 2008, with the increase moderating to 2.3 percent a year
    through 2012. 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 2.5 percent in 2007, moderating to 2.0 by 2011 and 2012,
    slightly less than CPI inflation, which is the usual pattern.
      The forecast of low inflation reflects the current very low core
    inflation rate, falling energy prices, modest inflation expectations,
    the downward pressure on inflation due to both domestic and global
    competition, and the Federal Reserve's monetary policy.

      Interest Rates: Short-term interest rates are projected to decline
    somewhat and long-term rates to rise slightly, achieving a more normal
    yield curve spread. The 3-month Treasury bill rate, which was 4.9
    percent at the end of December, is expected to decrease to 4.1 percent
    by 2011. The yield on the 10-year Treasury note, 4.7 percent at the end
    of last year, is projected to increase to 5.3 percent by 2010.
      The forecast rates are historically low: the projected averages for 3-
    month and 10-year Treasuries during 2007-2012 are lower than the
    averages for these instruments during each decade of the 1970s, 1980s,
    and

    [[Page 169]]

    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 2006, while the share of corporate profits is
    projected to decline from the unusually high levels of 2006 and those
    anticipated for 2007. In recent years, growth of hourly compensation
    adjusted for inflation has lagged the growth of productivity. During the
    projection period, however, real hourly 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 2006.
      Corporate profits before tax jumped sharply as a share of GDP in 2005
    and 2006 in part due to 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. Since 2004, however, corporate profits before tax
    have been higher than normal both because new investment has not
    qualified for the temporary acceleration and because the remaining
    depreciation permitted on 2003 and 2004 investment that used this
    provision has been thereby reduced.
      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. Personal dividend income's share, too,
    is projected to decline, reflecting the declining profit share. A slight
    rise is projected for proprietors' income, while the remaining share of
    the tax base, rental income, is projected to remain relatively stable at
    around its 2006 level.

                Comparison with CBO and Private-Sector Forecasts

      In addition to the Administration, the Congressional Budget Office
    (CBO) and many private-sector forecasters also make economic
    projections. CBO develops its projections to aid Congress in formulating
    budget policy. In the executive branch, this function is performed
    jointly by the Treasury Department, the Council of Economic Advisers,
    and the Office of Management and Budget. Private-sector forecasts are
    often used by businesses for current decision-making and in long-term
    planning, and the ``consensus'' or average serves as a useful benchmark
    for comparison. Table 12-2 compares the 2008 Budget assumptions with
    projections as of January 2007 by CBO and by the Blue Chip Consensus, an
    average of about 50 private-sector forecasts.
      The three sets of economic assumptions are based on different
    underlying assumptions concerning economic policies. The 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. The 50 or
    so private forecasters in the Blue Chip Consensus make differing policy
    assumptions. 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.

                                     Table 12-2.  COMPARISON OF ECONOMIC ASSUMPTIONS
                                                    (Calendar years)
    ----------------------------------------------------------------------------------------------------------------
                                                                       Projections
                                              ------------------------------------------------------------  Average,
                                                 2007      2008      2009      2010      2011      2012     2007-12
    ----------------------------------------------------------------------------------------------------------------
    GDP (billions of current dollars):
      2008 Budget............................  13,946    14,711    15,507    16,316    17,148    18,003
      CBO January............................  13,805    14,472    15,196    15,923    16,647    17,395
      Blue Chip Consensus January............  13,843    14,561    15,323    16,116    16,937    17,805

    Real GDP (chain-weighted): \1\
      2008 Budget............................       2.7       3.0       3.1       3.0       3.0       2.9        3.0
      CBO January............................       2.3       3.0       3.1       3.0       2.7       2.7        2.8
      Blue Chip Consensus January............       2.4       3.0       3.1       3.0       2.9       3.0        2.9

    Chain-weighted GDP Price Index: \1\
      2008 Budget............................       2.5       2.4       2.2       2.1       2.0       2.0        2.2
      CBO January............................       1.9       1.8       1.8       1.8       1.8       1.8        1.8
      Blue Chip Consensus January............       2.1       2.1       2.1       2.1       2.1       2.1        2.1

    Consumer Price Index (all-urban): \1\
      2008 Budget............................       2.1       2.6       2.5       2.4       2.3       2.3        2.4
      CBO January............................       1.9       2.3       2.2       2.2       2.2       2.2        2.2
      Blue Chip Consensus January............       2.0       2.3       2.3       2.3       2.3       2.4        2.3

    Unemployment rate: \2\
      2008 Budget............................       4.6       4.8       4.8       4.8       4.8       4.8        4.8
      CBO January............................       4.7       4.9       5.0       5.0       5.0       5.0        4.9
      Blue Chip Consensus January............       4.8       4.9       4.9       4.9       4.9       4.9        4.9

    Interest rates: \2\
      91-day Treasury bills:
        2008 Budget..........................       4.7       4.6       4.4       4.2       4.1       4.1        4.4
        CBO January..........................       4.8       4.5       4.4       4.4       4.4       4.4        4.5
        Blue Chip Consensus January..........       4.9       4.8       4.7       4.5       4.5       4.6        4.7

      10-year Treasury notes:
        2008 Budget..........................       5.0       5.1       5.2       5.3       5.3       5.3        5.2
        CBO January..........................       4.8       5.0       5.1       5.2       5.2       5.2        5.1
        Blue Chip Consensus January..........       4.8       5.0       5.2       5.2       5.2       5.3        5.1
    ----------------------------------------------------------------------------------------------------------------
    Sources: Congressional Budget Office; Blue Chip Economic Indicators, Aspen Publishers, Inc.
    January 2007 Blue Chip Consensus forecast for 2007 and 2008; Blue Chip October 2006 long-run extension for 2009--
      2012.
    \1\ Year-over-year percent change.
    \2\ Annual averages, percent.

      For real GDP, the Administration, CBO, and the Blue Chip Consensus
    anticipate moderate growth this year. The Administration projects 2.7
    percent growth on a year-over-year basis, slightly higher than either
    the Consensus or CBO's forecast, which are 2.4 percent and 2.3 percent,
    respectively. For calendar year 2008, the Administration, CBO, and the
    Consensus all forecast 3.0 percent real growth. The three forecasts are
    in agreement in both 2009 (3.1 percent) and 2010 (3.0 percent). In 2011
    and 2012, the Administration's projection is about the same as the
    Consensus growth rate but CBO's is slightly lower. Over the six-year
    span as a whole, the Administration, CBO and the Consensus all project
    average annual growth rates in a narrow range of 2.8 to 3.0 percent.
      All three forecasts anticipate continued low inflation in the range of
    1.8 to 2.5 percent as measured by the GDP price index; and, after 2007,
    between 2.2 and 2.6 percent as measured by the CPI, with CBO lower than
    the Administration and the Consensus, which are close to each other. The
    three unemployment rate projections are also similar with projected
    rates in the narrow range of 4.8 percent to 5.0 percent after 2007. All
    three project slightly falling short-term interest rates and a slight
    rise in long-term rates during the next few years, with the
    Administration's short-term rates slightly below the Blue Chip's and
    CBO's, and the long-term rate forecasts nearly identical.

                         Changes in Economic Assumptions

      The economic assumptions underlying this Budget for 2008 are similar
    to those of the 2007 Budget, as shown in Table 12-3.
      Real GDP growth is now expected to be 2.7 percent in 2007, 3.0 percent
    in 2008, and 3.1 percent in 2009 on a year-over-year basis, moderating
    gradually to 2.9 percent by 2012. In comparison, last year's Budget
    projections showed 3.3 percent real growth for both 2007 and 2008,
    moderating to 3.0 percent by 2012. Despite the lower real growth
    forecast this year, the level of nominal GDP is now projected to be
    higher than in the 2007 Budget projection because of a faster-than-
    expected rise in the GDP price index last year and slightly higher
    projected GDP inflation in the next few years.

                                          Table 12-3.  COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2007 AND 2008 BUDGETS
                                                          (Calendar years; dollar amounts in billions)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                             2006        2007        2008        2009        2010        2011        2012
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Nominal GDP:
      2007 Budget assumptions \1\.......................................      13,192      13,931      14,693      15,473      16,288      17,154      18,059
      2008 Budget assumptions...........................................      13,248      13,946      14,711      15,507      16,316      17,148      18,003

    Real GDP (2000 dollars):
      2007 Budget assumptions \1\.......................................      11,433      11,813      12,198      12,580      12,970      13,373      13,779
      2008 Budget assumptions...........................................      11,412      11,721      12,077      12,451      12,827      13,211      13,599

    Real GDP (percent change): \2\
      2007 Budget assumptions...........................................         3.4         3.3         3.3         3.1         3.1         3.1         3.0
      2008 Budget assumptions...........................................         3.3         2.7         3.0         3.1         3.0         3.0         2.9

    GDP price index (percent change): \2\
      2007 Budget assumptions...........................................         2.4         2.2         2.1         2.1         2.1         2.1         2.2
      2008 Budget assumptions...........................................         3.0         2.5         2.4         2.2         2.1         2.0         2.0

    Consumer Price Index (percent change): \2\
      2007 Budget assumptions...........................................         3.0         2.4         2.4         2.4         2.4         2.5         2.5
      2008 Budget assumptions...........................................         3.3         2.1         2.6         2.5         2.4         2.3         2.3

    Civilian unemployment rate (percent): \3\
      2007 Budget assumptions...........................................         5.0         5.0         5.0         5.0         5.0         5.0         5.0
      2008 Budget assumptions...........................................         4.6         4.6         4.8         4.8         4.8         4.8         4.8

    91-day Treasury bill rate (percent): \3\
      2007 Budget assumptions...........................................         4.2         4.2         4.3         4.3         4.3         4.3         4.3
      2008 Budget assumptions...........................................         4.8         4.9         4.7         4.6         4.4         4.3         4.3

    10-year Treasury note rate (percent): \3\
      2007 Budget assumptions...........................................         5.0         5.4         5.5         5.6         5.6         5.6         5.6
      2008 Budget assumptions...........................................         4.8         5.0         5.1         5.2         5.3         5.3         5.3
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    \1\ Adjusted for July 2006 NIPA revisions.
    \2\ Year-over-year.
    \3\ Calendar year average.

      The unemployment rate projection has been adjusted slightly,
    reflecting a new assessment of the ``natural

    [[Page 170]]

    rate'' consistent with stable inflation. While the 2007 Budget had the
    rate level at 5.0 percent in future years, the rate is now projected to
    stabilize at 4.8 percent in the outyears. The 3-month Treasury bill rate
    is expected to trend downward, ultimately to the same level, 4.3
    percent, as before. The 10-year Treasury note rate is now projected to
    rise to 5.3 percent by 2010, lower than the previous assumption that it
    would reach 5.6 percent.

                        Structural and Cyclical Balances

      Historically, a budget measure called the structural balance has
    provided an alternative perspective on the stance of fiscal policy as
    compared to the unadjusted budget balance which includes a component
    related to the cyclical performance of the economy. For example, when
    the economy operates below potential, the unemployment rate exceeds the
    long-run sustainable average consistent with price stability. As a
    result, receipts are lower and outlays for unemployment-sensitive
    programs (such as unemployment compensation and food stamps) are higher;
    the deficit is larger (or the surplus smaller) than 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 of the deficit that remains when the
    unemployment rate is at its long-run value is then called the structural
    deficit (or structural surplus). In the typical post-World War II
    business cycle, the structural balance has provided a gauge of the
    surplus or deficit that would persist if the economy were 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

    [[Page 171]]

    market's contribution to receipts is counted in the structural balance.
      Other factors unique to the current economic cycle provide additional
    examples of less-than-complete cyclical adjustment. The fall-off in
    labor force participation, from 67.1 percent of the U.S. population in
    1997-2000 to 66.1 percent in 2004-2006, appears to be at least partly
    cyclical in nature. Since the official unemployment rate does not
    include workers who have left the labor force, the conventional measures
    of potential GDP, incomes, and Government receipts understate the extent
    to which potential work hours have been under-utilized in the current
    expansion to date because of the decline in labor force participation.

                                                            Table 12-4.  ADJUSTED STRUCTURAL BALANCE
                                                             (Fiscal years; in billions of dollars)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                    2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011     2012
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Unadjusted surplus or deficit (-)...........    128.2   -157.8   -377.6   -412.7   -318.3   -248.2   -244.2   -239.4   -187.2    -94.4    -53.8     61.0
      Cyclical component........................     92.7    -28.7    -70.8    -33.4     -5.5     15.1      8.6     -4.8     -3.1     -0.4      0.0      0.0
                                                 -----------------------------------------------------------------------------------------------------------
    Structural surplus or deficit (-)...........     35.5   -129.0   -306.8   -379.3   -312.9   -263.3   -252.8   -234.6   -184.1    -93.9    -53.8     61.0
      Deposit insurance outlays.................      1.6      1.0      1.4      2.0      1.4      1.1      2.2      3.4      5.6      5.9      6.1      3.9
                                                 -----------------------------------------------------------------------------------------------------------
    Adjusted structural surplus or deficit (-)..     37.1   -128.0   -305.3   -377.4   -311.5   -262.2   -250.6   -231.2   -178.5    -88.0    -47.7     65.0
    --------------------------------------------------------------------------------------------------------------------------------------------------------
     NOTE: The NAIRU is assumed to be 4.8% in 2006 and subsequent years, 4.9% in earlier years.

      A third example is the fall-off in the wage and salary share of GDP,
    from 49.2 percent in 2000 to 45.3 percent in the second quarter of 2006.
    Again, this change is widely suspected to be partly cyclical. Since
    Federal tax collections 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.

    [[Page 172]]

      For all these reasons, the current estimates of the cyclical deficit
    are probably understated. The current unemployment gap is believed to be
    near 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 year 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 that year 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.
    Similarly, in 2006 the unemployment rate appeared to be slightly lower
    than the ``natural rate,'' rendering the structural deficit for that
    year slightly higher than the actual deficit, and that effect persists
    into 2007.

                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 2007 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 2007
              deficit is estimated to increase by $16.1 billion; receipts in
              2007 would be lower by $13.4 billion, and outlays would be
              higher by $2.7 billion, primarily for unemployment-sensitive
              programs. In fiscal year 2008, the estimated receipts
              shortfall would grow further to $27.7 billion, and outlays
              would increase by $8.0 billion relative to the base, even
              though the growth rate in calendar year 2008 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 2007-2012, the cumulative increase in the budget
              deficit is estimated to be $243 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 2007-2012, the
              cumulative increase in the budget deficit is estimated to be
              $689 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 2007 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
              2007 and 2008, outlays would be above the base by $10.8
              billion and $18.3 billion, respectively, due in part to lagged
              cost-of-living adjustments. Receipts would rise by $23.2
              billion in 2007, but then would rise by $44.5 billion above
              the base in 2008 due to the sustained effects of the elevated
              price level on the tax base, and to the temporary effect of
              higher 2007 interest rates on financial corporations' profits
              and taxes, resulting in a $26.1 billion improvement in the
              2008 budget balance. In subsequent years, the amounts added to
              receipts would continue to be larger than the additions to
              outlays. During 2007-2012, cumulative budget deficits would be
              $130 billion smaller than in the base case.
        In the fourth block, 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 $344 billion to outlays over 2007-
              2012 and $834 billion to receipts, for a net decrease in the
              2007-2012 deficits of $490 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-

    [[Page 173]]

              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 decreases
              cumulative deficits by a substantial $445 billion during 2007-
              2012. 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. Outlays for discretionary
              programs are assumed to be unchanged in spite of the higher
              inflation rate. 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 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             2007        2008        2009        2010        2011        2012      Effects,
                                                                                                           2007-2012
    ----------------------------------------------------------------------------------------------------------------

    Real Growth and Employment

    Budgetary effects of 1
     percent lower real GDP
     growth:
      (1) For calendar year 2007
       only: \1\
        Receipts................       -13.4       -27.7       -31.2       -33.8       -35.6       -37.6      -179.3
        Outlays.................         2.7         8.0        10.3        12.3        14.4        16.4        63.9
                                 -----------------------------------------------------------------------------------
        Increase in deficit (-).       -16.1       -35.7       -41.5       -46.1       -49.9       -54.0      -243.3

      (2) Sustained during 2007-
       2017, with no change in
       unemployment:
        Receipts................       -13.6       -43.6       -80.4      -123.2      -167.6      -216.2      -644.7
        Outlays.................         0.2         1.3         3.8         7.6        13.0        18.8        44.8
                                 -----------------------------------------------------------------------------------
        Increase in deficit (-).       -13.8       -44.9       -84.2      -130.8      -180.6      -235.0      -689.4

    Inflation and Interest Rates

    Budgetary effects of 1
     percentage point higher
     rate of:
      (3) Inflation and interest
       rates during calendar
       year 2007 only:
        Receipts................        23.2        44.5        38.4        34.4        36.1        38.2       214.8
        Outlays.................        10.8        18.3        15.2        14.1        13.4        12.6        84.4
                                 -----------------------------------------------------------------------------------
        Decrease in deficit (+).        12.4        26.1        23.2        20.4        22.7        25.6       130.4

      (4) Inflation and interest
       rates, sustained during
       2007-2017:
        Receipts................        23.2        71.3       116.5       160.5       206.4       256.5       834.3
        Outlays.................        11.2        32.9        52.1        68.6        83.3        96.1       344.1
                                 -----------------------------------------------------------------------------------
        Decrease in deficit (+).        12.0        38.3        64.4        91.9       123.1       160.4       490.1

      (5) Interest rates only,
       sustained during 2007-
       2017:
        Receipts................         9.7        28.5        38.7        41.9        45.0        47.4       211.1
        Outlays.................         7.7        21.5        31.0        36.6        39.7        41.5       178.0
                                 -----------------------------------------------------------------------------------
        Increase in deficit (-).         2.0         7.0         7.6         5.3         5.2         5.9        33.1

      (6) Inflation only,
       sustained during 2007-
       2017:
        Receipts................        13.4        42.7        77.7       118.3       161.0       208.5       621.6
        Outlays.................         3.5        11.7        21.9        33.6        46.4        59.0       176.2
                                 -----------------------------------------------------------------------------------
        Decrease in deficit (+).         9.9        31.0        55.8        84.7       114.6       149.5       445.4

    Interest Cost of Higher
     Federal Borrowing

    (7) Outlay effect of $100            2.5         5.1         5.2         5.2         5.3         5.5        28.8
     billion increase in
     borrowing in 2007..........
    ----------------------------------------------------------------------------------------------------------------
    $50 million or less.
    \1\ The unemployment rate is assumed to be 0.5 percentage point higher per 1.0 percent shortfall in the level of
      real GDP.