[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.

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    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

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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
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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.

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   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).
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  \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

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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.