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

    [[Page 169]]

                            12. ECONOMIC ASSUMPTIONS

      The U.S. economy completed its sixth consecutive year of economic
    expansion as 2007 drew to a close. \1\ Although some uncertainty exists
    about the short-run outlook, the Administration's economic forecast
    projects sustained growth in the years ahead. Since 2001, the U.S.
    economy has repeatedly demonstrated its resilience to shocks and
    setbacks while benefiting from pro-growth policies, including tax relief
    and ongoing efforts to promote investment in innovative technologies and
    to liberalize international trade. Federal Reserve monetary policy
    actions have also played a constructive role in prolonging the
    expansion.
    ---------------------------------------------------------------------------
      \1\  Economic performance is discussed in terms of calendar years.
    Budget figures are in terms of fiscal years.
    ---------------------------------------------------------------------------
      The economy has successfully overcome a series of shocks, including
    large declines in the stock market and business equipment spending; the
    terrorist attacks of September 11, 2001 followed by the onset of the
    Global War on Terror; sharp increases in prices for crude oil; and
    substantial damage and disruptions during the 2005 hurricane season. In
    the last two years a new set of shocks has troubled the economy. A
    housing market slowdown began in 2006 and is continuing into 2008. In
    2007, many high-risk mortgages went into default, causing losses at
    financial institutions. The heightened uncertainty resulting from these
    losses has threatened to curtail credit availability for many borrowers.
      Despite these unfavorable recent events, the U.S. economy continued to
    expand in 2007, with gains in productivity, incomes, and employment.
    More than 8 million net new payroll jobs have been added since August
    2003. The Administration's economic forecast projects that the current
    expansion will continue, providing a solid foundation of sustained non-
    inflationary real growth to underlie the Federal budget outlook.
    Nonetheless, facing mixed economic signals and the risk of slower
    economic growth, in January 2008 the President called for the enactment
    of an economic growth package to bolster business investment and
    consumer spending thus promoting growth and job creation.

                           Recent Economic Performance

      At the end of 2007, as the 2009 Budget was being prepared, U.S. real
    gross domestic product (GDP) had been increasing for 24 consecutive
    quarters, at an average annual rate of 2.8 percent. Over the most recent
    four quarters, real GDP also grew 2.8 percent. Increases in employment
    and gains in the productive efficiency of the U.S. workforce have
    combined to generate this sustained growth in real output.
        In labor markets, nonfarm payroll employment has increased
              by nearly 8.4 million net new jobs since the post-recession
              low in August 2003, with about 1.3 million of those job gains
              occurring during the most recent twelve months (through
              December).
        Reflecting the expanding job market, the unemployment rate
              was 5.0 percent at the end of 2007, which is up from its low
              point in March--4.4 percent--but noticeably lower than its
              average during each of the past three decades.
        Labor productivity gains--the increase in output per hour of
              labor--were especially strong earlier in the expansion,
              providing a substantial boost to growth in real GDP. On
              average, output per hour in the nonfarm business sector has
              increased at a 2.5 percent rate during the current expansion
              (since the final quarter of 2001). \2\
    ---------------------------------------------------------------------------
      \2\ The nonfarm business sector accounts for about three-fourths of
    the value of GDP, with households, nonprofit institutions, and
    government accounting for the remainder. The nonfarm business sector
    serves as the reference standard for productivity.
    ---------------------------------------------------------------------------
        These productivity gains have extended the strong
              productivity performance of the previous decade. Since the end
              of 1995, labor productivity in the nonfarm business sector has
              increased at a 2.6 percent average annual rate, more than a
              percentage point higher than the average growth rate from 1973
              to 1995--1.5 percent.
      Strong growth in labor productivity is a fundamental building block
    for long-term economic performance and is the basis for rising real
    wages and an increasing standard of living for American workers and
    families.
        Reflecting labor gains from stronger productivity growth,
              real hourly earnings of production workers have risen at an
              average annual rate of 0.5 percent over the past two years.
        Real disposable personal income per capita is up 11.7
              percent in the current expansion, compared with 8.6 percent
              during the equivalent period of the 1990s expansion.
      Other indicators also point to the sustained solid performance of the
    U.S. economy in recent years:
        Through the third quarter, real consumer spending had
              increased at a 2.6 percent annual rate so far in 2007,
              following increases of 3.4 percent during 2006 and 2.8 percent
              during 2005.
        Business investment in nonresidential structures continued
              to make strong real gains in 2007, rising at a 16 percent
              annual rate through the third quarter of the year, on track to
              being the strongest increase in more than two decades.
        Real business investment in durable equipment and software
              increased at a healthy 3.7 percent annual rate through the
              third quarter of 2007, following increases of 2.5 percent
              during 2006 and 7.1 percent during 2005.

    [[Page 170]]

        Real net exports continued to improve during 2007 as real
              exports grew 9.0 percent at an annual rate through the third
              quarter, while import growth slowed to just 1.8 percent. For
              the first time in over a decade, real net exports contributed
              positively to real GDP growth in 2006-2007.
      Although the overall performance of the U.S. economy has been good and
    the gains have translated into solid growth of income and wealth, the
    economy faces important challenges that have become more serious as 2008
    begins:
         The housing market and residential investment activity
              began to slow in 2006 and continued to fall throughout 2007,
              subtracting significantly from real GDP growth. Housing starts
              peaked at an annual rate of nearly 2.3 million units early in
              2006, but have since fallen to about 1.0 million units--the
              lowest level in over a decade. During the first three quarters
              of 2007, real residential investment spending was on track to
              subtract about 0.9 percentage point from overall real GDP
              growth. It now appears that the effects of the housing slump
              on real GDP growth will persist into 2008, holding down growth
              and delaying the expected rebound in activity.
         Financial uncertainty has increased as the effects of the
              housing slump spread to the subprime segment of the mortgage
              market, and then to financial markets more generally. The
              Federal Reserve has acted decisively to expand credit and to
              lower interest rates, and the Department of Treasury has also
              taken steps to restore confidence. These measures have helped
              maintain liquidity, but uncertainty remains high. Higher risk
              premiums on all but the most secure loans may exact a growth
              penalty in the near term that would be moderated by the
              President's proposals to promote economic growth.
         Energy prices--notably crude oil and gasoline prices--have
              increased sharply. The benchmark price for West Texas
              Intermediate crude oil increased from under $30 a barrel in
              September 2003 to near $100 a barrel in January 2008. Over the
              same period, the average retail price of gasoline nationwide
              rose from around $1.50 a gallon to over $3.00 a gallon. Higher
              energy prices slow growth, but the recent increase in prices
              has had a much smaller overall effect on growth than previous
              oil price shocks in the 1970s and 1980s.
         Large imbalances in U.S. international accounts persisted
              into 2007 with the current account deficit at 5.1 percent of
              GDP in the third quarter. Even so, the international
              imbalances have begun to improve for the first time in several
              years. A year earlier the current account deficit was 6.6
              percent of GDP.
      During 2007, the economy continued to grow in the face of these
    challenges. Growth appears to have slowed in the final quarter of 2007
    as the combination of weak housing markets, financial uncertainty, and
    higher energy prices have combined to limit demand. There are positive
    factors, however, that could help offset these negative developments and
    provide a foundation for revived growth by the end of 2008, especially
    if augmented by passage of the President's proposals to promote economic
    growth.
         Inflation has increased along with the rise in food and
              energy prices, but core inflation, excluding the volatile food
              and energy components, subsided from around 2.6 percent in
              2006 to 2.4 percent during 2007. With core inflation under
              control the prospects are good for a lower inflation rate in
              the long run when energy prices stabilize.
         Faster economic growth abroad has helped U.S. exports, and
              contributed to the decline in the current account deficit. The
              improvement in net exports has been large enough to offset the
              decline in growth from housing investment over the last four
              quarters.
         Employment growth slowed in 2007, but gains continued
              through the end of the year. The unemployment rate crept up
              from 4.5 percent to 5.0 percent, but unemployment remains well
              below its average level in earlier periods of slow growth.

                                Policy Background

      The fiscal and monetary policies of the past seven years contributed
    to good economic performance. 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
    various shocks it has faced since 2001. Those policies augmented by
    short-term proposals to promote economic growth continue to provide a
    solid foundation for future economic performance.

      Fiscal Policy: Beginning in 2001, the Administration proposed, and the
    Congress enacted, significant tax relief designed to promote recovery in
    output, income, and jobs--and to provide a strong basis for continued
    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 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 extended tax relief, helping to
    ensure that key provisions would continue and not expire. The quick
    adoption of an effective growth package of broad-based tax relief would
    bolster consumption and investment and help keep instability

    [[Page 171]]

    and uncertainty from causing additional harm to the overall economy.

      Monetary Policy and Interest Rates: As 2008 begins, the Federal
    Reserve has oriented monetary policy toward sustaining non-inflationary
    real economic growth. Beginning in 2004, as the expansion strengthened,
    the Federal Reserve raised the Federal funds rate in a steady series of
    increases from 1 percent eventually reaching 5.25 percent in 2006. The
    Federal funds rate remained at 5.25 percent for over a year. In
    September 2007, the Federal Reserve announced a fifty basis point
    reduction in its target rate in response to the threats to liquidity
    unfolding in financial markets. This was a preemptive action intended to
    maintain the level of aggregate demand in the economy and sustain the
    recovery. At the time of this action, the Federal Reserve stated:

                Economic growth was moderate during the first half of the
              year, but the tightening of credit conditions has the
              potential to intensify the housing correction and to restrain
              economic growth more generally. Today's action is intended to
              help forestall some of the adverse effects on the broader
              economy that might otherwise arise from the disruptions in
              financial markets and to promote moderate growth over time.
      Since then, the Federal Reserve has lowered interest rates further.
    The Administration's forecast for interest rates, presented below, is
    consistent with market expectations for the interest rate outlook at the
    time the forecast was completed in mid-November. It anticipates that
    rates will gradually recover when the current financial situation
    stabilizes. Long-term interest rates, notably the yield on 10-year
    Treasury notes, have been low by historical standards for many years.
    The 10-year rate has been less than 5.0 percent, except for brief
    intervals, for seven years. The forecast anticipates that the yield
    spread between short-term and long-term rates will eventually widen.

      Trade and Regulatory Policies and Competitiveness Initiatives: The
    Administration has sought 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 has been
    one of the Administration's top priorities. Efforts to negotiate and
    implement bilateral, regional, and multilateral agreements to promote
    international trade and investment with countries around the world are
    intended to create and expand markets for U.S. exports and strengthen
    the U.S. economy while also creating new economic opportunities for our
    trading partners. These policies will also help 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 are summarized in Table 12-
    1. The assumptions are based on information available as of mid-November
    2007 and are close to those of the Congressional Budget Office and the
    consensus of private-sector forecasters, as shown in Table 12-2 and
    discussed in more detail below.

      Real GDP, Potential GDP, and Unemployment Rate: Real GDP, which is
    estimated to have increased 2.7 percent during 2007 on a fourth quarter-
    over-fourth quarter basis, is also projected to increase 2.7 percent
    this year. This is somewhat below the economy's potential growth rate
    and reflects the growth penalty exacted by the housing slowdown and the
    energy price runup. As a result, the unemployment rate is projected to
    average 4.9 percent in 2008, up from 4.6 percent in 2007. In 2009, the
    rate of growth is projected to recover to 3.0 percent, and the
    unemployment rate to settle in on its long-run level of 4.8 percent,
    which is near the center of the range thought to be consistent with
    stable inflation. Beyond 2009, growth slows gradually as slower labor
    force growth lowers the economy's potential growth rate.
      The main sources of growth in demand in coming years are likely to be
    net exports, business investment, and, to a lesser extent, consumer
    spending. The contributions to overall growth from residential
    investment and the government sector are expected to be modest, although
    beyond 2008, housing should cease to be a negative influence on growth.
      Potential growth of real GDP (including the government sector) is
    projected to be about 3.0 percent over the next two years, trending down
    to 2.8 percent by 2013, because of an expected slowing in labor force
    growth. The labor force is projected to grow about 0.9 percent per year
    on average from 2006 through 2009, slowing to about 0.6 percent per year
    on average during 2009-2013 as increasing numbers of baby boomers
    retire.
       Trend productivity growth in the nonfarm business sector is assumed
    to be 2.5 percent per year. This is equal to the average pace of
    productivity growth so far in the current expansion, which began in the
    final quarter of 2001, and equal to the average pace of growth from 1995
    through 2000. It is also not far from the average growth rate throughout
    the post-World War II period since the end of 1948--2.2 percent.

      Inflation: Inflation was volatile in 2007, in large part because of
    fluctuations in energy prices. With the projected easing of these
    prices, inflation is likely to be lower. On a year-over-year basis, the
    CPI is projected to have increased 2.8 percent in 2007 and to increase
    by 2.7 percent this year but to settle down at a 2.3 percent rate in
    2010 through 2013. This infla

    [[Page 172]]

                                                              Table 12-1.  ECONOMIC ASSUMPTIONS \1\
                                                          (Calendar years; dollar amounts in billions)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                                                 Projections
                                                                        Actual  ----------------------------------------------------------------------------
                                                                         2006       2007       2008       2009       2010       2011       2012       2013
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Gross Domestic Product (GDP):
      Levels, dollar amounts in billions:
        Current dollars.............................................   13,195     13,837     14,480     15,215     15,987     16,782     17,603     18,462
        Real, chained (2000) dollars................................   11,319     11,573     11,886     12,245     12,615     12,982     13,351     13,727
        Chained price index (2000=100), annual average..............    116.6      119.6      121.8      124.2      126.7      129.3      131.8      134.5
      Percent change, fourth quarter over fourth quarter:
        Current dollars.............................................      5.4        5.1        4.8        5.1        5.0        5.0        4.9        4.9
        Real, chained (2000) dollars................................      2.6        2.7        2.7        3.0        3.0        2.9        2.8        2.8
        Chained price index (2000=100)..............................      2.7        2.3        2.0        2.0        2.0        2.0        2.0        2.0
      Percent change, year over year:
        Current dollars.............................................      6.1        4.9        4.6        5.1        5.1        5.0        4.9        4.9
        Real, chained (2000) dollars................................      2.9        2.2        2.7        3.0        3.0        2.9        2.8        2.8
        Chained price index (2000=100)..............................      3.2        2.6        1.9        2.0        2.0        2.0        2.0        2.0

    Incomes, billions of current dollars:
        Corporate profits before tax................................    1,806      1,896      1,920      1,971      1,970      1,947      1,950      1,981
        Wages and salaries..........................................    6,018      6,405      6,710      7,057      7,434      7,824      8,217      8,623
        Other taxable income \2\....................................    2,858      3,053      3,247      3,450      3,630      3,776      3,917      4,102

    Consumer Price Index: \3\
        Level (1982-84=100), annual average.........................    201.6      207.3      212.8      217.3      222.3      227.4      232.6      238.0
        Percent change, fourth quarter over fourth quarter..........      2.0        3.9        2.1        2.2        2.3        2.3        2.3        2.3
        Percent change, year over year..............................      3.2        2.8        2.7        2.1        2.3        2.3        2.3        2.3

    Unemployment rate, civilian, percent:
        Fourth quarter level........................................      4.5        4.8        4.9        4.8        4.8        4.8        4.8        4.8
        Annual average..............................................      4.6        4.6        4.9        4.9        4.8        4.8        4.8        4.8

    Federal pay raises, January, percent:
        Military \4\................................................      3.1        2.7        3.5        3.4         NA         NA         NA         NA
        Civilian \5\................................................      3.1        2.2        3.5        2.9         NA         NA         NA         NA

    Interest rates, percent:
        91-day Treasury bills \6\...................................      4.7        4.4        3.7        3.8        4.0        4.1        4.1        4.1
        10-year Treasury notes......................................      4.8        4.7        4.6        4.9        5.1        5.2        5.3        5.3
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    NA = Not Available.
    \1\ Based on information available as of November 15, 2007.
    \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 2009 have not yet been determined.
    \5\ Overall average increase, including locality pay adjustments. Percentages to be proposed for years after 2009 have not yet been determined.
    \6\ Average rate, secondary market (bank discount basis).

    tion rate projection extends the generally well-contained inflation
    experience of the last decade. The GDP price index is projected to have
    increased 2.6 percent in 2007, and to moderate to 2.0 percent by 2009,
    slightly less than the projected rate of CPI inflation, which is the
    usual pattern.
      The low inflation projection reflects the low core rate of inflation
    in 2007, well-contained inflation expectations, and the maintenance of
    low inflation in the long run consistent with Federal Reserve monetary
    policy objectives.

      Interest Rates: Interest rates declined sharply in the second half of
    2007. Short-term rates are projected to remain below 4 percent for the
    next two years and then to rise to 4.1 percent in 2011. The yield on the
    10-year Treasury note has also fallen as investors have sought the
    security of Treasury debt during the recent period of heightened
    financial uncertainty. In the projection period, long-term rates rise
    again as financial concerns are alleviated and a more normal historical
    relationship is restored. The 10-year rate is projected to increase to
    5.3 percent by 2012.
      These forecast rates are historically low, reflecting lower inflation
    in the forecast. After adjusting for inflation, the projected real
    interest rates are close to their historical averages.

      Income Shares: The share of labor compensation in GDP was low by
    historical standards in 2007 and is expected to increase, while the
    share of corporate profits is projected to decline from the unusually
    high levels it has reached. So far in the current expansion, the 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 exceed productivity growth, which would
    raise the labor share in GDP back closer to its historical average,
    while constraining profits.
      While the overall share of labor compensation is expected to increase
    by about 1 percentage point of GDP, the wage share is expected to rise
    proportionately less

    [[Page 173]]

    than the share of supplements to wages and salaries. Rising health
    insurance costs will put upward pressure on the share of supplements
    while holding down the expected rise in the cash wage share.
      Corporate profits before tax have risen sharply as a share of GDP
    since their recent low point in 2001. Profits have benefited from lower
    interest rates and moderate wage growth. The sharp increase in
    productivity growth in 2001-2003 also gave a boost to profits. More
    recently, corporate earnings overseas have helped raise the profits of
    American corporations. Some of these factors are not likely to continue
    at the same pace in future years, and profits relative to GDP are
    expected to moderate over the forecast period, ending much closer to
    their historical average in 2013.

                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 ``Troika'' consisting of the Department of Treasury, 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 2009 Budget assumptions with projections as of January 2008 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 these differences, the three sets of economic
    projections, shown in Table 12-2, are fairly close. The similarity of
    the Budget's economic projections to both the CBO baseline projections
    and the Consensus forecast underscores the conservative nature of the
    Administration forecast.

                                     Table 12-2.  COMPARISON OF ECONOMIC ASSUMPTIONS
                                                    (Calendar years)
    ----------------------------------------------------------------------------------------------------------------
                                                                       Projections
                                              ------------------------------------------------------------  Average,
                                                 2008      2009      2010      2011      2012      2013     2008-13
    ----------------------------------------------------------------------------------------------------------------
    GDP (billions of current dollars):
      2009 Budget............................  14,480    15,215    15,987    16,782    17,603    18,462
      CBO January............................  14,330    14,997    15,812    16,651    17,453    18,243
      Blue Chip Consensus January \2\........  14,448    15,150    15,906    16,705    17,551    18,428

    Real GDP (chain-weighted): \1\
      2009 Budget............................       2.7       3.0       3.0       2.9       2.8       2.8        2.9
      CBO January............................       1.7       2.8       3.5       3.4       2.9       2.6        2.8
      Blue Chip Consensus January \2\........       2.2       2.7       2.8       2.9       2.9       2.8        2.7

    Chain-weighted GDP Price Index: \1\
      2009 Budget............................       1.9       2.0       2.0       2.0       2.0       2.0        2.0
      CBO January............................       1.9       1.8       1.8       1.8       1.9       1.9        1.8
      Blue Chip Consensus January \2\........       2.1       2.1       2.1       2.1       2.1       2.1        2.1

    Consumer Price Index (all-urban): \1\
      2009 Budget............................       2.7       2.1       2.3       2.3       2.3       2.3        2.3
      CBO January............................       2.9       2.3       2.2       2.2       2.2       2.2        2.3
      Blue Chip Consensus January \2\........       2.9       2.3       2.3       2.3       2.3       2.3        2.4

    Unemployment rate: \3\
      2009 Budget............................       4.9       4.9       4.8       4.8       4.8       4.8        4.8
      CBO January............................       5.1       5.4       5.1       4.8       4.8       4.8        5.0
      Blue Chip Consensus January \2\........       5.0       5.0       4.8       4.8       4.8       4.8        4.9

    Interest rates: \3\
      91-day Treasury bills:
        2009 Budget..........................       3.7       3.8       4.0       4.1       4.1       4.1        4.0
        CBO January..........................       3.2       4.2       4.6       4.7       4.7       4.7        4.3
        Blue Chip Consensus January \2\......       3.4       3.9       4.5       4.5       4.5       4.5        4.2

      10-year Treasury notes: \3\
        2009 Budget..........................       4.6       4.9       5.1       5.2       5.3       5.3        5.1
        CBO January..........................       4.2       4.9       5.2       5.2       5.2       5.2        5.0
        Blue Chip Consensus January \2\......       4.3       4.8       5.2       5.2       5.2       5.2        5.0
    ----------------------------------------------------------------------------------------------------------------
    Sources: Congressional Budget Office; Blue Chip Economic Indicators, Aspen Publishers, Inc.
    \1\ Year-over-year percent change.
    \2\ January 2008 Blue Chip Consensus forecast for 2008 and 2009; Blue Chip October 2007 long-run extension for
      2010-2013.
    \3\ Annual averages, percent.

    [[Page 174]]

      The biggest differences in the forecasts are for real GDP growth in
    2008. The Administration, CBO, and the Blue Chip Consensus all
    anticipate slow to moderate growth this year, but the Administration
    projects 2.7 percent growth on a year-over-year basis, while the
    Consensus projects 2.2 percent growth, and CBO forecasts a 1.7 percent
    growth rate. For calendar year 2009, the forecasts are closer. The
    Administration forecasts 3.0 percent real growth, while the Consensus
    forecast is for 2.7 percent and CBO expects 2.8 percent. In 2010-2011,
    the Administration expects growth to average 3.0 percent, while the
    Consensus projects an average of 2.9 percent. For this period, CBO is
    the outlier, expecting a relatively sharp bounce-back that pushes up the
    growth rate to an average of 3.5 percent. In the final two years of the
    forecast period, the Administration expects growth to slow with the
    decline in the potential growth rate as the baby-boom cohort begins to
    retire in large numbers. CBO also expects the growth rate to decline for
    this reason (and because they assume a negative effect from the current-
    law expiration of the 2001-2003 tax cuts), but so far the Consensus has
    not incorporated the likely demographic slowdown in its long-range
    projections. 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 2.7 to 2.9 percent, with the Administration forecast being the
    highest.
      The three inflation forecasts are much closer. All three forecasts
    anticipate a slowdown in inflation in 2008-2009 followed by continued
    low inflation in the range of 1.8 to 2.1 percent as measured by the GDP
    price index and between 2.2 and 2.3 percent as measured by the CPI. CBO
    has a lower forecast than the Administration and the Consensus. The
    three unemployment rate projections are also similar with projected
    rates converging on 4.8 percent following somewhat higher unemployment
    over the next 2 to 3 years. All three forecasts recognize the sharp
    decline in Treasury interest rates at the end of 2007. All three
    forecasts anticipate that long-term rates will rise between 2008 and
    2009 and converge on a higher level in 2011 and beyond. That long-term
    stable value is 5.2 percent for CBO and the Consensus and 5.3 percent
    for the Administration. There are more differences in the forecasts of
    short-term interest rates. The Administration expects lower short-term
    rates to persist for some time before rising to 4.1 percent. CBO and the
    Consensus expect short-term rates to rise to 4.7 percent and 4.5
    percent, respectively, within three years. This would elevate real
    short-term interest rates above their historical average and in
    combination with the long-term interest rate forecasts would generate a
    tightly compressed yield curve. The Administration forecast anticipates
    a gradual restoration of a more normal yield curve spread.

                         Changes in Economic Assumptions

      The economic assumptions underlying this Budget for 2009 are similar
    to those of the 2008 Budget, as shown in Table 12-3.
      Real GDP growth is now expected to be 2.2 percent in 2007, 2.7 percent
    in 2008, and 3.0 percent in 2009 on a year-over-year basis, moderating
    gradually to 2.8 percent by 2012 and 2013. In comparison, last year's
    Budget projections implied 2.6 percent real growth for 2007, 3.0 percent
    growth in 2008, 3.1 percent in 2009, and moderating to 2.9 percent by
    2012. The lower real growth forecast in this year's budget combined with
    a slightly lower inflation forecast lowers the projected level of
    nominal GDP compared with the 2008 Budget projection.

      The long-run unemployment rate projection is unchanged from the 2008
    Budget at 4.8 percent. The 3-month Treasury bill rate is expected to
    remain well below last year's forecast for most of the projection period
    but to end at the same place, 4.1 percent. The 10-year Treasury note
    rate is again projected to rise to 5.3 percent.

                        Structural and Cyclical Balances

      An alternative budget measure called the structural balance provides a
    useful perspective on the stance of fiscal policy compared with the
    unadjusted budget balance. The unadjusted balance is affected by the
    cyclical performance of the economy. 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 than they would be if all the
    resources were employed at their normal levels; and 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 is called the cyclical
    component. The remaining portion of the deficit is then called the
    structural deficit (or structural surplus). It represents the deficit
    that would prevail if all resources were employed at their normal long-
    run levels. The structural balance provides a gauge of the surplus or
    deficit that would persist if the economy were operating at the
    sustainable level of unemployment.
      Estimates of the structural balance are based on the historical
    relationship between changes in the unemployment rate and real GDP
    growth, known as ``Okun's Law,'' as well as relationships of
    unemployment and real GDP growth with receipts and outlays. These
    estimated relationships take account of the major cyclical changes in
    the economy and their effects on the budget, but they do not reflect all
    possible cyclical relationships. For example, the sharply rising stock
    market during the second half of the 1990s 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, but economists have not been able to pin
    down the cyclical component of the stock market exactly, and for that
    reason, all of the stock market's

    [[Page  175]]

                      Table 12-3.  COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2008 AND 2009 BUDGETS
                                      (Calendar years; dollar amounts in billions)
    ----------------------------------------------------------------------------------------------------------------
                                                         2007     2008     2009     2010     2011     2012     2013
    ----------------------------------------------------------------------------------------------------------------
    Nominal GDP:
      2008 Budget assumptions \1\....................   13,903   14,665   15,458   16,265   17,094   17,946   18,840
      2009 Budget assumptions........................   13,837   14,480   15,215   15,987   16,782   17,603   18,462

    Real GDP (2000 dollars):
      2008 Budget assumptions \1\....................   11,623   11,975   12,346   12,718   13,100   13,484   13,878
      2009 Budget assumptions........................   11,573   11,886   12,245   12,615   12,982   13,351   13,727

    Real GDP (percent change): \2\
      2008 Budget assumptions........................      2.6      3.0      3.1      3.0      3.0      2.9      2.9
      2009 Budget assumptions........................      2.2      2.7      3.0      3.0      2.9      2.8      2.8

    GDP price index (percent change): \2\
      2008 Budget assumptions........................      2.5      2.3      2.2      2.1      2.0      2.0      2.0
      2009 Budget assumptions........................      2.3      2.0      2.0      2.0      2.0      2.0      2.0

    Consumer Price Index (percent change): \2\
      2008 Budget assumptions........................      2.1      2.6      2.5      2.4      2.3      2.3      2.3
      2009 Budget assumptions........................      2.8      2.7      2.1      2.3      2.3      2.3      2.3

    Civilian unemployment rate (percent): \3\
      2008 Budget assumptions........................      4.6      4.8      4.8      4.8      4.8      4.8      4.8
      2009 Budget assumptions........................      4.6      4.9      4.9      4.8      4.8      4.8      4.8

    91-day Treasury bill rate (percent): \3\
      2008 Budget assumptions........................      4.7      4.6      4.4      4.2      4.1      4.1      4.1
      2009 Budget assumptions........................      4.4      3.7      3.8      4.0      4.1      4.1      4.1

    10-year Treasury note rate (percent): \3\
      2008 Budget assumptions........................      5.0      5.1      5.2      5.3      5.3      5.3      5.3
      2009 Budget assumptions........................      4.7      4.6      4.9      5.1      5.2      5.3      5.3

    ----------------------------------------------------------------------------------------------------------------
    \1\ Adjusted for July 2007 NIPA revisions.
    \2\ Year-over-year.
    \3\ Calendar year average.

    contribution to receipts is counted in the structural balance.
      No two business cycles are alike and some factors unique to the
    current economic cycle also appear to affect the deficit in ways not
    reflected in the usual cyclical adjustments. The fall-off in labor force
    participation, from 67.1 percent of the U.S. population in 1997-2000 to
    66.1 percent in 2004-2007, may 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
    because of the decline in labor force participation.
      Another factor in the current cycle is the fall-off in the wage and
    salary share of GDP, from 49.2 percent in 2000 to 46.0 percent in 2007
    (through the third quarter). This change may also be at least partly
    cyclical. Since Federal tax collections depend heavily on wage and
    salary income, the decline in the wage share of GDP suggests that the
    true cyclical component of the deficit could be understated for this
    reason as well.
      There are also lags in the collection of tax revenue that can delay
    the impact of cyclical effects beyond the year in which they occur. The
    result is that even after the unemployment rate has fallen, receipts may
    remain cyclically depressed for some time until these lagged effects
    have dissipated.
      For all these reasons, the current estimates of the level of the
    cyclical deficit are probably understated. The current unemployment gap
    is near zero, and the Administration forecasts that it will rise only
    slightly and temporarily, but in the broader sense discussed above, the
    cyclical gap is likely to be larger.

                                                            Table 12-4.  ADJUSTED STRUCTURAL BALANCE
                                                             (Fiscal years; in billions of dollars)
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                                           2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011     2012     2013
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    Unadjusted surplus or deficit (-)..    128.2   -157.8   -377.6   -412.7   -318.3   -248.2   -162.0   -410.0   -407.4   -160.0    -94.8     48.0     29.3
      Cyclical component...............     39.4    -85.1   -127.2    -82.1    -32.0     15.0     15.4    -12.6    -12.4     -2.6     -0.1  .......  .......
                                        --------------------------------------------------------------------------------------------------------------------
    Structural surplus or deficit (-)..     88.8    -72.7   -250.3   -330.7   -286.4   -263.2   -177.4   -397.4   -395.0   -157.4    -94.7     48.0     29.3
      Deposit insurance outlays........      1.6      1.0      1.4      2.0      1.4      1.1      1.5      1.9      3.5      5.2      5.4      5.6      5.3
                                        --------------------------------------------------------------------------------------------------------------------
    Adjusted structural surplus or          87.2    -71.7   -248.9   -328.7   -285.0   -262.1   -175.9   -395.5   -391.6   -152.3    -89.3     53.7     34.7
     deficit (-).......................
    --------------------------------------------------------------------------------------------------------------------------------------------------------
    NOTE: The NAIRU is assumed to be 4.8%.

    [[Page 176]]

      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 and 2007 the unemployment rate appeared to be
    slightly lower than the ``natural rate,'' rendering the structural
    deficit for those years slightly higher than the actual deficit. For
    2008-2009, the unemployment rate is slightly higher than the ``natural
    rate,'' and the structural deficit falls slightly below the actual
    deficit.

                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 2008 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 2008
              deficit is estimated to increase by $16.4 billion; receipts in
              2008 would be lower by $13.8 billion, and outlays would be
              higher by $2.6 billion, primarily for unemployment-sensitive
              programs. In fiscal year 2009, the estimated receipts
              shortfall would grow further to $28.9 billion, and outlays
              would increase by $8.2 billion relative to the base, even
              though the growth rate in calendar year 2009 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 2008-2013, the cumulative increase in the budget
              deficit is estimated to be $251 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 2008-2013, the
              cumulative increase in the budget deficit is estimated to be
              $706 billion.
      For inflation and interest rates:
        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 2008 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
              2008 and 2009, outlays would be above the base by $12.5
              billion and $20.7 billion, respectively, due in part to lagged
              cost-of-living adjustments. Receipts would rise by $21.2
              billion in 2008, but then would rise by $40.9 billion above
              the base in 2009 due to the sustained effects of the elevated
              price level on the tax base, and to the temporary effect of
              higher 2008 interest rates on individuals' incomes and taxes
              and financial corporations' profits and taxes, resulting in a
              $20.2 billion improvement in the 2009 budget balance. In
              subsequent years, the amounts added to receipts would continue
              to be larger than the additions to outlays. During 2008-2013,
              cumulative budget deficits would be $114 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 $390 billion to outlays over 2008-
              2013 and $793 billion to receipts, for a net decrease in 2008-
              2013 deficits of $402 billion.
        The outlay effects of a one percentage point increase in
              interest rates alone are shown in the fifth block. The
              receipts portion of this rule-of-thumb is due to the Federal
              Reserve's deposit of earnings on its securities portfolio and
              the effect of interest rate changes on both individuals' in

    [[Page 177]]

              come (and taxes) and 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 $444 billion during 2008-
              2013. This large effect is because the additional 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, holding
    interest rates and other economic assumptions constant.
      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                                2008        2009        2010        2011        2012        2013      Effects,
                                                                                                                                                   2008-2013
    --------------------------------------------------------------------------------------------------------------------------------------------------------
                         Real Growth and Employment

    Budgetary effects of 1 percent lower real GDP growth:
      (1) For calendar year 2008 only: \1\
        Receipts........................................................       -13.8       -28.9       -32.6       -35.2       -36.2       -38.1      -184.8
        Outlays.........................................................         2.6         8.2        10.5        12.7        15.0        17.1        66.0
                                                                         -----------------------------------------------------------------------------------
          Increase in deficit (-).......................................       -16.4       -37.1       -43.1       -47.9       -51.2       -55.2      -250.9

      (2) Sustained during 2008-2018, with no change in unemployment:
        Receipts........................................................       -14.0       -45.3       -83.8      -128.3      -170.5      -219.2      -661.1
        Outlays.........................................................         0.1         1.0         3.3         7.5        13.4        19.2        44.4
                                                                         -----------------------------------------------------------------------------------
          Increase in deficit (-).......................................       -14.1       -46.3       -87.1      -135.8      -183.8      -238.4      -705.5

                        Inflation and Interest Rates

    Budgetary effects of 1 percentage point higher rate of:
      (3) Inflation and interest rates during calendar year 2008 only:
        Receipts........................................................        21.2        40.9        38.0        36.0        36.9        38.8       211.9
        Outlays.........................................................        12.5        20.7        17.4        16.3        15.3        15.2        97.4
                                                                         -----------------------------------------------------------------------------------
          Decrease in deficit (+).......................................         8.7        20.2        20.6        19.7        21.6        23.7       114.5

      (4) Inflation and interest rates, sustained during 2008-2018:
        Receipts........................................................        21.2        64.5       108.3       153.8       197.3       247.6       792.7
        Outlays.........................................................        12.9        38.2        60.3        77.9        92.1       108.9       390.2
                                                                         -----------------------------------------------------------------------------------
          Decrease in deficit (+).......................................         8.4        26.3        48.0        75.9       105.2       138.7       402.5

      (5) Interest rates only, sustained during 2008-2018:
        Receipts........................................................         7.4        19.9        27.0        30.1        33.1        35.7       153.2
        Outlays.........................................................         8.9        24.8        36.4        42.2        45.9        48.5       206.7
                                                                         -----------------------------------------------------------------------------------
          Increase in deficit (-).......................................        -1.5        -5.0        -9.4       -12.1       -12.8       -12.8       -53.5

      (6) Inflation only, sustained during 2008-2018:
        Receipts........................................................        13.8        44.5        81.1       123.4       163.7       211.3       637.9
        Outlays.........................................................         4.1        13.7        24.7        37.4        49.0        64.8       193.7
                                                                         -----------------------------------------------------------------------------------
          Decrease in deficit (+).......................................         9.8        30.9        56.4        86.0       114.7       146.5       444.2

                  Interest Cost of Higher Federal Borrowing

    (7) Outlay effect of $100 billion increase in borrowing in 2008.....         2.0         4.1         4.5         4.9         5.1         5.3        25.9

    --------------------------------------------------------------------------------------------------------------------------------------------------------
    * $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.