[Analytical Perspectives]
[Economic Assumptions and Analyses]
[12. Economic Assumptions]
[From the U.S. Government Printing Office, www.gpo.gov]
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12. ECONOMIC ASSUMPTIONS
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.
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\1\ Economic performance is discussed in terms of calendar years.
Budget figures are in terms of fiscal years.
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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\
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\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.
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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.
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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
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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
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Table 12-1. ECONOMIC ASSUMPTIONS \1\
(Calendar years; dollar amounts in billions)
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Projections
Actual ----------------------------------------------------------------------------
2006 2007 2008 2009 2010 2011 2012 2013
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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
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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
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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)
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Projections
------------------------------------------------------------ Average,
2008 2009 2010 2011 2012 2013 2008-13
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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
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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.
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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
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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.