[Economic Report of the President (2001)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 2

Macroeconomic Policy and Performance



The United States achieved a growth milestone early in 2000. In
February the duration of the economic expansion, measured from the last
business cycle trough in March 1991, reached 107 months, eclipsing the
previous record set in the 1960s. With private payroll employment
growth strong in November 2000, the expansion appeared to still have
steam left after 116 months. Even more remarkable than the length of
this marathon expansion has been its ongoing strength. In the ninth
consecutive year of economic growth, driven by vigorous investment and
accelerating productivity, real GDP grew a torrid 6 percent between the
second quarter of 1999 and the second quarter of 2000, yet core inflation
(which excludes changes in food and energy prices) remained tame. It is
probably not surprising after such a surge that growth moderated in the
third quarter. Nevertheless, the unemployment rate in November remained
a low 4.0 percent.

Strong and rising productivity growth well into an expansion and the
prolonged coexistence of low unemployment and low inflation have not
previously been seen together in the postwar period. Together with a
sustained high rate of investment in new technology, this confluence of
indicators is evidence that the United States is indeed in a New Economy.
But even a New Economy cannot claim to have banished the business cycle,
and indeed risks remain. For example, oil price shocks were associated
with the onset of recession twice in the 1970s and again in 1990, and oil
prices have increased sharply in the past 2 years. Yet the fundamental
soundness of today's economy augurs well for its ability to weather the
oil price storm, just as it weathered the turmoil of the Asian, Russian,
and Latin American financial crises in 1997-98. Indeed, the U.S. economy
appears to be at a unique juncture in its modern history, reaping the
benefits of sound policies and a business environment rife with new
technological possibilities.

This chapter describes the fruits of these policies and technological
developments as they manifest in the recent performance of the overall
economy. But it also looks to the future. In particular, the chapter
discusses the importance of preserving the fiscal discipline that has
contributed in a major way to encouraging investment and supporting the
strong economic performance of recent years.

The chapter begins with a review of macroeconomic developments during
2000. This review identifies several positive trends that herald a New
Economy, such as sustained high investment rates, continued strong
productivity growth, and low unemployment with stable core inflation.
But it also notes two potential caution signals: a low and falling
private saving rate and a widening trade deficit. Although either of
these could become the source of problems, each appears, in the short
run at least, to be a side effect of the economy's investment-led growth
rather than an indicator of poor performance. Low private saving, as
measured in the standard national income accounts, has been accompanied
by large increases in wealth that are not part of saving as
conventionally measured. In large part these increases in wealth stem
from the unprecedented recent rise in the stock market, reflecting, among
other things, investors' optimism about the prospects for continued rapid
growth in corporate profits. Similarly, the widening deficit in the
Nation's international accounts may well reflect not only low private
saving out of current income here at home but also, as discussed in
Chapter 4, the attractiveness to foreigners of investing in the
United States.

Although the evidence is widespread that there really is something new
about the economy, it is not clear just how much the basic parameters of
macroeconomic performance have changed. Productivity growth has certainly
been strong of late. But just how much of the increase in productivity
growth is due to temporary factors such as the phase of the business
cycle, and how much represents an improved long-term trend? The economy
has been able to achieve remarkably low unemployment rates without
igniting inflation. But has the concept of a minimum sustainable rate of
unemployment consistent with stable inflation lost relevance, and if not,
has that rate changed? Recently, the succession of positive developments
that suggest we are in a New Economy has also led forecasters to keep
revising their short-term forecasts upward. But does this mean simply
that those particular forecasts were wrong, as forecasts have been before,
or has the New Economy rendered the forecasters' models obsolete? None of
these questions can yet be answered definitively, but this chapter's
discussion of the Administration's forecast and the short-term economic
outlook addresses some of them. Because the forecast plays such an
important role in the budget process, this Administration has
consistently been cautious about giving too much weight to recent
favorable deviations from longer term trends. But if productivity
continues to accelerate and policy remains sound, the economy could
yet again outperform the forecast.

The last part of the chapter shifts the focus from the short-term
performance of the economy and the economic outlook to the long-term
fiscal outlook. The remarkable turnaround in Federal Government finances
over the past 8 years has created a virtuous cycle in which fiscal
prudence has helped keep interest rates attractive for investment,
and the resulting strong, productive investment has generated a healthy
and growing economy that yields ever-larger budget surpluses. As a result,
the United States is on track to be free of public Federal debt before
the middle of the next decade. Even if the economy continues to perform
reasonably well, however, that outcome is not guaranteed if the
government makes unwise fiscal choices. Moreover, as this chapter
will document, demographic trends are pushing us toward a situation
in which an aging population will put pressure on the budget and
deficits could reemerge. Maintaining fiscal discipline today is critical
to building up the resources and the economic strength needed to address
these demographic pressures down the road.

The Year in Review

After growing rapidly between mid-1999 and mid-2000, the economy
showed signs of moderating in the second half of 2000. Nevertheless,
real GDP grew at a 4.2 percent annual rate over the first three quarters
of 2000, following 4 consecutive years of growth in excess of 4 percent.
Once all the data are in, growth in 2000 is likely to have been near
the 4 percent average annual rate that has been achieved since 1993
(Chart 2-1). The pattern of spending in 2000 was similar to what it had
been in the preceding 2 years (Table 2-1), with consumer expenditures
growing faster than income, business investment in equipment and software
growing robustly, and domestic spending outpacing domestic income to
produce a further decline in net exports. With the economy already
operating at a very low level of



unemployment, one measure of labor input, hours worked, grew at only a
1.3 percent annual rate in the first 11 months of 2000, and the labor
force participation rate was flat. Nevertheless, economic growth
continued to be strong because of surging labor productivity (Chart 2-2).
Although rising energy prices contributed to an increase in overall
inflation, core inflation increased only modestly despite continued
tight labor markets.

In 2000 the economy had to negotiate several speed bumps. First, the
explosive growth in the stock market that in recent years has fueled both
consumer spending and investment came to a halt. Technology stocks in
general and Internet stocks in particular fell sharply after peaking in
the spring, and near the end of the year they were down from their 1999
close. This cooling of the stock market most likely played a role in
slowing growth in consumer spending and business investment as the year
progressed. Rising energy prices probably also helped slow the economy,
as did increases in interest rates associated with monetary tightening
by the Federal Reserve between June 1999 and May 2000. The challenge for
policymakers has been to negotiate these speed bumps and keep the economy
on a sustainable growth path with low unemployment and stable inflation.
Success in doing so thus far has given the United States a record-breaking
economic expansion that has now lasted almost 10 years.



Private Domestic Spending

The rich technological opportunities and booming stock market that
characterize the New Economy have affected the shape of aggregate demand
in recent years. The effect of these technological opportunities can be
seen most directly in the very high rates of investment in business
equipment and software. And it is the expectation of substantial payoffs
from those investments that has fueled much of the increase in the stock
market. The surge in the stock market between 1994 and 1999, in turn,
generated enough wealth to affect consumption noticeably. And even though
the stock market stumbled in 2000, consumption retained considerable
momentum from the buildup of wealth in prior years.

Households

Consumer spending was exceptionally strong in the first quarter of 2000
and then slowed somewhat in the second and third quarters. Even with the
slowdown, real consumer expenditures rose 5.3 percent between the third
quarter of 1999 and the third quarter of last year, continuing to outpace
growth in disposable personal income (Chart 2-3). Purchases of motor
vehicles and parts, which surged in the first quarter, fell back later
in the year. Even so, through November at least, 2000 was on track to
become the best-selling year ever for light motor vehicles. After growing
at a very rapid pace in 1998 and 1999, residential investment was lower
in the third quarter of 2000



than it had been a year earlier, as higher mortgage interest rates
contributed to slowing demand.

The increase in consumption expenditures in 1999 and 2000 is generally
explained by the sharp increase in household wealth since 1994. According
to the standard life-cycle model of consumer behavior, increases in wealth
are not spent all at once; instead, people generally aim to raise their
living standards over the remainder of their lives by spending only a
portion of that new wealth each year. Historical evidence suggests that
each $1 change in stock market wealth leads to a permanent change in
future consumer spending of about 3H cents per year, with most of the
effect phasing in by the third year. The rate of growth in consumption
is affected during the transition from one permanent level to another,
but persistent changes in the rate of growth of consumption require
persistent changes in wealth. The increase in stock market wealth from
1994 into early 2000 raised consumption growth by about 1N percent per
year. The lagged effects of these past increases in stock market wealth
probably continued to boost consumption in 2000.

Increased consumption due to this wealth effect reduces saving out of
current income, and in fact the household saving rate as conventionally
measured in the national income and product accounts fell below zero in
the third quarter of last year (Chart 2-4). However, this measure of
saving does not include capital gains, because these gains do not
represent income earned from current production. When income and saving
are augmented by changes in net worth--mainly capital gains--that are not
related to current



saving, the picture is quite different: the resulting ``wealth-adjusted
saving rate'' jumped up in 1995 and has generally stayed high since. To
the extent that these changes in household net worth reflect revised views
of the future productivity of the underlying assets, the low official
personal saving rate is not evidence that households are overextended or
living beyond their means. It does mean, however, that households are
contributing little or nothing to the pool of national saving available
for new investment.

Looking more closely at the financial condition of households, there is
little question that, even with some stock market setbacks last year, the
overall picture of household net worth remains strong. Within this sector,
however, some households are net creditors, while others are net debtors
and could be subject to financial stress. The Federal Reserve's Survey of
Consumer Finances shows, for example, that 14.5 percent of families in
1998 (up from 13.6 percent in 1995) owed annual debt payments exceeding
40 percent of their income. Other indicators of the financial condition
of households, such as credit card delinquencies and bankruptcies, show
less potential stress. Although these indicators suggest that some
households could find themselves in trouble if economic conditions
weakened sufficiently, the kinds of credit imbalances that could
precipitate financial problems for the macroeconomy are not in evidence.

Businesses

Very strong investment in the equipment and software category, and
especially in information processing equipment and software, is one of
the hallmarks of the New Economy. In 1999 and 2000 growth in investment
in information processing equipment and software was roughly 25 percent
at an annual rate (Chart 2-5). An important component of this growth
appears to reflect replacement of the large but rapidly depreciating
stock of this equipment that has been built up in recent years. The
primary motivation for this strong pace of investment continued to be
rapidly declining prices of computer equipment. Fears of year-2000 (Y2K)
problems may have suppressed computer investment in the fourth quarter of
1999. But when these worries passed with the New Year, computer
investment rebounded strongly in the first half of 2000. Moreover, the
strong stock market gains since 1994 have made such investment easier to
finance. Stock market valuations continued to support investment spending
in 2000, as the dividend-to-price ratio remained low.

Construction of office buildings was strong in 2000, but industrial
construction continued at a pace below rates seen earlier in the decade.
With energy prices up sharply, investment in drilling and mining was
also strong, accounting for nearly one-third of the growth in total
investment in nonresidential structures between the third quarter of 1999
and the third quarter of 2000.



After declining sharply relative to sales in 1998 and 1999, inventories
moved up a bit in late 2000. Nevertheless, the aggregate inventory-to-
sales ratio remains very low by historical standards, and an inventory
overhang that could threaten the expansion is not in evidence.

Credit conditions tightened for some borrowers over the course of 2000.
Arguably, however, credit markets were doing a good job of distinguishing
among borrowers according to their credit risk. As the year progressed,
lower rated corporate borrowers faced higher interest rates, and banks
appeared to have tightened their lending standards. High-quality borrowers
did not see the same increase in borrowing costs, and profits in general
remained high, suggesting that business investment in general was not
subject to a credit crunch. As with households, some businesses would
have trouble borrowing or meeting their debt service obligations if
economic conditions weakened sufficiently, but the overall financial
condition of businesses was sound in 2000, with little or no indication
of the kinds of imbalances that would precipitate an economic or
financial crisis.

Government Spending and Fiscal Policy

Government expenditures for consumption and investment have grown more
slowly than GDP during this expansion, and Federal expenditures have fallen
in real terms. In the first three quarters of 2000, Federal Government
expenditures fell at a 2.9 percent annual rate. Increases were recorded
at the State and local level, but government in the aggregate made a
negligible contribution to growth in GDP.

One measure of whether fiscal policy is stimulating or restraining
economic activity is the change in the standardized, or structural,
budget balance. In contrast to the actual budget balance, the structural
balance controls for the effect of cyclical economic activity by
estimating what receipts and outlays would be if the economy were
operating at potential output. After 1995 the structural deficit
shrank, although not as fast as the actual deficit (Chart 2-6),
indicating that fiscal policy was restrictive. The structural balance
turned positive in 1999 and is estimated to have increased further in
2000 as fiscal restraint has continued. As discussed later in this
chapter, the turnaround in the Federal budget balance has been so
substantial that, until recently, increases in public saving have more
than offset declines in private saving, and national saving has increased
as a share of GDP.

International Influences

U.S. exports grew robustly in 2000 as many of our foreign trading
partners experienced renewed economic growth after a slump caused by
the Asian economic crisis. But imports grew even more rapidly,
reflecting strong growth in consumption and investment. Imports of
capital equipment accounted for more than one-third of the growth in
imports during the first three quarters of the year. As a result, the
U.S. current account deficit



continued to widen. And real net exports (exports minus imports)
continued to make a negative contribution to aggregate demand. As
discussed in Chapter 4, however, the widening of the trade and current
account deficits in the past few years most likely is a sign of the
strength of the new American economy, not a sign of weakness.

A country runs a current account deficit when its domestic spending
exceeds its income earned from production and it borrows abroad to
fund that extra spending. Put another way, a current account deficit
reflects an excess of domestic investment over domestic saving, with
the excess investment funded by foreigners. The wealth effects
discussed previously have generated substantial growth in consumption,
some of which has been met through imports. Moreover, as discussed in
Chapter 4, imports represent a significant share of U.S. investment,
including investment in information technology. At the same time,
investment in the New Economy of the United States has been attractive
to foreigners, and this has supported the dollar. Arguably, the U.S.
economy is in a transitory phase in which national saving is being held
down by especially low private saving out of current income, and foreign
saving is being attracted by the extraordinary investment opportunities
in the United States, the clear frontrunner in making New Economy
investments.

Monetary Policy and Financial Markets

Monetary and financial market developments in 2000 were not particularly
unusual for an economy experiencing a long expansion with a period of
extraordinary stock market gains. The stock market took a breather last
year, and credit conditions reflected the exercise of monetary restraint
by the Federal Reserve.

Equity Markets

The 1990s saw a remarkable bull market in stocks. The Wilshire 5000
index (the most comprehensive index of U.S. stock prices) quadrupled
between the end of 1989 and the end of 1999, with more than three-quarters
of the gain coming after 1995. At the end of 1999 the market value of U.S.
stocks was over $17 trillion--more than $10 trillion higher than at the
end of 1995. Indicative of the importance of the New Economy, technology
stocks, and particularly Internet stocks, showed spectacular gains in
1998-99. The market capitalization of Internet companies (defined as those
in the Wilshire 5000 Internet index, which seeks to include all companies
that derive a substantial fraction of their business from the Internet)
increased from $145 billion in December 1997 to $1.6 trillion in December
1999. Internet stocks alone accounted for about 23 percent of the total
increase in stock market wealth over that period.

The sharp increase in stock prices came to a halt in 2000. The Standard
& Poor's 500 index of large-company stocks was down 11 percent as of
December 15, while the Nasdaq Composite Index, after climbing 22 percent
between January and its peak in March, fell sharply and was down 35
percent as of December 15. Total stock market wealth had fallen by 10
percent as of November 30, compared with an average annual increase of
around 17I percent over the past decade. Reversing their previous pattern
of outperforming the overall market, technology and Internet stocks did
even worse than stocks generally in 2000 (Chart 2-7). Internet stocks
were particularly notable for their roller-coaster ride. Instead of
being a major contributor to growth in market capitalization as in 1999,
Internet stocks subtracted $630 billion from the broader market in 2000
(Chart 2-8).

In the absence of irrational investor behavior, stock market prices
reflect the discounted present value of future corporate cash flows,
where the discount rate includes a risk factor. Thus, rational
explanations for the performance of the stock market last year are
likely to be found in the factors affecting such a valuation. For example,
a rise in interest rates reduces the present value of future cash flows;
hence the rise in interest rates since last summer was probably a
dampening factor. Increasing expectations that Federal Reserve
tightening and other factors would slow the economy could also have
reduced expectations of future profits and hence of future cash flows.
Disappointing earnings reports may have reduced expectations of future
profitability as well. Finally, it is possible that the higher growth



potential that technology companies have enjoyed--and continue to
enjoy--has already been priced into the market, as this sector ceased to
outperform the rest of the market.

Interest Rates

Between June 1999 and May 2000 the Federal Reserve raised its target
for the Federal funds rate (the rate banks charge each other for overnight
lending) by 175 basis points, from 4.75 percent to 6.5 percent. (A basis
point is 1/100th of a percentage point.) In the second half of 1999, when
the Fed began its rate hikes, both Treasury yields and corporate bond
yields rose as the Federal funds rate rose. Yields on Treasury and other
fixed-income securities of all maturities increased (Chart 2-9). Beginning
in early 2000, however, the Treasury yield curve (which plots the yields
of Treasury securities of different maturities, from shortest to longest)
began to exhibit atypical behavior. Instead of displaying its normal,
upward-sloping shape, the yield curve became inverted: yields on longer
term securities fell below those on shorter term securities. This
development appears to have been determined mostly by supply conditions
in the market for Treasury securities, associated with a growing
recognition that substantial Federal budget surpluses were likely to
emerge, and therefore that the stock of Treasury securities might
decline. This perception was reinforced in January 2000, when the
Treasury detailed plans for buying back Federal debt.



The decline in intermediate- and long-term Treasury yields was not
mirrored in the market for private sector securities, where yields on
longer term corporate bonds did not retreat much from their late-1999
levels. The anomalous behavior of Treasury yields raised questions about
their role as a benchmark for evaluating interest rates (Box 2-1).
Although yield curves for corporate bonds and other privately issued
instruments did not become inverted, they were flatter than usual in
the first half of the year, reflecting the Fed tightening and the
perceived likelihood that economic activity would slow to a sustainable,
noninflationary pace. As discussed earlier, borrowing costs increased
for the riskiest borrowers, but yields on higher quality corporate debt
remained relatively stable.

Labor Markets and Inflation

For the most part, 2000 marked another year in which the unemployment
rate remained very low without generating excessive inflation or
inflationary expectations. The unemployment rate averaged 4.0 percent
in the first 11 months of 2000. Sharp increases in oil prices beginning
in early 1999 did push up the overall consumer price index (CPI) by 3.4
percent in the 12 months ending in November. Until very recently,
however, the rise in oil prices did not feed into most other prices, and
core inflation (which does not include changes in oil prices) rose only
2.6 percent over the same period. On the other hand, import prices are
no longer as much of a restraint on overall inflation as they were for
several years in the late 1990s. In contrast to earlier

______________________________________________________________________________
Box 2-1.  Are Treasuries Being Swapped out of Their Benchmark Role?

U.S. Treasury securities provide investors with a financial vehicle that
is both free of default risk and highly liquid (that is, easily turned into
cash). These properties have made Treasuries a widely used benchmark for
determining and assessing interest rates on other assets that are less
liquid or less safe. Historically, for example, new corporate debt has
typically been marketed in terms of its yield relative to that of a
benchmark asset, such as Treasury securities, rather than at a price in
dollars or a yield in percent, and the performance of corporate bonds is
often assessed relative to that of Treasuries. Thus changes in the pricing
of the credit risk associated with other financial instruments (the spread
between their yield and that of Treasuries) can be separated from changes
in interest rates generally (as represented by changes in the yield on
Treasuries). The Treasury yield curve is also a useful tool in economic
forecasting. For example, a narrowing of the spread between short-term and
long-term rates is often taken as a sign that economic activity is expected
to moderate.

Many observers believe that yields on long-term Treasuries were driven
down in 2000 by the growing consensus that the supply of these securities
would be markedly reduced in the future. Interest rate swaps began to
receive more attention as an alternative benchmark. A swap is the exchange
of a stream of variable-interest-rate payments, usually tied to the London
interbank offer rate (LIBOR), for a stream of fixed-interest-rate payments.
Swaps have durations ranging from a few months to many years. For example,
one party to a swap may expect to receive a variable stream of payments
tied to LIBOR (and an implicit principal balance) over the next 5 years
but would prefer the certainty of fixed payments. The second party agrees
to pay a fixed periodic amount in exchange for that variable stream of
payments. The swap rate is expressed as a fixed rate that market
participants are willing to exchange for a floating rate. Underlying
implicit balances are not exchanged.

The swaps market is sufficiently deep and liquid, and trading takes
place across a sufficiently broad range of maturities, to provide an
alternative yield curve to that of Treasuries and an alternative benchmark
for assessing other interest rates. The increased prominence of the swaps
market illustrates how financial markets have begun to adapt to the
anticipated paydown of marketable Federal debt associated with the improved U.S. fiscal situation.
------------------------------------------------------------------------------

years when import prices (including oil prices prior to 1999) were falling,
nonpetroleum import prices are now on a rising trend, although the rates
of increase have so far been modest (Chart 2-10).



Wages and compensation registered solid increases in nominal terms in
2000. From the standpoint of businesses, however, these wage increases
were more than offset by strong productivity gains, with the result that
unit labor costs (compensation per unit of output) did not put upward
pressure on product prices (Chart 2-11). From the standpoint of workers,
increases in the CPI associated with higher energy prices have meant
smaller increases in real wages and compensation than in some recent years.

The Economic Outlook

Although economic performance remained strong in 2000, the resilience
of the new macroeconomy of fast productivity growth and a very strong
labor market could be tested in the coming year or so. Chapter 3 provides
ample reason to be optimistic about future productivity increases, but it
remains uncertain how much of the recent increase in productivity growth
will be sustained in the long run. Absorbing the inflationary pressures
from the recent rise in oil prices, as well as diminishing restraint from
non-oil import prices, will be easier if productivity growth continues
strong. On the demand side, the very low private saving rates of recent
years might not persist, raising the question of whether the transition
from a stock market-fueled consumption boom to a more sustainable
consumption pace will be



accomplished smoothly. Toward the year's end, stock market declines and
higher interest rates charged to high-risk corporate borrowers added a
note of uncertainty to financial markets. Fortunately, the economy
remains remarkably free of the kinds of imbalances typically associated
with the ends of expansions. Core inflation remains low, inventories in
most industries remain lean in relation to sales, and the outlook for the
economy remains good.

Growth of GDP is projected to moderate to 3.2 percent during 2001 and
to remain at or near this growth rate through 2007 (Table 2-2). These
growth rates are below estimates of the trend growth in aggregate supply,
and as a result, the unemployment rate is projected to edge up gradually
to 5.1 percent, the middle of the range of unemployment compatible in
the long run with stable inflation. The growth of aggregate supply is
projected to edge down over the 11-year budget window, reflecting a return
to more traditional rates of productivity growth, a slower rate of
population growth, and the anticipated retirement of the first wave of
the baby-boom generation.

The Near-Term Outlook

The prospects for another year of solid growth rest on continued growth
of aggregate supply, stable core inflation, and the sound application of
fiscal and monetary policy. When inflation is used as an indicator,
economic activity now appears to be in the neighborhood of its potential,
as measures of core inflation have risen slightly or not at all.

Potential output is expected to increase at a solid 3.8 percent annual
rate in 2001 and 2002, about the same as its growth rate from 1995 to
2000. This estimate is based on the prospect that a large and rapidly
growing level of investment spending will continue to support rapid growth
of capital services per hour worked. At these levels of investment
spending, structural productivity is expected to increase at about a 2.8
percent annual rate. The labor force, another component of aggregate
supply, is expected to grow at about a 1 percent annual rate.

The projected real GDP growth rate of 3.2 percent per year during 2001
and 2002 is somewhat slower than the rise in potential output, and as a
consequence the unemployment rate is projected to edge up 0.3 percentage
point per year during those years. At these growth rates, any tightness in
labor and product markets will unwind.

Consumption, which constitutes two-thirds of GDP, is expected to be
the major factor in the deceleration of GDP, as the stimulus to
consumption growth from the 1995-99 bull market in stocks recedes into
the past. Real private nonresidential investment, which has grown more
than twice as fast as real GDP during the past 2 years, is projected to
continue to outpace activity as a whole. Even so, its growth is expected
to moderate. The fall in the relative price of investment goods, a cause
of the recent investment strength, is expected to persist.

Exports have rebounded strongly since mid-1999, reflecting the rebound
in activity from the depressed levels of the Asian economic crisis.
Looking ahead, activity in the industrial countries as a group--which
has grown rapidly in the past year--is projected to slow slightly in 2001.
As a result, exports are projected to grow at a slower, but still strong,
rate in 2001. As fast as exports have grown, imports have grown even
faster, and so both net exports and the current account deficit have
deteriorated. During the next few years, import growth is expected to
come down with the projected deceleration of U.S. GDP. Nevertheless,
imports generally grow roughly two times faster than GDP, and as a result,
the current account deficit is projected to widen further before it narrows.

Productivity and the NAIRU

The level of unemployment consistent with stable inflation remains
temporarily depressed by the still-surprising increase in productivity
growth. Permanent declines in this unemployment rate may have been caused
by, among other things, the development of the temporary help industry and
the Internet job market. These factors were discussed in more detail in
last year's Report. The acceleration of productivity after 1995 appears
to have initiated a process that allows the unemployment rate to fall
lower temporarily, with less consequence for inflation, than would have
been possible otherwise. The rate of growth of nominal hourly compensation
has increased during the past 4 years, but these nominal increases have
not resulted in much of an increase in price inflation. Businesses have
been able to grant these larger pay increases without higher inflation,
partly because increases in unit labor costs have remained stable, as
rising productivity growth offset the rising compensation gains.

The new, higher trend growth of productivity since 1995 has temporarily
lowered the NAIRU (the nonaccelerating-inflation rate of unemployment,
that is, the unemployment rate consistent with stable inflation), because
it can take many years for firms and workers to recognize this favorable
development and incorporate it into their wage setting. In the meantime
the productivity surprise can stabilize inflation of unit labor costs
and prices even at unemployment rates below the previous NAIRU. A 1-
percentage-point surprise in trend productivity growth is estimated to
lower the NAIRU by 1G percentage points. The effect of the increase in
productivity growth in holding down the NAIRU cannot last indefinitely,
however. If productivity growth is maintained at the current high level,
it will cease to be unexpected, demands for real wage increases will
eventually rise to match productivity growth, and the short-term NAIRU
will gravitate back to its long-term level.

Some evidence points to an upward drift of real wage expectations--
although the jury is still out. Private sector wages, as measured by the
employment cost index, have increased 1H percentage points faster than
expected inflation over the past four quarters (as measured by the
University of Michigan Survey of Consumers). This is the largest gain in
expected real wages in more than 15 years. Even so, this growth in
expected real wages remains well below recent productivity increases.
Nor has real hourly compensation (deflated by the price of output)
grown as fast as productivity. As a result, the labor share of GDP has
continued to erode and is now about 1 percentage point below its 40-year
average.

As the slow process of adjustment by wage setters to a higher level of
productivity growth proceeds, the NAIRU--currently estimated to be in a
range centered around 4G percent--is expected to edge up gradually to
5.1 percent by 2007. This upward drift closely mirrors the projected path
for the unemployment rate. As a result, the Administration expects price
inflation to flatten out at levels barely above current rates: 2.1
percent for the GDP price index and 2.7 percent for the CPI.

Inflation Measurement and the Federal Surplus

The wedge between the CPI and the GDP measures of inflation has an
important effect on Federal budget projections. A larger wedge reduces
the Federal budget surplus because cost-of-living adjustments for Social
Security and other indexed programs increase with the CPI, whereas
Federal revenue increases roughly in line with the slower growing GDP
price index. The effect is reinforced by the use of the CPI to index
income tax brackets and other features of the tax code. Of the two
indexes, the CPI tends to increase faster because it measures the price
of a fixed market basket. In contrast, the GDP price index increases
less rapidly than the CPI, because it reflects choices of economic agents
to shift their purchases away from items with increasing relative prices
and toward items with decreasing relative prices. In addition, the GDP
price index includes investment goods, particularly computers, whose
relative prices have been falling rapidly. Computers, in particular,
receive a much larger weight in the GDP price index (1.2 percent) than
in the CPI (0.08 percent in November 2000).

Over the past 6 years, the version of the CPI designed to be consistent
with current methods (the CPI-U-RS) has increased 0.6 percentage point
per year faster than the GDP price index. The projected wedge is in line
with this 6-year average, and this is reflected in the Administration's
inflation projections.

The Stock Market, Saving,
and Consumption Prospects

Consumption has been an engine of demand growth during this expansion,
growing faster than income in 7 of the past 8 years. By the third quarter
of 2000, personal outlays exceeded disposable personal income, and the
personal saving rate dropped to -0.2 percent. The rise in the ratio of
net worth to income--a consequence of the 5-year surge in stock prices
from 1995 to 1999--accounts for the strength of consumption over this
period (Chart 2-12). The increase in the consumption-to-income ratio over
the past 5 years is roughly consistent with the rule of thumb that
attributes an eventual 3H-cent gain in consumption from every dollar
increase in stock market wealth. In the near term, current stock market
values support the current level of the consumption rate.

The growth rate of consumption, however, is another matter. The stock
market declined in the second half of 2000, foreshadowing a period when
consumption growth is unlikely to exceed the growth of income. As a result,
it appears probable that consumption will decelerate in the year ahead.
Because consumption accounts for about two-thirds of GDP, this
deceleration, if it comes to pass, will have a restraining effect on
aggregate demand.

Over the long term (the next 5 years or so) the saving rate is likely
to increase from its current level. But predicting whether the saving
rate will rise from a pickup of income or from a slowdown of consumption
depends on



the interpretation of the increase in the stock market from 1995 to 1999.
Today's stock valuations do not bear the same relation to
apparent dividend prospects as in the past. Through about 1996, a stable
rule of thumb tied the value of the stock market to a proxy for the
apparent present value of dividends. But this relationship broke down
after 1996 as the stock market soared ahead of this valuation model.

Assuming that the current value of the stock market is appropriate,
either dividend prospects have greatly improved or the so-called equity
risk premium (discussed below) has fallen. These two alternative
explanations for the rise in stock market values have different
implications for the sustainability of consumption growth. If dividend
prospects have improved, the low saving rate means that consumers are
spending some of their future dividend income today. In this scenario,
consumption need not slow; rather, the saving rate will rise if and
when dividend income outpaces other components of income.

A substantial but still controversial literature suggests that stocks
have been undervalued for most of the past century. As discussed in last
year's Report, the additional riskiness of stock returns over that of
bond returns does not appear to be enough to justify the higher returns
on stocks (the equity risk premium), unless investors are extraordinarily
risk averse or their investment horizon is very short. According to this
line of argument, it follows that the lower initial price (and higher
expected return) traditionally demanded by investors has been excessive.
As investors have come to regard the equity risk premium as excessive,
they have bid up stock prices to current levels.

But if stock prices have risen because of erosion of the equity risk
premium, then investors are paying more for the rights to a given stream
of dividends--that future stream has not increased. And without any
change in the stream of dividends, the path of future consumption cannot
differ much from the one that the consumer had planned before the decline
in the equity risk premium. Certainly those investors who have received
large capital gains are richer and can spend more, but this effect should
be partly offset by those who wish to become stockholders and who must
now save more to purchase a given quantity of stock.

With the actual prospects for dividends and profits uncertain, one
cannot know today which of these explanations for the 1995-99 stock
market rise is correct. But some may incorrectly perceive that the
rise in stock prices foreshadows higher dividends when it only
reflects a decline in the equity risk premium. If the increased
stream of dividends fails to materialize, consumption will probably
slow relative to income. In any case, the present value of future
consumption must equal the present value of future income. It follows
that either dividends must grow much faster than other forms of
income, or consumption must grow more slowly than nondividend income,
or some combination of these two. In either case, the saving rate
would be expected to increase.

The Long-Term Projection

Growth of productivity during the past 5 years has been impressive--
so impressive that it seems reasonable to wonder whether it can be
sustained. As discussed in Chapter 1, productivity accelerated by 1.6
percentage points from 1973-95 to 1995-2000, about 0.4 percentage point
of which can be explained by capital deepening and the direct
contribution of productivity growth in the computer sector. Although
business cycle dynamics often underlie much of the year-to-year variation
in productivity growth, this factor appears to have played only a minor
role in the post-1995 acceleration. The growth of output from 1991 to 1994
put underutilized labor back to work, and so the traditional cyclical
rebound from the 1990-91 recession had largely played itself out by 1995.
The Council of Economic Advisers estimates that the level of productivity
had risen about 2 percent above its trend by 1995, and that it edged up
only slightly further above its trend from 1995 through 2000.

Another 1.2 percentage points of the productivity acceleration can be
attributed to faster growth in total factor productivity, the variation
in aggregate output that is not explained by changes in inputs. This
acceleration represents improvements in technology and means of
organization, and Chapter 3 describes evidence that supports this view.
However, the evidence is not conclusive, and forecasters are left
wondering whether some of the acceleration represents one-time
improvements that have shifted productivity to a higher level rather
than a permanently higher rate of growth.

Capital deepening is projected to play just as strong a role in the
near future as in the recent past. However, it is not prudent to expect
the same contribution from total factor productivity as in the recent
past, and therefore the Administration projects that structural
productivity will grow at about a 2.8 percent annual rate during the
next 2 years. Actual productivity may grow somewhat less rapidly, as the
economy slows. With the labor force and the other components of
aggregate supply expected to grow about 1 percent per year, potential
output is projected to grow about 3.8 percent at an annual rate.

Structural productivity is projected to slow a bit further in the
later years of the 10-year budget window. It is expected to grow at a
2.3 percent annual rate from 2003 to 2007, and then to trail off to
2.1 percent from 2007 to 2011. These slower growth rates are more in
keeping with the pace of productivity growth over the past two decades
or so.

In addition to productivity, the factors on the supply side whose
growth rates affect GDP growth include population, the labor force
participation rate, the employment rate, and the workweek, as shown
in Table 2-3. In line with the latest projection from the Bureau of the
Census, the working-age population is projected to grow at a 1.1 percent
annual rate through 2008. The labor force participation rate is expected
to inch up by less than 0.1 percent per year. The average workweek is
projected to remain flat over the entire projection period. In contrast,
the employment rate is projected to decline roughly 0.1 percent per year
as the unemployment rate edges up to 5.1 percent--the middle of the range
judged consistent with long-run inflation stability. From 2008 forward,
growth in the working-age population is projected to slow a bit, and the
labor force participation rate will begin to fall as the first cohort of
the baby boom, those born in 1946, reach the early retirement age of 62.
Together, the supply-side factors imply potential real GDP growth of 2.9
percent by the end of the decade.

Long-term interest rates are expected to remain flat over the entire
11-year projection span at a yield of 5.8 percent on 10-year Treasury
notes. The 91-day Treasury bill rate is currently above the yield on
10-year notes--an unusual situation that tends to occur when the market
expects the economy to slow. Another reason for this inversion of the
yield curve is that the ongoing reduction in Federal debt has led
investors to expect a diminishing supply of Treasury securities. (See
the earlier discussion of the yield curve.) Consistent with the projected
slowdown in real activity, the interest rate on 91-day Treasury bills
(which was 6.2 percent at the time the Administration projection was
finalized) is projected to decline to 5.3 percent during the next
several years. Real long-term interest rates, calculated by subtracting
the Administration's expected rate of inflation (2.7 percent as measured
by the CPI) from projected nominal rates, are projected to be similar
to their historical average.

On the income side, the Administration's projection is based on the
long-run stability of the labor share of GDP. At present, the labor
share of GDP is the lowest it has been in more than 30 years, and the
Administration projects this share to rise, returning partway toward
its long-run average. Wages as a share of total compensation are
expected to erode, as other labor income, especially employer-provided
medical insurance, is expected to grow faster than wages. With the labor
share of GDP rising, the capital share is expected to edge down.
Within the capital share, a rise in the depreciation share (a
consequence of a high-investment economy) is projected to come at
the expense of the profit share. Profits before tax, which were 9.4
percent of GDP in the third quarter of 2000, are projected to fall to
7.1 percent by 2011.

The Administration does not believe that an annual growth rate of
just over 3 percent is the best the economy can do. Rather, it is hoped
that the policies that this Administration has in place will generate
even better results than in the projection. For the purpose of prudent
budget planning, however, this projection reflects a balance between
upside and downside risks.

As of November 2000 the current expansion, having lasted 116 months,
was the longest on record, and there is no apparent reason why it cannot
continue. Expansions do not die of old age. The current situation of low
inflation, high productivity growth, and lean inventories reveals no sign
of an end to the expansion, although growth is expected to moderate. The
likely prognosis remains similar to that of last year: sustained job
creation and continued noninflationary growth.

The Fiscal Terrain in the New Economy

The turnaround in the finances of the Federal Government since 1993
has completely changed the fiscal outlook for decades to come. Whereas
just a few years ago the Nation faced deficits as far as the eye could
see, the prospect now--if appropriate budget discipline is maintained--
is for an extended period of surpluses that would wipe out the entire
outstanding public Federal debt. Instead of being a drain on the saving
available to finance investment, the Federal Government is acting as an
additional source of national saving. Indeed, until very recently the
annual rise in public (Federal plus State and local government) saving
has more than offset the annual decline in private saving. A virtuous
cycle has been created in which fiscal discipline has promoted strong
economic growth, and that strong growth has boosted the surplus.

Challenges lie ahead, however, and it will be important to preserve
the fiscal discipline that was so hard won. In particular, the aging of
the population will begin to put downward pressure on the surplus just
a few years from now, as the number of Social Security and Medicare
beneficiaries rises relative to the number of workers paying into these
systems. Imprudent, irreversible decisions to dissipate the surplus now
would leave little time to recover before the first members of the baby-
boom generation begin to retire. Prudent decisions today about what to
do with the surpluses currently projected will not only help sustain the
current performance of the economy but also address the fiscal policy
challenges posed by population aging. Fiscal responsibility requires
restraint in cutting taxes and in launching new spending programs, so
that the public debt will continue to fall. It also calls for flexibility
in our policy priorities, as the composition and hence the needs of our
population change.

Strong Public Saving: The Payoff from
Deficit Reduction

Changes in Federal policy produced large budget deficits in the 1980s,
and despite deficit reduction measures taken in the Omnibus Budget and
Reconciliation Act of 1990, the country still faced a bleak budget
outlook in 1993. But a succession of subsequent actions helped to turn
this situation around. The Omnibus Budget and Reconciliation Act of 1993
(OBRA93) reduced the deficit through progressive changes in the income
tax structure and effective constraints on spending. Welfare reform
legislation changed the Nation's welfare programs in ways that encouraged
work and hence reduced government spending needs. The Balanced Budget Act
of 1997 dramatically reduced real growth in Medicare expenses through
restraint on provider prices and payment systems. The difference between
the pre-OBRA93 deficit path and the current situation is stunning. Where
Federal deficits were once projected to grow from 4.6 percent of GDP in
1992 to double-digit percentages by 2009, the current outlook is for a
long string of surpluses in excess of 2 percent of GDP (Chart 2-13). The
national debt, which had reached almost half of GDP in 1992 and was
projected to surpass GDP by 2009, has instead begun to decline and,
under June 2000 projections, will be eliminated before the middle of
the next decade (Chart 2-14).

One very important consequence of this turnaround has been an increase
in national saving. The large Federal budget deficits in the 1980s and
early 1990s represented public dissaving (that is, negative saving) and
thus were a drain on the pool of national saving (the sum of public and
private saving)



available for investment. The improvement in the Federal budget balance
since 1993 has turned the public sector into a net saver. National saving
rose as a share of GDP in the 1990s (Chart 2-15). As discussed earlier,
private saving has been particularly low recently, and this has restrained
national saving. Thus, without the improvement in the Federal budget
balance since 1993, national saving would have been lower than it has
been, interest rates would have been higher, and investment would have
been constrained.

In the 1980s the Federal Reserve sought to keep the economy stable in
the face of the fiscal stimulus from large Federal budget deficits, and
the result was to push interest rates up. Although fiscal stimulus can
be helpful in propelling an economy out of a recession, it is a source of
inflationary pressure when the economy is close to full employment.
Moreover, a mix of loose fiscal policy and tight monetary policy produces
high interest rates, which discourage investment relative to current
consumption. This is what happened in the 1980s. In the 1990s, by contrast,
an improved Federal budget outlook and fiscal restraint allowed the Fed
to pursue an accommodative monetary policy--one that not only promoted
economic expansion but also was more conducive to keeping interest rates
down and stimulating investment.

Lower interest rates and a declining national debt have important
direct consequences for the budget. Federal interest outlays have already
fallen from their 1991 high of 3.3 percent of GDP (or nearly 15 percent of
total Federal outlays) to less than 2H percent of GDP most recently (12
percent of



outlays), and they are projected to fall still further. The cumulative
savings in interest payments on the national debt since 1993 amount to
over $330 billion, compared with the pre-OBRA93 baseline. Lower interest
rates have also benefited household borrowers. In mid-2000 each
percentage point added to interest rates would have added about $860 per
year to payments on a $100,000, 30-year mortgage; $70 per year to payments
on a $10,000, 4-year car loan; and $140 per year to payments on a $20,000,
10-year student loan. A rough estimate is that interest rates would be 2H
to 3 percentage points higher if pre-OBRA93 economic and budget conditions
had prevailed. Under that scenario Federal debt held by the public would
be roughly 1H times as large as GDP by the middle of the next decade,
rather than essentially eliminated as under current projections.

What Caused the Surpluses?

The changes in fiscal policy that began in 1993 played an important
role in bringing down the budget deficit. In addition to those already
mentioned, these changes included budget enforcement rules that Congress
imposed on itself requiring that tax cuts or increased spending in one
area be offset by deficit-reducing measures elsewhere in the budget.
Finally, changes in the economy generated large increases in income that
caused Federal tax revenue, particularly individual income tax receipts,
to rise faster than GDP despite no further increase in statutory tax rates.

Controlling Expenditure

Spending discipline and a strong economy have combined to push Federal
budget outlays to their lowest level as a share of GDP since 1974. Total
outlays declined from 22.2 percent of GDP in fiscal 1992 to 18.2 percent
in the most recent fiscal year. Only 1 percentage point of this decline
represents a retracing of the increase in spending between 1989 and 1992
associated with the 1990-91 recession (Table 2-4). The changes in net
interest outlays already mentioned accounted for 0.9 percentage point
of the 4.0-percentage-point reduction from 1992 to 2000. Declines in
discretionary outlays for national defense accounted for another 1.9
percentage points.

Discretionary outlays are outlays for defense and nondefense programs
subject to annual appropriations by the Congress; they account for about
a third of total Federal spending. Discretionary spending has been subject
to dollar caps since 1990, and these caps were generally effective over
the 1990s in limiting the growth of outlays. The rest of the budget
besides interest and discretionary spending consists of mandatory outlays
for programs such as Social Security, Medicare, and food stamps. Spending
on these programs generally depends on the number of beneficiaries and
the benefit amounts to which they are entitled by law. Budget enforcement
provisions did not put specific dollar limits on spending for mandatory
programs but did require that any legislation that would increase
mandatory spending be offset by an equivalent amount of deficit reduction
elsewhere in the budget.

Some Federal Government expenditures, such as unemployment
compensation, are sensitive to the business cycle, so that overall
spending might be expected to fall as the economy booms. In general,
however, the cyclical component of spending is much smaller than that
of revenue, which is discussed below. In the past, spending for welfare
was also sensitive to the business cycle, but the 1996 welfare reform
legislation devolved control of program spending to the States and
transformed this component of Federal spending into fixed block grants.
Thus any cyclical fluctuations in spending on these programs are now
more likely to occur at the State and the local levels than at the
Federal level. The combination of low inflation and low unemployment
has been especially helpful in keeping government spending down during
this economic expansion, because both keep down the levels of expenditure
from transfer programs whose benefits are indexed to inflation. Changes
to expenditure programs during this Administration have also been a
factor. As already noted, the 1996 reform reduced welfare caseloads by
encouraging work, and the 1997 Balanced Budget Act made changes to the
Medicare payments system that have at least temporarily constrained
growth in health care spending.

Rising Incomes and Revenue

Federal Government receipts vary with the business cycle in the
opposite direction from expenditures, growing during booms and shrinking
in recessions. In fact, receipts, especially income tax revenues, play
an important role as an automatic stabilizer of the economy. The
progressivity of the income tax system causes income tax receipts to
fall faster than income during a recession, cushioning the impact of the
recession on after-tax income. Thus some of the improvement in the
Federal budget since 1993 reflects a normal cyclical recovery. But growth
in receipts, especially personal income tax receipts, has been especially
strong in the past few years, when the economy has been expanding rapidly.
This has happened even though statutory tax rates have not increased.

Individual income tax receipts have risen from less than 8 percent of
GDP in 1994 to nearly 10 percent most recently. From 1994 to 1998 the
growth in that ratio contributed approximately $140 billion in
additional cumulative revenue. This faster growth in revenue relative
to GDP reflects two main factors: faster growth in taxable income than
in income generally, and a rise in receipts due to rising real incomes
and the progressive structure of income tax rates.

According to Treasury Department and Congressional Budget Office
analyses of the 1994-98 period, nearly 60 percent of the increase in
individual income tax liabilities relative to GDP arose from rapid
growth in adjusted gross income (AGI) relative to GDP. Of this 60
percent, about 17 percentage points occurred because the taxable
components of personal income grew faster than the other income
components of GDP. The rest reflects strong growth in sources of AGI
that are not included in GDP (because this income is not earned as a
result of current production), such as capital gains realizations and
retirement benefits. The former have been particularly important
(Chart 2-16): growth of capital gains alone accounts for 30 to 40
percent of the additional revenue.

The remaining growth in individual income tax liabilities relative to
GDP (about 40 percent) reflects the growth of revenue that results from
rising real incomes in a progressive tax system. Although statutory
individual income tax rates have not increased since 1993, the average
tax rate on non-capital gains AGI has increased. Two factors account
for most of this increase. First, for taxpayers in general, income
has grown faster than inflation. As a result, more taxpayers have
more income taxed in the higher brackets, even though the brackets
are indexed for inflation. Second, more taxable income is accruing
at the top of the distribution of taxpayers, and hence more is subject
to the top tax rates. Tax return data indicate that the share of
taxpayers with AGIs above $200,000 (in 1998 dollars) rose over the
1994-98 period, and those taxpayers experienced faster growth in
income



than the average taxpayer. Incomes grew even faster for taxpayers
with more than $1 million in AGI.

The share of income taxes collected from taxpayers at the top of the
distribution has increased in recent years, but only because their
before-tax incomes have increased significantly; their share of total
after-tax income has increased as well. Impressive growth in the stock
market contributed to the taxable incomes of these households through
higher capital gains realizations, greater taxable retirement benefits,
and increased compensation in the form of stock options. Labor earnings,
which have increased the most for married couples at the top of the
income distribution, have also contributed. Capital gains, and the
taxes on those gains, had already been surging for a few years before
the significant reduction in tax rates on capital gains that took place
in 1997--and both capital gains and the taxes on those gains continued
to surge after tax rates were cut.

It bears repeating that the additional tax revenue that has contributed
to an improved budget outlook has come during a period in which income
tax rates have not been increased at all for the overwhelming majority
of taxpayers, and no income tax rates have been increased since 1993.
The increases in marginal tax rates in OBRA93 affected only the highest-
income households (1.2 percent of all taxpayers), but many of these
households (and others) got tax relief in 1997 when capital gains tax
rates were reduced. Many taxpayers with more modest incomes enjoyed
meaningful tax relief over this period from other changes in the tax code.
The Earned Income Tax Credit was expanded several times in the 1990s,
most significantly in 1993, and taxes were reduced substantially for
lower and middle-income families in 1997 through the child tax credit
and new, education-related tax credits, which are phased out at higher
income levels. Thus, at any given level of real taxable income, average
tax rates have been constant or falling since 1993. For a family of four
earning the median income, real income has been rising while the average
tax rate has fallen, even after accounting for payroll taxes.

Thus the strong revenue growth that has helped produce growing budget
surpluses and rising national saving has been associated with very strong
increases in income. Indeed, real after-tax incomes throughout almost all
of the income distribution rose strongly over the 1993-99 period. The
rising tide has lifted all boats, even after inflation and taxes, and
even as government deficits were eliminated. This experience contrasts
with that of the 1980s, when higher after-tax private incomes came at
the expense of public saving, and increases in income were more skewed
toward the top of the income distribution.

The Importance of Maintaining Fiscal Discipline

The improved budget outlook since 1993 reflects real changes in the
economy and in policy and represents the achievement of budget discipline.
The U.S. economy has reaped the benefits of reduction in the public debt
and increased public saving. Nevertheless, the course of the budget and
of the economy in the years ahead remains highly uncertain. This makes it
especially important to maintain fiscal discipline now, when the economy
is strong and the Nation can most afford it--just as a prudent family
saves extra income in good times for a future rainy day.

Economic and Policy Uncertainty

As noted in the discussion of the economic outlook, the economic
assumptions underlying the budget projections reflect a cautious view of
whether recent favorable economic developments will continue. However, a
serious economic downturn or an adverse productivity shock would cut into
the projected surpluses and slow the paydown of the national debt. Also,
the recent very strong growth in revenue relative to GDP is unlikely to
be sustained, because taxable income--in particular, the capital gains
component--cannot continue to grow faster than GDP indefinitely. (The
surplus projections do, in fact, assume a leveling off of individual
income tax collections relative to GDP, and a decline in total taxes
relative to GDP.) Even when uncertainties are acknowledged, however,
it seems most likely that the budget can be kept in surplus if budget
policy remains disciplined.

Maintaining that discipline entails an appropriate recognition of
current policy priorities while preserving significant amounts of the
available surpluses as a margin of safety and to meet future needs.
Budget projections are typically based on current law and practice, but
there are always pressures to change current law. For example, analysts
have pointed to the possibility that discretionary spending might well
rise faster than projected. Also, various tax provisions now scheduled
to expire could be extended, and changes could be made to the alternative
minimum tax, in ways that would reduce revenue. The pressures to deviate
from existing policies do not invalidate the usefulness of projections
based on those policies, but they do remind us that part of the challenge
of maintaining fiscal discipline will involve addressing these issues.

The Demographic Challenge

One force affecting future budget surpluses that is both large and
inevitable is the aging of the population. Projections indicate that
the population aged 65 and over will rise from its current share of about
12H percent of the total population to nearly 21 percent by 2040 (Chart
2-17). As a result, the share of the population that is at or beyond
retirement age relative to that of the working-age population (the
elderly dependency ratio) will rise dramatically.

These demographic changes imply changes in the demands that certain
government programs place on the Nation's resources and in the role these
programs play in the dynamics of the Federal budget. Currently, Federal
outlays for health and retirement programs for the elderly are a large
share of the budget, but payroll contributions tied to Social Security
and Medicare are even larger. Thus the Social Security and Medicare
systems are net contributors to the unified budget surplus today. Fairly
quickly, however, the surpluses in these systems will start to shrink and
eventually turn into deficits if changes are not made. At the same time,
retirement and health programs for the elderly will take up an increasing
share of Federal outlays. The costs per beneficiary of both Social
Security and Medicare are expected to rise in the future, implying an even
more dramatic increase in spending on the elderly than population
projections alone would suggest. The Medicaid program will also be affected
through its coverage of nursing home care: over time, Medicaid is projected
to pay an increasing share of the health care bills of the elderly.

Long-term projections indicate that, under current policies, spending
on Social Security and Medicare will grow dramatically as a share of GDP,
from 6.1 percent in fiscal 2000 to 11.2 percent in 2040 (Chart 2-17) and
12.4 percent by 2075. The Social Security trust fund has been growing
since the 1980s and will continue to grow over the next several years.
But current projections (based on assumptions of the Social Security
trustees) show that Social Security payroll tax revenue will fall short
of outlays starting in 2015 and that the trust fund will be depleted in
2037. At that point current



receipts will cover only about 70 percent of outlays. In addition
to the demographic challenge, Medicare faces pressures associated
with projected increases in health care costs. During this
Administration the strong economy, along with a slowing in
the growth of health costs, have significantly brightened the short-term
outlook for Medicare. However, policy changes still appear necessary to
maintain its financial soundness in the long run. Outlays for the
hospital insurance portion of Medicare are now expected to exceed
corresponding tax receipts starting in 2010, and the hospital insurance
trust fund is expected to run out in 2025. Finally, the long-term
implications of demographic change for national saving are aggravated
by the fact that private saving is also likely to decline as the
population ages, because older people tend to draw down their private
assets during retirement.

The projected erosion of the Social Security surpluses will reduce the
unified budget surplus starting fairly soon. Moreover, the gap between
benefits and receipts continues to widen beyond the 75-year window used
for the long-run projections of the Social Security trustees; hence the
pressure on the budget intensifies over time. Although they have not
eliminated these long-term pressures, developments in the economy that
have produced a long expansion and higher productivity growth have
improved the budget outlook over that 75-year period even more
dramatically (primarily through the power of compounding) than they have
improved the short- term outlook. A projection of the Administration's
economic and policy assumptions based on the June 2000 Mid-Session
Review of the budget suggests that the unified budget could remain in
surplus throughout the next 75 years (Chart 2-18).

Of course, 75-year projections are fraught with uncertainty, because
over this span it is easy for a particular set of economic and policy
assumptions to be proved wrong. For example, starting with the baseline
projection in Chart 2-18, slower-than-expected growth in tax revenue--
or a tax cut--that reduced receipts as a share of GDP to their 1994
level of 18.1 percent would hasten the return of deficits. A similar
outcome would occur if discretionary spending were to rise proportionally
with GDP instead of merely rising with inflation, as the projections
assume. Obviously, various combinations of tax cuts and spending
increases could produce even more adverse changes. Other assumptions
could also prove inaccurate. More rapid productivity growth or a larger-
than-expected increase in immigration would improve the long-term
surplus outlook. Slower productivity growth or continuing rapid growth
in health care costs would significantly worsen it. So, too, could a
lower fertility rate or longer life expectancy than is assumed by the
Social Security trustees.

Addressing the Challenge

Current economic and demographic projections indicate that, with the
benefits and tax rates specified under current law, Social Security and
Medicare will not pay for themselves over the long run. Some combination
of modified benefits, increased payroll taxes, or alternative financing will



be necessary to resolve the imbalance. A growing economy helps with this
resolution, even if needed changes are postponed to the future. But
starting to address the challenge now would reduce uncertainty about
what, if any, adjustments future generations will face and would give
today's workers greater notice so that they can better plan for their
retirement.

A strong economy with adequate saving is critical. The virtuous cycle
of fiscal discipline and changes in the economy that have boosted
productivity and growth has already paid off: with the vastly improved
long-run budget outlook, national saving has increased in a way that
contributes to preserving prosperity over the long run and meeting the
demographic challenge. But even in a New Economy policymakers must
confront scarcity and trade-offs. New tax cuts or spending programs
should be well thought out, target high-priority public needs, and
include an assessment of overall benefits, costs, and risks. The most
effective fiscal strategy to prepare for the future is to pursue policies
that boost the productive capacity of the economy. These include
encouraging productive public investments in infrastructure and human
capital--as well as maintaining fiscal discipline, to encourage public
saving and private investment.

Productive public investment complements private investment in
raising the economy's capacity to produce goods and services. For
example, decades of economic growth have overwhelmed many of the
Nation's sanitation, public transportation, and road systems whose
original designs date back 50 to 100 years. Investments in modernizing
and expanding this infrastructure can improve health outcomes, reduce
pollution, ease congestion, and enhance job prospects. As discussed in
Chapter 5, education is especially important for preparing Americans to
prosper in the New Economy, yet an estimated $127 billion in additional
repairs is needed to rebuild the Nation's schools. Clean, safe schools
are better learning environments that will pay dividends well into the
middle of this century.

To the extent such investments in infrastructure increase the Nation's
capital stock and productive capacity, they contribute to stronger
economic growth and raise real incomes. This in turn increases future
revenue and reduces the payout of government transfers. But such
investment must be undertaken wisely. Poorly thought out investments
could prove counterproductive by crowding out more-productive private
investment.

Investments in human capital provide another means of maintaining
prosperity and preparing for the future. Increased education and
training can enhance workers' productivity in much the same way that
increases in the amount and quality of physical capital do. State and
local governments are mainly responsible for primary and secondary
education, but as described in Chapter 5, the Federal Government's
more limited role can be crucial as well. Federal programs are also
important for postsecondary education and lifetime learning. In recent
years the Federal student loan program has been especially successful
at making college more affordable, helped along by the fiscal discipline
that has allowed an easing of interest rates; at the same time the
Administration's efforts to improve loan repayment have saved taxpayers
more than $14 billion. The Administration's Lifetime Learning tax
credit allows some educational expenses to be deducted from income,
further improving the affordability of college. Although such tax
credits reduce current government revenue, the investment in human
capital that they stimulate adds significantly to future private income
and income tax receipts. In 1998 the mean earnings of high-school
graduates aged 18 or over amounted to $22,895, whereas persons with a
bachelor's degree had mean earnings of $40,478. This difference in
income generated an estimated tax liability for the bachelor's degree
holder that was 2.4 times as large as that of the high-school graduate,
suggesting that funding education can be good for the Nation's fiscal
integrity as well as for personal incomes.

Finally, preserving some share of future budget surpluses will allow
public saving to continue to contribute to national saving, increase the
amount of capital available in the economy, and support continued
economic growth. It will also allow a continued paying down of the
public debt, perpetuating the virtuous cycle that has been so good
for the New Economy. Debt reduction also helps shrink the demands on
the Federal budget as interest payments are reduced and eventually
eliminated. Interest savings alone could pay for a large share of the
added expenses associated with demographic change and provide a margin
of safety against unforeseen adverse economic events.

One way to emphasize the importance of not spending the surplus is
to create a ``lockbox'' for the Social Security and Medicare trust fund
surpluses. Funds placed in a lockbox could not be used to pay for other
programs, but instead would have to be saved. Although the precise
amount that the government should save is not necessarily equal to
that which would accumulate in the lockbox, such a provision might be
an effective way to ensure that significant saving does occur.

Fiscal prudence that preserves the current surpluses, combined with
appropriate public investment, would generate more national saving and
investment than a policy of large tax cuts or spending increases.
Greater saving and investment, in turn, would produce a stronger and
more productive economy in the future. Besides directly improving the
outlook for Social Security and Medicare under their current structure,
such an outcome would provide more resources to deal with any changes
to those programs in the future.

Conclusion

U.S. economic performance in 2000 continued to illustrate the
benefits that have accrued from a combination of sound policies and a
blossoming of technological opportunities. Strong growth, accelerating
productivity, low unemployment, and low inflation continue to
characterize the longest economic expansion on record. The fiscal
stance of the Federal Government has been completely turned around,
from one of spiraling deficits to one in which it is reasonable to
contemplate the elimination of the public debt. The critical task
now is to maintain the fiscal discipline that has been achieved and
to focus on ensuring that adequate resources are available for the
coming demographic challenge.