12. ECONOMIC ASSUMPTIONS
Five years ago, at the beginning of the new millennium,
optimism about the Nation’s economic future
abounded, but that period of optimism was followed
by a succession of shocks whose cumulative severity
was as great as any previous setback in the postwar
period. Now, five years later, the effects of these shocks
have been overcome and faith in the economy and the
future are once again on the rise.
Negative Shocks
Six substantial shocks buffeted the economy starting
in 2000.
The stock market bubble burst in March 2000; by
October 2002, the market had lost half its value. Household
equity wealth fell by $7 trillion, wiping out twothirds
of the equity gain from the last half of the 1990s.
Business investment slowed to a trickle beginning in
mid-2000 as the stock market decline mirrored a dramatic
revision in business expectations, and collapsed
the following year as firms began to work off a huge
overhang of what was now perceived to be excess capital.
The over-investment was due in part to inflated
expectations about the return on new technology and
to a surge in Y2K-related computer hardware and software
investment that ended abruptly in 2000. Not until
2003 did capital spending turn up. This nearly threeyear
slump was one of the longest and deepest in the
postwar period.
The terrorist attacks of September 11th and the possibility
of even more dangerous attacks depressed consumer
and business confidence for a time, while substantially
increasing the resources that governments,
families, and businesses needed to devote to security
measures. The War on Terror, especially as fought
through the campaigns in Afghanistan and Iraq, also
contributed to heightened uncertainties. The increased
uncertainty hampered investment planning and contributed
to the slump in investment spending.
Corporate accounting scandals were uncovered
throughout 2002–2003. Although the scandals had been
long in the making, their sudden revelation came as
a further shock to confidence. The subsequent bankruptcy
of some once-well-regarded corporations further
shook investor confidence, and the revelation of conflicts
of interest at several major accounting firms and Wall
Street brokerage houses cast doubt on the reliability
of the information and advice provided by them, again
making investors leery of putting money at risk in the
market. The scandals and the reaction to them had
the effect of prolonging the slump in business investment.
Recession or slumping growth mired major U.S. trading
partners for most of this period which restrained
U.S. exports, especially of manufactured goods. Output
in Japan and in the European Union grew only 1 percent
per year on average during 2001–2003; outright
declines occurred in several countries during this period.
Oil prices doubled in 2003–2004. The benchmark
price of West Texas intermediate crude oil jumped from
$28 per barrel in May, 2003, to $55 at its peak in
late October, 2004. Prices moved down thereafter, closing
the year at $42. On balance, however, the rise
in oil prices slowed U.S. growth during 2004.
Timely Response
Policymakers responded quickly and appropriately to
this series of adverse shocks. Expansionary policies,
both fiscal and monetary, were adopted in a timely
manner, and when combined with the inherent resilience
of the American economy, succeeded in overcoming
the forces of restraint and minimizing the actual
downturn in 2001. From the peak in the fourth
quarter of 2000 to its low point in the third quarter
of 2001, real Gross Domestic Product (GDP) edged down
a mere 0.2 percent. Partly because of quick policy action,
both consumer spending and housing investment
held up much better during the 2001 slump than in
previous business downturns, which helped limit the
decline in real output. During the subsequent recovery
through mid-2003, however, growth was not as robust
as usual, which is not surprising in light of the shocks
that continued to buffet the economy and the relatively
mild downturn that limited the likely size of the rebound.
Policymakers responded to the disappointing recovery
by providing additional fiscal and monetary stimulus.
This renewed stimulus worked, and as a result, the
economy has achieved robust growth and an improved
labor market since mid-2003 without a significant increase
in inflation or interest rates. As 2005 begins,
the near-term economic outlook is promising. A wide
range of indicators suggests that the economy will continue
to expand at faster than normal rates of growth.
More than 100 thousand new jobs are being created
monthly, adding to the purchasing power of workers;
consumer spending remains strong; businesses’ capital
spending is growing at a rapid rate, and order books
are lengthening; home sales have reached record levels,
boosting home prices and household wealth; and manufacturing
production and exports are again expanding.
The stock market finally bottomed in 2002, and it has
risen sharply since last August, adding to household
wealth and reducing the cost of capital to business.
By early 2005, the major stock market indices had
reached their highest levels since mid-2001.
Looking beyond the next few years, the outlook is
also encouraging. Over the long-run, the growth of out188
ANALYTICAL PERSPECTIVES
put and the standard of living depend critically on productivity
growth, and there is reason to be optimistic
here. Productivity growth accelerated in the second half
of the 1990s, and surprisingly in view of the shocks
of recent years, it stepped up again after 2000 to reach
a pace not seen in over fifty years. A slowdown from
this torrid pace is expected by the Administration and
most other forecasters, but even with a slowdown, productivity
growth is expected to remain strong over the
next decade, and with it the rise in the standard of
living.
The Administration’s near- and medium-term economic
projections assume that the economy will not
face exceptional disturbances in the coming years, unlike
the last five. With that provision, the Administration
anticipates strong, sustained growth, rising employment,
and relatively low inflation and interest
rates. The economic assumptions underlying the budget
are close to those of the consensus of private-sector
forecasts, and for real growth below those of the Congressional
Budget Office. The prospects of a lengthy
sustained expansion, exceptionally high productivity
growth, and the Administration’s policies mean that
actual performance could exceed the official projections.
In the interest of sound, prudent budgeting, however,
the Administration has adopted a cautious economic
forecast.
Policy Actions
Fiscal Policy: The Administration proposed, and
Congress enacted, significant tax relief in each of the
past four years designed to overcome the shocks that
were restraining the economy and restore strong growth
of output, income, and jobs. In addition to providing
much needed near-term stimulus, the 2001 and 2003
Acts also were designed to raise long-term growth by
reducing the disincentives and distortions in the tax
system. These Acts reduced marginal tax rates on income,
dividends, and capital gains. Lower tax rates encourage
individuals and businesses to produce more,
save more, and invest more. More saving and investment
create capital, add to economic growth, and raise
the standard of living. The combined tax relief from
the four Acts totaled $68 billion in fiscal year 2001,
$89 billion in 2002, $159 billion in 2003, and $272
billion in 2004, moderating to $189 billion in 2005.
Economic Growth and Tax Relief and Reconciliation
Act: This act lowered marginal income tax rates; reduced
the marriage tax penalty; and created a new,
lower 10 percent tax bracket, among other changes.
In July 2001, near the low point of the 2001 recession,
taxpayers began receiving rebate checks reflecting their
lower liability with the new 10 percent bracket; lower
withholding schedules also went into effect at that time.
With the benefit of hindsight, the fiscal stimulus from
the tax relief was exceptionally well-timed: economic
growth during the prior half-year had ground to a halt,
yet it had resumed by year-end despite the terrorist
attacks on September 11th.
Job Creation and Worker Assistance Act: In March
2002, the President signed this Act, which was designed
to halt the ongoing slide in business capital spending
and to aid unemployed workers. The Act permitted immediate
depreciation of 30 percent of the value of qualified
new capital assets put in place during the three
years ending in September 11, 2004. Accelerated depreciation
provided an incentive for firms to invest. For
a limited time, more of a qualified investment could
be written-off for tax purposes, thereby lowering the
cost of capital and providing an incentive for firms to
speed up their capital spending. The Act also extended
unemployment insurance benefits to workers who had
exhausted their normal benefits.
Jobs and Growth Tax Relief Reconciliation Act: In
May 2003, the President signed both another extension
of unemployment insurance benefits and the 2003 jobs
and growth tax cut, which was designed to invigorate
the lackluster recovery then underway. The Act lowered
income tax rates, reduced the marriage penalty, raised
the child tax credit, and raised the exemption amount
for the individual Alternative Minimum Tax. Significantly,
the Act reduced income tax rates on dividend
income and capital gains, which reduced distortions in
the tax code from the double taxation of corporate earnings.
To stimulate business capital spending further,
the Act raised the percentage of an asset’s value that
could be expensed immediately from 30 to 50 percent
and lengthened the window of opportunity for businesses
to take advantage of this benefit from September
11, 2004 to the end of the year. The Act also improved
the outlook for small business investment and hiring
by raising the maximum amount that a small business
could expense from $25,000 per year to $100,000.
Working Families Tax Relief Act: In October 2004,
the President signed this Act, which extended parts
of the President’s tax relief plan that were scheduled
to expire at the end of 2004 and reinstated several
expired or expiring business-related tax incentives. In
doing so, the Act protected taxpayers from several
scheduled tax increases. The Act also provided tax relief
to certain military personnel with families, and simplified
the tax code for many families by creating a
uniform definition of a qualifying child for tax purposes.
The short-term benefits of the substantial tax relief
of the past four years are evident in the strong expansion
now underway. The longer-term benefits will be
apparent in a more efficient allocation of the Nation’s
resources in coming years and a sustained increase in
economic activity.
Monetary Policy: During the past four years, monetary
policy has been focused on overcoming negative
shocks and restoring strong, sustained growth. From
the beginning of 2001 through mid-2003, the Federal
Reserve lowered the target Federal funds rate 13 times,
from 61/2 percent to 1 percent. That low rate was maintained
until June 2004 when the Federal Reserve began
to increase the funds rate gradually. Over the course
of 2004, it became increasingly evident that the economy
was once again growing strongly and labor mar189
12. ECONOMIC ASSUMPTIONS
kets were improving, which reduced the need for monetary
stimulus.
By December 2004, the Federal Reserve had raised
the funds rate to 21/4 percent, a level that it believed
was still accommodative. In its statement accompanying
the December increase, the Federal Reserve indicated
that it intended to move at a measured pace to reduce
the accommodative stance of monetary policy further.
As of early January, financial futures markets expected
the funds rate to reach 3 percent by the end of 2005.
As a result of the accommodative monetary policy
along with low expected inflation and sub-par growth,
interest rates fell sharply from mid-2000 to mid-2003.
The 91-day Treasury bill rate tracked the path of the
funds rate, dropping by about 5 percentage points from
its 2000 peak to a plateau of about 1 percent from
mid-2003 to mid-2004, then rising to 2.2 percent by
the end of 2004. As is usually the case, the swings
in the longer-term interest rates were less than those
of short-term rates. The yield on the 10-year Treasury
note, for example, fell three percentage points from
mid-2000 to 3.2 percent by mid-2003. This was its lowest
level since the late 1950s. The yield fluctuated
around a mild upward trend from mid-2003 to the end
of 2004, finishing the year at 4.2 percent, a level that
is still relatively low.
Private-sector financial instruments followed a similar
pattern to U.S. Treasuries. The rate on 30-year
fixed rate mortgages, for example, fell to 5.2 percent
in June 2003, which was its lowest level since the early
1960s. The mortgage rate, like the long-term Treasury
yield, then fluctuated around an upward trend and by
the end of December 2004 had reached a level of 5.7
percent. Even so, the mortgage rate remained below
its level in any month from the mid-1960s to early-
2003.
Low interest rates have spurred interest-sensitive
spending on such items as motor vehicles and housing.
They have enabled homeowners to refinance their mortgages,
saving on mortgage payments and enabling families
to access some of their built-up home equity. Lower
interest rates have enabled consumers, businesses, and
governments to reduce their interest expenses. Finally,
low rates have helped support the stock market.
In late 2002, the stock market responded to the cumulative
effects of fiscal and monetary stimulus and
the prospects of strong, sustained growth. Equity prices
rose rapidly from the end of the third quarter of 2002
through the end of 2003. After remaining about unchanged
during the first eight months of 2004, equity
prices rose strongly once again. All told, from the beginning
of October 2002 to the end of 2004, the S&P 500
and the Dow Jones Industrial Average gained about
45 percent; the hard-hit, technology-laden NASDAQ
soared 85 percent. By the end of 2004, the S&P,
NASDAQ and the Dow were at their highest levels
since June 2001.
Recent Developments
Economic Growth: Beginning in the second quarter
of 2003, the contractionary forces that had held back
growth during the initial phase of the recovery gave
way to stronger forces of expansion. During the year
ending in the first quarter of 2004, inflation-adjusted
Gross Domestic Product (GDP) increased 5.0 percent,
the fastest advance of any four-quarter period in nearly
two decades. Growth moderated to a 3.3 percent pace
in the second quarter, but then picked up in the third
quarter to a substantial 4.0 percent rate. Growth in
the fourth quarter continued at a healthy pace. (Official
estimates of fourth quarter growth were not available
at the time the Budget was printed.) Although still
relatively strong, growth in 2004 was hampered by the
rise in oil prices.
Labor Market: In response to this stronger growth
of output, the labor market also improved markedly.
The Nation’s payrolls began to increase in September
2003; by December 2004, there were 2.5 million more
jobs than at the August low. (Based on preliminary
indications from the Bureau of Labor Statistics, this
figure is likely to be revised up, to at least 2.6 million,
in the benchmark revision that will become available
in early February after the Budget is printed.) The
unemployment rate, which reached a peak of 6.3 percent
in June 2003, fell to 5.4 percent by December
2004. Although still above its long-run sustainable rate,
the level of the unemployment rate at the end of last
year was lower than the average for the decades of
the 1970s, 1980s, and 1990s.
Components of Aggregate Demand: During the six
quarters from the second quarter of 2003 through the
third quarter of 2004 (the latest quarter available when
the Budget went to press), real GDP grew at a robust
4.6 percent annual average rate. That was a significant
improvement from the sub-par 2.1 percent average pace
during the first six quarters of the recovery. Faster
growth of both consumer and business spending were
largely responsible for the shift.
Consumer spending accounts for 70 percent of GDP,
so its faster growth recently played a significant role
in boosting overall growth. Consumer confidence took
an upturn in early 2003, and as labor markets began
to improve a few months later, consumers became increasingly
willing and able to spend. During the six
quarters ending in the third quarter of 2004, real consumer
spending increased at a 3.9 percent annual rate,
up from 3.3 percent during the prior six quarters. The
saving rate, which had already declined to a historically
low 1.0 percent by early 2003, fell even further to a
mere 0.3 percent by November 2004. Underlying the
gains in consumer spending have been increasing
household wealth, led by higher home and stock prices,
and rising after-tax incomes, supported by an improving
labor market and tax relief.
Low mortgage interest rates and growing incomes
also contributed to an exceptionally strong housing
market. During the six quarters ending in the third
190 ANALYTICAL PERSPECTIVES
quarter of 2004, real residential investment rose at a
10.5 percent average annual rate, a considerable step
up from the 5.2 percent pace during the initial six
quarters of the expansion. Housing starts during the
six quarters through the third quarter of last year were
at the highest level in 25 years; home sales were at
the highest level since recordkeeping began in the
1960s. Housing starts, home sales, and real residential
investment eased during the second half of 2004, in
part because of the rise in mortgage rates from their
2003 lows and in part because housing activity had
risen to unsustainable levels. While the level of housing
investment is expected to remain strong, housing is
not projected to lead the expansion in 2005–2010.
The turnaround in business capital spending was
even more dramatic and it contributed significantly to
the step-up in the pace of overall economic activity.
During the latest six quarters of available data, real
business fixed investment grew at an average annual
rate of 11.3 percent. In contrast, investment fell at a
6.2 percent pace during the prior six quarters. Underlying
the recovery of capital spending has been the
acceleration of overall output, more favorable financial
conditions including low interest rates, a rising stock
market, and the temporary provision of accelerated depreciation
that expired at the end of 2004. Business
investment is expected to continue at a rapid rate as
the expansion matures.
The foreign sector was a small drag on overall growth
during the six quarters through the third quarter of
2004, trimming about one-third of a percentage point
from GDP growth. That was an improvement over the
first six quarters of the expansion when net exports
reduced growth by about three-quarters of a percentage
point on average. Throughout the expansion, growth
of U.S. exports was restrained by slow growth overseas.
The exchange value of the dollar peaked in February
2002, declining 12 percent on a trade-weighted basis
against the currencies of our major trading partners
by September 2004. During the last three months of
2004, the dollar declined another six percent, which
should work to reduce the U.S. trade imbalance during
2005. Although this has been a substantial decline, it
has merely retraced an earlier run-up so that by mid-
January 2005 the dollar had returned to its level of
1997.
The government sector grew more slowly during the
latest six quarters. Real Federal purchases continued
to grow strongly, at a 6.1 percent annual rate, led by
spending on the War on Terror, but real State and
local purchases increased at a slow 0.3 percent pace,
down from 2.4 percent during the first six quarters
of the expansion. State and local governments restrained
spending to cope with exceptionally large fiscal
deficits created by the sharp fall-off in revenues from
mid-2001 to early-2002. Although State and local government
revenues are on the rise again, their combined
revenues had only returned to their level in early 2001
by the third quarter of 2004.
Productivity Growth: In contrast to the initial six
quarters of the expansion when output growth was entirely
accounted for by strong productivity growth, during
the subsequent six quarters both increased labor
hours and productivity have contributed to increased
output. Since the official business cycle peak in the
first quarter of 2001, productivity has risen at a remarkable
4.2 percent average annual rate. By way of
contrast, during 1996 through 2000, productivity
growth averaged 2.5 percent per year, and during 1974
through 1995, productivity growth was a mere 1.4 percent
on average. Usually productivity growth surges
temporarily during the initial phase of a recovery and
then slows markedly. In the current expansion, productivity
growth during the six quarters ending in the
third quarter of 2004 was even faster than during the
prior six quarters.
The exceptional productivity performance during the
last four years has helped keep inflation low and thereby
enabled the Federal Reserve to focus monetary policy
on overcoming shocks and restoring sustainable
growth. Because of robust productivity growth, businesses
have not had to rely on labor input to the extent
they otherwise might have, which has hampered employment.
Over the long term, however, the faster the
growth of productivity, the faster will be the growth
of our output and standard of living. In the long run,
faster productivity growth will not permanently restrain
employment growth.
Inflation: The Consumer Price Index (CPI) rose 3.3
percent during 2004, up from 1.9 percent during 2003.
Much of the pick up was due to a surge in energy
prices, which rose at a 17 percent annual rate, compared
with just 7 percent during 2003. Excluding the
volatile food and energy components, the core CPI rose
2.2 percent during 2004, compared with 1.1 percent
during 2003.
Higher energy prices may have indirectly contributed
to higher core inflation as they fed through to the costs
of non-energy goods and services. Businesses also may
have increased their markup of prices over unit labor
costs, which had been subdued by weak demand earlier
in the expansion. Reflecting the decline in crude oil
prices in the closing months of 2004, gasoline prices
moved down in November and December, suggesting
that the energy-related upward push on the CPI was
abating.
Summary: Entering 2005, the economy appears
poised for continued strong expansion. Overall growth,
led by consumer and business spending, is at a pace
that suggests the steady creation of new jobs and a
lower unemployment rate. Core inflation, although
higher than in 2003, is still relatively low. Interest
rates, too, are at historically low levels.
Economic Projections
The Administration’s economic projections, based on
information available as of early December, are summarized
in Table 12–1. These assumptions are close to
those of the Congressional Budget Office and the con191
12. ECONOMIC ASSUMPTIONS
Table 12–1. ECONOMIC ASSUMPTIONS 1
(Calendar years; dollar amounts in billions)
Actual
2003
Projections
2004 2005 2006 2007 2008 2009 2010
Gross Domestic Product (GDP):
Levels, dollar amounts in billions:
Current dollars ................................................................ 11,004 11,731 12,392 13,083 13,797 14,537 15,306 16,112
Real, chained (2000) dollars .......................................... 10,381 10,842 11,233 11,626 12,011 12,395 12,782 13,179
Chained price index (2000=100), annual average ........ 106.0 108.3 110.4 112.6 114.9 117.3 119.8 122.3
Percent change, fourth quarter over fourth quarter:
Current dollars ................................................................ 6.2 6.3 5.5 5.6 5.4 5.4 5.3 5.3
Real, chained (2000) dollars .......................................... 4.4 3.9 3.5 3.4 3.2 3.2 3.1 3.1
Chained price index (2000=100) .................................... 1.7 2.3 1.9 2.0 2.1 2.1 2.1 2.1
Percent change, year over year:
Current dollars ................................................................ 4.9 6.6 5.6 5.6 5.5 5.4 5.3 5.3
Real, chained (2000) dollars .......................................... 3.0 4.4 3.6 3.5 3.3 3.2 3.1 3.1
Chained price index (2000=100) .................................... 1.8 2.1 1.9 2.0 2.1 2.1 2.1 2.1
Incomes, billions of current dollars:
Corporate profits before tax ........................................... 874 998 1,307 1,276 1,265 1,266 1,270 1,292
Wages and salaries ........................................................ 5,104 5,345 5,649 5,988 6,340 6,719 7,104 7,502
Other taxable income 2 ................................................... 2,311 2,451 2,549 2,675 2,798 2,917 3,047 3,181
Consumer Price Index: 3
Level (1982–84=100), annual average .......................... 184.0 188.9 193.4 197.8 202.5 207.4 212.4 217.5
Percent change, fourth quarter over fourth quarter ...... 1.9 3.4 2.0 2.3 2.4 2.4 2.4 2.4
Percent change, year over year .................................... 2.3 2.7 2.4 2.3 2.4 2.4 2.4 2.4
Unemployment rate, civilian, percent:
Fourth quarter level ........................................................ 5.9 5.4 5.3 5.1 5.1 5.1 5.1 5.1
Annual average ............................................................... 6.0 5.5 5.3 5.2 5.1 5.1 5.1 5.1
Federal pay raises, January, percent:
Military 4 ........................................................................... 4.7 4.15 3.5 3.1 NA NA NA NA
Civilian 5 .......................................................................... 4.1 4.1 3.5 2.3 NA NA NA NA
Interest rates, percent:
91-day Treasury bills 6 .................................................... 1.0 1.4 2.7 3.5 3.8 4.0 4.1 4.2
10-year Treasury notes .................................................. 4.0 4.3 4.6 5.2 5.4 5.5 5.6 5.7
NA = Not Available.
1 Based on information available as of December 3, 2004.
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; 2003 and 2004 figures are averages of various rank- and longevity- specific adjustments; percentages to be proposed for
years after 2006 have not yet been determined.
5 Overall average increase, including locality pay adjustments. Percentages to be proposed for years after 2006 have not yet been determined.
6 Average rate, secondary market (bank discount basis).
sensus of private-sector forecasters, as described in
more detail below and shown in Table 12–2. In brief,
the assumptions call for a continuation of the recent
trends of strong, sustained growth, improving labor
markets, low inflation, and, even allowing for a projected
rise in the next few years, relatively low interest
rates.
Real GDP, Potential GDP, and Unemployment Rate:
Real GDP, which is estimated to have increased 4.4
percent in 2004 on a year-over-year basis, is projected
to increase 3.6 percent this year. During the next few
years, growth is likely to continue to exceed the longrun
potential growth rate. As a result, the unemployment
rate, at 5.4 percent in December, is projected
to decline to 5.1 percent at the end of 2006 and then
remain at that level. That rate is the center of the
range that is thought to be consistent with stable inflation.
The main sources of growth in demand in coming
years are likely to be business capital spending, net
exports, and to a lesser extent, consumer spending. The
contributions to overall growth from residential investment
and the government sector are expected to be
small at best.
Potential growth is approximately equal to the sum
of the trend rates of growth of the labor force and
of productivity. Potential GDP growth is projected to
be 3.2 percent through 2008, and then edge down to
3.1 percent during 2009–2010, primarily because of an
assumed slowing in labor force growth. The labor force
is projected to grow about 1.2 percent per year through
2008 on average, slowing to about 0.8 percent yearly
on average during 2009–2010 as increasing numbers
of baby boomers enter retirement.
Trend productivity growth is assumed, conservatively,
to be 2.6 percent per year. That pace is noticeably below
the average since the business cycle peak in the first
quarter of 2001 (4.2 percent per year). It is, however,
close to the pace during 1996–2000 (2.5 percent) and
not far from the average since the official productivity
series began in 1947 (2.3 percent).
192 ANALYTICAL PERSPECTIVES
Inflation: Inflation increased in 2004, in large part
because of the surge in energy prices. With the recent
easing of these prices, inflation is likely to be lower
in 2005. On a year-over-year basis, the CPI is projected
to increase 2.4 percent this year and remain close to
that level in each year through 2010. This inflation
rate is lower than the average during each decade of
the 1970s, 1980s, and 1990s. The GDP chain-weighted
price index is projected to increase around 2.0 percent
in each year through 2010, slightly less than the CPI,
which is the usual pattern.
The forecast of low inflation reflects the current very
low core inflation rate, modest inflationary expectations,
the additional downward pressure on wages and
prices that will persist until excess labor and capital
resources are fully re-employed, and the Federal Reserve’s
focus on removing policy accommodation at a
measured pace so as to avoid an over-heated economy.
Interest Rates: As usually occurs during an expansion,
interest rates are projected to rise. The 3-month Treasury
bill rate, which was 2.2 percent at the end of December,
is expected to increase to 4.2 percent by 2010.
The yield on the 10-year Treasury note, 4.2 percent
at the end of last year, is projected to increase to 5.7
percent by 2010. The larger increase at the shorter
end of the maturity spectrum than at the longer end
is also typical of past cyclical experience.
The forecast rates are historically low: the projected
averages for 3-month and 10-year Treasuries during
2005–2010 are lower than the averages for these instruments
during each decade of the 1970s, 1980s, and
1990s. The relatively low projected yields are due largely
to the relatively low projected inflation rate. Adjusted
for inflation, the projected real interest rates are close
to their historical averages.
Income Shares: The share of labor compensation in
GDP is projected to rise from its low level in 2004
while the share of corporate profits is projected to decline
from the unusually high levels of 2004 and anticipated
for 2005. In recent years, growth of labor compensation
adjusted for inflation has not kept up with
the growth of productivity. During the projection period,
however, labor compensation is expected to catch up,
which would raise the labor share in GDP back to its
historical average.
Among the components of labor compensation, the
wage share in GDP is expected to rise from its recent
low level while the share of supplements to wages and
salaries is expected to remain at around the high level
reached in 2004. The supplement share in GDP has
risen because of rapidly growing health insurance contributions
paid by employers and by sharply higher employer
contributions to defined-benefit pension plans.
Corporate profits before tax as shown in Table 12.1
jumps sharply as a share of GDP in 2005 because of
the end of the accelerated depreciation permitted by
the 2002 and 2003 tax acts. Accelerated depreciation
lowered profits before tax compared with what they
otherwise would have been in 2003 and 2004 by allowing
firms to write off more of their investment sooner.
After 2004, however, corporate profits before tax will
increase both because new investment will not qualify
for the temporary acceleration and because the remaining
depreciation permitted on investment that used this
provision will be less.
Among the other income components, the share of
personal interest income in GDP is projected to decline
reflecting the low nominal interest rates of recent years.
The remaining shares of the tax base (dividends, rental
income, and proprietors’ income) are projected to remain
relatively stable at around their 2004 levels.
Comparison with CBO and Private-Sector
Forecasts
In addition to the Administration, the Congressional
Budget Office (CBO) and many private-sector forecasters
also make economic projections. CBO develops
its projections to aid Congress in formulating budget
policy. In the executive branch, this function is performed
jointly by the Treasury, the Council of Economic
Advisers, and the Office of Management and Budget.
Private-sector forecasts are often used by businesses
for long-term planning. Table 12–2 compares the 2006
Budget assumptions with projections by the CBO and
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 private-sector forecasts are based
on their appraisals of the most likely policy outcomes,
which vary among the forecasters. The Administration
forecast generally assumes that the President’s Budget
proposals will be enacted. The CBO baseline projection
assumes that current law as of the time the estimates
are made remains forever unchanged. Despite their differing
policy assumptions, the three sets of economic
projections, shown in Table 12–2, are very close. The
similarity of the Budget economic projection to both
the CBO baseline projection and the Consensus forecast
underscores the cautious nature of the Administration
forecast.
For real GDP, the Administration, CBO, and the Blue
Chip Consensus anticipate strong growth this year. The
Administration projects 3.6 percent growth on a yearover-
year basis, about the same as the private sector
consensus and slightly below CBO’s forecast. For calendar
year 2006, the Administration, at 3.5 percent,
is mid-way between the consensus (at 3.4 percent), and
CBO’s 3.7 percent. Thereafter, the Administration’s projection
is very close to the consensus growth rate but
generally below CBO’s. Over the six-year span as a
whole, the Administration and the private sector consensus
both project a 3.3 percent average annual
growth rate, CBO 3.5 percent.
All three forecasts anticipate continued low inflation
in the range of 1.5 to 2.1 percent as measured by the
GDP chain-weighted price index, and between 1.9 and
2.5 percent as measured by the CPI, with CBO lower
than the Administration and the private sector consensus,
which are close to each other. The three unem193
12. ECONOMIC ASSUMPTIONS
Table 12–2. COMPARISON OF ECONOMIC ASSUMPTIONS
(Calendar years)
Projections Average,
2005–10 2005 2006 2007 2008 2009 2010
GDP (billions of current dollars):
2006 Budget .............................................................................................. 12,392 13,083 13,797 14,537 15,306 16,112
CBO January ............................................................................................. 12,396 13,059 13,766 14,486 15,210 15,940
Blue Chip Consensus January 2 ............................................................... 12,398 13,066 13,762 14,496 15,265 16,098
Real GDP (chain-weighted): 1
2006 Budget .............................................................................................. 3.6 3.5 3.3 3.2 3.1 3.1 3.3
CBO January ............................................................................................. 3.8 3.7 3.7 3.4 3.1 2.9 3.5
Blue Chip Consensus January 2 ............................................................... 3.6 3.4 3.2 3.2 3.1 3.3 3.3
Chain-weighted GDP Price Index: 1
2006 Budget .............................................................................................. 1.9 2.0 2.1 2.1 2.1 2.1 2.0
CBO January ............................................................................................. 1.8 1.5 1.7 1.8 1.8 1.8 1.7
Blue Chip Consensus January 2 ............................................................... 2.0 2.0 2.1 2.1 2.1 2.1 2.1
Consumer Price Index (all-urban): 1
2006 Budget .............................................................................................. 2.4 2.3 2.4 2.4 2.4 2.4 2.4
CBO January ............................................................................................. 2.4 1.9 2.1 2.2 2.2 2.2 2.2
Blue Chip Consensus January 2 ............................................................... 2.5 2.3 2.4 2.4 2.4 2.4 2.4
Unemployment rate: 3
2006 Budget .............................................................................................. 5.3 5.2 5.1 5.1 5.1 5.1 5.2
CBO January ............................................................................................. 5.2 5.2 5.2 5.2 5.2 5.2 5.2
Blue Chip Consensus January 2 ............................................................... 5.2 5.2 5.1 5.1 5.1 5.1 5.1
Interest rates: 3
91-day Treasury bills:
2006 Budget .......................................................................................... 2.7 3.5 3.8 4.0 4.1 4.2 3.7
CBO January ........................................................................................ 2.8 4.0 4.6 4.6 4.6 4.6 4.2
Blue Chip Consensus January 2 .......................................................... 3.0 3.8 4.1 4.3 4.2 4.2 3.9
10-year Treasury notes:
2006 Budget .......................................................................................... 4.6 5.2 5.4 5.5 5.6 5.6 5.3
CBO January ........................................................................................ 4.8 5.4 5.5 5.5 5.5 5.5 5.4
Blue Chip Consensus January 2 .......................................................... 4.7 5.3 5.6 5.6 5.6 5.6 5.4
Sources: Congressional Budget Office; Blue Chip Economic Indicators, Aspen Publishers, Inc.
1 Year-over-year percent change.
2 January 2005 Blue Chip Consensus forecast for 2005 and 2006; Blue Chip October 2004 long-run extension for 2007 - 2010.
3 Annual averages, percent.
ployment rate projections are also similar with a projected
rate just above 5 percent in the later years of
the forecast. All three project slightly rising interest
rates during the next few years, with CBO’s increase
slightly larger than those of the Administration and
the private sector projection.
Changes in Economic Assumptions
The economic assumptions underlying this Budget
are similar to those of the 2005 Budget, as shown in
Table 12–3.
As in last year’s Budget, real GDP growth is expected
to be 3.6 percent in 2005 on a year-over-year basis
and moderate gradually to 3.1 percent in the outyears.
Consequently, the levels of real GDP projected this year
are little changed from those of the 2005 Budget when
allowance is made for the Commerce Department’s historical
revisions to the National Income and Product
Accounts released in July 2004. The level of nominal
GDP is now projected to be higher than in the 2005
Budget because of a faster-than-expected rise in the
GDP price index last year and higher projected GDP
inflation in the coming years.
The unemployment rate projection is virtually identical
to last year’s. As in the 2005 Budget, the rate
is expected to decline to 5.1 percent by 2007 and remain
at that relatively low level. Interest rates are expected
to trend upward, as before. However, by 2009 the 3-
month Treasury bill rate is projected to be 0.3 percentage
point lower than in the 2005 Budget, and the yield
on the 10-year Treasury note is expected to be 0.2 percentage
point lower.
Structural and Cyclical Balances
When the economy is operating below potential, as
is projected to be the case for the next few years, the
unemployment rate exceeds the long-run sustainable
average consistent with price stability. As a result, receipts
are lower than they would be if resources were
more fully employed, and outlays for unemploymentsensitive
programs (such as unemployment compensation
and food stamps) are higher; the deficit is larger
(or the surplus is smaller) than would be the case if
the unemployment rate were at its sustainable longrun
average. The portion of the deficit (or surplus) that
can be traced to this factor can be called the cyclical
component. The portion that would remain if the unem194
ANALYTICAL PERSPECTIVES
Table 12–3. COMPARISON OF ECONOMIC ASSUMPTIONS IN THE 2005 AND 2006 BUDGETS
(Calendar years; dollar amounts in billions)
2004 2005 2006 2007 2008 2009 2010
Nominal GDP:
2005 Budget assumptions 1 .............................................................................................................................. 11,622 12,197 12,807 13,460 14,163 14,902 15,671
2006 Budget assumptions ............................................................................................................................... 11,731 12,392 13,083 13,797 14,537 15,306 16,112
Real GDP (2000 dollars):
2005 Budget assumptions 1 .............................................................................................................................. 10,837 11,226 11,608 11,994 12,377 12,763 13,159
2006 Budget assumptions ............................................................................................................................... 10,842 11,233 11,626 12,011 12,395 12,782 13,179
Real GDP (percent change): 2
2005 Budget assumptions ............................................................................................................................... 4.4 3.6 3.4 3.3 3.2 3.1 3.1
2006 Budget assumptions ............................................................................................................................... 4.4 3.6 3.5 3.3 3.2 3.1 3.1
GDP price index (percent change): 2
2005 Budget assumptions ............................................................................................................................... 1.2 1.3 1.5 1.7 2.0 2.0 2.0
2006 Budget assumptions ............................................................................................................................... 2.1 1.9 2.0 2.1 2.1 2.1 2.1
Consumer Price Index (percent change): 2
2005 Budget assumptions ............................................................................................................................... 1.4 1.5 1.8 2.1 2.4 2.5 2.5
2006 Budget assumptions ............................................................................................................................... 2.7 2.4 2.3 2.4 2.4 2.4 2.4
Civilian unemployment rate (percent): 3
2005 Budget assumptions ............................................................................................................................... 5.6 5.4 5.2 5.1 5.1 5.1 5.1
2006 Budget assumptions ............................................................................................................................... 5.5 5.3 5.2 5.1 5.1 5.1 5.1
91-day Treasury bill rate (percent): 3
2005 Budget assumptions ............................................................................................................................... 1.3 2.4 3.3 4.0 4.3 4.4 4.4
2006 Budget assumptions ............................................................................................................................... 1.4 2.7 3.5 3.8 4.0 4.1 4.2
10-year Treasury note rate (percent): 3
2005 Budget assumptions ............................................................................................................................... 4.6 5.0 5.4 5.6 5.8 5.8 5.8
2006 Budget assumptions ............................................................................................................................... 4.3 4.6 5.2 5.4 5.5 5.6 5.7
1 Adjusted for July 2004 NIPA revisions.
2 Year-over-year.
3 Calendar year average.
Table 12–4. ADJUSTED STRUCTURAL BALANCE
(In billions of dollars)
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Unadjusted surplus or deficit (–) ...................................... 125.5 236.2 128.2 –157.8 –377.6 –412.1 –426.6 –390.1 –312.1 –250.8 –232.9 –207.3
Cyclical component ....................................................... 86.3 127.3 66.0 –62.8 –102.0 –60.2 –30.0 –13.4 –0.7 –0.2 ............ ............
Structural surplus or deficit (–) ......................................... 39.2 108.8 62.1 –95.0 –275.6 –351.9 –396.6 –376.6 –311.4 –250.6 –232.9 –207.3
Deposit insurance outlays ............................................ 5.3 3.1 1.6 1.0 1.4 2.0 0.3 1.0 2.3 2.3 2.2 1.8
Adjusted structural surplus or deficit (–) .......................... 44.5 111.9 63.7 –94.0 –274.1 –350.0 –396.3 –375.7 –309.1 –248.3 –230.7 –205.5
NOTE: The NAIRU is assumed to be 5.2% through calendar year 1998 and 5.1% thereafter.
ployment rate was at its long-run value is then called
the structural deficit (or structural surplus).
Historically, the structural balance has often provided
a clearer understanding of the stance of fiscal policy
than has the unadjusted budget balance which includes
a cyclical component. In the typical post-World War
II business cycle, the structural balance has provided
a clearer gauge of the surplus or deficit that would
persist in the long run with the economy operating
at the sustainable level of unemployment.
Conventional estimates of the structural balance are
based on the historical relationship between changes
in the unemployment rate and real GDP growth on
the one hand, and receipts and outlays on the other.
For various reasons, these estimated relationships do
not take into account all of the cyclical changes in the
economy. One example of a cyclical phenomenon not
captured in these estimates was the sharply rising
stock market during the second half of the 1990s. It
boosted capital gains-related receipts and pulled down
the deficit. The subsequent fall in the stock market
reduced receipts and added to the deficit. Some of this
rise and fall was cyclical in nature. Receipts would
probably be higher today, if the cyclical component were
removed from the stock market, although recently the
stock market has recovered some of its earlier losses
with a positive effect on receipts. It is not possible,
however, to estimate the cyclical component of the stock
market accurately, and for that reason, all of the stock
market’s contribution to receipts is counted in the structural
balance.
Other factors unique to the current economic cycle
provide other examples of less than complete cyclical
adjustment. The extraordinary fall-off in labor force
participation, from 67.1 percent of the U.S. population
in 1997–2000, to 66.0 percent in 2004 appears to be
195 12. ECONOMIC ASSUMPTIONS
at least partly cyclical in nature, and most forecasters
are assuming some rebound in labor force participation
as the expansion continues. 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 underutilized
in the current expansion to date because of
the decline in labor force participation.
A third example is the fall-off in the wage and salary
share of GDP, from 49.2 percent in 2000 to 45.5 percent
in the third quarter of 2004. Again this change is widely
suspected to be at least partly cyclical. Since Federal
taxes depend heavily on wage and salary income, the
larger-than-predicted decline in the wage share of GDP
suggests that the true cyclical component of the deficit
is understated for this reason as well.
There are also lags in the collection of tax revenue
that can delay the impact of cyclical effects beyond
the year in which they occur. The result is that even
after the unemployment rate has fallen, receipts may
remain cyclically depressed for some time until these
lagged effects have dissipated.
For all these reasons, the current estimates of the
cyclical deficit are probably understated and perhaps
by a large margin. The current unemployment gap is
only 0.3 percentage points, and the Administration forecasts
that the gap will be closed within two years,
but in the broader sense discussed above, the cyclical
gap in receipts is likely to be much larger than this
and will not close as quickly.
From 1999 to 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 those years
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.
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 moderate
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 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 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 12–6.
For real growth and employment:
• As shown in the first block, if in 2005 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 2005
deficit is estimated to increase by $13.0 billion;
receipts in 2005 would be lower by $10.2 billion,
and outlays would be higher by $2.8 billion, primarily
for unemployment-sensitive programs. In
fiscal year 2006, the estimated receipts shortfall
would grow further to $21.8 billion, and outlays
would increase by $8.1 billion relative to the base,
even though the growth rate in calendar year 2006
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 2005–2010, the
cumulative increase in the budget deficit is estimated
to be $195 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
2005–2010, the cumulative increase in the budget
deficit is estimated to be $529 billion.
• The third block shows the effect of a one percentage
point higher rate of inflation and one percentage
point higher interest rates during calendar
year 2005 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 2005 and 2006, outlays would
be above the base by $11.0 billion and $19.1 billion,
respectively, due in part to lagged cost-ofliving
adjustments. Receipts would fall by $10.0
billion in 2005, due to the temporary effect of
higher interest rates on finanical corporations’
profits and taxes, but then would rise by $28.4
billion above the base in 2006 due to the sustained
196 ANALYTICAL PERSPECTIVES
effects of inflation on the tax base, resulting in
a $9.3 billion improvement in the 2006 budget
balance. In subsequent years, the amounts added
to receipts would continue to be larger than the
additions to outlays. During 2005–2010, cumulative
budget deficits would be $38 billion smaller
than in the base case.
• In the fourth block example, 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 $388 billion
to outlays over 2005–2010 and $492 billion to receipts,
for a net decrease in the 2005–2010 deficits
of $104 billion.
The table also shows the interest rate and the inflation
effects separately. These separate effects for interest
rates and inflation rates do not sum to the effects
for simultaneous changes in both. 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 outlay effects of a one percentage point increase
in interest rates alone are shown in the
fifth block. The receipts portion of this rule-ofthumb
is due to the Federal Reserve’s deposit of
earnings on its securities portfolio and the shortterm
effect of interest rate changes on financial
corporations’ profits (and taxes).
• The sixth block shows that a sustained one percentage
point increase in the GDP chain-weighted
price index and in CPI inflation decrease cumulative
deficits by a substantial $257 billion during
2005–2010. This large effect is because the receipts
from a higher tax base exceeds the combination
of higher outlays from mandatory cost-of-living
adjustments and lower receipts from CPI indexation
of tax brackets.
The last entry in the table shows rules of thumb
for the added interest cost associated with changes in
the budget deficit.
The effects of changes in economic assumptions in
the opposite direction are approximately symmetric to
those shown in the table. The impact of a one percentage
point lower rate of inflation or higher real growth
would have about the same magnitude as the effects
shown in the table, but with the opposite sign.
197 12. ECONOMIC ASSUMPTIONS
Table 12–5. SENSITIVITY OF THE BUDGET TO ECONOMIC ASSUMPTIONS
(In billions of dollars)
Budget effect 2005 2006 2007 2008 2009 2010
Total of
Effects,
2005-2010
Real Growth and Employment
Budgetary effects of 1 percent lower real GDP growth:
(1) For calendar year 2005 only: 1
Receipts ............................................................................................................... –10.2 –21.8 –24.3 –25.6 –27.0 –28.4 –137.2
Outlays ................................................................................................................ 2.8 8.1 8.8 10.6 12.5 14.7 57.4
Increase in deficit (–) ..................................................................................... –13.0 –29.8 –33.0 –36.2 –39.5 –43.1 –194.6
(2) Sustained during 2005–2010, with no change in unemployment:
Receipts ............................................................................................................... –10.4 –34.0 –62.9 –94.5 –129.0 –166.3 –497.1
Outlays ................................................................................................................ * 0.5 2.1 5.0 9.3 15.3 32.2
Increase in deficit (–) ..................................................................................... –10.4 –34.5 –65.0 –99.5 –138.4 –181.6 –529.3
Inflation and Interest Rates
Budgetary effects of 1 percentage point higher rate of:
(3) Inflation and interest rates during calendar year 2005 only:
Receipts ............................................................................................................... –10.0 28.4 37.1 24.7 26.0 27.4 133.6
Outlays ................................................................................................................ 11.0 19.1 17.5 16.3 15.7 15.5 95.2
Decrease in deficit (+) .................................................................................... –21.0 9.3 19.6 8.3 10.3 11.9 38.4
(4) Inflation and interest rates, sustained during 2005–2010:
Receipts ............................................................................................................... –10.0 22.7 67.2 100.7 136.0 175.1 491.7
Outlays ................................................................................................................ 11.4 34.5 56.9 76.8 95.0 113.3 387.8
Decrease in deficit (+) .................................................................................... –21.4 –11.8 10.4 24.0 41.0 61.8 103.9
(5) Interest rates only, sustained during 2005–2010:
Receipts ............................................................................................................... –20.5 –11.4 6.3 11.8 16.0 20.9 23.1
Outlays ................................................................................................................ 8.8 24.3 37.0 46.0 53.3 60.1 229.5
Increase in deficit (–) ..................................................................................... –29.3 –35.7 –30.7 –34.1 –37.3 –39.2 –206.4
(6) Inflation only, sustained during 2005–2010:
Receipts ............................................................................................................... 10.5 34.0 60.8 88.6 119.7 153.8 467.4
Outlays ................................................................................................................ 2.7 10.5 20.5 32.0 43.7 56.2 165.5
Decrease in deficit (+) .................................................................................... 7.8 23.6 40.3 56.6 76.0 97.6 301.9
Interest Cost of Higher Federal Borrowing
(7) Outlay effect of $100 billion increase in borrowing in 2005 ............................ 1.3 3.5 4.2 4.7 5.0 5.4 24.2
* $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.
