ECONOMIC ASSUMPTIONS

Introduction

    The U.S. economy has expanded since the end of 2001, albeit at a slower pace than in a typical recovery. However, the economy now appears poised for an extended period of strong growth accompanied by falling unemployment, rising living standards, low inflation, and moderate interest rates. Signals coming from a growing number of forward-looking indicators are reinforcing this view, which is shared by the Blue Chip consensus of private sector forecasters.

    Forecasters are recognizing and markets are responding to recent fiscal and monetary stimulus, the favorable underlying fundamentals of low inflation and strong productivity growth, and the waning of negative influences on the economy. The quick and successful conclusion to the war in Iraq has lifted the pall of uncertainties that weighed on consumer and business long-term decision making. Consumer and investor confidence, badly shaken as geopolitical tensions mounted earlier in the year, have recovered. The stock market, which has been on an upward trend since March, is once again adding to, rather than reducing, household wealth.

    Fiscal and monetary policies are focused on quickly returning the economy to sustainable, healthy growth. The recently enacted fiscal relief package will boost consumer and business spending and will augment the nation's long-term growth potential. Expansionary monetary policy will stimulate growth and provide insurance against the possibility of deflation. In June, the Federal Reserve reduced its target federal funds rate by 25 basis points to one percent, the lowest level since 1958.

    The Administration's economic projections for the Mid-Session Review show growth accelerating sharply beginning this summer, leading to more jobs and rising incomes. This projection assumes the economy will be free of significant, new negative economic shocks.

    A stronger economy seems likely given the powerful, positive forces at work and the fading of the negative factors that have held the economy back recently. However, predicting the exact timing of the shift from moderate to stronger growth is always problematic and the shift might come later than forecast. The Administration's economic projection balances the upside possibilities and downside risks and thus provides a prudent basis for forecasting the budget outlook.

Policy Actions

    Fiscal Policy: In response to the subpar expansion experienced to that point, in January the President proposed substantial tax relief for the American people. On May 28th, the President signed the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) which included all the key features of the President's proposal. The Act accelerated many of the tax reductions passed in the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) that were scheduled to take effect several years from now. The 2003 jobs and growth tax cut also reduced the tax rate on dividends and capital gains; and on the business side, it temporarily increased incentives designed to speed up investment.

    The key provisions of the 2003 Act that will help propel the economy in the near-term and boost long-term growth include:

• Lower marginal income tax rates retroactive to January 2003, as shown in Table 3. Under the 2001 tax cut, these rates were scheduled to take effect in 2004 and 2006. The lower tax rates were incorporated in new lower payroll withholding schedules that employers introduced beginning on July 1. Because the new tax rates cover all 2003 income but withholding schedules during the first half of the year were based on the higher rates passed in 2001, many taxpayers will overwithhold in 2003. These taxpayers will receive larger tax refunds, or pay less in remaining taxes, when they file their 2003 returns next spring.

• A reduction in the maximum tax rate on dividends, applying to dividends received in taxable years beginning on or after January 1, 2003 and before 2009, to 15 percent for taxpayers above the 15 percent marginal income tax bracket. Prior to the 2003 jobs and growth tax cut, dividend income was taxed at the rates applicable to other ordinary income, which could be as high as 38.6 percent. For those tax filers in the 10 or 15 percent tax brackets, the dividend tax rate was reduced to only five percent through 2007 and zero in 2008.

• A reduction in the maximum tax rate on net capital gains (the excess of net long-term gains over net short-term losses), applying to transactions occurring after May 5, 2003 and before January 1, 2009, from 20 percent to 15 percent for taxpayers above the 15 percent marginal tax bracket, and from 10 percent to five percent (and zero for 2008) for lower income taxpayers.

    On the business side, the 2003 jobs and growth tax cut:

• Increased the bonus depreciation on qualified new investment to 50 percent from the 30 percent allowed under the March 2002 Job Creation and Worker Assistance Act. The remaining 50 percent is depreciated according to the general schedules. This provision applies to new capital put in place before January 1, 2005.

• Raised to $100,000 from $25,000 the maximum amount of new investment that can be expensed by small businesses. This provision applies to new capital put in place by the end of 2005.

    Temporary expensing lowers the after-tax cost of acquiring new capital and thereby provides a stimulus to new investment when it is most needed to help achieve a self-sustaining expansion. All told, the business tax relief is estimated to be $13 billion during the second half of this calendar year, of which $10 billion will flow through corporations and $3 billion will go to individuals who own non-corporate businesses. In calendar year 2004, business tax relief will total about $49 billion, of which about $37 billion will flow through corporations and $12 billion will go to individuals.

    These tax reductions enacted in the 2003 jobs and growth tax act will ease tax restraints on economic activity, thereby accelerating economic growth in the near-term and raising the long-term level of economic activity.

• Reductions in marginal tax rates will reduce the disincentives facing individuals to work more, to earn more, to save more, and to invest more. Non-corporate businesses such as sole proprietorships and partnerships will also benefit from these rate reductions. When small businesses face lower tax rates they have more ability and greater incentive to invest in new equipment and hire additional workers.

• Lower tax rates on dividends and capital gains will lower the after-tax cost of new investment and thereby lead to a higher rate of investment.

• Lower tax rates on dividends and capital gains will also reduce the distortions in the pattern of investment across economic sectors generated by the tax system so that the composition of this investment will be more appropriate, and therefore more productive.

• The reduction in the capital gains tax will encourage the relatively high risk, forward-looking investments that help sustain a vibrant economy.

• The tax rate reductions on capital income generally, and especially on dividends and capital gains, will also combine to raise asset values across the economy. The existence but not the extent of this effect is certain. Whatever the magnitude, the effect on the economy is to provide an additional source of stimulus. For both individuals and businesses, rising asset values will improve balance sheets. For individuals this can mean increased consumption levels; for businesses a stronger balance sheet may mean lower borrowing costs or greater flexibility to take advantage of new business opportunities.

    In addition to those provisions already described, other provisions of the 2003 jobs and growth tax act will also contribute to aggregate demand by raising household after-tax incomes, further strengthening the economy:

• An increase in the child tax credit to $1,000 for 2003 and 2004: On three successive Fridays beginning July 25th, the Treasury will issue up to $400 per child rebate checks to about 25 million families with children for a total of about $12 billion in tax relief. Including households that will receive the benefit next spring when they file their 2003 tax returns, the increased child credit will provide tax relief totaling $16 billion. Under the 2001 tax cut, the child credit was scheduled to be $600 for calendar years 2003 and 2004, rising to $700 for 2005 through 2008, to $800 in 2009, and to $1,000 in 2010.

    Moreover, the President has called on Congress to expand the benefits of the higher child tax credit to low-income tax filers beginning this year. Some low income families receive all or part of the benefit of a higher child tax credit in the form of a refund because they pay little or no income taxes. The 2001 tax cut increased the refundable portion of the credit, but not until 2005.

• A reduction in the marriage penalty: For 2003 and 2004, the standard deduction amount for married couples filing a joint return will be twice the standard deduction amount for single filers, an acceleration of provisions in the 2001 tax cut. Prior to the 2003 jobs and growth tax cut, the standard deduction for couples was 167 percent of that for single filers. The width of the 15-percent tax bracket for married couples is also increased to twice the width for single taxpayers in 2003 and 2004. Prior to the 2003 jobs and growth tax cut, the maximum taxable income in the 15-percent bracket for joint filers was 167 percent of the corresponding amount for single filers. Under the 2001 tax cut, the marriage penalty provisions were scheduled to phase-in over the period between 2005 and 2009.

• An increase in the Alternative Minimum Tax (AMT) exemption amount: In 2003 and 2004 the AMT exemption will increase by $4,500 for single filers and $9,000 for married taxpayers to ensure that the income tax relief is not reduced by the AMT. (The AMT is a parallel tax system using a broader tax base and generally lower tax rates than the regular income tax. Taxpayers pay the higher of their tax liabilities as determined by the regular income tax and AMT calculations.)

    The tax relief in the 2003 jobs and growth tax cut was front-loaded to provide the maximum boost to the economy when it is needed the most. During the second half of calendar year 2003, individual and corporate net tax payments combined are estimated to be nearly $50 billion lower, and during calendar year 2004 about $146 billion lower. Tax relief, including the refundable portion of the child tax credit, is estimated to total $258 billion during 2003 through 2008 and $268 billion during 2003 through 2013. In addition, the 2003 jobs and growth tax cut provides $20 billion in grants to states during FY 2003 and 2004.

    The boost to household after-tax income from the 2003 jobs and growth tax cut will be substantial during the second half of 2003, providing about $40 billion in tax relief. That, in turn, will boost consumer spending and saving. The increased consumer spending will help the economy maintain its momentum as businesses ramp up their investments in new plant and equipment. The additional saving will improve household balance sheets and enable families to increase future spending.

    Even the most effective tax policies take time before they affect spending and then business hiring. The President recognized that many workers would exhaust their unemployment benefits in the interim. In response, on May 28th the President signed into law an extension through December 31, 2003 of the Temporary Extended Unemployment Compensation Act. This program assists unemployed workers who exhaust their regular benefits by providing up to 13 weeks of extended unemployment benefits. Those workers in states with high and rising unemployment are eligible for an additional 13 weeks of extended benefits after they exhaust their initial 13 week extension. The estimated budget costs of the unemployment extension are $2.3 billion in FY 2003 and $3.6 billion in 2004.

    Monetary Policy: Very low inflation has enabled the Federal Reserve to pursue a monetary policy that provides the economy with additional stimulus. In November, the Federal Open Market Committee (FOMC) lowered its target Federal funds rate from 1 3/4 percent to 1 1/4 percent. At its May meeting, the Committee signaled its willingness to make further cuts in the future to this already-low rate. In response, interest rates, especially at the long end of the maturity spectrum, fell sharply. At its meeting in June, the Committee reduced the funds rate to one percent. This was the thirteenth cut since the start of 2001 when the rate stood at 6.5 percent.

    Interest rates fell during the first half of this year in response to the weaker-than-expected economy and indications from the FOMC that monetary policy was focused on stimulating activity and avoiding deflation. The three-month Treasury bill rate dropped from 1.2 percent in December to 0.9 percent in late June. Rates declined even more at the longer end of the maturity spectrum. The yield on the 10-year Treasury note fell from 4.0 percent in December to 3.5 percent by the end of June. The last time long-term Treasury rates were this low was in the late 1950s. Long-term corporate bond yields also declined this year, reaching their lowest levels since the mid-1960s; mortgage rates fell to the lowest levels since the late 1950s. Partly in response to the FOMC's actions, the money supply (M2) grew at an 9.0 percent annual rate during the first six months of 2003, up from 7.4 percent during the prior half year.

Recent Developments

    Real Gross Domestic Product (GDP) grew at a 1.4 percent annual rate in the fourth quarter of 2002 and again in the first quarter of 2003. Although the first official estimate of GDP growth for the second quarter will not be announced until the end of July, it appears likely the economy continued to expand at about this same pace. Growth in this neighborhood is well below the rate needed to stimulate robust business investment in new plant and equipment and to create sufficient new job opportunities for unemployed workers and entrants into the labor force.

    There are gathering signs, however, that faster growth is in the offing. The Index of Leading Indicators rose a substantial 1.0 percent in May, a significant break from the flat trend since early 2002. Eight of the ten components of the Index contributed to the May gain. Among the components, the strongest signals have come from the major stock market indexes, which by early July had risen 25 to 35 percent above their low points in March, and from a survey reading of consumers' confidence in the future, which rose 24 percent from March to June.

    Elsewhere, there are further indications of an improving economy. The hard-pressed manufacturing sector increased production slightly in May after reducing it during the prior three months. Surveys of purchasing managers suggest order books are firming, although other readings on new orders are not quite as encouraging. A rise in shipments of capital goods suggests that business investment in equipment and software in the second quarter likely rose again after declining in the first quarter. Business inventories are relatively low compared with sales, suggesting that a pickup in overall final demand would be augmented by a rebuilding of inventories.

    In the labor market, private sector employment continued to contract through June as rapid productivity growth allowed moderate output growth to be achieved with a smaller workforce. Since the cyclical peak in the first quarter of 2001, productivity growth in the nonfarm business sector has averaged a robust 3.4 percent per year despite the recession and subsequent subpar recovery. That pace even exceeds the 2.2 percent average during the prior five years of expansion. Strong productivity growth is a very healthy development for the economy because it eventually leads to higher standards of living. In the short-run, however, when aggregate demand growth is below that of productivity growth unemployment rises.

    The unemployment rate was 6.4 percent in June compared with an average of 5.9 percent in the fourth quarter of 2002 and 4.2 percent at the cyclical peak. The rise in unemployment underscores both the difficulties in predicting when an economic acceleration will take hold and the need for the recent fiscal and monetary policy actions designed to hasten that acceleration to return the economy to full employment.

    Consumer spending, which accounts for 70 percent of GDP, continues to underpin overall activity. Real consumer expenditures rose at a 2.0 percent annual rate in the first quarter and appear to have maintained at least that pace in the second quarter. Consumers continue to be willing to make big-ticket purchases, such as motor vehicles, boosted by widespread discounts and financing incentives.

    Home sales remain at record levels, and these in turn have boosted consumer spending on furniture and appliances. In May, combined new and existing home sales reached the second highest level on record, exceeded only by sales in January 2003. Extraordinarily low mortgage rates have helped make homebuying more affordable to the average family than at any time in the past three decades. The low rates have also enabled homeowners to refinance their higher-rate, older mortgages, thereby improving household balance sheets and providing additional liquidity to spur future consumption.

    Government spending on consumption and investment has been mixed. At the federal level, national defense spending increased significantly in the second quarter because of the war with Iraq. At the state and local level, spending edged down slightly in the first quarter and probably was weak in the second quarter as governments continued to cope with unexpected shortfalls of receipts and widening budget deficits.

    Declining net exports have restrained overall growth for some time. Although the dollar has declined for the past year and a half, the positive effects of this on U.S. exports have been more than offset by much faster growth in the United States than in our trading partners. Consequently, our imports adjusted for inflation have grown more rapidly than our exports. The deterioration in net exports was temporarily halted in the first quarter, but that was probably reversed in the second quarter as the foreign sector likely again subtracted substantially from real GDP growth. The dollar declined seven percent against our major trading partners during 2002 and fell another 10 percent during the first half of 2003. At some point, the dollar's depreciation will help make U.S. producers more competitive at home and abroad.

    Inflation drifted lower during the first half of 2003 despite a short-lived surge in energy prices that occurred in the months leading up to the Iraq war. During the first five months of 2003, the overall Consumer Price Index (CPI) rose at a 2.3 percent annual rate, down from 2.4 percent during 2002. Energy prices rose at a 16.5 percent pace during the first five months; excluding the volatile food and energy components, the "core CPI" rose at only a 1.1 percent rate, down from 1.9 percent last year. All of the rise in the CPI during 2003 was accounted for by rising service sector prices. Prices of goods in the CPI hardly changed, on balance, from December to May. While low inflation is desirable, too low inflation or outright deflation may be harmful. The pickup in economic activity expected in the coming months will help minimize the risks of deflation in the United States.

Revised Economic Assumptions

    The economic assumptions for the Mid-Session Review, summarized in Table 4, differ from those used in the Administration's 2004 Budget in that they incorporate the fiscal, monetary, and economic developments discussed above.

    During the second half of this year and into 2004 and 2005 growth is now projected to be somewhat stronger than anticipated in the February Budget, while inflation and interest rates are now projected to be lower. The unemployment rate is slightly higher in the near term, reflecting the higher current level.

    During the outyears, the Mid-Session Review and budget forecasts of the key economic variables are quite close. The revised assumptions, both in the near-term and outyears, are very similar to those of the Blue Chip consensus of private sector forecasts.

    Real GDP, Potential GDP, and Unemployment: Real GDP during the four quarters of this year is expected to rise 2.8 percent compared with 3.4 percent in the budget. All of the downward revision reflects the weaker-than-expected growth during the first half of this year; during the second half of 2003, projected growth in the Mid-Session Review is stronger than in the budget. During 2004 and 2005, growth is now projected to be slightly higher than in the budget, reflecting the favorable effects from the 2003 jobs and growth tax cut and the lower interest rates. In the outyears, growth is expected to be 3.1 percent per year, the same as in the budget and equal to the Administration's estimate of the nation's potential growth rate.

    The unemployment rate is expected to decline to 5.1 percent by 2007 and remain at that level. The Administration estimates this level of the unemployment rate to be consistent with stable inflation. It is also the same as the Blue Chip private-sector consensus long-run, sustainable unemployment rate.

    Inflation: As measured by the CPI, inflation during the four quarters of 2003 is projected to be 1.9 percent, about the same as in the budget. Inflation during the first quarter was higher than expected, largely due to the surge in energy prices, but for the year this is about offset by the subsequent decline in oil prices and consequent lower inflation. For the next few years, inflation is projected to be slightly below that anticipated in the budget because of the current very low inflation rate. Even as the expansion gathers momentum, the excess slack in labor and capital markets is likely to keep inflation under control. In the outyears, the CPI is projected to rise 2.3 percent per year; the broader GDP price index is projected to rise 1.8 percent yearly. These are the same inflation rates as in the budget.

    Interest rates: Reflecting the recent cuts in the federal funds rate and the moderate growth in the economy, interest rates are currently significantly lower than anticipated in the budget. As economic activity picks up and private credit demand increases, rates are expected to rise. By 2008, the 91-day Treasury bill rate is expected to reach 4.3 percent, up from 0.9 percent at the end of June. The yield on the 10-year Treasury note is projected to rise to 5.3 percent by 2008, up from 3.5 percent at the end of June. These outyear rates are very close to those in the budget and are generally consistent with the interest rate expectations implicit in the yield curve.

    Income Shares: Because of the significantly different effective tax rates applied to different types of income, the budget receipts projection is affected by the projected growth rates of different types of income (or, equally, the changes in the share of each type of income in GDP). On average, wages and salaries, along with corporate profits, face the highest effective tax rates. The share of wages and salaries in GDP is projected to rise as labor markets tighten in the coming years. The share of "other labor income" in GDP, which includes worker fringe benefits such as health insurance and pension payments paid by employers, is also expected to rise. These benefits, however, are not taxed.

    The share of corporate profits before tax in GDP will be affected by the pickup in economic activity and by the temporary 50 percent bonus depreciation provisions of the 2003 jobs and growth tax cut. The stronger growth during the next few years will tend to raise the profits share. However, through the end of 2004 this will be more than offset by the depreciation provision which lowers profits before tax by allowing firms to write off more of their investment sooner. After the expiration of the bonus depreciation at the end of 2004, taxable profits will rise (and corporate tax receipts will be boosted) because the remaining depreciation on eligible investments will be lower. Taking these various factors into consideration, the share of corporate profits before tax in GDP is expected to decline to 5.9 percent next year and jump to 9.6 percent in 2005. In subsequent years, the share is projected to decline to 8.3 percent by 2008.

    Among the other components of taxable income, the share of personal interest income is expected to decline, reflecting the lagged effects of past declines in interest rates. The GDP shares of dividends, rents, and proprietors' income, all of which have relatively low effective tax rates, are projected to remain at about their 2003 levels.