SUMMARY

    The President's Budget, released in February, focuses on the challenges posed by three overriding national priorities: winning the war against terrorism, securing the homeland, and restoring strong economic growth and job creation. Significant progress has been made in all three areas.

    This Mid-Session Review of the Budget revises the estimates of receipts, outlays, and the deficit to reflect economic, legislative, and other developments since February. The deficit for 2003 is now estimated at $455 billion, up from the $304 billion deficit estimated in February, for the following reasons:

• Economic and Other Reestimates. The economic assumptions for this review, discussed later in the chapter "Economic Assumptions," reflect weaker-than-anticipated economic growth since February. Slower growth, lower estimates of wage and salary income, and other economic factors have reduced receipts from the levels estimated in the budget. In the interest of cautious and prudent forecasting, the revised estimates also include a downward adjustment for revenue uncertainty of $15 billion in 2003, $30 billion in 2004, and $15 billion in 2005. These reestimates in receipts are partially offset by lower outlays due to revised economic and technical assumptions. The net effect of all economic and other reestimates is to raise the projected deficit by $66 billion in 2003 and $95 billion in 2004.

• Iraq War. Funding for Operation Iraqi Freedom in supplemental appropriations enacted in April, including costs for military action and reconstruction assistance, increases spending by $47 billion in 2003 and $20 billion in 2004. These estimates do not reflect what the Administration has previously indicated are expected but undetermined additional costs arising from ongoing operations in Iraq, extending beyond 2003.

• Jobs and Growth Act. Enactment of a jobs and growth bill that was larger for 2003 and 2004 than proposed in the February Budget raises the projected deficit by $13 billion in 2003 and $36 billion in 2004. Of this increase, $9 billion in 2003 and $11 billion in 2004 is due to temporary state fiscal assistance included in the final enacted bill. In later years, the enacted tax relief is smaller than proposed in the Budget, which reduces the deficit projected in those years relative to the February estimates.

• Other Legislation and Policy Changes. Final 2003 appropriations action, non-war related costs in the April supplemental, extension of the program to help unemployed Americans by providing an additional 13 weeks of unemployment benefits, and other policy changes raise spending by $26 billion in 2003, $17 billion in 2004, and smaller amounts in subsequent years.

    The reasons for changes in receipts and spending from the February Budget are discussed further in the "Receipts" and "Spending" chapters of this Review.

    The deficit is projected to increase slightly from $455 billion in 2003 to $475 billion in 2004. As a share of the economy, the projected deficit remains steady in these two years, at 4.2 percent of Gross Domestic Product (GDP). These deficit levels are well below the postwar deficit peak of 6.0 percent of GDP in 1983, and are lower than in six of the last twenty years.

    Even more important, after 2004, the deficit is projected to decline rapidly in response to the economy's return to healthy and sustained growth. By 2006, the deficit is cut in half. Chart 1 shows that the decline is even more pronounced as a share of the economy, falling from 4.2 percent of GDP in 2003 and 2004 to 1.7 percent of GDP in 2008.

    Today's deficits reflect an economy in recovery from recession, increased spending in response to the war on terror and homeland security needs, and the reversal of a massive surge in individual income tax collections. Although large in nominal terms and a legitimate subject of concern, these deficits are manageable if we continue pro-growth economic policies and exercise serious spending discipline.

The Turnaround from Surplus to Deficit

    When the Administration took office, the budget was forecast—by both the Administration and the Congressional Budget Office—to run cumulative surpluses of $5.6 trillion over the 10 years from 2002 to 2011. These forecasts were good-faith estimates that took into account no subsequent spending or tax changes, no recession, no collapse in the stock market, no September 11th terrorist attacks, no revelation of corporate scandals, no additional homeland security spending, and no war on terror. As shown in Table 2, the largest factors behind the subsequent change in surplus estimates are a weaker economy than originally projected and other reestimates in receipts and outlays, such as weaker capital gains realizations and higher growth in health care costs. These reestimates account for 53 percent of the change in the 2003 budget balance from the $334 billion surplus estimated in the April 2001 Budget to the current estimate of a $455 billion deficit.

    By far the largest reestimate from the April 2001 projection has been in receipts. In the late 1990s, revenue from the individual income tax surged far above historical rates of growth, due to increased capital gains realizations from a booming stock market, growth in stock options and bonus income to high-income taxpayers, and other factors. At the height of the revenue surge in 2000, total receipts came in nearly $300 billion above long-term historical trends. This receipts "bubble" more than accounted for the $236 billion budget surplus in that year. The Administration's April 2001 projection, like those of the previous administration, the Congressional Budget Office, and other forecasters, assumed this level of receipts would continue. The subsequent reversal of the receipts surge has brought today's receipt levels far below the original April 2001 estimates.

    Policy actions account for the remainder of the change in the budget outlook since April 2001. The President proposed, and Congress enacted, three major tax bills in the past two and a half years. The first tax cut, the Economic Growth and Tax Relief Reconciliation Act of 2001, came just after the economy had entered into recession. Its immediate tax relief in the summer and the fall of 2001 boosted consumer demand and helped to ensure the recession was short and shallow. The second tax cut, the Job Creation and Worker Assistance Act of 2002, provided incentives for business investment to jump-start the recovery. This spring, Congress passed the Jobs and Growth Tax Relief Reconciliation Act of 2003, proposed by the President in January to strengthen the recovery and accelerate job creation from its current subpar pace. In 2003, the effects of these three tax cuts account for 23 percent of the change in the budget balance from the original April 2001 projection. Even without these tax cuts, the deficit this year would be projected at $278 billion—and, of course, the economy would have been even weaker had the tax cuts not been enacted, with substantially greater job losses.

    Policy action on the spending side of the budget has also increased the deficit. The largest spending increases, in the areas of defense and homeland security, came in response to the terrorist attacks of September 11, 2001 and the ensuing wars in Afghanistan and Iraq. The effects of this and other new spending account for 24 percent of the change in the budget balance since April 2001.

Prospects for the Economy and the Budget

    The key to improvement in the budget outlook is a healthy recovery with strong job creation. Since the submission of the budget in February, prospects for sustained economic growth have brightened on several fronts:

• Passage of the President's jobs and growth tax package will stimulate consumer spending, improve incentives to work, and encourage individual and business investment.

• Successful action to free the Iraqi people from the regime of Saddam Hussein has removed uncertainty about the timing and outcome of the war.

• A further reduction in short-term interest rates by the Federal Reserve last month and historically low long-term rates provide an attractive climate for investment and a strong housing market.

• Upturns in consumer and investor confidence indicate economic improvement is in the offing.

    All of these developments combine to suggest that the economy is poised to return to healthy and sustained growth—creating jobs, reducing the unemployment rate, and raising incomes.

    A healthy economy is essential to an improved budget outlook because it generates more revenue and reduces the pressure for spending in unemployment-sensitive programs. But strong growth alone is not sufficient. It is vital to exercise discipline over federal spending growth, keeping new policy action within the framework set by the President's Budget and this year's Congressional Budget Resolution. Both the Budget and the Resolution fund the priorities of the war on terror and homeland security, while restraining the overall growth of discretionary appropriations to a four percent level, consistent with the average growth in family income. If discretionary spending instead continued to grow at the average 7.4 percent rate experienced between 1998 and 2003, it would add a cumulative $400 billion to the deficit over the next five years.

    Holding discretionary spending to four percent growth overall requires us to make choices, to set priorities, and to exercise fiscal discipline. Even in priority areas such as homeland security, we must be sure that funding increases are well spent. The Administration's efforts to assess and improve the performance of federal programs across the government, discussed further in the chapter "Progress Implementing the President's Management Agenda," will help to ensure that taxpayer dollars are directed to programs that provide the greatest benefit.

    It is important to restrain increases in mandatory as well as discretionary spending to the levels envisioned by the Budget and the Resolution. Proposals for concurrent receipt of military retirement benefits and veterans' disability compensation, and increases in highway spending above the levels in the Budget, are examples of new proposals—however well-intended—that have the potential to undermine the fiscal framework designed to move the budget toward balance. The Administration renews its call for budget enforcement mechanisms that will restrain policy action above the limits set forth in the Budget and the Resolution.

    While we work to improve today's budget position, we must keep in mind the real fiscal danger: the unsustainable long-term finances of the nation's two major entitlement programs. Even if the budget were in balance today, the growth in the future costs of Social Security and Medicare beyond their dedicated resources would create deficits that grow ever larger as a share of the economy in the decades to come. The President is committed to reforming these programs in a way that modernizes their benefits and restructures their financing to ensure that they provide benefits not only for those in or near retirement today, but for generations to come.

    The fundamentals of the economy remain sound. With renewed economic growth, and with judicious stewardship of the people's money, we can return the budget to a stronger position in the years ahead.