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This volume is one of a series of reports on the state of the economy and the budget issued periodically by the Congressional Budget Office (CBO). In accordance with CBO's mandate to provide objective and impartial analysis, the report contains no recommendations.

The analysis of the economic outlook presented in Chapter I and the analysis of economic growth in Chapter III was prepared by the Fiscal Analysis Division under the direction of William J. Beeman and Jacob S. Dreyer, with the assistance of Trevor Alleyne, John Canally, Suzanne Cooper, Robert A. Dennis, Victoria S. Farrell, Douglas R. Hamilton, George R. Iden, James Kiefer, Steve Parker, John F. Peterson, Martin A. Regalia, Frederick C. Ribe, Frank S. Russek, Jr., Matthew A. Salomon, John R. Sturrock, Eng Meng Tan, Helena Tang, Stephan S. Thurman, and Bragi Valgeirsson.

The baseline outlay projections were prepared by the staff of the Budget Analysis Division under the supervision of James L. Blum, C.G. Nuckols, Michael Miller, Charles Seagrave, Robert Sunshine, and Paul Van de Water. The revenue estimates were prepared by the staff of the Tax Analysis Division under the direction of Rosemary D. Marcuss and Kathleen M. O'Connell, with the assistance of Valerie Amerkhail, Mark Booth, Neil Fisher, Richard Kasten, Jeffrey Miller, Linda Radey, Frank Sammartino, and Bill Steele.

Chapter II was written by Paul N. Van de Water, with contributions by Rosemary Marcuss, James Blum, Michael Miller, Kathy Ruffing, and Mark Weatherly. Paul Christy was the principal author of Appendix A. Richard Krop prepared Appendixes B and F. Andrew Haughwout wrote Appendix C. Paul Van de Water and Marianne Deignan assembled the data for Appendix D. Frank S. Russek, of the Fiscal Analysis Division, prepared Appendix E.

Paul L. Houts supervised the editing and production of the report, assisted by Nancy H. Brooks. Major portions were edited by Patricia H. Johnston, Francis S. Pierce, and Sherry Snyder. Debra M. Blagburn coordinated the preparation of the report. The authors owe special thanks to Dorothy J. Kornegay, L. Rae Roy, Earnestine Miles, and Thelma L. Jones, who typed the many drafts. Additional assistance was provided by Shelbah Adams.
 

Rudolph G. Penner
Director
January 1987
 
 

SUMMARY

I - THE ECONOMIC OUTLOOK

• The CBO Economic Forecast and Medium-Term Projections
• Fiscal and Monetary Policy
• Recent Economic Developments

II - THE BUDGET OUTLOOK

• Choices in Baseline Budget Projections Since August 1985
• Budget Projections Under Alternative Economic Assumptions
• Spending Projections by Major Category
• Revenue Projections by Major Source
• Baseline Credit Projections

III - ECONOMIC GROWTH, CAPITAL FORMATION, AND THE FEDERAL DEFICIT

• The Growth of Real GNP Since World War II
• Potential Output as an Alternative Measure of Growth
• Causes of Slower Growth
• The Role of Investment in the Growth Slowdown
• Implications for the Five-Year Budget Projections

APPENDIXES

A - Baseline Concepts and Assumptions
B - Baseline Spending and Credit Projections by Budget Function
C - Federal Receipts and Expenditures in the National Income and Product Accounts
D - Analysis of Congressional Budget Estimates
E - Estimates of Potential Output
F - Historical Budget Data
 

TABLES
S-1.	Baseline Budget Projections, Deficit Targets, and Underlying Economic Assumptions
S-2.	The CBO Forecast for 1987 and 1988
S-3.	Changes from the CBO August Baseline Deficit Projections
I-1.	The CBO Forecast for 1987 and 1988
I-2.	Medium-Term Economic Projections for Calendar Years 1989-1992
I-3.	Medium-Term Economic Projections for Fiscal Years 1989-1992
I-4.	Alternative Economic Projections
I-5.	Fiscal Policy as Measured by the Standardized-Employment Deficit
I-6.	Selected Measures of Monetary Policy
I-7.	Real GNP and Industrial Production
I-8.	Recent Trends in Real Business Fixed Investment
I-9.	Current Indicators of Business Fixed Investment and Surveys of Capital Spending Plans for 1987
I-10.	Government Purchases of Goods and Services
II-1.	CBO Baseline Budget Projections
II-2.	CBO Baseline Projections for On-Budget and Off-Budget Spending and Revenues
II-3.	Changes from CBO August Baseline Projections
II-4.	CBO Budget Projections Under Alternative Economic Assumptions
II-5.	Effects on CBO Baseline Budget Projections of Selected Changes in Economic Assumptions
II-6.	CBO Baseline Outlay Projections for Major Spending Categories
II-7.	CBO Baseline Outlay Projections for Entitlements and Other Mandatory Spending
II-8.	Budget Financing and Debt
II-9.	Baseline Revenue Projections by Source
II-10.	Revenue Effects of Legislation Enacted Since August 1986
II-11.	CBO Baseline Credit Projections
III-1.	Estimates of the Importance of Selected Factors in the Productivity Slowdown
III-2.	Net Saving, Additions to Wealth, and Investment Flows as Percent of GNP
III-3.	A Comparison of Average Growth Rate Projections for Real GNP, Employment, and Productivity
III-4.	Budget Effects of One-Half Percentage Point Less in Real GNP Growth Than Projected
A-l.	Defense Inflation Rates Under CBO Baseline Assumptions
B-l.	CBO Baseline Budget Authority Projections by Function
B-2.	CBO Baseline Outlay Projections by Function
B-3.	CBO Baseline Credit Projections by Budget Function
C-1.	Relationship of the Budget to the Federal Sector of the National Income and Product Accounts
C-2.	Projections of Baseline Revenues and Expenditures on a National Income and Product Accounts Basis
D-1.	Congressional Budget Resolutions and Actual Budget Outlays
D-2.	Sources of Differences Between Actual Budget Totals and First Budget Resolution Estimates
E-l.	Equations for Estimating Potential Output and Its Components
E-2.	Historical Estimates of Potential GNP and the Standardized-Employment Deficit
F-l.	Revenues, Outlays, Deficits, and Debt Held by the Public, Fiscal Years 1962-1986
F-2.	Revenues, Outlays, Deficits, and Debt Held by the Public, Fiscal Years 1962-1986
F-3.	Revenues by Major Source, Fiscal Years 1962-1986
F-4.	Revenues by Major Source, Fiscal Years 1962-1986
F-5.	Outlays for Major Spending Categories, Fiscal Years 1962-1986
F-6.	Outlays for Major Spending Categories, Fiscal Years 1962-1986
F-7.	Outlays for Entitlements and Other Mandatory Spending, Fiscal Years 1962-1986
F-8.	Outlays for Entitlements and Other Mandatory Spending, Fiscal Years 1962-1986
FIGURES
S-l.	Baseline Revenues and Outlays
S-2.	Major Economic Assumptions
S-3.	Federal Debt Held by the Public
I-1.	Alternative Economic Assumptions
I-2.	Standardized-Employment Deficit
I-3.	Recent Movements in Short- and Long-Term Interest Rates
I-4.	Nominal and Real Interest Rates
I-5.	Common Stock Prices
I-6.	Money Growth and Targets in 1986
I-7.	Velocity: Deviations from Trend Level
I-8.	GNP and Domestic Final Demand
I-9.	Recent Inflation Rates
I-10.	Measures of Inflation
I-11.	Private Nonfarm Wages
I-12.	Occupational Shifts and Wages
I-13.	Personal Saving Rate
I-14.	Real Business Fixed Investment
I-15.	Oil Prices and Oil Rigs in Operation
I-16.	The Exchange Rate and Relative Interest Rates
II-1.	CBO Baseline Deficit Projections
II-2.	Federal Deficit Under Alternative Economic Assumptions
II-3.	Outlays by Category as Percents of GNP
II-4.	Revenues by Source as Percents of GNP
III-1.	Actual and Potential Gross Domestic Product
III-2.	Civilian Population and Labor Force
III-3.	Civilian Labor Force Participation Rates
III-4.	Business Productivity Growth and Its Trend
III-5.	Productivity by Sector
III-6.	Proportions of Adult Women and Youth in the Civilian Labor Force
III-7.	Real Expenditures of Industry on Research and Development as a Percent of Real Gross National Product
III-8.	Estimates of the Interest Rate Effects of a $50 Billion Increase in the Deficit
III-9.	Net Saving and Investment
BOXES
I-1.	The Exchange Values of the Dollar
II-1.	Spending Reductions Under the Balanced Budget Act
II-2.	Recent Trends in Real Defense Spending
II-3.	Budgetary Treatment of Credit Programs

 

Despite the record high federal budget deficit for fiscal year 1986, a continuation of current policy would imply substantially lower budget deficits in coming years. The Congressional Budget Office (CBO) projects that the baseline federal deficit will decline from $221 billion in 1986 to $174 billion in 1987, $169 billion in 1988, and $85 billion in 1992. In relation to gross national product (GNP), the deficit is projected to decline from 5.3 percent of GNP in 1986 to 3.6 percent in 1988 and 1.4 percent in 1992.

These budget projections are contingent on CBO's forecast of a moderate pickup in economic growth from its subdued pace in 1986, and a modest decline in both short-term and long-term interest rates over the projection period from their average levels in 1986. They also assume that current taxing and spending laws remain unchanged and that both defense and nondefense discretionary appropriations are held to zero real growth. The budgetary outlook and the economic assumptions underlying the forecast are presented in Summary Table 1.

The economic expansion has now entered its fifth year. Over the four quarters of 1986, the economy grew at a 2½ percent rate--about the same as in 1985 but substantially below its growth in the first two years of recovery. Unemployment in 1986 was slightly below that of 1985 but still averaged 7.0 percent. Total employment grew rapidly, however, by about 2.3 percent. Most of the new jobs were still in the service-producing sector. There was a continuing weakness in the goods-producing sector, at least partially attributable to the widening trade deficit. Inflation decreased in 1986, especially as measured by the Consumer Price Index (CPI), largely because of the precipitous decline in oil prices at the beginning of the year. Despite the continuing depreciation of the dollar against most other currencies, prices of imports did not move up as sharply as many forecasters had anticipated. Interest rates--especially long-term rates--fell considerably as a result of the easing of inflation, the sluggish growth of the economy, and the expectation of lower federal deficits.

CBO forecasts a moderate pickup in economic activity in 1987 and 1988. Real GNP is expected to grow just under 3 percent annually. Like most other forecasters, CBO anticipates that the trade sector will be the major contributor to the stronger growth, which should bring unemployment down to an average of 6.6 percent in 1987 and 6.5 percent in 1988.

CBO's forecast calls for a fairly substantial rise in reported inflation, from 2½ percent in 1986 (as measured by the implicit GNP deflator) to about 3.7 percent in 1987-1988. On the consumer level, CBO sees inflation rising from the artificially depressed rate of 1 percent, to 1½ percent in 1986, to almost 4½ percent in 1987 and 1988. The rise in inflation will reflect, among other things, somewhat higher oil prices and rising import prices caused by the falling dollar. Interest rates in 1987 and 1988 are expected to average near their present levels.

Under these economic assumptions, CBO projects a sharp decline of the baseline budget deficit in 1987 and a further moderate reduction in 1988. About half of the expected decline in the 1987 deficit results from one-time factors, including an increase in revenues under the Tax Reform Act of 1986, asset sales, and shifts of outlays into adjacent years. After 1987, revenues under current laws are projected to grow at an annual rate of nearly 8 percent--slightly faster than GNP--while baseline outlays grow only 5 percent per year, which is substantially below the 10 percent annual growth rate experienced earlier in the 1980s and less than the projected growth in the economy (see Summary Figure 1).

Baseline budget deficits, although declining throughout the projection period, exceed by large amounts the targets established by the Balanced Budget and Emergency Deficit Control Act of 1985. The 1988 deficit would have to be cut $61 billion below the baseline in order to reach the goal of $108 billion. For fiscal years 1989 through 1991, the baseline deficit averages about $100 billion over the statutory targets (see Summary Table 1).

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