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Mr. Chairman, Representative Spratt, and Members of the Committee, I am pleased to be here today to discuss the current outlook for the budget and the economy. Last week, the Congressional Budget Office (CBO) released The Budget and Economic Outlook: An Update, which I will summarize today.

Recently enacted legislation and the continued sluggish behavior of the U.S. economy have reduced the projected federal budget surpluses for fiscal year 2001 and future years. CBO projects that the total budget surplus in 2001 will be $153 billion--$122 billion lower than CBO estimated in May. About two-thirds of the decrease results from new legislation; one-third comes from a weaker economy and other factors. Despite that drop, if the $153 billion surplus materializes in 2001, it will equal 1.5 percent of gross domestic product (GDP), the second largest surplus as a share of the economy since 1951.

Because of the smaller total surplus, CBO now projects a small on-budget deficit for this year. (The on-budget accounts exclude the spending and revenues of Social Security and the Postal Service.) If current tax and spending policies are maintained and the economy performs as estimated, CBO projects small deficits or surpluses in on-budget accounts for the next four years; however, steadily increasing on-budget surpluses reemerge by the middle of the decade. The projected surpluses would allow all public debt that is available for redemption to be retired by 2010.
 

The Budget Outlook

For the five years from 2002 through 2006, CBO projects surpluses totaling $1.1 trillion, which come almost entirely from off-budget accounts (see Table 1). For the 10-year period through 2011, CBO estimates that under current policies, surpluses will total $3.4 trillion. Social Security makes up about three-quarters of that total. In 2010, the on-budget surplus reaches 1 percent of GDP, and the total surplus grows to 3 percent of GDP. Those estimates should be viewed cautiously, however, because future economic developments, technical estimating errors, and future legislative actions could produce substantial deviations--a point that CBO discussed in detail in its January report on the budget and economic outlook.

Total surpluses for the 2002-2011 period are $2.2 trillion less than CBO projected in May, when it last published its budget baseline (see Table 2). New legislation accounts for $1.8 trillion of that decrease, and changes in the economic forecast account for another $0.3 trillion; the remainder stems from other changes (technical ones not directly driven by new legislation or by changes in the components of CBO's economic forecast).

The Economic Growth and Tax Relief Reconciliation Act of 2001 (Public Law 107-16) is estimated to reduce revenues by $70 billion in 2001 and nearly $1.2 trillion over the 2002-2011 period. That law changed numerous tax provisions, including lowering income tax rates, establishing a 10 percent tax bracket, increasing tax credits for children, repealing the estate tax, lessening the so-called marriage penalty, raising the limits on contributions to retirement accounts, and enhancing education incentives. In addition, the law increases outlays for refundable tax credits by $4 billion in 2001 and $88 billion between 2002 and 2011.

Many of the provisions of P.L. 107-16, especially the ones with the greatest impact on the budget, phase in over time. Moreover, most of the provisions expire at the end of calendar year 2010. Extending all provisions through 2011 would reduce revenues by an additional $255 billion over the 2002-2011 period.

Other legislation will also increase projected outlays through 2011. Providing additional assistance to farmers will increase spending by $5.5 billion in 2001, and the 2001 Supplemental Appropriations Act is projected to boost spending by $83 billion from 2002 through 2011. Because legislative changes will leave less money available to reduce outstanding federal debt, interest payments will increase by $413 billion over the next 10 years, CBO estimates.

Lower projections of economic growth over the next few years, along with other revisions to the economic forecast, will diminish surpluses by $283 billion between 2002 and 2011, according to CBO's projections. (Those revisions reflect changes in the economic outlook since January, when CBO last updated its economic assumptions.) In addition, technical changes will reduce surpluses by $177 billion.

In the Administration's Mid-Session Review, the Office of Management and Budget's (OMB's) baseline budget projections are similar, though not identical, to those presented by CBO. For 2001, OMB estimates a small on-budget surplus, whereas CBO estimates a small on-budget deficit. In each year of the projection period, CBO's estimates are lower than OMB's--overall, CBO's figure for total surpluses from 2002 through 2011 is $445 billion less. Although that discrepancy may seem large, it results from differences of just 1.0 percent in total projected revenues for the period and 0.7 percent in total projected outlays.
 

The Economic Outlook

CBO has revised its economic forecast to reflect the weakness in the U.S. economy during the first half of 2001. Although economic activity has slowed to a crawl, CBO believes that the economy will narrowly avoid recession and recover gradually next year. CBO now expects that the levels of both nominal and real (inflation-adjusted) GDP will be lower in 2001 and 2002 than it anticipated in January. CBO also has raised its estimates of the unemployment rate and long-term interest rates for the next few years and lowered its estimate of short-term interest rates.

CBO's current forecast assumes that growth of real GDP will average 1.7 percent this calendar year and 2.6 percent next year--for both years, those rates are about three-quarters of a percentage point lower than CBO estimated in January (see Table 3). CBO's projections do not incorporate the annual revisions to the national income and product accounts published by the Commerce Department's Bureau of Economic Analysis at the end of July, which were released after CBO's forecast was completed. Incorporating those revisions could move budget projections in either direction but probably not by very much.

Inflation, as measured by growth in the consumer price index for all urban consumers, is 0.4 percentage points higher for 2001 and 0.2 percentage points lower for 2002 than the estimates in the January forecast.

Short-term interest rates are projected to be lower in the next few years than CBO previously anticipated, but long-term rates are expected to be slightly higher. Interest rates on three-month Treasury bills are forecast to be about a full percentage point lower for both 2001 and 2002 than the levels estimated in January. However, the interest rates paid on 10-year Treasury notes are projected to be between 0.3 and 0.4 percentage points higher than previously anticipated.

CBO does not forecast fluctuations of the economy beyond two years. Instead, it extends historical patterns in the factors--increases in the labor force, rising productivity, and the rate of national saving--that underlie the growth of potential GDP. After incorporating those patterns, CBO makes economic projections that extend three to 10 years out.

For 2003 through 2011, CBO projects that growth of nominal GDP will average more than 5.2 percent a year and that growth of real GDP will average 3.2 percent--levels slightly above those estimated in January. According to CBO's projections, inflation in the 2003-2011 period will average 2.5 percent, which is similar to the rate that was anticipated last winter. Interest rates over the period will average 4.9 percent for three-month Treasury bills and 5.8 percent for 10-year Treasury notes, CBO projects--figures that are also similar to January's projections.

CBO's economic projections incorporate the effects of the recently enacted tax legislation. In the short run, the rebate of taxes payable on income earned in 2001 may help counter the economic slowdown by encouraging consumer spending. In the long run, the impact of the new tax law on GDP is uncertain, but any effect is likely to be small. Analysis of the law's economic effects is complicated by the sunset mechanism built into it, which establishes expiration dates for all of its provisions. People's expectations about the law's expiration in 2011 could affect their decisions about consumption, work, and saving over the next 10 years. For the purposes of its economic projections--but not for its budget calculations--CBO has ignored the expiration.

Like all forecasts, CBO's forecast is very uncertain, and economic activity could be significantly slower--or faster--than CBO currently expects. Indeed, economic indicators released since CBO's forecast was completed in July suggest a weaker economy than assumed in the projections, though the nature of economic activity (weak business investment offset by moderate consumer spending and spending on residential structures) is close to CBO's expectation. In light of additional weakness in construction spending and in the manufacturing sector, the latest estimate for the second quarter of this year indicates that output growth was only 0.2 percent, rather than the 0.7 percent first estimated. And indicators for July, the first month of the current quarter, suggest that growth may be less than CBO assumed because of much weaker business investment. Short-term interest rates in the current quarter are also likely to be lower than assumed in July because the Federal Reserve cut its intended federal funds interest rate another 25 basis points in August.

Much of the uncertainty about medium-term growth involves the pace of investment in information technologies. The increase in the growth rate of overall productivity in the late 1990s resulted both from greater amounts of capital per worker, mainly in the information technology sector, and from more rapid growth in total factor productivity (reflecting both labor productivity and capital), probably in large part the result of innovative uses of information technologies throughout the economy. The question now is what the pace of investment in information technologies will be over the medium term and the extent to which those investments will lead to significant cost savings in other sectors of the economy.

The economic perspectives of OMB and CBO are generally quite similar, but the differences in those outlooks still account for a large part of the difference between the two agencies' budget projections. The Administration's current economic projections anticipate stronger near-term growth than CBO's projections do, with a sharp improvement in economic conditions by the end of this year. As a result, corporate profits in the Administration's forecast return to recent levels almost immediately, and the unemployment rate remains below 5 percent (see Table 4). By contrast, in CBO's forecast, profits remain weak in the near term, and the unemployment rate rises to 5.2 percent by the end of 2002. After 2002, the Administration's projections of nominal GDP and of tax bases (such as corporate profits and wages and salaries) remain slightly stronger than CBO's. Throughout most of the period, the Administration anticipates significantly lower interest rates on Treasury securities than CBO does, although the implications of that difference for the budget are limited at a time when publicly held debt is being paid down.