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The Congressional Budget Office (CBO) is required by section 202(f) of the Congressional Budget Act of 1974 to submit an annual report on budgetary options to the House and Senate Committees on the Budget. This year, the report is in two parts. This volume, Part I, presents projections of federal revenues and spending that would occur if current laws and policies continued unchanged for the next five years. It also examines the state of the economy and the economic outlook with these budget policies. Part II, Reducing the Deficit: Spending and Revenue Options, presents for Congressional consideration a number of broad strategies to reduce projected budget deficits and various specific options for cutting outlays and increasing revenues. In accordance with CBO's mandate to provide objective and impartial analysis, these reports contain no recommendations.

The analysis of the economic outlook presented in Chapter I was prepared by the Fiscal Analysis Division under the direction of William J. Beeman and Jacob S. Dreyer, with the assistance of Robert A. Dennis, Victoria S. Farrell, Douglas R. Hamilton, George R. Iden, Stephen A. Parker, John F. Peterson, Martin A. Regalia, Frederick C. Ribe, Frank S. Russek, Jr., Matthew A. Salomon, John R. Sturrock, Stephan S. Thurman, Lucia S. Foster, Stacy A. Miller, Jeffrey Steger, and Bragi Valgeirsson.

The baseline outlay projections were prepared by the staff of the Budget Analysis Division under the supervision of James L. Blum and C.G. Nuckols. 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, Neil Fisher, Robert Lucke, Preston Niblack, Linda Radey, and Jan Sundgren. Paul N. Van de Water and Rosemary D. Marcuss were the principal authors of Chapter II and Appendix A. The other appendixes were prepared by David A. Bashore, Paul T. Christy, Andrew F. Haughwout, Richard F. Krop, and Kathy A. Ruffing, who also prepared many of the tables and boxes in Chapter II. James L. Blum wrote Chapter III.

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

Rudolph G. Penner
Director
February 1986
 
 

SUMMARY

CHAPTER I - THE ECONOMIC OUTLOOK

• The Economic Outlook
• Fiscal and Monetary Policy
• Recent Economic Developments

CHAPTER II - THE BUDGET OUTLOOK

• Baseline Budget Projections
• Changes in Baseline Budget Projections Since August
• Differences Between CBO Baseline and Administration Current Services Projections
• Budget Projections Under Alternative Economic Assumptions
• Spending Projections By Major Category
• Revenue Projections By Major Source
• Baseline Credit Projections

CHAPTER III - AUTOMATIC SPENDING REDUCTIONS UNDER THE BALANCED BUDGET ACT

• Provisions of the Balanced Budget Act
• Budget Base Levels for 1987
• Calculations for the Illustrative Sequestration
• Sequestration Results

APPENDIX A BASELINE CONCEPTS AND ASSUMPTIONS

APPENDIX B BASELINE SPENDING AND CREDIT PROJECTIONS BY BUDGET FUNCTION

APPENDIX C FEDERAL RECEIPTS AND EXPENDITURES IN THE NATIONAL INCOME AND PRODUCT ACCOUNTS

APPENDIX D HISTORICAL BUDGET DATA
 

SUMMARY TABLE 1.	BASELINE BUDGET PROJECTIONS, DEFICIT TARGETS, AND UNDERLYING ECONOMIC ASSUMPTIONS
SUMMARY TABLE 2.	THE CBO FORECAST
SUMMARY TABLE 3.	CHANGES IN CBO BASELINE DEFICIT PROJECTIONS SINCE AUGUST 1985
SUMMARY TABLE 4.	ALTERNATIVE ECONOMIC AND BUDGET PROJECTIONS
SUMMARY TABLE 5.	EFFECT OF SEQUESTRATIONS ON BUDGET OUTLAYS FOR 1986 AND 1987
TABLE I-1.	THE CBO FORECAST FOR 1986 AND 1987
TABLE I-2.	MEDIUM-TERM ECONOMIC PROJECTIONS FOR CALENDAR YEARS 1988-1991
TABLE I-3.	MEDIUM-TERM ECONOMIC PROJECTIONS FOR FISCAL YEARS 1988-1991
TABLE I-4.	ALTERNATIVE ECONOMIC PROJECTIONS
TABLE I-5.	AGGREGATE MEASURES OF FISCAL POLICY
TABLE I-6.	NET SAVINGS AND INVESTMENT FLOWS AS PERCENT OF GNP
TABLE I-7.	GROWTH RATES OF CREDIT MARKET DEBT, NONFINANCIAL SECTORS
TABLE I-8.	SELECTED MONETARY POLICY MEASURES
TABLE I-9.	REAL GNP AND INDUSTRIAL PRODUCTION
TABLE I-10.	EMPLOYMENT AND UNEMPLOYMENT
TABLE I-11.	COMPENSATION, PRODUCTIVITY, AND UNIT LABOR COSTS
TABLE I-12.	INFLATION
TABLE I-13.	RECENT TRENDS IN BUSINESS FIXED INVESTMENT
TABLE I-14.	CURRENT INDICATORS OF BUSINESS FIXED INVESTMENT AND SURVEYS OF CAPITAL SPENDING PLANS FOR 1986
TABLE I-15.	GROWTH RATES OF REAL GNP AND GDP, 1982-1985
TABLE I-16.	GOVERNMENT PURCHASES OF GOODS AND SERVICES
TABLE II-l.	CBO BASELINE BUDGET PROJECTIONS
TABLE II-2.	CHANGES IN CBO BASELINE DEFICIT PROJECTIONS SINCE AUGUST 1985
TABLE II-3.	DIFFERENCES BETWEEN ADMINISTRATION CURRENT SERVICES PROJECTIONS AND CBO BASELINE
TABLE II-4.	BASELINE PROJECTIONS UNDER ALTERNATIVE DEFENSE ASSUMPTIONS
TABLE II-5.	CBO BUDGET PROJECTIONS UNDER ALTERNATIVE ECONOMIC ASSUMPTIONS
TABLE II-6.	EFFECTS ON CBO BASELINE BUDGET PROJECTIONS OF SELECTED CHANGES IN ECONOMIC ASSUMPTIONS
TABLE II-7.	CBO BASELINE OUTLAY PROJECTIONS FOR MAJOR SPENDING CATEGORIES
TABLE II-8.	CBO BASELINE OUTLAY PROJECTIONS FOR ENTITLEMENTS AND OTHER MANDATORY SPENDING
TABLE II-9.	BASELINE REVENUE PROJECTIONS BY SOURCE
TABLE II-10.	CBO BASELINE CREDIT PROJECTIONS
TABLE III-l.	BUDGET BASE LEVELS FOR THE 1987 SEQUESTRATION UNDER ALTERNATIVE ECONOMIC ASSUMPTIONS
TABLE III-2.	CHANGES IN CBO BASELINE BUDGET PROJECTIONS TO CALCULATE BUDGET BASE LEVELS FOR SEQUESTRATION
TABLE III-3.	BASE LEVEL OUTLAY ESTIMATES FOR THE 1987 SEQUESTRATION
TABLE III-4.	CALCULATING THE ILLUSTRATIVE SEQUESTRATION FOR 1987
TABLE III-5.	SEQUESTRATION PERCENTAGE REDUCTIONS UNDER ALTERNATIVE BASE LEVEL DEFICIT ESTIMATES FOR 1987
TABLE III-6.	ILLUSTRATIVE SEQUESTRATION FOR DEFENSE PROGRAMS FOR 1987
TABLE III-7.	ILLUSTRATIVE SEQUESTRATION FOR NONDEFENSE PROGRAMS FOR 1987
TABLE III-8.	EFFECT OF SEQUESTRATION ON BUDGET OUTLAYS FOR 1986 AND 1987
SUMMARY FIGURE 1.	BASELINE REVENUES AND OUTLAYS
SUMMARY FIGURE 2.	MAJOR ECONOMIC ASSUMPTIONS
SUMMARY FIGURE 3.	FEDERAL DEBT HELD BY THE PUBLIC
FIGURE I-1.	ALTERNATIVE ECONOMIC ASSUMPTIONS
FIGURE I-2.	MEASURES OF FISCAL POLICY
FIGURE I-3.	RECENT SHORT- AND LONG-TERM INTEREST RATE MOVEMENTS
FIGURE I-4.	COMMON STOCK PRICES
FIGURE I-5.	MONEY GROWTH AND TARGETS IN 1985
FIGURE I-6.	VELOCITY: DEVIATIONS FROM TREND LEVEL
FIGURE I-7.	REAL GNP GROWTH RATES: BEFORE AND AFTER BENCHMARK REVISIONS
FIGURE I-8.	CYCLICAL COMPARISONS OF EMPLOYMENT GROWTH
FIGURE I-9.	REAL WAGES
FIGURE I-10.	CYCLICAL COMPARISONS OF PRODUCTIVITY GROWTH
FIGURE I-11.	NOMINAL AND REAL OIL PRICES
FIGURE I-12.	PERSONAL SAVING BEHAVIOR
FIGURE I-13.	BUSINESS INVESTMENT
FIGURE I-14.	REAL INVENTORY-SALES RATIO, NONFARM BUSINESS
FIGURE I-15.	EXCHANGE RATE
FIGURE I-16.	THE EXCHANGE RATE AND RELATIVE INTEREST RATES
FIGURE II-l.	FEDERAL REVENUES, OUTLAYS, AND DEFICIT AS PERCENTS OF GNP
FIGURE II-2.	SOURCES OF CHANGE IN BASELINE DEFICIT PROJECTIONS
FIGURE II-3.	FEDERAL DEFICIT UNDER ALTERNATIVE ECONOMIC ASSUMPTIONS
FIGURE II-4.	OUTLAYS BY CATEGORY AS PERCENTS OF GNP
FIGURE II-5.	REVENUES BY SOURCE AS PERCENTS OF GNP
BOX I-1.	REVISING THE NATIONAL INCOME ACCOUNTS
BOX I-2.	THE OIL PRICE COLLAPSE
BOX I-3.	THE PLIGHT OF THE AGRICULTURAL SECTOR
BOX I-4.	MERCHANDISE TRADE DATA REPORTING PROBLEMS
BOX I-5.	NET FACTOR INCOME FLOWS
BOX II-l.	ON-BUDGET AND OFF-BUDGET SPENDING AND REVENUES
BOX II-2.	FEDERAL GOVERNMENT BORROWING AND DEBT

 

The outlook for reducing budget deficits has improved dramatically since last summer, and financial markets have responded with a sharp rally. Although overall economic activity has not yet reacted to these improved financial conditions, the Congressional Budget Office (CBO) expects economic growth to pick up this year.

In 1985, the economy grew at a comparatively low rate of 2.3 percent, well below the substantial gains in the first two calendar years of the current expansion. Growth in productivity came to a halt as employment continued to grow rapidly. The unemployment rate edged down during 1985 and, despite three full years of recovery, the inflation rate remained almost unchanged from the moderate rates attained during the last recession.

Most forecasters, including CBO, anticipate that growth in real gross national product (GNP) will be somewhat faster this year--at about 3½ percent--than it was in 1985. The tremendous rally in financial markets during the second half of 1985 and the sharp decline in the dollar have enhanced the prospects for a pickup in economic activity in 1986. The rise in stock prices and the decline in interest rates will encourage consumer spending and business capital spending, while the decline in the dollar should halt the deterioration in the trade sector. If lower oil prices are sustained, the sharp drop in prices early this year will contribute to growth in economic activity and restrain inflation.

The improvement in financial conditions and the decline in the dollar last year were, at least partially, the result of the dramatic change in the outlook for reducing future budget deficits. The implementation of the Balanced Budget and Emergency Deficit Control Act of 1985 (Public Law 99-177), together with earlier Congressional action, will reverse the recent trend of rising budget deficits. Although a federal district court recently ruled that certain aspects of the Balanced Budget Act are unconstitutional, the deficit targets established by the act still remain in effect. These targets would lower projected deficits from about $208 billion in the current fiscal year to $144 billion in fiscal year 1987, with annual reductions of $36 billion thereafter. The decline in the structural deficit from fiscal year 1986 to 1987 would be about 1.5 percent of potential GNP, the third largest such reduction in fiscal stimulus since the mid-1950s. By itself, such an abrupt shift in fiscal posture could temporarily slow the economic expansion in 1987. But several other factors--including the decline in the dollar, lower interest rates, and the fall in oil prices--are expected to counteract the contractionary effects of the budget shift.

CBO's new baseline budget estimates show much smaller deficits in the 1987-1990 period than the baseline projection of last summer (see Summary Table 1). While the policies of last year's budget resolution were not fully carried out, Congressional action to date has significantly lowered projected defense and nondefense spending. The projected decline in budget deficits under the policy assumptions of the baseline occurs because revenues are projected to grow in response to both inflation and growth in real incomes, while outlays are projected to grow only slightly faster than the rate of inflation (see Summary Figure 1). The baseline assumes no real growth in defense and nondefense appropriations above a base already cut by the 1986 sequestration called for in the Balanced Budget Act. The additional action needed to comply with the deficit targets amounts to about $37 billion in fiscal year 1987, or $354 billion over the 1987-1991 period.

The sharp decline in long-term interest rates in 1985 seemed to reflect a market expectation of less Treasury borrowing in future years. Sectors of the economy that are interest-sensitive, such as residential construction, already show signs of increased strength. But the major benefit of reduced budget deficits will come, it is generally agreed, in their long-run effects on living standards. Other things being equal, lower deficits should reduce real interest rates and foreign capital inflows, thereby encouraging increased domestic capital formation and reduced foreign indebtedness.

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