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The business situation.


PROFITS from current production-- profits before tax with inventory valuation adjustment (IVA) and capital consumption adjustment (CCAdj)--declined $3 1/2 billion in the second quarter, following an $11 billion increase in the first.

Domestic profits of nonfinancial corporations increased $1/2 billion, following an increase of $2 billion, as a small increase in profits per unit of product more than offset aa small decline in real gross corporate product. The increase in unit profits resulted from a larger increase in unit price than in unit cost.

Domestic profits of financial corporations increased $2 billion, following an increase of $5 1/2 billion, and profits from the rest of the world declined $5 1/2 billion, following an increase of $3 1/2 billion.

Profits before tax.--Profits before tax (PBT) increased $7 billion in the second quarter, following a decline of $11 1/2 billion in the first; an increase of $12 1/2 billion in domestic PBT was partly offset by a decline of $5 1/2 billion in rest-of-world PBT.

The contrast between the increase in PBT and the decline in profits from current production is due to the CCAdj, which declined $4 1/2 billion, and to the IVA, which declined $6 billion. Both of these adjustments are reflected in the current production measure but not in PBT.

The CCAdj is the difference between depreciation based (like PBT) largely on tax accounting, on the one hand, and economic depreciation as defined by BEA, on the other. In the second quarter, as in the first, tax-based depreciation declined slightly while economic depreciation continued to increase; as a result, the CCAdj declined. The decline in tax-based depreciation reflected the provisions of the Economic Recovery Tax Act of 1981, under which newly purchased 5-year assets are depreciated in 1986 at a lower rate than 5-year-old assets that drop out of the depreciation base.

The IVA removes the capital-gains-like element from profits based on tax accounting when inventory prices increase; likewise, it removes the capital-loss-like element when inventory prices decline. In the second quarter, the IVA was positive but smaller than in the first, as overall inventory prices continued to decline but by less than in the first. In manufacturing, inventory prices dropped more than in the first quarter, while in trade, inventory prices generally increased after declining in the first quarter.

Dividends increased $2 1/2 billion. This increase can be viewed as the sum of an unusually large $12 billion increase in net dividend payments by domestic corporations and an unusually large $9 1/2 billion decline in net dividend payments by the rest of the world. Net dividend payments by domestic corporations and by the rest of the world are not independent of each other because most dividends paid by the rest of the world are received by domestic corporations. Thus, a decline in payments by the rest of the world results in a decline in gross dividend receipts by domestic corporations and, accordingly, in an increase in net dividend payments by domestic corporations.

Profits with IVA but without CCAdj.--The quarterly measure of profits available by industry increased $1 billion, following an increase of $14 1/2 billion. Profits of domestic nonfinancial corporations increased $4 1/2 billion, as higher profits in manufacturing and in transportation and public utilities were partly offset by lower profits in trade.

In manufacturing, the profits increase followed two quarters of decline. The only industry not sharing in the increase was motor vehicles, although petroleum's increase reflected special factors. In motor vehicles, profits declined $1.5 billion, to $5 billion, as the domestic output of new autos (see NIPA table 1.18) fell sharply in response to the sluggish sales and resulting large inventory buildup in preceding quarters. In petroleum, profits increased but the increase represented only a partial rebound from a very low first-quarter level that had reflected the payment of a large fine to the U.S. Department of Energy by a major corporation; in the absence of the fine, profits would have declined in both quarters, reflecting the path of petroleum prices. In transportation and public utilities, lower petroleum prices contributed to increased profits.

In trade, most of the decline in profits occured at the retail level, as inventory prices increased and prices of goods sold declined.

Profits of domestic financial corporations were up $2 billion, with property and casualty insurance carriers more than accounting for the increase.

Profits from the rest of the world-- equal to inflows from the rest of the world less outflows to the rest of the world--were down $5 1/2 billion. Inflows dropped $4 billion, with foreign petroleum affiliates accounting for much of the decline, and outflows increased $1 1/2 billion.

Federal Budget Developments

When Congress enacted what became known as the Gramm-Rudman-Hollings Act 9 months ago, it was believed that a course had been found to bring the Federal deficit under control. The course set by the act was to eliminate the deficit by fiscal year 1991 through budget outlay reductions; the act did not provide for tax increases. The outlay reductions were to result from legislative actions, or failing such actions, through automatic cuts. It was also believed at that time that the fiscal year 1986 deficit would be in the low $200 billion range, partly as a result of $11.7 billion in outlays sequestered under the act for that year. Two months later, in the February submission of the fiscal year 1987 budget, the fiscal year 1986 deficit was estimated to be $202.8 billion. (See the February 1986 SURVEY OF CURRENT BUSINESS for a discussion of the act and the 1987 budget.) Seven months later, in the mid-session review of the 1987 budget, the 1986 deficit was estimated to be $230.2 billion, $17.9 billion higher than the record 1985 deficit.

This article first reviews budget developments since February on the basis of the mid-session review of the 1987 budget and then, taking off from the sequestration report submitted in August, discusses the current status of the Gramm-Rudman-Hollings legislation and its role in determining the 1987 deficit.

The mid-session review

Revised estimates of Federal unified budget receipts and outlays for fiscal years 1986 and 1987 were submitted to Congress by the Office of Management and Budget in early August. These estimates reflect revised economic assumptions, reestimates of tax collections and agency spending based on more recent experience, policy changes, and legislation passed by Congress since the February budget. The estimates do not include the proposed Tax Reform Act of 1986.

On the basis of the revised economic assumptions, real GNP increases less in calendar year 1986 than expected earlier this year (table 1). From the fourth quarter of 1985 to the fourth quarter of 1986, real GNP is expected to increase 3.2 percent, almost a percentage point less than estimated in February. This lower growth is the result of a weaker-than-expected first half of 1986. Real GNP is expected to increase 4.0 percent through the second half of 1986 and to increase at 4.2 percent through 1987. According to the administration, "the steep decline in oil prices and interest rates, and the appreciation of foreign currencies relative to the dollar have improved the economic outlook for 1987.' Consumer prices rise considerably less in 1986 than expected in February--0.6 percent compared with 3.7 percent. The unemployment rate is unchanged, and the interest rate on 91-day Treasury bills is lower than expected earlier.

For fiscal year 1986, a $230.2 billion deficit is estimated, compared with $202.8 billion in February (table 2). Receipts are $11.9 billion lower; revised economic assumptions--primarily lower personal incomes and corporate profits--account for $11.0 billion of the revision.

Outlays in 1986 are $15.5 billion higher; upward revisions of $16.0 billion due to reestimates and policy changes were partly offset by a $0.5 billion downward revision due to revised economic assumptions. On a program-by-program basis, the revision is the net of $24.9 billion in upward revisions and $9.5 billion in downward revisions. The largest upward revisions were for national defense ($5.6 billion) and for the Commodity Credit Corporation (CCC) ($5.1 billion). The sources of the revision in national defense were not detailed. The revision in CCC is due to changes in the 1986 crop forecast. Other major upward revisions are $2.6 billion for the Federal Deposit Insurance Corporation, reflecting more bank failures than expected earlier, and $1.2 billion due to the delay in the sale of Conrail. The largest downward revision is for net interest ($3.9 billion), largely reflecting lower interest rates.

For fiscal year 1987, a deficit of $143.9 billion is estimated, compared with $143.6 billion in February. Receipts are $19.2 billion lower; downward revisions of $19.7 billion and $0.4 billion due to revised economic assumptions and policy changes, respectively, were partly offset by a $0.9 billion upward revision due to reestimates.

Outlays in 1987 are $18.9 billion lower--revised economic assumptions contributed $12.7 billion; reestimates, $3.9 billion; and policy changes, $2.3 billion. On a program-by-program basis, the revision is the net of $30.3 billion in downward revisions and $11.4 billion in upward revisions. The largest downward revisions are for net interest ($9.0 billion), largely reflecting lower interest rates; social security ($4.9 billion), which will be discussed later; medicare ($3.8 billion), reflecting new payment regulations; and CCC ($1.8 billion), reflecting the revised crop forecast. The largest upward revisions are for the outlays against which Outer Continental Shelf receipts are offset ($2.4 billion), reflecting the effect of the drop in oil prices on those receipts, and for the Agricultural Credit Insurance Fund ($1.0 billion), reflecting lower-than-anticipated loan repayments.

As pointed out in the preceding paragraph, social security was revised down $4.9 billion. This total reflects two downward revisions--the removal of a proposed 3.7-percent COLA, effective January 1, 1987 ($5.5 billion) and fewer beneficiaries than previously estimated ($0.6 billion)--and an upward revision from a proposed 0.8-percent COLA in January 1987 ($1.2 billion). Under current law, the social security COLA is equal to the third-quarter-to-third-quarter increase in the Consumer Price Index (CPI) if the CPI increase is 3 percent or more; if the increase is less than 3 percent, no COLA is triggered. According to the revised economic assumptions, the CPI will increase 0.8 percent from the third quarter of 1985 to the third quarter of 1986, compared with 3.7 percent in the earlier economic assumptions. The administration proposes to pay a 1987 COLA based on the revised assumptions, although a COLA is not required by law. (Independently, Congress is considering a similar action.)

Revised NIPA estimates.--BEA has prepared estimates of the Federal sector on the national income and product account (NIPA) basis consistent with the revised unified budget estimates (table 2, and table 3 for the quarterly pattern). On this basis, fiscal year 1986 receipts are $12.8 billion lower, expenditures are $8.7 billion higher, and the deficit is $21.5 billion higher than estimated in February.

All categories of receipts, except contributions for social insurance, are revised down in fiscal year 1986. The largest declines are in corporate profits tax accruals ($7.8 billion), reflecting lower profits in the revised economic assumptions, and in indirect business tax and nontax accruals ($4.0 billion), reflecting lower windfall profit taxes.

The upward revision in expenditures is largely accounted for by purchases of goods and services. National defense purchases are revised up $2.9 billion, and nondefense purchases are revised up $5.5 billion. Within nondefense purchases, the purchase of agricultural commodities by the OCC are revised up $3.8 billion, reflecting the revised crop forecast, and all other purchases are revised up $1.7 billion. On balance, all other expenditures are revised up $0.3 billion, the net of $5.6 billion in upward revisions and $5.4 billion in downward revisions. The upward revisions are for subsidies less the current surplus of government enterprises ($2.5 billion), reflecting higher agricultural subsidies; for grants-in-aid to State and local governments ($2.3 billion); and for transfer payments to persons ($0.8 billion). Partly offsetting these increases are downward revisions in net interest paid ($3.2 billion), largely reflecting lower interest rates, and in transfer payments to foreigners ($2.2 billion).

For fiscal year 1987, receipts are $15.5 billion lower, expenditures are $10.6 billion lower, and the deficit is $4.9 billion higher. The downward revision in receipts is more than accounted for by corporate profits taxes ($12.1 billion), down for the same reason as in 1986, and by indirect business taxes ($5.0 billion), reflecting, in part, the windfall profit tax. In February, receipts of this tax were estimated at $2.7 billion, but with the steep decline in oil prices, it is now estimated that there will be no receipts from this tax in 1987.

The revision in expenditures is the net of $16.0 billion in downward revisions and $5.4 billion in upward revisions. The downward revisions are for net interest ($7.7 billion), down for the same reason as in 1986; for transfer payments to persons ($3.3 billion), reflecting the revised social security COLA; for foreign transfers ($2.8 billion); and for subsidies less current surplus ($2.2 billion), reflecting lower agricultural subsidies. The upward revisions are for grants-in-aid ($3.4 billion) and for purchases of goods and services ($2.0 billion).

Table 4 shows the relation between unified budget receipts and NIPA receipts, and table 5 shows the relation between unified budget outlays and NIPA expenditures.

Cyclically adjusted deficit.--As measured using cyclical adjustments based on middle-expansion GNP, the Federal deficit on the NIPA basis increases $10.7 billion in calendar year 1986, a relatively modest increase (table 6). On a quarterly basis, the deficit peaks in the second quarter of 1986, then declines every quarter through the end of fiscal year 1987. The cyclically adjusted budget based on middle-expansion trend GNP is associated with a middle-expansion trend unemployment rate of 7.4 percent. The cycically adjusted deficit on a 6-percent unemployment rate is lower, but follows the same quarterly pattern.

The sequestration report

In late August, the Congressional Budget Office (CBO) and the Office of Management and Budget (OMB) submitted to Congress the initial sequestration report for fiscal year 1987. This report was the first step in the Gramm-Rudman-Hollings process designed to reduce the 1987 deficit, if necessary, to the $144.0 billion deficit limit. Under this process, CBO and OMB were required to prepare economic assumptions and a base-line budget based on projections of receipts and outlays under current laws. Spending or tax changes in the proposed congressional budget reconciliation were not included because the resolution had not yet been passed. Based on this base-line budget, potential outlay reductions needed to reduce the deficit to the required limit were calculated.

The original act required that the sequestration report was to be transmitted to the Comptroller General of the General Accounting Office (GAO), reviewed and changed, if necessary, and then forwarded to the President on August 25. However, the Supreme Court, in early July, ruled this part of the process unconstitutional, on the ground that GAO's involvement violated executive authority. Under another provision of the act, the 1987 report was sent, instead, directly to Congress. A special budget committee, comprised of members of the Senate and House budget committees, are to report a joint resolution affirming the outlay cuts. The joint resolution would then have to pass both chambers and be signed by the President (or be passed again over a veto) to take effect. A revised sequestration report reflecting congressional actions is due October 5.

Table 7 shows the economic assumptions underlying the sequestration report, and table 8 shows the base-line budget and the proposed specified outlay cuts for 1987. It should be pointed out that the base-line budget in the report and the unified budget estimate for 1987 in the mid-session review are not the same. As mentioned above, the base-line budget is based on current laws as of August 15; the unified budget estimate includes administration fiscal policy proposals.

According to the sequestration report, the 1987 deficit will exceed the limit by $19.4 billion and, therefore, outlays will have to be cut by that amount if Congress and the administration fail to agree on an alternative policy. National defense outlays that are not exempt will have to be cut $9.7 billion, or 5.6 percent across the board. Nondefense outlays that are not exempt will have to be cut $9.7 billion also, or 7.6 percent across the board. National defense outlays subject to the across-the-board cut amount to $169.0 billion; nondefense outlays amount to $107.8 billion. Within national defense, 1987 outlays for military personnel are not exempt as they were in 1986 and would incur the largest dollar cut. According to CBO, such a cut in military personnel outlays would result in a furlough of 200,000 military personnel. Within nondefense, the largest cuts would occur in agriculture ($1.7 billion, including $0.9 billion for CCC), medicare ($1.3 billion), and international affairs and income security ($0.8 billion each).

Congress can minimize the potential 1987 outlay cuts by applying a $10.0 billion deficit limit margin provided by the act. Applying that margin means that outlays would have to be reduced only $9.4 billion to reach a $154.0 billion deficit for 1987. Congress could achieve that deficit in either of two ways: (1) Allow an $11.0 billion receipts windfall in 1987 from the proposed Tax Reform Act of 1986 to count as a deficit reduction measure, or (2) enact the fiscal year 1987 congressional budget resolution, which mandates $9.2 billion in savings through reconciliation, in which laws are changed to reduce spending or increase taxes. Each way has problems, however. Counting the windfall from the tax reform in 1987 implies that a $17.0 billion shortfall in 1988 (the estimates are from the Joint Committee on Taxation) would also have to be counted, making it more difficult to meet the 1988 deficit limit of $108.0 billion. The budget resolution proposes $7-$9 billion in savings in appropriation bills, but these bills were, when Congress recessed, running about $1 billion over the resolution's combined target.

Neither the administration nor Congress desires to have the automatic outlay cuts take effect. OMB has stated that the defense cuts are not acceptable, and one of the principal sponsors of the act has stated that the uniform cuts are "not going to happen.' It is generally believed that Congress will find an acceptable alternative way to reach the deficit limit. It must be found soon, however, because Congress has scheduled October 3 as the target for adjournment.

As of late September, the Senate had approved a bill that reduced the deficit $13.3 billion, mostly by asset sales, improved tax collection procedures, and shifting of outlays into fiscal year 1986. Asset sales include $2.1 billion from the already-planned sale of Conrail and $5.0 billion from the sale of loans. The improved tax collection procedures would increase receipts about $4.0 billion, through the acceleration of collections and strengthened tax-collection efforts. The bill also requires the Department of Treasury to pay the fourth-quarter payment ($680 million) of general revenue sharing to local governments by September 30--the end of fiscal year 1986. Legislation that generally paralleled the Senate bill was being prepared in the House except that the House version included an additional $2.0 billion in deficit reductions, largely through cuts in medicare and other spending.

Second-quarter NIPA revisions

The 75-day revisions of the national income and product accounts estimates for the second quarter of 1986 are shown in table 9. The revised estimate of the second-quarter increase in real GNP is unchanged from the estimate issued a month ago; upward revisions in some components were offset by downward revisions in others. The largest upward revision, $3.5 billion, was in change in business inventories, and the largest downward revision, $3.4 billion, was in net exports.

Table: 1.--Economic Assumptions Underlying the Mid-Session Review of the Fiscal Year 1987 Budget

Table: 2.--Federal Government Receipts and Expenditures

Table: 3.--Federal Government Receipts and Expenditures, NIPA Basis

Table: 4.--Relation of Federal Government Receipts in the National Income and Product Accounts to the Unified Budget

Table: 5.--Relation of Federal Government Expenditures in the National Income and Product Accounts to the Unified Budget

Table: 6.--Cyclically Adjusted Surplus or Deficit (-), NIPA Basis

Table: 7.--Economic Assumptions Underlying the Fiscal Year 1987 Sequestration Report

Table: 8.--Base-line Budget and Specified Outlay Reductions for Fiscal Year 1987

Table: 9.--Revision in Selected Component Series of the NIPA's, Second Quarter of 1986
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Title Annotation:Second quarter, 1986
Publication:Survey of Current Business
Date:Sep 1, 1986
Previous Article:Foreign direct investment in the United States: detail for position and balance of payments flows, 1985.
Next Article:National Income and Product Account tables.

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