A key issue in the political debate about President's Bush proposed tax cut will be the outlook for the federal budget surplus. In our view, the likely budget impact of the current slowdown is sufficiently small that it should not be a deciding factor in the decision over passage of a tax cut bill.

The issue will arise because the debate in Congress this spring will take place against a backdrop of falling demand and some risk of a recession. There is already considerable evidence of declining consumer confidence and expected cutbacks in consumer spending. In response to that decline in consumer spending and to falling profits, businesses will on their part cut back on their outlays for plant and equipment. That combination of factors could push the economy into recession with broad declines in income, production, sales and employment.

But we see three mitigating factors that are likely to prevent the current slowdown from turning into a full blown recession - or at the least, imply that an actual turndown would be mild.

Most notably, recent productivity growth appears to be on a higher trajectory than it had been for at least the previous quarter century. In the last half decade, productivity - or hourly output per worker - has risen about 1.5% more each year than it rose in the previous few decades. This spurt in productivity growth and the higher incomes that have resulted have been the defining characteristics of the current expansion and will provide a cushion for the slowdown. Even with the sharp drop in economic activity toward the end of last year, productivity growth continued strong. That means that average earnings and incomes can continue to rise even with a slowing economy and rising unemployment. At the end of the day, the slowdown will feel like a recession to those who lose their jobs - but most of the labor force will continue to enjoy productivity based increases in income.

Second, the Federal Reserve is prepared to act boldly to prop up demand and still has plenty of scope for stimulating the economy by cutting interest rates. Lower interest rates can stimulate housing demand and, through higher share prices, consumption in general. Even after the recent reduction in the federal funds rate to 6%, that key interest rate remains more than four percentage points higher than the rate of inflation, leaving room for further cuts. Indeed, the financial markets are already expecting a further reduction to 5% by the fall of 2001.

Finally, the very expectation of a substantial tax cut will help to maintain consumer spending. While there will be plenty of wrangling in Congress over the eventual size of the tax cut, consumers probably feel confident already that the outcome will be somewhere between the proposals put forth during the presidential campaign - more than the $700 billion in tax cuts proposed by Al Gore even if less than the $1.3 trillion proposed by George Bush.

These moderating factors underlie the continued consensus projection among forecasters that the economy will expand at a rate of about 2% during the coming year. In this soft landing scenario, what will happen to the size of the federal budget surplus? In a nutshell, if the current slowdown is mild and the economy returns to its previous growth path by 2003, the reduction in the budget surplus should not be significant enough to influence legislative decision making.

To see why we say this, we distinguish between the structural surplus and the cyclical surplus - terms that non-economists may get used to hearing in the next few months as the tax debate plays out. Economists calculate the structural surplus as that surplus that would exist, under the existing tax and spending policies, if the economy operates at a sustainable level of full employment.

When the unemployment rate falls below that sustainable full employment level, as it has in recent years, the actual budget surplus becomes greater than the structural surplus. Economists call that difference the "cyclical surplus". Now that the economy is slowing down, there will be a reduction in that cyclical surplus. The government will collect less in tax revenue as incomes and corporate profits fall. In addition, a slowing economy means more federal government outlays for unemployment insurance, welfare payments and other programs.

Experience shows that every one dollar of cyclical reduction in GDP reduces the budget surplus by about 40 cents. Using that rule of thumb, the cyclical surplus for this year might fall from about $150 billion to about $70 billion even if growth fell to only 1 percent. That's because such a drop in economic growth from the earlier projection of 3 percent growth would be equivalent to a reduction of about $200 billion in GDP from the prior forecast. And 40% of that would be $80 billion.

But even in a scenario that includes an actual downturn in 2001 and a partial recovery in 2002, the budget surplus for 2003 could be back on the track of the Congressional Budget Office (CBO) ten year forecast. Two years of such sharply below par growth in 2001 and 2002 might cut something like $240 billion from the $4.6 trillion of surplus that it forecast over the next ten years, leaving a surplus of more than $4.3 trillion.

While our conclusions are based on rough estimates of uncertain events, the CBO projections that we have used are considered quite conservative. In fact, the Clinton Office of Management and Budget in its final budget calculations raised its projection of the 10 year surplus to more than $4.9 trillion and the CBO is expected to project an even larger revised surplus.

The bottom line is that there are very large budget surpluses ahead that could be used to finance a major tax cut, provide the projected funds for Social Security, meet new spending needs for Medicare and defense, and reduce the outstanding national debt. It is a remarkable opportunity that should not be missed.