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/69? 105Ti CONGRESS 1st Session O EREETAIE I *J HOS HOUSE OF REPRESEN | REPORT 105-393 THE 1997 JOINT ECONOMIC REPORT RE P 0 R T OF HE: JOINT ECONOMIC COMMITTEE CONGRESS OF THE UNITED STATES ON THE 1997 ECONOMIC REPORT OF THE PRESIDENT NovmanER 8, 1997.-Conmitted to the Committee of the Whole House on the State of the Union, and ordered to be printed US. GOVERNMENT PRINTING OmCE WASHINGTON 1997 JOINT ECONOMIC COMMITTEE [Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress] House of Rqeresentuave. JIM SAXTON, New Jersey, Chairnan THOMAS W. EWING, Illinois MARK SANFORD, South Carolina MAC THORNBERRY, Texas JOHN DOOL1TFLE, California JIM McCRERY, Louisiana FORTNEY PETE STARK, Califhrnia LEE H. HAMILTON, Indiana MAURICE D. HINCHEY, New York CAROLYN B. MALONEY, New York Senate CONNIE MACK, Florida, Vice Chairman WILLIAM V. ROTH, JR, Delaware ROBERT F. BENNETT, Utah ROD GRAMS, Minnesota SAM BROWNBACK, Kansas JEFF SESSIONS, Alabama JEFF BINGAMAN, New Mexico PAUL S. SARBANES, Maryland EDWARD M. KENNEDY, Massachusetts CHARLES S. ROBB, Virginia CHRISTOPHER FRENzE, Executive Director HowARD ROSEN, Minority StaffDirector (I) LETTER OF TRANSMITTAL CONGRESS OF THE UNITED STATES, JOINT ECONOMIC COMMITITEE, Washington, DC, November 8, 1997. . Hon. NEWT GINGRICH, Speaker of the House, House of Representatives, Washington, DC. DEAR MR. SPEAKER: Pursuant to the requirements of the Employment Act of 1946, as amended, I hereby transmit the 1997 Joint Economic Report. The. analyses and conclusions of this Report are to assist the several Committees of the Congress and its Members as they deal -with economic issues and legislation pertaining thereto. Sincerely, JIM SAXTON, Chairman. (III) CONTENTS Page ............................................................... JOINT ECONOMIC COMMITTEE MAJORITY .............................................................. The Roots of the Current Expansion .............................................................. ECONOMIC GROWTH IN 1997 SUMMARIES OF SELECTED JOINT ECONOMIC COMMITTEE STUDIES .............................................................. 1 3 5 MAJORITY STAFF Monetary Policy ............................................................... ...................... Lessons From Inflation Targeting Experience .................. The Importance of the Federal Reserve .............................. .................... ....................... Establishing Federal Reserve Inflation Goals ................. ...................... A Response to Criticisms of Price Stability ....................... ................ Transparency and Federal Reserve Monetary Policy ............. Tax Policy ............................................................... ..................... Taxes and Long-Term Economic Growth ........................... ............. The Administration's Proposal for a Tuition Tax Credit .......... The Welfare-to-Work Tax Credit .............................................................. The Inefficiency of Targeted Tax Policies ........................... ..................... .................... The Economic Effects of Capital Gains Taxation ............... Optimal Capital Gains Tax Policy: Lessons From the 1970s, 1980s and 1990s ............................................................... ..................... Payroll Taxes and the Redistribution of Income ............... ............................................. Other Selected Topics .................. ......................................... Tradable Emissions ..................... ......... College Affordability: Tuition Tax Credits vs. Saving Incentives .............................. Budget Process Reform ................................ 17 19 19 19 19 19 20 21 21 21 21 21 21 22 22 22 22 22 23 105TH CONGRESS Ist Sessin I HOUSE OF REPRESENTATIVES REPORT 105-393 THE 1997 JOINT ECONOMIC REPORT NOVEMBER 8, 1997.-Committeed to the Committee of the Whole House on the State of the Union and ordered to be printed Mr. SAXroN, from the Joint Economic Committee, submitted the following REPORT Report of the Joint Economic Committee on the 1997 Economic Report of the President ECONOMIC GROWTH IN 1997 The economic expansion that began in the second quarter of 1991 continues to generate economic and employment gains, even as the inflation rate continues to decline. Economic growth has been solid over the last four quarters, and employment growth has been sufficient to push the civilian unemployment rate below 5 percent. The overall economic situation is sound and the outlook for continued growth remains healthy. Among the positive labor market indicators are the lowest unemployment rate in 24 years, near-record highs in the employmentpopulation ratio and labor force participation rate, and continued growth in payroll employment (according to the Bureau of Labor Statistics, establishment survey). On the other hand, continued stagnation in earnings and income for middle and low-income workers, according to a variety of measures, remains a concern. The sustained economic growth of recent years has contributed to reducing the federal budget deficit and has improved the fiscal situation at the state level as well. Furthermore, the healthy economic environment eases the implementation of policy changes such as deficit reduction and welfare reform. A sustained and stable economic expansion is an ideal time to address other structural issues in federal policy as well. The challenge for federal policy is to build on the progress made to date in removing impediments to economic expansion, improving the potential for economic growth and raising U.S. living standards. (I) 2 Joint Economic Committee The operations of the Joint Economic Committee (JEC) have been focused on the needs of Congress and the public in the 105th Congress. The goals of maximum efficiency, quality, and productivity have guided the Committee in meeting resource constraints and managing Committee functions and procedures. As a result, the Committee has enjoyed a very productive year, and we are naturally pleased that JEC research products and hearings have been well received. In the First Session of this Congress, the JEC released more than 25 studies and reports and held 17 hearings. The emergence of the information age over the last two decades has caused enormous changes in the economy and in the dissemination of information. As a result, brevity and timeliness are at a premium. Consequently, the format of JEC research products has changed in the 105th Congress. Shorter studies substantively addressing issues raised in the Economic Report of the President as well as other issues before Congress have proven quite effective. This emphasis on substance, reliability, timeliness, and conciseness will continue to be characteristic of the JEC in the next session of Congress. In conclusion, 1997 has been a successful year for the Joint Economic Committee. We are looking forward to another constructive year when Congress returns in 1998. REPRESENTATIVE JIM SAXTON, Chairman. SENATOR CONNIE MACK, Vice Chairman. SENATOR JEFF BINGAMAN, Ranking Minority Member. 3 JOINT ECONOMIC COMMITTEE MAJORITY 5 THE ROOTS OF THE CURRENT ExPANSION A JOINT ECONOMIC COMMM rEE STUDY Jim Saxton (R-NJ) Chairman Joint Economic Committee United States Congress April 1997 Executive Summary After briefly summarizing recent macroeconomic experience, this paper explains why the current economic expansion has been sustained - despite growing tax burdens partly related to the Budget Act of 1993. The key reasons for this sustained recovery include. * The economic and financial market stabilizing effects of a credible antiinflationary monetary policy. * The fact that monetary policy has produced stable growth in total spending dominating fiscal policy's influence on both aggreg te demand and interest rate moveenets. The paper concludes with an assessment of the longer term prospects for growth. -.E- ta' C m-- D WF*,sUZ205101 i22422517 P F be- Ad 7 TME ROOTS OF THE CURRENT EXPANSION INTRODUCTION After briefly summarizing recent macroeconomic experience, outlining salient features of the current expansion, and discussing likely near-term trends, this paper explains why the current expansion has been sustained - despite growing tax burdens partly related to the Budget Act of 1993. The key reasons for this sustained recovery include: * the economic and financial market stabilizing effects of a credible anti-inflationary monetary policy; * the fact that monetary policy has produced stable growth in total spending, dominating fiscal policy's influence on both aggregate demand and interest rate movements; and * the export-promoting effects of lowered tariff barriers and free trade. The paper then briefly assesses both longer term economic prospects and likely future Federal Reserve policy action. RECENT PERFORMANCE OF THE MACRO ECONOMY The current economic expansion is now six years old and continues to proceed at a moderate, albeit below-normal pace. Despite a frequent "saw-tooth pattern" in various month-tomonth or quarter-to-quarter economic statistics, the current expansion has persisted, now ranking among the longer post-World War 11 economic expansions. Furthermore, this sustained expansion is expected to continue into the foreseeable future since no obvious cyclical imbalances are evident that have disrupted earlier recoveries.' Cbaraeteristics of the CurrentExpansion A SuomnedIRecowy While the current expansion would rank below average in terms of its overall strength compared to earlier recoveries of comparable length, this recovery has been remarkably sustained. Real gross domestic product (GDP) growth, for example, has averaged 2.4 percent compared to 'In particular, inventory imbalances, coporate or bank baance-sheet distortions, overbuilding inthe constnction indusny, resurgens of inflation, or sharp interest rate increases are neither evident nor expected. 8 2 Joint Economic Committee Study earlier expansions of similar length of about 3.6 percent (see Chart 1). Yet, the recovery has lasted 72 months compared to the average post-war peacetime expansion of 43 months'. Similarly, nominal GDP growth has expanded at a sustained pace of 5.0 percent, somewhat below its typical post-war recovery growth rate (see Chart 2). Real GDP ,.. La 3.7% s.Es 2.3% LO Lo " Ls 3l 1 as: i Other aggregate measures of economic activity tell a similar story. The ma expansion's employment growth, for example, has been sustained, but below average when compared to earlier cycles (see Chart 3). Partly because of weak labor force growth, however, the unemployment rate has dropped considerably to 5.3 percent. This recovery's increases in wage income and productivity growth 7 1 have been especially sluggish by historical 2 standards. In fact, real median weekly , s earnings have actually fadlen since 1993; J .0 Ckn ml m. -. 19993 199 9999 199 Fa-. Chart I Nominal GDP 5.8s 41% %la lA] annual data show a continuous decline of real earnings during this period. These earnings data suggest some groups have not participated in the recovery. Specifically, unlike during previous expansions, many middle class income earners have not shared in the gains attained by others during this expansion. LS LO 9991 cFA. am ,M 99. a9 .999 . .,,,-. Chads 2 Enployment Growth 35% 3.11n While most private-sector GDP , 2.01. components have shared in this moderate } uI1% below-average growth, a few sectors u +% have made notable, healthy contributions. One such sector which led the recovery '9 was investment spending, especially 4S% equipment investment. Information procL essing investment accounts for a sizable 999s999 1 am am9 1 919 999 199 portion of this increase. Another notable ac sector contributing significantly to the reChart 3 covery was the export sector. Export growth has consistently exceeded GDP growth; therefore, this sector's GDP share has steadily grown during this expansion. Inventory investment, however, has been increasingly better man'Source: National Bureau of Economic Research,Inc. 9 3 The Roots of the Currein Expnsion aged, as evidenced by lower inventory/ Inventory to Sale Ratio sales ratios (see Chart 4). This develop- ment, of course, enhances the likelihood of continued economic expansion since "5 ; it minimizes the likelihood of important inventory corrections. 174 1 2I- 's Lower, More Stable Inlahlion j Another important characteristic of -\ _ _\ __ __ _ this expansion is the notable absence of inflationary pressures that have often plagued previous recoveries. Most broad- IM4 1u'4 .--. - 194 1s- CPI Core Rate " .4 . Ij 3. % 3o. LS Lo t + I 1593 I IM _ff c-' -t 1994 19" * -_ - Chart 5 This benign infla- Commodity Prices tion performance has a Mooit D0.5 number of important implications which will 120 _ | l l 5995 m9 19r / Be So:Jo.odfCo-. 3 3.7% U" inflation, currently remain well behaved (see Chart 6). 70 _ 19m, soo M&Is * IS'. Chart 4 based measures of inflation (such as GDP deflators, the Consumer Price Index, and the Producer Price Index) have been remarkably well-behaved (see Chart 5). Similarly, wage costs remain relatively tame despite unemployment rates remainmg below these levels previously associated with rising price and wage pressures. Furthermore, forward-looking market price indices (such as various commodity price indicators), which in the past have accurately signaled rising expectations of future 1i ; loo _ . s 1* 7.' 'vls I 1soo I2 important to note that the gradual diminution of I 1s93 l1 Mo Chart 6 further examined bebe low. Nonetheless, it is 1"t4 Pr-sb, 1997. inflation and expectations of future inflation have been associated with a gradual reduction 'Comodity prices (as measured by the Jostnal of Commercecommodity price idex) began increasing in le accompsnied by a 300 basis-point increase in the Fed funds rate (from Febnuary 1993. This incrase was soon 1994 to late January 1995). In short, the Federal Rescrvc responded to forwand-looking signals of heightened inflationary expeeations and acted pre-emptiely to stile such expectations before the increases became self- fulffirln&: 10 Joint Economic Committee Study 4 of both short- and long-term interest rates (see Charts 7 and 8). At the same time, it is noteworthy that this lower, more stable inflation is associated with reduced inflation volatility (as well as lower volatility of inflationary expectations). Accordingly, those financial markets sensitive to inflation expectations will be more stable than otherwise. This enhanced financial market stability is evi- dent in recent years' performance of the bond, money, commodity, foreign ex- Inflation v. Long-Te.r ,. _ - _ . _ Intemt Rate. I _ AY J TA ._ . _ - l l l-l _ In change, and equity markets. Expansion Eqaeded to Continue The current expansion is expected to continue; consensus forecasts call for continued expansion of real GDP in the neighborhood of 2.5 to 3.2 percent in 1997. The reason for this expected continued expansion is that no important imbalances have emerged that typically have derailed expansions in the past. In par- Chart7 Inflation vs Short-Term nteret Rate. - m - _ ticular, inflation appears to be in check _ , with little evidence of an imminent resur-gence. Accordingly, none of the imbal_ , I. ances typically associated with inflation or expected inflation are evident; i.e., Chart a neither individuals nor businesses appear to be making decisions based upon expectations of important increases in inflation. More specifically, total debt is rising but relatively slowly, and the overall balance sheets of individuals, businesses, as well as banks appear to be in reasonably good shape. Banks, for example, are much better capitalized than they were earlier in the decade. The commercial real estate overbuilding which characterized the late 1980s appears to be significantly worked off Inventories are increas- ingly better managed with current inventory-to-sales ratios low by historical standards.4 Furthermore, no important policy adjustments are anticipated that could derail the recovery. Should monetary policy be adjusted, sharp interest rate movements are not anticipated; the Federal Reserve appears to be close to a "neutral" monetary policy stance so that any changes will likely be marginal in nature. Currently, only a modest Federal Reserve tightening is imbedded in short-term interest rate fiutures markets. Similarly, no sharp change of fiscal policy is anticipated that might disrupt the economic expansion; viewed from a conventional perspective, fiscal policy is expected to remain modestly restrictive since it has been constrained by concerns about budget balance. Betsh lower, more stable inflation and technological advances Gartly explain this improved management 11 The Roots of the Current Expansion 5 REASONS FOR THE SUSTAINED ECONOMIC ExPANSION Perhaps the distinguishing characteristic of the current expansion is its sustainability. In particular, this expansion has persisted despite recent increases in tax (and regulatory) burdens as epitomized by the Budget Act of 1993. The expansion has continued because certain positive factors have worked to offset the perverse effects of these recent tax increases. The key positive ingredients contributing to this offset include: I) the potent stabilizing effects of a credible price stabilizing monetary policy; 2) the stable expansion of aggregate spending and output which has been principally determined by monetary, not fiscal, policy and which has contributed significantly to reduction in the budget deficit, and 3) the export-promoting effects of lowered tariff barriers. The Stabilizing Effects of a Credible, Price-Stabilizing Monetary Policy A key ingredient of recent Federal Reserve monetary policy has been a persistent emphasis on price stability as a key policy objective. Federal Reserve officials have repeatedly endorsed the goal of price stability in speeches, testimony, interviews, and official publications. The preemptive policy move to tighten monetary policy, beginning in February 1994, was important in demonstrating that these public pronouncements were genuine; the move also served to condition market expectations, thereby, enhancing the Federal Reserve's inflation-fighting credibility. Market participants now expect Federal Reserve policy action at the first signs of resurgent inflation. As a result of these actions, most broad-based measures of inflation registered modest increases and continued to moderate. Indeed, a sustained reduction of inflation has brought some broad-based measures of inflation to their lowest rates of inflation in 30 years.' And few signs suggest that a meaningful resurgence of inflation is imminent. This credible, sustained reduction in inflation has several very important implications relating to the durability of the expansion: * Lowers interest rates: First, this convincing, sustained reduction in inflation has gradually lowered expectations of fiuture inflation. Accordingly, the inflationary expectation's component of interest rates dissipated from the structure of both shortand long-term interest rates; interest rates are lower as a result (see Charts 7 and 8). * Stabilizes financial markets and interest sensitive sectors: Second, as inflation diminishes, the variability of inflation also is reduced. Lower inflation is associated with lower volatility of inflation. Accordingly, financial markets have less tendency to overshoot or undershoot their fundamental values. This lower volatility has the effect of reducing uncertainty premiums of interest rates; financial markets tend to become more stable and predictable. In short, lower inflation stabilizes financial markets. 'GDP prices in faurlth-uarter of 1996 measueed by the chaintype GDP price index, for example, registered the lowest yearlyear percent change in 30 years 12 6 Joint Economic Committee Study As a result, market participants tend to become more confident or self-assured and more willing to invest, take risk, and innovate. Businesses are able to better plan, coordinate, and control inventories, thereby improving efficiency. Furthermore, this enhanced financial stability works to stabilize various interest-rate sensitive sectors of the economy and, therefore, the macro economy as well. 6 * Enhances workings of the price system: Third, lower inflation is associated with lower (relative) price dispersion. Lower inflation Iowers the variability between individual prices or reduces the noise and distortions in the price system. 7 As a result, the price system can better serve its information and aflocative functions. Consequently, the economy operates more efficiently and, therefore, grows faster. * Acts like a tax cut: Fourth, lower inflation is analogous to a tax cut in several important ways. Like a tax cut, for example, lower inflation removes distortions in the price system. Lower inflation minimizes those interactions of inflation with existing nonindexed portions of the tax code that effectively result in higher taxation.' Furthermore, lower inflation effectively lessens inflation as a source of government revenue; it minimizes seignorage as well as govemment's ability to reduce its outstanding debt via inflation. In short, credible disinflation works to lower interest rates, stabilize financial markets and interest-sensitive sectors of the economy, promote efficient operation of the price system, and effectively lower taxation. All of these effects contribute to promoting the sustainability of the expansion. The Gradual but Stable Deceleration of Total Spending Another contribution to the expansion's persistence has been the Federal Reserve's management of nominal aggregate demand; the macro economy has experienced a very gradual but stable deceleration of aggregate spending. Nominal aggregate spending is principally determined by monetary, not fiscal, policy, and it must be reduced in order to diminish inflation. 9 Accordingly, 6 This enhanced stability is documented in G. Bigg, "Why Has the Economy Become Less Volatile?," Prudential Economics. November 1996, volume 12, number It. This analysis shows that real GDP growth has become less volatile in recent years. The standard deviation of real GDP growth has fallen significantly from 1985 (as has a moving 20-quarter-slandard deviation of real GDP growth). The primary reason for this reduction is a large decline in the volatility of the interest rate sensitive sectors of the economy (consumer durables, equipment investment, and residential spending). 7 Sbe, for example, Guy Debelle and Owen Lamont, "Relative Price Variability and Inflation: Evidence from U.S. Cities," Journal of Political Economy, February 1997, vol. 105, no. 1. 8 Remaining portions of the tax code that are not indexed, for example, include capital gains taxation, estate taxation, and forms of corporate taxation. 'Articles reviewing the argument that monetary policy dominates fiscal policy as a determinant of aggregate spending include, for example, Bennet T. McCallum, "Monetary Versus Fiscal Policy Effects: A Review of the Debate," in The Monetary Versus Fiscal Policy Debate Lessons From Two Decades, edited by R.W. Hafer, Rowman &Allanheld Publishers, Totown, N.J., 1986 (see esp. pp. 10, 23-24); and Lawrence Meyer and Robert Rasche, "Empirical Evidence on the Effects of Stabilization Policy," Stabilization Policies: Lessons From the '70't and Imolications for the '80's. Center for the Study of American Busness, 1980 (see pp. 51,54). 13 The Roets of the Current Expansio 7 the way in which the Federal Reserve manages the required reduction in aggregate spending is important in determining the expansion's durability. Nominal GDP . I,, 14. . . 1 a . 9, I 12% In recent years, the Federal Reserve - while maintaining a focuson price stability - has conducted monetary policy so as to foster the forward momentum of spending growth while at the same time very gradually reducing its growth. This has worked to slowly squeeze inflation out of the system while at the same time allow for stable real GDP growth. Specifically, the Federal Reserve has adopted a "gradualist" approach to managing aggregate demand so that nominal GDP growth decelerates in a very gradual manner. Over the last 12 quarters, for exampie, nominal GDP growth has ad- _ 1_ 4 _ I growth since the early 1980s has two 156 156 ima Le5 i4 1196 Chart 9 Real GDP fII ITI I I II _ - 6% - - 5% j vanced at about 5 percent annual-*Al ized. The Fed's central tendency forecast for fourth-quarter nominal *t GDP for 1997 over 1996's fourthquarter is 4.50 to 4.75 percent. Thus, the Federal Reserve expects a modest slowdown. Nominal GDP's a 1564 .edora [I Il Li :1\j-a I ^ 1'. 1H I IL 1 l/1 i1 2= _ A* 0 I I lIi 2% 2 IMs 199 i. 1w >Ra important characteristics: downward long-term trend growth and successively lower peaks in nominal GDP growth (see Chart 9). Chart 10 I The Federal Reserve, therefore, has not attempted to achieve price stability too quickly, to avoid jolting or shocking the economy into a slowdown or recession. By avoiding such sharp disruptions, monetary policy has not been subject to the subsequent strong political pressures to "jump start" or reinflate the economy, thereby re-introducing the type of stop-go policies that historically produced policy-induced business cycles. By conducting policy in this gradualist manner, the Federal Reserve has sustained the expansion. Real GDP growth, for example, has persisted, albeit at a below-normal rate of about 2.6 percent annualized since the expansion began in the second-quarter of 1991. Notably, unlike the downward stopping trend characterizing the growth of nominal GDP, real GDP trend growth is positive, albeit only modestly so. Furthermore, successive peaks in real GDP do not show the downward trend evidenced by those of nominal GDP (see Chart 10). - 14 s Joint Economic Committee Study The stable growth in GDP in recent years not only has fostered the durability of the current expansion but has contributed importantly to reducing the Federal budget deficit.'° Tax revenues, for example, have consistently been stronger than expected. In promoting the above-described stable growth in total spending, monetary policy has dominated fiscal policy's influence on both aggregate demand and interest rates." The Export-Promoting Effects of a More Open Economy Persistent growth in exports, related to lower trade barriers implemented in recent years, has also contributed to the sustained nature of this expansion. The U.S. economy has become increasingly open as measured by the fraction of GDP accounted for by the sum of what is exported and imported.' 2 Moreover, export growth has exceeded GDP growth in every year of this expansion. Accordingly, exports have become a steadily larger fraction of GDP (increasing from about 10 percent in 1991 to about 12 percent in 1996). The U.S. dollar, of.course, has helped to foster this export growth since, in general, it has been relatively stable, especially when viewed historically and measured on a trade-weighted basis. Furthermore, the growth and increasing openness of newly emerging markets also have supported this growth and have helped exports contribute to the sustained U.S. expansion. LONGER TERM PROSPECTS FOR GROWTH While near-term economic activity has been sustained principally by the judicious, gradual disinflation of the Federal Reserve, monetary policy's ability to enhance long-term economic growth is limited to minimizing the growth-inhibiting effects of inflation. Monetary policy, therefore, can help to foster an environment in which growth can occur but has little influence on actually promoting the long-term growth potential of the economy. As indicated above, while this expansion's longevity is impressive, its overall strength is well below that experienced in typical recoveries in the past. Furthermore, such modest growth is expected to persist into the foreseeable fuiture. Part of the reason for this below-average performance has been perverse fiscal and regulatory policy in recent years. Although marginal income tax rate increases in 1990 and 1993 retraced only a portion of the marginal rate cuts of the 1980s, other forms of taxation have steadily increased. Increases have occurred in payroll taxes, excise taxes on gasoline, alcohol, tobacco, and various luxuries, state and local taxes, and federal user fees. Additionally, because significant portions of the tax code are not indexed for "'For documentation of this assertion, see Chris Frenze, Whither the Budget Deficit - and Economy?, Joint Econormic Committee study, July 1996. "For a survey of the relationship between deficits and interest rates, see George Iden and John Sturrock, 'Deficits and Interest Rates: Theoretical Issues and Empirical Evidence," Staff Working Psoers. Congressional Budget Ofice, January 1989. '>Thisfraction has steadily increased in recent years to about 25 percent and increased more during this expansion than in previous expansions of similar length. See, for example, Gail Makinen, 'The Current Economic Expansion: How Does it Compare with the Past." Congressional Research Service report for Congress, June 1996. 15 T11Ross af the Current Expansao 9 (persistent, albeit lower) inflation, taxation has effectively increased for unindexed items such as capital gains, estate taxation, and various aspects of corporate and capital taxation. Also, our progressive income tax system - while indexed for inflation - is not adjusted for real growth. Hence, as the economy grows, individuals eventually are pushed into higher tax brackets. Much of this increased taxation not only creates distortions (and adds to deadweight loss) but it adds to multiple layers of taxation on saving and investment, thereby adversely affecting incentives to save, invest, and innovate, consequently thwarting longer term growth. AU of these factors help to explain why taxation as a percentage of GDP has increased to record levels in recent years. 13 In addition to this increased taxation, regulatory burdens have also increased substantially since the late 1980s. Available measures of the costs of regulation show a substantial increase in regulatory costs since about 1988. One study, for example, documents that total macroeconomic regulatory costs increased about 23 percent from 1988 to 1996.14 Such regulatory burdens have been shown to adversely affect economic growth. " In order to improve on this recent subpar growth, policies focusing on and promoting longterm growth are essential. A variety of policy initiatives are consistent with such a goal. They include tax reforms reducing the multiple layers of taxation on saving or capital (and moving toward consumption-based taxation); spending control (and privatization); persistent deregulation efforts; continued open-market, free-trade policies; and a price stabilizing monetary policy. Inflation should remain well contained with the Fed's likely continued commitment to price stability. This commitment would be enhanced with explicit inflation targeting, which has already been successfully adopted by a number of other countries.' (Expanded issuance of inflationindexed bonds by the U.S. Treasury might also enhance the credibility of such an inflation targeting effort.) Moreover, Federal Reserve attention to key forward-looking market price indicators might also contribute to the necessarily pre-emptive nature of such efforts. This report was written by the Joint Ecornoic Committees Chief Macroconomist, Dr. Robert Keleher. "In 1996, total gaverment rts as a percent of GDP mse to 30.4 percent Historical Tables: Budget of the United States Gowenment, Ficat Year 1998, Table 1St. p. 260. "See Thomas D. Itopins, "Regulatory Costs in Profile," Center fot6 Ihe Stud of American Businem Washington University in St Lois, Policy Siudy Number 132, August 1996, p. . "See, for example, Wayne B. Gray, `Te Cost of Regulation: OSHA, EPA, amnThe Produethtty Slowdown," American Economic Rceiew. December 1957, vol. 77, no. 3. pp. 993-1006. 6 ' See Robert E. Keleher, Lessons fn Febraly 1997. Inflahon T eting Eperience, Joint Enmic Committee Report, 17 SUMMARIES OF SELECTED JOINT ECONOMIC COMMITTEE MAJORITY STAFF STUDIES 19 19 MONETARY POLICY LESSONS FROM INFLATION TARGETING EXPERIENCE This report reviews how a number of central banks around the world have successfully implemented inflation targets to guide monetary policy. The study also lends support to the Federal Reserve's current emphasis under Chairman Alan Greenspan on price stability and low inflation. THE IMPORTANCE OF THE FEDERAL RESERVE The Federal Reserve-our central bank-is one of the country's most powerful economic institutions. The Federal Reserve is a very relevant topic for Congress, not only because the Constitution gives monetary powers to Congress, but also because Congress, having created the Fed, has critically important responsibility for Federal Reserve oversight. This paper provides a brief overview of what Members of Congress should know about the Federal Reserve. It is intended to lay the groundwork for several forthcoming papers involving issues related to congressional oversight of Federal Reserve monetary policy and the goal of price stability. ESTABLISHING FEDERAL RESERVE INFLATION GOALS Recently, several Members of Congress have endorsed the concept of price stability as the principal policy objective for Federal Reserve monetary policy. After outlining current institutional arrangements and congressional responsibilities, the reasons why the goal of stabilizing the purchasing power of money is appropriate are detailed. Moreover, this paper demonstrates that such a goal (I) has a rich historical heritage, (2) recently has been successfully adopted in several countries, (3) in effect, implicitly has worked in the United States in recent years, and (4) has already been endorsed by a number of Federal Reserve officials. Although inflation has receded, and hence price stability is no longer a "headline-grabbing' issue, the paper highlights several important reasons why now is the opportune time to adopt such a strategy. The U.S. legislative history of this approach is summarized and essentials of current price stability legislation presented. A RESPONSE To CRiTCIsMs OF PRICE STABILITY A number of criticisms have been directed at the strategy of mandating price stability as the primary goal for monetary policy. These criticisms have been addressed in this paper and shown not to withstand scrutiny. Price stability remains a viable policy goal. In particular. 20 20 * Price stabilizing monetary policy not only retains a good deal of flexibility so that other policy goals are achievable, but this policy itself works to stabilize economic activity. * Inflation is not necessary to foster labor market adjustment and may work to remove existing wage flexibility. Price stability, on the other hand, likely would work to promote such flexibility. An environment of price stability and low interest rates does not constrain monetary policy; central banks can pursue stimulative policy via a variety of channels under stable prices. Price stability, however, does minimize the need for such stimulative policy. The CPI remains a viable price index measure suitable for use as an inflation target. Despite some measurement bias, the CPI has many advantages which outweigh its disadvantages. The best research suggests that the benefits of price stability far outweigh its costs; price stability is well worth its price. This research indicates that inflation's costs are high, even at low levels of inflation. TRANSPARENCY AND FEDERAL RESERVE MONETARY POLICY Today's changing financial environment requires more transparent Federal Reserve monetary policy. Such transparency would help to establish understandable rules and procedures, to eliminate unnecessary market uncertainties and volatility, and to minimize the costs of anti-inflation monetary policy. Transparent monetary policy is characterized by openness and a lack of secrecy and ambiguity. Transparency is multi-dimensional and includes the clarification of policy goals, of policy procedures, and the timeliness in reporting policy decisions. More transparent monetary policy has a number of advantages. It can work to (I) clarify policy objectives, (2) improve the workings of financial markets, (3) enhance central bank credibility, (4) reduce the chances of monetary policies manipulation for political purposes, (5) foster better monetary policymaking, and (6) complement congressional monetary policy oversight responsibilities. Recently, many central banks have recognized these advantages and have moved toward making their monetary policies more transparent. The Federal Reserve has made some progress on this front but generally has lagged behind some other central banks. The Federal Reserve could move toward a more transparent policy by: adopting explicit inflation targets, reporting more frequently to the Congress, releasing information earlier, and providing more information to the public. 21 21 TAX POLICY TAXES AND LONG-TERM ECONOMIC GRowTH This report examines how tax reduction improves incentives to work, save, and invest and increases long-term productivity and economic growth. The 1960s and 198Os are cited to illustrate the positive effects of tax cuts. Keynesian and free-market perspectives are compared. THE ADMINISTRATION'S PROPOSAL FOR A TUmON TAX ICREDrr This report finds that the Administration's proposal for a tuition tax credit does not adhere to the principles of good economic design for the tax laws, is of limited value as an incentive for post-secondary enrollment to students at the margin, creates minimal stimulus for economic growth, and has the potential for producing a heavy regulatory burden and high administrative cost. THE WELFARE-To-WORK TAX CREDIT The Administration has proposed a Welfare-to-Work Tax Credit aimed at providing job opportunities for long-term welfare recipients. Several studies have shown that an earlier version of this plan, which also used tax credits to subsidize wages of target groups, was not an effective or economical way of helping target group members obtain jobs. It is unlikely that the new features in the Welfare-to-Work Tax Credit will result in outcomes significantly different than those produced by its predecessor. Furthermore,'the proposed plan may create other problems and inefficiencies which are common to targeted tax credits of its kind. THE INEFFICIENCY OF TARGETED TAX POLICIES A number of proposals for tax relief have been introduced by Members of Congress from across the political spectrum. Disagreement now lies in how the tax relief should be delivered. In his fiscal year 1998 budget, President Clinton unveiled a targeted tax-cut program which would reward tax credits to certain groups for certain activities. Many economists and policy analysts would prefer a more general, broad-based approach to tax cuts which would not single out specific activities for preferential treatment. Specifically, targeted tax policies are economically inefficient and may encourage abuse of the tax system. THE ECONOMIC EFFECTS OF CAPITAL GAINS TAXATION There is broad recognition that the current tax system is systematically biased against saving, investment, and work effort. One form of bias is the multiple taxation of saving and investment under various provisions of the current income tax structure. Proposals to mitigate this tax bias have been offered by the Clinton Administration as well as by Members on both sides of the political aisle. One 22 22 proposal that has attracted bipartisan support in the past is the reduction of the capital gains tax rate. This paper weighs the statistical evidence on capital gains tax reduction and finds that such a change would have a positive impact on economic and employment growth. In addition, a capital gains tax reduction would partly abate the problem of taxing inflationary gains. OPTIMAL CAPITAL GAINS TAX POLICY: LESSONS FROM THE 1970s, 1980S, AND 1990s This study analyzes data from previous changes in the capital gains tax rate and concludes that the current capital gains tax rate is too high. The study shows that a reduction in the capital gains tax would generate large revenue gains in the short run and would be roughly revenue neutral in the long run. In addition, a lower capital gains tax rate would improve the efficiency of capital markets and benefit the entire economy. Furthermore, failure to adjust capital gains for inflation results in excessively high effective capital gains tax rates, imposing an unfair burden on taxpayers even when the inflation rate is relatively low. PAYROLL TAXES AND THE REDISTRIaBrnON OF INCOME It is misleading to focus on the burden imposed by payroll taxes without accounting for the future benefits they provide through the Social Security program. Low-wage workers, in particular, can expect to receive retirement benefits that exceed the amount of their payroll tax contributions. In contrast, middle- and high-wage workers can expect to pay more into the system than they will receive in benefits. Consequently, the Social Security system redistributes a substantial amount of money from middle- and high-wage workers to low-wage workers. Thus the payroll tax burden should be viewed in the context of lifetime tax payments and Social Security benefits. OTHER SELECTED TOPICS TRADABLE EMISSIONS Tradable emissions have proven to be an efficient market-based tool for reducing the cost of pollution control. Exchanging emissions in competitive markets with low transactions costs can be used as a way of finding the lowest cost points of abatement in an industry or geographical region. The Congress used this approach in creating tradable sulfur dioxide allowances in the Clean Air Act Amendments of 1990 to reduce the cost of acid rain control, a policy which has demonstrated great success. New pollution control policies would benefit from the use of tradable emissions as a method of reducing a national abatement cost already estimated at over $100 billion. COLLEGE AFFORDABILITY: TtimON TAX CREDITS VS. SAVING INCENTIVES Despite government efforts to improve college affordability over the years, it is now clear that federal aid programs have fallen short of their expectations: tuition continues to rise, more students graduate with larger debts, government costs have grown dramatically, and affordability for the neediest
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