The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
4<
/lo
105th CONGRESS
2nd Session
}
HOUSE OF REPRESENTATIVES
{
REPORT
105-807
THE 1998 JOINT ECONOMIC REPORT
REPORT
OF THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ON THE
1998 ECONOMIC REPORT
OF THE PRESIDENT
together with
MINORITY VIEWS
October 10, 1998. Committed to the Committee of the Whole
House on the State of the Union, and ordered to be printed
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON: 1"S
JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
HOUSE OF REPRESENTATIVES
JIM SAXTON, New Jersey,
Chairman
SENATE
CONNIE MACK, Florida, Vice Chairman
THOMAs W. EWING, Illinois
WILLIAM V. ROTH, JR., Delaware
MARK SANFORD, South Carolina
ROBERT F. BENNETT, Utah
MAC THORNBERRY, Texas
JOHN DOOLIT1LE, California
ROD GRAMS, Minnesota
JIM McCRERY, Louisiana
FORTNEY PETE STARK, California
JEFF SESSIONS, Alabama
LEE H. HAMILTON, Indiana
MAURICE D. HINCHEY, New York
CAROLYN B. MALONEY, New York
SAM BROWNBACK, Kansas
JEFF BINGAMAN, New Mexico
PAUL S. SARBANES, Maryland
EDWARD M. KENNEDY, Massachusetts
CHARLES S. ROBB, Virginia
CHRISTOPHER FRENZE, Executive Director
ROBERT KELEHER, ChiefMacroeconomist
HOWARD ROSEN, Minority Staff Director
Preparedforprintingby
Joseph Cwiklinski, DarrylEvans,
Colleen Healy, and JuanitaMorgan
(II)
LETTER OF TRANSMITTAL
CONGRESS OF THE UNITED STATES,
JOINT ECONOMIC COMMITTEE,
Washington, DC, October 10, 1998.
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 1998 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,
[im Saxton,
Chairman.
(III)
CONTENTS
OVERVIEW OF THE MACROECONOMY .......................
1
3
Monetary Policy ...................................... 5
........ 5
EstablishingFederalReserve Inflation Goals .....
....... 19
Lessons From Inflation Targeting Experience .....
.......... 27
A Response to Criticisms of PriceStability .....
Transparencyand FederalReserve Monetary Policy .......
41
53
Budget Policy ........................................
Trends in CongressionalAppropriations:FiscalRestraint
53
in the 1990s ........................
65
Budget Process Reform ........................
77
Tax Policy and Capital Formation ......................
..... 77
The Economic Effects of CapitalGains Taxation .....
95
Expanding IRA Benefits ..............................
..... 111
Reducing MarriageTaxes: Issues and Proposals ....
145
The Links Between Stocks and Bonds ..................
151
International Economics .............................
151
IMf Financing:A Review of the Issues .................
FinancialCrises in Emerging Markets: Incentives and the
IA4F ..........................................
163
173
.....................
in
Japan
Economic
Situation
The
MAJoRITY STAFF REPORT .....................................
. 179
U.S. Economy Continues to Prosper Despite Global Financial
Instability .......................................
181
RANKING MINORITY MEMBER'S VIEWS AND MINORITY STAFF REPORTS ....
Pockets of High Unemployment in a Low Unemployment
185
Economy ......................................
The 1990s Economic Expansion: Who Gainedthe Most? .. 219
The Impact of MismeasuredInflation on Wage Growth ....
239
Technology and Economic Growth: A Reviewfor
Policymakers ..................................
259
('I)
REPORT
105TH CONGRESS
2nd Session
I
HOUSE OF REPRESENTATIVES
105-807
THE 1998 JOINT ECONOMIC REPORT
October 10, 1998.-Committed to the Committee of the Whole House on the State of
the Union and ordered to be printed
MR. SAXTON, from the Joint Economic Committee,
submitted the following
REPORT
together with
MINORITY VIEWS
Report of the Joint Economic Committee on the 1998 Economic Report of the
President
OVERVIEW OF THE MACROECONOMY
The performance of the macroeconomy over the past several quarters
and into the first half of 1998 has been quite favorable. Low and
declining inflation has been associated with lower interest rates,
sustained, healthy overall economic and employment growth, together
with the lowest rate of unemployment in decades. This growth has been
healthy enough to generate the tax revenues producing the first annual
budget surplus since 1969. Most economic observers agree that this
extended performance was related to the fact that no important macroeconomic policy mistakes have been made in recent years. In particular,
Federal Reserve Policy has gradually squeezed inflation out of the system
so as to promote economic growth. Congressional spending restraint
together with tax relief has enabled the economy to continue to expand,
while at the same time reducing the budget deficit.
By most measures, general inflation rates have continued to trend
downwards in recent years. This trend has persisted into 1998. Gross
domestic product (GDP) deflators are registering their lowest year-over-
year inflation rates in decades. The core Consumer Price Index also has
recorded the lowest year-over-year inflation rates since the 1960s.
2
Similarly, producer prices show downward trending price changes with
little sign of inflation in the earlier stages of processing. Commodity
price indices actually show persistent weakness. In short, general price
measures show continued disinflation and very low rates of measured
inflation.
This lower inflation has translated into lower interest rates. Both
long-term and short-term rates have decreased. Recently, the Federal
Reserve has lowered short-term rates while long-bond yields of Treasury
securities reached their lowest level since the 1960s.
Lower inflation and lower interest rates have worked to foster
economic growth. Indeed, real GDP growth has averaged better than
3.75 percent over the last six quarters (at the time of this writing). Much
of that strength has occurred in interest-rate sensitive sectors such as
investment, consumer durables, and housing.
Payroll employment gains have been impressive, while household
employment growth has been strong enough to enable the overall
unemployment rate to fall to its lowest levels in decades. Similarly, the
employment/population ratio and labor force participation rates are close
to all-time highs.
This forward momentum in production, employment, and economic
activity has been consistent enough to generate sizable increases in tax
revenues. Spending restraint on the part of the Congress prevented this
added revenue from being spent. Accordingly, these revenue gains
together with this rigid congressional spending restraint eliminated the
budget deficit; a yearly budget surplus was actually obtained for fiscal
year 1998, the first time since 1969.
Of course, recent disturbances in international financial markets
have raised concerns about the export sector, financial markets, as well
as the general prospects for maintaining positive economic performance.
These disturbances should remind policymakers that a prudent, flexible
policy stance is most appropriate at this juncture. But macroeconomic
policies of tax relief, spending restraint, and price stabilizing monetary
policy should remain key policy ingredients to further boost economic
performance.
REPRESENTATIVE JIM SAXTON,
Chairman.
SENATOR CONNIE MACK,
Vice Chairman.
MAJORITY STAFF REPORT
..... ..............
MONETARY POLICY
ESTABLISHING FEDERAL RESERVE INFLATION GOALS
INTRODUCTION
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 (1) 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.
In the context of this paper, the policy of price stability will
generally refer to inflation targeting whereby target bands are used for
changes in some conventional broad price index or measure of inflation.
BACKGROUND: INSTITUTIONAL ARRANGEMENTS, CONGRESSIONAL
RESPONSIBILITIES, AND PREVIOUS APPROACHES
In order to assess the appropriateness of adopting the monetary policy
goal of price stability, some background material-a brief review of the
current monetary regime as well as congressional responsibilities-is
essential.
The Current Monetary Regime
A cogent description of current monetary institutional arrangements
perhaps is best provided by Milton Friedman:
... a world monetary system has emerged that has no
historical precedent: a system in which every major
currency in the world is, directly or indirectly, on an
irredeemable paper money standard .
.
. It is worth
stressing how little precedent there is for the present
situation. Throughout recorded history ...
commodity
6
money has been the rule. So long as money was
predominantly coin or bullion, very rapid inflation was
not physically feasible . . . The existence of a
commodity standard widely supported by the public
served as a check on inflation ... The key challenge
that now faces us in reforming our monetary and fiscal
institutions is to find a substitute for convertibility into
specie that will serve the same function: maintaining
pressure on the government to refrain from its resort to
inflation as a source of revenue. To put it another way,
we must find a nominal anchor for the price level to
replace the physical limit on a monetary commodity.'
In other words, the emergence of this fiat money, flexible exchange
rate system (after the demise of the Bretton Woods System in the early
1970s), means there is no reliable mechanism anchoring the price system;
no reliable store or standard of value exists.' Instead, the stability of the
current monetary regime fully depends on the competence of central
bankers to provide these critical functions of a dependable monetary
system: to substitute for the reliability of a commodity standard.
Congressional Authority
At the same time, the Congress has clear legal authority over
regulating the value of money. Specifically, the U.S. Constitution
(Article I, Section 8) explicitly gives Congress the power over money and
the regulation of its value. This responsibility was delegated by Congress
to the Federal Reserve; the Federal Reserve was created by an act of
Congress. This delegation implies that Congress has important
responsibilities for overseeing the conduct of Federal Reserve monetary
policy.
Of course, at the time of the creation of the Federal Reserve and for
most of the period until the demise of the Bretton Woods System, the
'Milton Friedman, 'Monetary Policy in a Fiat World," in Money Mischief:
Episodes in Monetary History, Harcourt Brace Jovanovich, New York, 1992, pp.
249, 252-4.
2 Furthermore,
current monetary arrangements are unlikely to change in the near
future. Specifically, because the potential for sharply changing demands for
international monetary reserves is associated with the rapid growth of emerging
markets and the evolution of the European Monetary Union, a near-term stable,
international monetary anchor appears unlikely.
7
United States was on some form of commodity standard so that no
explicit price anchor mandate was essential.' With the emergence of fiat
money/flexible exchange rate arrangements in the early 70s, however,
such a mandate-which Congress clearly has the authority to
implement-is not only appropriate but necessary.
The Failure of Other Approaches
Unfortunately, inappropriate or multiple and conflicting monetary
policy goals for the Federal Reserve have been prescribed and found
wanting during much of the period since the demise of Bretton Woods.
In part, such prescription reflects Keynesian predilection for managing
real economic activity and full employment macroeconomic policy goals,
culminating in the Full Employment and Balanced Growth Act of 1978
(Humphrey-Hawkins Act). This Act prescribes multiple and conflicting
policy goals and, accordingly, has made it more difficult to achieve
viable objectives of monetary policy such as price stability.
But (intermediate) monetary targeting for the Federal Reserve also
was prescribed during this period. These monetary targets proved less
reliable than expected for a number of reasons relating partly to
deregulation.
This post-Bretton Woods experience has culminated in the
realization that price stability is the single, appropriate goal for monetary
policy; a monetary standard securely anchoring the price system is
essential. This view is now embodied in current price stability legislation
described below.
RATIONALE FOR ADOPTING THE GOAL OF PRICE STABILITY
Given this background, it is natural that Congress should move to
consider making price stability the explicit key objective for monetary
policy. A number of specific reasons indicate why price stability is the
appropriate monetary policy goal; these reasons relate not only to
3 With the existence
of a fixed exchange-rate gold standard at the time the Federal
Reserve was created, monetary policy was not seen as a potent tool of
government economic policy making. (Federal Reserve policy was guided by
the behavior of the gold reserve ratio following Central Bank practice under the
gold standard.) Accordingly, congressional oversight was not seen as a high
priority responsibility. With the emergence of the fiat system described above,
this mechanism has changed, and monetary oversight now is accorded more
importance.
8
efficient provision of monetary services but to minimizing the many
disruptive costs of inflation.
* Price stability enables money to best perform its various
functions.
Money can best provide its functions of a medium of
exchange, a store of value, and a standard of value under a
regime fostering price stability. Such stability anchors the
price system so that comparative values can be established and
accurately measured.
* Price stability enables the price system to work better.
Price stability enables the price system-the information or
signaling mechanism of free-market economies-to function
effectively by directing resources to their most beneficial use.
Price stability is associated with both lower inflation volatility
and with lower (relative) price dispersion than inflationary
circumstances. Lower inflation reduces the variability between
individual prices or reduces the noise and distortions in the
price system.4 This allows the price system to better serve its
information and allocative functions. As a result, the economy
operates more efficiently and therefore grows faster.
* Price stability promotes transparency, accountability, and
credibility.
Explicitly adopting price stability as the principal monetary
policy goal serves to promote transparency, accountability, and
credibility to monetary policy. Furthermore, explicit inflation
targets reduce incentives of the monetary authority to renege
or backslide on its commitment to price stability.
*
Price stability enhances fiscal discipline.
Explicit price or inflation targeting prevents the use of inflation
as a revenue source for the government. More specifically,
price stability minimizes seignorage as well as government's
ability to reduce its outstanding debt via inflation. Moreover,
price stability minimizes those interactions of inflation with
non-indexed portions of the tax code that effectively result in
higher taxation. Lowering inflation, therefore, in many ways
4See,
for example, Guy Debelle and Owen Lamont, 'Relative Price Variability
and Inflation: Evidence From U.S. Cities,' Journal of Political Economy. vol.
105, no. 1, February 1997.
9
acts like a tax cut by removing these potential sources of
revenue.5
Moreover, adopting the goal of price stability and moving to lower
inflation has a number of beneficial economic effects relating to
minimizing the disruptive costs of inflation:
* Price stability lowers interest rates.
A credible, sustained reduction of inflation will lower
expectations of future inflation. Accordingly, the inflationary
expectations component of interest rates will dissipate from the
structure of both short- and long-term interest rates and interest
rates will decline.
* Price stability works to stabilize financial markets and
interest-sensitive sectors of the economy.
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. Thus, lower inflation stabilizes
financial markets. As a result, market participants tend to
become more confident or self-assured and more willing to
invest, take risk, and innovate. Businesses are better able to
plan and coordinate, thereby improving efficiency.
Furthermore, this enhanced financial stability works to
stabilize interest-rate-sensitive sectors of the economy and,
therefore, the macro economy as well.
*
Price stability promotes growth.
By enabling the price system to work better, enhancing fiscal
discipline and minimizing tax distortions, lowering interest
rates, and helping to stabilize both financial markets and
interest-sensitive sectors of the economy, price stability
promotes economic growth. Resources can engage in
productive activities rather than finding ways to circumvent
5 This
argument is especially relevant in circumstances when tax limitation
provisions and/or balanced budget regimes are being implemented; i.e., when
stricter fiscal regimes are put in place. It is in these circumstances that
government will look for new revenue sources.
10
costs of inflation. Several recent empirical studies have found
that lower inflation is associated with higher growth. 6
ADDITIONAL CONSIDERATIONS
In addition to these important reasons for adopting price stability as the
primary goal of monetary policy, a number of additional considerations
lend further support to the argument.
(1) Historically, this view has been endorsed by many of the world's
most preeminent monetary economists: Support for the goal of price
stability under fiat money is, of course, not novel. Many of the economic
profession's most revered monetary writers have supported this
objective.
Probably history's most famous monetary debate occurred during
the Napoleonic era when Britain went off the gold standard. During this
period, classical bullionist writers such as Henry Thornton and David
Ricardo recognized that under these circumstances the Bank of England
had responsibility to regulate the value of money; in effect, to provide a
stable monetary standard substitute for gold convertibility. This
endorsement of price stability under fiat money was later supported by
such eminent economists as John Stuart Mill and Alfred Marshall. Knut
Wicksell further refined existing approaches to achieving price stability;
his views were widely embraced by other Swedish economists such as
Gustav Cassel. Famous British economists during the interwar period
such as Ralph Hawtrey and John Maynard Keynes also endorsed price
stability as the appropriate goal for monetary policy.7 The view was also
supported by esteemed economists in the United States such as Irving
Fisher, Henry Simons, and Lloyd Mints, as well as most modern-day
monetarists. 8
6 See,
for example, Robert Barro, 'Inflation and Economic Growth," National
Bureau of Economic Research Working Paper No. 5326, October 1995; Brian
Motley, 'Growth and Inflation: A Cross-Country Study," Center for Economic
Policy Research, publication no. 395, March 1994; and Todd E. Clark, "CrossCountry Evidence on Long-Run Growth and Inflation," Economic Inquir, vol.
35, no. 1, January 1997.
7 This
support is especially evident in Keynes' Tract on Monetary Reform, as
well as his Treatise on Money.
8A history
of the price stabilization movement was published by Irving Fisher in
1934. See Stable Money: A History of the Movement. Adelphi Co., New York,
1934.
I1
(2) Both historical and contemporaneous evidence indicate that the
price stability objective can work quite successfully: A good deal of
empirical evidence shows that price stability or inflation targeting
regimes have worked successfully. Historically, the first such regime
was the Swedish price stabilization regime of the early 1930s. Upon
suspending gold payments in 1931, Swedish authorities explicitly
announced the adoption of a price stability standard, a monetary policy
explicitly directed to stabilize the internal purchasing power of the krona.
The policy was remarkably successful: prices were stabilized, contributing significantly to the stability of the domestic economy and
insulating the Swedish economy from the 1930s' worldwide depression.9
More recently, the single monetary policy goal of price stability has
been successfully implemented in a number of countries. Explicit,
quantifiable inflation targets have been adopted by Canada, the United
Kingdom, Australia, New Zealand, Sweden, Spain, and Finland. In fact,
the summary of a recent conference sponsored by the Federal Reserve
proclaimed that, "Central banks throughout the world are moving to
adopt long-term price stability as their primary goal."'0 The evidence to
date indicates these policies have been quite successful. Those countries
adopting a price stability goal, for example, significantly improved their
inflation performance. Specifically, they have all dramatically lowered
their inflation rates since adopting targets for inflation, often to lower
rates not observed for decades. Several of these countries reached their
inflation objectives well ahead of schedule; inflation targets have often
been met or undershot. Preliminary studies have shown that those
countries adopting explicit inflation targets have outperformed other
countries not only in terms of lowering inflation but in a number of other
9The
Swedish experience led Irving Fisher to assert that 'This achievement of
Sweden will always be the most important landmark up to its time in the history
of (price) stabilization," Irving Fisher, Stable Money. Adelphi Co., New York,
1934, pp. 408-9. (parenthesis added). For further documentation of this episode,
see Manuel Johnson and Robert Keleher, Monetary Policy. A Market Price
Approach, chapter 13, Quorum Books, Westport, Connecticut, 1996.
t0George
A. Kahn, 'Achieving Price Stability: A Summary of the Bank's 1996
Symposium," Economic Review. Federal Reserve Bank of Kansas City, vol. 81
no. 4, fourth-quarter 1996, p. 53.
12
criteria as well. 1 ' This evidence underscores the argument that explicit,
quantifiable goals of price stability can be implemented successfully.
(3) Recent Federal Reserve policy focus on price stability has also
been successful: The Federal Reserve's emphasis on price stability in
recent years has also worked to lower inflation, thereby contributing to
the sustainability of the current expansion. While the Federal Reserve
has not adopted explicit, quantifiable inflation targets like the central
banks of countries cited above, Federal Reserve officials have repeatedly
endorsed price stability in speeches, testimony, interviews, and official
publications. The preemptive policy move to tighten monetary policy
beginning in February 1994 demonstrated that these public pronouncements were genuine and so this move not only worked to reduce inflation
but also enhanced the central bank's inflation fighting credibility.
This credible disinflation policy has worked to lower interest rates,
stabilize financial markets and interest sensitive sectors of the economy,
promote the efficient operation of the price system, and, in effect, act like
a tax cut in many ways."2 All of this has contributed to promoting the
sustainability of the expansion and further demonstrates the value of
price stability as a principal policy goal.
(4)
Price stability as the principal goal of monetary policy has
already been endorsed by several Federal Reserve policy-makers:
Adopting price stability as the primary goal of monetary policy has
received the support of many academic economists as well as many
officials and policy-makers of the Federal Reserve system itself. For
example, Federal Reserve regional bank presidents from the New York,
Richmond, St. Louis, San Francisco, and Cleveland banks have all
explicitly endorsed price stability as monetary policy's primary policy
goal.
"See, for example, Bennett T. McCallem, 'Inflation Targeting in Canada, New
Zealand, Sweden, the United Kingdom, and in general," National Bureau of
Economic Research Working Paper no. 5579, May 1996. p. 9.
12See Robert Keleher, The Roots of the CurrentExpansion, a Joint Economic
Committee study, April 1997, for a more detailed discussion of the contribution
of monetary policy to the sustainability of the expansion.
13
THE OPPORTUNE TIME To ADOPT TARGETS FOR PRICE STABILITY
Although inflation has receded and hence price stability is no longer a
"headline-grabbing" issue, there are several important reasons why now
is the opportune time to adopt targets for price stability:
* Cement current gains.
Adopting targets for price stability would ensure the many
beneficial economic effects of low inflation are maintained.
Such targets are easiest to implement when inflation is already
low, political opposition is relatively weak, and price stability
has attained a degree of credibility as a proper goal for
monetary policy. In short, the current period is the politically
opportune time to cement gains and credibility that have been
achieved, thereby minimizing the costs of moving to price
stability."3 Adopting formal price stabilization goals now when
political barriers are relatively low ensures that procedures for
maintaining price stability are in place when inevitable
difficult tightening decisions have to be made in the future.
* Remove incentives to backslide.
As memories of high inflation fade, interest groups
increasingly emphasize near-term benefits of stimulative
monetary policy; demands for monetary relief from adverse
changes in interest rates, foreign exchange rates, or output
proliferate. Implementing explicit targets for price stability
would serve to insulate the Federal Reserve from such political
pressures.
Furthermore, without targets for price stability, incentives grow for
inflationary policies when inflation is low. Specifically, short-sighted
\policy-makers recognize that surprise (unexpected) expansionary policies
are more potent than expected policy changes. So when inflation is
reduced and is expected to remain subdued, stimulative policies that are
a surprise have a larger economy-boosting impact. In short, as inflation
13Targets for price stability should be introduced when there is a realistic chance
of reducing inflation (i.e., when inflation is low or trending down); credibility
is an important reason for targets and hitting the first target is especially
significant for establishing credibility. See Charles Freedman, 'The Canadian
Experience with Targets for Reducing and Controlling Inflation," Inflation
Targets, edited by Leonardo Leiderman and Lars Svensson, Center for Economic
Policy Research, Glasgow, 1995, p. 28.
14
is reduced, incentives increase for policy-makers to unexpectedly
stimulate the economy. Pre-commitments to explicit price targets reduce
these perverse incentives.' 4
*
*
Govern by rules rather than by men.
While the Federal Reserve has performed admirably under the
regimes of Chairmen Volcker and Greenspan, there is no
guarantee that it will continue to perform so well in the future
under different management. Institutionalizing the goal of
price stability will help ensure that Federal Reserve
performance depends more on a transparent system of rules
rather than upon the vagaries of individuals and is less prone
to political manipulation or pressure. Adopting such rules
would provide a political buffer, preventing future
administrations from manipulating monetary policy when there
are incentives to do so.
Prevent the use of inflation as a source of government
revenue.
Continued pressures on fiscal policy to balance the budget,
resolve entitlement problems, and limit taxation will induce
government policymakers to look for alternative revenue
sources. Inflation, after all, can serve as a mechanism to
finance government spending and reduce real government debt.
Adopting explicit rules for price stability would prevent the use
of monetary policy for such purposes.
ALLOWANCE FOR FLEXIBILITY
One of the key criticisms of adopting inflation targets is that such a
strategy would remove monetary policy's flexibility. With fiscal policy
constrained so that it cannot be used for stabilization policy, it is argued
that monetary policy is the only tool left for this purpose and therefore
should remain relatively unencumbered.
This criticism seems misplaced for several reasons. Certainly the
international experience with inflation targeting provides ample evidence
that, in practice, inflation targets leave room for a good deal of flexibility.
In particular, inflation targets normally consist of bands rather than point
estimates. They are usually multi-year in nature. The relevant targeted
inflation index often is adjusted for volatile (supply-side) components.
And even after such adjustment, some countries (e.g., New Zealand)
14In
economic jargon, this is referred to as the 'time inconsistency" problem.
15
allow for further exceptions to specified targets. All of these
considerations allow for considerable flexibility, yet maintain a focus on
long-term price stability.
Furthermore, if unanticipated shocks are 'demand-side" in nature,
inflation targets automatically direct appropriate monetary policy
responses that work to stabilize the economy. Finally, by adopting
inflation rather than price level targets, some accommodation of
unanticipated one-time supply-side shocks are allowed for (i.e., inflation
targets do not require offsetting deflation and hence associated economic
disruption as do price level targets).' 5 In sum, inflation targets retain a
good deal of flexibility for monetary policy.
LEGISLATIVE HISTORY
In the United States, legislation mandating price stability for monetary
policy is not new. As ably documented by Irving Fisher, a series of bills
to stabilize the purchasing power of money or the general price level
were introduced and re-introduced during the 1920s and 1930s."6 The
most prominent sponsors of these bills were T. Alan Goldsborough (MD)
and James A. Strong (KS). Congressional hearings were held on several
of these price stabilization bills and during these hearings, the idea of
price stabilization received significant support from academics,
businessmen, and farmers. Opposition came from various officials of the
Federal Reserve System."
"Because offsetting deflation is not required by inflation targets, these targets
embody 'base drift" (an ever-increasing price level). In other words, inflation
targets imply that the price level becomes 'non-stationary"; once disturbed, the
price level does not return to its previous level. Because of this characteristic,
inflation targets are associated with greater long-term variance and uncertainty
of prices. Nonetheless, because inflation targets enhance policy flexibility, they
are viewed as more realistic politically.
16See
Irving Fisher, StableMoney: A History ofthe Movement, Adelphi Co., New
York, 1934 (see chapters V and VI).
17Governors
Strong, Harrison, and Norris as well as Board members Meyer,
Miller, and Young voiced opposition to the idea. Director of Research
Goldenweiser also opposed the idea during such hearings. See Fisher, pp. 150206.
16
The Goldsborough Bill mandating price stability passed the House
of Representatives on May 2, 1932 by an overwhelming vote of 289-60. 8
The Bill, however, was blocked in the Senate principally by Senator
Carter Glass (Federal Reserve officials testified in opposition to the Bill).
Price stability, of course, has been identified as one of several
economic objectives mandated to the Federal Reserve as embodied in the
Employment Act of 1946 and the Full Employment and Balanced Growth
Act of 1978 (Humphrey-Hawkins Act). The need to focus primarily on
price stability, however, re-emerged as a legislative priority in the Neal
Resolution. This congressional Resolution instructed the Federal
Reserve to gradually eliminate inflation within five years and then to
maintain price stability. The initiative, however, remained in committee.
CURRENT PRICE STABILITY LEGISLATION
The Mack-Saxton Bill was introduced during the 104th Congress in
September 1995 and reintroduced during the 105th Congress in April
1997. The Bill includes the following features:
*
Establishes long-term price stability as the primary goal of
Federal Reserve monetary policy.
*
Repeals the Full Employment and Balanced Growth Act of
1978 (Humphrey-Hawkins Act) and the multiple policy goals
mandated by this Act; amends portions of the Employment Act
of 1946.
*
Places responsibility on the Federal Reserve to numerically
define price stability and set the time table for achieving it.
* Requires the Federal Reserve to report to Congress semiannually and provide information on the numerical progress
toward achieving the price stability goal.
* Requires the Federal Reserve to describe variables used to
gauge its own progress toward price stability and to report to
Congress when it changes methods for measuring its own
progress.
As these features suggest, the Bill is a significant step forward in
moving to make long-run price stability a reality. But the legislation may
not be the final word on this issue. Continued progress on this front, for
example, might include additional ingredients to:
"8This bill mandated price stability and additionally gave the Federal Reserve the
power to raise or lower the price of gold when necessary. See Fisher pp. 186-7.
17
*
*
*
Allow for significantly improving the transparency of
monetary policy; specifically, requiring that Federal Reserve
reporting and disclosure be more timely, frequent, thorough
and detailed as well as more accessible to the public., This
might involve, for example, requiring an explicit 'inflation
report" detailing the inflation outlook to be presented at more
regularly scheduled congressional oversight hearings.
Promote the transparency of Federal Reserve and Treasury
exchange rate policy and clarify the relationship of this policy
Such
to mandated Federal Reserve inflation goals.
of
precedence
the
clarification would involve identifying
inflation objectives vis-a-vis exchange rate policy as well as
simplifying and clarifying related decisionmaking processes.
Require the Federal Reserve to identify before the fact what
remedial action will be undertaken should price stability goals
not be achieved.
IMPLICATIONS FOR CURRENT MONETARY POLICY
Regardless of the success of price stability legislation in the United States
Congress, the Federal Reserve should move forward on several fronts
unilaterally to adopt these features fostering price stability and enhanced
transparency. Doing so will not only promote the credibility of monetary
policy but will also help to remove uncertainties spawning unnecessary
market volatility. These actions will enable market prices to serve as
more reliable sources of information and policy indicators and furthermore will foster improved market discipline on monetary policy.
SUMMARY AND CONCLUSIONS
Currently, our fiat money system has no reliable price anchor or standard
of value. At the same time, Congress has the legal authority and
oversight responsibility for regulating the value of money and providing
for such an anchor. There are many reasons for and benefits from
adopting price stability as the primary goal of monetary policy. This
objective has been endorsed not only by many of the world's most
esteemed monetary economists but also by many Federal Reserve
officials. Both historical and contemporary evidence demonstrates that
such a strategy works quite well. Furthermore, the approach allows for
ample monetary policy flexibility; there are many reasons why this
approach should be adopted now.
The time has come to introduce price stability as a legislative goal.
Current price stability legislation is not the first to advocate stable
18
money, but it offers much of what was the best in earlier initiatives. Such
legislation deserves the support of both Houses.
/
19
LESSONS FROM INFLATION TARGETING EXPERIENCE
INTRODUCTION
While some forward-looking U.S. Congressmen have promoted price
stability and introduced legislation to make it the primary goal of Federal
Reserve monetary policy, many other countries, including Canada, The
United Kingdom, New Zealand, Sweden, Spain, Finland, Australia, and
Israel have moved forward beyond the rhetoric, explicitly adopting price
stability as the primary goal for their monetary policy. There is a
growing consensus that under current monetary arrangements, the single
appropriate goal of monetary policy should be price stability.'9 ,2 0
There are many important lessons from this surprisingly rich
international experience relevant to both U.S. legislators (charged with
Federal Reserve oversight) as well as to Federal Reserve policy makers
themselves. After briefly summarizing the benefits of price stability, this
paper succinctly summarizes these key lessons to highlight possible
policy approaches and promote awareness of this important issue.
THE RATIONALE FOR PRICE STABILITY
The foreign governments and Central Banks cited above recognize the
following well-known benefits of and rationale for price stability:
* Anchors the Price System.
Recent decades have witnessed both the breakdown of the
Bretton Woods System as well as disappointment with the
performance of monetary aggregates as guides for monetary
policy. This left a fiat money system with no reliable anchor
of value. Such an anchor is needed to provide a standard of
value, so that comparative values can be established and
accurately measured. Price (or inflation) targets resulting in
price stability provide such an anchor.
Allows the Price System to Function Effectively.
*
Importantly, price stability enables the price system-the
information or signaling mechanism of free market
19Current monetary arrangements entail a fiat money, flexible exchange rate
regime.
20This goal has been explicitly endorsed by a number of Federal Reserve officials
including several Federal Reserve Bank Presidents.
20
*
*
*
economies-to function effectively by directing resources to
their most beneficial use, thereby fostering efficiency.
Promotes Stability and Growth.
By minimizing price volatility, distortions affecting the price
system, as well as uncertainty and inflation premiums, price
stability not only promotes economic and financial market
stability but also lowers interest rates and fosters sustainable
economic growth.2 ' Indeed, a benefit of a credible price
stability goal is that market forces could serve as natural
stabilizers.
Eliminates Distortive Effects of Inflation Interacting with
the Tax Code.
Since investors continue to pay income taxes on the inflation
component of interest and dividend income as well as capital
gains attributable to inflation, price stability would eliminate
these and other forms of tax distortion and such "taxation
without representation."
Promotes Transparency, Accountability, and Credibility.
Explicitly adopting price stability as the principal monetary
policy goal serves to promote transparency, accountability, and
credibility to monetary policy. Furthermore, explicit inflation
targets reduce incentives of the monetary authority to renege or
backslide on its commitment to price stability.2 2
2 'Recent
empirical research has documented a negative relationship between
inflation and economic growth. See, for example, Robert J. Barro, 'Inflation and
Economic Growth," NBER Working Paper 5326, October 1995; Brian Motley,
'Growth and Inflation: A Cross Country Study," Federal Reserve Bank of San
Francisco Working Paper 94-08; and Stanley Fischer, 'The Role of
Macroeconomic Factors in Growth," NBER Working Paper No. 4565, December
1993.
2 2The
'time inconsistency" problem arises when inflation is reduced, but shortsighted policy makers recognize that surprise (unexpected) expansionary policies
can have significant short-term economy-boosting effects. In short, as inflation
is reduced, incentives for policy makers to unexpectedly stimulate the economy
increase. Pre-commitments to explicit price targets reduce these perverse
incentives.
21
LESSONS FROM RECENT INFLATION TARGETING EXPERIENCE
Recognizing these benefits, the governments and central banks of
Canada, The United Kingdom, Australia, New Zealand, Sweden, Spain,
Israel, and Finland explicitly have adopted targets for price stability as
the principal goal of monetary policy.?, 24 Other countries, such as
Germany and Italy, also have embraced price stability.
There are many important lessons from this recent international
experience with targets for price stability. These lessons, summarized in
the following paragraphs, should be of special interest to both legislators
interested in monetary policy oversight as well as to monetary policy
makers themselves.
The Single Explicit Goal of Price Stability Can Be
Successfully Implemented.
The single monetary policy goal of price stability has been successfully
implemented in a number of countries. Explicit, quantifiable inflation
targets have been adopted by a number of countries including Canada,
The United Kingdom, New Zealand, Sweden, and Finland. Evidence to
date indicates these experiments have been quite successful. Those
countries adopting a price stability goal, for example, significantly have
improved their inflation performance. Specifically, they have all dramatically lowered their inflation rates since adopting targets for inflation,
often to lower rates not observed for decades. Several of these countries
reached their inflation objectives well ahead of schedule; inflation targets
have often been met or undershot. Preliminary studies have shown that
those countries adopting explicit inflation targets have outperformed
other countries not only in terms of lowering inflation but in a number of
other criteria as well. 5
Lesson #1:
23The
reasons these governments opted for explicit price stability goals included
disappointment with fixed exchange rate arrangements and/or monetary
aggregate targeting.
24 Sweden successfully adopted price stability as a goal of monetary policy in the
1930s. See, for example, Robert Keleher, 'The Swedish Market Price Approach
to Monetary Policy of the 1930's," Contemporary Policy Issues Vol. IX, No.2,
April 1991.
25See, for example Bennett T. McCallem, "Inflation Targeting in Canada, New
Zealand, Sweden, The United Kingdom, and in general." NBER Working Paper
No. 5579, May 1996, p.9 .
22
This evidence underscores the argument that explicit, quantifiable
goals of price stability can be implemented successfully. While implicit
goals of price stability may also work, in some cases it appears that
explicit targets can help further to achieve price stability in a number of
ways discussed below; however, price stability goals must be credible.
Many of the lessons enumerated below provide guidelines to enhance the
credibility, and therefore the likely success, of inflation targets.
Lesson #2:
Targets for Price Stability Can Take the Form of
Inflation Targets Rather Than Price Level Targets.
Central Banks recently embracing explicit targets for price stability have
adopted inflation targets rather than price level targets.26 There are
important differences between these two forms of targets for price
stability. With an increase in prices, for example, price level targets
require an offsetting decline in (deflation of) prices whereas inflation
targets merely require a cessation of the increase. This difference has
several important implications. Inflation targets, for example, allow for
more policy flexibility in responding to (one-time) supply-side shocks
since no price deflation (and hence less real economic disruption) is
required. Because of this enhanced policy flexibility, inflation targets are
viewed as more realistic politically and hence, more credible. But
because offsetting deflation is not required by inflation targets, these
targets also embody "base drift" (an ever-increasing price level) and
greater longer term variance and uncertainty of prices.2"
Lesson #3:
The Consumer Price Index (CP1) Can Be Used as the
Inflation Target.
Although countries adopting explicit inflation targets recognize wellknown mis-measurement biases of consumer price indices, they all have
used the CPI (or variants of the CPI) as the basis of their inflation target.
These biases are viewed as being relatively minor and outweighed by the
CPI's practical advantages: namely, its familiarity, ready availability,
minor revisions, and convenience in communication with the public.
Additionally, most countries using CPI targets adjust the index for
volatile components and non-monetary influences. Adjustments have
2 6The
price stabilization regime adopted in Sweden during the 1930s, however,
focused on price level stability as its primary goal (Keleher op.cit.).
27
Inflation targets imply that the price level becomes 'non-stationary"; once
disturbed, the price level does not return to its previous level. Some economists
argue that inflation targets can be an effective first step to price level targeting
at a later date.
23
often been made for volatile food and energy components as well as for
housing costs or mortgage payments and indirect taxes. Despite
imperfections, therefore, the CPI target is viewed as practical and
useable. Should the U.S. CPI be revised to account for measurement
biases, an adjusted version may still be a viable target. But alternative
price indices may also be workable and not precluded from consideration.
Inflation Targets Should Take the Form of Bands
Rather Than Point Estimates.
Countries adopting explicit inflation targets generally have specified
target bands (or tolerance intervals) rather than point estimates for their
inflation targets. These bands allow for the realities of measurement
imprecision as well as unexpected shocks to specific prices.
Accordingly, existing inflation targets normally have a tolerance width
of about two percentage points.
In addition to tolerance bands and above-cited adjustments to the
CPI, some countries (e.g., New Zealand) have provided for escape
clauses which allow for further modifications or exceptions in cases of
special circumstances. These features all help to make adherence to
explicit targets more believable and hence more credible.
Establishing the Credibility of a Price Stabilizing
Lesson #5:
Monetary Policy Takes Time.
Experience in several countries indicates that establishing the credibility
of inflation targeting arrangements is not easy and occurs only over an
extended time frame.O The mere announcement of such targets does not
by itself readily lend credibility to inflation targets. It is only after a
record of price stability and the establishment of complementary
institutional arrangements that credibility develops, implying that
inflationary expectations and risk premiums of interest rates will
disappear only slowly over time. 29
Lesson #4:
2 8The
credibility of price stabilizing policy refers to the public's belief that the
central bank will adhere to the policy consistently. Such credibility is important
because it influences expectations affecting interest and exchange rates and
thereby affects the cost of reducing inflation in terms of lost output and
employment.
29See, for example, John Judd, Inflation Goals and Credibility,' Weekly Letter
Federal Reserve Bank of San Francisco, Number 95-19, May 12, 1995.
24
Lesson #6:
Inflation Objectives Should be Multi-Year in Nature
So As to Allow for a Gradual Adjustment to Price
Stability.
Countries adopting inflation targets have employed a multi-year time
frame in establishing their inflation objectives so as to allow for a
gradual, extended adjustment to price stability. An extended time period
is essential for complete disinflation to occur. Such an approach
considers not only the long lags of monetary policy on inflation, but also
the long-term contracts and the lags in the adjustment of both behavior
and inflationary expectations. Establishing multi-year objectives
increases the chances of success by allowing for a gradual conditioning
of expectations; hence, these objectives minimize economic disruption
while enhancing the credibility of inflation goals.
Lesson #7:
Inflation Targets Should be Accompanied by More
Open, Transparent Monetary Policy Reporting by
Central Banks.
Central Banks adopting explicit inflation targets have improved their
communication and reporting about the intent of and progress toward
achieving their stated targets. These banks recognize that for their
policies to be successful, their policy goals should be transparent;
objectives should be understandable, simple, explained, justified, and
restated frequently. Accordingly, these banks have more regularly issued
increasingly informative inflation reports. The Bank of England and the
Central Bank of New Zealand, for example, issue quarterly inflation
reports whereas the Swedish Riksbank issues such a report three times a
year. These reports are useful in both publicizing and explaining'policy
goals to the public as well as to the financial press. The reports
sometimes present an explicit inflation outlook and spell out ongoing
inflation developments. Such improved communication about both
policy targets and the actual inflation record is an essential element in
improving the credibility of inflation targets, thereby reducing the costs
of disinflation.
Lesson #8: The Inflation Targets for Monetary Policy Should be
Consistent With Other Macroeconomic Policies of the
Government.
Most countries adopting explicit inflation targets recognize that monetary
policy goals of price stability should be consistent with other macroeconomic policies of the government. A disinflation monetary policy
program which is inconsistent with other macroeconomic policies may
not be credible and hence may be more costly to implement than
otherwise would be the case.
25
Exchange rate objectives, for example, should be subordinate to
inflation targets for the latter to be credible, implying that the priorities
of the Treasury Department (or Minister of Finance) should be made
compatible with central bank objectives. Similarly, if levels of public
spending and budget deficits are high and increasing, the credibility of
price stability goals may be difficult to maintain. 3 0 ,3 '
One element of government debt policy is particularly notable in this
regard. Specifically, issuing inflation indexed bonds adds to the
credibility of monetary policy aimed at price stability because such debt
issuance removes government incentives to use inflation as a financing
tool (at least for that portion of the debt that is indexed). Indexed debt
cannot be inflated away, and such debt shifts the risks of inflation onto
the issuer (government) as opposed to the debt holder.3 2 Accordingly,
incentives for inflation are reduced and the credibility of price stability
goals is enhanced.
Notably, most countries recently adopting inflation targets also issue
inflation indexed debt. The United Kingdom, New Zealand, Canada, and
Sweden, for example, all issue indexed debt and all have had successful
inflation targeting experiences.
Mandating the Goal of Price Stability Should Not Be
Lesson #9:
Accompanied by Directives on Specific Procedures as
to How the Central Bank Should Achieve Price
Stability.
Successful experience in implementing price stability as the monetary
policy goal has been associated with the use of several (intermediate)
policy indicators or guides rather than a single (intermediate) policy
target. Indeed, adoption of inflation targets represents movement away
from a rigid adherence to explicit intermediate policy targets. Thus,
30 Pressures
to monetize the debt and/or deficit may increase with rising interest
rates.
3 t This
is the rationale underlying European debt and deficit criteria (under the
Maastricht Treaty) for entry to the European Monetary Union. This also
underpins the German desire for a European 'Stability Pact" agreement to bolster
the credibility of the EMU.
32As Treasury's Lawrence Summers has stated, 'Governments that sell inflation
insurance will tend to avoid inflation." Lawrence Summers, 'Comments on Why
are Central Banks Pursuing Long-Run Price Stability," Federal Reserve Bank of
Kansas City Symposium on uAchieving Price Stability," Jackson Hole,
Wyoming, August 29-31, 1996.
26
successful approaches to price stability involve instrument independence
but not goal independence; i.e., a mandated price stability goal but central
bank independence as to what procedures or guides to use to best achieve
this goal.
More specifically, successful pursuit of inflation targets has not been
achieved by targeting monetary aggregates, interest rates, or real
economic activity; i.e., unemployment rates or economic growth. Some
successful price stabilizing central banks, however, have used market
price variables such as exchange rates, commodity prices, or measures of
price expectations as policy guides. 33
SUMMARY AND CONCLUSION
A number of countries recognize the many potent benefits of price
stability and consequently have explicitly adopted it as the principal goal
of monetary policy. To date, preliminary evidence suggests the inflation
targeting experience of many foreign central banks has been quite
successful and promises to continue to provide excellent results. A
number of very important lessons can be learned from the accumulated
knowledge and experience in The United Kingdom, New Zealand,
Australia, Spain, Canada, Sweden, Finland, and other countries. This
paper briefly summarized these key lessons with the hope of improving
congressional legislative initiatives dealing with the goal of price stability
for U.S. monetary policy.
33See,
for example, Keleher, op cit, Charles Freedman, 'What Operating
Procedures Should be Adopted to Maintain Price Stability? Practical Issues,"
Paper presented at Federal Reserve Bank of Kansas City Conference on
'Achieving Price Stability," Jackson Hole, Wyoming, August 29-31, 1996.
27
A RESPONSE TO CRITICISMS OF PRICE STABILITY
INTRODUCTION
Central banks in several industrialized countries have made price stability
the primary goal of monetary policy in recent years. 34 Similar proposals
have been made for the U.S. Federal Reserve. A number of criticisms
have been directed at this strategy.
With deficit-manipulating fiscal policy no longer viewed as an
appropriate tool for macroeconomic stabilization policy, some critics
argue that a price stability mandate for monetary policy removes the only
remaining governmental economic policy tool capable of stabilizing the
macroeconomy over the business cycle.
Other critics posit that price stability is an inappropriate policy goal,
contending that some positive inflation improves the workings of the
economy by providing "the grease" for labor market adjustment and by
ensuring that monetary policy remains viable and potent while
minimizing deflation risk. Some cost-benefit (welfare) analysts contend
that the costs of pursuing price stability outweigh its benefits. Still other
critics focus on the measurement problems of defining price stability and
using existing biased price indices such as the Consumer Price Index
(CPI) as an inflation gauge.
This paper addresses key criticisms of price stability as monetary
policy's primary goal. Each criticism is addressed and, for reasons that
will be delineated, found to be without merit.
THE CRITICISMS
Criticism #1: Mandating price stability as the primary goal of
monetary policy removes the only remaining policy tool
capable of stabilizing the macroeconomy over the
business cycle. Withfiscalpolicy in a "balanced budget
mode "andtherefore deficit-manipulating fiscal policy
no longer capable of serving a stabilization role,
monetary policy must retain flexibility essential to
assume stabilization responsibilities. Without such
-
3 4These
countries include Australia, Canada, Finland, New Zealand, Spain,
Sweden, and The United Kingdom.
H.Rept. 105-807 - 98 -2
28
flexibility, nothing remains to stabilizea macroeconomy
vulnerable to various shocks.
This criticism overlooks the workings of fiscal stabilizers as well as
important stabilizing properties of both price stability and the manner in
which price stability should be (and has been) implemented. Price
stability itself works to stabilize the economy in several important ways:
it lowers interest rates and, because lower inflation is associated with
lessened volatility of inflation, it also lowers interest rates' risk and
uncertainty premiums, thereby stabilizing both financial markets and
interest rate sensitive sectors of the economy. 3 5 Businesspeople and
investors no longer base their decisions on expectations of future
inflation. Moreover, price stability fosters more efficient operation of the
price system and effectively acts like a tax cut. 36 As Federal Reserve
officials themselves have emphasized repeatedly, price stability lays the
groundwork for maximum sustainable long-term economic growth.
In responding to demand-side "shocks" or disturbances such as
sudden spending slow-downs, price stabilizing monetary policy and
counter cyclical policy are one and the same; such recessionary forces
would put downward pressure on prices, but monetary policy under a
price stability goal would be exerted in the opposite direction to stabilize
the economy. Thus, inflation targeting would automatically work to
minimize or offset demand-side disturbances to the macroeconomy,
thereby removing or minimizing one key source of business cycle
disturbance. Indeed, if the Federal Reserve successfully stabilizes prices,
recession is less likely since most economic downturns occur in response
to monetary policy actions to stem excessive buildups of inflation.
Furthermore, inflation targeting provides enough flexibility to
manage even supply-side disturbances. International experience demonstrates, for example, that inflation targets are normally bands or ranges,
allowing a good deal of flexibility in responding to such disturbances.
Adjustments to price indices for volatile (often supply-side) price
35See
Robert E. Keleher, The Roots of the CurrentExpansion, a Joint Economic
Committee report, April 1997, for an explanation of how anti-inflationary
monetary policy has contributed to the current expansion.
3 6Price
stability removes distortions to the price system and eliminates those
interactions of inflation and the tax code that lead to higher taxation on capital.
Price stability implies tax rates are effectively lowered on items such as capital
gains and/or depreciation allowances.
29
components such as food and energy are common. Furthermore, escape
clauses for special situations have also been used, and multi-year targets
emphasizing the long-term nature of price stability are typical. All of
these factors allow for policy reactions that promote a gradual transition
back to price stability, minimizing the disruption of supply-side shocks
while at the same time allowing leeway for near-term counter cyclical
policy. Additionally, inflation targeting as opposed to price level
targeting implies that inflationary supply-side disturbances need not be
offset by episodes of deflation: i.e., inflation targeting allows for a more
flexible, gradual, and non-disruptive return to stability.
In short, adopting price stability as the primary goal of monetary
policy allows for a significant degree of flexibility so that in practice, it
does not preclude achieving other desirable goals. A "gradualist" pursuit
of price stability typically does not conflict with stabilization goals. And
demand-side as well as supply-side disturbances can be readily managed.
Operationally, central banks pursuing price stability have not completely
abandoned stabilization goals; they have adopted "gradualist" approaches
and cushioned transitions to price stability.
Empirical evidence supports these assertions. The recent U.S. disinflation experience, for example, has been associated with lower interest
rates, stable financial markets, significant contributions from interest-rate
sensitive sectors, and a remarkably sustained recovery. Similarly, at least
one study has demonstrated that those countries recently adopting
inflation targets have not only significantly lowered their inflation rates
but have outperformed other (non-inflation targeting) countries in several
other respects as well.3" Furthermore, because of Sweden's price stability
regime, it outperformed most other countries in the turbulent 193 Os. 38
Additionally, some evidence suggests that lower inflation is associated
with higher economic growth. 3 9 Criticism suggesting the stabilization
37See,
for example, Bennett T. McCallum, 'Inflation Targeting in Canada, New
Zealand, Sweden, The United Kingdom, and in General," National Bureau of
Economic Research, Working Paper No. 5579, May 1996, p. 9 .
38 See Robert Keleher, 'The Swedish Market Price Approach to Monetary Policy
of the 193 Os," ContemporaryPolicy Issues, Volume IX, No. 2, April 1991.
39 See,
for example, Robert J. Barro, 'Inflation and Economic Growth," National
Bureau of Economic Research, Working Paper No. 5326, October 1995; Ruth
Judson and Athansasios Orphanides, 'Inflation, Volatility, and Growth," Board
of Governors of the Federal Reserve System, May 1996; and Brian Motley,
'Growth and Inflation: A Cross-Country Study," Federal Reserve Bank of San
30
function vanishes under inflation targeting regimes, therefore, has little
basis in either theory or fact and thus cannot be used as an argument to
discredit the goal of price stability.
Criticism#2: A strict price stability targetfor monetary policy is
suboptimal since it renders labor market adjustments
inoperative in the face of unemployment disturbances
and inflexible wages. With downward rigid nominal
wages, some positive inflation is essential tofoster labor
market (real wage) adjustment to unemployment disturbances. Pricestability, on the other hand, lowers real
wageflexibility and the allocativeefficiency of the labor
market Accordingly, the cost of eliminatinginflation is
higher than many believe since at low levels of inflation
a permanent tradeoff between unemployment and
inflation emerges; the unemployment costs of
eliminating inflation increase as inflation approaches
zero.40
This criticism misses the mark for a number of important reasons. It
recycles repudiated Keynesian arguments regarding macroeconomic
policy and the labor market. 4 ' According to this view, price stability will
result in increased (persistent) unemployment. This rise in unemployment, in effect, results from insufficient aggregate demand and,
accordingly, its remedy is to pursue expansionary policies that produce
more (albeit moderate) inflation. This higher inflation works to permanently lower unemployment. As the arguments below show,
increasing inflation to reduce unemployment is inappropriate for a
number of reasons.
Francisco, Working Paper 94-08.
40 In
other words, the Phillips Curve is non-linear and not vertical at low levels
of inflation.
writings of John Maynard Keynes in the 1930s reflected the special
circumstances characterizing The United Kingdom but not the United States.
Specifically, British labor markets in the 1920s and 1930s exhibited not only
high unemployment but a substantial degree of rigidity reflecting powerful,
entrenched labor unions, unemployment insurance, minimum wage laws, and
welfare schemes that had minimal influence in more flexible U.S. labor markets
in the 1920s and early 1930s.
4'The
31
This criticism rests on the presumption that nominal wages are
(downwardly) rigid when both inflation and expectations of future
inflation are eliminated. But empirical evidence that nominal wages are
rigid even during periods of moderate inflation is not conclusive. 4 2 Some
researchers, for example, find little evidence of such wage rigidity.4 3
Furthermore, there is anecdotal evidence that wage flexibility may have
increased as union membership has declined (as a percentage of the labor
force) and as higher percentages of workers are employed in smaller
firms whose wage arrangements are more likely to resemble 'auction"
rather than 'contract" formats.
Empirical evidence mustered to support the view that wages are
rigid under price stability is based largely on historical data from periods
of moderate inflation. While some evidence supporting some wage
rigidity may exist during periods of moderate inflation, there is little if
any evidence that nominal wages would be downwardly rigid under price
stability. Indeed, there is reason to believe that wages likely would
become more flexible after a period of stable prices since such a regime
would generate a different set of expectations and hence foster different
behavior on the part of both suppliers and demanders of labor services."
Historical episodes of relatively stable prices in the early 1900s,
especially the 1920s, much of the 1950s, and even the mid-1990s indicate
4 2Moreover,
the methodology used to assess such rigidity is dubious.
Specifically, observations of the frequency of downward wage adjustments
(during moderate inflation) are used to draw inferences about wage 'rigidity."
With positive productivity growth, it is not obvious why negative wage
movements would be expected under price stability. Furthermore, economic
definitions of wage 'rigidity" pertain to the responsiveness of nominal wages to
changes in unemployment rather than to simply the frequency of negative
(nominal) wage adjustments.
43See, for example, A. Crawford, and C. Dupasquier, "Can Inflation Serve as a
Lubricant for Market Equilibrium," in Economic Behavior and Policy Choice
Under Price Stability. Ottawa, Bank of Canada, 1994, pp. 49-80; David E.
Lebou, David J. Stockton, and William L. Wascher, 'Inflation, Nominal Wage
Rigidity, and the Efficiency of Labor Markets," Finance and Economics
Discussion Series, Board of Governors of the Federal Reserve System, 94-95,
October 1995; and Kenneth J. McLaughlin, "Rigid Wages?," Journal of
Monetary Economics, 34 (1994), pp. 383-414.
44See, for example, Robert J. Gordon, "Comments and Discussion," Brookings
Papers on Economic Activity, 1, 1996, p. 62.
32
that during these periods unemployment rates were low, not high, as
predicted by this view. In short, workers' resistance to wage cuts
depends on the monetary regime; nominal wage rigidity is not
necessarily a permanent characteristic of the labor market.
Of course, some wage rigidity may be related to longstanding labor
market institutions (e.g., minimum wage laws, unemployment insurance,
union strength, etc.) that adjust only very slowly to changes in both
money regime and price expectations. Accordingly, such institutional
rigidity cannot readily be affected by changes in a monetary policy or
policy regime. And changing these institutions is not the function of
monetary policy; the monetary authority can only establish a regime that
influences expectations of future inflation. The problem of gradual labor
market adjustment in this case, therefore, is institutional wage rigidity,
not price-stabilizing monetary policy. It would be a serious monetary
policy mistake to adopt, in effect, inflationary policies to accommodate
these institutions.
The strategy of adopting inflationary policies "to lubricate' the labor
market depends on "money illusion" and would fail to lower real wages,
to facilitate labor market adjustment, to make the labor market more
flexible, or to lower unemployment. 4 5 Instead, this policy would have the
unintended effect of making nominal wages increasingly downwardly
rigid and upwardly flexible. 4 6 Thus, such policy does not predictably
lower real wages or the unemployment rate. Indeed, even moderate
inflation cannot produce sustained benefits and often leads to both higher
unemployment and higher inflation. Furthermore, higher inflation
would increase the noise in relative wage changes, thereby reducing the
efficiency of the wage setting process. 4 7 Additionally, this criticism
illusion" refers to the argument that workers will not accept a
reduction in their real wage brought about by lowering nominal wages but will
accept an identical real wage reduction implemented by increasing the price
level.
45"Money
would occur because persistent inflation would work to strengthen the
above-mentioned institutional rigidities (causing nominal wages to become more
downwardly rigid). At the same time, strengthened expectations of future
inflation would bring about more frequent recontracting of nominal wages
resulting in increased flexibility in the upward direction.
4 7See Ben
Bernanke and Frederic Mishkin, Inflation Targeting: A New
Framework for Monetary Policy?," National Bureau of Economic Research,
Working Paper No. 5893, January 1997, p. 29 (footnote 12).
46This
33
ignores the employment promoting effects of price stability as described,
for example, in Keleher (1997).4
Fortunately, with theoretical advances in recent years, this view is
now a minority position.4 9 Such criticism of price stability rests on
neither solid theoretical nor empirical ground. Wage rigidities-to the
extent they do exist-cannot be mitigated by altering monetary policy.
Promoting more inflation to lubricate the labor market would only work
to lessen existing wage flexibility. And contrary to this criticism, price
stability and stabilizing price expectations would work to promote rather
than to inhibit such flexibility.
Criticism#3: Positiveinflation is essential to allow monetarypolicy to
pursue expansionary policy in a low interest rate
environment. With positive inflation rates, central
banks can respond to negative aggregatedemandshocks
by driving nominal short-term rates below expected
inflation, thus making the realFedfunds rate negative
and boostingthe economy. Underpricestability (or zero
inflation), on the other hand, the zero interestratefloor
on nominal interestrates translatesinto an equivalent
non-negativefloorforreal short-term rates, limiting the
centralbank's ability to reduce realshort-term rates and
stimulate the economy. Yet historically, negative real
(short-term) interest rates have been essential
ingredients in facilitating economic recoveries and
bolstering thefinancialsystem in situationsoffinancial
crisis or strain. Thus, zero inflation importantly
constrains monetary policy by removing this degree of
freedom and removing the central bank's ability to
pursue expansionarypolicies in these circumstances.
Pricestability, therefore,poses importantrisks. Positive
inflation allowsfor broadermonetarypolicy options and
is needed '(to lubricatethe wheels of monetarypolicy. "
This criticism reflects remarkable confusion as to the working of
monetary policy. It suggests monetary policy may be unable to lower
4 8Robert
E. Keleher, The Roots of the Current Expansion, a Joint Economic
Committee study, April 1997.
4 9See Carl Walsh, 'Nobel Views on Inflation and Unemployment," Economic
Letters Federal Reserve Bank of San Francisco, 97-01, January 10, 1997, p. 2.
34
short-term interest rates and therefore unable to stimulate the economy
under conditions of price stability or deflation. Yet, clearly, the
monetary authority can use open market operations to purchase a wide
spectrum of financial assets in pursuing expansionary policy; monetary
policy need not work exclusively through short-term rates. Most notably,
long-dated securities or foreign exchange, for example, easily could be
purchased and used as transmission vehicles for expansionary monetary
policy. 5 0 But even if the monetary authority wanted to remain in shortdated securities, it could continue to purchase such securities in the open
market, thereby creating reserves until broad money and credit
aggregates expanded and forward-looking market prices (such as
commodity prices and foreign exchange rates) suggested a depreciation
in the value of domestic currency. Monetary policy, therefore, can be
expansionary despite low short-term interest rates. Furthermore, the
discount window remains available for use in these circumstances. In
short, monetary policy can be highly potent through a wide variety of
channels in stimulating a weak economy even if interest rates are low.
Empirical indicates that expansionary monetary policy has in fact
occurred under noninflationary conditions (for example, in the United
States, Britain, and Sweden during the 1930s)."' In sum, there is no
theoretical foundation for and little, if any, empirical evidence supporting
the argument that monetary policy cannot be expansionary in low interest
rate environments.
This criticism is more an indictment of the effectiveness of real
interest rates as guides or indicators for monetary policy than a challenge
to the potency of monetary policy in a low rate environment. To repeat
a well-known lesson of monetary theory: it is often misleading to equate
a particular level of interest rates with the stance of monetary policy.
Criticism of price stability as limiting the ability of policy to stimulate
5 0Such
action would push up bond prices and depreciate the foreign exchange
rate.
5'See,
for example, Milton Friedman and Anna Schwartz, A Monetary History
of the United States 1867-1960, 1963, Princeton: Princeton University Press;
Frederic Mishkin, 'General Discussion: Overview Panel," Achieving Price
Stability, Federal Reserve Bank of Kansas City, 1996, pp. 339-340; Frederic
Mishkin, uThe Channels of Monetary Transmission: Lessons for Monetary
Policy," Federal Reserve Bank of New York, February 1996, p. 22; and Christina
Romer, 'What Ended the Great Depression?," Journal of Economic Historv.
December 1992, 52, No. 4, pp. 757-784.
35
the economy by lowering short-term interest rates is an example of this
common error. Indeed, real interest rates are particularly unreliable
guides to monetary policy for a number of reasons. 52 Rather than interest
rates, jointly assessed market price indicators (such as commodity prices
or foreign exchange rates) as well as broad measures of the money supply
are normally reliable monetary policy indicators in noninflationary
circumstances.
Finally, the criticism fails to recognize that a credible policy of price
stability implies the absence of deflation and deflationary expectations.
Such a policy lessens the chances of both negative demand shocks and
financial strains of the type requiring stimulative policies suggested in
the criticism. In short, potential problems requiring stimulative monetary
policy are less likely to occur with a credible price stability policy.
In sum, the presence of low interest rates and the absence of
inflation do not constrain monetary policy; stimulative policy can still
occur via a wide variety of channels in these circumstances. Price
stability, however, does minimize the need for such stimulative policy
and this environment highlights the limitations of real interest rates as
policy guides.
Criticism #4: Once inflation is underway, it is better to tolerate
moderate inflation than to bear the significantcosts of
reducing it to zero. Welfare analysis suggests that
reducing inflation to zero is inappropriatesince at
modest/moderatelevels of inflation, the discountedcosts
of reducing inflation outweigh the accompanying
discounted benefits. In short, the cost of going from
moderate inflation to zero inflation does not warrantthe
benefits ofprice stability.5 3
52Real interest rates can be inappropriate guides to monetary policy not only
because they are unobservable, depending on accurate measures of inflationary
expectations, but also because their equilibrium values constantly change with
alterations in returns to (and productivity of) capital.
popular version of this argument is sometimes referred to as Howitt's
Rule, which states that the policy of disinflation should be continued until an
inflation rate is reached such that the present value of the costs of further
disinflation equal the present value of the gains from additional disinflation. See
Daniel L. Thornton, "The Costs and Benefits of Price Stability: An Assessment
of Howitt's Rule," Federal Reserve Bank of St. Louis Review March/April 1996,
p. 33.
53One
36
Evaluating such arguments is difficult because proper assessments
necessarily entail both comprehensive and accurate measures of the
discounted (private and public) costs and benefits of reducing inflation
over extended periods of time. The availability of such figures is
exceptionally difficult given the current state of knowledge.
For example, whether particular measures of the cost of inflation are
comprehensive is difficult to know. Earlier attempts to measure these
costs were based on partial equilibrium models with inflation interpreted
as a tax on real money balances.5' These estimates of the cost of inflation
were quite low but later refined general equilibrium estimates of these
costs of the inflation tax were higher. 5 5 More recently, research has
focused on the interaction of inflation and the tax code. These later
calculations are more comprehensive and find significantly higher costs
of maintaining existing inflation than those interpreting inflation as a tax
on money balances.5 6 These more recent results suggest that since the
costs of inflation are so high, inflation should be reduced.
Yet most analysts concede that even these most recent calculations
are incomplete, omitting, for example, quantification of both inflation's
uncertainty costs and the cost of inflation's distortion of the price
system." Thus, even these more comprehensive cost estimates most
likely are understated.
5 4See,
for example, M.J. Bailey, 'The Welfare Cost of Inflationary Finance,"
Journal of Political Economy, p. 64, April 1956: pp. 93-110; M. Friedman, 'The
Optimum Quarterly of Money," in The Optimum Ouantitv of Money and Other
Essays, 1969, University of Chicago Press, Chicago, pp. 1-50.
55See, for example, Richard Black, Donald Coletti, and Sophie Monnier, 'On the
Costs and Benefits of Price Stability," Bank of Canada Conference on Price
Stability, Inflation Targets, and Monetary Policy, May 1997, p. 27. These
estimates are sensitive to the specification of money demand and the definition
of money (see p. 27).
56See Black, Coletti, and Monnier, op.cit., p. 28.
for example, Black, Coletti, and Monnier, op. cit., p. 26; Robert E. Lucas,
"On the Welfare Costs of Inflation," Center For Market Policy Research
Stanford University, February 1994, p. 22; and Gregory Hess and Charles
Morris, 'The Long-Run Costs of Moderate Inflation," Economic Review. Federal
Reserve Bank of Kansas City, Second Quarter 1996 (Volume 81, No. 2), p. 84.
57See,
37
In addition, the accuracy of these (discounted) costs and benefits of
inflation is exceedingly difficult (if not impossible) to establish. Reasons
include the following:
* Estimates depend on factors difficult to measure.
The costs of reducing inflation depend significantly on factors
notoriously difficult to quantify, such as price expectations, the
credibility of policy makers, and the stickiness of prices and
wages. Furthermore, there is no way to know how these
factors may change in the future.
* Estimates depend on arbitrary assumptions.
The measured costs and benefits of inflation are often
conjectural, depending heavily on unavoidable assumptions.
For example, the results depend on 1) what discount rate is
assumed, 2) whether inflation is presumed to influence the
level or growth rate of output, 3) which tax structure is
assumed, or 4) whether various costs or benefits of inflation
are presumed to be transitory (one-time events) or permanent
in nature. 5 8 If these key assumptions are changed, the
conclusions can change dramatically.
*
The power or robustness of the estimates is low at modest
levels of inflation.
The application of welfare theory to crude, imperfect realworld data is problematic. The power or robustness of relevant
empirical estimates is low; these estimates are sensitive and
can change dramatically with alternative specifications and/or
methodology. This is especially the case when such estimates
are made for environments of low levels of inflation where
relatively few data points or observations exist.
As a consequence of this lack of precision, numerical estimates of
the discounted costs and benefits of moving from low levels of inflation
to zero inflation must be regarded with a good deal of caution and
reservation.
Nonetheless, despite these many significant problems, the most
recent, most comprehensive, and likely most accurate estimates indicate
that the costs of even "low" or "a little" inflation are significantly larger
58 See,
for example, Thornton, op. cit. pp. 33-34.
38
than suggested by critics of price stability.5 9 This research suggests that
those critics advocating continued inflation have substantially
underestimated its costs, and that the perverse effect of inflation on
output is significantly larger at lower rates of inflation than previously
believed. These estimates indicate that large net gains would accrue by
moving to price stability; the benefits of price stability significantly
outweigh its costs.
Prominent examples of such research include Lucas (1994) and
Feldstein (1996).' Lucas' estimates of the U.S. welfare cost of inflation
attaches much higher costs to low rates of inflation than previous
estimates. Feldstein argues that the benefit of moving to price stability
from low levels of inflation substantially exceeds its costs; he maintains
that very large net gains would be made by moving to zero inflation.
Focusing on the interaction of inflation and the tax structure, Feldstein
contends that these interaction effects cause substantial welfare losses
even at low levels of inflation. He argues that the effects of the
interaction of inflation and capital taxation are much larger than
distortions to money demand and the resulting seignorage. 6 ' More recent
studies by a number of other researchers substantiate these results for
both the United States and other countries. 6 2
In conclusion, this welfare cost criticism of price stability, therefore,
does not withstand close scrutiny, depending only on arbitrary
assumptions and selective methodology. To be sure, there are formidable
problems of calculating comprehensive and accurate measures of the net
59 Comparisons
of the results of these studies are difficult to make because of the
many differences cited above. A thorough review of the literature is found in
Black, Coletti, and Monnier, op. cit.
E. Lucas, Jr., "On the Welfare Cost of Inflation," Center for Economic
Policy Research, Stanford University, February 1994; Martin Feldstein, "The
Costs and Benefits of Going from Low Inflation to Price Stability," National
Bureau of Economic Research, Working Paper No. 5469, February 1996.
60Robert
6 t Feldstein,
62See
op. cit., pp. 51-52.
contributions summarized in "The Costs and Benefits of Achieving Price
Stability," NBER Reporter, Spring 1997, pp. 29-30, to be published by the
University of Chicago Press in National Bureau of Economic Research
conference volume. See also Andrew B. Abel, "Comment," in Reducing
Inflation: Motivation and Strategy, edited by Christina D. Romer and David H.
Romer, University of Chicago Press, Chicago, 1997.
39
benefits of moving to zero inflation from low levels of inflation.
Nonetheless, the best recent research suggests that the benefits of moving
to zero inflation substantially outweigh the costs of doing so; price
stability is well worth its cost.
Criticism#5: The true rate of price inflation cannot be measured
accurately with broad price indices such as the
Consumer Price Index There are well-documented
measurementbiases of the CPIinvolving overestimates
of inflation: ie., the true rate of inflation is below the
measured rate. These biases imply that the CPI (and
other broad inflation measures) cannot be employed as
usefulpolicy goals. As a consequence, price stability or
inflation targeting is unworkable as a strategy for
monetary policy and cannot, in practice, be
implemented.
While mismeasurement bias certainly exists and should be considered,
the problem is not a major one and is certainly easily manageable.
Estimates of the CPI inflation bias do vary, but most fall within a range
of about 0.5 percent to as much as 2.0 percent per year.6 3 Any price
stability or inflation target adopted, therefore, could easily include an
adjustment equal to the estimated measurement bias. And since such
targets normally take the form of bands, uncertainties associated with
these estimates could be reflected in the band width. Furthermore, some
of the CPI measurement bias is already being remedied by the Bureau of
Labor Statistics and plans for correcting other problems are already
underway.' An adjusted CPI inflation target, therefore, could readily
serve as a viable inflation policy goal.
But the inflation targeting strategy is not necessarily wedded to the
CPI or any single measure of price change. Should the CPI not be
chosen, other indices are readily available and accessible.
The rich international experience of inflation targeting provides
many lessons in this regard. Despite recognized measurement bias in
63 Alternative
price indices have problems of their own, so no practical alternative
exists. See, for example, Charles Steindel, 'Are There Good Alternatives to the
CPI?," Current Issues Federal Reserve Bank of New York, Volume 3, Number
6, April 1997.
64See Bureau of Labor Statistics, U.S. Department of Labor, 'Measurement
Issues in the Consumer Price Index," June 1997.
40
their respective CPI inflation measures (or equivalents), the several
countries that have adopted explicit inflation targets all have successfully
used the CPI (or equivalent) measure as the basis for their inflation
targeting and anti-inflation programs. Measurement bias is viewed as a
relatively minor problem outweighed by the CPI's many practical
advantages: namely, its familiarity, ready availability, minor revisions,
and convenience in communicating with the public. Notably, most
countries using CPI inflation targets adjust the index for volatile
components and non-monetary influences. Despite imperfections,
therefore, CPI targets are viewed as quite practical and useful; the CPI is
certainly a viable price or inflation target.
SUMMARY AND CONCLUSIONS
A number of criticisms have been directed at the strategy of mandating
price stability goals 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:
* 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, unlike price
stability.
* 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 and highlights the limitations of real interest
rates as effective monetary policy guides.
* 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 recent 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.
41
TRANSPARENCY AND FEDERAL RESERVE
MONETARY POLICY
INTRODUCTION
Today's changing financial environment demands 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 antiinflation monetary policy. Two reasons underscore the need for greater
transparency.
First, previous commodity-based monetary standards anchored the
price system and established well-understood, automatic rules governing
central bank actions.6 5 Until the demise of the (Bretton Woods)
commodity-linked international monetary system in the early 1970s, the
actions of the central bank were predictable in given circumstances,
obviating the need for explicit delineation of objectives and operating
procedures.
Today, no monetary standard or price anchor has emerged to replace
the previous system's rules. As a result, both the goals of monetary
policy and the principles that govern policy remain unclear. This
uncertainty makes financial markets more volatile and anti-inflation
monetary policy more costly than necessary.
Second, monetary policy transparency can make financial markets
less volatile and can help them better reflect relevant information for
monetary policy. Milton Friedman recognized the relationship between
the information revolution and the disciplinary role of financial markets:
The information revolution has greatly reduced
the cost of acquiring information and has enabled
expectations to respond more promptly and
accurately to economic disturbances, including
changes in government [monetary] policy. As a
result, both the public at large and financial markets
J.M. Keynes, Treatise on Money: The Applied Theory of Money,
MacMillan, London, 1971, p. 207.
6 5See
42
have become far more sensitive to inflation and
more sophisticated about it than in earlier times."
Because of this phenomenon, central banks are increasingly obliged
to pay more attention to, respond to, and in effect be disciplined by
inflationary signals in the foreign exchange, commodity, and bond
markets. Many central banks have found that increased transparency
improves the efficiency of financial markets and, therefore, enhances
their usefulness for market participants as well as for the central banks
themselves; Recognizing transparency's benefits, these central banks not
only have adopted explicit goals in the form of inflation targets but have
also improved their reporting of progress in achieving these targets, of
procedures and indicators used in conducting policy, and of policy
decisions. The Federal Reserve has also made some progress on this
front but generally has lagged behind several other central banks.
The U.S. Congress, of course, has an inherent interest in and responsibility for increased Federal Reserve transparency because of its
oversight responsibilities for monetary policy. By enforcing greater
transparency in the form of mandated explicit policy goals and improved
reporting requirements, Congress' oversight responsibilities would be
simpler and less burdensome. Congress can learn from these developments and international experience, in effect delegating a portion of
oversight responsibility to the financial markets and allowing them to
play a larger disciplinary role.
After defining transparency and describing reasons for and consequences of traditional central bank secrecy, this paper presents the case
for increased Federal Reserve transparency. Historical improvements in
Federal Reserve transparency are documented, and comparisons to other
central banks are made. Several forms of transparency are delineated and
specific recommendations for improved transparency are described.
DEFINITION OF TRANSPARENCY
Dictionaries define "transparency" as easily seen through or detected;
obvious, candid or open, clear; free from guile. A transparent monetary
policy is characterized by lack of secrecy, obfuscation, or ambiguity, and
should be understandable to those outside the policy process including
both ordinary citizens as well as legislators responsible for policy
oversight.
66See Milton Friedman, 'Monetary Policy in a Fiat World," in Money Mischief,
Harcourt Brace Jovanovich, New York, 1992, pp. 254-5 [parenthesis added].
43
The concept of transparency for monetary policy has multiple
dimensions. Transparency is relevant for policy goals as well as for
policy procedures or "policy apparatus'; i.e., the instruments, indicators,
and procedures used in conducting policy to attain given policy goals.
Goal clarification, however, is the more important component of a
transparent monetary policy since such clarification helps to identify
which instruments, indicators, and procedures are best suited to achieve
stated objectives. If price stability is identified as the proper goal of
monetary policy, for example, then the policy instruments, indicators,
and procedures chosen should maximize the probabilities of achieving
this goal. Different goals may necessitate different variables for these
purposes. Notably, one of the lessons of international inflation targeting
experience is that successful central banks focus more on goal
clarification than on explanation of policy procedures." Nonetheless,
markets work better when more information is available, when policy
goals are well known, and when central bank reactions to indicator
variables are understood.
Timeliness is another dimension of transparency. Prompt disclosures of policy objectives, of progress in achieving these goals, and of
procedures used in implementing policy are important elements of an
open monetary policy. Transparent monetary policy, therefore, necessarily involves not only the clarification of objectives, but the timely and
more complete disclosure of policy decisions and their underlying
rationale.
CENTRAL BANK SECRECY
The historical reluctance of central banks to become open and transparent
is well known. Many journalists, academics, and Members of Congress
have recognized that secrecy and ambiguity are part of the culture of
central banks.' Furthermore, recent research has demonstrated that the
Federal Reserve has considerable information about important policy
See Robert E. Keleher, Lessons From Inflation TargetingExperience, A Joint
Economic Committee Report, February 1997.
68
See Marvin Goodfriend, 'Monetary Mystique: Secrecy and Central Banking,"
Journal of Monetar= Economics 17, 1986, pp. 63-92, and references cited
67
therein.
44
variables beyond what is known to commercial forecasters, suggesting
that current policy is not transparent in nature. 69
The Federal Reserve, for example, has explicitly defended secrecy,
opposed full disclosure, and (historically) objected to inflation targets.7 0
The argument has been that fuller disclosure would promote unnecessary
volatility in financial markets, benefit certain speculators, and interfere
with the execution of monetary policy. More fundamentally, historical
central bank opposition to transparency seemingly relates to a distrust of
market mechanisms stemming from the original lender-of-last-resort
function of central banks, as well as to bureaucratic rent seeking behavior
on the part of central bankers in order to protect their privileged
monopolistic position while avoiding accountability. 7"
69See,
for example, Christina D. Romer and David H. Romer, 'Federal Reserve
Private Information and Behavior of Interest Rates," NBER Working Paper 5692,
July 1996.
70 See
Goodfriend, op. cit. for a review and analysis of the Federal Reserves'
defense of secrecy. See also Robert E. Keleher, 'The Pros and Cons of an
Immediate Release of the FOMC Directive," unpublished memo, Federal Reserve
Bank of Atlanta, June 1984. For documentation of Federal Reserves' historical
opposition to inflation targets, see Irving Fisher, Stable Money, Aldephi Co., NY,
1934.
7 1For an
analysis of bureaucratic incentives for covertness, see John F. Chant and
Keith Acheson, 'The Choice of Monetary Instruments and the Theory of
Bureaucracy," Central Bankers. Bureaucratic Incentives, and Monetary Policy.
edited by Eugenia Toma and Mark Toma, Kluwer Academic Publishers, Boston,
1986, pp. 107-128 (esp. pp. 109-11).
The original lender-of-last-resort (LOLR) function of central banks was
premised on a belief in the inability of market mechanisms to prevent contagious
bank runs causing contractions of the money supply and economic activity.
Earlier provision of LOLR services involved the use of the discount window
which necessarily involved proprietary information about individual bank loans
and the individual portfolios of banks. Part of the responsibility of the LOLR
was to maintain public confidence in the banking system while at the same time
protecting the proprietary information of troubled banks. This function
contributed to the culture of central bank secrecy which continues to this day.
45
CONSEQUENCES OF SECRECY
Secrecy on the part of central banks such as the Federal Reserve has
important consequences. The lack of an understandable price stability
objective, for example, often results in multiple, alternating policy goals,
producing unnecessary uncertainties and fostering volatility in financial
markets. As a result, these markets react to any news suggesting the
Federal Reserve is shifting policy objectives. Financial markets also
respond to policy moves or statements of Federal Reserve officials since
this information provides further clues as to Federal Reserve policy
objectives as well as to its "economic model" or "policy apparatus."
Therefore, uncertainty premiums build into interest rates causing them
to be higher than would otherwise be the case. Furthermore, without a
specific understandable policy objective, the central bank cannot be held
accountable for its actions, and its credibility suffers. This deterioration
of credibility raises the costs of disinflationary monetary policy.
Secrecy of the monetary policy process and policy indicators also
promotes increased financial market uncertainty, unnecessary volatility,
and, accordingly, larger uncertainty premiums in interest rates. Since
markets are unsure as to what variables are used as policy indicators and
what weights various data are accorded, markets react to any data
releases they believe will influence Federal Reserve behavior.
Partly as a result of recognizing these consequences, much of the
rationale for central bank secrecy recently has been discredited by the
force of logical argument as well as by empirical evidence. Some
central banks themselves have recognized the value of transparency.
THE CASE FOR TRANSPARENT MONETARY POLICY
Establishing understandable monetary policy goals, informing the public
about policy decisions in a timely fashion, and explaining how other
variables are employed in the policy process have a number of
advantages which work to improve monetary policy. Recognizing these
advantages has prompted the central banks of several countries to adopt
more transparent approaches to monetary policy. Specifically, a more
evidence that increased central bank disclosure does not disrupt markets,
see Michael T. Belongia and Kevin Kliesen, "Effects on Interest Rates of
Immediately Releasing FOMC Directives," Contemporarv Economic Policy Vol
XII, October 1994, pp. 79-91; and Daniel L. Thornton, 'Does the Fed's New
Policy of Immediate Disclosure Affect the Market?," Review Federal Reserve
Bank of St. Louis, November/December 1996, pp. 77-88.
72For
46
transparent policy approach would make a number of contributions to
Federal Reserve monetary policy, to the economy, and to financial
markets. Improved transparency, for example, would:
* Help to clarify the primary long-term policy objective.
A more open, forthright policy process would create powerful
incentives for monetary policymakers to carefully outline the
primary objectives of monetary policy. This process, in turn,
would create incentives to keep attention focused on such goals
as well as to adopt procedures, indicators, and instruments that
would maximize the chances of achieving these objectives.
* Improve the workings and usefulness of financial markets.
Contrary to assertions of the Federal Reserve, empirical
evidence shows that central bank provision of more complete
and timely information does not increase the volatility of
financial markets. Instead, financial markets work better when
inflation objectives are clarified and more timely and detailed
information is readily available. A more open, transparent
policy environment improves the workings of financial
markets because unnecessary uncertainties and confusion are
minimized and market volatility is reduced. More information
enables private sector expectations to adjust faster to changes
in monetary policy, allowing private sector agents to learn
faster and minimize disruption of policy change. With a
consequent reduction in uncertainty premiums, interest rates
will be lower, bolstering bond and equity markets. The result
is improvement of the information content of these financial
market prices, and their increased usefulness as conveyers of
market sensitive information.
*
Improve central bank credibility.
A more transparent, open monetary policy also enhances
central bank credibility. As monetary policy goals and procedures become well known and understood, the public more
quickly learns about changes in policy, and central banks
become more committed to achieving their publicly stated
goals. As they begin to achieve these goals with greater
regularity, central banks achieve enhanced credibility.
This improved credibility, in turn, enables expectations to
adjust faster to changes in monetary policy, fostering more
flexibility in labor and other markets and lowering
47
*
*
employment and output costs of disinflation. Goals such as
price stability, therefore, can more easily be attained, managed,
and maintained.
Minimize the chances policymakers would manipulate
policy for political purposes.
A more transparent monetary policy lessens the chances that
73
policymakers will manipulate policy for political purposes.
Open, transparent and well-known policy goals and procedures
would allow private analysts and financial markets to
constantly monitor Federal Reserve actions and readily detect
any manipulation of monetary policy for political purposes.
Markets would quickly react to such manipulation by
immediately revising inflationary expectations, and such action
would readily be obvious to everyone. Consequently, the
opportunity for central bankers to surprise the markets with
stimulative policy would be severely constrained.7
Work to improve monetary policy.
More transparent monetary policy would encourage and lead
to more open debate and criticism; private sector analysts
could more openly critique central bankers' actions, procedures, and rationale. Such criticism, in turn, would oblige
the monetary authority to defend its policy objectives,
decisions, and procedures. The Federal Reserve would be
forced to openly confront and reconcile inconsistencies in its
policy; incentives would be created for the central bank to get
its analysis right. This resulting competition of ideas and more
open dialogue would inevitably lead to improved, more
informed policymaking.
*
Complement congressional oversight responsibilities.
A more transparent monetary policy would serve to
complement responsibilities of the Congress for overseeing
Federal Reserve policy. As suggested above, more timely,
detailed Federal Reserve disclosure and a more open approach
to monetary policymaking would help to improve the workings
In technical jargon, transparency would help to minimize the 'time
inconsistency problem."
74 See Andrew G. Haldane, 'Introduction," Targeting Inflation, edited by
73
Andrew Haldane, Bank of England, 1995, pp. 10-11.
48
of financial markets and enable these markets, in effect, to
better discipline monetary policy. As such, these markets
could serve to complement congressional responsibilities for
overseeing monetary policy. In particular, Congress could
adopt a strategy to enhance transparency and thereby impose
increased market discipline on Federal Reserve policy.
Committees responsible for monetary policy oversight could
closely monitor key market variables in assessing and
evaluating the appropriateness of the stance of monetary
policy. In effect, Congress could facilitate the delegation of
some oversight responsibility to the market. Congressional
oversight, therefore, would be simplified.
ADOPTION OF MORE TRANSPARENT CENTRAL BANK POLICIES
Recently, the Federal Reserve as well as several other central banks have
adopted more transparent monetary policies. In the 1990s, for example,
a number of central banks identified price stability as their primary
policy goal and, accordingly, adopted explicit inflation targets."5 But the
commitmentlo transparency has taken these central banks far beyond the
adoption of inflation targets. Many of these banks, for example, have
consciously made improved transparency a goal of their respective
institutions." In implementing their strategies, for example, several of
these banks immediately disclose policy decisions when they are made.
These announcements are often accompanied by a detailed discussion as
to the rationale for the policy move. More frequent and higher quality
published materials, testimony, and speeches also are elements of such
strategies to improve transparency. Some of these banks publish
inflation forecasts as part of their efforts."
The Federal Reserve has also made moves to become more
transparent in recent years. Such moves, for example, include:
See Robert E. Keleher, Lessons From Inflation TargetingExperience, A Joint
Economic Committee Report, February 1997.
75
See, for example, Gordon G. Thiessen, Governor of the Bank of Canada,
"Towards a More Transparent and More Credible Monetary Policy," Remarks,
Montreal, Quebec, October 9, 1996; Andrew G. Haldane, op.cit. pp.1 0-11; and
Frederic S. Mishkin and Adam S.Posen, "Inflation Targeting: Lessons from Four
Countries," Economic Policy Review (Special Issue on Inflation Targeting),
August 1997, Volume 3, number 3.
77 The Bank of England's Inflation Report is often cited to illustrate this point.
76
49
immediate notification of FOMC policy decisions;
* earlier release of the FOMC policy directive; and
* release of more information such as regional information
contained in the so-called "Beige Book."7 8
In addition, the Federal Reserve provides a significant amount of
information about its operations in various publications, reports,
speeches, and testimony.
*
RECOMMENDATIONS FOR MORE TRANSPARENT FEDERAL
RESERVE MONETARY POLICY
Although the Federal Reserve has come a long way from its earlier, more
secretive approach to policy, its journey toward openness is still
incomplete. Indeed, Federal Reserve policies still lag behind the more
transparent policies of many of the world's more innovative central
banks.
In view of its lackluster record on openness, the Federal Reserve
should work to transform its historic secretive "culture" by adopting a
number of changes to make U.S. monetary policy more transparent. In
particular, the Federal Reserve should:
* Adopt explicit inflation targets.
The most important step the Federal Reserve could take in
moving to a more transparent policy would be to explicitly
adopt price stability as the primary goal of monetary policy.
As previous Joint Economic Committee studies have
demonstrated, this can best be accomplished by adopting
For descriptions of the historical evolution of Federal Reserve disclosure
policy, see, for example, Anna J. Schwartz, 'Central Banking in a Democracy,"
unpublished manuscript presented at Western Economic Association meetings,
Seattle, Washington, July 9-13, 1997; and Marvin Goodfriend, op.cit.
Before 1967, the record of policy action was published only in the Federal
Reserve Board's Annual Report. Beginning in mid-1967, the Board began to
release this record 90 days following an FOMC meeting. In March 1975, the
Federal Reserve further reduced the delay from 90 days to 45 days. In May
1976, the release was further changed from 45 days to a few days after the next
regularly scheduled FOMC meeting (a week or two earlier than previously).
Recently, this report has been released on Thursday following the next regularly
scheduled FOMC meeting. The uBeige Book" was formerly the "Red Book,"
which had (lower-level) confidential status until mid-1983.
78
50
*
*
*
inflation targets as many other successful central banks have
done.
Report to the Congress more frequently on monetary
policy.
The Federal Reserve could improve the transparency of
monetary policy by reporting more frequently to the Congress
than biannually as is now the practice. Reporting quarterly or
every four months would be more appropriate.
Release information earlier to the public.
The transparency of policy could also be improved by earlier
release of information to the public. With speedy modem
information processing equipment, it no longer should take
more than six weeks to prepare and release (edited) minutes of
FOMC meetings. Furthermore, while some delay may be
appropriate, there appears to be little reason for a five-year
delay in releasing verbatim transcripts of FOMC meetings as
well as "Greenbook" forecasts and "Bluebook" analyses.
Provide more useful information to the public.
The Federal Reserve can improve its information dissemination
function in many ways. At the time FOMC decisions are
announced, for example, more detailed explanations as to the
rationale for policy change could be provided, perhaps
involving a brief press conference. When the FOMC decides
to leave policy unchanged, an explanation regarding why no
action was taken can be just as important as providing rationale
for an actual change in policy."9
The Federal Reserve also could keep markets better informed
about its current policy position. When market expectations
appear to be at a variance with the Federal Reserve's internal
expectation, for example, the Federal Reserve could make an
effort to condition market expectations by providing more
information about its policy intentions, goals, strategy, and
"model of the economy." This would help foster predictability
and promote financial market stability.
More information about current inflation, Federal Reserve
progress in reaching inflation targets and explanations as to
The Federal Reserve's current practice is to issue a brief statement when it
changes policy, but to give no explanation when it holds rates steady.
79
51
how FOMC decisions and Federal Reserve policy instruments
and indicators help to achieve price stability would also be
useful. Such reporting might include the provision of
"inflation reports" and inflation forecasts similar to some other
central banks. Furthermore, advance identification of the form
of FOMC action to be undertaken should inflation objectives
not be reached also would be useful.
A review of the Federal Reserve system's procedures for
classifying the confidentiality of documents also would be
helpful in moving the system to a more open, transparent
central bank. The Federal Reserve, for example, could make
available to the public more internal research, forecasts,
memos, and internal briefings that are currently restricted
unnecessarily. The taxpayers, after all, are the ultimate
financiers of such efforts.
SUMMARY AND CONCLUSIONS
Transparent monetary policy is characterized by openness and a lack of
secrecy and ambiguity. Monetary policy transparency involves a number
of different dimensions including the clarification of policy goals and
policy procedures as well as the timeliness in reporting policy decisions.
More transparent monetary policy has a number of advantages. It
would, for example, 1)clarify policy objectives, 2) improve the workings
of financial markets, 3) enhance central bank credibility, 4) reduce the
chances of monetary policy 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 other central banks. The Federal Reserve could move
toward a more transparent monetary policy by 1) adopting explicit
inflation targets, 2) reporting more frequently to the Congress, 3)
releasing information earlier, and 4) providing more information to the
public.
BUDGET POLICY
|
TRENDS IN CONGRESSIONAL
APPROPRIATIONS: FISCAL RESTRAINT IN THE 1990S
INTRODUCTION
Balanced federal budgets have not been a regular occurrence since the
1950s, and this persistence of deficit spending has greatly influenced the
debate about budget policy during the past four decades. However, the
dynamics of deficit spending changed dramatically in July 1997 when
Congress passed, and the President signed, legislation that slowed the
growth of spending enough to allow the federal budget to reach balance
by 2002. Thanks to the robust economic expansion, unexpectedly strong
revenue collections are now allowing balance to -be achieved as early as
the current fiscal year (FY1998).
The purpose of this report is to review trends in congressional
budget policy, measured here as changes in discretionary appropriations
spending. Since it is the only portion of the budget that Congress revisits
and directly sets each year, discretionary spending is the most immediate
reflection of congressional budget policy. Two-thirds of federal spending
is classified as entitlement or mandatory spending, which budget scholar
Allen Schick defines as programs where "spending increases are not at
the discretion of Congress but are prescribed by existing law and are built
into baseline projections.'"8 Whereas the dynamics surrounding most
entitlement programs make frequent changes to them politically difficult,
the structure of the annual appropriations process grants Congress the
8
initiative (though not the final say) in setting policy ' For this reason,
this paper limits its discussion of congressional budget policy to changes
in discretionary spending.
80
Allen Schick, The FederalBudget (Washington, DC: Brookings Institution,
1995), 192.
For authority on the dynamics of both discretionary and mandatory spending
policy, see Aaron Wildavsky, the new Politics of the Budgetary process, 2nd ed.
(New York, NY: Harper Collins, 1992).
81
54
RECENT TRENDS IN DISCRETIONARY SPENDING
In order to compare spending from different time periods, differences in
inflation and the size of the economy must be taken into account. For
example, $100 had much greater purchasing power in 1965 than it does
today. Therefore, this analysis examines discretionary spending measured
two ways: in real terms (adjusted for inflation) and as a share of gross
domestic product (GDP). In addition, the analysis distinguishes between
the three different kinds of discretionary spending: defense, international
and non-defense domestic. A complete set of historical data is included
in Table 2 through Table 5 at the end of the paper.8 2
As can be seen in Figure 1, recent congressional budget policy has
successfully reduced the amount of discretionary spending, measured
either in real-dollar terms or as a share of GDP. Between 1990 and 1998,
Figure 1. Real discretionary outlays, 1990-2002
12%
$650
6401
r
5"3514
me
603.9~~~~~~~~~~~~~~~*
s5450.3
9
m1 1 | m
5400
199
199
I92
193
n194 1995 I96 17
a X| X~~~~~6%
1"9 1999 200
2001-2002-
*Projected
Source: Joint Economic Committee and Office of Management and Budget.
Nominal outlays were adjusted to 1998 dollars using the implicit price deflator
for each type of spending. Figures indicate outlays by fiscal year. The sum of
the components may not equal the total for a given year because each series is
deflated separately and then rounded to the nearest decimal point. Figures for
1998 are estimates for current year outlays and do not include any supplemental
appropriations. All data are from Office of Management and Budget, Historical
Tables and Analytical Perspectives, Budget of the united States Government,
FiscalYear 1999 (Washington, DC: Government Printing Office, 1998).
82
55
total discretionary spending fell $77 billion, or 12 percent, measured in
inflation-adjusted 1998 dollars.8 3 As a share of GDP, discretionary
outlays have followed the same trend, falling from around 9 percent of
GDP at the beginning of the decade to well below 7 percent in 1998. In
1996 alone, discretionary outlays were reduced by $32 billion, the largest
single-year drop since 1969. Although there was an increase the
following year, total discretionary spending in 1998 was still $38 billion
below the 1995 level.
Figure I also indicates expected levels discretionary outlays for
fiscal years 1998 to 2002. Under the Budget Act of 1990, discretionary
spending is capped at levels specified by law. The Balanced Budget Act
of 1997 implemented a new set of discretionary spending caps for fiscal
years 1998 to 2002. Assuming lawmakers comply with the spending
caps, real discretionary outlays will fall from current levels by an
Relative to 1990, discretionary
additional $38 billion by 2002.'
spending in 2002 will be down more than $115 billion or 18 percent.
The data in Figure 1 indicate the trend in total discretionary
spending, but a related interest is how spending in specific categories has
changed. As previously noted, discretionary spending generally falls into
one of three categories: defense, international or domestic. To a certain
degree, the amount spent on defense and international programs is
dictated by international factors. As might be expected, the end of the
Cold War has been accompanied by real decreases in spending on
defense and international programs. In contrast, domestic discretionary
spending has enjoyed relatively unrestrained real growth since.
Figure 2 presents the amount of discretionary spending for fiscal
years 1990 to 1998 (in real 1998 dollars). As can be seen, domestic
discretionary spending experienced real increases each year until it
reached an all-time high in 1995. In 1996, domestic discretionary
spending was cut by $9.3 billion, the largest single-year reduction in
domestic outlays since 1982. Even with the $6 billion increase in 1997
Because all figures have been rounded to the nearest decimal point, some
rounding error may be evident.
84 Of course, if the spending caps are broken then these projected savings will
not materialize.
83
56
and 1998, domestic discretionary spending is still $3.3 billion below the
1995 level.8 5
Figure 2. Real domestic discretionary outlays, 1990-1998
5280
- 4.0%
271.9
3S270
25.
268.6_-JS
3.8%
$260252
eoWS22334 i ¢ X-3~~~~~~~26.6%
$250
$240~~~~~~~~~~~~~~~~~~~~
i
S230_229.2
A,
S220
]
_\
a
|
_ -3.4%
WWRI
5200
3.0%
1990
1991
1992
1993
1994
1995
1996
1997
1"8
Source: Joint Economic Committee and Office of Management and Budget
Since biannual elections reshape Congress every two years, an
alternative way of identifying trends in congressional budget policy is to
aggregate discretionary spending by congressional sessions. Doing so
reveals that the 104th Congress (FY 1996-97) was the most fiscallyrestrained session of Congress in the 1990s. Total discretionary outlays
in the 104th Congress were $74 billion lower than in the previous
Congress (Table 1), a reduction of more than 6 percent. 8 6 As a share of
85 Since the new discretionary spending caps make no distinction between
domestic non-defense and international outlays, protected amounts for 19992002 are not included.
The figures in Table I indicate the net change in outlays relative to the
previous two-year budget cycle. Thus, legislation enacted by one Congress that
affected spending in a different fiscal year is not credited to the relevant
Congress. For example, 1041 Congress rescinded $9.1 billion in budget
authority for the fiscal year 1995. The resulting outlay reductions, however, are
included in the spending totals for the 103rd Congress. Figures for the 105'
Congress are not included because appropriations for 1999 have not been
completed.
86
57
GDP, discretionary outlays fell almost a full percentage point, from 7.8
percent in the 103rd Congress to 7.0 percent in the 104th Congress.
Table 1. Change in discretionary outlays from previous Congress
(billions of 1998 dollars)
Congress
101st
102nd
103rd
104th
(FY90-91)
(FY92-93)
(FY94-95)
(FY96-97)
Total
Defense
International
Domestic
+511.1
-$33.2
-$43.0
-$74.1
-419.0
476.4
-$69.5
457.0
+$4.6
-51.1
-$2.6
-S5.9
+526.4
+$45.4
+$30.2
-510.9
Source: Joint Economic Committee and Office of Management and Budget.
Note: Totals may not sum due to rounding.
Although previous Congresses also reduced overall discretionary
spending, large defense cuts allowed for real increases in domestic
spending. In the last four Congresses (FY1990 to FY1997), defense
spending fell $222 billion in real terms.
In contrast, domestic
discretionary spending enjoyed real increases during the 1990s. Domestic
outlays climbed an average of $34 billion in each of the three Congresses
prior to the 104th, totaling $102 billion. The 104th Congress reversed this
trend: domestic outlays in the 104th Congress were $10.9 billion below
what was spent in the 103rd Congress (Figure 3). The 104th Congress is
Figure 3. Change in real domestic outlays by Congress
S50 -+S45.4
S40
~~~~~+S30.2
_
S30 -
+S26.4
S20
$0
-$l0
-$20
_1.
101st
102nd
103rd
104th
Congress
Source: Joint Economic Committee and Office of Management and Budget.
58
the only Congress in the past 36 years to exact spending reductions in all
three categories.
DISCRETIONARY SPENDING OVER THE LONG TERM
Two findings emerge from an analysis of discretionary spending over the
long run. The first is that the fiscal restraint achieved in the 1990s
reverses the long-term upward trend in discretionary spending (Figure 4).
Between 1962 and 1990, growth in discretionary spending outpaced
inflation by more than 46 percent, reaching an all-time high of $641
billion in 1991. Although actual expenditures have been increasing over
time, discretionary spending as a share of GDP has fallen steadily. After
peaking at 13.6 percent of GDP in 1968, discretionary outlays fell to an
all-time low of 6.6 percent in 1998.
Figure 4. Real discretionary outlays, 1962-2002
S700 -
-20%
S600
r
18%
16%
5500---o
3~~~~~~~~~~~~~~~
$400
12%
2
5300 1
10%
5200
so
4
1962
1967
1972
1977
1982
1987
1992
1997
2002*
*Amounts for 1999-2002 are projected.
Source: Joint Economic Committee and Office of Management and Budget.
The second conclusion about discretionary spending is that while
defense and international spending have remained at relatively stable
levels over the past 36 years, domestic spending has sky-rocketed (Figure
5). In real terms, both defense and international outlays in 1998 were
actually below their 1962 level. International outlays have consistently
remained below their 1962 level and were down 43 percent in 1998.
Spending on defense has experienced expansions as well as contractions,
although total defense outlays have never been 30 percent greater than the
59
1962 level. In 1998, defense spending was down 15 percent from its level
36 years ago.
Figure 5. Net percent change in real discretionary spending
250%
_
200%
l150%
10,
50%
0%
- .......
~ ~
;
~
_/ - __~~~
-50%
-100%
1962
1967
1972
1977
1982
1987
1992
1997
Source: Joint Economic Committee and Office of Management and Budget.
The most dramatic trend visible in Figure 5 is the large growth in
domestic spending. Spending on non-defense domestic programs increased
by approximately 228 percent between 1962 and 1998. The only extended
period during which domestic spending growth was interrupted was during
the early 1980s, a period during which increases in defense spending more
than offset the savings from reductions in domestic spending. The
cumulative long-ter n impact of this surge in domestic spending growth is
considerable. Over the period 1962- 1998, if domestic spending had grown
at the same rate as defense spending, the federal government would have
spent $4.3 trillion less than it actually did (measured in 1998 dollars), an
amount larger than the entire federal debt held by the public. The fact that
domestic programs have enjoyed relatively unrestrained growth, even in
the face of rising budget deficits, suggests that curbing domestic spending
can be an extremely difficult task.
CONCLUSION
Two conclusions about congressional budget policy are evident from the
data presented in this paper. First, recent efforts to curb discretionary
spending have successfully stemmed, at least for the time being, the
long-term upward trend in spending growth. The 104th Congress became
H.Rept. 105-807 - 98 - 3
60
the first Congress on record to impose real reductions in all three
categories of discretionary spending. In addition to continuing the
long-term downward trend in defense and international spending, the
104th Congress reversed the upward trend in real domestic spending.
Whereas each of the three previous Congresses increased domestic
spending by an average of $34 billion each, the 104th Congress cut
domestic discretionary outlays by close to $11 billion. Even with the
increase in fiscal year 1997 and 1998, domestic spending in 1998 was
down still $3.3 billion from the all-time high reached at the end of the
103rd Congress.
The second conclusion is that all types of discretionary spending need
to be kept in check in order to preserve the savings achieved thus far. As
indicated above, most of the long-term growth in discretionary spending
is attributable to increases in domestic expenditures. If the growth in
domestic outlays had been limited to the same growth rate of defense
outlays, the federal government would have spent $4.3 trillion less over
the past three-and-one-half decades. However, this trend has not been
fully apparent in overall discretionary spending totals due to reductions in
defense and international spending. If Congress desires to avoid a return
to deficit spending, then fiscal restraint must be applied to all types of
spending.
61
Table 2. Federal outlays in billions of nominal dollars.
Discretionary
FisWl
international
Domestic
Mandatory
Net
Total
Ioterest
Oudays
Year
Total
Defense
1962
72.1
52.6
5.5
14.0
27.9
6.9
1963
1964
1965
196
If7
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
19S5
1986
1987
1988
19S9
1990
1991
1992
1993
1994
1995
1996
1997
19s
75.3
79.1
77.8
90.1
106.4
117.9
117.3
120.2
122.5
128.4
130.2
138.1
157.J
175.3
196.
218.5
239.7
276.1
307.8
325.8
353.1
379.2
415.7
438.3
444.0
464.2
488.6
500.3
533.0
534.0
540.4
543.3
545.1
533.8
548.3
552.7
53.7
55.0
51.0
59.0
72.0
82.2
82.7
81.9
79.0
79.3
77.1
80.7
87.6
89.9
97.5
104.6
116.8
134.6
158.0
185.9
209.9
228.0
253.1
273.8
282.5
290.9
304.0
300.1
319.7
302.6
292.4
282.3
273.6
266.0
271.6
265.1
5.2
4.6
4.7
5.1
5.3
4.9
4.1
4.0
3.8
4.6
4.8
6.2
8.2
7.5
8.0
8.5
9.1
128
13.6
12.9
13.6
16.3
17.4
17.7
15.2
15.7
16.6
19.1
19.7
19.2
21.6
20.8
20.1
18.3
19.0
I.9
16.3
19.5
22.1
26.1
29.1
30.9
30.5
34.3
39.7
44.5
48.3
51.1
62.0
77.9
91.3
1053
113.8
128.7
136.1
127.0
129.7
134.9
145.2
146.8
146.2
157.5
167.9
181.1
193.6
212.3
226.4
240.2
251.4
249.5
257.6
26S.6
23.3
31.2
31.8
35.0
40.7
49.1
53.7
61.1
72.9
S6.8
98.1
109.8
151.3
169.J
IS2.5
204.8
221.7
262.3
301.7
334.9
365.4
361.5
401.3
416.1
421.5
448.5
485.9
568.7
596.8
648.2
670.2
715.5
738.5
785.6
809.0
72.4
7.7
8.2
3.6
9.4
10.3
11.1
12.7
14.4
14.8
15.5
17.3
21.4
23.2
26.7
29.9
35.5
42.6
52.5
68S.
S5.0
89.8
111.1
129.5
136.0
138.7
151.8
169.3
184.2
194.5
199.4
198.8
203.0
232.2
241.1
244.0
242.7
Source: Office of Management and Budget
Note: Totals may not sum due to rounding.
106.S
1113
11.5
118.2
134.5
157.5
178.1
183.6
195.6
210.2
230.7
245.7
269.4
3323
371.8
409.2
458.7
504.0
590.9
678.2
745.8
808.4
851.9
946.4
990.5
1,004.1
1,064 5
1,143.7
1,253.2
1,324.4
1,381.7
1,409.4
1,461.7
1,515.7
1,560.5
1,601.2
1,667.8
62
Table 3. Federal outlays in billions of real 1997 dollars.
Discretionary
Fiscal
Year
Total
Defense
International
Domestic
Mandatory
Net
Total
Interest
Outlays
1962
430.9
313.8
33.0
S1J
133.5
33.2
595.2
1963
431.0
308.2
29S
90.8
132.7
36.9
598.3
1964
443.6
312.1
25.1
104.5
146.1
38.5
625.9
1965
430.5
288.9
24.8
114.9
147.2
39.7
615.2
1966
479.6
320.5
25.7
131.7
159.5
42.4
678.9
1967
548.4
375.6
26.6
143.9
180.4
44.9
770.8
1968
581.0
406.9
23.4
147.9
211.4
46.7
836.1
1969
548.3
389.8
18.4
137.3
221.6
51.3
818.4
1970
528.0
364.4
16.8
144.5
241.9
55.1
822.4
1971
504.1
331.3
14.9
155.9
275.6
54.2
831.6
1972
487.7
304.5
16.9
164.7
317.0
53.9
856.4
1973
466.0
277.5
16.9
170.4
345.8
57.9
867.8
1974
457.1
267.6
20.3
168.0
357.3
66.7
879.4
1975
470.9
261.5
24.4
184.2
446.8
65.6
981.6
1976
486.2
250.6
20.7
214.6
470.7
70.3
1,025.6
1977
501.3
250.0
20.1
231.0
470.7
73.2
1,043.4
1978
521.6
250.3
20.3
250.4
492.8
81.0
1,093.5
1979
528.2
256.6
20.3
251.3
491.6
89.9
1,108.0
1980
550.4
265.6
26.0
258.7
525.3
101.8
1,175.8
19S1
551.1
279.4
24.8
246.4
551.7
121.3
1,222.4
1982
543.4
304.7
22.1
215.5
574.8
140.1
1,257.0
1983
560.7
327.1
22.2
210.0
599.1
141.5
1,299.9
1984
569.9
332.0
25JS
210.8
569.9
168.5
1,307.0
1985
600.2
353.2
26.6
219.0
610.5
189.7
1,399.3
1986
618.3
374.8
26.5
215.4
613.4
193.9
1,424.4
1987
612.4
380.9
22.0
207.4
602.1
192.0
1,405.2
1988
624.8
385.4
21.9
215.5
615.2
203.2
1,442.0
1989
635.2
390.4
22.1
220.7
635.8
217.4
1,487.1
1990
630.3
375.0
24.6
229.2
710.2
227.2
1,566.8
1991
640.8
3S1.8
24.0
233.4
711.2
230.0
1,58I.0
1992
622.3
348.6
22.8
249.8
748.5
229.0
1,599.2
1993
615.6
331.8
24.7
258.2
753.7
222.5
1,591.1
1994
603.9
313.9
23.1
266.4
786.9
221.S
1,612.0
1995
591.0
297.0
21.9
271.9
791.2
247.3
1,629.4
1996
559.3
277.1
19.4
262.6
823.8
251.1
1,634.2
1997
561.4
276.9
19.6
264.7
826.4
248.6
1,636.6
1998
552.7
265.1
18.9
268.6
872.4
242.7
1,667.8
Soorce: Joint Economic Committee and Office of Management and Budget.
Note: Totals may not sum due to rounding.
63
Table 4. Federal outlays a percentage of gross domestic product (GDP).
Fiscal
Year
Total
162
12.7%
93%
1.0%
2.5%
4.9%
1.2%
1I.S%
1963
12.6%
9.0%
0.9%
2.7%
4.7%
13%
18.6%
1964
12.4%
8.6%
0.7%
3.0%
4.9%
13%
18.5%
1965
113%
7.4%
0.7%
3.2%
4.6%
13%
17.2%
1966
12.0%
7.J%
0.7%
3.5%
4.7%
1.2%
17.9%
1967
13.1%
8.9%
0.7%
3.6%
5.0%
13%
19A%
1968
13.6%
9.5%
0.6%
3.6%
5.7%
13%
20.5%
1969
12.4%
8.7%
0.4%
3.2%
5.7%
13%
19.4%
1970
11.9%
8.1%
0.4%
3.4%
6.1%
14%
19.4%
1971
IIA%
73%
03%
3.7%
6.8%
1.4%
19.5%
1972
10.9%
6.7%
0.4%
3.8%
7A%
13%
19.6%
1973
10.0%
5.9%
0.4%
3.7%
7.5%
13%
I.$%
1974
9.6%
5.6%
0.4%
3.6%
7.6%
1.5%
18.7%
1975
10.2%
5.6%
0.5%
4.0%
9.7%
1.5%
21A%
1976
10.1%
5.2%
0.4%
4.5%
9.8%
1.5%
21.5%
1977
10.0%
4.9%
0.4%
4.6%
93%
1.5%
20.8%
1978
9.9%
4.7%
0.4%
4.8%
93%
1.6%
20.7%
1979
9.6%
4.7%
0.4%
4.6%
8.9%
1.7%
20.2%
1980
10.2%
5.0%
0.5%
4.7%
9.6%
1.9%
21.7%
1981
10.1%
5.2%
0.4%
4.5%
9.9%
23%
22.2%
1982
10.1%
5.8%
0.4%
4.0%
IOA%
2.6%
23.2%
1983
103%
6.1%
OA%
3.8%
10.7%
2.6%
23.6%
1984
9.9%
6.0%
0.4%
3.5%
9.5%
2.9%
223%
19S5
10.1%
6.2%
0.4%
3.5%
9.S%
3.2%
23.1%
1986
10.0%
63%
0.4%
3.4%
9.5%
3.1%
22.6%
1987
9.6%
6.1%
03%
3.2%
9.2%
3.0%
21.8%
1988
9.4%
5.9%
03%
3.2%
9.1%
3.1%
21.5%
1989
9.1%
5.7%
03%
3.1%
9.1%
3.2%
21A%
1990
8.8%
53%
03%
3.2%
10.0%
3.2%
22.0%
1991
9.1%
5.5%
03%
33%
10.2%
33%
22.6%
1992
8.7%
4.9%
0.3%
3.5%
10.6%
3.2%
22.5%
1993
83%
4.5%
03%
3.5%
103%
3.1%
21.8%
1994
7.9%
4.1%
03%
3.5%
10.5%
3.0%
21A%
1995
7.6%
3.8%
03%
3.5%
103%
3.2%
21.1%
1996
7.1%
3.5%
0.2%
33%
IOA%
3.2%
20.7%
1997
6.9%
3.4%
0.2%
3.2%
10.1%
3.1%
20.1%
I"S
6.6%
3.2%
0.2%
3.2%
10.5%
2.9%
20.0%
Discretionary
Defense
International
Source: Joint Economie Committe and Offiee of M
Note: Totals may not tum due to rounding.
agem
Domestic
t and Budget
Mandatory
Net
Interest
Total
Oudays
Table 5. Discretionary outlays by Congress
Congress
Total
Defense
87th
147.4
106.3
88th
156.9
106.0
862.0
622.0
62.9
172.6
12.6%
9.1%
0.9%
2.6%
9.3
41.6
874.1
601.1
49.9
219.4
11.8%
8.0%
0.7%
3.1%
275.5
12.6%
8.4%
0.7%
3.5%
696.1
52.3
1,129.3
796.7
41.8
285.2
13.0%
9.1%
0.5%
3.4%
1,032.1
695.8
31.6
300.4
11.6%
7.7%
0.4%
3.5%
92.8
953.7
582.0
33.8
335.1
10.4%
6.3%
0.4%
3.7%
14.4
113.1
928.0
529.2
44.7
352.3
9.9%
5.6%
0.5%
3.8%
187.4
15.5
169.2
987.5
500.6
40.8
44S.5
10.1%
5.1%
0.4%
4.6%
221.4
17.6
219.1
1,049.8
507.4
40.7
501.7
9.7%
4.7%
0.4%
4.7%
26.4
264.8
1,101.4
544.9
50.9
505.1
10.1%
5.1%
0.5%
4.6%
631.8
44.3
425.5
10.2%
6.0%
0.4%
3.9%
685.3
52.4
429.8
10.0%
6.1%
0.4%
3.5%
485
422.8
9.8%
6.2%
0.4%
3.3%
9.2%
5.8%
0.3%
3.2%
5.4%
0.3%
3.2%
1,02a0
90th
235.2
164.9
9.0
61.4
91st
242.7
160.9
7.8
74.0
92nd
258.6
156.4
9.4
93rd
295.9
1683
94th
372.1
95th
458.2
99th
100th
794.9
882.3
952.8
Domestic
30.3
55.2
98th
International
10.7
10.4
6789
Defense
Defense
131.0
97th
Total
Total
196.5
583.9
Domestic
Domestic
International
89th
96th
International
Percent of GDP
I
Billions of real 1997 dollars
Billions of nominal dollars
292.6
395.8
481.1
556.3
594.9
26.5
33.7
32.9
32.3
256.7
280.1
293.0
325.4
1,104.1
1,170.2
1,230.7
1,260.0
755.7
775.8
44.0
436.3
9.0%
101st
1,033.3
619.8
38.8
374.7
1,271.1
756.8
48.6
462.6
102nd
1,074.4
595.0
40.8
4387
1,237.9
680.4
47.5
5080
4.7%
0.3%
3.5%
103rd
1,08.4
555.9
40.9
491.6
1,194.9
611.0
44.9
538.3
7.8%
4.0%
0.3%
3.5%
104th
1,082.1
537.6
37.3
507.1
1,120.8
553.9
39.0
527.3
7.0%
3.5%
0.2%
3.3%
Source: Joint Economic Committee and Office of Management and Budget.
Note: Totals may not sum due to rounding. See infra note 7 for additional explanation.
s.5%
as
BUDGET PROCESS REFORM
INTRODUCTION
This paper reviews problems in the Federal budget process and the
reasons that make some procedures and institutional structures
counterproductive in helping to control the size of government, resulting
in increased spending to levels higher than necessary. As a prescription
for a healthier economy, this study recommends improvements in the
budget process to reduce the bias toward spending and excessive
government.
OVERSPENDING AND EXCESSIVE GOVERNMENT
The size of government can be a major determinant of the growth rate of
the economy. Up to a point, contributions by government are essential
to healthy growth, since government provides the basic framework of a
property-rights system and enforcement of those rights, both of which
permit a sophisticated economy to function. In addition, government
usually provides physical infrastructure like transportation systems,
public safety and health protection, and other public goods necessary for
a complex economy.
There is a point, however, after which the size of government and
the type of expenditures it makes become a hindrance to economic
growth and the well-being of the nation. The hindrance occurs not only
because of the large size of government and the burden of paying for its
activities, but also because a large and overly complex government makes
the public's understanding of the decision-making process more difficult.
This permits special-interest groups to seek benefits for themselves
behind a veil of confusion. The problem of special-interest influences is
not new; in fact, Madison warned the Nation of this problem even before
the adoption of our Constitution."
In the United States, growth in government has been significant
since the 1930s. In 1930, Federal expenditures constituted 3.3 percent of
gross domestic product (GDP); the estimate for 1997 is 20.8 percent.
Much of the increased spending has been facilitated by the accumulation
of debt and inflationary increases in the money supply. The size of the
Federal Government has exceeded the point at which it makes a
constructive contribution to economic growth, and current budgetary
processes do not appear helpful in controlling this spending.
Much of the spending problem lies in human nature and the political
process. The rational self-interest of people in and outside of government
87
James Madison, FederalistPaperNo. 10, November 1787.
66
often causes the steering of benefits to small, well-organized interest
groups at the expense of taxpayers and the electorate at-large. 8 8 Policy
makers expand budgets to fund programs of questionable public value in
order to gain the support of these groups, while the taxpayers remain
largely ignorant of the cost to themselves of these political rewards.
Within the government bureaucracy, self-interest takes the form of
agencies expanding their own budgets and responsibilities beyond the
point of effective execution of their programs. One estimate, for
example, puts the potential output of a government bureaucracy at twice
the level of a competitive industry facing similar demand and cost
parameters. 8 9 The large size and complexity of programs not only
prohibit the public from understanding the real decision process with its
rewards to special-interest groups, but they also reduce the quality of the
services to those who are the putative beneficiaries.
Economists use the term "deadweight burden" to refer to the net
losses resulting from the imposition of some government policies. The
deadweight burden of government spending is found in the actions of
individuals who respond to the incentives created by government
interference in the market economy. For example, individuals expend
resources competing for the purely redistributional opportunities created
by government programs. These resources are not spent on producing
wealth, but on the seeking of government license to conduct some
activity. The resources could have been employed to produce goods and
services demanded by the economy rather than lost on non-productive
competition.
Recent studies have begun to evaluate the aggregate effects of
government size on economic growth. One statistical evaluation suggests
that the optimal size of the Federal Government is in the range of 17
percent of GDP, roughly four percentage points lower than current levels,
the equivalent of about $280 billion in expenditures.' Another study,
focusing on the period 1949-1989, concluded that, in order to achieve
Economic theory predicts that there is a rational self-interest in bearing the
cost of organizing a small group to pressure government to adopt policies by
which small per capita costs are apportioned among a large group in order to
provide large per capita benefits to the small group.
88
89
William A. Niskanen, Bureaucracyand Representative Government, Aldine
Publishing, Chicago, 1971.
90 Lowell Gallaway and Richard Vedder, The Impact of the Welfare State on the
American Economy, Joint Economic Committee, 1995.
67
maximum economic growth rates, total government taxes-federal, state,
and local-should have been in the 21.5 to 22.9 percent range, and that
such levels would have produced growth rates for the economy of 5.56
percent per annum instead of the 3.50 percent rates actually achieved. 9 '
An understanding of the real problem behind the numbers requires
a look at the types of programs supported as the size of the budget
increases. At lower levels of spending, programs tend to include those
which facilitate the functioning of the economy and provide a foundation
for work, saving, and investment. But those programs expanding most
rapidly as government size increases beyond a certain point tend to be
those that substitute inefficient government spending for private-sector
activities, thereby generating deadweight losses.
THE FISCAL PROCESS AND GOVERNMENT GROWTH
The Fiscal Illusion
The ability of special interests to drive government size beyond effective
levels, and much of its energy to the production of narrowly focused
benefits, has been made possible by the relatively new tradition of
persistent deficit financing. Deficit financing, as an alternative to
reducing spending or raising taxes, is attractive in a representative
democracy, because it defers the cost to taxpayers of the associated
spending. But while the potential penalties are hidden from the
electorate, they are no less burdensome from a macroeconomic viewpoint
than those generated by direct taxation.
From the fiscal-discipline perspective, the chief procedural problem
with deficit financing is the bifurcation of the spending and finance
decisions. The ability to obscure the real cost makes the decision to
approve spending easier and reduces the pain of analyzing the real need
for, or quality of, the expenditure in question. Only when the deficit
level reaches significant proportions does the cost of this process
become apparent. Reducing a large deficit, however, has the unattractive
feature of putting decision makers in the position of cutting programs, all
of which now have established constituencies, or raising taxes. On the
other hand, by combining spending and tax increase decisions, the
responsibility for the cost is placed on the political leaders who are taking
91 Gerald W. Scully, What Is the Optimal Size of Government in the United
States? National Center for Policy Analysis, November 1994.
68
credit for program benefits. This is the deficit bias in a representative
democracy. 9 2
One economic penalty of deficit financing, as well as tax financing,
is the alternatives foregone in the more efficient private sector. Instead
of taking funds from taxpayers who are consumers and savers, debt
financing takes funds directly from capital markets and reduces
investment in the economy. Even though we know that demand by the
Federal Government will "crowd-out" private investment opportunities,
this effect is difficult to measure. The "fiscal illusion," or overrating
benefits vis-a-vis costs, is promoted because debt financing hinders a
comparison between the quality of the spending program and the quality
of the forgone alternatives. Not only is dollar cost separated from the
decision, but the real cost, the private sector projects that go
unaccomplished, is also not identified, even in the most remote manner.
This is not the case when individuals can see the taxes withheld from
their paychecks, and the cost to them is clear.
Price-level inflation is another potential consequence of debt
financing. If the Nation's central bank, the Federal Reserve System,
rapidly increases the money supply to offset borrowing in capital
markets, inflation will result. There is a fair amount of evidence that the
Federal Reserve System responds to the political needs of the moment,
leaving the potentially negative consequences to fall beyond the political
time horizon of policy makers. For example, during the Kennedy
Administration, economic growth, not price stability, was the overriding
concern. The Fed responded accordingly, helping to expand the economy
more rapidly, but inflation followed soon thereafter. 93
KEYNESIAN THEORY AND RESULTING SPENDING INCREASES
The chief philosophical change in U.S. fiscal policy came as a result of
the introduction of Keynesian economic theory, which suggested that the
Federal Government's fiscal process could be used to influence the level
of economic activity. According to this theory, deficit financing could
be used to stimulate economic growth and increase employment. The
92
The seminal work in this area is James M. Buchanan and Richard E. Wagner,
Democracy in Deficit: The PoliticalLegacy of Lord Keynes, Academic Press,
1977.
The shift in Fed policy in response to changes in administrations is
documented in Robert E. Weintraub, 'Congressional Supervision of Monetary
Policy," Journalof Monetary Economics 4 (1978), pp. 341-362.
93
69
new philosophy was dominant in academic circles following World War
II, but it did not find effective support within the Federal Government
until the 1960s. Then the new philosophy was welcomed by fiscal
activists in government as an economic justification for increased
spending without the need to vote for tax increases. This produced a
deficit spending pattern which is with us today.
As a percent of GDP, the deficit itself has increased sharply since
1971, and according to General Accounting Office (GAO) and
Congressional Budget Office (CBO) estimates, it will increase at an even
greater pace when the baby-boom generation begins to retire around
2010.9 The Federal debt has already become so large that interest
payments have quadrupled over the last 25 years. In 1997 interest
payments are estimated to be $357 billion, which is 23 percent of outlays.
Longer term trends reveal a more difficult time ahead for the U.S.
economy, if deficit spending is not reduced and a surplus restored.
Today's deficits are less than 3 percent of GDP, but current spending
policies will lead to deficits at the 23 percent level by the year 2025. As
the deficit increases to this level, the economy will stagnate as interest
rates rise, confidence in the Federal Government weakens, and incentives
to invest decrease.
PAST EFFORTS AND NEW PROPOSALS FOR PROCESS REFORM
Since 1974, several initiatives have been taken to change the budget
process, but their impact on controlling deficits and spending levels has
been negligible for various reasons. Some of the measures have actually
thwarted efforts to control spending, because they have reduced the
understanding of the process and ignored the value to a representative
democracy of keeping decision making visible. Such measures should
keep fiscal issues within the political arena and make this venue a more
accurate reflection of the will of the people.
Transparency and Accountability
There are several proposals which improve fiscal discipline by
increasing the clarity of the decision-making process, fixing
responsibility for decisions, and increasing accountability for those
decisions. The "transparency" theory suggests that too complex a
decision-making process will reduce the ability of taxpayers and voters
to hold budget policy makers accountable. If voluminous and byzantine
documents are employed or lengthy, repetitious, and overlapping
94 United States General Accounting Office, FederalFiscalTrends: Fiscal Years
1971-1995, November 1996.
70
procedures are part of the budget decision-making process, the public's
understanding of the process suffers, and this damages accountability.
Policy makers might even promote confusion as part of a plan to assist
special interests. In the making of budget policy, this type of intentional
ambiguity is evidenced by creative accounting, hiding tax burdens,
overestimating program benefits, and providing overly optimistic
economic forecasts. 9 5
In light of the transparency theory, it is interesting to look at the
complaints from congressional observers as they review the current
budgetary process. The chief complaints revolve around the complexity,
duplication, and time-consuming nature of the budgetary process. For
example, spending policy is now made in three distinct phases: budget,
authorization, and appropriation. Each requires a separate set of
hearings, reports, votes, and procedures, and the Congress must act
several times on each spending proposal. The result is a system so
confusing that it is difficult to identify responsible individuals, key votes,
or actual policy direction. Adding to the complexity are stop-gap
measures intended to plug various process loopholes which have
permitted evasion of budgetary discipline. The high level of technical
detail required in following these rules and calculating fiscal implications
resulting from these measures not only complicates decision making, but
also pushes the process even further into the hands of unelected technical
specialists, both of which reduce transparency.
The 1974 Budget Act and Other Measures
A relatively recent reform in the budget process was the passage of
the 1974 Congressional Budget and Impoundment Control Act. Its
enactment, according to its legislative history, was intended to gain
"control" of the budget. A practical interpretation of this goal was to
provide the Congress with additional resources and procedures so that the
Legislative Branch could compete with the Executive Branch in the battle
of the budget. The Act created a Budget Committee in each House of the
Congress to act as a focal point for the consideration of targets for
spending in broad functional categories. It also established the
Congressional Budget Office to provide technical support and advice
independent of the Executive Branch. However, as a fiscal discipline
measure, the Act, in its original version, was not effective. Federal
95 Alberto Alesina, Ricardo Hausmann, Rudolf Hommes, and Ernesto Stein,
Budget Institutions and FiscalPerformance in Latin America, Working Paper
Series, Number 5586, National Bureau of Economic Research, May 1996.
71
spending rates increased following enactment, and deficits were still a
problem.
Continued high levels of spending and increased deficits in the
1980s led to the passage of two additional key budget reform laws, the
Balanced Budget and Emergency Deficit Control Act of 1985, also
known as Gramm-Rudman-Hollings (GRH), and the Budget Enforcement
Act (BEA) of 1990. GRH's goal was the elimination of the deficit, and
it included the unusual disciplinary measure of automatic across-theboard cuts in the budget, "sequestrations," in the event that
predetermined targets were not met through the normal budgetary
process. The GRH approach was eventually abandoned in the face of
massive deficit increases caused by the savings and loan bailout. BEA,
on the other hand, was passed in order to enforce the budget agreements
concluded by the Congress and the Bush Administration. It provided for
pay-as-you-go (PAYGO) rules to ensure that future mandatory spending
policy changes were "deficit-neutral" and included spending caps for
discretionary programs. BEA remains in force through fiscal year 1998.
The 1974 Congressional Budget and Impoundment Control Act
further weakened budgetary discipline. First, it added a third layer of
budgetary action, the congressional budget process. Despite the fact that
it gave some sense of order to congressional budgeting, the new Act
included procedures that actually diminished the ability to understand
what direction fiscal policy was taking at the program or committee level.
This confusion was created by setting spending targets in functional areas
for which no committee or individual felt responsibility. The new
process also made more ambiguous the direction of a member's votes on
spending policy, making it possible to vote for spending control in the
budget phase and to vote later for increased spending in the
appropriations process.
Second, this ambiguity was increased by the Act's requirement that
"current policy" baselines be used as the starting point for consideration
of a new budget. Current policy includes increases for program growth
from inflation, increased numbers of program beneficiaries, and
increased use of services by incumbent beneficiaries. Confusion was
generated by the perception that any proposed spending levels below
current policy were program reductions, allowing some policy makers to
claim savings while permitting others to claim increases. In any case,
these automatic increases biased spending upward.
The 1974 Act was intended as a vehicle for increased congressional
control and budgetary initiative, and in accomplishing that purpose, it
wrested control at the expense of the Executive Branch. As a process for
72
maintaining fiscal discipline, however, shifting power from the more
centralized executive to a decentralized legislature is a move in the wrong
direction. Competition among committees for available revenues under
a decentralized budget process will lead to increased spending. For
example, there are currently 15 spending committees in the House and 16
in the Senate. These committees have no responsibility for overall
budget levels, so they tend to focus their efforts on providing program
resources for their individual constituencies. 9 6 An analogy often
employed to make the incentives in this type of situation clear is that of
the communal apple tree. The absence of clear ownership leads to
overuse as members of the communal group compete to get their share of
apples before they disappear. Spending committees are likewise in
competition to take advantage of budgetary resources for expanding
programs.
The record of Federal budget deficits over the last 200 years
provides evidence that a decentralized spending process leads to more
spending and greater deficits than a process which is centralized. In
testimony before the House Budget Committee, one expert contrasted
two periods of centralized spending authority in the Congress with two
period of decentralized authority. As a percent of gross national product
(GNP), the centralized periods produced deficits of .26 and -.77 percent
(a surplus), while the decentralized periods produced deficits of .69 and
3.67 percent of GNP.97
In summary, the 1974 Act not only shifted budgeting initiative and
power away from the centralized executive to a decentralized legislature,
but it also further decentralized the legislative budgetary process, and
along with amendments for such controls as PAYGO, made the
congressional process more complex and less transparent, and it made
individual members and committees less accountable. The PAYGO rules
also limit policy options with respect to reducing taxes because they
preclude using spending cuts in discretionary programs to offset revenue
reductions. This in itself is a bias toward bigger government. To
improve the discipline of the spending process, the Congress will need
to consider reforms which maintain the advantages of an organized
96
Prepared Statement of John F. Cogan, in How Did We Get Herefrom There:
Reform of the FederalBudget Process, Hearings before the Committee on the
Budget, U.S. House of Representatives, Report No. 104-28.
The centralized periods were 1799-1885 and 1922-1931; the decentralized
periods were 1866-1921 and 1931-1995. Ibid.
97
73
process, but which improve clarity and accountability. This might
include allowing the expiration of the PAYGO rules in 1998.
A CONSTITUTIONAL AMENDMENT REQUIRING A BALANCED BUDGET
Given the continuing problems of high spending levels and large deficits,
a balanced budget amendment to the Constitution is an important
component of a national policy for achieving and maintaining a healthy,
growing economy. As one key fiscal-control measure in a strategy for
controlling government spending, such an amendment has the potential
of reversing a trend of excessive expenditures which have long been a
drag on the productive elements of our society. The fiscal illusion would
diminish, because policy makers would be dealing with current costs as
well as current benefits in their decision calculus. Such comparison of
costs and benefits would produce more careful analysis of the need for
and quality of the benefits, leading to higher quality programs and lower
spending levels.
Experience at the state level shows that balanced-budget
requirements do have an effect in producing balanced budgets. Fortyeight of the 50 states have some type of balanced-budget requirement,
and, in general, that requirement plays a significant role in forcing policy
makers to act with more fiscal discipline. A survey of 49 states by the
U.S. General Accounting Office (GAO) suggests that such a requirement,
along with a tradition of balanced budgets and concerns over the impact
on bond ratings, has been a primary motivation in fiscal discipline.9
The chief objection to the current version of the amendment under
consideration has been the lack of a tax limitation provision in the
amendment, a proviso which requires a supermajority vote to increase
revenues, thereby focusing budget-balancing activity on the spending
reduction side of the equation. Such a disciplinary measure might be
particularly important during the initial transition stage under the
amendment, when existing programs with their established constituencies
would fight hard to avoid program reductions and encourage policy
makers to increase taxes instead. At the national level, recent fiscal
history shows that pressure for tax increases can be significant.
Experience at the state level suggests, however, that revenue increases
are not the chief mechanism for achieving balance. GAO notes in a
study of 25 states that half of projected current-year budget deficits were
U.S. General Accounting Office, Balanced Budget Requirements: State
Experiences and Implicationsforthe FederalGovernment, March 1993, pp. 3898
39.
74
achieved by spending reductions. 9 Only a few states have a taxlimitation provision.
An objection to an amendment also has been made on the grounds
that capital expenditures should not be subject to a balanced-budget
discipline, because payment for investment projects should be made
along with their consumption (they should be amortized) and not made
out of current revenues. State governments typically use separate capital
accounts for long-term investment spending. To create a separate
undisciplined account, however, would provide a major loophole for
enabling every policy maker to hide favorite programs under the label of
"investment." The operative reason to avoid financing large capital
projects out of current revenues at the state level is the spike created in
revenues to accommodate the investment under a balanced-budget
scenario. While spikes may sometimes occur at the state level, at the
national level, the aggregated total of investments in infrastructure,
research and development, and other capital projects averages out into a
smoother pattern and tends not to produce spending spikes. The use of
accumulated amounts in trust funds also reduces this problem.
Another reservation about the amendment is generated by viewing
the Federal budget as a macroeconomic stabilizer, automatically going
into deficit by spending more and receiving less revenue during an
economic downturn.1" This concept is a holdover from the Keynesian
activist philosophy which asserts that deficits can help generate recovery.
Proponents of this view ignore the negative incentives generated by
increased transfer payments during recessions or the drain of increased
borrowing on capital markets and the economy. Spending that causes
delay in the response of resource markets, regardless of how wellintentioned, slows economic recovery. Also, by increasing the fiscal
burden of government, regardless of how it is financed, the rate of
economic recovery from recessions is reduced.
The larger portion of the increased deficit during recessions is
produced by revenue loss, which may be handled by waiving the
balanced budget requirement or reducing spending. If these options are
not in order, rather than failing to adopt a balanced-budget requirement,
which would entail a far more costly economic burden, policy makers
could always elect to change the mix of spending, reducing some
99
Ibid., p. 27.
100 A stable monetary policy will be a much more effective mechanism for
reducing excessive amplitude in the business cycle.
75
programs in order to permit an increase in others. Raising taxes during
a recession would not promote recovery, as it may signal a lack of fiscal
discipline and an intention to increase spending in the long run, as has
often been the result with previous tax increases.'0 '
FURTHER PROPOSALS TO INCREASE TRANSPARENCY
Some proposed rules for enforcing fiscal discipline may be only
marginally successful. The additional complexity of these rules may be
matched only by the tenacity shown in circumventing them, and, if the
transparency theory is correct, more complicated rules only permit
additional opportunities to shrink from accountability. If accountability
is missing from the process, it would probably make little difference to
fiscal discipline whether the rule at issue is a constitutional rule or
something less; accountability would be circumvented with little political
cost. Most analysts would agree that the most effective way for budget
issues to be addressed under a democratic system is to keep the decision
making a part of the political process. Keeping a representative form of
government focused on promoting the general welfare requires an
understanding by the represented as to how budgets are made. Improving
transparency and accountability should decrease the influence of narrow
special-interest constituencies seeking benefits at the expense of the
general public.
Several possible reforms are suggested by this analysis, among them
changes in congressional rules which would strengthen control of the
spending process. Concentrating the spending power in the hands of one
committee in each House may seem extreme, but this has been the
practice in the past. Alternatively, the Congress may choose to follow its
own lead and provide more power to the Executive Branch, as it has in
granting line-item veto authority to the President. Centralized power
improves accountability in this case because one representative and one
party must lead and take responsibility. The record becomes easier to
read.
Given the President's visibility, a larger role for him may prove
constructive from a transparency perspective. The Senate version of the
Balanced Budget Amendment to the Constitution, for example, includes
a provision which improves transparency and accountability. Section 3
requires the President to submit a budget that is in balance. This
provision may be more important than any requirement imposed on the
101 Richard Vedder, Lowell Gallaway and Christopher Frenze, Taxes and
Deficits: New Evidence, Joint Economic Committee, October 1991.
76
Congress, because it makes a President and his party's position clearer
on tax and spending levels.
A similar argument could be made for the substitution of a joint
resolution on the budget for the concurrent resolution instituted by the
1974 Budget Act. A concurrent resolution, one which is a vehicle
between the House and Senate only, is employed to finalize their
agreement on the budget for the upcoming fiscal year. A joint resolution
would require presidential approval, and, thereby, raise the visibility of
the President as a politically accountable budgetary official. In the
absence of the constitutional amendment with a requirement for the
President to submit a balanced-budget provision, ajoint budget resolution
would be an improvement over the current process. At least one budget
reform bill before the Congress includes this feature.
As a further option to improve the budget targeting process by fixing
responsibility, the Congress may choose to define spending targets on a
committee-by-committee basis, rather than the current functional
approach. In doing so, the Congress would establish "ownership" of a
spending record and relevant disciplinary successes or failures.
Finally, in the spirit of improving the understanding of actions taken
in the budget-making process, the Congress should adopt the previous
year's spending level as the baseline for considering the budget. This
will provide every member with an opportunity to vote explicitly for
increases or decreases in spending, regardless of their programmatic
origin.
CONCLUSION
One of the biggest criticisms of proposals to improve transparency in the
fiscal process has been that greater understanding of the process is no
guarantee that some President, Congress, or political party will not
increase taxes, spending, or deficits. This is a possibility. The issue
behind improved transparency, however, is not the final course of fiscal
policy; it is whether budgets reflect the public will and promote the
public welfare, or whether they are fashioned behind a smokescreen
which facilitates special-interest goals. Comprehensive reform to
improve this accountability is urgently required.
TAX POLICY AND
CAPITAL FORMATION
I
TaE 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 of Congress on both sides of the political aisle. One
proposal that has attracted bipartisan support in the past is the
reduction of the capital gains tax rate. In 1989, for example, the U.S.
House of Representatives passed a capital gains tax reduction with
bipartisan support, though it was not passed in the Senate. 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. It would also partly abate the unfair effects of
taxing inflation-generated gains.
BACKGROUND
A capital gain is the increase in the value of a capital asset realized
over its cost basis. For example, an asset purchased for $1,000 and
sold for $1,500 generates a capital gain of $500. This nominal gain is
subject to the capital gains tax. Because capital gains are not adjusted
for inflation, much of the tax is paid on illusory, inflation-generated
gains.
The Revenue Act of 1978 allowed taxpayers to exclude 60 percent
of capital gains from income taxation (a 50 percent exclusion was
allowed since 1942). The Economic Recovery Tax Act of 1981
reduced the top tax rate on regular income from 70 to 50 percent,
yielding a maximum effective capital gains tax rate of 20 percent (0.5 x
0.4). The 60 percent exclusion was eliminated under the Tax Reform
Act of 1986, thus raising the maximum tax rate on capital gains to 28
percent, a 40 percent increase. The increase was largest for middle
income taxpayers whose tax rate increased from 8.7 to 15 percent, a 72
percent increase. The 1986 Act capped the statutory rate for capital
gains at 28 percent so that subsequent increases in the income tax rate
78
rate of 28 percent remains in place, though a variety of proposals have
been introduced to lower it below 20 percent.
MACROECONOMIC EFFECTS
Except for a brief recession in 1990-91, the U.S. economy has enjoyed
a 15-year expansion that is still underway. However, the growth rates
of the economic upswing that began in 1991 have been relatively low
compared to other post-war expansions. As a result, American
incomes and living standards have been growing more slowly.
These low growth rates can be partly attributed to counterproductive tax policies that undermine long-term growth by
discouraging saving and investment. Although broad tax reform is
needed to address the deficiencies in the tax code, many economists
believe that reducing the capital gains tax rate is an important step in
the right direction. A capital gains tax reduction would enhance
incentives to save and invest by increasing the after-tax return from
investment. The effects of a capital gains tax reduction should not be
overstated; nonetheless, its beneficial effects on the economy would
make a significant contribution to long-term growth.
Increasing Investment and Economic Growth
Economic growth depends on two factors: the quantities of
available inputs, such as capital and labor, and the productivity of those
inputs. Economic growth cannot occur unless the quantity of inputs
increases, productivity improves, or both. Investment in capital is
therefore crucial to economic growth for at least two reasons. First, by
contributing to capital formation, investment increases the amount of
capital available in the economy. Second, investment enhances labor
productivity because capital and labor are productive complements.
The critical link between investment and economic growth is a widely
accepted economic principle.
Unfortunately, the level of investment in the United States
compares unfavorably with that of other countries and with the United
States' own history. Annual U.S. investment is only half the level it
was in the 1960s and 1970s. In addition, net private domestic
investment dropped from an average of 7.4 percent of gross domestic
product (GDP) between 1960 and 1980 to an average of only 3.0
percent since 1991.102 Consequently, the growth rate of the capital
stock in the United States has also been declining. Figure 1 shows a
clear downward trend in the growth rate of the non-residential stock of
capital. This downward trend has serious implications for the economy
102 Margo Thorning,
"Trends in Investment and Tax Policy: Time for a
Change?" Business Economics 30 (January 1995), p. 23.
79
given the strong relationship between investment and economic
growth.
The diminishing growth of investment can be partly attributed to
high costs of capital. The cost of capital measures the return an
investment must yield before a firm or an individual is willing to
undertake the investment. High capital gains tax rates lower the return
on investment, thus increasing the cost of capital and depressing
overall investment in the economy. Conversely, a capital gains tax
10 3
reduction would lower the cost of capital and stimulate investment.
The effects of increased capital formation would reverberate
throughout the economy in the form of higher wages, rising living
standards, job creation, and economic growth.
Furthermore, the U.S. capital gains tax rate exceeds that of any
industrialized nation except that of the United Kingdom and Australia
(however, even these countries index gains for inflation, whereas the
United States does not). Because the United States must compete
internationally for capital, high capital gains tax rates place the United
States at a disadvantage relative to its competitors. Some of the United
The cost of capital is also affected by interest rates and depreciation costs.
Some of the fluctuations in Figure 3 reflect changes in investment due to
fluctuations in these variables.
103
80
States' major competitors, such as Germany and Hong Kong, exempt
long-term gains from taxation altogether; and other countries, such as
Japan, tax capital gains very lightly. As a result, these countries
typically experience higher saving, investment, and productivity
growth rates than the United States. The data indicate that a lower
capital gains tax rate would help improve U.S. global competitiveness.
Statistical Studies
Several studies have attempted to measure the macroeconomic
effects of a capital gains tax reduction. Two of the most recent studies
were conducted by DRI/McGraw-Hill and by Allen Sinai, chief global
economist at Primark Decision Economics, formerly with Lehman
Brothers. Both studies estimate the impact of a 50 percent capital
gains exclusion for individuals and a 25 percent tax rate for
corporations (the existing rate is 35 percent). The studies conclude that
a capital gains reduction of this size would benefit the economy.
Allen Sinai'0 4
Dr. Sinai estimates that reducing the capital gains tax rate would
lower the cost of capital, thus increasing business capital spending by
approximately $17.6 billion per year. The higher levels of investment
and capital formation would generate increased economic activity,
raising the level of real GDP by an average of $51 billion annually.
The increase in entrepreneurial activity and productivity would
generate close to a half million new jobs by the year 2000.
In addition, the value of the stock market would rise, leading
many investors to shift their assets toward equities. This shift would
raise household net worth by an average of 2.1 percent per year. Dr.
Sinai estimates that the national saving rate would increase by about
$44.1 billion per year, partly because of the increased income
generated from additional economic activity, and partly because of the
increase in personal and corporate saving which occurs when capital
gains are taxed at a lower rate. The increased saving would help keep
interest rates from rising in the face of increased economic activity.
Dr. Sinai concludes that a "Capital gains tax reduction increases
savings, capital spending and capital formation, economic growth,
jobs, productivity and potential output." He notes that "The increases
relative to what might have happened otherwise are definitely
significant, but small to modest in magnitude."
Dr. Sinai notes that more targeted capital gains relief, such as an
increase in capital gains allowed on home sales, should also stimulate
'04 Written testimony by Allen Sinai prepared for the Senate Finance
Committee, March 13, 1997.
81
Table 1. Allen Sinai's Estimates of the Effects of a Capital Gains
Tax Reduction" 2 AverageI per Year, 1997 - 2002
0.35
Employment/
Real GDP
Unemployment
$51
level, (in 1992 $ billion)
6
payroll, millions
0.1
growth, percentage points
0.2
unemployment rate
Productivity Growth
Business Capital Spending
percentage points
$17.6
total, (in 1992 $-billion)
0.1
change
Hourly Compensation
S&P 500.
0.1
percentage points change
0.8
percentage change
National Savings
Household Net Worth
$44.1
(in $-billion)
percentage change
2.1
3
Federal Tax Receipts
change from baseline, OTA $17.2 Cost of Capital
pretax equity, % change -6.8
change from baseline, JCT $4.5
composite, % change
-2.7
_______________________________________________________________________________________________
Source: Testimony of Allen Sinai before the Senate Finance Committee, March 13,
1997.
l Assumes a 50-percent exclusion of long-term capital gains for individuals and a 25
percent capital gains tax rate for corporations effective January 1, 1997.
2Estimates are preliminary and subject to change
3 OTA - Office of Tax Analysis, U.S. Department of Treasury; JCT - Joint
Committee on Taxation.
Estimates with unlocking and macroeconomic feedback effects. Numbers depend on
estimates of unlocking effect.
economic activity, but the magnitude of the effects would be
drastically reduced. He states that a capital gains reduction targeting
the sale of homes would increase housing activity, "but much less
benefit would accrue to savings, in general, capital formation,
productivity and the maximum sustainable rate of economic growth."
The major findings of Dr. Sinai's study are summarized in Table 1.
DRYMcGraw-Hill' 0 5
The DRI study, summarized in Table 2, estimates that cutting the
capital gains tax rate would lower the net cost of capital, thus raising
DRIIMcGraw-Hill, "The Capital Gains Tax, Its Investment Stimulus, and
Revenue Feedbacks," (April 1997).
105
82
Table 2. DRI/McGraw-Hill's Estimates of the Effects
of a Capital Gains Tax Reduction Total, 1998 - 2007
Real GDP (percent change from baseline)
0.4
Real Capital Spending (percent change)
1.5
Capital Stock (percent change from the baseline)
1.2
Productivity (percent change)
0.4
Net Cost of Capital (percent change)
-3.0
Total Federal Tax Receipts (in $-billion)
$7
Based on 50 percent exclusion of long-term capital gains for
individuals and 25 percent tax rate for corporations.
the level of business spending by about $18 billion in 2007. Over a 10year period, the capital stock would rise 1.2 percent above its baseline
level, increasing productivity by roughly 0.4 percent. Real GDP could
be 0.4 percent higher than in the baseline due to the effects of increased
investrnent. The study notes: "The evidence suggests to almost all
economists that a capital gains cut is good for the economy and
roughly neutral for tax collections."
These conclusions largely conform to the findings of other studies
which have analyzed the macroeconomic effects of a capital gains tax
reduction. Most economists now agree that reducing the capital gains
tax rate would encourage investment, boost productivity, raise living
standards, and stimulate economic growth. However, some analysts
argue that the macroeconomic effects of a capital gains tax reduction
would be minimal unless the saving rate increases to provide additional
resources for investment. It is argued that the saving rate is unlikely to
increase as a consequence of a capital gains tax reduction since
empirical studies have found only a weak relationship between saving
rates and rates of return.
However, empirical studies which seek to measure the response of
the saving rate are inadequate for two main reasons. First, saving is
taxed at several levels, the capital gains tax being only one of these
levels. Most studies analyze only the effects of a reduction in one level
of taxation but ignore other taxes which may be rising. As a result,
there are offsetting factors which are not included in the models. An
example of this occurred in the 1980s when falling income tax rates
accompanied a decline in the saving rate. The 1980s, however, marked
83
a period in which other taxes were rising. For example, the Social
Security Amendments of 1983 enacted a phase-in for the taxation of
Social Security benefits. Middle-income individuals who earned
interest from saving could be pushed into the phase-in level, thus
subjecting them to taxation. In these circumstances, this would be a
disincentive to saving. In addition, rising payroll tax rates more than
offset the reduction in income tax rates. The higher level of payroll
taxes reduced most taxpayers' after-tax income, out of which people
could save, thus dampening the saving incentives associated with the
income tax reduction.
The second reason that empirical studies may be flawed is that
they use data from the National Income Accounts which measures
saving on an income-flow basis. In other words, they measure how
much of an increase in income is saved rather than consumed. Incomeflow models cannot measure saving which arises from an increase in
wealth. For example, the increase in the value of assets in the stock
market is treated as an increase in wealth, not income. Saving which
arises from increasing wealth are not captured by many models. This
is an important point to note because a capital gains tax reduction is
more likely to increase saving through wealth effects as opposed to
income effects.
Business Creation and Entrepreneurship
Capital gains taxation further effects economic and employment
growth through its impact on entrepreneurial activity and business
creation. Entrepreneurship is the driving force of a market economy. It
is crucial to job creation, innovation, and productivity. Entrepreneurship
is affected by, among other things, the strength of the incentives that
motivate entrepreneurs to undertake innovative projects and the ability
of the entrepreneur to raise enough capital to finance projects. The
taxation of capital gains discourages innovation, risk-taking, and capital
investment, thus diminishing entrepreneurial activity in the economy.
Capital gains taxation effects entrepreneurship through its impact
on venture capital, an important source of funding for entrepreneurial
projects. High capital gains tax rates lower the potential return from
backing innovative companies, thus restricting the amount of venture
capital available to new firms. Some analysts argue that most venture
capital comes from tax-exempt sources such as pension funds and
Another important reason why saving may have fallen is the 1982-83
recession which lowered individuals' incomes. It is believed that individuals
reduced their saving in order to be able to maintain the same level of
consumption.
106
84
foreign investment; therefore, a capital gains tax reduction would not
have much effect on venture capital.
However, several studies indicate that informal venture capitalists
are extremely important sources of investment and are especially
critical to the formation of new companies. Professors John Freear and
William Wetzel, Jr. of the University of New Hampshire found that
private individuals are a crucial source of funding for new technologybased firms, accounting for 48 percent of seed capital funds. Their
study states that "At the seed stage, private individuals invested more
funds, in more rounds, for more firms than any other single source."' 0 7
Formal venture capital becomes more important during later stages of
development.
Another study, conducted by Coopers & Lybrand, concludes:
"Creating new jobs - especially in young technology companies requires risk capital.. .The risk capital invested in technology
companies is provided primarily by investors subject to capital gains
taxation. [Furthermore,] risk capital investors seek capital gains, not
dividends."108 The importance of informal investors to the venture
capital process suggests that a capital gains tax reduction would effect
the amount of venture capital available to new companies.
The taxation of capital gains may further limit the amount of
entrepreneurial activity in the economy by reducing the incentives to
entrepreneurship. Israel Kirzner, a professor at New York University,
describes entrepreneurship as a discovery process. In other words, the
entrepreneur is an innovative, resourceful, risk-taking individual who
discovers otherwise overlooked opportunities.
Whereas most
individuals are motivated by a known set of economic incentives, such
as wages or promotion potential, the entrepreneur is motivated by the
potential return that may be earned from entering into a situation with
unknown outcomes. This is why entrepreneurs are described as risktakers: they are motivated by the uncertain return that may potentially
be earned from discovering a previously unnoticed opportunity.
If the potential returns are taxed heavily, the entrepreneur's
motivation is reduced. Hence, high capital gains tax rates may divert
innovative, would-be entrepreneurs toward different career paths. The
economy is harmed by the reduction in entrepreneurial activity, not
107
John Freear and William E. Wetzel, Jr., "Who Bankrolls High-Tech
Entrepreneurs?" American Councilfor Capital Formation Centerfor Policy
Research, (undated).
log Coopers & Lybrand, "Generating Economic Growth through Young
Technology Companies," (undated).
85
only because business and job creation declines, but also because
possible improvements to living standards are left undiscovered.' 0 9
TAx REVENUE
In an attempt to estimate the revenue effects of a capital gains tax cut,
the Joint Committee on Taxation (JCT) used Congressional Budget
Office (CBO) estimates of capital gains realizations under the 28
percent tax rate for the 1990-95 period. The JCT concluded that a
capital gains tax reduction would cost the government billions of
dollars.
This JCT analysis, however, was based on grossly inaccurate data.
Figure 2 illustrates the difference between actual capital gains
realizations and CBO estimates. For the period 1990-94, CBO
overstated capital gains realizations by $737 billion. The use of a
massively overstated baseline led forecasters to overestimate the extent
of revenue loss associated with a tax cut.
These substantial CBO errors occurred for two primary reasons.
First, high capital gains tax rates cause realizations to decline because
the penalty associated with selling assets is high. CBO did not
adequately account for this behavioral response in its estimation
109 Israel Kirzner, Discovery and the CapitalistProcess. (Chicago: University
of Chicago Press, 1985), pp. 9 3 -1 1 8 .
86
process.
Second, the CBO analysis did not account for the
macroeconomic effects described in the previous section. In other
words, CBO assumed that a change in the capital gains tax rate is
neutral in its effect on the economy. For these reasons, CBO massively
overstated the projected levels of realization.
Historical Evidence
Historical evidence undermine the claim that capital gains tax
reductions lower revenue. Figure 3 shows that, historically, taxes paid
on capital gains have tended to increase after a reduction in the capital
gains tax rate. When capital gains tax rates were lowered in 1978 and
again in 1981, revenue climbed steadily despite government
forecasters' claims that it would fall. Conversely, when the tax rate
increase was enacted in 1987, revenue began declining, although
forecasters predicted it would increase.
Maximum caIta
Gains Tax Rate
Revenue
For instance, capital gains tax revenue equaled $36.2 billion (0.5
percent of GDP) in 1994 (the last year for which finalized IRS data are
available). In contrast, $36.4 billion (0.6 percent of GDP) was
collected in 1985, after adjusting for inflation. Thus, tax revenue in
1994 was slightly lower than in 1985 even though the tax rate was
higher, the economy was larger, and the stock market was stronger in
87
1994. The historical data suggest that the government could collect
more revenue if the capital gains tax rate were reduced
Effects on Tax Revenue
The result that tax revenue tends to increase following a reduction
in the tax rate may seem counterintuitive; however, there are many
offsetting factors which must be considered. In the static analysis, tax
revenue inevitably falls because the same level of realizations is being
taxed at a lower rate. In addition, tax receipts may fall if taxpayers
reclassify regular income as capital gains in order to take advantage of
the lower rate.
On the other hand, a reduction in the capital gains tax rate creates
three effects which tend to increase tax revenue. The first is the
unlocking effect, which expands the tax base because realizations
increase in response to the lower tax rate. The magnitude of the
unlocking effect is quite controversial and will be discussed in greater
detail in the next section. The second is the dynamic effect, which
measures the increase in tax revenue generated from the impact of
lower tax rates on economic growth. The third effect measures the
increased tax revenue resulting from an increase in the value of
existing assets. When capital gains tax rates are lowered, the value of
existing assets necessarily increases. Tax revenue rises as owners of
stock pay taxes on the higher value of their assets when realized.
The impact on tax revenue depends on the relative magnitude of
each of these offsetting factors. In the past, government forecasters
have used a static analysis which does not consider the macroeconomic
effects or the effects of an increase in the value of assets. In general,
more comprehensive studies find that a reduction in the capital gains
tax rate will be revenue neutral, and may even generate small revenue
gains. The DRI/McGraw-Hill study finds that the positive revenue
effects outweigh the negative, and therefore federal tax revenue should
increase by approximately $7 billion over 10 years. The results of the
DRI study are summarized in Table 3.
88
Table 3. Estimated Impact of Capital Gains Tax Reduction
on Federal Tax Revenue for Select Years
of 1997 dollars)'
_______________(billions
Static Effect
Unlocking Effect 2
Asset Prices
Income
Reclassification
Macroeconomic
Effect
______
1998
-14
15
13
-2
0
2002
-16
2
9
-2
4
2007
-20
2
8
-2
11
1998 - 2007
-168
47
95
-21
54
12
-3
-1
7
Total
Source: DRI/McGraw-Hill, "The Capital Gains Tax, Its Investment
Stimulus, and Revenue Feedbacks," Table 1, (April 1997).
' Effects of a 50 percent exclusion of capital gains for individuals
and a 25 percent tax rate for corporations.
2DRI uses a conservative estimate of 5 percent additional unlocking
over the 10-year period.
Unlocking Effect
When capital gains tax rates are high, investors avoid paying the
tax by holding onto assets they would have otherwise chosen to sell.
This creates a "lock-in effect," which lowers capital gains realizations
by shrinking the tax base. CBO failure to adequately account for this
behavioral response caused it to underestimate the extent of lock-in and
overestimate capital gains realizations as shown in Figure 2 above.
Economists estimate that trillions of dollars in equity are currently
locked into assets because investors refuse to pay a high tax on their
profits. Reducing the capital gains tax rate would unlock a portion of
this capital, allowing the government to tax the increased realizations.
Although analysts agree on the existence of the unlocking effect,
its magnitude and duration are controversial.
Estimates of the
unlocking effect depend on assumptions made about taxpayer
responsiveness to changes in the tax rate. CBO estimates have found a
low level of responsiveness, leading some analysts to conclude that the
unlocking effect is insignificant. However, other studies have found a
high degree of taxpayer responsiveness. An analysis by economists at
the Office of Tax Analysis (OTA) at the U.S. Department of Treasury
states that while no study can provide definitive conclusions:
89
...we find strong evidence of responsiveness to capital
gains tax rates. [Our findings] show that the marginal
tax rate on long-term gains has a significant powerful
negative impact both on the proportion of taxpayers
realizing gains and on the value of capital gains
declared by realizers. That is, despite theoretical
misgivings that many analysts have expressed, the data
continue to imply that the realizations response would
be sufficient to yield revenue increases from capital
gains reductions. '
The results of various studies differ due to divergent
methodologies. CBO uses an approach which estimates aggregate
responsiveness, while OTA focuses on individual taxpayer behavior.
Many analysts believe that the former approach understates the
unlocking effect and the latter overestimates it; the true measure may
be somewhere in between. The important point to note is that all
studies find some evidence of unlocking, suggesting that capital gains
realizations do increase when the capital gains tax rate is reduced.
Furthermore, a study by economists Robert Gillingham and John
Greenlees analyzed both methods and concluded: "Existing analyses
do not provide conclusive evidence on the revenue effects of changes
in the taxation of capital gains...The weight of the evidence from both
[approaches] does not suggest, however, that a reduction in the capital
11
gains rate from existing levels would decrease tax revenue.""'
A study by the National Bureau of Economic Research indicates
that when the unlocking effect is taken into account, the revenuemaximizing capital gains tax rate falls somewhere between 9 and 21
percent. This rate does not account for the increased revenue generated
from the asset value and dynamic effects discussed previously." 2
WHO WOULD BENEFIT?
Earlier legislation to reduce the capital gains tax rate was defeated in
large part because opponents of a tax cut portrayed it as a windfall for
"° Robert Gillingham, John S. Greenlees, and Kimberly D. Zieschang, "New
Estimates of Capital Gains Realization Behavior: Evidence from Pooled
Cross-Section Data," Department of Treasury OTA Papers, (May 1989), p.
27.
"' Robert Gillingham, and John Greenlees, "The Effect of Marginal Tax
Rates on Capital Gains Revenue," National Tax Journal 45 (June 1992), p.
167.
112 Testimony by Mark A. Bloomfield prepared for the Senate Finance
Committee, February 15,1995, p. 10.
90
the rich. It is obvious that affluent investors would benefit from a
capital gains tax reduction, but benefits would also accrue to
individuals across the income spectrum. The DRI/McGraw-Hill study
notes: "Often overlooked benefits flow to all workers and middle
income citizens, and the overall economy wins. The middle class will
benefit from greater appreciation in their pensions ...Small businessmen
will gain from more generous tax treatment of the gains on their
enterprise. And all employees will see wage gains tied to investmentdriven higher productivity."" 3 DRI's research director, David Wyss,
notes that "The capital gains cut helps most people and hurts no
one.""14
Furthermore, the notion that all investors are affluent gentlemen
coupon-clippers is no longer true. Over the past decade, the stock
market has seen a surge of middle income investors. A survey released
earlier this year by the NASDAQ Stock Market found that stock
ownership among Americans has doubled in the past seven years to 43
percent of the adult population. The survey also found that:' 116
=> 47 percent of the investors are women;
=> 55 percent are under the age of 50; and
=> 50 percent are not college graduates.
Mutual funds have become especially popular with middle income
Americans as a source of investment for pension funds and as an
alternative to traditional bank accounts and government securities,
which generally yield lower returns. According to the survey, the
proportion of American adults investing in mutual funds has tripled
over the past seven years from 13 to 40 percent. Another study
conducted for the mutual fund industry found that 29 percent of mutual
fund shareholders have household incomes below $40,000; 38 percent
113 DRI/McGraw-Hill, "The Capital Gains Tax, Its Investment Stimulus, and
Revenue Feedbacks," (October 1995), p. 3.
114 Testimony by David Wyss prepared for the House Committee on Ways and
Means, March 19, 1997.
Marcy Gordon, "Stock Market Looks More Like Face of America, Survey
Says," The Associated Press Business News, February 21, 1997.
116 The survey, conducted by Peter D. Hart Research Associates, was based on
20-minute interviews with a national sample of 1,214 investors. The margin
of error is plus or minus 3.2 percentage points.
115
91
have incomes between $40,000 and $75,000; and 33 percent have
household incomes over $75,000.1 7
These results suggest that a capital gains tax reduction would
directly benefit many Americans across the income spectrum. A
stronger economy also would generate indirect benefits for individuals
who do not participate in the stock market. However, these indirect
gains are much more difficult to quantify. Consequently, it is
important that the capital gains debate is not relegated to a discussion
of numbers and distributional tables.
Shortcomings of Distributional Tables
Policy makers have become heavily reliant on distributional tables
which illustrate the effect of a proposed tax change on the tax liabilities
and tax burdens of different income groups. As mentioned earlier, past
legislation to reduce the capital gains tax rate was defeated largely on
the basis of distributional analysis. Distributional tables must be
interpreted with great caution.
Michael Graetz of Yale University, formerly the Deputy Assistant
Secretary at the Treasury Department's Office of Tax Policy, warns
that distributional tables should not guide tax policy."18 Distributional
tables are necessarily based on many assumptions and over
simplifications that cannot capture the wide variety of behavioral and
economic responses which occur in reality. For instance, most
distributional tables only represent tax payments, but do not reflect the
fact that low and middle income individuals are the major recipients of
government transfer payments. Thus, the numbers overstate the true
tax burden on these individuals. Consequently, the assumptions and
simplifications used to construct the tables often lead to misleading
results.
Graetz points out that the three government agencies responsible
for constructing distributional tables (CRO, JCT, and OTA) implement
divergent methodologies based on their own judgments and
interpretations of the theoretical issues. The divergent methodologies
produce conflicting tables which confuse the policy-making process
and can significantly skew the results to bolster a particular political
"' The 1996 study, conducted by the Investment Company Institute, was
based on telephone interviews with a randomly selected sample of 1,165
mutual fund shareholders in mid-1995. The survey data does not include
individual households that only own mutual funds in 401(k) employer
sponsored retirement plans.
118 Michael J. Graetz, DistributionalAnalysis of Tax Policy, edited by David
F. Bradford. (Washington D.C.: The AEI Press, 1995), pp. 15-78.
H.Rept. 105-807 -98 -4
92
view. The inaccuracies are not necessarily a consequence of intent, but
of the elusive nature of the impact of tax changes on the economy.
Graetz suggests that distributional analysis is best explained
through words, not numbers, and heavy reliance on these imperfect
tables may compromise the soundness of the affected tax legislation.
Distributional tables should not be ignored -- they do contain important
information when interpreted properly. However, it is extremely
important to recognize that they do not relay a complete or perfectly
accurate analysis.
TAx FAIRNESS
Opponents of a capital gains tax reduction argue that capital gains are
already subject to preferential treatment, and a further rate reduction
would only motivate many taxpayers to reclassify regular income as
capital gains in order to take advantage of lower tax rates. However,
there are many provisions in the tax code which discriminate against
saving and investment and outweigh the preferential treatment of
capital gains.
First, taxpayers purportedly benefit from a provision which allows
them to defer tax payment on capital gains until the gains are realized.
Whereas most interest income is taxed as it accrues, a capital gain is
not taxed until the asset is sold and the gain is realized. However, the
benefit of deferral is at least partially offset since the money associated
with capital gains is subject to several levels of taxation: it is taxed
when earned as individual income, when claimed as corporate income,
when realized as a capital gain, and if held until death, it may be
subject to estate taxes.
Second, many claim that capital gains are awarded preferential
treatment because the tax is forgiven if the asset is held until death.
This provision benefits a relatively small portion of the population
since most people save to finance their retirement, to guard against
unforeseen mishaps, or to achieve a desired goal such as purchasing a
home or college education. These individuals save because they plan
to realize their earnings during their lifetimes, and accordingly, they
are unlikely to benefit from the death provision. Even those who do
hold their assets until death may not escape taxation entirely if their
assets become subject to the estate tax.
Third, capital gains are supposedly given preferential treatment
since the statutory capital gains tax rate is capped at 28 percent, as
opposed to regular income, which is capped at a rate of 39.6 percent.
This benefit is diminished since the effective tax rate often exceeds 28
percent due to various phase-out provisions in the tax code. In
addition, the realization of a capital gain may push individuals into a
higher income tax bracket, thus further increasing their tax liability.
93
Finally, the most inequitable provision of capital gains taxation is
the failure to index gains for inflation. Since capital gains are not
adjusted for inflation, individuals often pay taxes on inflationgenerated gains. As a result, the effective tax rate may exceed the
statutory maximum. In years of particularly high inflation, the
effective tax rate exceeded 100 percent; consequently, many
individuals have paid capital gains taxes on capital losses.
Figure 4 illustrates the undue burden created by taxing
inflationary gains. It shows the total tax paid on an average stock
purchased in June of different years and sold in June of 1994. The
bottom region of each bar reflects the portion of the tax paid on real
gains, while the top region shows how much tax was paid on inflation.
The taxing of inflationary gains is unfair and counter-productive
because it intensifies the lock-in effect. Many investors choose to hold
onto their assets, not only to avoid paying high capital gains taxes, but
also to avoid paying taxes on illusory gains. If capital gains were
indexed, much of this capital would become unlocked, allowing the
government to tax the increased realizations.
S
.
.S~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Tax on Inflation
l
Tax on Real Gain
Finally, it should be noted that the concern over income
reclassification (classifying regular income as capital gains) is
misplaced. Income reclassification would not be the consequence of
lower capital gains tax rates; it is already the consequence of a
complicated tax system which treats various types of income
differently depending on their source and who receives them.
94
Taxpayers already have an incentive to take advantage of tax loopholes
to avoid paying high taxes on their earnings. Possibly the only solution
that would eliminate tax arbitrage is the transition to a flatter, less
complicated tax structure which closes loopholes and reduces
individuals' ability to exploit the system.
CONCLUSION
Saving and investment are crucial to economic growth and rising living
standards. However, high costs of capital, double and triple taxation of
saving, and taxation of inflationary gains discourage these activities,
thus lowering economic efficiency and long-term growth prospects.
While broad tax reform is needed to address the deficiencies of the
existing tax code, many economists believe that reducing the capital
gains tax rate is the single most effective policy measure which can be
enacted immediately to promote efficiency and economic growth.
In the past, attempts to stimulate long-term economic growth
through a capital gains tax reduction were thwarted by inaccurate
estimates of revenue losses and misleading distributional tables. This
discussion should focus on the macroeconomic effects of cutting the
capital gains tax rate rather than on the questionable distributional
effects. It has been estimated that reducing the effective capital gains
tax rate would add $51 billion per year to real GDP, raise productivity
growth by 0.1 percentage points per year, and create a half million new
jobs over the next three to four years. A capital gains tax cut would
also stimulate business creation and help equalize the inequities that
prevail under the current tax code.
A meaningful debate should therefore incorporate the
macroeconomic effects of a capital gains tax reduction and concentrate
on the positive growth effects of a tax cut. When these effects are
taken into account, it becomes increasingly apparent that a capital
gains tax reduction would benefit the government as well as taxpayers
in all income brackets
EXPANDING IRA BENEFITS
The current tax code is biased against saving and investment activities
that are important to economic expansion and to our quality of life.
This bias discourages families from saving for future expenses and
unforeseen needs. It also impedes economic progress by limiting the
amount of domestic resources available for investment.
Providing new saving incentives to raise the U.S. saving rate is a
primary goal for many policy makers. One of the most important
saving incentives under current law is the Individual Retirement
Account (IRA). IRAs offer families attractive tax benefits that
encourage them to save for retirement, but restrictions on their use
prevent or discourage many families from taking advantage of these
benefits. Liberalizing these restrictions could substantially increase
IRA participation and boost personal saving in the United States,
thereby creating new incentives for financial empowerment and
economic growth.
WHAT IS WRONG WITH THE CURRENT TAx SYSTEM?
An ideal tax code would be completely neutral, it would neither
encourage nor discourage any type of activity. (Of course, perfect
neutrality is impossible to achieve because taxes necessarily affect
individuals' decisions by distorting relative prices in the economy.)
The current tax code seriously violates the principle of neutrality by
favoring current consumption relative to saving (i.e., future
consumption).
The disparity between the treatment of current consumption and
saving occurs because the existing tax system is primarily an "incomebased" system. The problem arises because the definition of income
used to define the tax base generally includes both saving and the
income earned from saving (i.e., interest, dividends, etc.). Thus
income that is saved is taxed at two different levels. This double
taxation raises the price of saving relative to the price of consumption.
For instance, consider a worker who receives a $2,000 bonus at
work and is deciding between using the funds to start a saving account
for graduate school or to pay for a vacation. If the worker chooses to
save the bonus, the $2,000 is taxed as wage income, leaving $1,700 to
deposit in the saving account (assuming a marginal tax rate of 15
percent). Any interest or dividends earned in the saving account are
also taxed as income. In contrast, if the worker chooses to spend the
bonus on a vacation, the $2,000 is taxed once as wage income, but any
benefit derived from the vacation is not taxed. In other words, income
used for consumption is taxed only once at the time the income is
96
earned, but income used for saving is taxed twice, once when the
income is earned and again when the saving generates any earnings.
This additional burden penalizes families who save. However,
saving is important to a family's quality of life and to the potential for
economic growth. Saving helps families finance education, home
purchases, retirement and other important expenses. It also guards
families against financial uncertainties, such as unemployment or
medical emergencies. Moreover, a high level of saving provides the
business sector with the resources it needs to invest in human capital
(such as worker education and training) and physical capital (such as
plants and equipment that enhance worker productivity). Saving and
investment also provide new, start-up firms with the capital they need
to grow and create new jobs. In brief, saving and investment are key
determinants to economic growth and productivity improvements. A
larger, more productive economy generates new jobs, higher wages
and better living standards.
Switching to a Consumption-Based Tax
Because saving is important to future economic prosperity, many
policy makers have proposed restructuring the tax code to reduce or
eliminate the bias against saving. Most tax reform proposals have one
element in common: they would transform the current income-based
tax system into one that is consumption based. Consumption-based
taxes only tax the portion of income that is spent, they do not tax the
portion of income that is saved. Thus, the main difference between the
two types of taxes is that income-based systems tax the resources that
people put into the economy, whereas consumption-based systems tax
the resources that people take out of the economy.
Murray
Weidenbaum of Washington University in St. Louis notes: "Under a
consumption-based tax, the basic way to cut taxes legally is for
individuals and families to save more and for companies to invest
more. To minimize tax liability under the existing tax structure,
taxpayers have to earn less."' 19
Numerous studies have found that switching to a consumptionbased tax would boost private saving and long-term economic growth.
For instance, Eric Engen of the Federal Reserve Board and William
Gale of the Brookings Institution found that moving from the existing
system to a flat-rate consumption tax would raise the long-term saving
rate by one-half percentage points and increase gross domestic product
119 Murray L. Weidenbaum, "True Tax Reform: Encouraging Saving and
Investment," Business Horizons, May 1995, Volume 38, No. 4.
97
(GDP) by 1 to 2 percent in the long run.' 2 0 Although these numbers
are small in magnitude, they would make a significant contribution to
future living standards.
The existing tax system is not a pure income-based system
because it contains some provisions to shelter saving from taxation.
One of these is the IRA. Contributions to an IRA are deducted from
income and then taxed when the proceeds are withdrawn from the
account and spent. Thus, the portion of income that families save in an
IRA is taxed only once. IRA expansion would, therefore, be a simple
way to begin the transformation toward a fairer, more efficient
consumption-based tax. Expanding IRAs would not require a major
overhaul of the current tax code and could, therefore, be implemented
immediately, laying the foundation for broad-based reform in the
future.
How IRAs
WORK
IRAs are available to all individuals with earned income and to their
spouses, but different individuals receive different tax benefits
depending on their situation. If neither spouse is an active participant
of an employer sponsored retirement plan, then each spouse can
establish an IRA and contribute $2,000 to the IRA annually. The
contribution is deducted from taxable income, and the interest earned
in the account is not taxed while it accrues.
When funds are withdrawn from the IRA, the entire amount of the
withdrawal is subject to income tax. If funds are withdrawn before the
individual reaches the age of 591/2, the distribution is subject to a 10
percent penalty. Premature withdrawals are allowed without penalty in
the case of the individual's death or disability, to pay for medical
expenses that exceed 7.5 percent of adjusted gross income (AGI), or to
purchase health insurance while unemployed. In addition, distributions
are not penalized if they are withdrawn in the form of a lifetime
annuity. Minimum distributions are required each year when the
individual reaches the age of 70 '2, and contributions are not allowed
after this age.
If either spouse is an "active participant" of an employer plan, the
couple still can make fully tax deductible contributions to their IRAs as
long as their combined AGI does not exceed $40,000 ($25,000 for
single filers). Partial deductions are allowed for taxpayers with AGI
between $40,000 and $50,000 ($25,000 and $35,000 for single filers).
120 Eric M. Engen and William G. Gale, "Consumption Taxes and Saving: The
Role of Uncertainty in Tax Reform," The American Economic Review, May
1997, 87: 114-155.
98
Couples who do not qualify for tax deductible contributions based on
their incomes can still benefit from IRAs because their savings
accumulate on a tax deferred basis.' 21 The benefit of tax deferral is
quite substantial and is discussed later.
Expanding IRAs
Recent changes in the tax laws have liberalized the restrictions on
IRA participation.
The Taxpayer Relief Act of 1997 gradually
doubles the income limits at which fully deductible contributions are
allowed. For couples filing jointly, the income limit will increase from
$40,000 to $80,000 with a phase-out range of $80,000 to $100,000.
For single tax filers, the income limit will increase from $25,000 to
$50,000 with a phase-out range of $50,000 to $60,000. In addition, a
spouse who is not an active participant of an employer plan will be
allowed to make a fully tax deductible contribution to an IRA even if
his or her spouse is a participant of an employer plan provided that
their joint AGI does not exceed $150,000 (phase-out range of $150,000
to $160,000). Finally, the 10 percent penalty on early withdrawals will
not apply if the proceeds are used to finance higher education expenses
or "first-time" homebuyer expenses.' 22"123 A more detailed outline of
the new IRA provisions is contained in the Appendix.
The new legislation has made important progress in the expansion
of IRAs. Increasing the income limits and changing spousal rules will
make deductible contributions available to a large majority of middleincome families; liberalizing the restrictions on early withdrawals will
encourage IRA participation. However, the contribution limit of
$2,000 is too low and cannot allow families the opportunity to increase
their saving significantly. The maximum contribution must be raised
in order to provide new incentives for financial empowerment and
economic growth.
In February 1997, Congressmen Jim Saxton (R-NJ), Richard
Armey (R-TX) and Tom DeLay (R-TX) introduced H.R. 891, a bill
121 For individuals who make non-deductible contributions, only the earnings
generated by the savings are taxed upon withdrawal because the principle is
taxed at the time the contribution is made.
122 Penalty-free withdrawals for first-time homebuyer expenses are subject to a
$10,000 lifetime cap. A "first-time" homebuyer is defined as someone who
has not had a property interest in a principle residence for at least two years.
123 The new tax laws also created two new types of IRAs: Roth IRAs and
Education IRAs. Contributions to these accounts are not tax deductible, but
the proceeds are not subject to income tax when withdrawn as long as certain
conditions are met. The benefits discussed throughout this paper mainly apply
to traditional tax deductible IRAs.
99
that would gradually increase the maximum deductible contribution
from $2,000 per year to $7,000 per year.'2 4 Raising the contribution
level to this amount would generate significant benefits for middleincome families and for the economy.
BENEFITS FOR MIDDLE-INCOME FAMILIES
IRAs were established in 1974 to encourage individuals to save for
retirement if they were not covered by employer sponsored retirement
plans. In 1981, IRA participation was expanded to include all workers
regardless of their participation in an employer pension plan. The Tax
Reform Act of 1986 limited IRA participation so that workers with
employer plans could make tax-deductible contributions only if they
met certain income limits. As a result, most of the tax benefits from
IRAs are now directed toward low- and middle-income families who
otherwise might not save without the appropriate incentives. IRAs
provide several important tax benefits that would be augmented if the
maximum contribution were increased above $2,000.
Tax Deductible Contributions.
Individuals who qualify for tax deductible contributions can lower
their tax liabilities for the year in which a contribution is made. If a
married couple invests the maximum amount of $2,000 each, they
would lower their taxable income by $4,000. This would result in a tax
cut of up to $600 for families in the 15 percent tax bracket and $1,120
for families in the 28 percent tax bracket. If the maximum contribution
were increased, the savings would be much higher. For instance, if the
contribution were raised to $7,000, as proposed in H.R. 891, a family
in the 15 percent tax bracket could lower their tax bill by as much as
$2,100, and a family in the 28 percent tax bracket could lower their tax
bill by $3,920.
Tax Deferred Contributions.
The benefit of tax deferral allows individuals to potentially lower
their tax liabilities over time. Many workers often have higher
incomes during their working years than during their retirement years,
thus they may fall into a lower tax bracket when they retire. IRAs
allow individuals to potentially lower their tax liabilities by deferring
their taxes to a time when their marginal tax rates are lower. Consider
an individual who contributes $60,000 to an IRA during his or her
working years when he or she falls in the 28 percent tax bracket. The
124 The bill is also co-sponsored by Spencer Bachus (R-AL), Steve Chabot (ROH), Jo Ann Emerson (R-MO), Mark Foley (R-FL), Martin Frost (D-TX),
Dan Miller (R-FL), Christopher Smith (R-NJ), Bob Stump (R-AZ), James
Talent (R-MO), and Dave Weldon (R-FL).
100
contri-butions allow the individual to defer up to $16,800 of taxes. If
the individual's marginal tax rate falls to 15 percent during retirement
when the funds are withdrawn, the $60,000 contributions generate a
maximum tax liability of only $9,000. Deferring taxes thus allows the
individual to save $7,800.
Conversely, tax liability will increase if an individual falls into a
higher tax bracket when distributions are made. However, the
individual can choose to make non-deductible contributions if this is
believed to be the case so that the distributions are taxed at the lower
marginal tax rate. Even if distributions are taxed at a higher marginal
tax rate, the benefit of tax deferred saving (discussed next) often
outweighs the cost associated with moving into a higher tax bracket.
Tax Deferred Saving.
Not only are contributions to IRAs tax deferred, but income
earned in an IRA, or "inside build up," is also tax deferred. In other
words, the interest earned in the account is not taxed while it accrues.
Therefore, more money can be reinvested in the account each year.
This allows assets to grow at a much faster rate.
The benefit of tax deferred saving generates significant gains for
families that will often outweigh the tax increase associated with
moving into a higher tax bracket. Consider an individual who
contributes $2,000 per year to a tax deductible IRA that earns 10
percent annually. Table 1 shows that the individual would accumulate
$126,005 after 20 years. If the savings are withdrawn at the end of the
20th year and taxed at 28 percent, the individual would be left with
$90,724. If an equivalent amount of dollars were contributed to a nondeferred account (such as a saving account at a financial institution)
under the same rate assumptions, the individual would have only
$64,683 after 20 years. 12 5 Thus, the benefit of tax deferral is worth
$26,041 in this example. The income tax rate for a middle-income
individual would have to increase to over 48 percent to equalize the
value of the two accounts (the highest tax rate under current law is 39.6
A $2,000 contribution to a regular saving account generates a tax liability
of $560, assuming a 28 percent marginal tax rate. A $2,000 contribution to an
IRA generates no tax liability. In order to equalize the values of the two
contributions, one must assume that the $560 tax liability generated by the
former is deducted from the contribution. Thus, this example assumes $2,000
annual contributions to the IRA and $1,440 annual contributions to the saving
account. In other words, $2,000 pre taxes equal $1,440 after taxes. Upon
withdrawal, the entire IRA distribution is subject to income tax, but only the
earnings from the saving account are taxed.
125
101
Table 1.
VALUE OF TAX DEFERRED SAVING
IRA Balance
(10% growth)
IRA Balance, after
tax
(28% tax bracket)
Non-Deferred
Balance,
after tax (28% tax
bracket)
After 5
Years
After 10
Years
After 15
Years
After 20
Years
$13,431
$35,062
$69,899
$126,005
$9,670
$25,245
$50,328
$90,724
$8,913
$21,531
$39,394
$64,683
33.64%
38.59%
43.64%
48.67%
Equalizing Tax
Rate
Source: Joint Economic Committee calculations.
percent).' 26 This demonstrates that even if the individual is in a higher
tax bracket during retirement years, the benefit of tax deferral would
probably outweigh the tax increase associated with the higher tax
bracket.
Tax deferred saving also makes IRAs attractive to individuals
who do not qualify for tax deductible contributions. Table 2 below
shows that if an individual contributes $2,000 after taxes to an IRA
earning 10 percent annually, he or she would have $126,005 after 20
years. If the savings are withdrawn at the end of the 20k" year, the
earnings would generate a tax liability of $24,081 (only investment
earnings are taxed when distributions are withdrawn), leaving the
individual with $101,924. If after-tax contributions of $2,000 were
made each year to a non-deferred account, the individual would have
only $89,838 after 20 years. In this case, the benefit of tax deferred
saving is worth $12,086.
126 This is a modified example from Wallace F. Helin, "Deferring Tax is Good
Financial Planning," ManagementAccounting (USA), December 1994.
102
Table 2.
VALUE OF TAX DEFERRED SAVING WHEN CONTRIBUTIONS
ARE NOT TAX DEDUCTIBLE
IRA Balance
(10% growth)
IRA Balance, after
tax
(28% tax bracket)
Non-Deferred
Balance,
after tax (28% tax
bracket)
After 5
After
After 15
After 20
Years
Ya
Years
Years
Years
$13,431
$35,062
$69,899
$126,005
$12,470
$30,845
$58,727
$101,924
$12,379
$29,904
$54,714
$89,838
$91
$941
$4,013
$12,086
Difference
Source: Joint Economic Committee calculations
This benefit would be even more valuable if the annual
contribution were raised above $2,000. For instance, if an individual
contributed $7,000 per year to an IRA earning 10 percent annually, he
or she would have $356,733 after taxes at the end of 20 years. If the
contributions were made to a non-deferred saving account, the
individual would have $42,300 less.
Financial Independence.
The personal saving rate in the United States averaged only 4.9
percent during the 1990s compared to 7.4 percent in the 1960s and 8.1
percent in the 1970s.'2 7 The low rate of personal saving indicates that
American families are not saving enough for future expenses and
unforeseen financial needs. In 1992, the median value of all assets
Council of Economic Advisers, Economic Report of the President,
(Washington, DC: Government Printing Office) 1997, Table B-28.
127
103
held by families who owned assets was only $13,000128 (excluding
home equity)-hardly enough to ensure a family's financial security.
Raising the limit on deductible contributions would provide families
with the opportunity and incentives they need to save more.
The $2,000 ceiling on IRA contributions has been in place since
1981. This limit does not reflect changes in the economy and in the
role of IRAs that have taken place. For instance, the $2,000 limit does
not reflect the increase in economy-wide prices and wages. It does not
reflect the fact that individuals may need more money during
retirement because of longer life expectancies, rising medical costs,
and the deterioration in the financial status of Social Security.
Moreover, a wider variety of expenses have been given penalty-free
status so that the role of IRAs has expanded beyond that of a saving
vehicle for retirement only. The $2,000 limit may have been adequate
in the early 1980s, but it now needs to be increased to reflect the
changes that have taken place since then.
Raising the contribution limit would make IRAs an important
saving vehicle for middle-income families. A family that contributes
$7,000 per year to an IRA earning 8 percent annually would have
$249,092 after taxes (assuming a 28 percent marginal tax rate) after 20
years. A nest egg of this size could be used to finance retirement,
children's education, a home purchase, and other important expenses.
It would also guard families against future financial uncertainties, such
as unemployment or unforeseen medical expenses.
A higher
contribution limit would, therefore, allow families to become
financially independent and less reliant on the federal safety net.
Furthermore, since IRAs are self-directed, families have the
freedom to invest their savings as they see fit. This allows them the
opportunity to increase their incomes relative to what the government
can provide for them through social spending programs.
Benefits for Low-Income Families
A common argument against IRA expansion is that low-income
families would not benefit because they do not have enough disposable
income from which they can save. However, low-income families
would benefit from IRA expansion regardless of whether they
participate in IRA saving. Any policy that boosts the level of saving
will generate significant benefits for low-income families. A higher
saving rate provides more resources for investment. A higher level of
128 Arthur B. Kennickell and Martha Starr-McCluer, "Changes in Family
Finances from 1989 to 1992: Evidence from the Survey of Consumer
Finances," FederalReserve Bulletin, October 1994.
104
investment stimulates productivity improvements and economic
growth. As mentioned earlier, a larger, more productive economy
generates new jobs, higher wages and better living standards.
Expanding IRA benefits would, therefore, benefit everyone in the
economy, even if they do not participate in IRA saving.
BENEFITS FOR THE ECONOMY
IRA expansion would benefit the economy by enhancing the incentive
to save and, in turn, the incentive to invest. Investment is important to
the economy because it increases the domestic stock of capital, thereby
promoting productivity improvements that lead to higher wages and
better living standards.
Investors have two sources of funds available to them: national
saving (the sum of private and government saving) and foreign
investment. If national saving falls short of investment demand, then
investors must compete for scarce resources, thereby driving up the
interest rate. Higher interest rates, in turn, attract foreign capital. The
inflow of foreign capital allows investment to increase even if national
saving is low. However, relying on foreign capital has several
drawbacks. First, the profits from the investment flow overseas so that
less benefit accrues to the U.S. economy. Second, the foreign
borrowing has to be repaid with interest so that future generations
inherit a less wealthy, more burdened economy. Third, high interest
rates increase the cost of capital, thus preventing investment from
increasing as much as it otherwise would. A high national saving rate
is, therefore, desirable because it reduces investors' reliance on foreign
capital and places downward pressure on long-term interest rates.
Would IRA Expansion Increase National Saving?
PersonalSaving
There are some analysts who contend that IRA expansion would
not increase personal saving. These analysts argue that expanding IRA
benefits would merely encourage families to shift their existing savings
into IRA investments, so that net saving would be unaffected.
Although this argument may have theoretical appeal, the weight of the
evidence suggests that asset-switching does not occur to any great
extent in reality.
Some of the most compelling evidence against this argument has
been provided by James Poterba of MIT, Steven Venti of Dartmouth
College and David Wise of Harvard University. Poterba, Venti and
Wise have analyzed saving data for families who contributed to IRAs
after participation rules were expanded in 1981. The data show that
the increase in IRA saving far outweighed the decrease in the holdings
of non-IRA assets. The data also show a low level of substitution
105
between IRAs and other retirement plans, such as 401(k) plans. The
authors conclude that the increase in IRA saving that occurred in the
1980s largely represented new saving.12 9 Several other studies concur
with this conclusion.
It is reasonable to believe that some degree of asset switching
takes place, especially in the first two or three years in which taxpayers
establish new IRAs. However, most families save very little and have
not accumulated enough assets to shift into IRA investments for more
than a few years.' 3 0 As mentioned earlier, the median value of assets
held by families in 1992 was only $13,000. This amount could fund
IRA contributions for a married couple for only three years (and even
less if IRA contribution limits are raised). Thus, asset switching is
thought to be negligible beyond the transition period.
Overall, the evidence strongly suggests that expanding IRA
benefits would generate new saving. However, the contribution limit
needs to be raised above $2,000 in order for IRAs to have a significant
impact on new saving. The studies discussed above analyze IRA
contributions made in the 1980s when the maximum tax rate on
income was higher than it is now. Because tax rates are lower than
they were prior to 1987, the tax benefit from IRAs is smaller now than
it was in the 1980s. Thus, IRA expansion in the current tax
environment may not generate the same incentives as it did in 1981
unless the contribution limit is raised to enhance the tax benefits.
Government Saving
A rise in personal saving would not necessarily raise the national
saving rate. Some critics admit that expanding IRAs would raise
personal saving rates, but argue that IRA expansion would generate
large revenue losses that would adversely affect the federal deficit (i.e.,
Government dis-saving may offset the
government dis-saving).
increase in personal saving so that national saving is unchanged.
However, the loss in government revenue is not as large as many
forecasters portray. IRA savings are merely tax deferred, not tax
exempt. Consequently, government revenue falls in the short run when
contributions are made, but increases in the long run when distributions
are withdrawn. For instance, in Table 1 above, tax deductible
129 James Poterba, Steven Venti and David Wise, "Personal Retirement Saving
Programs and Asset Accumulation: Reconciling the Evidence," National
Bureau of Economic Research, May 1996.
130 Martin Feldstein, "The Effects of Tax-Based Saving Incentives on
Government Revenue and National Saving," National Bureau of Economic
Research, March 1992.
106
contributions of $40,000 are made over 20 years. These contributions
generate earnings of $86,005 that are not taxed while they accrue.
Overall, government revenue falls by $35,281 (126,005 x 0.28) over
the 20 years that contributions are being made. However, when the
funds are withdrawn after 20 years, the individual pays income taxes
equal to $35,281 on the entire distribution so that the government
recovers the lost revenue when the distribution is made. Some
individuals may end up in lower tax brackets when distributions are
made, but others will end up in higher tax brackets so that, on average,
the revenue effect of expanding IRAs should be roughly neutral in the
long run. Many forecasters only estimate the effect on revenue for a
five-year period. Such short-term estimates are important because of
their impact on current operating expenses, but they are misleading
because they do not capture the large revenue gains that occur in the
long term when IRA funds are withdrawn.
The real loss in revenue occurs because income saved in IRAs is
taxed only once instead of twice.' 31 However, this decline in revenue
is offset by at least two factors. First, as shown in Tables 1 and 2,
investment earnings in an IRA are not taxed while they accrue. As a
result, the savings appreciate at a faster rate relative to savings in a
non-deferred account with the same interest rate. When the higher
level of income is withdrawn and taxed, the government collects more
revenue than it otherwise would. For instance, in Table 2, the IRA
generates earnings of $86,005 whereas the regular saving account
generates earnings of only $61,924. Thus, the earned income in the
IRA generates a higher tax liability than the earned income in the nonIRA account. As a result, IRA expansion can potentially generate
revenue gains in the long run.
Second, economist Martin Feldstein notes that it is inappropriate
to concentrate on the loss in personal tax revenue while ignoring the
gain in corporate tax revenue.'3 2 An increase in private saving
increases the capital stock, and the return on this additional capital
increases corporate tax payments. The increase in corporate tax
payments should be sufficient to offset the loss of personal income tax
revenue. Dr. Feldstein concludes that:
131 Some analysts argue that IRA expansion does not reduce government
revenue at all because the increase in saving is new. In other words, the
income would have been consumed instead of saved without the enhanced
IRA incentives. Since consumption is taxed only once, there is no loss in
revenue.
132 op. Cit., "The Effects of Tax-Based Saving Incentives on Government
Revenue and National Saving."
107
Recognizing the important effect of IRA plans on corporate tax
revenue changes previous conclusions about the revenue effects of IRA
plans in fundamental ways. The revenue loss associated with IRAs is
either much smaller than has generally been estimated or is actually a
revenue gain, depending on time horizon and key parameter values.' 3 3
Overall, it is reasonable to expect that IRA expansion will not
result in large revenue losses and may even generate small revenue
gains in the long run. As a result, it is likely that IRA expansion will
increase the national saving rate, thereby generating long-run economic
gains that raise wages and living standards.
CONCLUSION
Saving is essential to a family's financial security and to the potential
for economic growth. However, the existing tax code discourages
saving by taxing the income used for saving at two or three different
levels. Several proposals have been introduced to reduce or eliminate
this bias in order to encourage more saving. One proposal that would
enhance saving incentives is the expansion of IRAs.
Recent changes in the tai laws have made important progress in
expanding IRAs. The income limits at which deductible contributions
begin to phase out will gradually double; spouses without employer
pension plans will be allowed to deduct their contributions even if their
spouses are covered by employer plans; and penalty-free withdrawals
will be allowed for first-time homebuyer and higher education
expenses. These changes will make IRA benefits available to more
middle-income families and encourage IRA participation. However,
the current contribution limit of $2,000 is too low and does not provide
families with sufficient opportunities to significantly increase their
savings.
Raising the maximum contribution limit above $2,000 would
enhance the tax benefits of IRAs, thereby encouraging more families to
save. Families that contribute to their IRAs could amass a significant
amount of savings from which they could finance important expenses
and unforeseen needs. Moreover, an increase in personal saving would
promote economic growth and productivity improvements. Lowincome families who do not participate in IRA saving would benefit
from productivity-driven increases in wages and living standards.
133
Ibid
108
APPENDIX
CHANGES IN IRA PROVISIONS
__________
I
Existing Rules
Maximum
contribution allowable
$2,00O
Income limit for fully
tax deductible
contributions
Joint tax filers
Single tax filers
$40,000
$25,000
Phase out for tax
deductible
contributions
Joint tax filers
Single tax filers
Penalty-free
withdrawals'
Rules applying to
uncovered spouses 3
$40,000 - $50,000
$25,000 - $35,000
Death or disability
Health insurance if
unemployed
Lifetime annuity
Catastrophic medicalexpenses
An individual who is not an
active participant of an
employer sponsored plan
cannot make a deductible
IRA contribution if his or
her spouse is an active
participant of an employer
plan unless their joint AGI
is $40,000 or less (partial
deduction allowed for AGI
between $40,000 and
$50,000).
[
New Rules
$2,UU0
$80,000'
$50,0002
$80,000 - $100,000'
$50,000 - $60,0002
Death or disability
Health insurance if
unemployed
Lifetime annuity
Catastrophic medical
expenses
Qualified college expenses
"First-time" homebuyer
expenses ($1 0,000lifetime cap)
An individual who is not
an active participant of an
employer sponsored plan
will be allowed to make a
deductible IRA contribution even if his or her
spouse is an active
participant of an employer
plan as long as their joint
AGI is less than $150,000
(partial deduction allowed
for AGI between $150,000
and $160,000).
Phase in as tolows: S30,U0U0460,00 in I998:s 1i,000-soi,000 in 1999; s52,000-1(,1,000
in 2000; $53,000-$63,000 in 2001; $54,000-$64,000 in 2002; $60,000-$70,000 in 2003;
$65,000-$75,000 in2004; $70,000-$80,000 in 2005; $75,000-$85,000 in 2006; and $80,000S100,000 in 2007 and after.
2 Phase in as follows: $30,000-$40,000 in 1998; $31,00044 1,000 in 1999; $32,000-542,000
in 2000; $33,000-543,000 in 2001; $34,000-$44,000 in 2002; 540,000-550,000 in 2003;
545,000-555,000 in2004; 550,000-560,000 in 2005 and after.
3Changes effective in 1998
109
In addition to the changes made to traditional IRAs, two new
types of IRAs have been created: Roth IRAs and Education IRAs.
Roth IRA
Beginning in 1998, taxpayers will be allowed to make an after-tax
contribution of up to $2,000 per year to a Roth IRA. Contributions are
not tax deductible, but income earned in the account accrues tax free.
The key benefit of the Roth IRA is that qualified distributions are tax
free. In other words, the income earned in the account is never taxed.
Qualified distributions include withdrawals made: (1) after the age of
59 1/2; (2) in the case of death or disability and (3) for the purpose of
paying first-time homebuyer expenses. Qualified distributions must be
made five years after the first contribution is made to the account. All
other distributions are subject to a 10 percent early withdrawal penalty,
and the earned income is subject to income tax. Penalty-free
withdrawals are allowed for qualified college expenses, catastrophic
medical expenses, or to purchase health insurance if unemployed.
Although the 10 percent penalty is waived for these distributions,
income tax still applies to the earnings. Individuals can continue
contributing to a Roth IRA after reaching reach the age of 70 1/2, and
there are no required minimum distributions at this age. Contributions
to Roth IRAs begin to phase down for single tax filers with AGI
between $95,000 and $1 10,000 and for joint tax filers with AGI
between $150,000 and $160,000. It is important to note that the total
contribution between a Roth IRA and a regular IRA cannot exceed
$2,000 annually. Any contribution made to either account in excess of
$2,000 is subject to a 6 percent penalty.
Education IRA
Beginning in 1998, taxpayers will be allowed to make an after-tax
contribution of up to $500 per year to an Education IRA for each
qualifying child. This contribution can be made in addition to the
$2,000 contribution to a Roth IRA or a regular IRA. Contributions are
not tax deductible, but income earned in the account is tax free for
qualified higher education expenses. All other distributions are subject
to a 10 percent penalty, and earned income is subject to taxation. The
contribution income limits are identical to those of the Roth IRA.
Before the account's beneficiary reaches the age of 30, any funds
remaining in the account must be rolled over into another Education
IRA for a qualifying child, or they must be liquidated. The liquidated
funds are subject to the 10 percent penalty and to income tax (to the
extent of earned income).
REDUCING MARRIAGE TAxEs:
ISSUES AND PROPOSALS
Marital status may affect a couple's federal income tax liability.
Couples who pay more taxes when they are married than they would
pay if they were single are said to incur "marriage penalties." Couples
who pay less taxes as a consequence of marriage are said to receive
"marriage bonuses." This paper discusses the sources of marriage
taxes and their economic effects. It then examines some of the
proposals that have been offered to reduce marriage penalties.
SOURCES OF MARRIAGE TAXES
The federal income tax code treats married couples as a single
economic unit by taxing their combined incomes on a joint return.' 3 4
Marriage penalties and bonuses occur because many provisions in the
tax code treat joint filers differently than two single filers with the
same total income. The tax code contains 66 provisions that can affect
a married couple's tax liability.' 3 5
Tax Rate Schedules
The two most common sources of marriage taxes are the standard
deduction and the widths of the tax brackets. Figure I shows that the
~~._
*-.
.
_
.
Spouses are allowed to file separately, but doing so usually results in a
combined tax liability that is at least as great as their tax liability under joint
filing.
135
American Institute of Certified Public Accountants, "Marriage
Penalty/Divorce/Domestic Relations Tax Issues," February 13, 1998.
134
112
combined standard deduction for two individuals filing single returns is
$8,500, but the standard deduction for a married couple filing a joint
return is only $7,100. Thus, joint filing increases a couple's taxable
income by $1,400. Two single parents filing as heads of households
would increase their taxable income by $5,400 if they were to marry.
(This provision does not affect couples who itemize.)
Table I below shows that the tax brackets for joint filers are not
twice as wide as those for single filers or heads of households. As a
result, more of a couple's combined income may be taxed at a higher
marginal tax rate under joint filing, and in some cases, a couple's
combined income may push them into a higher tax bracket.
Table 1. Federal Income Tax Brackets, 1998
aI6s~>
.
$0 - 42,350
$42,350 - 102,300
$102,300 -155,950
$155,950- 278,450
$278,450 +
Single,
Jo
Head o
ue
fd
$0 - 25,350
$0 - 33,950
$25,350 - 61,400
$33,950 - 87,700
$61,400- 128,100 $87,700- 142,000
$128,100- 278,450 $142,000 - 278,450
$278,450 +
$278,450 +
i
e'
15%
8%
1%
6%
39.6%
These features of the tax code can create marriage penalties or
bonuses for a particular couple depending on the division of income
between spouses. Examples are provided in Appendix 1.
The Earned Income Tax Credit (EITC)
At low levels of income, marriage taxes primarily arise because of
the standard deduction and the EITC, a tax credit for low-income
workers. Table 2 shows that three different EITC schedules exist for
households with no children, households with one child, and
households with two or more children. For each schedule, the size of
the credit increases over a phase-in range of income up to a maximum
amount; the maximum credit is awarded over a specified range of
income; the size of the credit then decreases over a phase-out range of
income until it reaches zero.
The EITC can affect a couple's tax liability for at least two
reasons. First, the size of the credit does not depend on a household's
filing status. In other words, eligibility for the credit is the same for
singles, heads of households, and married couples. Thus, combining
113
two incomes on a joint return may push a couple into the phase-out
range of the EITC and reduce the size of their credit. Second, the size
of the credit does not increase for households with more than two
children. Combining more than two children into one household may,
therefore, result in a smaller tax credit. The size of the credit may also
be reduced if two unmarried individuals each bring one child to a
marriage. In this case, each child brings rise to a smaller credit
because the maximum credit available to households with two children
is less than twice the maximum credit available to households with one
child.'3 6
Table 2. EITC Schedules, 1998
M;ku-Xum
4 X&Credit
Inoe
P e
age
Maximum
'
Credit Range,
Icome
e-
Outange
No children
One child
$341
$2,271
$0 - 4,460 $4,460 - 5,570 $5,570 - 10,028
$0 - 6,680 $6,680 - 12,260 $12,260 - 26,470
Two or
more
children
$3,756
$0 - 9,390 $9,390 - 12,260 $12,260 - 30,095
These features of the EITC can create large marriage penalties or
bonuses for low-income couples. An example of how the EITC creates
marriage penalties is provided in Appendix 1.
Means-Tested Tax Provisions
Marriage taxes can also arise because of many provisions in the
tax code that provide credits, deductions, and exemptions on the basis
of income. In many cases, the income limit at which a tax break
phases out for joint filers is not twice as high as the income limit
applicable to single filers. In such cases, a couple's combined income
may disqualify them from claiming a tax break that they are eligible for
as singles.
For example, the child tax credit allows taxpayers to claim a $400
tax credit in 1998 for each of their dependent children. The full credit
is available to single tax filers with adjusted gross incomes (AGI) less
than $75,000 and to joint tax filers with AGI less than $110,000.
136 Joint Committee on Taxation, Impact on Individuals and Families of
Replacing the Federal Income Tax, Joint Committee Print JCS-8-97
(Washington, DC: Government Printing Office) 1997, pp. 37-38.
114
Consider two workers, each with one child and each earning $65,000.
If both workers were single, each could claim the maximum credit.
However, if the workers were married to each other, they would be
ineligible for the credit because their combined income of $130,000
would exceed the income threshold for joint filers. The phase out of
the credit would, therefore, create an $800 marriage penalty for the
couple.
Phase-out provisions can also create marriage bonuses in some
cases. For instance, a worker earning $80,000 would not qualify for
the maximum child tax credit when single, but would qualify for it
when married to a spouse who earns less than $30,000.
Other means-tested provisions that may affect a couple's joint tax
liability include the reduction of personal exemptions and itemized
deductions at high levels of income, the taxation of Social Security
benefits above certain levels of income, and the phase out of deductible
contributions to Individual Retirement Accounts.
Division of Income
Whether a particular couple receives a marriage penalty or bonus
(or neither) depends primarily on their division of income.' 3 7 Marriage
penalties can only occur if both spouses have earned incomes. Couples
with one earner almost never pay penalties and usually receive
bonuses. In general, marriage penalties are more likely to occur if a
couple's income is evenly divided between husband and wife, and
marriage bonuses are more likely to occur if a couple's earnings are
largely attributable to one spouse. For a given level of income, the
largest penalties are usually paid by two-earner couples with a 50-50
income split, and the largest bonuses are usually received by oneearner couples (100-0 income split).
It is very difficult to quantify the average size of marriage taxes or
the number of couples affected by them because many assumptions
must be made about each couple's financial characteristics. A recent
study by the General Accounting Office (GAO) found that the current
data was insufficient to make such an assessment.' 3 8
137 Other factors such as level of income, number of children, and allowable
deductions are also important.
138 United States General Accounting Office, Income Tax Treatment of
Marriedand Single Individuals, Report No. GAO/GGD-96-175, (Washington,
DC: Government Printing Office) September 1996.
115
THE ECONOMIC EFFECTS OF JOINT TAx FILING
The Second-Earner Bias
Joint tax filing creates a "second-earner bias" in the federal income tax
code. The bias occurs because the income of the secondary earner is
stacked on top of the primary earner's income. As a result, the
secondary earner's income may be taxed at a relatively higher marginal
tax rate.
To elaborate, consider a married couple in which the husband
works outside the home earning $40,000 per year, and the wife is a
homemaker who earns no taxable income. If the couple claims the
standard deduction and two personal exemptions, their taxable income
would be $27,500, and they would fall in the 15 percent tax bracket.
Their tax liability would reflect a marriage bonus of $1,834. If the
wife decides to enter the labor force earning $25,000 per year, her
income would be added to her husband's income to yield a combined
taxable income of $52,500. The wife's additional income would push
the couple into the 28 percent tax bracket and create a marriage penalty
of $529.
Figure 2 shows that if the wife were allowed to file a single tax
return, the first $6,950 of her income would not be taxed, and the
remaining $18,050 would be taxed at 15 percent. However, under joint
filing, the first $14,850 of her income is taxed at 15 percent, and the
remaining $10,150 is taxed at 28 percent. Thus, joint filing reduces the
wife's after-tax income by $2,362 relative to single filing.
Joint tax filing essentially treats the incomes of the primary and
secondary earners differently. In this example, the primary earner
enters the work force at a zero percent tax rate, and the last dollar of
116
income he earns is taxed at 15 percent. The secondary earner enters
the labor force at a 15 percent tax rate, and the last dollar of income she
earns is taxed at 28 percent. Even if the wife's income did not push the
couple into a higher tax bracket, she still would be affected by the
second-earner bias because she still could not take advantage of a zero
tax bracket. Thus, more of her income would be taxed at a higher rate.
The second-earner bias is a consequence of joint tax filing and,
therefore, affects all couples regardless of whether they incur marriage
penalties or bonuses. However, the effect of the bias is more severe if
the secondary earner's income creates a marriage penalty.
Effect on Labor Supply
Married women are typically the secondary earners of their
households for at least two reasons. First, wives, on average, earn less
than their husbands. Thus, their incomes are usually less essential to
their families' economic well being. Second, married women tend to
move in and out of the work force, between full-time and part-time
jobs, depending on their families' needs.' 3 9 As a result, they are often
less attached to the work force relative to their husbands. A great deal
of research indicates that the labor supply of secondary earners is
highly sensitive to marginal tax rates. Because married women are
usually secondary earners, joint tax filing may distort their labor supply
decisions.
Several studies have confirmed that married women are more
responsive to high marginal tax rates relative to other demographic
groups. 40 One study by Barry Bosworth and Gary Burtless of the
Brookings Institution estimates that female labor supply increased by
an average of 61 hours per year between 1981 and 1989 in response to
the marginal tax rate reductions of the 1980s."' This gain represents a
5.4 percent increase above previous trends. The largest gains occurred
among married women in high-income families.' 4 2
139 Howard V. Hayghe and Suzanne M. Bianchi, "Married Mothers' Work
Patterns: the Job-Family Compromise," Monthly Labor Review, Vol. 117,
June 1994, pp. 24-30.
140 See for example, Michael J. Boskin and Eytan Sheshinski, "Optimal Tax
Treatment of the Family: Married Couples," Journal of Public Economics,
Vol. 20, No. 3, 1983, pp. 281-287.
141 Barry Bosworth and Gary Burtless, "Effects of Tax Reform on Labor
Supply, Investment, and Saving," Journal of Economic Perspectives, Vol. 6,
No. 1, Winter 1992, pp. 3-25.
142 High-income households experienced the largest reductions in marginal tax
rates during the 1980s.
117
Another study by Nada Eissa of the University of California in
Berkeley concludes that the labor supply of high-income married
women "increased dramatically" in response to the marginal tax rate
reductions of the Tax Reform Act (TRA) of 1986.143 Eissa estimates
that a 10 percent increase in the after-tax wage increased the labor
supply of high-income married women by approximately 8 percent. At
least half of the increase is believed to represent labor force
participation.
The research suggests that once married women enter the labor
force, they are less likely to exit in response to work disincentives. In
other words, high marginal tax rates may not induce women to leave
the work force to the same extent that low marginal tax rates encourage
them to enter. For married women already in the labor force, high
marginal tax rates may have a larger impact on decisions regarding
how many hours to work and the form in which compensation is taken
(e.g., cash wages or non-taxable fringe benefits).
The distortions in labor supply created by the second-earner bias
may impose considerable costs on the economy in terms of lost
economic output and reduced efficiency. Estimates indicate that the
economic cost of taxing wives at relatively higher marginal tax rates
outweighs the associated increase in revenue. 144 An optimal tax system
should, therefore, tax the secondary earner at a relatively lower
marginal tax rate in order to maximize economic efficiency.' 4 5
HISTORY OF MARRIAGE TAXES 1 "
When the individual income tax was established in 1913, all
individuals filed their taxes separately under an individual tax
schedule. As a result, the tax code was marriage neutral-individuals
paid the same income tax whether they were single or married.
Because the tax code was also progressive, one-earner couples often
paid higher taxes than two-earner couples with identical incomes. For
143 Nada Eissa, "Taxation and the Labor Supply of Married Women: The Tax
Reform Act of 1986 as a Natural Experiment," National Bureau of Economic
Research Working Paper No. 5023, February 1995.
144 Martin Feldstein and Daniel Feenberg, "The Taxation of Two-Earner
Families," National Bureau of Economic Research Working Paper No. 5155,
June 1995.
145 Op. Cit., Bosworth and Sheshinski
146 Historical discussion draws from Gregg A. Esenwein, "The Federal Income
Tax and Marriage Neutrality," Congressional Research Service, January 31,
1997; and Edward McCaffery, Taxing Women, (Chicago: University of
Chicago Press) 1997.
118
instance, a couple with one wage earner making $100,000 per year was
taxed at a higher rate than a couple with two wage earners making
$50,000 each.
Couples with the same incomes could also pay different taxes
depending on their state of residence. States with community property
laws allowed couples to split their incomes evenly between two tax
returns regardless of who actually earned the income. The benefit of
income splitting lowered the tax liabilities of married couples in
community property states. In contrast, couples residing in common
law states were not allowed to split their incomes for tax purposes and
often paid higher taxes.
As the size and scope of federal income taxation grew during
World War II, Congress set out to equalize the treatment of similarly
situated married couples. In 1948, Congress established joint filing,
thus extending the benefit of income splitting to all married couples
regardless of their state of residence. The 1948 law effectively created
marriage bonuses for the majority of couples.
The 1948 law was perceived by many as a singles penalty because
single workers paid substantially higher taxes than one-earner couples
with the same incomes. In 1969, Congress responded to the concerns
of single workers by narrowing the tax brackets for joint filers, thus
reducing the discrepancy in tax liabilities between singles and their
married counterparts. The narrowing of the tax brackets created the
marriage penalty that exists in today's laws. The creation of the EITC
in 1975 increased marriage penalties for some low-income couples
who reduced their EITC eligibility by marrying.
As more women entered the work force during the 1970s, more
couples were subject to the marriage penalty and opposition to the
1969 tax changes grew. Congress responded by including a provision
in the Economic Recovery Tax Act (ERTA) of 1981 that granted twoearner couples a tax deduction of up to $3,000. The deduction reduced
the size of the marriage penalty for most couples incurring a penalty
and entirely eliminated it for some. The deduction also increased the
marriage bonuses received by many two-earner couples.
Five years later, the second-earner deduction was repealed in TRA
1986 and replaced with broad-based tax reform. The standard
deduction for married couples was increased, and the 14 bracket tax
schedule was reduced to only two tax brackets. In addition, the
maximum marginal tax rate on income was lowered from 50 percent to
28 percent. TRA 1986 sharply reduced or eliminated the marriage
penalty for the majority of two-earner couples. The law also reduced
119
the severity of the second-earner bias because the flatter tax code
allowed fewer opportunities to be pushed into a higher tax bracket.
The Omnibus Budget Reconciliation Act (OBRA) of 1990 created
a third marginal income tax rate of 31 percent, thus slightly increasing
the size of marriage taxes for high-income couples. Two years later,
OBRA 1993 added two more tax brackets of 36 and 39.6 percent to the
tax schedule. OBRA 1993 also expanded the size and coverage of the
EITC. Together, these changes significantly increased marriage taxes
for couples at the low and high ends of the income scale.
In 1995, Congress once again tried to grant tax relief to twoincome families. The U.S. Senate considered a proposal to increase the
standard deduction for joint filers to twice that of single filers; and the
U.S. House of Representatives passed a bill that would have provided a
tax credit to any couple who paid a marriage penalty. The Senate
proposal was included in the Balanced Budget Act of 1995, but the
entire bill was vetoed by President Clinton.
Trends among Married Couples
The federal income tax code was largely structured when oneearner couples represented the traditional family, and earnings equality
between husbands and wives was rare. Thus, the large majority of
married couples benefited from marriage bonuses, and relatively few
were affected by the creation of marriage penalties inl969. However,
changes in social attitudes, demographic patterns, and labor markets
have contributed to a growth in marriage penalties.
For instance, the labor force participation rate of married women
increased by 49 percent between 1970 and 1996, from 41 to 61
percent.' 47 This increase led to a rise in the proportion of two-earner
couples. Between 1970 and 1996, the proportion of married couple
families with both spouses in the work force increased by nearly onethird, from 46 to 60 percent, and the proportion with only one spouse
in the work force fell by almost 40 percent, from 36 to 22 percent. 148
Moreover, married women's median income increased by 42
percent between 1974 and 1996, after adjusting for inflation.
However, the median income of married men fell by approximately 4
percent over the same time period.'4 9 The relative increase in married
women's incomes has led to greater earnings equality between
147
U.S. Bureau of the Census, Internet, Statistical Abstract of the United
631.
States 1997, Table No.
U.S. Bureau of Labor Statistics, unpublished data.
U.S. Bureau of the Census, Internet, Current Population Survey (CPS):
1947-1996, Table P-7.
148
149
120
husbands and wives. The proportion of working-aged married couples
in which each spouse earned at least one-third of the couple's income
doubled between 1969 and 1995, from 17 to 34 percent.' 5 0
The trend toward more two-earner couples with greater income
equality means that more married couples are potentially subject to
larger penalties. As a result, several proposals to reduce or eliminate
the burden on two-earner couples have been introduced.
REDUCING MARRIAGE PENALTIES
Changes in the tax laws relating to married couples have tried to
balance three different principles of tax equity:
* the principle of horizontal equity requires couples with the
same ability to pay taxes to incur the same tax liabilities;
* the principle of marriage neutrality requires a couple's tax
liability to be the same whether they are married or single; and
* the principle of progressivity requires tax liability to increase
as a percentage of income as income rises.
A tax system can achieve any two of these principles
simultaneously, but it cannot achieve all three. The existing tax code
achieves the principles of horizontal equity and progressivity, but it is
not marriage neutral.
The inconsistency among the three goals of tax equity poses a
difficult problem for policy makers seeking to reduce or eliminate the
marriage penalty. Any proposal to alleviate the burden will necessarily
entail trade-offs between different groups of taxpayers and different
goals of tax policy. As a result, subjective decisions must be made
regarding the proper unit of taxation, the appropriate measure of a
household's ability to pay, the equitable treatment of married versus
single taxpayers, and the extent to which the tax code should promote
social policy goals at the expense of economic efficiency.
The Proposals
Several proposals to reduce the marriage penalty have been
introduced by Members of Congress. All of the proposals would
maintain marriage bonuses and none would eliminate all marriage
penalties for all couples. (Marriage neutrality can only be achieved by
reverting to a system of individual filing or though fundamental tax
reform.) Although, the effect of any proposal depends on how revenue
losses would be offset, some observations can be made about the
Congressional Budget Office (CBO), "For Better or for Worse: Marriage
and the Federal Income Tax," (Washington, DC: Government Printing Office)
June 1997, p. 38.
150
121
different proposals. A summary of the proposals is provided in Table 3
at the end of this section.
OptionalFilingStatus
The Marriage Tax Elimination Act (H.R. 2456), introduced by
Congressmen Jerry Weller (R-IL) and David McIntosh (R-IN), would
allow couples the option of filing jointly, as they do now, or filing as
two singles on the same tax return.' 5 ' Thus, couples could choose the
filing status that provides them with the lower tax liability. The Joint
Committee on Taxation (JCT) estimates that optional filing would
reduce federal government revenue by $101 billion over five years.
The legislation has been cosponsored by 236 Members in the House.
Optional filing would eliminate most marriage penalties and
maintain marriage bonuses. Thus, the tax code would be marriage
neutral for couples who choose to file as singles, and it would favor
marriage for most other couples.
The proposal would eliminate penalties arising from the standard
deduction and the widths of the tax brackets. A reduced penalty could
exist for couples with children. If single, these couples could take
advantage of the relatively wider tax brackets and higher standard
deduction under the head of household filing status. The head of
household tax schedule would not be available to married couples
under the optional filing proposal.
In addition, a reduced penalty could exist for EITC-eligible
couples because eligibility for the EITC would be based on joint
income regardless of which tax schedule a couple chooses to use. If
EITC eligibility were based on individual income, then low-income
spouses would qualify for the EITC even if they were married to
wealthy spouses: This would result in a redistribution of income from
low- and middle-income households to high-income households.
Under optional filing, the marriage penalty for EITC-eligible couples
would be reduced by a maximum of $210 (reflecting the reduced
penalty in the standard deduction).
Finally, a reduced penalty could exist for middle- and highincome couples because eligibility for various tax breaks would be
based on joint income. As a result, the penalties arising from the
phase-out provisions of the tax code would remain because a couple's
151 Similar bills have been introduced by John Kasich, R-OH (H.R 2462);
Sheila Jackson-Lee, D-TX (H.R. 3059); and Kay Bailey Hutchison, R-TX (S.
1314).
122
combined income could push them beyond the phase-out threshold of a
particular tax break. 152
Optional filing would only lower the tax liabilities of couples who
incur marriage penalties under joint filing. The size of a couple's tax cut
would equal the size of their marriage penalty (except for the exceptions
noted above in which the penalty is not eliminated). Thus, for a given
level of income, couples with roughly equal incomes would receive the
largest tax cuts because they generally pay the largest penalties.
Couples who receive marriage bonuses under current law would not be
affected by the proposal-their tax liabilities would remain the same.
Examples illustrating the effect of optional filing on various couples are
contained in Appendix 2.
Allowing couples to choose their filing status means that couples
with equal incomes may not pay the same income tax. Some observers
argue that ending horizontal equity would be unfair because couples
with the same total income are equally well off and, therefore, should
incur the same tax liability. Others believe that income alone is not a
good measure of a couple's economic well being.' 53 For instance, two
couples may not be equally well off if the earners in the first couple
work 40 hours a week at a higher wage, and the earners in the second
couple earn the same total income by working a greater number of
hours at a lower wage. Thus, requiring couples with equal incomes to
pay the same income tax may not necessarily satisfy the goal of
horizontal equity.
Opponents of optional filing note that the proposal would increase
compliance costs relative to current law. Couples would have to
calculate their taxes jointly and individually to determine which
provides them with the lower tax liability. Furthermore, specific rules
would have to be made regarding the division of deductions for
couples who choose to file individually.
Income Splitting
Two separate bills would eliminate most marriage penalties by
reinstating income splitting. Although the two bills would be
implemented differently, both would have the same effect on couples'
tax liabilities. The first bill, titled the Marriage Protection and Fairness
Act (H.R. 3104), was introduced by Congressmen Bob Riley (R-AL)
Optional filing eliminates the penalty arising from the limitation of
itemized deductions and personal exemptions.
152
'"Op. Cit., CBO, p. 9.
123
and Matt Salmon (R-AZ).' 5 4 The bill would allow each spouse to
apply the single tax rate schedule to half of the couple's taxable
income. The standard deduction used to determine taxable income
would be increased to twice the standard-deduction for single returns.
The JCT estimates that the proposal would reduce federal government
revenue by $153 billion over five years. The legislation has been
cosponsored by 83 Members in the House.
The second bill, titled the Marriage Tax Penalty Elimination Act
of 1998 (H.R. 3734), was introduced by Congressmen Jerry Weller,
David McIntosh, Bob Riley, and Wally Herger (R-CA)."' (This bill
represents a collaborative effort by the primary sponsors of the three
major marriage penalty bills to support a single piece of legislation.)
The proposal would increase the standard deduction and the widths of
the tax brackets for joint filers to twice the applicable amounts for
single filers. Revenue estimates are not yet available, but should be
similar to those of H.R. 3104. The legislation has been cosponsored by
45 Members in the House.
Income splitting proposals are similar to optional filing because
they adjust for differences in the tax schedules between single and joint
filers. However, the proposals differ from optional filing because they
make no distinction regarding the division of income between spouses.
In other words, couples are treated as if each spouse earns half of their
total income regardless of which spouse actually generates that income.
Income splitting would, therefore, provide all couples with the most
favorable tax treatment by effectively treating them like two singles
with a 50-50 income split. This favorable treatment would reduce
taxes for nearly all married couples. Couples with equal incomes
would receive equal tax cuts, thus maintaining horizontal equity.
Moreover, income splitting would create marriage bonuses for
most couples and increase bonuses for couples already receiving them,
including one-earner couples. Thus, the proposals reduce marriage
neutrality by heavily favoring marriage. Examples illustrating the
effect of income splitting on various couples are contained in Appendix
2.
As with optional filing, income splitting would only eliminate
penalties arising from the standard deduction and the widths of the tax
brackets. A reduced penalty could exist for couples with children (who
54 A similar bill was introduced in the Senate by Lauch Faircloth, R-NC (S.
1285).
55 A similar bill was introduced in the Senate by Kay Bailey Hutchison (S.
1999).
H.Rept. 105-807 -98 - 5
124
would otherwise file as heads of households if they were single),
couples eligible for the EITC, and couples subject to the various phaseout provisions of the tax code.
Opponents contend that income splitting has two primary
disadvantages.
First, some analysts argue that the proposals
inefficiently uses scarce fiscal resources because a portion of the large
revenue loss would finance bigger bonuses for couples who already
receive them. Second, the establishment of income splitting in 1948
was perceived as a singles penalty because single taxpayers paid
substantially higher income taxes than one-earner couples with the
same total incomes. Complaints from single taxpayers led to the
creation of the marriage penalty in 1969. A return to income splitting
may bring about the same perceived inequities for single taxpayers
who would have to bear a substantially larger share of the total tax
burden (although their tax liabilities would remain the same).
Second-EarnerDeduction
The Marriage Penalty Relief Act (H.R. 2593), introduced by
Congressman Wally Herger and Congresswoman Barbara Kennelly
(D-CT), would revive the second-earner deduction that was in the law
between 1981 and 1986. Under this proposal, couples with two earners
could deduct 10 percent of the income of the lesser earning spouse up
to a maximum deduction of $3,000. The deduction would be available
to couples whether they itemize or claim the standard deduction. The
JCT estimates that the second-earner deduction would reduce federal
government revenue by $45 billion over five years. The legislation has
been cosponsored by 182 Members in the House.
Under the second-earner deduction, most couples incurring
marriage penalties under current law would have their penalties
reduced; some would have their penalties eliminated or converted into
bonuses. Two-earner couples receiving bonuses under current law
would receive larger bonuses. Thus, the proposal increases marriage
neutrality for some couples and reduces it for others. One-earner
couples would not be affected by the proposal and would continue
receiving bonuses.
As with the other proposals, the second-earner deduction does not
address the structural penalty in the EITC. However, it would reduce
penalties for some EITC-eligible couples by reducing the income
stacking problem that can potentially push a low-income couple into
the 15 percent tax bracket. For instance, two single parents, each with
one child and each earning $10,000, would not pay any federal income
tax. However, if they married each other, their combined income
would push them into the 15 percent tax bracket and generate a $315
125
federal income tax liability under current law. If they were allowed to
deduct $1,000, their tax liability would fall to $165, thus reducing their
marriage penalty by $150. The proposal could reduce marriage
penalties for some EITC-eligible couples by a maximum of $450
(reflecting the value of a $3,000 deduction at 15 percent).
A $3,000 deduction would reduce the income tax liability of a
two-earner couple by a maximum of $450 to $1,188 depending on their
tax bracket. Thus, the dollar value of the deduction would be more
valuable at high levels of income, but this may be appropriate because
the dollar value of marriage penalties increases substantially with
income. The proposal would not affect the tax liabilities of one-earner
couples. Examples illustrating the effect of the second-earner
deduction on various couples are contained in Appendix 2.
Under a second-earner deduction, two-earner couples would pay
less taxes than one-earner couples with the same total incomes. Some
observers argue that this would penalize one-earner couples by
increasing their share of the total tax burden (although their tax
liabilities would remain the same). Others believe that two-earner
couples are not as well off as one-earner couples with the same total
incomes. For instance, a one-earner couple benefits from the nonearning spouse's work inside the home, the value of which is not taxed.
The homemaker's non-taxed services increase the couple's economic
well being. In contrast, a couple with two wage earners might have to
pay for the services that a stay-at-home spouse provides, thus reducing
their economic well being. In this respect, the two-earner couple is
worse off and should pay less income tax.
Opponents of the proposal point to two disadvantages. First, the
deduction would not eliminate any of the structural penalties in the tax
code-it would merely reduces them. Second, part of the revenue loss
would finance larger bonuses for couples who already receive them.
Other Proposals
Several other bills aimed at providing broad-based tax relief would
also reduce the size of the marriage penalty. Some of these proposals
are briefly summarized below.
* H.R. 1584 (Sam Johnson, R-TX) includes a provision that would
allow couples affected by marriage penalties to claim a tax credit
of up to $145 against their tax liabilities.
* H.R. 2718 (Joe Knollenberg, R-MI) would reduce marriage
penalties by increasing the standard deduction for joint filers to
twice that of single filers. The bill would also lower marginal
tax rates for all taxpayers from 15, 28, 31, 36, and 39.6 percent to
14.25, 26.6, 29.45, 34.2, and 37.62 percent, respectively.
126
Lowering the marginal tax rates would reduce the size of
marriage penalties relative to current law by reducing the tax
associated with being pushed into a higher tax bracket.
* H.R. 3151 (John Thune, R-SD) and H.R. 3175 (William "Mac"
Thornberry, R-TX) would expand the 15 percent tax bracket.
This would provide less opportunity for a secondary earner's
income to push a couple into the 28 percent tax bracket, thus
reducing marriage penalties for millions of middle-income
couples. The proposal would also reduce marriage penalties at
higher levels of income relative to current law because more
income would be taxed at the 15 percent tax rate.
Table 3. Summary of the Marriage Penalty Proposals
Effect on:
Two-earner couples
with penalties
Two-earner couples
with bonuses
One-earnercouples
with bonuses
EITC-eligible
couples
Marriagetax
Reduced or
eliminated
Nefctoefct
No effect
No effect
Penalty reduced by
maximum of $210
Tax liability
Reduced
No effect
No effect
Sometimes reduced
Bonuses increased
Bonuses increased
Penalty reduced by
maximum of $210
Reduced
Reduced
Sometimes reduced
Marrigge
Optional
Filing
Reduced, eliminated,
Income
Splitting
Marriagetax
Tax liability
SecondEarner
Deduction
or converted to
bonuses
Reduced
Marriagetax
Reduced, eliminated,
or converted to
bonuses
Bonuses increased
No effect
Penalty reduced by
maximum of $450
Tax liability
Reduced
Reduced
No effect
Sometimes reduced
Table. 3 Summary of the Marriage Penalty Proposals (cont'd.)
Relative
Structuralpenalties
Relative effect on goals of tax policy:
complexity
eliminated
Progressivity
Horizontal
Marriage
equity
neutrality
Optional
Increased
Decreased
Maintained
Standard deduction
and widths of tax
Decreased
Maintained
Maintained
Standard deduction
and widths of tax
brackets
Low
$153 (H.R. 3104)
Decreased
Maintained
No structural
penalties eliminated,
only reduced
Low
$45
Filing
Income
Splitting
SecondEarner
Deduction
5-Year revenue
loss (billions)
No net effect
High
$101
brackets
t5
00
129
EFFECT ON LABOR SUPPLY OF SECONDARY EARNERS
Eliminating or reducing marriage penalties is likely to increase the
labor supply of married women by reducing the second-earner bias.
One study estimates that if marriage penalties were eliminated after the
1986 tax reforms (when penalties were less severe than they are today),
the labor supply of married women would have increased by an
average of 46 hours per year."56 The effect would have been greater
among married women from high-income families and married women
who earned substantially less than their husbands.
Reducing marriage taxes will affect two different aspects of the
labor supply decision. First, it will affect the decision of a nonworking spouse to enter the labor force. Any proposal that reduces a
secondary earner's average tax rate'5 relative to current law will
increase his or her after-tax income. This incentive will encourage a
non-working spouse to enter the labor force. Second, reducing
marriage taxes will affect the decision of a working spouse to work
more hours. Any proposal that reduces a secondary earner's marginal
tax rate"58 relative to current law will increase the return to extra work.
This incentive will encourage a working spouse to work more hours.
The various proposals discussed above will either enhance the labor
supply incentives of secondary earners or leave them unaffected.
Table 6 at the end of this section summarizes the effect of the different
proposals on the labor supply of secondary earners.
Optional Filing
Labor Force Participation
If a homemaker's decision to enter the labor force creates a
marriage penalty under joint filing, the couple would choose to file as
singles under the optional filing proposal. Single filing eliminates the
second-earner bias because the income of the secondary earner is taxed
separately. Thus, the non-working spouse enters the labor force at a
zero tax rate instead of entering at the primary earner's higher marginal
tax rate. The elimination of the second-earner bias lowers the
secondary earner's average tax rate relative to current law and
increases his or her after-tax income. This incentive will always
156 Deenie Kinder Neff, "Married Women's Labor Supply and the Marriage
Penalty," Public Finance Quarterly, Vol. 18, No. 4, October 1990, pp. 42032.
157 The average tax rate is defined as tax liability divided by income.
158 The marginal tax rate is defined as the tax rate imposed on an additional
dollar of income earned.
130
encourage a non-working spouse to enter the labor force if the couple
opts for singlefiling.
However, if the non-working spouse is deciding to enter the labor
force at an income that is substantially lower than the primary earner's
income, then the couple would likely receive a marriage bonus under
joint filing. In this case, the couple would not choose to file
individually because doing so would increase their combined tax
liability. Thus, optional filing would not affect the labor supply
decisions of the non-working spouse.
Number of Hours Worked
For second-earner spouses already in the work force, optional
filing may encourage more work effort in some cases. Individual filing
will either lower the marginal tax rate of the secondary earner or leave
it unchanged (it will never increase the secondary earner's marginal tax
rate). If the marginal tax rate falls, then an additional dollar of income
earned will be taxed at a lower rate. This incentive will encourage the
lesser earning spouse to work more hours. If the marginal tax rate
remains unchanged, optional filing will not generate any additional
benefits at the margin and, therefore, will not affect the labor supply
decisions of the secondary earner.
Table 4 provides two examples to illustrate how optional filing
might affect a working spouse's decision to work more hours. In the
first example, the primary earner earns $75,000 and the secondary
earner earns $25,000. Joint tax filing results in a marriage penalty of
$329. Thus, the couple chooses to file as singles. Single filing reduces
the secondary earner's marginal tax rate from 28 percent to 15 percent.
Table 4. Effect of Optional Filing on Number of Hours Worked
Income of primary
earner
Income of
secondary earner
$75,000
$25,000
BXfiling
Single;
filingfi"
$329
$0
XJoint-
Penalty/(bonus)
$60,000
$40,000
filing
Single
filIng
$1,477
$0
Joint
.
28%
15%
28%
28%
Second earner's
marginal tax rate
Note: (1) Assumes the standard deduction and two personal exemptions.
(2) Marginal tax rates do not include payroll, state or local taxes.
Source: Joint Economic Committee calculations
131
In other words, out of an additional dollar of income earned, the
secondary earner keeps 72 cents under joint filing and 85 cents under
single filing. The reduction in the secondary earner's marginal tax rate
increases the value of his or her work at the margin and encourages
him or her to work more hours. Hence, optional filing enhances the
secondary earner's labor supply incentive relative to current law.'5 9
In the second example, the primary earner earns $60,000 and the
secondary earners earns $40,000. Once again, the couple can lower
their tax liability by filing as singles. However, in this example, using
the single tax rate schedule does not lower the secondary earner's
marginal tax rate. Thus, there is no additional benefit to working more
hours. As a result, optional filing does not enhance the secondary
earner's labor supply incentives even though the couple opts for single
filing.
Overall, optional filing would affect secondary earners differently
depending on each couple's income and division of income. In
general, optional filing always encourages a non-working spouse to
enter the labor force if the couple opts for individualfiling. Among
working spouses, optional filing encourages a secondary earner-to
work more hours if the couple opts for individual filing and if
individualfiling lowers the secondary earner'smarginal tax rate. The
proposal is more likely to increase the number of hours worked by
secondary earners in high-income households. It is less likely to
increase labor supply among secondary earners in low- and middleincome households unless the couple's combined taxable income is
grouped around the marginal tax-rate breakpoints.
According to many analysts, allowing couples to file as singles
would be economically more efficient than the current system of joint
filing because it would reduce distortions in labor supply that impose
economic costs on households (in terms of foregone income) and on
the economy (in terms of foregone output).
Income Splitting
Labor Force Participation
Under the income splitting proposals, the higher standard
deduction and wider tax brackets allow more of the secondary earner's
159 Although the secondary earner's marginal tax rate may fall under single
filing, the primary earner's marginal tax rate may increase, thus discouraging
work effort by the primary earner. Thus, the net effect on labor supply for the
couple is ambiguous in some cases. However, many studies have found that
the labor supply of secondary earners is more responsive to marginal tax rates
than the labor supply of primary earners. If this is the case, single filing
should result in a net increase in total hours worked by the couple.
132
income to be taxed at a lower rate. This will often (but not always)
reduce a secondary earner's average tax rate relative to current law and
increase his or her after-tax income. This incentive will encourage
many non-working spouses to enter the labor force. Hence, the effect
of income splitting is similar to that of optional filing: it will either
encourage labor force participation by non-working spouses, or it will
have no effect on the incentive to enter the labor force.
Table 5 below provides two examples to illustrate how income
splitting might affect a homemaker's decision to enter the labor force.
In the first example, the primary earner earns $40,000 per year and the
non-working spouse is deciding whether to accept a job at $20,000 per
year. Under current law, the secondary earner's new income generates
a tax liability of $3,670. Thus, his or her average tax rate is 18 percent.
Under income splitting, the secondary earner's income generates a tax
liability of only $3,000. Thus, income splitting lowers the average tax
rate to 15 percent and increases after-tax income by $670. This
incentive encourages the non-working spouse to enter the labor force.
Hence, income splitting enhances the incentive to enter the labor force
relative to current law.
Table 5. Effect of Income Splitting on Labor Force Participation
Income of
primary earner
Income of
secondary earner
$40,000
$20,000
~C~ren
Inome
wsplitting
$40,000
$10,000
M innt
l:
Icm
p'mel
Second earner's $3,670
$3,000
$1,500
$1,500
Second earner's
18%
15%
15%
15%
Second earner's $16,330
$17,000
$8,500
$8,500
Note: (1) Assumes the standard deduction and two personal exemptions. (2)
Average tax rates do not include payroll, state or local taxes.
Source: Joint Economic Committee calculations
In the second example, the non-working spouse is deciding
whether to accept a job at $10,000 per year. In this case, income
splitting does not affect the secondary earner's average tax rate. All of
the secondary earner's income is taxed at 15 percent under either
133
provision. Hence, income splitting does not affect the non-working
spouse's decision to enter the labor force.' 6 0' 161
Although income splitting and optional filing have very similar
effects on labor force participation, it is difficult to determine which
proposal would encourage more working spouses to enter the labor
force. Optional filing always encourages entry if a couple chooses to
file individually, but not all couples will choose to file individually.
Income splitting will encourage entry in many cases, but not all. Thus,
it is difficult to determine which proposal would have the greater effect
on the labor force participation of secondary earners.
Number of Hours Worked
The wider tax brackets and higher standard deduction under
income splitting make it more difficult for a secondary earner's income
to push the couple into a higher tax bracket. Thus, the proposals will
reduce the secondary earner's marginal tax rate in some cases. This
incentive will increase the return to working an additional hour and
will encourage secondary earners to increase their labor supply. As
with optional filing, income splitting is more likely to reduce marginal
tax rates among secondary earners in high-income households. It is
less likely to reduce marginal tax rates among secondary earner's in
low- and middle-income household's unless the couple's taxable
income is grouped around the marginal tax rate breakpoints.
Both of the income splitting proposals would be economically
more efficient relative to current law because they would reduce
distortions in labor supply created by the second-earner bias. The
enhanced work incentives created by income splitting would reduce the
economic costs imposed on households and the economy. (H.R. 3104
may be more efficient than H.R. 3734 because it imposes the same
160 Income splitting almost always reduces a couple's average tax rate
regardless of whether a second earner enters the work force. Thus, the couple
receives a tax cut (or an increase in after-tax income) even if labor supply
does not increase. As a result, the primary earner can work less and maintain
the same standard of living. However, income splitting may also lower the
primary earner's marginal tax rate, thus encouraging more work effort.
Hence, the net effect on the couple's labor supply is ambiguous when the
second earmer does not increase his or her labor supply.
161 Although the effect of the two income-splitting proposals on tax liabilities
is the same, each proposal is implemented differently. As a result, they may
have slightly different effects on labor supply incentives. For instance, H.R.
3104 can reduce the income stacking problem to a greater extent than H.R.
3734. Hence, H.R. 3104 can reduce secondary earners' average tax rates to a
relatively greater extent in some cases and generate stronger work incentives.
134
marginal tax rate on primary and secondary earners. In contrast, H.R.
3734 can impose a relatively higher marginal tax on secondary earners.
As noted earlier, an optimal tax system would impose a lower marginal
tax rate on secondary earners because they are relatively more sensitive
to labor supply incentives.)
Second-Earner Deduction
The second-earner deduction permits the lesser earning spouse to
deduct 10 percent of the first $30,000 of income, thus lowering the
couple's taxable income by a maximum of $3,000. The deduction,
therefore, reduces the marginal tax rate on the first $30,000 of income
earned by the secondary earner. Hence, the proposal is likely to
increase labor supply among second-earner spouses who earn less than
$30,000 per year.
For instance, consider a couple in which one spouse earns $30,000
per year, and the other is a homemaker who is deciding whether to
enter the labor force at $20,000 per year. Under current law, the
$20,000 of income generates a tax liability of $3,000. If a 10 percent
deduction is allowed, the secondary earner can deduct $2,000 of
income from taxation, thus increasing his/her after-tax income by
$300. The increase in after-tax income encourages the homemaker to
enter the labor force. Moreover, each additional dollar of income
earned will give rise to a 10 cent deduction. Thus, the secondary
earner will continue to receive an additional benefit from working
more hours until his or her income reaches $30,000. However, a
working spouse who earns more than $30,000 does not derive any
additional benefit from working more hours and, therefore, is not
affected by the deduction.
CONCLUSION
All of the marriage penalty proposals currently under consideration
would maintain marriage bonuses, and none would eliminate all
marriage penalties for all couples. In particular, penalties would
remain for couples with children, low-income couples eligible for the
EITC, and middle- and high-income couples subject to the various
phase-out provisions of the tax code.
Moreover, the various proposals would affect couples differently
depending on their level and division of incomes. In general, optional
filing would be most favorable to couples with roughly equal incomes.
At each level of income, these couples currently receive the largest
marriage penalties and, therefore, would receive the largest tax cuts if
they were permitted to file as singles. In contrast, income splitting
would provide the greatest benefit to one-earner couples, who would
have their marriage bonuses increased.
135
All of the proposals would be economically more efficient relative to
current law because they would reduce the second-earner bias that
exists under joint filing. As a result, many non-working spouses would
be encouraged to enter the labor force, and many working spouses
would be encouraged to work more hours. The increase in labor
supply among secondary earners would reduce the economic costs
imposed on households (in terms of foregone income) and on the
economy (in terms of lost output). The various proposals would affect
labor supply differently depending on each couple's income and
income split. In general, optional filing and income splitting would
enhance work incentives to the greatest extent; the second-earner
deduction would have the smallest effect on labor supply. All of the
proposals would likely affect labor force participation to a greater
degree than hours worked.
Table 6. Effect of Proposals on Labor Supply of Secondary
Earners
OpI_
gona ation
,El
Filing
Hours
worked
Income
Splitting
More_
Increases or
no effect l
ParticiP- Increases or
ation
no effect
Hours
Increases or
worked
no effect
Particip-
No effect
eindividall
l
l
Increases or
no effect
Increases or
no effect
Increases
Increases
Increases for
spousesf
earning less
than $30,000
Increases for
spousesf
earning less
than $30,000
MrReduces
e
efficient
ation
SecondEarner
Deduction
Hours
worked
Reduces
Slightly
more
efficient
136
APPENDIX 1
EXAMPLES OF MARRIAGE PENALTIES AND BoNuSES
The standard deduction and marginal tax rate breakpoints can create
marriage bonuses for married couples with largely unequal incomes.
Table Al. 1 shows the tax liability of a couple earning $60,000 when all
of the income is earned by one individual. If the worker is single,
he/she incurs a federal income tax liability of $11,559. However, if the
worker marries a spouse with no earned income, their combined tax
liability falls to $7,795-a marriage bonus of $3,764.
The bonus occurs for two reasons. First, when a worker marries a
spouse with no earned income, the couple's personal exemptions
double and their standard deduction increases by $2,850 (see Figure
AL.I). Thus, the couple reduces their taxable income by $5,550 when
filing jointly. Second, under joint tax filing, the wage earner's income
is subject to wider tax brackets so that less income is taxed at 28
percent and more income is taxed at 15 percent (see Figure A 1.2).
Table Al. 1 Sources of the Marriage Bonus
Married
Unmarried
AGI
- Standard Deduction
- Personal Exemption
Taxable Income
Marginal Tax Rate
Worker
Non
Worker
Combined
Joint
Filing
$60,000
$0
$60,000
$60,000
(4,250)
(2,700)
0
0
(4,250)
(2,700)
(7,100)
(5,400)
53,050
0
53,050
47,500
28%
0%
28%
$7,795
$11,559
$0
$11,559
Tax Liability
($3,764)I
Marriage
Penalty/(bonus)
Source: Joint Economic Committee calculations
137
138
The same features of the tax code can create a marriage penalty
when the income is more evenly divided between husband and wife.
Table A1.2 outlines the tax liability of a couple earning $60,000 when
the income is divided equally between the two individuals. If the two
individuals were single, they would file separate tax returns, and each
would incur a federal income tax liability of $3,457.50. Their
combined tax liability would be $6,915. However, if the two
individuals were married, their total tax liability would be $7,795.
Thus, the couple's income tax increases by $880 upon marrying.
The penalty occurs for two reasons. First, when two individuals
with earned income marry each other, their personal exemptions
remain the same, but their standard deduction is reduced by $1,400
(see Figure A1.3). As a result, their taxable income increases by this
amount. Second, because the tax brackets for joint filers are not twice
as wide as those for individual filers, some of their combined income is
pushed out of the 15 percent tax bracket into the 28 percent tax bracket
(see Figure A1.4).
Table A1.2 Sources of the Marriage Penalty
Unmarried
Worker
1
Worker
2
Combined
Married
Joint
Filing
AGI
$30,000
$30,000
$60,000
$60,000
- Standard Deduction
(4,250)
(4,250)
(8,500)
(7,100)
- Personal Exemption
(2,700)
(2,700)
(5,400)
(5,400)
Taxable Income
Marginal Tax Rate
23,050
15%
23,050
15%
46,100
47,500
28%
$6,915
$695$,5
$7,795
Tax Liability
$3,457.5 $3,457.5
0
0
Marriage
Penalty/(bonus)
Source: Joint Economic Committee calculations
$880
139
140
Consider a couple in which each individual has one child and
each earns $10,000. Table Al.3 shows that if the two individuals file
as heads of households, they incur no federal income tax liability, and
each receives the maximum EITC of $2,271. Their combined income
tax liability is negative $4,542. If the two individuals are married, their
tax liability is negative $1,81 1-a marriage penalty of $2,731, or 14
percent of total income.
The penalty occurs for three reasons. First, joint filing reduces
the couple's combined standard deduction by $5,400 (see Figure A 1.5).
Thus, their taxable income increases by this amount and pushes them
into the 15 percent tax bracket. Second, eligibility for the EITC begins
to phase out at AGI $12,260 regardless of filing status. Thus, each
individual qualifies for the maximum credit if single, but if married,
their combined income pushes them into the phase-out range of the
EITC (see Figure A1.6) and reduces the size of the credit for which
they qualify. Third, when the two individuals are single with one child
each, they qualify for two separate tax credits worth a combined
maximum value of $4,542. However, combining their incomes and
children into one household makes them eligible for only one credit
worth a maximum of only $3,756.
Table A1.3 EITC as a Source of Marriage Penalties
Unmarried
Worker Worker Combined
1
2
AGI
- Standard Deduction
- Personal Exemption
Taxable Income
$10,000 $10,000
(6,250) (6,250)
(5,400) (5,400)
$20,000
(12,500)
(10,800)
0
0
Marginal Tax Rate
0%
0%
Federal Income Tax
0
0
0
-2,271
-2,271
-4,542
Credit
0
Married
Joint
Filing
$20,000
(7,100)
(10,800)
2,100
15%
j
Total Tax Liability
-$2,271 -$2,271
-$4,542
Marriage
Penalty/(bonus)
$2,731
Source: Joint Economic Committee calculations
315
-2,126
-$1,811
l
141
142
APPENDIX 2
EFFECT OF VARIOUS PROPOSALS ON MARRIED COUPLES
The following tables illustrate how the three main marriage penalty
reduction proposals would affect hypothetical low-, middle- and highincome couples depending on their division of income. The analysis
does not account for behavioral changes that might occur if any of the
proposals were adopted.
Table A2.1 shows that none of the proposals would eliminate the
structural penalty in the EITC. Therefore, a reduced penalty could
exist for many EITC-eligible couples.
Table A2. Effect of Various Proposals on Tax Liability of Couple
Earning $20,000
Current Law
Single tax liability
Joint tax liability
Penalty/(bonus)
-$4,542
-$1,811
$2,731
-$182
-$1,811
($1,629)
-$3,031
-$1,811
$1,220
-$1,811
$0
($1,629)
-$1,811
$0
$1,220
Optional Filing
Tax liability
Tax cut
Penalty/(bonus)
-$2,021
$210
$2,521
Income Splitting (HIR. 3104 and H.R. 3734
Tax liability
Tax cut
Penalty/(bonus)
-$2,021
$210
$2,521
-$2,021
$210
($1,839)
-$2,021
$210
1,010
Second-Earner Deduction
Tax liability
Tax cut
Penalty/bonus
-$1,961
$150
$2,581
-$1,811
$0
($1,629)
-$1,886
$75
$1,145
Notes: (1) Assumes each spouse has one child for EITC calculation.
Calculations reflect the child tax credit that will be effective in 1998.
Source: Joint Economic Committee calculations
(2)
143
Table A2.2 shows that for middle-income couples, optional filing
would eliminate penalties and maintain bonuses. Couples with the
same income could pay different amounts of income tax. Income
splitting would eliminate penalties and increase bonuses. Couples with
the same income would receive equal tax cuts, thus maintaining
horizontal equity. The second-earner deduction would reduce or
eliminate penalties for two-earner couples. The third example shows
that the deduction would increase bonuses for two-earner couples who
receive them under current law. One-earner couples would not be
affected by the deduction.
One-earner couples would continue
receiving the largest bonuses under all of the proposals.
Table A2.2 Effect of Various Proposals on Tax Liability of
Couple Earning $60,000
CurrenL Law
Single tax liability
Joint tax liability
Penalty/(bonus)
$6,915
$7,795
$880
$11,559
$7,795
($3,764)
$8,567
$7,795
($772)
$7,795
$0
($3,764)
$7,375
$420
($1,192)
Optional Filing
Tax liability
Tax cut
Penalty/bonus
$6,955
$840
$40
Note: Assumes the standard deduction and two personal exemptions
Source: Joint Economic Committee calculations
Table A2.3 shows that for high-income couples, a reduced penalty
may exist because of the phase-out provisions of various tax breaks.
(Certain phase-out provisions can create reduced penalties for middleincome couples as well.) In this example, income-splitting results in a
144
reduced penalty for the couple with a 50-50 income split. The penalty
arises because of the limitation of itemized deductions. (The value of
itemized deductions is reduced for taxpayers with AGI more than
$124,500 regardless of filing status. Thus, two individuals earning
$75,000 each can take full advantage of their deductions when single,
but when married to each other, they must limit their deductions
because their combined income of $150,000 pushes them beyond the
phase-out threshold.) Under optional filing, this particular structural
penalty is eliminated, although other phase-out provisions can create
penalties for some couples. The second-earner deduction reduces the
tax liabilities of the two-earner couples by $930. This amount reflects
the value of a $3,000 deduction at the 31 percent tax rate ($3,000 *
0.31).
Table A2.3 Effect of Various Proposals on Tax Liability of Couple
Earning $150,000
-UI VUe IaUw
Single tax liability
Joint tax liability
Penalty/(bonus)
$26,338
$28,119
$1,781
$32,561
$28,119
($4,442)
$27,183
$28,119
$936
Optional Filing
Tax liability
Tax cut
Penalty/(bonus)
$26,338
$1,781
$0
$28,119
$0
($4,442)
$27,183
$936
$0
Income Splitting (H.R. 3104 and H.R. 3734)
Tax liability
Tax cut
Penalty/(bonus)
$26,552
$1,567
$214
$26,552
$1,567
($6,009)
$26,552
$1,567
($631)
Second-Earner Deduction
Tax liability
Tax cut
Penalty/bonus
$27,189
$930
$851
$28,119
$0
($4,442)
$27,189
$930
$6
Note: Assumes couples claim itemized deductions equal to 18 percent of AGI
when single and when filing jointly.
Source: Joint Economic Committee calculations
THE LINKS BETWEEN STOCKS AND BONDS
SUMMARY
The value of the stock market is heavily influenced by the yield
on 10-year Treasury bonds. In conjunction with expected corporate
earnings, the bond yield predicts a remarkable 92% of changes in the
value of the stock market. When the stock market deviates from the
level predicted by bond yields and expected earnings, these
deviations have a significant influence on stock-market returns
during the following year.
The yield of 10-year Treasury bonds and the "expected earnings yield" of
the Standard and Poor's 500 have a very strong relationship. The
"expected earnings yield" is not what most people think of as the yield on
stocks: annual dividends as a share of current price. Instead, the earnings
yield is annual earnings as a share of current price-regardless of whether
these earnings are distributed to shareholders in the form of dividends or
retained for future use.'62 Furthermore, the expected earnings yield refers
not to how much companies have earned over the past 12 months, but to
how much analysts expect companies to earn over the next 12 months.
As Figure 1 shows, the expected earnings yield of the S&P 500 and
the yield of 10-year Treasury bonds have tracked each other's
movements very closely over time. In fact, from January 1981 through
December 1997, variations in the yield on 10-year Treasury bonds
predicted a remarkable 92 percent of the variation in the expected
earnings yield of the S&P 500.
This close link makes intuitive sense. The yield on bonds is the
amount of money a bondholder should expect to earn per year, given the
amount he's invested. For example, if a bond yields 6 percent, the
bondholder should expect to earn $6 per year for every $100 invested.
The yield of the S&P 500 is similar. It's the amount of money a
shareholder should expect his companies to earn during the next year,
given the amount he's invested. For example, an expected yield of 6
percent suggests that an investor foresees his companies earning $6 in
income for every $100 in stock price.
162
In
this paper,
aeamings'
refers to operating earnings.
146
Figure 1
STOCK YIELDS VS. BOND YIELDS
1%
10-year TreasuiyBond Yeld
-- Expected Eumd Yield S&P 500
16%
14%
12%
10%
8%
N
6%
4%
81
82
83
4
85
86
87
St
89
90
91
92
93
94
95
J
Soum: Tremur Department, MES hutrnasonl, In.,Wag Strt Jouual
96
kC
ot
97
_mk
The natural market process of investors chasing higher yields should
keep bond yields and stocks yields moving together over time. If the
yield on stocks increases-for example, due to an increase in earnings
expectations-investors should chase this extra yield by shifting their
portfolios toward stocks and away from bonds. By bidding-up the price
of stocks, this portfolio shift should reduce the excess stock yield caused
by the increase in earnings expectations. Meanwhile, the shift away from
bonds should bid-down bond prices, thereby raising their yield.
Similarly, if the yield on stocks falls-for example, due to a decrease in
earnings expectations-investors may bid-down the price of stocks
(raising the stock yield back up) and bid-up the price of bonds (lowering
the bond yield), thereby resulting in an overall decrease in both the stock
yield and the bond yield.
In addition, stocks and bonds may tend to move together over time
because they're similarly effected by certain macroeconomic
developments. For example, a decrease in the expected future inflation
should increase the price people are willing to pay for bonds, which
promise fixed payments in the future. Why does this happen? Because
lower inflation means that fixed future payments will be worth more, in
147
terms of the amount of goods and services they can buy. Similarly, a
drop in inflation expectations should make any given level of expected
corporate earnings more valuable.' 6 3
At least one study suggests that changes in inflation are actually a
better gauge of the stock market than interest rates are. This study,
however, uses past earnings rather than expected earnings in making its
calculations. When bond yields are used in conjunction with expected
earnings, they show that bond yields do have a greater influence on stock
prices than inflation does. Using expected earnings makes more
theoretical sense than using past earnings. Bonds look forward to future
payments. Past earnings are not a future-looking indicator; expected
earnings are.'64
Figure 2 shows the extent to which differences between the yield on
stocks and the yield on bonds have influenced subsequent stock-market
performance. The Figure consists of 192 points, each representing a
month from January 1981 through December 1996. The horizontal axis
measures the extent to which, during each month, the yield on stocks
differs from what's predicted by the yield on bonds. The vertical axis
measures the percentage change in the S&P 500 during the following 12month period. As Figure 2 shows, the greater the yield on stocks, relative
to the yield predicted by bonds, the greater the subsequent 12-month
return on the S&P 500.165
Despite the close long-term link between the two yields, they don't
necessarily tend towards equality. At least three key differences between
the yields on stocks and bonds may affect their relative yields.
A decrease in expected inflation should increase both stock prices and bond
prices. However, because the tax code fails to index either depreciation
schedules or capital gains for inflation, stocks may respond more to changes in
inflation than bonds do. A drop in inflation should not only decrease the extent
to which stock-market investors discount expected future earnings, but also raise
both the amount of expected future earnings and their value, after-tax.
163
'Do Stock Prices Follow Interest Rates or Inflation," John E. Golob and
David G. Bishop, December 1996, RWP 96-13, Federal Reserve Bank of Kansas
City.
164
From January 1981 through December 1997, variations in the difference
between the actual stock yield and the stock yield predicted by I O-year Treasury
bonds predicted 18 percent of the variation of stock-market returns during
subsequent 12-month periods.
165
148
Figure 2
EXCESS STOCK YIELDS VS. FUTURE CHANGE OF
S&P 500
55%
*..
35%
..
~~~~~~~.
**
15%
.*
15%
-3
Souree
*
-2
~I.;--.
.
.
--.
*.
........ ,
'';'"
*.,.-
-I
0
Tresiu Departmwt BES 1ntevnaim_, Inc, Wafl Stree Jmoal
1
2
Mmi~E-oe.k
CoMWmit.
First, stocks are riskier than government bonds, meaning
investors may demand a 'yield premium' when they invest in
stocks. This yield premium should be fairly consistent over
time.
* Second, the yield on stocks is determined by using earnings
expected during the next twelve months, a period of time much
shorter than investors' potential time horizons. If corporateearnings growth is expected to be relatively high in the next 12
months (compared to future years), investors may demand an
additional premium from the yield on stocks, to compensate
them for low expectations about future earnings. On the other
hand, if corporate-earnings growth is expected to be unusually
low over the next 12 months (compared to future years),
investors may be willing to accept a lower yield from stocks
than they otherwise would, as they foresee much better times
ahead.
149
And third, differences in how these earnings are taxed may
affect how much investors value them. This difference may
change greatly over time. For example, allowing companies to
deduct dividends paid to shareholders or stock-market investors
to index their capital gains for inflation could lower the yield on
stocks that investors demand, relative to the yield on bonds.
The formula that describes the link between the percentage yield on
the S&P 500 and the percentage yield on 10-year Treasury bonds, during
the period from 1981 to 1997, is:
*
S&P Yield = .037 + 1.0175 (Treasury Yield)
We can then use this formula to get an implied fair-market value for
the S&P 500.
Given that:
S&P Yield = (100) (Expected Earnings)/ S&P Price
Therefore,
S&P Price = (100) (Expected Earnings)/ [037 + 1.01 75 (Treasury
Yield)]
For example, in January 1998 the S&P 500 were expected to earn
$50.70 over the following 12 months.'" So if the yield on 10-year
Treasury bonds was 5.5 percent, the implied fair-market value of the
S&P 500 was 900.
The S&P 500 has exceeded its implied fair-market value since April
1996. There are at least four different ways that the actual value of the
S&P 500 can be reconciled with its implied fair-market value.
* Investors may shift their portfolios toward bonds, driving-down
bond yields until these securities no longer offer a yield
unusually high in relation to the yield on stocks.
* Investors may shift their portfolios away from stocks, drivingup the yield on the S&P until it's commensurate with the yield
offered on bonds.
* Analysts may raise their expectations about future corporate
earnings, which would also drive up the yield on stocks.
166
IBES International, Inc.
150
*
The long-term relationship between stock yields and bond
yields may change, so that the current gap in yields becomes
consistent with the future preferences of investors. In other
words, investors may increase their appetite for stocks versus
bonds, irrespective of the yields they offer.
CONCLUSION
The yield on 10-year Treasury bonds and the expected earnings yield of
the S&P 500 tend to move together over time. The lower the yield on
bonds, the more that stock-market investors are willing to pay for
earnings expected during the next twelve months. For the 20-month
period ending December 1997, the stock market was consistently
overvalued compared to its usual relationship with bond yields and
expected earnings. Based on the past relationship between overvalued
stocks and subsequent stock-market performance, stocks should
underperform in 1998. On the other hand, we may be witnessing a
change in the long-term relationship of stocks and bonds, based on the
changing preferences of investors. If so, this may mitigate the risk of the
stock market underperforming during the next year.
INTERNATIONAL
ECONOMICS
|
IMF FINANCING: A REVIEW OF THE ISSUES
INTRODUCTION
The 1999 budget proposal submitted by President Clinton calls for an
$18 billion appropriation for the International Monetary Fund (IMF).
This $18 billion appropriation request consists of two parts: $14.5 billion
for a quota increase, and $3.4 billion for a new IMF credit line called the
New Arrangements to Borrow (NAB).'6" The proposed quota increase
and NAB commitment represent the U.S. share of a larger package of the
proposed IMF expansion. The great majority of IMF lending activities
are financed out of the quotas provided by member countries.
The quota increase and NAB are not needed to complete the Asian
bailouts already underway; current IMF funds are sufficient to complete
this assistance. The new funding would be used to finance future loans
in addition to those already announced. Even after the completion of the
Asian bailouts, the IMF would hold $30 billion in gold, retain some
quota resources, and have access to an unused $25 billion IMF credit line
known as the General Arrangements to Borrow (GAB).
The key issue before Congress is whether the IMF should be
expanded through government-financed contributions and credit lines.
The IMF was established in 1945 to finance temporary balance of
payments problems under the fixed exchange rate system in place for
most of the post-WWII period through 1973. However, under the
flexible exchange rate system existing during the past three decades, IMF
objectives have become less clear and focused. To an increasing extent,
longer term financing is used fot purposes other than short-term external
adjustment problems. Recent IMF loan packages, for example, have
required long-term restructuring of major sectors of national economies
and significant adjustments to economic policy.
of Management and Budget, Budget of the UnitedStates Government,
Fiscal Year 1999, 1998, p. 129.
16 7Office
152
This alteration in IMF lending underlines an important change in the
nature of LMF objectives. According to Columbia University Professor
Charles W. Calomiris, who has served as an LMF economist and World
Bank consultant:
In the 1990s, the IMF has stretched the notion of
liquidity assistance beyond any reasonable
definition. IMF programs in Mexico and Asia are
now macroeconomic bailouts that restore the
solvency of clearly insolvent financial institutions.
That objective has nothing to do with bank or
government liquidity, or with temporary imbalances
in the balance of payments."6
Recently, IMF operations have been the center of growing controversy.
Points of contention include:
* Moral hazard: IMF bailouts encourage investors to assume
additional risk in pursuit of extra-normal returns in the
expectation that losses will be absorbed by the IMF and
ultimately the taxpayers of affected countries.
* Exposure of taxpayer funds: U.S. government funds are used
directly and indirectly in subsidized bailouts that promote
perverse incentives leading to a more vulnerable financial
system.
* Inappropriate conditions: Counterproductive policies that
undermine economic performance are sometimes imposed by
the IMF as loan conditions.
* Transparency: The IMF is a closed and secretive organization
that operates in a manner inconsistent with openness, as well
as U.S. performance and accountability standards.
The lack of transparency makes analysis of the IM1 and its
performance problematic. As former World Bank Chief Economist
(Latin America) Sebastian Edwards has noted:
For any outsider it is extremely difficult-utterly
impossible some would even say-to fully evaluate
the functioning of the IMF. Many of its decisions
are confidential, as are most of the key documents
168TestiMony of Charles Calomiris before the Joint Economic Committee,
Congress of the United States, February 24, 1998, p. 20.
153
that set the Fund's policy position. Moreover, the
details of specific programs, including... memoranda
of understanding, and other documents are also
confidential. This makes the evaluation of programs'
performance very difficult.'6
IMF PERFORMANCE AND RESULTS
Under the Government Performance and Results Act (GPRA),
government programs are to be planned and reviewed using objective and
measurable criteria whenever possible. Under the Act, the IMF's
appropriation must be evaluated on the basis of its objective contribution
to U.S. international economic policy. As the first quota increase to be
considered after the GPRA went into effect, Congress has an important
responsibility to review the current IMF appropriation with a focus on the
performance and results of IMF activities.
The size of the current and future bailouts will reduce available IMF
resources and ultimately lead to yet another request for more funding.
The IMF has already suggested that an even greater quota increase will
be needed relatively soon.'70 The magnitude of the recent bailouts, as
well as the pending quota increase, suggest that a fundamental
reevaluation of the IMF, its operations, goals, as well as its financing, is
needed. In recent months, a threshold has been reached in IMF lending
that raises basic questions about IMF decision-making, openness, policy
advice, performance, and over- reliance on direct government funding.
One diversion in an IMF performance review is the dubious
contention that under existing budget rules the IMF appropriation is not
a net outlay and therefore involves no taxpayer cost. Although current
accounting rules mask the cost of the IMF quota increases to the U.S.,
economic analysis clarifies the true nature of the transaction: real
economic resources are transferred at subsidized interest rates from the
U.S. economy to other nations. It is doubtful that these resources will
ever be fully recovered. The U.S. may hold a paper IOU or an IMF
computer entry, but the nature of the IMF quota increase entails a
169 Edwards,
Sebastian, "The International Monetary Fund and the Developing
Countries: A Critical Evaluation," Carnegie-Rochester Conference Series on
Public Policy 31, 1989, p. 9.
' 70Chote, Robert, "IMF Chief Calls for $160 Billion Increase," FinancialTimes,
December 13/14, 1997.
154
transfer of economic resources from the U.S. economy. If this were not
so, there would be no point in an appropriation in the first place;
Additional costs of these IMF bailouts were delineated by Professor
Charles Calomiris in recent testimony before the Joint Economic
Committee:
Three kinds of cost figure prominently: (1)
undesirable redistributions of wealth from taxpayers
to politically influential oligarchs in developing
economies; (2) the promotion of excessive risk
taking and inefficient investment; and (3) the
undermining of the natural process of deregulation
and economic and political reform which global
competition would otherwise promote."'
One additional reason for concern about IMF intervention is IMF's
operations, which are based on below-market funding costs and
below-market lending rates. As Sir Alan Walters has indicated:
By its very nature, IMF assistance [has been] given
at a subsidized interest rate, in the sense that the rate
charged was below that which the country could
obtain on the international capital markets. The
subsidies have both widened and deepened over
time.'n
Economic analysis indicates such taxpayer subsidies to IMF
borrowers lead to inefficient results and a misallocation of economic
resources. Part of the reason for this inefficiency was identified in the
testimony of former Federal Reserve Governor Lawrence Lindsey before
the Joint Economic Committee. As Lindsey argued:
... there is no real assessment of credit worthiness [in
IMF lending]. Quite the contrary, an apparent
requirement to get an IMF loan is that the borrower
17
'Testimony of Charles Calomiris before the Joint Economic Committee,
Congress of the United States, February 24, 1998, p. 2.
' 72Walters, Alan. "Do We Need the IMF and The World Bank?," Current
Controversies, No. 10, Institute of Economic Affairs, London 1994, p. 11
[brackets added].
155
is not creditworthy, in that the borrower could not
obtain private sector funding.'" 3
The IWF's practice of loan subsidies and the resulting misallocation
of resources raises serious policy concerns. The recent orientation of
IMF lending towards subsidizing loans to insolvent entities is troubling
and qualitatively marks an important departure from past practices.
Given this change and the significant increases in IMF loans, its
compatibility with the objectives of U.S. international economic policy
must be considered by Congress. Specific reforms of the IRF are
discussed in a later section of this paper.
THE IMF AND ASIA
Important questions have been raised by the recent IMF bailouts of South
Korea, Indonesia, and Thailand. These IMF loans are tied to a number
of conditions in the form of policy changes, some of which involve
improved supervision of financial institutions and efforts to eliminate
corruption. Additional loan conditions often include tax increases, tight
monetary policies, and other guidelines that foster austerity.
On November 20, 1997, a high U.S. Treasury Department official
was reported to have designed a framework for future Asian bailouts
referred to as the "Manila plan," named for the location of the formative
meeting and modeled after the structure of the Indonesian bailout." 4 The
Manila plan calls for IME loans to provide the initial lending support to
a distressed economy, supplemented by backup funds contributed by
major nations such as the United States. Almost immediately, the
Koreans requested IMF assistance that quickly grew into the largest
bailout package ever made by the IMF. The Treasury Department had
a very public role not only in the general design of the bailout framework
but also in the specific components of the Korean bailout.
Both the Korean government and the IMF have agreed to the bailout
terms. An IMF package of loans amounting to $21 billion will be
supplemented by the World Bank, the United States, and others for a
total of $57 billion. Unfortunately, the first Korean bailout failed to
restore confidence, and a second bailout based on debt restructuring was
implemented. The IVF has enough resources on hand to cover the $21
173Testimony of Lawrence Lindsey before the Joint Economic Committee,
Congress of the United States, February 24, 1998, p. 2 [brackets added].
174 Davis, Bob and G. Pierre Goad, "Asia Reaffirms U.S. Primary on Bailouts,"
Wall Street Journal, November 20, 1997.
H.Rent I1Oi-Rfl7-QR-
156
billion committed in the first bailout, and congressional action will have
no bearing on whether these funds are disbursed. However, the Asian
crisis does provide a useful point of departure for analysis of the major
issues.
Brief Background
In recent years, a number of Asian economies experienced rapid
capital inflows brought about by the region's fast growth, high returns on
investment, and desire for diversification on the part of investors in
developed countries. Perceived exchange rate risk was minimized
because many of these countries tied their currencies to the U.S. dollar.
This capital, in turn, was often allocated by centralized, bureaucratic, and
sometimes corrupt government-controlled banking systems into
questionable long-term (e.g., real estate) projects. "I In other words,
poorly regulated financial institutions in these countries made long-term
loans that were financed by short-term foreign liabilities. The result was
large amounts of short-term dollar denominated debt together with
maturity and currency mismatches.
Risk Reassessment
For a number of reasons, lenders began to reassess risk. Dollar
appreciation against the yen not only forced these economies to tighten
monetary policy to defend their currencies but also significantly hurt
their export markets. These developments encouraged speculation
against the pegged exchange rate. Rapid disinflation, asset price
deflation, and declines in collateral value further weakened poorly
regulated financial sectors. Heightened exchange rate risk, capital
outflows, and eventually exchange rate depreciation resulted.
Possible Contagion
As the exchange rate in these countries depreciates, debt
denominated in dollars instantly becomes more burdensome (because the
debt now must be repaid in dollars that are more valuable) and financial
sector weakness is exacerbated. As a result, risk assessment worsens,
leading to an increased demand for limited dollar reserves.
At this point, proponents of IMF intervention argue that if no
assistance is provided in the form of short-term dollar loans, further
capital flight will occur, resulting in accelerated currency depreciation,
interest rate increases, and further asset price deflation. If the trend
175At this earlier stage, the IMF and World Bank should have criticized the
banking practices of these countries and made recommendations for reform.
157
continues, they argue, these problems may spread: contagion can occur
and capital flight can accelerate. The result may be competitive
devaluations and the possible adoption of protectionist measures in
affected countries that are export markets for the United States.
Consequently, there may be a severe slowdown in the local economy and
a sharp decrease in living standards. Additionally, the U.S. economy's
investors, equity market, export sector, and employment could also be
impacted.
IMF ASSISTANCE
Advocates of IMF intervention maintain that prompt IMF assistance in
the form of short-term hard currency loans can temporarily bolster
confidence by providing assurance that back-up lending or emergency
liquidity provision is readily available. According to proponents of IMF
bailouts, this can work to restore investor confidence and prevent
worsening capital flight by guaranteeing a reliable source of foreign
exchange reserve loans. IMF lending can temporarily stabilize the
situation and stem contagion. In short, the case for immediate IMF
lending is to keep the problem from getting worse and to reduce the size
of the calamity.
PROBLEMS WITH THE IMO BAILOUTS
Despite potential stabilizing effects in the short run, there are a number
of major problems with current IMF bailout practices:
IMF Lending Creates Moral Hazard.
*
IMF bailouts not only fail to change incentives to correct
reckless lending behavior, but also embody incentives
encouraging this behavior. Existing lending practices persist
because both borrowers and lenders recognize that if loan
problems should occur, a bailout will readily materialize.' To
176Some economists argue that the Mexican bailout created incentives for future
IMF bailouts and, consequently, is partly responsible for current problems in
Asia. For example, Allan Meltzer said: "The IMF's programs drive a large
wedge between the social risk - the risk borne by the troubled country - and the
private risk borne by bankers. This is one source of moral hazard, and one
reason we have a crisis-generating system. A common argument in its defense
is that Mexico repaid its loans to the U.S. government and the IMF. That
argument misses the point. If banks and financial institutions had taken losses in
-Mexico, they would have exercised elementary judgment about risks in Asia."
Testimony of Allan Meltzer before the Joint Economic Committee, Congress of
the United States, February 24, 1998, p. 3 .
158
*
*
change such incentives, some lenders and borrowers should
suffer losses and shoulder some of the risks of their poor
decisions. Insolvent institutions should be allowed to fail.
Necessary adjustments should be allowed to occur. Lending
at market-determined, non- subsidized interest rates would also
work to minimize moral hazard.
U.S. Taxpayer Funds Are Overly Exposed.
Current IMF (and Treasury) bailout practices often expose
U.S. taxpayer funds. The Exchange Stabilization Fund (ESF)
has been used to provide back-up financing for several IMF
bailout packages. Since U.S. taxpayers do not participate in
emerging market lending/borrowing decisions, the case for
using their funds for these purposes is problematic. This use
of the ESF circumvents the congressional appropriations
process so that taxpayers have no voice regarding the
Treasury's use of their funds. The IMF and Treasury have not
seriously considered alternative sources or mechanisms of
funding to minimize taxpayer exposure, such as IMF
borrowing from the market (like the World Bank and other
development banks) or IMF gold sales."' At a minimum,
Treasury and the IMF should clearly explain why
taxpayer-financed lending may be necessary.
The IMF Often Attaches Inappropriate Lending
Conditions to Its Loans.
The IMF ties several forms of conditions to its loans.
Austerity conditions involving tax increases are often part of
these lending programs, and these conditions are sometimes
applied indiscriminately to countries facing different sets of
circumstances. Critics argue that these conditions result from
inappropriate use of economic models focusing principally on
aggregate demand management and not on supply conditions.
Despite rhetoric to the contrary, less emphasis is placed on
government restructuring or downsizing as the important
element of this conditionality. Additionally, IMF conditionality often impedes the necessary adjustment process, is
177 Proposals
for IMF borrowing from capital markets have been made before.
See, for example, The Brandt Commission, Common Crisis North-South:
CooperationforWorld Recovery,
MIT Press, Cambridge, Mass., 1983, p. 14.
159
frequently reactive rather than pro-active, and often involves
an unspecified timetable, allowing loan recipients to backslide
on required adjustments.
* IMF and Treasury Policies Should Be More Transparent.
Both IMF and U.S. Treasury bailout policies remain overly
secretive, ambiguous, and ill-defined. Because these policies
are seldom explained to the public, unnecessary misunderstanding, resentment, and opposition often result. A good deal
more transparency is called for from both of these
taxpayer-financed institutions. Explicit specification of the
IMF's objectives, for example, should be accompanied by
clarification of the procedures and practices by which it
accomplishes these objectives. At a minimum, full explanations of the conditions, lending terms, subsidies involved, and
the rationale as to why such lending is necessary are essential.
Additionally, those entities actually receiving taxpayer
subsidies should be identified.
The notion that IMF policies can be counterproductive is not limited
to IMF critics. A recent IMF internal study found that elements of its
conditions imposed on Indonesia sparked a bank crisis that deepened the
financial crisis in other Asian nations. This IME analysis underscores the
counterproductive potential of IMf policies and highlights its lack of
transparency. 178
-OVERVIEW OF POLICY IMPLICATIONS
The Administration's IMF appropriation request may result in a number
of alternative outcomes. The entire $18 billion appropriation could be
approved without any significant conditions being attached.
Alternatively, the entire appropriation could be rejected due to concerns
about the effects of IMF expansion, as well as IMF reforms required for
continued U.S. funding. Intermediate alternatives could include a range
of incremental funding options probably tied to a variety of conditions on
the IMF.
Regardless of the status of new funding for the IME, the recent
transition of IMF lending from provision of short-term liquidity to
subsidization of insolvency is troubling. Lack of transparency has
178 Sanger,
David E., "IMF Reports Plan Backfired, Worsening Indonesia Woes,"
New York Times, January 14, 1998.
160
permitted the IMF to make this transition without much public
recognition in the United States.
The adoption of more transparent practices by the IMF is necessary
if Congress is to be adequately informed about this important element of
U.S. economic policy. Minutes of IMF board meetings should be
publicly released (after appropriate editing of any proprietary and
intelligence information), loan program documents and staff reviews of
loan programs should be made public, and an independent advisory board
should be established to annually review IMF activities.
Furthermore, the subsidization of IMF lending at below-market
interest rates exposes the fallacy that there is no cost associated with
quota contributions. Base IMF lending rates, currently under 5 percent,
are, after all, below the rate at which the U.S. government can borrow.
Although some IMF loans are made at higher rates, artificially low
borrowing and lending rates characterize IMN lending operations. These
below-market borrowing rates do not adequately reflect the potential risk
posed by insolvent borrowers, and thereby exacerbate the moral hazard
problem discussed above. The Congress must decide whether this policy
of subsidized loans for insolvent entities is a desirable objective of U.S.
international economic policy.
As Walter Bagehot, eminent former editor of The Economist,
explained in his classic formulation more than a century ago, a lender of
last resort should lend freely at a penalty interest rate. Subsidized loans
are not necessary to assist illiquid borrowers and are counterproductive
for insolvent entities. Economic efficiency would be promoted by IMF
lending at market interest rates determined in international financial
markets.
Accordingly, Congress could stipulate that U.S. funds should not be
used to provide subsidized loans. This would help contain the moral
hazard problem and encourage the IMF to operate on a more
economically efficient basis. Another market-oriented reform would
encourage IMF issuance of securities in the financial markets instead of
relying so heavily on government funds.
RECOMMENDATIONS
In view
financial
the IMF
financial
of these many problems, any continued or additional U.S.
support of the IMF should be accompanied by guarantees that
itself meets certain conditions. In particular, to receive U.S.
support, the IMF should:
161
*
0.
*
*
Work to minimize the moral hazard problem both by ensuring
that some costs are borne by those lenders and borrowers
initiating the ill-fated loans and lending more in accordance
with market-determined interest rates.
Explore alternative funding sources or mechanisms to
minimize U.S. taxpayer exposure.
Promotelending conditions that work to attract capital as well
as to foster private sector economic growth, free markets, and
smaller public sectors.
Become significantly more transparent in a number of specific
ways. Clearly identifying policy objectives as well as the
procedures and practices used to achieve these objectives is
essential.
CONCLUSION
This paper has reviewed some of the major issues on both sides of the
debate over IMF funding. The concerns raised regarding moral hazard,
transparency, taxpayer exposure, and conditionality are widely
recognized. For example, the Treasury has acknowledged the validity of
the moral hazard problem, the IMF has recognized the damage perverse
conditionality may cause, and such IMF loan conditions are widely
criticized from various points of view. Furthermore, almost all analysts
recognize the benefits of a more transparent IMF. Consequently, it
appears likely that any congressional action on IMF funding will include
conditions intended to mitigate these concerns.
IMF reforms are needed irrespective of what happens to the
Administration's IMF appropriation proposal now before Congress. Two
IMF reforms are especially needed at this time: improved transparency
and increased use of market interest rates. Improved transparency would
require the public disclosure of IMF decision-making meetings as well
as program documents and related material. Future IMF loans should
employ market interest rates, not subsidized rates that exacerbate the
moral hazard problem.
FINANCIAL CRISES IN EMERGING MARKETS:
INCENTIVES AND THE IMF
INTRODUCTION AND SUMMARY
This paper argues that perverse economic incentives are an important
factor contributing to recent financial crises increasingly plaguing many
of today's emerging market economies. These incentives, in turn, are
spawned.by a pernicious combination of conditions, which all too often
frequent these developing economies. In particular, the combination of
overly generous public safety nets (e.g., implicit or explicit public,
uncircumscribed deposit insurance), risk-enhancing structural change in
the financial system, and inadequate levels of owner-contributed bank
capital often promote excessive risk taking. These conditions contributed
to producing the severe financial crisis in the U.S. thrift and banking
industries in the 1980s and are increasingly present in an even more
virulent form in today's emerging economies.
Recent IMF lending and prospects for future lending not only
reinforce existing risk-promoting incentives in emerging economies but
also create incentives for additional risky lending by international
financial institutions.
These arguments highlight a number of interesting implications and
suggest important policy recommendations to limit such adverse
incentives.
THE U.S. EXPERIENCE
In the 1980s, the U.S. financial sector experienced changes that allowed
more risk taking in the face of expanded public deposit insurance. As the
financial sectors' equity capital diminished, this combination ultimately
resulted in financial crises involving both banks and savings and loan
associations (S&Ls). More specifically, U.S. financial markets changed
in a number of ways. The elimination of most interest-rate ceilings and
limited product deregulation, together with the subsequent erosion of
geographic restrictions, enabled lenders to seek higher returns in new,
unfamiliar, and higher-risk ventures. These risk-enhancing changes,
together with generous, expanded public deposit insurance guarantees
and diminished capital bases, created the (perverse) risk-taking incentive
structure cited above.'" Deregulation per se is not a problem.' It is
Lenders could reap the rewards of successful high-risk ventures and be
assured depositors would be backstopped with taxpayer-supported funds in case
such ventures failed. These perverse incentives are worsened when banks suffer
1"9
164
only when risk-enhancing changes are combined with overly generous
public deposit insurance (or other public guarantees), and depleted
capital, that the perverse incentive structure becomes especially
relevant.' 8 ' Most analysts now agree that this pernicious combination
was largely responsible for severe U.S. financial problems experienced
in the 1980s and early 1990s.'82
EMERGING MARKETS EXPERIENCE
These same forces are largely responsible for the pervasive and
unprecedented increase in both the frequency and severity of financial
crises in the world's emerging economies.' 8 3 Conditions promoting
losses and their capital base shrinks. Such banks then have little to lose by
gambling.
I" As Charles Calomiris has eloquently stated, financial deregulation and
liberalization are not inherently destabilizing. Partial bank liberalization where profits are private and losses are public - is the threat to stability.
Privatization of both profits and losses produces very stable banking systems."
Charles W. Calomiris, " The IMF as Imprudent Lender of Last Resort," May 20,
1998, p.6 . For an excellent overview of this problem, see also Charles W.
Calomiris, Testimony before the Joint Economic Committee, Hearing on the
International Monetary Fund and International Policy, February 24, 1998; and
Charles W. Calomiris, The Post Modem Bank Safety Net, American Enterprise
Institute Press, Washington, D.C., 1997.
18, Deposit insurance is not necessarily a problem if it is narrowly circumscribed
and (properly) limited. Otherwise, it can promote significant moral hazard.
Caprio and Klingebiel (1996) indicate that while 'fewer banks failed in the
1980s than during the Depression ... depositor losses per dollar of deposits were
higher." Gerald Caprio, Jr. and Daniela Klingebiel, 'Bank Insolvency: Bad Luck,
Bad Policy, or Bad Banking: Annual World Bank Conference on Development
Economics," 1996, p. 82. Barth and Litan document that the savings and loan
resolution costs in recent years exceeded the losses borne by all uninsured
depositors in the 1920s and early 1930s. See James Barth and Robert Litan,
'Preventing Bank Crises: Lessons From Bank Failures in the United States,"
paper presented at conference co-sponsored by the Federal Reserve Bank of
Chicago and the Economic Development Institute of the World Bank, Chicago,
June 11-13, 1997, p. 3.
182
183 Documentation of this significant worsening of financial crises can be found,
for example, in Carl-Johan Lindgren, Gillian Garcia, and Mathew I. Saal, Bank
Soundness and Macroeconomic Policy, IMF, 1996, p. 20; and Morris Goldstein
and Phillip Turner, " Banking Crises in Emerging Economies: Origins and Policy
165
perverse (risk-taking) incentives, however, are even more potent in
modem emerging economies than in developed economies for a number
of important reasons. Financial market risk-enhancing structural change
in emerging economies, for example, is especially pronounced because
it not only embodies the types of financial market change occurring in
developed economies, but also takes on additional forms as well.
Conventional structural change, such as the liberalization of interest rate
ceilings, lowered reserve requirements, and lessened product restrictions,
is quite common. But liberalization of capital controls and moves to
privatize heretofore government-controlled financial structures make
such structural change even more important in modem emerging
economies than' in developed economies. All of these changes have
taken place in an environment with low levels of owner-contributed
equity capital due in part to previous state ownership and restrictions on
both domestic and foreign ownership of financial institutions."i4
Combining this pervasive structural change with the widespread
adoption of generous government-sponsored risk subsidies or public
safety nets (such as explicit or implicit uncircurnscribed deposit
insurance), often without an adequate supervisory framework, provides
all the ingredients for a substantial increase in perverse incentives
promoting both excessive risk-taking and crisis-prone financial
systems."'5
Options," B.I.S. Economic Papers no. 46, October 1996, p.5. Caprio and
Klingebiel (1996) conclude that financial crises are 'more costly in the
developing world - losses tend to be larger relative to income than in the
industrial world." Gerald Caprio and Daniela Klingebiel, 'Bank Insolvencies:
Cross Country Experience," World Bank Policy Research Paper 1620, July 1996,
p. 10.
'84See James R Barth, R. Dan Brumbaugh, Jr., Lalita Ramesh, and Glenn Yago,
uThe Role of Governments and Markets in International Banking Crises: The
Case of East Asia," paper presented at Sixth Conference on Pacific Basin
Business, Economics, and Finance, Hong Kong, May 28-29, 1998, pp. 25-28.
185 Alexander Kyei documents that most IMF member countries surveyed began
to establish deposit protection schemes in the 1980s. See Alexander Kyei,
'Deposit Protection Arrangements - A Survey," IMF Working Paper,
WP/95/134. See footnote 3 (above) for references documenting the worsening
incidence of financial crises in emerging economies. Papers by Demirguc-Kunt
and Detragiache show that (1) the presence of deposit insurance in emerging
economies tends to increase the probability and severity of systemic banking
166
Further exacerbating this situation is the fact that emerging
economies' banking sectors are usually larger as a share of financial
intermediation simply because their bond and equity markets are
relatively underdeveloped. This absence of developed equity markets
also works to foist more risk on bank-based intermediation. Factors
causing banking crises in these countries, therefore, likely will create
broader financial havoc than would otherwise be the case. And because
emerging economies tend to be smaller, more open, relative to larger
economies such as the U.S., the potential impact of perverse incentives
on mobile, international capital and foreign exchange rates in these
economies can be significant. 186
THE ROLE OF THE IMF
IMF bailouts work to solidify and fortify these perverse incentive
structures in a number of ways. Since the IMF lends to countries
promoting risk-taking incentives, IMF lending often supports and
encourages the proliferation of these incentives. This is especially the
case when, as currently, IMF lending works to help insolvent rather than
illiquid banks. Moreover, by effectively creating another (international)
layer of government guarantees, IMF lending serves to foster additional
risk taking, particularly by large international financial institutions. IMF
bailouts, after all, importantly shield these institutions from the high risk
of lending to emerging economies with vulnerable banking systems.
What emerging-market economies are left with, therefore, is a highly
vulnerable, risk-subsidized financial system particularly exposed to
foreign exchange risk. In short, IMF lending promotes both risk-taking
incentive structures and foreign exchange mismatches in emerging
economies.
problems, and (2) banking crises are more likely to occur in liberalized financial
systems of emerging economies. See Ash Demirguc-Kunt and Enrica
Detragiache, 'The Determinants of Banking Crises: Evidence From Industrial
and Developing Countries," World Bank Policy Research Paper No. 1828,
September 1997, and Ash Demirguc-Kunt and Enrica Detragiache, "Financial
Liberalization and Financial Fragility," unpublished, March 1998.
'" In this case, perverse incentives can work to encourage an additional form of
excessive risk taking, involving betting on the foreign exchange rate.
167
It is now well known that the IMF (perhaps inadvertently) promotes
such perverse incentives."8 This recognition is illustrated, for example,
by recent statements of Federal Reserve Chairman Alan Greenspan,
Bundesbank President Hans Tietmeyer, as well as members of the G- 10,
and others. Greenspan recently asserted, for example, that:
...an important contributor to past (financial) crises
has been moral hazard....interest rate and currency
risk-taking, excess leverage, weak financial systems,
and interbank funding have all been encouraged by
the existence of a safety net. The expectation that
national monetary authorities or international
financial institutions will come to the rescue of
failing financial systems and unsound investments
clearly has engendered a significant element of
excessive risk-taking."'
Similarly, Tietmeyer recognized the IMF's moral hazard problem:
The IMF should reevaluate its policies and should
question itself on how far its policy generates moral
hazard. The IMF should consider whether it is
better to tackle problems with large sums of bailout
money or whether it might be better to involve
private sector creditors at an earlier stage.' 89
The seriousness of the IMF's moral hazard problem also has been
recognized in the recommendations of the G- 10 countries' 1996 report
as well as in other recent studies."9
187 Most analysts recognize that IMF monies inevitably find their way to assist
politically influential entities. As these entities come to expect this assistance,
their risk-taking behavior is altered, resulting in moral hazard. The IMF also
provides political cover for affected governments to impose taxes on innocent
parties (i.e., the middle class) in order to finance repayment of IMF loans. By
enabling the initial risk-takers to importantly circumvent the costs of their
miscalculations, this IMF cover helps to further solidify moral hazard.
188 Alan Greenspan's remarks before the 34' Annual Conference on Bank
Structure and- Competition of the Federal Reserve Bank of Chicago, May 7,
1998, p. 3. (parenthesis and emphasis added).
*189 Hans Tietmeyer, as quoted in The FinancialTimes, March 23, 1998.
See Group of Ten (G-10), 1996, The Resolution of Sovereign Liquidity
Crises: A Report to the Ministers and Governors, Basle and Washington, D.C.,
190
168
IMPLICATIONS
Since a root cause of recent international financial problems is perverse
incentives created by a combination of overly generous public safety
nets, risk-enhancing changes in financial structures, and depleted capital
bases, a number of important policy implications merit attention:
*
Financial change fostering risk taking in the presence of both
generous public safety nets and low levels of ownercontributed equity capital is a reliable leading indicator of
financial crises.' 9 '
* Banking crises are a symptom and leading indicator of
additional problems in the financial sector. Empirical studies
of emerging economies show that banking crises are leading
indicators for currency or balance-of-payments crises rather
than the reverse.'9 2 Recent studies also find that variables
heretofore considered "fundamental," such as fiscal and current
account deficits, seem not to be associated with crises.' 93
Bank for International Monetary Fund, May. See also Morris Goldstein's recent
study which argues that finding a way to reduce moral hazard created by such
international lending should top the agenda. Morris Goldstein, The Asian
Financial Crisis: Causes. Cures. and Systemic Implications. Institute for
International Economics, Washington, DC, June 1998; p. 46.
19' See references in footnote 7 for empirical evidence supporting this argument.
19 See Graciela Kaminsky and Carmen Reinhart, 'The Twin Crises: The Causes
of Banking and Balance-of-Payments Problems," International Finance
Discussion Papers 1996-544 (March 1996), for evidence supporting this
argument. See also Roberto Chang and Andres Velasco, "Financial Fragility and
the Exchange Rate Regime," NBER Working Paper No. 6469, March 1998; and
Jeffery Sachs, Aaron Tornell, and Andreas Velasco, 'Financial Crises in
Emerging Markets: The Lessons from 1995," NBER Working Paper No. 5576,
May 1996, for additional evidence supporting this argument.
193 See, for example, Michael P. Dooley, "A Model of Crises in Emerging
Markets," NBER Working Paper No. 6300, December 1997, pp. 6, 7 and
references cited therein. It is "on budget" fiscal deficits that seem unrelated. If
contingent liabilities (including expected bailout costs) were properly factored
in and accounted for, measured fiscal deficits would likely be significantly
larger.
169
*
*
*
*
Studies have shown that international capital mobility is not
necessarily a principal cause of recent financial crises.'"
Rather, sharp changes in capital flows are often symptoms or
reflections of perverse underlying incentive structures facing
financial institutions. Accordingly, policy recommendations
to prevent financial crises by slowing capital mobility through
taxing financial transactions, for example, may be
inappropriate.
Similarly, foreign exchange speculators are not the cause of
recent financial crises. Rather, speculators recognize
-underlying unhealthy incentives, banking problems, and
unsustainable -financial conditions and take advantage of
them.'9
Exchange rate systems of one sort or another do not
necessarily cause financial (banking, currency, or balance-ofpayments) crises. Rather, sharp foreign exchange rate
movements often reflect underlying perverse risk incentive
structures (as described above). Stable exchange rate systems
require stable underlying risk-taking incentive structures.
Thus, successful exchange rate or international monetary
reform must be preceded by (or at least accompanied by)
reform of public safety. net systems so as to minimize perverse
incentives for risk taking.
The proper ordering of economic liberalization or the
sequencing of financial reform is important in many emerging
economies.- Structural reform of the financial system, for
example, should only be undertaken once an efficient,
contingent liabilities (including expected bailout costs) were properly factored
in and accounted for, measured fiscal deficits would likely be significantly
larger.
'9 See Graciela Kaminsky, Saul Lizondo, and Carmen Reinhart, 'Leading
Indicators of Currency Crises," IMF Working Paper WP/97/79, July 1997, p. 13;
Frederic Mishkin, 'International Capital Movements, Financial Volatility and
28
Financial Stability," NBER Working Paper No. 6390, January 1998, p. .
A recent study found no empirical evidence to support the notion that hedge
funds were responsible for the Asian currency crisis of 1997. See Stephen
Brown, William Goetzmann, and James Park, uHedge Funds and the Asian
Currency Crises of 1997," NBER Working Paper No. 6427, February 1998.
'9
170
competent supervisory/ regulatory framework is in place to
contain moral hazard. Similarly, the domestic financial system
should be strengthened prior to capital account liberalization. '96
POLICY RECOMMENDATIONS
There are alternative ways to limit the above-cited ingredients creating
perverse incentives for risk taking. One approach is to improve supervision of the banking system while maintaining public safety nets. Such
enhanced supervision is often favored by the domestic and international
regulatory bureaucracies because it increases their budgets and influence.
To some extent, this approach is embodied in some forms of IMF
conditionality. An unavoidable problem is that such an approach takes
years to properly implement and would likely create a permanent,
bureaucratic supervisory structure.
Another way to limit these perverse incentives is to restrict or
circumscribe the public safety net (or public deposit insurance) in the
face of a structurally changed financial system. Over the years there
have been a number of such recommendations involving, for example,
proposals for co-insurance, narrow banking, subordinated debt, riskpriced deposit insurance, and mechanisms for rapid closure and
resolution of insolvent banks (to minimize regulatory forbearance). The
IMF has not actively promoted this alternative. Like improved
supervision, such proposals would take a substantial amount of time to
implement.
Another institution promoting these perverse incentives, of course,
is the IMF. Accordingly, restricting additional funding to the IMF would
be one way to curtail expectations of future IMF financial assistance in
financial crises and hence to limit these perverse incentives. Minimizing
additional, redundant layers of moral-hazard-producing public subsidization of risk is an appropriate response to this problem. Clearly,
limiting additional IMF funding and additional permanent expansions of
the IMF is a viable policy option. But constructive IMF reform proposals
that can work to modify these perverse incentives should also be
considered. Proposals to minimize IMF interest rate subsidies, for
example, can work to constrain risk-promoting incentives. And
provisions to promote IMF transparency can help to foster better
See, for example, Ronald 1.McKinnon and Huw Pill, 'Overborrowing: A
Decomposition of Credit and Currency Risks,' unpublished paper, November
1997, p. 25.
196
171
risk-subsidizing activities. These features are central to the IMF
Transparency and Efficiency Act of 1998 (HR 3331).
THE ECONOMIC SITUATION IN JAPAN
SUMMARY
Japan is in an economic crisis. Increasing spending on public works and
lowering taxes-without permanently changing tax rates-will not only fail
to create a sustainable economic recovery but will aggravate the perilous
long-term fiscal problems that Japan has to face. Despite very low
interest rates, Japanese monetary policy is tight, not loose. Until the
Bank of Japan loosens enough to end expectations of deflation, a
sustained economic recovery will remain difficult, even if Japan manages
to cleanse its banking system of its large problem with non-performing
loans.
JAPANESE ECONOMIC GROWTH
Japan has not been the same since the stock-market collapse of 1990-92.
Its economy grew at an average annual rate of less than 1 percent from
1992 through 1995, expanded 3.9 percent in 1996, but fell back down to
less than 1 percent growth in 1997. This year the economy is back in
recession: GDP fell at a 5.3 percent annual rate in the first quarter, the
second straight quarterly drop. The unemployment rate is 4.1 percent, a
45-year high; industrial production is 11.2 percent lower than the same
time last year. In the first quarter of 1998, the Bank of Japan's (BOJ)
quarterly Tankan survey, which measures business confidence, recorded
its steepest decline since the first oil crisis in the 1970s. The second
quarter's Tankan survey reported further declines: inventories are pilingup and businesses are cutting investment in plant and equipment.
Worse, this may be just the tip of the iceberg. A recent Working
Paper from the BOJ implies that Japan's long-term growth potential may
be zero. That study presents a reasonable case that, in coming decades,
increases in productivity will be overwhelmed by a demographic shift
toward a smaller working-age share of the population and a decline in
investment capital as people draw-down their assets to finance their
retirements. 197
Matsumura, Watanabe and Uemura; Chu-choki teki na Nihon Keizai no
Seicho Ryoko-Koreika To ni Tomonau Rodo Tonyuryo Gensho no Eikyo wo
Chushin ni; Working Paper 98-4; analysis by Robert Alan Feldman, Chief
Economist and Managing Director, Morgan Stanley Dean Witter (Japan).
Another recent research paper suggests that if Japan successfully embarks on
structural reforms and manages to increase the rate of growth in technology and
fertility that it may increase its long-term growth rate to I percent per year.
Yutaka Kosai, Jun Saito, Naohiro Yashiro; Declining Population and Sustained
197
174
CURRENT JAPANESE POLICY
Japan's most recent $120 billion (16.65 trillion yen) stimulus package is
unlikely to lead to sustained growth. It consists of:
* $55 billion in public works,
* $30 billion in temporary income-tax rebates this year and next
($210 per taxpayer and $105 per dependent),$5 billion in
incentives for business and housing investment,
* $15 billion to increase liquidity in the real-estate market
* $15 billion for government lending to small- and medium-size
businesses, and
* vague pledges to lower marginal tax rates on business and
workers.
-This package offers only very small gains for the economy. In
addition, most of the gains that do materialize would detract from Japan's
future growth potential, as the fiscal stimulus won't change the incentives
to work, save or invest, but would leave future Japanese taxpayers with
a higher level -of government debt to finance.
A much more effective fiscal policy would focus on reducing
marginal tax rates, particularly the excess capital-gains tax on transfers
of land. A recent survey of sixty countries' tax rates on corporate profits
distributed to shareholders found Japan's to be the highest. The central
governmelnt's marginal tax rates on family income and corporate profits,
including capital gains, range up to 50 percent. Corporations that sell
real estate face both the normal corporate tax rate plus an additional levy
of up to 15 percent.
Since 1992, the Japanese government has spent almost 80 trillion
yen ($600 billion) on a variety of measures to try to stimulate the
-economy-so far, without lasting success. Last year's budget deficit was
3.4 percent of GDP. That's the equivalent of the U.S. running a deficit
of about $275 billion. If a stimulative Keynesian-style fiscal policy were
the key to recovery, Japan's economy would be booming already.
In addition, Japan's demographic position makes temporary tax
rebates and public-works spending particularly dangerous. At present,
Japan has 4 working-age people to support each retiree; by 2015, it will
have only 2.3; by 2050 the ratio will be down to 1.6. A group of
economists recently performed a "generational accounting" of many of
Economic Growth: Can They Coexist?; Papers and Proceedings of the American
Economic Association (May 1998).
175
the world's leading economies. This kind of analysis measures the extent
to which tax and spending policies would have to change so that future
generations won't have to pay higher net taxes during their lifetimes than
current newborns have to pay. Of all the countries in the study, Japan's
fiscal situation was the worst. Japan would have to immediately and
permanently cut total government spending or raise tax revenue by about
15 percent to bring its generational accounts into balance. And the
longer it waits the greater the changes it will eventually need.
MONETARY POLICY
The Japanese economy is deflating. The GDP deflator was negative in
1995 and 1996, slightly positive in 1997 and now poised to fall again in
1998. Tokyo real-estate prices have dropped about 70 percent since
1990. Wages and prices at both the wholesale and retail level also appear
headed downward.
This deflation is due to a tight monetary policy. The attached chart
shows just how restrictive the BOJ has been. Under the Bretton-Woods
agreement the dollar was pegged to $35 per ounce of gold. The yen was
pegged to about 360 per dollar, effectively pegging the yen to 12,600 per
ounce of gold. As the chart shows, the dollar price of gold went up to
about 20 times its Bretton-Woods level by 1980, before eventually
settling down to around 8 to 12 times this level. The yen price of gold
started out by following a similar path to the dollar. Except, unlike the
dollar, which eventually stabilized, once the yen started recovering it
never stopped getting stronger.
Imagine if starting in the mid-1980s, the Federal Reserve had started
tightening monetary policy so much that today it only took $100 or $150
to buy an ounce of gold, rather than about $300. The wrenching changes
our economy would have undergone would have been devastating.
Rather than accepting the price increases of the 1970s and trying to keep
prices stable from there, the economy would have been thrown hard into
reverse. Prices throughout the economy would have had to adjust
downward: first real estate, then producer prices and ultimately,
consumer prices, wages and salaries. This is what has been going on in
Japan. A monetary policy that has paid too little heed to the importance
of a fixed standard in reaching long-term price stability has been forcing
the economy to deflate.
The BOJ's lending rate has been a mere 0.5 percent for almost three
years; long-term rates have fallen as low as 1.1 percent. That's the
lowest long-term interest rate anywhere since the early 1600s.
Conventional wisdom is that with interest rates so low, monetary policy
must be loose. However, what conventional wisdom misses is that
176
interest rates are low because people expect deflation, not because
monetary policy is loose.
If monetary policy were really loose,
expectations of inflation would be driving long-term interest rates up, not
down.
In times of high inflation-when money is literally losing its value
versus goods and services-people scramble to convert cash into goods
and services before these items get even more expensive. People will
also rush to borrow, thinking that they'll be able to pay their loans back
with cheaper money. Deflation can have the opposite effects.
Consumers sit on their money as it will be able to buy more goods and
services in the future than it can today.
That's happening in Japan. Department-store sales in March were
more than 20 percent below sales in March 1997. This was not only the
12th straight monthly drop but the biggest decline since 1965, when they
started collecting this data. Deflation can lead to a pileup of inventories
and a slowdown in business-like in the U.S. during the Great Depression.
Japan's inventories have been up 7.3 percent since last year and its
inventories-to-sales ratio has hit its highest level since May 1975.
Also, the demand for credit can dry-up, as people fear having to pay
back their loans with money that's more valuable than when they
borrowed. The result: abnormally low interest rates. Meanwhile, those
who do seek credit often get turned away, as banks can't trust collateral
-like real estate-to hold its value over the term of the loan. This April,
bank lending in Japan was down 2.5 percent from last year, the biggest
drop on record. To put this in perspective, in the past 25 years U.S. bank
lending has never decreased compared to the previous year, the worst
performance being a 2.5 percent increase.
In Japan, the deflationary environment may be so strong that it
outweighs any progress the country makes on other economic matters.
In a deflationary environment even a healthy banking system might not
lend-not to. mention a system with perhaps $600 billion in nonperforming loans. Also, although cutting marginal income-tax rates
would help increase Japan's long-term growth, in the short-run it might
exacerbate the deflation-unless the BOJ stood ready to meet an increase
in the demand for yen with a higher rate of growth in the money supply.
The way to get around this problem is to end expectations of
deflation and move the economy back to long-term price stability. This
will require the BOJ to stop targeting interest rates (an often-ineffective
policy tool during periods of deflation) and start pumping yen into the
economy by buying Japanese Government Bonds (JGBs). It should do
this until the yen is so plentiful that people no longer expect deflation.
177
An end to expectations of deflation would get consumers buying and
borrowing again and banks willing to lend.
RISK FACTORS
An effort to end expectations of deflation by pumping yen into the
economy could at least temporarily weaken the yen. This, in turn, could
raise concerns about setting off another round of devaluations in
southeast Asia-a round that might even include China and Hong Kong
-as these countries fear being unable to export to Japan.
This fear is overblown. Here's why.
* Japan's trade surplus is a function of the fact that it saves more
than it invests. A monetary policy loose enough to end
expectations of deflation would decrease saving and increase
investment, as both consumers and businesses stopped
postponing purchases. The resulting reduction in excess
Japanese saving would lead to smaller Japanese trade surpluses.
* By boosting the Japanese economy, a sufficiently loose
monetary policy would lead to increased spending-on both
domestic goods and those from abroad. Japanese consumers
have huge amounts of accumulated wealth. Expectations of
deflation will keep this wealth from being spent, as consumers
wait for prices to drop further. Price stability would "unlock"
this buying power.
* As Japanese interest rates rose in response to the end of
deflation expectations, the yen would rise too, at least partially
countering the initial drop in its exchange value.
* If Japan both ended expectations of deflation and cut marginal
tax rates, investment capital would flow in, leading to a growing
Japanese economy, a higher yen and greaterJapanese demand
for foreign goods.
U.S. businesses may also be concerned about a decline in the yen
due to a Japanese monetary policy that focused on ending deflation. But
they shouldn't be. The yen is twice as strong against the dollar as it was
in 1985; U.S. unemployment has fallen as low as 4.3 percent-a 28-year
record. If the U.S. can't live with the yen weakening now, when can we?
In addition, a looser monetary policy in Japan may actually increase U.S.
exports, as Japanese consumers open-up their wallets, purses and bank
accounts in response to an end to deflation. Also, more imports from
Japan may make it easier for the Federal Reserve to avoid raising interest
rates, as it would keep U.S. inflation low even as some fear the strength
of our labor market.
178
Index of U.S. Dollar and Japanese Yen vs. Gold
(1= Bretton-Woods' Era Peg)
100
10
I
Jo.. J.
To II
Jo . Ja. Jo. Jag. J.. Jog. Ja.
IF To to go IAI
II
I
J.. Jao. Ja. Jo.
34
go of
or
J.. Jo. Jo. Jo. Jo.. Ja. Ja.
go
if
II
I3
as
go
4
J*.
Ja.
Jo. Jg.
go
so
t7 go
CONCLUSION
Japan is in a deflationary recession. At present, it's fighting this problem
with public-works and Keynesian-style tax rebates. Supply-side solutions
would include a monetary policy that focuses on price stability by ending
expectations of deflation and a tax policy that encourages people to work,
save and invest. Ending deflation is particularly important. Without
price stability, banking reforms alone might not be able to get people to
borrow and banks to lend. And, with the exception of cutting the capital
gains tax, lower marginal tax rates might aggravate deflation in the short
term-unless done in combination with a new monetary policy. If
combined, however, a new monetary policy and lower tax rates would
truly stimulate Japan's economy.
RANKING MINORITY MEMBER'S VIEWS AND
MINORITY STAFF REPORTS
U.S. ECONOMY CONTINUES TO PROSPER DESPITE
GLOBAL FINANCIAL INSTABILITY
Over the last year, the U.S. economy experienced another year of
strong economic growth. The current economic expansion, which began
in March 1991, is soon to surpass the previous expansion, which lasted
from November 1982 to July 1990, and become the longest peacetime
recovery. Economic performance, as measured by traditional indicators,
posted several historic records over the last year.
* The unemployment rate has remained below 5 percent during
every month since July 1997. This is the first time in 25 years
that the unemployment rate has been that low.
* This low level of unemployment has not translated into higher
prices within the economy. Inflation, as measured by changes
in the Consumer Price Index (CPI), has been relatively stable,
increasing by a little over 1l/2 percent over the last year. Except
for one year, 1986, inflation has not been this low since the
beginning of the 1960s.
* The "misery index," which is a combination of the unemployment rate and changes in the CPI, is at its lowest level in over
30 years.
* The economy continued impressive job growth over the last
year. Payroll employment grew by more than three million,
almost twice the 40 year average of annual net job growth.
* After 20 years of stagnation, real average weekly earnings rose
by 3V/2 percent over the last year, thereby representing an
improvement in living standards for American workers.
* The improvement in wages was coupled with productivity gains
of 2 percent in the non-farm business sector and 4 percent in the
manufacturing sector. This recent pick-up in productivity
growth has enabled workers to enjoy larger wage gains without
putting upward pressure on inflation.
* Over the last four years, real nonresidential fixed investment
has been more than 10 percent of gross domestic product
(GDP). This investment grew by more than 13 percent just in
the last year. Strong improvements in investment contributed
to lifting productivity growth.
* A key domestic economic development over the past year was
bringing the Federal budget into surplus for the first time in 40
years. This achievement was a result of policy changes-both
182
reductions in government expenditures and increases in taxesover the last decade. In addition, higher than expected tax
revenues, due to the strong economy, brought the budget into
surplus earlier than projected.
Although there is a lot to celebrate in the current economic expansion, there remain several areas of concern.
* Despite the fact that the national average unemployment rate is
at an historic low, there remain significant pockets of high
unemployment around the country. Between 15 and 20 percent
of the more than 3,000 counties in the United States experienced unemployment rates above 8 percent during the first half
for 1998.
* Economic prosperity in the United States over the last year
occurred against the backdrop of global financial market
instability and economic crises throughout the world. What
began as a liquidity shortage in Thailand turned into a series of
financial crises, spreading from East Asia to Russia and
possibly Latin America. The consequences of these financial
crises are just beginning to be felt in the United States.
* In the past, rising Federal budget deficits have diverted capital
away from productive investment in the private sector.
Although the Federal budget ended Fiscal Year 1998 in surplus,
this improvement was more than offset by further declines in
private- saving, due in part to the recent rise in wealth
accumulation. The personal saving rate-the share of personal
income which is not consumed-in now at an historic low level.
This- shortage of saving translates into insufficient resources
available for robust domestic- investment, thereby increasing
the demand for foreign capital. This helps explain why real
interest rates remain high, even as nominal interest rates
continue to fall.
* The rising gap between domestic saving and investment is
reflected in the worsening current account deficit. Despite
strong domestic economic performance, the current account
deficit grew by more than $180 billion over the last year. This
represents the largest deficit, in absolute terms, in U.S. history.
* Improvements in the trade of services helped prevent a larger
current account deficit. On the other hand, much of the increase
in the deficit was concentrated in an increase in the
183
*
merchandise trade deficit, which grew to close to $135 billion
over the same period. The financial crisis in East Asia and the
strengthening of the U.S. dollar against other major trading
currencies, seriously weakened crucial U.S. export markets
abroad and reduced import prices domestically. As a result,
U.S. exports to the Pacific Rim countries dropped by 15 percent
over the last year while imports from that region grew by 5
percent. The trade deficit is expected to further deteriorate over
the next year, as the full impact of the global financial crisis
begins to be felt.
The initial impact of the financial and economic crises abroad
on the U.S. economy is already being felt and is expected to
worsen over the next year. Economic growth is beginning to
show some indication of weakening. U.S. financial markets are
already experiencing the insecurity being felt abroad. And
deterioration of the trade deficit has already begun to place
pressure on those workers employed in import-competing and
export industries. The global financial and economic crisis is
expected to have a significant impact on the distribution ofjobs,
income and wealth of American workers over the coming year.
SENATOR JEFF BINGAMAN
Ranking Minority Member
Working Paper Series
offered to the
JOINT ECONOMIC COMMITTEE
MINORITY
UNITED STATES CONGRESS
Senator Jeff Bingaman, Ranking Democrat
Pockets of High Unemployment in a
Low Unemployment Economy
Robert Gibbs
October 1998
preliminary draft
This series of papers, offered to the
Democratic members of the Joint Economic Committee,
addresses the major economic issues related to raising
living standards for American workers and their families.
187
Pockets of High Unemployment in a
Low Unemployment Economy
Robert Gibbs'
1.
Introduction
The U.S. unemployment rate stood at 4.5 percent in June. 1998, one of its lowest points in 28
years. The decline in the national rate since 1992, coupled with reports of scattered labor
shortages in occupations ranging from computer programmers to sales clerks. has dampened
debate about workforce preparation and local mismatches between worker skills and job
requirements. Implicit in the current complacency about unemployment is the assumption that a
low national rate translates into low rates across the country.
In fact, the national rate masks considerable variation in local unemployment rates. Wheeler and
Sioux counties in Nebraska experienced a 1.0 percent rate in the first quarter of 1998. while the
rate in Luna county, New Mexico, topped 35 percent. Almost 100 counties nationwide had rates
below 2 percent and roughly one-third were below 4 percent, a reflection of extremely tight labor
markets for workers in those areas.
At the other end of the spectrum, some 320 counties in the first quarter of 1998 had rates above
10 percent. That means that I in every IOU.S. counties was experiencing severe unemployment
at a time when the national unemployment situation was being watched suspiciously for signs of
an overheating economy. If the net is cast just slightly more widely to include counties with
unemployment rates above 8 percent, the number of counties jumps to 617, or about I in 5 U.S.
counties. These counties all had I st quarter- 1998 rates above the peak national unemployment
rate following the 1990-91 recession, and so comprise an "unrecovered" group.2 Most of these
high unemployment counties are experiencing unemployment rates at least twice as high as the
current national average.
But does it matter that a certain number of counties lie at the upper end of the unemployment rate
distribution? Are these counties really important to the national economy? Although many
counties with unemployment rates above 8 percent (henceforth called "high unemployment
l Visiting regional economist at the Joint Economic Committee of the U.S. Congress,
Minority Office.
2 This threshold is based on the national 1990-91 recession high of 7.6 percent. Because
the quarterly county employment statistics provided by BLS are not seasonally adjusted,
however, using 7.6 as a threshold would probably overstate the number of counties above the
threshold: On average, unadjusted I st-Quarter national unemployment rates are .4 percentage
points higher than the seasonally adjusted rates.
H.Rept. 105-807 -98 - 7
188
Table 1. U.S. County Unemployment Rates, 1998-Ql
Unemployment rate
Number of counties Percentof counties
-
97
3.1
2.1 - 4 percent
904
28.8
4.1 - 6 percent
955
30.4
6.1 - 8 percent
567
18.1
297
9.5
238
7.6
82
2.6
3140
100.0
2 percent or lower
1 8.1 - 10 percent
10.1 - 15 percent
Higher than 15 percent
189
counties") have small populations. a sizable number are major population centers. such as 4 of
the 5 New York boroughs? Collectively. high unemployment counties had a population of 30
million and a workforce of over 13 million in 1997. about II percent of the national total. These
counties are therefore not merely small. isolated pockets impervious to economic prosperity, but
include some of the great employment centers of the United States. Nor are these counties found
in only a few regions: 43 states have at least I county with high unemployment. In 8 states. more
than 20 percent of the workforce resides in high unemployment counties. In West Virginia and
New York. more than a third live in high unemployment areas.'
By definition. unemployment is the loss of unrecoverable human resources. The portion of a
worker's life spent unemployed cannot be regained and the idle skills and abilities are lost
permanently. Unemployment represents a double jeopardy for the economy. because it not only
involves the loss of productive capacity, but it also requires the increased disbursement of public
funds to those unemployed. National effects aside. high unemployment counties face depressed
demand for local private goods.and services. additional demands on public services. and possibly
increased social pathology, Furthermore, few of them are likely to realize the goal of providing
self-sustaining work to all who need it. as embodied in current welfare reform policy. For these
places. a low national unemployment rate is an irrelevant statistic that says little about the
experiences of local residents.
This paper explores the possibilities for improving conditions in high unemployment counties by
identifying local and regional characteristics that affect the unemployment rate. The character of
high unemployment counties is diverse in terms of location, population, and economic base. But
they also share a number of important characteristics, many of which are sensitive to direct or
indirect public policy. In brief, high unemployment counties generally have higher levels of the
following attributes than other counties: employment in agriculture and retail trade, state
unionization rates, share of residents who belong to a racial or ethnic minority, share of adults
without a high school diploma, average AFDC payments prior to 1996 welfare reform
legislation, remoteness from cities, physical amenities. and location in the West. These same
counties have lower levels of manufacturing and wholesale trade employment. lower
employment growth, smaller shares of college graduates. smaller urban populations. and are less
likely to be located in the South, once other attributes have been controlled for.
It is important to keep in mind that for most of the 617 counties under discussion, unusually high
rates are persistent, indicative of a much larger problem of long-term economic and social stress.
Temporarily high unemployment resulting from a plant closing, for instance, affects a significant
number of counties each year, and most U.S. counties are subject to this type of event at some
Manhattan's unemployment rate in the first quarter of 1998 was 7.5 percent.
The eight states and the percentage of workers living in high unemployment counties
are as follows: West Virginia (36.4), New York (35.3), Alaska (27.9), Montana (26.1), New
Mexico (25.8), Idaho (23.5), Mississippi (23.4), and Oregon (22.5).
2
190
time or another. For the majority of high unemployment counties. however. such short-term
events are an additionalstress. and most likely a reflection of underlying conditions. such as
overreliance on a declining industry. Thus. this analysis of unemployment can be read more
generally as an analysis of long-term economic distress. The bad news. then, is that there are
few. if any, quick fixes to persistent local problems. The good news is that the geographic
stability of these problems provides an identifiable. stationary target for long-term interventions.
II.
What Causes Geographical Variation in Unemployment Rates?
To understand why some counties have very high unemployment levels, it is helpful to
understand why unemployment occurs in the first place, and how local unemployment rates are
only partly related to national economic trends. In the simplest of economic models.
unemployment occurs when the supply of workers exceeds the demand for those workers (the
number of jobs available). and it persists until wages fall enough to restore supply and demand
equilibrium. At the national level, this insufficient demand for workers. which can be traced
back to a weak demand for goods and services. drives the changes in unemployment rates
observed during economic downturns. Contrarily, periods of econpmic expansion are
characterized by rising labor demand brought on by growth in the national quantity of goods and
services purchased.
But sustained economic expansion alone can never drive the unemployment rate to zero.
Inevitably, there is a structuralmismatch between the requirements of vacant jobs and the skills
of available workers in a particular location. due to shifts in product demand and production
technology. Furthermore, even if overall skills and job requirements in the economy were equal.
frictional unemployment would occur because individual workers and employers need time to
find the most productive match.
Each of these types of unemployment--demand-deficient, structural, and frictional-- has a
geographic dimension that helps to explain unemployment differences across local labor markets.
Local unemployment rates may react very differently to a national economic slowdown or
expansion based on their particular mix of industries, with some areas leading a national trend,
and others lagging. As noted in the introduction, the industry mix will accordingly affect the
persistence of unemployment. Moreover, at any point in time, demand-deficient unemployment
will persist where wage rates are higher than the long-run sustainable level, given the
productivity of the workforce.
It is likely, however, that much of the geographic variation in unemployment can be attributed
either to rigidities in the local economic and demographic structure, or to the frictional forces
that prevent instantaneous matching of workers and firms, and that are also affected by local
characteristics. Structural mismatch will be more severe where the local industry mix is
changing rapidly, or where changes in an industry's product demand leads to sudden job creation
or loss.
191
In addition, some areas have populations that have suffered historically from chronic
unemployment, weak labor force attachment, and/or limited job skills. In standard economic
models, migration eliminates such structural unemployment in the long-run. But these models
typically fail to consider the costs of gathering infomiation about job opportunities in other
places, the complex labor supply decisions of dual-earner households, and the psychic costs of
leaving local kinship and friendship networks. all of which diminish the likelihood of
employment-equalizing migration.
Frictional unemployment is a function of job turnover, the difficulty and method of job search,
and the ability to hold out for the best possible offer. These, in turn depend on the skills and
education required by the job, or held by the worker. In areas with a large proportion of highskill jobs/workers, relatively low turnover and brief periods between jobs pushes down the
frictional component of unemployment.
III.
How Large is the Problem of High Unemployment Areas?
The seriousness of locally high unemployment can be described by considering its magnitude and
geographical distribution. That is, how many people and areas are affected by locally high
unemployment, and how widespread is the phenomenon?
The 617 high unemployment counties combined had a labor force of 13.4 million people. about
II percent of the national total in the first quarter of 1998. Some 1.5 million workers in these
counties were unemployed, representing 29 percent of total unemployment in the United States.
High unemployment counties can have large or small populations: 35 counties have populations
of more than 100,000, and 184 counties. about a third, have populations of fewer than 20,000.
The 25 largest high unemployment counties are shown in Table 2. At the top of the list are 3 of
the 5 New York City boroughs, the only counties with populations exceeding one million.
Scattered throughout are central counties of large urban areas, mostly along the East Coast or
California. Small and medium-size high unemployment counties are distributed relatively evenly
across the nation.
High unemployment counties are found in all 4 Census regions of the country. The largest
number are in the South, with 281 counties, but the largest proportions of high unemployment
counties within a region are the West (35 percent) and the Northeast (24 percent), while they are
relatively sparse in the Midwest (12 percent) (table 3). The uneven regional distribution is
particularly apparent when examined across the 9 Census divisions. Among these, the Pacific
division has the highest percentage of high unemployment counties-55 percent, or 91 of 164
counties. At the other extreme, the Great Plains states have just 33 high unemploymen counties,
5 percent of their total, and New England has 9 high unemployment counties, 13 percent of all
counties in the census division.
4
192
Table 2. Twenty-five largest High Unemployment Counties
County
Population
(1997 Est.)
Unemployment
Rate
1. Kings, NY
2,240,384
10.5
2. Queens, NY
1,975,676
8.1
3. Bronx, NY
1,187,984
11.1
4. Fresno, CA
754,396
16.8
5. El Paso, TX
701,576
10.1
6. Baltimore (city), MD
657,256
9.1
7. Kern, CA
628,605
14.2
8. Hudson, NJ
551,451
8.1
San Joaquin, CA
542,504
12.8
10. District of Columbia
528,964
9
11. Hidalgo, TX
510,922
19.2
12. Stanislaus, CA
421,818
14.5
13. Richmond, NY
402,372
8.1
14. Monterey, CA
361,907
17.2
15. Tulare, CA
353,175
18.3
16. Cameron, TX
320,801
12.8
17. Santa Cruz, CA
240,488
10.4
18. Atlantic, NJ
236,569
8.7
19. Yalima, WA
218,318
13.1
20. Barnstable, MA
205,128
8.5
21. Merced, CA
196,123
19.7
22. Butte, CA
194,160
10.2
23. Webb, TX
183,219
9.7
24. St. Lucie, FL
179,559
8.2
25. Dona Ana, NM
168.470
9.9
l9.
193
Table 3. Regional distribution of High Unemployment Counties (HUCs)
Region/Division
No. of HUCs
ReIion/Division
of HiU~s
Pct. of all HUCs
I
of
~
of total in
I Pct. region
Northeast
52
8
24
Midwest
127
21
12
South
281
46
20
West
157
25
35
Total
617
100
20
New England
9
1
13
Middle Atlantic
43
7
29
East North Central
106
17
18
West North Central
93
15
26
South Atlantic
82
13
17
East South Central
94
15
22
West South Central
33
5
5
Mountain
66
11
24
Pacific
91
15
55
Total
617
100
20
194
Although found in all regions. high unemployment counties are nonetheless notable for their
marked geographic clustering, as the map in Figure I illustrates. In the West. for instance. large
portions of the Pacific Northwest. the Central Valley of California. and the Colorado Plateau are
high unemployment areas. The South's high unemployment counties lie primarily in the Rio
Grande Valley, the lower Mississippi Valley, especially in the Delta region. and the Appalachian
Highlands. Unemployment in the Northeast and Midwest is clustered in the northern tier
counties of Minnesota, Michigan. New York. and Maine. Note, too, that high unemployment is
unusual in the broad central section of the country, and relatively infrequent along the Atlantic
coast.
The fact that these clusters are geographically well-defined suggests strongly that regional
characteristics are key determinants of differences in unemployment rates. High unemployment
counties are a fairly stable group--the counties they comprise tend to experience high
unemployment over an extended period. The next section examines in more detail the
persistence of unemployment in these 617 counties.
IV.
How Persistent are High Unemployment Rates?
One line of thinking on unemployment is that there will always be a group of counties with high
unemployment, but because local economies are dynamic in the long-run, the distribution of
unemployment across the nation will change over time as local characteristics change. Economic
hardship, in other words, gets spread around, much as many households move into and out of
poverty.
But in fact, the economies of places with distressed labor markets are not particularly dynamic.
One way to see this is to compare the high-unemployment counties' rates with average
unemployment rates over a number of years. Unfortunately, this comparison is not
straightforward, because the variation of county rates around the average can be expected to
differ during years of economic expansion and contraction. If for example, the threshold for high
unemployment is 8 percent when the U.S. average is 5 percent, what would the relevant threshold
be if the national average of county unemployment is 8 percent? Merely holding the difference
between the average and the threshold constant (at 3 percentage points) could be inappropriate if
the variance of rates around the 8 percent average changes.
One solution is to convert county unemployment rates into standardized rates that measure how
many standard deviations a given unemployment rate is from the average. A threshold of 0.6
standard deviations above the mean is used to be consistent with the 8 percent high
unemployment threshold in 1998. By this measure, most of the counties classified as "high
unemployment" in 1998 were high unemployment counties as far back as 1979. During the
1980's. an average of 58 percent of the current high unemployment counties fell above the
standardized threshold in a given year; in the early 1990's, two-thirds of more of these counties
5
195
did so. Furthermore. two-thirds of the 617 high unemployment counties in 1998 were above the
high-unemployment threshold in a majority of the 19 years available for this study, and 135 (22
percent) of these were high unemployment counties every year since 1979.
V.
Characteristics Associated with High Unemployment Counties
Geographic variation in the three types of unemployment discussed above arise from the
economic, demographic, and natural resource characteristics of local areas. Although they are
not linked in a one-to-one correspondence, the theoretical types are useful for describing
expected relationships between local attributes and unemployment rates. In this section. these
relationships are outlined and preliminary evidence of their presence is marshaled. The key local
factors to be considered can be grouped into market-related, locational, demographic, and human
capital characteristics.
Market-relatedcharacteristics
The most obvious association between unemployment and other attributes of the local area is the
ability of the economy to generate a sufficient number of new jobs to match the labor supply.
Where employment growth is high, unemployment should be lower unless there is an unusually
strong influx of migrants. Labor supply growth could indeed outstrip growth in demand for a
number of reasons. High wages, for example, have consistently been found in the social science
literature to attract working-age migrants into a region. Their impact on job growth is less clear.
If local wages are not reflected in a commensurate level of productivity, job growth (and
therefore labor demand) will suffer.
Even where wages are not especially high, migrants may be attracted to non-economic aspects of
the local area, such as its climate and topography. Many migrants are willing to accept a lower
wage and a greater uncertainty of employment in exchange for an enhanced quality of life, thus
raising supply relative to demand. The attraction of physical amenities has increased relative to
economic incentives for interregional migrants during the 1990's, suggesting that the association
between amenities and unemployment may have increased as well (Cromartie and Nord, 1996).5
County unemployment rates necessarily reflect patterns of growth and decline among local
industries. Counties where employment is concentrated in "old" industries, or industries with
rapidly changing labor requirements may experience high unemployment. In addition, there is
evidence that a diversified economy, particularly one based'on services, cushions workers against
Physical amenities are measured later in this report as a standardized index that
combines attributes related to climate, elevation, topography, and proximity to water. The
amenity index is scaled to a normal distribution with mean equal to zero and a unit variance.
6
196
cyclical downturns and allows quicker transitions to new jobs. A comparison of major industry
distributions by unemployment rate, however, reveals that although high unemployment counties
have slightly higher employment shares in agriculture, mining, and government, there are no
sharp differences in the mix of industries between high unemployment counties and all other
counties (table 4).
For nonmetropolitan counties, an alternative measure of industry-specific influence in the local
economy exists that uses income as well as employment share. A comparison of county types by
industry "dependence" developed at the U.S. Department of Agriculture's Economic Research
Service (ERS) shows that high unemployment counties are more likely to be dependent on the
employment and income derived from government services and mining than counties with lower
unemployment rates. This is not surprising. Government-generated income and employment
tends to dominate only when basic industrial activity is weak, or other kinds of economic stress
such as low income exist. Mining-dependent counties face chronic sharp boom-and-bust cycles.
At any given time, a substantial number of these counties will exhibit the effects of depressed
world demand for their particular mineral.
Nonmetropolitan counties with high unemployment are much less likely, however, to be farmdependent, a finding seemingly at odds with the lack of impact shown by simple employment
share above. The fact that the economic typology is not applied to metropolitan counties, where
farming-related unemployment rates are higher, may explain the apparent discrepancy. This
relationship will be discussed in more detail below.
Locational
One of the most striking features of high unemployment counties is their strongly
nonmetropolitan character. Just 9 percent of the counties lie in metro areas, compared with 30
percent of non-high unemployment counties (table 5). The 56 metropolitan high unemployment
counties are evenly spread among the Northeast, the South, and the West; only 2 are found in the
Midwest. High unemployment counties are particularly unusual among counties in metropolitan
areas of one million people or more (3 percent, or II out of 311 counties), but their incidence
rises among smaller metropolitan counties (table 6). For nonmetropolitan counties, the highest
incidence of high unemployment counties is among counties with urban populations of less than
20,000 that are not adjacent to a metropolitan area. Adjacency to a metropolitan area appears to
matter, in part because adjacent nonmetro counties are more diversified economically, and in
part because their commuting links with urban centers increase workers' abilities to search for
new jobs.
Human capital
The probability of being unemployed rises sharply for lower levels of education. Adults without
a high school diploma face unemployment rates more than four times as high as college
graduates. Many of the least-educated adults are in insecure, low-quality jobs, leading to higher
rates of turnover and greater vulnerability to occupational and industrial change. Areas where a
large proportion of adults have low educational attainment often have trouble attracting
7
197
Table 4. Industry mix of EIUCs and non-HIUCs
[
Industry
HUCs
non-EIUCs
.(percent of total employment)
Agri., Forestry, Fishing
2.1
1.6
Mining
1.5
1.2
Construction
5.2
5.6
Manufacturing
13.5
13.7
Trans., Comm.,
Utilities
4.1
3.9
Wholesale Trade
2.4
3.3
Retail Trade
16.2
16.1
FIRE
4.1
4.8
Services
21.3
22.3
Government
17.8
16.1
Total
100.0
100.0
County Typology
(nonmetro onl
v
)
#
%.#
%
Farm-dependent
90
17
466
27
Mining-dependent
56
10
91
5
Manufacturing-dep
125
23
390
22
Services-dependent
67
12
256
15
Govermment-dep
90
17
165
9
Nonspecialized
117
21
371
21
Total
545
100
1738
100
198
Table 5. Urbanicity of High Unemployment Counties
Metropolitan Status
No. of HUCs
Pct of all HUCs
Pct of all counties
in status
Metro
56
9
7
Normetro
561
91
24
Total
617
100
20
Large core metro
9
1
5
Large fringe metro
2
<1
2
Medium metro
23
4
7
Small metro
22
4
11
High urban, adjacent
22
4
16
Rural-urban Continuum
High urban, nonadjacent
28
5
25
Low urban, adjacent
119
19
19
Lowurban, nonadjacent
183
30
28
No urban, adjacent
60
10
24
No urban, nonadjacent
149
24
28
617
100
20
Total
199
Table 6. Metro status by region, High Unemployment Counties
Status
Northeast
Midwest
South
West
Total
18
32
2
4
19
17
56
34
30
100
34
125
22
140
561
6
22
47
25
100
Metro
%
Nonmetro
%
200
prospective employers. or for that matter. keeping those whose main motivation for staying is the
low local wage level. For these reasons, both structural and frictional unemployment tends to be
elevated in counties with lower average education levels. Average years of schooling in high
unemployment counties is 10.6 years vs. 10.9 years in other counties. 6
A more telling comparison between high unemployment counties and other counties is the share
of adults at very high and very low levels of educational attainment. For instance. 13 percent of
all counties have a high proportion of college graduates (15 percent or more of the adult
population) but less than 3 percent of high unemployment counties do. Similarly while I in 5
counties nationally have a high proportion of high school dropouts (20 percent or more), the rate
for high unemployment counties is greater than I in 3.
Demographics
Worker demographics also vary greatly from place to place. These often operate at the individual
level. but affect aggregate unemployment as well. Worker characteristics that affect entry and
exit from the labor force. such as age, are associated especially closely with geographic
differences in frictional unemployment. Very young workers (teenagers and young adults) move
into and out ofjobs with greater frequency than older workers because they are less likely to
assume the financial responsibility of maintaining a household, and because they are still in the
job-sampling phase of their work lives. Hence counties with a greater share of young workers in
the labor force should see higher unemployment rates. A similar argument could once be made
for women's labor force participation, but their employment dynamics have changed dramatically
since the 1970's.
The legacy of institutionalized discrimination and separation that marks the landscape in many
parts of the United States is evident in the strong association between high unemployment rates
and the geographic concentration of racial and ethnic minorities. Blacks, Hispanics, and/or
American Indians make up a significant share of the population (at least 25 percent) in 31 percent
(192) of high unemployment counties, compared with 19 percent of all other counties (table 7).
Similarly, 32 percent of all counties with significant minority populations are also high
unemployment counties. The strongest association is for American Indians -- 57 percent of
counties where they form a significant presence experience high unemployment.
In some cases, however, the persistent association of racial or ethnic minorities with specific
types of work creates a specious connection between minority presence and unemployment. A
clear example of this can be found in the West, where Hispanics are disproportionately employed
in agriculture, and where agriculture often depends heavily on seasonal labor. Of the region's
446 counties, 45 percent of the 60 counties with a large proportion of Hispanics are high
unemployment counties, compared with 34 percent of other western counties. But of the 425
western counties where agriculture employs less than a tenth of the workforce, there is no
6
The average educational attainment in low-unemployment counties is 11.5 years.
8
201
Table 7. Racial and Ethnicity Characteristics in HUCs and non-HUCs
County type
No. of
HUCs
Pct of all
HUCs
Pet of
non-HUCs
Pct of low
unempL
counties
HUCs as
pet of all
counties
Black
118
19
11
7
29
Hispanic
50
8
4
3
33
Native American
26
4
1
<1
57
All mmonties
192
31
16
10
32
AllHUCs
617
100
-
19
202
difference in the incidence of high unemployment between counties with a large Hispanic
population and those without.7
VI.
Relative Importance of County Characteristics
Although unemployment rates are the outcome of many factors working simultaneously, some of
these factors can be expected to play a large role in explaining geographical difference in
unemployment. while others will have a more marginal influence. Furthermore. many of these
factors are difficult to disentangle. Rural counties, for example, tend to have fewer college
graduates. and both rurality and lower education levels are likely to be associated with higher
unemployment rates. In some cases, seemingly important factors may derive most of their
explanatory power from their linkage with other factors--rurality's apparent effect on
unemployment may work mostly through education and industrial structure. To separate and
compare the marginal contribution of each variable, the characteristics are included together in a
series of regression analyses of county unemployment rates.
The findings reported here are based on two models of unemployment. First, local characteristics
are related to simple county unemployment rates, which allows a quantifiable relationship to be
established between specific rates and each characteristic. Next, these same characteristics are
related to each county's presence in. or absence from, the high unemployment group. The first
analysis, then, uses local attributes to help explain a county's unemployment rate and the second
uses them to "predict" whether a county falls into the high unemployment category.
All of the characteristics discussed so far are considered simultaneously in the analysis. A few
additional variables that have been found to influence unemployment rates in other studies are
also included. These are the average union membership rate for the state and the state's average
AFDC payments in 1995. High unionization rates have historically been associated with slower
economic growth and more rigid local wage scales. Both of these conditions are expected to
increase unemployment. It has also been hypothesized that high AFDC payments might increase
frictional unemployment by raising the lowest wage rate that job seekers are willing to accept
(known as the "reservation wage").
Finally, two measures of the surrounding local labor market area have been added to capture
nearby effects -- the unemployment rate and the average earnings per job for all counties in the
commuting zone other than the county of interest. In many small counties, where out-commuting
Among the 384 western counties in which agricultural constitutes less than 5 percent of
total employment, Hispanic counties are less likely to be high unemployment counties (26%)
than are non-Hispanic counties (3 1%).
9
203
is common, the job market in adjoining counties may be of equal or greater significance to local
residents.
How well do local characteristicsexplain county unemployment rates?
As shown in table 8, local characteristics explain a little more than half the variation in
unemployment rates across counties.' In the discussion that follows, the impacts of individual
characteristics on the unemployment rates of all counties in the United States are described. A
partial estimate of the contribution each type of characteristic makes toward explaining
9
geographical variation is also provided.
Market-relatedcharacteristics
A number of the market-related local characteristics are strong predictors of
unemployment rates, particularly employment growth in the previous year and the state's
union membership rate. Nationally, the unemployment rate in a county with employment which
grew one standard deviation above the mean (about 4 percent) was 0.4 percentage points lower
than a county with average growth. A I 0-percentage-point higher unionization rate translates
into a I percentage point higher unemployment rate. For example, if a county in a state with a 10
percent union membership rate has 6 percent unemployment, an otherwise identical county in a
state with a 20 percent union membership rate could expect to have 7 percent unemployment.
At the national level, earnings per job in the county is not a significant predictor of
unemployment, although earnings in the entire commuting zone is significant, indicating that
commuting tends to even out unemployment across counties within the local area. The earnings
effect is relatively small, however -- a difference of $5,000 in average earnings per job yields a
0.2 percentage-point lower unemployment rate. In other words, to reduce unemployment in a
county by a percentage point (say, from 8 to 7 percent), average earnings per job would have to
fall $25,000, more than the earnings difference between the richest and the poorest counties in
the nation in 1996.
The remaining variation is due to several causes, including the inevitable omission of
other factors that may influence unemployment rates, which is many cases are unquantifiable or
difficult to measure. Additionally, the factors that are included in the model are subject to
measurement error, which always reduces the explanatory power of those factors.
9Technically, the absolute impact described in this paper is measured by the regression
coefficient associated with each independent variable. Since variables are measured in different
units, however, and/or have different variances, direct comparisons using the regression
coefficients can be misleading. We therefore use a standardized estimate (the regression
coefficient divided by its standard deviation) as a broad, though still imperfect, measure of
relative importance.
10
204
Table 8. Relationship between Local Characteristics and Unemployment Rates
Choroctetistic
Silnificant? (Directionl
Standardized effect of additional unit on
Mrket-, lated
Employment growth. 1996-97
Yes (-)
.0
12
Eartnmisperiob, 1996
No
State unionization rte
Yes (+)
0.18
Averae state AFDC payment
Yes (")
0.06
Percent
employed in_
Agriculture
Yes (5)
0.03
Manafsctuning
Yes -)
.0.04
Miniog
Goveroment
No
No
Wholesale-Tragde
Yes -f
-0.10
Retail Trade
Yes ()
0.11
Trnsmpont.
Common., atndtUtilities
No
Finance. Insurance. Real Estate
No
Constructon
No
Commumtig shed's Unertployment
Yes f+)
0.42
Communting shed's Ertinsts per job
Yes (+)
0.07
Locfos.. I
Midwest (compared with Northeast)
No
South
Yes (-
West
Yeslf)
0.09
Small, remote (compared with la.e
Yesf+-
0.15
Amenity index
Yes (+)
0.07
-0.00
Dcmoxaphic
Percent black
Yes(+)
0.13
Percent Hisponic
Yes (+)
0.09
Percentages 16-19
No
HI ao.a capitol
Perceot with college degtee
Yes -)
-0.13
Percent with less than hish school
Yes 1+)
0.27
205
Key industries affecting unemployment include agriculture and retail trade (greater
employment boosts unemployment), and manufacturing and wholesale trade (greater
employment decreases unemployment).'" In addition to the seasonal effects of agriculture and
retail trade, the workforce in these industries tends to have lower average education levels and
lower occupational status for a given level of education. Retail trade tends to employ younger
workers who have higher-than-average turnover rates.
The unemployment rate in the rest of the commuting zone was added to control for external
factors that may nonetheless affect workers in the county. As one would expect, a county's
unemployment rate correlates reasonably well with unemployment rates elsewhere in the
commuting zone, each percentage point increase in the rest of the zone raising the county's rate
by half a percentage point.
Locational characteristics
Overall, the locational factors discussed earlier continue to affect local unemployment rates even
after controlling for confounding influences. Rural and western locations are associated with
higher unemployment, as are high-amenity locations. The South continues to exert a negative
influence on unemployment rates, although its effect is dampened after controlling for
demographic factors and union membership rates. The effects of being a small remote county are
particularly notable, increasing unemployment by more than I percentage point relative to the
core counties of large metropolitan areas.
Demographic characteristics
The proportion of the population that is black or Hispanic is strongly, positively associated with
unemployment rates. Controlling for all other factors, a county in which one-third of the
population is black will have an unemployment rate I-percentage point higher than a county with
no black residents. The impact of the proportion of Hispanic residents is slightly smaller. The
proportion of the population that is 16-19 years old, the teenage cohort, appears to have no effect
on geographic differences in unemployment. This may be because there is relatively little
variation in the proportion of the population composed of teenagers.
Human capital characteristics
The educational composition of the adult population emerges as one of the key determinants of
differences in local unemployment rates. A one-standard-deviation increase in college
10
The lack of seasonal adjustment in the unemployment data may play a role in the
prominence of some industries. Agriculture's impact is likely to be greater during the first quarter
of the calendar year, when labor demand is lowest. Likewise, retail employment typically falls
following the December holidays. However, the impact of both agriculture and retail
employment is significant (although smaller) even in models of average annual unemployment.
11
206
completion rates (about 6 percentage points) shaves nearly half a percentage point off the county
unemployment rate. A similar increase in the proportion with less than a high school diploma
would raise the rate by over half a point.
The relative importance of local characteristicsvaries by region
Stephen Marston (1985) first observed that conclusions about the relationship between
unemployment rates and local characteristics are unlikely to hold in all places. That is, not only
do characteristics vary from region to region, but the fundamental relationship between
characteristics such as employment growth and unemployment rates can vary as well due to a
variety of structural forces." Thus, otherwise well-targeted policies designed to alter a single
risk factor (say, education levels) may have much greater impacts on unemployment in some
regions than others.
A separate analysis of each of the four Census regions confirms that the structure of
unemployment is quite different from place to place (table 9). In the Northeast. the size of the
college-educated population is a dominating influence on unemployment rates. The size of the
manufacturing and trade sectors are also of much greater importance. Surprisingly unimportant
are several characteristics that are key at the national level-commuting zone effects, employment
growth, demographic characteristics, and the proportion of adults who do not have a high school
diploma.
Another case of regional differences is the role of agriculture, which is sensitive to its production
context. In the Midwest, greater agricultural employment is strongly associated with lower
unemployment rates, the reverse of both the national results and of those in the West. The
discrepancy in the findings for agriculture is largely explained by regional differences in the
kinds of crops grown and in the way that agricultural production is integrated into the local
economy. In the West, counties with substantial agricultural employment are often metropolitan.
These counties rely on labor-intensive production, typically requiring large numbers of migrant
or seasonal workers who are officially unemployed part of the year. Great Plains agriculture is
relatively capital intensive, employing far less seasonal labor, and generating very low rates of
unemployment
Also more important in the Midwest is the role of natural amenities - again. contrary to the
West, where amenity differences are of no significance. Meanwhile, the West is different from
the Northeast in that college completion is insignificant, but having a higher proportion of the
"' A good example of this is the relative openness of the local economy. Local
employment growth may have a greater impact on the unemployment rate if there are structural
barriers to in-migration. Another example is the strength of internal transactional relationships
between establishments in the area. Where these relationships are strong, factor productivity
(including labor) is likely to be higher due to agglomeration forces, and a higher wage level is
sustainable without depressing labor demand and raising unemployment.
12
V
207
Table 9. Regional divergence from the national model
Characteristic
Northeast
Midwest
South
West
Market-related
Employment growth, 1996-97
NS
Earnings per job, 1996
NS
State unionization rate
NS
Average state AFDC payment
NS
NS
NS
NS
(-)
NS
L
Percent employed in:
Agriculture
Manufacturing
L
L
(+)
Sign. (-)
Mining
Government
Wholesale Trade
L
Retail Trade
Transport., Commun., and Utilities
Finance, Insurance, Real Estate
Sign. (+)
Construction
Commuting shed's Unemployment Rate
Commuting shed's Earnings per job
S
S
NS
Locational
L
Small, remote (compared with large urban)
Amenity index
NS
NS
Demographic
Percent black
NS
NS
NS
Percent Hispanic
NS
Percentages 16-19
Humtan capital
Percent with college degree
L
NS
S
NS
Percent with less than high school
NS-Not significant at .05 level; L=Standardized estimate > by at least .I; S=Standardized estimate < by at least .1;
Sign.=Now significant at .05 level; () indicates change of sipn.
208
adult population without a high school diploma is very much related to higher unemployment.
Perhaps most intriguing, greater manufacturing employment is associated with higher
unemployment rates in the West, possibly due to the specific type of manufacturing occurring
there. or perhaps a result of the lingering effects of the severe 1990-91 recession in California.
and Boeing's recent woes in Washington State.
The South most closely mirrors the United States as a whole in the relative importance of local
characteristics. Its chief differences are in the effect of local earnings and employment growth,
both having somewhat greater influence on the region's unemployment rates than is the case
nationally.
VIL.
Characteristics that Distinguish High Unemployment Counties
As expected, most of the local attributes that figure prominently in determining county
unemployment rates in general are also key in predicting high unemployment counties (table 9).
The salient differences between the two models are that agricultural employment, manufacturing
employment, and location in the South no longer significantly affect a county's chances of being
classified as "high unemployment". The apparent contradiction between models suggests that
these attributes may be important in predicting unemployment rates within categories (i.e., "highunemployment" or "other"), but not between categories.
Other characteristics do appear to make a difference between categories. A Midwestern location
now decreases the likelihood of being a high unemployment county, and higher proportions of
young adults increase that likelihood.
VIII. Summary and Policy Implications
High unemployment, defined as a rate exceeding 8 percent, afflicted some 617 counties
containing over 13 million workers during the first quarter of 1998. Although these high
unemployment counties are found in every region of the nation, they tend to be grouped into
geographic clusters. Despite their wide distribution across the country, they often share a number
of economic, demographic, and locational features that distinguish them from the more
prosperous areas of the United States.
High unemployment counties overall have higher levels of the following attributes than other
counties: employment in agriculture and retail trade, state unionization rates, share of residents
who belong to a racial or ethnic minority, share of adults without a high school diploma, average
AFDC payments prior to 1996 welfare reform legislation, remoteness from cities, physical
13
209
amenities, and location in the West. These same counties have lower levels of manufacturing
and wholesale trade employment, lower employment growth. smaller shares of college graduates.
smaller and less-urban populations, and are less likely to be located in the South. once other
attributes have been controlled for.
Two-thirds of counties with high unemployment have suffered from insufficient labor demand
for most of the last two decades, with unemployment rates well above the national average. This
stability in relative unemployment rates is not surprising because many of the most important
characteristics associated with high unemployment change very slowly over time. For example.
the racial and ethnic mix of the local population may change rapidly in urban areas. but in rural
areas, where high unemployment counties are concentrated, such changes are gradual if apparent
at all. Likewise the education mix of the workforce responds primarily to changing skill
requirements. But most of the recent industrial change occurring in high unemployment
counties, as in most other places, is from manufacturing to services, which changes the skills
requirements of local employers in unpredictable ways, depending on the particular types of
services where employment growth is concentrated.
The relationship between particular local characteristics and the unemployment rate can
strengthen or weaken over time as well, and be a potential source of movement into and out of
high-unemployment status. A good example is the changing effect of women's labor force
participation. In the 1970's, women were more likely to be unemployed than men due to their
more frequent entry into and exit from the workforce, as well as to the nature ofjobs deemed to
be "woman's work." But by the 1990's, the gender gap in unemployment had all but
disappeared, and the share of the labor force composed of women is no longer an important
source of geographic variation in unemployment (U.S. Department of Labor, 1993).
Regressions of unemployment rates on data from each year of the 1990's confirm that these
relationships do change over time. Over the course of the decade, counties with large
proportions of minorities became more likely to have high unemployment, as did agricultural
counties. Other associations with unemployment are weaker now than was true a decade ago,
including the links between unemployment and the proportion of local workers engaged in
manufacturing, retail trade, and government; state union membership rates, and the proportion of
the working-age population who are teenagers.
What does this mean for policy interventions? First, one must distinguish policies focused on
changing local attributesfrom policies designed to change the relationship between
unemployment and the attribute. The effect of women's labor force participation is a case of the
latter. Women's participation rates still differ considerably across counties. Yet policies that
removed barriers to working women, such as child care tax credits and stronger Federal
enforcement of anti-bias and sexual harassment laws reduced turnover and encouraged job ladder
promotion, which in turn played a role in weakening the link between gender and unemployment
Most policies related to demographic associations with unemployment would necessarily be of
this nature. For example, counties with large minority populations would benefit from a variety
14
210
of policies intended to strengthen antidiscrimination laws and to promote the quality of education
and training for disadvantaged groups.
Other policies would need to be developed to change the local characteristic itself if local
unemployment rates are to be reduced. In most cases this requires a commitment to long-term.
comprehensive (not piecemeal) economic development that is rarely possible if carried out by
local stakeholders alone. A recent series of reports based on ERS's Rural Manufacturing Survey
concludes that recent fundamental changes in production technologies and management
practices, both requiring a more highly-skilled workforce, is as evident in rural areas as in cities.
More establishments, including those in high unemployment counties, could be encouraged to
participate in this "New Economy" if the proper investment incentives were more widely
available, or if these incentives were better targeted to areas with high unemployment. Such
incentives would attack persistent unemployment from several angles because they would help
alter the industry mix as well as the education and skill mix of the area.
Policies designed to raise local educational attainment without simultaneously creating high-skill
work would prove less effective, but may still be useful in communities where intercounty
commuting is a feasible alternative to local employment. At least one previous study has
demonstrated that college graduates from disadvantaged areas will often return to them because
of social and family ties, even when job prospects are inferior to those of other destinations
(Gibbs, 1998). Although they may not work in their county of residence, they create income for
local consumption, and are unlikely to experience the job instability of their less-educated peers.
Hence raising "locally-grown" college graduates can be a good investment for non-remote
counties afflicted with persistently high unemployment.
As one section of the analysis in this paper suggested, not all anti-unemployment policies could
be applied across high unemployment areas with uniform results. Recall, for example, that the
association between agricultural employment and unemployment was negative in the Midwest,
but strongly positive in the West. Thus a policy that attempted to ameliorate unemployment by
encouraging the transfer of workers from farming to other jobs would have little impact in the
former region, but could make a real difference in the latter. Likewise tax incentives aimed at
promoting advanced production technologies in rural manufacturing establishments would both
encourage manufacturing and the presence of college graduates. Yet northeastern counties would
find this strategy far more compelling than those in the West as a way of reducing
unemployment. One implication of this diversity is that it should be considered carefully
whether a proposed policy is more sensibly implemented at a state, or even local, level rather
than nationally.
Another potential problem with "one-size-fits-all" policies is that not all high unemployment
counties exhibit most of the local attributes associated with high unemployment. For example,
239 high unemployment counties have adult educational attainment levels above the average for
all counties. Diversity of conditions should not be a stumbling block to creating local
unemployment solutions, but again, a call to consider the proper level of public intervention
(federal, state, local), and to target assistance according to local needs rather than a broad-brush
is
211
approach. Note, too, that while many of these counties lack a number of the critical ingredients
for high unemployment, nearly all of them possess at least one major risk factor. To illustrate, if
educational attainment levels, presence of racial/ethnic minorities, employment growth, and
urbanization/remoteness are considered simultaneously, only 22 of the 617 are atypical high
unemployment counties in all of these attributes.
It must be acknowledged that effective and sensible remedies may not exist in all cases. Clearly
a policy to reduce the physical amenities of a county for the sake of reducing unemployment
would encounter stiff opposition. Neither would it improve the welfare of workers in the long run
to enact policies to discourage unionization efforts. Even where remedies do exist, the ability to
change a characteristic or its association with unemployment may be limited by deeplyembedded historical or economic realities. Counties with large proportions of blacks and
Hispanics have legacies of underinvestment in human and physical capital, and of low-paying,
unstable jobs, which affect their attractiveness for prospective new employers as well as their
ability to generate new entrepreneurial activity intemally. Without a fundamental shift in the mix
of jobs, policies aimed at equality in hiring and promotion can only work at the margins of
unemployment reduction.
Finally policies designed to reduce unemployment without considering other measures of
workers' well being create more problems than they solve. Local economic development
initiatives aimed at attracting any industry, for instance, may well increase employment. Yet if
average newjob quality is low, areas that pursue this strategy also increase the risks associated
with a high-turnover labor force and employers who view the county as a convenient source of
cheap labor, at least until a better location can be found. For some counties, this may be the only
feasible approach, but it should always be a last resort.
The preferable anti-unemployment strategy, from both a local and a national prospective, should
proceed along two broad lines: I) aggressive human capital investments in school quality, college
enrollment, and job training; 2) concurrent assistance and encouragement of New Economy
employers, who demand a higher-skill workforce and are less exposed to the threat of
competition from cheaper labor elsewhere. Recall that earnings and unemployment were found
in this analysis to be very weakly associated. A county need not fear being saddled with a "highwage/high-unemployment" labor mix if high wages flow from a well-prepared workforce
engaged in advanced production processes. On the contrary, as the global economy becomes
increasingly integrated, high wages and employment levels are likely to form a necessary
partnership to ensure local prosperity in the next century.
16
212
References
Cromartie, John B., and Mark Nord. "The Changing Structure of Rural Migration, 1986-1994."
Staff Report No. xx, Economic Research Service, U.S. Department of Agriculture, 1996.
Gibbs, Robert M. "College Attendance and Return Migration Among Rural Youth." in Rural
Education and Trainingin the New Economy: The Myth of the Rural Skills Gap. Robert
M. Gibbs, Paul L. Swaim, and Ruy Teixeira, editors. Ames: Iowa State University Press,
.1998.
Hall, Robert. "Turnover in the Labor Force." Brookings Paperson Economic Activity, Vol. 3,
1972, pp. 709-764.
Marston, Stephen T. 'Two Views of the Geographic Distribution of Unemployment." Quarterly
Journalof Economics, February 1985, pp. 57-79.
Murphy, Kevin J. "Which Local Characteristics are Most Important?
Geographic Differences in U.S. Unemployment Rates: A Variance Decomposition
Approach." Economic Inquiry, Vol. 23, Jan. 1985, pp. 135-158.
Partridge, Mark D., and Dan S. Rickman. "County Unemployment in Georgia: The Causes and
Potential Role for Economic Development Policy." Review of RegionalStudies, Vol. 2,
Summer 1996, pp. 17-40.
. "State Unemployment Differentials: Equilibrium Factors vs. Differential
Employment Growth." Growth and Change, Vol. 28, Summer 1997, pp. 360-379.
U.S. Department of Labor, Women's Bureau. Handbook on Women Workers: Trends and Issues,
1993.
Vedder, Richard, and Lowell Gallaway. "Spatial Variations in U.S. Unemployment." Journal of
Labor Research, Vol.27, No.3, Summer 1996, pp. 445-461.
Distribution of County Unemployment Rates
1st Quarter, 1998
35
30.4
28.8
30
25
18.1
20
9.5
10
7.6
3.1-
2.6
0
0to 2
2 to 4
4to 6
6 to8a
Unemployment Rate
Source: Joint Economic Committee, Minority
6to 1O
10 to15
16+
High Unemnployment Counties in the U.S..
Rates greaterthan 8 percentIn 1998-JQshown in gray
eb
Persistence of High Unemployment In High Unemployment Counties
1979 to 1998
100
90
80
70
79
80
81
82
83
84
85
86
87
88
89
Year
Source: Joint Economic Committee. Minority Staff
90
91
92
93
94
95
98
97
98
216
Characteristics of Low and High Unemployment Counties
Based on unmployment roesfor the 1st quarw of 1998
Important
County Group
Charaeristic
Low
Unemployment
(-8 %)
High
Unemployment
(>8 %)
(
Very High
Unemployment
.
(>10 %)
4
Totalnumber
[2525
| 320
617
3
(percent with chasuctrsti~c)
Einployment Loss, 1996-97
35
45
47
High Earnings (>30KC perjob)
23
13
13
I1l
1]9
22.
4
8
4
31
7w
74
,LargeBlackPop
(>5%
'Large' Hispanic POp (>25%;
'Large' IndnPop (25%)
'Lar eMinority Pop p25%)
T
1.
T
116,
T36
"L-Pe'College Pop (>20%)
15
3
.2
Large" Dropout Pop (>40%)
16
36
41
Northeast
7
8
4
Midwest
30
32
33
29
South
*
52
34
West
*
11
25
33
Metr
*o
31
9
'8
69
91
92
27
16
16
Nonmetnm
Chractscs of nome
Fuming-dependent
*
Services-dependent
15
12
12
Nonspecializd
21
21
18
Mammuctoring-dep
22
22
18
GovL-dependet
*
9
16
21
Minigndepcdent
*
5
10
10
t,
.
Relationship Between County Characteristics and Unemployment Rates
An increase in
employment growth, 1996-97,
lowers the unemployment rate by 0.41 percentage points
An increase in
local earnings per job
raises the unemployment rate by 0.24 percentage points
An increase in
aite's unionization rate
raises the unemployment rate by 0.64 percentage points
An increase in
average state AFDC payment (1995)
raises the unemployment rate by 0.22 percentage points
An increase In
employment share in agireulture
raises the unemployment rate by 0.12 percentage points
An increase in
employment share in mytufacturing
lowers the unemployment rate by 0.13 percentage points
An increase in
employment share In wholesale trade
lowers the
An increase in
employment share in retail trade
raises the unemployment rate by 0.39 percentage points
An increase in
percent Black
raises the unemployment rate by 037 percentage points
An increase in
percent Hispanic
rases the unemployment rate by 0.30 percentage points
An increase in
share of adults with college degree
lowers the unemployment rate by 0.46 percentage points
An increase in
share of adults without a HS diploma
raise the unemployment rate by 0.95 percentage points
An increase in
the value of the amenity Index
raises the unemployment rate by 0.23 percentage points
Residence in
the South
lowers the unemployment rate by 0.27 percentage points compared
with residence in the North
Residence in
the West
raises the unemployment rate by 0.33 percentage points compared
with residence in the North
Residence in
a small, remote county
raises the unemployment ate by 0.51 percentage points compared
with residence in a large city.
.nemploymentrate by 0.36 percentage points
t-1
P-
Working Paper Series
offered to the
JOINT ECONOMIC COMMITTEE
MINORITY
UNITED STATES CONGRESS
Senator Jeff Bingaman, Ranking Democrat
The 1990s Economic Expansion:
Who Gained the Most?
Bruce W. Klein
September 1998
This series of papers, offered to the
Democratic members of the Joint Economic Committee,
addresses the major economic issues related to raising
living standards for American workers an-i their families.
H.Rept. 105-807 -98 - 8
221
The 1990s Economic Expansion:
Who Gained the Most?
Bruce W.Klein
Executive Summary
The economic expansion that began in March 1991 has been widely touted as the longest
peacetime expansion of the last 50 years. By implication. Americans today should be enjoying
rising household incomes and expanded economic opportunities. This study set out to determine
if this has in fact happened. and how the fruits of the expansion have been shared byAmericans
of different income levels. The analysis takes a closc look at the recovery's effects on five
different income groups.
The results of the study are unexpected and disturbing. The 1990s recovery has been longer. yet
less robust than previous periods of expansion. The primary beneficiaries of the expansion were
those with the highest incomes. whose incomes grew. By contrast. 80 percent of the population
experienced only very small increases in their income -- roughly, between I and 4 percent
increase -- during the first 6 years of the expansion. A rising tide may lift all boats. as President
John F. Kennedy was fond of saying, but it may not always lift all boats equally.
A closer look at the recovery reveals that there were marked differences between the first phase
of the expansion. from 1991 to 1993, and the second phase, from 1993 to 1996. During the
'Bush recovery' of 1991 to 1993, the 4 lower income groups experienced income losses. Only
the very rich, who constitute the top 5 percent of the population. benefitted substantially. By
contrast. during the Clinton recovery' (1993 to 1996). all groups experienced at least some
income growth. Still, it took until 1995 for the incomes' of the lower 3 income groups to surpass
their 1991 levels.
The paper concludes that Congress, the Administration. and the Federal Reserve should pursue
ways of boosting wages and closing the income gap. Specific recommendations are made to
maintain policies that are non-inflationary, yet pro-expansionary policies that shift income to,
and create opportunities for, individuals without a high school education, and policies that
encourage households with middle and lower incomes to save and invest.
222
I.
The 1990s Economic Recovery
All free market economies experience business cycles and the United States has experienced 6
such cycles since 1961.1 During each cycle, gross domestic product (GDP) has grown during the
upswing (recovery) and dropped or leveled off during the downswing (recession). Recoveries are
also associated with a fall in unemployment levels, a rise in disposable personal income, and
higher levels of consumer confidence and spending.
FIGURE 1: PER CAPITA GDP AND THE BUSINESS CYCLE, 1961 TO 1997
to
_
.5
2400D
0
0)
83 22000
h
0 18D
0
0
C.)
-
61
64
67
70
-
73
76
79
82
88
88
91
94
Shaded areas represent recessionary periods.
Solid line represents the trend.
Figure I shows how per capita GDP has fared over the business cycles between 1961 and 1997.
In general, per capita income tends to fall during recessions and begin to rise during recoveries -moving from below the 36-year trend (the solid black line) to above trend. Per capita GDP
during the 1991 to 1996 recovery does not appear to follow this pattern -- it remains below trend
until 1996.
-2-
223
In 1961, President John F. Kennedy spoke of the effects of an economic expansion in terms of a
rising tide lifting all boats. The idea has become part of common economic wisdom and its
implication is that as an economy recovers, all households are made better off -- higher income.
lower unemployment, expanding opportunities, and more purchasing power. It does not appear
that this maxim holds for the current recovery which began in 1991. This paper takes a close
look at the relationship between the 1990s expansion and changes in income across households.
The current recovery began in March 1991. Overall, it has been characterized by a rapid rise in
the stock market, near constant or declining prices for consumer goods, rising pay for all highly
skilled workers, new opportunities for highly-skilled women, and the lowest unemployment rates
in 30 years. Individuals with equity investments and advanced degrees, especially in technical
fields, have tended to do well during this recovery. These individuals have been able to take
advantage of the capital-intensive and skill-intensive characteristics of the recovery.
From the start of the expansion through the 4th quarter of 1997, total growth for the economy as
a whole has been 17.3 percent. with a respectable average annual growth rate of 3.1 percent.
Overall income measures showed smaller but positive increases during the expansion. Median
household income rose 2.3 percent over the 1991 to 1996 period; mean household income rose
7.9 percent; and disposable personal income recorded a 12.8 percent increase.
But totals and averages hide important details of the story. The first few years of the expansion
witnessed anemic growth. For the first 2 quarters of the expansion. GDP grew at an average
annualized rate of only 0.8 percent, and only 1.3 percent in the third quarter. The first five years
of the 1990s recovery were less robust than the first five years of all other recoveries since 1961
(Makinen, 1996).
Growth began to accelerate in 1993. The upward movement was accompanied by record stock
market performance, higher pay for technically-skilled college graduates, and salary growth for
women with advanced degrees. These two periods of the recovery -- referred to in this paper as
the "Bush recovery' of 1991-1993 and the 'Clinton recovery' of 1993-96 -- showed very
different patterns of both growth and income distribution. Part of the differential may be
explained by a time lag, which is often encountered in recoveries. Declines in unemployment
lag behind GDP growth and until unemployment drops, household incomes are slow to improve.
Comparisons With Other Recoveries
The 1990s recovery produced widely different affects across income groups, a result that runs
contrary to expectations about the nature of economic expansions. Table 4 compares the current
expansion to 5 other recoveries beginning in the 1960s.
-3-
224
Table 4: Average Quarterly Changes in
Per Capita Gross Domestic Product
During Recent Recoveries
Date and Length of Recovery
(according to NBER)
Average Quarterly Change
in per capita GDP
February 1961 to December 1969
(36 quarters)
$120.42
November 1970 to November 1973
(12 quarters)
$176.08
March 1975 to January 1980
(19 quarters)
$133.05
July 1980 to July 1981
(4 quarters)
$91.75
November 1982 to July 1990
(31 quarters)
$158.52
March 1991 to December 1996
(23 quarters)
$100.09
Average Quarterly Change in GDP over 36 years (144 quarters): $97.25
The 1990s recovery is the second weakest in terms of per capita GDP growth. posting a $100.09
average quarterly increase (through 4th quarter 1996), compared to averages ranging from $91.75
to $176.08 forthe five other recoveries. Equally telling isthat income for individuals in 4 ofthe
5 income groups did not recover to their 1989 levels (the peak year of the 1980's expansion),
despite 6 years of recovery. (See Table 5 below.)
Table 5
Comparison of 1989 and 1996 Mean Income Levels
Year
Low
Low-Middle
Middle
Upper-Middle
High
1989
$8,884
$22,018
$36,599
$55,362
$114,499 (adj.)
1996
8,596
21,097
35,486
54,922
115,514
Note: Data are in 1996 dollars. Source: U.S. Bureau of the Census, Current Population Survey and an adjustment
factor from unpublished Bureau of the Census data.
-4-
225
11.
The Recovery as Experienced by Various Income Groups
To determine what happened in both phases of the 1990s recovery, we examine the effects of the
expansion between 1991 and 1996 on households in five income groups. The five income groups
represent five equal-size slices (called quintiles) of total population. That is. quintiles are
constructed so that 20 percent of the population falls into each group. The quintiles and their
household income ranges are as follows:2
*
*
*
*
*
Low income
Low-middle income
Middle income
Upper-middle income
High income
Up to $14,768
$14,769 to $27.760
$27,761 to $44.006
S44.007 to $68.015
Above $68,015
These household income figures represent the total annual amount of cash income of all members
residing within a single housing unit. Cash income includes wages and salaries. self-employment
income. interest. dividends, government cash welfare, and pensions.
Wages
The most important element of income for all but the richest of Americans is wages and salaries.
To examine the typical wages earned by workers in each quintile. wages are grouped into ten
equally-sized slices (deciles).' As useful background information, Table I presents hourly wages
for the top earners in each decile. for male and female workers. between 1991 and 1996.
-5-
226
TABLE l: HOURLY WAGE BY TOP OF DECILE, 1991 TO 1996
MALE WORKERS
2nd
3rd
4th
5th
6th
8th
9th
$5.77 $7.28
$9.01
$10.65
$12.42
$14.50
$17.13
$20,15
$25.69
1992
$5.66 $7.15
$8.81
$10.57
$12.26
$14.30
$16.83
$19.99
$25.58
1993
$5.60
$7.16
$8.71
$10.60
$12.10
$14.19
$16.64
$19.89
$25.75
1994
$5.54 $7.11
$8.48
$10.26
$11.83
$13.97
$16.50
$19.89
$25.61
1995
$5.65 $7.14
$8,49
$10.20
$11.97
$13.98
$16.43
$19.64
$25.61
1996
$5.68 $7.08
$8.49
$10.04
$11.85
$13.93
$16.34
$19.74
$25.27
-5.8
-5.7
-4.6
-3.9
-4.6
-2.0
-1.6
1st
1991
Percent Change
1991 to 1996
-1.6
-2.7
7th
FEMALE
WORKERS
1st
2nd
3rd
4th
5th
6th
7th
8th
9th
1991
$5.01
$5.96
$7.01
$8.15
$9.31
$10.84
$12.56
$15.00
$19.22
1992
$5.08 $5.92
$6.97
$8.16
$9.34
$10.96
$12.54
$15.15
$19.55
1993
$5.08 $6.00
$7.02
$8.18
$9.39
$10.90
$12.91
$15.54
$19.70
1994
$5.03
$5.92
$6.94
$8.04
$9.27
$10.73
$12.71
$15.56
$20.00
1995
$4.98 $5.94
$6.95
$7.99
$9.18
$10.58
$12.57
$15.36
$19.73
1996
$4.96 $5.94
$6,95
$8.00
$9.19
$10.72
$12.64
$15.38
$19.91
-0.3
-0.9
-1.8
-1.3
-1.1
0.6
2.5
3.6
Percent Change
1991 TO 1996
-1.0
-6-
227
Figure 2 displays a summary of the data, which shows that hourly wages declined for all male
workers during the 1990s expansion and for all but the top 3 deciles of female workers. Wage
declines during the expansion help explain the income results experienced by 4 of the 5 income
groups.
FIGURE 2: CHANGE IN HOURLY WAGES FOR MEN AND WOMEN
BY WAGE DECILES, 1991 TO 1996
4x
2% 1
o4
t
1%
d
-
2d
3
3
hl4
4
6
5
|
7FEMALEWORKERS
61 h
7h
°3%
-4%
-6%
-6%
Deciles
-7-
8h
9 h
| OMALE WORKERS
228
Another way to examine trends in wages is to look at the association between hourly wages and
education. Table 2 presents these data for 1991 through 1996, for male and female workers.
TABLE 2: AVERAGE HOURLY WAGES OF MEN AND WOMEN
BY EDUCATIONAL LEVELS, 1991 TO 1996
MALE WORKERS
LESS THAN
HIGH SCHOOL
HIGH SCHOOL
SOME
COLLEGE
COLLEGE
COLLEGE
ADVANCED
DEGREE
1991
$9.76
$12.40
$14.50
$19.73
$25.68
1992
$9.76
$12.44
$1380
$20.07
$25.21
1993
$9.59
$12.30
$19.97
1994
$9.42
$12.38
$13.69
$13.63
$20.13
$25.35
$25.98
1995
1996
$9.19
$8.85
$12.22
$13.50
$13.37
$20.12
$26.02
$11.95
$19.80
$25.70
PERCENT CHANGE
1991 to 1996
-9.3
-3.6
-7.8
0.4
0.1
LESS THAN
HIGH SCHOOL
HIGH SCHOOL
SOME
COLLEGE
COLLEGE
COLLEGE
ADVANCED
DEGREE
1991
1992
$7.22
$9.34
$9.32
$11.08
$14.59
$19.22
$7.51
$10.80
$15.06
$19.14
1993
$7.50
$9.32
$S0.83
1994
$7.48
$9.39
$10.71
$15.07
$15.27
$19.46
$20.70
1995
1996
$7.19
$6.69
$9.21
$10.50
$15.28
$20.12
$9.12
$10.53
$15.08
$20.27
PERCENT CHANGE
1991 to 1996
-7.3
-24
-5.0
34
5.5
FEMALE WORKERS
Wages for men at all educational levels either dropped slightly or stagnated during the recovery
period. Wages for women without a college degree declined as well. Women with college and
advanced degrees were the only group to experience a sizable increase in wages during the
recovery (3 to 5 percent). Weak income performance for workers without higher degrees is a
result of many factors, including employers' increased demand for specialized highly-skilled
employees, and reduced demand for semiskilled manufacturing employees.
-8-
229
Summary of Effects by Income Groupand Phase
The 1990s expansion was experienced differently across income groups. In the first 6 years of
the expansion. 80 percent of the population experienced positive but very small increases in their
income' - roughly, between I and 4 percent. Only the highest income group experienced a
substantial increase (7.5 percent ),while the top 5 percent did best of all (19.3 percent increase).
Table 3 presents annual mean income by quintile for 1991 to 1996 and percent changes over
time.
TABLE 3: MEAN INCOME BY QUINTILE AND PERCENT CHANGE,
1991 TO 1996
Lowest
QuintiIe
Second
Quintile
Third
Quintile
Fourth
Quintile
Highest
Qulntile
Top
5 percent
Mean
Median
1991
58,387
$20.907
534,729
552,942
$107,412
S168,732
543,685
834,706
1992
1993
1994
1995
1996
$8,150
58,048
$8,218
58,597
58,596
$20,332
$20,257
520,353
520,999
521,097
5 S52,584
534.25
552,769
$33,956
853,353
534,286
535,113
853,977
554,922
$35,486
$107.800
$109,942
$112,164
$112 642
8115,514
$172.230
$188.697
8193,789
5194,404
5201.220
543,435
544,983
545,665
546,265
547.123
34,261
833,922
U4,158
535,082
$35,492
Percent Change
1991 to 1998
Percent Change
1991 to 1993
Pereent Change
1993 to 1996
2.7
0.9
2.2
3.7
7.5
19.3
7.9
2.3
-3.8
-3.1
-2.2
-0.3
2.4
11.8
3.0
-2.3
6.8
4.1
45
4.1
5.1
6.6
4.8
4.6
Most notably, the recovery resulted in very different income profiles during its two phases.
During the Bush recovery of 1991 to 1993, the 4 lower income quintiles showed slight income
losses (-0.3 percent to -3.8 percent ). Even the highest quintile showed only amodest 2.4
percent increase in income. Only the top 5percent of the population benefitted substantially,
with an almost 12 percenv increase over the 3-year period.
It would seem that 1993 was a pivotal year, thereafter, incomes in all groups were on thp rise.
Between 1993 and 199, mean income rose 4 to 7 percent across the five quintiles, an average
incrase, of 4.6 percent It is important to note that it took until 1995 for the lower 3 quintiles to
surpass Wheir1991 income levels. Figure 3 presents the percentage change in income for each
quintile , uring the 2 phases of the recovery.
-9-
230
FIGURE 3: CHANGES IN HOUSEHOLD INCOME BY QUINTILE
DURING THE BUSH AND CLINTON RECOVERIES
Percentage Change In
MeanIncome
Lowest
Quintile
Second
Quintile
*1991-1996
01993-1996
_31991-1993
Third
Ouinilet
Fourth
Quintite
Highest
Quintile
Top
5%
-5%
0%
5%
10%
15%
20%
25%
Interestingly, the lowest and the highest income groups experienced the largest income changes.
The top 5 percent income group, as noted above, enjoyed an overall increase of 19.3 percent
over the 6 year period, much of which came from the large increase in 1992 to 1993 (9.6 percent).
The lowest income group experienced the largest losses during the Bush recovery (-3.8 percent),
and the largest gains during the Clinton recovery (6.8 percent ). The middle quintiles, on the
other hand, experienced more moderate results each year, with gains and losses of roughly I
percent annually.
A more detailed description follows for each quintile, focusing on educational backgrounds and
trends in wages and other sources of income.
Effects by Income Group
Low-Income Households
In 1996, low-income households had a mean income of $8,596. (See Table 3.) The upper limit of
$14,768 in household income for this group is below the poverty threshold of $16,036 for a
household of four persons.
-10-
231
Wages earned by low-income households declined during the current expansion. Between 1991
and 1996, both men and women in the lower deciles of the wage distribution experienced declines
in real wages (see Figure 2 and Table 1). The current minimum wage of $5.15 an hour yields only
$10,300 annually, which is $2,341 below the 1996 poverty threshold for a family of one adult and
two children, and $515 below the poverty level for one adult and one child. As noted, this lowest
income group experienced the sharpest decline in income during the Bush recovery (-3.8 percent)
and the largest increase (6.8 percent ) during the Clinton recovery. There is no single reason to
explain this pattem.
The low and low-middle income groups include a large proportion of people who are
unemployed, on welfare, and/or recipients of Food Stamps. The impact of wage stagnation on
these two quintile can be seen in the large number of people receiving Food Stamps and living
below the poverty line. Figure 4 presents key poverty indicators during the 1990s recovery: 36.5
million Americans were living in poverty in 1996 and 25.5 million people received Food Stamps.
FIGURE 4: FOOD STAMP PROGRAM PARTICIPANTS, UNEMPLOYED PERSONS
AND POOR PERSONS, 1991 TO 1996
Millions
40
PERSONS
INPOVERTY
30
-
-
~~~25Mi3
FOODSTAMPREOPiD4TS
20
10
W
_211.
_
1
1-
1914
19#1
UNEMPLOYED
PERON
1991
1#12
199
1595
Low-income individuals who receive welfare payments -- which are not indexed to inflation -- saw
their buying power substantially erode during the recovery. Between 1991 and 1995, average
monthly benefits per family declined 13.1 percent in real 1995 dollars (The Green Book 1996).
The one bright spot for this income group is the decline in unemployment. So many new jobs
were created in the current expansion that the number of people on welfare began declining even
before the implementation of the welfare reform measures (Council of Economic Advisors, 1997).
- I-
232
Since 1991, unemployment has continued to decline steadily, reaching the lowest levels in more
than a generation. Indeed, higher employment levels and an increase in the average number of
hours worked are the primary reasons for the net gain in income, despite stagnating wages, by the
low-income group.
Low-Middle Income Households
Households in the low-middle income group had an annual income between $14,769 and $27,760
in 1996 and an average income of $21,097. Male earners in these households had wages that
mostly fell in the third, fourth, and fifth deciles ($7.08-$ 11.85 per hour) and female earners fell in
the third to sixth deciles ($5.94-$ 10.72). Male workers in these deciles were hard hit during the
1991 to 1996 period, with wage cuts of about 5 percent. Female workers in the third to sixth
deciles had essentially stagnant wages during the recovery.
Most men and women in the low-middle income group have a high school education or less. A
small portion of the women have attended college. As Table 2 shows, hourly wages of men with
less than a high school education declined 9.3 percent, or $.91, on average between 1991 and
1996.
Middle-Income Households
Income levels for the middle group of households have stagnated during the expansion. Mean
income in 1996 was $35,486, and actual income ranged from $27,761 to $44,006. Male workers
in this group of households were concentrated at or above the middle of the pay distribution, but
none were in the top 10 percent. Their wages range from about $10 to $20. The men in these
households were primarily high school and college graduates. Female workers were concentrated
in the fourth to seventh deciles of wages, on average earning from $6.95 to $12.64 per hour. The
women were mostly high school graduates, some attended college or and some had a college
degree. Between 1991 and 1996, the wages of men in this group dropped 2 to 5.7 percent, and
the wages of women remained about constant.
Despite the rapid and large increase in stock prices during the course of the current expansion,
stock holdings of the middle-income group have not increased significantly. Half of all families
with incomes between $25,000 and $50,000 owned stock either directly or indirectly through
retirement accounts, such as 401 (k) plans, but their median holdings were only $8,000 (Kennickell
et al., 1997). This amount of holdings does not provide enough dividends or capital gains to
significantly supplement earnings.
Most homeowners have more equity in their home than any other asset. Nationally, average home
values have kept just slightly above inflation. Between 1991 and 1997, the real median sale price
of existing homes averaged a gain of 0.7 percent per year, or 0.85 percent at a compounded rate.
Even computed as a return on a 20 percent downpayment, this equates to a 4.3 percent annual
return -- better than a passbook savings account but worse than the stock market.
-12-
233
Upper-Middle Income Households
The upper-middle group ranged in income from $44,007 to $68,015, with a mean income of
$54,922. Working men in these households were in the top 20 percent of wage earners with
hourly earnings of$16 or more. Men's wages in the top 20 percent of the distribution declined
slightly during the expansion. Working women in this group were in the top 50 percent of
earners and had hourly wages in 1996 from about $9 and above. They had at least some college
and possibly an advanced degree, while the men usually had a college degree or an advanced
college degree.
Wages for men in this group declined slightly since 1991. and wages for women were about the
same or better than at the recovery's start. Upper-middle class workers are among the highest
paid in the economy and have experienced very little wage decline, if any. They are the
beneficiaries of the shift in employers' needs to highly-skilled technical workers. On average.
wages of all college graduates tend to be 1.67 times higher than wages of high-school-only
graduates. Wages of advanced degree holders are 2.2 times higher than wages of high-schoolonly graduates.
About half to two-thirds of this group owned stock, with holdings up to $40,000, although most
of those in the high end were elderly householders. Median stock holdings are below $20,000, an
amount that is starting to be significant for income generation.
High-Income Households
For the highest income quintile, household income started at $68,016 and had a mean of
$115,514 in 1996. Working men in this group were concentrated in the top 10 percent of earners
and working women were in the top 20 percent of women earners. Most of the members of this
group worked in highly-paid occupations, such as law, medicine, software systems engineering,
and industries, such as finance, computers, and communications. Income gains in the 1990s
expansion were asset-intensive, skill-intensive, and oriented towards proving economic
opportunities to women. This group was well-equipped to benefit from the expansion and did so.
The top 5 percent highest-income households fall within this quintile. In 1996, the lower limit
of the top 5 percent started at $119,540 and had a mean of $201,220.' In 1995, the median net
worth for the top 5 percent was about $500,000, and about $250,000 for those in the lower 15
6
percent of the high-income quintile. Median stock holdings were about $50,000 for the low end
and about $100,000 for the high end.'
Assets and stock holdings at this level accumulate significant amounts of income which may be
used to increase current consumption or saved for retirement and other uses. Moreover, the
return on stock holdings has been excellent in the 1990s. Between March 1, 1991 and December
1, 1997, Standard and Poor's 500 average rose 1.5 times, and the Dow Jones Industrial Average
-13-
234
rose 2.7 times. This rise in asset value is likely to widen the gap at retirement time between
income groups that accumulated stock-based savings in the 1990s and those that did not.
Extrapolatingto 1997
Household income data are currently only available through 1996. To address changes between
1996 and 1997, one source of comparable data is real per-capita personal disposable income -- a
measure based on aggregate economic activity which includes income that does not get
distributed to households. The two measures track each other rather closely. On average between
1991 and 1996, personal disposable income rose 1.4 percent while mean household income rose
1.5 percent. In 1997, disposable personal income rose by 2 percent. If the relationship between
the two income measures continues to hold, overall real mean income can be expected to have
increased by a healthy 2.1 percent in 1997. Since increases in the overall mean during the
expansion have been greater than or about equal to the means in the lower 4 quintiles, it is
reasonable to conclude that income of all groups will have grown by at least 2 percent in 1997,
thus posting another year of income growth during the Clinton recovery.
111. Public Policy Recommendations
Income gains during an economic expansion which result in widening the distribution of income
is unwelcome news. A widening income gap exacerbates the economic conditions of lowerincome groups, limits opportunities for upward mobility, and makes the American dream an
increasingly elusive concept for the majority of Americans. Given the nature of the current
recovery, policies may be needed to correct for the shifts in income distribution and boost the
income of lower income groups.
Three broad recommendations emerge. First. policies that are pro-expansionary, yet noninflationary should be maintained and expanded, where possible. Second, policies that shift
income to, and create opportunities for. individuals without a high school education continue to
be needed. And third, policies should be enacted to encourage the middle-income and lowmiddle income groups to save and invest more.
1. Pro-expansionarypolicies. The current expansion has thus far produced very gradual changes
in income for many Americans. GDP growth in 4 of the years between 1992 and 1997 has been
below the average postwar expansionary growth rate (3.1 percent). With such gradual
performance, it becomes difficult to spread the benefits of an economic expansion over the entire
population. Some workers have not yet experienced the benefits of the expansion or many more
have benefitted to a much lesser degree extent than others. Some industries, occupations, and
asset holders have prospered while others have not.
Although all income groups on average have probably met and exceeded their 1989 income
levels, the current recovery may need to extend a few more years in order to reach hard-pressed
households and depressed areas. Mayors across the country are just beginning to see
improvements in their poor neighborhoods.9 The continuing expansion has created labor
shortages in some locations. These shortages are difficult for business, but create dramatic
-14-
o
235
opportunities for workers to get advances in training and move into higher-paying jobs. This is
particularly true for high school graduates.
In order to enable the benefits of the expansion to flow to the least advantaged groups, the
Federal Reserve must exercise caution in tightening monetary policy. waiting for hard evidence
of inflation before making any moves. The Administration should promote growth by
encouraging investment, trade, and employment. Raising the minimum wage, and raising public
awareness of the availability of the Earned Income Tax Credit (EITC) could also help lowerincome households.
2. Creatingopportunities. As technological change permeates the work world, workers without
a college education will continue to experience a constant or growing earnings gap with their
college educated counterparts. Workers with some college or an associates degree generally have
less earning power than those with 4-year college degrees, and workers with less than a high
school education face the most severe earnings outlook.
Even modest changes to encourage completion of high school and college would be beneficial.
and the federal government has a good track record of sponsoring such programs. Education
policies aimed at expanding GED programs and college degree completions are possibly among
the most cost effective approaches. Both educational efforts can be handled at the state and local
levels through existing federal programs. Remote-site courses, computer-link courses. and
weekend and evening sessions give adults the flexibility to complete a diploma or a 4-year
college degree and still work and care for themselves and their families.
To expand opportunities for people with low income, special training vouchers could be issued
that provide training at the right time and in the right place. For example, local organizations
coordinating job training might be subsidized for training pre-qualified, low-income applicants
for specific job vacancies identified by employers. The option of providing relocation expenses
and services for welfare recipients who find jobs in other locations could also be revisited.
3. Saving and investment. Another way to increase national income in addition to job earnings is
to improve the quality and quantity of investment. Increased personal saving is an important
ingredient to increasing investment. At least one author strongly indicates that asset
accumulation is the way out of poverty (Sherraden, 1991). It can be encouraged even among the
lowest income groups and is effective at building wealth. One approach is embodied in the
Assets for Independence Act. The Act includes a demonstration program of dedicated savings
accounts for low-income families. Account funds would be matched by the federal government
in conjunction with a third party such as a non-profit community-based organization. Account
funds could only be used for purchasing homes, funding small businesses, or paying for postsecondary education.
In another approach, Senator Kerrey (D-NE) has proposed a universal child savings account.
Deposits into the account would begin at birth and could involve federal resources such as credits
and tax deferments. Such a savings account would start all children off with money in the
bank."
-15-
236
For the middle class, an effective strategy for building wealth through asset accumulation
involves regular purchases of a stock or a mutual fund. Such a strategy is equivalent to income
averaging, which allows investors to pay the average price for equities over time instead of
coming into the market all at once and taking on the added risk of purchasing at above-average
prices. Recently, Congressman Saxton (R-NJ), Chair of the Joint Economic Committee
recommended a $200 interest and dividend exclusion from adjusted gross taxable income for the
middle class and below. An exclusion of this nature. if properly promoted by the banking and
finance industry, could stimulate middle-income groups to start investing.
Acknowledgments: The author received insightful comments on earlier drafts from Laurence
Mishel. Howard Rosen, Kerry Sutten, and Frank Levy. Bettie Landauer-Menchik provided
statistical consultation on the tables and charts.
List of Figures &Tables
Figure 1:
Per Capita GDP and the Business Cycle, 1961-1997.
of the President. 1998.
Figure 2:
Changes in Hourly Wages for Men and Women by Wage Deciles, 1991-1996.
Source: Current Population Survey, Bureau of the Census; analysis by Economic
Policy Institute.
Figure 3:
Changes in Household Income by Quintile During the Bush and Clinton
Recoveries. Source: Current Population Survey, Bureau of the Census.
Figure 4:
Poverty, Food Stamp Recipients, and Unemployment, 1991-1996. Source:
Bureau of the Census, Food an Nutrition Services, US Department of Agriculture,
and Bureau of Labor Statistics.
Table I
Hourly Wage by Top of Decile, 1991-1996. Note: All numbers are 1996 Dollars;
data are adjusted for inflation using the CPI-U XI deflator. Data source:
Economic Policy Institute analysis of US Bureau of the Census, Durrent
Population Survey data.
Table 2
Average Hourly Wages of Men and Women by Educational Levels, 1991-1996.
Data are in 1996 dollars and are adjusted for inflation using the CPI-U-XI
deflator; source is the Economic Policy Institute analysis of US bureau of the
Census Current Population Survey data.
Table 3
Mean Income by Quintile and Percent Change, 1991-1996. Data are in 1996
dollars and are adjusted for inflation using the CPI-U-XI deflator; source is the
-16-
Source: Economic Report
237
Economic Policy institute analysis of US bureau of the Census Currcnt Population
Survey data.
Table 4
Average Quarterly Changes in Per Capita GDP During Recent Recoveries
-17-
238
NOTES
1.
1961 is used as the starting point for this analysis because some of the statistics used
cannot properly be applied to earlier periods.
2.
The quintiles were constructed using 1996 income data. The figures are in 1996 constant
dollars which permits comparisons across time excluding price inflation.
3.
Although there are 10 deciles. the tenth decile is open-ended. Table I displays only the
nine lower categories.
4.
Although median income is a better measure of central tendency for the entire income
distribution. the mean is appropriate in the four bounded income groups, and for
comparative purposes the mean is also used in the high-income group.
5.
This mean income figure may be skewed upward somewhat by a small group of
.superstars in certain high-paying white-collar occupations and in the sports and
entertainment industries (Frank and Cook, 1995). For example. a lawyer's median
weekly salary, excluding the self-employed, was $1,149 in 1996. but superstar lawyers
earned $1 to $3 million per year.
6.
For comparison purposes. the median net worth for the middle-income group was
$55,000 in 1995. These are estimates interpolated from data in Kennickell et al., 1997.
7.
Based on linear interpolation of data in Kennickell et al.. 1997.
8.
Discussion at the U.S. Conference of Mayors, February 1998. Washington. DC.
REFERENCES
Council of Economic Advisors, 'Explaining the Decline in Welfare Receipt, 1993-1996,"
Council of Economic Advisors, Washington. D.C., 1997.
Frank, R.H. and Cook. P.J, The Winner Take All Society, The Free Press, New York, 1995.
The Green Boot,Ways and Means Committee, United States House of Representatives, United
States Government Printing Office, 1996.
Kennickell, A.B., M. Starr-McClure, and A.E. Sunden, 'Family Finances in the U.S.: Recent
Evidence from the Survey of Consumer Finances," FederalReserve Bulletin, Vol. 83, No. I,
January 1997.
Makinen, G., 'The Current Economic Expansion: How Does It Compare With the Past?" CRS
Report for Congress, No 96-577, 1996.
Sherraden, P. Asselsfor the Poor, M.E. Sharpe, Armonk, New York 1991.
-18-
Working Paper Series
offered to the
JOINT ECONOMIC COMMITTEE
MINORITY
UNITED STATES CONGRESS
Senator Jeff Bingaman, Ranking Democrat
I
* The Impact of MismeasuredInflation
on Wage Growth
Dean Baker
September 1998
This series of papers, offered to the
Democratic members of the Joint Economic Committee,
addresses the major economic issues related to raising
living standards for American workers and their families.
241
The Impact of Mismeasured Inflation
On Wage Growth
Dean Baker
Executive Summary
Recent calls for adjusting the consumer price index (CPI) downward, as recommended by the
Boskin Commission, could have a significant impact on federal spending and income taxes. A
subject less well studied is the potential effect of a CPI adjustment on wages and living standards.
This analysis set out to determine if errors in the government's measurement of inflation in the
past have actually affected the path of wage growth in the economy.
A situation that offers some insights occurred during the inflationary period of 1967-1982.
During that time, an important component of the CPI -- the rate of inflation in owner-occupied
housing -- was calculated erroneously by the government, resulting in a significantly higher overall
inflation rate than was actually the case. The problem was fixed in 1983 and a more accurate CPI
was recalculated for the previous years. As a result, it is possible to examine whether wages
followed the official CPI reported during that period or the truer, lower measure of inflation.
This paper analyzes inflation and wages using several types of Phillips Curve regressions. Results
of the analysis strongly suggest that the error in the measurement of inflation in this period had a
direct impact on wage growth. Wages appear to change in step with the CPI, regardless of
whether it is accurate. In the context of the current debate, if the CPI is adjusted downward to
show a lower measured rate of inflation, then wages are likely to grow more slowly than they
would have otherwise. This point is independent of whether or not the CPI is actually overstated.
A downward adjustment in the CPI, as recommended by the Boskin Commission, would lower
nominal wage growth by approximately 1.1 percentage points annually. If the Commission is
right, this would still allow for real wage growth, where wage growth exceeds the true rate of
inflation. However, if the Commission is wrong, a 1.I percentage point reduction in wage growth
would cause real wages to fall unnecessarily.
These results caution against making any changes in the CPI that are not clearly warranted by
empirical evidence. Even if changes to the CPI are warranted, their expected impacts should be
well publicized so that workers and firms can incorporate this information when they set wage
targets. Otherwise, there is a significant risk that lowering the CPI will lead to lower real wages
for most workers.
Page I
242
I.
Introduction
Recently the accuracy of the consumer price index (CPI) has been called into question. Critics
have charged that the CPI has historically been running above the true level of inflation. The
Boskin Commission, for example, reported to Congress that the CPI is currently overstated by 1.I
percentage points annually (Senate Finance Committee, 1996). Most of the debate has focused on
the budgetary implications of an inaccurate rate of inflation. Since many federal spending
programs and the income tax brackets are indexed to the CPI, a lowering of the CPI would
reduce spending and raise tax revenues by several hundred billion dollars over the next ten years.
Changes to the CPrs measure of inflation could have other economic effects as well. For example,
if workers and firms look to the CPI as a measure of inflation when they bargain over wages, then
adjusting the CPI downward would have the effect of lowering wage growth for workers. This
could happen through contracts that explicitly specify that wages be adjusted in accordance with
increases in the CPI. More typically, it may be the result of union contracts that are negotiated
with the CPI serving as a target. These contracts then set a pattern for wages for the rest of the
economy. Under these circumstances, adjusting the CPI downward would generally lead to lower
wage increases for workers.
This paper examines whether errors in measuring inflation have actually affected the path of wage
growth in the economy. It does this by looking at the impact of an error that affected the CPI's
measure of inflation in the years from 1967 to 1982. During this period, the Bureau of Labor
Statistics (BLS) applied a methodology, which it now views as erroneous, for measuring the rate
of inflation in owner-occupied housing. This erroneous methodology had a significant impact onthe measured rate of inflation for the period from 1967 to 1982. In 1983, BLS adopted a new
methodology, which virtually all economists now agree is a better procedure, and recalculated
what the rate of inflation would have been over this period using the current methodology. Since
there is a significant gap between the official CPI reported from 1967 to 1982 and the current
method (called CPI-UX I), it is possible to go back and examine which measure seemed to have
more impact on the movement in wages.
If the official CPI seems to have had more impact on wages, it implies that wages are affected by
the reported rate of inflation, whether or not it is accurate. If the more accurate CPI-UXI seems
to have had more impact on wages, then it would imply that wages. generally follow the actual
rate of inflation, and are not affected by an erroneous measure published by the government.
The experience from this period should provide some basis for determining if wage growth would
be affected by proposed adjustments to the CPI. If it turns out that wages primarily follow the
official CPL then any downward adjustments in the CPI would likely lead to lower wage growth.
Alternatively, if it turns out that wages primarily follow the CPI-UXI, then wage growth would
likely not be affected by any changes in the measure of inflation.
Page 2
243
This paper has four parts. The first part examines the relationship between wage growth and
inflation. The second part describes a set of statistical tests that examine whether wages followed
an erroneous measure of inflation in the period from 1967 to 1982. The third part discusses some
of the implications of these statistical tests. The fourth part is a summary and conclusion.
II.
Wages and Inflation
According to economic theory, workers should care about inflation because they are concerned
about real wages. That is, they care about what their wage income will actually buy. To determine
how much their wages can buy at different points in time, workers need some measure of
inflation. This permits a comparison of the purchasing power of different nominal wage rates.
For example, a worker earning $11 an hour in 1996 is somewhat worse off than a worker who
earned $10 an hour in 1990, because, according to the CPI, inflation through this period increased
consumer prices by 20 percent. This means that a worker would need to be earning $12 an hour in
1996 to be able to buy as much as a worker who earned $10 an hour in 1990.
But how do workers know what the true rate of inflation is, and therefore what prices and wages
should be set at? Workers may be generally aware of a rise in the price of the goods they
purchase, but the rate of increase in these prices will vary considerably across workers depending
on their specific consumption patterns. Also, a considerable portion of expenditures go to
occasional purchases of large durable goods. For example, a worker's perception of the rate of
increase in car prices might vary considerably depending on the last time she bought a car. In
addition, it may be hard for workers to distinguish between paying more for a product due to
quality improvements, and paying a higher price for a product of identical quality. For these
reasons, and others, it would be hard for a worker to have direct knowledge of the true rate of
inflation in consumer products.
It might then be expected that workers would rely on official measures of inflation published by
the government to determine whether they are better or worse off at different points in time, or to
decide whether a specific nominal wage was reasonable. Similarly, unions would use the
government's measure of inflation to set targets for nominal wages in their wage negotiations.
In fact, nominal wages have tracked at least one measured rate of inflation fairly closely. Figure I
shows the annual change in average hourly compensation (wages and benefits) and the rate of
inflation as measured by the GDP price index. This index is used by the Commerce Department to
measure inflation throughout the economy, not just in consumer goods and services. It is used
here to avoid some of the complications in the CPI discussed below.
As can be seen in Figure 1, the two lines generally move together. During the sixties, annual rates
of inflation and compensation growth both rose as inflation increased through the decade.
Page 3
244
Compensation consistently exceeded inflation through this period, as workers saw rapid
improvements in their living standards. (The extent to which the compensation line is above
the
inflation line is the increase in real compensation.) This was possible because of rapid productivity
growth in the U.S. economy.
FIGURE 1: INFLATION AND COMPENSATION GROWTH
a
e
0C
-Average
hourly
compensation
Er
r.
By
- - *-GPinflator
0
1960
1965
1970
1975
1980
1985
1990
1995
The 1970s saw further rises in both annual rates of inflation and compensation growth, as oil price
shocks pushed the inflation rate higher. The gap between the growth in average compensation
and
inflation was smaller during this decade than in the sixties because of slower productivity growth.
In the eighties and nineties, the rates of inflation and annual compensation growth have both fallen
considerably. At the same time, the two lines moved even closer together (even crossing in several
years) as improvements in real wages slowed further. This slower improvement in living standards
is due to continued declines in productivity growth and a redistribution from wages to profit over
the last decade. This redistribution has meant that workers' compensation has not kept pace with
overall productivity growth.'
Page 4
245
Figure I shows that inflation and compensation growth generally move very closely together
although productivity growth and the distribution of profits and wages can cause the curves to
converge or diverge. If wages generally track the rate of inflation, the next question is whether
wages specifically track the CPI. If so, what happens to wage growth if the CPI is adjusted? The
next section investigates the impact on wage growth of a wrongly calibrated CPI between 1967
and 1982.
m.
Testing the Impact of Mismeasured Inflation
In 1983, the Bureau of Labor Statistics (BLS) changed the way it treated owner-occupied
housing in the CPI. Prior to 1983, the CPI measured the rate of inflation in owner-occupied
housing by tracking the cost of buying a new home. This meant measuring the prices at which
homes were sold, and also the cost of other aspects of home purchases, such as mortgage interest
rates or closing fees. Virtually all economists agree that this was an incorrect procedure. A home
purchase is in part an investment, not just a consumption expenditure.' As a result of the near
consensus on this point among in-house and outside economists, a decision was made to change
the treatment of owner-occupied housing in the CPI. Beginning in January of 1983, the CPI
included an estimate of the cost of renting owner-occupied housing. This new category, which
replaced the earlier category of home ownership costs, was called "owner-equivalent rent." It
was intended to focus on the consumption aspect of home ownership, but to exclude costs that
result from purchasing a home as an investment.
After BLS made this change it decided to go back and recalculate prior years' inflation using its
new owner-equivalent rent measure. It did this to produce a consistent, and presumably more
accurate, measure of inflation to be used by researchers and policy analysts. This new index, the
CPI-UXI, was recalculated back to 1967.3 It was during the period from 1967 to 1982 that the
difference between the two measures was important. The rapid rise in housing prices and
mortgage interest rates in this period caused the home ownership measure to rise much more
rapidly than the owner-equivalent rent measure. Because housing expenditures of homeowners
are such an important part of total consumption (and therefore have a large weight in the CPI),
the difference between these measures had a substantial impact on the overall CPI. The
cumulative difference over the 16-year period between the inflation rate recorded by the original
CPI and the recalculated CPI-UXI was 10.4 percentage points, an average of 0.7 percentage
points annually.
The gap between these two measures of the rate of inflation provides for a natural experiment,
where it is possible to test which measure of inflation had more of an impact on wage growth at
the time. Two separate sets of tests that make use of Phillips Curve regressions were run to
determine whether wages followed more closely the official CPI that was in effect during the
1967-1982 period or the CPI-UX I. (Both sets of tests are described more fully in the Appendix.)
Phillips Curve regressions are one of the most commonly used tools by macroeconomists. The
Page 5
246
Congressional Budget Office and other government agencies, as well as private sector
economists, routinely use them to forecast inflation. The regressions used in this analysis follow
closely the methodology used by the Congressional Budget Office.
The first set of tests used standard Phillips Curve regressions to examine the relationship between
inflation and unemployment. 4 These regressions seek to explain the current rate of inflation as a
function of the inflation rate in the recent past, and current and recent rates of unemployment. The
second set of tests involved wage Phillips Curve regressions. These regressions seek to explain
current wage growth as a function of the inflation rate in the recent past, and current and recent
rates of unemployment.
The standard Phillips Curve regressions can be seen as a way of measuring the impact of
mismeasured inflation on wages indirectly. They examine the change in the rate of inflation, which
is presumably largely determined by changes in the rate of wage growth, which are then passed on
to prices. The wage Phillips Curves should pick up the effect of mismeasured inflation on wages
directly.
In both sets of tests, the CPI-UXI was used as the measure of past inflation. A separate variable,
"ERRX1," was then added to the tests. This variable is equal to the difference between the CPIUXI rate of inflation and the rate of inflation reported by the official CPI. Since most economists
now view the CPI-UXI as the correct measure of inflation for this period, ERRXI represents the
error in the officially reported rate of inflation for each quarter.
The tests were set up so that if only the true rate of inflation, as measured by the CPI-UX I,
affected inflation or wage growth, the ERRXI variable would have no explanatory power in these
regressions. That is, there should be no relationship between the size of ERRXI in a given
quarter (and its size in the recent past) and the change in the rate of inflation or rate of wage
growth. These changes should be fully explained by the other variables included in the tests.
The results, however, show that in both sets of regressions, the ERRXI terms have substantial
explanatory power. In Table I of the Appendix, the sum of the coefficients of the lagged ERRXI
terms in the 8th row (the lags give the value of the ERRXI variable for the recent past) is large
and highly significant statistically. In one of the three regressions, it is significant at the 5 percent
level, which means that this relationship would not have appeared by random chance more than
one in twenty times. In the other two regressions the coefficients are significant at the one percent
level, which means that the relationship would not have occurred by random chance more than
one time in a hundred. The reason for running the regression in three different forms is to reduce
the likelihood that some quirk in the data is generating these results. The tests here provide solid
evidence that the error in the CPI over this period had a real impact on the actual inflation rate the
economy experienced.
The wage Phillips Curve regressions clearly indicate that the basis of this effect was the impact of
the error on wages. The results of these regressions are presented in Table 2 in the Appendix.
Page 6
247
Again the regressions show large coefficients on the lagged values of ERRXI term. The sums of
these lagged terms are all close to one (see row 7), which suggests that the error in the CPI was
fully passed on in the form of more rapid wage growth. These coefficients are also highly
significant statistically. In two of the three regressions they are significant at the one percent level,
in the third they are significant at the five percent level.
In short, the two sets of Phillips Curve regressions discussed here provide solid statistical
evidence that the error in the CPI from 1967 to 1982 had a substantial impact on wage growth
and may have been passed on completely in the form of higher wages. The standard Phillips Curve
regressions provide evidence for this impact indirectly, by indicating that errors in the measure of
inflation affected the actual rate of inflation. The wage Phillips Curves provide more direct
evidence by showing that the errors in the measure of inflation directly affected the rate of wage
growth.
IV.
Implications
The most immediate and important implication of these tests is that wages appear to change in
step with official measures of inflation, regardless of whether or not these measures are accurate.
The tests imply that workers and firms accept the CPI as a measure of inflation and use it as a
basis for setting wages over time. This means that changes to the CPI that alter the way it
measures inflation are likely to have an impact on wage growth. In the context of the current
debate, if the CPI is adjusted downward to show a lower measured rate of inflation, then wages
are likely to grow more slowly than they would have otherwise. This point is independent of
whether or not the CPI is actually overstated, as some economists have claimed.
This last point is worth emphasizing. If the Boskin Commission is correct in concluding that the
CPI is currently overstated by 1.1 percentage points annually, and if the CPI is adjusted
downward to correct for this overstatement, then wages in the future would rise by approximately
1.1 percentage points less each year than would otherwise be the case. Wage agreements would
tend to follow the new lower measure of inflation shown by the adjusted CPI.
However, the economy could clearly support a more rapid rate of wage growth, as it is presently
doing. Again, if the Boskin Commission is correct, then the gap between the growth in average
compensation and the true inflation rate is 1.I percentage points more than is indicated by the CPI
at present. This means that productivity growth has been understated (it is approximately 1.1
percent higher than current data show), and that real wages have been increasing by 1.1
percentage points more than the current CPI indicates.5 Real wages could continue to increase at
the same rate as they have been, i.e., by 1.1 percentage points more relative to the new
"corrected" CPL than to the current CPI. Adjusting the CPI would lower real wage growth to a
considerably slower rate than the economy can sustain.
Page 7
248
If the Boskin Commission is wrong, the effect of making a downward adjustment would be
exactly the same in terms of slowing the rate of real wage growth. However, in this case, the
"corrected" CPI would actually be understating the true rate of inflation by 1.I percentage points
annually, and real wages would be expected to decline in coming years.
The possible impact of adjusting the CPI on wage growth is no reason to maintain an inaccurate
CPI. But it should provide grounds for caution in making changes that are not clearly warranted
by the evidence. It also indicates the importance of widely publicizing the expected impact of any
changes in the CPI. If average wages are rising 1.0 percentage point annually against the current
CPI, then they should be rising 2.1 percentage points annually against a Boskin Commissionadjusted CPI. Any lower rate of increase would imply a redistribution from workers to
corporations.
Rethinking NAIRU
There are two other areas where the findings of these tests have important implications. The first
is in the theory of a non-accelerating inflation rate of unemployment (NAIRU). In the last two
decades, macroeconomists have generally believed that the economy had a NAIRU -- a level of
unemployment below which the economy could not fall without causing inflation to accelerate.
Usually this unemployment rate was placed at 6.0 percent. (Recently, though, the NAIRU has
been lowered since the unemployment rate has been below 6.0 percent for close to four years, and
the inflation rate has declined during this period.) Many members of the Federal Reserve Board's
open market committee have used some version of the NAIRU theory to guide their actions on
interest rates.
Much of the statistical support for the NAIRU theory depends on the economy's behavior in the
period from 1967 to 1983. This period includes the largest sustained inflation of the post-war era.
The inflation is usually explained by the oil shocks and by an analysis that implies that the
economy was below its NAIRU for much of this period. However, Eisner (1997) has already
provided a serious basis for questioning whether low rates of unemployment actually lead to
accelerating inflation. His results suggest an asymmetric relationship between inflation and
unemployment. In examining the post-war period, he found that high rates of unemployment lead
to lower rates of inflation, but that low rates of unemployment do not lead to higher rates of
inflation.
If the error in the CPI measure of inflation was an important contributor to the acceleration of
inflation during the 1967-1982 period, it would further undermine the traditional NAIRU view. It
would mean that there is even less evidence that low unemployment rates lead to higher inflation
rates and that the Fed need not fear further declines in the unemployment rate. It would be worth
further examining the evidence for an asymmetric relationship between inflation and
unemployment with the inclusion of a variable for the error in the inflation measure over this
period.
Page 8
249
Capital/LaborDistribution
The other area where these findings could have significant implications is the distribution of
income between capital and labor. During the 1967-1982 period, there was a very large
redistribution of corporate income from capital to labor. In 1966, the capital share of corporate
GDP (profits plus interest) was 18.8 percent. In 1978, the peak profit year of the late seventies,
the corporate share had dropped to 14.2 percent. This share declined further to 10.8 percent in
1982, although the recession was a major factor in this further drop-off since profits always
decline during recessions. There has never been a widely accepted explanation for this large shift
6
in income shares. (In recent years, the capital share has risen again, to 16.9 percent in 1996).
A partial explanation of the shift from capital to labor over this period could be that wage
bargains were guided by a mismeasured CPI. A third set of tests was used to examine the
relationship between the CPI error and changes in income shares. The results of these tests,
shown in Table 3, are less conclusive than the earlier sets. The sum of the coefficients of the
ERRXI term is generally close to 0.1, which suggests that the 10.4 percentage cumulative error
in the CPI might have led to a I.0 percentage point increase in the labor share of income over this
period. (This would mean about $450 a year at present to an average worker.) However, these
coefficients are not statistically significant, which suggests they may just reflect random factors in
the data.
While it is disappointing that these tests do not provide more conclusive results, perhaps this
should not be surprising. The earlier tests indicated that the errors in the CPI were passed on in
the form of higher wages, which in turn are assumed to have been largely passed on in the form of
higher prices. The fact that profit shares fell during this period implies that the wage increases
were not fully passed along in higher prices. It is reasonable to believe that firms might have
originally tried to pass along higher wage costs fully, but then were forced to lower their prices by
cutting back on profit margins. This process may have occurred at a very uneven pace, since the
economy was subject to oil shocks and several other unusual jolts during this period. For this
reason, the relationship between the error in the CPI and the redistribution from capital to labor
may not be as simple as the one tested in the regressions discussed here. This relationship clearly
needs to be researched further.
It is also worth noting that between 1994 and 1996 there was a shift in income shares from labor
to capital of nearly a full percentage point. This shift cannot be explained by cyclical factors, since
capacity utilization rates actually fell slightly over this period and the unemployment rate has been
nearly constant. On the other hand, roughly during this same period, BLS has made several recent
changes in its procedures which have lowered the CPI relative to the true inflation rate in the
economy. In January 1995, BLS changed its procedures for measuring the rate of inflation in
generic drugs. It also changed the way it aggregated price data for shelter and for food consumed
at home. In June 1996 it changed its procedures for aggregating other prices. The net effect of
these changes would be to lower the measured rate of inflation in the CPI by approximately 0.25
percentage points annually relative to the true rate of inflation. These changes in the CPI are not
Page 9
250
large enough to fully explain the shift in income shares the economy has experienced since 1994,
but they may well have been a significant factor in this shift.
V.
Conclusion
This paper has examined the possibility that a mismeasured index of inflation can have real
consequences for workers and the economy. It found evidence that the substantial overstatement
in the official consumer price index used from 1967 to 1982 had a significant impact on wage
growth. The evidence suggests that this error may explain part of the acceleration of inflation over
this period as well as the large shift in shares of corporate income from capital to labor.
The results in this paper should be seen as preliminary. The period under investigation was an
extraordinary one. It includes the Vietnam War, the Nixon era wage-price controls, and both
OPEC oil shocks. There were many erratic jumps in wages and prices throughout this sixteenyear period. Further analysis is needed before it can be determined conclusively that the error in
the measurement of inflation during this period had a real impact on wage growth and the
economy. However, the results presented in this paper do provide preliminary evidence for this
conclusion.
These results also caution against making any changes in the CPI that are not clearly warranted by
empirical evidence. They imply that these changes will affect the actual path of wage growth. If
changes to the CPI are warranted, their expected impacts should be well publicized so that
workers and firms can incorporate this information when they set wage targets. Otherwise, there
is a significant risk that lowering the CPI will lead to lower real wages for most workers.
Page 10
251
NOTES
I
It is important to recognize that this graph shows average hourly compensation. Real
average hourly compensation has continued to grow, although very slowly in recent years.
However, average compensation provides no information about the distribution among
workers. Median hourly compensation, the compensation received by a worker in the
middle of the wage distribution, has fallen over most of the last decade and a half.
2
For a discussion of the issues around the change in the treatment of owner-occupied
housing in the CPI see Gillingham and Lane, 1982.
3
Baker (1996) shows that the differing treatment of owner-occupied housing in the period
prior to 1967 would have little impact on the CPI measure of inflation.
4
The original Phillips Curve described a relationship between rates of wage growth and
unemployment discovered by A.W. Phillips in 1958. However, it has become standard to
refer to the relationship between inflation and unemployment as the "Phillips Curve."
5
The understatement in productivity growth will not be exactly the same as the
overstatement in the CPI. Productivity is usually given for the business sector as a whole
which includes investment goods and a somewhat different consumption basket than
appears in the CPI. However, consumption does constitute the bulk of business sector
output, and many of the criticisms directed against the CPI have also been raised in the
context of investment goods (see Gordon, 1990), so the assumption that any
overstatement in the CPI is the same as the understatement in productivity growth should
provide a reasonable approximation.
6
Nordhaus (1974) suggests that the decline in capital shares in the first portion of this
period may have been attributable to the failure of firms to fully appreciate the impact of
the inflation of the late sixties on the replacement cost of their capital. According to this
view, they failed to increase their mark-ups enough to cover the higher replacement costs
they would eventually face. It is worth noting that this view implies a mistaken response to
inflation that is believed to be accurately reported, rather than failing to recognize the
inaccuracy of official inflation numbers.
7
These changes are discussed in Armknecht, Moulton, and Stewart (1995) and BLS
(1996).
Page II
H.Rept. 105-807 -98 - 9
252
REFERENCES
Armknecht, P.A., B.R. Moulton, and K.J. Stewart. 1995. "Improvements to the Food at Home,
Shelter, and Prescription Drugs Index in the U.S. Consumer Price Index." BLS Working Paper #
263. Washington, D.C.: Bureau of Labor Statistics.
Baker, D. 1996. Getting Prices Right: A Methodologically Consistent Consumer Price Index,
1953-94. Washington; D.C.: Economic Policy Institute.
Bureau of Labor Statistics, 1996. "Extending the Improvements in the CPI Sample Rotation
Procedures and Improving the Procedures for Substitute Items." BLS Press Release. Washington,
D.C.: Bureau of Labor Statistics.
Congressional Budget Office. 1994. The Economic and Budget Outlook: An Update.
Washington, D.C.: Congressional Budget Office.
Eisner, R. 1997. "A New View of the Nairu," in Improving the Global Economy: Keynesianism
and the Growth in Output and Employment, edited by P. Davidson and J. Kregel. Brookfield,
Vermont: Edward Elgar Publishers.
Gordon, R. 1990. The Measurement of Durable Goods Prices. Chicago: University of Chicago
Press.
Gillingham, R. and W. Lane, 1982. "Changing the Treatment of Shelter Costs for Homeowners in
the CPI." Monthly LaborReview, June.
Nordhaus, W.D. 1974. "The Falling Share of Profits." Brooking Paperson Economic Activity #1,
pp. 169-208.
Senate Finance Committee. 1996. Toward a More Accurate Measure of the Cost ofLiving. Final
Report to the Senate Finance Committee from the Advisory Commission to Study the Consumer
Price Index. Washington, D.C.: U.S. Senate.
Page 12
253
APPENDIX
Standard Phillips Curve Regressions
The first set of tests of the impact of the erroneous measure of inflation in the 1967-1982 period
includes the error as an explanatory variable in a standard Phillips Curve regression. The model is
essentially identical to the Phillips Curve regressions used by the Congressional Budget Office to
determine NAIRU (CBO 1994) with the addition of a variable that includes the gap between CPIU measure of inflation and the CPI-UXI measure of inflation, lagged over four quarters:
(1) In, = C + EbIN,4 + Eb,U, + b3FAE,., +bPRD, + b,NIXON, + bNIXOFF, +Eb7 ERR,, + e,
where In, = inflation at time t,
C is a constant,
N= the sum of the coefficients on 16 lagged quarters of inflation,
EbIN,
E bU,, = the sum of the coefficients on current and lagged unemployment rates, with the
lags going back eight quarters,
bFAE,., = the coefficient of the difference in the previous quarter between food and
energy inflation, and the general rate of increase of consumer prices,
bPRD, = the coefficient for the gap between productivity growth in the current period and
the trend rate of productivity growth,
b,NIXON, = the coefficient for a dummy variable for the period where wage price controls
were in effect in the early 1970s,
b6 NIXOFF, = the coefficient for a dummy variable associated with the period immediately
after the removal of wage price controls in 1974,
E b7ERR, = the sum of the coefficients on the difference between the CPI-U measure of
inflation and the CPI-UXI measure of inflation, lagged four quarters, and
e, = an error term.
The regression was run for the years 1960 to 1995. The measure of inflation used as the
dependent variable was both the chain-weighted GDP price index and the GDP deflator. Both of
these measures of inflation use the owner-equivalent rent measure for owner-occupied housing
and therefore should not have been affected by the error in the CPI in the 1967-82 period.
Page 13
254
If the erroneous measure of inflation had no impact during this period, the sum of the coefficients
of the ERR term should be close to zero. The impact of actual past rates of inflation on the
current rate of inflation should be fully picked up the lagged values of the inflation measure. There
should be no relationship between the size of the error in the reported CPI and the current rate of
inflation. Alternatively, if the error in the official measure of inflation is passed on fully in current
inflation, then the sum of the coefficients should be one.
Table I shows the results of these regressions. The dependent variable in the first column is the
annualized inflation rate as measured by the GDP chain-weighted price index. The dependent
variable in second column is the annualized inflation rate as measured by the GDP deflator. The
third column shows the results of a regression that used the rate of inflation as measured by the
CPI-UXI as the dependent variable. The sum of the coefficients of the ERR term is barely
affected by the choice of deflator. In all three cases, it is highly significant. Also, in all three
regressions, the sum of the coefficients is close enough to I so that the hypothesis that the sum is
equal to I cannot be rejected at standard levels of significance.
Wage Phillips Curves
Another way to test for the impact of mismeasured inflation is to construct a wage Phillips curve,
where the dependent variable is the rate of increase in the nominal wage, rather than the price
level. The model tested was:
(2) Dwage, = C + btrendpr, + Eb.XINF, + EbU,, + bNIXON, + bNIXOFF, +EbERR,, + e,
where C = a constant
btrendpr,, = trend productivity growth at time
EbXJN, i = the sum of the coefficients on 16 lagged quarters of inflation as measured by
the CPIU-XI,
2 bU,j = the sum of the coefficients on current and lagged unemployment rates, with the
lags going back four or eight quarters,
b4NIXON, = the coefficient for a dummy variable for the period where wage price controls
were in effect in the early 1970s,
b5NIXOFF, = the coefficient for a dummy variable associated with the period immediately
after the removal of wage price controls in 1974,
E b6 ERR,, = the sum of the coefficients on the difference between the CPI-U measure of
inflation and the CPI-UX I measure of inflation, lagged four quarters, and
e, = an error term.
Page 14
255
The regressions were run for the years 1964 to 1995. The measure of wage change used as the
dependent variable was the average hourly compensation series from the Bureau of Labor
Statistics' Productivity and Costs data. As with the price Phillips Curve, if wages are only affected
by actual inflation and not mismeasured inflation, the impact of past inflation on wages should be
fully picked up by the lagged XINF terms. The sum of the coefficients of the ERRXI term should
be close to zero. Altematively, if the mismeasured inflation has the same impact as actual
inflation, then the sum of ERRXI terms should be close to the sum of the coefficients of the
XINF terms.
Table 2 presents the results from these regressions. The first column shows the results from- a
regression using 16 lagged quarter lags of inflation as measured by the CPI-UXI and eight lagged
quarters of the unemployment variable. The second column shows the result of an identical
regression except the sum of the coefficients of the lagged inflation variable was constrained to
equal one. The third column shows the results of a regression that included only four lagged
quarters of inflation. In all three cases the sum of the coefficients on the lagged ERR term is close
to one and highly significant. This suggests that the error in the reported rate of inflation was
passed on completely in the form of higher wages.
Capital and Labor Shares
There was a very large redistribution of shares of corporate income during the 1967-1982 period
from capital to labor. A third set of tests was performed to determine the extent to which the
mismeasured inflation rate may have been a factor in this redistribution. In these tests, the change
in the labor compensation share of corporate GDP was the dependent variable.
The model tested was:
(3) Dlabsh, = C +Eb,U,j + +EbERR, + e,
where Dlabsh is the change in the labor share as measured by compensation divided by gross
domestic corporate product in the national income product accounts,
C is a constant,
2 bU, = the sum of the coefficients on current and lagged unemployment rates, and
E, b2 ERR,., = the sum of the coefficients on the difference between the CPI-U measure of
inflation and the CPI-UXI measure of inflation, lagged eight quarters.
Table 3 gives the results of this set of tests. The first column shows the results of a regression for
the period from 1962 through 1995 using four lagged quarters of the unemployment variable. The
second column gives the result of a regression that covers the same time period using eight lagged
quarters of the unemployment variable. The third column gives the result of a regression that
covers the more narrow period from 1967 through 1983 when the CPI error would have been a
Page 15
256
factor. As can be seen, the sum of the coefficients on the ERR term are positive (row 3) and
economically important, but fall short of standard levels of statistical significance.
Page 16
257
Table 1
Standard Phillips Curve Regressions
Dependent Variable
GDP- chain
price index
GDP deflator
CPI-UX1
Constant
3.31
(5.81) ...
3.13
(5.44)*-'
2.81
(3-55)---
Lagged Inflation'
1.00
1.00
1.00
Food and Energy Inflation'
0.15
(2.66) ..
0.11
(1.51)
0.33
(3A 6)...
Productivity Deviation'
-0.05
(1.80)1
0.00
(0.16)
--
On,
.1.07
(1.83)'
-0.95
(1.61)
-1.37
(1.56)
Off'
3.46
(7.31)-..
3.07
(6.24)..
1.66
(2.15)"-
Lagged Unemployment'
-0.57
(6.15) ..
-0.54
(5.77)'..
-0.48
(3.73)...
ERRXI '
0.70
(3.51)'"*
0.85
2.09
129
0.69
(3.44) ..
0.85
1.96
129
0.78
(2.41)"
0.94
1.88
127
R-Bar Squared
DW
Observations
t-statistics in parenthesis
I significant at .10 level - significant at 0.05 level
- significant at 0.01 level
a) Inflation is lagged 16 quarters and is constrained to follow a third degree polynomial distributed lag with the far end
point restricted to zero. The sum of the lags is restricted to equal 1.
b) Food and energy inflation is the difference in the inflation rate between the overall CPIU and the core CPIU, lagged
one quarter.
c) Productivity deviation is the difference between trend productivity growth and actual productivity growth for the
quarter, as calculated by the Congressional Budget Office (CBO).
d)On isadtummy variable for the five quarters from 1971:3to 1972:3. Following CBO's methodology, it is assigned a
value of 0.8 for these quarters.
e) Off is a dummy variable for end of wage price controls. Following CBO, it equals 0.4 in 1974:2 and 1975: 1, and 1.6
in 1974:3 and 1974:4.
f) The unemployment rate variable is the current rate and eight lagged quarters.
g) ERRXI is the difference between the CPIU measure of the rate of inflation and the CPI-UXI measure of the rate of
inflation, lagged four quarters.
Page 17
258
Table 2
Wage Phillips Curve Regressions
Dependent Variable
Average Hourly
Compensation
Average Hourly
Compensation
Average Hourly
Compensation
Constant
5.45
(4.84)---
5.23
(4.87)-..
1.17
(1.15)
Lagged Inflation
1.07
1.00
0.76
(9.81) ...
Trend Productivity Growth
b
(8.58)*1
0.57
-(3.35) ...
0.59
(3.44)---.
0.90
(4.72)...
On'
1.70
(2.41) ...
1.70
(2.41)*-
1.89
(2.29)--
Off'
2.43
(3.74)---
2.51
(3.92) ..
0.73
(1.12)
Lagged Unemployment'
-I.10
(5.97)---.
-1.02
(7.19)---.
-0.24
(1.84)-
ERRXI'
1.24
(2.98)--0.76
2.02
127
1.43
(4.70) ..
0.76
2.01
127
0.88
(2.5l)0.66
1.56
127
R-Bar Squared
DW
Observations
,-statisfcs in parenthesis
*significant at .10 level *significant
at 0.05 level -- significant at 0.01 lievel
a) Inflation is as measured by the CPI-UXI lagged 16 quarters and is constrained to follow a third degree polynomial
distributed lag with the far end point restricted to zero. In the first regression the sum of the lags is not restricted to equal
1, while in the second it is restricted to equal I. The third regression includes only four lagged quarters of the CPI-UXI.
b) Trend productivity is the trend for rate of growth for each business cycle, as calculated by the Congressional Budget
Office (CBO).
c) On is a dummy variable for the five quarters from 1971:3 to 1972:3.
d) Off is a dummy variable for end of wage price controls for the four quarters from 1974:2 to 1975:1.
e) The unemployment rate variable is the current rate and eight lagged quarters in the first regression. In the second
regression it is the current rate with four lagged quarters .
f) ERRXI is the difference between the CPIU measure of the rate of inflation and the CPI-UXI measure of the rate of
inflation, lagged eight quarters.
Page 18
Working Paper Series
offered to the
JOINT ECONOMIC COMMITTEE
MINORITY
UNITED STATES CONGRESS
Senator Jeff Bingaman, Ranking Democrat
Technology andEconomic Growth:
A Review for Policymakers
Kenan PatrickJarboe
February1998
This series of papers, offered to the
Democratic members of the Joint Economic Committee,
addresses the major economic issues related to raising
living standards for American workers and their families.
260
Technology and Economic Growth:
A Review for Policymakers
Kenan Patrick Jarboe
February 1998
261
Technology and Economic Growth:
A Review for Policymakers
EXECUTIVE SUMMARY
It is generally accepted as a given, both within the economics profession and the public at
large, that technology is a key factor in economic growth. However, once that simple sentence is
examined more carefully, the view is much more complex.
There is a general consensus among economists that the level of output is a function of a
number of inputs: capital (K - land, plant and equipment), labor (L- number of workers and hours
worked), human capital (H -the skills of the work force) and technologyAlnowledgetinnovation (A originally the residual, now "total factor productivity"). There is also general agreement as to the
relative magnitude of total factor productivity.
However, there is an ongoing debate as to how to treat technology and knowledge in the
models:
*
*
*
*
Is it an independent variable?
Is it embodied in capital goods or in worker skills?
If it is embodied in capital goods or human capital, is it still an independent factor?
Is it a factor that augments the other factors?
Traditional growth accounting treats "'A" as an external factor. Endogenous growth theory
postulates that R&D and knowledge is the result of intentional activity and is therefore a function
of economic incentives.
From the point of view of analyzing technology policy, neither of these macroeconomic
modjls fuly captures the innovation process with its complex dynamics and interrelations.
Traditional growth accounting appears to be "science-push," while new growth theory is "marketpull." Going beyond the process of innovation, there are questions as to how the various factors
interrelate, what is the difference between knowledge, technology and innovation, and whether and
how to include other intangible factors such as organizational and managerial capabilities.
All of the models suffer from conceptual and measurement difficulties. A-better
understanding is needed of the institutional framework - both that which allows for economic
growth and that which fosters innovation and technological development - and on the dynamics of
i
262
the innovation process. In this regard, further exploration of alternative economic models, such as
evolutionary economics, may be a promising direction for future research.
On the micro-economic side, there is general agreement that investment in formal research
and development (R&D) generates a significant private rate ofreturn (that which the company doing
the R&D can hope to gain) and an even higher social rate of return (including the benefit to other
companies and to society as a whole). Accompanying the high social rate of return is a high level
of spillover from R&D activities. Research cannot be fully controlled by firms and the knowledge
produced can be used by others. Beyond simply intra-industry spillovers (from one firm in the same
industry to another firm), research also indicates a significate spillover of technology between
industries and nations.
The differential between the private and social rates of return is generally taken as evidence
of a market failure (less than socially optimal investment by market forces alone) requiring
government investment in R&D. Estimates of the rate ofunderinvestment are significant Spillovers
and market structure effects may also contribute to market failures and the need for government
investment in R&D.
However, federally-funded research is generally hard to analyze using rates-of-return
techniques because of the multiple (and non-economic) goals of most government programs. In this
regard, public project evaluation techniques might benefit from an exploration of how the private
sector evaluates R&D opportunities. Of particular importance is the role of the government in the
process of diffusion and adoption - as opposed to a focus solely on the direct funding of technology
development activities. A promising approach may lie in the use of detailed case studies. Such case
studies could lead to a better understanding of the technological development process and of how
and where investment (public or private) can gain the best leverage.
In addition to technical and conceptual problems at both the macro and micro level, there is
also a general agreement as to problems with the data, especially in measuring R&D spending.
These include concerns over the quality of the data, the issue of price indices, and the correct
depreciation rate for R&D. Questions are raised as to whether R&D spending captures the right
inputs. Most economists would agree that formal R&D is only one important input; learning-bydoing is equally important To overcome some of the data difficulties, some researchers have turned
to scientific indicators and bibliometric approaches - patents and citations. These approaches'are,
however, fraught with their own problems.
From the perspective of a policy analyst much of the debate can seem to be abstract and
technical. However, the models developed and the issues raised can be useful in the development
of technology policy, trade policy and intellectual property law, among other areas. For example,
the models can be useful in determining how best to structure technology policy programs. The
research on international technological spillovers is especially significant for technology policies
relating to foreign participation, direct foreign investment and international technological
cooperation. Likewise, the debate over the economic nature of knowledge (i.e. is it fundamentally
different from other commodities? and if so, how?) has profound ramifications for intellectual
property policies.
ii
263
One of the more interesting policy questions concerns productivity growth resulting from
new technologies. As of yet, the impacts of new technologies, especially computer and information
technologies, have not shown up in the productivity data. Recent research shows that they may only
now be beginning to have a measurable effect. If true, the current estimates of the economy's noninflationary growth potential may need to be re-evaluated - with significant consequences for
monetary policy.
In conclusion, a great amount of useful work has been done over the past decade on the
issues of economic growth and the rate of return of investment in technology - leading to the
following generally agreed upon facts:
*
*
*
technology, innovationand knowledge are importantfactorsin economic growth:
there is a significantprivate returnon R&D investment atthefirm and industry level
- and an even greatersocialreturn on investment; and,
there is a positive socialvalue of raisingthe level of investment in technology and
knowledge creation over that determined by the market.
However, many unanswered questions remain and much research still must be done before
existing economic studies, macro and micro, can provide detailed assistance to policymakers in the
quest for technological-driven economic growth. How factors of growth interact, what incentives
are useful to spur on the innovation process, and the role and nature of technology spillovers are all
areas where further economic research can provide insights to policymakers.
From the perspective of a policy analyst, the fiuture research agenda should pursue a goal of
better understand the dynamics of the innovation process. Rather than get bogged down in the
specific outcomes of the theoretical models and rate-of-return analysis, policymakers should search
for insights in the discussion of the nature of technology and analysts and theorists should strive for
a better understanding of "knowledge" and the innovation process.
iii
265
Technology and Economic Growth:
A Review for Policymakers
Kenan Patrick Jarboe
Februay 1998
INTRODUCTION
This paper presents an overview of research on the economic impacts of technology.
Specifically, the review focuses on two areas of analysis: macroeconomic growth theory and the
contribution of technologyllmowledge/innovation to economic growth; and studies of the rate of
return on investments in technology. It is not the purpose of this paper to present a comprehensive
survey of the economics literature or of what economics can tell us about technological change. Nor
is it to offer an in-depth, technical critique of the research. Rather, this paper is meant to give an
overview of these two areas ofresearch - macro and micro - with special attention to the relevance
of the studies to public policy issues. The review raises questions about the research and suggests
future directions with an emphasis on issues confronting policymakers.
The paper is divided into four sections. The first section reviews macroeconomic growth
theory, including traditional growth accounting and the new endogenous growth theory. The next
section looks at microeconomic studies, specifically studies on the rates of return to investment in
technology. The third section discusses the public policy implications of these studies. The paper
concludes with suggestions for directions for future research.
266
MACROECONOMICS:
GROWTH THEORY - OLD, NEW AND FUTURE
Modem macroeconomic growth theory has its beginnings with the growth accounting studies
of Solow (1957), Abramovitz (1956), Kendrick (1957, 1961), Denison (1962), and others. While
these studies are based on concepts and ideas of earlier economists, their contribution was the
determination of the relative contribution of capital (K - physical capital in the form of land,
buildings and equipment) and labor (L - the number and hours of people working) to the level of
economic output Surprisingly, they found that the traditional inputs of capital and labor
accumulation contributed relatively little. Solow (1957) described the residual-what was left over
after accounting for capital and labor - as "technical advances." The term was originally not meant
to imply "technology," but was used to describe any change that caused the production function to
shift - thereby increasing the growth potential above the rates of capital and labor accumulation.
GROWTH ACCOUNTING
Ever since these path-breaking studies, economists have been seeking to better understand
this "residual" in order to reduce what Abramovitz (1956, 1993) called the "measure of our
ignorance." As a result, "growth accounting" models include a factor for this "residual" generally
called "total factor productivity" (A), which in some models becomes "technology" or knowledge."
Some models also add human capital (H), which accounts for improvement in worker skills and
knowledge. Some even include the contribution to growth from increased economies of scale.
Despite all of the research on growth accounting over the past 40 years, studies appear to
disagree over the amount of growth in total output explained by the various factors. Jorgenson
(1996) finds that 83 per=t of economic growth can be explained by capital and labor accumulation.
Technological change and fertility rates explain the remaining 17 percent. On the other hand, Boskin
and Lau (1992) came up with an estimate of 49 percent for the contribution of technical progress.
This apparently wide difference in the figures may, however, overstate the true difference
between the models. Boskin and Lau (1992) calculated the contribution of the traditional factors of
labor and capital to growth and the size of the residual ("technical progress") from a number of
studies (see Table 1). They also modified the calculations by removing any adjustments to the data
for quality improvements made by the original authors, since some studies include the quality
improvement of capital goods in the contribution of capital to the level of economic output. This
change greatly alters the conclusion of some studies. For example, the contribution of technical
progress in Jorgenson, et aL (1 987) jumps from the original 24 percent to 69 percent without quality
adjustments.
2
267
TABLE 1
IMPUTED CONTRIBUTIONS OF THE DIFFERENT SOURCES OF GROWTH
(in percent without quality adjustments)
&udy
nrme
Capital
Lahor
TEC7
Scale
Rgress
Perind
Abramovitz (1956)
1869-1953
22
33
48
Solow (1957)
1909-1949
21
24
51
Kendrick (1961)
1889-1953
21
34
44
1909-1929
26
(26)
15
(15)
32
(54)
16
(54)
33
(10)
58.
(20)
10
(10)
12
(12)
9
(9)
Denison (1962)
with quality adjustment
1929-1957
with quality adjustment
Denison (1967)
with quality adjustment
1950-1962
25
(25)
19
(34)
47
(32)
Kuznets (1971)
1889-1929
1929-1957
1950-1962
34
8
25
32
14
19
34
78
56
Jorgenson/Griliches (1972)
with quality adjustment
1950-1962
40
(49)
8
(21)
51
(30)
Kendrick (1973)
1948-1966
21
24
56
Denison (1979)
with quality adjustment
1929-1976
15
(15)
26
(46)
50
(30)
9
(9)
Denison (1985)
with quality adjustment
1929-1982
19
(19)
26
(46)
46
(26)
9
(9)
Jorgenson, et al.(1987)
with quality adjustment
1948-1979
12
(47)
20
(30)
69
(24)
Boskin and Lan (I1M), Table 2.2. Note: pmpaegs
mny not sa to 100%/due to appraimatin erl
Much of the remaining variation in the findin of these studies can be attributed to
methodological differences. The studies use different types of aggregate real output as a measure
of growth. real net national product; reia private nonfarm gross net product; real national income;
real gross private domestic product real gross national product; and, real aggregated value added.
Thus, there is generalagreement among the studies as to the relative contribution of "technical
progress" once methodological differencs, such as in how to incorporatefactorssuch as quality
changes, are removed
3
H.Rept. 105-807 - 98 - 10
268
However, it must be noted that not all economists agree as to the relative importance of
technical progress in all cases. For instance, Krugman (1994) argues, based on work by Lau and
Kim (1993, 1994) and Young (1992, 1994a, 1994b), that Asian growth rates are not due to technical
progress but mainly due to significant increases in inputs ofphysical and human capital - contrary
to generally accepted understanding.
ENDOGENOUS GROWTH THEORY
In the past decade or so, a new variation which conceptualizes the model very differently has
emerged. Called either "new growth theory" or "endogenous growth theory," these models
reformulate the growth equation so that knowledge and technology is not treated as an exogenous
or outside activity (see Romer, 1990; Grossman and Helpman, 1991). Under traditional growth
accounting, technical progress is taken as a given. In the endogenous growth theory, technological
advance is seen as the result of intentional activities by economic actors; the production of
knowledge is a function of the economic rate of return. This "knowledge capital" is selfperpetuating and, therefore, economic growth is continuous with no need for constant boosts from
outside (exogenous) "technical change."
According to its proponents, endogenous growth theory is not interested in measuring the
size of the residual but in explaining the process. For example, Grossman (1996) argues that growth
accounting techniques cannot explain growth because they are accounting techniques, not structural
models.
New growth theory also stresses the difference between "knowledge" and other forms of
capital. Previously, knowledge was assumed to be a pure public. good that moves freely. New
growth theory assumes that technology/knowledge varies in terms of both rivalry (ability of more
than one person to use the economic good at the same time - a non-rival good is one that can be
used by more than one person at a time, such as a software program) and excludability (the ability
of someone to prevent others from using the economic good). As a result, there are spillovers from
knowledge, unlike from other commodities (an assumption that follows from the microeconomic
studies of rates of return - see next section).
It is the existence of spillovers that makes the accumulation of knowledge self-perpetuating.
As Grossman and Helpman (1991) explain:
In the neoclassical models of capital accumulation, growth often peters out unless exogenous
productivity gains preserve the incentives for investment. By contrast, investment incentives
in the economies we study are endogenously maintained by technological spillovers. These
spillovers allow successive generations ofresearchers to achieve technological breakthroughs
using fewer resources than their predecessors. The resulting declines in the real cost of
invention counteract any tendency for profits to fall. In short, the process of knowledge
accumulation generates endogenously the productivity gains that sustain growth in the long
run. (p. 336)
4
269
These endogenous growth models come in numerous variations. Grossman and Helpma.(1994), Amable (1994), and McCallum (1996) provide some overviews of the literature; Fagerberg
(1994) presents a useful discussion of the how both growth accounting and new growth theory
wrestle with the question of differing growth rates among nations. In an especially interesting
version, Young (1993) has extended the models in an attempt to incorporate both formal R&D and
informal learning-by-doing.
Not all economists accept these formulations of the growth model. Mankiw, David Romer,
and Weil (1992), Islam (1995), and Jorgenson (1996) argue that modifications to the traditional neoclassical model do a better job of explaining the empirical evidence as to the difference in growth
rates among nations. Jones (1995a) proposes a "semi-endogenous" R&D-based model, in keeping
with his findings (Jones, 1995b) that endogenous R&D models are not supported by the evidence.
INTERACTION AMONG FACTORS
At the heart of the debate over the models is the question of how to treat technologyknowledge-innovation. Is it an independent variable? Is it embodied in capital goods or in worker
skills? If it is embodied in capital goods or human capital, is it still an independent factor? Or is it
a factor that augments the other factors?
It would be misleading, however, to assume that the debate over how to treat the various
factors for modeling purposes gives policymakers much guidance as to the importance of the various
factors for spurring growth. Simply because some models treat technology as embodied in capital
does not mean that the most important policy lever for spurring growth is capital formation and/or
the saving rate. Nor does the fact that some models treat technology as exogenous mean that the
development of technology is outside of the influence of government.
It should also be noted that the use of percentage contributions, as shown in Table 1, can be
misleading for policy discussion. Such percentages do not indicate the total contribution of a factor
to the level of economic output - and thus, the factor's importance to economic growth. For
example, a healthy growth rate in total factor productivity (TFP) may appear as a small contribution
to the total level of output when labor and capital are also growing at a fast rate - such as in a
rapidly growing developing nation. The same TFP growth rate may appear as a larger contribution
when labor and capital accumulation is smaller - such as in a more mature economy. This does not
mean that TFP is less important in the former case and more important in the latter.'
In part, this is also a debate as to how to model the interactions among all factors of growth.
As Abramovitz (1993) puts it: "surely there can be few economists who do not sense that there are
two-way connections between technological progress, economies of scale, tangible capital
I I am gitrdbl to Kennth Anow for this obseration. Person cmm
5
December 15, 1997.
270
accumulation, and human and other intangible capital accumulation." (p. 221) Yet, most models
continue to struggle with these interactions.
It can hardly be denied that technology and other "intangible" factors (i.e., factors that cannot
be seen or measured directly) are inherently wrapped up in other factors. As Abramovitz (1993)
states:
... the compensations of both "capital" and "labor" now contain elements properly attributed
to intangible capital. On one hand, intangible capital in the form of education and training
is embodied in labor, and the return to that capital forms a large part of "labor's" earnings.
On the other side, accumulations of intangible capital in the form of knowledge acquired by
R&D and in the form of business capability acquired by investment in the corporate
structures of management and administration and in market development yield significant
parts of the compensation that our measures attribute to "capital." (p. 229-230)
But treating technology as simply part of either capital or labor would be a mistake. Such
a formulation misses the complex relationship between technology, capital and labor. As Boskin
and Lau (1996) states:
To take a simple example, the benefits of successful R&D in improved microprocessors to
the economy depend upon, among other things, the amount of tangible capital that can
benefit from better and faster microprocessors, the human capital necessary for people to be
able to use the computer, and other forms of technology, such as advanced software, that can
better utilize the capabilities of the better microprocessors. (p. 106)
From the point of view of a policy analyst, the task is to find and understand the levers of
economic growth. Simply knowing that capital includes new technology and that labor includes
worker skills and knowledge does not give guidance on how to boost growth. Nor does simply
knowing that technology is important Rather, it is important to understand the interaction between
increases in capital, labor, knowledge, and higher technological sophistication and utilization.
CHARACTERISTICS OF KNOWLEDGE
One very important set of insights can be gained from the debate over growth theories. Two
characteristics of knowledge in the new growth theory lead to a very special exploration of a role of
government. As mentioned earlier, new growth theory assumes that technology/knowledge can be
a non-rival good that can be used by more than one person at a time, but can be excludable so that
others can be prevented from using it. This combination of non-rival yet excludable creates,
according to the theorists, a tension between competition and intellectual property protection.
Market efficiency requires competition to ensure that prices are set at marginal cost. However,
according to this formulation, endogenous technological progress requires incentives, often in the
form of monopoly profits. Thus, in the new growth theory, how an economy manages this tension
is important in the growth mix.
6
271
The second characteristics ofknowledge is the spillover - both to other industries and within
the process of discovery. Those spillovers call for a government role because of the non-socialy
optimal level of investment that may be produced (see the discussion in the next section on
microeconomic studies). Note that according to some formulations of the model, it is possible to
have an overinvestment in R&D (Stokey, 1995). According to the proponents of new growth
theories, understanding the mechanisms of spillover will help design government policies to
maximize benefits (see Grossman and Helpman, 1994).
CAPTURING INNOVATION
Irnically, one of the problems with the new growth theory models is the result of exactly
what makes them different from traditional growth models - the endogenous nature of technology
development The models overstate the response of R&D to pure economic forces (i.e., profitability
of the investment). Many researchers have emphasized the role of uncertainty and serendipity in the
discovery process. According to Abramovitz (1993), the new growth theory is overly concerned
with the effect of capital accumulation on technological progress rather than on studying the entire
process of technological progress:
It is doubtlessly true that the terms on which capital is supplied has some, perhaps much,
influence on the direction as well as the pace of technological progress. But it may also
derive from an evolution of scientific and technological knowledge quite unrelated to the
terms of factor supply. There is still far too much that is poorly understood about the
influence of relative factor costs, about the evolution of science and technology, and about
the political and economic institutions and modes of organization on which the discovery or
acquisition of new knowledge depend. (p. 237)
Some claim that is there no evidence to support the new growth theory's claim about the
response of the research endeavor to incentives. Kortum (1996) argues, "not much evidence is
available about the true elasticity of technological change with respect to research effort A model
of endogenous R&D and exogenous technological change (in which the true elasticity is zero) is
surprisingly hard to reject." (p. 206) The question of how the research enterprise responds to
economic incentives is still an open issue - especially in the more non-commercial side of basic.
science (see Dasgupta and David, 1994, and Stephan, 1996, for an overview of research on the
economics of science).
Another basic problem with the existing endogenous models is their emphasis on formal
research as the driver of economic growth. By focusing only on formal R&D, the models capture
only part of the process. In some cases, the models seem to assume a trade off of research labor and
manufacturing labor- as discussed above. Yet, economists have long known about the complexities
of knowledge, including the importance of leaming-by-doing (Arrow, 1962, 1994)- that is, tacit
knowledge that accuwmulates only through experience. In the current era of rapid product innovation,
the manufacturing / R&D dichotomy (also known as the '1eaming-or-doing" approach) looks more
and more like an industrial era concept. Under new forms of organization, R&D activities and
7
272
manufacturing activities are necessary compliments (see Kenney and Florida, 1993). Thus, learningby-doing models may be more realistic than the leaning-or-doing formulations.
It is also unclear as to how the models - traditional growth accounting or endogenous growth
theory - differentiate between knowledge, technology and innovation. The difference is important
Endogenous growth theory asserts that knowledge is cumulative and does not depreciate. But,
technology - in which much of knowledge is embodied - does depreciate. Nor is it clear that "A"
encompasses just technology or whether it remains closer to the original definition of the residual
as any thing that moves the production function - "technical progress" or "total factor pruductivity'-and therefore includes other intangible factors such as organizational and managerial capabilities.
DATA ISSUES
In addition to technical and conceptual issues, studies of the impact of technology suffer from
data and measurement problems. One of the major data problems concerns the price deflator (see
Griliches, 1994, for a discussion of this problem). Since the price deflator is used to adjust for
quality improvement of products at the firm level, a small error in the price index will have a large
impact on the estimation of the contribution of R&D to productivity growth. As the problems
associated with finding the correct price index for rapidly changing computer technology has shown,
getting the deflators right is not a simple task. Other problems, as outlined by Griliches (1994)
include the inability to measure productivity generally in the economy as outputs shift into the
"unmeasurable" sectors such as government and services - and poorer data response from industry.
There is also a question as to the accuracy of R&D spending data. Changes in the R&D tax
credit may have caused finns to switch the classification of some activities between R&D and nonR&D expenditures. Questions have been raised as to whether accounting rules require company
R&D expenditures only above a certain dollar threshold, so that spending by smaller companies may
not show up (Scherer, 1992). Another problem is that R&D expenditures do not cover informal
research and "learning-by-doing" activities.
LmIMTATIONS OF THE MODELS
As a result of these weaknesses in the models, the public policy implications coming out of
new growth theory may be too strong in terms of the response of the R&D endeavor to economic
stimuli -just as the policy implications coming out ofthe traditional growth models underplay the
role of technology. As Grossman and Helpman (1994) readily admit, "we do not profess to
understand fully the determinants of technological progress." (p. 42) Discussing the problem of
relying on cross-country regressions of factors of growth, Mankiw (1995) concludes "(p)olicy
makers who want to promote growth would not go far wrong ignoring most of the vast literature
reporting growth regressions. Basic theory, shrewd observation, and common sense are surely more
reliable guides for policy." (pp. 307-308)
8
273
In the final analysis, none of the macroeconomic models to date have managed to capture the
true nature of the complexity of the innovation process. The traditional growth accounting models
are "science-push." They assume that innovation comes from advances in science. On the other
hand, endogenous growth models are "market-pull." They assume that demand, in the form of
economic incentives, will pull an innovation through the process.
Yet, as most researchers who study the innovation process know, both of these processes are
false as a sole description - and true in combination. The innovation process is a complex
relationship of market demand, scientific opportunities, serendipity and deliberative actions. Models
that focuson only apartoftheprocess are incomplete. Nelson(1994) sums it up whenrhe says:
While the new formal neoclassical growth theories do treat technological change in a richer
and more sophisticated way than did the earlier neoclassical theory, there is still a large gap
between the formal treatment in these recent papers and what economists studying
technology and technical change know. (p. 319)
THE NEXT AGENDA
Closing that gap between the formal growth models and the current-state-of-klowledge about
the innovation process is clearly the research agenda for the future. That is not an easy task. As
Solow (1994) states:
. .. there is an internal logic - or sometimes non-logic - to the advance of knowledge that
may be orthogonal to the economic logic. This is not to deny the partially endogenous
character of innovation but only to suggest that the 'production' of new technology may not
be a simple matter of inputs and outputs. I do not doubt that high financial returns to
successful innovation win divert resources into R&D. The hard part is to model that happens
then. (p. 52)
Going beyond the innovation process, further work is needed if the models are to be able to
adequately incorporate the complexities of the growth process. As Fuhrer and Little (1996) put it
in the summary to a recent conference on the subject:
It may be helpful to understand the input to production that is neither human or physical
capital not simply as "technology," but as an aggregate of the state of technology,
orgairfitinil and managerial ability, and "economic culture." These concepts are not easily
measured, but given the inability of relatively well-measured constructs to explain the
variation in productivity in disaggregated data, we must try to model and measure these
intangibles better if we are to understand significant differences in growth and productivity
over time and across countries. (p. 31)
9
274
North (1995, 1996) argues that the models need to incorporate a deeper understanding of
institutions:
Current theory stems from the development of national income and growth accounting
literature and explores the superficial aspects of economic growth - technology or human
or physical capital - rather than the structure of incentives and disincentives that make up
the institutional framework on an economy and polity. (1995, p. 2)
... a comprehensive understanding of economic performance through time requires a
melding of theories of institutional, demographic, and stock of knowledge changes in order
to have an overall approach to the issues. We have only begun to explore the interaction
between these three sources of economic performance but I believe we can go far in
developing useful models of the interaction between them not only in terms of institutions
providing the incentive structure for demographic and technological change but also in terms
of the ways in which demographic-and-stock-of-knowledge-perceived "imperatives" have
in turn shaped the change in institutions. (1996, p. 9)
One of the more interesting attempts to move beyond the problems with the existing
analytical framework is the evolutionary model of economic growth fueled by technical advances,
as originally described by Nelson and Winter (1982). Since then, attention to "evolutionary
economics" has expanded (see Nelson, 1995, and Witt, 1993, for surveys of the field). Based on
Schumpeter, these models look at the behavior of finms in developing and utilizing knowledge in
a search-and-leaming mode. Arthur (1994) offers another version of a mathematically formalized
model based on increasing, rather than decreasing, returns on investment.
As Nelson (1997) argues:
The basic issues behind the choice of models is whether one can comprehend technological
advance, or economic growth largely driven by technological advance, within a model that
assumes 'rational expectations' on the part of the actors, and moving equilibrium in the
system as a whole. I think it is absolutely clear that the answer is no.
He calls for a closer tie between "formal" theories of economic behavior and "appreciative" theory
(see Nelson and Winter, 1982).
Such alternative theories are not widely accepted within the economics profession. However,
from the point of view of a public policy analyst, these and other alternative models may be worth
exploring for policy insights.
10
275
MICROECONOMICS:
RETURNS ON INVESTMENT IN R&D
Beginning with the path brealing analysis by Griliches (1958), numerous studies have been
carried out on the return on investment in R&D. These studies calculate not only the private rate of
return (to those undertaking the research) but also the social rate of return based on the consumer
surplus created. Table 2 summarizes only a very few of the numerous studies.
TABLE 2
EXAMPLES OF PRIVATE AND SOCIAL RATES OF RETURN FROM PRIVATE R&D
(in percent)
zh*
Private
Pyiyate
nCRp,,r
Otial
Ratp nfRpterhn
Terleckyi (1974)
20 -30
50
Mansfield, et al. (1977)
25
56
Sveikauskas (1981)
7 - 25
50
Scherer(1982, 1984)
29-43
64- 147
Goto-Suzuki (1989)
26
80
Bernstein-Nadiri (1991)
15 -28
20 -110
Adapted from GOriiches (1992), Nadiri (1993), CEA (1995) and Mohnen (1996).
The range of outcomes in these and other studies can be explained by the differing
assumptions and data used. Although the methodology for calculating both private and social
returns on investment is relatively straightforward, it requires a number of assumptions and can
utilize a variety of estimating techniques. Mansfield, et al. (1977) aggregates across a set of case
studies; Terleckyi (1974) uses a technology flow approach based on the coefficients from the inputoutput tables to estimate the amount of 'borrowed" R&D; Bernstein and Nadiri (1991) use a cost
function approach. Differences also arise due to differing data sets (cross-section versus time-sies)
and units of analysis (product, firm or industry). As Griliches (1992) notes, "(t)he main set of issues
revolves around the question of how output is measured and whether the available measures actually
capture the contribution of R&D (diret or spilled-over), and how R&D 'capital' is to be constructed,
deflated and depreciated." (p. S33)
The methodology can also be used (as it was originally by Griliches, 1958) to study specific
technologies. Trajtenberg (1990) analyzed a specific technology, the CT Scanner, and finds a social
rate of return of 270 percent. In a study of information technology, Brynjolfsson and Hitt (1993)
11
276
find the social rate of return to be over 80 percent Table 3 summarizes a number of studies on
publicly-funded agricultural research (both technology specific and aggregate).
Regardless of their differences, these studies come to the same basic conclusions: there is
a significantprivate return on R&D investment at thefirmn and industry level - andan even greater
social return on investment.
TABLE 3
RATES OF RETURN FOR PUBLIC R&D IN AGRICULTURE
(in percent)
StudXv
CaHe
RaterfReturn
Griliches (1958)
Hybrid corn
35-40
Hybrid sorghum
20
Peterson (1967)
Poultry
21-25
Schmitz-Seckler (1970)
Tomato harvester
37-46
Griliches (1964)
Aggregate
35-40
Evenson (1968)
Aggregate
41-50
Knutson-Tweeten (1979)
Aggregate
28-47
Huffman-Evenson
Crops
45-62
Livestock
11-83
Aggregate
43-67
(1991)
(from Griliches,1992)
UNDERuIVESTMENT, MARKET FAILURE AND SPILLOvERS
The finding of high social rates of return is often used to bolster the positive role of
government in R&D finding. The large difference between the private rate of return (what a
company can hope to gain) and the overall social benefit indicates an underinvestment in R&D.
Assuming a conservative estimate of 30 percent for the rate of return on R&D, Jones and Williams
(1997) estimate that the optimal level of R&D investment is four times larger than current
investment That underinvestnent is taken as a market failure requiring a government response.
12
277
The reason for a higher social return on R&D investment is the incomplete appropriability
of the benefits of an innovation. In competitive markets, a firm cannot charge for all of the
improvement of a new product or process, since the older technology is still available. Thus, some
of the benefit flows to the consumer in the form of better quality/performance and/or lower price.
Another reason the social return is often higher than the private return is the spillover from
R&D activities to other firms. Since knowledge is a non-rival commodity (see earlier discussion of
new growth theory), it is very difficult for the producer to maintain a monopoly on the results of
R&D activities. Other companies utilize the research to improve their products and process at a
fraction of the cost of the original research. In addition to intra-industry spillovers (from one firm
in the same industry to another firm), research also indicates a significant spillover of technology
between industries. Such spillovers, both intra- and inter-industry, create a "free-rider" problem
whereby some gain freely from the effort of others. This adds to the disincentive to invest in R&D,
intensifYing the problem of under-investment - and hence the need for government action.
Tassey (1997) argues that market structure effects - not just the gap between social and
private rates of return - contribute to market failure. Market failure stems from uncertainty and
questions of appropriability and manifests in both technology and market-related risk. These
market-related risks are associated with the market structure, "either access to individual markets
or the efficiency by which several industries or markets interact to form supply chains." (p. 90) The
result is not*simply an under-investment in R&D, but a skewing of funding toward less risky, shortterm projects
Not only do companies and nations gain from these externalities, but the process of discovery
itself is enhanced. Researchers benefit from all previous known work on the subject Without this
process ofknowledge accumulation - sometimes referred to as "standing on the shoulders of giants"
- the process of scientific discovery would be severely limited. It is this cumulative effect that
allows knowledge to escape the fate of diminishing returns on investment, and thereby contribute
to self-sustained economic growth.
GOVERNMENT
R&D
When looking at what the government should do to maintain optimal investment in R&D,
specifically federally-funded R&D, the results of the studies are much more difficult to interpret
A number of studies of government contracted R&D (Griliches, 1980; Griliches and Lichtenberg,
1984; Lichtenberg and Siegel, 1991) show either zero or negative rates of return. Yet, other studies
conclude that government fiuding raises the productivity of private R&D (Link, 1981; Levy and
Terleckyi, 1982; Levin and Reiss, 1984; Mansfield and Switzer, 1984; Leyden and Link, 1991;
Toole, forthcoming). According to Hal (1996), these studies show that every dollar of federallyfunded R&D raises private R&D funding by 3 percent Mansfield (1991, 1992) finds that the return
on academic research - much of which is federally funded - to be an estimated 28 percent As
shown earlier in Table 3, studies of publicly-finded agricultural research indicate significant rates
of return.
13
278
As this range of results indicates, determining the rate of return for government programs is
fraught with difficulty (see Jaffe, 1998). The bulk of federal R&D spending is for non-economic,
mission-specific research, especially military and space. Since such mission-specific research does
not result directly in marketable new products and processes, the benefits are not easily captured in
the consumer surplus approach. The agricultural research, on the other hand, resulted in specific
market-relevant innovations. Another factor not captured in the studies is the role of government
programs in the diffusion and adoption of a new technology. As Bonus and Stowsky (1998) put it,
"(t)he historical experience strongly suggests that the US government's direct R&D sponsorship has
often been far less important for commercial success than its support to diffusion and use." (p. 51)
LIMITATIONS ON THE TECHNIQUE
Although useful in establishing the importance of research activities, the entire methodology
of calculating rates of return suffers from a number of problems. As Mansfield (1991) admits in his
study of academic research, "it is by no means a full or satisfactory solution to the long-standing and extraordinarily difficult - problem of evaluating the payoff to society from academic research."
(p. 11) Trajtenberg (1990) warns that his finding of a 270 percent social rate of return for the Cr
scanner should be taken "with a grain (or two) of salt" (p. 167)
To begin with, these approaches have the same technical estimation and data problems (e g.,
what deflator to use) as do the macroeconomic studies. In addition, as Hall (1996) points out, a
small change in the R&D depreciation estimate will have a large impact on the estimate of the rate
of return. On a conceptual level, rate-of-return studies suffer fron a narrowness of focus. They are
very sensitive as to what is included and excluded in the measurement of costs and benefits. As the
General Accounting Office (1997) points out, R&D spending is an indicator of the level of effort but
not a good indicator of the results of that effort (i.e., innovative success). Nor is formal R&D
spending the only important input into the innovation process (as discussed in the earlier section).
Additionally, attempts to look only at quantifiable returns on investment may overlook the many
non-monetary gains from research.
Because of the limitation of both the data and the methodology, return on investment studies
have only limited usefulness for specific public policy decisions regarding program evaluation and
incremental budgetary decisions. They tend to be studies of the total return on investment, not the
return on investment of an additional dollar of research. Nor are these rate-of-return studies an
analysis of the future potential of any particular research activity. As the Congressional Budget
Office (1993) reports, "(t)he type of research most likely to yield commercially valuable
breakthroughs in the future can best be determined not by economists who study historical data, but
by researchers and industrialists who study the state of technology." (p. 2)
In addition, as Tassey (1997) points out, when attempting to analyze macro-effects, such
studies,
encounter substantial difficulties in isolating the effects of the project on economic activity
occurring beyond the industry or market initially affected. . .. most individual R&D
14
279
projects and the resulting outcomes are sufficiently small that estimating the bottom-line
economic impacts for the target industry, let alone the whole economy, can be quite difficult.
(p. 206)
PATENTS AND BIBLOMETRIC STUDIES
To overcome some of the problems associated with rates of return studies, some researchers
have turned to other indicators of R&D activities (see Griliches, 1990). Jaffe uses patent data to
determine the spillovers of R&D spending (1986) and the benefits of university research (1989).
Jaffe, Trajtenberg and Henderson (1993) use a citation-weighted approach to patent data to look at
the geographical effect of spillovers. Narin, Hamilton and Olivastro (1995, 1997) tie research
references with patent data and finds a strong link between academic research and US-invented
patents. Acs, et aL (1992) replicates the Jaffe (1989) study of the impacts of university research
using the Small Business Administration's count of innovations as instead of patents. Using this
technique, they find an even larger impact of university research on corporate R&D.
Adams (1990, 1993) and Adams and Sviekauskas (1993) use a count of scientific articles,
weighted by the number of scientists in the field, to construct a measure of the "stock of scientific
knowledge." This research bolsters the findings of the traditional econometrics approaches that
academic research is a strong contributor to productivity growth. Interestingly, Adams finds a lag
of roughly 20 years between academic research and its effect on productivity - much longer than
in other studies. However, as Adams himself points out, this "stock of knowledge" approach can
be criticized on a number of grounds, such as the problem in the relative importance of a scientific
paper in different disciplines.
These techniques suffer from their own data problems. For example, changes in patent law
and the operations of the Patent Office have introduced biases in the data. As the General
Accounting Office (1997) points out, the use of patents varies across industries. There is a great
propensity to patent in some technological areas while others rely upon other ways of protecting their
intellectual property (e.g., trade secrets) or do not seek such protection at all. Nor do patents
distinguish between major breakthroughs and minor improvements. Likewise, bibliographic
measures, such as the number of citations, suffer from interdisciplinary comparisons. Some
disciplines publish fewer research papers than others for the same amount of research results. In
addition, there is a question as to whether measures such as the frequency of citation gives any
indication of the level of innovation.
DIFFICULTIS AND INSIGHTS
In part, the difficulties faced by all of these microeconomic studies are a result of the nature
of the research enterprise itseLf As was true with the macroeconomic studies, these microeconomic
techniques attempt to match an input (resources) with an output (papers, productivity). In doing so,
they fail to take into account the throughput. They look only at an outcome, either a specific
15
280
product/technology or an aggregate level of productivity or research, without adequately capturing
the process of innovation with its complex relationships and uncertainties.
Still, the insights gained from rates-of-return studies can be useful for public policy. Ratesof-return studies clearly indicate the positive social value of raising the level of investment in
technology and knowledge creation over that determined by the market In addition, such studies
are useful in program design, as will be discussed in the next section.
16
281
PUBLIC POLICY IMPLICATIONS:
WHY IT MATTERS
For policymakers and analysts, much of the debate summarized can seem to be abstract and
technical. Nonetheless, the issues raised can have profound implications for a number of policy
areas, such as technology policy, trade policy, intellectual property protection, monetary policy,
education and training, tax policy, and policy coordination.
TECHNOLOGY POLICY
Obviously, many of the findings of these economic studies are directly relevant to science
and technology policy. The macro and macroeconomicstudies reviewed above strongly show the
benefit of public investment in technology and knowledge creation due to increased economic
growth andsignificant social rates ofretun. These studies can also offer insights for policymakers
on the design and operation of technology programs and policies.
On the macro side, the models can be used to assess policy options. Bartelsman (1990) uses
an endogenous growth model to conclude that spending on R&D by the federal government
increases the growth rate of productivity at low levels of funding but federally-funded research
crowds out private research at higher levels by drawing away human capital resources from more
commercially-oriented activities, thereby leading to a decline in productivity. Grossman and
Helpman (1991) argue that policies that subsidize the sale of technology products could raise the
return to inventors but increase the cost ofthe innovation process by bidding up salaries of scientists
and engineers.
The results of the models must be viewed with caution, as they may be due to the models'
formulation. In the case of the two examples cited above, both models seem to assume a fixed
supply of human capital for R&D activities. They do not account for incentives drawing additional
labor into the research enterprise. Second, the Bartelsman model assumes that government research
only affects productivity indirectly through spillover (e.g., spin-offs from military research). While
both of these assumptions are plausible in part, they do not completely hold. The findings do,
however, raise interesting questions.
Based on these models, most economists are still reluctant to advocate specific programs of
technology assistance - even though most advanced (and many developing) nations have wellestablished R&D programs. The prevailing view among economists is summed up by Molmen
(1996) whenhe states that while we know that spillovers exist andare important, "we know too little
about how knowledge is created and transmitted to recommend a sectorial specialization in R&D."
(p. 57) But since spillovers are important, policy should concentrate on facilitating the transmission
and absorption of knowledge.
17
282
Romer (1990) argues that "(a)lthough all the research is embodied in capital goods, a subsidy
to physical capital accumulation may be a very poor substitute for direct subsidies that increase the
incentive to undertake research. In the absence of feasible policies that can remove the divergence
between the social and private returns to research, a second-best policy would be to subsidize the
accumulation of total human capital." (p. S99) Most economists would agree that such a policy
focused on education and increased skils is a clear path to economic growth, improved productivity
and reduced inequality.
Although the "second-best" policy of improving human capital is important in its own right.
it would be a mistake to simply revert to the notion of embodying technology in either capital and/or
labor. The goal should be the creation of those "feasible policies" - based on an understanding of
the innovation system - which increase the incentives to not only undertake R&D, but to utilize the
results of that R&D in a timely and meaningfal fashion.
The process of policy experimentation is key in using the models for insight As Romer
(1998) states:
Theoretical models .:. are not to the stage where they can give us much specific guidance
about. say, the optimal share of R&D in GDP or the best mechanism for government supporL
However, it has changed how we should think about the problem. Before, we started from
a presumption that strong property rights and market trading were the optimal institutions
for supporting economic activity. Departures from these institutions could be justified only
on specific grounds - external effects, income distribution, etc. What the theory of
endogenous growth has established is that while this traditional conclusion continues to
apply with full force in the realm of objects, it does not, indeed logically cannot apply when
dealing in the realm of ideas. Thus, there should no longer be any debate about whether
some departure from market mechanisms is called for. Instead, what we should be asking
is what the right institutions are in this new area.
Romer goes on to argue that it will take careful experimentation and rigorous evaluation to learn
what are those institutions.
It is clear that the development of such new institutions will require both experimentation
and evaluation of public policies as we attempt to find our way in this new era of knowledge-based
economics. As mentioned earlier, Jaffe (1996) argues that the Commerce Department's Advanced
Technology Program (ATP) should utilize the concept of spillovers in picking research projects.
Specifically, he suggests that ATP should fund those projects with the potential for significant social
public and private rates of retum with a clear path to commercialization in order to maximize
spillovers. To do so, Jaffe warns, will require a better understanding of the mechanisms of
appropriation and spillovers and the social and private rates of return.
Tassey (1997) argues for government assistance when the projected social rate of return is
high, but the expected private rate of return to the innovator is below the existing corporate hurtle
rate. When the private rate of return is above the corporate hurtle rate, government help is not
warranted. He also argues for employing options valuation techniques now being used to assess
IS
283
industrial R&D projects. A modified combination of these two private-sector methodologies can
help government programs develop an optimal portfolio of R&D projects.
Economic impact assessment has become a greater part of technology policy management
and will become even more important given the Government Performance and Results Act of 1993.
It is therefore important to invest in improving the methodologies. One possible area for future
exploration would be a comparison of government evaluation techniques with those used by R&D
managers in the private sector - as begun by Tassey (1997). See Huaser (1996) for a review ofthe
R&D management literatlur.
Such a direct translation should be done with care. According to the General Accounting
Office (1997), many of the indicators used by the private sector to measure the contribution of R&D
to the firm's profitability are not directly translatable to the public sector. Special care must be taken
with respect to both mission-specific and basic research - those areas of research with little direct
commercial benefit but potentially huge indirect economic benefit However, as a workshop by the
National Research Council (1995) concluded, the task is difficult but not impossible.
TRADE POLICY
International trade is intrinsically linked to science and technology policy and the debate over
the nature of spillovers (i.e., whether they are international or localized) is relevant Analysis of
spillovers at the cross-national level by Coe and Helpman (1995) finds the rate of return on R&D
in the G-7 countries to be 152 percent. They also find that a nation's productivity depends on
foreign as weU as domestic R&D spending. Cameron (1996) comes to a different conclusion as to
the importance of international spilovers. He argues that most spillovers are localized. Therefore,
domestic research is more important
This question impinges directly on trade policy - specifically what the government should
do, if anything, to protect domestic technologies. It also raises a number of public policy questions
related to issues of foreign participation in US R&D activities, direct foreign investment and
international technological cooperation, such as:
*
*
*
*
How important is international research?
Does the United States have the ability to absorb foreign technology?
Do we need to be the leaders in science in order to be competitive in technology (i.e.,
if imitation is cheaper and just as effective, why should we spend money on science)?
What should we do, if anything, about the international free rider problem, i.e, the
use of US-famded research by others?
Regarding the question of free-riders, it can be argued that international spillovers are a
positive-sum activity. If the US economy gets a good rate of return from government-flnded R&D,
19
284
it should not matter that others may benefit as well. Their gain is not our loss. Likewise, if others
increase their levels of R&D investment, the United States should benefit from their spillovers.2
For the most part, proponents of the endogenous growth theory argue that open trade
promotes technology and growth. Nonetheless, F. Rivera-Batiz (1996) argues that although open
trade generally promotes growth, it can under certain circumstances reduce technological change and
therefore growth. According to Rivera-Batiz, this happens when trade raises the production of laborintensive industries and takes human capital away from R&D activities. This argument remains
controversial within the economics community, however.
Again, the models must be viewed carefully before accepting their policy conclusions. In
the above example, it appears that the model follows the leaming-or-doing approach, whereas the
learning-by-doing variation may be more appropriate (see earlier discussion). If absorption of
foreign technology and imitation is easy, then production may be as important, if not more, than
R&D.
INTELLECTUAL PROPERTY PROTECTION
Closely tied to technology policy is the area of intellectual property protection. As
mentioned earlier, knowledge is treated in the endogenous growth models as an explicit outcome of
incentives. The models are also based on the incomplete appropriability of the results of that
research. Such a combination creates a tension between the need to provide incentives in the form
of monopoly rents and the need to allow others to utilize the knowledge. These models can be used
to further our understanding of the tradeoffs involved in intellectual property rights. For example,
rates-of-return techniques could be used to analyze a recent proposal by some pharmaceutical
manufacturers to extend patent protection on certain drmgs in return for royalty payments to the
government
MONETARY POLICY
One interesting policy tie-in to studies of the rates of return on new technologies - and the
contribution of new technologies to productivity and economic growth - concerns monetary policy.
Despite much hype and anecdotal evidence, data on the overall productivity of the economy
do not seem to show any impact firm new computer and information technologies. However, recent
research on the industry and firm level shows that the new technologies may now be having an
impact Brynolfason and Hitt (1996) argue that this 'productivity paradox" was over in large firms
by 1991. Their research shows that "computers contribute significantly to firm-level output, even
after accounting for depreciation, measurement error, and some data limitations." (p. 557) They
21
am pteful to Adam Jaffe for tbis point Personalco=micains, December 1997.
20
285
estimate that the gross marginal product for computer capital averages 81 percent for the firms in
their sample.
The current debate over productivity measures is a carry-over of the ongoing discussion over
the "productivity puzzle." Specifically, that issue concerned whether or not the productivity of
R&D, as measured by elasticities and rates of return, declined in the 1980s - and what caused the
decline. Part of that decline, according to Hall (1993, 1996), may have been a statistical artifact
(even though it must be remembered that Hall's conclusions are focused on private rates of return
on R&D, not productivity growth in general). As was discussed earlier, the choice ofprice deflators
can have a large impact on the measurement of the rate of return.
Regardless of that caveat, the issue of the impact of new technologies on productivity is far
from understood. As discussed in the earlier sections, we do not have adequate models of the
innovation process, nor do we clearly understand how various factors interact (i.e., technology,
organizational structures, worker skills) to increase productivity. Specifically, we do not fully
understand the role of the complimentarities between technologies. Economic historians and
theorists have pointed out that new technologies often require a host of other changes technological, institutional/organizational, and in worker skills and knowledge - before they can be
fully utilized. One example is the case of electric motors replacing steam engines in the factory
system. According to Rosenberg (1996), it took 40 years before the full impact of this change was
felt, because of the need for complimentary changes in power transmission technologies, plant
design and organizational procedures.
This delay, caused by the time needed to build up these complimentary assets, could be a
major reason behind the "productivity paradox." It may be that those complimentary assets for
computer and information technologies are now in place. If so, the economy may see a sustainable
boost in productivity as a result of the last decade's increased investment in computer and
information technologies. If not, the technological change may result in a short-term boost to
productivity but may not produce a sustained productivity increase.
The resolution of these issues has direct ramifications on monetary policy. Currently, there
is a debate surrounding the potential non-inflationary growth rate of the economy. There are those
in both the business and economic communities who argue that the US economy has entered a new
era - labeled in the press "the New Economy" or "the New Paradigm." One of their arguments is
that new technologies are creating a sustained productivity boost. Thus, the economy can growth
faster than the current long term rate of 2 to 2Y2 percent, without triggering inflationary pressures.
The Federal Reserve Board can therefore be more expansionary in setting monetary policy. It should
be noted, however, that proponents of "the New Economy" also describe a number of other factors
as key too either lowering the possibility of inflation or raising the potential growth rate - ranging
from increase globalization to the Reagan tax cuts to the shrinking of the federal budget deficit
This "New Paradigm" has been roundly criticized by some economists, such as Krugman
(1997) and Blinder (1997). Nonetheless, if new technologies are raising the productivity levels at
a sustained higher rate, then there may be room for the economy to grow faster than the recent
historic trend. It on the other hand, new technologies are providing only a one-time or short-term
21
286
boost in the productivity rate, then the critics may be correct about the inflationary dangers of the
New Paradigm.
EDUCATION AND TRAINING POLICY
It is clear from a review of the economic models that human capital is an important factor
in economic growth. And, thus, all of the models support what Romer characterized as the secondbest policy of education, training and skill development. Yet, it is also clear that "technical change'
owes a lot to the process of learning-by-doing. Key to this process is how worker skills and
managerial know-how are developed and shared - in essence, the process of knowledge spillovers.
Education and training policy may benefit, therefore, from an effort to gain insights on the spillover
process explored in the macro and microeconomic models.
TAX POLICY
Although not directly the topic of this paper, tax and capital formation are important policy
tools with respect to capital accumulation. All growth models agree that capital accumulation is a
critical factor in economic growth. Thus, tax policies which reward saving and investment are
generally thought of by economists as necessary for economic growth. What is unclear from the
models is the interaction between the various factors - and therefore if and how tax incentives
should be targeted. A better understanding of these factors could provide useful guidance to
policymakers as they design specific elements of tax policy.
POLICY CooRDINATIoN
As stated earlier, growth theory (both new and old) tells us that all factors (capital
accumulation, education and skills, and R&D) are critical and they compliment one another.
Therefore, any policy which focuses on one to the exclusion of the others is incomplete. Creating
and sustaining economic growth is a process of having the right policies in a number of areas -with
each set of policies complimenting rather than hindering the other. This need for a coordinated
multi-facet approach may be the most useful and important policy insight to be gained from a review
ofthe growth theory literatu
22
287
CONCLUSION:
WHERE Do WE Go FROM HERE
A great amount of useful work has been done over the past decade on the issues of economic
growth and the rate of return of investment in technology. From the perspective of a public policy
analyst, there are a number conclusions that can be drawn from the review of this work. First, the
research contains numerous policy-relevant insights. It is time to systematically harvest these
insights - while understanding and paying close attention to the limitations of the models. In the
case of growth theory, this means using the models to gain insights specifically on policies related
to trade, intellectual property and tax. In the case of microeconomic studies, insights into the nature
and extent of spillovers can have a great deal of relevance for technology and trade policy, among
other policy areas.
The second conclusion concerns the limitations of the models. Current growth models, while
an improvement over previous growth accounting techniques, are still relatively simplistic. More
work needs to be done to refine the models with respect to:
*
how do the various factors, such as physical capital, human capital and technology,
interact; and,
*
what are the factors that go into increasing technological progress.
Going beyond existing theory, more research is needed to close the gap between the new
growth models and case studies of innovation. The same can be said for microeconomic studies.
Rather than more precise estimates, both macroeconomic growth theories and microeconomic
studies of rates of return should be mined for their insights - especially concerning the nature,
degree and dynamics of spillovers. There is a vast body of literature on innovation and technological
development (for example, see Nelson, 1993, and Rosenberg, 1994). As Nelson (1997) states, "these
institutionally oriented, appreciative theoretic studies have been much more illuminating about the
microeconomics of technological advance than most of the econometric studies." The insights
gained from such should also be mined in the development of better microeconomic models.
Likewise, those who study the innovation process might gain valuable insights from the rigorous
microeconomic models.
As discussed earlier, current rate-of-return techniques are only partially useful in
understanding how to design effective technology programs. Nor are private sector techniques
directly applicable. However, the Government Performance and Results Act of 1993 is forcing
programs to justify themselves. This provides an opportunity for further research on evaluation
techniques - where the bottom line is contribution to economic growth, not profitability. Further
work should look into combining private sector evaluation methods with the economic research on
spillovers with a specific focus on public policy.
23
288
Productivity and economic growth are of special importance for the current public policy
debate. Further analysis is needed, specifically on:
*
what is the overall trend in productivity;
*
is the "prouctivity paradox" over (i.e., are we beginning to see the payoff from
investments in information technology); and,
*
if so, is this payoff large enough to boost the non-inflationary growth rate beyond 2/2
percent
Such research should be undertaken specifically with the question of non-inflationary growth in
mind. In essence, this research should extend the existing new growth theory models to include
monetary policy.
Work on data problems should also continue. Development of new data sources and new
measurement methodologies is critical to advancing our knowledge base. For example, the Bureau
of Economic Analysis created a one-time satellite R&D account as part of the national income and
production accounts (see BEA, 1994). Further efforts should be undertaken and improved, in all
areas of research and innovation indicators (see National Research Council, forthcoming).
In summary, economic research has supplied polcymakers with three important findings:
*
technology, innovation andAnowledge are importantfactorsin economic growth;
*
there is asignificantprivatereturn on R&D investment at thefirm and industry level
- and an even greatersocialreturn on investment; and
*
there is a positive social value ofraisingthe level of investment in technology and
knowledge creationover that determined by the market.
However, many unanswered questions remain and much research still must be done before
existing economic studies, maceo and micro, can provide detailed assistance to polcymakers in their
quest for achieving technological-driven economic growth. From the perspective of a polcy analyst,
the future research agenda should pursue a goal of better understanding the dynamics of the
innovation proces. Rather than get bogged downinthe specific outcomes of the theoretical models
and rate-of-retum analysis, polcymakers should search for insights in the discussion of the nature
of technology and analysts and theorists should strive for abetter understanding of "knowledge" and
the innovation process.
24
289
CITATIONS
Abramovitz, Moses, 1956. '<Resource and Output Trends in the United States Since 1870,"
American Economics Review, vol. 46, May, pp. 5-23.
1993. "The Search for the Sources of Growth: Areas of Ignorance, Old and New,"
Journalof Economic History, vol. 53, #2, June.
Acs, Zoltan J., David B. Audresch, and Maryann P. Feldman, 1992. "Real Effects of Academic
Research: Comment," American Economic Review, March, pp. 363 -367.
Adams, James D., 1990. "Fundamental Stock of Knowledge and Productivity Growth," Journal
of PoliticalEconomy, vol. 98, August, pp. 673-702.
1993. "Science, R&D, and Invention Potential Recharge: U.S. Evidence," American
Economic Review, vol. 83, May, pp. 458-462. (also published as CES Discussion Paper
93-2 Census Bureau, January 1993).
Adams, James D. and Leo Sveikauskas, 1993. "Academic Science, Industrial R&D, and the
Growth of Inputs," CES Discussion Paper 93-1, Census Bureau, January.
Amable, Bruno, 1994. ¶Endogenous Growth Theory, Convergence and Divergence," in Gerald
Silverberg and Luc Soete (eds.) The Economics of Growth and Technical Change:
Technologies, Nations, Agents, Edward Elgar Publishing.
Arrow, Kenneth, 1962. The Economic Implications of Learning by Doing," Review of
Economic Studies, vol. 29, June, pp. 155-173.
_______,
1994. "TheProduction and Distribution of Knowledge," in Gerald Silverberg and
Luc Soete (eds.) T7e Economics of Growth and Technical Change:Technologies,
Nations, Agents, Edward Elgar Publishing
Arthur, W. Brian, 1994. IncreasingReturns and PathDependence in the Economy. University
of Michigan Press, Ann Arbor, Michigan.
Bartelsman, Eric J., 1990. "Federally Sponsored R&D and Productivity Growth," FEDS 121,
Federal Reserve Board of Governors, Washington DC.
Bernstein, Jeffery and M. Ishaq Nadiri 1991. ProductDemand Cost of Production, Spillovers,
and the Social Rate ofReturn to R&D, NBER Working Paper No. 3625.
25
290
Blinder, Alan S., 1997. "The Speed Limit Fact and Fancy in the Growth Debate," The American
Prospect,no. 34, SeptembedOctober, pp. 57-62
(http://epn.org/prospectl33/33blinfs htnil).
Borrus, Michael and Jay Stowsky, 1998. 'Technology Policy and Economic Growth," in Lewis
M. Branscomb and James H. Keller (eds.) Investing in Innovation: Creatinga Research
andInnovation Policy that Worla, MIT Press, Cambridge, MA.
Boskin, Michael J. and Lawrence J. Lan, 1992. "Capital, Technology, and Economic Growth,"
in Nathan Rosenberg, Ralph Landau, and David C. Mowery (eds.), Technology and the
Wealth of Nations, Stanford University Press, Stanford CA.
, 1996. "Contributions of R&JD to Economic Growth," in Bruce L.R Smith and
Claude E. Barfield (eds.) Technology, R&D, and the Economy, The Brookings Institution
and American Enterprise Institution, Washington, DC.
Brynjolfsson, Erik and Lorin Hitt, 1993. 'Is Information Systems Spending Productive? New
Evidence and New Results," Proceedings14th InternationalConference on Information
Systems, Orlando, FL
1996. "Paradox Lost? Firm-level Evidence on the Returns to Information Systems
Spending,"Management Science, voL 42, no. 4, April, pp. 541-558.
Bureau of Economic Analysis (BEA), 1994. "A Satellite Account for Research and
Development," Survey of Cwrent BusineSS, November, p. 3 7 .
Cameron, G., 1996. "Innovation and Economic Growth," Discssion paper no. 277, Centre for
Economic Performance, London School of Economics, February.
Coe, David T. and Elhanan Helpman, 1995. "International R&D Spillovers," European
EconomicReview, vol 39, pp. 859-887.
Congressional Budget Office (CBO), 1993. "A Review of Edwin Mansfield's Estimate of the
Rate of Return from Academic Research and its Relevance to the Federal Budget
Process," CBO Staff Memorandum, April.
Council of Economic Advisors (CEA), 1995. "Supporting Research and Development to
Promote Economic Growth. The Federal Government's Role," Executive Office of the
President, October.
Dasgupta, Partha and Paul A. David, 1994. "'Toward a New Economics of Science," Research
Policy, voL 23, September. pp. 487-521.
Denison, Edward, 1962. "United States Economic Growt," JournalofBusiness, vol 35, pp.
109-121.
26
291
1967. Why Growth Rates Differ: PostwarExperience in Nine Western Countries,
Brookings Institution, Washington, DC.
, 1979. Accountingfor Slower Growth: the United States in the 1970s, Brooklings
Institution, Washington, DC.
. 1985. Trends in American Economic Growth 1929-1982, Brookings Institution,
Washington, DC.
Evenson, R., 1968. "The Contribution of Agricultural Research and Extension to Agricultural
Production," Ph.D. thesis, University of Chicago.
Fagerberg, Jan, 1994. "Technology and International Differences in Growth Rates," Journal of
Economic Literature, vol. XXXI, September, pp. 1147-1175.
Fuhrer, Jeffrey C. and Jane Sneddon Little, 1996. "Technology and Growth: An Overview," in
Jeffrey C. Fuhrer and Jane Sneddon Little (eds), Technology and Growth, Federal
Reserve Bank of Boston, Conference Series No. 40, June, pp. 1-32.
General Accounting Office (GAO), 1997. "Measuring Performance: Strengths and Limitations
of Research Indicators," GAO/RCED-97-91, United States General Accounting Office,
March.
Goto, A. and K. Suzuki, 1989. "R&D Capital, Rate of Return on R&D Investment and Spillover
of R&D in Japanese Manufacturing Industries," Review of Economics and Statistics, vol.
LXXI (4), pp. 555-564.
Griliches, Zvi, 1958. "Research Cost and Social Returns: Hybrid Corn and Related
Innovations," Journal ofPoliticalEconomy, vol. LXVI, pp. 419-431.
. 1964. "Research Expenditures, Education, and the Aggregate Agricultural Production
Function," American Economic Review, voL LIV(6), pp. 961-974.
, 1980. "Returns to Research and Development Expenditures in the Private Sector," in
John W. Kendrick and Beatric N. Vaccara (ads.) New Developments in Productivity
Measurement and Analysis, University of Chicago Press, pp. 419-462.
, 1990. "Patent Statistics as Economic Indicators: A Survey," Journalof Economic
Literature,vol. 28 (4), pp. 1661-1707.
,1992. "The Search for R&D Spillovers," ScandinavianJournalofEconomics, vol.
94, supplement, pp. 29-47.
27
292
1994. "Productivity, R&D, and the Data Constraint," Amenrcan Economic Review,
voL 84 # 1,March, pp. 1-23.
Griliches, Zvi and Frank Lichtenberg, 1984. 'R&D and Productivity Growth at the Industry
Level: Is There Still a Relationship?, 'in Zvi Griliches (ed) R&D, Patents, and
Productivity, University of Chicago Press, pp. 465-501.
Grossman, Gene M., 1996. 'Discussion " in Jeffrey C. Fuhrer and Jane Sneddon Little (Cds),
Technology and Growth, Federal Reserve Bank of Boston, Conference Series No. 40,
June, pp. 83-89.
Grossman, Gene M. and Elhanan Helpman, 1991. Innovation and Growth in the Global
Economy, MIT Press, Cambridge, MA.
Grossman, Gene M. and Elhanan Helpman, 1994. "Endogenous Innovation in the Theory of
Growth," JournalofEconomic Perspectives,vol. 8, Winter, pp. 23-44.
Hall, Bronwyn H., 1993. "Industrial Research During the 1980s: Did the Rate of Return Fall?"
Brookings Paperson EconomicActivity, Microeconomics, # 2, pp. 289-343.
. 1996. "The Private and Social Returns to Research and Development," in Bruce LIR
Smith and Claude E.Barfield (eds.) Technology, R&D, and the Economy. The Brookings
Institution and American Enterprise Institution, Washington, DC.
Hauser, John R., 1996. "Metrics to Value R&D: An Annotated Bibliography," Special Report
No. 96-121, Marking Science Institute, December.
Huffinan, W.E. and RE. Evenson, 1991. Sciencefor Agriculture. Iowa State Press.
Islam, Nazrul, 1995. "Growth Empirics: A Panel Data Approach," QuarterlyJournalof
Economics, vol. 110, #4, pp. 1127-1170.
Jaffe, Adam B., 1986. "Technological Opportunity and Spillovers of R&D: Evidence for Firns'
Patents, Profits, and Market Value," American Economic Review, December, pp. 984 1001.
. 1989. "Real Effects of Academic Research," American Economic Review, December,
pp. 957-970.
1996. "Economic Analysis of Research Spillovers: Implications for the Advanced
Technology Program," National Institution of Standards and Technology, December.
(httpi/twww.atplnistpgovtwww/eao/gcr7O8.htxn)
28
293
1998. "Measurement Issues," in Lewis M. Branscomb and James H. Keller (eds.)
Investing in Innovation: Creatinga Researchand Innovation Policy that World, MIT
Press, Cambridge, MA.
Jaffe, Adam B., Manuel Trajtenberg, and Rebecca Henderson, 1993. "Geographical Localization
of Knowledge Spillovers as Evidenced by Patent Citations," Quarterly Journalof
Economics, vol 108, pp. 577-598.
Jones, Charles I., 1995a. "R&D Based Models of Economic Growth," JournalofPolitical
Economy, vol 104, #4, pp. 759-784.
1995b. 'Time Series Test of Endogenous Growth Models," Quarterly Journalof
Economics, voL 110, #2, May, pp. 495-526.
Jones, Charles 1.and John C. Williams, 1997. "Measuring the Social Return to R&D," Finance
and Economics Discussion Series (FEDS) 1997-12, Federal Reserve Board, Washington,
DC, February.
Jorgenson, Dale, 1996. "Technology in Growth Theory, " in Jeffrey C. Fuhrer and Jane Sneddon
Little (eds), Technology and Growth, Federal Reserve Bank of Boston, Conference Series
No. 40, June, pp. 45-77.
Jorgenson, Dale and Zvi Griliches, 1972. "Issues in Growth Accounting: A Reply to Edward F.
Denison," Survey of CurrentBusiness, vol. 52, no.5, Pat IL pp. 65-94.
Jorgenson, Dale W., Frank M. Gollop and Barbara M. Fraumeni, 1987. Productivityand US
Economic Growth, Harvard University Press, Cambridge, MA.
Kendrick, John W., 1957. "Productivity Trends: Capital and Labor," Review of Economics and
Statistics. vol. 38, August, pp. 248-257.
. 1961. Productivity Trends in the UnitedStates, Princeton University Press.
. 1973. PostwarProductivity Trends in the United States: 1948-1969, Columbia
University Press, New York.
Kenney, Martin and Richard Florida, 1993. Beyond Mass Production.Oxford University Press,
New York.
Kortum, Sanual S., 1996. "Discussion," in Jeffrey C. Fuhrer and Jane Sneddon Little (eds),
Technology and Growth, Federal Reserve Bank of Boston, Conference Series No. 40,
June, pp. 201-207.
Krugman, Paul, 1994. "Me Myth of Asia's Miracle," ForeignAffairs, vol. 73, #6, NoviDec.,
pp. 62-78.
29
294
1997. "How Fast Can the U.S. Economy Growr HarvardBusiness Review, JulyAugust, pp. 123-129.
Knutson, M. and LG. Tweeten, 1979. 'Toward an Optimal Rate of Growth in Agricultural
Production Research and Extension,' American JournalofAgnculiuralEconomics, voL
61, pp. 70-76,
Kuzoets, Simon S., 1971. Economic Growth of Nations. Harvard University Press, Cambridge,
MA.
Lau, Lawrence and Jogn-ll Kim, 1993. Srhe Role of Human Capital in the Economic Growth of
the East Asian Newly Industrialized Countries," miuneo, Stanford University, (cited in
Krugman, ForeignAffairs).
1994. -TheSources of Growth of the East Asian Newly Industrialized Countries,
Journalof the Japaneseand InternationalEconomies, (cited in Krugmnan, Foreign
Affairs).
Levin, Richard C. and Peter Reiss, 1984. -Tests of a Schumpeterian Model of R&D and Market
Structure," in Zvi Griliches (ed) R&D, Patents, and Productvity,University of Chicago
Press.
Leyden, D.P. and A.N. Link, 1991. "Why are Government R&D and Private R&D
Complements?," Applied Economims, voL 23, pp. 1673-1681.
Levy, David and Nestor Trleckyi, 1982. "Effects of Government R&D on Private Investment
and Productivity Macroeconomic Evidence," paper prepared for the Southern Economic
Association.
Lichtenberg, Frank R. and Donald Siegel, 1991. -The Impact of R&D Investment on
Productivity-New Evidence using Linked R&D-LRD Data," Economic Inquiry, voL 29,
pp. 203-228.
Link, Albert N., 1981. "Allocating R&D Resources: A Study of Determinants of R&D by
Character of Use," Auburn University.
Mankiw, N. Gregory, 1995. "TheGrowth of Nations," Brookings Papers on Economic Activity,
no. 1, pp. 275-326.
Mankiw, N. Gregory, David Romer, and David Weil, 1992. "A Contribution to the Empirics of
Economic Growth," Quarterly Journal of Economics, vol 107, no.2, May, pp. 407-437.
Mansfield, Edwin, 1991. "Academic Research and Industrial Innovation," Research Policy, voL
20, February, pp. 1-12.
30
295
1992. "Academic Research and Industrial Innovation: A Further Note," Research
Policy, vol. 21, pp. 295-296.
Mansfield, Edwin, J. Rapoport, A. Romeo, S. Wagner and G. Beardsley, 1977. "Social and
Private Rates of Return from Industrial Innovations," QuarterlyJournalof Economics,
vol. 77, pp. 221-240.
Mansfield, Edwin and Lome Switzer, 1984. "Effects of Federal Support on Company-Financed
R.&D: The Case of Energy," Management Science, vol. 30, pp. 562-571.
McCallum, Bennett T., 1996. Neoclassical Vs. Endogenous Growth Analysis: An Overview,
NBER Working Paper No. 5844.
Mohnen, Pierre, 1996. "R&D Externalities and Productivity Growth,"
SciencelTechnology/Industry Review, # 18, pp. 39-66.
Nadiri, Ishaq, 1993. Innovation and TechnologicalSpillovers, NBER Working Paper Series,
Working Paper No. 4423, August
Narin, Francis, Kimberly Hamilton and Dominic Olivastro, 1995. "Linkage between
Agency-Supported Research and Patented Industrial Technology," Research Evaluation,
vol. 5, no. 3, December, pp. 183-187.
1997. "The Increasing Linkage between U.S. Technology and Public Science,"
Research Policy, vol. 26, no. 3, December, pp. 317-330.
National Research Council, 1995. "Research Restructuring and Assessment: Can We Apply the
Corporate Experience to Government Agencies?" National Research Council, National
Academy of Sciences Press, Washington, DC.
forthcoming. "Industrial Research and Innovation Indicators for Public Policy:
Workshop Report," Board on Science, Technology, and Economic Policy, National
Research Council, National Acaedmy of Sciences Press, Washington, DC.
Nelson, Richard R. (ed.), 1993. NationalInnovation Systems: A ComparativeAnalysis, Oxford
University Press, New YorkL
. 1994. "What has been the Matter with Neoclassical Growth Theory?," in Gerald
Silverberg and Luc Soete (eds.) The Economics of Growth and Technical Change:
Technologies, Nations, Agents, Edward Elgar Publishing.
1995. "Recent Evol.utionary Theorizing about Economic Change,"
pp. 48-90.
Economic Literature, voL XII,
- 1997. Personal Communications, November, 17.
31
Journal of
296
Nelson, Richard R. and Sidney Winter, 1982. An EvoLutionary Theory of Economic Change,
Harvard University Press, Cambridge MA.
North, Douglass C., 1995. "Some Fundamental Puzzles in Economic History/Development,"
EconWPA paper # ewp-eh/9509001, Economic Working Paper Archives at Washington
University, St. Louis (http://econwpawustl.edu).
, 1996. "Economic Performance Through Time: The Limits of Knowledge,"
EconWPA paper # ewp-eh/96120004, Economic Working Paper Archives at Washington
University, St. Louis (http://econwpa wustLedu).
Peterson, W.L, 1967. "Return to Poultry Research in the United States," Journalof Farm
Economics, voL 49, pp. 656-669.
Rivera-Batiz, Francisco L., 1996. "Mhe Economics of Technological Progress and Endogenous
Growth in Open Economies," in Georg Koopmann and Hans-Eckart Scharrer (eds.), The
Economics of High-Technology Competition and Cooperationin Global Markets,
Nomos-Verlagsgesellschaft, Baden-Baden, Germany.
Romer, Paul M., 1990. 'Endogenous Technological Change," Journalof PoliticalEconomy,
vol 98(5), October, pp. S71-S107.
1994. "Me Origins of Endogenous Growth," Journal ofEconomic Perspectives, vol.
8, Winter, pp. 3-22.
1998. Personal communications, January, 19.
Rosenberg, Nathan, 1994. Exploringthe Black Box, Cambridge University Press, New York.
1996. "Uncertainty and Technological Change," in Jeffrey C. Fuhrer and Jane
Sneddon Little (eds), Technology and Growth, Federal Reserve Bank of Boston,
Conference Series No. 40, June, pp. 91-110.
Scherer, F.M., 1982. "Interindustry Technology Flows and Productivity Growth," Review of
Economics and Statistics, voL LXIV, pp. 627-634.
, 1984. "Using Linked Patent and R&D Data to Measure Interindustry Technology
Flows," in Z. Griliches (ed.) R&D. PatentsandPnoductiviy,University of Chicago
Press, Chicago.
1992. "Schunpeter and Plausible Capitalism," Journalof Economic Literature, voL
XXX, June, pp. 1416-1433.
32
297
Schmitz, A. and D. Seckler, 1970. "Mechanized Agriculture and Social Welfare: The Case of
the Tomato Harvester," American JournalofAgricultural Economics, vol. 52, pp. 567-577.
Stephan, Paula E., 1996. "The Economics of Science," Journalof Economic Literature, vol.
XXXIV, September, pp. 1199-1235.
Stokey, Nancy, 1995. "R&D and Economic Growth," Review ofEconomic Studies, vol. 62, pp.
469-489.
Solow, Robert, 1957. "Technical Change and the Aggregate Production Function," Review of
312 320
- .
Economics andStatistics, vol. 39 pp.
. 1994. "Perspectives on Growth Theory," Journal ofEconomic Perspectives, vol. 8,
Winter, pp. 45-54. ,
Sveikauskas, Leo, 1981. "Technology Inputs and Multifactor Productivity Growth," Review of
Economics and Statistics, vol. 63, pp. 275-282. Tassey, Gregory, 1997. The Economics ofR&D Policy,-QuorumBooks, Westport, Connecticut
Terleckyi, Nelson, 1974. Effects ofR&D on the ProductivityGrowth ofIndustries: An
Exploratory Study, National Planning Association, Washington, DC.
Toole, Andrew A., forthcoming. "The Impact of Federally Funded Basic Research on Industrial
Innovation: Evidence from the Pharmaceutical Industry".
Trajtenberg, Manuel, 1990. Economic Analysis of ProductInnovation: The Case of CT
Scanners, Harvard University Press, Cambridge, MA.
Witt, Ulrich (ed), 1993. Evolutionasy Economics, Edward Elgar, Brookfield, VT.
Young,Alwyn, 1992. "A Tale of Two Cities: Factor Accumulation and Technical Change in
Hong Kong and Singapore," NBER MacroeconomicsAnnual 1992, MIT Press (cited in
Krugmran, ForeignAffairs).
, 1993. "Invention and Bounded Leaming by Doing,"`Journal ofPolitical Economy,
voL 101, no.3, June, pp. 443-472.
, 1994(a). "Lessons from the East Asian NICs: A Contrarian View," European
Economic Review Papersand Proceedings,May (cited ii Krugman, ForeignAffairs).
1994(b). "The Tyranny of Numbers: Confronting the Statistical Realities of the East
Asian Growth Experience," NBER Working Paper #4680, March (cited in Krugman,
ForeignAffairs).
33
298
For additional information, please contact:
Joint Economic Committee, fl
G-01 Dirksen Senate Office Building
Washington, DC 20510
@FedFRASER