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1711
106th CONGRESS
1st Session
}
SENATE
{
REPORT
106-169
THE 1999 JOINT ECONOMIC REPORT
REPORT
OF THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
ON THE
1999 ECONOMIC REPORT
OF THE PRESIDENT
together with
MINORITY VIEWS
October 4, 1999.-Ordered to be printed
U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON: 1999
JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
SENATE
HOUSE OF REPRESENTATIVES
CONNIE MACK, Florida, Chairman
WILLIAM V. RoTH, JR., Delaware
ROBERT F. BENNETT, Utah
ROD GRAMS, Minnesota
SAM BROWNBACK, Kansas
JEFF SESSIONS, Alabarna
CHARLES S. ROBB, Virginia
PAUL S. SARBANES, Maryland
EDWARD M. KENNEDY, Massachusetts
JEFF BINGAMAN, New Mexico
JIM SAXrON, NEW JERSEY, Vice Chairman
MARK SANFORD, South Carolina
JOHN DOOLITTLE, California
TOM CAMPBELL, California
JOSEPH S. Pn-rs, Pennsylvania
PAUL RYAN, Wisconsin
PETE STARK, California
CAROLYN B. MALONEY, New York
DAVID MINGE, Minnesota
MELVIN L. WATT, North Carolina
Shelley S. Hymes, Executive Director
James D. Gwartlney, ChiefEconomist
Howard Rosen, MinorityStaffDirector
ii
LETFER OF TRANSMITFAL
October 1, 1999
HON. TRENT LoTrr
Majority Leader, U.S. Senate
Washington, DC
DEAR MR. LEADER:
Pursuant to the requirements of the Employment Act of 1946, as
amended, I hereby transmit the 1999 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,
2A<
CONNIE MACK
Chairman
iii
CONTENTS
OVERVIEW OF THE ECONOMY ...........................................
1
MAJoRIrrY STAFF REPORT
5
Introduction...........................................
1. Economic Stability and Monetary Policy ................................... 7
I. The Importance of Price Stability ........................................... 7
8
II. Inflation and the Tax Code ...........................................
III. Two Key Propositions of Monetary Policy ............................ 9
IV. The Remarkable Record of the Last Two Decades .............. 11
V. The Limitations of Monetary Policy ..................................... 13
16
VI. Conclusion ..........................................
2. Why Economic Growth Matters and How to Achieve It ........ 17
I. The Importance of Economic Growth .................................... 17
II. Determinants of Economic Growth ....................................... 18
III. Institutions and Policies for Economic Growth ................... 20
3. Why Has the United States Grown Faster
26
Than Other Large Economies? ..........................................
I. Size of Government and Economic Growth ........................... 26
II. Labor Market Flexibility and Growth .................................... 31
III. Entrepreneurship and Growth .......................................... 34
35
IV. Conclusion ..........................................
4. A Case Study in Rapid Growth: Ireland .................................. 36
36
I. Ireland's U-Turn ..........................................
II. The Impact of the Policy Changes ......................................... 38
5. Record and Prospects of the U.S. Economy ............................. 40
I. Growth of the U.S. Economy Since 1945 ............................... 40
II. Demographic Changes and Economic Growth ...................... 42
III. The Slowdown of Growth During the 1970s ....................... 44
IV. The Underpinnings of Growth During the 1990s ................ 46
V. Future Prospects for the U.S. Economy ................................ 49
VI. The U.S. Economy Is at a Crossroads .................................. 53
55
6. The Federal Budget ..........................................
55
.......................
Decades
Two
Last
the
I. Federal Spending Over
II. Federal Taxes Over the Last Two Decades ........................... 57
III. The Coming Decade: Cutting Taxes, Retiring Debt,
and Bolstering Retirement Security ..................................... 59
IV. Does the CBO Underestimate Future Revenue? .................. 62
63
V. Why Tax Relief Is Necessary ..........................................
65
.....................................
VI. Fiscal Policy and America's Future
V
7. Five Indefensible Features of the Tax System
. . 67
I. The Optimal and Revenue-Maximizing Tax Rates ................. 67
II. Reform # 1: Reduce the Double Taxation
of Corporate Income .............................................
70
III. Reform #2: Reduce Marginal Rates
on Social Security Recipients ............................................. 71
IV. Reform #3: Reduce or Eliminate the Estate and Gift Tax ....74
V. Reform #4: Eliminate the Marriage Penalty .......................... 74
VI. Reform #5: Make Health Insurance Fully
Tax Deductible for Individuals ............................................. 76
VII. Concluding Thought .............................................
77
8. Capital Gains, Growth, and Inflation .
......................................
78
I. Capital Gains and Economic Growth ...................................... 78
II. The Nature and Uniqueness of Capital Gains ........................ 79
III. The Optimal Capital Gains Tax Rate ................................... 79
IV. The Double Taxation of Investment Returns ....................... 80
V. Inflation and the Taxation of Capital Gains .......................... 80
VI. Indexation .............................................
82
VII. Beneficiaries of Lower Capital Gains Rates
and Indexing .............................................
83
VIII. Conclusion .............................................
86
9. International Financial Markets
.
................................ 87
I. Causes of Recent Currency Crises .......................................... 87
II. Pegged Exchange Rates and Currency Crises ....................... 88
III. Fixed Exchange Rates Work for Developing Countries ...... 90
IV. A Vision for the International Financial System .................. 93
V. The United States and the International Monetary Fund ....... 97
10. Summary of Recommendations
.
............................. 100
RANKING MINORITY MEMBER'S VIEWS
AND MINORITY STAFF REPORT .............................................
103
U.S. Economic Prosperity:
Non-InflationaryGrowth, Low Unemployment,
and Rising Incomes ...................
.......................... 105
Pockets of High Unemployment in a
Low Unemployment Economy ............................................. 133
vi
106"CoNGEESs
SENATE
T
st esseion
REPORT
{ 106-169
THE 1999 JOINT ECONOMIC REPORT
Mr. MACK, from the Joint Economic Committee,
submitted the following
REPORT
together with
MINORITY VIEWS
OVERVIEW OF THE ECONOMY
The performance of the U.S. economy continues to be impressive.
During the last 161/2 years, the United States has experienced only eight
months of recession. While growth is lower than it was during the 25
years following World War II, there is evidence that this too may be
changing. In summary, the U.S. economy is healthy and strong.
The current economic expansion, which began in the second
quarter of 1991, has lasted for 102 months. It is expected to surpass the
record 106-month expansion of 1961-69. The current expansion
appears to be highly resilient. Compared with previous expansions, it
has featured low and stable inflation, unusually strong growth in
investment, and an unexpected recent upturn in the growth of
productivity.
Most observers agree that this extended run of good performance
has occurred in large part because the United States has made no major
macroeconomic policy errors in recent years. In particular, the Federal
Reserve has gradually but steadfastly reduced inflation. If current
projections hold, inflation will be below 2 percent this year for the
third consecutive year. The United States has not achieved this degree
of price stability since the early 1960s. Lower inflation has translated
into lower interest rates. Although the Federal Reserve recently acted
to nudge short-term rates higher, long-term rates are generally lower
than they have been during the last three decades.
Lower inflation and interest rates have fostered economic growth.
Real gross domestic product (GDP) has grown an average of 3.85
percent over the last six quarters. For 1999 as a whole, the
I
Congressional Budget Office forecasts real GDP growth in excess of 4
percent - the best rate since 1984.
Economic growth has produced impressive gains in both
employment and productivity. During the first eight months of this
year, the rate of unemployment fluctuated between 4.2 percent and 4.4
percent, rates not seen since the 1960s. Unlike previous economic
expansions, productivity has not suffered as the expansion has aged. In
fact, the growth of productivity has accelerated in recent years.
Productivity in manufacturing grew 5.3 percent in the past year.
Overall productivity grew a healthy 3 percent from the second quarter
of 1998 to the second quarter of 1999. Because productivity in the
service sector is especially difficult to measure, overall productivity
growth may actually be higher than the official figure.
Forward momentum in productivity, employment, and economic
activity has led to a sizable increase in federal tax revenue.
Consequently, the federal government ran its first budget surplus in a
generation last year. The Congressional Budget Office projects an even
larger surplus for 1999. The federal government has not run back-toback budget surpluses since 1956-57. If current projections hold, the
budget will remain in surplus throughout the next decade.
In the last few years, the United States has been one of the few
consistent bright spots in the world economy. It is important for the
rest of the world, as well as for ourselves, that the U.S. economy
continue to grow. It is also important that we better understand the
sources of growth and prosperity so we can follow policies that
encourage them. The majority staff report focuses on the topic of
maximum sustainable economic growth and analyzes the factors that
contribute to it. We believe that the staff report will enhance
understanding of why some economies succeed while others fail.
Through its hearings and staff reports, the Joint Economic Committee
endeavors to shed light on the important economic issues facing the
United States. Additional information is available on our Web sites (for
the office of the chairman, <http://jec.senate.gov>; for the office of the
vice chairman, <http://www.house.gov/jec>).
SENATOR CONNIE MACK
Chairman
REPRESENTATIVE JIM SAXTON
Vice Chairman
2
MAJORITY STAFF
REPORT
3
INTRODUCTION
The U.S. economy is healthy. Both inflation and unemployment
are low. The economic stability the United States has experienced
since 1982 is unprecedented. The current expansion is already the
second longest on record, and is on course to become the longest. Even
though most of Asia and Latin America are in recession (or beginning
recovery), the U.S. economy continues to grow.
This report focuses on the long-term growth of the U.S. economy,
and examines how it compares both to rates of growth in other
countries today and rates of growth that the United States itself has
experienced in previous periods. It addresses such questions as: What
accounts for the movement of the U.S. economy from stagflation in the
late 1970s to low inflation and almost continuous growth since 1982?
How does the growth of the recent period compare with that of the
1950s and 1960s? What lessons can be learned from the experience of
other economies? What are the economic prospects for the future and
what steps might be taken to improve our future rate of growth?
The emphasis of this report is on achieving the maximum
sustainable rate of economic growth. Both "sustainable" and "growth"
are key words. Reports of this type often focus on current conditions
rather than the underlying factors that determine long-term economic
performance. Yet over the long term, seemingly small differences in
annual growth rates exert a huge impact on living standards.
Growth is a complex phenomenon resulting from the interaction of
institutions, incentives, and individual preferences. While there is no
precise recipe for economic growth, we do have a good idea of the
main ingredients. They include monetary stability, competitive
markets, secure property rights, and an appropriate size of government.
Government policies strongly influence economic growth. Unsound
policies can lead to stagnation or even a shrinking economy, while
sound policies can increase the rate of growth. The United States has
recently had faster growth than other large industrialized countries, but
growth in the 1990s has been slower than in many previous decades.
Current international experience and historical experience suggest that
there is nothing inevitable about slower growth. This leads us to
conclude that the U.S. economy could achieve a higher rate of
sustainable growth.
It is important to distinguish between economic stability and
economic growth. An economy can be stable even though its growth
rate is well below its potential. Stability is necessary but not sufficient
for fast growth. Section 1 explains the all-important connection
between monetary policy and economic stability. Sections 2 to 5
analyze the primary ingredients of long-term growth. Sections 6 to 8
5
explain how changes to the federal budget and tax policy can increase
economic growth. Section 9 describes how the United States can help
promote stability in international financial markets. Section 10
summarizes our recommendations for growth.
In the next few years, policy makers will confront issues that will
influence the growth rate of the U.S. economy and the living standards
of Americans for decades to come. This report explains the issues and
presents a blueprint for achieving maximum future prosperity.
6
1. ECONOMIC STABILITY AND MONETARY POLICY
If nothing else, the experience of the last decade has reinforcedearlier
evidence that a necessary condition for maximum sustainable
economic growth is price stability.
Alan Greenspan
Testimony to the House Committee on
Banking and Financial Services
July 22, 1999
Three decades ago, policy makers and economists alike generally
thought that monetary policy could be used to smooth ups and downs
in the business cycle and keep unemployment low. However, efforts to
use monetary policy in this manner led to inflation and economic
instability during the 1970s. People do not act mechanically, as the
models of three decades ago assumed; they change their expectations
and behavior in response to policies. Once this became better
understood, the limitations of monetary policy became more evident.
During the last fifteen years, monetary policy has focused on a more
narrow objective-price stability. The closer monetary policy has
come to achieving price stability, the more stable the economy has
been and the lower the rate of unemployment has fallen.
When policy makers sought to achieve more than monetary policy
could deliver, they created instability. In contrast, when they focused
on the objective that monetary policy could deliver, they enhanced the
overall performance of the economy.
I. The Importance of Price Stability
The high standard of living that Americans enjoy is the result of
gains from specialization, division of labor, and mass production
processes. To realize those gains, trade and a smoothly functioning
price system are necessary. High and variable rates of inflation
generate uncertainty and reduce the efficiency of a market economy.
Price stability contributes to economic growth and the efficient use of
resources in several ways.
1. Price stability reduces the uncertainty accompanying
decisions, such as saving and investing, that involve transactions
across time. When the general level of prices is constantly changing
from year to year, no one knows what to expect. Unanticipated changes
of even 3 percent or 4 percent in the rate of inflation can turn an
otherwise profitable venture into an unprofitable one. The uncertainty
generated by inflation reduces the attractiveness of both saving and
7
investing. As a result, both will be lower than they would be under
price stability.
2. When the price level is stable, relative prices direct resources
more consistently toward the most productive uses. Prices
communicate important information about the relative scarcity of
goods and resources. Inflation distorts this information. Some prices
can be easily and regularly changed, but that is not true for other
prices, particularly those set by long-term contracts. There will be
delays before the prices for rental agreements, items sold in catalogs,
mortgage interest rates, and collective bargaining contracts can be
modified. Because some prices respond more quickly than others,
unanticipated changes in inflation affect relative prices as well as the
generalprice level. As a result, prices become a less reliable indicator
of relative scarcity. Producers and resource suppliers then make
mistakes they would not make under stable prices, and the allocation of
resources is less efficient.
3. People respond to high and variable inflation by spending
less time producing and more time protecting themselves from
inflation. Because failure to anticipate the rate of inflation can have a
substantial effect on one's wealth, individuals divert scarce resources
from production toward speculation. Funds flow into speculative
investments such as gold, silver, and art objects rather than into
productive investments, such as buildings, machines, and technological
research, that expand the economy's potential output and generate
economic growth.
II. Inflation and the Tax Code
Inflation can also hurt economic growth through interaction with
the tax code. Even modest rates of inflation can alter the effective tax
rate on savings and investment, making it substantially higher than the
statutory tax rate. That is true even if the overall tax structure is
indexed. There are two major areas where such inequities are
particularly important.
1. Inflation and capital gains taxes. Inflation increases the
effective tax on capital gains. If someone buys an asset for $1,000 and
sells it for $2,000, the gain is $1,000. If the statutory tax rate on capital
gains is 20 percent, the tax liability is $200. If the general price level
was stable during the years the asset was held, the 20 percent rate is the
effective tax rate. So, when prices are stable, the effective and statutory
tax rates are the same.
In contrast, consider what happens when inflation pushes the price
level up by 50 percent during the holding period of the asset, so that
$1,000 at the start of the period is equal to $1,500 at the end. If the
8
asset is sold for $2,000, the real (inflation-adjusted) capital gain,
measured in current dollars, is only $500. Nonetheless, under current
law, the capital gains tax is still $200 because the 20 percent rate does
not adjust for the effect of inflation. The statutory capital gains rate is
only 20 percent, but the real, effective tax rate is 40 percent-$200
divided by the real capital gain of $500. When assets are held for
lengthy periods, even low inflation can drastically alter the effective
tax rate on capital gains, forcing people to pay taxes even when they
suffer real capital losses. This increases the cost of capital, thereby
deterring investment and retarding economic growth.
2. Inflation and taxes on interest. Inflation also increases the
effective tax on interest and thereby reduces the incentive to save.
Suppose prices are stable and an individual in the 28 percent tax
bracket earns 5 percent interest on $100 of savings. After taxes, the
individual ends up with $3.60. Because prices are stable, the after-tax,
inflation-adjusted interest rate is 3.6 percent.
Now consider what happens when persistent inflation of 5 percent
pushes nominal interest rates up to 10 percent. After taxes the
individual ends up with $7.20 ($10 less the 28 percent tax liability).
But $5 of this is due to inflation, leaving the individual with an aftertax, inflation-adjusted interest return of only $2.20 (2.2 percent). The
effective tax rate is 56 percent, twice the statutory rate.
These examples highlight one benefit of price stability: it keeps
effective tax rates on capital gains and interest in line with statutory
rates. Inflation pushes effective tax rates on capital gains and interest to
exceedingly high levels.'
m. Two
Key Propositions of Monetary Policy
It is crucial to understand two things about monetary policy.
1. Persistent increases in the general level of prices are always
the result of excessive growth in the money supply. Inflation is a
monetary phenomenon. Inflation is the result of too much money
chasing too few goods. When the money supply expands more rapidly
than goods and services, the additional money is used to bid up the
general level of prices. Viewed from another perspective, when the
supply of money exceeds the quantity that people are willing to hold at
the existing price level, they spend more, putting upward pressure on
the price level. If the increase in the money supply was unanticipated,
the additional spending may stimulate output and employment in the
'Inflation also reduces the value of depreciation allowances. This results in an
overstatement of the net income derived from depreciable assets, which
increases the effective tax rate imposed on them. It also causes the effective
tax rate on the return from depreciable assets to exceed the statutory rate.
9
Figure 1.1: Inflation Volatility in the
United States, 1830-1998
Inflation volatility*
(10-year standard deviation ofCPI)
1830 1850 1870 1890 1910 1930 1950 1970 1990
Sources: Global Financial Data; Haver Analytics.
Note: *Based on December-to-December changes in Consumer Price Index.
short run. However, sustained expansion of the money supply at an
overly rapid rate soon pushes the price level upward, causing inflation.
The experience of the United States and other countries is
consistent with this view. Low rates of growth in the money supply are
associated with low inflation, while high rates are associated with high
inflation. The long-term link between growth in the money supply and
inflation is one of the most consistent empirical relations in economics.
2. Monetary policy can achieve price stability. When it does, it
has done its part to promote maximum growth and employment.
When the general level of prices shows signs of rising, monetary
restraint can bring it back under control. The Federal Reserve can drain
reserves from the banking system and increase the federal funds rate
(the rate banks pay to borrow from each other the deposits they hold as
reserves at the Federal Reserve). By shifting to a more restrictive
monetary policy, the Federal Reserve reduces total spending, which
places downward pressure on the price level. Correspondingly, the
Federal Reserve can combat deflation-a decline in the general level of
prices-by shifting to a more expansionary monetary policy.
The level of prices reflects monetary policy. Monetary policy
should focus on attaining price stability. Price stability reduces
uncertainty, improves the efficiency of markets, and promotes full
employment.
10
How should price stability be defined? Federal Reserve Chairman
Alan Greenspan has testified on several occasions that price stability is
the point at which changes in the general price level are no longer a
significant consideration when people make economic decisions.
Implicit in this definition is the element of credibility. If prices are
stable today but people believe they will rise in the future, long-term
interest rates will stay higher than necessary, limiting the investment
needed to raise living standards. When monetary policy achieves stable
prices and convinces the public that the price stability will continue in
the future, it has done its part to promote economic growth and
prosperity.
IV. The Remarkable Record of the Last Two Decades
Since the double-digit inflation of the 1970s, policy makers and
economists alike have become increasingly aware of the importance of
price stability. Under the chairmanships of Paul Volcker and Alan
Greenspan, the focus of the Federal Reserve has been to reduce
inflation and move toward price stability.
This policy has been highly effective. It is informative to place the
current policy in historical perspective. Figure 1.1 shows the ten-year
moving standard deviation of inflation from 1830 to 1998. A low
standard deviation indicates little volatility in year-to-year changes in
inflation. When inflation is low and steady over a lengthy period,
people come to anticipate it and adjust their choices accordingly. Longterm interest rates tend to be low and do not change much in response
to unanticipated blips in the price level. Because the figure measures
volatility over ten-year moving periods, it indicates credibility-the
extent to which people can count on the continuation of the policy. The
lower the standard deviation, the closer the economy comes to longterm price stability. As the figure shows, inflation was steadiest in the
two decades prior to World War I, the 1960s, and the last ten years. It
was more volatile from 1830 to 1870, 1915 to 1950, and from the
1970s to the early 1980s.
Figure 1.2 takes a closer look at inflation and its volatility during
the last four decades. As the top frame shows, inflation rose from 1965
to 1980, and was particularly high and variable in the 1970s. It fell
abruptly during the recession of 1982 and has been on a gradual
downward trend since. The bottom frame illustrates that after falling
during the first half of the 1960s, the ten-year volatility of inflation
rose persistently throughout the next two decades. It fell sharply in the
late 1980s and early 1990s, following a decade of relative price
stability, and since 1991 has remained below 1.5 percent. If inflation
11
Figure1.2: Inflation and Inflation Volatility
in the United States, 1958-1998
Inflation rate (%)
(December-to-December rate - CPI)
ML
A IXa
I
I12
8
6
4
2
2
/X E V
4~~~~~~
_e_
v\
__)\
v
1958 1963 1968 1973 1978 1983 1988 1993 1998
Inflation volatility*
(1-year standard deviation of CPI)
41
3
2
1
0
.I
1958 1963 1968 1973 1978 1983 1988 1993 1998
Sources: Global Financial Data; Haver Analytics.
Note: *Based on December-to-December changes in Consumer Price Index.
can be maintained in the 1 percent to 2 percent range during the next
few years, the ten-year volatility of inflation may reach an all-time low.
Many economists argue that monetary shocks have been a major
source of economic instability.2 If they are correct, periods of price
2
Milton Friedman summarized this position when he stated, "Every major
contraction in this country has been either produced by monetary disorder or
greatly exacerbated by monetary disorder. Every major inflation has been
produced by monetary expansion." Milton Friedman, "The Role of Monetary
Policy," American Economic Review, v. 58 (March 1968), p. 12.
12
Figure 1.3: Increased Stability of U.S. Economy
Time in
recession
(%)
44.1
40 30320
3020 -
10~~~~~~~2.
1855-1909
1910-1959
1960-1982
1983-1999*
Source: Carl Walsh, Federal Reserve Bank of San Francisco Economic Letter
99-16, May 14, 1999.
Note: *Final period ends with June 1999.
stability should also be associated with stable growth and a high level
of employment. This has indeed been the case. Not only has inflation
been low and relatively stable during the last 16 years, but the overall
stability of the economy has been unprecedented. As Figure 1.3 shows,
the amount of time the U.S. economy has spent in recession has
declined from 44 percent during 1855-1909 to only 4 percent since
1982. The current era has had the least amount of recession of any
comparable period in American history.
Monetary policy deserves most of the credit for the remarkable
stability of the U.S. economy since 1982. From 1983 to 1998, the yearto-year change in inflation never exceeded 1.2 percentage points. The
Federal Reserve followed policies consistent with low and stable
inflation and its policies led to economic stability. This experience
provides strong evidence that monetary policy consistent with price
stability is a key, perhaps the key, to stable growth and an environment
that permits unemployment to fall.
V. The Limitations of Monetary Policy
- While monetary policy can achieve price stability, several
important economic objectives are beyond its reach. Efforts to use
13
monetary policy to achieve these objectives will not only fail; they will
lead to economic instability.
1. Stop-go monetary policy cannot smooth the ups and downs
of the business cycle. Rather, it increases economic instability. In
the 1960s and 1970s it was widely believed that monetary policy could
be used to smooth the ups and downs of the business cycle. The
proponents of this view argued that monetary policy could stimulate
the economy during recessions and restrain it during booms, promoting
higher average growth, more stable output, and lower unemployment.
As the experience of the 1970s shows, monetary policy makers
lack sufficient information to adjust policy to smooth the business
cycle. There is a lag between when a policy change is instituted and
when it begins to affect output and employment. Studies indicate that
the lag is lengthy and unpredictable, generally ranging from 6 to 18
months. Furthermore, changes in economic conditions are often the
result of unforeseen economic shocks such as droughts, wars, political
revolutions, and financial crises. Our ability to forecast such shocks is
limited. Proper timing would require monetary policy to change an
unknown and variable number of months before a recession or boom
that itself is unlikely to be foreseen. That is beyond the capability of
economics.
Incorrectly timed attempts to stabilize the economy through
monetary policy have destabilizing effects. Accordingly, most
economists now believe that monetary policy should follow a stable
and transparent course focused on price stability. If it achieves price
stability, output and employment will also be relatively stable.
2. Expansionary monetary policy cannot enhance the longterm growth of output and employment. Attempts to use monetary
policy in expansionary fashion lead to inflation. Once people come
to expect inflation, it no longer spurs output and employment. While
economists continue to debate how quickly people alter their
expectations in response to a change in the rate of inflation, the
controversy is about whether there may be some temporary impact.
Almost all economists now agree that in the long run, trying to
stimulate employment through expansionary monetary policy causes
inflation and destabilizes the economy.
3. Expansionary monetary policy cannot reduce the
unemployment rate. In the 1960s and 1970s, many economists
thought there was a tradeoff between inflation and unemployment.
They believed that the unemployment rate could be reduced if we were
willing to tolerate a little more inflation. This view was incorporated
into policy. The Full Employment and Balanced Growth Act of 1978
14
implicitly assigned the Federal Reserve System responsibility for
reducing unemployment to no more than 4 percent.3
An unanticipated shift to a more expansionary policy may
temporarily reduce the unemployment rate. However, any reduction
will be short-lived. As soon as decision makers anticipate the higher
rate of inflation and adjust their decisions accordingly, unemployment
will return to its normal level-the sustainable rate consistent with the
composition of the labor force and structure of the labor market. Even
high rates of inflation will fail to reduce unemployment once people
anticipate them. There is no permanent tradeoff between inflation and
unemployment.
4. Expansionary monetary policy cannot permanently reduce
interest rates. Expansionary policy leads to high rather than low
interest rates. Political leaders often suggest that the Federal Reserve
follow a more expansionary monetary policy to reduce interest rates.
The Federal Reserve can use its control over bank reserves to influence
short-term interest rates. However, the Federal Reserve's control over
long-term interest rates is far more limited. Furthermore, while
monetary expansion may reduce short-term interest rates, if it persists
it will increase long-term rates. Persistent monetary expansion leads to
inflation. Once people begin to anticipate higher inflation, long-term
interest rates rise.
High interest rates do not necessarily mean that monetary policy is
too restrictive. In the United States, interest rates were high during the
1970s, a period of expansionary monetary policy and inflation. On the
other hand, low interest rates do not necessarily signal that monetary
policy is expansionary. Interest rates in the United States were
relatively low during the 1960s and 1990s, periods of more restrictive
3 Economists
refer to the relationship between inflation and unemployment as
the Phillips Curve. Paul Samuelson and Robert Solow, who later won Nobel
Prizes in economics, claimed, "In order to achieve the nonperfectionist's goal
of high enough output to give us no more than 3 percent unemployment, the
price index might have to rise by as much as 4 to 5 percent per year. That
much price rise [inflation] would seem to be the necessary cost of high
employment and production in the years immediately ahead." Paul A.
Samuelson and Robert Solow, "Analytical Aspects of Anti-Inflation Policy,"
American Economic Review, v. 50 (May 1960), p. 192. The alleged inflationunemployment tradeoff was even incorporated into the Economic Report of
the Presidentfor 1969 (p. 95).
Today, the dominant view among economists is that economic stability
and the highest sustainable rate of economic growth are goals best achieved
by maintaining long-term price stability. Senator Connie Mack (R-Florida)
has introduced the Economic Growth and Price Stability Act of 1999, which
would make long-term price stability the primary goal of Federal Reserve
policy.
15
monetary policy. During the Great Depression, interest rates fell to less
than 1 percent. Rather than reflecting an expansionary monetary
policy, low interest rates reflected a highly restrictive monetary policy
that was causing deflation and the expectation of a falling price level.
Internationally, the picture is the same. The highest interest rates in
the world have occurred in countries experiencing hyperinflationArgentina and Brazil in the 1980s and Russia in the 1990s, for
example. In the late 1990s, interest rates in Japan fell below 1 percent.
As with the United States during the Great Depression, low interest
rates in Japan today reflect a highly restrictive monetary policy that has
led to a falling price level and the expectation of deflation.
VI. Conclusion
The experience of the last two decades highlights the importance
of monetary policy. Monetary policy helps the economy most when it
focuses on providing price stability. Price stability enables people to
make more accurate economic decisions, enabling them to employ
labor and other resources to the fullest extent under existing conditions.
16
2. WHY ECONOMIC GROWTH MATTERS
AND HOW TO ACHIEVE IT
I. The Importance of Economic Growth
Good monetary policy is necessary but not sufficient for economic
growth. A country can have economic stability yet lack dynamism
because excessive taxes and regulation hinder growth.
Economic growth is the key to higher living standards. Output and
income are closely linked; in fact, output must grow for income to
grow. Expansion in output per person is vitally important because it
makes higher living standards possible.
Over long periods, seemingly small differences in growth rates
have big effects on income. The "rule of 70"4 helps to illustrate this
point. Dividing 70 by a country's average growth rate approximates the
number of years required for income to double. At an average annual
growth rate of 2 percent, income doubles in 35 years (70 divided by 2).
In contrast, at a 4 percent annual growth rate, income doubles in only
17.5 years (70 divided by 4). If two countries have the same initial
income level, after 35 years the income of the country growing at 4
percent will be twice that of the country growing at 2 percent.
Sustained reductions in annual rates of growth can cause major
problems, while sustained increases can help resolve them. The budget
deficits of the U.S. during the last ten years illustrate this point. From
1990 to 1992, real GDP grew only 0.9 percent a year. Largely as a
result, the federal budget deficit ballooned from $152 billion (2.8
percent of GDP) in 1989 to $290 billion (4.7 percent of GDP) in 1992.
In contrast, from 1994 to 1998, real GDP grew 3.4 percent a year and
the large budget deficit of 1992 became a $69 billion surplus by 1998.
The most important problem currently confronting the U.S.
economy is planning for the increased burden of retirement and health
care benefits as the "baby boom" generation starts to retire beginning
around 2010. The weight of the burden will depend on the growth of
the U.S. economy in the years immediately ahead. If the economy
grows at a 3.5 percent annual rate during the next two decades, real
GDP will be 100 percent above the current level 20 years from now.
That will substantially increase the economy's ability to support the
baby boomers in retirement. On the other hand, if the economy grows
at only 2.4 percent a year, as it did from 1986 to 1995, real GDP 20
years from now will be only 60 percent above the current level.
Clearly, the burden of Social Security and Medicare will be much
4 Also
known as the rule of 72. For lower numbers, using 70 provides more
accurate results; for higher numbers, using 72 provides more accurate results.
17
Figure2.1:Key Determinants of Economic Growth
1. Investment in physical and human capital
2. Technological improvements
3. Efficiency of institutions and policies
(A) Secure property rights and political stability
(B) Competitive markets
(C) Monetary stability
(D) Freedom to trade with foreigners
(E) Size of government and level of taxes
greater if growth is slower. As these and other programs are modified,
it is vitally important for policy makers to focus on how the changes
will affect future economic growth.
II. Determinants of Economic Growth
Economic growth is complex. Several factors play important roles,
and they are often related. Weakness in one or two key areas can
undermine growth. Although economics does not provide a precise
recipe for economic growth, it does highlight several ingredients that
are important. 5
Figure 2.1 lists the major factors that influence economic growth.
Building on the work of Robert Solow, many economists stressed the
importance of inputs and technology as sources of economic growth
during the three decades following World War 11.6 The Solow model
indicates that growth results from expansion in the resource base and
improvements in technology. Several researchers sought to measure
the growth of the stock of physical and human capital and use these
figures to estimate their contribution to the growth of output. The
unexplained residual was thought to be the result of advancements in
technology.
Inputs are vitally important for economic growth, but they are not
created and used in a vacuum. The economic environment influences
5There
is nothing automatic about economic growth. Of the 152 countries for
which data are available, 45 (about 30 percent) experienced reductions in real
GDP per person from 1990 to 1997.
6 Robert Solow, "A Contribution to the Theory of Economic Growth,"
QuarterlyJournal of Economics, v. 70 (February 1956), pp. 65-94.
18
the incentives to supply inputs and the efficiency with which they are
used. Reflecting this point, recent work on economic growth integrates
the quality of the economic environment-property rights, monetary
stability, taxation, government spending, and regulation-into the
analysis of growth. In many ways, this "new growth theory" is a return
to the approach of Adam Smith, who also stressed the importance of
the economic environment.' The new approach has several strands.
1. Investment in physical and human capital. Investment in
physical capital (tools, structures, and machines) and human capital
(education and training) can increase the productivity of workers.
When workers make more goods and services valued by others, they
can increase their incomes. Other things being equal, countries using a
larger share of their resources to produce tools, machines, and factories
tend to grow more rapidly. Spending more on education and training
also tends to enhance economic growth.
Investment is not a free lunch. As more is spent to increase
physical and human capital, less is available to spend on goods and
services for current consumption. Furthermore, if investment is to
expand output and income, it must be channeled into productive
projects. High rates of investment do not always lead to more rapid
growth, as the centrally planned economies of Eastern Europe and the
former Soviet Union illustrate. They had high rates of investment but
unimpressive rates of growth, because they invested so much in
unproductive projects.
2. Technological advancements. Research and brain power can be
used to discover lower-cost methods of production and to produce
valuable new products. During the last 250 years, science and
technology have exerted a remarkable impact on living standards. The
steam engine and later the internal combustion engine, electricity, and
nuclear energy have vastly altered our sources of power. The railroad,
automobile, and airplane have dramatically changed both the cost and
speed of transportation.
Science and technology continue to transform our lives. During the
last 30 years, life-saving drugs, heart transplants, MRI and CAT scans,
and laser surgery have transformed health care. Word processing
equipment, fax machines, and electronic mail have vastly improved the
speed and accuracy of communications. In the home, new technologies
7
The new approach builds on the work of Peter Bauer and Douglass North.
See P. T. Bauer, Dissent on Development: Studies and Debates in
Development Economics (Cambridge, Massachusetts: Harvard University
Press, 1972) and D. C. North, Institutions, Institutional Change, and
Economic Performance (Cambridge: Cambridge University Press, 1990).
Other leading contributors to the new approach include Robert Barro, Arnold
Harberger, and Gerald Scully.
19
ranging from microwave ovens to personal computers have improved
the quality of our lives. If anything, the speed of technological
development appears to be accelerating as we head into the next
century.
However, technology alone does not produce economic growth.
Developing countries are in a position to emulate (or import at low
cost) technologies that have been successful in developed countries. If
technology were the primary factor limiting the creation of wealth,
most developing countries would rapidly be catching up to developed
countries. However, many developing countries have fallen farther
behind even though modem technology is readily available to them.
3. Economic environment. Investment and technology are
important for economic growth. But they are influenced by a country's
institutional structure and the policy environment. Countries with a
sound economic environment tend to attract investors willing to supply
resources and adopt technological improvements. It is vitally important
to incorporate the institutional and policy structure of countries into the
analysis of economic growth. Models of economic growth that fail to
incorporate the economic environment may well be omitting the key
factor underpinning sustainable growth. The key difference between a
centrally planned economy and a market economy is the economic
environment.
m. Institutions and Policies
for Economic Growth
Economic theory suggests several key institutions and policy
factors that are important for the achievement of maximum economic
growth. Figure 2.1 lists them.
1. Secure property rights and political stability. A legal system
committed to protecting individuals and their property is a minimal
prerequisite for sustained economic growth. Private ownership protects
property and property owners against those seeking to acquire wealth
by violence, theft, or fraud. Without well-defined and well-enforced
property rights, investors will not be willing to buy equipment and
other fixed assets that fuel economic growth.
The most important thing about private ownership is the incentives
it provides. Private ownership holds people accountable for their
actions. Under private ownership, people get ahead by providing things
that other people value and by engaging in actions that increase the
value of resources. To use a good or resource, you must buy or lease it
from the owner. Each economic participant faces the cost of using
scarce resources. To succeed in business, you must bid resources away
from other potential users and provide customers with goods and
services more valuable than the cost of production. There is therefore a
20
strong incentive to use resources productively-to discover and
undertake actions that generate economic growth. 8
A volatile political climate undermines the security of property
rights. Some governments have confiscated physical and financial
assets, imposed punitive taxes, and used regulations to punish their
political enemies. Countries with this kind of history find it difficult to
guarantee the security of property rights and gain the confidence of
potential investors.
2. Competitive markets. Competition is the disciplining force of a
market economy. As Adam Smith stressed long ago, when competition
is present, even self-interested individuals engage in actions that
promote the general welfare. In a competitive environment, producers
must woo the dollar "votes" of consumers away from other suppliers.
To do so, they must produce goods efficiently and provide consumers
with worthwhile products. Sellers who cannot provide quality goods at
competitive prices are driven from the market. This process leads to
improvement in both products and production methods, while directing
resources toward projects where they are able to produce more value. It
is a powerful stimulus for economic growth.
Such policies as unhampered entry into business and freedom of
exchange with foreigners enhance competition and thereby help to
promote economic progress. In contrast, business subsidies, price
controls, entry restraints, and trade restrictions stifle competition and
retard economic growth.
3. Stable money and prices. A stable monetary environment
provides the foundation for the efficient operation of a market
economy. In contrast monetary and price instability generate
uncertainty and undermine the security of contracts. When prices
increase 10 percent one year, 30 percent the next year, 15 percent the
year after that, and so on, individuals and businesses are unable to
develop sensible long-term plans. In response, people save less, and
businesses move their activities to countries with a more stable
monetary environment. Foreigners invest elsewhere, and citizens often
go to great lengths to get their savings out of the country. As a result,
potential gains from capital formation and business activities are lost.
4. Freedom to trade with foreigners. International trade makes it
possible for people to specialize in making the things they are best atthose they produce most efficiently. Trade also enables people to use
8For evidence that a legal system that protects property rights, enforces
contracts, and relies on the rule of law to settle disputes promotes economic
growth, see Stephen Knack and Philip Keefer, "Institutions and Economic
Performance: Cross-Country Tests Using Alternative Institutional Measures,"
Economics and Politics, v. 7 (1995), pp. 207-27. See also Tom Bethell, The
Noblest Triumph (New
York: St. Martin's Press, 1998).
21
Figure2.2: Growth in U.S. Trade Sector
Exports
as a % of
real GDP
12
10
8-
6
4
-
2
A
_ _ _ _ _ _ _ _ _ _ _ _ _ _
1960 1965 1970 1975 1980 1985 1990 1995
3
imtports
as a % of
real GDP/
12
101
14
8
2
1960 1965 1970 1975 1980 1985 1990 1995
Sources: Economic Report of the President, 1999; Haver Analytics.
the revenue from selling the things they produce for goods that are
produced most efficiently abroad. Specialization and trade are mutually
advantageous. Each trading partner produces more and earns more
income than would otherwise be possible. Economists call this the law
of comparative advantage. 9
9 The
impact of international trade on the level and growth of income is an area
where economic fallacies abound. See Joint Economic Committee, Office of
22
Both reductions in trade barriers and lower transport costs lead to
more international trade. As a country shifts more and more of its
resources toward economic activities that it performs well, it achieves
higher levels of output and income. Increased openness and lower
transport costs have helped expand international trade during the last
several decades. Approximately 21 percent of the world's total volume
of output is now sold in a different country from where it was
originally produced-double the proportion of 1960.
As Figure 2.2 shows, the exports and imports of the United States
have grown rapidly in recent decades. Exports increased from 7
percent of GDP in 1980 to 13 percent in 1998. Imports rose even
faster, from 7 percent of GDP in 1980 to 16 percent in 1998. The
expansion in the trade sector has contributed to the health of the U.S.
economy.
5. Appropriate size of government. Governments can enhance
growth by providing an infrastructure for the smooth operation of
markets. Important functions in this area include a legal system capable
of protecting people and property, and a monetary system that provides
price stability. In addition, governments may enhance growth by
providing a limited set of goods-which economists call public
goods-that are troublesome to supply through markets because of the
difficulties of making all who enjoy the goods pay for them. Examples
include national defense, flood control, and air and water quality.
Government spending that expands educational opportunity and the
development of human capital may also stimulate economic growth.
However, a government that grows too large retards economic
growth in a number of ways. First, as government grows relative to the
market sector, the returns to government activity diminish. The larger
the government, the greater is its involvement in activities it does
poorly.
.Second, more government means higher taxes. As taxes take more
earnings from citizens, the incentive to invest, develop resources, and
engage in productive activities declines.
Third, compared to the market sector, government is less
innovative and less responsive to change. Growth is a discovery
process. In the market sector, entrepreneurs have strong incentives to
discover new and improved technologies, better methods of doing
things, and opportunities that were previously overlooked. Also, they
are in a position to act quickly, as new opportunities arise.10 In
the Chairman, "12 Myths of International Trade," July 1999, available online
at <http://www.senate.gov/-jec/tradel .html>.
'0The writings of Israel Kirzner and Joseph Schumpeter highlight this point.
See Israel M. Kirzner, Competition and Entrepreneurship (Chicago:
University of Chicago Press, 1973); and Joseph A. Schumpeter, The Theory of
23
Figure 2.3: Size of Government Versus Growth
C
C
U
B
C
W.
C1
I.
U
Size of government as a percentage of GDP
government, the nature of the political process lengthens the time
required to modify bad choices (such as ending ineffective programs)
and adjust to changing circumstances. As the size of government
expands, the sphere of innovative behavior shrinks.
Finally, as government grows, it becomes more heavily involved in
redistributing income and in regulatory activism. That induces people
to spend more time seeking favors from the government and less time
producing goods and services for consumers.'
Government provision of certain core goods and services can
enhance economic growth. However, as government grows larger it
eventually retards growth as it undertakes more and more activities for
which it is ill suited. Figure 2.3 illustrates the expected relationship
between the size of government and economic growth, assuming that
government undertakes the most beneficial activities first. As the size
of government (horizontal axis) expands from zero, initially the growth
rate of the economy-measured on the vertical axis-increases. The
part of the curve from point A to point B shows the initial positive
impact of more government on economic growth. However, as
government becomes increasingly large, it spends increasingly more on
Economic Development, trans. Redvers Opie (Cambridge, Massachusetts:
Harvard University Press, 1934-original German-language publication
1912).
"Gordon Tullock, "The Welfare Costs of Tariffs, Monopolies, and Theft,"
Western Economic Journal, v. 5 (1967), pp. 224-32; and Anne 0. Krueger,
"The Political Economy of the Rent-Seeking Society," American Economic
Review, v. 64 (1974), pp. 291-303.
24
activities that yield few or even negative benefits. The rate of economic
growth falls, as shown by the part of the curve to the right of point B.12
A government that engages in appropriate activities and is not too large
maximizes economic growth. Expanding government beyond the
optimal size retards growth.
2
1 For
a formal model with the characteristics outlined here, see Robert J.
Barro, "Government Spending in a Simple Model of Endogenous Growth,"
Journalof PoliticalEconomy, v. 98 (1990), pp. S103-S125.
25
3. WHY HAS THE UNITED STATES GROWN FASTER
THAN OTHER LARGE ECONOMIES?
Compared to other large industrial nations, the recent performance
of the United States is quite impressive. As Figure 3.1 shows, during
the 1990s the United States has been the fastest-growing of the seven
largest industrial economies. The U.S. growth rate has been twice that
of Italy and significantly higher than those of Japan, the United
Kingdom, France, and Canada. Only Germany has achieved similar
growth during the decade, and during the past six years even its growth
has been sluggish-just 1.5 percent a year.
The strong performance of the U.S. economy is surprising given
that the United States is a high-income country. There is some
tendency for lower-income countries to grow faster because they can
profit from technologies whose costs of development have been borne
by higher-income countries. But the United States already had the
highest income of the large industrial nations in 1990, so the U.S.
economy grew fastest despite the costs of technological leadership.
Why has the United States grown faster than other large industrial
economies? The previous section explained how the economic
environment makes a difference. In many respects, the institutions and
policies of the seven largest industrial economies are similar. All are
stable democracies with mature legal systems capable of protecting
property rights. During the 1990s, inflation in all has been low and
relatively stable. With the possible exception of Japan, all are relatively
open economies with similar trade policies. Each has a well-educated
labor force. These characteristics also apply to the other long-time
members of the Organisation for Economic Co-operation and
Development (OECD), a sort of "rich countries club."
The economic environments of the large industrial countries do,
however, differ in three major areas that influence economic growth:
size and growth of government, regulation of labor markets, and
attractiveness of the economy to entrepreneurs.
I. Size of Government and Economic Growth
The size of government is smaller and its growth has been more
modest in the United States than in other high-income countries.
Consider the evidence on the link between size of government and
economic growth. As the upper part of Figure 3.2 indicates, seven
long-time OECD members-Sweden, Denmark, France, Belgium,
Austria, Finland, and Italy-had total government expenditures of 48
percent or more of GDP in 1998. Annual economic growth during the
1990s in these "big government" economies ranged from Sweden's 1.1
26
Figure3.1: Growth of the 7 Largest Industrial
Economies During the 1990s
Growth of
avg. annual
real GDP,
1990-98 (%)
2.6
2.4
1.9
1.9
1.8
2 -1.7
1.3
:1
France Japan Canada U.K. Germany U.S.
Ital
Sources: OECD HistoricalStatistics: 1960-94; OECD Economic Outlook June 1999.
Figure3.2: Economic Growth of OECD Countries,
- Big Government Versus Small Government
ICountries with
vernment spending > 48% of 1997 GDP
p-
Sweden
60.8
Denmark
Sweden
Denmark
France
ISL.3
France
Belgium
51.0
Belgium
Austria
49.4
Austria
Finland
19.1
Finland
Italy
19.1
Average
Italy
Average
52.7
_
p
I I 1.1
I 2.5
I *1.7
I
I
I 1
I
U 11.7
.
.
.
| Countrieswith government spending < 35% of 1997GDP
Ireland
Australia
33.1
Irelan d
32.9
Austral ii3
U.S.
Average
328
32191
p-
P- P-
P-
,
I
,
,
I
7F.1
U.ArE
0
Averag
1
0 1 2 3 4 5 6 7
Avg. annualgrowth rate
of GDP, 1990 -98 (%)
10 20 30 40 50 60
Govesrnment spending
as;a%ofGDP
Sources: OECD HistoricalStatistics: 1960-94; OECD Economic Outlook June 1999.
27
59-884 0 - 99 -- 2
percent to Denmark's 2.5 percent. The average growth of the seven
nations was 1.7 percent. By way of comparison, three long-time OECD
members-Ireland, Australia, and the U.S.-had total government
expenditures of less than 35 percent of GDP in 1998. Annual economic
growth in these "smaller government" economies ranged from 2.6
percent in the United States to 7.1 percent in Ireland. Their group
average was 4.3 percent, more than twice the average for the big
government group. The highest growth rate among the big government
group-Denmark's 2.5 percent-was slightly below the lowest rate
among the small government group.
Figure 3.3 looks at the relationship between the size of government
and growth over a longer period-the last four decades. The size of
government at the beginning of a decade is measured on the horizontal
axis, while the growth of real GDP during that decade is measured on
the vertical axis. The graph contains four dots for each of the 21 OECD
members on which data were available. The plot shows a clear
relationshiF: slower growth is associated with more government
spending.'
In the 1960s and 1970s, government spending as a share of GDP
ranged from a low of around 15 percent to a high of more than 60
percent. The dots representing low levels of government-less than 20
percent of GDP-are either almost on the regression line or well above
it. There is therefore no evidence that government expenditures were
too small to maximize growth in any of these countries. Put another
way, the evidence indicates that all of these countries were to the right
of point B on the curve in Figure 2.3.'4
13The equation in Figure 3.3, known as a regression equation, expresses the
relationship numerically. The equation includes "dummy variables"
(adjustment factors) for the data points in the 1960s and 1970s to take into
account that growth rates then were significantly different than during other
decades. The variable for the size of government is significant at the 99
percent level, meaning that there is only a I percent possibility that such a
result could have been generated purely by chance. The coefficient is -.07,
meaning that a 10 percentage point increase in size of government as a share
of GDP reduces the long-term annual growth rate of real GDP by seven-tenths
of a percent. The R2 statistic indicates that the variable for the size of
government and the dummy variables for the 1960s and 1970s "explain" 62
percent of the variation in growth among the 21 countries involved.
4 For additional
details, see James Gwartney, Robert Lawson, and Randall
Holcombe, "The Size and Functions of Government and Economic Growth,"
Joint Economic Committee, April
1998, available online at
<http://www.house.gov/jec/growth/function/function.htm>;
Edgar Peden,
"Productivity in the United States and Its Relationship to Government
Activity: An Analysis of 57 Years, 1929-1986," Public Choice, v. 69 (1991),
pp. 153-73; and Gerald Scully, What Is the Optimal Size ofGovernment in the
28
Figure 3.3: Economic Growth Declines as Size
of Government Increases, 1960 - 1998
Growth = 5.42 -.07 (Gov't) + 1.81('60s) + .87('70s)
10
.
-4.72)
a4
0
10
20
30
(Z59)
(461)
40
50
60
Total government expenditures as a % of GDP
(at beginning of decade)
Source: Derived from OECD HistoricalStatistics: 1960-1994 and OECD Economic
Outlook June 1999. This analysis is based upon 84 observations (21 OECD
countries for which data were available times 4 decades).
During the last four decades, the size of government has expanded
in every OECD country, while the rate of growth in every country,
with the exception of Ireland, has fallen. However, there has been
considerable variation in the magnitude of government expansion. If
big government retards long-term growth, as Figures 3.2 and 3.3 imply,
the countries with the largest increases in government should
experience the sharpest reductions in growth.
Since 1960, the size of government as a share of GDP has
increased 20 percentage points or more in six long-time OECD
countries: Denmark, Finland, Greece, Portugal, Spain, and Sweden. On
the other hand, it has increased 10 percentage points or less in four
long-time OECD countries: Iceland, Ireland, the United Kingdom, and
the United States. Figure 3.4 presents data on the growth rates of these
two groups, along with the average for OECD countries (bottom line of
the table). Among the "rapid expansion in government" group, the
United States? (Dallas: National Center for Policy Analysis, 1994). While the
methods employed by each study were different, all found that the growthmaximizing size of government was considerably smaller than the actual size
of government in all OECD countries.
29
Figure 3.4: Economic Growth in OECD Countries with
Most and Least Expansion in Size of Government
U
Growth rate of real GDP
(% per year)
Countries with
least growth in size
of govY as a share
of GDP (< 10%)
Iceland
Ireland
United Kingdom
United States
Average
1960
(1)
1998
(2)
Change
(3)
'60-65
(4)
'90-'98
(5)
Change
(6)
28.2
28.0
32.2
28.4
29.2
36.2
33.1
40.2
32.8
35.6
8.0
4.5
4.1
3.5
4.4
2.3
7.1
1.9
2.6
-2.2
3.0
-1.6
-1.8
4t
3.5
-0.6
Countries with
most growth in size
of govt as a share
of GDP (5 20%)
Denmark
Finland
Greece
Portugal
Spain
Sweden
Average
24.8
26.6
17.4
17.0
13.7
31.0
21.8
55.1
49.1
41.8
43.6
41.8
60.8
48.7
30.3
22.5
24.4
26.6
28.1
29.8
27.0
5.9
5.6
7.2
6.5
8.5
2.5
1.3
1.7
2.7
2.2
-3.4
4.9
6.4
1.1
1.9
-3.8
-4.5
Average for
21 OECD countries*
27.3
44.3
17.0
5.6
2.4
-3.2
Gov'tas a % of GDP
5.1
8.0
4.4
6.4
-4.3
-5.5
-3.8
-6.3
b
Sources: Derived from OECD Historical Statstics and OECD Economnic Outlook (various issues).
Note:
*All countries for which data were available inthe sample period were induded. The
counties are U.S., Japan, Germany, France, Italy, U.K., Canada, Australia, Austria,
Belgium, Denmark, Finland, Greece, Iceland, Ireland, Netherlands, New Zealand,
Norway, Portugal, Spain, and Sweden.
average annual growth of real GDP fell from 6.4 percent in 1960-65 to
1.9 percent in the 1990s, a drop of 4.5 percentage points. Among the
"slower expansion in government" group, the average annual growth of
real GDP fell from 4.1 percent in 1960-65 to 3.5 percent in the 1990s, a
drop of only 0.6 percentage points. The best country in the "rapid
expansion in government" group experienced a greater drop in growth
30
than the worst country in the "slower expansion in government"
group.' 5
In 1960 government expenditures as a share of GDP for every
country in the top part of Figure 3.4 exceeded the OECD average
(bottom line of table) of 27.3 percent. At the same time, their average
GDP growth rate of 4.1 percent was below the OECD average of 5.6
percent during the 1960s. The situation was exactly the opposite for
this same set of countries in the 1990s. After their ratios of government
expenditures to GDP dropped below the OECD average, their growth
rates rose above the average.
The reverse happened to the nations in the bottom part of Figure
3.4. In 1960 their government expenditures as a share of GDP were
below the OECD average, and their average GDP growth rates were
higher than the OECD average. By 1998 their government
expenditures had risen above the OECD average and their average
growth rates had fallen below it. Because these statistics are for the
same countries and country groupings, they are particularly revealing.
II. Labor Market Flexibility and Growth
Compared to other high-income countries, the United States has a
labor market with less regulation and more wage flexibility. That
makes it easier for employees to move among industries and
occupations in response to changing conditions.
Several factors contribute to this flexibility. First, collective
bargaining in the United States, Canada, and Japan is decentralized-it
takes place at the company or plant level. In contrast, wage-setting is
highly centralized in Western Europe, where negotiations between a
union (or federation of unions) and an association of employers set
wages in various industries, occupations, or regions. Even the wages
paid to nonunion employees by nonassociation employers are
determined by these negotiations. Therefore, as Figure 3.5 indicates,
the number of workers whose wages are set by collective bargaining is
far greater than union membership in France, Germany, and Italy.
aWhile the growth of government in Japan was slightly less than 20
percentage points, it is revealing nonetheless. At the beginning of the 1960s,
government spending was only 17.5 percent of GDP, and it averaged only 22
percent of GDP during the decade. With small government, the Japanese
economy registered an average annual growth rate of 10.4 percent in the
1960s. Over the next three decades, the Japanese government grew steadily;
by 1998 government spending was 36.9 percent of GDP. Average annual
economic growth fell to 5.3 percent in the 1970s, 3.8 percent in the 1980s, and
1.6 percent in the 1990s.
31
Figure3.5: Share of Employees with Wages
Set by Collective Bargaining
Unionized workers % of employees
|
1980
as a % of non-farm with wages set by
labor force, 1995
collective bargaining01995
38
Canada
9
France
29
Germany ra
39
l
37
A
___-
i
95
y
1 91
92
85
Italy ?M K
~~~~~~~82
34
United
Kingdom
24
Japan
N
16
United
States
M
1
47
70
28
1 26
18
Sources: OECD, Employment Outlook July 1994, Table 5.7; OECD, Employment
Outlook July 1997, Table 3.3; and OECD, Country Surveys (various issues).
Nationwide wage-setting reduces the flexibility of wages across
occupations, industries, and regions.
Second, Western European countries have regulations mandating
lengthy periods of prior notification or months of severance pay for
dismissing workers. Firms are often required to obtain approval from
the government to dismiss workers. While the stated objective of these
regulations is to enhance job security, they make entry into the labor
force more difficult. Because it is more costly to dismiss workers, it is
more costly to hire them. When dismissal is costly, employers are
reluctant to add workers even during periods of strong demand.
Countries with highly restrictive dismissal regulations also have high
rates of unemployment, particularly among young workers seeking to
enter the labor force.
Finally, generous unemployment benefits and other transfers to the
able-bodied unemployed reduce the cost of being unemployed. People
32
Figure3.6: Replacement Rate
of Unemployment Benefits
Average gross replacement rates
1"-~-;~~_25
-- 25-~11
Canda
-a28
=
Canada
-m
30
I';;
France
I
37
38
29
28
Germany
6
Italy
18
18
United
Kingdom
_
Japan
United
States
0
~~2
~~ 3
24
9~~
10
_1~~0
=
1
5
12
Sources: OECD, OECD Jobs Strategy: Making Work Pay (1997), Figure 2;
OECD, Implementing the OECD Jobs Strategy: Member Countries'
Experience, Table 5.
respond with longer periods of job search, causing the unemployment
rate to rise. Overly generous benefits offer an alternative to work,
reducing output by idling workers.
Figure 3.6 shows the replacement rate, which is the size of the
average unemployment benefit expressed as a percentage of the wages
a person earned when employed. Unemployment benefits in Western
Europe and Canada are far more generous than in Japan and the United
States. Throughout the 1990s, unemployment in France, Germany,
Italy, and Canada has been 4 to 8 percentage points higher than in
Japan and United States. High unemployment in those countries is not
33
due to cyclical factors; rather, it reflects the structure of their labor
markets.16
The United Kingdom illustrates what labor market reform can do
to unemployment. During the 1980s, various reforms made labor
markets more competitive. At the same time, unemployment benefits
were scaled back. Increasingly, the unemployment rate in the United
Kingdom resembles that of the United States rather than other Western
European countries.17
III. Entrepreneurship and Growth
The United States has a business climate that is relatively favorable
to entrepreneurship. As we will discuss later, taxation on savings and
capital formation are high. In other respects, however, the U.S.
economy provides opportunity for entrepreneurs. In particular, the
capital markets in the United States are more open than in most other
countries. The U.S. capital market is the largest in the world. It
provides entrepreneurs with a wide variety of sources for financial
capital. A number of financiers specialize in providing venture
capital-start-up funds for high-risk but potentially high-reward
business activities. For companies that wish to tap investment from the
public directly, U.S. stock markets offer well developed channels for
doing so. The practice of offering stock options to employees, as a way
of encouraging entrepreneurial behavior within companies, is more
highly developed in the U.S. than in other countries. The
encouragement of aggressive entrepreneurial behavior has been an
important source of recent economic growth, particularly in the hightechnology sector.
6
1 For
additional details, see Edward Bierhanzl and James Gwartney,
"Regulation, Unions, and Labor Markets," Regulation, v. 21 (Summer 1998),
pp. 40-53.
Unemployment benefit systems are complex. Initial replacement rates
among the large industrial economies are quite similar. However, Western
European countries generally permit workers to draw benefits for longer than
the United States does. Replacement rates often vary with the previous level
of earnings, family size and situation, the previous length of employment, and
the duration of unemployment. The OECD has calculated the replacement
rates in member countries for recipients at two different income levels, three
family situations, and three time periods of unemployment. The average
replacement rates for these 18 different categories provide a reasonably good
estimate of cross-country variations in the average replacement rate. The
replacement rates of Figure 3.6 were derived by this method.
17
In the summer of 1999, unemployment in the United Kingdom was 6.1
percent, versus 10.5 percent in Germany, 11 percent in France, and 12 percent
in Italy. Figures are OECD standardized measures of unemployment.
34
IV. Conclusion
There is abundant evidence that secure property rights, competitive
markets, price stability, openness to international trade, and smaller
government enhance economic growth. If the United States is to
achieve its full potential, it must diligently pursue these objectives. The
experience of Western Europe is that big government-high
government expenditures and extensive regulation-leads to sluggish
growth.
35
4. A CASE STUDY IN RAPID GROWTH: IRELAND
The experience of Ireland in the last four decades offers a case
study in how much difference the right policies can make to economicgrowth .
I. Ireland's U-Turn
From the early 1960s to the mid 1980s, the Irish government
followed policies that hampered economic growth. Government
spending rose from 28 percent of GDP in 1960 to 43 percent in 1974
and 52.3 percent in 1986.18 Taxes were high, monetary policy was
unstable, and trade restraints limited international exchange. By the
mid 1980s, Ireland was on the verge of collapse. Real growth had
fallen sharply. Unemployment soared to more than 17 percent during
1985-87. People were leaving the country in search of opportunity.
Out of desperation, the Irish government began to shift policy.
Government spending was sliced, tax rates were lowered, monetary
policy became more stable, and trade became more open.
1. Smaller government. By the mid 1980s, government spending
was out of control and the size of the government debt was expanding
rapidly, peaking at 120 percent of GDP in 1986. An attempt in 1983 to
balance the budget by raising taxes had failed, throwing the economy
into recession and leading to even higher levels of government debt.
Finally, in 1987, the Irish government decided to try the alternative
approach of reducing government spending. Government employment
was cut by about 10 percent between 1986 and 1989.'9 As Figure 4.1
shows, total government outlays fell from 50 percent of GDP in 1986
to less than 40 percent in 1989. They have continued to recede in the
1990s, reaching 33.1 percent of GDP in 1998. The improvement in the
budget situation reduced interest rates and led to increased confidence
in the Irish economy, which created more investment.
2. Lower tax rates. As the size of government shrank, the tax
burden on both individuals and businesses was systematically reduced.
As Figure 4.2 shows, the top marginal rate imposed on personal
income was sliced from 65 percent in 1984 to 58 percent in 1986 to 48
percent in 1992. Most recently, it has been reduced to 46 percent.
Corporate tax rates have also been reduced sharply, from the top rate of
'8Figures are from OECD Historical Statistics: 1960-1994 (Paris:
Organisation for Economic Co-Operation and Development, 1996), Table 6.5.
'9Alberto Alesina and Roberto Perotti, "Fiscal Adjustments in OECD
Countries: Composition and Macroeconomic Effects," National Bureau of
Economic Research Working Paper W5730 (1996), p. 25.
36
Figure4.1: Ireland's Government Outlays
as a Share of GDP
% of
nominal
GDP
50
.
40
30 .
1982
1986
.
1990
1994
1998
Source: OECD Economic Outlook 1999.
Figure4.2: Ireland's Top Marginal Tax Rates
T op
arginal
rm
ite (%s)
I1
_M
0y
IPersonal
tax
%in
_/
Source: Price Waterhouse, Individual Taxes: A Worldwide Summay (various issues).
37
50 percent in 1987 to the current rate of less than 30 percent. The
reductions have increased incentives to work, invest, and innovate.
3. Sound monetary policy. Monetary policy has improved
substantially since the late 1980s. Ireland's annual rate of inflation has
fallen and become more stable (Figure 4.3). Since 1987, inflation has
averaged 2.5 percent a year, down from an average of 12.7 percent a
year from 1970 to 1986.
4. Openness to international trade. When Ireland joined the
European Union (EU) in 1973, it was required to harmonize its trade
policy with that of the EU over the next decade. Ireland benefitted
from free trade within the EU and from EU tariff rates being lower
than the rates previously imposed by the Irish government. The
increased openness of the Irish economy propelled exports from 50
percent of GDP in 1980 to 60 percent in 1990 and 84 percent in 1997.
Once heavily dependent upon neighboring Britain as a trading partner,
Ireland's trade is now more diversified. Britain now accounts for only
27 percent of Irish exports, down from 47 percent in 1979.
HI. The Impact of the Policy Changes
What impact have these policies had on the Irish economy? The
turnaround since the late 1980s has been remarkable. As Figure 4.4
shows, the annual growth rate of real GDP rose from 2.3 percent in
1982-87 to 4.8 percent in 1988-93. From 1994 to 1998 the Irish
economy grew 8.9 percent a year. Ireland's growth rate has been the
strongest by far in Europe during the 1990s. Certainly, the Irish
experiment reinforces the view that open and competitive markets,
reduction in the size of government, lower tax rates, and stable
monetary policy matter-indeed, they matter a great deal.
The lone blemish on Ireland's economic record is unemployment.
Ireland's unemployment rate has fallen from its 17 percent rate in the
late 1980s to 6.6 percent today. This compares favorably with the EU
average of 10.2 percent, but it is still about half again as high as the
rate of the United States. Irish unemployment benefits are still quite
generous and the labor market would profit from additional
deregulation. Nonetheless, the overall picture is a remarkable success
story.
38
Figure4.3: Ireland's Inflation
Annual
source: OECD Economic Outlook, 1999.
Figure4.4: Ireland's GDP Growth
Annual real
GDP growth (%)
21
8.9
V4
U
4.8
4]
2.
2.3
0.
1982-1987
1988-1993
Source: OECD Economic Outlook, 1999.
39
1994-1998
5. RECORD AND PROSPECTS OF THE U.S. ECONOMY
I. Growth of the U.S. Economy Since 1945
Compared to other large industrial nations, the United States has
had impressive economic growth during the 1990s. However, the
growth is much less impressive when compared with the 25 years
following World War H. Growth during the 1950s and 1960s was
considerably more robust than it has been during the 1990s. 20
Moreover, the case of Ireland suggests that the 1990s have no special
characteristics that have made it inevitably a period of slower growth.
Faster growth is achievable if the right policies are in place.
Figure 5.1 presents data on the growth rates of real GDP,
productivity, and real hourly compensation. To highlight long-term
growth rather than short-term cyclical movements, the data are 32quarter moving averages: each observation shows the average growth
rate over the previous eight years.
The growth rates of real GDP, productivity, and hourly
compensation tend to move together, as one would expect. Real GDP
measures total output, while productivity measures output per hour.
When productivity changes, real GDP tends to change in the same
direction. Productivity growth provides the basis for increases in
compensation. Therefore, when productivity rises or falls, so does
hourly compensation.
The growth rates of real GDP, productivity, and hourly
compensation were all higher in the 1960s and early 1970s than during
the last 25 years. The long-term growth rates of productivity and
hourly compensation fell in the 1970s and have remained on a lower
plateau since. All three indicators have been rising during the last few
years, but remain well below the rates of the 1960s and early 1970s.
All of this raises a question that is crucial for the U.S. economy
and for the federal government: Is the increase in the long-term growth
rate since 1995 merely a temporary phenomenon, or is it a more
permanent movement?
2GDuring
the 25-year period 1949 to 1973, the average annual growth rate of
real GDP was 3.9 percent. During the last 25 years (1974 to 1998) the average
growth rate was 2.7 percent. Growth rates of real GDP in recent decades have
been as follows: 1960-69-4.4 percent; 1970-79-3.2 percent; 1980-89-2.7
percent; 1990-98-2.6 percent.
40
Figure5.1: Growth of Real GDP, Productivity,
and Hourly Compensation
Growth of real GDP (%)
(32-quartermoving average)
61
n
nn
rn
rn-I
IIU Kecession
n
5
4
3
2
1980 1985 1990
1965 1970 1975 1980 1985 1990
Growth of real hourly compensation (%)
(32-quartermoving average)
3.751
-O.,
1965 1970 1975 1980 1985 1990 1995
Sources: Haver Analytics; Economic Report ofthe President, 1999.
41
.
II. Demographic Changes and Economic Growth
Changes in the age profile of the population affect both the level of
income and its growth. Most people spend their twenties and early
thirties developing skills through higher education, training, and job
experience. During this phase, their productivity and earnings are
generally below average. When people approach retirement, their
productivity often declines because of worsening health and because
their job skills may not be as up-to-date as they once were. Thus, the
productivity and earnings of people over 60 are also generally below
average. People 35 to 59 generally have the combination of education,
experience, and health that results in the highest levels of productivity.
Earnings figures confirm that the average real earnings of individuals
reach a peak during these years.
An increase in the share of the population 35 to 59 years old tends
to push average productivity and earnings upward. When workers 35 to
59 are expanding as a share of the labor force, it enhances the growth
of productivity and output. In contrast, an increase in the share of the
population younger or older tends to retard growth.
The top frame of Figure 5.2 shows the percentage of the labor
force ages 35 to 54 since 1960, and ages 35 to 59 from 1977 forward.
The share of these groups fell by almost 10 percentage points from
1965 to 1980. This trend reversed during the 1980s as the "baby boom"
generation entered its prime working years. During the last decade, the
percentage of the labor force ages 35 to 54 rose from 40 percent to 50
percent. Currently, approximately half of the U.S. labor force is 35 to
54 years old, up from only 36 percent in 1980. The share of the labor
force in the prime-age category will not change much during the next
decade, but in about 15 years it will begin to shrink, and by 2020 it will
return to the levels of the late 1980s.
What do these demographic trends have to do with economic
growth? The bottom frame of Figure 5.2 shows how the changing age
composition of the labor force during the last several decades has
influenced average productivity. The influx of youthful, inexperienced
workers accompanying the entry of the baby boom generation into the
labor force between 1960 and 1980 reduced average productivity by
about eight percentage points. This negative impact on productivityand its growth-was particularly sharp during the 1970s.
The impact reversed during the 1980s, and in the 1990s the rapid
growth of prime-age workers has boosted both productivity and its
growth. Between 1991 and 1998, the growth of prime-age workers as a
share of the labor force increased average productivity by a total of
four percentage points. On an annual basis, this factor alone added
42
Figure 5.2: Impact of Demographics on
Labor Productivity and Growth
|MaximumtoI
Share
of labor
occur in 2006
force (%)
60-
._;.
Persons
ag 35-d59
. .PS
Ogo
3020.
-_
I
I
1960 1970
I
1980
I
I
I
1990 2000 2010
I
2020 2030
(a) 'Prime-age'workers
Maximum to
Relative
labor productivity
occur in 2006
(1980 = 100)
.
108
106 - 104
102-100
98
1960
1970 1980
1990
2000 2010
2020
(b) Effect of changing demographics
on laborproductivity
Sources: Bureau of Labor Statistics; U.S. Census Bureau.
43
2030
approximately one-half of a percentage point to the growth rate of
productivity from 1991 to 1998. 21
Prime-age workers will continue to comprise a large share of the
labor force during the decade ahead. However, when the baby boom
generation starts retiring around 2010, the situation will change
dramatically. During the decade following 2010, the number of retirees
will increase sharply, while the share of the prime-age workers will
fall.2 2 This combination will be a drag on the growth of the economy
during the second and third decades of the next century.
m. The Slowdown of Growth During the 1970s
The growth rates of real GDP, productivity, and hourly
compensation fell sharply in the 1970s. Demographic changesspecifically the entry of numerous youthful, inexperienced workers
into the labor force-adversely affected productivity. Sharp increases
in the price of oil in 1973 and 1981 also contributed to the slowdown,
2 1The
productivity index in the bottom frame of Figure 5.2 was derived by
weighting the age-earnings profile for males in 1998 by the percent of the
labor force in each age category for each year in the data set. Mathematically,
the ratio for each of the "i" years is equal to the sum of (Pa9s x Ai) divided by
the sum of (Pa9g x Aa8g ), where Pa9s is equal to the 1998 annual earnings
within each of the "a" age categories (e.g. 20-24, 25-29, and so on), A^; is the
percent of the labor force in each age cell during the ith year, and Aao is the
percent of the labor force in each age cell during the 1980 base year. The ratio
was derived for each year.
For 1960 to 1998, the number of persons with earnings in each age cell
was used to derive the share of the labor force in the age cell. For years
beyond 1998, the representation in each age cell is based on population
projections. Our projections (based upon U.S. Census Bureau forecasts of
population growth) assume that the rate of labor force participation in each
age category will remain the same as it was in 1998. When the share of the
labor force in the high-earnings (productivity) age categories is large relative
to the 1980 base year, the ratio will be greater than 100. Increases (reductions)
in the share of the labor force in the prime-earnings age groupings will cause
the ratio to rise (fall). The index estimates the amount by which earnings, and
thus productivity, differ from the 1980 base year as the result of changes in the
age composition of the labor force. Data before 1976 use ten-year age
categories instead of the five-year categories present in the rest of the data.
22The number of Americans over age 70 is projected to increase from 27.3
million in 2010 to 34.8 million in 2020 and 47.8 million in 2030. Bipartisan
Commission on Entitlement and Tax Reform, Final Report to the President
(Washington: Government Printing Office, 1995), p. 13; 1995 Annual Report
of the Boardof Trustees of the FederalOld Age and Survivors Insurance and
Disability Insurance Trust Funds (Washington: Government Printing Office,
1995), p. 21 .
44
Figure5.3: Changing Composition of
Total Government Spending*
h
1960 1965
1970 1975 1980 1985 1990 1995
Sources: U.S. Department of Commerce, Bureau of Economic Analysis, Survey of
Current Business, March 1998; Economic Report ofthe President, 1999.
Note: *Government spending is composed of federal, state, and local expenditures
and investment.
by reducing the efficiency of vast amounts of capital. Many machines
and structures designed for cost effectiveness at pre-1973 energy prices
were too costly to operate at higher prices. Energy prices fell
throughout most of the 1980s, but initially people were not sure
whether lower energy prices were temporary or more permanent. It
took time to adjust to the new situation, so growth did not immediately
rebound.
In addition to the unfavorable impact of demographic changes and
higher energy prices, inappropriate policies also contributed to the fall
in the growth rate during the 1970s. Monetary policy was unstable:
both the rate and volatility of inflation rose throughout the decade. It
takes time to regain lost credibility, and even though inflation declined
during the 1980s, the adverse consequences of the earlier monetary and
price instability lingered. The growth of government also played a role
in the slowdown. As Figure 5.3 shows, total government expenditures
(federal, state, and local) rose from less than 29 percent of GDP in
45
1965 to more than 35 percent in 1975. They fluctuated around this high
level from 1975 to 1990.23
IV. The Underpinnings of Growth During the 1990s
While the long-term growth rate of the U.S. economy remains
below the levels achieved during the 25 years following World War II,
there are signs that it is increasing. The 32-quarter average annual
growth rates of real GDP, productivity, and hourly compensation have
all increased sharply during the last few years. Just as the slowdown of
the 1970s reflected several negative factors, the improved performance
of the U.S. economy during the 1990s is the culmination of several
positive developments.
1. Monetary and price stability. Monetary policy since 1982 has
achieved low, stable inflation. As the Federal Reserve has kept the
inflation rate low and stable, it has regained credibility it lost in the
1970s. People are now more confident that the Federal Reserve will
follow policies consistent with price stability. That helps keep interest
rates low and reduces the uncertainties accompanying investment and
other choices that involve income and costs across time periods.
2. Lower defense spending and smaller government. During the
1990s, there has been a modest reduction in government spending as a
share of the economy. It has fallen from approximately 35 percent of
GDP in 1991-1993 to less than 33 percent in 1998. As Figure 5.4
shows, federal spending fell from 25 percent of GDP in 1992 to less
than 22 percent in 1998. The primary factor responsible for the decline
has been lower defense spending now that the Cold War has been won.
Defense spending fell from 7.5 percent of GDP in 1986-1987 to 4
percent in 1998. Had it not fallen, government spending as a share of
the economy would have remained virtually unchanged during the
1990s.
3. Lower trade barriers. Numerous countries have reduced their
trade barriers during the last 15 years. The United States has modestly
reduced barriers, particularly those that apply to trade with Canada and
Mexico. Following on the heels of the U.S.-Canadian Free Trade
Agreement of 1988, the North American Free Trade Agreement
(NAFTA) took effect in 1994. As the result of these two agreements,
trade now flows more freely among the three largest North American
nations. By 2004, tariffs on most products among these three countries
23The data of Figure 5.3 on government expenditures include capital
expenditures as well as government consumption and transfer payments.
Government investment is often omitted from data purporting to give "total
government expenditures."
46
Figure5.4: Changing Composition
of Federal Spending
Federal I
I spending
% of
GDP
25
23
Federalspending I
. less defense
I
21
sk
.~~~~~'4
19
N**
17
1980
1983
1986
1989
1992
1995
1998
1980
1983
1986
1989
1992
1995
1998
Sources: U.S. Department of Commerce, Bureau of Economic Analysis,
Survey of CurrentBusiness, March 1998; Economic Report of
the President, 1999.
will be phased out. Restrictions on financial investments and trade in
services such as banking are also being removed.
Responding to lower trade barriers and reductions in transport and
communications costs, the U.S. trade sector has grown sharply. Since
1990, imports have risen from 10 percent of GDP to 16 percent. During
the same period, exports have expanded from 9 percent of GDP to 14
percent. Trade is a positive-sum activity: both parties gain from it.
47
4. Favorable demographics. The sharp increase in the share of the
labor force in the prime-age, high-productivity categories during the
1990s has enhanced productivity per worker. An increased share of the
population in their peak earning years has also boosted government
revenue. People 35 to 59 pay considerable taxes from their relatively
high incomes but consume relatively few government services. In
contrast, rapid growth in the number of young people increases
government spending for education, while rapid growth in the number
of the elderly increases government spending for Social Security and
health care. In the 1970s, the presence of more children and young
adults pushed government, particularly state and local governments,
toward more spending. The presence of more people in their peak
earning years in the 1990s has helped generate budget surpluses at all
levels of government.
5. Welfare reform. In 1996, the federal government enacted
sweeping welfare reforms. It ended the "entitlement" status of welfare,
whereby anyone with children who had a sufficiently low income
automatically qualified for federal benefits. States were given much
greater latitude in setting eligibility requirements and time limits for
those receiving benefits. Since 1994, the share of the U.S. population
on welfare has fallen by almost half, a substantially larger 24reduction
than can be attributed to the general strength of the economy.
For the economy as a whole, the cost of hiring workers includes
transfer payments as well as compensation directly paid to workers. By
making work less attractive for those who face entering the labor force
in low-paying jobs, transfer payments to the able-bodied unemployed
tend to increase the unemployment rate. By reducing transfer payments
to the able-bodied unemployed, welfare reform reduces the cost of
hiring, thereby increasing private-sector hiring and economic growth.
Once in the labor force, workers in low-paying jobs acquire skills that
help them stay employed and move into higher-paying jobs, whereas if
they remain unemployed they never acquire the skills. At least one
study suggests welfare reform alone is responsible for a reduction in
the unemployment rate of one percentage point.25
Considering the favorable factors that emerged during the last few
years - a sustained period of low inflation, increased trade, an
increase in the relative number of persons in their prime earning years,
24 General
economic growth only accounts for about 20 percent of the
reduction in welfare caseloads since 1994, and less since 1996. Economic
Report of the President, 1999 (Washington: Government Printing Office,
1999), p. 119.
John Mueller, "The Answer to Three Puzzles: Welfare Reform Lowered
Unemployment," LBMC Report (Lehrman Bell Mueller Cannon, Inc.,
Arlington, Virginia), July 23, 1999.
48
25
Figure 5.5: Real Fixed Investment
as a Share of GDP
611960 1965 1970 1975 1980 1985 1990 1995
Source: Haver Analytics.
and smaller government in the post-Cold War era - it would have
been surprising if there had not been an increase in growth and
productivity.
V. Future Prospects for the U.S. Economy
The U.S. economy expanded at an annual rate of 2.7 percent
during the 1980s and 2.6 percent during the 1990s. This is less than the
rates of the 1960s and 1970s. During the last five years, real GDP has
grown at a 3.4 percent annual rate. Does the recent higher growth
reflect primarily short-term cyclical factors or is it the beginning of
more robust long-term growth? Two factors are emerging that should
enhance the future growth of the U.S. economy: strong investment and
leadership in high-technology industries.
1. Growth of real fixed investment. Figure 5.5 presents data on
both total real fixed investment and nonresidential real fixed
investment as a share of GDP during the last four decades. The
49
interesting thing is the recent strength of these numbers, particularly
the figures for nonresidential fixed investment. During the current
expansion, nonresidential fixed investment has risen from 8.9 percent
to 12.7 percent of GDP. The latter figure is two percentage points
higher than during any recent expansion.
Purchases of durable equipment, such as machines, have been the
driving force underlying the rapid growth of investment. Real
purchases of producers' durable equipment rose from $389 billion in
1992 to $770 billion in 1998-an unprecedented rate of growth (Figure
5.6). The investment trend of the 1990s is important because capitalmore and better equipment-enhances the future productivity of
workers. In turn, higher productivity per worker provides the basis for
rapid growth of income.
2. Growth of the high-technology sector. Evidence is mounting
that the United States is in the midst of a boom in high technology.
Striking increases in growth have occurred in semiconductors,
software, the Internet, and biotechnology. The size of the high-tech
sector rose from 4.9 percent of GDP in 1985 to 6.1 percent in 1990 and
8.2 percent in 1998 (Figure 5.7). According to the U.S. Department of
Commerce, information technology industries have generated about
one-third of the recent growth of the U.S. economy. 26
The United States occupies a position of world leadership in high
technology. As Figure 5.8 shows, personal computer usage in the
United States is substantially greater, both absolutely and per person,
than in Western Europe and Japan. The U.S. has over half of the
world's Internet users and more than 60 percent of the world's Internet
host computers."
Consumer applications of the World Wide Web such as book
selling and stock trading are well known, but business-to-business
electronic commerce on the Web is much larger and potentially more
important for economic growth. Web connections to suppliers and
customers are promoting faster, more accurate, and lower-cost
28
transactions throughout the economy.
26See
The Emerging Digital Economy (Washington: U.S. Department of
Commerce, 1998).
27
In the United States, 48 percent of the population uses personal computers,
versus 26 percent in Japan and 22.5 percent in Western Europe. In the United
States, 29 percent of the population uses the Internet, versus 8 percent in Japan
and 7 percent in Western Europe. (These calculations are based on figures
from Computer Industry Almanac.)
28For additional evidence on the size and importance of Internet commerce in
the United States, see The Internet Economy Indicators(Austin: University of
Texas Center for Research in Electronic Commerce, 1999).
50
Figure5.6.- Real Investment in
Producers' Durable Equipment
Billions
of real
1992 $
700 4
600
500
400
300
200
100
UkI I
1960
,I
I
1965
I
1970
I
I.
1975 1980
.
1985
1990
1995
Source: Haver Analytics.
Figure 5.77: Growth of High-Technology Sector
% of
8.2
GDP
8 47.2
7
6.1
6
4.9
4.2
3
-
1977
-
1980
1985
1990
1995
1998
Sources: Bureau of Economic Analysis, Survey of CurrentBusiness, March 1998;
Economic Report of the President, 1999.
51
Figure5.8: U.S. Leadership in Personal
Computer and Internet Usage
Millions *
[O PC usage
129
120-- OW
r*
112
Internet usage
fi9
100 or
80-
90
tX 77
0H
60 - -e
_<3
33 29
40-
20~~~~~~~~~~2
200~ f~,, __
I0
Rest of
world
umlteu
States
Source: Computer Industry Almanac.
Note: *Millions of personal computers in use / millions of weekly Internet users.
Increasingly, we live in a world where growth is driven by brain
power and entrepreneurship. The economic structure of the U.S.-the
legal structure, dynamic venture capital market, recent record of price
stability, openness of the economy, and reliance on markets-provides
a favorable environment for success in this new world.
Besides the growth of fixed investment and of the high-technology
sector, other factors influencing growth also appear positive or at least
neutral. If the Federal Reserve continues to remain vigilant, there is no
reason why the relative price stability of recent years cannot be
maintained. The positive effects on growth from the trade sector will
also continue. While the demographic changes in the decade ahead will
not be as favorable as they have been during the 1990s, they will still
be quite positive. Therefore the evidence points to a robust rate of
growth being sustainable at least for the next decade.
52
VI. The U.S. Economy Is at a Crossroads
The prospects for the U.S. economy are bright. If we continue to
follow a stable monetary course and expand the openness of the
economy, economic growth in the decade ahead is likely to be the most
robust since the 1960s. Sustaining the recent annual growth of 3.5
percent is not only possible, it is likely. However, to achieve robust
growth, we must control the size of government. Big government
means slow growth, and rapid growth in government leads to economic
stagnation. The recent history of the major Western European
economies, Japan, and even Canada illustrate this point (see Figures
3.3 to 3.5).
Because of the favorable demographics resulting from the
unusually large share of the population in their prime earning years, tax
revenue will be high and, if new programs are not adopted, government
spending will decline as a share of GDP in the near future. In addition,
both major political parties support the use of the Social Security
surplus to pay down outstanding federal debt. This will reduce future
interest costs, which will also help reduce the relative size of
government. Post-Cold War defense cuts facilitated reductions in the
size of government as a share of the economy in the 1990s. In turn,
smaller government contributed to recent economic growth. Favorable
demographic trends can play the same role in the decade ahead.
However, dangers lurk beneath the favorable demographics and
projected revenue growth. New spending initiatives will be tempting. It
would be short-sighted to adopt them. As the baby boomers begin to
retire, the impact of demographics on the budget will change
dramatically. If we are not sensitive to this situation, the combination
of new spending commitments and current obligations to future retirees
will cause the U.S. to become a stagnating "big government" economy
sometime after 2010.
The United States is at a crossroads. We can use the revenue
increases accompanying the current favorable demographics to
undertake new spending initiatives. If we choose this route,
government spending will rise sharply when the baby boomers retire.
Between 2010 and 2030, persons age 65 and over will increase from 12
percent to 18 percent of the population. Given current commitments,
this change alone will increase government spending as a share of the
economy by 4 to 6 percentage points. Should we undertake additional
commitments, particularly to the elderly, the U.S. will be
"Europeanized" when the baby boomers retire. The big-government
European nations have been surpassed by others following more
sensible policies. The United States will experience the same fate if we
allow our government to get too big.
53
The alternative is to control government spending and allow the
favorable demographics of the upcoming decade to reduce the relative
size of government. It would also be helpful to reform the pay-as-yougo Social Security and health care programs in a manner that
encourages private saving and economizing behavior. If we choose this
alternative, the future of the U.S. economy is exceedingly bright. The
budget choices in the years immediately ahead will determine which
route we will take. The following section addresses this topic.
54
6. THE FEDERAL BUDGET
From 1961 to 1997; the federal government ran a budget deficit
every year except 1969. The era of persistent deficits gave way to
surpluses starting in 1998. If there are no major changes in fiscal
policy, budget surpluses are projected throughout the next decade even
if the average growth rate of real GDP is only 2.3 percent to 2.5
percent, which is lower than the current rate. If the growth of the
economy is stronger, the surpluses will be exceedingly large,
particularly if there is no major reduction in taxes. 29
Both more rapid growth of revenue and slower growth of spending
have helped bring about the fiscal turnaround of the 1990s. Pushed
along by favorable demographics-the increasing share of the
population in prime-age earning years-income has grown rapidly
during the last five years (see Figure 5.2). With progressive taxation,
federal tax revenue rises as a share of the economy as real income
grows. During the current expansion, it has risen to a peacetime high of
20.6 percent of GDP. In the aftermath of the Cold War, certain
expenditures, particularly those for defense, have fallen as a share of
the economy. In 1997, the Congress and the President agreed to limits
on discretionary spending (roughly speaking, the portion of the federal
budget that does not consist of income-transfer programs such as
Social Security and Medicare). At present the limits are due to expire
after fiscal 2002. If they are adjusted for inflation after 2002,
government spending is projected to fall to 17.1 percent of GDP by
2009. That would be the lowest level since the mid 1950s, when
Dwight Eisenhower was president.
I. Federal Spending Over the Last Two Decades
As Figure 6.1 shows, there was an upward trend in federal
spending as a share of GDP from 1950 to 1983. In 1983, federal
spending reached 23.6 percent of GDP, its highest level since World
29 During
the 1960s and 1970s, the fiscal policy ideas of John Maynard Keynes
and his followers exerted a major impact. Keynesians believed that fiscal
policy exerted a strong effect on total demand and that budget deficits could
be used to stimulate output and employment. During the 1970s, expectations
and the crowding out of private spending as the result of higher interest rates
accompanying budget deficits were integrated more fully into
macroeconomics. As economists became more aware of the offsetting effects
accompanying budget deficits (and surpluses), the popularity of the deficits
and the Keynesian view waned. The almost total absence of criticisms of the
large budget surpluses projected for the upcoming decade is a reflection of the
change in views among economists concerning the potency of fiscal policy.
55
Figure 6.1: Federal Spending as a Share of GDP*
% of
GDP
22420 *
18
-
1694
14 1949
1959
1969
1979
1989
1999
2009
Sources: Haver Analytics; Congressional Budget Office, The Economic and Budget
Outlook: An Update (July 1999); Budget of the UnitedStates
Government, F. Y. 2000, HistoricalTables.
Notes: *Data are nominal figures for fiscal years. Federal spending is outlays.
Years beyond 1998 are projections from the Congressional Budget Office.
War II. Much of the growth of federal spending in the early 1980s
resulted from the Reagan Administration's buildup of the U.S. military.
Defense spending rose from 5.2 percent of GDP in 1981, the last
budget of the Carter Administration, to 6.1 percent in 1983. When the
Reagan Administration took office, the tide of Communism was at its
high-water mark. Soviet troops were occupying Afghanistan, and
Soviet-supported regimes in Nicaragua, Angola, and Mozambique
threatened neighboring countries. In Europe, France and Italy had
large, powerful Communist parties; Soviet propaganda had briefly
threatened the stability of the North Atlantic Treaty Organization
(NATO); and the suppression of Poland's Solidarity movement made it
seem that Communism's grip on Eastern Europe was unyielding. The
Reagan Administration's response was decisive in turning the tide of
the Cold War, ending the threat of Soviet Communism and making it
possible to reduce defense spending as a share of the economy in the
1990s. 30
explosion in nondefense spending, which began in the 1970s, was not so
easily contained. Falling inflation also contributed to high levels of federal
spending in the 1980s. As inflation fell from 13.5 percent in 1980 to 3.2
percent in 1983, spending was often based on projections of inflation that
proved too high.
30The
56
Figure 6.2: Federal Receipts as a Share of GDP
% of
16 r1959
1969
1979
1989
1999
2009
Sources: Haver Analytics; Congressional Budget Office, The Economic and
Budget Outlook: An Update (July 1999); Budget of the UnitedStates
Government, F. Y 2000, HistoricalTables.
Notes: *Data are nominal figures for fiscal years. Years beyond 1998 are
projections from the Congressional Budget Office.
II. Federal Taxes Over the Last Two Decades
When President Reagan and the 97h Congress took office, federal
taxes were 19.7 percent of GDP, equalling the highest level since
World War II.31 Marginal tax rates as high as 70 percent and
expansionary monetary policy combined to cause stagflation. President
Reagan's tax cuts reduced marginal tax rates by 25 percent across the
board. At a time when many in the West were losing confidence in
capitalism, the Reagan tax cuts reaffirmed faith in the creative powers
of a free people in a free economy. Lower tax rates restored incentives
to work and invest, liberating the economy. Once fully implemented,
the tax cuts reduced federal receipts to 17.5 percent of GDP, 2.2
percentage points lower than in 1981. Real GDP grew rapidly
following the 1982 recession.
Figure 6.2 presents data on tax revenues as a share of the economy.
During the last 40 years, taxes have generally ranged from 16.1 to 19.7
3'This matched the 1969 level, under the Johnson Administration's last
budget.
57
percent of GDP, usually falling below 18.5 percent. Prior to the current
period, there were two peaks: 1969, due to the Vietnam War
surcharges on income taxes; and 1981, just before the Reagan tax cuts.
Within two years of each peak, the fiscal pendulum swung back and
taxes were reduced by over 2 percentage points of GDP.
Under the Clinton Administration, taxes as a share of GDP have
climbed each year, from 18.4 percent of GDP in 1994 (the year of the
first Clinton budget) to the current peacetime record of 20.6 percent.
This is partly a result of President Clinton's 1993 package of tax
increases, which raised the top marginal rate from 31 percent to 39.6
percent. It is also a consequence of two other factors. First, as
economic growth enables taxpayers in general to earn more, they are
pushed into higher tax brackets ("real bracket creep"). Second, capital
gains tax revenue is included in taxes even though the capital gains on
which they are based are not included in GDP.
Figure 6.3: Federal Deficit/Surplus
as a Share of GDP*
% of
GDP
3.5
,
2.5
1.3
0.5
k
'.
i
40a
I
h
1A
-1.5-
-2.5
-3.5-4.5
W
q
-5.5
-1A~~~~~
I
-1959
1969
1979
1989
1999
Sources: Congressional Budget Office, The Economic and Budget Outlook
An Update (July 1999); Budget of the United States Government,
F. Y 2000, HistoricalTables.
Notes: *Data are nominal figures for fiscal years. Years beyond 1998 are
projections from the Congressional Budget Office.
58
2009
III. The Coming Decade: Cutting Taxes, Retiring Debt, and
Bolstering Retirement Security
Figure 6.3 shows the pattern of budget deficits and surpluses as a
share of GDP during the last 40 years. Deficits were present throughout
the 1960s (except 1969), and increased in the 1970s and 1980s.
Following the recovery from the 1990 recession and one-time
expenditures due to the savings and loan crisis, the situation changed
dramatically. The increase in economic growth of the last five years
has accelerated the shrinkage of the deficit.
With taxes exceeding 20 percent of GDP, and spending below 20
percent of GDP and falling, budget surpluses are projected for the next
ten years and beyond. If limits on discretionary spending are extended
beyond fiscal 2002 and adjusted for inflation, revenues are on a path to
exceed expenditures by a total of $2.9 trillion over the next ten years,
with surpluses totaling $1.1 trillion during 2000-2004 and $1.8 trillion
32
during 2005-2009.
The budget for fiscal year 2000 passed by the 106t Congress
provides for tax cuts totalling $792 billion over ten years, which will
come from the $996 billion of on-budget surpluses.3 3 The entire
amount of the Social Security surpluses will be set aside in a "lockbox"
to provide for greater retirement security. The surpluses in the lockbox
will be used to retire publicly held debt by as much as $1.9 trillion.3 4
The tax cut still leaves $254 billion of on-budget surpluses that can be
used for further debt reduction or increased spending on Medicare
reform, national defense, or other priorities.3 5
The Congress and the Clinton Administration have developed
contrasting proposals for using the on-budget surpluses projected to
Congressional Budget Office, "The Economic and Budget Outlook: An
Update," July 1, 1999.
33 H. Con. Res. 68, conference report agreed to by the House of
Representatives on April 14, 1999 and the Senate on April 15; H.R. 2488, the
Taxpayer Relief and Refund Act of 1999, conference report adopted by both
Houses of Congress on August 5, 1999.
34 One method of strengthening Social Security would be to allow future
recipients to invest a portion of their payroll tax in personal savings accounts
in exchange for lower future benefits. This would have the twin virtues of
increasing personal savings and reducing future demands on the Social
Security system. However, a way must be found to shift toward an
"investment-based" system without endangering the benefits promised to
current and future retirees.
3 5This figure also takes into account the effect of the 1999 supplemental
appropriations bill and contingent emergencies. Statement of Dan L. Crippen,
director of the Congressional Budget Office, to the Senate Budget Committee,
July 21, 1999.
59
32
59-884 0 - 99 - 3
accumulate over the next decade. Figure 6.4 compares the proposals.
As the figure shows, the federal government does not have to choose
among significant tax cuts, deep debt reductions, or maintenance of
entitlement spending levels. Under current budget projections, it can
accomplish all of them. Specifically,
*
*
*
*
*
Taxes can be cut by $792 billion.
Publicly held debt of $1.9 trillion can be retired.
Mandatory entitlement spending can increase by 73 percent over
1999 levels, from $977 billion to $1.69 trillion.
Discretionary spending can increase (as provided in the fiscal 2000
budget resolution) by $222 billion more than if the current limits
were left in place and not adjusted for inflation. 3 6
Even with all these other activities, $254 billion will be left over
for other purposes."
In contrast, the Clinton Administration has proposed to raise taxes
above the current all-time high-level, increase spending, and retire less
of the outstanding debt. Over the next 10 years, President Clinton's
proposals
*
*
*
Increase taxes by $95 billion.
Increase spending by $1.033 trillion.3 8
Provide for on-budget surpluses totalling only $54 billion.
The Clinton Administration has endorsed the idea of a "lockbox"
for off-budget surpluses, so both the Congress and the President would
reduce publicly held debt by $1.9 trillion. As Figure 6.4 clearly
illustrates, the tax cut debate is not about taxes and debt retirement. It
is about spending! The President wants to use every penny of the $1
trillion in on-budget surpluses (plus a tax increase) to increase
spending. The Congress would use these surpluses to reduce the tax
36AII
the figures here are calculated using the assumptions of the nonpartisan
Congressional Budget Office. The figure of $222 billion is $197 billion below
the CBO baseline, which assumes inflation adjustments from 2003 to 2009.
Taking into account increased interest payments, and the net increase in
mandatory spending under the budget resolution, total spending would be $50
billion less than the CBO baseline.
37If some of this remaining surplus is used to retire debt, there will be
additional savings due to reduced interest payments.
38These numbers are from the CBO's analysis of the Mid-Session Review,
contained in CBO Testimony, Statement of Dan L. Crippen to the Senate
Budget Committee, July 21, 1999. They are relative to the CBO baseline, and
include the proposed expenditures for Universal Savings Accounts.
60
Proposals for~~~~~~~~~~~~~~~~~~~~~~~
6.4:
Figure
Opposing
Figure 6.4: Opposing Proposals for
On-Budget Surpluses, 2000-2009
106th Congress
1000
800
$792 billion
600
Tax cut
H.R. 2488
H.Con.Res. 68
spending
restraint
400
billion
~~~~~~~$254
__
200
0
billion
-$50
Surpluses
Spending
Taxes
-100
(relative to CBO baseline)
Clinton Administration
$1033 billion
1000.
800
-
600
400 - -
Net tax
increase
F.Y. 2000
budget
-10°0
budget
spendingincreases
(including
Medicare)
200 _
0
*
-
$54 billion
$95 billion
1_
Taxes
Spending
Surpluses
(relative to CBO baeline)
Sources: Congressional Budget Office, Joint Committee on Taxation,
and Joint Economic Committee.
Note: F.Y. denotes fiscal year.
burden of the American people. There is little difference between the
two with regard to the retirement of debt. In fact, the Congressional
plan provides a slightly larger amount for this purpose.
61
IV. Does the CBO Underestimate Future Revenue?
If the spending caps are maintained through 2002 and thereafter
adjusted for inflation, the Congressional Budget Office's revenue
projections indicate that $2.9 trillion will be available for debt
retirement, tax cuts, or spending increases. There are two major
reasons to believe that the CBO's calculations underestimate the
growth of federal revenue. First, the CBO assumes federal tax revenues
will increase less rapidly than nominal income. Under a progressive tax
structure; the opposite is true. According to CBO's projections,
nominalGDP will increase by 53.1 percent during the next ten years
but federal revenue will increase by only 49.6 percent. This implies
that for every 10 percent of growth in nominal GDP, federal revenue
grows only 9.4 percent. Under progressive taxation, this forecast does
not make sense. While federal income tax brackets are indexed for
inflation, they are not indexed for growth in real income. Thus, a larger
and larger share of income will be taxed at higher rates as real income
grows. Most observers agree that federal revenue grows 10 to 30
percent faster than nominal GDP, rather than 6 percent slower than
nominal GDP as the CBO estimates. If federal revenue grows 10
percent faster than nominal GDP, during the next ten years it will be
$966 billion more than the CBO forecast.
Second, the CBO assumes real GDP will grow an average of less
than 2.5 percent a year during the next decade. This is exceedingly
conservative. During the last five years, real GDP grew at an annual
rate of 3.4 percent a year, and during the last 15 years it has averaged
3.1 percent a year. Given the high percentage of the work force that
will be in its prime earning years in the decade ahead, the CBO's
projection is too low. Even if real GDP growth is only 2.8 percent a
year, federal revenues will exceed the CBO forecast by $385 billion
over the ten-year period.
Thus, the CBO's projections underestimate federal revenues, and
therefore budget surpluses. It is highly likely that federal revenues
during the next ten years will be around $1.3 trillion more than the
CBO forecast.39 Attractive growth and favorable demographics will
make it possible to initiate new programs and expand spending as the
President proposes. But it would be a mistake to do so. Following such
a plan during the next decade will plant the seeds of big government
and slow growth when the baby boom generation retires during the
subsequent decade.
39For
additional details, see the testimony of James Gwartney at the Joint
Economic Committee Hearing on Tax Cuts and the Budget Surplus,
September 13, 1999, online at <http://www.senate.gov/-jec/gwartney.htm>.
62
V. Why Tax Relief Is Necessary
Americans are not under-taxed. As Figure 6.2 shows, taxes are
currently at a peacetime high. Without a major tax cut, they will remain
at or near that level during the next decade. If anything, the tax cut
proposed by Congress was too small. Of the $792 billion in tax
reduction, only $156 billion would have taken effect during the first
five years. The Congressional tax cut was only 0.7 percent of GDP
during the ten year period-0.4 percent during the first 5 years and 1.0
percent during the last five years. After the tax cut was fully phased in,
tax revenues would still have taken 18.8 percent of GDP-a level that
is still higher than 40 of the last 50 years. There are several reasons
why taxes should be reduced.
1. It will be tempting for Congress and the President
(regardless of party) to spend the surpluses. Given the current
structure of the U.S. economy and the favorable demographics that will
continue until the baby boom generation starts retiring around 2010,
economic growth is almost certain to generate sizeable surpluses. It
will be tempting to spend the surpluses. President Clinton has already
proposed $1.03 trillion in new spending initiatives. High levels of
taxation that bring in more revenues will lead to more spending. But it
would be a mistake to follow this course. Big government leads to
slower growth, so spending increases financed by the surpluses of the
next decade would retard future growth.
2. A tax cut is an insurance policy against a future recession.
Critics of a tax cut argue that future surpluses will be sharply reduced
or even eliminated if the economy goes into a recession. The projected
surpluses are based on a modest long-term annual growth rate (2.5
percent a year), which is less than the decade average achieved during
the 1960s, 1970s, 1980s, and the 1990s so far. The actual growth rate
during the next decade is far more likely to exceed 2.5 percent than it is
to fall short of it. However, suppose the economy does fall into a
recession. Taxes reduce the efficiency of resource use and incentives to
produce and generate income. Thus, a tax cut-particularly one that
reduces the highest effective tax rates on investment income-will
make a future recession both less likely to occur, and less severe if it
does occur.
3. Even if only the Social Security surpluses are used to retire
outstanding debt, the federal debt will fall rapidly-perhaps too
rapidly. Even if just the funds in the Social Security lockbox are used
to pay down debt, by the end of 2009, publicly held debt will fall from
its current level of $3.6 trillion to $1.7 trillion. However, some of the
publicly held debt is needed by the Federal Reserve to conduct
63
Figure6.5: Privately Held Federal Debt
% of
GDP
0..
.
.
.
.
.
.
.
.
.
.
.
.
1918 1925 1932 1939 1946 1953 1960 1967 1974 1981 1988 1995 2002 2009
Sources: U.S. Census Bureau, The StatisticalHistory ofthe United Statesfrom
ColonialTimes to the Present;HistoricalTables, Budget of the United
States Government, FiscalYear 2000;Congressional Budget Office.
monetary policy. Assuming that the Federal Reserve's holdings of debt
increase at the same rate as during the last decade, it will need $870
billion in national debt in 2009. That means that net privately held debt
will fall from $3.1 trillion currently (40 percent of GDP) to just $826
billion in 2009.40 Figure 6.5 shows the path of the privately held debt
as a share of GDP during the last 80 years and projects the ratio for the
next decade under these assumptions. Privately heldfederal debt will
fall to 6 percent of GDP in 2009, its lowest level since before World
War I
Rapid retirement of debt could exert a destabilizing influence on
financial markets and jeopardize the, dollar's role as the world's
4 0Only
privately held debt creates an interest liability for the federal
government. The government both pays and receives the interest on debt held
by government agencies and by the Federal Reserve (after the Federal Reserve
deducts its operating expenses).
64
preferred reserve currency. Dollar-denominated, risk-free Treasury
bills and bonds currently play an important role in financial markets.
They are widely held by central banks and currency boards around the
world. They are also widely held by state and local government
pension funds and private funds seeking secure assets. Paying down
the debt to very low levels would force holders of Treasury securities
to search for other highly secure interest-earning assets, perhaps bonds
denominated in euros or yen.
VI. Fiscal Policy and America's Future
With the bulk of the baby boomers in their peak earning years,
income should grow rapidly and federal spending should decline as a
share of the economy during the next decade. It will be important to
restrain federal spending during this period because the situation will
change dramatically starting around 2010. Currently, persons age 65
and over are approximately 12 percent of the U.S. population. Federal
spending on health care, social security and other entitlements targeted
toward the elderly consume roughly 8 percent of GDP. When the baby
boomers retire between 2010 and 2025, persons 65 and over will
increase to 18 percent of the total. Under current law, this factor alone
will push federal spending up by more than 4 percentage points as a
share of GDP by 2025.
The role of government in the provision of retirement security and
health care needs to be re-evaluated. The current Social Security
system discourages savings, investment, and work. It also promotes
dependency. A system that placed less reliance on pay-as-you-go
funding and more on investment could encourage both a higher rate of
economic growth and greater financial security for elderly Americans.
In recent years, Roth IRAs and similar modifications have moved us in
this direction. Other options that would allow individuals to channel
more of their earnings into personal retirement savings accounts should
be pursued.
Currently, government involvement in health care reduces the
incentive of individuals to choose among health care providers and
shop for providers that supply the most value per dollar of expenditure.
The current system also reduces the incentive of suppliers to
economize. This perverse structure helps explain why costs of medical
services have risen almost twice as fast as the general level of prices
during the last three decades.
The favorable budgetary situation during the years immediately
ahead may actually make it more difficult to undertake meaningful
reforms in these two areas. The easy option will be to simply pour
more funding into existing programs. Doing so, however, would be
65
l
shortsighted. Unless Social Security and health care are restructured,
total government spending (federal, state, and local) will alnost
certainly rise to 40 percent of GDP when the baby boomers retire. No
country has been able to sustain real growth above 2 percent a year
with government spending of this magnitude. A European-style, biggovernment economy will lead to European-style growth, rates of just
1 percent to 1.5 percent per year. If, on the other hand, Social Security
and health care are reformed in a sensible manner and government
spending in other areas is restrained and reduced as a share of the
economy in the decade ahead, the future of the U.S. economy is
exceedingly bright.
66
7. FIVE INDEFENSIBLE FEATURES OF THE TAx SYSTEM
As the U.S. economy heads into the next century, federal taxation
will continue to be a dominant policy issue. It is not hard to understand
why: the federal government will collect an enormous $1.9 trillion in
taxes in 2000. Measured as a share of GDP, federal taxes now stand at
a peacetime high of 21 percent, up from just 3 percent 100 years ago.
The extraction of $1.9 trillion each year from workers, retirees,
business owners, consumers, savers, and investors imposes substantial
costs on taxpayers over and above the revenue transferred to the
government. In the long run, comprehensive tax reform could greatly
reduce the harmful side effects caused by the federal tax system,
benefitting taxpayers and encouraging economic growth.
Reforms can be made to both the tax base and tax rates. The tax
base is the items and transactions that are taxed; the tax rate is the
percentage of the tax base that the taxpayer has to pay the government.
Much of the trouble with the tax code results from the overly
complicated definitions of the tax base. The federal income tax code
contains confusing rules regarding the "income" to be included on the
numerous tax forms, while certain types of income face multiple layers
of taxation. For example, corporate profits distributed to shareholders
in the form of dividends are taxed at both the business level and the
individual level, biasing taxpayers against investment and encouraging
businesses to take on debt.
I. The Optimal and Revenue-Maximizing Tax Rates
In the case of each tax, it is important to recognize the distinction
between the optimal tax rate and the revenue-maximizing rate. Taxes
provide the government with revenue, but they also squeeze out
productive activity. At the optimal tax rate, the government's use of the
additional tax revenue provides net benefits to citizens that are
sufficient to cover the cost of the productive activity squeezed out by
the tax. The optimal tax rate balances the value of the lost output
against the value of what might be provided with the additional
revenue; it is the best rate for the economy.
In contrast, the revenue-maximizing rate ignores the cost of the lost
output accompanying the higher tax rate. It focuses only on whether a
higher rate will generate additional revenue.4 1 The revenue derived
from a tax is equal to the tax rate multiplied by the tax base. Higher tax
41The
revenue-maximizing rate would be an optimal rate only if the
government placed no value on the welfare of citizens. This may be the case
for autocratic regimes.
67
Figure 7.1: Optimal and RevenueMaximizing Tax Rates
Tax
rate (%)
rates cause the tax base to shrink. At the revenue-maximizing tax rate,
the revenue reduction due to the shrinkage of the tax base exactly
offsets the revenue gain due to the higher rate.
Figure 7.1 illustrates the revenue-maximizing tax rate and its
relationship to the optimal tax rate. As the tax rate (measured on the
vertical axis) increases, tax revenue (measured on the horizontal axis)
initially expands. However, as the tax rate continues to increase, the tax
base (productive activity) declines, causing revenue to increase less
than proportionally. Eventually, at the revenue-maximizing rate (point
A), the shrinkage in the tax base is so large that a higher tax rate fails
to generate any additional revenue. Still higher rates actually reduce
revenue.
Think of what is happening as higher tax rates eventually extract
the maximum amount of revenue. As the revenue-maximizing rate is
approached, output declines and the tax base shrinks by such a large
amount that a higher rate fails to raise additional revenue. Economists
refer to the loss of output accompanying the imposition of a tax as the
"excess burden" of taxation. Because the excess burden is so large
68
relative to the revenue raised, tax rates at or near the revenuemaximizing point harm the economy. The optimal tax rate is always
lower-generally substantially lower-than the revenue-maximizing
rate. In Figure 7.1, the optimal rate is a point such as B, C, or D rather
than point A.42
This analysis highlights the destructiveness of high marginal tax
rates, which are the rates applicable to the additional earnings of a
taxpayer. Even as high marginal rates distort prices, reduce production,
and encourage wasteful tax avoidance, they also shrink the tax base so
much that they generate little additional revenue. In some cases, the
government would actually collect more revenue if the high marginal
rates were lowered. Studies indicate marginal income tax rates greater
than 40 percent fall into this category.4 3 Given the destructive impact
of high marginal rates on output and the efficient use of resources,
governments should avoid imposing tax rates in the range above or
even near the revenue-maximizing rate.
During the last 15 years, recognition of the effects of high marginal
tax rates has caused many countries to reduce their highest marginal
rates.44 The United States lowered personal income tax rates during the
1980s, but has gone against the grain and pushed rates upward in the
1990s. The result has been that the tax burden has risen (see Figure
7.2). With the federal budget now running a sizeable surplus, and with
much larger surpluses virtually certain in the years immediately ahead,
it is an opportune time to reduce tax rates and eliminate the worst
features of the current tax system.
With these basic principles in mind, the following reforms would
substantially improve the fairness, economic efficiency, and simplicity
of the federal tax code.
42For
an in-depth discussion of the optimal tax rate and the revenuemaximizing rate, see James D. Gwartney and Randall G. Holcombe, Optimal
Capital Gains Policy: Lessons from the 1970s, 1980s and 1990s, Joint
Economic Committee, June 1997, especially pp. 7-8.
43See Dwight Lee, ed., Taxation and the Deficit Economy (San Francisco:
Pacific Institute, 1986); Lawrence Lindsey, The Growth Experiment: How the
New Tax Policy is Transforming the US. Economy (New York: Basic Books,
1989); and Martin Feldstein, Tax Avoidance and the DeadweightLoss of the
Income Tax (Cambridge, Massachusetts: National Bureau of Economic
Research, 1996). For certain types of taxes, the revenue-maximizing rate may
be substantially less than 40 percent.
44of 105 countries for which data were available, 59 cut their top marginal tax
rates from 1990 to 1997, 28 raised them, and 18 left them unchanged. James
Gwartney and Robert Lawson, Economic Freedom of the World: 1998/1999
Interim Report (Vancouver: Fraser Institute, 1998), pp. 54-8.
69
Figure 7.2: Tax Burden
% of
total
compensation
Payrolland |
personal
income taxes
28
22
\
w~~~
26
24
I
Payroll, personal
income, and corporate
income taxes
0*/
e
20
1980
1985
1990
1995
Source: Derived from Economic Report of the President, 1999.
II. Reform #1: Reduce the Double Taxation of Corporate Income
Corporations pay taxes on their profits. If they distribute some of
the profits to shareholders in the form of dividends, the profits are
subject to income tax. If corporations retain after-tax profits, the
income increases their value and pushes their share prices upward.
Shareholders again pay, not through the income tax but through the
capital gains tax. Taxing profits at the corporate level and again at the
individual level reduces the return on equity investment, constricting
the pool of capital available for businesses. It also artificially biases
businesses toward financing investments with debt, because interest is
a deductible expense.
Consider the situation of Susan Shareholder, who owns a share in
XYZ Corporation. If XYZ earns $1 per share, the amount Susan
receives is reduced by the 35 percent federal tax on corporate income,
leaving her with 65 cents. If XYZ distributes the remaining 65 cents in
the form of a dividend, she may be taxed as much as 39.6 percent,
leaving her with as little as 39 cents. In this case, the effective tax rate
70
on the $1 of earnings is 61 percent. Even if Susan's personal income is
taxed at a 15 percent rate, the lowest rate, the effective marginal tax
rate is still 45 percent (the 35 percent corporate rate plus 15 percent of
the remaining 65 cents used to finance each dollar of dividends). If
XYZ retains its after-tax profit and the stock price rises to reflect that,
when Susan sells her share (after holding it for more than one year),
her capital gain is taxed as much as 20 percent. This leaves her with 52
cents of every $1 of net income generated by XYZ. In this case, her
effective tax rate is 48 percent (the 35 percent corporate rate plus 20
percent of the remaining 65 cents). Regardless of whether it was
realized as dividends or capital gains, Susan's share of XYZ's profits
has been taxed twice, leading to combined rates ranging from 45
percent to 61 percent. Tax rates this high could be substantially
reduced without losing appreciable revenue. Lower tax rates would
lead to higher rates of capital formation and faster economic growth,
and may even increase tax revenue.
Taxes on dividends and capital gains at the individual level should
be lowered or eliminated. Alternatively, corporations could be allowed
to deduct dividends paid to shareholders just as they currently deduct
interest costs. Either reform would reduce the excessive taxation of
corporate income.45
m. Reform
#2: Reduce Marginal Rates
on Social Security Recipients
Americans in their 60s and 70s are increasingly healthy and
energetic. Many would prefer to continue working so that they can earn
more now and save more for the future.4 6 Unfortunately, current tax
laws strongly discourage them from doing so.
The income and payroll taxes imposed on older Americans are
particularly burdensome when combined with the "earnings test,"
which automatically reduces Social Security benefits for recipients
who earn more than a specified amount from working. Recipients age
62 to 64 lose $1 of benefits for every $2 they earn above $9,600 a year.
Recipients age 65 to 69 lose $1 of benefits for every $3 they earn
45Some
people speak as if there is an entity called business that can be taxed
independently of individuals. That is a myth; all taxes are paid by people.
Even if a business collects the tax and writes the check to the government, the
burden of the tax still falls on people in the form of higher product prices,
lower wages, or lower returns on investments.
46Eugene Steuerle, Christopher Spiro, and Richard W. Johnson, "Can
Americans Work Longer?" Straight Talk on Social Security and Retirement
Policy, no. 5 (August 15, 1999), Urban Institute.
71
above $15,500 a year.4 7 Like other workers, older workers are also
subject to the payroll tax of 15.3 percent (divided equally between
workers and employers), and federal, state, and local income taxes of
15 percent and up.
The combined effect of lost Social Security benefits plus payroll
and income taxes means that for every $100 that persons age 62 to 64
earn, they get to keep only $25.4 The situation is not much better for
those age 65 to 69: for every $100 they earn, they keep only $41.49
Social Security recipients in their 60s face effective marginal tax
rates of 59 to 75 percent even when their earnings are low.5 0 Such high
rates have no justification. The economy suffers because it is deprived
of the knowledge and skills of productive workers. The elderly are
harmed because the law discourages them from providing for
themselves and, as a result, they become more dependent on the
government. The earnings test applies only to income from work. A
person can be a millionaire and still receive full Social Security
47According
to the Social Security Administration, Social Security recipients
age 65 to 69 lost $3.9 billion in benefits in 1998 as the result of the earnings
test. Eliminating the earnings test would substantially increase the supply of
labor from older Americans at almost no cost to the federal budget. Leora
Friedberg, "The Labor Supply Effects of the Social Security Earnings Test,"
National Bureau of Economic Research Working Paper W7200 (June 1999).
4 8Suppose that a
Social Security recipient age 62 to 64 earns an additional
$107.65 above the $9,600 threshold. Payroll taxes take $15.30, income taxes
$15, and reductions in Social Security benefits $50. This is a marginal tax rate
of 75 percent ($80.30 - $107.65). People paying more than the 15 percent
marginal income tax rate or living in areas with state and local income taxes
face even higher rates. These calculations assume that the 7.65 percent of the
payroll tax levied on the employer is both earned and paid by the employee.
This is a valid assumption because it is a component of the employee's
earnings. If the productivity of an employee is not worth the cost of direct
compensation as well as the taxes accompanying employment, an employer
will not hire the worker.
4 9Consider the
situation for Social Security recipients age 65 to 69 with
earnings above the $15,500 threshold. For each extra $107.65 they earn,
payroll taxes take $15.30, income taxes $15.00 and reductions in Social
Security benefits $33.33. The marginal tax rate is 59 percent ($63.63 +
$107.65). Those with higher incomes or living in areas with state and local
income taxes face even higher rates.
501n some instances, the interaction of the earnings test, the payroll tax, federal
income tax, and state and local income taxes leads to marginal tax rates of 100
percent or more. Such confiscatory rates completely remove the incentive to
work.
72
benefits as long as earnings from work do not exceed the modest
earnings ceilings. 5 '
President Clinton persuaded the 103"d Congress to raise the tax on
Social Security benefits for couples earning more than$44,000 a year
and singles earning more than $34,000 a year.5 2 Prior to 1993 only 50
percent of Social Security benefits were subject to income tax. This
made sense because recipients had already paid income taxes on the
"employee share" of the payroll tax." Arguing that additional revenues
were needed to balance the budget, the Clinton plan made 85 percent
of Social Security benefits subject to tax. Even though the budget is
now running a surplus, the tax has not been removed.
The current tax system deprives our economy of the knowledge
and experience of many older workers. Two out of three Social
Security recipients do not work. Of those who do work, two out of
three earn less than would be the case if their earnings did not reduce
their Social Security benefits. 5 4 As the health of older Americans
continues to improve, the harmful side effects of the current system
will worsen.
Several steps need to be taken to remove roadblocks limiting the
economic participation of older Americans. First, the earnings test for
Social Security benefits should be repealed. This might be done
independently or as part of a comprehensive reform of Social Security
designed to encourage personal savings, while providing recipients
with greater flexibility and a more secure property right to benefits that
they have earned. Second, the 1993 Clinton Social Security tax
increase should be repealed. It is unfair to tax the income paid into the
Social Security system and then tax the benefits funded by the
payments. Third, consideration should be given to exempting workers
drawing Social Security from at least the "employee share" of the
payroll tax. This tax will not provide them with any additional benefits.
5'The structure of the current system reflects the "lump of labor" fallacy, the
idea that the total number of jobs is fixed and therefore one person's
employment deprives another of a job. This concept has no relevance in an
economy that has created 33 million additional jobs during the last 16 years.
Furthermore, as the baby boomers age, more older workers would help the
economy continue to grow.
' 2The income thresholds are not indexed for inflation, so an increasing number
of Social Security recipients pay income taxes on their benefits each year.
53This was consistent with the tax treatment of private pensions. Benefits from
private plans are not subject to taxation if the beneficiaries have already paid
income taxes on the premiums financing the plans.
' 4Gary and Aldona Robbins, "Retiring the Social Security Earnings Test,"
Institute for Policy Innovation, May 6, 1999.
73
Workers should be permitted to either keep this share of their payroll
tax or use it to fund a privately controlled savings plan.
IV. Reform #3: Reduce or Eliminate the Estate and Gift Tax
If a taxpayer owns a small business valued in excess of $650,000 at
death, the federal government taxes the heirs on the value over this
amount, even if they continue operating the business. The estate tax
imposes rates as high as 55 percent-the second-highest rate in the
world. Effective tax rates range from 37 percent to nearly 80 percent in
some instances.55
The estate and gift tax raises little if any net revenue, promotes
widespread tax avoidance, and causes substantial harm to the economy.
A recent study concludes that it inhibits capital accumulation and
economic growth; threatens the survival of family businesses and
depresses entrepreneurial activity; violates the tax principles of
fairness, simplicity and efficiency; and adversely impacts the
conservation of environmentally sensitive land.56 All told, the costs
imposed by the estate and gift tax far outweigh any benefits.
The estate and gift tax also biases people toward consumption,
undermining capital formation. People who can accumulate assets
choose between consuming their wealth today or saving and investing
it. Wealth that is consumed cannot generate additional goods or
services in the future. In contrast, when people defer consumption,
capital becomes available for those seeking to generate additional
goods and services in the future.
Recently, a number of states, including New York, Louisiana,
Kansas, Delaware, and Iowa have enacted legislation to eliminate or
significantly reduce the burden of state-imposed estate taxes. The
federal government should work in the same direction by increasing
the share of wealth people can leave to their heirs and eventually
eliminating this tax altogether.
V. Reform #4: Eliminate the Marriage Penalty
Because the. federal income tax code does not recognize that
marriage is, in part, an economic partnership in which husbands and
R. Bartlett, "Why Death Taxes Should Be Abolished," National
Center for Policy Analysis Policy Backgrounder 150 (August 18, 1999); Joint
Committee on Taxation, U.S. Congress, "Present Law and Background
Relating to Estate and Gift Taxes," JCX-298 (1998).
56
Joint Economic Committee, "The Economics of the Estate Tax," December
1998, at <http://www.house.gov/jec/fiscal/tx-grwth/estattax/estattax.pdfP.
55Bruce
74
wives share their incomes equally, most married couples pay a
marriage penalty.
The main reason for the penalty is that the standard deduction and
tax brackets are not twice as much for married couples as for singles.
In 1999, the standard deduction is $4,300 for singles. Married couples
receive a standard deduction of $7,200, while unmarried couples
receive two deductions of $4,300, for a total of $8,600.
The marriage penalty reaches all the way up the income ladder.
After the standard deduction and personal exemption, a single person
faces the lowest 15 percent tax rate on the next $25,750 earned. Income
above that is taxed at 28 percent or more. This means two single
workers get the low 15 percent rate applied to up to $51,500 in taxable
income (two times $25,750). In contrast, married couples are permitted
to earn only $43,050 in the 15 percent bracket.
Once it is recognized that marriage is an equal partnership, it is
clear that every married couple that uses the standard deduction or
itemizes deductions and has income in the 28 percent tax bracket or
above incurs the marriage penalty. The only married taxpayers who
avoid it are those who both itemize and are in the 15 percent bracket.
The marriage penalty is bad public policy. The family has been the
central supportive institution of society for several thousand years.
Governments, despite their good intentions, are ill-equipped to deal
with many problems that can be ameliorated by strong families. It is
vitally important that public policy not weaken the family.
The best way to eliminate the marriage penalty is to make the
standard deduction and the tax brackets for married couples twice the
amounts for singles.57 Senator Kay Bailey Hutchison (R-Texas) has
introduced a bill to do just that. As an alternative, she has also
introduced a bill that would allow "income splitting," so that married
couples could choose to be taxed as two single filers, each earning half
of the couple's combined income.
57This
implies that the width of each tax bracket must double as taxpayers
move to higher brackets.
It has been proposed that married couples have the choice of filing as
singles. This would reduce the marriage penalty, but if one spouse earned all
or most of the income, the tax liability of the couple would be higher than that
of another couple with the same joint income, but a more equal division of
earnings between husband and wife. Families where one spouse stays at home
or works much less than the other would be penalized.
75
VI. Reform #5: Make Health Insurance
Fully Tax Deductible for Individuals
Fringe benefits such as health care insurance are a component of
employee compensation, not a "gift" from employers. Employers who
offer extensive fringe benefits can attract workers with lower money
wages, while those who offer few fringe benefits have to pay higher
wages. In essence, employees pay for health insurance and other fringe
benefits in the form of lower money wages. There are two major
reasons why employers and employees find it mutually advantageous
to include health care insurance and other fringe benefits in the
compensation package: the ability to obtain the benefit cheaper as the
result of economies of group purchase, and tax advantages. Both are
important in the case of health insurance benefits. 5 8
When employees in the United States receive health insurance
benefits as part of their compensation package, the benefits are not
taxed.5 9 In contrast, families and individuals purchasing health
insurance directly must do so with after-tax earnings. 6 0 This difference
in tax treatment makes the direct purchase of health insurance more
costly and reduces the competitiveness of the industry.
Consider two individuals, Smith and Brown. Both receive
compensation of $1,200 per month and take the standard deduction.
Smith receives $900 of taxable earnings and $300 of health insurance.
If Smith is taxed at a 20 percent rate, his tax bill is $180 (20 percent of
the $900 of taxable earnings). This leaves Smith with after-tax
compensation of $1,020 ($720 in after-tax earnings and $300 in the
form of health insurance benefits). Brown's employer does not offer
health insurance. Therefore, her total compensation of $1,200 is
taxable. Brown's tax bill is $240 (20 percent of $1,200), $60 more than
Smith. If Brown purchases the same $300 health insurance package as
Smith, she is left with $60 less than Smith merely because she
purchased insurance directly rather than through an employer.
5 8Approximately
two-thirds of non-elderly adults purchase health insurance
through group plans offered by their employers.
59 Employer-provided health insurance originated during World War II as a
means to escape wage controls. Because health insurance was not counted as a
wage increase, it enabled employers to raise total compensation and attract
additional workers.
WOTaxpayers who itemize can deduct health insurance expenses only to the
extent that their total medical expenses exceed 7.5 percent of adjusted gross
income. Self-employed individuals can currently deduct only 60 percent of
their family's health insurance expenses; this amount will be 70 percent in
2002 and 100 percent in 2003.
76
This discriminatory treatment is unfair and it should be eliminated.
It is not a proper function of government to channel most workers into
"one size fits all" insurance plans provided through employers.
Discriminatory treatment could be eliminated either by taxing
employer-provided health care as income or by making the purchase of
health insurance tax deductible for individuals and families. The latter
is far more politically feasible. The recent tax bill passed by Congress
would have made health insurance premiums tax deductible. President
Clinton vetoed the bill.61
VII. Concluding Thought
The taxes discussed here fall into two categories. They either
impose such high marginal rates that they undermine productive
activity and the wise use of resources, or they unfairly tax a socially
beneficial action. The excessive taxation of nominal capital gains,
particularly those phantom gains that merely reflect inflation, is also
indefensible. However, because of the complexity of this issue and the
unique characteristics of capital gains, the subject requires a separate
section, which follows.
6 1The
current structure also discriminates against small employers. Group
health plans covering a large number of employees are generally more
economical than those covering only a small number. As a result, large firms
are more likely to offer health insurance than smaller ones. This, along with
differential tax treatment, provides large firms with a competitive advantage.
77
8. CAPITAL GAINS, GROWTH, AND INFLATION 6 2
The present tax treatment of capital gains and losses is both
inequitable anda barrierto economic growth. The tax on capitalgains
directly affects investment decisions, the mobility and flow of risk
capitalfrom static to more dynamic situations, the ease or difficulty
experienced by new ventures in obtaining capital, and thereby the
strength andpotentialgrowth of the economy.
President John F. Kennedy
Special Message to the Congress on
Tax Reduction and Reform
January 24, 1963
Capital gains reflect increases in the value of resources. As such,
they are central to economic growth and prosperity. Capital gains are
the result of investments that have already been taxed and often occur
across long intervals, making inflation an important consideration.
Taxpayers also have the power to choose when (and, sometimes,
whether) to sell an asset and realize gains that will trigger a capital
gains tax liability. These attributes need to be kept in mind when
considering the proper tax treatment of capital gains.
I. Capital Gains and Economic Growth
High capital gains taxes reduce the incentive for individuals to
invest in the new equipment that fuels economic growth. While other
factors obviously play a role in determining economic growth, lower
capital gains tax rates encourage faster growth. This relationship
suggests that some of the recent unexpected strength in the U.S.
economy stems from the 1997 reduction in capital gains tax rates.
Capital gains reward risk-takers who develop and invest in new
businesses that are critical to creating jobs, increasing wages, and
stimulating economic growth. Entrepreneurs frequently rely on venture
capital to help finance new firms, sell their companies, or make initial
public offerings (IPOs). Lowering capital gains taxes raises the aftertax return, prompting more entrepreneurs to start new companies or
expand current operations. Cutting the rates on capital gains taxes
unleashes more venture capital to fund new firms.
62 This
section is based on a staff report from the Joint Economic Committee,
"Cutting Capital Gains Tax Rates: The Right Policy for the 21' Century,"
August 1999, available online at <http://www.senate.gov/-jec/capgains.htm>.
78
Lowering capital gains tax rates and indexing gains for inflation
would reduce the cost of capital. In turn, lower capital costs would
encourage entrepreneurship, new businesses, and investment.
Abundant capital spurs technological innovations that allow workers to
produce more with less effort by providing additional capital per work
hour. That situation leads to greater economic growth, lower
unemployment, and higher real wages.
A recent, comprehensive ten-country study by researchers at the
London Business School and Babson College demonstrates the strong
connection between the pace of new business formation and the speed
of economic expansion. In comparing the economic development of
various nations, the study concluded that the "variation in rates of
entrepreneurship may account for as much as one-third of the variation
in economic growth." 6 3
II. The Nature and Uniqueness of Capital Gains
Because investors often do not realize (receive money from)
capital gains until years after they invest, the nominal value of the
gains is influenced by inflation. If any inflation occurs during the
investment period, the real gain differs from the nominal gain. If
someone invests $100 in a stock and sells the stock a year later for
$102, the nominal gain is 2 percent. If inflation is also 2 percent,
though, the real gain is zero. If inflation is 10 percent, the investor
suffers a real loss of approximately $8.
Many taxpayers have the wherewithal to delay the realization of
capital gains until their tax situation is most advantageous. Taxpayers
are extremely sensitive to changes in capital gains tax rates. This
phenomenon explains why it is so important to measure capital gains
correctly, treat them properly, and not tax them punitively.
mH. The Optimal Capital Gains Tax Rate
Recall that the optimal tax rate is less than the revenue-maximizing
rate. Establishing the revenue-maximizing rate sets an upper bound for
63See
"New Entrepreneurs Appear Vital to Healthy Economic Growth," Wall
Street Journal, June 24, 1999, p. Al. Another recent study of the impact of
capital gains taxes on venture capital concludes that "[C]apital gains tax rates
have an important effect at both the industry, state, and firm-specific levels.
Decreases in the capital gains tax rates are associated with greater venture
capital commitments. Increases in capital gains tax rates have a consistently
negative effect on contributions to the venture industry." Paul A. Gompers and
Josh Lerner, "What Drives Venture Capital Fundraising?" National Bureau of
Economics Working Paper 6902 (January 1999), p. 2.
79
the optimal rate. A study by Lawrence Lindsey, then of Harvard
University and later a member of the Federal Reserve Board of
Governors, estimated that the revenue-maximizing capital gains tax
rate was roughly 15 percent.64 Furthermore, evidence indicates that the
1997 cut in the capital gains rate from 28 percent to 20 percent
increased tax revenue. This evidence is consistent with Lindsey's
findings.
If the capital gains tax rate that maximizes revenue is
approximately 15 percent, the optimal rate is lower still. Therefore,
cutting the current top rate of 20 percent further would be a move
toward the optimal rate. It would improve economic efficiency,
increase wages, and cause greater economic expansion. 65
IV. The Double Taxation of Investment Returns
Some people mistakenly contend that the tax system gives special
preference to capital gains over labor income because the 10 percent
and 20 percent tax rates on long-term capital gains are lower than the
tax rates on ordinary income. This analysis neglects the fact that
investors receive returns from corporate stock based on after-tax
corporate profits. Double taxation of returns to capital invested in
corporations causes effective (compound) tax rates to substantially
exceed both statutory capital gains tax rates and ordinary income tax
rates applied to labor income, as the previous section explained.
V. Inflation and the Taxation of Capital Gains
One of the most inequitable characteristics of the way the U.S. tax
system treats capital gains is that it forces people to pay taxes on
inflation. The nominal gain of an investment has two components: real
"Lawrence Lindsey, "Capital Gains Taxes Under the Tax Reform Act of
1986: Revenue Estimates Under Various Assumptions," National Tax
Journal,v. 40 (September 1987), pp. 489-504.
65 Many
economists maintain that abolishing the capital gains tax would be
optimal for economic growth. Federal Reserve Chairman Alan Greenspan has
supported this position. In testimony before the Senate Banking Committee on
February 25, 1997, he stated, "The point I made at the Budget Committee was
that if the capital gains tax were eliminated, that we would presumably, over
time, see increased economic growth which would raise revenues for the
personal and corporate taxes as well as the other taxes we have. The crucial
issue about the capital gains tax is not its revenue-raising capacity. I think it's
a very poor tax for that purpose. Indeed, its major impact is to impede
entrepreneurial activity and capital formation. While all taxes impede
economic growth to one extent or another, the capital gains tax is at the far
end of the scale. I argued that the appropriate capital gains tax rate was zero."
80
appreciation and price increases that merely reflect inflation. If Susan
Shareholder invests $20,000 in XYZ Corporation and over one year
earns a nominal gain of 5 percent ($1,000), assuming inflation is 3
percent, then $600 of the gain reflects the increase in the general level
of prices, and only $400 is the real appreciation. The real capital gain
in this case is slightly less than 2 percent.66
The U.S. tax system penalizes capital gains by taxing nominal
gains that merely reflect inflation. People in effect pay taxes on
inflation, a situation that not only compounds the bias against
investment but also is unfair. Taxes owed to the government should not
increase because of inflation that the government itself creates. Paying
taxes on inflation also depresses investment and increases inefficiency
by heightening the "lock-in effect." Investors continue to hold assets
when it is economically inefficient because selling them would
generate high taxes on the capital gains. The lower the nominal rate of
return, the greater the inflation component of the return. Investors with
low rates of return suffer a greater percentage erosion through taxes of
real returns than do investors with high rates of return. Indexing gains
for inflation would eliminate this inequity and improve economic
efficiency.
Because the calculations of capital gains are not adjusted for
inflation, investors frequently pay astonishingly high effective capital
gains tax rates, sometimes more than 100 percent. Even worse, often
investors have to pay taxes on real capital losses, implying an infinite
tax rate! Analyzing tax data from 1993, the Congressional Budget
Office (CBO) recently found that without the current tax law restricting
losses to $3,000 annually, in aggregate there were no real capital
gains, only net real capital losses. Even with the $3,000 loss limit,
inflationary gains accounted for slightly more than half of the nominal
gains. The CBO concluded,
Taking account of that loss limit, capital assets other
than bonds generated net capital gains of $81.4 billion,
on average, before adjustment for inflation but only
$39.5 billion once that adjustment was made. Thus,
66The nominal return equals the product of the real return and inflation. In this
example there is a 5 percent nominal rate of return and a 3 percent inflation
rate. The formula to solve for the real return is
real return = (nominal return - inflation) - I
where figures are expressed as I plus a decimal (so a 5 percent return becomes
1.05). In the example, the nominal return of the investment equals 1.05. The
inflation component is 1.03. Dividing the former by the latter (1.05 1.03)
and subtracting I (for the original investment) to solve for the real return
yields 0.0194, or 1.94 percent.
81
since inflation-adjusted capital gains amounted to
about one-half of nominal gains in 1993, the effective
tax rate on inflation-adjusted gains was about twice the
rate currently applied to nominal gains.67
Since the top capital gains tax rate in 1993 was 28 percent, most
investors on average paid an effective capital gains tax rate of double
that-56 percent.
VI. Indexation
Indexing gains for inflation would reduce the lock-in effect by
eliminating taxes on gains that merely reflect inflation. Even with the
present low inflation, real after-tax rates of return fall far below pre-tax
nominal rates of return. A one-year investment made in 1997, with a
nominal return of 6 percent, yielded a real, after-tax return of less than
4 percent. The combination of inflation and capital gains taxes took
more than one-third of the original nominal return. Federal Reserve
Board Chairman Alan Greenspan, who has advocated completely
abolishing the capital gains tax, has also supported indexing capital
gains. Asked to choose between lowering the tax rate and indexing
gains for inflation, he responded as follows:
Actually I'd go to indexing. And the reason I would is
that it's really wrong to tax a part of a gain in assets
which are attributable to a decline in the purchasing
power of the currency, which is attributable to poor
governmental economic policy. So for the government
to tax peoples' assets which rise as a consequence of
inferior actions on the part of government strikes me
as most inappropriate. I would therefore say, that at a
minimum, indexing capital gains at least eliminates
that problem.68
Some critics maintain that indexing capital gains for inflation
would pose administrative problems. However, Great Britain and
Australia have already successfully indexed gains. Their experience
illustrates that the administrative difficulties can be overcome.
Indexation would eliminate the indefensible practice of taxing illusory
gains. It would also increase fairness by lowering the astronomically
67Congressional
Budget Office (CBO), "Perspectives on The Ownership of
Capital Assets and the Realization of Capital Gains," May 1997, p. 28.
68AIan Greenspan, testimony before the Senate Banking Committee, February
25, 1997.
82
high effective capital gains tax rates imposed on many investors.
Additionally, the "unlocking effect" accompanying indexing would
lead to more efficient use of billions of dollars of capital assets.
VII. Beneficiaries of Lower Capital Gains Rates and Indexing
The debate surrounding capital gains taxes frequently focuses on
the issue of who would benefit from rate cuts. Critics of lower rates
and indexing argue that these policies would almost exclusively help
the "wealthy." While it is certainly true that high-income taxpayers
would be better off with these changes, the argument is simplistic and
incomplete. A more thorough analysis shows that for a variety of
reasons, cutting rates and indexing gains for inflation would improve
the welfare of citizens at all income levels.
1. Capital gains taxes and the elderly. Capital gains taxes impose
heavy costs on the elderly. The elderly often incur high capital gains on
their houses or other assets they have held for many years and sell to
finance retirement. According to the CBO,
Older people account for a disproportionately larger
share of realized capital gains and the taxes paid on
capital gains. People 65 years old and older made up
12 percent of all taxpayers in 1993, but they realized
30 percent of total net capital gains and paid 30
percent of the tax on capital gains. Taxes on capital
gains accounted for 7 percent of the income taxes paid
overall, but 18 percent of the taxes paid by those 65
years old and older and 5 percent of the taxes of those
under 65.69
People 65 and older who have held assets for a long time,
including during the high inflation of the 1970s, face extraordinarily
high real capital gains tax rates. Inflation has a bigger impact on capital
gains for the elderly than for others. As the CBO observes, "[T]he
elderly are more likely to realize losses after adjustment for
inflation."70 Indexing gains for inflation would address this unfairness
and provide substantial relief for the elderly. It would also provide the
elderly with additional resources to address their health and retirement
needs. Indexing gains for inflation would unlock billions of dollars in
assets held by the elderly. In the absence of indexing gains or lowering
69 CBO,
"Perspectives," p. 3.
CBO, "Perspectives," p. 31.
70
83
rates, many of the elderly will hold assets until death, at which time
they may be able to pass them along to their heirs tax-free.
2. Low- and middle-income taxpayers. High effective tax rates
on capital gains hurt low-income people, because investing in stocks or
in businesses is one of the few ways they can accumulate wealth. High
capital gains taxes punish the poor, the young, and those at the start of
their careers, because these people are furthest from the sources of
capital. The tax most severely hurts those trying to create wealth, not
those who already have it. Therefore, cutting capital gains tax rates and
indexing gains for inflation would benefit those who are not yet
wealthy, but who are trying to become so.
Many people who do not have high annual incomes pay capital
gains taxes. According to the CBO, "Nearly two-thirds of tax returns
reporting capital gains are filed by people whose incomes are under
$50,000 a year.",7 1
Many people think that those in the highest income brackets would
receive nearly all of the benefits of lower capital gains taxes. That is
not so. Statistics of income must be used cautiously here. Somebody
earning $25,000 a year in wages who sells an asset he has owned for
20 years and makes a capital gain of $100,000 is counted as earning
$125,000 that year. As Figure 8.1 illustrates, people with annual
incomes (excluding capital gains) under $75,000 paid nearly half of
capital gains taxes. Incorporating capital gains in the income
calculation gives the false impression that the numbers reflect people's
normal annual incomes. Excluding capital gains reveals that people
whose typical income places them in the middle brackets realize
significant capital gains.
Many middle-income taxpayers invest through mutual funds,
which by law must make annual capital gains distributions on which
investors pay taxes. In 1988 the amount that mutual funds paid in
capital gains to shareholders, excluding institutional investors, was 3
percent of the total amount of capital gains, but by 1994 it had risen to
13 percent. With the continued increase in mutual fund participation,
the figure now is likely to be still higher.73 Investors in mutual funds
have almost no discretion over the timing of capital gains taxes and
have less ability than high-income taxpayers to rearrange their finances
to minimize capital gains taxes.
71CBO,
"Perspectives," p. 2.
The CBO acknowledges this circumstance. "The disadvantage [of using
yearly IRS returns] is that annual 'snapshots' can be misleading. For example,
a taxpayer of modest income who sells a business may appear to have a very
high income in that year." CBO, "Perspectives," p. 10.
73Diana B. Henriques and Floyd Norris, "Rushing Away From Taxes?" New
York Times, December 1, 1996.
84
72
Figure8.1: Who Pays Capital Gains Taxes
E
Income
under $75,000
Income
Dover $75,000
a
Source: Heritage Foundation, based on IRS Public Use File, 1993.
3. High-income taxpayers. High-income taxpayers generally have
the greatest flexibility and resources to minimize the capital gains taxes
they pay. They can defer the realization of gains for long periods, and
they are less likely than low- and middle-income taxpayers to use
mutual funds. Accordingly, the share of capital gains taxes paid by
high-income taxpayers tends to fall when the capital gains tax rate is
high and increases when the rate is
low. 74
This phenomenon is what
happened following the 1987 increase in the top rate on capital gains
from 20 percent to 28 percent. Measured in constant dollars, the capital
gains realized by both the top I percent and top 5 percent of income
recipients in 1994 were only 61 percent of their 1985 levels."
74For
evidence, see Congressional Budget Office, "How Capital Gains Tax
Rates Affect Revenue: The Historical Evidence," March 1988, p. xiv.
75Gwartney and Holcombe, p. 13.
85
Realizations fell despite the rising incomes and stock prices of the
period.
VIII. Conclusion
Economic growth is the proper focus for evaluating capital gains
taxation. Rather than attempting to maximize the revenue from capital
gains taxes, policy makers should seek to promote economic growth.
Lower capital gains tax rates promote economic growth by reducing
the cost of capital, encouraging new business start-up firms and other
entrepreneurial activity, and increasing the prices of stocks and other
assets. These factors are particularly important in high-technology
fields.
The optimal tax rate-the rate that maximizes economic growthis always less than the revenue-maximizing rate. Empirical evidence
indicates that the revenue-maximizing rate for capital gains is
approximately 15 percent. Therefore, the optimal tax rate for capital
gains has to be less than 15 percent.
The current system taxes phantom gains that reflect inflation. In
many cases, inflation results in tax rates that exceed 100 percent of real
capital gains. These exorbitant rates are grossly unfair and exacerbate
the lock-in effect. Indexing capital gains for inflation would be the
single most powerful and effective policy to reduce inefficiency while
increasing tax fairness.
Contrary to the conventional wisdom, the elderly, along with lowand middle-income taxpayers, would be the primary beneficiaries of
lower capital gains tax rates and indexation. Because they often sell
assets that they have worked their entire lives to accumulate, the
elderly realize a large share of the total capital gains realizations and,
therefore, pay a large share of capital gains taxes. Compared to those
with higher incomes, low- and middle-income taxpayers possess less
financial flexibility, and, consequently, have less ability to adjust their
investments to reduce capital gains tax liabilities.
86
9. INTERNATIONAL FINANCIAL MARKETS
While the U.S. economy has been stable, the same has not been
true of many other economies. The Clinton Administration's response
to the Asian currency crisis and related crises in Russia and Brazil
indicates a lack of understanding of the role played by monetary policy
and flawed exchange rate regimes in generating economic instability.
Furthermore, the United States is inviting future currency crises by
supporting policies of the International Monetary Fund (IMF) that
preserve defective monetary arrangements and have the potential to
harm the American economy.
I. Causes of Recent Currency Crises
The key danger to international economic stability and growth in
recent years has come from currency crises. To understand why the
currency crises have happened one must understand the basic choices
in exchange rate policy. There are two main issues. The first is whether
to impose exchange controls, which restrict people's ability to use the
domestic currency to buy foreign goods, services, and assets such as
currency, stocks, and bonds. During the last two decades, many
countries have eliminated exchange controls. No developed country
has significant controls. Among the developing countries that attract
large amounts of foreign investment, Chile and China are the most
notable that impose significant controls. While exchange controls can
insulate a country from currency crises, they involve the government in
financial central planning-the use of controls to determine what
people can buy abroad. Exchange controls also generate opportunities
for corruption and other economic inefficiencies.
The second main issue in exchange rate policy is the choice of
exchange rate regime. There are three general types of exchange rate
regimes: fixed rates; floating rates; and pegged rates, a middle
category. A fixed exchange rate is one that is held constant in terms of
a foreign "anchor" currency. Under a fixed rate, maintaining the
exchange rate is the only goal of monetary policy, and adequate
institutional arrangements exist to guarantee the exchange rate.
Examples of fixed exchange rates include dollarized systems and
currency board systems. Countries with dollarized systems use a
foreign currency for domestic transactions and they do not issue a
domestic currency, except perhaps in the minor form of coins. The
best-known dollarized system is Panama, which has used the U.S.
dollar as its official currency since 1904. A currency board issues a
domestic currency and maintains foreign reserves equal to 100 percent
or slightly more of the monetary base (notes and coins in circulation
87
plus bank reserves) so as to always be in a position to preserve the
exchange rate with the anchor currency. Hong Kong and Argentina are
most notable among the countries with currency boards or currency
board-like systems.
A floating exchange rate is one that is not held constant in terms of
an anchor currency. Under a "clean" (unmanaged) float, the only goal
of monetary policy is to influence domestic economic conditions - for
example, to maintain domestic price stability. The exchange rate
receives no attention. New Zealand is apparently the only country
today that has a clean float and has maintained it for a long period.
Other countries with floating exchange rates, including the United
States, have "dirty" (managed) floats, under which their central banks
sometimes seek to influence the exchange rate through the purchase or
sale of foreign exchange, but not so often as to create a persistent
conflict between the goals of maintaining the exchange rate and
achieving domestic economic goals.
Pegged exchange rates and related arrangements such as target
zones fall somewhere in between fixed and floating rates. Under a
pegged rate, the exchange rate is kept at a constant value (or held
within a specified range), but the institutional arrangements to prevent
eventual devaluation are absent. Furthermore, monetary policy can be
used to pursue objectives other than maintaining the pegged exchange
rate. With the passage of time, this leads to conflicts, forcing a choice
between devaluing the currency or sharply reducing the growth of the
money supply. Politically, it is usually easier to devalue because a
devaluation is completed more quickly and is more easily blamed on
external forces. This also helps explain why when pegged exchange
rates come under speculative attack, governments usually fail to extend
them full support.
If a country is going to maintain full convertibility of its currency,
it must either adopt a floating exchange rate or give up the freedom to
use monetary policy for purposes other than maintaining a fixed
exchange rate. A country cannot both peg its exchange rate and
continue to pursue an independent monetary policy. It will only be a
matter of time before conflicts arise between trying to use monetary
policy to achieve various domestic goals and maintaining the peg. This
has caused Milton Friedman to refer to pegged exchange rates as a time
bomb. Just as a time bomb will explode, a pegged exchange rate will
eventually be abandoned, usually during an economic crisis.
II. Pegged Exchange Rates and Currency Crises
The 1990s have seen five big international currency crises: those of
the European Monetary System in 1992-93; Africa's CFA franc zone
88
ih 1993-94; Mexico in 1994-95; Asia in 1997; and Russia/Brazil since
then. 7 6 The hardest hit countries have been those whose pegged
exchange rates interacted with other features making their financial
systems susceptible to trouble. The countries of the European
Monetary System were otherwise strong and enjoyed economic growth
despite the crisis, but in Russia, for example, a weak banking system,
shaky government finances, and a withdrawal of foreign investment
combined to plunge the country into recession. With a different type of
exchange rate, Russia would still have had many problems, but it
would not have suffered the currency catastrophe of August 1998.
One alternative to a pegged exchange rate is a floating rate.
Currencies with managed floats today include the U.S. dollar, the euro,
the British pound, the Brazilian real, the Indonesian rupiah, and the
Russian ruble. That short list includes three highly credible currencies
and three currencies with low credibility, which is indicative of the
mixed performance of floating exchange rates. The dollar, the euro,
and the pound, which are all issued by developed countries, have
inflation in low single digits and low interest rates to match. The real,
the rupiah, and the ruble, which are all issued by developing countries,
have recently had double-digit inflation and interest rates so high as to
discourage business activity.
Developed countries have been far more successful than
developing countries at maintaining good currencies under floating
exchange rates. It is hard to name any developing country that has had
a floating exchange rate and has been able over a long period to
maintain such characteristics of a credible currency as low inflation,
relatively low interest rates, and the absence of exchange controls.
Floating exchange rates sound good in theory for developing
countries because they avoid problems with the balance of payments.
In practice, however, they bring with them other problems that are just
as bad. In particular, floating rates allow inflation to creep up to a point
where it becomes difficult to reduce. Many developing countries seem
trapped in an endless cycle of pegged exchange rates that eventually
lead to a currency crises, followed by inflation that is difficult to
control under floating exchange rates, followed by a return to pegged
rates.
76France,
Ireland, Italy, Portugal, Spain, and the United Kingdom devalued
their currencies as a result of the crisis of the European Monetary System.
Finland, Norway, and Sweden, which were outside the system, also devalued.
The CFA franc zone included Benin, Burkina Faso, Cameroon, Central
African Republic, Chad, Comoros, Congo, Cote d'lvoire, Equatorial Guinea,
Gabon, Mali, Niger, Senegal, and Togo. In the Asian crisis, Indonesia,
Malaysia, the Philippines, Singapore, South Korea, and Taiwan devalued their
currencies, as did a few other developing countries in Asia and elsewhere.
89
Figure 9.1: Central Banks Devalue Often
Monetary
authority
Countries
Dates
Permanent
devaluations and
temporary suspensions
of exchange rate
Central bank
185
1668
(Sweden)present
(170+
countries)
At least 85 percent have
devalued in peacetime
and suspended in
wartime, most several
times. Devaluations less
frequent before World
War I.
Currency
board or
currency
board-like
83
1849
(Mauritius)present (12
countries)
One peacetime
devaluation (Eastern
Caribbean Currency
Board 1976); four
wartime suspensions
(Argentina 1914-27;
Hong Kong, Malaya,
Philippines 1941-5).
Dollarization
120
before 1278
(Andorra)present (28
countries)
Apparently none.
Source: Kurt Schuler, Should Developing Countries Have Central
Banks? Currency Quality and Monetary Systems in 155 Countries
(London: Institute of Economic Affairs, 1999), pp. 86-7.
Note: "Countries" is the number of countries ever having a
system.
mI.Fixed Exchange Rates Work for Developing Countries
Developing countries that have established fixed exchange rates
have broken out of the cycle of pegging, devaluation, and inflation.
They have done so by. strengthening rather than devaluing their
currencies. Establishing truly fixed exchange rates requires replacing
central banking with dollarization or a currency board, because central
banks generally cannot maintain fixed rates. Figure 9.1, which contains
data covering several centuries, shows that the great majority of central
90
banks have devalued their exchange rates, while the great majority of
currency boards and dollarized systems have never devalued. There is
really no point in having a central bank except to be able to use it to
respond to domestic economic conditions, but eventually that conflicts
with a fixed exchange rate. American experience supports this view.
The United States abandoned the gold standard in 1971 because a
pegged exchange rate with gold conflicted with the Nixon
Administration's desire to keep increasing the supply of money so as to
try to avoid a recession. A pegged exchange rate is inherently highly
politicized because its conflicting goals invite intervention by
politicians to sort things out.
Figure 9.2 indicates that developing countries without central
banks have had better currencies and higher economic growth than
developing countries with central banks. Although the data of Figure
9.2 only cover the period from 1971 (when the Bretton Woods gold
standard ended) to 1993, recent events and studies indicate that as a
group, developing countries with central banks continue to perform
worse than those without central banks." In the currency crises of the
1990s, there have been no devaluations in countries with fixed
exchange rates maintained by currency boards or dollarization. The
currency board-like systems of Argentina and Hong Kong (which have
loopholes that orthodox currency boards do not) have experienced
temporarily high interest rates and even recessions, but have suffered
less than some neighboring countries with pegged exchange rates and
have not devalued their currencies.
No monetary system can guarantee good economic performance all
by itself, but the evidence indicates that currency boards and
dollarization improve the chances of success for developing countries.
By making monetary policy transparent and anchoring it to a stable
foreign currency, they avoid balance of payments problems and ensure
low inflation. That prevents internally generated shocks caused by bad
monetary policy, which frequently occur under central banking. Hence
trade and investment tend to grow more steadily, making the economy
less vulnerable to external shocks.
Many people are uncomfortable with the thought that central
banking cannot work well in most developing countries. As an
alternative to replacing central banks, they have proposed giving the
central banks more political independence, to make them more like the
Federal Reserve System is in relation to the U.S. Congress and the
President. The hope is that those central banks will then be able to
77Atish R. Ghosh, Anne-Marie Gulde, and Holger C. Wolf, "Currency Boards:
The Ultimate Fix?" International Monetary Fund Working Paper 98/8
(January 1998).
91
59-884 0 - 99 - 4
Figure 9.2: Central Banking Has Performed Poorly in
Most Developing Countries
Developed
countries
Developing
countries
with central
banks
Developing
countries
without
central banks
2.3%
2.0%
2.6%
26%
1.5%
1.3%
7.2%
84%
2.4%
2.7%
7.5%
28%
Ever had inflation over
100% a year, 1971-93
0%
35%
26%*
Had currency controls
in 1993
11%
89%
43%
Annual growth per
person, 1971-92
Median
Mean
Standard deviation
Ever had inflation over
20% a year, 1971-93
Exchange rate
63%**
90%
50%
depreciated against U.S.
dollar, start of 1971 to
end of 1993
Source: Kurt Schuler, Should Developing Countries Have Central
Banks? Currency Quality and MonetarySystems in 155 Countries
(London: Institute of Economic Affairs, 1996), Tables 2-6 and 11.
Notes: *All these inflations occurred in former Soviet republics
that used the Russian ruble until they began issuing their own
currencies, or as part of a deceleration to much lower inflation in
countries that replaced central banking with other monetary systems.
**The U.S. dollar depreciated against gold, and is included
among currencies that depreciated.
Data include all countries with at least I million people. All
developed countries had central banks in this period. Data end with
1993, but more recent events and studies indicate that developing
countries with central banks continue to perform worse than those
without.
92
perform as well as the Federal Reserve. Unfortunately, studies indicate
that for developing countries, making the central bank more
independent has no significant effect on reducing inflation. 8 Mexico's
inflation-triggering devaluation in 1994 and Russia's in 1998 both
occurred under central banks that had a high degree of political
independence, at least on paper. Economists are uncertain why political
independence for the central bank does not reduce inflation
significantly in developing countries, but puzzling as it may be, it is a
brute fact that policy makers should acknowledge.
IV. A Vision for the International Financial System
Responsibility for recent currency crises rests with the affected
countries. The crises arose from their mistakes in exchange rate policy,
which only they can correct. Even so, the United States can offer them
some help. For one thing, it can avoid imitating their mistakes. The
Treasury and the Federal Reserve are correct to resist the desire of
some academic economists and foreign officials to establish target
exchange rate zones among the dollar, euro, and yen. Target zones are
a loose form of pegging, and ultimately have the same problem of
conflicts between the goal of maintaining the exchange rate and the
goal of influencing domestic economic conditions.
By acting in a way that enables the U.S. economy to continue
growing, the United States can provide a good market for the exports
of countries that have experienced currency crises. Over the last few
years the United States provides one of the few bright spots in the
world economic picture. The large trade deficit that the United States is
running is not a sign of weakness; rather, it reflects that our economy is
stronger than the economies of our trading partners.
Encouraging developing countries to adopt better monetary
policies can help ensure that the American people continue to support
openness. Controversies about the "dumping" of foreign goods, such as
those recently involving Russian and Brazilian steel, occur in part
because large, sudden devaluations of foreign currencies can give
producers in those countries short-term advantages that are not based
on their underlying productivity and would not otherwise occur. Better
monetary policies can reduce or eliminate such devaluations.
1. Two bad approaches: tight money and easy money. Because
the Clinton Administration and most other policy makers have
assumed that every country must have a central bank, countries that
have suffered currency crises recently have considered their choice as
78Alex
Cukierman, Central Bank Strategy, Credibility, and Independence:
Theory andEvidence (Cambridge, Massachusetts: MIT Press, 1992).
93
being between two equally undesirable approaches: the tight-money
approach favored by the International Monetary Fund (IMF) and the
easy-money approach favored by many of its critics.
The IMF, supported by the Clinton Administration, has supported a
tight-money approach that seeks to bring back the foreign capital
whose flight contributed to the currency crisis. The tight-money
approach involves avoiding default on foreign debt as much as
possible; keeping the exchange rate from depreciating much further
after an initial devaluation; maintaining high interest rates; and using
IMF loans as stopgap funding. The main problem with the tight-money
approach is that the interest rates it requires can easily exceed 30
percent a year, which degrades the balance sheets of domestic financial
institutions and can intensify the capital flight it is intended to stop.
Very high interest rates tend to cause deep and prolonged recessions.
Indeed, Indonesia, Russia, and Brazil-three of the six most populous
countries in the world and three of the IMF's biggest borrowers-have
recently suffered recessions of this type.
Advocates of the easy-money approach favor keeping interest rates
low, letting the currency depreciate if that is the consequence. 79 In
some cases, they also seem to favor defaulting on a country's foreign
debt. The main problem with the easy-money approach is that the
currencies of most developing countries do not inspire confidence. If
such countries keep interest rates too low they risk large-scale flight
from the domestic currency, triggering massive depreciation and much
higher inflation. Despite having devalued their currencies, Indonesia
and Brazil continue to need interest rates above those of currency
board or dollarized systems to prevent further depreciations.
Russia in 1998 took the different but still painful route of
defaulting on its government debt and reimposing certain kinds of
exchange controls. Exchange controls attempt to prevent capital from
leaving the country. Because the tight-money approach has not worked
well, exchange controls are now gaining supporters, and the IMF and
its members are pondering their desirability. But exchange controls are
inefficient, and over time people find ways to evade them. The
government then faces a choice: reliberalize, or reinforce controls with
increasingly dictatorial measures that are at odds with a market
economy.
2. A third approach: financial integration. There is a third
approach that avoids the high interest rates of the tight-money
approach, the possibly uncontrollable currency depreciation of the
easy-money approach, and exchange controls. It can be termed the
79 World
Bank, Global Economic Prospects 1998/99: Beyond FinancialCrisis
(Washington: World Bank, 1998), pp. 87-90.
94
financial integration approach. It starts by asking a fundamental
question the other approaches neglect: Why do people worry about
flows of capital between New York and, say, Thailand, but not
between New York and New Jersey? The answer is that their degrees
of financial integration differ. New York and New Jersey have no
exchange controls, a unified monetary policy (in fact, a common
currency), and a common banking system. If $1 billion in deposits
move from New York to New Jersey, it does not cause a big
contraction in loans in New York and a big expansion in loans in New
Jersey. An active interbank market and nationwide branch banking
make most U.S. bank deposits in effect part of a huge nationwide pool.
In general, the location of bank deposits does not dictate the location of
bank loans: banks can lend where the opportunities for profit are
greatest, even if they do not gather many deposits there. Moreover, the
U.S. pool of bank deposits is well integrated into the worldwide pool
for dollar lending.
Thailand, on the other hand, has exchange controls, a distinct
monetary policy, and a separate banking system from New York. The
Thai financial system is not well integrated with the financial system of
the United States and the rest of the world. If $1 billion in deposits
moves from New York to Thailand, exchange risk and lack of
international branch banking tend to dictate that the resulting loans will
be in Thailand. If the money moves back to New York, bank loans in
Thailand tend to fall, which can be serious because the Thai banking
system is so much smaller than the U.S. system.
The tight-money and easy-money approaches retain the status quo
under which Thailand and other developing countries are only partly
integrated into world financial markets. The exchange control variant
of the easy-money approach calls for reducing the extent to which
developing countries are integrated into world financial markets. In
contrast, the financial integration approach calls for bringing
developing countries fully into world financial markets, so that their
financial relation to New York is more like New Jersey's relation.
3. Implementing the financial integration approach. Two steps
are necessary to implement the financial integration approach. One is
to make monetary policy much more reliable by establishing currency
boards or dollarization in countries whose currencies have performed
much worse than the major world currencies. Currency boards or
dollarization enable a country to end exchange controls, if they are in
place.
So, rather than advise developing countries to retain their central
banks, the U.S. government should advise those whose central banks
have performed poorly that they would be better off with currency
boards or dollarization. There should be no element of arm-twisting to
95
end central banking, but U.S. advice should stress establishing
monetary arrangements that work well instead of propping up those
that perform poorly.
The other step is to end protectionism in the financial sector.
Foreign banks and other financial firms should be allowed to buy local
banks, to establish branch networks, and in general to compete on
equal terms with locally owned financial firms. Deregulation that
opens up the local financial system to foreign participation enables the
financial system to become more geographically diversified. In
contrast, deregulation that simply removes barriers to competition
among local financial firms keeps all their eggs in the local basket,
leaving them as vulnerable as ever to a national currency crisis or
recession.
Through the Group of 7 (G-7), the Group of Ten (G-10), and the
Group of 22 (G-22) nations, the U.S. government is working on
proposals to strengthen supervision of banks and other financial
institutions across the world. It will take time to implement their
recommendations,
which
promise worthwhile
incremental
improvements but no giant steps forward. A quick way to bring the
banking systems of many countries up to a high international standard
is to open them to the infusion of knowledge and capital that foreign
banks can bring.
Countries that have financial integration have suffered less than
others from the Asian currency crisis and its aftershocks. A developing
country well integrated into the world financial system is Panama,
which uses the U.S. dollar as currency and has an extensive presence of
foreign banks. Panama has not suffered at all from the problems
affecting Mexico, Venezuela, and other nearby countries: interest rates
have remained near U.S. levels.
Hong Kong provides additional evidence on this point. Although
its currency board is not entirely orthodox and new foreign entrants are
restricted from establishing branches to compete with other banks,
Hong Kong is more deeply integrated with world financial markets
than anyplace else in Asia. During the last few years, Hong Kong has
suffered more financial problems than Panama, but far fewer than
Thailand, Indonesia, or South Korea.
After many years of restricting foreign participation in their
domestic financial systems, Thailand, Indonesia, and South Korea now
appear to be headed in a more liberal direction. During their currency
crises, the foreign banks that had already been allowed into the market
were notably free of the troubles affecting domestic banks. Russia's
currency crisis bankrupted many of its large banks because they were
weak, domestically owned firms protected from foreign competition. In
contrast, Brazil's currency crisis weakened but did not destroy its
96
banks in part because many are now foreign owned and can draw on
their parent banks for support during difficult times.
V. The United States and the International Monetary Fund
The Clinton Administration last year received Congressional
approval for an increase of $14.5 billion in the general U.S.
contribution ("quota") to the IMF and $3.5 billion for an IMF
emergency fund called the New Arrangements to Borrow. The first
customer of the New Arrangements to Borrow was Brazil, which
devalued its currency less than two months after receiving a loan. The
IMF acts as a channel for some countries, mainly developed countries,
to lend at below-market interest rates to developing countries. In light
of the poor results of recent IMF programs, one must ask if the money
the United States is contributing has been well used. In the last two
years, the IMF has arranged stabilization packages for five of the most
important developing countries-Thailand, Indonesia, South Korea,
Russia, and Brazil. The currencies of all five depreciated sharply even
after the IMF began to lend, and all went into recessions, though they
are now recovering.
The effectiveness of IMF programs does not depend solely on the
IMF; it also depends on the borrowing countries, whose cooperation in
many cases is half-hearted. But the failure of IMF programs to quickly
stabilize currencies in its biggest recent programs is symptomatic of the
IMF's loss of focus. The organization was established in 1945 to
support the Bretton Woods gold standard. The IMF's focus was on
helping member countries experiencing exchange rate problems to
avoid or soften the impact of devaluations. The breakdown of the
Bretton Woods system in 1971 stripped the IMF of its original role and
left it searching for a new one. After some conflict, it eventually settled
into an agreement with its sister organization the World Bank to
concentrate on near-term economic stabilization, leaving the World
Bank to concentrate on longer-term structural economic adjustment.
1. The IMF has gotten in over its head. Especially in its current
programs in Thailand, Indonesia, and South Korea, the IMW has moved
far beyond its traditional concern with exchange rate problems to
comprehensive involvement in the economy. It has told the
governments of those countries to close banks, stop subsidizing
industries, open up the clove trade, and so on.S0 The countries
borrowing from the IMF have agreed to its conditions voluntarily, in
the sense that they could have chosen not to borrow if they disliked the
80Details
of the programs can be found on the IMF's Web site,
<http://www.imf.org>.
97
conditions. But the conditions attached to some of the recent big IMF
programs are broad, vague attempts to solve every economic problem
at once something the IMF lacks the expertise to do.
The IMF and the Clinton Administration have defended the IMF's
comprehensive involvement by claiming that the crises in Thailand,
Indonesia, and South Korea were mainly deep structural crises of the
economy rather than simple currency crises.8 ' If the IMF programs in
those countries were obvious successes, the argument might carry
some weight. But they do not appear to have been especially successful
(see Figure 9.3). Thus, the position of the IMF and the Clinton
Administration is dubious, to say the least. If the IMF is to be useful, it
needs to match its aims with its capabilities. It should renew its focus
on currency stability, which is listed as its most concrete purpose in
Article I of its Articles of Agreement.
Currency stability does not mean exchange rates must be fixed, but
it does imply that the IMF should stop supporting the central banks
with bad records, which cause the worst currency instability. Among
the five countries of the recent big IMF programs, only Thailand had a
central bank with a good long-term record of currency stability (until
recently). Compared to its value against the dollar at the start of 1971,
the year the Bretton Woods system ended, Thailand's currency is
worth roughly three-fifths as much. South Korea's is worth only about
one-quarter as much as it was in 1971, Indonesia's 1/20 as much,
Russia's 1/20,000 as much, and Brazil's one-trillionth as much.
2. IMF programs need a clear standard of evaluation. Although
the exchange rate parities of the Bretton Woods system are long gone,
there is an obvious standard for evaluating the success of IMF
programs: whether the currencies of countries that receive loans from
the IMF perform roughly as well as the world's major currencies (the
dollar, euro, and yen). If not, currency boards or dollarization provide
simple, effective ways of providing currencies that are as good as the
major currencies. Without such a standard, there is no accountability,
and hence no way to prevent repeated failures. The IMF has strayed so
far from its original focus that its role now overlaps considerably with
that of the World Bank. It is worth reconsidering whether the two
organizations should be merged. Meanwhile, the U.S. government
should use its voice and vote at the IMF to refocus the organization on
improving monetary policy rather than on comprehensively meddling
in the economies of borrower countries.
B1Economic Report of the President, 1999 (Washington: Government Printing
Office, 1999), p. 246.
98
Figure 9.3: Data on Recent Big IMF Programs
Exchange rate
at start of IMF
program
(month)
Most
depreciated
exchange rate
(month)
Exchange
rate, June
30, 1999
Economic growth,
1997 (actual)/
1998 (estimated)/
1999 (estimated)
Thailand
Exchange
rate vs.
dollar,
June 30,
1997
25.79
32.00 (8/97)
55.50 (1/98)
36.67
-0.4 / -8.0 / 1.0
Indonesia
2,350
3275 (10/97)
16,650 (6/98)
6,840
4.6/ -15.3 / -1.5
South Korea
888.10
1164 (12/97)
1,963 (12/97)
1,154
5.5 / -7.0 / 4.5
Brazil
1.08
1.20 (12/98)
2.17 (3/99)
1.79
3.2/0.5/ -1.0
Russia
5.78
6.21 (7/98)
26.14 (4/99)
24.32
0.7 / -5.7 / -8.3
Country
s0
'0
Sources: International Monetary Fund, World Economic Outlook, December 1998; IMF Web site,
<http://www.imf.org>; Timothy Lane, Atish R. Ghosh, Javier Hamann, Seven Phillips, Marianne.
Schulze-Ghattas, and Tsidi Tsikata, "IMF Supported Programs in Indonesia, Korea, and Thailand: A
Preliminary Assessment" (preliminary copy, January 1999, available at IMF Web site), p. 42; Stanley
Fischer, "The Asian Crisis: the Return of Growth," (speech delivered June 17, 1999, available at IMF
Web site); press reports.
10. SUMMARY OF RECOMMENDATIONS
Economic growth is the key to progress and prosperity. While the
stability of the U.S. economy during the last 16Y 2 years has been
exceptional, the growth rate is still below the average of the 1960s and
early 1970s. Historical and international experience indicate that it is
possible to raise the long-term rate of growth with appropriate policies.
Throughout this report, we have analyzed various factors that influence
economic growth. The following recommendations highlight the policy
implications of our analysis. These recommendations will help the U.S.
economy achieve its full potential and thereby create a more
prosperous future for Americans.
Monetary policy
* Establish price stability as the primary long-term objective of the
Federal Reserve.
Government spending
*
*
Control the growth of federal spending and reduce it as a share of
GDP.
Reform Social Security and health care in a manner that will
provide individuals with more freedom of choice and reduce their
dependency on the federal government.
Trade
*
Work to reduce trade barriers through the World Trade
Organization and extend the North American Free Trade
Agreement (NAFTA) to other countries.
Taxes
* Reduce or eliminate the double taxation of corporate income.
* Reduce marginal tax rates on the earnings of Social Security
recipients by repealing the "earnings test" and eliminating the
double taxation of benefits.
* Reduce or eliminate the estate and gift tax.
* Eliminate the marriage penalty.
* Lower the tax rate on capital gains and index gains for inflation, or
eliminate capital gains taxes entirely.
* Make health insurance fully tax deductible for individuals.
100
International finance
* Recognize that in developing countries central banking has not
worked well, whereas currency boards and dollarization have.
* Give programs of the International Monetary Fund a clear standard
of evaluation: currency stability.
* Consider merging the International Monetary Fund and the World
Bank.
This staff report was prepared by James Gwartney, Chief
Economist to the Chairman, and James Carter, Chris Edwards,
Angela Ritzert, Kurt Schuler, Charles D. Skipton, Robert Stein,
Lawrence Whitman, and Victor Wolski, with assistance from
David Landau. Contact James Gwartney (202-224-2989) with any
questions or comments.
This staff report reflects the views of the authors only. These
views do not necessarily reflect those of the Joint Economic
Committee, its Chairman, Vice Chairman, or any of its Members.
101
RANKING MINORITY
MEMBER'S VIEWS
AND
MINORITY STAFF
REPORT
103
US Economic Prosperity:
Non-Inflationary Growth, Low Unemployment
and Rising Income
RECENT DEVELOPMENTS IN THE US ECONOMY
For the first time in over a generation, most Americans are enjoying
economic prosperity. Unemployment is down, inflation is low and
incomes are rising. Much of this improvement in the economy can be
traced to eliminating the federal budget deficit and increasing
productivity-enhancing investment.
The US economy is currently in its ninth consecutive year of
economic growth, the nation's longest peace-time expansion.
The economy has grown on average by more than 3 percent a
year since 1991. There are virtually no signs of any economic
slowdown on the horizon, as real GDP growth during the second
quarter of 1999 was nearly 4 percent. Nine years of sustained growth
has made the US economy the envy of the world.
Unemployment is at its-lowest rate since the early 1970s.
Gross Domestic Product
14
12
6, 10
C
a.~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~.
1999: 02
2
0
1994
1991
SOUr:.:EcononzkR.pod of th. P,..id-nt
1997
1990
1993
1999
1999
The unemployment rate has been at or below 5 percent during
each month since April 1997. During the first half of 1999, the
unemployment rate averaged 4.3 percent, the lowest rate in more than
25 years. The unemployment rate in the United States is currently
lower than that in Japan and many European countries.
Almost all groups within the economy have been enjoying
improvements in unemployment. At 1.6 percent, the unemployment
rate for college graduates in August 1999 remains the lowest of all
groups. By contrast, the unemployment rate for high school graduates
who do not go on to college is more than twice the college rate, at
slightly below 3.5 percent.
Unemployment Rate
12
C
10
0
LU
CC
I A
IX
4
ugus 99
U2
1948
1952
1956
1960
1964
1968
1973
1977
1981
1985
1989
1993
1998
Minorities and teenagers have achieved the greatest
improvements in unemployment rates. The unemployment rate for all
minorities fell from 12.7 percent in 1992 to 6.8 percent in August
1999. Over the same period, the unemployment rate for AfricanAmericans fell from 14.2 percent in 1992 to 7.8 percent in August
1999. The teenage unemployment rate fell from 20.1 percent in 1992
to 13.5 percent in August 1999. Although teenage and minority
unemployment rates remain well above the national average, they have
fallen to their lowest levels since the government began reporting such
106
rates. In general, minority and teenage unemployment rates tend to be
slower in responding to economic expansions, making improvements
in these unemployment rates harder to achieve. Most of the
improvements in these unemployment rates have occurred over the
last four years.
More Americans are currently working than ever before.
More than 64 percent of the working-age population are
currently employed. This constitutes the highest ratio of workers to
the total working-age population in recent history. The employmentpopulation ratio for African-Americans and Hispanics were 60.3
percent and 63.3 percent, respectively, in August 1999, not much
different from the national average.
Worker to Population Ratio
66
C0
0
52
1948
1951
1955
1958
1962
1965
1969
1973
1976
1990
1983
1987
1691
1994
1998
Nol BoghMn.gh 1990, d.al e.loe 1990
u.b...d pop.lsof co-.hI.O.dju.Wd I., Cu...ma~ d und...tf
Im
Pop,.(lon S3r-.Y
Lb., Sl-ll.b1, CSo.ur. Bu6.-. WO
After 20 years of stagnation, real average weekly earnings are
rising.
Real average weekly earnings were either falling or flat for
most of the last 20 years. Weekly earnings did not begin increasing
until well into the current economic recovery. Since 1996, real
average weekly earnings have increased by 6 percent. Despite this
recent increase, the level of real weekly earnings remains below its
pre-1980 level.
107
Real Average Weekly Earnings
330
$319.22
973
320
3100
a°
300
290
S
E
~~~~~~~~~~~~~~~~~~~~~$272.1
.
280
s
1
270
260
, 240
,
.
199 9
Ar~~~~~~~~~~~~~rJly
,
210
250
*ArilrI 1996
1984
1967
1970
1973
1976
1979
1982
1985
1988
1991
1994
1997
The recent improvement in wages has not appeared to have
placed upward pressure on inflation. Growing competition originating both at home and abroad - lower producer costs and
improvements in productivity continue to restrain increases in
consumer prices.
Inflation has fallen to its lowest rate in almost 30 years
continued declines in the unemployment rate.
-
despite
During the first half of 1999, inflation rose by an annual rate
of 2.2 percent. Falling commodity prices, significant reductions in
transactions costs and moderate business expenses have contributed to
keeping prices low. At a recent hearing before the Joint Economic
Committee, Federal Reserve Chairman stated that the economy had
reached "price stability." This stability makes it easier for businesses
and consumers to plan ahead.
108
Inflation Rate
18
14
.E12
U
10
E 8
OS4
-4
1948
1953
1958
1983
1988
1973
1978
1983
1988
1993
1998
Employment costs remain low.
U
The Employment Cost Index (ECI), which measures the costs
to employers of hiring workers, remains low. The ECI includes both
the cost of wages and benefits. Low employment costs have bolstered
corporate profits during the 1990s, which, in turn, have helped fuel the
recent.4stock market surge. Corporate profits have also enabled
companies to expand payrolls -by hiring more people and paying
them more-and increase their investments.
Employment Cost Index
8
1983
3
1985
1999: Q2
1
1987
1989
1991
109
1993
1995
1997
1999
Employment continues to grow.
Nonagricultural employment grew by more than 20 million
between 1992 and August 1999, adding, on average, approximately
2.8 million jobs annually and 230,000 jobs per month. These data
reflect net increases in employment, representing the change in total
employment, not the gross number of new jobs created or eliminated.
The distribution of the close to 20 million net new jobs created since
1992 is as follows:
Annual Growth In US Employment
4
1.5
3.5
0~~~~~~~~~~~~~~~~~~.
-1.2
-2
1990
1991
1992
1993
1994
1995
1999
1997
1999
1999-
TFk.1s.1 monthsof Im.
So-,-sm so of Lb, Stloft5
10.1 million
4.6 million
2.1 million
1.6 million
18.4 million
1.8 million
280,000
in traditional services
in wholesale and retail trade
in transportation and finance
in government (despite no increase in
federal government employment)
in all services (91 percent of the more
than 20 million jobs created)
in construction
in manufacturing. Manufacturing
employment increased by 748,000
jobs between 1992 and May 1998.
110
Nearly a half million jobs have been lost since then, primarily due to
the East Asian financial crisis.
Recent improvements in productivity have enabled wages and
incomes to grow.
Const
1.8
ton
ManufacturIng
0.3
_
Transportatlo
&Finance
2.1
Services
10.1
Retail &Whoeaale Trad
4.6
(inmillions)
Approximately 20 million net new jobs were created between 1992 and August 1999.
Sourc. B.urau tl Lt.bo, Statiab.
Productivity growth is the key to achieving sustainable
improvements in living standards. Productivity growth reflects real
improvements in the efficiency of workers and the equipment they
use. These efficiency improvements must be perceived to be longterm in order to result in sustainable increases in salaries and incomes.
If incomes rise faster than productivity (which was the case for much
of the 1970s), inflation can result. If productivity grows faster than
incomes (which was the case during much of the 1980s and early
1990s), then workers will experience real declines in their living
standards.
111
Productivity Growth
2.5
a.
2l
0
19651009
19701974
19761979
1500194
1951 1959
19900
1954
19951995
Productivity in the nonfarm business sector grew by more than
2 percent per year between 1995 and the first quarter of 1999. This
represents a doubling of the productivity growth rates experienced
during the 1980s. This increase in efficiency of workers and the
equipment with which they work is one of the greatest achievements
of the current economic expansion.
The key ingredient to improving productivity is increases in
productive investments.
Total private investment as a share of GDP fell from 15
percent in the mid 1980s to close to 12 percent in 1991. The
investment rate began growing in 1992, and reached more than 17
percent during the second quarter of 1999. This investment in plant,
equipment, research and development is critical to raising
productivity, which in turn enables companies to increase wages and
salaries without fear of reigniting inflation. These investments
continue to have positive impacts on productivity well into the future.
Recent investments in information technology and human
capital - through education and training - have been key factors in
raising US productivity over the last few years. In addition,
112
productivity gains have also resulted from structural changes in the
labor market over the last 20 years. Faster productivity growth can be
seen in quicker inventory turnover, a greater use of worker skills and
higher quality controls.
Private Investment Ratio
19
17i p. rce nt
1999:02
E
E2
17
e a
20
X
_
y
iL
2:
"
1i
,, 13514
0
*3
1
123-
14
21.
I
1982
So.8
rug
1984
-198l
198
1990
1992
1994
1999
1998
d rAn
In order to achieve a higher return, it is optimal to finance
domestic investment through domestic saving. There are two major
components of domestic saving - personal saving and government
surpluses. Since 1992, there has been a significant improvement in
public saving - by eliminating the federal budget deficit - and a
deterioration in personal saving.
The federal budget has moved from a deficit, which was close to 5
percent of GDP in 1992, to its current surplus of approximately 1
percent of GDP. Based on current economic assumptions, the
surplus is expected to continue growing.
A combination of an increase in tax receipts - due in part to
the strong economy and some changes in tax policies - and severe
constraints on total federal spending have resulted in bringing the
federal budget from deficit into surplus.
113
The Office of Management and Budget (OMB) recently
projected that the federal budget surplus is expected to grow over the
next decade. In addition, OMB and the Congressional Budget Office
(CBO) recently revised their surplus projections, based on more
optimistic economic assumptions. The most important change is an
increase in projected productivity growth over the next several years.
Raising the estimates for productivity growth between 1999 and 2002
from 1.3 percent to 1.6 percent, results in increasing projected
economic growth from 2.2 percent to 2.5 percent annually. Stronger
growth, in turn, stimulates higher tax receipts and puts less pressure on
federal spending, thereby raising the projections for surpluses during
this period.
Federal Budget Deficits/Surpluses
0:
0
Is
Cr
W
1980
..
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
.. ......
These revised surplus projections may be based on several
unrealistic assumptions, including real cuts in federal spending over
the next several years. These spending levels also exclude any
emergency spending, e.g. disaster relief and military initiatives, as
well as any future increases in defense spending. In addition, some
proposals assume that some of the budget surplus will be used to
reduce the public debt, thereby reducing federal interest payments on
that debt.
114
Much of the credit for the current economic expansion can be
traced back to the elimination of the budget deficit, thereby enabling
monetary policy to be more flexible.
Improvements in government saving seem to have been offset by
further reductions in private saving.
Americans have traditionally saved less than others around the
world. The US personal saving rate has been falling since the early
1980s. In addition, by 1998, the personal saving rate turned negative.
Since personal saving is the residual of personal disposable income
minus personal consumption during any particular time period, a
negative saving rate suggests that Americans, on average, are
consuming more than they earn.
Personal Savings Rate
la
* I
cE!
0 S
0..uo
*
U.8
0a1
I
C
-
, e
a
C
0
I .
1901
1984
1987
1990
1993
1996
1999
The saving rate is a little misleading, as it does not take into
account the accumulation of wealth. For example, many Americans
put their saving into their homes, and home-ownership is very high in
the United States. The asset value of housing is not included as
saving. Likewise, other investments, such as stocks and bonds, and
the accumulated returns on these investments, are also not included as
saving.
115
Regardless of these problems in defining saving, it is still
important to note the precipitous decline in the saving rate over the
last 20 years. Part of this decline may be explained by increased
investment in assets currently not included in the definition of saving.
Another factor may be the consequence of the significant shift in the
federal budget from deficit to surplus over the same period. This
improvement in government saving may have resulted in shifting more
financial burdens on to individuals, either by paying more for services
previously provided by the government, or by paying higher taxes.
The improvement in public saving - the move from budget
deficit into surplus - has been more than offset by the decline in
personal saving. Together, domestic saving has been inadequate to
finance the strong growth in domestic investment, making it necessary
for the United States to continue borrowing from abroad.
One consequence of this increasing gap in saving and investment
has been the widening gap in the US current account. The single
largest component of the current account deficit has been the
growing merchandise trade deficit.
US lworise Trade Defidtas a Puwit d GOP
4
3-6
3.4
1991
3.5 3
02.5
o25
IL
1.51
.
0.5
I
a4
1981
1983
1986
1987
1989
116
1991
1993
1995
1997
1999
(f1iu
Jif)
A combination of factors, including the East Asian financial
crisis, slow growth in the industrialized countries and the strength of
the US dollar, have contributed to widen the merchandise trade deficit.
The merchandise trade deficit in 1998 was close to $250 billion.
Initial monthly reports suggest that the deficit can be expected to reach
$300 billion in 1999. In terms of percent of GDP, the trade deficit is
currently as large as it was in 1987, prior to the Plaza Accord, which
resulted in significant changes in exchange rates.
The growing trade deficit helps explain some of the job losses
in the manufacturing sector discussed above. On the other hand, the
trade deficit may be currently serving as a "safety valve," preventing
the economy from over-heating and holding down inflation due to
falling import prices.
Recent economic developments abroad have contributed to the
current economic expansion in the United States. Increased
competition at home and abroad has tended to place downward
pressure on prices. Currently, US firms are reluctant to raise prices for
fear of losing markets to other competitors. This has enabled falling
world oil and other commodity prices to be passed on to consumers.
US economic growth has been outpacing the growth
experienced in most other major industrialized economies. This is due
to the strength in the US economy and continued weaknesses in the
rest of the world, particularly in East Asian and Europe. On the other
hand, slow growth abroad has depressed many of US industry's
traditional export markets. Weakened currencies abroad have boosted
US imports while making US exports more expensive. As a result, the
US merchandise trade deficit has increased, reflecting a significant
increase in imports and a decline in exports. This development has
placed considerable pressure on the US tradeable goods sector and its
workers.
Overall, there is much to celebrate in the current economic
expansion. At the same time, not everyone in America has enjoyed
the benefits of growing economy.
The economy seems to be split into two groups - those who
are able to share in the fruits of economy-wide growth, and those for
117
whom it takes longer to personally realize some of the broader
national economic gains. Economic statistics based on national
averages tend to camouflage the plight of this second group.
For example, per capita income growth across the nation
averaged 4.5 percent annually between 1991 and 1997. Despite this
strong growth, approximately 500 counties - almost 16 percent of all
counties - experienced no growth in average annual per capita
income. By contrast, the remaining 2580 counties experienced an
average per capita income growth of 5Y/2 percent annually during the
same period. The low per capita income growth ("low growth ")
counties constituted more than 24 million people, or roughly 10
percent of the nation's total population. These countries tended to
have a heavier reliance on farming and mining than the other
countries. Despite the recent pick-up in the California economy, 29
percent of all Western counties experienced almost no per capita
income growth.
As might be expected, the low growth counties had a higher
incidence of poverty, with almost 700,000 families in these counties
facing poverty in 1997. The low growth counties also had lower high
school and college graduation rates than the higher per capita income
growth counties. The low growth counties included large population
centers such as Los Angeles, Fresno, Santa Barbara, Queens and
Honolulu.
In addition to per capita income growth, there are regional
differences in unemployment rates. In 1998, 389 counties - 13
percent of all counties - experienced unemployment rates at or above
8 percent, close to twice the national average. A little more than half
of those counties
-
187 of them
-
experienced unemployment at or
above 10 percent. Less than one third of the counties which
experienced low per capita income growth also had high
unemployment rates.
The high unemployment counties constituted 20 million
people -7 percent of the national workforce. A sizable number, but
not all of high unemployment counties were major population centers.
These included two of the five New York boroughs. These counties
were not regionally concentrated: 39 states had at least one high
unemployment county. Yet some states do have a disproportionate
118
number of high unemployment counties. In 11 states, more than 10
percent of the state's workforce was found in high unemployment
counties. The high unemployment counties tended to correlate with
lower educational achievement and a persistence of high
unemployment. (See attached paper, "Pockets of High Unemployment
in a Low Unemployment Economy.")
In addition to a regional gap in per capita income and
unemployment, there has also been a widening gap between income
groups. Between 1989 to 1996, income growth was concentrated in
those families whose earnings were in the top 20 percent of the income
distribution. The remaining families experienced either no
improvement or actual declines in their income. The widening income
gap has resulted from income gains at the high end of the distribution
and income stagnation or losses for the vast majority of the others.
One of the factors behind the declines in living standards for
those on the lower end of the income distribution has been the erosion,
and in some cases even elimination, of several government programs.
Examples include welfare reform and the erosion in the real value of
the minimum wage.
THE MINIMUM WAGE
During the past two decades, the real value of the minimum
wage has been falling. This has hampered the ability of those at the
lower end of the socioeconomic scale to fully share in the benefits of
the recent economic prosperity. This erosion continues despite
moderate increases in other wage and salary indices.
Part of the continuous erosion in the minimum wage can be
explained by its legislatively-mandated structure. The minimum wage
can only be adjusted by an act of Congress. Thus, the minimum wage,
by its very nature, is reactive and is always trying to "catch up" to
changes in prices and other wages.
The minimum wage was first instituted in 1938 to help ensure
"maintenance of the minimum standard of living necessary for health,
efficiency, and general well-being of workers." The minimum wage is
one of the country's oldest income policy tools.
119
It covers employees of enterprises doing at least $500,000 in
business annually, as well as employees of smaller firms engaged in
interstate commerce, government workers, hospital workers, school
employees, and many domestic workers. In 1998, 4.4 million people
earned the minimum wage, which is currently set at $5.15.
Distribution of Minimum Wage Workers by Industry
1998
Industry
Number of Minimum
Wage Workers
Percent of all Minimum
Wage Workers
Retail Trade
2,334,000
52.7
Services
1,100,000
24.8
Manufacturing
299,000
6.8
Government
285,000
6.4
Most employees receiving the minimum wage work in fast
food restaurants, retail establishments, and low-end service jobs (such
as commercial housekeeping). More than half of those workers
earning the minimum wage are employed in retail trade. Another 25
percent of minimum wage workers are employed in agriculture and 6
percent of those workers are employed in the public sector.
The typical minimum wage worker is an adult woman, and
likely a minority. In 1998, women comprised almost two-thirds of
minimum wage workers, and seventy percent of minimum wage
earners were 18 years of age or older. A larger percentage of
minorities earn the minimum wage, by age group, than white workers.
The most recent increase in the Federal minimum wage
occurred in two steps in 1996 and 1997. On October 1, 1996 the
minimum wage was increased from $4.25 to $4.75, followed eleven
months later, on September 1, 1997, by an increase to $5.15. In 1996,
Congress instituted a separate, lower ($4.25) sub-minimum wage for
young workers, who are less than 20 years old during their first 90
days of employment with a particular employer.
120
After increases in the 1950s and early 1960s, the real value of
the minimum wage peaked in 1968, fluctuated during the 1970s, and
has, for the most part, been declining since then. The current
minimum wage, $5.15, is similar to its real value in 1983 and 1984,
and remains below its real value during the 1960s and 1970s. Over the
last 20 years, the real value of the minimum wage has fallen by 22
percent. By contrast, the real average wage for all hourly workers has
declined by 10 percent, or less than half that amount. Workers earning
the minimum wage have been experiencing a real decline in their
living standards - earning less and less for the same amount of work,
and falling farther and farther behind.
The minimum wage has weakened relative to average wages
in manufacturing and other private industries. At its peak in 1968, the
minimum wage was about half of the average wage in manufacturing.
Improvements in manufacturing wages and the continued erosion in
the minimum wage through the 1990s, has resulted in the minimum
wage standing currently at only approximately one-third of the
average manufacturing wage.
Real Value of the Minimum Wage
7.00
6.50
6.00
0
5.50 -1998:
5.15
5.00
4.50
4.00
1978
1982
1956
121
1990
1994
1999
The minimum wage does not guarantee a family income above
the poverty level. Working full-time at the minimum wage, an
individual would earn a gross salary of $10,300, without taxes and
benefits. After taking taxes into account - subtracting the payroll
tax and adding back the Earned Income Tax Credit - net income
would be $10,912. This is lower than the national poverty rate for a
family of one adult and one child ($11,235), one adult, two children
($13,133) and two adults, one child ($13,120). In order for an adult
working full-time to earn enough to meet the federal poverty guideline
for a family of two, the minimum wage would need to be set at $5.62.
For a single parent with two children, the minimum wage would need
to be at least $6.57.
Many states and localities have recognized that the federal
minimum wage is not adequate and have instituted higher minimum
wages for some or all workers. These initiatives fall into two
categories, based upon whether the public body is a state or local
government (county or municipality). State laws can mandate a
minimum wage that is higher than the federal level, but not lower.
Nine states - Alaska, California, Connecticut, Delaware, Hawaii,
Massachusetts, Oregon, Washington and Vermont - and the District
of Columbia have minimum wages which are higher than the federal
minimum wage. These range from $5.25 in Hawaii, Massachusetts
and Vermont to $6.50 in Oregon. These nine states and the District of
Columbia cover one-fifth of the working-age population.
In addition, over 30 cities and counties have adopted
ordinances which require those companies awarded municipal
contracts, their subcontractors, and/or those receiving economic
development funds to pay their employees a "living wage" set above
the federal minimum. Many living wage ordinances are based upon
poverty rates, adjusted for local living expenses for a family of two,
three, or four, and are frequently indexed. In addition, many localities
have begun adding a health care coverage component, by which firms
not providing health coverage must pay their employees an additional
amount. Many of the existing programs require an additional $ 1.00 an
hour in wages be paid to those workers not covered by health
insurance.
The 1996 and 1997 increases in the minimum wage have been
accompanied by falling unemployment rates for teenagers and
122
minorities, those groups most likely affected by the minimum wage.
Between 1996 and the first half of 1999, the unemployment rate for
teenagers fell from 16.7 to 13.5 percent, the Africa-American
unemployment rate has fell from 10.5 to 7.3 percent and the
unemployment rate for other minorities fell from 8.9 to 6.8 percent.
Similar patterns have also occurred in states which have recently
raised their minimum wage above the federal level. With respect to
living wage ordinances, 2 years following the establishment of a living
wage in Baltimore, the costs of city contracts declined, wages
increased, and unemployment declined.
Recent evidence flies in the face of the claims that increases in
the minimum wage necessarily lead to increased unemployment.
Three issues must be considered when estimating the impact of an
increase in the minimum wage on employment: the prevailing
minimum wage, the size of the increase and the economic
environment against which the increase is taking place. As the US
economy enters one of it longest expansions in recent history, there
are signs of labor shortages in many parts of the country. Raising the
minimum wage during a period of a tight labor market may result in
more employment. In addition, firms may be more willing to train
those workers employed at the minimum wage, thereby increasing
productivity. In addition, as people are being moved off the welfare
rolls and brought into the workforce, and other benefits are being
reduced, it is becoming increasingly important that full-time
employment brings enough earnings to purchase basic food, shelter,
and health care.
PRESCRIPTION DRUG BENEFIT
Concerns about rising prescription drug costs, the desire to
enable more seniors to take advantage of new effective medications,
and arguments that proper use of medications can decrease the reliance
on other, more expensive treatments have led to various initiatives to
incorporate a prescription benefit into the Medicare program. As part
of its plan to reform and expand Medicare, the Administration has
included a significant prescription drug benefit, similar to HR 1495,
Access to Prescription Medications in Medicare Act of 1999, proposed
by the Committee's Ranking Member, Congressman Pete Stark, in late
1998.
123
59-884 0 - 99 - 5
Since 1980, drug expenditures have grown in the double
digits, far more than the growth in total health care expenditures. In
1997 alone, drug expenditures grew by 14 percent, almost three times
the growth rate of total national health care expenditures, hospital
service expenditures and physician service expenditures.' Most of the
growth in drug expenditures can be traced to a significant increase in
volume, mix and availability. As the costs of prescriptions escalated
and an expanded number of new medicines provided cost-effective
alternatives to other medical therapies, private drug plans began
covering an increasing portion of all prescription drug payments
during the 1990s.
Yet those who rely the most on prescription drugs - the
elderly - do not have any comprehensive prescription drug coverage,
as a group. Although they comprise only 12 percent of the population,
the elderly account for a third of all prescription drug use.2 However,
almost 14 million elderly - approximately one-third of the 38
million people enrolled in Medicare in 1997- had no prescription
drug coverage at all. An additional 4 million people voluntarily paid
more and received limited prescription coverage. The rest were.
covered either through Medicaid or private employer-based plans.
Prescription drug costs have become a significant financial
burden on the elderly, as drugs are the single largest out-of-pocket
medical expense for seniors, many of whom have moderate incomes.
In 1994 and 1995, 76 percent of the seniors had incomes below
$30,000 and the average senior paid $558 for prescriptions. This
compared to an average of $355 spent by 55 to 64 year-olds during the
same period. In fact, a 1993 survey found that one in eight seniors
reported having to chose between medicine and food at some point
during the year.3
Employee Benefits Research Institute, Issue Brief 208, April 1999.
2
Ibid.
3
American Pharmacy, October, 1992; HCFA Office of Strategic
Planning, Data from the Current Beneficiary Survey, cited in staff
124
Additionally, private sector benefit managers are able to
negotiate lower drug prices than uninsured individuals. Consequently,
Medicare beneficiaries without supplemental private insurance for
prescription drugs spend twice as much on prescription drugs as their
counterparts with private insurance. 4
Drug ExpendHtures of the Elderly by Income In 1994-1995
2,
*
2E
e Co
i
=.
;.S
is
I... W..
$s,...
$85*S S
ses$s
$lis.*O
,.
$14B,,
$15.0,0
$52.605 a3,.6@0
fC
S.
$820.0
5,.0
S....
t.
$30.SIS
$4S,.61
$550.560
t.
C
$49.00
$859.SS0
$5600
t.
Ss.0
. 0... k.t
To address this deficit in health care coverage, the
Administration's prescription drug benefit would:
*
Be a voluntary plan, available for purchase by all
Medicare beneficiaries, generally, on a one-time only
basis;
*
Have no deductible, so that all enrollees would begin
benefitting from the plan with the first prescription
filled;
documents, Medicare Commission; Department of Health and Human
Services, unpublished data; Committee on Government Reform and
Oversight, US House of Representatives, Minority Staff Report,
"Prescription Drug Pricing in the United States: Drug Companies
Profit at the Expense of Older Americans," October 20, 1998.
4
Rogowski, The Gerontologist37:4 (August 1997).
125
*
*
*
*
Be phased-in from 2002 to 2008;
Have a subsidized premium, estimated at $24 a month
in 2002 and $44 per month when fully phased-in by
2008;
Pay for half of the prescription costs up to a total of
$5,000 total drug costs ($2,500 in Medicare payment)
by 2008; and
Be subsidized for beneficiaries with incomes below
135 percent of poverty (those individuals earning
below $11,000 and couples earning below $17,000
would pay no premium or co-payments). Those
people living 35 to 50 percent above the poverty rate
would pay only partial premiums.
Several cost saving mechanisms would be incorporated, as
well as incentives to employers, to maintain and develop retiree health
coverage which include a prescription drug benefit package similar to
(or better than) to the Administration's proposal. The Administration
estimates that its plan would cover roughly 31 'million older and
disabled citizens each year. It also estimates that the plan will cost
$118 billion over the next 10 years, mostly to be paid by cost savings
instituted elsewhere within Medicare ($64.5 billion) and partly out of
surplus budgetary revenues ($45.5 billion).
Although it is difficult to precisely predict all the potential
impacts of this Medicare prescription drug proposal, several types of
affects can be inferred from previous research. Some'studies have
shown that drugs can be used as effective substitutes for other kinds of
treatment.' For example, proper use of medication can be expected to
decrease hospital and nursing home costs.2 According to the General
Accounting Office, Medicaid's automated drug utilization system
reduced adverse drug reactions and saved more than $30 million in
five states.
See for example, the Employee Benefit Research Institute.
See New EnglandJournalof Medicine, March 4, 1999.
126
Adding a prescription drug benefit to Medicare might be
expected to increase prescription drug usage but not necessarily raise
overall medical costs. Financial incentives to drug manufacturers to
continue searching for new medicines which might substitute for
expensive existing drugs and for in-patient care will continue. In the
end, a prescription drug benefit might result in healthier seniors, and
curb, or even bring down, overall medical costs.
PROSPECTS FOR THE FUTURE
Recent data confirm that the US economy remains sound and
there are virtually no indications for a significant slowdown in the near
future. In fact, the lack of an economic slowdown has led some
economists to suggest that the traditional business cycle of recessions
and recoveries may be obsolete. It may be premature to come to that
conclusion, but the economy's performance over the last several years
in particular the long period of non-inflationary low
unemployment - clearly suggests that something new is happening
to the US economy.
There are several factors which are key to the future prospects
of the US economy:
Productivity is the key nutrient to.economic prosperity. The
more efficient the economy and our workers are, the more we can
afford to enjoy higher living standards. It is also important that
productivity not come at the expense of employment. Thus, our
objective should be to achieve robust productivity and economic
growth simultaneously. Economic growth will help re-employ those
workers who might have lost their jobs due to productivity gains.
Increased investment, both public and private, is necessary in order to
achieve the dual goals of raising productivity and overall economic
growth.
Between 1950 and 1970 productivity grew by 3 and 4 percent
annually. This high rate of productivity growth enabled workers to
enjoy considerable increases in their living standard. Since then,
productivity growth has been on average between I and 2 percent
annually. In response, workers wages have been stagnant or rising
127
only by a small amount. Since 1995, productivity growth has
increased by more than 2 percent annually.
Many analysts link recent increases in productivity with the
introduction of new technology, particularly in the information sector.
It is too early to confirm or deny this assessment, but if technology is
driving increases in productivity, the future could hold sustained
increases in productivity as continued investment, research and
development yield new products and more efficient practices.
The recent improvement in fiscal policy - moving from
continued deficits to surpluses - has resulted in lower interest rates,
which in turn has stimulated private investment. Increased
productivity-enhancing investment is the cornerstone to achieving
non-inflationary economic growth.
The key to future improvements in productivity and
investment is the ability to maintain favorable conditions for private
investment. These favorable conditions include avoiding a return to
the government budget deficits of the 1980s and unnecessary moves to
raise interest rates.
There are virtually no sighs of a resurgence of inflation in the
economy. Increased global competition, falling commodity prices and
weak currencies overseas - due to slow growth and the recent
financial crisis - are helping keep prices down in the United States.
The fact that low and falling unemployment has been coupled with
only modest increases in wages has also served as another major factor
behind low inflation in the United States. Low interest rates and
significant declines in other costs of doing business have also
contributed to keeping inflation low. These factors are expected to
remain in place for at least the near future.
Employment - The US economy is considered to be a "jobs
machine" -- having created, on net, some 20 million jobs since 1992.
Many of these jobs are in sectors which have traditionally paid higher
wages that in other sectors. On the other-hand, many of these new
jobs do not provide health care insurance coverage and pensions.
128
Unemployment is at its lowest rate in more than 30 years. The
gradual nature of this improvement combined with moderate economic
growth could keep unemployment rates low into the future. The fact
that the unemployment rate has been so low for so long has provided
previously low-skilled workers the opportunity to gain valuable
experience that assists them throughout their working lives. The drop
in unemployment has included hard hit areas and historically higherunemployed populations including minorities, the less educated and
youth. The longer this economic expansion continues, the greater the
prospects for meaningful inroads into skill development and income
growth for these historically disadvantaged populations.
There are three important concerns in the current economy the falling and recently negative saving rate, the growing trade
deficit and the growing income gap between the wealthy and the rest
of society.
Americans have traditional been low savers in comparison to
those living in other countries. On the other hand, more Americans
own their homes than others abroad. The concern is that since the mid
1970s, the US saving rate has been falling, and this year has gone
negative. In other words, on a monthly basis, Americans spend more
than they earn, after taxes. Private household saving an important
ingredient for domestic investment. Without a healthy home-grown
pool of capital, people must borrow from overseas the capital they
need to build plant and equipment, carry out research and
development, and create good paying jobs. Insufficient domestic
saving could lead to less investment or higher interest rates.
America's need to borrow capital from abroad has contributed
to a growing deficit in merchandise trade. US exports have been hurt
due to slow growth in Europe and Japan, and the financial crisis in
East Asia. In addition, strong growth at home and weak currencies
abroad have push up US imports. Over the first half of this year, US
imports have been running at I V2 times US exports. Insufficient
exports to pay for our imports further contributes to the need to borrow
from abroad.
During the 1980s, the United States was borrowing from
abroad to finance its ballooning budget deficits. During the 1990s, the
United States has been borrowing from abroad to finance its
129
investment boom, since domestic saving was insufficient. Stimulating
more domestic saving should thus help reduce some of the need to
borrow from abroad.
In addition, the United States has a strong interest in
rejuvenating economic growth around the world, particularly in those
countries which tend to buy US goods and services. Economic
stimulus and financial stability are key to achieving this objective.
The United States must also make sure that its currency does not
overvaluate, as it did in the 1980s. Maintaining exchange rate stability
is also important objective.
The trade deficit has noting to do with the level of
employment in the United States. For example, unemployment has
been falling to historic low levels during the same time that the trade
deficit has been rising to record highs. On the other hand, the trade
deficit reflects the composition of employment, i.e. the pressure on the
agriculture sector of the move out of manufacturing employment and
into services. In some cases, this compositional change has reflected a
move from high wage jobs with benefits to lower wage jobs without
benefits.
This shift, together with changes in technology and the lack of
skills in the workforce, has contributed to making it harder for most
American workers to "get ahead." On the other hand, the tremendous
gains in the stock market and other financial markets over the decade
have helped upper income people increase their wealth rather
substantially. The combination of both factors has resulted in a
growing income gap between the small share of wealthy people and
the majority of working people in this country. This growing income
gap has important economic, political and social consequences which
should not be denied or ignored.
One immediate way to address the growing income gap is to
strengthen the safety net for those who might not be enjoying the
benefits of the current economic expansion. For example, despite a
recent increase, the minimum wage, after inflation, remains
significantly below its level in the 1950s and 1960s. In addition to
making up for recent declines in the minimum wage, it is important to
remember that any further increases have to be protected from
inflation which further erodes the real value of the minimum wage.
130
Improving access to health care insurance and pensions would
also help the majority of Americans reduce their out-of-pocket
expenses. Stemming any further widening in the income gap, let alone
reducing it, does not have to mean taking wealth away from the rich.
It could be done by devoting more of the recent economic gains to
those people who's incomes have not been growing as much.
The United States is experiencing an unprecedented period of
economic prosperity. Unemployment is at a historic low and there is
no sign of a resurgence of inflation. After decades of budget deficits,
the government is currently operating in surplus and the
Administration is forecasting continued surpluses well into the future.
Interest rates are low and investment in booming. Economic
developments in the United States since 1992 are the envy of the
world.
As good as this story is, it is not complete. Economic
prosperity has not yet come to everyone in our society, and for most it
has come following a period of prolonged economic hardship. The
challenge before the nation is to both ensure the continuation of this
economic prosperity and to aim at sharing its benefits more widely
with all Americans.
REPRESENTATIVE FORTNEY PETE STARK
Ranking Minority Member
131
Working Paper Series
offered to the
JOINT ECONOMIC COMMITTEE
MINORITY
UNITED STATES CONGRESS
Congressman Pete Stark, Ranking Democrat
Pockets ofHigh Unemployment in a
Low Unemployment Economy
Robert Gibbs
July 1999
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.
133
Pockets of High Unemployment in a
Low Unemployment Economy
Robert Gibbs'
1.
Introduction
The current low unemployment rate is one of the undisputed success stories of the U.S. economy.
By early 1999 the U.S. unemployment rate stood near a 30-year low, at just over 4 percent. The
decline in the national rate since 1992, coupled with reports of labor shortages across the board,
has dampened concern about training the unemployed and debate about 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, however, the national rate masks considerable variation in local unemployment rates (see
Table I). At one end of the spectrum, Clay County, South Dakota and McPherson County,
Nebraska, experienced an average rate of 1.0 percent in 1998. Nationwide, 155 counties had
rates below 2 percent and well over 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, 187 counties had average 1998 rates above 10 percent, led by
Presidio County, Texas, at 32 percent. If the net is cast just slightly more widely to include
counties with unemployment rates above 8 percent, the number of counties jumps to 389, or
about I in 8 U.S. counties.2 Many counties were experiencing severe unemployment at a time
when the national economy was being watched suspiciously for signs of overheating. These
counties all had rates in 1998 above the peak national unemployment rate following the 1990-91
recession, and so comprise an "unrecovered" group. Most of these high unemployment counties
are experiencing unemployment rates at least twice as high as the current national average.
Does it matter that several hundred counties lie at the upper end of the unemployment rate
distribution? Are these counties really important to the national economy? Yes to both
questions. Counties with unemployment rates above 8 percent (henceforth called "high
unemployment counties") are not merely small, isolated pockets impervious to economic
' Visiting regional economist at the Joint Economic Committee of the U.S. Congress,
Minority Office.
2 A list of these counties and their 1998 unemployment rates are shown in Appendix
Table 1. The 8 percent threshold was chosen to approximate the national 1990-91 recession high
of 7.6 percent County unemployment data are drawn from the Local Area Unemployment
Statistics provided by the Bureau of Labor Statistics, U.S. Department of Labor.
134
Table 1. US. County Unemployment Rates, 1991
Unemploymn
rate
Number of cowuties
2 percent or lower
Pere of coniYes
155
4.9
2.1 -4 percent
1175
37.4
4.1 -6 percent
951
30.3
6.1 - 8 percent
470
15.0
8.1 - 10 percent
202
6.4
10.1- 15 percent
164
5.2
23
0.7
3140
100.0
Higher than 15 percent
135
prosperity, but include a number of important employment centers of the United States.
Collectively, high unemployment counties had a population of 20 million and a workforce of
over 8 million in 1998, about 7 percent of the national total. A sizable number of high
unemployment counties are major population centers, such as 2 of the 5 New York boroughs.
Nor are these counties found in only a few regions: 39 states have at least I county with high
unemployment. In 11 states, more than 10 percent of the workforce is found in high unemploy3
ment counties. In New Mexico, more than a quarter work 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 burden for the economy, because it not only
involves the loss of productive capacity, but it also requires the 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. Few such counties are likely to realize the goal of providing selfsustaining work to all who need it, as embodied in current welfare reform policy. For these
places, a low national unemployment rate 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 that can be 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, mining, government, and retail trade;
earnings per job; state unionization rates; share of residents who belong to a racial or ethnic
minority; share of adults without a high school diploma; remoteness from cities; physical
amenities; and location in the West. These same counties have lower levels of wholesale trade
employment, lower employment growth, smaller shares of college graduates, smaller urban
populations, and are less likely to be located in the Midwest, once other attributes have been
controlled for.
It is important to keep in mind that for most of the 389 counties with high unemployment, 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
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
The eleven states and the percentage of workers living in high unemployment counties
New Mexico (29.0), West Virginia (22.0), New York (17.7), Mississippi (16.2),
as
follows:
are
Alaska (16.9), Hawaii (16.7), Maryland (15.0), California (12.9), Arizona (11.2), Washington
(11.5), and Oregon (11.2).
136
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.
11.
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 389 high unemployment counties combined had a labor force of 8.7 million people, about 7
percent of the national total in 1998. An average of 935,000 workers were unemployed in these
counties each month, representing 18 percent of total unemployment in the United States. High
unemployment counties come in all sizes: 31 counties have populations of more than I 00,000,
and 218 counties, over half, 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 two of the five 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 Califomia. Small and
medium-size high unemployment counties are distributed relatively evenly across the nation.
High unemployment counties are found in all four Census regions of the country. The largest
number are in the South, with 217 counties, but the largest proportions of high unemployment
counties within a region are in the West (25 percent), while they are relatively sparse in the
Midwest (4 percent) and the Northeast (6 percent) (Table 3). The uneven regional distribution is
particularly apparent when examined across the nine Census divisions. Among these, the Pacific
division has the highest percentage of high. unemployment counties - 43 percent, or 72 of 166
counties. At the other extreme, the Great Plains states have just 12 high unemployment counties,
2 percent of their total, and New England has I high unemployment county, I percent of all
counties in the census division.
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, 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. By contrast, 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.
137
Table 2.
The 25 Largest High Unemployment Counties
County
Population
(1997 est)
Unemployment
rate (1998)
-
1. Kings, NY
2,240,384
9.3
2. Bronx, NY
1,187,984
9.9
3. Fresno, CA
754,396
13.9
4. El Paso, TX
701,576
10.1
5. Baltimore (city), MD
657,256
8.7
6. Kem, CA
628,605
12.0
7. San Joaquin, CA
542,504
10.6
8. District of Columbia
528,964
8.6
9. Hidalgo, TX
510,922
17.6
10. Stanislaus, CA
421,818
12.0
11. Monterey, CA
361,907
10.7
12. Tulare, CA
353,175
15.6
13. Cameron, TX
320,801
12.5
14. Atlantic, NJ
236,569
8.0
15. Yakima, WA
218,318
10.1
16. Merced, CA
196,123
15.3
17. Butte, CA
194,160
8.2
18. Webb, TX
183,219
9.4
19. St. Lucie, FL
179,559
10.7
20. Dona Ana, NM
168,470
8.9
21. Shasta, CA
163,178
8.9
22. Imperial, CA
143,706
26.0
23. Hawaii, HI
141,458
8.8
24. Cumberland, NJ
140,907
9.2
25. Yuma, AZ
130,016
26.0
138
Table 3. Regional Distribution of High Unemployment Counties (HUCs)
Region/Division
Number of
HUCs
Percent of all
HUCs
Percentof total
counties in region
Northeast
14
4
6
Midwest
47
12
4
217
56
15
South
West
111
28
25
Total
389
100
12
New England
<1
Middle Atlantic
13
3
9
East North Central
35
9
8
West North Central
12
3
2
South Atlantic
79
20
13
East South Central
65
17
18
West South Central
73
19
16
Mountain
39
10
14
Pacific
72
19
43
Total
389
100
12
139
I
Figure 1. High Unemployment Counties in the U.S.
Rates greaterthan 8 percentin 1998 shown in gray
o
a
cm
I'0
a
Ill.
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 ofjobs available), and it persists until real 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 economic 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 long-term shifts in product demand and
production technology rather than the business cycle. 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.
In addition, some areas have populations that have suffered historically from chronic
unemployment, weak labor force attachment, and 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 information 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.
141
Frictional unemployment is likely to vary geographically as well. The number of job seekers "in
transition" at a given point in time is a function of job turnover, the difficulty and method ofjob
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
high-skill jobs/workers, relatively low turnover and brief intervals between jobs push down the
frictional component of unemployment.
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 the counties in this unfortunate group will shift over time. That is, because
local economies are dynamic over the long-run, the distribution of unemployment across the
nation will change as local characteristics change. Economic hardship, in other words, gets
spread around, much as individual 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 county 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 rose-to 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 I
standard deviation above the mean is 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 51 percent of
the current high unemployment counties fell above the standardized threshold in a given year; in
the early 1990's, 65 percent of these counties did so. Furthermore, three-fifths of the 389 high
unemployment counties in 1998 were above the high-unemployment threshold in a majority of
the 19 years available for this study, and 56 (14 percent) of these were high unemployment
counties every year since 1979.
V.
Characteristics of 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 understanding the
142
relationships between local attributes and unemployment rates. The key local factors to be
considered can be grouped into market-related, locational, demographic, and education
characteristics. In this section, the reasoning behind the expected association between these
local factors and unemployment is discussed.
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 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 matched by commensurate levels of productivity, long-term job growth will be
sluggish.
Even where wages are not especially high, migrants may be attracted to the 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).'
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. There is evidence that
a diversified economy, particularly one based on services, cushions workers against cyclical
downturns and allows quicker transitions to newjobs. However, a comparison of major industry
distributions by unemployment rate reveals that although high unemployment counties have
slightly higher employment shares in agriculture, mining, and government (and slightly lower
shares in other industries), there are no sharp differences in the mix of industries between high
unemployment counties and all other counties (Table 4).'
The measure of physical amenities used in this report was developed by David
McGranahan at the Economic Research Service, USDA. The amenities measure is 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 a mean of zero and
a unit variance (see McGranahan, forthcoming, for a detailed discussion of the index).
5 It is also possible that the use of broad industry categories masks geographic
differences that would become apparent if employment were further disaggregated.
143
Table 4. Industry Mix in HUCs and Non-HUCs
Percent of total employment
Industry
HUCs
Non-HUCs
Agriculture, Forestry,
Fishing
2.5
1.6
Mining
2.0
1.2
Construction
4.6
5.6
. 12.7
13.8
4.0
3.9
Manufacturing
Transportation, Utilities,
Communications
Wholesale Trade
Retail Trade
2.4
3.2
15.3
16.2
3.8
4.8
21.3
22.2
19.0
16.1
100.0
100.0
Finance, Insurance,
Real Estate
Services
Government
-
-
Total
County Typology
(nonmetroonly)
Farm-dependent
63
18
493
25
Mining-dependent
42
12
105
5
Manufacturing-dependent
76
22
439
23
Services-dependent
40
12
283
15
Government-dependent
59
17
196
10
Nonspecialized
66
19
422
22
346
100
1938
100
Total
144
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 publicly-funded services and mining than counties with
lower unemployment rates. (Table 4) This is not surprising. Income generated from
govermment-related employment and income transfers tends to dominate the local economy only
when basic industrial activity is weak, or when 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.
While high unemployment counties overall have a higher-than-average proportion of workers
engaged in agriculture, nonmetropolitan counties with high unemployment are less likely to be
dependent on farming than other nomnetro counties. Part of this discrepancy can be explained by
differences in the way that industry dependence is measured, which is not directly related to local
employment share. In addition, agricultural workers are found disproportionately in nonmetro
areas, which as a group have above-average unemployment rates for a variety of other reasons. It
may be, then, that the relationship between agriculture and unemployment depends on its
geographic context, a point explored later in the paper.
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 29
percent of non-high unemployment counties (Table 5). The 35 metropolitan high unemployment
counties are nearly evenly distributed between the South and the West; none are found in the
Midwest, and only a handful in the Northeast (Table 6).
High unemployment counties are particularly unusual among counties in metropolitan areas of
one million people or more (2 percent, or 4 out of 179 counties), but their incidence rises among
smaller metropolitan counties (Table 5). For nonmetropolitan areas, the highest incidence of
high unemployment counties is in areas without large towns (10,000 or more residents) that are
not adjacent to a metropolitan area. Adjacency to a metropolitan area appears to have a positive
effect on employment, in part because proximity promotes economic diversification, and in part
because commuting links with urban centers increase workers' abilities to search for new jobs.
Adjacent counties are also often feasible residential locations for urban workers, who typically
have more education and skills than their rural counterparts, and therefore spend less time
looking for work.
145
Table 5. Urbanicity of High Unemployment Counties
Number of HUCs
Percentof all
HUCs
Percentof all
counties in status
Metro
35
9
4
Nonmetro
354
91
15
Total
389
100
12
6
Metropolitan Status
Urban influence'
Metropolitan:
Large metro
4
Small metro
31
8
Adjacent to large metro,
city > 10,000
7
2
Other adjacent to large
metro
8
2
7
Adjacent to small metro,
city> 10,000
18
5
10
Other adjacent to small
metro
98
25
16
Non-adjacent, city >
10,000
26
7
11
Non-adjacent, city 2,50010,000
104
27
19
Other non-adjacent
92
24
18
389
100
12
Nonmetropolitan:
Total
"Urban influence" divides all U.S. counties into 9 mutually exclusive groups. These
groups classify metro counties by the size of the metro area they are in and nonmetro counties by
their adjacency to each size of metro area and by the size of their own largest city or town (see
Ghelfi and Parker, 1997). "Other non-adjacent" counties are typically the smallest and most
remote.
146
Table 6. MetroStatus by Region, High Unemployment Counties
Status
Northeast
Metro
Midwest
South
West
Total
5
0
14
16
35
14
0
40
46
100
47
203
95
354
13
57
27
100
.9
Nonmetro
3
147
59-884 0 - 99 - 6
Education
The probability of being unemployed falls sharply as workers acquire more education. Adults
without a high school diploma face unemployment rates 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 prospective
employers, or even 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 10.4 years vs. 11.1 years in other counties.6
A more telling comparison between high unemployment counties and other counties is the share
of adults at either end of the educational spectrum. For instance, 13 percent of all counties in
1990 had a high proportion of college graduates (20 percent or more of the adult population) but
only I percent of high unemployment counties did. Similarly while 65 percent of counties
nationally had a high proportion of high school dropouts (25 percent or more), the rate for high
unemployment counties was greater than 90 percent.
Demographiccharacteristics
The demographics of the labor force varies greatly from place to place. Worker characteristics
that affect entry and exit from the labor force, such as age, are especially associated with
geographic differences in frictional unemployment. Younger workers 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 ofyoung 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 segregation 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 43 percent
(169) of high unemployment counties, compared with 16 percent of all other counties (Table 7).
Similarly, 28 percent of all counties with significant minority populations are also high
unemployment counties. The strongest association is for American Indians -- 51 percent of
counties where they form a significant presence experience high unemployment.
6
The average years of schooling in low-unemployment counties is 11.5 years.
148
Table 7. Racial and Ethnicity Characteristics in High Unemployment Counties (HUCs)
and Non-HUCs
County tpe
Number
of HUCs
Percentof
all HUCG
Percent of
non-HUCt
Black
95
24
11
5
24
Hispanic
52
13
4
2
34
Native American
Percent of low
unewployment
counties
HUG, as
percent
of all
counties
24
6
1
<1
51
AU inmmorilies
169
43
16
7
28
Total
389
100
-12
149
Consistency of attributes
Do all high unemployment counties possess the attributes enumerated above? Certainly not. For
example, 117 high unemployment counties have average adult education levels above the
average for all counties. The 389 high unemployment counties also include 297 that are not in
remote, sparsely settled areas and 173 with below-average shares of both Black and Hispanic
residents.
Even so, nearly all high unemployment counties possess at least major risk factor, and many have
several. Furthermore, if educational attainment levels, presence of racial/ethnic minorities,
employment growth, and urbanization/remoteness are considered simultaneously, only 24 of the
389 go against the profile of high unemployment counties for all of these attributes.
VI.
Quantifying the Relationship Between County Characteristics and Unemployment
Although unemployment rates are the outcome of many factors working simultaneously, some
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, for instance. 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 a model of unemployment in which local characteristics
are related to simple county unemployment rates, which allows a quantifiable relationship to be
established between specific rates and each characteristic. The analysis, then, uses local
attributes to help explain a county's unemployment rate.
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, the state's average
AFDCpayments to families in 1995, and its average weekly unemployment insurancepayment
per recipient.
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.
Unionization rates also vary markedly by industry type, especially within manufacturing. Because
broad industry measures -- "manufacturing" rather than "textile and apparel manufacturing," for
150
example - are used in the analysis, the union variable will also capture differences in the type of
manufacturing or services located in a county.
The legacy of Aid to Families with Dependent Children (AFDC), which was phased out in most
states by 1997, may also affect unemployment rates. The decision to look for work reflects an
array of costs and benefits. Prior to the passage of the Personal Responsibility and Work
Opportunity Reconciliation Act in 1996, parents of dependent children with insufficient income
were often entitled to receive AFDC. Receipt of AFDC could increase frictional unemployment
by raising the lowest wage rate that job seekers were willing to accept (known as the "reservation
wage"). Likewise, the higher the AFDC payment available from the state (and these varied
considerably by state), the more incentive recipients had to wait for better job offers. This would
have been an important consideration for recipients who typically faced ajob market
characterized by very low pay and often limited or no benefits. Now that AFDC has been
replaced by Temporary Assistance to Needy Families, the relatively large number of recipients in
AFDC-generous states who remained outside the labor force must now comply with work
requirements and may raise local unemployment rates, at least temporarily. Workers in states
with high unemployment insurance payments also have an increased incentive to wait for better
job offers, which should in turn increase frictional unemployment.
Finally, a measure of the surrounding local labor market area has been added to capture nearby
effects - 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 is common, the job market in
adjoining counties may be of equal or greater significance to local residents.
Predictorsof unemployment rates
While our regression analysis can test for a "significant" association between the presence or
level of a local characteristic and the local unemployment rate, controllingfor the effects of all
other characteristics,there is no definitive way to measure the relative significance of these
associations. Thus, several alternative measures were applied to the data.' Race, education, and
unionization rates emerged consistently as the strongest predictors of county unemployment.
Indeed as the national map in Figure I shows, high unemployment counties closely track areas
with large proportions of Black, Hispanic, and Native American residents, and low average
education levels. The association with unionization is less apparent, but undoubtedly plays a role
in areas with certain types of mining and manufacturing.
Most of the other characteristics with theoretical associations to unemployment turned out to
show an empirical relationship as well. As shown in Table 8, local characteristics explain more
The measures included comparing variables based on their OLS parameter estimates,
the standardized 'beta' coefficients, and elasticities evaluated at the mean of both the
independent and dependent variable.
151
than half the variation in unemployment rates across counties. 8 In the discussion that follows, the
impacts of local attributes on the unemployment rates of all counties in the United States are
described. More detailed results from the regression analysis are found in Table 8 and Appendix
Table I.
Market-relatedcharacteristics
A number of the market-related local characteristics are strong predictors of unemployment rates,
particularly the state's union membership rate. With all other local characteristics held
constant, a county whose state's unionization rate is a standard deviation above the average for
all states (about a 5.6 percentage-point difference) has a I percentage-point higher unemployment
rate than a county in an average state. Put differently, a 10-percentage-point higher unionization
rate translates into a 1.7 percentage-point higher unemployment rate. 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 7.7 percent unemployment.
Higher employment growth is associated with lower unemployment. Nationally, the
unemployment rate in a county with employment growth one standard deviation above the mean
(about 4 percent) was 0.4 percentage points lower than in a county with average growth.
Earnings per job in the county is a significant and positive predictor of unemployment, as high
labor costs may dissuade employers from opening or expanding operations, while also raising
reservation wages. County earnings also captures a portion of the impact of unionization at the
substate level. At the same time, earnings in the entire commuting zone is a significant and
negative predictor, indicating that high earnings in the area are more likely due to a high-skill,
high productivity economy, which tends to spread its effects across a multicounty area. The
earnings effect is relatively small, however -- a difference of $5,000 in average earnings per job
in the county yields a 0.14 percentage-point difference in unemployment rates. To reduce
unemployment in a county by a percentage point (say, from 8 to 7 percent), earnings per job
would have to fall $36,000.
In terms of key industries, greater employment in agriculture, manufacturing, mining,
government, transportation-utilities-communications (TUC), and retail trade boosts
unemployment, while greater employment in wholesale trade decreasesunemployment. 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. As noted earlier, the government sector tends to assume more importance where private
8 The remaining variation is due to several causes, including the inevitable omission of
other factors that may influence unemployment rates, which in many cases are unquantifiable or
difficult to measure. Additionally, the factors included in the model are subject to measurement
error, which always reduces the explanatory power of those factors.
152
Table 8. Relationship Between Local Characteristics and Unemployment Rates
Significance
and Direction
Characteristics
Market-relaied
Emolovment growth. 1996-97
Earnings per iob. 1996
State unionization rate
Standardized effect of
additional unit on
unemployment rate
-0.13
0.05
0.35
Yes
...
Yes
Yes
No
No
..
Average stateAFDC payment
State unemployment insurance
Percent employed in:
Agriculture
Y0+.08
Manufacturing
Yes (+)
0.05
Mining
Government
Wholesale Trade
Retail Trade
Yes
Yes
Yes i-)
Yes
Yes
No
0.05
0.06
-0.07
0.13
0.04
Transy/Utilities/Communications
Finance, Insurance. Real Estate
No
Construction
Earnings periob in commuting shed
-0.04
Yes
Localional
HYes
No
Midwest (compared with Northeast)
South
.-
West
Ys0.13
w/large urban)
Small remote (comrpared
Amenity index
Yes(+
Yes(+)0.13
0.09
0.14
Demolzraphk
Percent Black
Percent Hispanic
Percent Native American
yes (+)0.22
Yes (+)0.24
.0.14
Yes L.
Percentages 16-19
Yes(+
0.06
Human caPital
d-0.12
Percent with collegederee
Perent with Iessthanhighsrhnnl
.+)
0 36
153
sector demand is insufficient. The relationships between unemployment and the TUC and
manufacturing sectors, however, are more difficult to explain. This sector tends to be more
prominent in the core of large urban areas and pays relatively high wages, but these factors are
controlled for in the analysis.
Locationalcharacteristics
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 Midwest continues to exert a
negative influence on unemployment rates, and its effect is heightened after controlling for
demographic factors. The effects of being a small remote county are particularly notable,
increasing unemployment by a percentage point relative to the core counties of large
metropolitan areas.
Demographiccharacteristics
The proportion of the population that is Black, Hispanic, or Native American is strongly,
positively associated with unemployment rates. Controlling for all other factors, a county in
which the proportion of residents who are Black is one standard deviation above the mean (23
percent vs. 8 percent) will have an unemployment rate .6 percentage points higher than a county
with the mean proportion. The impact of a similar difference in the proportion of Hispanic or
Native American residents would be .7 and .4 percentage points, respectively.
Human capitalcharacteristics
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
completion rates (about 6 percentage points) shaves .3 percentage points off the county
unemployment rate. More critical by far, however, is the population without a high school
diploma. A similar increase in their proportion would raise the rate by about I point.
Relative importanceof local characteristics
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
154
variety of structural forces. 9 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 collegeeducated population is a dominating influence on unemployment rates. The size of the trade
sectors is also of much greater importance. Surprisingly unimportant are several characteristics
that are key at the national level - commuting zone effects, employment growth, most
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 to unemployment. Meanwhile, the West
is different from the Northeast in that college completion is insignificant, while high school
completion is very closely tied to higher unemployment.
Finally, 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
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.
155
Table 9. Regional Divergence from the Natonal Model
Characteristics
Midwest
Northeast
South
West
Market-related
Employment growth, 1996-97
Earnings perjob, 1996
NS
NS
NS
NS
|
L
State unionization rate
S
NS
SignL(+)
Sign.(-)
Average state AFDC payment
Percent employed in:
NS
Agriculture
(
NS
L
Sign.( +)
Sign.(-)
Manufacturing
Muinig
NS
NS
NS
Government
NS
NS
NS
NS
NS
NS
NS
Wholesale Trade
NS
Retail Trade
NS
TranrwUtiities/Cormn unications
NS
Finance, Insurance, Real Estate
Construction
Eanings perjob in conunting shed
S
.(-)
NS
Locational
Small remnote (compared with large urban)
NS
L
Amenity index
NS
NS
Demographic
Percent Black
Percent ages 16-19
NS
NS
NS
Percent Hispanic
NS
NS
NS
Human capital
Percent with colle e
LNS
S
NS
Percent with less than hih school
NS=Not significant at.05 level; L=Standardized estirnate > by at least .1; S=Standardized estimate < by at least .1;
Sign.=Now significant at .05 level; () indicates change of sign.
156
growth, both having somewhat greater influence on the region's unemployment rates than is the
case nationally.'0
VIL.
Summary and Policy Implications
High unemployment, defined as a rate exceeding 8 percent, afflicted some 389 counties
containing over 9 million workers during 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, mining, government, the TUC sector, and retail trade; state
unionization rates; earnings per job; share of residents who belong to a racial or ethnic minority;
share of adults without a high school diploma; remoteness from cities; physical amenities; and
location in the West. These same counties have lower levels of wholesale trade employment,
lower employment growth, smaller shares of college graduates, smaller urban populations, and
are less likely to be located in the Midwest, once other attributes have been controlled for.
Three-fifths 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
'° A number of alternative models to predict unemployment rates were tested, including a
state fixed-effects model and the inclusion of additional variables thought to have an effect on
unemployment, such as state unemployment insurance payments. While the fixed-effects model
explains variation in unemployment rates across counties slightly better than the model presented
here, the effects of individual independent variables (other than the state dummy variables) do
not change significantly. None of the additional variables are significant at the 5 percent level,
nor do they alter the significance of the basic variables. They are therefore omitted from the final
analysis.
157
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 and exit from the workforce, as well as to the nature of jobs deemed to be
"woman's work." The gender gap in unemployment had all but disappeared by the 1990's, and
the share of the labor force composed of women is no longer an important source of geographic
variation in unemployment (although this share still varies considerably from place to place).
Regressions of unemployment rates on data from each year of the 1990's confirm that
relationships between local characteristics and unemployment do change. 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, these findings help explain why the
neoclassical solution of redistributing labor from areas of low demand to areas of high demand
through migration is simplistic. First regions where high unemployment has persisted for twenty
years (and often many more) obviously retain their populations for other reasons. Kinship and
friendship networks are often important parts of individual and family survival strategies in these
places. Workers with very low human capital, limited proficiency in English, or other severe
barriers to employment may see little reason to incur the enormous economic and social costs of
breaking these sustaining ties and moving to a low-unemployment area. Remember, too, that
many individual attributes found disproportionately in high-unemployment counties are "risk
factors" for unemployment regardless of residence. Blacks and those with less than a high school
diploma, for instance, suffer unemployment rates higher than the local average in Atlanta just as
they do in Sunflower County, Mississippi. Long-distance migration exposes them to new and
unknown labor market risk while curtailing their previous support network.
Even for workers without employment barriers or other labor market disadvantages, community
or family ties and the attachment to place may be strong enough to prevent them from seeking
higher education or better employment opportunities elsewhere. Perhaps the question ultimately
becomes whether the current geographic distribution of jobs should be taken as a given or ceded
primacy over the non-job-related preferences of the nation's citizens. If not, then local and
regional economic development policies assume an equal role with workforce development
policies as a means of combating persistent and severe spatial inequities.
A first step is to distinguish policies focused on changing local attributes from 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. 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
158
associations with unemployment would necessarily be of this nature. For example, as national
standardized test scores reveal, counties with large. minority populations would benefit from a
variety of policies intended 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 the Rural Manufacturing Survey,
designed by the Economic Research Service (USDA), concludes that technological change
requiring a more highly-skilled workforce is as evident in rural areas as in cities. Perhaps more
establishments, including those in high unemployment counties, could be encouraged to adopt
advanced production technologies and management practices if the proper investment incentives
were more widely available, or if these incentives were better targeted to areas with high
unemployment. Such incentives would also 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 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.
One of the messages emerging from the analysis is that Federal anti-unemployment policies may
well be limited in what they can achieve. Few such 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 no impact in the former region, but
might 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. Thus it
should be considered carefully whether a proposed policy is more sensibly implemented at a
state, or even local, level rather than nationally.
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
159
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 internally. 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 new job 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 for
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, is really
very much an economic growth strategy as well. Such a strategy should proceed along two broad
lines: aggressive human capital investments in school quality, college enrollment, and job
training; and concurrent assistance and encouragement of advanced technology 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 "high-wage/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.
160
References
Cromartie, John B. and Mark Nord. "The Changing Structure of Rural Migration, 1986-1994."
Rural Economics Division, Economic Research Service, U.S. Department of Agriculture,
Staff Paper No. 9615, 1996.
Ghelfi, Linda M. and Timothy S. Parker. "A County-Level Measure of Urban Influence." Rural
Economy Division, Economic Research Service, U.S. Department of Agriculture, Staff
Paper No. 9702, 1997.
Gibbs, Robert M. "College Attendance and Return Migration Among Rural Youth." in Rural
Education and Training in 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.
McGranahan, David A. "Natural Amenities Drive Rural Population Change," Food and Rural
Economics Division, Economic Research Service, U.S. Department of Agriculture,
Agricultural Economic Report, forthcoming 1999.
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 Regional Studies, 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.
161
Appendix Table 1. Unemployment Model: Means, Coefficients, and Standard Errors of
Local Characteristics
Characteristics
Mean
Parameter
Standarderror
Market-related
.97
-0.0886
0.0092
Earnings oer mob.1996
21.54
0.0252
0.0099
State unionization rate
12.12
0.1765
0.0107
Average state AFDC payment
298
0.0003
0.0006
State unemolovment insurance
182
-0.0018
0.0019
Employment growth. 1996-97
Percent employed in:
Agriculture
1.7
1.0558
0.2051
13.7
0.1387
0.0559
1.3
0.3453
0.1095
16.4
0.2701
0.0737
3.1
-1.1104
0.2297
16.2
0.8479
0.1064
Transp/Utilities/Communications
3.9
0.5571
0.1733
Finance. Insurance. Real Estate
4.7
0.1097
0.2296
Construction
5.5
0.1741
0.1603
Manufacturina
Mining
Government
Wholesale Trade
Retail Trade
_0.0201
23.52
Earnines off iob in commutina shed
Locational
_
0.0098
=
Midwest (compared with Northeast)
.35
-0.5116
0.1724
South
.45
-0.1879
0.2138
West
.14
1.2383
0.1960
Small remote (compared w/larae urban)
.17
1.0674
0.2086
0
0.1682
0.0237
Percent Black
8.44
0.0440
0.0035
Percent Hispanic
4.51
0.0603
0.0041
Percent Native American
1.43
0.0685
0.6693
Percent aees 16-19
9.62
0.0533
0.0244
Amenitv index
Demographic
Human capital
=
Percent with college degree
13.36
-0.0512
0.0102
Percent wdh less than high school
30.46I
0.098
0.0076
162
Appendix: U.S. Counties with Unemployment Rates at or above 8 Percent in 1998
Unemployment
State/County
rate, 1998
Ahha
Bullock
Butler
Choctaw
Conecuh
Dallas
Greene
Lowndes
Monroe
Sumter
Washington
Wilcox
9.3
10.3
10.2
8.2
9.2
12.5
10.0
10.4
8.4
11.8
12.3
Alska
Bethel
Haines
Kenai Peninsula
Nome
Northwest Arctic
Prince of Wales-Outer Ketchikan
Southeast Fairbanks
Valdez-Cordova
Wade Hampton
Wrangell-Petersburg
Yakutat
Yukon-Koyukuk
8.0
10.2
10.2
9.4
11.4
12.0
9.8
8.3
13.9
8.8
12.4
13.1
Arimna
Apache
Navajo
Santa Cruz
Yuma
16.6
13.3
15.9
26.7
163
Arkansa
Ashley
Bradley
Calhoun
Chicot
Desha
Drew
Jackson
Lawrence
Lee
Mississippi
Newton
Ouachita
Randolph
St. Francis
Searcy
Van Buren
Woodruff
8.4
10.9
9.9
8.2
8.9
8.5
10.1
8.4
8.5
10.5
8.6
9.9
10.1
8.3
9.4
8.1
11.0
California
Alpine
Butte
Calaveras
Colusa
Del Norte
Fresno
Glenn
Imperial
Kern
Kings
Lake
Lassen
Madera
Mariposa
Merced
Modoc
9.2
8.2
8.8
19.5
10.0
13.9
12.6
26.0
12.0
12.1
9.7
9.4
12.8
8.2
15.3
11.5
164
Monterey
Plumas
San Benito
San Joaquin
Shasta
Sierra
Siskiyou
Stanislaus
Sutter
Tehama
Trinity
Tulare
Yuba
10.7
9.9
10.4
10.6
8.9
11.7
12.8
12.0
15.4
8.9
12.5
15.6
13.1
Colorado
Conejos
Costilla
Dolores
Saguache
San Juan
8.1
13.9
10.4
9.1
14.8
District of Columbia
8.6
Florida
Glades
Gulf
Hamilton
Hardee
Hendry
Highlands
Indian River
St.Lucie
8.9
11.2
8.4
10.9
11.8
8.1
8.0
10.7
Appling
Baker
Burke
9.5
9.0
11.9
165
8.2
8.2
10.2
11.1
11.2
11.0
9.5
12.4
8.3
11.6
8.3
10.8
15.2
8.6
Dougherty
Emanuel
Glascock
Hancock
Jefferson
Johnson
Macon
Randolph
Telfair
Terrell
Toombs
Turner
Warren
Wheeler
Hawaii
Hawaii
Kauai
8.8
9.3
Idaho
Adams
Benewah
Boundary
Clearwater
Idaho
Shoshone
Valley
13.6
11.2
8.5
12.6
10.3
10.3
8.9
Illinois
9.3
10.2
8.8
10.0
10.3
8.8
8.4
8.5
Alexander
Franklin
Gallatin
Hamilton
Jasper
Johnson
Lawrence
Montgomery
166
Perry
Pope
Pulaski
Saline
Wabash
White
Williamson
10.0
10.4
10.7
9.3
9.4
8.2
8.3
Kansas
Linn
8.6
Kentu
Adair
Carter
Casey
Elliott
Fulton
Green
Harlan
Lawrence
Lewis
Magoffin
Martin
Russell
Taylor
Wayne
14.8
11.0
8.1
12.3
8.8
16.2
11.6
9.5
11.0
13.4
10.0
26.9
21.7
10.8
Bienville
Caldwell
Catahoula
Concordia
East Carroll
Franklin
Madison
Morehouse
Red River
10.7
8.1
9.8
14.2
13.6
10.6
11.8
11.7
13.3
167
9.7
8.3
8.3
14.0
Richland
Sabine
Webster
West Carroll
Maine
9.3
Washington
Maryland
8.6
9.7
10.7
9.5
10.3
8.7
Allegany
Dorchester
Garrett
Somerset
Worcester
Baltimore City
mihgan
10.3
8.0
9.9
9.6
11.6
8.6
10.6
9.5
8.2
Cheboygan
Gogebic
Keweenaw
Mackinac
Montmorency
Ontonagon
Presque Isle
Schoolcraft
Wexford
Mpneoa
Clearwater
Marshall
10.7
8.4
Attala
Bolivar
Chickasaw
Claibome
Clay
9.1
8.3
8.3
10.1
8.7
168
Coahoma
Holmes
Humphreys
Issaquena
Jefferson
Jefferson Davis
Kemper
Leflore
Monroe
Noxubee
Panola
Quitman
Sharkey
Simpson
Sunflower
Tallahatchie
Tishomingo
Washington
Wilkinson
9.6
10.0
10.2
12.4
14.8
10.3
9.2
8.4
9.9
9.8
8.3
10.2
12.0
9.7
10.9
11.5
10.6
8.8
9.4
Missonr
Pemiscot
Stone
Taney
Wayne
8.3
12.0
8.4
10.5
Big Horn
Blaine
Glacier
Granite
Lincoln
Mineral
Phillips
Roosevelt
Sanders
9.8
9.0
13.4
9.8
12.6
11.2
8.3
8.4
10.6
169
Nevada
Esmeralda
Lander
8.3
10.2
New Jersey
Atlantic
Cape May
Cumberland
8.0
10.5
9.2
Newv Mexico
Catron
Chaves
Cibola
Dona Ana
Guadalupe
Luna
McKinley
Mora
Rio Arriba
San Juan
San Miguel
Taos
11.5
10.2
9.5
8.9
10.4
26.9
8.8
20.1
9.3
8.5
8.6
12.8
New York
Bronx
Essex
Franklin
Hamilton
Jefferson
Kings
Lewis
St. Lawrence
9.9
8.2
8.2
10.9
9.4
9.3
8.4
8.1
NorCaroina
Edgecombe
Graham
Halifax
8.9
8.8
8.4
170
Richmond
Scotland
Swain
Tyrrell
8.3
8.1
12.6
8.2
North Dakota
Rolette
9.5
bhom
Adams
Gallia
Guernsey
Huron
Meigs
Monroe
Morgan
Pike
Scioto
Vinton
11.0
8.4
8.0
8.2
10.8
9.0
13.0
9.0
9.4
10.8
klhboma
Choctaw
Coal
Haskell
Latimer
Okmulgee
Seminole
Sequoyah
10.2
8.2
11.5
11.2
8.2
8.9
8.0
0=mn
Baker
Coos
Crook
Curry
Douglas
Grant
Hood River
8.3
9.7
8.8
8.4
9.0
12.9
9.6
171
8.3
8.5
10.6
8.2
8.0
9.7
8.4
Josephine
Klamath
Lake
Malheur
Morrow
Wallowa
Wheeler
Pennsylvania
Forest
Huntingdon
8.8
8.0
South Carolina
Chester
Lee
Marion
Marlboro
Williamsburg
8.2
8.1
8.7
10.9
10.6
South Dakota
Buffalo
Dewey
Shannon
Ziebach
10.2
13.9
11.2
11.3
Tennessee
Carroll
Clay
Decatur
Fentress
Hardeman
Haywood
Houston
Jackson
Lake
Lauderdale
Lawrence
8.6
12.8
9.0
8.9
12.0
10.3
10.8
8.2
10.2
8.3
9.0
172
Lewis
Meigs
Stewart
Trousdale
Wayne
11.4
8.5
10.4
8.8
13.7
iTeas
Brooks
Cameron
Cass
Coleman
Dimmit
Duval
El Paso
Floyd
Frio
Hidalgo
Jasper
Jim Hogg
Jim Wells
Kinney
La Salle
Loving
Marion
Matagorda
Maverick
Morris
Newton
Orange
Panola
Presidio
Reeves
Sabine
Starr
Tyler
Uvalde
Val Verde
9.5
12.5
8.4
9.3
15.8
12.8
10.1
8.2
9.2
17.6
10.9
9.6
8.9
9.5
8.6
10.6
10.4
12.0
26.3
12.4
11.6
9.1
9.8
32.4
10.5
8.8
27.9
8.6
10.7
9.4
173
Ward
Webb
Willacy
Winkler
Zapata
Zavala
8.0
9.4
20.7
9.1
12.3
22.2
Buchanan
Dickenson
Lancaster
Lee
Northumberland
Russell
Surry
Tazewell
Wise
13.9
16.7
11.2
8.5
9.7
9.7
8.6
9.0
11.0
Washinglon
Adams
Chelan
Columbia
Ferry
Franklin
Grant
Grays Harbor
Klickitat
Lewis
Okanogan
Pacific
Pend Oreille
Skamania
Stevens
Yakima
10.5
8.4
11.6
9.7
9.8
8.8
9.5
10.2
8.1
10.1
9.4
11.9
10.0
8.8
10.1
West Virgnia
Barbour
11-3
174
Boone
Braxton
Calhoun
Clay
Fayette
Grant
Lewis
Lincoln
Logan
McDowell
Mason
Mingo
Nicholas
Pleasants
Pocahontas
Randolph
Ritchie
Roane
Summers
Tucker
Tyler
Webster
Wetzel
Wirt
Wyoming
10.0
10.7
16.4
10.8
9.1
9.1
8.2
11.1
11.0
11.4
11.8
12.6
8.7
11.7
8.7
8.8
10.7
11.0
9.2
10.5
8.2
8.7
10.1
14.7
9.3
wosonsn
Menominee
8.7
175
@FedFRASER