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Union Calendar No. 194
109r CONGRESS
}
HOUSE OF REPRESENTATIVES
THE 2005 JOINT ECONOMIC
REPORT
REPORT
OF THE
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED .STATES
ON THE'
2005 ECONOMIC REPORT
OF THE PRESIDENT
ToGETHER WTH
MINORITY VIEWS
1.S. GOVERNMENT PRINTING OFFICE
WASHINGTON: 2005
{
REPORT
109-353
JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]
HOUSE OF REPRESENTATIVES
SENATE
JIM SAXTON, New Jersey, Chairman
PAUL RYAN, Wisconsin
PHIL ENGLISH, Pennsylvania
RON PAUL, Texas
KEVIN BRADY, Texas
THADDEUS G. MCCOTTER, Michigan
CAROLYN B. MALONEY, New York
MAURICE D. HINCHEY, New York
LORETTA SANCHEZ, California
ELuAH E. CUMMINGS, Maryland
ROBERT F. BENNETT, Utah, Vice Chairman
SAM BROWNBACK, Kansas
JOHN E. SUNUNU, New Hampshire
JIM DEMINT, South Carolina
JEFF SESSIONS, Alabama
JOHN CORNYN, Texas
JACK REED, Rhode Island
EDWARD M. KENNEDY, Massachusetts
PAUL S. SARBANES, Maryland
JEFF BINGAMAN, New Mexico
CHRISTOPHER FRENZE, Executive Director
ROBERT KELEHER, ChiefMacroeconomist
CHAD STONE, DemocraticStaffDirector
(ii)
LETTER OF TRANSMITTAL
CONGRESS OF THE UNITED STATES,
JOINT ECONOMIC COMMITTEE,
Washington, DC, December 16, 2005.
HON. J. DENNIS HASTERT,
Speaker of the House, House ofRepresentatives,
Washington, DC.
DEAR MR.
Employment Act of 1946, as amended,
of the
hereby transmit the 2005 Joint
to the requirements
SPEAKER: Pursuant
I
Economic Report. The analyses and conclusions of this Report are to
assist the several Committees of the Congress and its Members as they
deal with economic issues and legislation pertaining thereto-:
Sincerely,
Jim Saxton,
Chairman.
(iii)
CONTENTSOverview of Current Macroeconomic Conditions ......................... 1
9
MAJORITY STAFF REPORTS ........................................
Economic Effects of Inflation Targeting ................................ 10
Individuals and the Compliance Costs of Taxation .;.. ............. 26
OPEC and the High Cost of Oil ........................................ 33
*
MINORITY ViEWS AND DEMOCRATIC STAFF REPORTS ...................
Ranking Minority Member's Views and Links to
Minority Reports ........................................
(v)
62
64
Union Calendar No. 194
109TH CONGRESS}
15' Session
HOUSE OF REPRESENTATIVES
)109-353
{REPORT
THE 2005 JOINT ECONOMIC REPORT
December 16, 2005.-Committed to the Committee of the Whole House on the
State of the Union and ordered to be printed
MR. SAXTON,
from the Joint Economic Committee,
submitted the following
REPORT
together with
MINORITY VIEWS
Report of the Joint Economic Committee on the 2005 Economic Report of the
President
U.S. Macroeconomic Performance
*
Introduction and Background:
This introduction provides a broad economic overview of the
performance of the U.S. economy since about 2003. Beginning in
about 2003, the macroeconomy finally began to shake off the throes or
burdens of the adjustments required by bursting stock market and
investment bubbles. When an asset price (or stock market) bubble
bursts, banks necessarily have to contract their lending and consolidate
their portfolios. Such adjustment is tantamount to a slowdown in
investment: i.e., such a stock market adjustment is associated with a
downward movement in investment. The stock market peak occurred
in the spring of 2000. The Dow and Nasdaq stock price indices, for
example, peaked in January and March 2000, respectively. Overall,
then, stock market prices began to fall sharply in the spring of 2000.
Notably, most of the Nasdaq's large decline took place prior to January
2001, and consequently, had nothing to do with the Administration's
economic policy. As stock prices fell, the financial cost of investment
2
increased and various measures of investment growth declined: i.e.,
declines in investment led to declines in economic activity. The
investment sector, then, played a very important role in influencing
recent cyclical economic activity. The seeds of this unsustainable
stock market bubble, however, were sown in the period prior to the
spring of 2000, since the stock market bubble burst beginning in the
first quarter of 2000.
Many economists have noted that the economic weakness of 20002001 (or the "Post Bubble" or "Adjustment Economy)" was inherited
from earlier periods involving an asset-price contraction in the late
1990s. (See Figure 1).
Figure 1
Real Gross Domestic Product
%Change -Annual Rate
SAAR, BiI.Chn.2000S
8
6
--------
7
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--
- - -_
-- -
-- i---7
72
P tBubbI.--o -I - _Adjustont Ecoo y
L
Il
(I 0%)
---
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7oecast'
43
2-2
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Econon,,
98
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01
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02
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03
4
Sumous"-
us E(3n%)
04
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S.u-: Beau of Economic
AuulyHis/-luv
A.rAlylcsJ
"BlueChipCorsonsus
Furthermore, the economic and financial strength of the late 1990s was
unsustainable, with some of that strength borrowed heavily from the
"irrational exuberance" of sharp stock market and balance sheet gains.
In sum, changes in the investment sector have been much larger
and more prominent than changes in most other sectors, including real
GDP. The investment sector, for example, was significantly weaker
than real GDP during downturns and significantly stronger than real
GDP during recoveries (see Figure 2).
3
Figure 2
Real Private Nonresidential Fixed Investment
%
V
5
- AR.
K MC-M
Real Gross Domestic Product ---a
20 is
i
15
I
ANS
AK
-R
Kegs12
II
I
'LIt
-5
-10-
-15
1999
2000
2001
2002
2003
2004
2005
Brief Overview:
A brief overview of recent macroeconomic activity indicates that
the economy is expanding robustly with little sign of any meaningful
inflation. In the third quarter, for example, the most. recent data
indicate that real GDP growth was robust at 4.3%. Real GDP- has
grown at positive rates for 16 quarters in a row and at rates above 3.0%
for 10 quarters in a row. Consensus forecasts have real GDP'
increasing by 3.5% to 4.0% for the next few years. Figure 2 highlights
some of these facts.
Components of real GDP suggest that expansions- of real
nonresidential fixed investment should continue at a healthy pace.
The equipment and software component of real nonresidential fixed
investment, for example, has been growing on average at a double digit
rate (11.7%) since the third quarter of 2003. Its leading indicator,
capital good orders, continues to .trend upward.
Another interesting observation relates to academic research
relevant to U.S. economic growth. Recent research has thoroughly
established that the volatility of U.S. GDP has consistently fallen for a
number of years. This reduction of volatility means-that the economy
is not only growing robustly, but that growth is more stable than in the
past. This fosters a reduction in risk premiums and lower interest rates.
For
Significant improvement can be seen. in other sectors.
example, 4.5 million jobs have been added to the existing payrolls
since May of 2003. The U.S. has gained many more jobs than key
European economies. Similarly, the unemppoyMIen rate, now at
*
4
5.0%, is historically low and below the average U.S. unemployment
rate for the 1970s, 1980s, and 1990s. Further, the U.S. unemployment
rate is lower than most European rates.
The housing sector has performed much better than most analysts
predicted.
Housing sales have remained strong and residential
investment elevated.
Another prominent feature of the recent U.S. economy is the lower
and more stable rate of inflation we have experienced. While most
broad measures of inflation provide similar information, we
nonetheless use the core PCE on a year-over-year basis, depicted in the
accompanying figure (see Figure 3). The persistently lower rate of
inflation depicted there has helped to calm financial markets and
reduce risk premiums. This persistently lower rate of inflation has in
turn fostered lower expectations of future inflation and, consequently
helped to lower interest rates.
In short, the macroeconomy has established a remarkably solid
record with measures of aggregate economic activity registering not
only relatively rapid growth figures, but exceptionally stable noninflationary growth. These surprisingly strong results, it will be
remembered, occurred in the face of a literal barrage of supply side
shocks (discussed below) that were readily absorbed by this
exceptionally resilient economy.
Figure 3
Inflation
(Coe PCE)
5
4 -
-
i
~ ~~~~
Is
I
--
-
--
I
l
I
l
I
i
I
I
I
I
I
%Change -Yea to Yeer
~ ~
~
I
-I
I
I
iI
I
.
l
l
I
I
l
I
I
= 100
~ ~ ~~~~~~~~~~~~~
I
\ ^
I
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SA. 200
l
lI
I
I
I
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IX
l
I
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85
86
So
PCE: P-."
87 88
89
90 91
92
of Ek
Ane
I He-r o."
Co.ooopiiEnnete
93 94 95 -96 97 98 99
00
01
02 03 04 05
5
Policy Contribution
With this impressive record as. a backdrop - particularly in the face
of the many negative shocks absorbed by the economy - a question
facing policymakers is: Why has the economy performed so well? Put
bluntly, the economy has advanced at a healthy, stable pace with little
sign of meaningful inflation because of the economic policies that have
been adopted. These policies will be briefly summarized.
Monetary Policy:
In adopting a flexible, implicit inflation targeting strategy, the
Federal Reserve's monetary policy contributes to minimizing inflation,
reducing the volatility of inflation, and anchoring the price system.
Over time, the credible implementation of this strategy works to calm
and stabilize markets, such as the money, capital, and foreign exchange
Some argue that this strategy also works to reduce
markets.
macroeconomic volatility. This more stable set of markets works to
promote economic growth. Recent monetary policy, then, has likely
made a number of contributions to the workings of the macro
economy. In particular, this credible, implicit inflation targeting
approach works to lower inflation, lower the volatility of inflation,
lower the volatility of economic activity, and promote economic
growth (see Figure 4).
Figure 4
*
CPI-U: All Items Less Food and Energy
%
C~np.-
Y.-,tY-
SA.1982.84=100
10 Year Treasury Note Yield at Constant Maturity
%
po
l
18
I
l
I - - - - - - - - - - - - - - - - - 16 -- - - - - - - - - --
---
'
12 -
10
.
II
AlI
14
- ---- -- ->---------------------------
"
----
--
-
-------
------
-----
__
- lli
----------- ------ 2 __---------0
so
*
Tax Poliy
8
85
go,
95
00
05
6
Whereas the Federal Reserve's current monetary policy performs a
number of important functions, tax policy can play a major role in
promoting investment or capital formation and consequently, economic
growth. Accordingly, the tax-policy endorsed by the Administration is,
for the most part, focused on a limited number of key objectives that
often relate to economic growth.
In assessing initial economic conditions during the current
expansion, it became obvious that investment and capital formation
were weaker than desirable. The argument that with an entrenched
income tax in place, saving, investment, and capital formation were
over-taxed and further, taxed multiple times, seemed to be underscored
by the data. Accordingly, a tax program was proposed which lowered
the tax rates on dividends and capital gains, and expanded expensing
for business investment. More specifically, the "Jobs and Growth Tax
Relief Act of 2003" was passed and contained a number of provisions,
most notably, a reduction in both dividend and capital gains tax rates. '
There were a number of reasons to lower these tax rates on capital:
o Removing some of the bias toward the multiple taxation of
capital and investment.
o Lowering tax rates so as to affect behavior and promote
additional incentives to save and invest.
o Removing some of tax burden's dead-weight loss.
o Maintaining the U.S. as an attractive investment outlet for
international investors.
o And, most importantly, fostering capital formation so as to
promote economic growth.
As the data in Figure 2 suggest, these tax cuts are associated with
higher trend growth in business investment spending and increases in
the value of stock market. The NIPA data, for example, suggest that
after the 2003 tax cuts, various categories of non-residential fixed
investment began trending up at more rapid rates. Similarly, most
common measures of stock market value (e.g., Dow Jones, Nasdaq, or
S&P) began advancing at a faster pace. In addition, since the tax cuts
were implemented, the country has experienced higher economic
growth, increases in payroll employment, lower unemployment, and
more tax revenue. In short, the timing of investment and stock market
activity appear to be consistent with the case made by proponents of
the tax cuts.
1The highest capital gains rate of 20 percent was lowered to 15 percent while
the highest rate on dividend income was reduced from 35 percent to 15
percent. See Alan Auerbach and Kevin Hassett, "The 2003 Dividend Tax
Cuts and the Value of the Firm: An Event Study," NBER working paper
11449, June 2005, p.1.
7
Furthermore, a number of studies (and empirical evidence) support
this conclusion.
The findings of several studies tend to support the view that
changes in the tax law .have significant impacts on economic activity
and economic growth.
A review of the problems caused by high dividend taxes shows that
the U.S. had the second highest dividend tax rate in the OECD. In light
of this finding, lowering the dividend tax rate in the US may be more potent than if undertaken elsewhere.
Furthermore, Auerbach and Hassett (2005) find strong evidencethat the 2003-change in the dividend tax law had a significant impacton US equity-markets. -It could be, therefore, that by reducing those
forms of taxation -that work to tax capital in multiple ways a more
rational system can result.
A similar view;- was outlined by Ben Bernanke (then - CEA
Chairman):
"...tax legislation passed in 2003 provided incentives for
businesses to expand their capital investments and reduce the cost
of capital by lowering tax rates on dividends and capital gains.. .the
effects are evident in the investment and employment data.
its trough in the-first quarter of 2003, business fixed investment has
increased, over 21 percent; with the. biggest -gains coming in
equipment and software." 2
-From
In sum; the macroeconomy has advanced sharply in recent years-in
part because of the contribution of a, tax relief effort that lowered
taxation on-capital, promoted economic growth, and provided potent
tax relief.
Conclusion.:
Recent economic data indicate that the economy is quite robust and
advancing at a healthy pace:. Our economyhas -weathered a barrage ofnegative supply shocks (including -a -stock market bubble-bursting, a
terrorist attack, a severe hurricane followed .by a severe flood, two
wars, corporate scandals, and a sharp increase- in the price. of oil).
Given this array of significant hurdles, the economy's performance is
remarkable.. Part of the reason for this performance relates to the
contributions of monetary policy's focus. on price stability, which leads
to a lowering of inflation, the volatility of inflation, and.the volatility of
economic activity, thereby fostering economic growth. Another reason
-
S. Bernanke, "The Economic Outlook," Chairman, President's Council
of Economic Advisors, Testimony before the Joint Economic Committee,
October 20, 2005, pp.3-4.
2 Ben
8
for this remarkable performance is the pro-growth tax policy that has
been embraced and allowed to lower the cost of capital. A further
contribution relates to our flexible price system, which has enhanced
the economic resiliency we enjoy.
Consequently, the economic outlook remains positive. According
to Federal Reserve and private economic forecasts, the economy is
expected to grow at a healthy pace through 2006.
Jim Saxton
Chairman
Joint Economic Committee
Robert F. Bennett
Vice Chairman
Joint Economic Committee
MAJORITY STAFF REPORTS
10
Economic Effects of Inflation Targeting
Introduction
The theoretical case for inflation targeting (IT) has been spelled
out during the course of the last 15 years in a number of publications,
including several JEC studies. The case for IT is a strong one,
supported by a number of compelling arguments. According to
proponents, adopting IT certainly does make a difference by improving
the performance of the economy, the financial system, and the inflation
rate. The arguments supporting this approach, however, will not be
repeated here; these arguments have been amply described elsewhere.
Instead, one component of the arguments supporting the adoption of IT
will be reviewed and assessed.
In particular, IT proponents contend that its adoption will help to
calm and stabilize financial markets. More precisely, the adoption of
credible IT will provide an anchor to the financial system and to
financial markets. In so doing, financial markets will stabilize as
inflation is driven from the price system. Temporary deviation of
inflation will be ignored. This credibly-reduced inflation is associated
with less volatile financial markets, smaller risk premiums, and lower
inflationary expectations. In this view, then, IT is associated with
more stable financial markets.
On the other hand, some economists contend that IT is associated
with asset price bubbles, and thus, asset price volatility. In particular,
as credible IT works to stabilize conventional measured inflation, to
reduce risk premiums, and to tame economic fluctuations, economies
experience more risk taking and more risky investment. Economies
will also experience increased stock price volatility and associated
asset price bubbles. According to this view, there is a kind of "moral
hazard" of economic policymaking: the more stable/predictable the
economic environment, the more risk taking and risky investment take
place. Proponents of this view point to several classic episodes in
which asset price bubbles followed periods of price stability; e.g., the
U.S. during the 1920s as well as more recent episodes in Japan and the
U.S. In this view, then. IT is associated with more volatile asset prices
and financial markets, the opposite contention of the above, more
conventional view.
This paper briefly describes these alternative views, reviews
relevant empirical evidence, and attempts to reconcile these seemingly
conflicting positions.
11
An Unconventional View: Inflation Targeting (IT) and Asset Price
Volatility
Recently, a few economists have broken. rank with the
conventional view supporting IT. These economists contend that low
inflation environments tend not to be associated with asset price
stability. Instead, they argue that IT or low inflation environments tend
to be associated with asset price movements and bubbles (or financial
fragility) and asset price volatility. Fildaro, for example, states that: "'.. The achievement of a low, stable inflation environment
has not simultaneously brought about a more stable asset price
environment. The record over the last decade, in fact, has
raised the prospect of asset price booms and busts as a
permanent feature of the monetary policy landscape." 1
Similarly, Borio and Lowe (2002) argue that:
"...financial imbalances can build up in a low inflation
environment... while
low
and
stable
inflation
promotes
financial stability, it also increases the likelihood that excess
demand pressures show up first in credit aggregates and asset
prices, rather than in goods and services prices.. .We stress that
financial imbalances can and do build up in periods of
disinflation or in a low inflation environment," 2
Furthermore, in reviewing the economic environment of the past
30 years or so, Borio and White (2004) maintain that this environment
can be characterized as improving in price stability while at the same
time experiencing more financial instability. 3
Some endorsing this alternative view include some economists
sympathetic to the Austrian School and several economists affiliated
with at the Bank for International Settlements (BIS).4
This alternative view embodies some important implications.
Notably, proponents of this view contend that price stability or IT
' Fildaro, Andrew, "Monetary Policy and Asset Price Bubbles: Calibrating the
Monetary policy trade-offs," BIS Working Paper No. 155, June (2004), p.
2
Borio Claudio, and Philip Lowe, "Asset Prices Financial and Monetary
Stability: Exploring the Nexis,"
BIS Working Paper No. 114, (July 2002), Abstract, p. 1.
3 Borio, Claudio and William White, "Whither Monetary and Financial
Stability? The Implications of Evolving Policy Regimes," BIS Working Paper
No. 147 (February 2004).
4These authors, include, for example, Charles Bean, Claudio Borio, Philip
Lowe, William White, Andrew Filadro, Andrew Crockett, and others.
12
causes sharp movements in asset prices; i.e., price stability or IT is
associated with asset price bubbles.
According to proponents of this view, IT central banks themselves
increasingly (but unwittingly) work to create the environment
conducive to the formation of asset price bubbles or instabilities.
Specifically, as modem central banks learn to control inflation and
tame economic fluctuation, thereby stabilizing economic activity, these
economies will experience more risk taking. more innovation, more
investment and sometimes stronger advances in productivity. They
will experience increased stock market volatility and associated asset
price bubbles. Credible IT policies, therefore, stabilize conventionally
measured price indices while at the same time create new incentives to
take risk.
In this view, there is a kind of "moral hazard" of economic
policymaking: the more stable/predictable the economic environment,
the more risk taking, investment, and innovation take place. In sum,
low inflation environments are increasingly associated with financial
imbalances and asset price volatility.
The Conventional View: Inflation Targeting Calms and Stabilizes
Financial Market Prices
There are several theoretical explanations of how financial markets
are affected by the existing monetary regime. In particular, different
explanations exist as to how movements in financial market prices are
shaped by the adoption of IT and its associated consequent price
stabilization. One of the direct benefits of IT, for example, is the
calming, stabilizing effect it has on financial market prices and on the
market price system itself. In short, IT stabilizes prices and serves as
an anchor to the price system.
According to Levin et.al., for example;
"... .under an inflation-targeting regime, expectations about
inflation, particularly at longer horizons, should be "anchored"
by the target, and thus should be less affected by changes in
actual inflation.. .Having inflation expectations that are well
anchored - that is, unresponsive to short-run changes in
inflation - is of significant benefit to a country's
economy.....Keeping inflation expectations anchored helps to
keep inflation itself low and stable." 5
Jeremy Piger, "Does Inflation Targeting Make a Difference?", Monetary
Trends, Federal Reserve Bank of St. Louis, April 2004, p.1. See also Levin,
Andrew T., Natalucci, Fabio M.and Piger, Jeremy M., "The Macroeconomic
5
13
More specifically, as inflation rates are credibly lowered and as
stable prices eventually emerge, inflation and inflationary expectations
will have less of a disturbing effect on price movements. Price
reactions to both economic policy announcements and economic datareleases will be tempered. This reduction in inflation and inflationary
expectations will lower the variability of relative and nominal prices.
And this reduction of inflation and inflationary expectations will also
reduce uncertainty and thereby lower risk spreads.
Furthermore, distorting interactions of inflation with the tax code
will gradually be minimized. In short, the operation and working of
the price system will be improved as adopting IT will reduce market
volatility.
These factors will contribute to calming and stabilizing-a- number
of important markets including the short-term- money market, longterm bond market, foreign exchange market, sensitive commodity
markets, as well as equity marketsAll of these improvements will work to better enable to function,
improve market efficiency, and inevitably to improve economic growth
and performance.
Indirect Approaches-to Stabilize Markets
There are additional indirect, but important ways in which IT can
work further to calm and stabilize movements in market prices. More
specifically, IT necessarily involves an increase in central bank
transparency, which can work to further. stabilize markets. 6 The
benefits of monetary policy transparency cited in the literature include a reduction in both the level of and variability of inflation- as well as
output. 7
IT, after all, involves the announcement of and explicit public
identification of policy goals or policy rules.. This. involves providing
more information to the market. . Markets work better.. with more
information; more specifically, they absorb new information and use it.-
Effects of Inflation Targeting.". Federal; Reserve Bank of St. Louis Review,
July/August 2004, 86 (4).
6 Transparency has several dimensions. These involve explicit identification
of policy objectives, issuing inflation reports, policy announcements, and
testimony, i.e., providing much more information to the market. See for
example, Seth B. Carpenter, "Transparency and Monetary Policy: What Does
the Literature tell policymakers?" Working Paper, Board of Governors of the
Federal Reserve System, April 2004. p. 1.
7 See Carpenter, op. cit., p. 1.
14
to form common, concentrated expectations about the future. 8 As
markets begin to anticipate policy changes, the initial steps of the
monetary transmission mechanism between policy action and
economic activity begin to work more efficiently. 9 Policy surprises
affecting markets become smaller and fewer in number. Central bank
credibility begins to build and to anchor inflationary expectations,
thereby helping to stabilize financial markets. As one proponent put it:
"the strength of inflation targeting, vis-A-vis other
monetary regimes lies precisely in how transparency enhances
monetary credibility and anchors private expectations."'l
In short, increased transparency changes behavior so that markets
function better and in a more stable, predictable manner that works to
stabilize markets.
Empirical Evidence
In sum, alternative views as to the effects IT might have on
financial markets suggest that, the adoption of IT could result in
these markets becoming more volatile, less volatile, or unaffected
by IT. Existing evidence sheds some litht on validity of these
alternative views.
Does IT result in more Volatile Financial Markets?
Hard empirical evidence supporting the view that IT causes
financial market volatility appears difficult to muster. Much of the
literature sympathetic to this view is not focused directly on such
empirical evidence. Rather, it often deals with broader issues of
monetary policy and the policy role played by asset price "bubbles".
Borio and Lowe, for example, make such a connection:
"While low and stable inflation promotes financial
stability, it also increases the likelihood that excess demand
pressures show up first in credit aggregates and asset prices,
rather than in goods and services prices. Accordingly, in some
situations, a monetary response to credit and asset markets may
8See,
for example, Gavin, William, "Inflation Targeting," Business
Economics, April 2004, pp 30, 36.
9See, Charles Freedman, "Panel Discussion: Transparency in the Practice of
Monetary Policy," Review, Federal Reserve Bank of St. Louis, July/August,
2002, p.155 .
10 Klaus Schmidt-Hebbel and Matias Tapia, "Statement" (2002), p.1 1)
15
be appropriate to preserve both financial and monetary
stability.""
But the argument that price stability or IT itself fosters asset price
bubbles, asset price volatility, or financial instability has been neither
adequately nor convincingly established. And the case that financial
imbalances develop because of stable price environments, has not been
demonstrated; it has not been shown that price stability causes
financial instability. In short, no direct "hard core" or formal statistical
or econometric evidence* supports this view. Instead, anecdotal
compilations of "stylized facts" are used to assess historical episodes in
support of the- view. Additionally, only a few episodes appear to have
the characteristics (low inflation, credit growth, asset price bubbles,
etc) consistent with this view. Instead of such evidence, proponents
rely on assumptions relating to the credibility of policymakers,
investment activity, technological advances, or productivity gains that
can serve to constrain the price increases of goods and services. In
sum, little hard empirical evidence supporting the view that price
stability or IT contributes-to or causes volatile financial markets exists.
Empirical Evidence: Does IT matter? Is IT unrelated to economic
performance or to market volatility?
A number of studies have examined whether the adoption of IT
improves economic performance (as measured by movements in
inflation,, output, and/or interest rates) or affects the volatility of market
variables. In short, they have tested to -see if IT matters..
Several researchers have addressed this, question. Despite a good
deal of effort, however, some of their-empirical results have been
mixed. As a result, this .research in turn has raised a number of
methodological questions. More specifically, in assessing thesequestions in recent years, researchers have often used a common
methodology. The reason for this is that recentlyzboth IT and non-IT
countries experienced improvement in economic performance. as
measured,. for example, -by inflation or the level of interest rates.
Focusing on any one IT country in isolation might lead researchers to
falsely conclude that IT caused the improvement. But non-IT countries
may have experienced similar affects. Some researchers contend,
therefore, that to test for the effects of IT, improvements in IT
countries must be made relative to improvements in non-IT countries.
' Borio Claudio and Philip Loew, "Asset Prices, Financial and Monetary
Stability: Exploring the Nexis," BIS Working Paper No. 114, July 2002,
Abstract.
16
Examples of research results: Implying IT doesn't matter include
the following:
* Ammer and Freeman (1995) surveyed three IT countries, New
Zealand, Canada, and the United Kingdom. They found that
although each reached its inflation goal, bond yields suggested that
long-term inflationary expectations exceeded targets as did shortterm measures of inflationary expectations. This suggests that
these countries did not attain the credibility necessary to properly
anchor other prices and stabilize the price system. Moreover, there
is no evidence that announcement of an explicit IT policy would
reduce inflationary expectations. 12
* Johnson (2002) employed data from eleven countries. He
adopted a methodology which divided up his sample into inflation
targeting and non-inflation targeting countries. His results are
mixed. Specifically, he found that while the level of inflationary
expectations falls after announcing explicit inflation targets, the
variability of expected inflation does not. In describing his results,
Johnson contended that "inflation targets allowed a larger
disinflation with smaller forecast errors to take place in targeting
countries." 13
* Recent research by Ball and Sheridan (2003) is perhaps the
most forceful example of empirical work concluding that IT does
not matter. These authors, for example, conclude that:
"...on average, there is no evidence that inflation targeting
improves performance as measured by the behavior of
inflation, output, or interest rates....overall it appears that
targeting does not matter. Inflation targeting has no effect on
the level of long-term interest rates, contrary to what one
would
expect
if
targeting
reduces
inflation
expectations... targeting does not affect the variability of the
short-term interest rates controlled by policymakers.. .we find
John Ammer and Richard T. Freeman, "Inflation Targeting in the 1990s.
The Experiences of New Zealand, Canada, and the United Kingdom," Journal
of Economies and Business, 1995, 47:165-192, pp.165 ,189 .
13 David R. Johnson, "The Effect of Inflation Targeting on the Behavior of
Expected Inflation: Evidence from an 11 country panel," Journal of Monetary
Economies, 49 (2002) 1521-1538, p., 1537.
12
17
no evidence that inflation targeting improves a country's
economic performance." 14
In short, some research clearly concludes that IT does not matter.
Some Ouestions and Critique:
There are, however, a number of fundamental reasons why this
research and its conclusions are both questionable and in conflict with
the results of other research. For example, many economists question
the methodology employed in these studies. The selection and
identification of "non-IT countries," for example, is one of these
issues. Several economists, analysts, and even Federal Reserve
officials have pointed out that a number of key countries, including the
U.S., are identified as non IT countries in the studies because they do
not have explicit inflation taruets. But many of these countries
consistently pursued an implicit inflation targeting strategy. So the
label may be misleading and inappropriate for several countries.
This misspecification also applies to countries pegging their currencies
to a currency whose central bank is following ITs; (i.e., some countries
in Europe and Asia). These observations were made by, Gertler,
Mankiw, Federal Reserve officials and others.15 These contentions
draw into question the validity of the methodology and results of these
empirical studies.
Furthermore, recent IMF research surveys and delineates the many
dimensions to and ways of classifying and categorizing IT. This
research underscores the large number of variables that can be used to
select and define IT. It is a reminder that there may be no easy, simple
way of neatly identifying an IT central bank.
Because of the multi-dimensional character of IT regimes, it is
difficult to clearly and neatly dichotomize existing central banks into
IT and non-IT categories. Definitions of IT, for example, should be
The clean
adjusted to reflect the realities of "flexible" IT.
may
not be
dichotomization maintained by theoretical researchers
nearly as clean as suggested by the authors. Consequently, the
14 Ball, Laurence and Niarnh Sheridan, "Does Inflation Targeting Matter?,"
Paper presented at NBER Inflation Targeting Conference, January 2003
(March 2003), pp. 2,3,4,29.
15
See Gertler, Mark, "Comments on Ball and Sheridan," Prepared for the
NBER Conference on Inflation Targeting, January 2003. (June 2003), pp 1,35; Mankiw N. Gregory, (2001), "U.S. Monetary Policy During the 1990s.
NBER Working Paper No. 8471, Cambridge, Mass Sept 2003; and Marvin
Goodfriend, "Inflation Targeting inthe United States?," (2003) Paper
prepared for the NBER Conference on Inflation Targeting, January 2003.
18
empirical results may not be as clean as suggested by some of the
results of these papers.
Additionally, several statistical or econometric issues and critiques
were identified in much of this literature. In his comments on Ball and
Sheridan, for example, Gertler notes that "existing evidence in favor of
inflation targeting is open to identification problems."' 6 Ball and
Sheridan themselves assert that their empirical results are often not
strictly comparable to the results of other studies because of unusual
techniques that were employed. 17
Empirical Evidence: IT is related to macroeconomic performance
and to financial market volatility: IT does make a difference.
Despite the widespread practical support accorded IT in recent
years, not much hard empirical support was found favoring IT in early,
initial research. 18 As time passed and more historical data has come to
the fore, however, researchers have uncovered a number of important
empirical regularities tending to support IT. Some of the evidence
comes from single-country case studies suggesting that IT tends to
stabilize markets. Other evidence is cross-section support. For
example, a number of recent empirical studies examined the
relationship between IT and macroeconomic performance as well as
between IT and financial market behavior: i.e., these studies attempted
to assess whether IT matters. While mixed, the bulk of the new
evidence indicates that IT matters; IT has a positive significant impact
on economic and financial market performance.
The followina "bullet points" supply an abbreviated summary of
the recent key empirical studies relevant to this topic:
* In a (1996) report to the FOMC, David Stockton surveyed
existing literature related to price objectives for monetary policy. 19
In that survey, Stockton identified several well-known established
empirical relationships pertinent to this topic. They included the
following:
16 Gertler, Mark, "Comments on Ball and Sheridan," June 2003, Paper
prepared for the NBER Conference on Inflation Targeting, January 2003, p.1.
17 Ball and Sheridan, M.cit., p.28. (The unusual technique was regression to
the mean.)
18 See Neumann and Von Hagen, p.127.
19 David J. Stockton, "The Price Objective for Monetary Policy: An Outline of
the Issues," A Report to the FOMC Board of Governors, June 1996.
19
> Both cross-country and time-series evidence supports the
notion that inflation reduces the growth of real output (or
productivity).
> Inflation is positively related to the variability of relative
prices.
> Inflation is positively related to inflation uncertainty.
> In general, relative price variability and inflation
uncertainty adversely affect real output.
* In his recent book Inflation Targeting (2003), Truman
summarizes the principal conclusions of the empirical literature on
inflation targeting. 20
In particular, IT generally:
had a favorable effect on inflation, inflation
variability, inflation expectations, and the persistence of.
inflation.
> Has not had a negative effect on economic growth, the
variability of growth, or unemployment.
> Has had mixed effects on both the level and variability of
real, nominal, short-term, and long.:term.interest rates.
> Has had positive effects on exchange rate. stability.
> Has affected the reaction functions of the central. banks
that have adopted the framework.
> Has
* For the most part, economists have established empirically a
negative relationship between . inflation uncertainty- and real
economic activity. Elder (2004); for example, relates that:
"Our main empirical result is that uncertainty about
inflation has significantly reduced real economic activity over
Our findings suggest that
the post-1982 period...
reduce volatility in the
that
... macroeconomic policies
inflation process are likely to contribute to greater overall
growth." 2 2
* In a early study. Ammer and Freeman (AF) (1995) examined
three IT countries. This study provided mixed results for IT. On
the one hand, inflation did not exceed the targets and this result
Edwin M.Truman, Inflation Targeting in the World Economy, Institute for
International Economics, Washington, D.C. October 2003, p 72.
21 Ibid. p 72. (The points outlined were taken from Truman, p. 72.)
22 John Elder, "Another Perspective on the Effects of Inflation Uncertainty"
20
20
occurred without sharp increases in short-term rates. These
researchers found that "inflation fell by more than was predicted
by the models in the early 1990s, an indication of the effect of the
new regime."73 However, "longer term interest rates suggest that
none of these countries rapidly achieved complete long-term
credibility for their announced long-run inflation intentions." 24
* Some of the earlier (pre-2000) literature was summarized by
Neuman and von Hagen (NvH) and included the following
observations:
- Some authors find that "IT might ... serve to lock in gains
from disinflation rather than to facilitate disinflation." 25 After
introducing IT, inflation and interest rates remained below
values predicted by existing models.
)0 Other authors found that the "volatility of official central
bank interest rates.. .declined substantially after the
introduction of IT."2 6
* Neumann and von Hagen (NvH) (2002) reviewed earlier
studies of inflation targeting episodes. They presented "evidence
on the performance of IT central banks." 27 In particular, NvH
showed that "... IT has reduced short-term variability in central
bank interest rates and in headline inflation..." (The NvH paper)
"suggests that IT has indeed changed central bank behavior..."
(NvH) "looked at different types of evidence in order to validate"
(the claim that inflation targeting) "is a superior concept for
monetary policy." "Taken together, the evidence confirms that IT
matters. Adopting this policy has permitted IT countries to reduce
inflation to low levels and to curb the volatility of inflation and
interest rates...." .29 In discussing this paper, Mishkin reminds us
23
Neumann and von Hagen, pp.cit., p.128.
John Ammer and Richard T. Freeman, "Inflation Targeting in the 1990s:
The Experiences of New Zealand, Canada, and the United Kingdon," Journal
of Economics and Business. 1995; 47: 165-192, p. 189.
25
Neumann and von Hagen, pp.cit., p.128.
26 Ibjd., p.129.
27
Manfred J.M. Neumann and Jurgen Von Hagen, "Does Inflation Targeting
Matter?", Federal Reserve Bank of St. Louis, Review, July/August 2002, p.
130.
28 Ibid, p.127.
29 Ibid, pp. 128, 144 (parenthesis added)
24
21
that NvH "produce several pieces of evidence quite favorable to
inflation targeting." 3 0
* Johnson (2002) shows that inflation "targets reduced the level
of expected inflation in targeting countries" 3 ' ... "The evidence is
very strong that the period after the announcement of inflation
targets is associated with a large reduction in the level of expected
inflation..,that (significant) reduction took place in all 5 countries
with inflation targets. This is an important- success of inflation
targets."... "inflation targets allowed a larger disinflation with
smaller forecast errors to take place in targeting countries." 32 In
sum, inflation targeting presumably favorably affected the bond
and other markets by influencing inflationary expectations- and
reducing uncertainty premiums.
* Levin, Natalucci and Piger (LNP) (2004) find "evidence that
IT plays a significant role in anchoring long-term inflationary
expectations and in reducing the... persistence of inflation" 3 The
evidence suggests that IT practitioners can more readily delink
their inflationary expectations from realized inflation. 3 4 In short,
IT plays a significant role in anchoring long-term inflation
expectations and long-term interest rates themselves.. 3
> LNP find that "inflation targeting affects the public's
expectations about inflation"... "under an inflation targeting
regime, expectations about inflation, particularly at longer
horizons, should be 'anchored' by the target, and thus-should
be less affected by changes in actual inflation." "Keeping
inflation expectations- anchored helps to keep inflation itself
low and stable."3 6
Frederick Mishkin, "Commentary," FRB St. Louis Review, July/August,
2002, p. 144.
3' David R. Johnson, "The Effect of Inflation Targeting on the Behavior of
Expected Inflation: Evidence from an 11 country panel"
32 Journal of Monetary Economics 49 (202), p. 1522. ibid, pp/1537.
(parenthesis added).
33 Andrew T. Levin, Fabio M. Natalucci, and Jeremy M. Pager, "The
Macroeconomic Effects of Inflation Targeting," Federal Reserve Bank of St.
Louis, Jan. 23, 2004. Abstract.
34 Op0ci., Abstract
35 Op. cit., p.2
36 Jeremy Piger, "Does Inflation Targeting Make a Difference?" Monetary
Trends April, 2004
30
22
> In commenting on this paper, Uhlig (2004)... "concludes
that these figures seem to suggest that an environment of low
and stable inflation helps to reduce output volatility and
support economic activity."3 7
* Recent empirical research at the Federal Reserve by
Gurkaynak, Sack and Swanson (GSS) (2003) shows that the Fed
could boost the economy by being more transparent about its longterm inflation objectives. 38 GSS "show that the long-term interest
rates (of non-IT countries) react excessively to macroeconomic
data releases and to news about monetary policy. This overreaction is caused by changes in the market's long-term inflation
expectations." 3
IT, however, works to anchor (or prevent excess volatility in) longterm market's. Consequently, in IT countries (like the UK),
markets do not overreact or display over-sensitivity. The empirical
results of the paper suggest "that the central bank can help stabilize
long-term forward rates and inflation expectations by credibly
committing to an explicit inflation target."4 0 Commitment to an
explicit target will help stabilize both long rates and inflation
expectations.
* Other research conducted at the Federal Reserve also relates to
this evidence. Carpenter (2004), for example, surveyed empirical
studies of transparency. 41 The summarized results are mixed, but
suggest there is evidence of a relationship between IT and both
transparency and lower inflation. Moreover, it is emphasized by
several authors that there is no evidence that IT causes any harm.
Swanson (2004) showed that increased central bank transparency
acts to reduce financial market surprises and uncertainties. This
Jeremy M.Piger and Daniel L. Thornton, "Editor's Introduction," Federal
Reserve of St. Louis Review, July/August 2004, Volume 86, Number 4, p.5 .
38 See Refet S. Gurkaynak, Brian Sack, and Eric Swanson, "The Excess
Sensitivity of Long-Term Interest Rates, Evidence and Implications for
Macroeconomic Models," Finance and Economic Discussion Series, Federal
Reserve Board, November 17, 2003; William Gavin, "Inflation Targeting,
Why It Works and How to Make it Work Better," Business Economics, Vol
XXXIX April, 2004, p. 32.
39 See Gavin, op cit, pp. 32, 36 (parenthesis added)
40
GSS, gpgit. p.28.
41 Seth Carpenter, "Transparency and Monetary Policy: What Does the
Academic Literature Tell Policymakers?, "Working Paper, Board of
Governors of the Federal Reserve System, April 2004, pp 11 -13.
37
23
suggests that IT - which is tantamount to increased transparency of
policy goals - may aid in reducing financial market volatility and
stabilizing financial markets. 42
* Several studies establish that additional -central bank
transparency in the form of announced inflation target, works to
lower inflation and stabilizes output. Recently Fatas, Mihov, and
Rose (FMR), for example, found "that both having and hitting
quantitative targets (like IT) for monetary policy is systematically
and robustly associated with lower inflation ... Successfully
achieving a quantitative monetary goal (like. ITs) is also associated
with less volatile output." 43 These authors find that "... countries
with transparent targets for monetary policy achieve lower
inflation." 44 They found "that having a quantitative de jure target
for the monetary authority tends. to lower inflation and smooth
business cycles; hitting that. target de facto has. further positive
effects. These effects are economically large, typically statistically
significant and reasonably insensitive to perturbations in (their)
econometric methodology." 4 5
* Siklos (2004) found that "inflation-targeting countries.have
been able to reduce the nominal interest rate- to a greater extent
than have non-inflation targeting countries....It is also found that
central banks with the clearest policy objectives have a relatively
lower nominal interest rates." 46
This abbreviated review of some of the recent literature suggests
that overall, there is a good deal of evidence supporting the case for IT.
This review suggests that inflation targeting does matter. More
specifically, credible commitment to an explicit IT likely will work to
help lower and stabilize the level and variability of inflation. This
result occurs in part because of the reduction - and stabilization of
Eric T. Swanson, "Federal Reserve Transparency and Financial Market
Forecasts of Short-Term Interest Rates," Working Paper, Board of Governors
of the Federal Reserve System, February 9, 2004.
43 Antonio Fatas, Ilian Mihov, and Andrew K. Rose, "Quantitative Goals for
Monetary Policy," NBER Working Paper No. W 10846, October 2004,
Abstract (parenthesis added.)
44 Ibid, p.1
45 Ibid. p.21. (parenthesis added)
46
Pierre L. Siklos, "Central Bank Behavior, The Institutional Framework, and
Policy Regimes: Inflation Versus Non-Inflation Targeting Countries,"
Contemporary Economic Policy, vol 22, no. 3, July 2004, 331-343, pp 331,
332.
42
24
inflationary expectations. Hence, it will likely lower both the level and
variability of the long bond rate. IT will anchor the price system and
help to stabilize short-term interest rates, long-term interest rates, the
foreign exchange and stock markets. Some research suggests IT also
helps to dampen the business cycle and stabilize movements in output.
Additionally there is a body of evidence indicating that transparency
helps to stabilize markets and fosters central bank credibility.
Summary and Conclusions
After decades of debate, the case for inflation targeting is well
established. This paper focuses on one key ingredient of the argument
supporting inflation targeting. Namely, it examines the proposition
that a credible implementation of inflation targeting will calm and
stabilize various financial markets, anchor the price system, and limit
inflation as well as its variability and persistence. Other competing
views - i.e., (a) that inflation targeting has no impact on financial
markets and (b) that Inflation Targeting leads to asset price bubbles
and hence to financial market volatility - are briefly outlined.
These alternative views are presented and briefly contrasted with
existing empirical evidence. Some key findings include the following:
* There is little or no evidence that inflation targeting has
adverse effects on financial markets.
* Research finding that inflation targeting does not matter has
problems, in part related to the selection and definition of inflation
targeting countries.
* The weight of the existing empirical evidence appears to
support the case for inflation targeting; i.e. overall, it supports the
view that inflation targeting matters and will work
to calm and limit the variability of financial markets as well as the
persistence of inflation. It will serve to anchor the price system.
As the empirical literature suggests, this will likely foster healthier
economic growth.
There is little evidence that inflation targeting has adverse effects
on or hurts financial markets or the economy.
Accordingly,
adopting inflation targeting once price stability is attained likely will
make it easier to maintain. 48 As emphasized by Gertler, "the case
Ball and Sheridan, op.cit.. p. 29.
See Anthony M.Santomero, "Monetary Policy and Inflation Targeting in
the United States," Business Review, Federal Reserve Bank of Philadelphia,
Fourth Quarter 2004, p.1.
47
48
25
made for adopting formal targets in the U.S. is not that this system
would have improved past performance, but rather that it would help
future performance by preserving gains in credibility for Greenspan's
successor."49
Mark Gertler, "Comments on Ball and Sheridan." A Paper presented to the
NBER conference on Inflation Targeting, January 2003, p.5. The point was
also made by Ball and Sheridan, op. cit., p. 30
49
26
Individuals and the Compliance Costs of Taxation
It will be of little avail to the people that the laws are made by men of
their own choice, if the laws be so voluminous that they cannot be
read, or so incoherent that they cannot be understood; ... or undergo
such incessant changes that no man who knows what the law is today
can guess what it will be tomorrow. Law is defined to be a rule of
action; but how can that be a rule, which is little known, and less
fixed?
Alexander Hamilton or James Madison, The Federalist Papers,
No. 62.
Introduction
Taxes impose many costs. It would be easy to view the costs as
simply the amount of money a person gives to the tax collector.
However, the economic effects go beyond simply transferring money
from one party to another. Since Adam Smith, economists have been
concerned with the costs of taxation and have developed several
different measurements of the economic costs.
First, as Smith pointed out, taxes can change or alter behavior. This
may or may not be intentional. For example, taxes on cigarettes have
the stated purpose of reducing smoking. Likewise, tax incentives to
attend school may lead to an increase in the demand for schooling.
However, there are other costs that are not intentional. In the modern
economic literature, these costs are known as the excess burden (or
deadweight loss of taxation.) The excess burden is a loss of welfare
above and beyond the tax revenues collected.
Additionally, we should consider what Slemrod (2005) terms the
resource costs of taxation. These consist of two parts:
Compliance costs: the cost (usually thought of as time, but can
also be monetary) that is borne by individuals as a result of
paying their income taxes.* This includes record keeping,
learning about specific laws and forms, preparation time,
remittal time, and any monetary costs such as seeking
assistance from a certified public accountant, tax lawyer, or tax
preparer (such as H&R Block) or buying computer programs
Compliance costs also fall on businesses, however the focus here will only
be on the cost to individuals.
27
or books. It is a measure of the opportunity cost of complying
with the tax code.*
Enforcement costs: the costs associated with the
administrative operation of the Internal Revenue Service (IRS).
Empirical work on the deadweight loss of taxation has resulted in a
vast literature.t The purpose of the present study, however, is to
examine only one aspect of the resource costs: the compliance costs
associated with taxation. Compliance costs are a primary result of the
complexity in the tax system.1 It is commonly believed that
complexity reduces levels of voluntary compliance, either through
avoidance or evasion, likely increases the difficulty in administering
the tax law, and may reduce the. perceived level of fairness in the
Federal tax system.
While the tax system is obviously complex, it may not be that
complex for everyone. Some individuals (those with lower incomes)
qualify to fill out the 1040EZ, which is a comparatively easy
document. Others may fill out the 1040A, which, while not as easy as
the 1040EZ, is still not as complex as the 1040 basic form (see Table 1
for time estimates). Some people though, will use complex forms
simply due to financial transactions. Others will try to minimize taxes
by pursuing aggressive avoidance strategies. Ultimately, it is
important to understand whether complexity is a result of the
underlying transactions into which the taxpayer has chosen to enter, or
whether the complexity is embedded in the tax code.
This study will focus on these questions and how individuals react
when presented with complexity. The study will begin with a review
of the estimated costs of compliance across time periods and will then
examine the economic response of individuals to complexity.
Some of the literature on compliance costs includes the administrative costs
borne by the government, although here they are considered separately.
I See Vedder and Gallaway (1999). JEC (2005) provides a brief overview of
the topic.
I Complexity can have different effects, depending on the type of complexity.
For example, in some instances complex laws may lead to uncertainty in the
correct application of the law to particular facts. Or in may require complex
numerical calculations that, while potentially beneficial, may intimidate the
tax filer.
28
Cost Estimates'
The modem literature on compliance costs begins with the work of
Wicks (1965, 1966) who conducted the first study based on survey
information. Wicks handed out questionnaires to 380 students with the
request they mail the questionnaire to their parents. Adjusting for bias,
Wicks estimated compliance costs amounting to 11.5 percent of the
revenue raised.t
Slemrod and Sorum conducted the next survey (1984), this time of
Minnesota households. They found that on average a taxpayer spent
21.7 hours on tax matters, or close to 2 billion hours for society. They
estimated compliance costs as 5-7 percent of income tax revenue.
Blumenthal and Slemrod repeated the survey in 1990 and found
that time requirements for 1989 returns had increased to 3 billion
hours. In this study, individuals, on average, spent 27.4 hours on tax
matters, despite the intervening Tax Reform Act of 1986, which was
intended to simplify the tax code. t
The largest survey, conducted by the consulting firm Arthur D.
Little, Inc. (ADL) and commissioned by the IRS, was a mail
questionnaire sampling approximately 6,200 individuals. ADL also
conducted a diary study of time spent in 1983 by 750 individuals. The
results were broadly consistent with those of Slemrod (1984), although
there were important differences in the measurement of business
compliance costs, which are not discussed here. ADL estimated that
individual taxpayers spent 1.6 billion hours for tax year 1983 and 1.8
billion hours on 1985 returns.
The IRS now uses the ADL study as the basis for their estimates of
time compliance. These estimates are published in the instruction
booklets for the respective tax forms as part of the "Paperwork
Reduction Act Notice." For example, for tax year 2004, the IRS
The works cited here refer only to the compliance costs associated with the
U.S. federal income tax system. Scholars have surveyed the costs faced in
other countries, most notably with respect to Australia and the U.K. See
Slemrod and Sorum, (1984) and Blumenthal and Slemrod (1992) for a review
of this literature.
t Wicks (1966).
$The previous study (Slemrod and Sorum) did not include a category on the
time spent arranging financial affairs to minimize taxes, which the latter study
(Blumenthal and Slemrod) does include. For this reason, the 1982 survey
might have been biased downward slightly, although respondents may have
included the time estimates included in this category implicitly elsewhere.
Thus, the time estimates are roughly comparable, though the categories are
not. See Blumenthal and Slemrod (1992) for a discussion.
29
estimates the compliance burden for the standard 1040 at nearly 13.5
hours, on average (see Table 1below).*
Table 1, Estimated Preparation Time
Copying,
Learning
aboutthe
Preparing
law or
i Record
Form I keeping the form | the form
6 hr., 17
2 hr., 46 3 hr., 58
2004
I
min.
min. I min.
1040
3 hr., 37
3 hr., 8 2 hr., 42
1992
mi.
min.
1040 . min.
.hr., 10, 3 hr., 28 l
2004
l 5 hr. 13 mm. min.
min.
1040A
2 hr., 7
2hr.,8
lhr.,3
1992
min.
min.
min.
1040A
1hr.,41
hr.41
2004 !1
min.
mm.
_
1040EZ
1992
39 min.
33 min.
5 min.
1040EZ
j
assembling,
and sending
the form to
Totals
the IRS
13 hr.,
~~~~~~~34min.
35 min.
m.
.10
3425
35m.
2
.
344m.
min.
10 hr.,
26 min.
hr.
min.
6hr.,33
min.
3 hr.,46
min.
Ilhr., 51
min.
Source: Selected IRS instruction booklets, various years.
Two recent studies by Payne (1993) and Moody (2002) base their
estimates on the ADL/IRS time estimates. Payne uses data from the
ADL survey while Moody considers the number :of forms returned by type and simply adds the estimated totals per form to reach a
cumulative total. Payne estimates that time spent-complying equals 1.8
billion hours (for 1985) and Moody places the time at 2.8 billion hours
(for 2002).
Because the ADL survey is over 20 years old, the IRS wishes to
update its compliance estimates, which are derived from the survey- To
accomplish this task, the IRS turned to IBM. IBM has now completed
its Individual Taxpayer Burden Model (ITBM) and the results- have
been published in Guyton (2003.) The model is still being tested for
reliability, but its compliance estimates are consistent with other
studies. For tax year 2000, the ITBM model estimates a compliance
burden of 3.21 billion hours. Guyton, et al., apply three different wage
rates, $15, $20, and $25 respectively, yielding a compliance cost of
between $48 and $80 billion. If we add in the cost of paid preparers,
time estimates only reflect the-time to complete one specific form. It is
entirely possible, and if time estimates are to be believed, necessary, that other
forms, with their own time requirements will also be completed. The IRS
estimates preparation time for all of their forms, even though only a few are
listed in Table 1.
*The
30
tax software, and related expenses, which the authors estimate at $18.8
billion, we can estimate a compliance cost between $67 and $99
billion.
Slemrod (2004) estimates taxpayers spent 3.5 billion hours
complying with the tax code for tax year 2004. He follows the same
methodology as Guyton, et. al. but estimates the compliance cost using
the middle of the three wage rates ($20). Slemrod estimates a cost of
$70 billion.
A conservative estimate would be to use the Guyton study
methodology and estimate the cost at $20 per hour and then add the
costs for additional services, $18.8 billion, which yields a total cost of
$83 billion.
A recent Government Accountability Office (GAO) report reached
a similar conclusion. For individuals, GAO estimates compliance costs
between $67 billion to a little over $100 billion.* At the low end was
the aforementioned IBM/IRS study and Moody's estimates (2002)
were at the high end. It is important to remember that we are not
dealing with absolutes and that even at the low end, the compliance
costs are massive and are likely underestimated. They present a real
cost to society because every dollar that is lost to inefficiency
represents a dollar society could have used for productive purposes.
Individual Responses to Complexity
Economics is ultimately interested in how individuals behave
given certain constraints and how incentives influence behavior. Given
high compliance costs, it is important to understand what economic
responses people exhibit.
Substitution Effect. Because people have some understanding of
the time costs of preparing their taxes, many will choose to forgo the
process entirely and have someone else do the work. About half of all
taxpayers purchase assistance from an accountant or other tax
professionalt Those who purchased assistance spent about $158
(1995 dollars) on average, although the amounts varied widely
depending on the complexity of the return.t
Because leisure time is valuable, it is not surprising that so many
people seek assistance. Indeed, even some people with comparatively
simple returns, such as those who file the 1040EZ, seek assistance.§
*GAO
(2005) p. 12.
t Slemrod (2000).
Slemrod (2000).
I The 1040EZ
constitutes 75% of all forms H&R Block files per year. Indeed,
the fact that anyone would pay to have the form completed is a little
surprising. A much higher number of people seek help to complete form
1040A, which, though it is still complex, is not as time intensive as the 1040.
31
While seeking assistance will reduce the time costs of taxation,
records still need to be kept, and the individual must invest some level
of time and effort. Nevertheless, because tax preparers- have developed
a high level of expertise, they will be more efficient and will lower the
time requirements, but not necessarily the monetary costs, to comply
with the Code.
Taxpayer Confusion. For those who file themselves, complexity
can create confusion. People may intentionally take conservative filing
positions when faced with a complex area of the tax code that-seems to
offer no clear answers. Alternatively, some people may want to "roll
the dice" and try a more aggressive approach in the hope that
complexity may protect them in case of an audit.
In other cases, complexity may induce changes in behavior evenwhen the tax law-is clear and there is little chance of confusion. The
tax law may be clear in:some cases-but involve a large number of steps
or calculations that could be intimidating. This would not result in
confusion or uncertainty, but might still alter behavior. For example,
the Government Accounting Office (GAO) estimated that in tax year
1998, approximately 510,000 individuals did not itemize their
deductions and may have overpaid their taxes by $311 million.t
One- possible reason for this apparently irrational behavior is that
the GAO only considers the accounting costs involved. Itemizing may
save a taxpayer money, but the economic costs, such as the lost time,
may not be worth the accounting profit. Again, faced with a workleisure constraint,_ people may simply decide to take the standarddeduction in order-to save themselves time and potential headaches.
As would be expected, individuals seek the easiest methods to
complete the unpleasant process. of filing taxes. Over the past 20 years,
as technology has improved (especially- computers)j people have more
and easier options to assist them. Now, approximately half of all.
returns are filed electronically.1 IRS forms can be downloaded online,
saving individuals the time and effort of waiting in lines and traveling
for the proper forms. Also, programs like TurboTax and Quicken-can
further simplify the process by making, complex calculations that
that choose to pursue a more aggressive approach are also more likely
to seek ways that avoid or evade taxation; usually with the assistance of a tax
preparer. Comprehensive studies of tax evasion, though. older (1992), suggest
that noncompliance of both individual and corporate income tax cost the U.S.
Treasury $128.4 billion in that year (Slemrod, 2000).
t GAO (2001). In tax year 1999 31.7% of filers itemized their returns. Similar
numbers hold across time periods (Campbell, 2001).
: Balkovic (2005).
*Those
32
would have previously been done by hand. These programs do have a
monetary cost though.*
Lack of Transparency. Complexity in the tax laws obscures the
actual tax base and increases the tendency for people to "free ride" on
the contributions of others because each citizen's individual
contribution is just a drop in the bucket and doesn't affect what
benefits one receives from the government. This added effect of
complexity can, over time, increase the tendency of people to feel that
the tax system is not fair. People may call for marginal tax rates to
increase, so a higher percentage of the burden of taxation will fall on
the wealthier individuals in society.t Or, it can breed cynicism among
taxpayers, which can ultimately lead to intentional noncompliance.
Over time, this could make the collection duties of the IRS increasingly
difficult.
Complexity Creep. One lesson of economics is that legislation
can have unintended consequences. In tax law, one problem is that
complexity does not become evident until many years after a change in
the tax law. Consider the alternative minimum tax (AMT). In tax year
1990, only 132,000 people paid the AMT for individuals (there is also
an AMT for corporations). In 2000 that number rose to 1.3 million and
by 2010 the number is projected to rise to nearly 35 million, unless the
current law is changed.$
Ultimately, in order for a "voluntary" tax system to work, people
must believe in the inherent goodness of paying taxes and providing
for the public goods that all enjoy, even if the act itself is still painful.
Complexity undermines this process through many of the processes
mentioned above.
Conclusion
The Internal Revenue Code now consists of more than 1.4 million
words and the result is complexity and taxpayer confusion.§ The
combination of compliance, administrative and welfare costs lead to
very large economic costs and create strong disincentives to complying
with the tax system. Tax reform is necessary and worthwhile.
However, for tax reform to be successful, legislators should keep filing
Some filers -those with incomes below a certain income threshold - can
now use certain tax programs for free if they file online. This has the added
bonus of providing sound assistance while reducing time costs.
I Several surveys, summarized in Slemrod (2000), suggest that people have a
hard time identifying the true burden of taxation and frequently believe that
the wealthier classes bear a smaller share of the burden than is actually the
case.
I See Schuler (2001) for an overview of the AMT. For the data on future AMT
filers, see National Taxpayer Advocate (2004), p. 3.
§National Taxpayer Advocate (2004).
33
and administrative costs to a minimum and they should apply low
marginal tax rates to a broad economic base. These simple guidelines
should ensure that tax reform reduces disincentives to work, save, and
invest.
Brian Higginbotham
Economist
34
References
Arthur D. Little, Inc. 1988. Development of Methodology for
Estimating the Taxpayer Paperwork Burden. Final Report to the
Department of the Treasury, Internal Revenue Service, Washington,
D.C., June.
Balcovic, Brian. 2005. "Individual Income
Preliminary Data, 2003," IRS SOI Bulletin, (Winter).
Tax Returns,
Blumenthal, Marsha, and Joel Slemrod. 1992. "The Compliance
Cost of the U.S. Individual Income Tax System: A Second Look after
Tax Reform," National Tax Journal45, no. 2 (June): 185-202.
Campbell, David and Michael Parisi. 2001. "Individual Income
Tax Returns, 1999." IRS SOI Bulletin, (Fall).
Gale, William G. and Janet Holzblatt. 2002. "The Role of
Administrative Issues in Tax Reform: Simplicity, Compliance, and
Administration," in Zodrow, George R. and Peter M. Mieszkowski,
United States Tax Reform in the 21st Century. Cambridge University
Press.
Government Accountability Office. 2005. Tax Policy: Summary of
Estimates of the Costs of the Federal Tax System (GAO-05-878).
August 26.
Government Accounting Office. 2001. Tax Deductions: Estimates
of Taxpayers Who May Have OverpaidFederalTaxes by Not Itemizing
(GAO/GGD-010-529). April 12.
Guyton, John L., John F. O'Hare, Michael P. Stavrianos and Eric J.
Toder. 2003. "Estimating the Compliance Cost of the U.S. Individual
Income Tax." National Tax Journal56 no. 3 (September): 673-688.
Harberger, Arnold C. 1974 (originally published 1964). "Taxation,
Resource Allocation, and Welfare," in Arnold C. Harberger, Taxation
and Welfare. Chicago: University of Chicago Press.
Moody, Scott. 2002. "The Cost of Tax Compliance." The Tax
Foundation, February.
Payne, James L. 1993. Costly Returns: The Burdens of the US.
Tax System. San Francisco: Institute for Contemporary Studies.
35
Rosen, Harvey S. 1998. Public Finance (5 h ed.). New York: The
McGraw-Hill Companies.
Schuler, Kurt. 2001. "The Alternative Minimum Tax for
Individuals: A Growing Burden," Joint Economic Committee, May.
2001. "Hidden
Costs of Government
Spending,"
Joint
Economic Committee, December.
Slemrod, Joel. Testimony, Committee on Ways and Means,
Subcommittee on Oversight, Hearing on Tax Simplification,
Washington, D.C., June 15, 2004
Slemrod, Joel, and Jon Bakija. 2000. Taxing Ourselves
Cambridge, MA: The MIT Press.
(2 nd
ed.).
Slemrod, Joel, and Nikki Sorum. 1984. "The Compliance Cost of
the U.S. Individual Income tax System." National Tax Journal 37, no.
4 (December): 461-484.
Vedder, Richard K. and Lowell E. Gallaway. 1999. "Tax
Reduction and Economic Welfare," Prepared for the Joint Economic
Committee, April. .
Wicks, John H. 1965. "Taxpayer Compliance Costs from the
Montana Personal Income Tax," Montana Business Quarterly, (Fall):
37-42.
. 1966. "Taxpayer Compliance Costs from Personal Income
Taxation," Iowa Business Digest, (August): 16-2 1.
36
OPEC and the High Price of Oil
I. Introduction
This paper explores the reasons for high crude oil prices. It finds
that the world is not running out of crude oil, on the contrary, it exists
in great abundance. Crude oil also is not very expensive to produce.
The cost of producing crude oil in the Middle East is less than $5 per
barrel and even in higher cost producing areas is nowhere near today's
price.
The reason for the high price of oil is an artificial scarcity imposed
on the market by the Organization of the Petroleum Exporting
Countries (OPEC). The flow of oil to the market is restricted through
collusion and the underdevelopment of the vast oil resources controlled
by the OPEC cartel. The cartel controls 70 percent of the world's
known oil reserves but contributes only 40 percent to world oil
production.
Since the oil embargo of 1973, the price of crude oil also has been
subject to wide swings. The reason is that OPEC has difficulty
manipulating its output to fit changing market conditions and
compounds the problem with secretiveness. Independent producers are
left guessing what OPEC will do next and what market share it will
claim. In the capital intensive oil industry this added uncertainty
hinders investment decisions and lengthens the lead time of supply
responses to a higher price.
Increases in world oil consumption have been driven principally by
developing countries in Asia. Asian crude oil consumption has more
than doubled since 1985. U.S. crude oil consumption, by comparison,
increased just 12 percent in 25 years while the size of the economy
more than doubled. Non-OECD countries now account for 40 percent
of world crude oil consumption.
OPEC used the increase in oil demand to build up its market share
until 1998. Since the oil price collapse in 1998 that followed the Asian
currency crisis, the cartel has redoubled its efforts to preempt price
declines and allowed increases in oil demand to push up the price.
OPEC today barely produces more crude oil than it did in 1977. It has
been sitting on spare capacity while the price has soared and is
expected to collect an increase in oil revenue of $92 billion for 2005
alone.
Part II of this paper cites geological estimates of the oil resource on
earth and presents data on the amount of proven oil reserves; the
concern over an eventual world oil shortage is addressed; and the cost
of producing crude oil in different parts of the world is examined. Part
III reviews the size of OPEC's oil reserves, its rate of production, the
37
price volatility it has caused since the oil embargo of 1973, the manner
in which it manipulates output, and its secretiveness. Part IV addresses
non-OPEC production and the effect that OPEC has on it. Part V
examines trends in oil consumption in developed and developing
countries over time. Part VI analyzes oil price developments since
1998 in detail and discusses secondary market factors often blamed for
oil price shocks. Part VII considers the long-run outlook, and Part VIII
presents the conclusions.
II. Supply of Oil
The oil resource. Oil exists on earth in different forms and in
enormous quantity. The Energy Information Administration (EIA)estimates the world's recoverable conventional oil endowment at 3.3
trillion barrels, i.e., liquid oil in underground reservoirs, of which only
950 billion barrels have been removed in 145 years-of production as of
2004. Annual oil consumption in. 2004 was 30 billion barrels. At that
rate the remaining conventional oil would last another 78 years. In
addition, there are more. than 4 trillion barrels of oil in the form of socalled oil sands and extra heavy oil, and- at least another 2.6 trillion
barrels in the form of oil shale.'
All this oil is not available. for immediate consumption. The
availability of oil for consumption follows a hierarchy of cost related to
the difficulty of finding it, making it accessible and extracting it from
the ground. The economic concept of oil supply thus is different from
the physical concept of how much oil exists. As an illustration,
roughly two-thirds of the conventional oil known to exist in reservoirs
traditionally has been abandoned as uneconomic, although that share is.
shrinking.2 How much is recovered varies with the price of oil. If the
' This estimate was generated by the Energy Information Administration
(EIA) from the U.S. Geological Survey (USGS) estimates and other federal
government sources; see Guy Caruso, "When Will World Oil Production
Peak?" 10'h Annual Asia Oil and Gas Conference, June 13, 2005, EIA,
http://www.eia.doe.gov/neic/speeches/main2005. html#June; Pete McCabe,
senior USGS geologist, "USGS Official Upbeat About Oil Reserves Outlook,"
Oil & Gas Journal, 103, 16 (4/25/2005): 32; Sam Fletcher, "Industry, U.S.
Government Take New Look at Oil Shale," Oil & Gas Journal, 103, 15
(4/18/2005): 26.
2 The amount of oil abandoned is not included in the 3.3 trillion barrel
estimate. For a schematic on recoverable oil estimation with a hypothetical
conventional 6 trillion barrel oil-in-place resource base, see John H. Wood,
Gary R. Long, and David F. Morehouse, "Long Term World Oil Supply
p.3;
2004,
18,
August
posted
Scenarios,"
http://www.eia.doe.gov/pub/oilgas/petroleum/feature articles/2004/worldoils
upply/oilsupply04.html; see also Edward D. Porter, "Are We Running Out of
Oil," American Petroleum Institute (API), Discussion Paper #081, December
38
price falls, oil field development will be curtailed. If the price rises,
progressively more costly oil will be developed and produced. In
addition to price, technology has a major impact on oil supply.
Improved survey and recovery methods can increase knowledge about
the location and size of oil deposits and reduce the cost of extraction. 3
Geological estimates of the physical oil resource itself have grown over
time as technology advanced. U.S. Geological Survey (USGS)
estimates have a history of upward revision.
Known reserves. In order to produce oil, detailed knowledge
about its location and the structure of deposits must be gathered, wells
drilled and pipes laid for collecting the oil lifted from the ground. This
activity is referred to as oil field development. The amount of oil that
can be produced as a result of a given investment in oil field
development is considered a "known" or "proven" oil reserve. The
standard for proven reserve estimation is virtual certainty that the oil
can be produced economically under existing technical conditions.
"Known" reserves can be viewed as a producer's oil inventory in the
ground that is drawn down by ongoing production and restocked
through incremental oil field development. Known reserves can be
bought and sold in-ground. Figure 1 shows the size of world's known
oil reserves since 1980.
1995, which refers to an original conventional oil-in-place resource base
between 6 and 8 trillion barrels and provides information on increasing
recovery percentages.
3To those who waive off blind faith in technology, a recent graphic in the
Wall Street Journal may be instructive. It shows a survey ship atop the ocean
sending seismic signals below to explore for oil beneath the ocean floor. The
ocean is about 2 1/3 miles deep; the signals reach to a depth another five miles
below the ocean floor. In October 2003, Unocal announced finding oil after
drilling a well in the Gulf of Mexico through water and rock to a depth of
35,966 feet. That distance is the cruising altitude of jet aircraft. "Deep
Drilling in the Gulf," Wall Street Journal, June 23, 2005.
39
KNOWN OIL RESERVES
Figure 1
Billions of Barrels
1,400 1,200 -
||
_||||i|E
1,000 -
l
800 600- -
_i
i
l 1
2400°- _ li
1980
1985
1990
1995
2000
2005
One approach to measuring whether the supply of oil is keeping up
with demand is to track the size of the world's in-ground oil inventory
and compare it to the rate .of production. In 1980 known oil reserves
stood at 645 billion barrels; today they stand at 1.278 trillion- barrels..
This means that enough new oilfwas developed to replace all the.oil
produced in 25 years and nearly double the-reserves. In 1980, the
rate of production. was 60 million barrels per day (b/d). The known
reserves would. have lasted for 29 years at that rate; if nor new oil had
been developed: Much was said at the time about the world.irunning
out of oil, because the price was at an all-time high. But, in 2004 the
rate of production was. 82.5 million-b/d and at-that rate today's reserves
would last more than 40. years. Figure 2 shows the history- of reserve
life expectancy over time, also-called the reserves-to-production ratio.
40
Figure 2
WORLD OIL RESERVES-TO-PRODUCTION RATIO
Life of Reserves
Years
50
0
3
0 82 84 86 88 90 92 94 96 91 00 02 04
Source: The BP Statistical Review of World Energy, June 2005.
World oil shortage. Predictions of a world oil shortage are based
on the notion of the oil supply as fixed. They miss the fact that the rate
at which the physical oil resource enters the world's economic oil
supply inventory depends on the price and development costs, which in
turn depend on the state of technology. Proponents of the so-called
peak production theory warn that an increasing rate of production will
eventually reach an unsustainable level from which it must decline.
They foresee a growing shortage arising after the peak has been
reached. 4 In the first place, this prediction fails to acknowledge that
the price system will reallocate consumption among alternative
resources long before any one of them run short. The occurrence of a
peak in the rate of oil production at some point is to be expected and
does not necessarily represent an adverse market event. Production
profiles for minerals, commodities, and manufactured products
typically increase at first and eventually decline as they are overtaken
4 This
view draws on the bell-shaped production profile made famous by M.
King Hubbert, a geologist who predicted the production peak for the
continental U.S. The profile derives from the declining flow rate of producing
oil fields due to diminishing natural underground pressure. Hubbert's model
underestimated U.S. production in total, mainly because it fails to account for
secondary and tertiary recovery methods. The peak production theory as such
is a truism. Given the assumption of a fixed quantity of recoverable oil, an
increasing rate of production must lead to a peak and a subsequent decline,
more or less abrupt depending on the steepness of the upswing.
41
by substitutes. In the case of crude oil, that may be natural gas. Rather
than experiencing a shortage, the world likely will leave a surplus of
oil in the ground.
Secondly, the theory denies that there is any elasticity to the supply
of oil, that the price mechanism can provide any inducement for
increased oil development. Instead, the prediction is premised on a
Yet, while ongoing production
fixed quantity of oil reserves.
obviously reduces the physical quantity of oil in existence, oil reserves
have been increasing as shown. The premise of a fixed oil supply has
been proved wrong time and again by experience, as reserve
estimates and the timing of production peaks have been surpassed.
Daniel Yergin, chairman of Cambridge Energy Research Associates
(CERA), has ventured a guess that the word has "run out" of oil five
times already. He also points out that the share of "unconventional
oil," such as oil sands and extra heavy oil, will rise from 10 percent of
total capacity in 1990 to 30 percent by 2010.5 In other words, oil
considered "unconventional" today will become "conventional" in
the future. The EIA shows a history of steadily increasing world oil
resource estimates since 1942 when no more than 600 billion barrels of
oil were thought to exist on earth. That is less than one-fifth of the
current USGS estimate of conventional oil deposits alone. The peak
will keep moving to the right for some time to come.
Costs. "Lifting" costs refer to costs incurred in operating existing
wells to extract oil from developed oil reserves. Persian Gulf wells
have the highest flow rates and the lowest lifting cost. Saudi Arabia's
oil minister stated in October 1999, that its cost is less than $1.50 per
barrel.7 In the North Sea, one of the higher cost producing areas,
operating costs have been estimated between $3 and $6 per barrel.8
The EIA shows average direct oil and gas lifting costs worldwide of
$3.87 per barrel in 2003.9
The cost measure of greatest significance for the future oil supply
is incremental reserve development cost. It represents the cost of
Yergin, "It's Not the End of the Oil Age," editorial, Washington Post,
July 31, 2005.
6Guy Caruso, "When Will World Oil Production Peak?" 10 Annual Asia Oil
EIA,
2005,
13,
June
Conference,
Gas
and
http://www.eia.doe.gov/neic/speeches/main2005.
7 "Saudi Oil Policy Combines Stability with Strength, Looks for Diversity,"
Oil & Gas Journal 98, 3 (January 17, 2000): 17. The statement refers to
"full" cost, but the context indicates operating cost.
8 Thomas R. Stauffer, "Trends in Oil Production Costs in the Middle East,
Elsewhere," Oil & Gas Journal, 92, 12 (March 21, 1994): 107
9
Performance Profiles of Major Energy Producers 2003;
http://www.eia.doe.gov/emeu/perfpro/chl sec5.html.
5 Daniel
42
creating additional oil reserves and can be thought of as an inventory
replacement cost. The "Big Four" Persian Gulf producers Iran, Iraq,
Kuwait, and Saudi Arabia, have by far the lowest replacement cost; it
has been estimated between $1 and $2 per barrel.' 0 The U.S., being
the most intensely developed oil producing area in the world, faces
some of the highest costs among major producers, upwards of $25 per
barrel in the lower 48 states. Figure 3 shows incremental cost ranges
for major oil producing countries throughout the world. "
The sum of lifting and development costs in much of the Middle
East thus falls in a likely range of $2.50 to $3.50 per barrel and
certainly is below $5 per barrel. The OECD cites costs in the Middle
East of less than $5 per barrel of oil as does the EIA. 12 The costs cited
in this paper do not include taxes, which can be substantial.
10 Thomas R. Stauffer, "The Economic Cost of Oil and Gas Production: A
Generalized Methodology," The OPECReview 28, 2 (June 1999): 192.
" Worldwide cost studies of more recent vintage have not been found, but the
EIA's data on foreign finding costs per barrel of oil equivalent (boe) show that
costs have remained stable since 1994. Finding costs are the exploration,
development, and property acquisition costs of replacing oil and gas reserves
removed through production. The three-year average foreign cost computed
by the EIA, in real terms, has moved between $5 and $6 per barrel from 1994
to 2003, except in 1996 when it was $4.73. Prior to 1994 finding costs had
been higher. In the U.S. costs rose in the past two three-year periods;
http://www.eia.doe.gov/ emeu/perfpro/figl6.gif. However, as an absolute
measure finding costs are problematic, because the data comes only from U.S.
companies subject to the EIA's Financial Reporting System (FRS) and for the
reasons given in note 13 following.
12 OECD Economic Outlook, Vol. No. 76, December, 2004/2, p.123; "Oil
Production Expansion Costs For The Persian Gulf, 1994-2010," EIA, January
1996, Table 6 and author's calculations.
43
Figure 3
INCREMENTAL CRUDE OIL PRODUCTION COSTS
Iraq
i
Iran
0
S.Arabia
0
I
I
E
Kuwait
Venezuela
J
I
|
Nigeria
I
I
I
I
I
]
I
l
Russia
.
Alaska N. Slope
U.K. North Sea
U.S. Offshore
Alberta
.
I
I
I
I
I
I
I
I
I
25
30
.
U.S. Lower 48
o
5
10
15
20
35
$PER BARREL
Source: Thomas R. Stauffer, "Trends in Oil Production Costs in the Middle
East, Elsewhere," Oil & Gas Journal, 92, 12 (March 21, 1994): 105-107.
Technological advances have made unconventional oil
development economical. In 2004, Canada's oil sands production
exceeded 1 million barrels per day. Canada's oil sands projects are
reported to require a price of oil around $25 per barrel to be profitable,
implying development plus operating costs in that range. 1 3 This
means that world oil reserves can be replenished and produced at
a cost of less than $5 per barrel by the world's low-cost producers,
and a cost in the vicinity of $25 per barrel by high-cost producers
in existing oil producing areas.14 However, development investments
are large in absolute terms and essentially irreversible. This exposes
Canadian Association of Petroleum Producers, "Canadian Crude Oil
Production and Supply Forecast, 2004-2015,". p.5; Sam Fletcher, "N.
American Unconventional Oil a Potential Energy Bridge," Oil & Gas Journal,
April 11, 2005; 103, 14, p.22; Tamsin Carlisle, "A Black-Gold Rush in
13
Alberta," Wall Street Journal, September 15, 2005.
Exploration costs per barrel of oil are difficult to isolate and assign
appropriately because (a) most new oil is found through incremental
development of existing oil fields, (b) time lags in oil discovery and
development complicate exploration cost assignment to production volume,
and (c) oil and gas tend to occur together but not in fixed proportion. Oil
sands development requires no exploration. The cost of exploration perboe
thus is not a useful concept. See M.A. Adelman, The Genie out of the Bottle,
World Oil since 1970, (MIT Press, 1995), 20 and 37, for a critique of this
measure. In any event, according to its oil minister, Saudi Arabia's cost of
finding new reserves is less than
10 cents per barrel (op. cit.).
14
44
high-cost producers to added risk, especially in a market that is subject
to manipulation (see discussion of non-OPEC producers in Part IV.)
III. The OPEC Cartel
Low cost producers collude openly. Established in 1960, the
Organization of the Petroleum Exporting Countries (OPEC) is an
intergovernmental cartel. The member nations own different oil fields
and operate production facilities through state-owned oil companies in
the Persian Gulf, Africa, South-East Asia and South America. The
membership includes Iran, Iraq, Kuwait, Saudi Arabia ("The Big
Four"), Qatar, the United Arab Emirates (U.A.E.), Algeria, Libya,
Nigeria, Indonesia, and Venezuela. OPEC conducts formal meetings
to discuss oil prices and output, share information, and coordinate the
market activity of its member countries for the purpose of increasing
their oil revenue. In 1982, OPEC started to assign explicit crude oil
production quotas to each individual member country (Iraq has not
been part of the production agreements since 1998). Previously, the
OPEC members had coordinated the offer prices they posted for their
crude oil. Professor M.A. Adelman, whose studies of the oil industry
span decades, has described the cartel as follows:
OPEC is a forum whose members meet from time to time to
reach decisions on price or on output. Fixing either one determines
the other. ... They refrain from expanding output in order to raise
prices and profits. Because each member's cost is far below the
price, output could expand many fold if each producer followed his
own interest to expand output, which would lower prices and
revenues. Only group action can restrain each one from expanding
output. '
Needless to say, if U.S. companies engaged in price fixing and
concerted output restriction they would be in per se violation of antitrust laws.
Holdina back the flow of oil. OPEC has huge known oil reserves.
Its reserves are currently estimated at 885 billion barrels versus 393
billion barrels for non-OPEC producers (Figure 4). 16 Yet OPEC
releases its oil to the market at an artificially low rate. OPEC today
barely produces more than it did in 1977 when world oil
consumption was 61.8 million b/d whereas consumption is now
approaching 85 million b/d. In 2004 OPEC's daily production was
M.A. Adelman, "The Real Oil Problem," Regulation (Spring 2004): 20.
M.A. Adelman is professor of economics emeritus at the Massachusetts
Institute of Technology.
16 "Annual Special World Wide Report," Oil & Gas Journal, 102, 47
(December 20, 2004); EIA presents but does not certify foreign reserve
estimates.
15
45
32.9 million barrels compared to 50 million barrels for non-OPEC
countries (Figure 5). Non-OPEC production, which was about the
same as OPEC's in 1977, has increased by two-thirds since 1977 and
today far exceeds OPEC's rate of production. Professor Adelman has
observed that "for lower-cost output to fall or stagnate, while
higher-cost output rises, is like water flowing uphill. Some special
explanation is needed...."
Figure 4
KNOWN OIL RESERVES
Billions of Barrels
1,400
1,200 1,000i
OPEC
800
600
400200 1980
Non-OPEC
1985
1990
1995
2000
2005
The special explanation is that OPEC holds back output to support
the price, whereas producers acting independently sell what they can
when the market price exceeds their cost. The OECD concurs, stating
that, "OPEC and the reserve-rich producers in the Middle East have
incentives to exploit [their] cost advantage by trading off market share
for a higher price."' 7 Given the large size of its known reserves, OPEC
definitely has the ability to increase production substantially. Even
OPEC delegates reportedly have indicated that the cartel is capable of
raising production by one-third to 44 million b/d by 2009.18
M.A. Adelman, "World Oil Production and Prices 1947-2000," The
Quarterly Review of Economics and Finance 42 (2002): 169. Professor
Adelman provides a thorough discussion of the OPEC cartel, its output
manipulation and its effect on price in this article. OECD Economic Outlook,
Vol. No. 76, December, 2004/2, p. 12 3 .
'8 Carola Hoyos, "West Told Oil Demand is Too Much for OPEC," Financial
Times (FT), July 7, 2005.
17
46
Figure 5
OPEC And Non-OPEC Oil Supply
Millions of Barrels Per Day
60
50
Non-OPEC
40
Oil
Embargo
30
~'Peius,.
20
Asian
Currency
crisis
".an-Iraq
_
war
O
iPirevios
f
OPEC_
Productidn Peak
10
'S
Durce
0
1970
1975
1980
1985
1990
1995
2000
Spare -capacity. Moreover, OPEC has-had substantial excess shortrun production capacity. Figure 6, reproduced from the IMF's April
2005 World Economic Outlook, shows OPEC idle production capacity
over time.
Figure 6
OPEC'S SPARE PRODUCTION CAPACITY
- 4u
- (19701-04; millions of barrels a day)
. . .p |1 __ Capacity -
Production
- 30
- 20
-
1970
73
76
79
82
85
88
91
94
97
2000
1l
03
Source: IMF World Economic Outlook, April 2005.
OPEC's spare short-run production capacity has been viewed as a
"safety margin" that can be tapped quickly-within 30 days according to
the EIA's definition-in case of supply disruptions or demand surges
and its reported decline. as a reason for higher prices. This logic is
inverted. OPEC does not hold excess production capacity for the
benefit of oil buyers. Significant, persistent excess production capacity
is an indication of strategic output curtailment.
At an average
worldwide lifting cost of less than $4 per barrel, a price of, say, $20 per
47
barrel would yield more than $16 in gross margin. Producers who forgo
this size margin on any appreciable volume of sales have a strategic
motivation. Non-OPEC producers do not hold excess capacity. From
the beginning of 2002 to the first quarter of 2004, the worldwide average
crude oil price rose from less than $20 to $30 per barrel and also
exhibited short-term swings close to ten dollars in magnitude. Several
OPEC members were sitting on excess short-run capacity during this
time that could have been activated within a month's time. As the price
rose above $30 per barrel, more of the excess capacity was activated (the
gross margin exceeding $26 per barrel), but to this day Saudi Arabia is
reported to have surplus production capacity of 0.9 to 1.4 million b/d.1 9
This surplus is not being used to lower the price. In the wake of
Hurricane Katrina, OPEC declared its willingness to produce as much
oil as needed. As Hurricane Rita gained strength in the Gulf of Mexico,
OPEC even announced suspension of its output quotas. But when asked
about discounting oil Saudi Oil Minister Ali Naimi said: "Absolutely
not. I don't want to bring it on the market unless the consumer wants it
at the commercial rate." 2 0 The commercial rate was near $70 per barrel
at the time. Katrina, though more devastating than anticipated, had no
adverse effect on the price of crude oil after the fact; the price actually
fell because buyers' stocks from the strategic petroleum reserves were
released to the market. Thus the price of crude oil will be lower and
more stable if spare capacity is held by oil buyers (in the form of oil
stocks), not if it is held by oil sellers with monopoly power.
Price volatility. The price of oil used to be low and stable. The
price per barrel fluctuated over months, not years and by cents or ten
cents, not tens of dollars, notwithstanding increasing oil consumption,
threatening political events and severe weather conditions. From the
end of World War II until the oil embargo of 1973, Arabian Light
crude oil sold for less than $2.50 (about $10 in 2004 dollars) per barrel
in Ras Tanura, Saudi Arabia's Persian Gulf oil terminal. Then OPEC
imposed the oil embargo; the price shot up and started to gyrate.
Figure 7 shows the history.
'9 EIA, Table 3a, OPEC Oil Production; Reuters reports OPEC's president
stated that OPEC has spare capacity of 2 million b/d. "Oil Prices Near
'Acceptable' Levels: OPEC," October 29, 2005.
20 Bhushan Bahree, "OPEC Suspends its Output Quotas," Wall Street Journal,
September 21, 2005, p. A5.
48
Figure 7
CRUDE OIL PRICES SINCE 1945
90
80
--
Iran-Iraq
War .
-
-
-
-
70
e60
Oil
I
Embargo
240
i_
a
1
_-t
s
j
10
0 .1
1945
,,,.,,
,, ,, ', .,,,,,.1
, ,,,
1955
1905
1975
1985
1995
_nominal price __price In 2004 dollars
Source: BP Statistical Review of World Energy, June 2005
Output manipulation. OPEC's effectiveness as a cartel has been
questioned because an unstable price could suggest a lack of control
over the market. Furthermore, prices had fallen below $20 for many
years which seemed low compared to the price peaks of the 1970's and
1980's. However, under changing market conditions it is far more
difficult to maintain price or profit targets with compensating output
adjustments that are timed correctly than it is to simply push the price
above cost. In a dynamic market OPEC cannot go through an output
adjustment process only once to get the margin it wants. It has to keep
manipulating output and will know only after the fact if it could have
driven the price higher or if it caused the price to rise too much. To
maximize its profit over time, OPEC must take into account that a
price level achieved in the short-run may not be sustainable in the longrun, because demand is more price sensitive (elastic) in the long-run as
is the output of alternative suppliers. Once customers and competitors
have had time to react to a higher price, OPEC may have to cut output,
accept a lower price or a combination of both. Large price swings
reveal errors in forecasting and execution, not. a lack of power to
move the price.
In the 1970's OPEC misjudged the industrialized world's ability to
conserve and find substitutes for oil and drove the price too high.
Consumption fell by 6.4 million barrels per day from 1979 to 1983. At
the same time, OPEC underestimated non-OPEC supply. Oil fields in
Alaska's North Slope, Mexico, and the North Sea had been discovered
49
and committed to development before the 1973 OPEC oil embargo.21
OPEC reduced its production up to 14 million barrels per day from
1977 to 1985-a reduction of 45 percent-and managed to hold the
market price in a range between $15 and $21 per barrel for the most
part from 1986 to 1999.22 World output continued growing, because
the price remained above the incremental cost of non-OPEC producers.
Had there been no cartel action to prevent it, the price would have
fallen back down to OPEC members' cost.
OPEC's internal management problems further complicate the
execution of joint output plans. Holding back output cooperatively is
difficult, because each producer's incentive individually is to expand
output when the price exceeds cost. Professor James L. Smith of the
Southern Methodist University provides a most apt description of the
cartel: "OPEC acts as a bureaucratic syndicate; i.e., a cartel weighed
down by the cost of forging and enforcing consensus among its
members, and therefore partially impaired in pursuit of [its] common
good." 23 Professor Adelman is blunter: "Since cooperation is usually
difficult, reluctant and slow, members' output overshoots or
undershoots the demand. Prices are volatile not because of methods of
production or consumption, but because of the clumsy cartel."24
A study released in June 2005 by the Federal Trade Commission
(FTC) confirms that OPEC has tried to cut or increase production to
enforce a per barrel price band of $22 to $28 per barrel. The FTC
concludes that while these efforts where only sporadically effective,
OPEC "has been successful in exercising a significant degree of market
power and in obtaining prices above competitive levels." The
Economist reports that OPEC cleverly reduced its quotas to stop prices
from softening whenever oil stocks in OECD countries started rising. 25
M.A. Adelman, The Genie out of the Bottle, World Oil since 1970, (MIT
Press, 1995), pp. 150-153.
22 In over 30 years, the world-wide weighted average crude oil price computed
by the EIA fell to a low between $9 and $10 for just eight weeks. Data
supplied by EIA.
23 James L. Smith, "Inscrutable OPEC? Behavioral Tests of the Cartel
Hypothesis," The Energy Journal;2005, 1.
Professor Smith presents quantitative evidence of the cartel's output
manipulation. He also discusses reasons why several other studies had failed
to do so. Professor Smith is Cary M. Maguire Chair in Oil and Gas
Management.
24 M.A. Adelman, "World Oil Production and Prices 1947-2000," The
QuarterlyReview of Economics andFinance42 (2002): 171.
25"Gasoline Price Changes: The Dynamic of Supply, Demand, and
Competition," Federal Trade Commission, June 2005, p.23; "Oil in Troubled
Waters--A Survey of Oil," Economist, (April 30, 2005), p.4 .
21
50
Indeed, OPEC has collected enormous monopoly rents since 1973.
The Economist cited an estimate in 2003 that over $7 trillion dollars in
wealth has been transferred from American consumers alone to oil
producers since the 1973 oil embargo by keeping the oil price above its
true market-clearing level. 26 The EIA estimates that OPEC will collect
$430 billion in net oil export revenues in 2005; that is $92 billion more
than in 2004.27 Stable or not, high oil prices are hugely profitable.
for OPEC and they are kept high only by collusion. Addressing the
Houston Forum in October 1999, Ali I. al-Naimi, Saudi Arabia
Minister of Petroleum and Mineral Resources, stated that "one thing is
for sure: Saudi Arabia cannot accept a low oil price. Yet it cannot
defend the world oil price all by itself, it can do so only in cooperation
with other producers. We have tried doing it alone in the past and it
did not work." 2 8
Secretiveness. Among the troubling characteristics of OPEC is its
lack of transparency. It does not permit outside inspection of its
reserves or production facilities, does not release timely, accurate
output data and does not reveal its future output plans or price targets.
Inadequate information from OPEC renders industry data incomplete
and forecasts highly unreliable. 29 This adds unnecessary uncertainty
that can misdirect investment decisions and set off or exacerbate
speculative forces in the oil market. Born from internal posturing and
cheating relative to the cartel's quota allocations, the OPEC member's
aversion to transparency serves no positive purpose. Secretiveness
fosters duplicity in the members' dealing with each other and with
the outside world.
Transparency International's Corruption
Perceptions Index 2005, surveyed 159 countries and. rated them on a
corruption scale from 0 (most) to 10 (least). It shows seven OPEC
countries with a score of less than 3.3°
IV. Non-OPEC Producers
Crude oil is sold in standardized grades on a world market.
Individual oil producers typically do not account for enough supply to
move the market price to their advantage. They are price takers.
Hence they operate close to their short-run pumping capacity. With the
"The End of the Oil Age," Economist, October 25, 2003, p.1 1.
27 "OPEC Revenue Fact Sheet," EIA, June 2005.
28 "Saudi Oil Policy Combines Stability with Strength, Looks for Diversity,"
Oil &Gas Journal(January 17, 2000): 98, 3, p.18 .
29 Bhushan Bahree, "Oil Forecasts Are a Roll of the Dice," Wall Street
Journal, August 2, 2005.
30 "Transparency International Corruption Perceptions Index 2005,"
Transparency International, The Coalition Against Corruption;
http://www.transparency.org/surveys/index.html#cpi.
26
51
upper bound of operating costs estimated at $6 per barrel, producers
who take the market price as given would leave highly valuable output
in the ground, if they do not operate their wells at capacity. Each well
is subject to a declining flow rate which steadily raises a well's
operating cost per barrel of oil produced. When a well's operating or
lifting cost exceeds the market price, it is capped. Short-run output
flexibility is provided by the rate at which aging wells are shut down,
which depends on the market price.
Non-OPEC producers will respond to a rising oil price by keeping
older wells operating longer and by drilling new ones. But upfront
investment in new production is essentially irreversible. Since
investors know that OPEC can move the price up as well as down but
do not know what its plan is, they are more hesitant to invest than they
would be if the market were not subject to manipulation. The
heightened uncertainty can delay an adequate supply response to a
rising price. By the same token, once new supply capacity is in place
it takes an exceedingly low price (below operating cost) to shut it
down. According to Adelman, "Oil prices fluctuate more because
betting on price must include calculations about not just supply and
demand, but also about OPEC's quota decisions, plus the members'
fidelity to their promises. Hence, the world oil market is less
predictable, more volatile, and more herky-jerky." 3 ' The IMF World
Economic Outlook concludes: "The unpredictability and volatility of
oil prices also has deleterious effects on investment in the oil sector. ...
The impact of price volatility on investment could generate a vicious
cycle whereby low or delayed investment activity could in turn add to
Claude Mandil, Executive Director of the
price volatility." 3 2
International Energy Administration (lEA), in a statement dated June
29, 2005 and posted on the IEA website, has called for OPEC
governments to announce clearly their programs and schedules for new
capacities. They have not done so.
V. Demand for Oil
Economic growth. Oil is needed for industrial production, electric
power generation, and transportation. In the developed countries, oil
demand from all three was increasing rapidly prior to 1973. But the oil
price spikes of the 1970's and 1980's caused the OECD countries to
curtail their demand for oil through input substitution and conservation.
Industry .and utilities in substantial measure have shifted to other
energy sources (e.g., natural gas). The transportation sector was forced
to conserve fuel through minimum mileage requirements for cars in the
31
32
M.A. Adelman, "The Real Oil Problem," Regulation, Spring 2004, 20.
IME World Economic Outlook, April 2005, Chapter IV, p. 160.
52
U.S. and high gasoline taxes in other countries. World oil consumption
fell as a result and even substantial economic growth in OECD
countries thereafter caused it to rise only gradually. Since 1979, U.S.
oil consumption increased by 12 percent in which time the nation's
real GDP more than doubled. Figure 8 shows the much lower
trajectory of OECD oil consumption since the 1980's compared to the
period prior to the embargo. In non-OECD countries meanwhile,
economic growth has led to greater increases in oil consumption. In
1973 non-OECD countries accounted for 27 percent of world oil
consumption; in 2003 they accounted for 40 percent. Developing
Figure 8
WORLD OIL CONSUMPTION
90
Iran-Iraq
80
Non-
Embargo
o ° /40
7 - -
OECD~~~~~~OEC
__ __
E°3
'
g
COUNTRIES
20
|~~~~~~~Scarce
EIA Data|
.
1960
1965
1970
1975
1980
1985
1990
1995
2000
economies are much less energy and oil efficient than the more
developed economies and their growth is more oil dependent.
The People's Republic of China (PRC) for example is less than half as
efficient in the use of oil per unit of GDP as the OECD average. 3 3
Some countries, such as the PRC and Indonesia, actually subsidize the
use of oil domestically to mitigate the adverse impact of high oil prices
on their economy.
Asian demand. Economic development in Asia is a major new
force in the world, and its oil consumption accounts for most of the
increase. Figure 9 shows the steep rise in Asian consumption. It
overtook U.S. oil consumption first in 1997 and, after the Asian
currency crisis had set it back temporarily, again in 2000.
33
James Hookway, "Thailand Tries to Prop Up Economy," Wall Street
Journal, August 30, 2005.
Paul Blustein and Craig Timberg, "High Oil Prices Met With Anger
Worldwide," Washington Post, October 3, 2005.
34
53
Figure 9
US AND ASIAN OIL CONSUMPTION
25
20
E
u~~~~~s,
_ - _Asl~~~Asan/
>
10
5
_
1980
.
1985
_
_
_ _. _
_ _
1990
_
~ ~ ~
1995
n~tA.
2000
Of the 4.8 million barrel increase in daily world oil consumption
from 2001 to 2004, 3.29 million (69 percent) came from non-OECD
countries and 2.32 million (48 percent) came from non-OECD
countries in Asia. The new demand has been coming primarily from
the PRC and India. From 1990 to 2003 the shares of oil consumption
by the three largest oil consuming nations in Asia changed
dramatically: The PRC's share rose from 18 percent to 26 percent,
India's share rose from 8.5 percent to 10.5 percent, and Japan's share
of oil consumption fell from 38 percent to 25 percent. The PRC is now
the largest oil consuming nation in Asia.
VI. Analysis of Oil Price Developments Since 1998
OPEC reclaims market share. Growing Asian demand helped
OPEC to boost its oil production and market share from their 1985
levels without causing the price to decline further. The steep rise in
Asian oil demand starting in 1986 (Figure 8) coincides with the recovery
of OPEC's rate of production (Figure 4) and market share, which
increased from 29 percent in 1985 to 40 percent by 1994. In 1997,
OPEC committed a miscalculation, however, and suffered a severe
setback. It raised its production ceiling substantially by 2.5 million b/d
in anticipation of further demand growth from Asia, but it guessed
wrong. 3 5 The currency crisis of late 1997, instead, caused Asian
demand to fall. The result was a market price that dipped below $10 per
barrel for the first time since 1973, and a $51 billion year-over-year
reduction in oil revenue.
For a more extensive discussion of this event and OPEC's subsequent
actions, see Wilfrid L. Kohl, OPEC behavior, 1998-2001, The Quarterly
Review of Economics andFinance42 (2002), 210-213.
35
54
Price rises as OPEC restrains output. OPEC quickly lowered its
output quotas and kept them below the level adopted in December
1997 for the next seven years. This despite the fact that world oil
consumption recovered and in 1998 was higher than in 1997. The
attacks of September 11, 2001 caused oil demand to fall, but world oil
consumption was still 4.4 million b/d higher in 2002 (78.5 million b/d)
than it had been in 1998 (74.1 million b/d). Yet OPEC cut its quotas
for all of 2002 to a level 5.8 million b/d below that of December 1997
(21.7 vs. 27.5 million b/d). Its market share fell to 37.6 percent.
World oil consumption subsequently accelerated, increasing by 1.53
million b/d from 2002 to 2003 (to 79.9 million b/d), and by 2.57
million b/d from 2003 to 2004 (to 82.5 million b/d). OPEC finally
raised its quotas in 2003 and regained market share, but it subsequently
lowered its quotas again, while the price was rising. As late. as. April
2004, it reduced its quotas to 23.5 million b/d. In December. 2004, it
resolved to cut back member output that was exceeding its quotas. 36
Prices had been in the mid-$30s per barrel in December 2004;. by the.
last week of January 2005, they exceeded $40 per barrel and continued
to climb. Only in April of this year did OPEC bring the quotas back up
to the level in effect at the beginning of 1998. It finally raised its
output ceiling by another 0.5 million b/d effective July 1, 2005. On
June 25 of this year OPEC's president was quoted by The Wall Street
Journalas saying.that there was a need to observe price further before
raising the production ceiling again. The price for West Texas
Intermediate crude .oil had just reached $60 per barrel. 37
OPEC's 133rd meeting on December 10, 2004; EIA, Country Analysis
Briefs, "OPEC," June 7, 2005.
37 "OPEC President Will Wait Before Making Output Hike," The Wall Street
Journal,June 25, 2005.
36
55
Figure 10
60
WORLDWIDE AVERAGE CRUDE OIL PRICE
50
,I
-1
A,
w
X 40
m
'u 30
-
en
20
5
I
10
10
N
ii
n I
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Figure 11
40
---- --
, OPEC OIL OPEC QUOTAS AND OIL SUPPLY
:4 30
02
'I
. 25
20
w 20
=
15
E10
0
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
OPEC's quotas are set for crude oil only. Total oil supply consists
of lease condensate, natural gas plant liquids, and refinery processing
gain in addition to crude oil. Because of these additional components
56
and deliberate overproduction by some members, OPEC's total oil
supply exceeds its quotas. As Figure 11 shows, total OPEC supply
nevertheless correlates to the crude oil quotas and was held below or
close to its 1998 level until 2004 when it moved modestly higher. In
2004, world oil consumption had grown to 82.5 million b/d and the price
had been rising almost continuously since early 2003.
When demand increases and sufficient additional oil is not offered
to fully accommodate the increment, buyers. will allocate among
themselves what quantity is available by bidding the price up. Since
1998, OPEC has managed its rate of oil production so that when demand
increased it would not be fully accommodated and the price-was bid up.
There were brief phases when demand declined, and OPEC may have
been concerned that Asian demand would recede again. It may. have
been overly restrictive in its production and also slow to invest in
capacity expansion for this reason. OPEC shrouds its oil industry in
secrecy. It is not known to what extent its conduct has been shaped by
an overly cautious strategy to prevent another price collapse or by a
deliberate plan to bring about a higher price. The fact is that the price
of oil did not have to rise. OPEC members hold more than enough
oil reserves to satisfy increases in demand, and in the Middle-East- it
costs less than $5 per barrel to produce more oil. Yet despite facing
increases in world- oil consumption year after year, OPEC did not
raise its output quotas above the level of early 1998 until April of
2005.
Other explanations for high oil prices. An inadequate supply side
response to increasing demand magnifies the price impact of any
occurrence that lessens, even minimally, the amount of oil available for
purchase. In the short-run input substitution typically is a very limited
option, which makes oil buyers willing to bid the crude oil price up
disproportionately to try to meet their requirements (demand is
inelastic). This heightens concerns over events that normally would not
move the price of oil on the world market, such as accidents or labor
strikes somewhere in the oil supply chain. Natural disasters, terrorist
attacks or production problems in a major oil producing country
certainly can have an effect on the price of oil, but these events also are
usually compensated for in short order in an unfettered market. Supply
shocks of this kind occurred prior to the oil embargo of 1973 as well,
but they were absorbed so quickly that annualized price data shows
no variations (see the nominal price line in Figure 7). It is also useful
to recall the complaint by Mr. Ali I. al-Naimi that Saudi Arabia-the
largest oil producer in the world-cannot hold up the market price of oil
by itself, which strongly suggests that no other country can either,
whatever the nature of the supply problem. The reason for high oil
57
of the oil supply by the cartel
restriction
collective
ongoing,
is
the
prices
members.
Refinery "bottlenecks." OPEC has claimed that insufficient
refinery capacity is linked that to high crude oil prices. 3 8 This is not
logical. Refineries process crude oil. If they are operating at full
capacity, then the rate at which they can use unprocessed crude oil has
reached a limit and they will not bid the price up to buy more. On the
other hand, if OPEC were to bring more crude oil on the market, that
would lower the price.
Different grades of crude oil require different types of refining
capacity. In the short-run, imbalances can arise that may cause price
differentials among different crude oil grades to. widen temporarily.
This has occurred with respect to lower sulfur (sweet) and higher sulfur
(sour) crude oil grades. But refiners in time adapt their facilities to
changing price differentials for different quality grades. The dramatic
upward price trend in all crude oil grades cannot be explained by
limitations in all or some types of refining capacity.
OPEC's output restriction expected to continue. When an
increase in oil scarcity is perceived to be temporary, the spot price of
crude will rise but oil futures prices for long term delivery will not.
Crude oil delivery prices exceeding $60 per barrel extend to 2011.
This timeframe is longer than it takes to drill more wells and increase
production capacity. Saudi Arabia earlier this year embarked on a $50
billion program to expand its petroleum industry over the next five
years to 2010.39 OPEC has indicated that it could increase production
by 11 million b/d by 2009. Daniel Yergin of Cambridge Energy
Research Associates (CERA) recently stated that "between 2004 and
2010, capacity to produce oil (not actual production) could grow by 16
million barrels per day-from 85 million barrels per day to 101 million
barrels a day-a 20 percent increase. Such growth over the next few
years would relieve the current pressure on supply and demand." 4 0
The CERA forecast is based largely on projects already under
development that had been approved in the 2001-2003 timeframe with
lower price expectations than current prices. The forecast implies a 3
percent average annual compound growth rate of capacity. Since 2001,
world oil consumption has been increasing at an average annual
compound growth rate of 2 percent. How can oil futures prices remain
Acting for the OPEC Secretary General, Dr. Adnan Shihab-Eldin delivered
a speech at an OPEC/IEA luncheon on September 28, 2005, "OPEC-1EA
Outlook;"
Market
Oil
International
the
and
Cooperation
http://www.ope.org/opecna/Speeches/2005/OPECIEA.htm.
39 Wall Street Journal, June 6, 2005.
40 Daniel Yergin, "It's Not the End of the Oil Age," editorial, Washington
Post, July 31, 2005.
38
58
so high then? Yergin goes on to say that the capacity growth is "pretty
evenly divided between OPEC and non-OPEC." Therein lays the
answer. If OPEC does not fully utilize its capacity, then incremental
production could be as much as halved and prices would stay high.
OPEC has a history of holding back production to support the market
price and it could continue to do so, compensating for non-OPEC
supply increases. As Phil Verleger of the Institute for International
Economics and The Economist put it: "Investors [in oil futures]
believe the OPEC cartel will cut output to stop prices falling.",41 If
demand continues to grow sufficiently, OPEC may even have room to
raise its production at a controlled pace while prices remain high or are
pushed higher. The OECD puts it this way: "The less elastic global oil
demand and non-OPEC supply are in the long-run, the greater are
OPEC's incentives to restrict output and thus raise prices in the face of
rising world demand."4 2
VII. The Long-Run
Oil futures prices over $60 per barrel for delivery as late as six
years hence (201 1) point to a scenario in which strong demand growth
from developing economies compensates for countervailing market
forces and strengthens OPEC's. pricing power. However, the longer
the timeframe considered, the greater the elasticity of global oil
demand and of non-OPEC supply is likely to be. Six years was the
timeframe from the oil embargo (1973) to the oil price peak (1979).
Thereafter the price plummeted. Oil sands production today is at a
beginning stage, just as Alaskan and North Sea production had been in
the 1970's. The use of oil in developing nations is relatively inefficient
and also may experience improvements similar to those in more mature
economies.
Moreover, new technologies in the oil intensive
transportation sector, for example hybrid electric vehicles, are gaining
acceptance and could be deployed throughout the globe, not only in
developed countries. 43
Since the Asian currency crisis, OPEC has taken pains to reduce
output at any sign of softening demand. It has increased output only
gradually when demand has risen.
This strategy indicates
preoccupation with price in the near tem, not with long-run forces
mobilized by large margins over incremental development cost. The
market price has moved far beyond the $22 to $28 per barrel price
"Oil in Troubled Waters, A Survey of Oil," Economist, April 30, 2005, p. 4.
At the time the price was $40 per barrel. Both spot and futures prices are now
over $60 per barrel.
42 OECD Economic Outlook, Vol. No. 76, December, 2004/2, p.123
43 See, for example, Jathon Sapsford, "General Motors Joins Rush to Make
Hybrids in China," Wall Street Journal, October 31, 2005
41
59
band OPEC once sought to maintain. It appears that OPEC's members
have been adjusting upward their view of what the long-run sustainable
crude oil price is along with the upward movement of the market price.
In June of this year, OPEC's ministers reportedly indicated that they
would "like to see" a price below $50 per barrel, but there was no
consensus on how much lower, though not below $30.44 More recently
OPEC officials are said to believe that the market may support a price
well above $50 per barrel. 45 The enormous revenue increases for
OPEC brought on by the price surge-from $338 billion in 2004 to an
estimated $430 billion in 2005 alone-provide a powerful inducement
for members to regard a high price as the "right" price. It will be
difficult for OPEC's members to change their bias toward
underproduction when it has resulted in growing riches. This could
portend continuation of high prices for the next several years and a
subsequent recurrence of the price decline seen after 1979.
VIII. Conclusion
The world is not running out of oil. Crude oil is an abundant
resource. The rate at which it enters the world's economic oil supply
inventory depends on the price, development costs, and technology.
The supply of oil therefore is not fixed, and known oil reserves, in fact,
have been increasing, not decreasing.
Unfortunately, the price of oil bears no relation to the scarcity of
oil in the ground or to the cost of getting it out of the ground. The
OPEC cartel controls 70 percent of the world's known oil reserves and
manipulates how much oil reaches consumers. It imposes an artificial
scarcity on the market that elevates the price manyfold above Middle
East production cost of less than $5 per barrel and far above the cost of
other producing areas as well.
The market price of oil is also highly unstable, because the cartel is
not able to accurately anticipate market changes and administer
compensating output adjustments. In the short-run, OPEC commits
errors in timing and sizing its output changes that set off price
gyrations. In the long-run, it has underestimated the elasticity of oil
demand and of non-OPEC oil supply. In the 1970's it drove the price
up over several years but then had to accept years of price declines. As
Bhushan Bahree, "OPEC Lifts Quota But Urges Increase In Refining
Capacity," Wall Street Journal, June 16, 2005.
45 Michael Williams, "Why OPEC's Over a Barrel," Wall Street Journal, June
16, 2005; September 17-18, 2005, Wall Street Journal, August 30, 2005.
Reuters reported OPEC's president stating that "... Oil prices were
approaching a level acceptable to both consumers and producers after recent
decreases," "Oil Prices Near 'Acceptable' Levels: OPEC," October 29, 2005.
44
60
a result, price trends do not even convey changes in the true scarcity of
oil.
The effect of the price distortion is worsened by OPEC's
secretiveness. The lack of transparency has no benefit to the cartel as a
whole and is associated with cheating and corruption. Other market
participants lack crucial market information including what price
OPEC intends to support and what market share will be left for them.
Especially in a capital intensive industry this delays appropriate supply
responses from non-OPEC suppliers and aggravates price volatility.
Most of the increases in oil demand since the late 1980's have
come from developing countries in Asia. Currently 40 percent of
world oil production is consumed and paid for by non-OECD
countries, up from 27 percent in 1973. One aspect of this shift in
demand is that developing countries increasingly are paying for
OPEC's enormous profits. The EIA estimates that from 2004 to 2005
alone OPEC's net oil revenue will increase by $92 billion.
Rising demand, on the whole, allowed OPEC to sell more crude oil
without lowering the price prior to 1998, and after the Asian currency
crisis, to raise the price while maintaining its sales volume. OPEC's
output quotas were the same in March 2005 as they were in early 1998.
Going forward, if demand continues to grow, OPEC may be able to
keep the price high. Oil futures prices are above $60 per barrel for
delivery dates to 2011, which is beyond the timeframe it would take to
bring substantial production increases online. OPEC is hinting that it
may support prices far above the $22 to $28 per barrel range it tried to
maintain in years past.
However, significant developments on the demand and the supply
side of the oil market are taking hold and could gain momentum
(among them hybrid electric vehicles and oil sands production). The
inflation adjusted historical crude oil price peak occurred in 1979.
That was six years after the oil embargo of 1973 when OPEC first
imposed dramatic price increases.
After the peak, the price
commenced a long, steep decline as input substitution, conservation
measures, and increased non-OPEC production lessened OPEC's
pricing power. The world may be in the first phase of another such
cycle.
Of course, the world could pressure OPEC to produce more oil and
provide more information about its oil fields and production plans, if
not to dismantle the cartel. The first step is to dispense with
misleading representations of oil resource depletion and to place shortrun disturbance to the oil supply outside the cartel in proper
perspective. Secondly, as a cause for high prices, less emphasis should
be placed on increases in oil demand, which, after all, emanate from
61
long awaited economic development in poor countries. Instead,
OPEC's restrictive output policy, large reserves, low costs, and surging
revenues should make the most headlines: "OPEC's output barely
higher than in 1977;" "Mid-East production costs less than $5 per
barrel;" "OPEC to collect $430 billion in 2005." The Third World will
need more oil in order to grow economically. It would benefit from
more responsible policies on the part of the world's oil producers with
the lowest cost and the largest reserves.
62
RANKING MINORITY MEMBER'S
VIEWS AND LINKS TO MINORITY
REPORTS
63
64
RANKING MINORITY MEMBER'S VIEWS AND LINKS TO
MINORITY REPORTS
I. OVERVIEW
The economy grew in 2005, but the benefits of that growth
continued to show up in the bottom lines of companies rather than in
the paychecks of workers. In the recovery from-the 2001 recession,
working families have been left behind from the start, and they
continued to be left behind in 2005.
The signature policies of the Bush Administration and the
Republican Congress have not addressed the problems facing ordinary,
American families. Successive rounds of tax cuts were poorly
designed:to stimulate job creation and produced a legacy of large
budget deficits. Those large and persistent budget deficits contributed
to an ever-widening trade deficit and massive borrowing from abroad.
Most of the benefits of the tax- cuts accrued to very high-income
taxpayers, while cuts in programs that benefit middle- and lowerincome families were viewed as the. best waysto pay for those tax cuts.
Policymakers faced a challenge in 2005 from the devastation
to the Gulf coast from Hurricanes Katrina and Rita. The- economy
suffered a blow to- employment and economic- activity, and a budget
that was already under strain had to absorb- additional. funding for
emergency relief and planned reconstruction.- -In addition, the
hurricanes focused attention on problems that had been ignored, such
as the lack of emergency preparedness, inadequate investment in
critical infrastructure, and, most sadly, neglect of our most
disadvantaged citizens.
Many economists predicted that the economy would be
resilient in the face of the hurricanes (see the JEC Democrats' report
PotentialEconomic Impacts of HurricaneKatrina), and they appear to
have been correct. However, the challenges facing. policymakers
remain (see Meeting America's Economic Challenges in the Wake of
Hurricane Katrina, a forum sponsored by the JEC Democrats and the
Democratic Policy Committee).
Unfortunately, there has been no change in the priorities or
policies of the Bush Administration and the Republican Congress to
address the problems facing the country's most disadvantaged-citizens
or to help ordinary working families deal better with job and retirement
insecurity and the rising costs of energy, health care, and education for
65 o
their children. The Congress ended the first session of the 109'h
Congress debating budget reconciliation bills that would cut spending
on programs that benefit middle- and lower- income families in order
to partially fund the extension of tax cuts that mostly benefit very highincome taxpayers. The rest of the tax cuts would be financed by
adding still more to the budget deficit.
The JEC Democrats' report, Potential Economic Impacts of
HurricaneKatrinacan be found at:
http://www.jec.senate. gov/democrats/Documents/Reports/katrinareport
sepO5.pdf
Materials from the JEC Democrats/Democratic Policy
Committee forum, Meeting America's Economic Challenges in the
Wake of HurricaneKatrina,can be found at:
http://www.iec.senate. gov/democrats/hearings.htm.
II. The Economy in 2005
The U.S. economy grew at an average annual rate of 3.8
percent over the first three quarters of 2005 despite the destruction
caused by the Gulf hurricanes in late August and September. That
growth rate is somewhat faster than the economy's long-term trend rate
of growth, which is generally thought to be in the range of 31/4 to 3 Y2
percent per year.
Above-trend growth was possible because productivity growth
was strong and there was still slack in the labor market from the
protracted jobs slump that began with the 2001 recession. A growing
economy led to a pick-up in job creation and a modest reduction in the
unemployment rate in 2005, but other indicators continued to point to
softness in the labor market.
The Labor Market
Over the first eight months of the year and prior to Hurricane
Katrina, employers added an average of 196,000 jobs per month to
their payrolls. Hurricane-related job losses contributed to a sharp
slowdown in aggregate job growth in September and October, but
national payroll employment picked up again in November when over
200,000 jobs were created. The unemployment rate, which was 5.4
percent at the end of 2004, came down in early 2005 and settled into a
narrow range around 5 percent for the rest of the year.
- 66
For an economy going through the most prolonged jobs slump
in the postwar period, any improvement in the labor market was
welcome. Nevertheless, many Americans remained unemployed and
the official unemployment rate did not reflect hidden unemployment
associated with depressed labor force participation. For those people
with jobs, wage growth lagged far behind growth in output and
productivity. Rising energy prices caused consumer prices to grow
substantially faster than wages. Moreover, wage growth was uneven,
with low-earning workers hit hardest by sluggish wage gains and more
recently by declining real wages.
A protracted jobs slump. The jobs slump associated with the
recession that began in March 2001 was the most protracted jobs slump
since at least the end of World War II (the period over which we have
comparable data). In fact, one would have to go back to the 1930s to
find a worse jobs slump.
On average in the postwar period, job losses have stopped
about a year after the onset of a recession and employment has begun
to increase after about 15 months. Within two years, employment has
surpassed its pre-recession peak and is expanding at a healthy pace.
The most recent jobs slump was dramatically different from that
pattern and even more protracted than the so-called "jobless recovery"
following the 1990-91 recession (Chart 1)..
The 2001 recession began in March and ended in November,
according to the National Bureau of Economic Research, the widely
recognized arbiter of business cycle dating. However, job losses
continued until May 2003-more than two years after the start of the
recession. It was not until January 2005, nearly four years after the
start of the recession, that payroll employment climbed above its
March 2001 level. Payroll employment increased in every month from
June 2003 through November 2005. However, the pace of job creation
over that period was just 149,000 jobs per month-only a little faster
than the pace needed to keep up with normal growth in the labor force.
Whereas it was common to- see job gains of 200,000 to
300,000 and sometimes 400,000 jobs per month in the 1990s
expansion, gains of that magnitude were rare in the recovery from the
2001 recession. The economy created 3.4 milion jobs between the end
of the recession in November 2001 and November 2005. That is 4.9
million fewer jobs than were created over a comparable period in the
recovery from the 1990-91 recession.
67
Indicators of labor market weakness. Millions of Americans who
want to work do not have jobs. Although the unemployment rate has
come down from its peak of 6.3 percent (reached in June 2003), the
rate of 5.0 percent in November 2005 was still 0.8 percentage point
higher than it was in January 2001 when President Bush took office
and a full percentage point higher than it was in 2000.
In November 2005, 7.6 million people were officially counted
as unemployed-1.6 million more people than were unemployed when
President Bush took office in January 2001 (Chart 2). To be counted
as unemployed, a person must be actively looking for work, but in a
weak labor market there can be considerable hidden unemployment
and underemployment if people who want to work have been
discouraged from looking for work and if people who want to work
full-time can only find a part-time job.
68
In a typical business cycle recovery, people come back into the
labor force as the prospects of finding a job improve, but in the most
recent jobs slump labor force participation has remained depressed
compared with what it was at the start of the recession. In November
2005 the labor force participation rate (the proportion of the population
working or actively looking for work) was 1.1 percentage points lower
than it was at the start of the recession in March 2001. As a result of
sluggish job creation and the depressed labor force participation rate,
the proportion of the population with a job (the employment-topopulation ratio) was 1.5 percentage points lower than it was at the
start of the recession.
In November 2005, 4.8 million people who were not in the
labor force said they wanted a job; about 1.4 million of these are
considered "marginally attached" to the labor force because they have
searched for work in the past year and are available for work. At the
same time, 4.2 million people were working part-time because of the
weak economy but wanted to be working full-time. The Bureau of
Labor Statistics estimates that if marginally attached workers were
included, the unemployment rate would have been 5.9 percent in
November 2005, and if those working part-time for economic reasons
were also included it would have been 8.7 percent.
A final indicator of labor market weakness is the fact that the
number of people unemployed for more than 26 weeks is twice as high
69
as it was when President Bush took office. Twenty-six weeks is the
cut-off for regular state unemployment benefits, and the President and
the Republican-controlled Congress failed to renew the Temporary
Extended Unemployment Compensation program when it expired in
December 2003. As a result, those who subsequently exhausted their
regular state benefits did not receive any additional federal benefits,
even though it was difficult to find a new job in a labor market that
remained relatively weak.
The number of long-term unemployed as a fraction of total
unemployment fell below 20 percent in June 2005 for the first time in
32 months-the longest stretch on record in which that fraction
exceeded 20 percent. In November 2005, a still-large 18.4 percent of
the unemployed had been without a job for more than 26 weeks.
Sluggish wage growth. For those workers who are employed, wage
gains have been swamped by increases in the cost of living. Over the
first 11 months of 2005, real (inflation-adjusted) average hourly
earnings of production and other nonsupervisory workers in private
nonfarm establishments fell at an annual rate of 0.7 percent. While the
most recent declines in real earnings have been especially sharp
because of the rise in energy prices, wages have been growing
relatively slowly for some time.
Since the economic recovery began in late 2001, output per
hour in the nonfarm business sector has grown at a 3.4 percent average
annual rate, but the average hourly pay and benefits of the workers
producing that output has grown at an average annual rate of just 1.5
percent after inflation.
Over most of that period non-wage benefits grew more rapidly
than wages, but that is because employers were absorbing higher costs
for the health insurance and other benefits they were providing. The
take-home pay of workers was stagnating. In the second and third
quarters of 2005, total pay (wages plus benefits) did not keep up with
inflation.
Strong productivity growth has boosted national income and
profits, but wages have lagged. From the end of the recession in the
fourth quarter of 2001 until the third quarter of 2005, aggregate
compensation (wages and salaries plus benefits) rose 20.4 percent,
while corporate profits rose 64.2 percent-more than three times as
fast. Aggregate wages and salaries rose just 16.6 percent. As a
70
percentage of national income, -wages and salaries reached an all-time
low in 2004 and remained near historically low levels in 2005.
Unequal wage growth. Real wages at the top of the distribution have
grown, while wages at the bottom have fallen. For example, from the
end of 2000 to the end of 2004, the usual weekly earnings of full-time
wage and salary workers in the middle of the earnings distribution
grew by just 0.2 percent per year after inflation (Chart 3). Earnings
near the top (the 90h percentile) rose by almost, 1 percent -peryear after.
inflation, while earnings near the bottom (the lhth percentile) fell by
0.3 percent per year, on average. That sluggish and unequal growth' in
earnings contrasts sharply with the experience from the end of 1994 to
the end of 2000, when real- wage gains were substantial throughout the
earnings distribution.
Chart '
Most recently, real wages have fallen and some of the largest
declines have been at the bottom of the distribution. For example,
from the third quarter of 2004 to the third quarter of 2005, the real
usual weekly earnings of workers fell throughout the distribution, with
declines of 3.0 percent at the 25th percentile and 2.7 percent at the 1 0 th
percentile. Real earnings at the 9 0 th percentile fell by 2.2 percent. In
the third quarter of 2005, median usual weekly earnings of full-time
71
workers were $649. Earnings at the 90"' percentile of the distribution
were $1,484, while those at the 1O'h percentile were $306.
Energy Prices, Inflation, and Monetary Policy
Energy prices were already rising before the Gulf hurricanes
hit, and, although prices abated somewhat from their storm-related
spikes, energy prices in November 2005 were considerably higher than
they were a year earlier. Prior to hurricane Katrina, the Energy
Information Agency (EIA) expected the average retail price of regular
gasoline to be $2.21 per gallon in the fourth quarter of this year, and to
decline to $2.18 by the end of next year. In its December 2005
forecast, the EIA is expecting average gasoline prices in the fourth
quarter to be $2.38 per gallon, with the same price expected to prevail
at the end of next year. Natural gas prices rose sharply as well, and
home heating costs are expected to be significantly higher in the winter
of 2005-2006 than they were the previous year.
As a result of rising energy prices in 2005, the consumer price
index (CPI) in November was 3.5 percent above its level a year earlier.
However, the underlying rate of inflation-a measure that is more
significant to the Federal Reserve's monetary policy decisions than the
overall CPI-appeared to be little affected by the acceleration in
energy costs. The core CPI (which excludes volatile food and energy
prices) grew a moderate 0.2 percent in each of the last two months. In
November, the core CPI was only 2.1 percent above its level a year
earlier. That suggests that little if any of the rise in energy prices had
so far translated into higher prices for non-energy consumer goods.
A stable underlying rate of inflation is a good thing for
macroeconomic stability, but households must still pay their energy
and food bills. The EIA currently expects that consumers will have to
spend over 25 percent more to heat their homes this winter than they
did last year. For those consumers whose homes are heated solely by
natural gas (nearly 58 percent of U.S. households), the increase in
winter heating expenditures is expected to be close to 40 percent.
Although core inflation has been tame, the Fed has been
raising its target for the federal funds rate-the short-term interest rate
it controls-since June 2004. For much of that period the Fed
described its actions as "removing policy accommodation." In other
words, concern over the weakness of the recovery in 2003 and early
2004 had led the Fed to keep short term interest rates very low, but
once the economy began to show stronger growth, the Fed began to
72
raise rates at what it called "a pace that is likely to be measured." The
policy announcement accompanying the 13th rate hike in December
2005 changed that language. The Fed no longer described monetary
policy as accommodative but it continued to signal the possibility of
further rate hikes "to keep the risks to the attainment of both
sustainable economic growth and price stability roughly in balance."
Rising energy prices could create a dilemma for the Fed if
those increases begin to feed into core inflation while at the same time
contributing to weaker household spending. In such a "supply-shock"
scenario, the Fed would have to choose between tightening monetary
policy (raising interest rates more than they otherwise would have) in
order to keep inflation contained or loosening monetary policy (cutting
interest rates or at least ceasing to raise them)- in order to strengthen
demand and keep unemployment from rising. To date, however, core
inflation and inflationary expectations have remained contained.
III. The Consequences of Irresponsible Fiscal Policy
When President Bush took office in January 2001, the
Congressional Budget Office projected- large and growing federal
budget surpluses under existing laws and policies (the so-called
baseline projection). Those surpluses were projected to cumulate to
$5.6 trillion over the 10 years from 2002 to 2011. In fact, of course,
the surplus was smaller than projected in 2001 and by 2004 a projected.
$400 billion surplus had turned into a deficit of over $400 billion
(Chart 4).
The fiscal year 2005 budget deficit was $319 billion, which is
much lower than was originally estimated in January of this year.
While the improvement in the 2005 budget is welcome, a deficit of
$319 billion is still very large and stands in marked contrast to the
surplus of $433 billion that CBO was projecting in January 2001 when
President Bush took office. Moreover, many analysts believe that the
improvement in the 2005 budget reflects temporary factors that have
boosted revenue this year but that the long-term budget outlook is little
changed and continues to show persistent large structural deficits.
73
Chart 4
Many factors have contributed to the return of large structural
budget deficits after a strong economy and the fiscal discipline of the
1990s had restored the budget to surplus. For example, the 2001
recession caused a temporary cyclical increase in the budget deficit.
But one of the main reasons for the re-emergence of large structural
deficits is the tax cuts enacted over the past four years.
Defenders of the tax cuts argue that they were necessary to pull
the economy out of the recession and that they will contribute to longterm growth. Some even argue that the tax cuts generate enough
revenue to pay for themselves.
In fact, however, the tax cuts were poorly designed to generate
short-term job-creating stimulus without adding to the long-term
budget deficit. A wide range of economists recognizes that tax cuts
increase the budget deficit. Dynamic analyses of the tax cuts by both
the Congressional Budget Office and the Joint Committee on Taxation
conclude that the negative effects of budget deficits tend to outweigh
any positive benefits from the tax cuts on economic growth. A
Congressional Research Service analysis of the dividend tax cut
reached the same conclusion.
74
Tax cuts and economic growth
Proponents of extending the 2001-2003 tax cuts argue that
those tax cuts are responsible for the current economic recovery and
that they need to be extended beyond their statutory expiration date in
order to promote continued economic growth. While the immediate,
one-time tax rebates that were part of the 2001 tax package provided
needed economic stimulus in the short-term, extending the tax cuts
beyond their scheduled expiration will do little to promote the saving
and investment needed for sustained long-term growth. Rather,
extending the tax cuts will increase the deficit, reduce national saving,
and ultimately result in lower national income.
Effects of the tax cuts so far. Despite over $800 billion in cumulative
tax cuts since 2001, economic growth in the period following the 2001
recession was not particularly strong, lagging behind the growth
experienced in the recoveries following previous recessions. In the
recovery following the 1990-91 recession, growth was more rapid than
in the current recovery, even with the tax increases enacted in 1990 and
1993.
The 2003 tax cuts, which lowered the tax rate on dividends and
capital gains and increased the amount of investment expense that
businesses could deduct in the first year, were intended to promote
saving and investment. Proponents of extending those tax cuts point
to the increase in business investment that followed enactment of the
tax cuts as evidence of their success. However, the increase in
business investment that started in the second quarter of 2003 was not
unexpected given the sharp drop in investment during the 2001
recession.
The increase in business investment in this recovery is not
particularly strong when measured against previous business cycles.
Business investment was only 5.8 percent higher in the third quarter of
2005 than it was in the first quarter of 2001. In contrast, business
investment was almost 26 percent higher at a similar point in the
recovery following the recession in 1990-1991.
Tax cuts do not "pay for themselves."
Supporters of the
Administration's economic policies claim that deficit-financed tax cuts
are not a problem because tax cuts lead to increased federal revenues.
Some suggest that the rapid growth in revenues in 2005 is evidence
that "tax cuts can pay for themselves."
75
While revenues were higher than expected in 2005, the
Congressional Budget Office (CBO) attributes little of the additional
revenues to higher-than-expected economic growth. Real economic
growth in 2005 was not stronger than projected by CBO or the Office
of Management and Budget at the beginning of the year. Much of the
recent revenue surprise is the result of strong corporate income tax
receipts following the expiration of the enhanced investment expensing
provisions enacted in 2002 and 2003. As CBO noted in its August
2005 update to its Budget and Economic Outlook:
"CBO now expects that when all revenues for 2005 are tabulated,
corporate tax receipts will exceed its March projection by $53 billion.
[Note: Receipts were actually $62 billion higher than the March
projection.] Only $1 billion of that difference can be attributed to the
revised economic outlook.
"...[T]he sources of the current strength in corporate tax receipts will
not be known until informationfrom tax returns becomes available in
future years, but CBO anticipates that most of that strength will be
temporary."
A comparison of actual revenues with revenue projections
done in January 2001 prior to enactment of the tax cuts does not
support the claim that tax cuts pay for themselves (Table 1). The
revenue shortfall in 2003 through 2005 is almost $900 billion more
than the projected cost of the enacted tax cuts.
It is important to keep in mind that even with the rapid growth
in revenues in 2005, federal revenue expressed as a share of GDP was
17.5 percent in 2005, well below an average revenue share of 18.2
percent since 1960. Federal revenues fell to 16.3 percent of GDP in
2004, the lowest level relative to the economy since 1959. It is not
surprising that the revenue share of GDP would grow as the economy
recovers. However, if the 2001-2003 tax cuts are extended, the
revenue share of GDP will drop below its current level after 2006.
76
Table 1
A Comparison of CBO Revenue Projections with Actual Revenues,
2003-2005
(Billions of dollars)
2003
CBO revenue
(January 2001)
projection
2004
2005
20035-
2,343
2,453
2,570
7,366
Actual revenues
1782
1.880
2,154
5,816
Revenue shortfall
561
573
416
1,550
CBO projected revenue
loss from the 2001-2004
tax cuts
179
265
211
655
Budget Deficits, Trade Deficits, and Economic Growth
Large and persistent budget deficits have contributed to
producing an ever-widening trade deficit that forces the United States
to borrow vast amounts from abroad and puts the economy at risk of a
major financial collapse if foreign lenders suddenly stop accepting U.S.
IOUs. Even if an international financial crisis is avoided, continued
budget and trade deficits will be a drag on growth in living standards.
Reduced national saving means lower national income. Large
federal budget deficits have caused U.S. national saving to plummet
since 2000. That decline in national saving has not translated into a
similar decline in national investment, but only because the United
States has run a large international trade deficit (Chart 5). Without the
substantial purchases of U.S. Treasury securities by foreign central
banks and others that have helped finance that deficit, U.S. interest
rates would almost certainly be much higher than they are now and
national investment would be much lower.
The relationship since 2000 among saving, investment, and the,
current account deficit contrasts sharply with the situation in the 1990s
expansion. In the 1990s, U.S. net national investment exceeded net
national saving, but both were growing as the improvement in the
federal budget contributed to higher-net national saving. An increasing
fraction of net national investment was being financed by U.S. saving
and a diminishing fraction by foreign. borrowing. After 2000, a
growing fraction of U.S. net national investment was financed by
foreign borrowing rather than U.S. saving.
77
If the United States continues to rely on foreign borrowing
rather than its own national saving to finance investment, growth in
national income will be curtailed. Maintaining investment through
foreign borrowing contributes to higher productivity growth in the
United States. However, the income from investment financed by
foreign borrowing accrues mostly to the foreign lenders. As long as a
high fraction of U.S. national investment is being financed by foreign
borrowing, future U.S. national income will be reduced by the costs of
financing and repaying those loans.
The trade and current account deficits are at record levels. The
deficit in goods and services (the difference between U.S. imports of
goods and services and U.S. exports of goods and services) rose to a
monthly record of $68.9 billion in October. Both in dollar terms and as
a share of GDP, the trade deficit will set another record in 2005. The
broader current account deficit, which includes income flows as well as
goods and services, was 6.3 percent of GDP in the second quarter of
2005 (the latest data available) and is on track to set a record in 2005.
The United States had to borrow nearly $670 billion to finance
its international payments imbalance in 2004. It is on track to have to
borrow nearly $800 billion in 2005.
78
A depreciation of the dollar will not restore balance any time soon.
After nearly three years of decline, the dollar rose in value against the
currencies of its trading partners in 2005. However, many analysts
believe that the rise in 2005 is temporary. More importantly,
notwithstanding the recent increase, the value of the dollar in
November 2005 was 11 percent lower than it was at its peak in
February- 2002 (based on the broadest trade-weighted exchange. rate
index, adjusted for differences in inflation among the various
countries).
In principle, a fall in the dollar can improve the trade deficit byencouraging exports and discouraging imports. However, changes to
imports and exports resulting from changes in the exchange rate can
take some time to play out, and the trade deficit may initially worsen
when the dollar depreciates (because the price of imports has gone up
but the quantity -purchased has not,yet gone down).
Moreover, the central banks of some Asian economies where
exports are viewed as an important source. of economic growth have
been resisting the appreciation, of their currency (which would hurt
their exports) by buying dollars. In recent years, for example, China
has intervened heavily in -the foreign exchange market by purchasing
U.S. Treasury securities and other dollar-denominated assets to keep its
currency from- rising beyond -its target exchange rate. In effect,
governments that intervene to support their currency are helping to
finance the U.S. trade deficit and limiting. adjustment through the
exchange rate.
Restoring fiscal discipline is one. of the best ways to reduce. the
trade deficit and -avoid problems from a- weak- dollar. Thus. far,
there has not been- a flight from- the dollar. among foreign holders.
However, private investors and foreign governments may suddenlydecide that the benefits of holding dollars no longer justify the risks. A
widespread dumping of dollar-denominated assets could precipitate- an
international financial crisis. But even an orderly further depreciation
of the dollar and reduction in foreign capital inflows is likely to be
accompanied. by inflationary- pressures from rising import prices and a
further tightening of monetary policy by the Fed.
Without an increase in national saving, any reduction in the
current account deficit would also entail reduced national investment
that would harm future growth. Private saving may rise some from its
very depressed levels, but it would be imprudent to count on that. As
many experts, including. Federal Reserve Chairman Greenspan, have
79
said, the best way to increase national saving is to reduce the federal
budget deficit. That is also one of the best ways to reduce the trade
deficit and to promote U.S. national investment and a rising standard of
living.
Distorted Budget Priorities
No matter what the budget situation, the challenge of dealing
with the effects of Hurricanes Katrina and Rita would have put shortterm strains on the federal budget. However, those strains would have
been easy to absorb if U.S. budget and economic policies were sound.
Unfortunately, instead of sound budget policies aimed at
preparing for the imminent retirement of the baby-boom generation,
the Bush Administration and the Republican Congress have refused to
adopt the kinds of budget enforcement rules that helped achieve fiscal
discipline in the 1990s; have pursued an open-ended commitment to
rebuilding Iraq that relies on supplemental appropriations rather than
the normal budget process; and have remained committed to extending
tax cuts that will add further to the budget deficit.
The end result is that policy priorities are distorted and
programs that help ordinary Americans cope in a difficult economy
become candidates for budget cutting in order to fund tax cuts. The
budget reconciliation process this year illustrates these misplaced
Congress was having difficulty completing the
priorities.
reconciliation process at the time this JEC annual report was
completed, but the JEC Democrats' study, The Impact on Families of
the House and Senate Spending and Tax Reconciliation Provisions: A
Preliminary Analysis, shows how families in different parts of the
income distribution would be affected by the plans under
consideration.
The report compares the dollar value of the loss in benefits
from cuts in spending that affect people directly with the gain in aftertax income from the tax cuts for families in each fifth of the income
distribution. Using the House bills as a model, the analysis shows that
families in the poorest fifth of the income distribution, which receive
only 3 percent of total family income, would bear 22 percent of the
cuts in spending directly affecting families and receive almost no
benefit from the tax cuts. In contrast, families in the richest fifth of the
income distribution would receive most of the benefits of the tax cuts,
and those benefits would far outweigh any loss from the spending cuts
(Chart 6).
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The JEC Democrats' report, The Impact on Families of the
House and Senate Spending and Tax Reconciliation Provisions: A
PreliminaryAnalysis, can be found at:
http://www.iec.senate. gov/democrats/Documents/Reports/budgetrecon
ciliationdec2005 .pdf
IV. Meeting America's Economic Challenges
The Joint Economic Committee- Democrats issued several
reports in 2005 analyzing America's economic challenges. In addition,
they co-sponsored a forumr at which distinguished policy experts
discussed those challenges in the wake of Hurricane Katrina. This
section summarizes those reports and provides web links to them.
Democratic Economic Forum: Meeting America's Economic
Challenges in the Wake of Hurricane Katrina
The JEC Democrats. and the Democratic Policy Committee cohosted a forum with distinguished economic policy experts Robert
Rubin, Alan Blinder, Alice Rivlin, Roger Altman,. Cecilia Rouse, and
Bruce Bartlett to discuss the economic challenges posed by Hurricane
Katrina and how working families are paying. the price for misplaced
budget priorities and other structural economic problems that existed
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before the hurricane and which remain unaddressed by the Bush
Administration.
The panel generally agreed that the devastating impact of
Hurricane Katrina will put short term strains on the federal budget, but
a long-term economic disaster looms if the Bush Administration does
not change course on economic policy. The panelists focused their
remarks on the historically large budget and trade deficits; growing
income disparities and the economic insecurity felt by the middle class;
and providing adequate education and training. The panel assessed the
economic challenges we face, evaluated current policies and how they
differ from those implemented in the 1990s, and discussed policies we
should pursue in the future.
Materials from the JEC Democrats/Democratic Policy
Committee forum, Meeting America's Economic Challenges in the
Wake ofHurricaneKatrina,can be found at:
http://www.jec.senate.gov/democrats/hearings.htm.
Poverty, Family Income, and Health Insurance
Annual data released in 2005 by the Census Bureau show that
the Bush administration's economic policies have not benefited most
working families. During the first term of the Bush administration,
income for the typical American household fell by $1,670, 5.4 million
more people slipped into poverty, and 6 million more joined the ranks
of those without health insurance.
The proportion of Americans living in poverty rose to 12.7
percent in 2004, up from 11.3 percent in 2000. Inflation-adjusted
median household income was $44,389 in 2004, down -from $46,058 in
2000. The number of Americans without health -insurance increased to
45.8 million in 2004, up from 39.8 million in 2000.
Key findings from the reports can be found in the following
three JEC Democratic studies:
Poverty Rate Increasesfor Fourth Consecutive Year
http://www jec.senate.gov/democrats/Documents/Reports/poverty7sep
2005.pdf
Household Income Unchanged in 2004, but Down Since 2000
http://www.iec.senate.zov/democrats/Documents/Reports/income7sep2
005.pdf
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The Number of Americans without Health Insurance Grew by 860,000
in 2004, Increasingforthe Fourth Year in a Row
http://www.jec.senate.gov/democrats/Documents/Reports/healthinsura
nce7sep2005 .pdf
Social Security Reform
Three reports by the JEC Democrats examined the negative
impacts of the President's plan to replace part of Social Security, with
private accounts.
The Negative Impacts of Private Accounts on Federal Debt,
Social Security Solvency, and the Economy finds that President Bush's
plan to replace part of Social Security with private accounts would lead.
to a massive increase in federal debt, weaken the solvency of Social
Security, and fail to increase national saving in preparation for the
retirement of the baby boom generation. Furthermore; if the benefit
cutbacks President Bush seems to favor were added to the plan; future
generations would face the double burden of large cuts in their
guaranteed Social Security benefits and paying down the higher federal
debt.
What if President Bush's Plan for Cuts in Social Security
Benefits Were Already in Place? finds that if President Bush's proposal
for price indexing Social Security benefits had gone into effect in 1979
instead of the current method, middle-class workers retiring this year
would receive a benefit 9 percent smaller than they would get under
current law. Benefit cuts would grow larger over time, and Social
Security .would replace an ever smaller share of workers' preretirement earnings. Indexing.would hit middle-income workers much
harder than upper-income workers, because middle-income workers
rely on Social Security for a much larger fraction of their retirement
income than do upper-income workers.
How the President's Social Security Proposals Would Affect
Late Baby Boomers finds that the President's proposals for price
indexing and the privatization tax accompanying private accounts
would significantly cut guaranteed Social Security benefits for 40- to
50-year-olds. The guaranteed Social Security benefit after both priceindexing and the privatization tax would be 27 percent less than under
current law for a 40-year-old worker who makes. about $36,000
annually.
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These three studies can be found at the following links:
The Negative Impacts of Private Accounts on Federal Debt, Social
Security Solvency, and the Economy
http://jec.senate. gov/democrats/Documents/Reports/ssprivateaccountsa
prO5.pdf
What if President Bush's Plan for Cuts in Social Security Benefits
Were Already in Place?
http://jec.senate. gov/democrats/Documents/Reports/ssprogindexingma
yO5.pdf
How the President'sSocial Security Proposals Would Affect Late Baby
Boomers
http://jec.senate. gov/democrats/Documents/Reports/babyboomersrepor
tmayO5.pdf
Pension Reform
Two reports examined ways to improve defined contribution
pensions for workers and reform the excesses of executive retirement
packages.
Two-Tiered Pension System Protects Executives, But Not
Average Workers argues that executives should have a stake in the fate
of their companies' pension plans in order to improve corporate
governance. Too often, the executives of companies that default on
their pension obligations escape with padded executive retirement
packages while the average worker is left with little or nothing.
Companies that underfund or default on their pension obligations
should be prohibited from funding and paying out benefits from special
executive pension plans.
Improving Defined Contribution Pension Plans examines the
risks associated with the shift from traditional employer-provided
pensions to defined contribution plans, where workers manage their
own retirement savings. Despite some of the advantages to employees
of defined contribution plans, most workers lack the experience and
financial expertise to manage the risks and responsibilities of these
plans. Low participation rates, low contribution rates, ill-informed
investment decisions, and early withdrawals of funds all contribute to
the increased retirement security risks associated with defined
contribution plans.
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These pension studies can be found at the following links:
Two-Tiered Pension System Protects Executives, But Not Average
Workers
http://www.jec.senate. gov/democrats/Documents/Reports/twotieredpen
sionsO6oct2005.pdf
Improving Defined ContributionPensionPlans
http://www.jec.senate. gov/democrats/Documents/Reports/dcpensionpIa
nsO6oct2005.pdf
Welfare Reform
Despite net increases in spending in both the House and Senate
welfare reauthorization bills, those measures still fall well short of the
amount needed to offset inflation and simply extend current welfare
policy. The funding shortfalls are even greater after accounting for the
significantly higher child care funding needs that would result from the
increased work requirements under both bills.
The JEC Democrats' report, Getting Real about Welfare
Funding: The Costs of Sustaining Current Policy Are Not Program
Expansions, finds that this year the real value of the basic Temporary
Assistance for needy Families (TANF) block grant was only 85 percent
of its fiscal year (FY) 1997 level. If funding remains fixed in nominal
terms, the purchasing power of the TANF block grant will continue to
erode, falling to just 75 percent of its original value by FY 2010.
Furthermore, from FY 2006 through FY 2010, the increase in child
care funding needed to offset inflation and higher work requirements
would total between $5.4 billion and $8.3 billion, according to CBO
data.
Getting Real about Welfare Funding: The Costs of Sustaining
Current Policy Are Not Program Expansions can be found at the
following link:
http://www.jec.senate. gov/democrats/Documents/Reports/tanfreporti un
e2005.pdf
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V. Conclusion
Despite solid economic growth and some improvement in the
labor market, 2005 was another disappointing year for American
families. Real wages fell in the face of rising energy prices and the
economic recovery continued to benefit mainly those who were already
well-off. Although the Gulf hurricanes focused attention on the many
challenges, new and old, facing policymakers, it was business-as-usual
for the President and the Republican Congress. Instead of focusing on
issues of concern to working families, they continued to devote their
energy to extending tax cuts for the rich. Meanwhile the problems of
large budget and trade deficits and the economic insecurity felt by
many American families remained unaddressed.
@FedFRASER