[House Report 109-353]
[From the U.S. Government Publishing Office]



                                                    Union Calendar No. 194
					
109TH CONGRESS              HOUSE OF REPRESENTATIVES                REPORT
  1st Session                                                      109-353
--------------------------------------------------------------------------



                     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 WITH
                       
                      MINORITY VIEWS
                      


      
      


                  U.S. GOVERNMENT PRINTING OFFICE
                  
                       WASHINGTON : 2005
                       
                       
                             
                             



                              
                            JOINT ECONOMIC COMMITTEE
[Created pursuant to Sec. 5(a) of Public Law 304, 79th Congress]

HOUSE OF REPRESENTATIVES	        SENATE
JIM SAXTON, New Jersey, Chairman        ROBERT F. BENNETT, Utah, Vice Chairman
PAUL RYAN, Wisconsin		        SAM BROWNBACK, Kansas
PHIL ENGLISH, Pennsylvania	        JOHN E. SUNUNU, New Hampshire		
RON PAUL, Texas				JIM DEMINT, South Carolina
KEVIN BRADY, Texas		        JEFF SESSIONS, Alabama
THADDEUS G. MCCOTTER, Michigan	        JOHN CORNYN, Texas
CAROLYN B. MALONEY, New York		JACK REED, Rhode Island
MAURICE  D. HINCHEY, New York		EDWARD M. KENNEDY, Massachusetts
LORETTA SANCHEZ, California		PAUL S. SARBANES, Maryland
ELIJAH E. CUMMINGS, Maryland		JEFF BINGAMAN, New Mexico


                CHRISTOPHER FRENZE, Executive Director
                 ROBERT KELEHER, Chief Macroeconomist
                  CHAD STONE, Democratic Staff Director



























                                     (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 of Representatives,
Washington, DC.
	DEAR MR. SPEAKER: Pursuant to the requirements of the Employment 
Act of 1946, as amended, I hereby transmit the 2005 Joint Economic 
Report.  The analyses and conclusions of this Report are to assist the 
several Committees of the Congress and its Members as they deal with 
economic issues and legislation pertaining thereto.
		Sincerely, 		




							Jim Saxton,
							   Chairman.



							


	









                                              (iii)







							





























								




									

                                         CONTENTS

Overview of Current Macroeconomic Conditions.........................1
MAJORITY STAFF REPORTS ..............................................9
   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.........................62
    Ranking Minority Member's Views and Links to
    Minority Reports ...............................................64






















                                         (v)




























                                                    Union Calendar No. 194
					
109TH CONGRESS              HOUSE OF REPRESENTATIVES                REPORT
  1st Session                                                      109-353
--------------------------------------------------------------------------
 
                     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 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 2000-2001 
(or the "Post Bubble" or "Adjustment Economy)" was inherited from 
earlier periods involving an asset-price contraction in the late 
1990s.  (See Figure 1).






 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).









* 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.
Significant improvement can be seen in other sectors.  For 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 unemployment rate, now at 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 
non-inflationary 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



* 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 
markets.  Some argue that this strategy also works to reduce 
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).







* Tax Policy
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.1
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.
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 evidence that the 
2003 change in the dividend tax law had a significant impact on 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.  From 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

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 economy has weathered a barrage of 
negative 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 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

                                              Union Calendar No. 194


MAJORITY STAFF REPORTS




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.


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 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 modern 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

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 data releases 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, long-term bond 
market, foreign exchange market, sensitive commodity markets, as well 
as equity markets.
All 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 
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-ï¿½-vis other monetary regimes 
lies precisely in how transparency enhances monetary credibility and 
anchors private expectations."10

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 light 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 be appropriate to preserve both financial and 
monetary stability."11

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 these questions in recent 
years, researchers have often used a common methodology.  The reason 
for this is that recently both 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.
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 short-term 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 no 
evidence that inflation targeting improves a country's economic 
performance." 14

In short, some research clearly concludes that IT does not matter.
  
Some Questions 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 targets.  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 
adjusted to reflect the realities of "flexible" IT.  The clean 
dichotomization maintained by theoretical researchers may not be nearly 
as clean as suggested by the authors.  Consequently, the 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."16  
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 following "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:

* 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:

* Has 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.21

* 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 the post-1982 
period...  Our findings suggest that ...macroeconomic policies that 
reduce volatility in the inflation process are likely to contribute 
to greater overall growth."22

* 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 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."23  
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.
* Other authors found that the "volatility of official central bank 
interest rates...declined substantially after the introduction of 
IT."26

* 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..."28 (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 that NvH "produce several 
pieces of evidence quite favorable to inflation targeting."30 

* Johnson (2002) shows that inflation "targets reduced the level of 
expected inflation in targeting countries"31 ... "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" 33 The evidence 
suggests that IT practitioners can more readily delink their 
inflationary expectations from realized inflation.34  In short, IT 
plays a significant role in anchoring long-term inflation expectations 
and long-term interest rates themselves.. 35

* 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."36
* 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."37  

* 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 long-term 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 over- reaction is caused by changes in the market's 
long-term inflation expectations." 39

IT, however, works to anchor (or prevent excess volatility in) 
long-term 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."40 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 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."45

* 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 
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. 47  Accordingly, adopting 
inflation targeting once price stability is attained likely will make 
it easier to maintain. 48  As emphasized by Gertler, "the case 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


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.1  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 
or books. It is a measure of the opportunity cost of complying with the 
tax code.2

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.3  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.4  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.



Cost Estimates5
The modern 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.6
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.7
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 
estimates the compliance burden for the standard 1040 at nearly 
13.5 hours, on average (see Table 1 below).8

Table 1, Estimated Preparation Time
Form
Record
keeping
Learning about the law or the form
Preparing the form
Copying,
assembling,
and sending
the form to the IRS
Totals
2004 1040
2 hr., 46 min.
3 hr., 58 min.
6 hr., 17 min.
34 min.
13 hr., 35 min.
1992 1040
3 hr., 8 min.
2 hr., 42 min.
3 hr., 37 min.
49 min.
10 hr., 26 min.
2004 1040A
1 hr., 10 min.
3 hr., 28 min.
5 hr. 13 min.
34 min.
10 hr. 25 min.
1992 1040A
1 hr., 3 min.
2 hr., 8 min.
2 hr., 47 min.
35 min.
6 hr., 33 min.
2004 1040EZ
4 min.
1 hr., 41 min.
1 hr., 41 min.
20 min.
3 hr., 46 min.
1992 1040EZ
5 min.
33 min.
39 min.
34 min.
1 hr., 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, 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.9 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 professional.10  
Those who purchased assistance spent about $158 (1995 dollars) on 
average, although the amounts varied widely depending on the complexity 
of the return.11  
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.12
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.13
In other cases, complexity may induce changes in behavior even when 
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.14 
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 work-leisure 
constraint, people may simply decide to take the standard deduction 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), people have more and 
easier options to assist them.  Now, approximately half of all returns 
are filed electronically.15  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 would have 
previously been done by hand.  These programs do have a monetary cost 
though.16
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.17  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.18
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.19  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 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

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 Tax Returns, Preliminary 
Data, 2003," IRS SOI Bulletin, (Winter).

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 Journal 45, 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 Overpaid Federal Taxes 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 Journal 56 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 U.S. Tax 
System.  San Francisco: Institute for Contemporary Studies.

Rosen, Harvey S. 1998. Public Finance (5th 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 (2nd ed.). 
Cambridge, MA: The MIT Press.

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): 16-21.


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 e
xamined.  Part III reviews the size of OPEC's oil reserves, its rate 
of production, the 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 so-called oil sands and extra heavy oil, and at least 
another 2.6 trillion barrels in the form of oil shale.1
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 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.


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 oil was 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 no new oil had been developed.  Much was said at the time 
about the world running 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.






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 
roducts typically increase at first and eventually decline as they are 
overtaken 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 
fixed quantity of oil reserves.  Yet, while ongoing production 
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.6  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 
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.10  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.11
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.



        
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.13  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 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.15
Needless to say, if U.S. companies engaged in price fixing and 
concerted output restriction they would be in per se violation of 
anti-trust laws.
Holding 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 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

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."17  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


Figure 5


Spare capacity.  Moreover, OPEC has had substantial excess short-run 
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


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 
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.19  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."20  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.






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 long-run, 
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 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
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."28
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 3.30

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 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."31  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 price 
volatility."32  Claude Mandil, Executive Director of the International 
Energy Administration (IEA), 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 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


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.33 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.34
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.  





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.35  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.  
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 
Journal as 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 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 
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 prices is the ongoing, collective restriction 
of the oil supply by the cartel members.
Refinery "bottlenecks."  OPEC has claimed that insufficient refinery 
capacity is linked that to high crude oil prices.38  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."40  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 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."42  

VII. The Long-Run
Oil futures prices over $60 per barrel for delivery as late as six 
years hence (2011) 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 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 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 
short-run 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 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.



RANKING MINORITY MEMBER'S VIEWS AND LINKS TO MINORITY REPORTS



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 lower-income families 
were viewed as the best way to 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 Potential Economic 
Impacts of Hurricane Katrina), 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 their children.  The Congress ended the first session of the 109th 
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 
high-income 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 Hurricane 
Katrina can be found at:
http://www.jec.senate.gov/democrats/Documents/Reports/
katrinareportsep05.pdf

Materials from the JEC Democrats/Democratic Policy Committee forum, 
Meeting America's Economic Challenges in the Wake of Hurricane Katrina, 
can be found at: 
http://www.jec.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 31/2 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.  

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.




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.






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-to-
population 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 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 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 90th percentile) rose by almost 1 percent per year 
after inflation, while earnings near the bottom (the 10th 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.  



	
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 
10th percentile. Real earnings at the 90th percentile fell by 2.2 
percent.  In the third quarter of 2005, median usual weekly earnings 
of full-time workers were $649.  Earnings at the 90th percentile of 
the distribution were $1,484, while those at the 10th 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 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.





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 
long-term 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.   



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 
umulative 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."

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 information from 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.









Table 1
A Comparison of CBO Revenue Projections with Actual Revenues, 2003-2005
(Billions of dollars)

2003
2004
2005
2003-2005





CBO revenue projection (January 2001)
2,343
2,453
2,570
7,366
Actual revenues
1,782
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.





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.

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 by 
encouraging 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 suddenly decide 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 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 short-term 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 
priorities.  Congress was having difficulty completing the 
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 after-tax 
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). 
Chart 6


The JEC Democrats' report, The Impact on Families of the House and 
Senate Spending and Tax Reconciliation Provisions: A Preliminary 
Analysis, can be found at:
http://www.jec.senate.gov/democrats/Documents/Reports/
budgetreconciliationdec2005.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 forum 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 co-hosted 
	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 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 of 
	Hurricane Katrina, 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 Increases for Fourth Consecutive Year
http://www.jec.senate.gov/democrats/Documents/Reports/poverty7sep2005.pdf

Household Income Unchanged in 2004, but Down Since 2000
http://www.jec.senate.gov/democrats/Documents/Reports/income7sep2005.pdf

The Number of Americans without Health Insurance Grew by 860,000 in 2004, 
Increasing for the Fourth Year in a Row
http://www.jec.senate.gov/democrats/Documents/Reports/
healthinsurance7sep2005.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' pre-retirement 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 price-indexing 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.

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/ssprivateaccountsapr05.pdf

What if President Bush's Plan for Cuts in Social Security Benefits Were 
Already in Place?
http://jec.senate.gov/democrats/Documents/Reports/ssprogindexingmay05.pdf

How the President's Social Security Proposals Would Affect Late Baby 
Boomers
http://jec.senate.gov/democrats/Documents/Reports/babyboomersreportmay05.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. 

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/
twotieredpensions06oct2005.pdf

Improving Defined Contribution Pension Plans
http://www.jec.senate.gov/democrats/Documents/Reports/
dcpensionplans06oct2005.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/
tanfreportjune2005.pdf



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. 

1 The 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.
2 Ben S. Bernanke, "The Economic Outlook," Chairman, President's 
Council of Economic Advisors, Testimony before the Joint Economic 
Committee, October 20, 2005, pp.3-4.
1 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.
3Borio, Claudio and William White, "Whither Monetary and Financial 
Stability?  The Implications of Evolving Policy Regimes," BIS Working 
Paper                                                                                                                                                                                             No. 147 (February 2004). 
4 These authors, include, for example, Charles Bean, Claudio Borio, 
Philip Lowe, William White, Andrew Filadro, Andrew Crockett, and 
others. 
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 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. 
8 See, for example, Gavin, William, "Inflation Targeting," Business 
Economics, April 2004, pp 30, 36.
9 See, 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.11)
11 Borio Claudio and Philip Loew, "Asset Prices, Financial and 
Monetary Stability: Exploring the Nexis," BIS Working Paper 
No. 114, July 2002, Abstract.

12 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.
14 Ball, Laurence and Niamh 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 1,3-5; 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 in the 
 United States?," (2003) Paper prepared for the NBER Conference on 
 Inflation Targeting, January 2003.
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, op. 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.
20 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"
23 Neumann and von Hagen, op.cit., p.128.
24 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, op.cit., p.128.
26 Ibid., 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)
30 Frederick Mishkin, "Commentary," FRB St. Louis Review, July/August, 
2002, p.144.
31 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 Op.cit., Abstract
35 Op. cit., p.2
36 Jeremy Piger, "Does Inflation Targeting Make a Difference?"  
Monetary Trends, April, 2004
37 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, op.cit. 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.
42 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. 
47 Ball and Sheridan, op.cit., p. 29.
48 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.
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
1 Compliance costs also fall on businesses, however the focus here will 
only be on the cost to individuals.
2 Some of the literature on compliance costs includes the administrative
costs borne by the government, although here they are considered 
separately. 
3 See Vedder and Gallaway (1999). JEC (2005) provides a brief overview 
of the topic.
4 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.
5 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.
6 Wicks (1966).
7 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.
8 The 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.
9  GAO (2005) p. 12.
10 Slemrod (2000).
11 Slemrod (2000).
12 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.
13 Those 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).
14 GAO (2001). In tax year 1999 31.7% of filers itemized their returns. 
Similar numbers hold across time periods (Campbell, 2001).
15 Balkovic (2005).
16 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.
17 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.
18 See Schuler (2001) for an overview of the AMT. For the data on 
future AMT filers, see National Taxpayer Advocate (2004), p. 3.
19 National Taxpayer Advocate (2004).
1 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?" 10th 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 Scenarios," posted August 18, 2004, p.3; http://www.eia.doe.gov/pub/oil_gas/petroleum/feature_articles/2004/
worldoilsupply/oilsupply04.html; see also Edward D. Porter, "Are We 
Running Out of Oil," American Petroleum Institute (API), Discussion 
Paper #081, December 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.
3 To 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.
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.
5 Daniel Yergin, "It's Not the End of the Oil Age," editorial, 
Washington Post, July 31, 2005.
6 Guy Caruso, "When Will World Oil Production Peak?" 10th Annual 
Asia Oil and Gas Conference, June 13, 2005, EIA, 
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/ch1sec5.html.
10 Thomas R. Stauffer, "The Economic Cost of Oil and Gas Production: 
A Generalized Methodology," The OPEC Review 28, 2 (June 1999): 192.
11 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/fig16.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.
13 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 Alberta," Wall Street Journal, September 15, 
2005.
14 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 per boe 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.).
15 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.
17 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.123.
18 Carola Hoyos, "West Told Oil Demand is Too Much for OPEC," Financial 
Times (FT), July 7, 2005.
19 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.
21 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 
Quarterly Review of Economics and Finance 42 (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.
26 "The End of the Oil Age," Economist, October 25, 2003, p.11.
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.
31 M.A. Adelman, "The Real Oil Problem," Regulation, Spring 
2004, 20.
32 IMF World Economic Outlook, April 2005, Chapter IV, p.160.
33 James Hookway, "Thailand Tries to Prop Up Economy," Wall Street 
Journal, August 30, 2005. 
34 Paul Blustein and Craig Timberg, "High Oil Prices Met With Anger 
Worldwide," Washington Post, October 3, 2005.  
35 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 and Finance 42 (2002), 210-213.   
36 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.
38 Acting for the OPEC Secretary General, Dr. Adnan Shihab-Eldin 
delivered a speech at an OPEC/IEA luncheon on September 28, 2005, 
"OPEC-IEA Cooperation and the International Oil Market Outlook;" 
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.
41 "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
44 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.






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