[Economic Report of the President (2003)]
[Administration of George W. Bush]
[Online through the Government Publishing Office, www.gpo.gov]


 
OVERVIEW


The events of 2002 brought new challenges for the U.S. economy and
for America's economic policy. Efforts to strengthen homeland
security and prosecute the war against terrorism placed new demands
on the economy. The recovery from the 2000-01 economic slowdown
continued, but with an unsatisfactory pace of job creation. These
developments make it all the more important to undertake policies
that promote growth, both in the United States and in the global
economy.
Reliance on markets is key to enhancing growth. Thanks to the
flexibility of markets, consumers, businesses, workers, and
investors can continuously adapt to changing economic circumstances.
The market constantly reshapes and redirects economic activity and
economic output in response to changes in producers' supplies and
costs and in consumers' incomes, demands, and the prices they face.
In turn, the market itself evolves, as new information, new
technologies, altered supplies, and other changes in the economic
and physical environments pose new problems and open up new
opportunities. Put simply, markets are dynamic.
This Report emphasizes the importance of dynamic markets in the
U.S. economy and the need to design public policies so as to
preserve and build on this dynamism. In particular, it discusses
recent developments and policies in the areas of corporate
governance, labor markets, regulation, taxation, and international
economic development. It describes the lessons that have been
learned from recognizing the dynamic flexibility of the U.S.
economy, and how the President's policy initiatives are putting
those lessons into practice, to foster economic growth and
prosperity in the United States and around the world.


Assessing Macroeconomic Performance

Chapter 1 of the Report reviews the most important events for the
economy in 2002. The components of aggregate demand--consumption,
investment, government purchases, and net exports--are discussed in
turn. Particular attention is paid to the valuation of the Nation's
stock of productive assets and to the link between these asset
values and demand. The chapter then discusses the near-term outlook
for the economy and the outlook for productivity growth, because
growth in productivity--output per worker--is the main influence
on long-run growth and living standards.
The U.S. economy grew at an annual rate of 3.4 percent through the
first three quarters of 2002. (The advance release for GDP in the
last quarter of 2002 became available only after this Report went
to press.) Although output rebounded after the terrorist attacks
of September 2001, job growth during the recovery has remained
unsatisfactory. However, the continued recovery in output over
the past year, and especially the robust improvements in
productivity, foreshadow a return to more vibrant job creation
in the future.
The contraction of 2001, although one of the mildest on record,
turned out to have started earlier and to have been more severe
than data available before July 2002 had indicated. The revised
data that became available at that time revealed that output had
dropped moderately in each of the first three quarters of 2001
before the rebound began in late 2001 and early 2002. Output fell
by a cumulative total of 0.6 percent from the peak at the end of
2000 to the trough in the third quarter of 2001, much less than
in most previous recessions. The mildness of the recession--in
spite of the effects of terrorist attacks, continued declines in
the stock market, and concerns over corporate governance--reflects
in large part the benefits derived from the flexibility of the
market-driven U.S. economy.
Monetary and fiscal policy also provided support for demand in the
face of these adverse developments. In 2001, faced with signs of a
slowing of economic activity, the Federal Reserve reduced the target
Federal funds rate 11 times during the year, for a total reduction
of 4.75 percentage points, to 1.75 percent. The Federal Reserve then
held the Federal funds rate steady through most of 2002, until a
half-percentage-point cut on November 6 brought it down to 1.25
percent.
Recent U.S. fiscal policy has pursued the goal of promoting economic
growth. Among the central components of a pro-growth fiscal policy
are measures to limit the share of output commanded by the
government, and measures to reduce disincentives to work, save,
and invest. The Economic Growth and Tax Relief Reconciliation
Act (EGTRRA), enacted in June 2001, lowered marginal tax rates
for all taxpayers. This tax cut will have important incentive
effects that will lead to higher incomes and improved long-term
living standards. EGTRRA also provided important support for
economic activity in the short term, because of the way in which
the tax rate reductions were set in place and the timing of the
act's passage.
On January 7, 2003, the President proposed a plan to enhance the
long-term growth of the economy while supporting the emerging
recovery. The President's plan would accelerate to January 1,
2003, many features of the 2001 tax cut that are currently
scheduled to be phased in over several years (including reductions
in marginal income tax rates, additional marriage penalty relief,
a larger child credit, and a wider 10 percent income tax bracket);
it would eliminate the double taxation of corporate income by
excluding dividends from individual taxable income; it would
increase to $75,000 the expensing limit for small business
investment; and it would provide $3.6 billion to the States to
fund Personal Reemployment Accounts for unemployed workers
(described below). The package would provide near-term support
to investment and improve the long-term efficiency of capital
markets, while at the same time insuring against a softening of
consumption by putting more money in consumers' pockets.
Relatively slow economic growth in several countries that are
important U.S. trading partners contributed to a widening of the
U.S. current account deficit, a broad measure of the balance of
the Nation's international goods and services transactions, in
2002. The current account is equivalent to the difference between
net national investment and net national saving, and therefore a
large current account deficit can reflect high investment, low
saving, or both. It follows that there is no one ``right'' level for
the current account balance. Indeed, the crucial question in
assessing the current account is not how large it is, but instead
whether investment is growing at a rate that supports higher
income and improved living standards for American households. The
foreign capital inflows that are the counterpart of the current
account deficit are a potentially important way in which to fund
this investment.


Improving Corporate Governance

Corporate governance is the system of checks and balances that
serves to align the decisions of corporate managers with the desire
of shareholders to maximize the value of their investments. It is a
largely private sector activity built on the bedrock of the
Nation's legal infrastructure. Good corporate governance can
substantially reduce the costs to investors of delegating decisions
to managers, as must inevitably occur when corporations obtain
external financing. Good governance also contributes to the ability
of U.S. corporations to maintain dispersed ownership and to the
existence of well-developed financial markets. It enables
corporations to compete more effectively in financial and product
markets that have become increasingly global. The economy then
benefits through more effective use of the available factors of
production, including managerial talent, external capital, and
natural and human resources. Importantly, strong corporate
governance improves the attractiveness of corporate investments
to households and other investors by more closely aligning
managers' actions with investors' interests, and by making
information about the corporation and the quality and diligence
of its management more transparent to outsiders.
Chapter 2 of this Report examines the evolution of institutions
for corporate governance in the United States. Last year was marked
by important reforms in U.S. corporate governance, including new
laws, government regulations, and private sector initiatives.
The reforms were in part a response to the failure of some managers
and accountants to provide accurate information about corporate
financial and operating performance--events that drew attention
to possible weaknesses in the current system of governance.
In calling for reform in March of last year, the President
articulated a plan based on three core principles of good corporate
governance: accuracy and accessibility of information, accountability
of management, and independence of external auditors. The plan
recognizes both the complexity of modern corporate governance
systems and their inherent flexibility. Its call for a careful
reexamination of private governance customs and legal rules was
followed by a series of private and public sector initiatives.
These include stepped-up enforcement efforts by State and Federal
Government authorities, facilitated by the President's creation
of a Corporate Fraud Task Force in July to focus on conduct by
managers and accountants that has been a source of concern. The
President also signed the Sarbanes-Oxley Act in July, which the
Securities and Exchange Commission is now implementing through a
series of new regulations.
Under the Sarbanes-Oxley Act, a new regulatory body is being created
to strengthen the incentives of auditors to meet their legal
obligation to serve the interests of shareholders and other
investors. The Securities and Exchange Commission must issue new
disclosure regulations, including rules designed to make it easier
for investors to gauge the incentives and performance of corporate
managers. State governments are also instituting changes; State
law is fundamental to the governance structures of corporations.
Private sector organizations were among the first to respond to
the President's call for reform. Self-regulatory organizations
such as those that operate the Nation's stock exchanges contribute
in important ways to the quality of U.S. corporate governance.
Along with individual investor organizations, corporate officials,
and others, these organizations have taken steps to strengthen U.S.
corporate governance.
Even in the midst of these reforms, it is important to remember
that change is not new to U.S. corporate governance. The U.S. system
of corporate governance is designed to be flexible. This flexibility
indeed accounts for its capacity to support economic growth over the
decades, and for its strong global reputation. The chapter
highlights the three main components of the U.S. corporate
governance system: external governance mechanisms, internal
corporate governance, and laws and regulations. External and
internal corporate governance mechanisms serve to align managers'
interests with those of shareholders and can adapt to changing
market conditions. The surety provided by the U.S. legal system in
upholding the contracts that investors enter into when they supply
capital to corporations contributes to the flexibility of the
corporate governance system. This framework, which relies on both
the flexibility of private institutions and the integrity of
public institutions, remains in place throughout the present reforms
and provides a model for other economies to follow.


Designing Dynamic Labor Market Policies

As noted above and in Chapter 1, employment growth during 2002 did
not keep pace with the recovery in output. From December 2001
through December 2002, nonfarm payroll employment fell by 181,000,
while the unemployment rate stayed between 5.5 and 6.0 percent.
These statistics may give the impression of a static labor market.
Yet dynamism remains the predominant characteristic of the labor
market in the United States: in 2002 millions of workers found
new jobs, started new businesses, and raised their earnings.
Chapter 3 of this Report documents some important dimensions of
these labor market dynamics and discusses their implications
for employment and productivity growth and for the design of policy.
The mobility of workers--across jobs, up the opportunity ladder, and
even in and out of employment--is one important dimension of a
dynamic labor market and one of the great strengths of the U.S.
labor market. American workers change jobs frequently, particularly
during the first decade of their working lives, in part because
doing so allows them to gain new experience and skills and,
importantly, to increase their earnings--most earnings growth
for younger workers comes about through job changes. For these
new entrants, however, employment itself is the key aspect of this
dynamic, because tenure on a job provides returns in terms of
skill development and on-the-job training. This improvement in
skills, in turn, makes possible the upward ratcheting effect
through which movement between jobs contributes to increased earnings.
Although staying on the ladder of upward mobility means maintaining
an attachment to the labor market, it does not necessarily mean
staying put in any one job. In a well-functioning labor market,
there are large and constant flows between employment and
unemployment, and a substantial number of jobs are created and
destroyed each year. These large, bidirectional flows are further
evidence of the flexibility of the U.S. economy, as expanding firms
and industries take on more workers while those in decline contract
their labor forces. Research shows that frequent job changes for
the young are, in an important sense, the means through which
individuals are matched to the jobs that will provide them with
the best opportunities.
Government policies are more effective when they recognize and
foster labor market mobility. Policies can support this mobility--and
earnings growth--by encouraging skill development and education.
Another important policy goal is to meet the desire of individuals
for social insurance against the adverse consequences of short-term
macroeconomic fluctuations and personal misfortune. Policymakers
face some difficult tradeoffs in designing social insurance,
however, because the provision of insurance can itself distort
behavior, making individuals less likely to enter employment or
to exert full effort toward finding a job. As an example, for
decades the Aid to Families with Dependent Children program provided
insurance against destitution, but it also created a financial
incentive for recipients to stay out of the work force. Welfare
reform and the Earned Income Tax Credit are examples of policies
that have supported individuals in time of need while also giving
them incentives to enter the labor market and find jobs.
The Administration has proposed a new policy to foster skill
development and increase the rewards associated with work for
those unemployed workers who face the most difficulty in finding
new employment. Qualifying workers would receive a Personal
Reemployment Account, with funds to be used for expenses such
as training, child care, or relocation. These accounts would be
targeted to those unemployed workers who are deemed most likely
to exhaust their unemployment benefits before finding a new job.
Those who find a new job within 13 weeks would be entitled to a
cash payment of the remaining funds in the account as a ``reemployment
bonus.'' Personal Reemployment Accounts thus would provide not
only support for training and skill development, but also a
monetary incentive for unemployed workers to find new jobs.


Developing Regulation for a Dynamic Economy

Competitive, efficient, and equitable markets are the cornerstone
of a flexible and dynamic economy. Regulation of economic activity
is an essential element of a market economy, but regulation can
hinder economic growth and well-being just as it can advance them.
Well-formulated regulation can lead to improved market outcomes,
but regulation that is ill conceived or that is not cost-effective
can have unintended consequences that actually make matters worse.
Chapter 4 of this Report illustrates how both the government and
the private sector play critical roles in ensuring a flexible
economic environment that promotes growth and prosperity by allowing
economic resources to be redeployed as opportunities evolve. The
chapter provides a framework for the evaluation of regulatory
policies, focusing on Federal regulation and how it can foster or
hinder economic dynamism.
Regulation stems from a number of needs. Some demands for regulation
reflect a desire to improve the efficiency of markets rendered
imperfect by spillover effects, informational problems, or lack
of competition. By compensating for or correcting these market
imperfections, such regulation may enhance growth. Other demands
for regulation, in contrast, reflect a desire to change market
outcomes, for reasons that may be compassionate or selfish,
far-sighted or opportunistic. Regulatory policy must identify and
deny those demands for regulation that seek only economic rents for
a privileged few, and instead be based on sound science and
economics, along with a careful evaluation of the social needs
behind the desire for regulation.
The chapter suggests some guidelines for evaluating both new
regulations and proposed regulatory reforms that will help reduce
the costs of regulation and achieve the best possible outcomes.
When regulation is necessary, it should be flexible and market
based, and the burden of each regulation should be justified by
the benefits it confers. An important Administration initiative
is the revision of the Office of Management and Budget's Guidelines
for the Conduct of Regulatory Analysis and the Format of
Accounting Statements. Conducted jointly by the Council of
Economic Advisers and the Office of Management and Budget, this
initiative stresses the principles of sound regulatory policy
based on economic analysis.
Part of a complete understanding of the consequences of regulation
is recognizing that the impact and efficacy of specific regulations
can change over time with changes in technology, economic conditions,
and scientific knowledge. The chapter provides several examples, one
of which is the President's Clear Skies Initiative. Aimed at
reducing power plant emissions of atmospheric pollutants, this
program was designed in light of scientific evidence linking
impairments of human health to exposure to certain polluting chemicals.
Importantly, however, Clear Skies has also been crafted in such a
way that economic incentives provide the mechanism for reduction of
these pollutants at least cost to the economy.
Regulatory review and reform offer an important means for
policymakers to control the buildup of regulatory costs and limit
the economic harm of outdated regulations. Yet although many
regulatory reforms have been clear successes, others have created
new problems. Examples include the experience with reform of the
savings and loan industry in the 1980s and the more recent
experience with electricity markets in California. To avoid in the
future the kinds of unsatisfactory outcomes that resulted from
these episodes, regulatory reform should be guided by the same
basic principles as the development of new regulations.


Analyzing Tax Policy

An efficient tax system adequately finances government activities
while imposing as few distortions as possible on household and
business decisions. A tax system with high marginal tax rates or a
complicated structure impedes work effort and saving and hinders the
risk taking and entrepreneurship that are the foundations of growth.
Tax rates that are unequal across activities encourage tax avoidance
and lead to potentially wasteful efforts at regulation, reporting,
and monitoring to control it. Tax deductions, exclusions, and credits
are often undertaken with the aim of targeting resources to
worthwhile social goals, but they can create considerable complexity
for taxpayers. They can also impose high effective tax rates in the
range of income over which the tax benefits are gradually withdrawn,
in some cases discouraging additional work effort among the very
people the preferences were intended to help. The combined result
of all of these imperfections can be a tax system that imposes
significant compliance costs and wastes resources by misallocating
them to nonproductive activities.
Chapter 5 of this Report considers how tax policy changes could
improve economic growth and real incomes for all Americans. Such
changes involve difficult questions of how best to balance the
sometimes competing objectives of simplicity, fairness, and faster
long-term growth. The chapter considers some approaches that
economists have identified to achieve the gains of higher incomes
and efficiency within the framework of the existing tax system.
Even relatively modest changes can lead to important improvements
in economic incentives and efficiency. In particular, the
opportunity exists to reduce significant differentials in tax
rates across different activities and to lower the tax on the return
to capital, in ways that improve incentives. Small improvements in
this regard can have large long-run effects, because saving and
investment decisions made now will affect capital accumulation,
technological change, and innovation for years to come.
The chapter discusses the President's proposal to abolish the
double tax on corporate income. The current taxation of corporate
income is an important example of how the current tax code falls
short of the goal of taxing income only once. Taxing corporate
income twice, once at the corporate and again at the individual
level, reduces the after-tax reward to investing. It distorts
corporate financing decisions, diminishes capital formation, and
results in too little capital being allocated to the corporate
sector. As a result, the capital stock grows more slowly than it
could otherwise, lowering the productivity of workers and thus the
growth of their real wages. The President's plan to eliminate this
double taxation will boost long-term efficiency and support
increased investment that will promote higher near-term growth
and job creation.
Taxing all income once, but only once, would greatly improve the
efficiency with which government revenue is raised. Tax preferences
represent a policy decision to exclude some income from the tax
base, but this poses a tradeoff: a higher overall tax rate is then
required to raise a given amount of revenue--and the higher rate
in turn increases the inevitable distorting effects of taxation
on the economy. Even taxing all income just once, however, would
leave in place the tax code's current distortion of the decision
between current consumption and future consumption (that is,
saving). A tax system based on consumption rather than income
would remove this distortion, but it would also require a higher
average tax rate than a system based on comprehensive income,
because the consumption tax would have a smaller tax base
(although it would be larger than the present income tax base).
The benefits of a consumption tax would have to be weighed against
the disincentive effects from this higher rate.
The chapter also discusses ways in which the dynamism of the U.S.
economy affects the evaluation of tax policies. For example, the
effect of the tax system on an individual taxpayer is not well
represented by a one-year, static snapshot of his or her income.
Rather, its impact changes significantly over time as the
taxpayer proceeds through the stages of life and his or her
earnings rise and fall. Earnings typically rise through the working
years, as the individual gains experience and accumulates human
capital, and then fall as the individual retires and exits the
work force. One's tax bill is also affected by, among other
things, changes in employment, marriage and divorce, having and
raising children, giving to charity, starting up a business, and
buying and selling assets. The ebbs and flows of the business
cycle also have an impact. In evaluating the distribution of the
tax burden and how changes in the tax code affect that distribution,
it is therefore important to consider the full range of individuals'
lifetime experiences. For example, a college student is likely to
have litle income today but will benefit from tax relief upon
entering the labor force. Conversely, a working couple nearing
retirement who currently pay the top marginal income tax rate
would benefit today from a reduction in that rate, but they might
benefit less in the future once they have retired and their
income is lower. In short, because everyone's tax situation
changes over time for a variety of reasons, proper analysis of
the distribution of taxation must consider not just who will
benefit from tax relief today but who will benefit in the future
as well.


Promoting Global Growth

Chapter 6 of this Report examines how countries throughout the
world can promote economic growth and thereby enhance the well-being
of their people. In recent years many countries, especially in the
developing world, have experienced robust growth, which has led to
reduced poverty, lower infant mortality, improved health outcomes,
and longer life expectancy. Many others, however, have been far
less successful at promoting growth and have not seen similar
improvements in social indicators.
The central theme of the chapter is that all countries can
experience faster growth by creating an economic environment in
which market signals lead to better economic performance. Three
principles guide these growth-oriented policy reforms. The first
is economic freedom, in which encouraging competition and
entrepreneurship leads to stronger growth. Economic freedom
involves, among other things, a stable domestic macroeconomic
environment with low inflation, appropriate government regulation,
encouragement of entrepreneurial initiative, and openness to the
global economy. The second pro-growth principle is governing justly.
This involves safeguarding the rule of law, controlling corruption,
and securing political freedom--all aspects of policy that are
vital for developing trust in the accountability and reliability
of government. The third principle is investing in people. These
investments include those that promote the health and education
of the population, making workers more productive.
No one of these principles is enough to guarantee strong growth;
rather, all three are mutually reinforcing aspects of a pro-growth
agenda. The specific policy measures that will implement these
pro-growth principles similarly involve a number of elements:
responsible fiscal and monetary policies, an appropriate size and
role of government, domestic flexibility and internal competition,
openness to the global economy, a healthy and educated population,
and sound institutions. Countries that pursue a broad range of
policies consistent with these principles perform better than
those that do not. During the 1980s and 1990s, for example, those
countries that were more open to the international economy grew
much faster on average than those that were more closed.
The President has inaugurated three important policy initiatives
designed to stimulate economic performance in countries around
the world: trade liberalization initiatives negotiated pursuant
to Trade Promotion Authority, which will promote countries'
openness to international trade and investment; the Millennium
Challenge Account, which will provide direct financial assistance
to developing countries adopting pro-growth policies; and reform
of the multilateral development banks, which will encourage
private sector involvement in results-oriented development programs
undertaken by the World Bank and the regional development banks.
Through these and other policies, the United States will help
countries address the challenge of improving their economic
growth. Ultimately, however, creating a pro-growth environment
is up to each country's own people and government. The initiatives
of the United States will help in important ways, especially by
reinforcing pro-growth decisions by governments and individuals.
They are not, however, substitutes for the adoption of good
policies in developing countries themselves, which are ultimately
the key to success.
The pro-growth agenda embodied in these three policy initiatives
will enhance growth and prosperity both at home and abroad. This
is the most direct way to improve standards of living and thus the
lives of people around the world.


Conclusion

The United States is recovering from both an economic downturn and
the aftershocks of the terrorist attacks of September 2001.
Government policies have aided this recovery in important ways, with
support from both fiscal and monetary initiatives. Perhaps most
important in ensuring recovery, however, has been the underlying
flexibility and dynamism of the U.S. economy. In the midst of the
downturn, workers continued to find new opportunities, savers
continued to reallocate their funds in search of greater returns,
and firms continued to regroup and to invest in future growth. The
economic policies of the Administration will likewise continue to
support this quest for growth, both here at home and around the world.