[Economic Report of the President (2004)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
Chapter 1

Lessons from the Recent Business Cycle

Economic conditions in the United States improved substantially
during 2003, with real gross domestic product (GDP), the most
comprehensive measure of the output of the U.S. economy, expanding
at an annual rate of more than 8 percent in the third quarter of the
year. Based on data available through the middle of January, a further
solid gain appears likely in the fourth quarter (the GDP estimate
for the fourth quarter was released after this Report went to press).
The improvement in the economy over the course of the year stemmed
largely from faster growth in household consumption, extraordinary
gains in residential investment, and a sharp acceleration of
investment in equipment and software by businesses. Payroll
employment bottomed out in July and increased 278,000 over the
remainder of the year. Financial markets responded favorably to
the strengthening of the economy, with the total value of the
stock market rising more than $3 trillion, or 31 percent, over
the course of 2003.

Despite this improvement, the U.S. economy has further to go to
make up for the weakness that began showing even before the economy
slipped into recession roughly three years ago. Until recently,
the recovery has been slow and uneven. Employment has lagged
behind gains in other areas. Strong fiscal policy actions by
this Administration and the Congress, together with the Federal
Reserve's stimulative monetary policy, have softened the impact of
the recession and have also put the economy on an upward trajectory.
The Administration's pro-growth tax policy, in particular, has laid
the groundwork for sustainable rapid growth in the years ahead.
This chapter discusses the distinctive features of the recent
recession and recovery, and it draws lessons for the future. The
key points in this chapter are:
 Structural imbalances, such as the ``capital overhang''
that developed in the late 1990s, can take some time
to resolve.
 Uncertainty matters for economic decisions, and was
likely a factor weighing on investment in recent years.
 Aggressive monetary policy can reduce the depth of a
recession.
 Tax cuts can boost economic activity by raising
after-tax income and enhancing incentives to work,
save, and invest.
 Strong productivity growth raises standards of living
but means that much faster economic growth is needed to
raise employment.


Overview of the Recent Business Cycle

The recent recession and recovery mark the seventh business cycle
in the U.S. economy since 1960. This cycle shares some common
features with previous business cycles. According to the National
Bureau of Economic Research (NBER), the unofficial arbiter of U.S.
business cycles, a recession is ``a period of falling economic
activity spread across the economy, lasting more than a few months,
normally visible in real GDP, real income, employment, industrial
production, and wholesale-retail sales.'' The recent recession,
like others, has involved a downturn in economic activity of
sufficient depth, duration, and breadth to be judged a recession by
the NBER.

The NBER also identifies the peaks and troughs of economic activity
that mark when recessions begin and end. In November 2001, the NBER
determined that the economy had peaked in March 2001. However,
revisions to economic data since the NBER's initial decision suggest
that the peak in activity was actually months earlier (Box 1-1).
In July 2003, the NBER determined that the economy had reached a
trough in November 2001.

Despite the similarities between the recent business cycle and
previous ones, this most recent cycle was distinctive in important
and instructive ways. One noteworthy difference is that real GDP
fell much less in this recession than has been typical. Chart 1-1
shows the path of real GDP over the past several years compared
with the average path of the six prior recessions, with the level
of real GDP at the economy's peak set equal to 100 in each case.
(All of the charts in this Report assume that the peak for the
recent recession was in the fourth quarter of 2000.) The chart
shows that the decline in real GDP in the recent recession was
smaller than the historical average; indeed, it was the second
smallest in any recession since 1960.

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Box 1-1: When Did the Recent Recession Begin?

The National Bureau of Economic Research (NBER) uses a variety of
economic data to determine the dates of business-cycle peaks and
troughs. This task is made more difficult because many of these data
series are subject to revision. For example, on November 26, 2001,
the NBER announced that a recession had begun in March 2001. Since
then, the four data series that the NBER used to determine the
timing of the recession have been revised. The revisions to these
series suggest that the recent recession began earlier than March
2001.

The four series cited by the NBER in their decision about the recent
business-cycle peak were revised as follows:
 Real personal income less transfers:When the NBER dated
the recession, this series showed a generally steady
rise throughout 2000 and early 2001. Subsequent
revisions reveal that income peaked in October 2000.
 Nonfarm payroll employment: The data at the time of the
recession announcement showed employment growing at a
substantial pace in early 2001, with 287,000 jobs added
from December 2000 to its peak in March 2001. Revised
data show that employment grew less than one-third
of this amount in early 2001 and peaked in February
2001.
 Industrial production:The original data used by the
NBER showed that this series peaked in September 2000.
Revised data show that this peak came even earlier, in
June 2000.
 Manufacturing and trade sales: Original data showed a
peak in August 2000; the most recent data show a peak
in June 2000.

Thus, the revised data show that the latest peak among the four
series was February 2001, with some series peaking considerably
earlier. Moreover, another data series, which the NBER has recently
announced it will incorporate into its business-cycle dating process,
also shows a peak before March 2001: monthly GDP reached a high
point in February 2001, according to the most recently available
estimates computed by a private economic consulting firm.

While some arbitrariness in determining the date on which a recession
began is inevitable, revisions since the NBER made its decision for
the most recent recession strongly suggest that the business-cycle
peak was before March 2001. The median date of the peak for the five
series discussed here is October 2000. Other data support the notion
that economic activity had slowed sharply or even begun to decline
by this point, including the stock market, business investment, and
initial unemployment claims. For these reasons, the analyses
throughout this chapter (including the charts that compare this
recession to past recessions) use the fourth quarter of 2000 as the
peak of economic activity and the start of the recession.

In October 2003, the NBER announced that it would defer consideration
of whether the latest business-cycle peak should be revised until the
results of the coming comprehensive revision of the National Income
and Product Accounts were released. The major results of this
revision were announced in December 2003, but the monthly
manufacturing and trade sales data and some of the detail needed to
estimate monthly GDP had not been released at the time this Report
went to press.
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This relatively mild decline in output can be attributed to unusually
resilient household spending. Consumer spending on goods and services
held up well throughout the slowdown, and investment in housing
increased at a fairly steady pace rather than declining as has been
typical in past recessions. In contrast, business investment in
capital equipment and structures has been quite soft in this cycle.
As discussed below, business spending during the past few years has
likely been held down by overinvestment in the late 1990s, as well
as by heightened business caution owing to terrorism and corporate
scandals. As a result of these forces, investment weakened sooner
and has recovered more slowly than in the typical cycle.

Another distinguishing feature of this cycle has been the weakness
in labor markets relative to output. In particular, the recovery in
employment--although now under way--lagged the upturn in output by
a much longer period than in prior recessions. This difference was
associated with unusually large productivity gains.

The balance of this chapter draws five distinctive lessons from
the recent business cycle in the United States. Chapter 3, The Year
in Review and the Years Ahead, presents details about developments
over the past year and discusses the Administration's forecast.


Lesson 1: Structural Imbalances
Can Take Some Time to Resolve

Business investment in equipment and software surged in the late
1990s. Real investment increased at an average annual rate of roughly
13 percent between the fourth quarter of 1994 and the fourth quarter
of 1999, compared with an average annual rate of less than 7 percent
over the preceding three decades. The surge in investment was led by
purchases of high-tech capital goods--computers, software, and
communications equipment--which increased at an average annual rate
of 20 percent over the period.

Economic theory implies that businesses invest when they believe
that there are profits to be made from that investment. In the late
1990s, several developments fed a perception that the expected future
return from newly installed capital would be considerably greater
than the cost of this capital. Rapid advances in technology had
lowered the price of high-tech capital goods dramatically throughout
the 1990s and especially in the second half of the decade. For
example, the quality-adjusted price index for business computers and
peripheral equipment fell at an average annual rate of
22 percent between late 1994 and late 1999. In addition, rapidly
growing demand for business output led firms to believe that newly
installed capital would be used productively, boosting the expected
return to investment.

Moreover, technological progress and legislation provided incentives
for strong investment in high-tech equipment. The development of the
World Wide Web enabled new and established firms to enter e-commerce,
and rapidly increasing household and business access to the Internet
provided a large base of potential customers for these firms. The
Telecommunications Act of 1996 provided for substantial deregulation
of the telecommunications industry and may have spurred investment
in that sector. In addition, concern that some computer systems might
be inoperable after December 1999 caused a wave of so-called
Y2K-related investment. Some analysis indicates that Y2K spending
alone boosted the growth rate of real equipment and software
investment by more than 3 1/2 percentage points per year in the latter
part of the 1990s.

Optimism about the potential gains from new capital, and from
high-tech capital in particular, was reflected not only in investment
decisions but also in a sharp rise in stock prices. From late 1994 to
late 1999, the Wilshire 5000--a broad index of U.S. stock
prices--nearly tripled. The Nasdaq stock price index, which is
heavily weighted toward high-tech industries, registered an even more
dramatic ascent, increasing more than fourfold over this period. The
increase in stock prices stimulated investment by reducing the cost
of equity capital. In addition, the rise in stock prices fueled a
consumption boom by boosting the wealth of a growing number of
Americans and more generally signaling better future economic
conditions. This consumption boom encouraged further business
investment.

In mid-2000, business equipment investment abruptly slowed. After
rising at an annual rate of 15 percent in the first half of the year,
real spending on business equipment and software inched up at about
a 1/4 percent annual rate in the second half. The slowdown in
high-tech equipment investment was especially dramatic. For example,
real outlays for computers had skyrocketed at an annual rate of 40
percent in the first half of the year, but grew at less than
one-quarter of that pace in the second half. This stalling of
investment preceded the downturn in the overall economy; by contrast,
in the typical business cycle, investment has turned down at the same
time as overall economic activity (Chart 1-2). The unusual timing
of the investment slowdown in this recession is the reason that the
recent business cycle has been widely viewed as an ``investment-led''
recession.

The sharp break in investment occurred in parallel with an apparent
reevaluation of future corporate profitability among financial market
participants. By the end of 2000, the Wilshire 5000 index of stock
prices was down 13 percent from its peak, and analysts had
substantially marked down their forecasts for S&P 500 earnings over
the coming year. The movements were even more dramatic in the
high-tech sector. The Nasdaq index of stock



prices dropped nearly 50 percent from its peak in March 2000 to the
end of the year. The prices of technology, telecommunications, and
Internet shares fell particularly sharply, along with near-term
earnings estimates. The elevated valuations of many such companies
also declined markedly. Indeed, the price-earnings ratio (where
``earnings'' are those expected over the next year) for the
technology component of the S&P 500 fell from a peak of more than 50
in early 2000 to less than 35 by the end of the year.

These facts and considerable anecdotal evidence suggest that business
managers and investors sharply revised downward the expected gains
from new capital investment during this period. One factor that may
have contributed to the downward revision is a possible slowing of
the pace of technological advance--the rate at which computer prices
were declining eased (from more than 20 percent in the late 1990s to
about half that in 2000), and the software industry reportedly
developed no new so-called ``killer applications'' that required or
spurred purchases of new hardware. In addition, firms may have been
disappointed by the response of households to e-commerce
opportunities and to new communications technologies such as
broadband. Finally, previous investments had not uniformly translated
into higher profitability, perhaps because the true potential of new
forms of capital could be realized only by changing other aspects of
production processes. For example, new computer systems designed to
lower inventory management costs might have required an expensive
reconfiguration of warehouses.

This reassessment of the gains from capital investment also implied
that existing stocks of some types of equipment exceeded the amount
of equipment that firms could put to profitable use. Such an excess
of the existing capital stock relative to the desired stock (often
called a capital overhang) is one type of structural imbalance that
can slow or reverse economic expansion. In the case of an excess
supply of capital, investment would be expected to slow until the
capital overhang dissipates through a combination of depreciation
in the existing stock and an increase in the desired stock due to
lower costs of capital or stronger final demand.

Resolving the structural imbalance that developed in the late 1990s
took considerable time. Real business spending on equipment and
software dropped more than 9 percent during the four quarters of
2001 and posted less than a 2 percent gain during the four quarters
of 2002. The high-tech categories showed especially sharp breaks in
their upward trends. In these categories, the effects of the capital
overhang were likely exacerbated by a reduction in normal replacement
demand following the Y2K-related investment spurt. The prolonged
period of sluggishness in business investment is another distinctive
feature of this business cycle. Real investment in equipment and
software typically has fallen less and has recovered more quickly
than it did in the current recession and recovery (Chart 1-2).

A similar structural adjustment appears to have taken place overseas,
where investment demand was also weak. The global slowdown in
investment hampered U.S. export growth, since capital goods
traditionally account for about one-third of the value of U.S.
exports. Real exports fell sharply in this recession and have
recovered only a little of their lost ground. In past recessions,
exports have typically leveled off but not declined
(Chart 1-3). Soft investment and weak export demand led to a long
period of weakness in manufacturing output, a topic discussed in
the next chapter.

Several forces have more recently moved existing capital stocks into
better alignment with desired stocks and thereby set the stage for a
renewal of robust investment demand. Previously installed capital
has depreciated, a process that occurs especially quickly for many
types of high-tech equipment. Rising demand for business output and
falling costs for high-tech capital (caused by ongoing technological
progress) have increased firms' desired capital stocks. The
elimination of capital overhangs, together with improved business
confidence and reductions in tax rates on capital income discussed
later in this chapter, are consistent with the marked upturn in
business investment spending in the second half of 2003.




Lesson 2: Uncertainty Matters
for Economic Decisions

The U.S. economy has been hit hard in the past few years by a number
of unexpected developments, including the tragic terrorist attacks
of September 11, 2001, the corporate governance and accounting
scandals of 2002, and the geopolitical tensions surrounding the war
with Iraq in 2003. In addition to having direct effects on the
economy, each of these events contributed to a climate of uncertainty
that weighed on household and business confidence and thereby
affected spending decisions.

The terrorist attacks have had substantial consequences for many
aspects of the U.S. economy. The heightened focus on security at
home, together with the determined efforts against terrorism around
the world, have required increases in some types of government
spending. The attacks hurt some industries directly: for example,
fear of new attacks and the inconveniences associated with heightened
airport security reduced air travel and tourism. Beyond these direct
economic effects, the unprecedented attacks on the United States
also generated uncertainty about future economic conditions.

Another setback for the economy was the series of revelations during
2002 regarding incomplete or misleading corporate financial reporting
and, in some cases, wrongful conduct by corporate management. The
number of financial restatements--that is, corrections to previous
statements of earnings--by U.S. public corporations reached a record
high in 2002. Although most of the restatements were not linked to
misconduct, they raised questions about the reliability of accounting
practices and the credibility of corporate financial disclosures.
The combination of these concerns and allegations of misconduct by
high-profile executives heightened investors' uncertainty about the
quality of corporate governance and the reliability of earnings
reports and projections.

In early 2003, uncertainty about the economic outlook increased
during the period leading up to the war with Iraq. One source of
this uncertainty was the potential effect of the conflict on the
capacity for producing and transporting oil in the Persian Gulf, and
thus on the future supply and price of oil. Observers were also
concerned about the amount of additional government spending that
would be needed to finance military operations and subsequent
reconstruction, as well as the danger of retaliatory terrorist
attacks on the United States. Finally, consumer confidence fell
sharply in early 2003, raising concerns that the consumer
demand that had supported the economy over the previous couple of
years might falter. Such concerns were plausible, given
that the 1990 Gulf War roughly coincided with a marked drop in
consumer confidence and the start of the 1990-1991 recession.



The uncertainties created by the three developments described above
had significant effects on financial markets. Stock prices dipped
noticeably in September 2001, recovered subsequently, but moved
down during the summer of 2002 and fell again in early 2003
(Chart 1-4). Risk spreads (the difference between interest rates
on corporate bonds and on comparable Treasury bonds) jumped
temporarily after the terrorist attacks and rose again in late 2002
during the peak of concerns about corporate governance. Because risk
spreads generally reflect the extra return investors require to hold
riskier corporate assets, the rise in spreads in 2002 indicated
investors' greater perceived probability of default, lesser
willingness to take on risk, or both.  Investor uncertainty also
was reflected in measures of the expected volatility of stock prices
based on option prices, which were elevated during each of the
episodes noted above (Chart 1-5).

Reductions in share prices and increases in bond yields raised the
cost of funding capital expenditures and thus directly discouraged
business investment. Increased uncertainty likely also had direct
effects on business decisions about investment and hiring:
uncertainty may cause firms to wait until they have more information
before committing to an investment. In this case, firm managers
hesitate to respond to a change in demand. Anecdotal evidence from
the past few years as well as some statistical analyses



suggest that uncertainty has a noticeable damping effect on
investment. Anecdotal evidence also suggests that uncertainty has
held back hiring in the past few years.

Household spending may also have been affected by uncertainty.
Economic theory and empirical evidence suggest that greater
uncertainty about future economic conditions may lead households to
raise saving and reduce spending. However, such effects are not
immediately apparent in the recent cyclical downturn--as will be
explained shortly, household spending has shown remarkable resiliency
over the past few years. A possible explanation for the seeming
discrepancy between this pattern and empirical work based on earlier
data is that the negative effects of greater uncertainty were offset
by lower taxes and the effects of lower interest rates.

While the uncertainty created by these unexpected developments has
hampered the economic recovery, household and business confidence
strengthened considerably during the second half of 2003. This
Administration and the Congress moved swiftly to address problems
with corporate governance. In March 2002, the President proposed a
set of reforms aimed at a wide range of corporate governance issues,
and in July 2002, Congress passed the landmark Sarbanes-Oxley Act. As
concerns about corporate governance have abated, and the durability
of the recovery has become more apparent, firms have begun to invest
and hire.

Lesson 3: Aggressive Monetary Policy Can
Reduce the Depth of a Recession

When the economy showed signs of weakening three years ago, the
Federal Reserve moved decisively to reduce interest rates to
stimulate the economy. During 2001, the Federal Reserve cut the
Federal funds rate eleven times for a total reduction of 4 3/4
percentage points. When the economy failed to gain much forward
momentum, the Federal Reserve reduced the funds rate another 1/2
percentage point in November 2002 and a further 1/4 percentage point
last June, to 1 percent. The decline in the Federal funds rate in
this economic downturn was larger and occurred more rapidly than in
previous downturns (Chart 1-6). One factor that likely contributed
to the Federal Reserve's willingness to cut the funds rate so
sharply was the low level of inflation. Core consumer price
inflation, as measured by the 12-month change in the consumer price
index excluding food and energy, was around 23\4 percent in early
2001 and fell to just over 1 percent by late last year. Thus, the
Federal Reserve was able to lower the Federal funds rate and keep it
low with little apparent risk of triggering an undesirably high
inflation rate.



Long-term interest rates on government securities and high-grade
corporate securities began falling in late 2000, likely in part
reflecting an anticipated decline in the Federal funds rate in
response to a weaker economic outlook. Throughout 2001, short-term
and medium-term interest rates declined along with the Federal funds
rate. However, long-term rates changed little, on net, because
market participants apparently expected the downturn to be
short-lived and believed that the Federal Reserve would soon begin
raising the funds rate. Then, in 2002, persistently weak economic
conditions, combined with the Federal Reserve's decisions to hold
the funds rate steady for much of the year and cut it further in
November, persuaded market participants that short-term rates were
likely to stay low for some time. As a result, long-term rates
fell substantially, on balance, in 2002. Long-term rates fluctuated
in 2003, but finished the year a little above where they started.

Interest rates on fixed-rate mortgages tracked long-term government
yields over this period, as they typically have. In 2003, the
interest rate on 30-year fixed-rate mortgages averaged more than
2 percentage points below the average in 2000. Low and falling
mortgage rates have provided strong support for housing demand over
the past few years. Indeed, residential investment has increased at
a fairly steady pace throughout the period of overall economic
weakness--a stark contrast to the pattern in past recessions, when
residential investment tended to fall sharply (Chart 1-7).



Declining mortgage interest rates have also fueled an enormous wave
of mortgage refinancing. (The response has been particularly strong
because technological and institutional advances in mortgage markets
have reduced the costs of such transactions.) In many refinancing
transactions, homeowners have ``cashed out'' some of their
accumulated home equity by taking out new mortgages that are larger
than the remaining balance on their previous mortgages. According to
a survey of households, more than half of the liquefied equity
funded either home renovations or household consumption and thus
may have helped to sustain aggregate demand. Another substantial
portion reportedly was used to pay down credit card debt, which
generally carries a higher interest rate than mortgage debt and,
unlike mortgage debt, is not tax-deductible. By moving from a
high-cost form of debt to a lower-cost one, households have been
better able to cope with their debt burdens. In particular, the
transition has held down the fraction of their income committed to
regular debt service payments, and thus has increased the amount
of income available for spending on discretionary items.

Low long-term interest rates have also reduced the cost of funds
to businesses. In some cases, this lower cost has been passed
directly to households. For example, motor vehicle manufacturers
made low-interest-rate loans available to car buyers in late 2001
and have generally maintained a high level of financing incentives
since then. These incentives have bolstered consumer outlays for
motor vehicles.

More generally, lower interest rates make it cheaper for firms to
finance new investment projects. The aggressive easing of monetary
policy since early 2001 has likely helped to support business
investment, even though the forces discussed earlier have, on
balance, caused investment to be weak.

Firms have also taken advantage of low long-term interest rates to
restructure their balance sheets. Net issuance of commercial paper
and net borrowing from banks were both negative in each of the past
three years, while net bond issuance was strong. By issuing
longer-term bonds and paying down short-term debt, businesses
have substantially lengthened the overall maturity of their debt.
This restructuring reduced firms' near-term repayment obligations
and locked in low rates for longer periods. The strengthening of
businesses' financial positions means that financial constraints
are less likely to restrain a further pickup in hiring and
investment.


Lesson 4: Tax Cuts Can Boost Economic
Activity by Raising After-Tax Income and
Enhancing Incentives to Work, Save, and Invest

The use of discretionary fiscal policy--explicit changes in taxes
and government spending, as opposed to those that occur
automatically as economic activity changes--to reduce cyclical
fluctuations in the economy has fallen out of favor with many
economists over the past several decades. Some have pointed to
the difficulties of crafting and implementing discretionary policy
quickly enough to provide stimulus while the economy is still weak
rather than accentuating an upturn that is already under way. It
has also been noted that a temporary reduction in taxes might be
mostly saved by households and thus encourage relatively little
additional spending. Moreover, some have argued that expansionary
fiscal policy can push up interest rates and thereby ``crowd out''
interest-sensitive spending. All told, before the recent business
cycle, many economists believed that monetary policy made the use
of discretionary fiscal policy unnecessary to stabilize the economy.

The experience of the past three years, however, shows that
well-designed and well-timed tax cuts are a useful complement to
expansionary monetary policy. Over this period, three bills have
made significant changes to the personal and corporate tax systems.
The President came into office with proposals for permanently
reducing taxes on work and saving. With the budget surplus having
reached its highest level relative to GDP in half a century, the
proposals were aimed predominantly at reducing tax-based impediments
to long-term growth. The proposals resulted in the Economic Growth
and Tax Relief Reconciliation Act (EGTRRA), which the President
signed into law in June 2001. In the wake of the terrorist attacks
of September 2001 and continuing softness in the economy, the
Congress passed the Job Creation and Worker Assistance Act (JCWAA),
which the President signed into law in March 2002. And, in early
2003, with the pace of economic growth still falling below its
potential and the labor market lagging behind, the President
proposed and the Congress enacted the Jobs and Growth Tax Relief
Reconciliation Act (JGTRRA), which the President signed into law in
May.

These three bills provided substantial short-term stimulus to
economic activity and helped put the economy on the road to
recovery. One source of stimulus has been the large boost to
after-tax personal income stemming from lower marginal tax rates,
a larger child tax credit, reduced tax rates on dividends and
capital gains, and other changes in the tax law. Real after-tax
income has increased much more than before-tax income over the past
three



years (Chart 1-8).  Over the preceding five years, average annual
growth in real after-tax income was more than 1/2 percentage point
below the growth rate of real before-tax income. Numerous studies
have shown that long-term tax cuts foster higher consumer spending.
Thus, the additional income provided by the tax cuts is likely to
have substantially boosted aggregate demand since 2000.

The tax cuts provided further stimulus by increasing incentives for
business investment. Some of these incentives came in the form of
bonus depreciation for business investment, an expansion in the
amount of expensing of investment available for small businesses.
The bonus depreciation was introduced in the 2002 tax cut (JCWAA),
which specified that 30 percent of the price of investments made by
September 10, 2004 could be treated as an immediate expense under
the corporate profits tax and the remaining 70 percent depreciated
over time according to the regular depreciation schedules. Moving
the depreciation closer to the time of new investment increased the
present value of depreciation allowances and the net after-tax
return on investment. The 2003 tax cut (JGTRRA) raised the bonus
depreciation to 50 percent of the price of new equipment and
extended the period of eligibility so that investments made by the
end of 2004 would be covered. It also increased the cap on
small-business expensing from $25,000 to $100,000 per year
through 2005, effectively lowering the cost of investment for
small businesses. These tax changes lowered firms' cost of capital
and likely provided support for investment at a crucial time.

The tax cuts also reduced the cost of capital and increased
incentives for business investment by lowering tax rates on personal
capital income. The 2001 tax cut (EGTRRA) phased out the estate
tax and reduced marginal tax rates on all forms of income. These
steps lowered the tax burden on capital income received from
corporations and also on income received through sole
proprietorships, partnerships, and S corporations (corporations for
which income is taxed through individual tax returns). In addition,
the 2003 tax cut (JGTRRA) reduced taxes on corporate dividends and
capital gains.

Altogether, these three tax bills provided $68 billion in tax
stimulus in fiscal year 2001, $89 billion in fiscal year 2002, $159
billion in fiscal year 2003, and $272 billion in fiscal year 2004.
However, the bills were designed not only to provide short-term
stimulus, but also to encourage stronger economic growth over the
long run. Lower tax rates on labor income provide an incentive to
increase work effort. Lower tax rates on capital income--the reward
for saving and investment--provide an incentive to do more of
these activities. Investment increases the amount of capital for
each worker and also increases the rate at which new technology
embodied in capital can be put to use. According to one study, the
cut in taxes on capital income in the 2003 tax package (JGTRRA)
reduced the marginal effective total tax rate on income from
corporate investment by 2 to 4 percentage points. Lower taxes on
dividends and capital gains also move the tax system toward a more
equal treatment of debt and equity, of dividends and capital gains,
and of corporate and noncorporate capital. This move increases
economic efficiency because it promotes the allocation of capital
based on business fundamentals rather than a desire for tax
avoidance.

In sum, the tax cuts supported by this Administration provided a
substantial short-term stimulus to consumption and investment and
promoted strong and sustainable long-term growth. In weighing the
merits of countercyclical monetary and fiscal policy, the stimulus
provided by discretionary fiscal policy may be especially important
in the low-inflation, low-interest-rate environment the country now
enjoys. Under these circumstances, the Federal Reserve may have less
room to cut interest rates, and direct stimulus to demand from
fiscal policy may be needed to ensure that the Nation's resources
are fully utilized in the face of cyclical weakness.


Lesson 5: Strong Productivity Growth Raises
Standards of Living but Means that
Much Faster Economic Growth is
Needed to Raise Employment

One distinctive feature of this recession and recovery has been the
remarkably fast growth of labor productivity--the amount of goods
and services that a worker with given skills produces from each
hour of work. The late 1990s had already witnessed an acceleration
of productivity growth from an average annual rate of around 1 1/2
percent between the fourth quarters of 1972 and 1995 to a roughly
2 1/2 percent rate between the fourth quarters of 1995 and 2000.
Productivity growth then picked up further, contrary to the usual
experience in which productivity growth has typically softened in
the quarters surrounding business-cycle peaks. In the latest
recession, productivity growth leveled off for just one quarter
before beginning to rise rapidly (Chart 1-9). Since the fourth
quarter of 2000, productivity has increased at an exceptional
annual rate of more than 4 percent per year.

Labor productivity growth can be decomposed into the skills of the
workforce (labor quality), increases in the amount of capital
services per worker-hour (capital deepening), and increases in total
factor productivity--a



residual category that captures the change in aggregate output not
explained by changes in capital and labor inputs. According to this
framework (as detailed in last year's Report), productivity growth
stepped up in the mid-1990s partly because the rapid pace of
business investment generated large increases in the amount of
capital available to each worker. Yet a larger part of this
acceleration owes to faster growth in the unexplained residual
category of total factor productivity.

The explanation for faster productivity growth in the past couple of
years is not clear (especially since the information needed to
decompose productivity growth over this period is quite limited).
One possibility is that weaker profits and skepticism about the
return to new physical investment have encouraged firms to make
better use of the resources they already had rather than investing
in new technology and capacity. This effort to increase what is
sometimes called organizational capital might involve, for
example, restructuring production processes and retraining workers
to take maximum advantage of new information-technology equipment
installed in the late 1990s. Another possibility is that firms
somehow induced extra work effort for a time because they were
hesitant to hire new workers until they were more confident that
increases in final demand would persist. A third possibility is that
the slower recent pace of gross investment may have been accompanied
by slower depreciation of the existing capital stock so that firms
lengthened replacement cycles and held on to their existing
equipment for longer periods. If this were the case, net investment
and the growth rate of the capital stock would have been stronger
than indicated by measures based on historical depreciation rates.

In the long run, productivity growth is the key determinant of growth
in living standards. Without labor productivity growth, our nation's
output and income would grow only at the rate at which the labor
force expands; if the labor force grows proportionally with
population, this would mean that income per person would be
unchanged. With productivity growth, income per person increases.
Indeed, U.S. average income is close to eight times as high as it
was one hundred years ago, similar to the increase in productivity
over this period. The recent robust gains in productivity have
boosted both corporate profits and employees' compensation.
Corporate profits declined sharply during the recession, but turned
around and rose briskly in 2003 (based on data through the first
three quarters). Average hourly earnings of production workers in
private industry have risen at an average annual rate of close to
3 percent over the past three years. Moreover, productivity growth
has reduced inflationary pressures by holding down growth in unit
labor costs. As a result, wage gains after adjusting for inflation
have been even more impressive by historical standards. In this
recession, real average hourly earnings, published in the Bureau
of Labor Statistics employment release, never fell below their
pre-recession levels, and increased nearly 3 percent in the eleven
quarters after the recession began. The experiences in past
recessions have been diverse, but many show a net decline in real
hourly earnings or much weaker growth even eleven quarters after
the start of the recession.

By definition, labor productivity multiplied by hours worked equals
output. Thus, in an arithmetic sense, faster productivity growth
generally implies that output must expand more rapidly to generate
employment gains. The same principle explains why the rapid pace
of productivity growth over the past couple of years has meant that
gains in output occurred without gains in employment, until recently.

Indeed, the performance of employment over the past couple of years
has been appreciably weaker than in past business cycles
(Chart 1-10). Employment was slow to pick up in the average previous
recovery, perhaps because employers delayed hiring until they became
confident that the increases in demand were sustainable. However,
such sluggishness typically has been short-lived (a quarter or two)
and followed by vigorous expansion. In contrast, in the current
business cycle, employment did not begin its recovery until nearly
two years after the upturn in real GDP. The performance of employment
in this cycle has lagged even that of the so-called ``jobless
recovery'' from the 1990-1991 recession. (Chart 1-10 shows data from
the establishment survey done by the Bureau of Labor Statistics
(BLS). The BLS household survey can show a different pattern--as it
has done over the past couple of years. As discussed in Box 1-2,
however, the BLS views the establishment survey as a more accurate
indicator of labor market conditions.)



Nonetheless, one should not conclude that rapid productivity growth
causes low employment growth. Rapid productivity growth means that
output must increase faster for employment to expand, but it also
means that the economy is capable of growing faster. In the long
run, the faster rate of potential output growth is undoubtedly a
good thing for living standards.

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Box 1-2: Two Surveys of Employment

Everyone who works is either employed by a firm or is self-employed.
Therefore, to count the total number of workers, one could ask each
person whether he or she is employed, or one could ask each firm how
many workers it employs. The Bureau of Labor Statistics, the
agency responsible for tracking employment, uses both approaches.
When the BLS asks individuals about their employment status, the
results are summarized in the household survey of employment. When
the BLS asks firms, it produces the establishment survey of
employment.

Though both surveys ask about employment, they have some important
differences that can cause their results to diverge. For example,
the establishment survey obtains data from about 160,000 businesses
and government agencies that represent about 400,000 worksites and
employ over 40 million workers. The sample covers about one-third of
all nonfarm payroll jobs in America. The household survey, in
contrast, collects data from about 60,000 households, thereby
directly covering fewer than 100,000 workers. The establishment
survey's larger base of respondents means the calculated margin of
error of its estimates is significantly smaller than that associated
with the household survey estimates. In addition, the establishment
survey is revised annually to match complete payroll records from the
universe of establishments participating in state unemployment
insurance programs, while the household survey is not.

Furthermore, definitional differences affect the scope of employment
measured by the surveys. The establishment survey estimate represents
the number of payroll jobs, or the number of jobs for which firms
pay compensation, while the household survey estimate represents the
number of employed persons. Because some people hold more than one
job, the total number of payroll jobs can exceed the total number of
employed persons. On the other hand, the household survey includes
employees working in the agricultural sector, the unincorporated
self-employed, unpaid family workers, workers in private households,
and workers on unpaid leave from their jobs. The establishment survey
excludes all of these categories because they are not reported on the
nonfarm business payrolls that provide the source data for the
survey.

These differences and other factors create a gap between the
household and establishment surveys' employment estimates, though
they tend to display similar long-term trends. The average gap since
1990 has been about 6 percent, or 8 million workers.

While long-term trends in the two surveys are similar, over shorter
periods of time their trends have sometimes diverged. This has been
the case since late 2001, when employment from the two surveys has
trended in opposite directions.  For the first time in the two
series' histories, one showed a large and sustained decrease in
employment while the other showed a large and sustained increase.
In particular, the establishment survey reported a decline in
employment of over 1.0 million from the end of the recession in
November 2001 to August 2003, while the household survey reported an
increase of over 1.4 million. In every month of 2003, the
establishment survey showed employment below the November 2001 level,
while the household survey showed it above this level. Such a
sustained string of divergence is unprecedented.

One possible explanation is that the establishment survey misses some
new firms and therefore may underestimate employment at the start of
an economic expansion. Past revisions to the establishment survey
offer some support for this theory. For the recent data, however,
this theory can explain at most the divergence since March 2003,
because establishment survey data up to that point appear consistent
with unemployment insurance records that cover all establishments.
Another possible explanation is that the household survey results
are overstated because of the way in which the survey results are
extrapolated to represent the entire population. Specifically,
information from the 2000 Census, together with estimates of how
the population is changing over time, are used to determine how many
actual U.S. households correspond to each household in the sample.
If, for example, immigration has been unexpectedly low because of
tighter border controls and the weaker labor market over the past few
years, the estimated number of U.S. households corresponding to each
household in the sample may be overstated. As a result, the
estimates of total employment (and other aggregates based on the
population estimates) from the household survey could be too high.

Both surveys contain valuable information about current economic
developments, but, as with all economic statistics, the data from
both surveys are imperfect. The Bureau of Labor Statistics has stated
that the establishment survey is generally the more reliable
indicator of current trends in employment. Still, the explanation
for why these two surveys' results have diverged so markedly over the
last few years, and what this might indicate about the economic
recovery, remains a puzzle.
---------------------------------------------------------------------

Conclusion

The U.S. economy is much stronger now than it was a year ago and,
as will be discussed in Chapter 3, prospects for the coming year
look solid. Nonetheless, the experiences of the past several years
remain relevant for the future. Understanding the negative forces
that weighed against the economy, as well as the policies that
contributed to the recovery, can help policy makers ensure that
economic activity maintains a strong upward trend in the years
ahead.