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


 
Overview

The U.S. economy made notable progress in 2003, propelled forward by
pro-growth policies that led to a marked strengthening of activity
in the second half of the year and put the United States on a path
for higher sustained output growth in the years to come.
The recovery was still tenuous coming into 2003, as continued fallout
from powerful contractionary forces--the capital overhang, corporate
scandals, and uncertainty about future economic and geopolitical
conditions--was offset by stimulus from expansionary monetary policy
and the Administration's 2001 tax cut and 2002 fiscal package.
The contractionary forces dissipated over the course of 2003, and
the expansionary forces were augmented by the Jobs and Growth Tax
Relief Reconciliation Act (JGTRRA) that was signed into law at the
end of May.
The economy appears to have moved into a full-fledged recovery,
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). Job
growth, however, began to pick up only late in 2003.
This Report discusses this turning of the macroeconomic tide, along
with a number of other economic policy issues of continuing
importance. The 14 chapters of this Report cover five broad
topics: macroeconomic policy, fiscal policy, regulation, reforms
of the health care and tort systems, and issues in international
trade and finance. In all of these areas, the Report highlights
how economics can inform the design of public policy and discusses
Administration policies.
The Administration's pro-growth tax policy, in concert with the
dynamism of the U.S. free-market economy, has laid the groundwork
for sustainable rapid growth in the years ahead. Well-timed fiscal
stimulus combined with expansionary monetary policy to offset and
eventually reverse the contractionary forces impacting the economy.
But there is still much to be done. The tax cuts must be made
permanent to have their full beneficial impact on the economy. A
stronger economy will also result from progress on the other aspects
of the Administration's economic agenda, including making health
care more affordable; reducing the burden of lawsuits on the
economy; ensuring an affordable and reliable energy supply;
streamlining regulations; and opening markets to international
trade. These initiatives are discussed in this Economic Report of
the President.


Macroeconomic Policy

Chapter 1, Lessons from the Recent Business Cycle, discusses the
distinctive features of the recent recession and subsequent
recovery, and draws five key lessons for the future. The recent
business cycle was unusual in that it was characterized by especially
weak business investment but robust consumption and housing
investment. This makes clear the first lesson, that structural
imbalances such as the ``capital overhang'' that developed in the
late 1990s can take some time to resolve. A number of events
contributed to a climate of uncertainty in 2003, including the
terrorist attacks of September 11, 2001, corporate governance
and accounting scandals, and geopolitical tensions surrounding
the war with Iraq. The second lesson from the recent business
cycle is that the effects of the uncertainty from these events
on household and business confidence can have important effects
on asset prices, household  spending, and investment. Resolution
of some of the uncertainties appears to have contributed to the
resurgence of growth.
Monetary and fiscal policies played a critical role in moving the
economy back toward potential. The third lesson is that aggressive
monetary policy can help make a recession shorter and milder. The
fourth lesson is that tax cuts can likewise boost economic
activity. Tax cuts raise after-tax income, while at the same time
promoting long-term growth by enhancing incentives to work, save,
and invest. Tax relief enacted in 2001 and 2002 helped lessen the
severity of the recession, while the 2003 tax cut appears to have
propelled the economy forward into a strong recovery. Job creation
has lagged behind, even as demand has surged. Thus, the fifth lesson
of the recent recession is that strong productivity growth, as was
experienced in 2003, means that much faster economic growth is
needed to raise employment. This productivity growth, however, is
not to be lamented, since it ultimately leads to higher standards
of living for both workers and business owners.
Chapter 2, The Manufacturing Sector, examines recent developments
and long-term trends in manufacturing and considers policy responses.
Manufacturing was affected by the economic slowdown earlier, longer,
and harder than other sectors of the economy and manufacturing
employment losses have only recently begun to abate. The severity
of the recent slowdown in manufacturing was largely due to prolonged
weakness in business investment and exports, both of which are
heavily tied to manufacturing.
Over the past several decades, the manufacturing sector has
experienced substantial output growth, even while manufacturing
employment has declined as a share of total employment. The
manufacturing employment decline over the past half-century
primarily reflects striking gains in productivity and increasing
consumer demand for services compared to manufactured goods.
International trade has played a relatively small role by comparison.
Consumers and businesses generally benefit from the lower prices
made possible by increased manufacturing productivity, and strong
productivity growth has led to real compensation growth for
workers. While the shift of jobs from manufacturing to services
has caused dislocation, it has not resulted, on balance, in a shift
from ``good jobs'' to ``bad jobs.'' The best policy response to recent
developments in manufacturing is to focus on stimulating the
overall economy and easing restrictions that impede manufacturing
growth. This Administration has actively pursued such measures.
Chapter 3, The Year in Review and the Years Ahead, reviews
macroeconomic developments in 2003 and discusses the Administration
forecast for 2004 through 2009. Real GDP growth picked up
appreciably in 2003, with growth in consumer spending, residential
investment, and, particularly, business equipment and software
investment increasing noticeably in the second half of the year.
The labor market began to rebound in the final five months of
2003. Inflation remained well in check, with core consumer
inflation declining by the end of the year to its lowest level in
decades. 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 by 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.
The Administration expects the economic recovery to strengthen
further in 2004, with real GDP growth running well above its
historical average and the unemployment rate falling. Boosted by
pro-growth policies and expansionary monetary policy, and on the
foundation of the underlying strength of the free-market society
in the United States, the economy is expected to continue on a
path of strong, sustainable growth.


Fiscal Policy

Chapter 4, Tax Incidence: Who Bears the Tax Burden?, discusses the
analysis of how the burden of a tax is distributed among taxpayers.
This question is important to policy makers, who want to know whether
the distribution of the tax burden (between rich and poor, capital
and labor, consumers and producers, and so on) meets their criteria
for fairness. The key result is that the economic incidence of a
tax may have little to do with the legal specification of its
incidence. Rather, it depends on the actions of market participants
in response to the imposition of the tax.
Distributional tables showing the tax burdens borne by different
income groups are an important application of incidence analysis.
When used properly, distributional tables can contribute to informed
decision making on the part of citizens and policy makers.
Unfortunately, mainstream economic analysis suggests that these
tables do not always accurately describe who bears the burden of
certain taxes. This problem does not arise from bias or lack of
economic knowledge on the part of the economists who prepare these
tables. Instead, it reflects resource and data limitations,
uncertainty about some of the economic effects of taxes, and
variations in the time frame considered by the analyses.
Nevertheless, the shortcomings of distributional tables can lead
to misperceptions of the impact of tax changes.
An important implication of the economic analysis of incidence is that,
in the long run, a large part of the burden of capital taxes is
likely to be shifted to workers through a reduction in wages.
Analyses that fail to recognize this shift can be misleading,
suggesting that lower income groups bear an unrealistically small
share of the burden of such taxes and an unrealistically small
share of the gain when capital income taxes are lowered.
Chapter 5, Dynamic Revenue and Budget Estimation, examines how taxes
affect the behavior of firms, workers, and investors and discusses
the implications for the estimated effects of a tax change on
revenue. Changes in taxes and spending generally alter incentives
for work, investment, and other productive activity--a higher tax
on an activity tends to discourage that activity. Revenue estimation
is called dynamic if it incorporates the behavioral responses to tax
changes and static if it does not incorporate these behavioral
responses.
To make informed decisions about a policy change, policy makers
should be aware of all aspects of its budgetary implications.
Currently, official revenue estimates of proposed tax changes
incorporate the revenue effects of many microeconomic behavioral
responses. However, these estimates are not fully dynamic because
they exclude the effects of macroeconomic behavioral responses.
Several obstacles have prevented macroeconomic behavioral
responses from being incorporated in such estimates. This chapter
discusses the ongoing efforts to provide a greater role for fully
dynamic revenue and budget estimation in the analysis of major
tax and spending proposals. At least in the near term, it may not
be practical for macroeconomic effects to be incorporated in
official estimates. But estimates of these effects should be
provided as supplementary information for major tax and spending
proposals. Dynamic estimation of policy changes should distinguish
aggregate demand effects from aggregate supply effects, include
long-run effects, apply to spending as well as tax changes,
reflect the differing effects of various policy changes, account
for the need to finance policy changes, and use a variety of models.
Reform of entitlement programs remains the most pressing fiscal
policy issue confronting the Nation. Chapter 6, Restoring Solvency
to Social Security, examines the largest entitlement program.
Social Security is a pay-as-you-go system in which payroll taxes on
the wages of current workers finance the benefits being paid to
current retirees. While the program is running a small surplus
at present, deficits are projected to appear in 15 years; by 2080,
the Social Security deficit is projected to exceed 2.3 percent of
GDP. These deficits are driven by two demographic shifts that have
been underway for several decades: people are having fewer children
and are living longer. The President has called for new initiatives
to modernize Social Security to contain costs, expand choice, and
make the program secure and financially viable for future generations
of Americans.
This chapter assesses the need to strengthen Social Security in
light of its long-term financial outlook. The most straightforward
way to characterize the financial imbalance in entitlement programs
such as Social Security is by considering their long-term annual
deficits. Even after the baby-boom generation's effect is no longer
felt, Social Security is projected to incur annual deficits greater
than 50 percent of payroll tax revenues. These deficits are so large
that they require a meaningful change to Social Security in future
years. Reform should include moderation of the growth of benefits
that are unfunded and would otherwise require higher taxes in the
future. However, the benefits promised to those in or near
retirement should be maintained in full. A new system of personal
retirement accounts should be established to help pay future
benefits. The economic rationale for undertaking this reform in
an era of budget deficits is as compelling as it was in an era of
budget surpluses.


Regulation

Chapter 7, Government Regulation in a Free-Market Society, discusses
the role of the free market in providing for prosperity in the
United States and considers situations in which government
interventions such as regulations would be beneficial. An important
reason for Americans' high standard of living is that they rely
primarily on markets to allocate resources. The government enables
the system to work by enforcing property rights and contracts.
Typically, free markets allocate resources to their highest-valued
uses, avoid waste, prevent shortages, and foster innovation. By
providing a legal foundation for transactions, the government
makes the market system reliable: it gives people certainty about
what they can trade and keep, and it allows people to establish
terms of trade that will be honored by both sellers and buyers.
The absence of any one of these elements--competition, enforceable
property rights, or an ability to form mutually advantageous
contracts--can result in inefficiency and lower living standards.
In some cases, government intervention in a market, for example
through regulation, can create gains for society by remedying
shortcomings in the market's operation. Poorly designed or
unnecessary regulations, however, can actually create new problems
or make society worse off by damaging the elements of the market
system that do work.
Chapter 8, Regulating Energy Markets, discusses economic issues
relevant to several energy markets, including natural gas,
gasoline, electricity, and crude oil. While energy markets
generally function well, some parts of the energy industry
have characteristics associated with market failures. These could
stem from the large fixed costs required to construct distribution
networks for electricity and natural gas that give rise to market
power in the form of a natural monopoly. Alternatively, the market
may not function well in the presence of negative externalities,
such as when energy producers and consumers do not fully take
into account the fact that burning fossil fuels may cause acid
rain or smog.
Minimizing disruptions is an important consideration in the design
of regulations to address shortcomings in energy markets. Federal,
state, and local regulations can have conflicting goals. If the
conflicting goals are not balanced, competing regulations could
lead to worse problems than the market failures the regulations
attempt to address. Moreover, regulations need to be updated as
markets evolve over time to ensure that their original goals still
apply and that these regulations are still the lowest-cost means of
meeting those goals.
The chapter also examines global trade in energy products. The
United States benefits from international trade in energy products
because meeting all U.S. energy needs from domestic sources would
require significant and costly changes to the U.S. economy,
including changes in the types of transportation fuels used by
Americans. But this leads to the possibility of occasional supply
disruptions. An important consideration is that the price of oil
is set in global markets, so that disruptions to the supply of oil
from areas that do not supply the United States affect domestic
prices of oil even if U.S. imports are not directly affected.
Fortunately, changes in the U.S. economy over the past three
decades and the increasing sophistication of financial markets
have diminished the impact of supply disruptions and temporary
price changes on the United States.
Finally, the chapter considers the role for government in subsidizing
research and development into new energy sources. In general, policy
makers should avoid forcing commercialization of new energy sources
before market signals indicate that a shift is required. One
potential problem with forcing this process is that technological
breakthroughs may lead to alternatives in the future that are hard
to imagine today. Premature adoption of new technologies would
raise energy costs before the need arises, causing society as a
whole to spend more on energy than needed.
Chapter 9, Protecting the Environment, discusses market-oriented
approaches to safeguarding and improving the environment. While
the free-market system typically promotes efficiency and economic
growth, the absence of property rights for environmental ``goods''
such as clean air and water can lead to negative externalities
that reduce societal well-being. This problem can be addressed by
establishing and enforcing property rights that will lead the
interested parties to negotiate mutually beneficial outcomes in
a market setting. If such negotiations are expensive, however, the
government can design regulations that consider both the benefits
of reducing the environmental externality as well as the costs of
the regulations.
Regulations should be designed to achieve environmental goals at
the lowest possible cost, promoting both environmental protection
and continued economic growth. Indeed, economic growth can lead
to increased demand for environmental improvements and provide
the resources that make it possible to address environmental
problems. Some policies aimed at improving the environment can
entail substantial economic costs. Misguided policies might
actually achieve less environmental progress than alternative
policies for the same cost. Environmental risks should be
evaluated using sound scientific methods to avoid possible
distortions of regulatory priorities. Market-based regulations,
such as the cap-and-trade programs promoted by the Administration
to reduce common air pollutants, can achieve environmental goals
at lower cost than inflexible command-and-control regulations.


Reforms of Health Care and the Legal System

Chapter 10, Health Care and Insurance, discusses the roles of
innovation, insurance, and reform in the health care market. U.S.
markets provide incentives to develop innovative health care
products and services that benefit both Americans and the global
community. The breadth and pace of innovation in the provision of
health care in the United States over the past few decades have
been astounding. New treatment options, however, have also been
associated with higher costs and concerns about affordability.
Research suggests that between 50 and 75 percent of the growth
in health expenditures in the United States is attributable to
technological progress in health care goods and services. A
strong reliance on market mechanisms will ensure that incentives
for innovation are maintained while providing high-quality care
in the most cost-efficient manner.
Health insurance plays a central role in the workings of the U.S.
health care market. An understanding of the strengths and
weaknesses of health insurance as a payment mechanism for health
care is essential to the design of reforms that retain incentives
for innovation while reining in unnecessary expenditures.
Over-reliance on health insurance as a payment mechanism leads
to an inefficient use of resources in providing and utilizing
health care. Reforms should provide consumers and health care
providers with more flexibility, more choices, more information,
and more control over their health care decisions.
Chapter 11, The Tort System, discusses the role of the U.S. tort
system and the considerable burden it imposes on the U.S. economy.
The tort system is intended to compensate accident victims and to
deter potential defendants from putting others at risk. Empirical
evidence, however, is mixed on whether the tort system effectively
deters negligent behavior. Moreover, the tort system is a costly
method of providing insurance against a limited number of injuries.
Research suggests that tort liability also leads to lower spending
on research and development, higher health care costs, and job
losses.
Ways to reduce the burden of the tort system include limits on
noneconomic damages, class action reforms, trust funds for payments
to victims such as in asbestos, and allowing parties to avoid the
tort system contractually. The Administration has proposed a number
of reforms to reduce the burden of the tort system while ensuring
that people with legitimate claims can recover damages.


International Trade and Finance

Chapter 12, International Trade and Cooperation, discusses how
growing trade helps to spur U.S. and global growth. Since the end of
the Second World War, international trade has grown steadily relative
to overall economic activity. Over time, countries that have been
more open to international flows of goods, services, and capital
have grown faster than countries that were less open to the global
economy. The United States has been a driving force in constructing
an open global trading system. The Administration has pursued, and
will continue to pursue, an ambitious agenda of trade liberalization
through negotiations at the global, regional, and bilateral levels.
New types of trade deliver new benefits to consumers and firms in
open economies. Growing international demand for goods such as
movies, pharmaceuticals, and recordings offers new opportunities
for U.S. exporters. A burgeoning trade in services provides an
important outlet for U.S. expertise in sectors such as banking,
engineering, and higher education. The ability to buy less expensive
goods and services from new producers has made household budgets
go further, while the ability of firms to distribute their
production around the world has cut costs and thus prices to
consumers. The benefits from new forms of trade, such as in
services, are no different from the benefits from traditional
trade in goods. Outsourcing of professional services is a prominent
example of a new type of trade. The gains from trade that take
place over the Internet or telephone lines are no different than
the gains from trade in physical goods transported by ship or
plane. When a good or service is produced at lower cost in another
country, it makes sense to import it rather than to produce it
domestically. This allows the United States to devote its resources
to more productive purposes.
Although openness to trade provides substantial benefits to nations
as a whole, foreign competition can require adjustment on the part
of some individuals, businesses, and industries. To help workers
adversely affected by trade develop the skills needed for new
jobs, the Administration has worked hard to build upon and
develop programs to assist workers and communities that are
negatively affected by trade.
The Administration has also worked to strengthen and extend the
global trading system. International cooperation is essential to
realizing the potential gains from trade. International trade
agreements have reduced barriers to international commerce, and
contributed to the gains from trade. A system through which
countries can resolve disputes can play an important role in
realizing these gains.
Chapter 13, International Capital Flows, discusses the economic
benefits and risks associated with the transfer of financial assets,
such as cash, stocks, and bonds, across international borders.
Capital flows have become an increasingly significant part of the
world economy over the past decade, and an important source of
funds to support investment in the United States. Around $2 trillion
of capital flowed into all countries in the world in 2002, with
around $700 billion flowing into just the United States. Different
types of capital flows--such as foreign direct investment, portfolio
investment, and bank lending--are driven by different investor
motivations and country characteristics. Countries that permit
free capital flows must choose between the stability provided by
fixed exchange rates and the flexibility afforded by an
independent monetary policy.
Capital flows can have a number of benefits for economies around
the world. For example, foreign direct investment can facilitate
the transfer of technology, allow for the development of markets
and products, and improve a country's infrastructure. Portfolio
flows can reduce the cost of capital, improve competitiveness,
and increase investment opportunities. Bank flows can strengthen
domestic financial institutions, improve financial intermediation,
and reduce vulnerability to crises.
A series of financial crises in emerging market economies, however,
has raised some concerns that financial liberalization can also
involve risks. In countries with weak institutions, poorly
regulated banking systems, or high levels of corruption, capital
inflows may not be channeled to their most productive uses. One
approach to limiting the risks from capital flows when legal and
financial institutions are poorly developed is to restrict foreign
capital inflows. Experience suggests, however, that capital controls
impose substantial, and often unexpected, costs. Instead, countries
are more likely to benefit from free capital flows and minimize any
related risks, if they adopt prudent fiscal and monetary policies,
strengthen financial and corporate institutions, and develop sound
regulations and supervisory agencies. The Administration has
promoted policies to help countries reap the benefits from the free
flow of international capital.
Chapter 14, The Link Between Trade and Capital Flows, shows that
trade flows and capital flows are inherently intertwined. Changes
in a country's net international trade in goods and services,
captured by the current account, must be reflected in equal and
opposite changes in its net capital flows with the rest of the
world. The large net inflow of foreign capital experienced by the
United States in recent years has funded more investment than could
be supported by U.S. national saving. Corresponding to these inflows
is the large U.S. current account deficit. These patterns reflect
fundamental economic forces, notably strong growth in the
United States that has made investment in this country attractive
compared to opportunities in other countries.
An adjustment of the U.S. current account deficit could come about
in several ways. Faster growth in other countries relative to the
United States could increase demand for U.S. net exports. Trade
flows could also adjust through changes in the relative prices of
U.S. goods and services compared to the prices of foreign goods
and services. Any narrowing of the U.S. current account deficit
would also require reduced net capital inflows into the
United States. This might occur if U.S. national saving
increased, reducing the need for foreign funds to finance U.S.
domestic investment, or if U.S. investment declined, so that the
United States required less capital inflows. Lower investment is
the least desirable form of balance of payments adjustment,
however, as it could slow the expansion of U.S. productive
capacity and reduce economic growth.
It is impossible to predict the exact timing or magnitude of any
adjustment in the U.S. current account balance. After a large
increase in the U.S. current account deficit in the 1980s, the
ensuing adjustments were gradual and benign. Public policies can
facilitate smooth changes in the U.S. current account and net
capital flows by creating a stable macroeconomic and financial
environment, promoting growth abroad, and encouraging greater
saving in the United States.


Conclusion

The future of the U.S. economy is bright. This is a testament to
the institutions and policies that have unleashed the creativity of
the American people and their spirit of entrepreneurship. History
teaches that the forces of free markets are the bedrock of economic
prosperity.
In 1776, as the Founding Fathers signed the Declaration of Independence,
the great economist Adam Smith wrote: ``Little else is requisite to
carry a state to the highest degree of opulence from the lowest
barbarism but peace, easy taxes, and a tolerable administration of
justice: all the rest being brought about by the natural course of
things.'' The economic analysis presented in this Report builds on
the ideas of Smith and his intellectual descendants by discussing
the role of the government in creating an environment that promotes
and sustains economic growth.