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


 
CONTENTS
--------
Page


overview .........................................................  17
Chapter 1. lessons from the recent business cycle ................  29
Overview of the Recent Business Cycle ............................  30
Lesson 1: Structural Imbalances Can Take Some Time to Resolve ....  33
Lesson 2: Uncertainty Matters for Economic Decisions .............  37
Lesson 3: Aggressive Monetary Policy Can Reduce the Depth of a
Recession ......................................................  40
Lesson 4: Tax Cuts Can Boost Economic Activity by Raising
After-Tax Income and Enhancing Incentives to Work, Save,
and Invest .....................................................  43
Lesson 5: Strong Productivity Growth Raises Standards of Living
but Means that Much Faster Economic Growth is Needed
to Raise Employment ...........................................  46
Conclusion .......................................................  51

Chapter 2. the manufacturing sector ..............................  53
Manufacturing and the Recent Business Cycle ......................  53
The Recent Downturn in Manufacturing Output ..............  54
Manufacturing Employment in Recent Years .................  56
Signs of Recovery in the Manufacturing Sector ............  57
Long-Term Trends .................................................  59
Manufacturing Output over the Long Term ..................  59
Manufacturing Productivity and Demand over the Long Term .. 60
Manufacturing Employment over the Long Term ..............  69
The Effects of Domestic Outsourcing and Temporary
Workers on Measurement of Manufacturing Employment ......  71
Effects of the Shift to Services on Workers' Compensation . 74
The Transition in Context ........................................  76
The Role of Policy ...............................................  80
Conclusion .......................................................  82

Chapter 3. the year in review and the years ahead ................  83
Developments in 2003 and the Near-Term Outlook ...................  83
Consumer Spending ........................................  84
Residential Investment ...................................  89
Business Fixed Investment ................................  90
Business Inventories .....................................  91
Government Purchases .....................................  92
Exports and Imports ......................................  92
The Labor Market .........................................  94
Productivity, Prices, and Wages ..........................  95
Financial Markets ........................................  97
The Long-Term Outlook ............................................  97
Growth in Real GDP and Productivity over the Long Term ...  98
Interest Rates over the Long Term ........................ 100
The Composition of Income over the Long Term ............. 100
Conclusion ....................................................... 101

Chapter 4. tax incidence: who bears the tax burden? .............. 103
Theory of Tax Incidence .......................................... 104
Incidence of an Excise Tax ............................... 104
Legal Incidence is Unimportant ........................... 106
Applied Distributional Analysis of Excise Taxes and
Subsidies .............................................. 107
Payroll Taxes .................................................... 107
Taxes on Capital Income .......................................... 110
Shifting Across Sectors .................................. 110
Shifting to Workers ...................................... 111
Applied Distributional Analysis and the Choice of Time
Frame ................................................... 113
Estate and Gift Taxes ............................................ 114
Conclusion ....................................................... 116

Chapter 5. dynamic revenue and budget estimation ................. 117
Revenue Estimation and Microeconomic Behavioral Responses ........ 118
An Example of Revenue Implications of Microeconomic
Behavioral Responses ................................... 118
Incorporation of Microeconomic Behavioral Responses
in Revenue Estimation .................................. 119
Macroeconomic Behavioral Responses to Policy Changes ............. 120
User's Guide to Dynamic Revenue and Budget Estimation ............ 122
Guideline 1: Dynamic Estimation Should Distinguish
Aggregate Demand Effects and Aggregate Supply Effects .. 122
Guideline 2: Dynamic Estimation Should Include Long-Run
Effects ................................................ 123
Guideline 3: Dynamic Estimation Should Be Applied to
Spending Changes as well as Tax Changes ................ 124
Guideline 4: Dynamic Estimation Should Reflect the
Differing Macroeconomic Effects of Various Tax and
Spending Changes ....................................... 124
Guideline 5: Dynamic Estimation Should Account for the
Need to Finance Policy Changes ......................... 125
Guideline 6: Dynamic Revenue Estimation Should Use a
Variety of Models Until Greater Consensus Develops ..... 126
Conclusion ....................................................... 127
Appendix: The Model Used in the Capital-Tax Example ...... 127

Chapter 6. restoring solvency to social security ................. 129
The Rationale for Social Security ................................ 130
Understanding the Financial Crisis ............................... 131
Misunderstanding the Financial Crisis ............................ 137
The Nature of a Prefunded Solution ............................... 139
Can We Afford to Reform Entitlements? ............................ 142
Conclusion ....................................................... 147

Chapter 7. government regulation in a free-market society ........ 149
How Markets Work ................................................. 149
Market Imperfections ............................................. 151
Regulation and Externalities ............................. 151
Regulation and Market Power .............................. 154
Regulation in the Absence of a Market Failure ............ 154
Conclusion ....................................................... 156

Chapter 8. regulating energy markets ............................. 157
Market Forces and Regulation in the Market for Natural Gas ....... 158
Market Forces and Regulation in Gasoline Markets ................. 159
Local and Federal Regulations May Conflict ............... 160
Local and State Regulations Lead to Different Market
Outcomes ................................................ 161
Market Forces and Regulation in Electricity Markets .............. 161
The Evolution of the Electric Industry from Local to
Interstate Markets ...................................... 162
Electricity Regulation in an Evolving Market ............. 163
Demand Response to Electricity Production Costs .......... 165
Energy and Trade ................................................. 167
U.S. Energy Sources ...................................... 167
Changes in the Oil Market ................................ 168
Trade in Oil and Price Stability ......................... 169
The Evolution of Energy Markets .................................. 169
Conclusion ....................................................... 172

Chapter 9. protecting the environment ............................ 173
The Free Market and the Environment .............................. 173
The Role of Government in Regulating the Environment ............. 174
Misplaced Reasons for Government Intervention ............ 177
Regulations Impose Benefits and Costs .................... 178
Using Science to Help Set Regulatory Priorities .................. 178
Overestimating the Risks: The Problem with ``Cascading
Conservatism'' ......................................... 179
Population-Weighted Risk Assessments .................... 180
Objective Versus Perceived Risk ......................... 180
Achieving Goals Through Cost-Effective Regulations .............. 181
Command-and-Control Regulations ......................... 182
Market-Based Price Regulations: Emission Fees ........... 183
Market-Based Quantity Regulations: Cap-and-Trade ........ 184
Emission Fees Versus Cap-and-Trade ...................... 186
The President's Cap-and-Trade Program ................... 187
Conclusion ...................................................... 188

Chapter 10. health care and insurance ........................... 189
The U.S. Health Care System as an Engine of Innovation .......... 190
The Value of Health Care Innovation ..................... 190
U.S. Leadership in Health Care Technology ............... 192
Insurance Reform as a Means of Providing Health Care
More Efficiently .............................................. 194
The Appropriate Use of Insurance ........................ 194
Moral Hazard ............................................ 195
Adverse Selection ....................................... 196
Health Insurance in the United States ................... 196
A Brief History of Health Insurance in the United States. 198
Proposals for Modernizing the Health Care Market ................ 199
Medicare Prescription Drug, Improvement, and
Modernization Act of 2003 .............................. 199
Next Steps in Improving Health Care Markets ............. 200
Conclusion ...................................................... 201

Chapter 11. the tort system ..................................... 203
The Changing Role of Tort Law ................................... 203
The Expansion of Tort Costs ..................................... 204
The Economic Effects of the Tort System ................. 207
Torts as Injury Compensation .................................... 207
The Principal Injury-Compensation Methods ............... 208
Administrative Costs .................................... 208
Compensation of Noneconomic Losses ...................... 209
Extent of Coverage ...................................... 210
Torts as Deterrence ............................................. 211
General Aviation and Deterrence ......................... 212
Other Evidence on Deterrence ............................ 215
The Limits of Tort Deterrence ........................... 215
Potential Tort Reforms .......................................... 215
Limiting Noneconomic Damages and Other Potential
Reforms ................................................ 216
Procedural Reforms ...................................... 217
Limiting the Scope of Tort Compensation ................. 217
Avoiding the Tort System ................................ 220
Conclusion ...................................................... 221

Chapter 12. international trade and cooperation ................. 223
Increased Trade Flows: Facts and Trends ......................... 223
The Benefits of Free Trade ...................................... 225
Comparative Advantage ........................................... 226
Assisting People and Communities Affected by Free Trade ......... 227
New Facets of Trade ............................................. 228
Intellectual Property ................................... 228
Services ................................................ 228
Intra-industry Trade and Intermediate Products .......... 230
International Cooperation and Disputes .......................... 231
Why Is There a Need for Cooperation? .................... 231
The Benefits of Dispute Settlement ...................... 234
Progress Toward Free Trade ...................................... 235
Conclusion ...................................................... 237

Chapter 13. international capital flows ......................... 239
Types of International Capital Flows ............................ 240
Foreign Direct Investment ............................... 241
Portfolio Investment .................................... 241
Bank Investment ......................................... 242
Benefits of International Capital Flows ......................... 242
Risks of International Capital Flows ............................ 244
Constraints Imposed by Free Capital Flows ....................... 247
Encouraging Free Capital Flows .................................. 250
Conclusion ...................................................... 252

Chapter 14. the link between trade and capital flows ............ 253
The Basic Accounting Identity ................................... 253
Trends in the U.S. Balance of Payments .......................... 258
Factors that Influence the Balance of Payments .................. 260
Possible Paths of Balance of Payments Adjustment ................ 263
Conclusion ...................................................... 264

Appendixes
A. Report to the President on the Activities of the Council of
Economic Advisers During 2003 ........................... 265
B. Statistical Tables Relating to Income, Employment,
and Production .......................................... 277

List of Tables

2-1.    Employment in Selected Manufacturing Industries .........  70
2-2.    Compensation in Selected Industries .....................  75
3-1.    Administration Forecast .................................  98
3-2.    Accounting for Growth in Real GDP, 1960-2009 ............  99
9-1.    Cost Savings of Tradable-Permit Systems ................. 186
10-1.   Important Medical Innovations and Associated Country
of Origin .............................................. 192
11-1.   Characteristics of State and Federal Tort Cases Decided by
Trial, 1996 ............................................ 206
11-2.   Compensation for Injury, Illness, and Fatality in the
United States, Selected Methods ........................ 209
12-1.   Leading U.S. Net Exports of Goods, 2002 ................. 225
12-2.   Status of Free Trade Agreements (FTAs) with the
United States .......................................... 236
14-1.   Current and Financial Account ........................... 259

List of Charts

1-1.    Real GDP ................................................  32
1-2.    Real Investment in Equipment and Software ...............  34
1-3.    Real Exports ............................................  36
1-4.    The Wilshire 5000 Index of Stock Prices .................  38
1-5.    Expected Near-Term S&P 500 Volatility ...................  39
1-6.    The Effective Federal Funds Rate ........................  40
1-7.    Real Residential Investment .............................  41
1-8.    Growth in Personal Income, Before and After Taxes .......  44
1-9.    Productivity in the Nonfarm Business Sector .............  46
1-10.   Total Nonfarm Employment ................................  48
2-1.    Real GDP and Manufacturing Industrial Production ........  54
2-2.    Manufacturing Industrial Production and Real Investment .  55
2-3.    Manufacturing Employment ................................  56
2-4.    Productivity in Manufacturing ...........................  57
2-5.    Employment in Manufacturing and Temporary-Help Services .  58
2-6.    Real GDP and Manufacturing Industrial Production ........  59
2-7.    Productivity Growth .....................................  61
2-8. 	Price Level by Category of Personal Consumption
Expenditures ..........................................  62
2-9.    U.S. Imports and Domestic Production of Goods ...........  63
2-10.   Nonagricultural Goods Trade as a Percent of Manufacturing
Output .................................................  64
2-11.   Nonagricultural Goods Net Imports as a Percent of Output . 64
2-12.   China's Trade in Goods ..................................  67
2-13.   U.S. Trade Deficit in Goods .............................  67
2-14.   U.S. Imports of Goods ...................................  68
2-15.   U.S. Exports of Goods ...................................  68
2-16.   Employment and Relative Productivity ....................  69
2-17.   Manufacturing and Professional and Business Services
Employment ............................................  72
2-18.   Outsourcing and Temporary-Help Services Employment ......  72
2-19.   Employment in Industry as a Percent of Total Employment .. 77
2-20.   Employment and Real Output in Agriculture ...............  79
2-21.   Agricultural Productivity ...............................  79
2-22.   Wholesale Prices ........................................  80
3-1.    Wealth-to-Income Ratio and Personal Saving Rate .........  88
3-2.    National Saving Rate ....................................  88
3-3.    Growth in Temporary-Help Services and Overall
Employment, 1990-2003 ..................................  95
4-1.    Distribution of Capital Income Tax Burden in the Long Run . 113
6-1.    Demographic Change and the Cost of Social Security
Through 2080 .......................................... 132
6-2.    Social Security's Annual Balances Through 2080 .......... 133
6-3.    Probability Distribution of Projected Annual Cost Rates . 136
6-4.    The Potential Impact of Commission Model 2 on Deficits
and Debt .............................................. 144
6-5.    The Long-Run Budget without Social Security Reform ...... 145
6-6.    The Long-Run Budget Deficit with Social Security Reform	. 146
8-1.    Required Specifications for Gasoline .................... 160
8-2.    Hourly Electricity Consumption, Wholesale Prices, and
Retail Prices in California ............................ 165
8-3.    Production Costs and Reserves of Alternative Transportation
Fuel Sources ........................................... 171
9-1.    National Concentrations of Air Pollutants ............... 176
9-2.    Particulate Matter Concentrations ....................... 176
9-3.    Relationship Between Actual and Perceived Risk of Dying . 181
9-4.    Unit-Level Sulfur Dioxide Emissions Trading in 1997 ..... 186
11-1.   Tort Costs as a Percent of GDP .......................... 205
11-2.   Tort Filings in 16 States ............................... 206
11-3.   General Aviation Liability Payouts and Accident Rates ... 213
11-4.   Accident Rate for Small Aircraft ........................ 213
11-5.   Small-Aircraft Production ............................... 214
11-6.   International Comparison of Tort Costs, 1998 ............ 216
12-1.   World Trade and GDP ..................................... 224
12-2.   World Trade in Goods and Services ....................... 229
13-1.   Global Capital Flows as a Percent of World GDP .......... 239
13-2.   World Capital Inflows in 2002 ........................... 240
13-3.   ``The Impossible Trinity'' .............................. 247
14-1.   Changes to the Balance of Payments Terminology in 1999 .. 255
14-2.   Balance of Payments ..................................... 258
14-3.   Exports and Imports of Goods ............................ 259
14-4.   Saving, Investment, and the Current Account Balance ..... 261
14-5.   Budget Deficit and the Current Account Balance .......... 263

List of Boxes

1-1.    When Did the Recent Recession Begin? ....................  30
1-2.    Two Surveys of Employment ...............................  49
2-1.    China and the U.S. Manufacturing Sector .................  65
2-2.    What is Manufacturing? ..................................  73
2-3.    The Evolution of the U.S. Agricultural Sector ...........  77
3-1.    Personal Saving and National Saving .....................  86
4-1.    Social Security and Transfer Payments in Distributional
Tables ................................................. 109
6-1.    The Retirement of the Baby-Boom Generation .............. 134
6-2.    Long-Term Projections and Uncertainty ................... 135
7-1.    Market Responses to Unexpected Shortages ................ 155
9-1.    Economic Growth Can Improve the Environment ............. 175
10-1.   Price Regulation and the Introduction of New Drugs ...... 193
10-2.   Who are the Uninsured? .................................. 197
11-1.   Punitive Damages ........................................ 211
11-2.   The Role of Class Actions in the Tort System ............ 218
11-3.   Asbestos and the Tort System ............................ 219
12-1.   Trade in Financial Services ............................. 230
12-2.   International Cooperation on Intellectual Property
Rights ................................................. 233
13-1.   Capital Controls in Emerging Markets .................... 245
13-2.   Choosing Among a Fixed Exchange Rate, Independent
Monetary Policy, and Free Capital Movements ............ 249
14-1.   A New Look for the Balance of Payments .................. 254
14-2.   Bilateral Versus Multilateral Balances .................. 257