[Economic Report of the President (2007)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 2


Productivity Growth


News about economic issues focuses on topics such as inflation,
international competitiveness, standards of living, and long-run
demographic challenges. Productivity growth rarely makes the
headlines. Why is productivity growth important to the nation?
Because higher productivity growth improves the outlook for all of
these issues. It helps keep inflation in check, makes it easier for
American businesses and workers to compete, raises standards of
living, and reduces the difficulty of meeting long-run demographic
challenges by increasing the total amount of resources available.
Over the past 10 years, gross domestic product (GDP) per capita has
grown faster in the United States than in almost every other advanced
industrialized country. The United States owes its recent strong per
capita growth in large part to strong labor productivity growth. A
continuation of this productivity growth is essential to increasing
real wages and maintaining the high standard of living in the United
States. To remain competitive, U.S. businesses must hold costs down
by getting the most out of the inputs they use-that is, they must
increase labor productivity. Similarly, for U.S. workers to earn
higher wages than workers in other countries while competing in a
global economy, U.S. labor productivity must exceed that of
lower-wage countries.
Labor productivity growth also holds the key to dealing with the
economic and fiscal challenges of a rapidly aging population. The
total amount of goods and services produced in a country, measured by
GDP, can grow only if productivity or hours of work increase. As the
baby boomers (those born between 1946 and 1964) reach retirement,
growth in total hours of work across the U.S. economy will slow, and
the United States will have to depend increasingly on productivity
growth to drive increases in GDP. While labor force growth will slow,
the elderly population will expand relatively quickly. Strong GDP
growth must continue in order to maintain the standards of living
for both the working age and the dependent populations.
The amount that U.S. workers produce has grown at remarkable rates
in recent years. Since 1995, productivity growth has averaged over
2.5 percent per year, compared to an average growth rate of about 1.4
percent per year over the preceding 20 years. Most other major
industrialized countries suffered a slowdown in productivity growth
between 2000 and 2005, but in the United States, growth accelerated
to about 3 percent, the fastest productivity growth of any G7
country-Canada, France, Germany, Italy, Japan, the United Kingdom,
and the United States-over that period. Given that the United States'
productivity was already among the highest and that these countries
have similar access to technological improvements and financial
markets, the sudden increase in U.S. productivity growth relative to
other developed countries is especially impressive.
Table 2-1 illustrates how small differences in productivity growth
rates can, over time, have large effects on the level of productivity
and hence on the standard of living. When productivity doubles, twice
as much output can be produced using the same level of labor. The
table lists four different productivity growth rates that correspond
to averages for different U.S. historical time periods, along with
the number of years it would take to double the standard of living
at that rate of growth. If productivity continues to grow at the rate
from the most recent period (3.1 percent), the U.S. standard of
living will double in about 23 years; at the slower productivity
growth rate experienced during the 1973-1995 period (1.4 percent)
,doubling would take more than twice as long.



This chapter reviews the sources of the recent strength in
productivity growth, highlighting the role that flexible markets and
entrepreneurship play in explaining cross-country differences. It
also explains the benefits of productivity growth and discusses how
policymakers can further promote it. Key points are:

 Recent productivity growth has been primarily driven by
efficiency growth (growth in how well labor and capital
inputs are used) and by capital deepening (growth in the
amount of capital that workers have available for use).

 Efficiency growth comes from developing new methods of
production and new products. Entrepreneurship and competition
make key contributions to such innovation.

 Investment in information technology (IT) capital and
innovative new ways of using it have been important sources
of productivity growth in many industries with particularly
high growth rates.

 Openness to international trade and investment is especially
important for fostering competition and thus productivity growth.

 Increases in the education and training of the U.S. workforce
have been and will continue to be important to long-run
productivity growth.

 Policies that encourage capital accumulation, research and
development, and increases in the quality of our educational
system can boost productivity growth over the long run.


The Basics of Productivity Growth: Framework and Recent Facts

In the United States, the most commonly used measure of labor
productivity is that for the nonfarm business sector, which excludes
all levels of government, nonprofit institutions, households, and
farms. Because output from nonbusiness entities is particularly
difficult to measure, nonfarm business labor productivity is thought
to best measure how labor productivity varies over time. For
international comparisons of productivity, total output per hour
worked is often used because data on hours by sector are not always
readily available.
Factors That Increase Labor Productivity
What increases labor productivity? Research on this question usually
divides changes in labor productivity into three sources: capital
deepening, increases in skill, and efficiency gains.
Capital Deepening
Capital deepening happens when businesses invest in more or better
machinery, equipment, and structures, all of which make it possible
for their employees to produce more. Matching employees with better
capital increases the number of goods employees produce in each hour
they work. Examples of capital deepening include the purchase of more
sophisticated machine tools for workers in the manufacturing sector,
or a faster computer system for a travel agent. A business may add
capital when it increases its workforce-for example, a travel agency
might buy additional computers when increasing the number of travel
agents it employs-but that does not constitute capital deepening if
the amount of capital available per worker does not increase.
Farming provides a classic example of the benefits of using more and
better capital. In 1830, it took a farmer 250 to 300 hours of work
to produce 100 bushels of wheat; in 1890, with the help of a
horse-drawn machine, the time dropped to between 40 and 50 hours;
in 1975, with the use of large tractors and combines, the 100 bushels
could be produced in just 3 to 4 hours. While it is most likely that
farmers were more educated in 1975 than they were in the 1830s, the
change in the farmer's skills alone could not be the source of this
dramatic efficiency gain; an important source is the use of better
capital.Changing from a hoe to the tractor would be categorized as
capital deepening, and the resulting increase in output is capital
deepening's contribution to productivity growth.
Increases in Skill
Just as a worker who is paired with a better machine can produce
more goods, a worker who learns a skill needed for production can
produce more output in less time. For example, a worker who takes a
class on how to use a computer increases the skill with which she
uses the computer; the computer is no faster, but the worker's
increased skill increases her output per hour worked and hence boosts
her productivity. Workers increase their skills through additional
education, training, on-the-job experience, and so on.
Efficiency Gains
Businesses achieve efficiency gains-more output with the same amount
of input-when they devise better ways of organizing and using the
equipment they own and the people they employ. Efficiency gains
include both process innovations, which increase productivity by
reducing the capital or labor needed to produce a unit of output,
and product innovations, which increase productivity by increasing
the value of output. For example, when Henry Ford began mass-producing
Model T's, the Model T itself was a product innovation, while the
moving assembly line was a process innovation. The combination of
improved process and product allowed the Ford Motor Company to reduce
its production costs and become more competitive.
A more recent example of process improvements that led to direct
efficiency gains may also be helpful in illustrating this concept.
Managers at a 3M tape manufacturing plant increased productivity by
reorganizing part of their production process. By moving machines
such as glue coaters and tape slitters closer to the packing
equipment and robotic transporters, 3M substantially increased labor
productivity at its plant. The reorganization reduced the need to
move output around the plant, and cut the length of the production
cycle. In addition, with all the packing supplies located in one
place, managers could see when they had more than they needed and
could cut costs by reducing excess inventories of supplies. This
improvement is an efficiency gain because the plant produced more
output without increasing capital or labor. This example is typical
of the innovative process: companies purchase and install new
machines-from computers to conveyor belts-but it takes time and
further innovation to learn how to take full advantage of the new
machines.
Entrepreneurship (developing new ways of doing business and making
risky investments to implement them) and competition partially
determine the degree to which innovation contributes to labor
productivity. If a business comes up with a new product or a new way
of organizing production and spends the resources to try it out, and
if the new way improves on the old, the business ends up with a
higher level of profit and an incentive to expand. Innovation by one
business is likely to have little direct effect on a nation's
productivity growth, but competition forces other businesses to
either come up with innovations of their own or to cede market share.
When this happens, capital investment and labor flow to businesses
with better methods of production, and productivity increases as a
result.
Entrepreneurship occurs on both small and large scales; many large
multi-nationals spend large sums on research and development in order
to innovate and expand, but individual entrepreneurs who operate on
a small scale may also innovate. The entry and growth of new
businesses, combined with the exit of older, less productive
businesses, has been found to be responsible for a substantial share
of efficiency growth.

Productivity Growth in Recent Years
Chart 2-1 illustrates how increases in skill, capital deepening,
and efficiency gains have contributed to productivity growth in
recent years. It is important to note that the relative sizes of
these contributions are only approximate and that some increases in
the quality of labor and capital may be counted as efficiency gains.
For example, economists can accurately measure education levels of
the labor force, but on-the-job training is also commonplace and
measuring the impact of this training on skill levels is difficult.
Similar issues arise in adjusting for the quality of capital,
particularly during periods of rapid technological changes. The net
result is likely an understatement of skill increases and capital
deepening, and a resulting overstatement of efficiency gains.
Chart 2-1 contrasts three periods, 1990-1995 (when U.S. productivity
growth was relatively slow), 1995-2000 (when the pace of productivity
growth quickened), and 2000-2005 (shows the most recent growth rate).
Over these 15 years, skill increased at a fairly steady pace of about
0.3 percent to 0.4 percent per year. The sources of this increase are
increased rates of college attendance and the increased experience
of the workforce. Increases in skill have been an important source of
long-run increases in labor productivity, and help explain why the
United States has high income levels relative to other countries.
Continuing a steady increase in skill is vital to maintaining solid
productivity growth into the future, a topic discussed at more
length in Chapter 2 of the 2006 Economic Report of the President.
But even when educational attainment among the young rises
substantially, the skill level of the workforce as a whole evolves
slowly. Because skill has




increased at a relatively steady rate, it cannot be the source of
the recent acceleration in productivity growth. Instead, capital
deepening and efficiency gains have been the key productivity-raising
factors. Between 1995 and 2005, increases in the quality and quantity
of the U.S. capital stock accounted for 1.1 percent per year in
productivity growth in the United States, more than doubling the
contribution of capital to productivity growth relative to the 1990
to 1995 period. The surge in productivity in the late 1990s resulted
not just from a rapid increase in the number of machines used in
U.S. production, but also from large quality improvements to the
capital stock. Many of these improvements came from the revolution
in information technology, which is commonly accepted as the
initiating force behind the acceleration. But investment in IT
capital alone was not the whole story. Firms needed to develop
processes that best used the new capital. In many ways, the first
increase in productivity growth (the higher growth rate between 1995
and 2000) was due to increased capital, while the second boost
(in the period between 2000 and 2005) occurred as firms became
better and better at using the new technology.

Productivity Growth and Worker Earnings
The previous section looked at the sources of recent productivity
gains, but did not discuss what productivity gains mean for a
worker's paycheck. This section examines how productivity growth
affects average compensation and which groups have gained the most
over time.
Productivity and Average Earnings
The economic gains from productivity growth reach workers directly
through growth in employee compensation, where compensation includes
wages and the contributions that employers make for benefits such as
health insurance and for government programs such as unemployment
insurance and Social Security. Chart 2-2 shows that over long periods
of time, productivity and real compensation grow at about the same
rate. Real wages have grown somewhat more slowly than compensation
and thus productivity over the last 20 years. The reason for this
difference is that non-wage compensation, particularly employer
contributions for health insurance, has accounted for an increasing
share of compensation over this time period.



Productivity growth is not a smooth process. Chart 2-2 shows that
even in the recent time period, 1995 to 2005, when average
productivity growth has been high, there are short periods of time
where productivity growth appears to slow sharply or accelerate
rapidly. Such changes in productivity growth are not uncommon. In
addition, productivity sometimes grows faster than compensation,
while sometimes compensation grows faster. Such short-term divergence
in growth rates follows regular patterns and has been repeated many
times. At times when productivity growth is particularly high,
compensation growth tends to lag behind for a period of time before
catching back up.
Why does compensation tend to lag behind productivity growth? When
productivity growth is high, economic growth can happen without
substantial employment growth. In other words, as productivity grows,
businesses are able to expand output in response to increased demand
without hiring more workers; the efficiency gains imply that each
individual worker produces more output in the same amount of time.
As the economy continues to expand, businesses once again begin to
hire new employees, and the increased demand for workers begins to
push up wages and compensation. Increased demand for workers leads
to a period in which compensation growth exceeds productivity growth,
and the two variables then converge for a while.
When productivity grows faster than compensation, businesses' profits
tend to rise because the value of the goods and services they sell
rises faster than their payroll costs. As a result, profits tend to
rise during periods of rapid productivity growth. As tight labor
markets bid up employee compensation, the increase in labor costs
cuts into profits, and profits return to normal levels. In this
process, profits vary more dramatically than employee compensation,
falling much more sharply during recessions and then growing much
more quickly in the early parts of the recovery. Because profits
represent returns to earlier investments, very high profits in some
years may not represent unusually large returns on investment
because they may be offset by years of losses or unusually small
profits.

Productivity and Income Differences
The productivity and compensation numbers used in this chapter
describe averages, but over the last 30 years, the economic gains
for some groups have not kept up with those averages, while the gains
for other groups have been well above the average. These uneven gains
have led to growing disparity (or inequality) in compensation and
wages. The same competition for workers that makes average employee
compensation track productivity growth over the long term will occur
for particular groups of employees within the overall labor force.
The compensation for groups whose productivity has increased relative
to the rest of the labor force will increase relative to average
compensation. A number of studies have shown that factors associated
with higher productivity-such as education and work experience-have
also been increasingly associated with higher wages. This is
consistent with the view that growing compensation disparity has been
driven by faster growth in productivity for skilled workers than for
the less skilled.
In the 1980s, the increase in disparity was seen both in falling
wages at the bottom of the wage distribution and rising wages at the
top. Since then, wages in the bottom half of the distribution have
either been flat or have grown modestly while disparity has continued
to increase in the upper part of the distribution. For example,
between 1990 and 2005 the wage at the 10th percentile grew 13 percent
while the median wage grew 10 percent, so the difference between
them narrowed somewhat. The wage at the 90th percentile of the
distribution grew 18 percent over that period, widening the gap
between the upper tail of the distribution and the median.
Why have wage levels grown increasingly disparate? Changes in
technology that increase the productivity advantages associated
with skill-often termed skill-biased technical change-appear to be
the most likely cause. That is, technological advances increased the
productivity of skilled workers more than the productivity of the
less skilled, leading employers to want to hire more skilled workers.
In doing so, employers bid up the wages of skilled workers, widening
the difference in pay associated with skill.
Why does skill-biased technical change appear to be the most
reasonable explanation for this trend? The main reason is that the
price that employers pay for skilled workers trended upward even
while the supply of skilled workers continued to grow. For example,
although the fraction of the work-force that is college educated has
grown consistently over the past 30 years (an increase in supply),
the additional wages needed for an employer to hire a college-educated
worker have also grown (an increase in price). Absent a shift in
demand, increases in supply should drive down prices, so a price
increase implies that demand has shifted toward skilled workers as
well.
Do improvements in the way goods and services are produced
necessarily lead to greater disparity in pay? If changes in
technology have increased disparity, does that mean that
technological change is always bad for those who are in the lower
portion of the wage distribution? There are two reasons to doubt that
this is true. First, economists studying earlier periods have found
that wage disparity actually narrowed in the first half of the 20th
century, providing evidence that, in some periods, change has favored
less skilled workers as opposed to skilled workers.
A second and more fundamental reason that productivity growth does
not leave a whole class of workers behind in the long run is that if
changes in technology raise the pay of relatively skilled workers,
they also increase people's incentives to invest in acquiring skills.
Many of the factors that increase an individual worker's productivity
depend on the worker's decisions to invest in developing new skills.
When the rewards to gaining skills increase, workers have increased
incentive to acquire additional skills. For example, over the past
30 years, there has been a substantial widening in the difference
between pay for workers with a bachelor's degree and pay for those
with only a high school diploma. For men, this difference grew from
50 percent in 1975 to 87 percent in 2004.
If this widening in pay differences represents an increase in the
amount a worker gains by getting a college education, then it gives
individuals a greater incentive to make such an investment in
education. Over the last 10 years, there has been an increase in the
percentage of people who choose to go to college rather than enter
the workforce directly out of high school. In 1992, the size of the
workforce with some college education was roughly the same as the
size of the workforce with a high school diploma or less. By 2006,
the workforce with at least some college had become 50 percent larger
than the workforce with no college. Other levels of education, such
as master's and doctoral degrees, have shown similar increases in the
rewards for obtaining such a degree and in the number of people
choosing to make that investment. From 1987 to 2003, wages for those
with an advanced degree increased faster than for those of any other
education group, and since the mid-1990s, the share of people age
30-39 with an advanced degree has increased by 38 percent. Thus
increased demand for skilled workers has been followed by an increase
in supply, which raises the average skill level in the economy and
leads to higher average productivity.

Understanding the Acceleration in U.S. Productivity:
Industry Analysis

Understanding why productivity growth in the United States has
increased requires knowing what factors in the economy have changed.
Chart 2-1 demonstrated that most of the recent increase came about
through greater capital deepening and efficiency gains. What the
chart did not tell us is why businesses increased their rates of
capital investment to bring about capital deepening and why
efficiency gains have been higher in the past decade than they were
for much of the previous two decades.
Productivity growth for the economy as a whole comes from investment
and innovation in a wide variety of businesses. A lot can be learned
about the sources of growth by looking at which kinds of investments
have grown most quickly, as well as which industries have had the
fastest productivity growth. The average rate of productivity growth
hides substantial differences across industries. In particular, the
surge in productivity in the late 1990s appears to be a story of
growth in industries making and using IT capital. Chart 2-3
illustrates that efficiency growth since 2000 has been particularly
strong in the high-tech sector, but that it has also been strong in
the distribution sector, which includes retail and wholesale trade,
transportation, and warehousing. Finance and business services also
showed strong efficiency growth and hence strong productivity growth.
Manufacturing, which has made small investments in IT capital
compared to the other sectors shown, has had the slowest recent
growth in efficiency.
The strong productivity growth in the distribution and financial
services sectors highlights one of the most striking differences
between the pre- and post-1995 periods. From the 1970s through 1995,
productivity growth in goods-producing industries was generally
greater than that in service-providing industries. However, since
1995, productivity growth in service-providing industries has
exceeded the growth in goods-producing industries (such as
manufacturing).
Given this difference, one of the most important insights into the
recent period of productivity growth comes from understanding why
service-sector productivity growth accelerated after a long period
of slow growth. As discussed above, capital deepening and efficiency
growth accounted for most of the acceleration of productivity growth
for the U.S. economy as a whole over the last decade.




In examining productivity growth rates over the recent period,
researchers have found it useful to characterize investments by
whether they involve a purchase of IT equipment, which is usually
defined as computer hardware, software, and telecommunications
equipment. Box 2-1 discusses some of the potential mechanisms,
such as intangible capital accumulation, through which IT capital
leads to productivity improvements.

----------------------------------------------------------------------
Box 2-1: Intangible Capital and IT Investment

While information technology clearly accounts for a sizable share of
productivity growth since 2000, the mechanisms through which it
induced this growth are not as clear. The assumption has been that
since efficiency growth has been the largest contributor to
productivity in this recent period, IT gains are embedded in this
growing efficiency. However, hidden within these increases in
efficiency may also be capital growth not captured in official
measures.
Standara measures of capital primarily count physical capital,but
businesses expend resources on many other activities that
aim to increase the value of future output. Some examples are
research and development spending, revamping a business's
organization, advertising aimed at improving consumers' perceptions
of a businessï¿½s brand, or developing a secret recipe. These kinds
of activities are often called intangible investment because they
build up assets that are valuable to firms but are not easily
measured.
Conceptually, these activities qualify as capital investment, but
they are not currently included in official capital measures because
they are hard to measure. Why does this matter when discussing
productivity? Expanding the definition of capital by including
intangibles would change the shares of the factors contributing to
labor productivity growth, increasing the share attributed to capital
deepening and reducing the share attributed to efficiency gains.
This shift would not only call into question the finding that IT
investment contributed to productivity mainly through efficiency
gains, but would also help explain why productivity did not
accelerate with early waves of IT investments. Indeed, it is
consistent with the hypothesis that for businesses to take full
advantage of their IT investments, they needed to develop innovative
business practices. Only when they made intangible investments to
complement their IT investments did productivity growth really
take off.
----------------------------------------------------------------------
The industries that produce IT equipment had particularly rapid
efficiency growth, resulting in falling prices accompanied by rapid
increases in the speed and power of IT equipment. These industries
directly brought up the average rate of productivity growth for the
economy, but their advances also had significant indirect effects by
driving a surge in IT equipment investment in other industries. The
increase in capital deepening in the 1990s was led by large
investments in IT equipment, but productivity gains from these
investments did not immediately emerge.
In the 1995 to 2000 period, industries with above-average investment
in IT equipment had significantly larger increases in their
productivity growth rates than did other industries. For example,
the retail trade and financial services industries had much higher
productivity growth over the 1995 to 2000 period than in the
preceding period, and had well-above-average investment in IT
equipment. Box 2-2 indicates that much of the retail trade
productivity gains occurred because of supply chain improvements
made possible by information technology. Research estimating the
contribution of IT-related forces-including both productivity growth
in IT-producing industries and the share of productivity growth
accounted for by IT investment in other industries-shows that
information technology accounted for more than half of productivity
growth from 1995 to 2000.
----------------------------------------------------------------------
Box 2-2: Information Technology, the Supply Chain, and Productivity
Growth in Retail Trade

The retail trade sector shows how IT investment, innovation,
competition, and flexible markets interact to affect productivity
growth. Retailers have made heavy investments in information
technology and have had rapid productivity growth, but changes in
the way that retailers use information technology-both in their
stores and with their suppliers-were necessary to generate this
surge in productivity growth. The focus here is on two types of
innovations: changes in the organization of the supply chain of
consumer goods and changes in the way retailers organize store
operations.
Manufacturers and retailers of consumer goods have increased their
use of electronic data interchange, allowing manufacturers to help
retailers manage inventories and avoid stockpiling and shortfalls.
Electronic data interchange also allows for automatic ordering,
billing, and payment. Retailers benefit from lower costs of carrying
inventory and reduced resources spent managing it, and manufacturers
benefit from being able to smooth out production. Because these
changes have enabled retailers to more reliably stock a wide variety
of goods, consumers have benefited from increased product variety.
Making these changes required an investment in IT equipment by
manufacturers and retailers, and required them to change the way
they exchanged information and interacted.
Large retailers also made internal changes that significantly
increased productivity. One change was an increase in the scale of
stores. Other important changes involved the use of information
technology and improved management practices. Examples include an
increased use of software to manage the flow of goods and staffing
levels in stores, and more cross-training of employees to make better
use of store labor. Rapid expansion of the largest firm put
competitive pressure on other retailers, leading them to cut costs
and, in many cases, to emulate the process improvements introduced
by the industry leader.
----------------------------------------------------------------------

Why Has Productivity Growth Accelerated in the U.S. While Slowing in
Other Countries?

The United States has experienced the fastest acceleration of
productivity growth among major industrialized countries since the
early 1990s. Chart 2-4 shows that, after lagging behind most of the
countries in the G7 between 1990 and 1995, the United States has
been the country with the fastest growth in GDP per hour worked in
the G7 between 2000 and 2005. Only the United States and Japan had
faster productivity growth in the most recent period than they did
in the early 1990s, and only the United States has shown consistent
acceleration over this time period.
Since all of these countries have, in principle, approximately the
same access to information and global markets, why have the other
major industri-alized countries not been able to post productivity
gains as large as those in the United States and Japan? The major
advances in this period appear to have come from opportunities that
developed from the rapid advancement in information technology.
While all developed countries had access to IT capital, the existing
economic environment in the United States put it in position to
quickly make the most of these opportunities. International openness
to investment and trade combined with highly flexible and lightly
regulated markets and an environment that fosters innovation appear
to be at least part of the answer.



International Openness

As discussed earlier, capital deepening has played a significant
role in U.S. productivity growth. Over the past 10 years, the United
States is second only to Canada in its annual growth rate of real
private investment. Real invest-ment in the United States over this
period increased at an annual rate of 5.1 percent, nearly double the
average rate of the other G7 countries (excluding Canada). The United
States has been able to accomplish this level of investment because
of its open and transparent investment environment.
While capital deepening played an important role in the productivity
gains experienced in the late 1990s, so did advances in information
technology. To benefit from the IT boom, firms had to invest large
amounts in computers, software, and employee training. From 1995
through 1999, U.S. investment in information-processing equipment and
software increased at an average rate of around 20 percent per year,
and total investment grew faster than in any other country in the G7.
To help fund these investments, the United States received
substantial flows of financial capital from abroad during this
period. While the United States might have invested in IT capital
without access to international financial markets, and while Europe
may not have invested more even if it was more open to international
capital flows, it is almost certain that the United States was able
to use its open investment environment to finance the increase in IT
capital.
Access to international financial markets tends to lower borrowing
costs and enable a country to increase capital investment rates
without increasing domestic savings. This outcome would not be
possible if businesses had access only to domestic financing.
International openness has also contributed in other ways to recent
efficiency gains in the United States. Since the early 1990s, the
United States has increased its openness to international trade.
From the North American Free Trade Agreement (NAFTA) (signed into
law in 1993) to the Trade Act of 2002 and the renewal of Trade
Promotion Authority in the same year, the United States has worked
to break down trade barriers. Lower trade barriers have in turn
increased the level of international competition in product markets.
Some U.S. companies have suffered from the increased competition;
some have benefited. The increased competition forces firms to seek
new ways of doing business to remain competitive, and because of
this, international trade may contribute to growth in innovation.

Flexible Labor Markets
Efficiency gains resulting from more flexible and competitive labor
markets have been another important reason why the United States was
able to benefit from recent shifts in technology. The United States
ranks first among G7 countries in the World Bankï¿½s Rigidity of
Employment Index, indicating very flexible labor markets relative to
other G7 countries. Japan, for example, ranks fourth among G7
countries, while France ranks last. The index averages measures of
the difficulty of hiring a new worker, restrictions on expanding or
contracting the number of working hours, and the difficulty and
expense of dismissing a worker. While other countries are tied with
the United States on the latter two measures, the United States owes
its first place rank to the ease with which American employers can
hire new employees.
Flexible labor markets allow workers to flow to high-productivity
and high-wage industries. Hiring and severance costs tend to increase
unemployment by making firms reluctant to hire new workers. They
encourage labor hoarding, a practice in which firms hold on to
workers not currently needed for production in order to avoid the
costs of hiring new workers when the firmï¿½s workforce needs to
expand. Labor hoarding lowers the level of produc-tivity and reduces
the average growth rate of productivity, as firms find it more
difficult to respond to innovations and shifts in demand.
Flexible labor markets improve productivity growth because they
allow firms to more easily adjust the size and scope of their
operations in response to economic developments. For example, after
an increase in efficiency, a firm may become more competitive and
decide to expand output and so need to hire more workers. The firm
may also wish to change the mix of workers it employs. Flexible
labor markets allow these transitions to occur at a low cost.

Low Costs of Starting a Business
Low costs of business entry with relatively few administrative
hurdles have also contributed to greater efficiency gains in the
United States. A recent study by the World Bank shows that the
United States, at 5 days, ranks behind only Canada and Australia in
terms of the number of days required to start a business, and has
the fourth lowest administrative costs to start a new business. New
businesses provide both a ready supply of new ideas and a source of
competition that forces larger businesses to innovate. Both of these
factors have likely given the United States an edge in taking
advantage of new opportunities made possible by IT advances. As with
flexible labor markets, the ease of starting a new business helps
with the level and the growth rate of productivity. Over long
periods of time, starting new businesses keeps the economic
environment competitive, which spurs innovation and helps push
inefficient firms out of the market place.


Policy Implications

What can the United States do to promote further productivity
growth? First, the most important way to encourage capital deepening
is to maintain the smallest possible difference between the
before-tax and the after-tax rates of return to investments. Capital
deepening makes workers more productive and leads to higher wages in
the long run. Making the tax cuts on capital gains and dividends
permanent would help in this regard. Chapter 3 of this report
discusses policy options affecting the taxation of capital.
Second, policies must encourage investment in skills. One way to do
this is to keep the tax rates on wage income low. If individuals see
little return to going to college, vocational school, or graduate
school because of high tax rates on moderate- to high-wage earners,
their incentives to invest in skill will be dampened. Chapter 3
further discusses how tax policy affects investment in skill.
Strengthening K-12 education, reducing our dropout rates, and
ensuring that all children receive
high-quality education will increase the skills of our workforce and
better prepare our citizens for further skill investment as adults.
The President's efforts over the past several years to improve
education and training with the No Child Left Behind Act, community
college initiatives, and job training reforms will help. Furthermore,
because learning begets learning, the returns should continue into
the distant future.
Third, we must remain open to foreign investment. Openness to
foreign capital has given the United States the flexibility it needs
to deepen its capital stock and improve its productivity without
necessitating a corresponding increase in domestic savings. To
maintain current growth rates we must keep pushing for freer trade,
especially in the area of services, which has become a significant
part of our economy. Chapter 8 of this report discusses policies to
increase our international openness.
Fourth, we must encourage innovation and entrepreneurship. The
President has outlined a competitiveness initiative that increases
public investment in basic research-an important complement to
private sector innovation-and strengthens math and science education
to provide the skills needed for technological innovation.

Conclusion
Maintaining a solid productivity growth rate is of great importance
to maintaining and increasing U.S. standards of living. The surge in
productivity growth since about 1995 has come from heavy business
investment in information technology, accompanied by large
efficiency gains from innovation and competition. The United States
has gained more from rapid advances in information technology than
the other major industrialized countries because its culture of
entrepreneurship and its flexible markets for products, capital, and
labor have allowed American businesses to make the most of these
changes.