A peer-reviewed version of this paper appears in the November 2012 edition of Energy Economics and is available for download through ScienceDirect.com (pdf).

“We’re in a competition all around the world, and other countries -- Germany, China, South Korea -- they know that clean energy technology is what is going to help spur job creation and economic growth for years to come. And that's why we’ve got to make sure that we win that competition. I don't want the new breakthrough technologies and the new manufacturing taking place in China and India. I want all those new jobs right here … in the United States of America, with American workers, American know-how, American ingenuity.”
President Barack Obama
May 6, 2011
Remarks at Allison Transmission Headquarters, Indianapolis, Indiana

Governments in most industrial countries have stepped up their promotion of clean energy technology in recent years. No longer a laggard, the U.S. government increased energy subsidies from $17.9 billion in fiscal year (FY) 2007 to $37.2 billion in FY 2010, according to the U.S. Energy Information Administration (EIA).^[1] The total includes a mix of direct expenditures, tax expenditures, the subsidy associated with loan guarantees, and research, development and deployment (RD&D) spending.

The Energy Improvement and Extension Act (EIEA), passed in late 2008, and the American Recovery and Reinvestment Act of 2009 (ARRA) account for much of the increase. The EIEA expanded or extended tax credits for renewable energy, energy-efficient appliances, plug-in electric vehicles, and liquid biofuels. ARRA, a broad fiscal stimulus package, included $35.2 billion to the Department of Energy (DOE) and added $21 billion in energy tax incentives over the life of the legislation.^[2] Using ARRA authority, cumulatively from September 2009 through November 2011, DOE underwrote $35.9 billion in loan guarantees for a range of energy-related technologies.^[3]

Figure 1 displays the U.S. spending stream on energy-related research and development since 1974. The graph shows the dramatic impact of the ARRA package.

Figure 1.^[4]

Public investments of these magnitudes, targeted at specific industries, arguably constitute an industrial policy, albeit a sectoral one, unlike the earlier proposals of the 1980’s —that is, a government strategy to steer resources toward select producers or technologies. The rationale and efficacy of these clean-energy expenditures call for scrutiny.

Proponents offer numerous reasons for scaling up particular energy technologies at the taxpayer’s expense. One set of reasons involves the need to remediate market failures that have not been corrected by other policies. For example, clean-energy technologies are said to emit fewer greenhouse gases than do traditional sources per unit of energy produced. The United States does not have an economy-wide policy to control greenhouse gases, most notably, one that puts a price on CO₂ that reflects the environmental harm associated with use of fossil fuels.

A far more effective policy than subsidies for clean energy research, development and demonstration would be a tax or a cap-and-trade regime that would put an appropriate price on carbon and other greenhouse gases. ^[5] Properly implemented, this alternative approach would help level the playing field for greener energy sources, for it would require emitters to pay prices that reflect the costs their emissions impose on society. The enhanced efficiency that would result has been widely recognized by economists. ^[6] True costs would flow to purchasers of goods and services that require energy, suitably inducing conservation. Emitters would have incentives to invest in equipment and new production techniques, use alternative fuels, and seek other methods to reduce emissions. And America’s innovators would channel their efforts into inventing, scaling up, and marketing competitive forms of clean energy. However, because existing market signals do not suffice to encourage climate-friendly technologies, carefully targeted federal funding seems warranted. But as we explain later, it is ironically only after incorporating the social costs of energy into market prices that many clean energy subsidies will succeed in deploying new technologies.

Some clean energy technologies, such as electric vehicles and biofuels, are also said to wean the economy from its inordinate dependence on oil, which is both volatile in price and supplied in part from unstable foreign sources. Like environmental damage, the security risks of relying on oil are not fully embedded in its price, and therefore, the argument goes, policies to reduce its use could be efficiency-enhancing.

A second set of reasons for sustaining clean-energy subsidies is less about correcting inefficient market outcomes than about tilting the market toward U.S. interests. In this view, strategic investments in clean energy technologies would increase U.S. firms’ market share of a growing industry and thus help American firms and workers win a larger portion of global business. Although the projected market growth of cleaner energy derives from the international community’s efforts to protect the environment, the objective here is economic. Proponents imply that capturing a larger market share would boost long-term U.S. “competitiveness” and create jobs in American firms that manufacture the exportable products.

Are these justifications sound? And even if convincing in theory, what happens in practice? That is, can the American political process successfully carry out the envisioned strategy? Section 2 of this paper reviews the history of industrial and energy technology policy since the 1970s. Section 3 examines the environmental and energy- independence rationales, and Section 4 analyzes claims about the potential role for government backing of clean energy to ensure U.S. competitiveness and save or create jobs. Section 5 explores the administrative and political challenges of implementing an efficient clean-energy research and development portfolio, and Section 6 sketches our recommendations.

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• Clean Energy Subsidies without a Price On Carbon May Be Money Down a Rat Hole

      

 

 

Repeated battles over the 2011 budget are taking attention from a more dire problem: the long-run budget deficit.

Divided government is no excuse for inaction. The bipartisan National Commission on Fiscal Responsibility and Reform, under co-chairmen Erskine Bowles and Alan Simpson, issued a report on the problem in December supported by 11 Democrats and Republicans—a clear majority of the panel's 18 members.

As former chairmen and chairwomen of the Council of Economic Advisers, who have served in Republican and Democratic administrations, we urge that the Bowles-Simpson report, "The Moment of Truth," be the starting point of an active legislative process that involves intense negotiations between both parties.

There are many issues on which we don't agree. Yet we find ourselves in remarkable unanimity about the long-run federal budget deficit: It is a severe threat that calls for serious and prompt attention.

While the actual deficit is likely to shrink over the next few years as the economy continues to recover, the aging of the baby-boom generation and rapidly rising health care costs are likely to create a large and growing gap between spending and revenues. These deficits will take a toll on private investment and economic growth. At some point, bond markets are likely to turn on the United States—leading to a crisis that could dwarf 2008.

"The Moment of Truth" documents that "the problem is real, and the solution will be painful." It is tempting to act as if the long-run budget imbalance could be fixed by just cutting wasteful government spending or raising taxes on the wealthy. But the facts belie such easy answers.

The commission has proposed a mix of spending cuts and revenue increases. But even this requires cuts in useful programs and entitlements, as well as tax increases for all but the most vulnerable.

The commission's specific proposals cover a wide range. It recommends cutting discretionary spending substantially, relative to current projections. Everything is on the table, including security spending, which has grown rapidly in the past decade.

It also urges significant tax reform. The key principle is to limit tax expenditures-tax breaks designed to encourage certain activities-and so broaden the tax base. It advocates using some of the resulting revenues for deficit reduction and some for lowering marginal tax rates, which can help encourage greater investment and economic growth.

The commission's recommendations for slowing the growth of government health care expenditures—the central cause of our long-run deficits—are incomplete. It proposes setting spending targets and calls for a process to suggest further reforms if the targets aren't met. But it also lays out a number of concrete steps, like increasing the scope of the new Independent Payment Advisory Board and limiting the tax deductibility of health insurance.

To be sure, we don't all support every proposal here. Each one of us could probably come up with a deficit reduction plan we like better. Some of us already have. Many of us might prefer one of the comprehensive alternative proposals offered in recent months.

Yet we all strongly support prompt consideration of the bipartisan commission's proposals. The unsustainable long-run budget outlook is a growing threat to our well-being. Further stalemate and inaction would be irresponsible.

We know the measures to deal with the long-run deficit are politically difficult. The only way to accomplish them is for members of both parties to accept the political risks together. That is what the Republicans and Democrats on the commission who voted for the bipartisan proposal did.

We urge Congress and the president to do the same.

      

 

 

Last week, a five-member congressional oversight panel harshly criticized how the U.S. Treasury has so far spent the first $350 billion tranche of the Troubled Asset Relief Program (TARP). The bulk of that money has been used to inject capital into a wide range of potentially viable but ailing banks, giving the government an ownership share in return for these funds. The panel had several complaints about the way TARP has been run, but its basic criticism -- widely held among members of Congress and the public -- was that the Treasury has not required the banks to use the money for increasing loans to business and consumer borrowers.

These findings have strengthened a growing interest in Congress to condition approval of the program's remaining $350 billion on a mandate that the Treasury not only track the funds but also require that they be used primarily to make new Main Street loans -- to support homeowners facing mortgage defaults, struggling municipalities and other troubled segments of the economy.

The criticisms behind this sentiment are misguided. For one thing, the position of banks is dire, and lending is almost sure to contract even if TARP is fully successful. Furthermore, while "following the money" might seem like the right thing to do in terms of accountability and oversight of federal tax dollars, it is actually infeasible because bank loans typically cannot be traced to a particular source of funds -- banks get their money for loans from a variety of sources, such as borrowing from other financial institutions and government or through private injections of new capital.

Much of the criticism of TARP reflects a fundamental misunderstanding of the basic financial problem that the program was intended to address. The first goal was to ameliorate the large and long-lasting contraction in lending that was the inevitable consequence of the mortgage-related losses by U.S. banks. This credit squeeze has already depressed bank lending and, if unabated, threatens to radically deepen and prolong the recession. It is unrealistic to expect troubled banks to make a lot of new loans. Only when the banks are stabilized can we expect them to raise new private capital to expand lending and fuel an economic recovery.

Look at the facts and the numbers: An International Monetary Fund analysis in October found that global banks and other lenders are likely to suffer losses of about $1.4 trillion from defaulting U.S. mortgages and consumer and corporate debt. (About half of that total is mortgage losses.) These losses, once recognized on the books of financial lenders, reduce their capital by an equal amount. That capital is the "backup" behind a lender's overall portfolio of loans and other investments. In the United States, each dollar of lender capital supports, on average, more than $10 in loans and other assets; the "leverage ratio" varies among different institutions and different kinds of assets.

Bank supervisors, following a complicated set of regulations, are charged with keeping bank capital from falling and remaining below a "safe" level. If a bank's capital does dip below certain levels, the bank is required to limit its lending. Equally important, as its capital falls relative to its assets, the bank would be considered increasingly risky by private markets, raising its cost of borrowing, lowering its stock price, and reducing its ability to attract new capital and expand its loans and investments. In short, for every $1 million of losses on bad loans, a bank must reduce its portfolio of loans by around $10 million, unless it can obtain new capital to offset the losses. Unchecked, this "deleveraging" process poses a serious threat to the economy.

The IMF has estimated that, without large infusions of government funds, U.S. and European banks over the period 2008-13 would be selling assets and failing to renew existing loans to the tune of $10 trillion, equivalent to a whopping 14.5 percent of their loan portfolios. More than half of this lending contraction would occur among U.S. banks. At this stage, therefore, TARP's success has to be judged not in terms of how many new loans it produces but what problems it has prevented -- fire sales of assets and the cutting off of credit lines.

So far, the TARP capital injection has reduced the size of the problem, but the problem remains large. We are not against providing additional help directly to homeowners, but any substantial diversion of TARP funds away from their central task would be a serious mistake and could worsen this very nasty recession. A restored financial sector must play its part in ending the recession and sustaining an economic recovery. Congress should release the second half of the TARP funds with rules that can actually be enforced and recognize what the program is trying to achieve -- a recapitalization of the banks to limit any further contraction of lending.

      

 

 

Executive Summary

In a recent paper, “Taking Back Our Fiscal Future,” a group of policy analysts from several Washington think tanks proposed a radical change in budget procedures related to Social Security, Medicare, and Medicaid as a way to address budget deficits projected for future decades. They urged Congress to establish 30‐year budgets, or caps, for these programs. The White House would conduct a review every five years. If it projected that expenditures would exceed the caps, the programs would face automatic cuts or related tax increases.

We agree that the nation faces large, persistent budget deficits that would ultimately risk significant damage to the economy. We also concur that policymakers should begin now to make the tough choices needed to avert such deficits.
 
But we believe the proposal set forth in “Taking Back Our Fiscal Future” (hereafter referred to as TBOFF) is misguided. It could jeopardize the health and economic security of the poor, the elderly, and people with serious disabilities. For one thing, it does not focus adequate attention on the main driver of our fiscal problem — the relentless rise in health care costs throughout the U.S. health care system. Without measures to slow the growth of total (public and private) health care spending, no solution to the nation’s fiscal challenges will prove sustainable. For another, it does not propose any action to restrain the hundreds of billions of dollars in entitlements that are delivered through the tax code and flow largely to more affluent Americans.

We believe there are better ways to begin tackling projected deficits, which we describe below.

In addition, TBOFF would establish budget procedures that closely resemble failed approaches of the past. We believe that the proposal’s formulaic budget caps backed by automatic cuts would fail to reduce projected deficits, just as when Congress tried such an approach under the 1985 Gramm‐ Rudman‐Hollings law.

We believe the TBOFF proposal is ill‐advised for three main reasons.

• First, TBOFF is unbalanced. It would subject Social Security, Medicare, and Medicaid to the threat of automatic cuts while giving a free pass to the open‐ended entitlements (or “tax expenditures”) enshrined in the tax code. These tax entitlements cost hundreds of billions of dollars a year, and their benefits flow largely to more affluent Americans. Nor would TBOFF place any obstacle in the way of deficit‐financed tax cuts (or increases in other spending) even as Social Security, Medicare, and Medicaid faced potentially deep reductions based on projections of spending as much as three decades in the future. Yet over the next 75 years, the cost just of making permanent the 2001 and 2003 tax cuts is 3½ times the size of the entire Social Security shortfall. Thus, the plan departs from the “shared sacrifice” approach that has characterized the major, successful deficit‐reduction laws of recent decades, such as those enacted in 1990 and 1993. Those agreements resulted when policymakers placed all parts of the budget “on the table” and developed balanced packages that combined reductions in major programs (particularly Medicare) with increases in taxes.

• Second, TBOFF seeks to force action to substantially reduce projected expenditures for Medicare and Medicaid without requiring measures to restrain the growth of health care spending throughout the U.S. health care system. The main driver of the high growth in projected expenditures for Medicare and Medicaid is the continued high growth in health care costs systemwide, not features unique to these two programs. For 30 years, per beneficiary spending in Medicare and Medicaid has grown at rates nearly identical to those for the health care system as a whole. As Congressional Budget Office director Peter Orszag recently noted, “Put simply, health care costs are the single most important factor influencing the federal government’s budget trajectory.” Fundamental, systemwide reform of health care financing and delivery is the key to controlling Medicare and Medicaid expenditures — and reducing projected long‐term deficits — without imposing draconian cuts that would harm the poor, the elderly, and people with serious disabilities.

• Third, budget targets enforced by automatic cuts have proved ineffective in curbing past deficits, and there is no reason to think they will succeed in the future. Under TBOFF, if the administration in office projected that expenditures for Medicare, Medicaid, or Social Security would exceed the caps that had been set for the next 30 years, automatic cuts would take effect. However, when policymakers previously tried to use budget targets backed by automatic cuts to force tough budget choices — under the 1985 and 1987 Gramm‐Rudman‐Hollings laws — the efforts failed. Policymakers first resorted to rosy assumptions to claim that the targets would be met and, when rosy scenarios proved insufficient, they resorted to accounting gimmicks and timing shifts in order to avert the automatic cuts. When such evasions were not enough, they waived or raised the budget targets. Ultimately, policymakers repealed the whole framework because it failed to produce the intended results. Opportunities for evasion under TBOFF would, if anything, be even greater. Projections of health care expenditures as much as three decades in the future — and hence of Medicare and Medicaid costs — vary widely among experts and involve considerable guesswork about future trends in medical technology and other matters. The potential for future administrations and Congresses to use rosy assumptions to avoid unpopular actions would be great.

In short, the TBOFF proposal is fundamentally flawed. If it worked, it could undermine the definedbenefit structure of Social Security, Medicare, and Medicaid, without adequately addressing the systemwide rise in health care spending that underlies our fiscal problems. And it would focus deficitcutting attention on programs that serve needier members of our society without a comparable focus on tax breaks for the more economically secure. If TBOFF did not work, it could prove counterproductive — by encouraging policymakers who were beginning to feel pressure to address long‐term deficits to substitute TBOFF’s procedural change for tough budgetary choices, only to have TBOFF’s easily‐evaded budget procedures subsequently fail to produce meaningful results. In the interim, the existence of the TBOFF procedures could create an illusion of progress, giving policymakers a false sense of security and easing pressure on them to strike effective bipartisan deals for long‐term deficit reduction.

• Adopting recommendations of Congress’ Medicare Payment Advisory Commission, which could generate substantial savings;

• Increasing the Medicare premiums that affluent beneficiaries pay;

• Instituting vigorous research programs to determine the comparative effectiveness of different health care treatments and procedures as well as what is causing the huge differences in health care costs across the country, and using the results as the basis for new policies to restrain health care costs without compromising health care quality;

• Curbing or eliminating outdated or unproductive tax expenditures;

• Switching to the Bureau of Labor Statistics’ alternative, more accurate Consumer Price Index in computing the annual cost‐of‐living adjustments in Social Security and other entitlement programs (while taking steps to shield low‐income and other vulnerable beneficiaries) and the annual inflation adjustments in the tax code;

• Reforming farm price supports; and

• Adhering to Pay‐As‐You‐Go rules for both increases in mandatory programs and tax cuts.

While, taken together, these proposals would have a substantial effect on future deficits, policymakers will need ultimately to enact more extensive measures to achieve long‐term fiscal sustainability. But, they need to get started. Working to reach agreement on measures such as those listed here would be much more productive than spending the next several years haggling over the contentious issues that would have to be resolved to turn TBOFF into a concrete plan and implement it, especially since the TBOFF procedures are not likely to lead to significant deficit reduction anyway.

In the following pages, we explain in greater detail why procedural fixes like those proposed in TBOFF would likely do more harm than good, and we elaborate on specific measures to consider that would be more fruitful in helping the nation start to take back its fiscal future.

For further information, please contact:

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President Bush's 2006 budget recommends $16.5 billion in budget authority for the nation's space program and roughly half of that will be devoted directly and indirectly to manned space activities. Most of the remainder will go toward supporting the NASA scientific program, which chiefly carried out with unmanned space vehicles. NASA's unmanned space probes and satellites have helped create a "golden age of astronomy" and given humankind a vastly improved understanding of the universe and their place in it. The scientific community widely views the manned space flight program as a large waste of resources.

The core of the manned space effort over the past 25 years has been the space shuttle. The shuttle was initially conceived and sold as an inexpensive and effective way of sending human beings into space on a large number of scientific and military missions. Originally it aimed at launching between 25 and 60 missions a year. But the staggering costs of the life-systems needed for manned space flight and the consequent limitations of weight-load and space capacity sharply downgraded its usefulness for both military and scientific missions.

Compared to unmanned delivery vehicles the space shuttle is too expensive for close-to-Earth missions and cannot support human life long enough to deliver payloads to further out regions of the solar system. The number of launches was cut sharply below the original plan and from 1998 to 2002, an average of only five launches a year were undertaken.

The scientific projects that are suitable for and carried out in the space shuttle are widely considered by scientists as low priority. Historian Alex Roland put it best: "Any specific mission you can identify to do in space, you can design and build an unmanned space craft to do it more effectively, more economically, and more safely."

As a result of changes in response to the Columbia disaster, the program has incurred additional costs and from now until they are retired in 2010, the space shuttles will be chiefly devoted to supporting the International Space Station.

The ISS, itself — whose costs will likely run well over $100 billion by the time it is completed — has been a major failure. Originally it was envisioned to house dozens of scientists and astronauts and to serve as a scientific lab, a space factory and a platform for eventually launching manned missions to Mars.

But spiraling costs and other problems led them to cut the crew size for the completed station to six and it is currently occupied by only two individuals, whose time is mostly spent on repair and maintenance, leaving little capacity for conducting scientific investigations.

Last year, the president proposed that the U.S. launch a grandiose new program to establish an occupied moon base and, beyond that, to pursue a long term goal of sending human beings to Mars. The costs of establishing and maintaining a moon base could themselves be several times greater than the ISS, but even these will pale beside the costs of sending and protecting humans on the 18-month to two-year, 560-million mile round trip to Mars.

And all of this for what? Per dollar spent, the president's immensely costly lunar and Mars projects would produce slim gains by way of advancing scientific knowledge, while draining large sums from NASA's truly productive scientific missions now carried out with unmanned vehicles.

The lunar-Mars program should be considered only if it demonstrate that the huge cost will generate greater advances in scientific knowledge than the same money devoted to NASA's scientific activities using unmanned vehicles. Given the proven success of the scientific program to date, I am confident the lunar-Mars program will be found wanting and by a large margin.

How about the manned space program simply as a grand spectator sport? The first manned flight to Mars would indeed be watched with excitement by billions of people. But the excitement soon dies. After 1972, the last three Apollo flights that had been planned for the moon were canceled, largely because the country was no longer interested.

This was also the fate of the shuttle once it had flown the first few times.

Given the budget deficits the country faces over the next decade and the much larger problems posed by Social Security and Medicare in subsequent decades, we can ill afford to waste increasing billions of dollars on losing investments like the manned space program and especially on the massive expense of a lunar base followed by a trip to Mars.

      

 

 

Until the end of 2003, the United States had been experiencing a "jobless" recovery, with employment stagnating at levels well below those in 2000. A widespread perception has arisen that a major culprit behind the dearth of jobs was the growing practice of U.S. firms to relocate part of their domestic operations to lower-wage countries abroad. "Offshoring" presumably caused a reduction in U.S. output and a corresponding loss of jobs.

In fact, after the 2001 recession, U.S. domestic production rose substantially, but output per worker—productivity—jumped so sharply that instead of rising, employment declined. That is the real cause of the jobless recovery. Had GDP growth been accompanied by a continuation of earlier rates of productivity growth, there would have been some 2 million more private sector jobs than there were at the end of 2003.

When firms send work overseas, those goods or services come back in the form of imports. But a careful look at U.S. import data—especially for service imports, where most offshoring growth occurred—indicates that while the total number of jobs affected by offshoring had increased, that number was still small relative to the millions of jobs affected by the productivity surprise.

POLICY BRIEF #136

What is Offshoring?

There is no official definition of the term "offshoring," but it has come to mean the actions of American firms in relocating some part of their domestic operations to a foreign country, including, for example, automobile firms switching purchases of auto parts from domestic plants to Mexico; computer or software firms transferring some of their programming operations to India; or financial firms relocating major parts of their record-keeping activities to one of the Caribbean countries.

In some cases firms locate overseas operations in foreign affiliates they own and control. Some fraction of the value of the firm's domestic sales now consists of intermediate goods or services imported from those affiliates. The Department of Commerce's Bureau of Economic Analysis (BEA) includes these intra-firm imports in its compilation of U.S. domestic and international economic accounts.

Overseas relocation need not, and very often does not, involve transactions with foreign subsidiaries. Firms can effectively relocate activities abroad by contracting for the purchase of goods and services from independent foreign firms. Nike, for example, has set up an extensive network of independent foreign producers under contract to produce goods for Nike's distribution channels in the United States. There are American and foreign firms who can act as intermediaries to arrange the production of goods and services abroad to meet the needs of smaller American firms that wish to outsource some part of their operations abroad.

While the advent of cheap, high quality, and virtually instantaneous information and communication facilities has substantially widened the range of services that can be outsourced abroad, the economic characteristics and consequences of these activities are very similar to the long-standing historical process through which falling transportation costs have sharply expanded the range of goods subject to import competition. More generally, the substitution of imports for domestic production and offshoring are simply different forms of the same phenomenon. Increases in this kind of activity large enough to have a significant effect on U.S production and employment should generate corresponding increases in U.S. imports of the relevant types of goods or services.

The immediate effect of an increase in offshoring is a reduction in U.S. employment, either through a rise in worker layoffs or a slowdown in new job creation. Over the longer run, however, the lower prices for consumer and investment goods made possible by the offshoring raise real wages and living standards here at home while consumption and investment spending rise and employment recovers. This Policy Brief deals only with the short run negative effects on jobs.

Employment Effects of the Productivity Speedup

By the end of 2003, gross domestic product in the U.S. nonfarm business sector had risen by more than 5 percent over the prior four quarters, and was almost 8 percent above what it had been three years before that at the peak of the boom. Yet the aggregate number of hours that employees worked had fallen by 4.5 percent—3 percent due to lower employment and 1.5 percent due to fewer average hours per week. An (admittedly mechanical) simulation can give some sense of the effect of the surge in productivity on the employment numbers. Productivity (output per hour) in the nonfarm business sector rose 2.6 percent a year between the fourth quarters of 1995 and 2000. In the next three years, it rose at a surprisingly strong 4.1 percent rate. If productivity growth over those three years had continued at its earlier pace, the aggregate hours of work needed to produce the fourth quarter 2003 GDP would have been more than 4.5 percent larger than it actually was. Employment in the nonfarm business sector would have been some 2 million persons higher, with the precise amount depending on just how much of the increase in total hours worked came from a recovery in the average length of the work week. The unemployment rate would probably have been somewhere around 5.0 percent.

If the alternative scenario had occurred, with its lower productivity growth and higher employment and worker income, the time-path of GDP itself would have been affected, although the extent and even the direction of the response is not obvious. But the alternative possibilities are irrelevant to the issue here: given the substantial growth of GDP that did occur, how much of the disappointing behavior of employment can be explained by acceleration of productivity as opposed to the growth of offshoring or other factors.

Without any increases in offshoring during the period, domestic production might have grown even faster than it did, with positive effects on employment. Nevertheless, had the nation experienced the millions of extra jobs, the rise in weekly hours, and the increase in wage and salary disbursements that would have occurred had productivity not accelerated, the media would now be paying far less attention to offshoring and low wage imports, and recent political rhetoric would not have so heavily featured the evils of NAFTA, Chinese competition, and offshoring.

The evidence about the dominating role of the recent productivity acceleration in explaining the jobless recovery does not address the size of employment effects on the increases in offshoring and import competition. Other evidence is needed to shed some light on this question.

Survey Evidence on Layoffs and Offshoring

The Bureau of Labor Statistics publishes a quarterly tabulation of "extended mass layoffs"—layoffs of fifty or more employees expected to last at least a month. Establishments that have made these layoffs are identified from federal and state unemployment insurance records, and are asked to assign the reason for them and to provide the total number laid off. Extended mass layoffs, for causes other than the ending of "seasonal" jobs, averaged 900,000 a year in 2002-2003. Among the relatively long list of reasons that respondents can assign for layoffs are "import competition" and "relocation overseas." Together, those two reasons accounted for only 4 percent of non-seasonal extended layoffs during this period.

These numbers, however, do not capture all of the layoffs and other effects on U.S. employment from changes in overseas outsourcing and imports. They exclude smaller scale layoffs (less than fifty at a time). In some cases import competition can indirectly result in a loss of sales in ways that may not be apparent to or identified by the losing firm. Moreover, the estimates cannot pick up any effects on employment that show up, not in layoffs, but in a reduction of domestic hiring by offshoring firms that would otherwise have been adding to their workforce. Where outsourcing takes the form of contracting (directly or through intermediaries) with independent foreign suppliers, rather than transferring operations to majority-owned foreign affiliates, some respondents may not report this as a "relocation." But even after allowing for all of this, the data suggest, with respect to layoffs at least, that import competition and relocation play a much more modest role in explaining the jobless recovery than is depicted in much of the media.

Indirect Evidence from Import Data

The overall effect. When part of the production of goods or services destined for domestic markets is shifted abroad, the value of the outsourced production returns as imports. If the disappointing employment growth of the past several years came about because America's production needs were being met to an increasing degree by production from foreign rather than American workers, as Americans increased the share of consumer and capital goods they bought from abroad, or as domestic firms expanded the share of their operations located abroad, this should show up as a rise in the inflation-adjusted value of imports relative to GDP. During the 1990s the import share rose steadily, but apart from some short-term fluctuations the share leveled off thereafter. It is difficult from this data to see how changes in the combination of import substitution and offshoring could have played a major role in explaining America's job performance in recent years.

The estimates on imports of goods come from relatively comprehensive U.S. customs data. Conceivably, the surveys of business firms used by the Department of Commerce to collect data on service imports may be missing some of the increase attributable to offshoring. I discuss later in this Policy Brief the issue of possible errors in the estimates of service imports. But the absolute size of any such errors in the import data cannot realistically be anywhere near large enough to alter the earlier conclusion that the speedup in productivity growth was by far the dominant factor behind the disappointing job growth.

Offshoring of Services

What can we say about the relative magnitude of the offshoring of services—software writers and computer technical support in India, clerical and record-keeping operations in the Caribbean, and call centers in a number of countries? Anecdotes abound, but was the growth of these operations sufficient to explain any significant part of the jobs problem? There is no fixed line of demarcation between offshoring activities and simple purchases of imported goods and services abroad. But the U.S. data on imports of services suggests that the growth of those imports was not large enough to have made a major, economy-wide impact in swelling layoffs or inhibiting job growth.

Up-to-date quarterly estimates are available for imports of what are called "other services," that is, all services excluding travel, transportation, and royalty fees. Business, professional, and technical services (BPT for short), many of which have been subject to offshoring activities, account for a little more than half of "other private services," with the rest consisting of educational, financial, insurance, and telecommunication services that are not themselves likely to be heavily imported as a result of overseas relocations. Within the broad "other private services" category, the United States has long been running a substantial and growing export surplus. Between 1997 and 2003 imports did grow strongly, but in absolute terms, exports grew even faster, providing job opportunities that offset at least some of the job losses attributable to the rise in imports. Because the activities that are outsourced abroad are likely to use less skilled and lower-wage labor, it is possible that the job losses from offshoring exceeded the job gains associated with the growth in exports, but the magnitude of the net loss could not have been very large.

To make estimates about the level and growth of offshoring, it would be most useful to have import data classified at some greater level of detail, for example BPT services, and within that category specific information about such items as services related to computers, software, and data processing. Unfortunately, 2002 is the latest year for which complete data are available at that level of detail. BPT imports grew strongly in the five years preceding 2002, especially in the earlier part of the period, but here also the United States continued to run a large and gradually expanding export surplus. Between 1997 and 2002, imports of BPT services remained a virtually constant fraction of the larger category of "other private service" imports. If one assumes that this stability has continued, it is possible to get a reasonably good fix on the growth in BPT imports through the end of 2003. That data in turn can be used to make a rough calculation of the impact of the potential size of jobs lost to the offshoring of BPT services.

To give the offshoring hypothesis the benefit of the doubt, ignore any employment gains associated with growing exports of BPT services, and assume that all of the rise in imports in such services relative to GDP since the last quarter of 2000 was associated with growth in outsourcing activities involving a loss of domestic jobs among the firms involved. To make a crude estimate of the possible substitution of foreign workers for U.S. workers, further assume that the number of displaced U.S. workers equaled the number of foreign workers hired; that the relocated operations typically involved lower skilled jobs with about two-thirds to four-fifths of the value produced per worker than the average for the U.S. "business services" industry; that the compensation per worker paid in the overseas locations ranged between one-fourth and one-sixth of U.S. compensation; and that all other costs of the offshore services were close to what they would be in the United States. Given these alternative assumptions, the increased imports between the end of 2000 and the end of 2003 imply an aggregate job loss from outsourcing of BPT services alone totaling between 155,000 and 215,000.

These are necessarily very rough estimates, based on some judgmental assumptions. Some Indian estimates, which I discuss later, give the number of Indian employees associated with the relocation of computer and related operations to that country. Depending on what one assumes about worker productivity in the Indian operations, those numbers suggest the possibility of somewhat larger numbers of job losses in the U.S. information technology sector than implied by the estimates for BPT as a whole given above. But even substantially larger numbers would still be small in relation to the size of the U.S. labor market and the magnitude of the annual job creation and destruction that characterizes the dynamic American economy.

A lot of the media attention has been focused on the relocation overseas of programming and other computer-related services. Imports of these services did rise sharply from 1997 through 2000, but the U.S. data show no increase over the next two years. Given the sharp decline in the demand for information technology products after the high-tech bubble burst in 2001, the stability of imports of computer and related services from 2000 to 2002 probably conceals a continued rise in the importance of offshoring. At the same time, the continued high level of American sales abroad allowed the United States to continue running a substantial export surplus of these computer-related services.

In sum, what the U.S. official trade data suggest is that the anecdotal evidence may indeed accurately reflect a substantial relative increase in the employment losses from the relocation of service-type activities abroad during recent years. But the data do not provide any evidence of an increase in offshoring of goods and services anywhere near large enough to have played a substantial role in shaping overall trends in U.S. employment. Moreover, in the broad area of BPT services, where offshoring is most important, the United States has a large export market that continues to expand, providing a growing number of jobs for American workers.

The Official U.S. Estimates

The data on imports and exports of BPT services are principally based on several surveys of business firms conducted by the Bureau of Economic Analysis. Substantial improvements have been made in the collection system over the last decade and a half. Nevertheless, an inspection of the data for India does raise some questions about the extent to which the data for particular categories of services are really capturing the rise in offshoring. The U.S. data shows a substantial decline in "other service imports" from India between 2000 and 2002, which is hard to square with the abundance of anecdotes and media attention. U.S. data covering unaffiliated trade with India in the more narrow category of BPT services (which is almost surely dominated by computer and related services) shows only $209 million in imports from India in 2002, about the same as in 2000. (Total service imports by U.S. multinationals from their Indian affiliates were not large enough to add much to these figures).

The low $209 million level of non-affiliated BPT and computer related imports in the U.S. data—and the absence of growth between 2000 and 2002—are impossible to reconcile with the anecdotal evidence. More importantly, data from Indian sources show a far higher level and a larger rate of increase in computer-related service exports to the United States than do the U.S. import statistics.

According to Indian data, exports to the United States of computer software and other information technology related services—a subcategory within business services—amounted to $1.1 billion in 1997-98, $3.7 billion in fiscal year 2000/2001, and $6.0 billion in 2002/2003, many times higher than shown in the U.S. import statistics. But these Indian data count as an export the revenue from arrangements whereby Indian firms, using Indian personnel, perform services at the U.S. site of their clients. In the U.S. data, the value of such services performed in this country are generally counted not as imports but as domestic production. Even after correcting for this difference, however, Indian computer and related service imports to the U.S. rose from $1.6 to $3.4 billion between 2000/2001 and 2002/2003, a level and a rate of increase much higher than implied by the U.S. import figures. And based on estimates derived from Indian data, the number of workers employed in producing computer and related services relocated from the United States to India could have increased by roughly 185,000 over the past four years.

It is not necessarily the case that it is the Indian data which are more nearly correct. There may be definitional reasons for some of the differences. And according to the data from Organization for Economic Cooperation and Development, the major industrial countries report imports of services from India that, in the aggregate, are a puzzlingly small fraction of the worldwide exports of services reported by India. But we do not know enough to form a good judgment. For a number of reasons, not least being the national attention paid to the offshoring phenomenon, we ought to have more information about this issue. Funds should be quickly provided to the BEA for a targeted research effort aimed at uncovering the reasons for the apparent discrepancy among different sources, and recommending any needed improvements in the U.S. data collection system.

Should it should turn out that the official estimates are seriously understating the relevant service imports, the assessment of the employment effects of offshoring made earlier in this Policy Brief and elsewhere, based on evidence from U.S. import data, would have to be significantly raised. But even a large increase in the estimate of the relevant service imports and their employment effects would still be quite small relative to the overall economy, the annual turnover in the American labor market, and the magnitude of the shortfall in job growth that has to be explained. Thus, for example, a large correction in the estimate of imports of BPT services, which are themselves only 0.4 percent of GDP, would imply only a very minor change in the reported acceleration of productivity growth over the last few years and its contribution to the slow recovery in employment until just recently.

The essential conclusion remains that offshoring, and more broadly import competition, while clearly having an important effect on some industries, workers, and communities, were not significant causes of the "jobless recovery."

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In early May the Federal Reserve signaled its concern about what it called the "minor risk" that today's one percent inflation could turn into a deflationary period of falling prices. Testifying before Congress later in the month Fed Chairman Alan Greenspan reiterated that concern. And just a few days ago, he told a group of world bankers that while the development of deflationary forces was a low probability event, the Fed will lean over backward to make certain they are contained.

Why the Concern About Deflation?

The combination of weak demand for goods and services and competitive pressures from an overhang of excess capacity can squeeze profit margins and force price discounts. The accompanying slack demand for labor will tend to slow the pace of money wage increases and lead to further price weakness. This is how recessions and sluggish recoveries painfully bring down the rate of inflation. And when inflation is already low, prices can actually begin falling.

Falling prices and the expectation of further declines can, in turn, exacerbate the weakness of demand. Consumers may delay some purchases in hopes of getting better prices. Potential home buyers and business investors are discouraged from borrowing for fear they will have to repay their debts out of earnings and revenues diminished by the decline in prices. A reduction in interest rates could overcome this barrier to investment. But, since interest rates can't fall below zero, many of those who worry about deflation fear that the Federal Reserve will have little power left to support demand and fight deflation if interest rates are already low when deflation begins.

What can we do about it?

The breathless tone of some of the media discussion about deflation reflects exaggerated fears. There are a number of monetary and fiscal tools available to stimulate demand and fight deflation, even after the short-term interest rate targeted by the Fed has been pushed down to zero (it is now 1-1/4 percent). Fed governor Ben Bernanke discussed some of these tools in a November speech. For example, the Fed could act to push down the interest rates on longer term government securities, thereby promoting lower rates on private loans and bonds, which are still significantly above zero. One powerful way to do this, he suggests, would be for the Fed to announce that it stood ready to make unlimited purchases of medium or even long-term Treasury securities at a price that would achieve some targeted low interest yield. Bernanke also suggested that, among other measures, the Fed could make interest-free loans to banks, accepting as collateral private debt obligations, and if it became necessary, could ask the Congress for authority to purchase such obligations itself. (This latter approach, however, would have to be very carefully crafted because the Fed would then be allocating capital among individual private firms).

If such monetary policy measures were not enough, the Federal government could generate additional demand with a large, temporary stimulus of tax relief and spending measures. Since households are likely to spend a smaller fraction of a temporary than a permanent tax cut, the size of the reduction should be calibrated accordingly. As Bernanke suggests, the addition to the deficit created by the stimulus could be financed by direct Fed purchases of Treasury securities, so as to prevent the added deficit from raising interest rates and to avoid a large increase in the publicly held federal debt.

While likely harmful in a prosperous or rapidly recovering economy, these measures could be safe and highly useful in an economy with low inflation or deflation, and plagued with chronically weak demand.

Is Japan a model of what inflation can do?

Japan's decade-long stagnation has, in the last four or five years, been accompanied by falling prices . But Japan should not be taken as an example of what inevitably follows from a modest deflation. In the first place, as economist Adam Posen has pointed out, Japan has used only some of the range of monetary tools available to fight deflation, and those belatedly. And with respect to fiscal policy, the Japanese have for some time been reluctant to undertake aggressive stimulus, on grounds that their debt has already grown sharply relative to GDP. But this objection could be overcome by having the Bank of Japan buy the government securities needed to finance the stimulus—as suggested above for the U.S.

Japan also has some deep structural problems that are inhibiting the growth in investment desperately needed to help end stagnation. While Japan has developed a number of world-class export industries, a recent study (2000) by the McKinsey Global Institute showed that a substantial fraction of domestic output is produced by firms with productivity far below those in corresponding U.S. industries. The study documented the regulations, restrictions, land policies, subsidies, and tax incentives that have provided an anti-competitive shelter for inefficient business practices and firms. The potential for modernizing "catch-up" investment in a wide range of domestically oriented industries has been inhibited by this web of protective devices, and political opposition has kept the pace of liberalization slow.

Since the bubble burst more than ten years ago, the Japanese banking system has become saddled with a massive volume of bad loans. Successive efforts to get the bad loans off the books and re-capitalize the banks have been frustrated or watered down by entrenched interests within the Japanese Diet, because that process might force many protected "zombie" firms into bankruptcy. It is difficult to determine the extent to which productive new investments have been deterred by an inability to get bank financing, rather than by the combined effects of stagnant aggregate demand and the protections afforded to existing business establishments. But it's probably much more the latter than the former.

Conclusion

Deflation, while not a likely forecast for the U.S, needs to be recognized as a downside risk, and the Fed is right to do so. But let's keep it in perspective. In particular, what has happened to Japan is not a model. The U.S. financial system is not hamstrung with a debilitating burden of bad loans. Compared to Japan, it shelters many fewer sectors from competition and imposes smaller barriers to investments that challenge existing industry structures. From a macro-economic standpoint, the Federal Reserve has made explicit its intent to move promptly to counteract faltering demand and its willingness to adopt innovative monetary tools should short term interest rates fall to zero. Most important, it seems quite likely that the appearance of deflationary forces would lead to a substantial further economic stimulus. Indeed, in the current political climate, the main concern is not that the response would be insufficient but that it would go beyond the needed temporary stimulus, providing yet another permanent tax cut, and loading more debt burdens on future generations.

      

 

 

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Controversies over the effects of fiscal policy on the economy have been at the heart of the policy debate surrounding the chronic deficits of the 1980s, the sharp rise in official budget surpluses in the late 1990s, and the equally sharp decline in the fiscal outlook recently.

This panel discussion, the first in an ongoing series on macroeconomic issues sponsored by the Brookings Institution, will examine a variety of questions regarding the effects of deficits on the economy: Do budget deficits matter? Under what circumstances and what time horizons are they good, bad, or neutral? How important are they to strong economic growth?

Following their remarks, panelists will answer questions from the audience.

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The fall in the stock market was caused in part by a rash of headline-grabbing cases of corporate mismanagement at WorldCom, Enron, Qwest Communications, Andersen Accounting, Global Crossing, Tyco International, and other companies. At the same time, the overall national economy, which seemed to be turning upward after a slowdown, now may be sagging again. At this forum, a number of Brookings scholars will discuss the implications of this crisis in corporate governance for public policy.

Issues for discussion will include: Can we estimate the direct effects of the corporate scandals on the U.S. economy? What are the effects on the federal budget? What are the implications for retirees? What is the role for public policy if workers as well as investors create valuable assets for corporations? How can policy—and the direct involvement of the public—enhance the effectiveness of transparency systems, including those that address financial disclosure and health and safety risks? How do recent changes in the state of the economy alter public perceptions of the role of government and of the images of the political parties? Has this altered the climate for the mid-term elections? What are the implications beyond our borders?

Scholars will speak on the following topics:

• William G. Gale: Budget and Retirement Issues
• Carol Graham: Economic Costs, International Impact
• Mary Graham: Transparency Issues
• Thomas E. Mann: Political Implications
• Charles L. Schultze: Corporate Governance in Historical Perspective

Copies of Brookings Policy Brief #106 on the costs of the corporate scandals will be distributed at this Forum.

To be webcast live.

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Authors Include: Kenneth J. Arrow, Elizabeth E. Bailey, William J. Baumol, Jagdish Bhagwati, Michael J. Boskin, David F. Bradford, Robert W. Crandall, Maureen L. Cropper, Christopher DeMuth, George C. Eads, Milton Friedman, John D. Graham, Wendy L. Gramm, Robert W. Hahn, Paul L. Joskow, Alfred E. Kahn, Paul R. Krugman, Lester B. Lave, Robert E. Litan, Randall Lutter, Paul W. MacAvoy, Paul W. McCracken, James C. Miller III, William A. Niskanen, William D. Nordhaus, Wallace E. Oates, Peter Passell, Sam Peltzman, Paul R. Portney, Alice M. Rivlin, Milton Russell, Richard L. Schmalensee, Charles L. Schultze, V. Kerry Smith, Robert M. Solow, Robert N. Stavins, Joseph E. Stiglitz, Laura D'Andrea Tyson, W. Kip Viscusi, Murray L. Weidenbaum, Janet L. Yellen, Richard J. Zeckhauser.


Interest of Amici Curiae

This brief is being submitted on behalf of a group of economists. The purpose of the brief is not to attempt to guide the Court on legal issues but to inform it on economic ones. To put ourselves in the best possible position to offer the Court our expertise, we have tried to understand, in light of the legal task confronting the Court, where our own economic expertise might have a useful role to play.

To that end, we understand that the lawyers who brought this case framed the following question for the Court's consideration: "Whether the Clean Air Act requires that the Environmental Protection Agency ignore all factors 'other than health effects relating to pollutants in the air'" when setting National Ambient Air Quality Standards (NAAQS). We also understand that this question has arisen in part because the United States Court of Appeals in Washington, D.C., whose responsibility it is to review air quality standards issued by the Environmental Protection Agency (EPA), has interpreted the Clean Air Act as barring the EPA from even considering the potential costs of its air quality regulations.

The merits of this legal debate between the D.C. Circuit and the counsel who have contested the D.C. Circuit's views are beyond the scope of our economic expertise and hence of this brief. Nonetheless, we respectfully offer the following observations with hopes that they may ultimately prove useful.

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Two decades ago, workers entering new jobs in established firms could look about and see that most of their older and more tenured fellow workers had climbed a fairly steep wage ladder and appeared to enjoy a relatively high degree of job security. Over the past 20 years intense media attention and some dramatic downsizing among large companies have created a widespread perception that corporate layoffs among senior workers, at all skill levels, have seriously eroded the prospects for job security as a reward for long service.

How accurate is this perception? Has job stability significantly worsened for the average American worker? What is the cost of layoffs to workers with substantial job tenure, and have these costs been rising?

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The looming problem in America's computer systems is not the only potential disaster the year 2000 could bring. Realistic planning for the 2000 decennial census is now being hamstrung by a stalemate between the administration and Congress over how to conduct that census. Since the census provides much of the data about regional and local areas that federal, state and local governments and American business firms require for their plans and operations—as well as for political redistricting—a failed census would indeed be a disaster. But that's precisely where we are headed.

By the census of 1990, the difficulties of physically counting all of the increasingly mobile American population had led to soaring budgetary costs and reduced accuracy. Blacks and other minorities were substantially undercounted relative to whites, and renters relative to homeowners. Armed with recommendations from three panels of the National Academy of Sciences and a blue-ribbon committee of the American Statistical Association, the Census Bureau decided, in designing the 2000 census, to augment the traditional physical counting of households with scientific sampling techniques. Carefully used, such an approach can produce both a reduction in costs and an improvement in accuracy.

Citing various objections, and fearful that a correction of the undercount among minorities and the poor would weaken their political base, the Republican majority in Congress has mounted a massive attack against the Census Bureau's plans. (Republicans are not inherently more partisan; if the electoral stakes had been reversed Democrats would be leading the charge against sampling.) The Census Bureau has, in effect, been ordered to plan two distinct types of census, one with and one without sampling. Under duress it is conducting a dual dress rehearsal, testing a traditional census in one location and a census with sampling in another. An evaluation of the results won't be available until late this year, and in any event, the Republicans have said they don't consider the dress rehearsal as indicative of whether sampling will work.

The delays and the two-track planning approach are beginning to threaten a potential fiasco. Conducting a decennial census is a massive enterprise, perhaps the biggest and most complex task the civilian arm of the federal government has to undertake. In 1990 more than 500,000 people—most of them temporary help—were engaged at one time or another in conducting the census. Moreover the decennial census is a one-time venture. It cannot be carried out on a "learn-as-you-go" basis, but must be meticulously planned in advance in all its details. Thousands of temporary supervisors have to be hired and taught how to supervise and administer training to scores of thousands of temporary enumerators. Tens of thousands of pages of training manuals have to be prepared and checked. The Census Bureau should be conducting dress rehearsals not to determine what kind of a census to undertake but to discover operational bugs in a census plan that has already been devised.

Most important, a census with sampling is not simply a traditional census with sampling added but a very different thing. To take only one example, if you are going to use sampling to complete and improve the enumerators' count, you can leave out a number of expensive operations such as the 1990 programs that tried—not always successfully—to reach such hard-to-find groups as parolees and probationers. Without the use of sampling to complete the count, a range of special programs to track down the hard-to-find must be designed and integrated into the census process.

Time is running out. The whole massive enterprise must be going full blast in less than two years. However capable, the Census Bureau cannot continue trying to prepare two different enterprises not knowing which one will be chosen.

It would be a major mistake for Congress to force the 2000 census to be carried out without the aid of sampling. According to the Census Bureau, that would add some $675 million to $800 million to budgetary costs. At best it would perpetuate the inaccuracies and inequities of the 1990 census, and more likely make them larger. There is only one thing that would be worse, and that is continuing to postpone a decision. The Census Bureau is coming perilously close to the point where it cannot carry out either kind of census in a responsible manner. And so, a word of advice to Congress and the administration: Settle this issue now.

     

 

 

Thank you for inviting me to give my views on the desirability of adopting a capital budget for the federal government. My acquaintance with budgeting concepts and practices began many years ago, first as Assistant Director and then as Director of the Budget Bureau—the forerunner of OMB. Over the intervening years I have studied and written about budgetary matters as a senior fellow at the Brookings Institution.

I am going to assume that the major issue before the Commission is not whether the federal government should provide budget accounting data that distinguishes capital from current outlays, accompanied by estimates of the depreciation of government capital. Information on federal investment has long been published in relatively full detail. More recently aggregative estimates of capital depreciation have also been published. Both scholars and government policy-makers could make good use of even more detailed presentations, especially for depreciation. This, of course, is not where the controversy lies. Rather, those who urge a capital budget for the federal government are proposing a general rule of budgetary operation: Under normal circumstances revenues should cover current operating expenditures (including depreciation of government capital), but net investment outlays should typically be financed by borrowing.1 Adopting such a rule would, in my view, be a mistake, probably at any time, but certainly under the circumstances now facing the nation and the government.

The Economic Consequences

In times of normal high employment, additional government investment outlays will necessarily displace some other types of spending in the economy. Government capital outlays financed by borrowing will come chiefly at the expense of privateinvestment. On the other hand, if government finances its capital outlays by reducing other, non-investment, spending, by raising taxes, or by forgoing otherwise scheduled tax cuts, the added government outlays will come principally at theexpense of private and public consumption, not private investment. Operating the federal government under a capital budgeting rule will lead to lower private investment than would be the case if government investment spending were paid for out of each year s revenues.

Let me elaborate briefly. In times of normal full-employment, each dollar of government borrowing absorbs a dollar of scarce private saving, and diverts that dollar away from financing private investment into Treasury securities. Some combination of two consequences will follow: there will be less domestic investment in private plant and equipment here at home, and borrowing from abroad will rise, with an accompanying rise in the U.S. trade deficit. Lower private domestic investment reduces the growth of productivity and the level of future national income. To the extent that private investmentis maintained through increased borrowing from abroad, future income is reduced by the added debt service we have to pay foreigners. On the other hand, however, unless we really go out of our way to design taxes hostile to saving and investment, most of the revenues from higher taxes will come at the expense of private consumption. And to the extent that we finance federal investment by cutting back the government s non-investment outlays, by definition we lower public consumption. And so if we want to take the resources needed for federal infrastructure investment out of the nation's consumption, rather than out of private investment, we ought to finance that federal investment out of the proceeds of current tax revenues and not from federal borrowing.

If the United States were in the situation now facing Japan with sluggish markets, huge private saving, and private investment opportunities constricted not by the availability of saving but by low demand and over-regulation, then routinely financing government investment through borrowing might be desirable. Or, even under conditions of high employment, if we were a high-saving, low-consumption country perhaps it wouldn t matter very much that the bond-financed public investment displaced private investment. But that is not our situation. The U.S private saving rate (including retained corporate earnings) has never been very high, and has dropped by a third since the early 1980's. At the same time the need for an increase in national saving and investment has risen sharply. As you know, the ratio of retirees collecting social security and Medicare benefits will begin rising very sharply starting sometime after 2010 as the baby boomers reach retirement age. Unless we institute a draconian slash in benefits those retirees are going to be consuming a growing fraction of the nation s output of goods, services, and medical resources, placing a real burden on the future workingpopulation. No set of purely financial arrangements can ease that burden. The only way to do so is by taking steps now so that the higher future consumption by the elderly will be matched by an increase in national output and income. In turn, the only reliable tool we have to do that is to increase national saving and investment. The additional investment will expand the quantity and quality of capital available to the nation s workforce, and thereby raise national productivity growth. By financing government investment out of current revenues rather than borrowing, we avoid the decrease in private investment which, in non-recession times, is inevitably the result of federal borrowing.

Under the current and prospective conditions facing the U.S. economy, financing the bulk of federal investment by borrowing would be appropriate only if two conditions were met: First, borrowing to finance federal investment causes lesspolitical pain than raising taxes or cutting other spending, and adoption of a capital budgeting rule would thereforesubstantially increase the level of federal investment-type spending. Second, the additional public investment would onaverage yield higher returns than the private investment it displaces.

The first condition might well be met—financing federal investment from borrowing rather than out of current revenues would most probably add significantly to the amount of funds appropriated by the Congress for programs and projects that could qualify as investments . A capital budget would include the depreciation of past investment outlays as an operating expense and so a growing volume of public investment would gradually lead to counter pressures, as the accumulating depreciation charges had to be covered out of current revenues. The expansion of investment outlays would ultimately be self-limiting, but a significant expansion would most probably occur. Thus, for example, the large increase in highway spending now contemplated in bills that are about to pass the Congress would surely have been even larger if the outlay could have been financed by borrowing.

There is no question that many federal infrastructure investments yield substantial benefits to the nation. And it may well be true that, if the projects or programs were carefully and objectively selected, some expansion in the current volume of federal investments would be beneficial to the nation. One the other hand, I think it highly unlikely that a major expansion in federal investment, made politically feasible by relaxing current budgetary constraints, would earn a return anywherenear sufficient to warrant the crowding out of private investment that the bond financing would occasion. As a consequence the net effect on national productivity growth would be negative.

In the case of private investment, competitive forces and the search for profits automatically exert some discipline over the quality of projects selected by private investors. The discipline of the bottom line is, of course, imperfect; errors and mistakes periodically occur, especially where the tax laws favor highly leveraged investments like real estate development. But the return on a business venture can be observed. And a string of investments that fail or that yield submarginal returns will most usually have painful consequences for those who put up the money. That fact operates powerfully in the right direction. It forces people to put their money where their mouth is.

No such forces operate in the public sector. Most public investments, unlike their private counterparts, produce benefits that are not sold in the marketplace and seldom show up as an increased stream of government revenues. The benefits accrue to the public, and in most cases are hard to measure. In any given case success or failure is usually far from obvious and almost always subject to dispute. There is a huge range of payoffs across different types of potential infrastructure investments and among different specific projects. Some areas of public life would indeed gain from an infusion of well-selected investments. But at the same time the record shows that political and parochial considerations play a very heavy role in the allocation of funds among broad areas for federally financed investments, and among specific projects within each area. There is also a tendency to use physical investments to deal with problems that could better be met with changes in economic incentives, in institutional arrangements, or in zoning laws. Thus, beyond a certain point,federal flood control projects do far less to limit damage from floods than would a combination of flood-insurance requirements and zoning laws. And, in the absence of other policies, trying to relieve traffic congestion by adding highway lanes will frequently spur developments which quickly congest the new lanes.

Recent arguments in favor of a large increase in public infrastructure investment often cite the work of economist David Aschauer. After examining national and state data on postwar productivity growth and public and private investment he concluded that a large part of the post 1973 decline in productivity growth could be associated with a decline in public investment. His results also implied the startling conclusion that a dollar s worth of public investment yielded a growth payoff three to four times higher than the equivalent outlay for private investment.

These claims for the superior efficacy of public infrastructure investment, however, are far greater than warranted by reality. For the past quarter century, national productivity growth has fluctuated narrowly around a trend of 1 percent a year, well below the rate of almost 3 percent a year which characterized them first twenty-five years after World war II. Just at the time that productivity growth was beginning to taper off in the early 1970s, the public investments associated with the building of the massive interstate highway system were winding down, as were the public school building programs necessitated by the postwar baby boom. By statistically relating changes in the rate of productivity growth to the changes in the level of public investment over the period, this coincidence of events can be made to suggest a causal relationship between public investment and productivity growth far stronger that in fact exists. Thus, a 1991 article by Laura Rubin of the Federal Reserve staff finds that changes in the school age population explain the downturn in productivity growth as well as any measure of the stock of public capital. And in its study of the economic effects of public infrastructure investment, the Congressional Budget Office cast substantial doubts on the estimates that assert vastly larger payoffs to public than to private investment. Thus, for example, the results obtained from studies like those of Aschauer change sharply when relatively modest alterations are made in the years covered by the study or in the specifications of the data.2. The Congressional Budget Office concluded its study of public infrastructure investment as follows: Although further, carefully selected investments in public infrastructure may well be productive, there is little evidence to suggest that substantial, across-the-board increases in current programs would be more productive on average than private investment. Recent budget agreements have succeeded in setting up rules that come close to enforcing pay-as-you-go discipline, and show some hope of continuing to be observed. To continue including investment outlays within that rule and to require that federal investment outlays ought to be paid for out of current revenues sets up a not unreasonable substitute for thebottom line criterion that the private market uses to discriminate high return from low return investment projects. If a public investment project can pass the political pain test of having to gain enough support to displace other potential outlays orlead to a tax increase, it is somewhat more likely to yield a reasonable return to society. While relaxing the current budget constraints on financing federal investment outlays would in all probability increase spending for such purposes, an important fraction of that spending would most likely have returns below the private investments they would displace.

In theory, explicit spending controls over the investment components of the budget could limit the extent to which bond-financed public investment would displace private investment. Indeed the current account budget could be targeted for a surplus equal to the federal borrowing used to finance capital outlays. But this would frustrate the whole purpose of inaugurating a capital budget. In effect the capital outlays would continue to be financed out of current revenues. The result would be no different form what we have now, except for the addition of more opaqueness to the budget process. In sum, we have no warrant to believe that a large increase in public investment, financed by borrowing, will, on average, yield the nation a return superior to that of the private investment such borrowing would displace. Indeed, in the case of debt-financed public investment outlays, the lack of a either a financial bottom line criterion or a political pain test strongly suggests that the average return to such investments is likely to be inferior to what they displace.

Some Political and Procedural Problems

When federal budgetary rules make it easier to finance one form of federal outlay relative to another, the advocates of particular programs within the Administration and the Congress, together with their organized supporters ,will begin to exert pressure to have their favored programs defined as investment. Quite properly it can be claimed that a very wide range of federal programs and projects have the character of an investment, in that they are costs undertaken today in the prospect of yielding a stream of social and economic benefits over the years ahead. Not only the standard spending on physical infrastructure, but federal outlays for research and development, education, labor market training, Head Start, perhaps part of Medicaid, and a number of other programs would surely be claimants for identification as investment. Given the purposes of the federal government, could one really argue that road and dam building would contribute to the future stream of national income and well-being while outlays for R&D and education would not? As I am sure other witnesses before the Commission have pointed out, this struggle for investment identity could lead to constant procedural battles over budget rules, struggles that have the potential for weakening the whole painfully won structure that has been erected in recent years to bring more discipline to the process.

The political use of budgetary accounting rules to promote favored projects could extend beyond the obvious definition of what is an investment. Central to the construction of a capital budget is the development of depreciation or amortization allowances that would have to be added to the current operating budget. The slower the depreciation or amortization schedule for an investment, the smaller the future annual amounts that would have to be recovered from current revenues and the smaller the short-term budgetary cost of an investment outlay. As Federal Reserve Governor Edward Gramlich pointed out to the Commission in his testimony last month, this would further complicate already arcane budget accounting rules. Advocates would politicize the process in trying to ensure a very gradual depreciation schedule for their favorite programs. And to the extent that investment was defined more broadly than traditional physical investments—education or R&D for example—there is little precedent or accounting guidance from private investments to set limits to the political debate and maneuvering. Whatever its substantive merits or demerits, the adoption of capital budget would—especially in its early years—vastly expand the intrusion of partisan and political advocacy into the definition and implementation of budget accounting.

State and Local Capital Budgets

Most state governments have long operated under capital budgets. If it has worked for them, why not for the federal budget? There are two reasons. First no state has its own Federal Reserve to print money and buy its securities when things get tough. Even in difficult circumstances they have to cover their debt service from current revenues. But the U.S. federal government has the Federal Reserve as its ultimate backstop. Buyers of Treasury securities know they will never suffer a default. They may, like buyers of any fixed income security, be damaged by surprise inflation, but they will be repaid. Without the backup of a money-creating central bank, the issuance of debt by states and localities is closely policed by the private bond markets. A state which begins to pile up excessive debt to the point where its repayment ability is even remotely questioned, finds its securities downgraded by the rating agencies and has to pay an interest rate premium whose magnitude gets worse the further the state goes into debt. Beyond a certain limit, what economists call the marginal cost of new bond-financed investment projects begins to rise steeply—borrowing an additional amount is not only itself costly, but far more important it raises the interest cost of all the existing state debt as it is rolled over. Thus as bond-financed publc investment projects are pushed beyond prudent bounds the budgetary costs of such outlays mounts steeply. This mechanism, again, isn t foolproof. But it is a powerful self-limiting device. It does not operate for the federal government. A second factor that places limits on the bond-issuing propensity of state governments, but which is not applicable to the federal government, is that a state s citizens can vote with their feet . States have to worry that if they build up substantial debts to finance investments of questionable worth, the resultant build-up of tax bills to service those debts will begin to cause many individual and business taxpayers to flee the state, and discourage new businesses from entering. And this can occur even if the particular bond issues and investments were favored by a majority of voters. The prospect that under the same circumstances U.S. citizens and business firms will emigrate is not completely absent, but is far less powerful than in the case of state and local governments.

     

 

 

In these final weeks of the presidential campaign the two candidates and their surrogates are bombarding the public with competing economic statistics. By careful selection of what economic statistics to emphasize and what beginning and ending years to use in calculating changes, each side has put together a set of data proving how well (poorly) the economy did when its (the other) party ran the government.

In the following pages, this Policy Brief seeks to help the interested reader peer through the fog of misused statistics by providing an unbiased depiction in words, figures, and charts of what has been happening to the major aspects of the economy.

From these data two main conclusions can be drawn about American economic performance. (1) After high inflation in the 1970s and a very deep recession in the early 1980s, the economy has recently performed well in simultaneously achieving low unemployment and low inflation. (2) Since the early 1970s under a variety of economic policies and administrations of both parties, output, productivity, and real incomes have grown very slowly and the distribution of income has become steadily more unequal.

POLICY BRIEF #6

I. Output And Productivity

By Charles L. Schultze

GDP

In cycles of prosperity and recession the nation's actual output (GDP) fluctuates relative to its capacity or potential GDP, which grows more steadily over time (figure I-1). During a recession, workers and plants are temporarily idle due to lack of markets for the goods they produce. Once the economy turns around, however, employment and output can, for a while, grow rapidly as unemployed workers and plants are put back to work. But once actual GDP rises to match potential GDP, output can grow on a sustained basis only as fast as potential GDP. By choosing the right dates (for example, 1982 to 1989, or 1992 to 1996) partisans can attribute rapid growth rates to the administration then in office. Unless the growth of the economy's potential is speeded up, however, the temporarily higher growth cannot be sustained.

The most important thing to note about the slower rate of growth in potential GDP since 1973 is its bipartisan nature—the slowdown has persisted through numerous changes in economic policy and the administrations of both parties.

The growth of potential GDP depends on two things: first, the growth in the number of workers available for work and the number of hours they work; and second, the growth in output per worker hour (productivity). Starting in the early 1970s the growth of GDP slowed down because of a decrease in the rate of productivity growth. After 1980 the long-run growth of GDP was further slowed by a decline in the growth of the working-age population.

Productivity

Figure I-2 highlights the slowdown in productivity growth (output per hour worked in the nonfarm business sector of the economy) from an average of 2.7 percent a year from 1947 to 1973 to 1.1 percent thereafter. Again, what stands out is that aside from minor year-to-year fluctuations the sluggish growth of productivity has persisted virtually unchanged for almost twenty-five years. While a decrease in national saving and investment (section VII) played a role in the productivity slowdown, the causes for much of it remain a mystery.

II. Income and Earnings

By Gary Burtless

Family Income

The most widely used measure of the economic position of middle class Americans is median family income. The family with median income is in the exact middle of the income distribution—one-half of families have income above and one-half below the median. In 1994 the median family received a little less than $38,800 in money income. Before 1973 median income adjusted for inflation displayed strong and fairly consistent growth, but since then it has fluctuated more erratically and grown very little if at all (figure II-1).

Median income is not a perfect measure of economic status. It ignores income not received in money, such as employer contributions to health and pension plans and Medicare reimbursements, which have grown in importance over the years. If nonmoney income sources were taken into account, median family income would show a small increase since 1973. Moreover, since 1959 the number of persons in an average family has decreased, so the same median income now supports greater consumption for each family member.

But even if we divide median income by the average number of persons in a family, the text table still shows a sharp fall in income growth after 1973.

Compensation

The typical American family derives most of its income from wages and other labor earnings, and wages depend heavily on workers' productivity. When productivity growth slowed after 1973, wage growth inevitably slowed, too. Figure II-2 shows that average hourly compensation (wages and fringe benefits) in the nonfarm business sector, which rose about 2.8 percent a year from 1947 to 1973, edged up just 0.5 percent a year thereafter.

Contrary to a popular view, the share of national output and income received by business owners has not grown at the expense of workers (figure II-3). Hourly compensation, adjusted for consumer price increases, has risen a bit more slowly than overall productivity in recent years. But the main reason for the discrepancy was not a widening of profit margins but the fact that the prices of goods and services that workers typically consume have risen somewhat faster than the prices of the goods and services workers produce in the business sector.

III. Inflation and Unemplogyment

By Charles L. Schultze

Inflation

Several kinds of economic developments can launch inflation. It typically takes substantial unemployment to slow it. Between 1965 and 1983, under administrations of both parties, the country suffered three large inflationary surges (figure III-1). After 1965 the economic stimulus from Vietnam War expenditures was not sufficiently contained by tax increases, spending cuts elsewhere in the budget, or a tight monetary policy. The next two inflationary episodes arose from massive increases in world oil prices in 1973-74 and again in 1979-80, made worse in each case by a modest amount of economic overheating.

Each of these inflations was followed by a recession. But only in the last of the three recessions (1981-82) was unemployment pushed high enough to reverse a substantial part of the earlier inflation. After another minor episode of overheating and rising inflation (in 1988-90), the recession of 1990-91 finally drove inflation back down almost to its 1950s lows. During the subsequent recovery from that recession, economic overheating and renewed inflation have been avoided, which bodes well for a continuation of prosperity.

Unemployment

Economic recessions are characterized by large increases in unemployment, as shown in figure III-2. When high levels of economic activity push unemployment to very low rates, inflation starts to rise.

The level of unemployment at which this begins to happen has changed over time. Lately, most economists have been surprised at how low unemployment has fallen (it averaged 5.25 percent in July and August 1996) without so far triggering a rise in inflation.

The United States has for some time enjoyed a substantially lower unemployment rate than most European countries, and a far smaller fraction of U.S. unemployment is relatively long term (figure III-3). But the wages of low-skilled workers in the United States have fallen sharply over the past two decades (see Figures IV-1, IV-2, IV-3 below), while they have not done so in Europe. In all the industrial countries the demand for such workers has shrunk in recent decades. In the United States, however, large wage decreases have made it possible for workers at the lower end of the skill ladder to find work; in Europe a more rigid wage structure has preserved the wages of low-skilled workers much better, but at the cost of having a larger fraction of them unemployed.

IV. Distribution Of Income And Wages

By Gary Burtless

Family Income

Over the past fifteen years the distribution of income in the United States has become strikingly less equal. By 1994 the average income of families in the top fifth (quintile) of the income distribution was 11 times greater than for those in the bottom fifth, compared with multiples of only 7 to 9 from 1950 to 1985 (figure IV-1).

And comparisons involving those in the top 5 or 10 percent of the income distribution would tell an even more dramatic story. Contrary to widely held beliefs, changes in the tax system during the Reagan years had little direct impact on the trends in inequality. Indeed the increased inequality shown in figure IV-1 reflects changes in pre-tax incomes. Even though the tax burdens of affluent families did decrease somewhat in comparison with burdens on middle-income and poor families, the overall effect was small and would hardly be visible if the diagram were redrawn to measure after-tax income. The change in income distribution primarily reflects underlying developments in American society, not government policies.

Changes in household structure contributed importantly to the increased inequality. Families with only a single parent, which are much more likely to be poor than other kinds of households, are a rising percentage of American households. At the other end of the income spectrum, an expanding share of married-couple families contain two earners. If both earners hold professional jobs, their combined income can place the family far up in the income distribution. Since the mid-1970s the nation has seen particularly fast growth in employment, hours of work, and earnings among married women in affluent families, and this trend has contributed noticeably to the growing gap between high-income and middle- and low-income families.

Wages

The single most important factor behind increased income inequality is the sizable increase in wage disparities. Figures IV-2 and IV-3 show trends in annual earnings from 1979 to 1994 for full-time male and female adult workers divided into five equal groups according to their earnings. Earnings of the lowest-paid male workers fell 20 percent, while men in the top fifth of workers saw their earnings climb 11 percent. Earnings gains among women were better than among men, but the trend toward greater inequality was just as powerful.

There is no consensus on the exact sources of greater wage inequality. But most economists believe technological trends have played a dominant role, boosting the demand for and wages of workers with higher skills and abilities while reducing the demand for and wages of less-skilled workers.

Greater immigration and trade liberalization have also contributed to the widening disparities, but only modestly. The trends toward greater wage inequality and reduced work opportunities for the less skilled are as strong in industries not affected by international trade as in those heavily affected, and in areas where foreign immigrants are uncommon as in areas with large numbers of immigrants.

V. Downsizing And Job Insecurity

By William T. Dickens

Polls reflecting rising public concern about job security, a flood of media reports, and accounts of thousands of jobs lost at IBM, AT&T, and other big companies suggest that chances of holding onto a job in the American economy have worsened. Yet statistical evidence on whether job security has deteriorated is decidedly mixed, and whether or not the incidence of job loss has increased, the change has been small. In the public's eye, things are much worse and this disparity is puzzling.

Job Losses

The federal government's monthly Current Population Survey (CPS) every few years asks how long people have been with their current employer. Figure V-1 shows that for the work force as a whole job tenure did not decrease between 1983 and 1991 (the first and last year for which the data are available). Job stability among older male workers did decrease, but the decrease was offset by increases in job tenure among women and younger men.

In early 1996 the fraction of workers who reported that they had lost a job during the previous three years was about the same as in the early 1980s (figure V-2).

Unemployment was higher then but adjusting for that difference does not make it clear whether displacement rates have risen. While the current proportion of unemployed workers reporting that they have been permanently laid off is high by historical standards, the monthly unemployment reports show that the rate of entry into unemployment due to job loss is somewhat lower now than during periods of similar unemployment rates in the past.

Whether or not there has been an increase in job loss, changes are small in comparison to the normal rates of destruction and creation of jobs, which have always been very high. At least 10 percent of all jobs (over 12 million) disappear every year and slightly more jobs are created.

Costs of Job Displacement

There are, nevertheless, grounds for the greater worry about job security. First, long-tenured employees who lose their jobs typically have to take a new one at significantly lower pay. In earlier years large and steady economywide wage gains, together with normal seniority increases on the new job, meant that displaced workers could restore their old earning power relatively quickly. But now, with much slower productivity gains and stagnant real wages, it takes far longer to recover, and many middle-aged workers who lose their jobs never do. One study showed that workers were three times as likely to suffer an income loss over a five-year period in the 1980s as during any similar period between 1967 and 1979. Second there has been a sizable increase in the fraction of job displacements accounted for by white-collar workers, who—unlike blue-collar workers—didn't have to worry as much about job insecurity in the past. Moreover, as shown in figure V-3, the share of unemployment accounted for by white-collar workers has been growing faster than their share in the labor force.

In sum, the incidence of job losses for tenured workers may have risen, but not by a large amount. White collar workers have experienced a notable increase in job insecurity, but the main problem for other workers is the much slower recovery of income losses after displacement.

VI. The Budget

By Robert D. Reischauer

Deficits

Federal deficits, the difference between the revenues and expenditures of the government during the year, have grown substantially over the past two and one-half decades. They averaged less than 1 percent of GDP during the 1950s and 1960s, increased to an average of 2.1 percent during the 1970s, and then rose to 4 percent in the 1980s. During the first six years of the 1990s, deficits have averaged 3.3 percent of GDP (figure VI-1).

Recessions swell the deficit, lowering revenues and raising spending for unemployment compensation and food stamps. When the annual deficit is estimated in terms of what it would be each year if the economy were stable at high employment, the description of basic trends given above is not substantially altered, although part of the deterioration in the deficit in the early 1990s and the improvement since then are seen to have been due to recession and subsequent recovery. Both the Congressional Budget Office and the Office of Management and Budget expect the 1996 deficit to be around $116 billion or 1.5 percent of GDP. That would be the smallest nominal deficit in fifteen years (since 1981) and relative to GDP the smallest in twenty-two years (since 1974). However, if further measures are not enacted to cut spending or raise revenues, deficits will begin to increase again in 1997 and drift up to exceed 3 percent of GDP by 2006.

Expenditures

Over the past four decades, federal spending has grown faster than the economy—rising from 17.9 percent of GDP during 1956-60 to nearly 22 percent during 1991-95. But other than interest payments on the debt, all of the growth was accounted for by increased spending on social security and health programs, both of which are directed largely at the elderly (figure VI-2). Spending on the balance of government activities—defense, international affairs, and domestic programs other than health—has declined as a share of the GDP by almost one-third, from 14.6 percent in 1956-60 to 10.3 percent in 1991-95. Within this category of spending, defense has declined in importance significantly and fairly steadily from just over 10 percent of GDP in the last half of the 1950s to 4.4 percent in the first half of the 1990s. The other spending in this category—civilian spending outside of social security, health, and interest—grew relative to the economy until the last half of the 1970s when it averaged 8 percent of GDP and then gradually declined to a shade below 6 percent of GDP in the first half of the 1990s.

Receipts

Federal receipts have remained a fairly steady 17 to 19 percent of GDP for thirty-five years (figure VI-3). This constancy masks significant changes in the importance of the two broad categories of federal revenue. Relative to the size of the economy, collections from income (personal and corporate) and excise taxes have shown a marked downtrend until quite recently, from 15.2 percent of GDP in 1956-60 to 11.4 percent in the 1991-95 period. Social insurance taxes and contributions, in contrast, have grown in importance. They amounted to 2.5 percent of GDP in 1956-60, but 6.7 percent of GDP over the past five years. The postwar growth in social insurance receipts kept up with the rising costs of social security, Medicare, and the other social insurance programs. But current social insurance tax receipts will soon begin to fall short of benefit payments due to the rapid growth of Medicare costs and, starting in the second decade of the next century, the large rise in the number of social security and Medicare beneficiaries relative to the number of workers paying social security taxes.

VII. Saving And Investing

By Barry P. Bosworth

Saving

Economic growth depends importantly though by no means solely on how much the nation invests. In turn, the amount we can invest is critically limited by how much we save. National saving is the fraction of the nation's output and income that we do not consume either privately or publicly and is therefore available for investment either at home or abroad. It is also equal to what the private sector saves minus what is absorbed in financing government budget deficits (figure VII-1).

Private saving was roughly stable at 9 to 10 percent of national income from 1950 through 1980. That was sufficient to meet our needs for private domestic investment, finance a small government budget deficit of 1 to 2 percent of national income, and still allow for investing enough abroad to build up a sizable creditor position with the rest of the world (foreign investment is shown in figure VII-2 as negative borrowing; the United States on balance was lending to and investing in other countries). But in the second half of the 1980s and in the early 1990s private saving declined. Financing a substantially increased budget deficit absorbed a growing fraction of the saving that remained. As a consequence overall national saving fell sharply and in the first half of the 1990s amounted to only 2.5 percent of national income. By 1995 national saving had recovered a little, but still amounted to only a little over 4 percent of national income.

Investing

The decline in the national saving rate led to two consequences. First, domestic investment fell from a little over 8 percent of national income in 1950-80 to a little under 4 percent in the first five years of the 1990s. Second, even that reduced volume of investment could not be supported by our shrunken national saving. As a consequence we had to rely on importing foreign saving to make up the gap, running a sizable trade deficit in the process. The United States shifted from the world's largest creditor nation to the largest net debtor. Although the reliance on foreign capital did limit the decline in domestic investment and moderate the harm to the nation's productivity growth from the fall in national saving, the gain is a mixed blessing because in the future we will have to pay interest and dividends to foreign investors on the funds we acquired.

Deficit Reduction

Deficit reduction will increase national saving. By reversing the decrease in national saving, two consequences will follow: the nation will increase domestic investment in productivity-enhancing assets and reduce the reliance on foreign borrowing, lower the U.S. trade deficit, and decrease the amount of dividends and interest it has to pay abroad.

Sources And Notes

Section I. GDP is gross domestic product in 1992 dollars, from the Department of Commerce. The basic revisions to the national income and product accounts (NIPA) have only been published back to 1959. For 1947-59 the earlier unrevised data on GDP, productivity, and employment were spliced to the revised series in 1959. Potential GDP is based on Congressional Budget Office annual estimates, interpolated quarterly and adjusted to reflect a nonaccelerating-inflation-rate-of-unemployment somewhat lower than the CBO estimates after 1992, falling to 5.6 percent (from the CBO's 5.8 percent). Productivity is output per worker in nonfarm business from the Bureau of Labor Statistics, reflecting the NIPA revisions after 1959.

Section II. Median family income is from the annual Census Bureau P-60 releases deflated by the CPI-U-X1 (which is the same as the published CPI-U from 1983 on). Compensation per hour in the nonfarm business sector is from the Bureau of Labor Statistics productivity data series, with the same splicing of pre-1959 data, deflated by the CPI-U-X1 rather than the CPI-W as in the published BLS series. Compensation share of national income in corporate sector is from NIPA, again with the pre-1959 unrevised data spliced to the later revised data.

Section III. Inflation. CPI data are from BLS. Before 1983 the Bureau's CPI-U-X1 was used as the superior measure of consumer price inflation. Unemployment Rates. European unemployment. Database from the OECD Employment Outlook, July 1996. "Europe" includes continental Europe less the former socialist countries plus the United Kingdom.

Section IV. Family income by quintiles. Census Bureau P-60 reports, various issues. Real Earnings. Author's tabulations of CPS tapes; earnings deflated by CPI-U-X1.

Section V. Job tenure. BLS tabulations are from answers in Current Population Survey (CPS). Displaced worker rates. "All worker" rates are from unpublished BLS tabulations derived from the CPS. three-year tenure rates through 1991-92 from April 1995 Monthly Labor Review; 1993-94 data estimated by author from unpublished BLS data. White-collar worker data. BLS published data from the monthly CPS. Job Turnover. Estimated by author from data in Stevens J. Davis, John Haltwanger, and Scott Shuh, Job Creation and Job Destruction, MIT Press (forthcoming), and Jonathon S. Leonard,"In the Wrong Place at the Wrong Time: The Extent of Functional and Structural Unemployment," In Unemployment and the Structure of Labor Markets, K. Lang and J. Leonard (Eds.) Basil Blackwell (1987).

Section VI. Actual expenditures, revenues, and deficit. Office of Management and Budget, Historical Statistics. High-employment deficit, and deficit projections. Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1997-2006.

Section VII. All data are from the NIPA. "Government" includes federal, state, and local governments. The annual surplus of state and local governments social insurance funds (principally the pension funds for their own employees) is classified as private saving. National saving and investment are measured net of capital consumption. National saving excludes the net investment of governments in civilian and military assets, and domestic investment is private investment only. The inclusion of net government capital accumulation in the saving and investment data would have made litle difference. Government investment averaged 2.1 percent of national income in 1960-79 and in the subsequent three periods shown in the figures that share was 1.2, 1.7, and 1.4 percent respectively.

The format of this Brief was inspired by that of The American Economy by Herbert Stein and Murray Foss, American Enterprise Institute, 1995.

     

 

 

The U.S. economy has performed superbly in recent years by way of reaching and maintaining both low unemployment and low inflation. But since the early 1970s, long-term economic growth in America has been disappointingly slow. And projections of future growth, including those of the Congressional Budget Office and the administration, foresee no pickup in the years ahead. While most Americans who want to work have jobs, their incomes and living standards havenþt been growing much, especially when compared with the halcyon days of the 1950s and 1960s when GDP was expanding 4 percent a year and incomes per family almost 3 ½ percent.

Not surprisingly, policymakers are looking about for ways to spur faster growth. From all along the political spectrumþfrom the National Association of Manufacturers to the AFL-CIO, from former Republican presidential hopeful Steve Forbes and GOP vice presidential nominee Jack Kemp to MIT economist Lester Thurow and investment banker Felix Rohatynþ come proposals to alter national economic policies to produce another 1 or 2 percent extra annual growth. (Needless to say, there is no agreement as to exactly what policy alterations are needed.)

If these policies could indeed produce those results, it would be a tremendous boon to the nation. Increasing annual GDP growth from its current 2 percent rate to 3 percent would, if continued for 10 years, add more than $4,000 annually to the $40,000 income of the average American family. A return to 4 percent growth would add $8,000. Notice, however, that a 1 percentage point speedup in growth requires a 50 percent increase and a 2 percent speedup a doubling in the growth that is now forecast!

Faster growth could do more than boost incomes. One percentage point of extra growth would raise federal revenues and lower interest payments on the debt enough to balance the budget at the end of the 10-year periodþso long as the growth-promoting policies didnþt themselves worsen the budget situation.

What changes in current national policies promise to produce higher growth? How much more growth are they likely to produce? And how much might each help in balancing the budget?

One often-mentioned change involves monetary policy. Current tight Federal Reserve policy, it is said, is a prime obstacle to growth. Whenever economic growth threatens to exceed 2 percent or so on a sustained basis, the Fed has shown itself ready to boost interest rates to prevent the higher growth from being realized. Perhaps a more venturesome policy of credit easing and lower interest rates would produce higher output without setting off inflationary pressures, giving U.S. citizens not only higher incomes, but lower budget deficits as well.

And even if the CBO, the administration, and the Fed are right about current limits to growth, perhaps policies could be devised to improve the nationþs future growth potential and allow the Fed to relax its caution. One pro-growth policy is a tax cut. A hotly debated issue here is the extent to which the initial revenue cost of a tax cut is offset by the revenue gains from the faster growth it generates. Two other pro-growth policies are relaxing and improving the economic efficiency of environmental regulation and expanding public investment in education and training.

The Federal Reserve

In times of economic þslack," when workers and industrial capacity stand idle, a Federal Reserve policy of easy credit and low interest rates can stimulate spendingþespecially on big-ticket items like housing, cars, and business investmentþthat puts idle workers and capital resources back to work and causes the economy to expand. But once the nation has reached full employment, more big increases in spending spurred by continued easy money policies will overheat the economy and drive up inflation. Beyond that point the nationþs spending and production can grow on a sustained basis only as fast as its productive capacity, its supply of goods and services, expands. Evaluating Federal Reserve policy, therefore, requires knowing first, how much slack there is in the economy and second, how fast the economy's productive capacity is capable of growing. Full employment—that is, zero slack—does not mean zero unemployment. Even in the best of times some unemployment exists. Millions of young people are looking for their first job, some firms and industries are having to lay off workers who then spend some time searching for a new job, and so on. Stimulating demand for goods, and the related demand for labor to produce those goods, to the point where unemployment is pushed below the full employment level will begin raising the rate of inflation in wages and prices.

Although the rate of unemployment consistent with full employment and stable inflation has varied a bit over time, most economists believe that today full employment is between 5 and 6 percent, and is probably not far from the 5.5 percent unemployment rate of midsummer. But it is at least conceivable that full employment today could be a little below its current level. That being the case, perhaps the Fed should carefully lower interest rates and probe the possibility that unemployment could be lowered a bit further without reigniting inflation. But even if unemployment could safely be reduced by, say, one-half percent, that would produce only a one-time rise in GDP of something like 1 percent. Thereafter GDP would resume its projected 2 percent growth rate. While any noninflationary gain would be welcome, this one-shot increase is a far cry from adding a sustained 1 percent to the annual growth rate. On the budgetary front it would lower the deficit in 2002 from $285 billion to something like $250 billion.

How Fast is U.S. Economic Potential Growing?

If the economy does not have enough slack to accommodate a large immediate increase in GDP, is it possible that the economyþs capacityþits potential GDPþcan grow faster than the 2 percent per year rate envisioned in the standard projections? Unfortunately, the evidence seems overwhelming that under current conditions and policies, the CBO projection of capacity growth is unlikely to be far off the mark. The 2 percent projected growth rate consists of a roughly 1 percent annual expansion in labor input and a little over 1 percent a year growth in productivity, or output per worker hour. The strong and steady expansion in labor force participation by women after World War II slowed after 1989, and there is no warrant to assume the earlier growth rate will resume. The labor input projection is likely to be reliable over the next 10-15 years.

Productivity is a little more open to question, but not much. From warþs end until about 1973, productivity grew almost 3 percent a year. Thereafter, despite the information revolution, productivity growth slowed sharply to little more than 1 percent. Economists can explain only part of the declineþthe reasons for much of it remain a mystery. But whatever the reasons, the productivity trend has remained remarkably steady for more than 20 years. Not knowing what caused the decline, we can't be sure productivity growth wonþt one day pick up again. But it would be foolhardy to plan national policy on that hope.

Policies to Increase Capacity Growth

If the prospective growth of the nationþs economic capacity puts a lid on what the Federal Reserve can do to raise GDP, could changes in national policy boost capacity growth? Such changes are possible, and I will examine several in a moment. But the cold facts of economic life tell us that no politically feasible policy is going to raise the current rate of economic growth by more than several tenths of a percentage point a year. We should not dismiss the benefits of what look like small increases in economic growth, especially if they persist for several decades. For example, a 20 percent increase in labor productivity growth would lift the overall economic growth rate from 2.1 percent a year to 2.3 percent. Continued for a generation, that increase would raise average family income more than $2,000 a year in todayþs dollars. But the increase in GDP and national income will not generate enough revenue gains to offset more than a modest fraction of the budgetary cost of these policies. To avoid widening the budget deficit, and thereby slowing growth, tax cuts or new public investments will have to be matched by cuts in federal spending over and above the massive cuts already needed to wipe out the budget deficits now in prospect. Whether the nation is willing to pay the costs and whether the gains are worth paying them are what we should be debating.

Tax Cuts

Federal income tax cuts are an ever-popular way to increase economic growth. Few if any serious supporters of tax cuts today would claim that the economic gain will be so large that the tax cuts will largely pay for themselves. But exactly how much additional GDP would be induced by a supply-side tax cut, and how much of the initial revenue loss would be offset by the revenue yield from that added GDP?

Broad tax cuts can increase growth in two ways: by expanding the labor supply and by stimulating private saving and investment. The critical issue in each case is how much? Economists measure the responsiveness of labor supply to a tax cutþthat is, to higher after-tax wagesþby laborþs supply elasticityþthe percentage change in labor supply induced by a 1 percent change in after-tax wages. Needless to say, not all studies produce the same answers. It is generally agreed that the elasticity is quite low for men, a good bit higher for married women, and somewhere in between for single women. The elasticity for the labor force as a whole probably lies within a range of 0.2 to 0.33. A 15 percent across-the-board cut in federal income tax rates would raise after-tax wages by some 5 percent. An elasticity of 0.2 would mean a 1 percent increase in labor supply; an elasticity of 0.33, a 1.7 percent increase. Because labor costs constitute a little under 70 percent of GDP, the resultant gain in GDP would lie between 0.7 percent and 1.1 percent. But that would be a one-time gain; thereafter, GDP will grow at the same rate as before but at a higher level.

What about the effects of a tax cut on private saving? Many economists find little effectþþsmall and hard to find" is how one textbook puts it. One of the higher estimates of the responsiveness of saving to changes in the after-tax return was made many years ago by Michael Boskin (later, chairman of the Council of Economic Advisers during the Bush administration). He estimated that historically a 1 percentage point change in the return to saving in the United States tended to lower consumption spending out of a given income by a little over 2 percent. Using a high response based on the Boskin estimate and a lower one half that size to accommodate the range of views, I estimate that a 15 percent cut in federal income tax rates would raise the private saving rate from its current 6.0 percent to somewhere between 6.15 and 6.3 percent.

The standard economic model of the growth process suggests that a 1 percentage point increase in the share of GDP flowing to saving and then into domestic investment would add about 0.1 percent to the annual growth of productivity and GDP. (If some of the extra saving went into investment overseas, the resulting inflow of earnings from abroad would raise the growth of the nationþs income about the same.) In recent years a þnew growth theory," still much in dispute, has suggested that investment yields a higher return than implied by the standard model. That possibility could yield an increased payoff, with each 1 percentage point increase in the new investment share adding 0.2 percent to the GDP growth rate. The combination of labor supply and saving increases from a 15 percent tax cut enacted this year would, on the conservative assumptions, raise GDP by 2002 some 0.8 percent above the level it would otherwise reach; on the optimistic assumptions the gain would be 1.4 percent. That gain would expand to a range of 0.8 to 1.6 percent 10 years from now. By 2002 the revenue loss would be $150 billion a year. The resulting gain in GDP would bring in added taxes of $20-30 billion. Thus the net cost to the budget of the tax cut would be $120-130 billion in 2002. If these costs were not matched by spending cuts (over and above those already needed to balance the budget), the deficit would rise, an increased share of private saving would be diverted to financing that deficit, and private investment would fall. In that case, the tax cut would slow economic growth.

From the standpoint of economic growth, the $125 billion in spending cuts needed to finance the net cost of a 15 percent tax reduction would be better used to reduce the budget deficit (or if the budget were already balanced, to produce a budget surplus). The spending cuts would reduce the deficit directly and gradually produce further large and growing budgetary savings by lowering interest rates and slowing the rise in federal debt. Initially the tax cuts would produce greater GDP gains. But six years after the spending cuts were fully in place, the gain in GDP from deficit reduction would equal the gain from the tax cut, and thereafter exceed it by a growing amount. After 15 years deficit reduction would add over 3.5 percent to GDP compared with a gain of 1.4 percent with the tax cut. The package of tax reductions proposed by presidential candidate Robert Dole last July included a 15 percent cut in personal income taxes only, whereas the 15 percent across-the-board tax cut analyzed here applies to both personal and corporate taxes. But the Dole proposal included a 50 percent reduction in the tax on capital gains. There is no reason to believe that the effect on economic growth from the Dole plan would be significantly outside the range estimated above (given the important caveat that the net costs of the tax cuts were fully offset by spending reductions).

Investment In Education and Training

Improving the quality of the workforce through investment in education and training has long been recognized as a spur to economic growth.

The combination of slow productivity growth and declining real wages for lower-skilled men over the past 20 years has called forth many proposals to upgrade education, especially for those who begin work right after high school. Could big public investments in education and training produce what tax cuts cannot, a substantial gain in the level or growth rate of the economy? Again, unhappily, the answer is no.

Well-known labor economist James Heckman has concluded that a good starting point for estimating the payoff to additional public investment in education and training would be to assume that it yields a rate of return of 10 percentþabout the same as the return to investment in business capital. The federal government now spends almost $30 billion a year on education and training (excluding student loans). If it launched a massive increase in that spending, amounting to 1 percent of GDP, its education budget by 2002 would grow to $130 billion, and extra spending cuts of $100 billion would be needed to keep the new spending from worsening the deficit. Given the assumption of a 10 percent rate of return, the extra spending would raise the long-term growth of GDP by 0.1 percent a year, about the same as growth-oriented tax cuts of the same magnitude.

Regulatory Rollback and Reform

Arguing that excessive and inefficient regulation depresses economic growth, the Republican Congress set about in 1995 to redesign and scale back the regulatory apparatus of the federal government, particularly environmental protection. How much added growth can realistically be expected from such a rollback?

Dale Jorgenson and Peter Wilcoxen have estimated that removing all environmental controls would eventually raise measured GDP by 3.2 percent, as labor, capital, and raw materials devoted to cleanup were shifted to producing the goods and services counted in GDP. Adjusting that estimate to account for statistical peculiarities involving the net economic costs resulting from the mandated installation of emission control devices gives a figure closer to 2.9 percent.

Of course no one proposes scrapping all environmental controls. But costs could be reduced in two ways. First, some environmental laws and regulations have economic costs that well exceed the value of their environmental benefits. Those laws and regulations could be scaled back. Second, relying less on detailed rules and more on economic incentives to control pollutionþfor example, charging effluent fees or auctioning off effluent and discharge permitsþcould significantly lower the cost of achieving the environmental goals we do set.

Realistically we should not expect to achieve all the theoretically available saving. It would be impossible to fine-tune the environmental cleanup so as to take all actions whose benefits exceed costs and none whose costs exceed benefits. Besides, voters have widely differing views as to the value of the benefits. An ambitious target might be to pare the economic costs of environmental regulation by 25 percent. That, according to the adjusted Jorgenson and Wilcoxen estimates, would yield a gain of 0.7 percent in the level of GDP. In turn, realizing most of the gains by the end of 10 years would temporarily raise GDP growth a little less than 0.1 percent a year. After that GDP would grow at its earlier rate but along a higher path.

Promising the Moon

Certainly policies exist that will increase the level or the rate of growth of the nation's economy—but only modestly. Even small increases in economic growth, if they persist for several decades, can boost noticeably the living standards of the next generation. But nothing that is realistically possible, not tax cuts, nor public investments, nor regulatory reform, will generate the large gains that many politicians are seeking—and promising. Moreover, neither tax cuts nor public investments will generate enough economic gain to pay for more than a small fraction of their budgetary costs. To avoid raising the deficit, and thereby lowering growth, they would have to be accompanied by spending cuts over and above the massive ones already required to erase the budget deficit. After witnessing the difficulties and shortfalls over the past two years in nailing down budget-balancing spending cuts, a reasonable person could well question whether now is the time to launch new policies that would, at best, provide small increments to growth, while running the risk of actually lowering growth by worsening the budget deficit.

     

 

 

Measured by the media attention and controversy it has attracted, The Bell Curve by Richard Herrnstein and Charles Murray was the publishing event of the decade.

The book presents a disturbing and highly pessimistic view of trends in American society. The United States, according to the authors, is rapidly becoming a caste society stratified by IQ, with an underclass mired at the bottom, an elite firmly ensconced at the top, and only a limited scope for public policy to boost the disadvantaged. But the bulk of the attention and controversy that swirled around the book focused not on its sweeping vision of what is happening to U.S. society, but on the authors' application of their theories about IQ to the question of race.

Charles Murray complained in the Wall Street Journal last December that the critics' focus was too narrow. We sympathize with Murray's frustration over the content and tone of some of the criticism that the book received. But the book may have fared even worse had the discussion of race and genetics not distracted attention from some serious problems of analysis and logic in its main arguments. There are indeed some useful messages in the book. But there is also much wrong with it.

High IQ Does Not Guarantee Success

Herrnstein and Murray are not the first to ask what determines economic success. Many studies, using many different sources of data, have examined the extent to which factors such as education, family background, and IQ can explain differences in people's wages or family income. On two points these studies agree closely. First, measurable differences among individuals--including IQ test scores--can explain only about 30-40 percent of the differences in economic outcomes. The remaining differences arise from unmeasurable factors--personality, looks, networking, perseverance, concern for the future, and just plain luck, to mention only a few. Second, differences in IQ alone (as measured by test scores) explain some fraction of the variation in income, but realistic estimates place that fraction at 10 percent or less.

The authors of The Bell Curve neither discuss this latter finding nor contradict it with any independent work of their own. They do use the National Longitudinal Survey of Youth--a comprehensive set of data from a sample of thousands of people aged 27-34 in 1992--to analyze the effect of scores on the Armed Forces Qualification Test (which Herrnstein and Murray argue is a better measure of IQ than any IQ test) on a wide range of social outcomes, such as illegitimacy, crime, and marital status. These analyses are useful. But nowhere do the authors use the information in the data set about wages, annual earnings, and incomes to analyze the extent to which the AFQT test scores can explain variations in the key economic out-comes--earnings and income.

Because the authors of The Bell Curve did not use their data to examine how much of the variation in income could be explained by AFQT, we did. Our findings are consistent with past research. Considered alone, AFQT scores explain only about 15 percent of the differences among people's hourly earnings. Results for annual earnings and family income are similar. Even the authors of The Bell Curve do not claim that cognitive test scores can explain much more than 16 percent of the variation in people's job performance.

And even these results overstate the independent effect of AFQT scores on economic outcomes, Because of both heredity and environment, there is a positive--though far from one-to-one--relationship between a person's socioeconomic background and his or her IQ test scores. Failing to take differences in people's backgrounds into account when considering the correlation between AFQT scores and earnings credits AFQT scores with some of the differences in earnings due to such things as the influence of home environment on learning, or family connections that might help someone get into a better school or job. To deal with this problem, we used a statistical procedure that allows us to separate the effects of test scores on a person's income or earnings from a range of other influences on economic outcomes, such as parental education and occupation, number of siblings, place born and raised, and ethnicity. All these things affect a person's success but, obviously, are not themselves affected by his or her own test scores. Again, what we find accords with what past researchers have found: test scores explain about 10 percent of the differences in the hourly earnings, annual earnings, or family income of the young people in the NLSY in 1993.

The effect of IQ on economic differences among people reflects two aspects of the relation between test scores and success. First, people with higher IQs tend to earn more. Thus, on average the person with an IQ of 115 will earn about 30 percent more than the average person with an IQ of 100. That's a big premium. But the variation of individual experience around that general tendency is immense. For example, more than 40 percent of the people with the 15-point higher IQ will earn a premium greater than 50 percent, while 35 percent will earn less than the average for the population as a whole. Second, precisely because of that wide diversity, the proportion of the over-all variations in income that can be explained by IQ is small. Thus, in the NLSY the average annual earnings of the 10 percent of people with the highest AFQT scores are 55 percent greater than the population average, while the earnings of the richest 10 percent are 200 percent higher.

Figure 1 shows the relation between AFQT scores and annual earnings in the NLSY. The black line shows how earnings were distributed among the young people surveyed. Many people are clustered around the average; the numbers gradually fall off as earnings go up, with only a few people at the very top. The red line shows how annual earnings would be distributed if everyone had the average AFQT score but otherwise continued to differ as they now do in all other ways. (That is, we added to or subtracted from each person's actual earnings the expected amount by which someone with his or her AFQT score had earnings different from the population mean.) The gray line reverses this calculation. It shows what the distribution of earnings would be if only AFQT mattered (we gave everyone the earnings expected for people with their AFQT score). If all that mattered was AFQT scores, U.S. society would clearly be very egalitarian. Eliminating differences due to IQ would have little effect on the overall level of inequality.

IQ as Economic Stratifier

If they make no use of the direct evidence on the importance of IQ in determining wages, earnings, and income, how do the authors of The Bell Curve conclude that IQ is becoming the decisive force in stratifying Americans economically? They construct a circumstantial case. First, they assemble data showing that test scores that reflect cognitive ability have become far more important in determining who gets into college, especially highly prestigious colleges, than was the case earlier in this century.

Second, they estimate (and partly speculate) that an extremely high proportion of the 10 percent of U. S. workers with the highest IQs is now employed either as members of "high-IQ" occupations or as business executives. Earlier this century, most high-scoring high school graduates did not go to college and, they speculate, were scattered more randomly throughout the workforce, many of them in relatively average or lower-paying jobs, where their superior IQs were rewarded with far less income and prestige than is now the case.

If people with high IQs were once much less well rewarded relative to the average than they are now, it must have been for some combination of two reasons: they were less likely to hold the better-paying jobs, or income was distributed much more equally, so that the earnings gap between good and poor jobs was less than it is now. Little evidence supports the first possibility. The second is demonstrably false.

In the first place, as various authors (for example, Claudia Golden and Robert Margo) have shown, over the past 50 years the income premium for a college education has not risen steadily! but has fluctuated around a more or less stable level in percentage terms. Moreover, while top colleges today do stress test scores more than they once did, the number of years of education people are likely to acquire has been predictable from test scores with an unchanged degree of accuracy (or inaccuracy) ever since the early part of the century. Next, although the past two decades have seen growing income inequality, the trend follows a large decline in inequality in the 1940s and has simply restored the inequality of the prewar era. Similarly, according to Golden and Margo, wages paid "professionals," relative to the average wage, actually declined from 1940 to 1960. They then rose again in recent years.

There is evidence from several studies that in the past several decades the role of IQ test scores in determining economic success has increased. But IQ is still far from a dominant force in shaping the distribution of income. The evidence in no way warrants the view that its growing importance has drastically altered the nature of U.S. society.

Changing IQ Is One Thing, Changing Lives Another

Herrnstein and Murray conclude that public policies can do little to raise IQ. Given the important role they assign IQ in determining social outcomes, this implies a deep skepticism about the potential for compensatory education, training, and related policies to improve the lot of the disadvantaged. Moreover, they offer little hope that further experimentation with Head Start or even better programs could help, since "The main lessons to be learned have already been learned: It is tough to alter the environment for the development of general intellectual ability by anything short of adoption at birth." Even school dropout prevention is of dubious value. Herrnstein and Murray ask, "If somehow the government can cajole or entice youths to stay in school for a few extra rears, will their economic disadvantage . . . go away?" and answer, "We doubt it."

As that answer starkly reveals, the authors' deeply pessimistic conclusions are based on an excessively ambitious goal. To be worthwhile, social interventions need not make economic disadvantages "go away." No program we know about will do so, and new miracle cures are unlikely. While some enthusiasts in the early days of the Great Society may have cherished hopes to the contrary, knowledgeable observers long ago became more realistic. Social interventions should not be judged on whether they "cure" the problem, but on whether they are likely to raise the earnings of the disadvantaged or otherwise improve their prospects enough to make the investment of government funds worthwhile. And a large body of research and program evaluation gives us the answer: some can, some can't, and on some the jury is still out.

What about early childhood education, such as Head Start? Using Herrnstein and Murray's most conservative estimate of the payoff to IQ, a single point in IQ is worth some $232 a year in earnings (1994 dollars). Herrnstein and Murray cite a 1982 analysis by Irving Lazar and Richard Darlington of six early childhood education programs. The median IQ gain by children completing these programs was 8 points at the end of the program, declining to 3 points by fourth grade, Herrnstein and Murray dismiss these results as small. But how much would such a gain be worth later in life? Based on their own results, 3 IQ points would lead to a yearly earnings gain of $696. With Head Start costing $5,400 for each student, a $696 increase in earnings each year over a person's working life would represent a real rate of return on investment of more than 5 percent--greater than the average return to investing in bonds. Herrrnstein and Murray correctly point out that the cognitive effects of early childhood education programs have not been large enough to erase the handicap of having been born to a disadvantaged family. But what appear to be small gains can, in fact, produce economically justifiable returns. And this is to say nothing of other reported gains, such as lower rates of teen pregnancy and higher rates of high school completion.

It also turns out that it is possible to do better than hazard guesses about the economic payoff to increasing the years of schooling for young people. Many states require students to attend school until a certain age. When combined with laws requiring children born later in the year to wait a year before starting school, these compulsory schooling laws generate differences in educational attainment for children born at different times of the year (students born late in the year reach the compulsory schooling age after having completed one fewer year in school). And these differences make it possible to identify the causal effect of education on earnings for those compelled to stay in school longer. In 1991 Joshua Angrist and Alan Krueger, using this "natural experiment," found that those required to spend another year in school earn 7-10 percent more than those who are not--a payoff quite similar to the payoff per year of schooling noted by simply comparing the average earnings of people with different amounts of education. Apparently, "cajoling" would-be dropouts to remain in school can raise their earnings.

Education and training programs are not the only way to improve earnings prospects. A program to de-segregate Chicago public housing nearly randomly assigned people to live either in poor inner-city housing or in apartments in well-off suburbs. A study later showed that those who moved to the suburbs were 25 percent more likely to be employed than those who stayed in the city, were less likely to drop out of school, and were twice as likely to attend college. Further evaluation of the potential for large-scale gains will be possible from the Department of Housing and Urban Development's "Moving to Opportunities" program, which aims to open the door to improvements like this for many more people.

Herrnstein and Murray do not report on two decades of evaluations of government-sponsored employment and training programs that, while not showing dramatic turn-about in people's lives, often find benefits greater than the costs. Examples include school dropout prevention programs, Job Corps, JTPA for adults, and several employment and training programs for welfare recipients.

Of course, not all investments in training and education are worthwhile. And, unlike the case with business investment decisions, markets cannot weed out bad social investments. But experimental evaluations can, if administrators and legislators act on them.

Discrimination Still Exists

Just as Herrnstein and Murray dismiss public intervention to aid the disadvantaged, they favor abandoning antidiscrimination law. While critics of The Bell Curve have focused on its claims about race, intelligence, and genes (see box), two other issues in the book having to do with race and intelligence have received little discussion: the conclusion that black-white earnings differences are due solely to IQ difference and the argument that reverse discrimination exists in America's colleges. Yet both arguments are more important to the book's case against antidiscrimination law than any arguments about race and genetics.

To understand the evidence about black vs. white earnings it is crucial to distinguish wage rates from annual earnings, to separate males from females, and to differentiate blacks with high IQ and socioeconomic status from other blacks.

Herrnstein and Murray lump together men and women and find that blacks with the same IQ as whites are paid the same hourly rates. We analyze the same data in more detail and with much greater attention to specifying status of people's family background and find the following. First, employed black men have hourly rates of pay that are about equal to those of whites with the same observable characteristics, including family background, education, marital status and test scores; black women have higher wage rates than comparable white women, although lower than white men. Second, however, black men are less likely to have a job or to work full-time. In the case of the average black male, annual earnings are nearly 20 percent below those of comparable white males. Black females, while having lower annual earnings than white men, earn more than comparable white women. Third, black males who are significantly above the black average with respect to IQ test scores, education, and family background have annual earnings much closer to those of comparable white males, and black women at the upper end of the scale appear to do better than their white counterparts.

Studies such as these, however, provide only weak evidence for or against the existence of discrimination. In the first place their results depend critically on just what measures of family background and other characteristics are used to determine who are "comparable" workers and job applicants. For example, June O'Neill, Derek Neal, and William Johnson analyze the same data, but when they do not include the extensive information on family background that we do, they find substantial differences between the wage rates of comparable black and white males, on the order of 10 percent. Second, the NLSY covers young workers, and the importance of the various determinants of earnings changes with age. Further, the effect of background on wages may reflect not only differences in job qualifications, but also discrimination against those with lower-class backgrounds.

Even more important, employers can know much more about someone than what we can know from the NLSY survey. Our data, for example, show only the number of years of school completed while an employer can find out which school a jobseeker attended and how good it is. Much more convincing evidence of continuing discrimination comes from audit studies, where carefully matched pairs of blacks and whites, men and women, or Hispanics and Anglos, apply for the same job. No study has found that minorities and women are advantaged in the job market; nearly all show that they continue to be discriminated against. One Urban Institute study found that whites or Anglos were offered jobs half again as often as the blacks or Hispanics with whom they were matched.

Herrnstein and Murray's claim that blacks score lower on tests than whites at the same college or in the same occupation also misses the point. They write as if they believed that test score differences of the size they find could only be the result of reverse discrimination. With some exceptions, however, those differences could be the result of race-blind processes that simply choose the best person for a given school or job.

Blacks, on average, score much lower than whites on standardized tests. If such tests were completely unrelated to performance, employers and colleges would ignore them, and the difference in test scores between blacks and whites at the same school or job would be the same as in the population as a whole. In fact test scores explain at most 10-25 percent of differences between people in job performance or success at school. Consequently, in groups of people chosen solely on the basis of ability, blacks and whites will have test scores more similar than blacks and whites in the population as a whole, but not much more. To reduce black-white differences in test scores to levels Herrnstein and Murray consider reasonable, colleges and employers would probably have to set higher standards for overall ability for blacks than for whites.

Although Herrnstein and Murray did not study college admissions decisions directly, we have. Our evidence suggests that there is indeed racial preference in admissions at elite colleges, but little or no evidence of such preferences at other institutions--where 86 percent of the college population is to be found. Further, we find little evidence that racial preferences in admissions lead to higher dropout rates for blacks as some have contended. A debate about the use of race in admission decisions would be healthy, but it must be based on a more careful reading of the evidence.

Unwarranted Pessimism

While most criticism of The Bell Curve has focused on the authors' claim that racial differences in IQ test scores are, in part, genetic, many of the book's most important claims have escaped scrutiny. They shouldn't. The book's basic premise--that IQ is becoming the decisive force in determining economic rewards and social position--is demonstrably false. Herrnstein and Murray's evidence on the difference between black and white test scores in various occupations does not show what they imply it does--massive reverse discrimination. In fact, their own evidence showing blacks and whites with the same test scores earn the same wages contradicts such a claim. Further, differences between blacks and whites in annual earnings, and the employment discrimination revealed in employment audits, suggest that blacks continue to be disadvantaged in the labor market. Because the authors sharply exaggerate the importance of I.Q, the book is excessively pessimistic about the potential role of carefully selected government programs in improving the lives of the disadvantaged. In all the controversy over the authors' claims about race and intelligence, these points should not get lost.

     

 

 

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