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Council of Economic Advisors

"Promoting Stronger Economic Growth: What Public Policy Can Do To Improve Productivity"

Remarks by Edward P. Lazear
Chairman, Council of Economic Advisers
At the Heritage Foundation

March 19, 2007

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Good afternoon. I am delighted to speak at the Heritage Foundation, an organization that ardently supports the principles of free enterprise, limited government, and individual freedom. The flexibility of the American economy has allowed it to continue growing despite a number of headwinds, the most obvious of which are high energy costs and a housing sector that saw a significant decline over the past year.

Economic Overview

The growth of our economy traces back to seeds that were sown well before I became the President’s chief economist. The President believes that the economy is best served by policies of limited government and low taxes, and he took actions early in his first term to reduce tax rates on wage income and on dividends and capital gains. Those policies paid off with high rates of economic growth, high levels of productivity improvements, high profits, and the strong labor market we now enjoy with rising real wages. Despite last year’s high energy prices and housing sector declines, the economy continued to grow at a solid pace last year. GDP grew 3.1 percent during 2006, roughly the same pace as during 2005, which is impressive given that residential investment subtracted 0.8 percentage points from growth over 2006. And it is all the more remarkable since we are well into the current business cycle expansion. Some economic headwinds will persist in 2007, but we expect the economy to show similar resiliency as it continues its expansion.

Equally compelling is the large increase in tax receipts flowing to the government the past couple of years as a result of the growing economy. That revenue, combined with some spending restraint, has allowed the government to achieve the goal of reducing the budget deficit in ahead of schedule. Now the President in his FY2008 budget has called for balancing the budget in 2012 with spending restraint and without increasing taxes. I believe that increasing taxes, as some have proposed, would be counterproductive for the economy.

There are two trends that are most important when looking at the economic scene as we move into 2007. First, the labor market has been very strong. The unemployment rate fell from 5 percent in late 2005 to 4.5 percent in February. The economy added 2 million payroll jobs over the past 12 months, and most impressive is that wages grew at an after-inflation rate of 1.8 percent, which is higher than the average rate during the second half of the 1990s. Jobs are available, employers are searching for talent, layoff rates are at a low point, and the gains that businesses have enjoyed during the past few years are now spreading to the average worker.

Second, part of our healthy economy has been fueled by demand for American goods abroad. In 2006, exports grew nearly 12.7 percent while imports grew 10.5 percent. This was the first time in nine years that exports grew faster than imports. Export demand has increased significantly, and export growth has been an important factor in pushing the American economy forward during a period when many were predicting a slowdown. Real export growth outpaced import growth in all four quarters of 2006. With consistent and open economic policies, these trends should continue through 2007 and into the next year.

Economic Report of the President

For CEA’s part, we recently released our annual Economic Report of the President. The most visible output of the Council, the Report discusses a variety of key economic policy issues. It is written to be accessible and useful to both economists and non-economists alike.

The Report begins with a review of the macroeconomy in 2006 and discusses the Administration’s forecast for the years ahead. Having reached a high level of resource utilization by year-end 2006, we expect that growth will slow a bit in 2007, but will continue at a solid pace, with GDP growing in the high 2 percent range.

Because tax policy is so important to the economy, the Report discusses pro-growth tax policy and how we can reduce tax distortions that hamper economic growth. The current tax code contains provisions that discourage investment and create impediments to efficiency that affect the level, distribution, and financing of capital investment. Estimates from research suggest that removing these tax distortions could increase real GDP by as much as 8 percent in the long run.

Looking to the long run, our greatest fiscal challenge is likely to be Medicare, another policy that the Report discusses. The projected long-term growth in entitlement spending is unsustainable because of the pressure it puts on future Federal budgets. And we feel them already. Each year growing mandatory spending puts budgetary pressure on discretionary spending. It is crucial that reforms to entitlement programs preserve protections against financial risk without having negative effects on the economy.

The events of 9/11 and hurricanes of 2005 have taught us that no one—young or old—is immune to the risk of large scale disasters. The Report examines catastrophic risk insurance as a method of insuring against such events. In particular, the Report looks at the effect government policies may have on individual decision making. Sometimes, well-intentioned backstop policies create adverse incentives that put people in harm’s way and increase the cost to the American taxpayer.

The President has made clear his view that diversified energy sources are important for national security and to ensure that the US economy is less vulnerable to the acts of others on whom we may not be able to rely. The Report looks at the details of these issues.

The final three chapters in the Report focus on the role of flexible and open markets in an efficient economy. One chapter provides an overview of currency markets, the thickest and deepest and most liquid of capital markets. The chapter discusses the different kinds of currency markets and how they work. A discussion of international trade and investment follows the currency discussion. Both Americans and others find investment opportunities in the U.S. worthwhile. We are able to attract outside foreign direct investment and other investment because of the strength of our economy and prospects for the future. Looking ahead, international trade liberalization in services presents significant opportunities for U.S. workers, firms, and consumers. In addition to attracting foreign investment, the U.S. also attracts foreign workers. The Report looks at international migration and comprehensive U.S. immigration reform.

The theme of productivity growth underlies much of this year’s Report. Policymakers face a challenge: productivity growth is important for economic growth and many of the underlying issues that they are trying to solve, but there is no single cause of productivity and no single policy to spur its growth. Tax policy can be structured to encourage productivity growth. Entitlement programs, on the other hand, may indirectly weigh on productivity growth if not reformed. Open commerce and financial markets allow productivity to flourish. Productivity growth is a common thread that ties the positive macroeconomic news together and plays a central role in our international competitiveness.

Productivity Growth

Productivity growth is closely tied to economic growth. It helps keep inflationary pressures moderate. It has proven to be one of our Nation’s most important economic fundamentals and a defining characteristic of our international competitiveness. And, although economists discuss productivity growth using macroeconomic data, its most important result is an increase in individual Americans’ standards of living.

The United States is the most productive large economy in the world. Output per capita is approximately 30 percent higher here than in the developed European countries and Japan. U.S. productivity growth and output per hour worked is among the highest in the world.

Growth in American productivity has been impressive in recent years. The Bureau of Labor Statistics reports that U.S. productivity growth since the end of 2000 has been 2.7 percent per year, outpacing the 2.6 percent average from 1996 to 2000. The current growth rate is substantially above that for the period between 1973 and 1995, when productivity growth averaged only 1½ percent.

Notice the marked increase in between the 1973-1995 period and the two most recent periods in Figure 1. Our growth rate is remarkable for a country that is already at the top of the productivity pyramid. Raising productivity would seem to be easier for countries that can learn from technological improvements made by other countries. But for the country that leads the world in productivity, a high growth rate is even more impressive. The impressive nature of American productivity growth stands out even more when we look at productivity growth rates for G7 countries since 1990. As seen in the blue bars of Figure 2, the U.S. increased its productivity growth rate over a period in which the productivity growth of most G7 countries decreased.

Average Annual % Change in U.S. Labor Productivity - bar chart has 4 groupings: 1950 to 1972, 1973 to 1995, 1996 to 2000 and 2001 to 2006. In the first group, the change was 2.8%. In the second group the change was 1.5%. In the third group, the change was 2.6% and in the fourth group, the change was 2.7%
Average Annual Productivity Growth Has Fallen for Most G7 Nations Since 1990 - bar graph shows percentage point difference in annual productivity growth rates, 1990-1995 vs 1995-2005 for Canada, France, Germany, Italy, Japan, the U.K. and the U.S. Only Canada and the U.S. are showing positive percentages.

What makes productivity grow? Labor becomes more productive either because it becomes more skilled, because it has more and better capital to work with, or because we come up with new and better ways to combine labor and capital. Thus, an environment that fosters growth in human capital, physical capital, and innovation is key to both our past growth and the growth we need for our future.

There have been a number of potential explanations for the productivity differences between the United States and other countries. The leading candidates include labor market flexibility and high levels of investment in both physical and human capital. A number of observers believe that low marginal tax rates on work, high incentives to invest in physical capital, and a climate of employment at will have been major contributors. Job security provisions pervasive in Europe and less prevalent in the United States are primary suspects for output limitations found in Europe.

In addition to having a free and mobile labor market, the U.S. also encourages entrepreneurship and business formation. By almost any measure, the U.S. is one of the leading nations in terms of the ease with which individuals can start a new business. Figure 3 shows that Canada and the US lead the G8 in the ease with which businesses can be initiated.

Days to start a business - bar chart shows the average number of days it takes to start a business in Canada, the U.S., France, Italy, the U.K., Germany, Japan and Russia. In that order it is quicker to get a business started.

As important as physical investment is to American productivity, human capital is a key driver of productivity growth in any country. Historically, the United States has led the G-7 in tertiary educational attainment (see Figure 4). The red bar for the U.S., which depicts tertiary educational attainment among the cohort of individuals currently aged 55 to 64, is the highest among G-7 countries. But it is also important to note that while our tertiary educational attainment has gone up, we have lost ground relative to the other G-7 countries—most notably Japan, Canada, and France. The blue bars, which show educational attainment among more recent cohorts, reveal that the US is no longer the leader in educational attainment. In order to maintain our edge in the future, it will be necessary to ensure that we do not allow our investment in human capital to slip.

Tertiary Educational Attainment - bar graph shows two bars for each country, Italy, Germany, The U.K., France, The U.S., Japan and Canada. The first bar shows percent of people, aged 55 to 64, with college degrees. The second bar shows people aged 25 to 34 with college degrees.

Another ingredient of economic growth is that individuals believe they have the ability to succeed in this society. When young people do not believe that they have a chance to attain levels of success commensurate with their effort, they cease trying. But the United States has always been a place where opportunities to move up are widespread. This is best illustrated by looking at the earnings of immigrants. First generation immigrants in 2003 had median incomes of about $27,000. Second generation immigrants had median incomes of about $38,000, which exceeds the median income of Americans from third and higher generations. Thus, in one generation, immigrants go from being below the median to above the median.

While output and productivity are of interest in and of themselves, they are of particular importance because wages and workers’ standards of living depend on productivity, even over the relatively short run. Over the longer run, hourly compensation and productivity grow together one-for-one.

The chart shown here (Figure 5) demonstrates the very strong correlation between productivity increases and real hourly compensation. Notice how closely the lines trace each other. While there are periods during which the two series diverge, they tend to catch up to one another. In particular, wage growth sometimes lags productivity growth—especially coming out of recessions. That was the case coming out of the recession in the early 1990s, where hourly compensation lagged productivity in the mid-90s and caught up only during the late 90s. And it was also true after the recession that occurred in 2001. In 2006 we saw significant increases in nominal wages above the levels of past years. Real hourly compensation also increased at a solid rate. These trends have helped real wages to begin to catch up with earlier productivity gains, despite high energy prices.

Productivity and Real Compensation Grow Together - the line chart, with a timeline from 1950 to 2005, shows the increase of both productivity and real hourly compensation. These data cover all persons (including supervisors and proprietors) in the nonfarm business sector. The real hourly compensation is compensation deflated by the price index for nonfarm output.

Recent experience illustrates that wages and productivity do not always move together over the very short run. It is also true that hourly wage growth is lower than compensation growth because benefits have been growing over time. Some of this is a real increase in worker well-being, but some may reflect rising costs of providing the same level of benefits.

Wage growth lagged productivity growth in the early parts of this recovery, but profits have enjoyed high rates of growth. This has raised the question of whether profits have displaced wages in our economy. Two points are relevant to this question. First, corporate profits are more volatile than is employee compensation. Second, profits and wages follow a distinct pattern over the business cycle: After a recession, productivity growth increases, and wages tend to remain flat. As a result, costs stay low and profits rise. As the labor market gets tight, wages increase and eat into profits, and the profit rate declines. The last three years have seen high profitability commensurate with high levels of productivity growth. Now wages are rising and our forecast is that profit rates will decline in the future, bringing them back to more normal levels. Normal profit levels should be sufficient to sustain incentives for business investment going forward.

Productivity gains have been an important component of recent output growth, but employment gains have also contributed to that growth. As we go into the future, unemployment rates are now sufficiently low that it is unrealistic to expect to see huge gains in output from increased labor. That is true even more so as we move into the distant future, because the slowing growth of the population and the aging of baby boomers will mean a smaller supply of workers to support the economic engine.

By far the single most important determinant of jobs in the economy is population. In Figure 6, it is apparent that there is a high correlation between population growth rates and labor force growth rates. It is also clear that population growth has slowed relative to the high rates that we experienced about one generation ago. In order to sustain growth in output, it will be necessary, therefore, to ensure that productivity increases. To put this in historical perspective, note that the U.S. working age population increased by 84 percent between 1950 and 2000. Between 2000 and 2050, the working age population is projected to increase by only 34 percent, while the elderly population is projected to more than double. And our situation, incidentally, is less problematic than that facing other countries. For example, Japan’s working age population is expected to decline by 39 percent over that same period, and Italy’s working age population will decline by 33 percent. All of these trends increase the dependency ratio and make productivity growth even more important to maintaining our standard of living.

Labor Force Growth and Population Growth: 1955-2006 - This line graph shows the percentage relationship between labor force growth and population growth


What can we do specifically to ensure that we continue to grow at high rates? First, we must make sure that marginal tax rates stay low. The most important way to encourage growth in an economy is to maintain the smallest possible difference between the before-tax and the after-tax rates of return to investments, both in physical and human capital. Raising the level of capital per worker makes workers more productive and leads to higher wages in the long run.

Second, we must ensure that we do not discourage investment in human capital. The strength of our economy depends to a large extent on the capital that is embodied in people through their skills. If individuals see little return to investments in their skills because of high tax rates on moderate to high wage earners, the incentives to invest in human capital will be dampened.

The President has outlined a competitiveness initiative to make sure that Americans have the skills to compete in the modern world. We must continue to push for reform in K-12 education, which has been the weakest component of our human capital investment structure. Fortunately, our colleges and graduate schools are the best in the world. But we must also make sure that those Americans who do not go on to college also get the skills that allow them to compete in a modern American economy. Strengthening K-12 education, reducing our drop-out rates, and ensuring that all of our young citizens receive high quality education will be important not only in the near future, but for the rest of the 21st Century.

Third, we must remain open to trade. Countries that have closed their borders in attempts to shelter domestic industries have suffered in productivity growth, which has cost their citizens dearly in terms of their living standards. It is important to ensure that those who are adversely affected by trade have a safety net available to them, but we must not use the losses of some as a justification for protectionist policies that will harm us and our children.

Finally, foreign investment has been an important source of capital for the United States. Openness to foreign capital has given the United States the flexibility it needs to deepen its capital stock and improve its productivity. We must make sure that we maintain our long tradition of allowing investment to flow freely into our economy.

In conclusion, productivity grows as a result of investment in physical and human capital, which leads to new technologies. The American economy is relatively unimpeded by restrictions that hinder productivity growth in other countries. We need to maintain the incentives to invest in physical and human capital to ensure that productivity growth will continue to generate improvements in the typical worker’s standard of living.

Again, thank you for the opportunity to discuss these issues with you.