[Economic Report of the President (2004)] [Administration of George W. Bush] [Online through the Government Printing Office, www.gpo.gov] CONTENTS -------- Page overview ......................................................... 17 Chapter 1. lessons from the recent business cycle ................ 29 Overview of the Recent Business Cycle ............................ 30 Lesson 1: Structural Imbalances Can Take Some Time to Resolve .... 33 Lesson 2: Uncertainty Matters for Economic Decisions ............. 37 Lesson 3: Aggressive Monetary Policy Can Reduce the Depth of a Recession ...................................................... 40 Lesson 4: Tax Cuts Can Boost Economic Activity by Raising After-Tax Income and Enhancing Incentives to Work, Save, and Invest ..................................................... 43 Lesson 5: Strong Productivity Growth Raises Standards of Living but Means that Much Faster Economic Growth is Needed to Raise Employment ........................................... 46 Conclusion ....................................................... 51 Chapter 2. the manufacturing sector .............................. 53 Manufacturing and the Recent Business Cycle ...................... 53 The Recent Downturn in Manufacturing Output .............. 54 Manufacturing Employment in Recent Years ................. 56 Signs of Recovery in the Manufacturing Sector ............ 57 Long-Term Trends ................................................. 59 Manufacturing Output over the Long Term .................. 59 Manufacturing Productivity and Demand over the Long Term .. 60 Manufacturing Employment over the Long Term .............. 69 The Effects of Domestic Outsourcing and Temporary Workers on Measurement of Manufacturing Employment ...... 71 Effects of the Shift to Services on Workers' Compensation . 74 The Transition in Context ........................................ 76 The Role of Policy ............................................... 80 Conclusion ....................................................... 82 Chapter 3. the year in review and the years ahead ................ 83 Developments in 2003 and the Near-Term Outlook ................... 83 Consumer Spending ........................................ 84 Residential Investment ................................... 89 Business Fixed Investment ................................ 90 Business Inventories ..................................... 91 Government Purchases ..................................... 92 Exports and Imports ...................................... 92 The Labor Market ......................................... 94 Productivity, Prices, and Wages .......................... 95 Financial Markets ........................................ 97 The Long-Term Outlook ............................................ 97 Growth in Real GDP and Productivity over the Long Term ... 98 Interest Rates over the Long Term ........................ 100 The Composition of Income over the Long Term ............. 100 Conclusion ....................................................... 101 Chapter 4. tax incidence: who bears the tax burden? .............. 103 Theory of Tax Incidence .......................................... 104 Incidence of an Excise Tax ............................... 104 Legal Incidence is Unimportant ........................... 106 Applied Distributional Analysis of Excise Taxes and Subsidies .............................................. 107 Payroll Taxes .................................................... 107 Taxes on Capital Income .......................................... 110 Shifting Across Sectors .................................. 110 Shifting to Workers ...................................... 111 Applied Distributional Analysis and the Choice of Time Frame ................................................... 113 Estate and Gift Taxes ............................................ 114 Conclusion ....................................................... 116 Chapter 5. dynamic revenue and budget estimation ................. 117 Revenue Estimation and Microeconomic Behavioral Responses ........ 118 An Example of Revenue Implications of Microeconomic Behavioral Responses ................................... 118 Incorporation of Microeconomic Behavioral Responses in Revenue Estimation .................................. 119 Macroeconomic Behavioral Responses to Policy Changes ............. 120 User's Guide to Dynamic Revenue and Budget Estimation ............ 122 Guideline 1: Dynamic Estimation Should Distinguish Aggregate Demand Effects and Aggregate Supply Effects .. 122 Guideline 2: Dynamic Estimation Should Include Long-Run Effects ................................................ 123 Guideline 3: Dynamic Estimation Should Be Applied to Spending Changes as well as Tax Changes ................ 124 Guideline 4: Dynamic Estimation Should Reflect the Differing Macroeconomic Effects of Various Tax and Spending Changes ....................................... 124 Guideline 5: Dynamic Estimation Should Account for the Need to Finance Policy Changes ......................... 125 Guideline 6: Dynamic Revenue Estimation Should Use a Variety of Models Until Greater Consensus Develops ..... 126 Conclusion ....................................................... 127 Appendix: The Model Used in the Capital-Tax Example ...... 127 Chapter 6. restoring solvency to social security ................. 129 The Rationale for Social Security ................................ 130 Understanding the Financial Crisis ............................... 131 Misunderstanding the Financial Crisis ............................ 137 The Nature of a Prefunded Solution ............................... 139 Can We Afford to Reform Entitlements? ............................ 142 Conclusion ....................................................... 147 Chapter 7. government regulation in a free-market society ........ 149 How Markets Work ................................................. 149 Market Imperfections ............................................. 151 Regulation and Externalities ............................. 151 Regulation and Market Power .............................. 154 Regulation in the Absence of a Market Failure ............ 154 Conclusion ....................................................... 156 Chapter 8. regulating energy markets ............................. 157 Market Forces and Regulation in the Market for Natural Gas ....... 158 Market Forces and Regulation in Gasoline Markets ................. 159 Local and Federal Regulations May Conflict ............... 160 Local and State Regulations Lead to Different Market Outcomes ................................................ 161 Market Forces and Regulation in Electricity Markets .............. 161 The Evolution of the Electric Industry from Local to Interstate Markets ...................................... 162 Electricity Regulation in an Evolving Market ............. 163 Demand Response to Electricity Production Costs .......... 165 Energy and Trade ................................................. 167 U.S. Energy Sources ...................................... 167 Changes in the Oil Market ................................ 168 Trade in Oil and Price Stability ......................... 169 The Evolution of Energy Markets .................................. 169 Conclusion ....................................................... 172 Chapter 9. protecting the environment ............................ 173 The Free Market and the Environment .............................. 173 The Role of Government in Regulating the Environment ............. 174 Misplaced Reasons for Government Intervention ............ 177 Regulations Impose Benefits and Costs .................... 178 Using Science to Help Set Regulatory Priorities .................. 178 Overestimating the Risks: The Problem with ``Cascading Conservatism'' ......................................... 179 Population-Weighted Risk Assessments .................... 180 Objective Versus Perceived Risk ......................... 180 Achieving Goals Through Cost-Effective Regulations .............. 181 Command-and-Control Regulations ......................... 182 Market-Based Price Regulations: Emission Fees ........... 183 Market-Based Quantity Regulations: Cap-and-Trade ........ 184 Emission Fees Versus Cap-and-Trade ...................... 186 The President's Cap-and-Trade Program ................... 187 Conclusion ...................................................... 188 Chapter 10. health care and insurance ........................... 189 The U.S. Health Care System as an Engine of Innovation .......... 190 The Value of Health Care Innovation ..................... 190 U.S. Leadership in Health Care Technology ............... 192 Insurance Reform as a Means of Providing Health Care More Efficiently .............................................. 194 The Appropriate Use of Insurance ........................ 194 Moral Hazard ............................................ 195 Adverse Selection ....................................... 196 Health Insurance in the United States ................... 196 A Brief History of Health Insurance in the United States. 198 Proposals for Modernizing the Health Care Market ................ 199 Medicare Prescription Drug, Improvement, and Modernization Act of 2003 .............................. 199 Next Steps in Improving Health Care Markets ............. 200 Conclusion ...................................................... 201 Chapter 11. the tort system ..................................... 203 The Changing Role of Tort Law ................................... 203 The Expansion of Tort Costs ..................................... 204 The Economic Effects of the Tort System ................. 207 Torts as Injury Compensation .................................... 207 The Principal Injury-Compensation Methods ............... 208 Administrative Costs .................................... 208 Compensation of Noneconomic Losses ...................... 209 Extent of Coverage ...................................... 210 Torts as Deterrence ............................................. 211 General Aviation and Deterrence ......................... 212 Other Evidence on Deterrence ............................ 215 The Limits of Tort Deterrence ........................... 215 Potential Tort Reforms .......................................... 215 Limiting Noneconomic Damages and Other Potential Reforms ................................................ 216 Procedural Reforms ...................................... 217 Limiting the Scope of Tort Compensation ................. 217 Avoiding the Tort System ................................ 220 Conclusion ...................................................... 221 Chapter 12. international trade and cooperation ................. 223 Increased Trade Flows: Facts and Trends ......................... 223 The Benefits of Free Trade ...................................... 225 Comparative Advantage ........................................... 226 Assisting People and Communities Affected by Free Trade ......... 227 New Facets of Trade ............................................. 228 Intellectual Property ................................... 228 Services ................................................ 228 Intra-industry Trade and Intermediate Products .......... 230 International Cooperation and Disputes .......................... 231 Why Is There a Need for Cooperation? .................... 231 The Benefits of Dispute Settlement ...................... 234 Progress Toward Free Trade ...................................... 235 Conclusion ...................................................... 237 Chapter 13. international capital flows ......................... 239 Types of International Capital Flows ............................ 240 Foreign Direct Investment ............................... 241 Portfolio Investment .................................... 241 Bank Investment ......................................... 242 Benefits of International Capital Flows ......................... 242 Risks of International Capital Flows ............................ 244 Constraints Imposed by Free Capital Flows ....................... 247 Encouraging Free Capital Flows .................................. 250 Conclusion ...................................................... 252 Chapter 14. the link between trade and capital flows ............ 253 The Basic Accounting Identity ................................... 253 Trends in the U.S. Balance of Payments .......................... 258 Factors that Influence the Balance of Payments .................. 260 Possible Paths of Balance of Payments Adjustment ................ 263 Conclusion ...................................................... 264 Appendixes A. Report to the President on the Activities of the Council of Economic Advisers During 2003 ........................... 265 B. Statistical Tables Relating to Income, Employment, and Production .......................................... 277 List of Tables 2-1. Employment in Selected Manufacturing Industries ......... 70 2-2. Compensation in Selected Industries ..................... 75 3-1. Administration Forecast ................................. 98 3-2. Accounting for Growth in Real GDP, 1960-2009 ............ 99 9-1. Cost Savings of Tradable-Permit Systems ................. 186 10-1. Important Medical Innovations and Associated Country of Origin .............................................. 192 11-1. Characteristics of State and Federal Tort Cases Decided by Trial, 1996 ............................................ 206 11-2. Compensation for Injury, Illness, and Fatality in the United States, Selected Methods ........................ 209 12-1. Leading U.S. Net Exports of Goods, 2002 ................. 225 12-2. Status of Free Trade Agreements (FTAs) with the United States .......................................... 236 14-1. Current and Financial Account ........................... 259 List of Charts 1-1. Real GDP ................................................ 32 1-2. Real Investment in Equipment and Software ............... 34 1-3. Real Exports ............................................ 36 1-4. The Wilshire 5000 Index of Stock Prices ................. 38 1-5. Expected Near-Term S&P 500 Volatility ................... 39 1-6. The Effective Federal Funds Rate ........................ 40 1-7. Real Residential Investment ............................. 41 1-8. Growth in Personal Income, Before and After Taxes ....... 44 1-9. Productivity in the Nonfarm Business Sector ............. 46 1-10. Total Nonfarm Employment ................................ 48 2-1. Real GDP and Manufacturing Industrial Production ........ 54 2-2. Manufacturing Industrial Production and Real Investment . 55 2-3. Manufacturing Employment ................................ 56 2-4. Productivity in Manufacturing ........................... 57 2-5. Employment in Manufacturing and Temporary-Help Services . 58 2-6. Real GDP and Manufacturing Industrial Production ........ 59 2-7. Productivity Growth ..................................... 61 2-8. Price Level by Category of Personal Consumption Expenditures .......................................... 62 2-9. U.S. Imports and Domestic Production of Goods ........... 63 2-10. Nonagricultural Goods Trade as a Percent of Manufacturing Output ................................................. 64 2-11. Nonagricultural Goods Net Imports as a Percent of Output . 64 2-12. China's Trade in Goods .................................. 67 2-13. U.S. Trade Deficit in Goods ............................. 67 2-14. U.S. Imports of Goods ................................... 68 2-15. U.S. Exports of Goods ................................... 68 2-16. Employment and Relative Productivity .................... 69 2-17. Manufacturing and Professional and Business Services Employment ............................................ 72 2-18. Outsourcing and Temporary-Help Services Employment ...... 72 2-19. Employment in Industry as a Percent of Total Employment .. 77 2-20. Employment and Real Output in Agriculture ............... 79 2-21. Agricultural Productivity ............................... 79 2-22. Wholesale Prices ........................................ 80 3-1. Wealth-to-Income Ratio and Personal Saving Rate ......... 88 3-2. National Saving Rate .................................... 88 3-3. Growth in Temporary-Help Services and Overall Employment, 1990-2003 .................................. 95 4-1. Distribution of Capital Income Tax Burden in the Long Run . 113 6-1. Demographic Change and the Cost of Social Security Through 2080 .......................................... 132 6-2. Social Security's Annual Balances Through 2080 .......... 133 6-3. Probability Distribution of Projected Annual Cost Rates . 136 6-4. The Potential Impact of Commission Model 2 on Deficits and Debt .............................................. 144 6-5. The Long-Run Budget without Social Security Reform ...... 145 6-6. The Long-Run Budget Deficit with Social Security Reform . 146 8-1. Required Specifications for Gasoline .................... 160 8-2. Hourly Electricity Consumption, Wholesale Prices, and Retail Prices in California ............................ 165 8-3. Production Costs and Reserves of Alternative Transportation Fuel Sources ........................................... 171 9-1. National Concentrations of Air Pollutants ............... 176 9-2. Particulate Matter Concentrations ....................... 176 9-3. Relationship Between Actual and Perceived Risk of Dying . 181 9-4. Unit-Level Sulfur Dioxide Emissions Trading in 1997 ..... 186 11-1. Tort Costs as a Percent of GDP .......................... 205 11-2. Tort Filings in 16 States ............................... 206 11-3. General Aviation Liability Payouts and Accident Rates ... 213 11-4. Accident Rate for Small Aircraft ........................ 213 11-5. Small-Aircraft Production ............................... 214 11-6. International Comparison of Tort Costs, 1998 ............ 216 12-1. World Trade and GDP ..................................... 224 12-2. World Trade in Goods and Services ....................... 229 13-1. Global Capital Flows as a Percent of World GDP .......... 239 13-2. World Capital Inflows in 2002 ........................... 240 13-3. ``The Impossible Trinity'' .............................. 247 14-1. Changes to the Balance of Payments Terminology in 1999 .. 255 14-2. Balance of Payments ..................................... 258 14-3. Exports and Imports of Goods ............................ 259 14-4. Saving, Investment, and the Current Account Balance ..... 261 14-5. Budget Deficit and the Current Account Balance .......... 263 List of Boxes 1-1. When Did the Recent Recession Begin? .................... 30 1-2. Two Surveys of Employment ............................... 49 2-1. China and the U.S. Manufacturing Sector ................. 65 2-2. What is Manufacturing? .................................. 73 2-3. The Evolution of the U.S. Agricultural Sector ........... 77 3-1. Personal Saving and National Saving ..................... 86 4-1. Social Security and Transfer Payments in Distributional Tables ................................................. 109 6-1. The Retirement of the Baby-Boom Generation .............. 134 6-2. Long-Term Projections and Uncertainty ................... 135 7-1. Market Responses to Unexpected Shortages ................ 155 9-1. Economic Growth Can Improve the Environment ............. 175 10-1. Price Regulation and the Introduction of New Drugs ...... 193 10-2. Who are the Uninsured? .................................. 197 11-1. Punitive Damages ........................................ 211 11-2. The Role of Class Actions in the Tort System ............ 218 11-3. Asbestos and the Tort System ............................ 219 12-1. Trade in Financial Services ............................. 230 12-2. International Cooperation on Intellectual Property Rights ................................................. 233 13-1. Capital Controls in Emerging Markets .................... 245 13-2. Choosing Among a Fixed Exchange Rate, Independent Monetary Policy, and Free Capital Movements ............ 249 14-1. A New Look for the Balance of Payments .................. 254 14-2. Bilateral Versus Multilateral Balances .................. 257