Delivered on March 19, 2007
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.
The growth of our economy traces back to seeds that were sown
well before I became the President's economic adviser. 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
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 point 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 ahead of schedule. The President in his
FY 2008 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
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
of Economic Advisers, 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
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 it 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
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 U.S. 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
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
In addition to attracting foreign investment, the U.S. 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 weigh indirectly 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
Productivity growth is closely tied to economic growth. It helps
to keep inflationary pressures moderate and has proven to be
both one of our nation's most important economic fundamentals and a
defining characteristic of our international competitiveness.
In addition, 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 output in the developed European countries and Japan.
U.S. productivity growth and output per hour worked are 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 1.5 percent.
Notice the marked increase between the 1973- 1995 period and the
two most recent periods in Chart 1. This productivity 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
The impressive nature of American productivity growth stands out
even more when we look at productivity growth rates for G-7
countries since 1990. As seen in Chart 2, the U.S. increased its
productivity growth rate over a period in which the
productivity growth of most G-7 countries decreased.
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. Chart
3 shows that Canada and the U.S. lead the G-8 in the ease with
which businesses can be initiated.
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. In Chart 4, the lighter 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
darker bars, which show educational attainment among more recent
cohorts, reveal that the U.S. 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.
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.
Chart 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. 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.
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
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
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 Chart 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.
What We Can Do
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
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
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 dropout 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
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
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.
Questions and Answers
QUESTION: Joanne Morrison with Reuters. You talked about
the health of the economy, and I know in the past you've mentioned
that the housing marketing decline isn't likely to move into
other areas. We have seen some weakness, and as of late we have had
this shock with the sub-prime market; many of the loans written
last year were sub-prime loans. I was wondering if you could
address that and see if there might actually be a risk of some sort
of contagion elsewhere in the economy.
DR. LAZEAR: The housing market obviously has had a
significant negative effect on economic growth. You mentioned the
shock in the sub-prime market. I don't think I would label it a
"shock." I think what we see in the sub-prime market is the
continuation of a trend that started a few months back, even a year
back. It's not an unexplained trend; obviously, when you see
interest rates going up, that's going to put pressure on adjustable
rate mortgages, and we tended to see it in that sector
I think the more important question, or the issue I would focus
on, is not so much whether it's going to spread. I don't think many
people believe that it's going to spread; it's simply too small a
part of the total economy for it to spread. The issue is whether
it's symptomatic of some more general underlying phenomenon that's
just showing up first in the sub-prime market. I think the answer
to that is, probably not. The evidence that we've seen is that
the banking sector is actually very strong, better capitalized
now than it was a year or two ago, so that sector looks like it's
in very good shape.
We do know that the housing market will have an impact on GDP at
least for the next six months, because there's a lag. So if you see
housing starts down in the second half of 2006, we know that's
going to play out during the first half of 2007. I think most
people are expecting that to turn around, hopefully in the near
future because sooner is better than later. But we are expecting
growth in the second half of 2007 to be along the lines of the
growth that we saw last year, somewhere in the 3 percent range, so
our forecast is still that 2007 will be a good year, kind of in the
QUESTION: My name is Ed Powers, no affiliation. You
briefly mentioned entitlement programs as a factor: Medicare,
Social Security, Medicaid. It seems like those are the "looming
monster" things to deal with in the future, and it doesn't seem
like much is happening at the present time. It appears that it has
to be a catastrophe before Congress will do something about it. How
do you see that as impacting the economy in the near and longer
terms, and what really can we do about it?
DR. LAZEAR: We see those impacts already because when you
have entitlement spending increasing, it crowds out other kinds of
investment. That's not to say that Medicare isn't an important
program, that Social Security isn't an important program; I
think everybody recognizes that those have been important and have
been positive contributors to the social fabric of the United
States. But they have to compete with other good programs as well,
and investment in education is a clear case in point. So when we
think about discretionary expenditures, like investment in
education programs, it seems to me that the major short-run
pressure is crowding out other kinds of investment that would
enhance the human capital stock of the United States and would
increase economic growth.
Whether we have to wait for a disaster or not remains to be
seen. As you know, the President has been pushing very hard on
this. Treasury Secretary Hank Paulson's been going to Congress,
trying to persuade people to come to the table, to come to talk to
us. We want to make some headway on this. It doesn't necessarily
mean we're going to solve everything in the next year, but any
movement in that direction is positive, and we'd like to get
started on that. The Administration would welcome having the
Democrats in Congress come talk. There are no conditions, no
preconditions. Let's get together; let's start moving on this.
There are surely some areas where we can make some progress, and
any progress on this would be positive.
So I hope we don't have to wait for a disaster. I hope that's
not the case. But it is tough, and I think we all recognize that it
is tough to make progress in this area.
QUESTION: Alison Acosta Fraser, The Heritage Foundation.
I don't think we need to wait for a disaster; I certainly hope not.
I know that there are many institutions, including The Heritage
Foundation, here in Washington and beyond who are working to
make sure that that's not the case, including setting up good
dialogues with the country and among lawmakers, so they can do
that with the President in a very bipartisan way.
The President also has a number of proposals on the health care
front that you may care to comment on. Two of them, I think, are
especially important. One of them is the tax treatment of health
care insurance. I think that's important because it changes
the incentives for purchase of health insurance and also really
equalizes the playing field. The second is a number of proposals
for Medicare that will really rein in by a quarter, I believe, the
long-term costs of the Medicare $32 trillion unfunded
DR. LAZEAR: Let me focus on the first one, because I
think that's probably the one that's most important in terms of
long-run success of the health program. We think of that initiative
as being one that can really change in a very dramatic way and a
very positive way the nature of health care in the United States.
The program, just to elaborate a little bit on what it is, is to
move to a $15,000 standard deduction on taxes and do that as a
replacement for the current deductibility of health care at the
As Alison mentioned, there are a couple of reasons for
doing that. One is that there is currently a distortion; it's both
a distortion and unfair in the way it treats employer contributions
to health care versus non-employer contributions to health care.
But I think more important is that it provides the right incentive
on the margin for people to take their health care expenditures
into account. Right now, people are not rewarded appropriately for
saving money on their health care plan, so they buy a Cadillac
plan, a significant portion of which is covered by the
This plan would move away from that. You would get your $15,000
exclusion irrespective of the plan that you bought, as long as it
was a qualifying plan. Then if you want to have a better plan,
you have that choice. If you want to have a plan that doesn't give
you first dollar coverage, you also have that choice.
That provides better incentives on the margin, and it also deals
with the uninsured. The reason that it deals with the uninsured
problem is that it gives people, even at the very bottom of the
working income distribution, a pretty significant amount of
money-something on the order of $2,000 to people earning
$15,000 a year.
Just think about when you're home at night, how many calls you
get from telemarketers. Well, you've got an opportunity here.
There's $2,500 lying on the table; think about how many insurance
companies are going to be calling these people and saying, "Guess
what? We can give you a health insurance policy that will cost you
$1,500, but you'll get $2,500 from the government. You can net the
$1,000 and then still have the $1,000. We'll take care of the whole
thing; you don't have to do anything." I think it's just a
significant opportunity. I think it could really have a very large
effect on transforming our health care.
It also meshes nicely with the second point that you mentioned,
which is the reform of Medicare. One of the problems that we've had
in the health care sector is that costs have been rising much more
rapidly than inflation, and that's been going on for a pretty
significant number of years now. Again, a part of that is a result
of people not having control over their own expenditures and not
having to face the incentives associated with their own
expenditures. This will give people better incentives in health
care and, we believe, will bring about additional efficiency
and cost saving in that sector.
So we think it's a fabulous plan. I've talked to people on both
sides of the political spectrum in terms of both politics and
economics. I've talked to a number of Democrats, influential
Democratic economists, and there is a lot of enthusiasm for this.
So I really hope that this thing gets some legs and that we can
actually move it forward. I think it would be terrific for the
country and terrific for the health care industry as well. I think
it would rationalize things and make things much more
Edward P. Lazear, Ph.D., is chairman
of the President's Council of Economic Advisers.