November 30, 2005

November 30, 2005 | WebMemo on

Does the World's Mightiest Economy Have an Achilles Heel?

The U.S. economy is the biggest in the world, and it just keeps growing bigger. Recent data from the Commerce Department confirm that economic growth is robust, faster than economists had expected. In annualized terms, the economy grew 4.3 percent larger during the third quarter of 2005, which also happened to be when three massive hurricanes ripped up the Gulf Coast. Some diehard pessimists remain skeptical-a sign of partisan times perhaps-but we share one concern about an Achilles heel on the American colossus.

The U.S. has maintained a persistent 20 percent per-capita GDP lead over other advanced economies during recent decades. One widely accepted explanation is that America enjoys government policies and institutions that are more pro-growth. For example, low marginal tax rates are a powerful incentive for companies like Microsoft, Apple, and Google. Yet political debate has not resolved whether the 2003 tax cuts, arguably one of the most important pro-growth policies in recent years, will expire or be made permanent. In other words, only one thing stands in the way of continuing American economic dominance: the U.S. Congress.


Comparing Economies


While the U.S. economy surges, Europe's economies remain neutered by self-inflicted labor rigidities; policies meant to protect existing workers have resulted in a dispirited and increasingly violent young underclass. Meanwhile, Japan's once-roaring version of managed capitalism has proven a failure at sustaining economic growth. While many eyes look to China as the great economic challenge of our times, we should not forget that it is terribly poor to begin with. China's fast growth from such a low base has resulted in per-capita output that is a mere 11 percent of America's, and already China is experiencing environmental blowback evidenced by the latest chemical spill in Harbin-one of many challenges to the command model of growth.

Comparing Economies


Pro-growth economists interpret the 20 percent gap in per-capita GDP as evidence of America's role as the lead innovator in the world economy. The U.S. bears the unique burden of pushing the technology frontier further, whereas other economies generally adopt technology developed elsewhere.

One interpretation of Chart 1, which shows cross-country GDP levels over time, is that without American-led technology innovation, the world economy would stall. Another interpretation is that other economies like Ireland, Japan, and the U.K. would take on the leadership role. Most Americans would prefer not to test either theory. But to maintain its productivity leadership, the U.S. economy must incessantly innovate, something measured by growth in investment.


Understanding the Latest GDP Data

The big surprise in Wednesday's data release was an upward adjustment in overall GDP growth, from 3.8 percent to 4.3 percent. But the details of the data release are where the debate over tax policy should focus. First, observe that investment has surged considerably in recent years. While many conservatives believe the pro-growth tax policy of the 2003 tax cuts were instrumental in stimulating investment, a fair counter-argument is that investment routinely cycles up after recessions. Yet as the chart below shows, GDP has grown faster over the 9 quarters since the tax cut than during the 16 quarters since the 2001 recession ended.

Latest GDP Data



More importantly, investment has surged considerably since the 2003 tax cuts, growing at a 9.2 percent rate, compared to 5.2 percent during the recovery and 6.0 percent, on average, over the previous two decades). Component measures of "nonresidential fixed" investment and "equipment and software" investment have also grown far faster than normal. An alternative theory is that war spending by the government explains the rapid growth of the last two years, but this is also not supported by the data on government spending, which is below-trend. As a side note, consumption spending rose faster after the 2003 supply-side tax cuts than it did following the more demand-side stimulus of the 2001 tax cuts.


Where is the Bad News?

The Achilles' heel in all this data is that the tax stimulus to investment is temporary. Congress is now debating whether to make tax cuts permanent and is leaning towards letting most of the cuts expire in order to finance its uncontrolled spending. Bonus depreciation already expired on January 1, 2005, and small business expensing is scheduled to expire at the end of 2007. Both chambers of Congress plan to extend the small business expensing provision, which will continue to help small businesses.

Investment rises when the rewards to investment rise, which happens when the tax rate on capital gains and dividends is lowered. The 2003 tax cuts unified the top tax rates applied to capital gains and dividends at 15 percent, down from a top rate of 20 percent for capital gains and 39.6 percent for dividends. These lower rates are scheduled to expire at the end of 2008. Currently, the Senate tax bill allows the capital gains and dividend tax cut to expire on schedule. If Congress continues to delay making permanent the low tax rate on capital, businesses executives will assume a higher cost of investment and reduce their business investment accordingly, to the detriment of the economy.

If America's current investment levels drop precipitously as the 2003 tax cut provisions expire, the Achilles' heel will be confirmed. Yet Americans are unlikely to notice, because overall prosperity won't fall off immediately. But make no mistake, the defining domestic battle of our time is about the fundamental levels of federal spending and taxation. And the big government forces are winning. It's worth remembering how the great empires of history lost power: slowly, blindly, and permanently.


Tim Kane, Ph.D., is Bradley Fellow in Labor Policy, and Rea S. Hederman, Jr., is Senior Policy Analyst, in the Center for Data Analysis at The Heritage Foundation.

About the Author

Tim Kane, Ph.D. Visiting Fellow
Center for Trade and Economics (CTE)

Rea S. Hederman, Jr. Director, Center for Data Analysis and Lazof Family Fellow
Center for Data Analysis