Long-Term Structural Change in the US Economy: Manufacturing is Simply Following the Path of Agriculture

A.  Introduction

A major theme of Trump, both during his campaign and now as president, has been that jobs in manufacturing have been decimated as a direct consequence of the free trade agreements that started with NAFTA.  He repeated the assertion in his speech to Congress of February 28, where he complained that “we’ve lost more than one-fourth of our manufacturing jobs since NAFTA was approved”, but that because of him “Dying industries will come roaring back to life”.  He is confused.  But to be fair, there are those on the political left as well who are similarly confused.

All this reflects a sad lack of understanding of history.  Manufacturing jobs have indeed been declining in recent decades, and as the chart above shows, they have been declining as a share of total jobs in the economy since the 1940s.  Of all those employed, the share employed in manufacturing (including mining) fell by 7.6% points between 1994 (when NAFTA entered into effect) and 2015 (the most recent year in the sector data of the Bureau of Economic Analysis, used for consistency throughout this post), a period of 21 years. But the share employed in manufacturing fell by an even steeper 9.2% points in the 21 years before 1994.  The decline in manufacturing jobs (both as a share and in absolute number) is nothing new, and it is wrong to blame it on NAFTA.

It is also the case that manufacturing production has been growing steadily over this period.  Total manufacturing production (measured in real value-added terms) rose by 64% over the 21 years since NAFTA went into effect in 1994.  And this is also substantially higher than the 42% real growth in the 21 years prior to 1994.  Blaming NAFTA (and the other free trade agreements of recent decades) for a decline in manufacturing is absurd.  Manufacturing production has grown.

For those only interested in the assertion by Trump that NAFTA and the other free trade agreements have killed manufacturing in the US and with it the manufacturing jobs, one could stop here.  Manufacturing has actually grown strongly since NAFTA went into effect, and there are fewer manufacturing jobs now than before not because manufacturing has declined, but because workers in manufacturing are now more productive than ever before (with this a continuation of the pattern underway over at least the entire post-World War II period, and not something new).  But the full story is a bit more complex, as one also needs to examine why manufacturing production is at the level that it is.  For this, one needs to bring in the rest of the economy, in particular services. The rest of this blog post will address this broader issue,

Manufacturing jobs have nonetheless indeed declined.  To understand why, one needs to look at what has happened to productivity, not only in manufacturing but also in the other sectors of the economy (in particular in services).  And I would suggest that one could learn much by an examination of the similar factors behind the even steeper decline over the years in the share of jobs in agriculture.  It is not because of adverse effects of free trade.  The US is in fact the largest exporter of food products in the world.  Yet the share of workers employed in the agricultural sectors (including forestry and fishing) is now just 0.9% of the total.  It used to be higher:  4.3% in 1947 and 8.4% in 1929 (using the BEA data).  If one wants to go really far back, academics have estimated that agricultural employment accounted for 74% of all US employment in 1800, with this still at 56% in 1860.

Employment in agriculture has declined so much, from 74% of total employment in 1800 to 8.4% in 1929 to less than 1% today, because those employed in agriculture are far more productive today than they were before.  And while it leads to less employment in the sector, whether as a share of total employment or in absolute numbers, higher productivity is a good thing.  The US could hardly enjoy a modern standard of living if 74% of those employed still had to be working in agriculture in order to provide us food to eat. And while stretching the analysis back to 1800 is extreme, one can learn much by examining and understanding the factors behind the long-term trends in agricultural employment.  Manufacturing is following the same basic path.  And there is nothing wrong with that.  Indeed, that is exactly what one would hope for in order for the economy to grow and develop.

Furthermore, the effects of foreign trade on employment in the sectors, positive or negative, are minor compared to the long-term impacts of higher productivity.  In the post below we will look at what would have happened to employment if net trade would somehow be forced to zero by Trumpian policies.  The impact relative to the long term trends would be trivial.

This post will focus on the period since 1947, the earliest date for which the BEA has issued data on both sector outputs and employment.  The shares of agriculture as well as of manufacturing in both total employment and in output (with output measured in current prices) have both declined sharply over this period, but not because those sectors are producing less than before.  Indeed, their production in real terms are both far higher. Employment in those sectors has nevertheless declined in absolute numbers.  The reason is their high rates of productivity growth.  Importantly, productivity in those two sectors has grown at a faster pace than in the services sector (the rest of the economy).  As we will discuss, it is this differential rate of productivity growth (faster in agriculture and in manufacturing than in services) which explains the decline in the share employed in agriculture and manufacturing.

These structural changes, resulting ultimately from the differing rates of productivity growth in the sectors, can nonetheless be disruptive.  With fewer workers needed in a sector because of a high rate of productivity growth, while more workers are needed in those sectors where productivity is growing more slowly (although still positively and possibly strongly, just relatively less strongly), there is a need for workers to transfer from one sector to another.  This can be difficult, in particular for individuals who are older or who have fewer general skills.  But this was achieved before in the US as well as in other now-rich countries, as workers shifted out of agriculture and into manufacturing a century to two centuries ago.  Critically important was the development of the modern public school educational system, leading to almost universal education up through high school. The question the country faces now is whether the educational system can be similarly extended today to educate the workers needed for jobs in the modern services economy.

First, however, is the need to understand how the economy has reached the position it is now in, and the role of productivity growth in this.

B.  Sector Shares and Prices

As Chart 1 at the top of this post shows, employment in agriculture and in manufacturing have been falling steadily as a share of total employment since the 1940s, while jobs in services have risen.

[A note on the data:  The data here comes from the Bureau of Economic Analysis (BEA), which, as part of its National Income and Product Accounts (NIPA), estimates sector outputs as well as employment.  Employment is measured in full-time equivalent terms (so that two half-time workers, say, count as the equivalent of one full-time worker), which is important for measuring productivity growth.

And while the BEA provides figures on its web site for employment going all the way back to 1929, the figures for sector output on its web site only go back to 1947.  Thus while the chart at the top of this post goes back to 1929, all the analysis shown below will cover the period from 1947 only.  Note also that there is a break in the employment series in 1998, when the BEA redefined slightly how some of the detailed sectors would be categorized. They unfortunately did not then go back to re-do the categorizations in a consistent way in the years prior to that, but the changes are small enough not to matter greatly to this analysis.  And there were indeed similar breaks in the employment series in 1948 and again in 1987, but the changes there were so small (at the level of aggregation of the sectors used here) as not to be noticeable at all.

Also, for the purposes here the sector components of GDP have been aggregated to just three, with forestry and fishing included with agriculture, mining included with manufacturing, and construction included with services.  As a short hand, these sectors will at times be referred to simply as agriculture, manufacturing, and services.

Finally, the figures on sector outputs in real terms provided by the BEA data are calculated based on what are called “chain-weighted” indices of prices.  Chain-weighted indices are calculated based on moving shares of sector outputs (whatever the share is in any given period) rather than on fixed shares (i.e. the shares at the beginning or the end of the time period examined).  Chain-weighted indices are the best to use over extended periods, but are unfortunately not additive, where a sum (such as real GDP) will not necessarily equal exactly the sum of the estimates of the underlying sector figures (in real terms).  The issue is however not an important one for the questions being examined in this post.  While we will show the estimates in the charts for real GDP (based on a sum of the figures for the three sectors), there is no need to focus on it in the analysis.  Now back to the main text.]

The pattern in a chart of sector outputs as shares of GDP (measured in current prices by the value-added of each sector), is similar to that seen in Chart 1 above for the employment shares:

Agriculture is falling, and falling to an extremely small share of GDP (to less than 1% of GDP in 2015).  Manufacturing and mining is similarly falling from the mid-1950s, while services and construction is rising more or less steadily.  On the surface, all this appears to be similar to what was seen in Chart 1 for employment shares.  It also might look like the employment shares are simply following the shifts in output shares.

But there is a critical difference.  The shares of workers employed is a measure of numbers of workers (in full-time equivalent terms) as a share of the total.  That is, it is a measure in real terms.  But the shares of sector outputs in Chart 2 above is a measure of the shares in terms of current prices.  They do not tell us what is happening to sector outputs in real terms.

For sector outputs in real terms (based on the prices in the initial year, or 1947 here), one finds a very different chart:

Here, the output shares are not changing all that much.  There is only a small decline in agriculture (from 8% of the total in 1947 to 7% in 2015), some in manufacturing (from 28% to 22%), and then the mirror image of this in services (from 64% to 72%).  The changes in the shares were much greater in Chart 2 above for sector output shares in current prices.

Many might find the relatively modest shifts in the shares of sector outputs when measured in constant price terms to be surprising.  We were all taught in our introductory Economics 101 class of Engel Curve effects.  Ernst Engel was a German statistician who, in 1857, found that at the level of households, the share of expenditures on basic nourishment (food) fell the richer the household.  Poorer households spent a relatively higher share of their income on food, while better off households spent less.  One might then postulate that as a nation becomes richer, it will see a lower share of expenditures on food items, and hence that the share of agriculture will decline.

But there are several problems with this theory.  First, for various reasons it may not apply to changes over time as general income levels rise (including that consumption patterns might be driven mostly by what one observes other households to be consuming at the time; i.e. “keeping up with the Joneses” dominates).  Second, agricultural production spans a wide range of goods, from basic foodstuffs to luxury items such as steak.  The Engel Curve effects might mostly be appearing in the mix of food items purchased.

Third, and perhaps most importantly, the Engel Curve effects, if they exist, would affect production only in a closed economy where it was not possible to export or import agricultural items.  But one can in fact trade such agricultural goods internationally. Hence, even if domestic demand fell over time (due perhaps to Engel Curve effects, or for whatever reason), domestic producers could shift to exporting a higher share of their production.  There is therefore no basis for a presumption that the share of agricultural production in total output, in real terms, should be expected to fall over time due to demand effects.

The same holds true for manufacturing and mining.  Their production can be traded internationally as well.

If the shares of agriculture and manufacturing fell sharply over time in terms of current prices, but not in terms of constant prices (with services then the mirror image), the implication is that the relative prices of agriculture as well as manufacturing fell relative to the price of services.  This is indeed precisely what one sees:

These are the changes in the price indices published by the BEA, with all set to 1947 = 1.0.  Compared to the others, the change in agricultural prices over this 68 year period is relatively small.  The price of manufacturing and mining production rose by far more.  And while a significant part of this was due to the rise in the 1970s of the prices of mined products (in particular oil, with the two oil crises of the period, but also in the prices of coal and other mined commodities), it still holds true for manufacturing alone.  Even if one excludes the mining component, the price index rose by far more than that of agriculture.

But far greater was the change in the price of services.  It rose to an index value of 12.5 in 2015, versus an index value of just 1.6 for agriculture in that year.  And the price of services rose by double what the price of manufacturing and mining rose by (and even more for manufacturing alone).

With the price of services rising relative to the others, the share of services in GDP (in current prices) will then rise, and substantially so given the extent of the increase in its relative price, despite the modest change in its share in constant price terms.  Similarly, the fall in the shares of agriculture and of manufacturing (in current price terms) will follow directly from the fall in their prices (relative to the price of services), despite just a modest reduction in their shares in real terms.

The question then is why have we seen such a change in relative prices.  And this is where productivity enters.

C.  Growth in Output, Employment, and Productivity

First, it is useful to look at what happened to the growth in real sector outputs relative to 1947:

All sector outputs rose, and by substantial amounts.  While Trump has asserted that manufacturing is dying (due to free trade treaties), this is not the case at all.  Manufacturing (including mining) is now producing 5.3 times (in real terms) what it was producing in 1947.  Furthermore, manufacturing production was 64% higher in real terms in 2015 than it was in 1994, the year NAFTA went into effect.  This is far from a collapse.  The 64% increase over the 21 years between 1994 and 2015 was also higher than the 42% increase in manufacturing production of the preceding 21 year period of 1973 to 1994. There was of course much more going on than any free trade treaties, but to blame free trade treaties on a collapse in manufacturing is absurd.  There was no collapse.

Production in agriculture also rose, and while there was greater volatility (as one would expect due to the importance of weather), the increase in real output over the full period was in fact very similar to the increase seen for manufacturing.

But the biggest increase was for services.  Production of services was 7.6 times higher in 2015 than in 1947.

The second step is to look at employment, with workers measured here in full-time equivalent terms:

Despite the large increases in sector production over this period, employment in agriculture fell as did employment in manufacturing.  One unfortunately cannot say with precision by how much, given the break in the employment series in 1998.  However, there were drops in the absolute numbers employed in manufacturing both before and after the 1998 break in the series, while in agriculture there was a fall before 1998 (relative to 1947) and a fairly flat series after.  The change in the agriculture employment numbers in 1998 was relatively large for the sector, but since agricultural employment was such a small share of the total (only 1%), this does not make a big difference overall.

In contrast to the falls seen for agriculture and manufacturing, employment in the services sector grew substantially.  This is where the new jobs are arising, and this has been true for decades.  Indeed, services accounted for more than 100% of the new jobs over the period.

But one cannot attribute the decline in employment in agriculture and in manufacturing to the effects of international trade.  The points marked with a “+” in Chart 6 show what employment in the sectors would have been in 2015 (relative to 1947) if one had somehow forced net imports in the sectors to zero in 2015, with productivity remaining the same. There would have been an essentially zero change for agriculture (while the US is the world’s largest food exporter, it also imports a lot, including items like bananas which would be pretty stupid to try to produce here).  There would have been somewhat more of an impact on manufacturing, although employment in the sector would still have been well below what it had been decades ago.  And employment in services would have been a bit less. While most production in the services sector cannot be traded internationally, the sector includes businesses such as banking and other finance, movie making, professional services, and other areas where the US is in fact a strong exporter.  Overall, the US is a net exporter of services, and an abandonment of trade that forced all net imports (and hence net exports) to zero would lead to less employment in the sector.  But the impact would be relatively minor.

Labor productivity is then simply production per unit of labor.  Dividing one by the other leads to the following chart:

Productivity in agriculture grew at a strong pace, and by more than in either of the other two sectors over the period.  With higher productivity per worker, fewer workers will be needed to produce a given level of output.  Hence one can find that employment in agriculture declined over the decades, even though agricultural production rose strongly. Productivity in manufacturing similarly grew strongly, although not as strongly as in agriculture.

In contrast, productivity in the services sector grew at only a modest pace.  Most of the activities in services (including construction) are relatively labor intensive, and it is difficult to substitute machinery and new technology for the core work that they do.  Hence it is not surprising to find a slower pace of productivity growth in services.  But productivity in services still grew, at a positive 0.9% annual pace over the 1947 to 2015 period, as compared to a 2.8% annual pace for manufacturing and a 3.3% annual pace in agriculture.

Finally, and for those readers more technically inclined, one can convert this chart of productivity growth onto a logarithmic scale.  As some may recall from their high school math, a straight line path on a logarithmic scale implies a constant rate of growth.  One finds:

While one should not claim too much due to the break in the series in 1998, the path for productivity in agriculture on a logarithmic scale is remarkably flat over the full period (once one abstracts from the substantial year to year variation – short term fluctuations that one would expect from dependence on weather conditions).  That is, the chart indicates that productivity in agriculture grew at a similar pace in the early decades of the period, in the middle decades, and in the later decades.

In contrast, it appears that productivity in manufacturing grew at a certain pace in the early decades up to the early 1970s, that it then leveled off for about a decade until the early 1980s, and that it then moved to a rate of growth that was faster than it had been in the first few decades.  Furthermore, the pace of productivity growth in manufacturing following this turn in the early 1980s was then broadly similar to the pace seen in agriculture in this period (the paths are then parallel so the slope is the same).  The causes of the acceleration in the 1980s would require an analysis beyond the scope of this blog post. But it is likely that the corporate restructuring that became widespread in the 1980s would be a factor.  Some would also attribute the acceleration in productivity growth to the policies of the Reagan administration in those years.  However, one would also then need to note that the pace of productivity growth was similar in the 1990s, during the years of the Clinton administration, when conservatives complained that Clinton introduced regulations that undid many of the changes launched under Reagan.

Finally, and as noted before, the pace of productivity growth in services was substantially less than in the other sectors.  From the chart in logarithms, it appears the pace of productivity growth was relatively robust in the initial years, up to the mid-1960s.  While slower than the pace in manufacturing or in agriculture, it was not that much slower.  But from the mid-1960s, the pace of growth of productivity in services fell to a slower, albeit still positive, pace.  Furthermore, that pace appears to have been relatively steady since then.

One can summarize the results of this section with the following table:

Growth Rates:

1947 to 2015




Total (GDP)
















The growth rate of output will be the simple sum of the growth rate of employment in a sector and the growth rate of its productivity (output per worker).  The figures here do indeed add up as they should.  They do not tell us what causes what, however, and that will be addressed next.

D.  Pulling It Together:  The Impact on Employment, Prices, and Sector Shares

Productivity is driven primarily by technological change.  While management skills and a willingness to invest to take advantage of what new technologies permit will matter over shorter periods, over the long term the primary driver will be technology.

And as seen in the chart above, technological progress, and the resulting growth in productivity, has proceeded at a different pace in the different sectors.  Productivity (real output per worker) has grown fastest over the last 68 years in agriculture (a pace of 3.3% a year), and fast as well in manufacturing (2.8% a year).  In contrast, the rate of growth of productivity in services, while positive, has been relatively modest (0.9% a year).

But as average incomes have grown, there has been an increased domestic demand in what the services sector produces, not only in absolute level but also as a share of rising incomes.  Since services largely cannot be traded internationally (with a few exceptions), the increased demand for services will need to be met by domestic production.  With overall production (GDP) matching overall incomes, and with demand for services growing faster than overall incomes, the growth of services (in real terms) will be greater than the growth of real GDP, and therefore also greater than growth in the rest of the economy (agriculture and manufacturing; see Chart 5).  The share of services in real GDP will then rise (Chart 3).

To produce this, the services sector needed more labor.  With productivity in the services sector growing at a slower pace (in relative terms) than that seen in agriculture and in manufacturing, the only way to obtain the labor input needed was to increase the share of workers in the economy employed in services (Chart 1).  And depending on the overall rate of labor growth as well as the size of the differences in the rates of productivity growth between the sectors, one could indeed find that the shift in workers out of agriculture and out of manufacturing would not only lead to a lower relative share of workers in those sectors, but also even to a lower absolute number of workers in those sectors.  And this is indeed precisely what happened, with the absolute number of workers in agriculture falling throughout the period, and falling in manufacturing since the late 1970s (Chart 6).

Finally, the differential rates of productivity growth account for the relative price changes seen between the sectors.  To be able to hire additional workers into services and out of agriculture and out of manufacturing, despite a lower rate of productivity growth in services, the price of services had to rise relative to agriculture as well as manufacturing. Services became more expensive to produce relative to the costs of agriculture or manufacturing production.  And this is precisely what is seen in Chart 4 above on prices.

To summarize, productivity growth allowed all sectors to grow.  With the higher incomes, there was a shift in demand towards services, which led it to grow at a faster pace than overall incomes (GDP).  But for this to be possible, particularly as its pace of productivity growth was slower than the pace in agriculture and in manufacturing, workers had to shift to services from the other sectors.  The effect was so great (due to the differing rates of growth of productivity) that employment in services rose to the point where services now employs close to 90% of all workers.

To be able to hire those workers, the price of services had to grow relative to the prices of the other sectors.  As a consequence, while there was only a modest shift in sector shares over time when measured in real terms (constant prices of 1947), there was a much larger shift in sector shares when measured in current prices.

The decline in the number of workers in manufacturing should not then be seen as surprising nor as a reflection of some defective policy.  Nor was it a consequence of free trade agreements.  Rather, it was the outcome one should expect from the relatively rapid pace of productivity growth in manufacturing, coupled with an economy that has grown over the decades with this leading to a shift in domestic demand towards services.  The resulting path for manufacturing was then the same basic path as had been followed by agriculture, although it has been underway longer in agriculture.  As a result, fewer than 1% of American workers are now employed in agriculture, with this possible because American agriculture is so highly productive.  One should expect, and indeed hope, that the same eventually becomes true for manufacturing as well.

Productivity: Do Low Real Wages Explain the Slowdown?

GDP per Worker, 1947Q1 to 2016Q2,rev

A.  Introduction, and the Record on Productivity Growth

There is nothing more important to long term economic growth than the growth in productivity.  And as shown in the chart above, productivity (measured here by real GDP in 2009 dollars per worker employed) is now over $115,000.  This is 2.6 times what it was in 1947 (when it was $44,400 per worker), and largely explains why living standards are higher now than then.  But productivity growth in recent decades has not matched what was achieved between 1947 and the mid-1960s, and there has been an especially sharp slowdown since late 2010.  The question is why?

Productivity is not the whole story; distribution also matters.  And as this blog has discussed before, while all income groups enjoyed similar improvements in their incomes between 1947 and 1980 (with those improvements also similar to the growth in productivity over that period), since then the fruits of economic growth have gone only to the higher income groups, while the real incomes of the bottom 90% have stagnated.  The importance of this will be discussed further below.  But for the moment, we will concentrate on overall productivity, and what has happened to it especially in recent years.

As noted, the overall growth in productivity since 1947 has been huge.  The chart above is calculated from data reported by the BEA (for GDP) and the BLS (for employment).  It is productivity at its most basic:  Output per person employed.  Note that there are other, more elaborate, measures of productivity one might often see, which seek to control, for example, for the level of capital or for the education structure of the labor force.  But for this post, we will focus simply on output per person employed.

(Technical Note on the Data: The most reliable data on employment comes from the CES survey of employers of the BLS, but this survey excludes farm employment.  However, this exclusion is small and will not have a significant impact on the growth rates.  Total employment in agriculture, forestry, fishing, and hunting, which is broader than farm employment only, accounts for only 1.4% of total employment, and this sector is 1.2% of GDP.)

While the overall rise in productivity since 1947 has been huge, the pace of productivity growth was not always the same.  There have been year-to-year fluctuations, not surprisingly, but these even out over time and are not significant. There are also somewhat longer term fluctuations tied to the business cycle, and these can be significant on time scales of a decade or so.  Productivity growth slows in the later phases of a business expansion, and may well fall as an economic downturn starts to develop.  But once well into a downturn, with businesses laying off workers rapidly (with the least productive workers the most likely to be laid off first), one will often see productivity (of those still employed) rise.  And it will then rise further in the early stages of an expansion as output grows while new hiring lags.

Setting aside these shorter-term patterns, one can break down productivity growth over the close to 70 year period here into three major sub-periods.  Between the first quarter of 1947 and the first quarter of 1966, productivity rose at a 2.2% annual pace.  There was then a slowdown, for reasons that are not fully clear and which economists still debate, to just a 0.4% pace between the first quarter of 1966 and the first quarter of 1982.  The pace of productivity growth then rose again, to 1.4% a year between the first quarter of 1982 and the second quarter of 2016.  But this was well less than the 2.2% pace the US enjoyed before.

An important question is why did productivity growth slow from a 2.2% pace between the late 1940s and mid-1960s, to a 1.4% pace since 1982.  Such a slowdown, if sustained, might not appear like much, but the impact would in fact be significant.  Over a 50 year period, for example, real output per worker would be 50% higher with growth at a 2.2% than it would be with growth at a 1.4% pace.

There is also an important question of whether productivity growth has slowed even further in recent years.  This might well still be a business cycle effect, as the economy has recovered from the 2008/09 downturn but only slowly (due to the fiscal drag from cuts in government spending).  The pace of productivity growth has been especially slow since late 2010, as is clear by blowing up the chart from above to focus on the period since 2000:

GDP per Worker, 2000Q1 to 2016Q2,rev

Productivity has increased at a rate of just 0.13% a year since late 2010.  This is slow, and a real problem if it continues.  I would hasten to add that the period here (5 1/2 years) is still too short to say with any certainty whether this will remain an issue.  There have been similar multi-year periods since 1947 when the pace of productivity growth appeared to slow, and then bounced back.  Indeed, as seen in the chart above, one would have found a similar pattern had one looked back in early 2009, with a slow pace of productivity growth observed from about 2005.

There has been a good deal of work done by excellent economists on why productivity growth has been what it was, and what it might be in the future.  But there is no consensus.  Robert J. Gordon of Northwestern University, considered by many to be the “dean in the field”, takes a pessimistic view on the prospects in his recently published magnum opus “The Rise and Fall of American Growth”.  Erik Brynjolfsson and Andrew McAfee of MIT, in contrast, argue for a more optimistic view in their recent work “The Second Machine Age” (although “optimistic” might not be the right word because of their concern for the implication of this for jobs).  They see productivity growth progressing rapidly, if not accelerating.

But such explanations are focused on possible productivity growth as dictated by what is possible technologically.  A separate factor, I would argue, is whether investment in fact takes place that makes use of the technology that is available.  And this may well be a dominant consideration when examining the change in productivity over the short and medium terms.  A technology is irrelevant if it is not incorporated into the actual production process.  And it is only incorporated into the production process via investment.

To understand productivity growth, and why it has fallen in recent decades and perhaps especially so in recent years, one must therefore also look at the investment taking place, and why it is what it is.  The rest of this blog post will do that.

B.  The Slowdown in the Pace of Investment

The first point to note is that net investment (i.e. after depreciation) has been falling in recent decades when expressed as a share of GDP, with this true for both private and public investment:

Domestic Fixed Investment, Total, Public, and Private, Net, percentage of GDP, 1951 to 2015, updated Aug 16, 2016

Total net investment has been on a clear downward trend since the mid-1960s.  Private net investment has been volatile, falling sharply with the onset of an economic downturn and then recovering.  But since the late 1970s its trend has also clearly been downward. Net private investment has been less than 3 1/2% of GDP in recent years, or less than half what it averaged between 1951 and 1980 (of over 7% of GDP).  And net public investment, while less volatile, has plummeted over time.  It averaged 3.1% of GDP between 1951 and 1968, but is only 0.5% of GDP now (as of 2015), or less than one-sixth of what it was before.

With falling net investment, the rates of growth of public and private capital stocks (fixed assets) have fallen (where 2014 is the most recent year for which the BEA has released such data):

Rate of Growth In Per Capita Net Stock of Private and Government Fixed Assets, edited, 1951 to 2014

Indeed, expressed in per capita terms, the stock of public capital is now falling.  The decrepit state of our highways, bridges, and other public infrastructure should not be a surprise.  And the stock of private capital fell each year between 2009 and 2011, with some recovery since but still at almost record low growth.

Even setting aside the recent low (or even negative) figures, the trend in the pace of growth for both public and private capital has declined since the mid-1960s.  Why might this be?

C.  Why Has Investment Slowed?

The answer is simple and clear for pubic capital.  Conservative politicians, in both the US Congress and in many states, have forced cuts in public investment over the years to the current low levels.  For whatever reasons, whether ideological or something else, conservative politicians have insisted on cutting or even blocking much of what the United States used to invest in publicly.

Yet public, like private, investment is important to productivity.  It is not only commuters trying to get to work who spend time in traffic jams from inadequate roads, and hence face work days of not 8 1/2 hours, but rather 10 or 11 or even 12 hours (with consequent adverse impacts on their productivity).  It affects also truck drivers and repairmen, who can accomplish less on their jobs due to time spent in jams.  Or, as a consequence of inadequate public investment in computer technology, a greater number of public sector workers are required than otherwise, in jobs ranging from issuing driver’s licenses to enrolling people in Medicare.  Inadequate public investment can hold back economic productivity in many ways.

The reasons behind the fall in private investment are less obvious, but more interesting. An obvious possible cause to check is whether private profitability has fallen.  If it has, then a reduction in private investment relative to output would not be a surprise.  But this has in fact not been the case:

Rate of Return on Produced Assets, 1951 to 2015, updated

The nominal rate of return on private investment has not only been high, but also surprisingly steady over the years.  Profits are defined here as the net operating surplus of all private entities, and is taken from the national account figures of the BEA.  They are then taken as a ratio to the stock of private produced assets (fixed assets plus inventories) as of the beginning of the year.  This rate of return has varied only between 8 and 13% over the period since at least 1951, and over the last several years has been around 11%.

Many might be surprised by both this high level of profitability and its lack of volatility.  I was.  But it should be noted that the measure of profitability here, net operating surplus, is a broad measure of all the returns to capital.  It includes not only corporate profitability, but also profits of unincorporated businesses, payments of interest (on borrowed capital), and payments of rents (as on buildings). That is, this is the return on all forms of private productive capital in the economy.

The real rates of return have been more volatile, and were especially low between 1974 and 1983, when inflation was high.  They are measured here by adjusting the nominal returns for inflation, using the GDP deflator as the measure for inflation.  But this real rate of return was a good 9.6% in 2015.  That is high for a real rate of return.  It was higher than that only for one year late in the Clinton administration, and for several years between the early 1950s and the mid-1960s.  But it was never higher than 11%.  The current real rate of return on private capital is far from low.

Why then has private investment slowed, in relation to output, if profitability is as high now as it has ever been since the 1950s?  One could conceive of several possible reasons. They include:

a)  Along the lines of what Robert Gordon has argued, perhaps the underlying pace of technological progress has slowed, and thus there is less of an incentive to undertake new investments (since the returns to replacing old capital with new capital will be less).  The rate of growth of capital then slows, and this keeps up profitability (as the capital becomes more scarce relative to output) even as the attractiveness of new investment diminishes.

b)  Conservatives might argue that the reduced pace of investment could be due to increased governmental regulations, which makes investment more difficult and raises its cost.  This might be difficult to reconcile with the rate of return on capital nonetheless remaining high, but in principle could be if one argues that the slower pace of new investment keeps up profitability as capital then becomes more scarce relative to output. But note that this argument would require that the increased burden of regulation began during the Reagan years in the early 1980s (when the share of private investment in GDP first started to slow – see the chart above), and built up steadily since then through both Republican and Democratic administrations.  It would not be something that started only recently under Obama.

c)  One could also argue that the reduced investment might be a consequence of “Baumol’s Cost Disease”.  This was discussed in earlier posts on this blog, both for overall government spending and for government investment in infrastructure specifically.  As discussed in those posts, Baumol’s Cost Disease explains why activities where productivity growth may be relatively more difficult to achieve than in other activities, will see their relative costs increase over time.  Construction is an example, where productivity growth has been historically more difficult to achieve than has been the case in manufacturing.  Thus the cost of investing, both public and private, relative to the cost of other items will increase over time.  This can then also be a possible explanation of slowing new investment, with that slower investment then keeping profitability up due to increasing scarcity of capital.

One problem with each of the possible explanations described above is that they all depend on capital investments becoming less attractive than before, either due to higher costs or due to reduced prospective return.  If such factors were indeed critical, one would need to take into account also the effect of taxes on investment returns.  And such taxes have been cut sharply over this same period.  As discussed in an earlier blog post, taxes on corporate profits, for example, are taxed now at an effective rate of less than 20%, based on what is actually paid after all the legal deductions and credits are included.  And this tax rate has fallen steadily over time.  The current 20% rate is less than half the effective rate that applied in the 1950s and 1960s, when the effective rate averaged almost 45%.  And the tax rate on long-term capital gains, as would apply to returns on capital to individuals, fell from a peak of just below 40% in the mid-1970s to just 15% following the Bush II tax cuts and to 20% since 2013.

Such sharp cuts in taxes on profits implies that the after-tax rate of return on assets has risen sharply (the before-tax rate of return, shown on the chart above, has been flat).  Yet despite this, private investment has fallen steadily since the early 1980s as a share of GDP.

Such explanations for the reason behind the fall in private investment since the early 1980s are therefore questionable.  However, the purpose of this blog post is not to debate this. Economists are good at coming up with models, possibly convoluted, which can explain things ex post.  Several could apply here.

Rather, I would suggest that there might be an alternative explanation for why private investment has been declining.  While consistent with basic economics, I have not seen it before.  This explanation focuses on the stagnant real wages seen since the early 1980s, and the impact this would have on whether or not to invest.

D.  The Impact of Low Real Wages

Real wages have stagnated in the US since the early 1980s, as has been discussed in earlier posts on this blog (see in particular this post).  The chart below, updated to the most recent figures available, compares the real median wage since 1979 (the earliest year available for this data series) to real GDP per worker employed:

Real GDP per Worker versus Real Median Wage, 1979Q1 to 2016Q2, rev

Real median wages have been flat overall:  Just 3% higher in 2016 than what they were 37 years before.  But real GDP per worker is almost 60% higher over this same period.  This has critically important implications for both private investment and for productivity growth. To sum up in one line the discussion that will follow below, there is less and less reason to invest in new, productivity enhancing, capital, if labor is available at a stagnant real wage that has changed little in 37 years.

Traditional economics, as commonly taught, would find it difficult to explain the observed stagnation in real wages while productivity has risen (even if at a slower pace than before). A core result taught in microeconomics is that in “perfectly competitive” markets, labor will be paid the value of its marginal product.  One would not then see a divergence such as that seen in this chart between growth in productivity and a lack of growth in the real wage.

(The more careful observers among the readers of this post might note that the productivity curve shown here is for average productivity, and not the marginal productivity of an extra worker.  This is true.  Marginal productivity for the economy as a whole cannot be easily observed, nor indeed even be well defined.  However, one should note that the average productivity curve, as shown here, is rising over time.  This can only happen if marginal productivity on new investments are above average productivity at any point in time.  For other reasons, the real average wage would not rise permanently above average productivity (there would be an “adding-up” problem otherwise), but the theory would still predict a rise in the real wage with the increase in observed productivity.)

There are, however, clear reasons why workers might not be paid the value of their marginal product in the real world.  As noted, the theory applies in markets that are assumed to be perfectly competitive, and there are many reasons why this is not the case in the world we live in.  Perfect competition assumes that both parties to the transaction (the workers and employers) have complete information on not only the opportunities available in the market and on the abilities of the individual worker, but also that there are no costs to switching to an alternative worker or employer.  If there is a job on the other side of the country that would pay the individual worker a bit more, then the theory assumes the worker will switch to it.  But there are, of course, significant costs to moving to the other side of the country.  Furthermore, there will be uncertainty on what the abilities of any individual worker will be, so employers will normally seek to keep the workers they already have to fill their needs (as they know what these workers can do), than take a risk on a largely unknown new worker who might be willing to work for a lower wage.

For these and other reasons, labor markets are not perfectly competitive, and one should not then be surprised to find workers are not being paid the value of their marginal product.  But there is also an important factor coming from the macroeconomy. Microeconomics assumes that all resources, including labor resources, are being fully employed.  But unemployment exists and is often substantial.  Additional workers can then be hired at the current wage, without a need for the firm to raise that wage.  And that will hold whether or not the productivity of those workers has risen.

In such an environment, when unemployment is substantial one should not be surprised to find a divergence between growth in productivity and growth in the real wage.  And while there have of course been sharp fluctuations arising from the business cycle in the rate of unemployment from year to year, the simple average in the rate since 1979 has been 6.4%.  This is well in excess of what is normally considered the full employment rate of unemployment (of 5% or less).  Macro policy (both fiscal and monetary) has not done a very good job in most of the years since 1979 in ensuring there is sufficient demand in the aggregate in the economy to allow all workers who want to be employed in fact to be employed.

In such an environment, of workers being available for hire at a stagnant real wage which over time diverges more and more from their productivity, consider the investment decision a private firm faces.  Suppose they see a market opportunity and can sell more. To produce more, they have two options.  They can hire more labor to work with their existing plant and equipment to produce more, or they can invest in new plant and equipment.  If they choose the latter, they can produce more with fewer workers than they would otherwise need at the new level of production.  There will be more output per unit of labor input, or put another way, productivity will rise if the latter option is chosen.

But in an economy where labor is available at a flat real wage that has not changed in decades, the best choice will often simply be to hire more labor.  The labor is cheap.  New investment has a cost, and if the cost of the alternative (hire more labor) is low enough, then it is more profitable for the firm simply to hire more labor.  Productivity in such a case will then not go up, and may indeed even go down.  But this could be the economically wise choice, if labor is cheap enough.

Viewed in this way, one can see that the interpretation of many conservatives on the relationship between productivity growth and the real wage has it backwards.  Real wages have not been stagnant because productivity growth has been slow.  Labor productivity since 1979 has grown by a cumulative 60%, while real median wages have been basically flat.

Rather, the causation may well be going the other way.  Stagnant and low real wages have led to less and less of an incentive for private firms to invest.  And such a cut-back is precisely what we saw in the chart above on private (as well as public) investment as a share of GDP.  With less investment, the pace of productivity growth has then slowed.

As a reflection of this confusion, conservatives have denounced any effort to raise wages, asserting that if this is done, jobs will be lost as firms choose instead to invest and automate.  They assert that raising the minimum wage, which is currently lower in real terms than what it was when Harry Truman was president, would lead to minimum wage workers losing their jobs.  As a former CEO of McDonalds put it in a widely cited news report from last May, a $15 minimum wage would lead to “a job loss like you can’t believe.”   Fast food outlets like McDonalds would then find it better to invest in robotic arms to bag the french fries, he said, rather than hire workers to do this.

This is true.  The confusion comes from the widespread presumption that this is necessarily bad.  Outlets like McDonalds would then require fewer workers, but they would still need workers (including to operate the robotic arms), and those workers would be more productive.  They could be paid more, and would be if the minimum wage is raised.

The error in the argument comes from the presumption that the workers being employed at the current minimum wage of $7.25 an hour do not and can not possess the skills needed to be employed in some other job.  There is no reason to believe this to be the case.  There was no problem with ensuring workers could be fully employed at a minimum wage which in real terms was higher in 1950, when Harry Truman was president, than what it is now.  And average worker productivity is 2.4 times higher now than what it was then.

Ensuring full employment in the economy as a whole is not a responsibility of private business.  Rather, it is a government responsibility.  Fiscal and monetary policy need to be managed so that labor markets are tight enough to ensure all workers who want a job can get a job, while not so tight at to lead to inflation.

Following the economic collapse at the end of the Bush administration in 2008, monetary policy did all it could to try to ensure sufficient aggregate demand in the economy (interest rates were held at or close to zero).  But monetary policy alone will not be enough when the economy collapsed as far as it did in 2008.  It needs to be complemented by supportive fiscal policy.  While there was the initial stimulus package of Obama which was critical to stabilizing the economy, it did not go far enough and was allowed to run out. And government spending from 2010 was then cut, acting as a drag which kept the pace of recovery slow.  The economy has only in the past year returned to close to full employment.  It is not a coincidence that real wages are finally starting to rise (as seen in the chart above).

E.  Conclusion

Productivity growth is key in any economy.  Over the long run, living standards can only improve if productivity does.  Hence there is reason to be concerned with the slower pace of productivity growth seen since the early 1980s, and especially in recent years.

Investment, both public and private, is what leads to productivity growth, but the pace of investment has slowed since the levels seen in the 1950s and 60s.  The cause of the decline in public investment is clear:  Conservative politicians have slowed or even blocked public investment.  The result is obvious in our public infrastructure:  It is overused, under-maintained, and often an embarrassment.

The cause of the slowdown in private investment is less obvious, but equally important. First, one cannot blame a decline in private investment on a fall in profitability:  Profitability is higher now than it has been in all but one year since the mid-1960s.

Rather, one needs to recognize that the incentive to invest in productivity enhancing tools will not be there (or not there to the same extent) if labor can be hired at a wage that has stagnated for decades, and which over time became lower and lower relative to existing productivity.  It then makes more sense for firms to hire more workers with their existing stock of capital and other equipment, rather than invest in new, productivity enhancing, capital.  And this is what we have observed:  Workers are being hired, but productivity is not growing.

An argument is often made that if firms did indeed invest in capital and equipment that would raise productivity, that workers would then lose their jobs.  This is actually true by definition:  If productivity is higher, then the firm needs fewer workers per unit of output than they would otherwise.  But whether more workers would be employed in the economy as a whole does not depend on the actions of any individual firm, but rather on whether fiscal and monetary policy is managed to ensure full employment.

That is, it is the investment decisions of private firms which determine whether productivity will grow or not.  It is the macro management decisions of government which determine whether workers will be fully employed or not.

To put this bluntly, and in simplistic “bumper sticker” type terms, one could say that private businesses are not job creators, but rather job destroyers.  And that is fine.  Higher productivity means that a firm needs fewer workers to produce what they make than would otherwise have been needed, and this is important for ensuring efficiency.  As a necessary complement to this, however, it is the actions of government, through its fiscal and monetary policies, which “creates” jobs by managing aggregate demand to ensure all workers who want to be employed, are employed.

The Impact of the Reagan and Bush Tax Cuts: Not a Boost to Employment, nor to Growth, nor to the Fiscal Accounts

Private Employment Following Tax Law Changes

A.  Introduction

The belief that tax cuts will spur growth and new jobs, and indeed even lead to an improvement in the fiscal accounts, remains a firm part of Republican dogma.  The tax plans released by the main Republican presidential candidates this year all presume, for example, that a spectacular jump in growth will keep fiscal deficits from increasing, despite sharp cuts in tax rates.  And conversely, Republican dogma also holds that tax increases will kill growth and thus then lead to a worsening in the fiscal accounts.  The “evidence” cited for these beliefs is the supposed strong recovery of the economy in the 1980s under Reagan.

But the facts do not back this up.  There have been four major rounds of changes in the tax code since Reagan, and one can look at what happened after each.  While it is overly simplistic to assign all of what followed solely to the changes in tax rates, looking at what actually happened will at least allow us to examine the assertion underlying these claims that the Reagan tax cuts led to spectacular growth.

The four major changes in the tax code were the following.  While each of the laws made numerous changes in the tax code, I will focus here on the changes made in the highest marginal rate of tax on income.  The so-called “supply-siders” treat the highest marginal rate to be of fundamental importance since, under their view, this will determine whether individuals will make the effort to work or not, and by how much.  The four episodes were:

a)  The Reagan tax cuts signed into law in August 1981, which took effect starting in 1982. The highest marginal income tax rate was reduced from 70% before to 50% from 1982 onwards.  There was an additional round of tax cuts under a separate law passed in 1986, which brought this rate down further to 38.5% in 1987 and to 28% from 1988 onwards. While this could have been treated as a separate tax change episode, I have left this here as part of the Reagan legacy.  Under the Republican dogma, this should have led to an additional stimulant to growth.  We will see if that was the case.  There was also a more minor change under George H.W. Bush as part of a 1990 budget compromise, which brought the top rate partially back from 28.0% to 31.0% effective in 1991.  While famous as it went against Bush’s “read my lips” pledge, the change was relatively small.

b)  The tax rate increases in the first year of the Clinton presidency.  This was signed into law in August 1993, with the tax rate increases applying in that year.  The top marginal income tax rate was raised to 39.6%.

c)  The tax cuts in the George W. Bush presidency that brought the top rate down from 39.6% to 38.6% in 2002 and to 35.0% in 2003.  The initial law was signed in June 2001, and then an additional act passed in 2003 made further tax cuts and brought forward in time tax cuts being phased in under the 2001 law.

d)  The tax rate increases for those with very high incomes signed into law in December 2012, just after Obama was re-elected, that brought the marginal rate for the highest income earners back to 39.6%.

We therefore have four episodes to look at:  two of tax cuts and two of tax increases.  For each, I will trace what happened from when the tax law changes were signed up to the end of the administration responsible (treating Reagan and Bush I as one).  The questions to address are whether the tax cut episodes led to exceptionally good job growth and GDP growth, while the the tax increases led to exceptionally poor job and GDP growth. We will then look at what happened to the fiscal accounts.

B.  Jobs and GDP Growth Following the Changes in Tax Law

The chart at the top of this post shows what happened to private employment, by calendar quarter relative to a base = 100 for the quarter when the new law was signed. The data is from the Bureau of Labor Statistics (downloaded, for convenience, from FRED).  A chart using total employment would look almost exactly the same (but one could argue that government employment should be excluded as it is driven by other factors).

As the chart shows, private job growth was best following the Clinton and Obama tax increases, was worse under Reagan-Bush I, and abysmal under Bush II.  There is absolutely no indication that big tax cuts, such as those under Reagan and then Bush II, are good for job growth.  I would emphasize that one should not then jump to the conclusion that tax increases are therefore good for job growth.  That would be overly simplistic.  But what the chart does show is that the oft-stated claim by Republican pundits that the Reagan tax cuts were wonderful for job growth simply has no basis in fact.

How about the possible impact on GDP growth?  A similar chart shows (based on BEA data on the GDP accounts):

Real GDP Following Tax Law Changes

Once again, growth was best following the Clinton tax increases.  Under Reagan, GDP growth first fell following the tax cuts being signed into law (as the economy moved down into a recession, which by NBER dating began almost exactly as the Reagan tax cut law was being signed), and then recovered.  But the path never catches up with that followed during the Clinton years.  Indeed after a partial catch-up over the initial three years (12 calendar quarters), the GDP path began to fall steadily behind the pace enjoyed under Clinton.  Higher taxes under Clinton were clearly not a hindrance to growth.

The Bush II and Obama paths are quite similar, even though growth during these Obama years has had to go up against the strong headwinds of fiscal drag from government spending cuts.  Federal government spending on goods and services (from the GDP accounts, with the figures in real, inflation-adjusted, terms) rose at a 4.4% per annum pace during the eight years of the Bush II administration, and rose at a 5.6% rate during Bush’s first term.  Federal government spending since the late 2012 tax increases were signed under Obama have fallen, in contrast, at a 2.8% per annum rate.

There is therefore also no evidence here that tax cuts are especially good for growth and tax increases especially bad for growth.  If anything, the data points the other way.

C.  The Impact on the Fiscal Accounts

The argument of those favoring tax cuts goes beyond the assertion that they will be good for growth in jobs and in GDP.  Some indeed go so far as to assert that the resulting stimulus to growth will be so strong that tax revenues will actually rise as a result, since while the tax rates will be lower, they will be applied against resulting higher incomes and hence “pay for themselves”.  This would be nice, if true.  Something for nothing. Unfortunately, it is a fairy tale.

What happened to federal income taxes following the changes in the tax rates?  Using CBO data on the historical fiscal accounts:

Real Federal Income Tax Revenues Following Tax Law Changes

Federal income tax revenues (in real terms) either fell or at best stagnated following the Reagan and then the Bush II tax cuts.  The revenues rose following the Clinton and Obama tax increases.  The impact is clear.

While one would think this should be obvious, the supply-siders who continue to dominate Republican thinking on these issues assert the opposite has been the case (and would be, going forward).  Indeed, in what must be one of the worst economic forecasts ever made in recent decades by economists (and there have been many bad forecasts), analysts at the Center for Data Analysis at the conservative Heritage Foundation concluded in 2001 that the Bush II tax cuts would lead government to “effectively pay off the publicly held federal debt by FY 2010”.  Publicly held federal debt would fall below 5% of GDP by FY2011 they said, and could not go any lower as some federal debt is needed for purposes such as monetary operations.  But actual publicly held federal debt reached 66% of GDP that year.  That is not a small difference.

Higher tax revenues help then make it possible to bring down the fiscal deficit.  While the deficit will also depend on public spending, a higher revenue base, all else being equal, will lead to a lower deficit.

So what happened to the fiscal deficit following these four episodes of major tax rate changes?  (Note to reader:  A reduction in the fiscal deficit is shown as a positive change in the figure.)

Change in Fiscal Deficit Relative to Base Year Following Tax Law Changes

The deficit as a share of GDP was sharply reduced under Clinton and even more so under Obama.  Indeed, under Clinton the fiscal accounts moved from a deficit of 4.5% of GDP in FY1992 to a surplus of 2.3% of GDP in FY2000, an improvement of close to 7% points of GDP.  And in the period since the tax increases under Obama, the deficit has been reduced by over 4% points of GDP, in just three years.  This has been a very rapid base, faster than that seen even during the Clinton years.  Indeed, the pace of fiscal deficit reduction has been too fast, a consequence of the federal government spending cuts discussed above.  This fiscal drag held back the pace of recovery from the downturn Obama inherited in 2009, but at least the economy has recovered.

In contrast, the fiscal deficit deteriorated sharply following the Reagan tax cuts, and got especially worse following the Bush II tax cuts.  The federal fiscal deficit was 2.5% of GDP in FY1981, when Reagan took office, went as high as 5.9% of GDP in FY1983, and was 4.5% of GDP in FY1992, the last year of Bush I (it was 2.5% of GDP in FY2015 under Obama).  Bush II inherited the Clinton surplus when he took office, but brought this down quickly (on a path initially similar to that seen under Reagan).  The deficit was then 3.1% of GDP in FY2008, the last full year when Bush II was in office, and hit 9.8% of GDP in FY2009 due largely to the collapsing economy (with Bush II in office for the first third of this fiscal year).

Republicans continue to complain of high fiscal deficits under the Democrats.  But the deficits were cut sharply under the Democrats, moving all the way to a substantial surplus under Clinton.  And the FY2015 deficit of 2.5% of GDP under Obama is not only far below the 9.8% deficit of FY2009, the year he took office, but is indeed lower than the deficit was in any year under Reagan and Bush I.  The tax increases signed into law by Clinton and Obama certainly helped this to be achieved.

D.  Conclusion

The still widespread belief among Republicans that tax cuts will spur growth in jobs and in GDP is simply not borne out be the facts.  Growth was better following the tax increases of recent decades than it was following the tax cuts.

I would not conclude from this, however, that tax increases are therefore necessarily good for growth.  The truth is that tax changes such as those examined here simply will not have much of an impact in one direction or the other on jobs and output, especially when a period of several years is considered.  Job and output growth largely depends on other factors.  Changes in marginal income tax rates simply will not matter much if at all. Economic performance was much better under the Clinton and Obama administrations not because they raised income taxes (even though they did), but because these administrations managed better a whole host of factors affecting the economy than was done under Reagan, Bush I, or Bush II.

Where the income tax rates do matter is in how much is collected in income taxes.  When tax rates are raised, more is collected, and when tax rates are cut, less is collected.  This, along with the management of other factors, then led to sharp reductions in the fiscal deficit under Clinton and Obama (and indeed to a significant surplus by the end of the Clinton administration), while fiscal deficits increased under Reagan, Bush I, and Bush II.

Higher tax collections when tax rates go up and lower collections when they go down should not be a surprising finding.  Indeed, it should be obvious.  Yet one still sees, for example in the tax plans issued by the Republican presidential candidates this year, reliance on the belief that a miraculous jump in growth will keep deficits from growing.

There is no evidence that such miracles happen.

An Update on the Impact of the Austerity Programs in Europe and a Higher Tax on Consumption in Japan: Still No Growth


GDP Growth in Eurozone, Japan, and US, 2008Q1 to 2014Q3

A.  Introduction

With the release last Friday by Eurostat of the initial GDP growth estimates for most of Europe for the third quarter of 2014, and the release on Monday of the initial estimate for Japan, it is a good time to provide an update on how successful austerity strategies have been.

B.  Europe

As was discussed in earlier posts in this blog on Europe (here and here), Europe moved from expansionary fiscal policies in its initial response to the 2008 downturn, to austerity programs with fiscal cutbacks starting in 2010/11.  The initial expansionary policies did succeed in stopping the sharp downturn in output that followed the financial collapse of 2008/2009.  European economies began to grow again in mid-2009, and by late 2010 had recovered approximately two-thirds of the output that had been lost in the downturn.

But then a number of European leaders, and in particular the leaders of Germany (Chancellor Angela Merkel and others) plus the then-leader of the European Central Bank (Jean-Claude Trichet), called for fiscal cuts.  They expressed alarm over the fiscal deficits that had developed in the downturn, and argued that financial instability would result if they were not quickly addressed.  And they asserted that austerity policies would not be contractionary under those circumstances but rather expansionary.  Trichet, for example, said in a June 2010 interview with La Repubblica (the largest circulation newspaper in Italy):

Trichet:  … As regards the economy, the idea that austerity measures could trigger stagnation is incorrect.

La Republicca:  Incorrect?


So what has actually happened since the austerity programs were imposed in Europe?  The chart at the top of this post shows the path of real GDP for the larger Eurozone economies as well as for the Eurozone as a whole, plus Japan and the US for comparison.  The data for Europe (as well as the US) comes from Eurostat, with figures for 2014Q3 from the November 14 Eurostat press release, while the data for Japan came most conveniently from the OECD.  Real GDP is shown relative to where it was in the first quarter of 2008, which was the peak for most of Europe before the 2008/09 collapse.

In a word, the results in Europe have been terrible.  Real GDP in the Eurozone as a whole is basically the same as (in fact slightly less than) what it was in early 2011, three and a half years ago.  To be more precise, real GDP in the Eurozone fell by a bit more than 1% between early 2011 and early 2013, and since then rose by a bit over 1%, but it has basically been dead.  There has been no growth in the three and a half years since austerity programs took over.  And Eurozone output is still more than 2% below where it had been in early 2008, six and a half years ago.

Since early 2011, in contrast, the US economy grew by 8.6% in real terms.  Annualized, this comes to 2.4% a year.  While not great (fiscal drag has been a problem in the US as well), and not sufficient for a recovery from a downturn, the US result was at least far better than the zero growth in the Eurozone.

There was, not surprisingly, a good deal of variation across the European economies.  The chart shows the growth results for several of the larger economies in the Eurozone.  Germany has done best, but its growth flattened out as well since early 2011.  As was discussed in an earlier post, Germany (despite its rhetoric) in fact followed fairly expansionary fiscal policies in 2009, with further increases in 2010 and 2011 (when others, including the US, started to cut back).  And as the chart above shows, the recovery in Germany was fairly solid in 2009 and 2010, with this continuing into 2011.  But it then slowed.  Growth since early 2011 has averaged only 0.9% a year.

Other countries have done worse.  There has been very little growth in France since early 2011, and declines in the Netherlands, Spain, and Italy.  Spain was forced (as a condition of European aid) to implement a very tight austerity program following the collapse of its banking system in 2008/09 as a consequence of its own housing bubble, but has loosened this in the last year.  Only in France is real GDP higher now than where it was in early 2008, and only by 1.4% total over those six and a half years.  But France has also seen almost no growth (just 0.4% a year) since early 2011.

C.  Japan

The new figures for Japan were also bad, and many would say horrible.  After falling at a 7.3% annualized rate in the second quarter of this year, real GDP is estimated to have fallen by a further 1.6% rate in the third quarter.  The primary cause for these falls was the decision to go ahead with a planned increase in the consumption tax rate on April 1 (the start of the second quarter) from the previous 5% to a new 8% rate, an increase of 60%.

The Japanese consumption tax is often referred to in the US as a sales tax, but it is actually more like a value added tax (such as is common in Europe).  It is a tax on sales of goods and services to final consumers such as households, with offsets being provided for such taxes paid at earlier stages in production (which makes it more like a value-added tax).  As a tax on consumption, it is the worst possible tax Japan could have chosen to increase at this time, when the economy remains weak.  There is insufficient demand, and this is a straight tax on consumption demand.  It is also regressive, as poor and middle class households will pay a higher share of their incomes on such a tax, than will a richer household.  With its still weak economy, Japan should not now be increasing any such taxes, and increasing the tax on consumption is the worst one they could have chosen.

With recessions conventionally defined as declines in real GDP in two consecutive quarters, Japan is now suffering its fourth recessionary contraction (a “quadruple-dip” recession) since 2008.  This may be unprecedented.  Japan’s output is still a bit better, relative to early 2008, than it is for the Eurozone as a whole, but it has been much more volatile.

Prime Minister Shinzo Abe was elected in December 2012 and almost immediately announced a bold program to end deflation and get the economy growing again.  It was quickly dubbed “Abenomics”, and was built on three pillars (or “arrows” as Abe described it).  The first was a much more aggressive monetary policy by the Central Bank, with use of “quantitative easing” (such as the US had followed) where central bank funds are used to purchase long term bonds, and hence increase liquidity in the market.  The second arrow was further short-term fiscal stimulus.  And the third arrow was structural reforms.

In practice, however, the impacts have been mixed.  Expansionary monetary policy has been perhaps most seriously implemented, and it has succeeded in devaluing the exchange rate from what had been extremely appreciated levels.  This helped exporters, and the stock market also boomed for a period.  The Nikkei stock market average is now almost double where it was in early November 2012 (when it was already clear to most that Abe would win in a landslide, which he then did).  But the impact of such monetary policy on output can only be limited when interest rates are already close to zero, as they have been in Japan for some time.

The second “arrow” of fiscal stimulus centered on a package of measures announced and then approved by the Japanese Diet in January 2013.  But when looked at more closely, it was more limited than the headline figures suggest.  In gross terms, the headline expenditure figure amounted to a bit less than 2% of one year’s GDP, but the spending would be spread over more than one year.  It also included expenditures which were already planned.  It therefore needs to be looked at in the context of overall fiscal measures, including the then planned and ultimately implemented decision to raise the consumption tax rate on April 1, 2014.  The IMF, in its October 2013 World Economic Outlook, estimated that the net impact of all the fiscal measures (including not only the announced stimulus programs, but also the tax hike and all other fiscal measures) would be a neutral fiscal stance in 2013 (neither tightening nor loosening) and a tightening in the fiscal stance of 2.5% of GDP in 2014.  The fall in GDP this year should therefore not be a surprise.

Finally, very little has been done on Abe’s third “arrow” of structural reforms.

On balance, Abe’s program supported reasonably good growth of 2.4% for real GDP in 2013 (see the chart above).  There was then a spike up in the first quarter of 2014.  However, this was largely due to consumers pulling forward into the first quarter significant purchases (such as of cars) from the second quarter, due to the planned April 1 consumption tax hike.  Some fall in the second quarter was then not seen as a surprise, but the fall turned out to be a good deal sharper than anticipated.  And the further fall in the third quarter was a shock.

As a result of these developments, Abe has announced that he will dissolve the Diet, hold new elections in mid-December with the aim of renewing his mandate (he is expected to win easily, due to disorder in the opposition), and will postpone the planned next increase in the consumption tax (from its current 8% to a 10% rate) from the scheduled October 2015 date to April 2017.  Whether the economy will be strong enough to take this further increase in a tax on consumption by that date remains to be seen.  The government has no announced plans to reverse the increase of 5% to 8% last April.

Japan’s public debt is high, at 243% of GDP in gross terms as of the end of 2013.  Net debt is a good deal lower at 134% (debt figures from IMF WEO, October 2014), but still high.  The comparable net debt figure for the US was 80% at the end of 2013 (using the IMF definitions for comparability; note this covers all levels of government, not just federal).  Japan will eventually need to raise taxes.  But when it does, with an economy just then emerging from a recession due to inadequate demand, one should not raise a tax on consumption.  A hike in income tax rates, particularly on those of higher income, would be far less of a drag on the economy.

The Government Debt to GDP Ratio is Falling

Fed Govt Debt as Share of GDP, 2006Q1 to 2014Q3

The US federal government debt to GDP ratio is falling.  A few years ago, conservative critics (such as Congressman Paul Ryan) argued that if drastic action were not taken immediately to slash government expenditures, consequent rapidly rising federal government debt would stifle growth and spiral ever upwards.  Liberals (such as Paul Krugman) argued that the federal deficit and debt were far less of a concern than these critics asserted:  With the recovery of the economy, both would soon start to fall.  And the detailed projections from the Congressional Budget Office backed this up, with projected falls in the debt to GDP ratio for at least a few years.  There would be a rise later if nothing further is done, in particular on medical costs, but the question at issue here is whether the debt to GDP ratio could fall in the near term without drastic cuts in government expenditures.  Conservatives asserted it would not be possible.

But these were projections and assertions.  The chart above shows the actual data.  With the release this morning by the Bureau of Economic Analysis of its first estimate of 2014 third quarter GDP (growth at a fairly solid 3.5% real rate), one can now see that there has been a downward turn in the debt to GDP ratio.  The ratio peaked at 72.8% of GDP in the first quarter of 2014, and dropped to 72.2% as of the third quarter.

The federal government debt figure used here is the debt held by the public.  There are also various trust funds (most notably the Social Security Trust Fund) that formally hold government debt in trust, but this reflects internal accounting within government.  The figures come from the US Treasury, with quarterly averages taken based on an average of the amounts outstanding each day of the quarter.  This average is then taken as a share of nominal GDP for the quarter (nominal GDP since debt is also a nominal concept).  And since nominal GDP reflects the flow of production over the course of the quarter, taking the daily average debt outstanding over the course of the quarter will better reflect the debt burden than simply taking debt as of the end of the quarter and dividing this by GDP (although this is commonly done by many).

There was an earlier downward dip in the public debt to GDP ratio in the third quarter of 2013, but this was due to special circumstances surrounding the delay by Congress to approve a rise in the statutory government debt ceiling.  Various accounting tricks were used to delay recognition of items that would add to the formally defined government debt in order to keep under the ceiling, which artificially suppressed the debt to GDP ratio in that quarter.  This carried over into the fourth quarter, with the Republicans forcing a shutdown of the federal government from October 1 by not approving a new budget.  The dispute was not resolved until October 16, when deals were reached to raise the debt ceiling and to approve a budget.  The debt ratio then returned to its previous path.

The fall in the debt ratio in 2014 is more significant.  Accounting tricks are not now being used due to debt ceiling disputes, and the fall reflects the continued fall in the fiscal deficit coupled with reasonably sound growth.  The deficit is estimated to have totaled $483 billion in fiscal 2014 (which just ended on September 30), or 2.8% of GDP.  This is sharply down from the $1.4 trillion (or 9.8% of GDP) of fiscal 2009, in the first year of the downturn.  The fiscal deficit has fallen primarily due to the recovery, but also due to cuts in federal government expenditures under Obama since 2010.  While not nearly as drastic as Congressman Ryan and other conservatives had insisted would be necessary, government spending has still fallen under Obama, in contrast to the increases allowed in previous downturns.

Note that the government expenditure cuts that were done do not represent what would have been the desirable path in deficit reduction:  As discussed in an earlier post on this blog, it would have been far better to follow a fiscal path similar to that followed by Reagan and others in earlier downturns, with government spending allowed to grow so that the economy could have more quickly returned to full employment.  Once full employment was reached, one would then consider fiscal cuts, if warranted, to address any debt concerns.

The path followed has thus been far from optimal.  But it has shown that the alarms raised by the conservative critics, that the debt to GDP ratio could not fall without drastic government cutbacks (far more severe than that seen under Obama), were simply wrong.