Assessment and recommendations
The economic expansion that followed the 2001 recession continues at a healthy pace. This is all the more remarkable since economic growth in 2006 – 3¼ per cent as in the year before – was achieved in the face of strong headwinds, such as surging energy prices until the summer and a sharp decline in home construction through the year. The resilience and continued good performance of the economy can in part be traced to past regulatory reforms that created a very competitive environment by international comparison and contributed to impressive efficiency gains over the past decade. With robust growth, labour markets have tightened and some capacity pressures have emerged. Still, given the energy price shock, core inflation has remained relatively well contained, as price and wage setters have expected the monetary authorities to keep inflation low. Although the fiscal stance has been broadly neutral, government finances have continued to improve thanks to an ongoing buoyancy of revenues that has outweighed additional spending. At the same time, the current account deficit has broadly stabilised relative to GDP – albeit at a high level, reflecting the strength of export growth and lower energy prices.
Challenges facing the US economy
Economic performance has improved considerably in the past decade or so. This is most manifest in the marked acceleration in productivity, the major determinant of standards of living. More recently, economic growth has remained fairly solid despite a sharp housing market correction, and prospects are good for continued expansion, although capacity pressures pose some inflationary risks. Nonetheless, there are a number of longer-term challenges facing the economy. Potential growth is slowing as demographic changes weigh on labour supply while there are considerable public spending pressures as the population ages. It is therefore all the more important to pursue policies that are conducive to further efficiency gains. Together with entitlement reform, this would facilitate putting government finances on a sustainable footing. Tax reform is also essential, both for efficiency reasons and better targeting those in need. In particular, it would be desirable to reduce the distorting and poorly targeted tax concessions in the housing market. Finally, improvements in the education system, which produces mixed results, are important to long-run productivity growth and competitiveness.
The trend growth rate of GDP has slowed, mainly because of tighter limits on how quickly employment can grow. In particular, the labour force participation rate, which used to be rising quickly, is now trending down. Against this background, this chapter considers three policies that bear on long-term employment trends. Raising the age at which workers become eligible for full social security benefits would discourage premature retirement and make the social security system more financially secure. The disability insurance system is discouraging a rising share of the population from staying in the workforce and should be made less generous and more selective. Substantial increases in the federal minimum wage are planned; however, increases in the Earned Income Tax Credit would achieve the same objectives more effectively and with less risk of job losses.
Ensuring fiscal sustainability
The recent improvement in federal government finances reflects surprisingly buoyant tax receipts rather than discretionary measures, with public spending as a share of GDP remaining on a rising trend. The new official target of balancing the unified federal budget by 2012 is the minimum, given the bleak longer-term fiscal outlook. Reintroduced budget rules may be helpful in achieving it. But reforming entitlement programmes is the main imperative. Under current law, public spending on retirement and health care is projected to approach by the middle of the century a fifth of GDP (equivalent to current total federal expenditure). Soaring budget deficits would entail a government debt that could reach twice the size of GDP at that time. The situation is particular worrying for health care programmes, where cost pressures compound the effect of population ageing. Whether revenues need to be increased will depend on the success in curbing spending. But tax reform is desirable in any case with a view to enhancing economic efficiency.
Household debt has risen particularly fast over the past decade in the United States. The outstanding amount of household financial liabilities increased from 89% of personal disposable income in 1993 to 139% in 2006, an unusually large rise by historical standards. Although similar run-ups occurred in other OECD countries, the increase was particularly substantial in the United States. The run-up in debt largely reflected the buoyancy of the housing market, the use of new financial instruments to extract equity from houses and the market entry of lenders willing to extend loans of lower credit quality. There has been recently a sharp rise of delinquencies among subprime borrowers, leading to financial difficulties among specialised lenders, which has so far not spread to other markets. US policies have traditionally played a key role in encouraging affordable homeownership. The tax system favours investment in housing, but at the expense of other household assets, and it mostly benefits highincome families rather than other house buyers. The government sponsorship of mortgage enterprises has also done little to promote affordable homeownership, but resulted in the accumulation of large mortgage loan portfolios, which pose a risk to financial stability and represent large contingent liabilities for the taxpayer. Policy recommendations are suggested to reduce these distortions.
Improving primary and secondary education
The average educational attainment of US students is weak by international comparison. For example, mean results of PISA test scores are below the OECD average. This is despite substantial resources devoted to the schooling system. One partial explanation for this is that academic standards, curriculum and examinations are not sufficiently challenging in most US states. In 2001, Congress enacted the No Child Left Behind Act (NCLB) to raise achievement levels, especially of certain groups that perform badly. The Act requires states to establish clear content standards as to what students should know, to regularly assess performance and to set thresholds for adequate yearly progress; it also requires schools where students are failing to meet such thresholds to improve or close, while enhancing options for parents of children in such schools to place their children elsewhere. The law appears to be well conceived, addressing key problems in a sensible manner. Preliminary indications are consistent with it raising school performance and closing achievement gaps. The NCLB legislation should therefore be reauthorised. Moreover, the NCLB framework of standards, assessment and accountability should be extended through upper secondary education. That said, there are a number of areas in which improvements could be made. Though the federal government cannot set standards, it could strengthen incentives for more states to make their standards more challenging. As well, the federal government should help states and districts to better test student achievement and assess progress.
Financing higher education
America’s higher education system is among the best in the world but there are, nevertheless, areas for improvement. In particular, there appear to be substantial financial barriers to higher education despite large government expenditures aimed at promoting access. Policy makers have proposed addressing these barriers by increasing student grants. However, grants are fiscally costly, they have unattractive efficiency and equity implications and research does not show them to be effective. Income tax concessions and state government subsidies suffer from similar problems. In contrast, international best practice seems to be converging on student loans with repayments that vary according to income. Income-contingent loans facilitate access to college at low fiscal cost and without the inefficiency and inequities that accompany grants, subsidies or tax concessions. At the same time, they do not discourage riskaverse or uninformed students in the way that conventional loans do. The United States has an income-contingent loan programme that should be expanded. While the design of repayments could be improved, the main problem with this programme is that lending limits are too low. Higher limits, especially for unsubsidised direct loans, would benefit students and promote access at little cost to the government. Were a good system of loans in place, then less cost-effective means of promoting access, such as grants and tax concessions, should be cut back.
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