Economic Growth, Budgetary Balance and 1997 Fiscal Policy

By Ooms, Van Doorn | Business Economics, October 1997 | Go to article overview

Economic Growth, Budgetary Balance and 1997 Fiscal Policy


Ooms, Van Doorn, Business Economics


Why should we balance the federal budget? Although a balanced budget is now firmly established in Washington as a political goal, presumably the ultimate purpose of a balanced budget is to raise national saving and investment, labor productivity, output, incomes, and future living standards. While this rationale may seem obvious to mainstream economists, it is often forgotten during the formulation of fiscal policy, with unfortunate consequences.

The issue posed with regard to economic growth is how much consumption society should sacrifice today to make investments that will increase incomes and consumption in the future. Economics provides little practical guidance on this question. Nevertheless, three considerations now argue that the recent growth of potential GDP of just over 2 percent per year is too low.

1. A public sense of "diminished expectations" has resulted from the near-stagnation of average real wages during the past twenty to twenty-five years. This stagnation stems from the sharp slowdown in labor productivity growth from an annual average of nearly 3 percent during the quarter century following World War II to about 1 percent since 1973.

2. The increasing inequality of earnings and incomes around this stagnating average has for the first time reduced real incomes for a significant portion of the U. S. population, especially for less-educated and less-skilled workers.

3. Retirement of the baby-boomers that will begin in just a decade will raise the ratio of the retirement-age to working-age population by about 50 percent over the next thirty years. This will put significant downward pressure on the living standards of both retirees and workers unless stronger growth produces a larger "economic pie" to be divided between them.(1)

If stronger growth should therefore be a high national priority, what can federal budget policy do to achieve it?

GROWTH, INVESTMENT, SAVING, AND THE BUDGET

Capital Formation and Economic Growth

A realistic evaluation of the potential for budget policies to increase economic growth requires some understanding of the sources of growth. Productive capacity is determined by the supplies of productive factors, such as labor, machines, structures, education, and skills, and the technology ("knowledge") that determines how productively these factors are used. This productive capacity, on a per capita basis, ultimately determines average living standards.

While estimates differ regarding the relative contributions of different factors to growth, virtually all studies have found that the increase in factor supplies, conventionally measured, leaves a very large proportion of growth "unaccounted for." The residual, unexplained portion is normally attributed to "technological change," usually identified with advances in knowledge and applied "know how." Solow's seminal work attributed 82 percent of the 1909-49 increase in labor productivity to technical progress, with the remaining 18 percent due to capital accumulation. The "growth accounting" of Denison, identifying more of the residual factors, attributed 44 percent of the 1929-82 increase in output per worker to "advances in knowledge" and 20 percent to capital accumulation; education of the labor force was found to contribute about 27 percent, with the remainder due to other factors, the most important being scale economies and improved resource allocation, principally the reallocation of labor to higher productivity jobs.2

In principle, budget policies might address any or all these sources of growth, and significant federal expenditures are, in fact, devoted to public physical capital, human capital, and R&D. Nevertheless, the focus of budget policy in recent years has been primarily on reductions in the federal budget deficit that might raise national saving and private capital formation. We therefore concentrate on this issue.

Although standard growth accounting appears to assign a relatively small role in growth to capital formation, this can be misleading. …

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