Make American Productivity Great Again: The case for targeted supply-side policies

In the post-WWII era, the US economy has been positioning itself as global technological leader. In 1990, the US had a leading role in the field of education by an arm’s length, but in 2017 it has been overtaken by many other OECD countries (Figure 1). The same is true for total R&D spending as a percentage of GDP (so-called R&D intensity): the US used to be one of the leading countries in R&D investment, but recently has made far less progress in raising growth than many other countries (Figure 2). A waning relative position in R&D spending does not seem to be limited to the US, but seems to be a pattern that applies to Anglo-Saxon countries in general. So obviously, one cannot solely blame the current US administration for sliding innovative capacity of the US economy, but we can’t say either that the Trump administration is making any efforts to reverse that trend. Moreover, it probably is aggravating the situation, given the (proposed) budget cuts in the fields of science, innovation and education.

The consequence of sluggish investment in the field of innovation, education and science most likely has a direct link to US labor productivity woes (Figure 3). Average annual US productivity growth has slowed down from 1.8% over the period 1970-2010 to a meagre 0.4% between 2010 and 2018. To compare, in the Euro Area the productivity slowdown between 1996-2010 and 2010-2018 was only 0.2ppts annually. The large drop in the US is due to a combination of poor capital contribution of 0.1ppts and a substantial slowdown of TFP growth. TFP growth deteriorated from an average annual growth of 1.1% over the period 1969-2010 to 0.4% in 2010 to 2018.

In the last two decades, US policymakers have not been giving science, innovation and education much attention. However, these factors are important pillars of US potential growth. Paul Romer, founding father of the endogenous growth theory, for which he received the Nobel Prize for Economics last year, has shown that growth of potential output is not an exogenous process, but requires investment in Research and Development (R&D) and human capital. Hence, US potential growth is not a completely autonomous process, but can be influenced by policy choices.

While previous administrations already weren’t making policy choices in favor of these growth drivers, the Trump administration is going one step further: it is slashing budgets for science, innovation and education. In the 2018 budget proposal, the administration aimed to reduce Research and Development (R&D) funding by 5%, but this figure is even positively biased, as it includes higher spending on defense R&D as well. In reality, the budget cuts for several public research bodies are much larger, with especially the Environmental Protection Agency (EPA) taking a hit. The 2019 Budget proposal was no different: NASA, the EPA, the National Institutes of Health, the National Science Foundation and various other institutions all face budget cuts in Trump’s plans. This year’s budget request from the Ministry of Education proposes to eliminate 29 programs, which embodies cuts of USD 8.5bn and lowers spending levels by 12% compared to fiscal 2019.

The Trump administration has taken a different approach to stimulating the economy. Instead of targeting endogenous growth factors, a generic tax cut was the policy of choice. This is an approach that was advocated by ‘supply-side economists’ in the early 1980s, based on the assumption that slashing tax rates would on balance generate more tax revenue because the increase in the tax base (caused by higher economic activity as higher-than-optimal marginal tax rates are reduced) would outweigh the loss in tax revenue due to lower taxation. However, there is no empirical evidence that this assumption - the US economy operating on the downward-sloping segment of the Laffer curve - holds in reality. In fact, Trump’s massive tax overhaul which was implemented early 2017, the Tax Cuts and Jobs Act (TCJA), is proving to be a costly one: estimates of the amount of debt added over a time span of ten years center around USD 1,500bn, as we will discuss below. So the generic tax cut will cost a lot of money, but is this the most efficient way to stimulate US economic growth? More specifically, the question we ask ourselves in this Special is: is the Trump administration making the best policy choices to boost the potential growth rate of the US economy, which is more important in the long run than a short-term boost to economic growth? In other words, which policy option would benefit the US economy the most?

We take a three-step approach in this study. First, to assess the supply side of the US economy we develop an endogenous framework which enables us to calculate the level of US potential growth. Second, we run a scenario analysis of what the impact on the US economy would have been if the Trump administration had launched an alternative plan focusing on innovation, science and education, rather than implementing the Tax Cuts and Jobs Act. Third, we examine if such a supply-side driven policy agenda would be effective in averting or mitigating the cyclical slowdown that we expect in 2020.

Our first step is to set up a framework which we can use to forecast US potential GDP growth. Potential GDP growth is the growth of output that the US economy can sustain over the longer term without triggering substantial inflationary pressure. It is possible for an economy to grow above potential output for a while, but ultimately a situation of overemployment, overtime for workers and a higher than usual rate of utilization of machinery will generally lead to upward pressure on wages and capital compensation and will pull back the economy toward more sustainable growth levels.

The level of potential output of an economy is determined by the supply side of the economy, which is determined by labor inputs and labor productivity per hour (figure 4). Labor inputs can be broken down into the amount of persons employed and the amount of hours worked by each worker. Labor productivity per hour is determined by capital per hour, which encompasses IT capital (software, computers, mobile phones, etc.) and non-IT-capital (buildings, infrastructure, machines), and a residual factor: total factor productivity (TFP). TFP arguably is the purest indicator of technology, as it indicates how productive both capital and labor are in generating value added. Some important proven key factors of TFP are Research & Development (R&D), human capital, domestic competition, technological catching-up, foreign competition through trade and entrepreneurship.

Our calculations show that, under current policies, the US has the potential to grow by 2.0% on an annual basis between 2019 and 2030.

Now that we have our fully endogenized supply-side framework in place, we can run scenarios what the impact of different policy options would be on the US economy. We run two scenarios. In our first scenario, we calculate the impact of a R&D stimulus package replacing the Tax Cuts and Jobs Act. In a second scenario, we assess the impact of a policy agenda focusing on actively stimulating human capital to levels of global frontrunner Germany. Before we can run these scenarios, however, we need to strip the effect from the TCJA from our baseline.

Stripping out the effect of the Tax Cuts and Jobs Act from the baseline

The Tax Cuts and Jobs Act was implemented in January 2017. According to initial calculations by the Tax Foundation, the Joint Committee on Taxation, and the Tax Policy Center, the Act will lower federal tax revenues by roughly USD 1500bn over ten years (2018-2027).

Most analysts tend to agree that the TCJA is costly, but the question is what additional economic growth it generates. According to a thorough study by the Tax Foundation, the TCJA would increase GDP by an average of 0.3ppts annually over the next decade. On average, US GDP would arrive at 2.13% under the new tax regime compare to 1.84% under the previous circumstances. 2018 would see the largest impact of the tax reforms, raising GDP growth by 0.44ppts compared to the baseline. According to our own calculations, the corporate tax cut from 35% to 21% would boost GDP by 1.9ppts vis-à-vis the baseline, registering the largest impact in 2018 of 1.6ppts. We expect a limited impact on private consumption, as the largest cuts as a share of income is going to taxpayers in the 95th to 99th percentiles of the income distribution. It is common knowledge that the wealthiest people have the lowest marginal propensity to consume.

If we shift our focus to the supply side of the economy, we have calculated that the impact of the TCJA results in a boost of capital contribution of 0.7ppts in 2018 vis-à-vis the baseline and an additional 0.3ppts in 2019. The impact in subsequent years is marginal at best. Moreover, we do not estimate a statistically and economically significant impact of lower corporate taxes on TFP growth.

In this first scenario, we conduct a thought experiment in which we calculate the counterfactual of what would happen if the US administration had not chosen to cut taxes and instead had invested this money (i.e. USD 1500bn) into stimulating R&D.

The government could stimulate R&D expenditure directly by raising subsidies to research institutes and universities, or by giving financial incentives to the private sector to spend more on R&D. A common instrument is the use of R&D tax credits, which seems to be an effective way to stimulate business R&D expenditure. A wide range of international research shows that additional public resources allocated to R&D tax credits leads to higher private R&D spending. Based on more recent studies we assume that an increase of USD 1000bn in tax credits would generate USD 500bn in additional private R&D expenditure.

Ultimately, we allocate USD 500bn of the TCJA revenue loss to public R&D investment and allocate 1000bn by raising the corporate R&D tax credit, which results in additional private R&D spending of 500bn. Both impulses are distributed over 13 years (2018-2030).

In our second scenario we assume that the US, next to the R&D policy stimulus, will raise its policy efforts to close the gap to the global frontrunner in the field of education: Germany. In scenario 2, higher productivity growth on the back of the impulse in R&D and human capital would result in additional economic growth of 14ppts in total, compared to our baseline scenario (Figure 6). So roughly speaking, an alternative education agenda would roughly double the GDP gains from scenario 1.

One of the upsides of higher potential growth is that it has a mitigating impact on negative cyclical swings as well. The line of reasoning here is simple: an economic bust due to weakness in aggregate demand is relative to the potential growth. A higher level of potential growth will therefore keep actual growth higher, and may even prevent it to go below zero. In our most recent forecasts, we have penciled in a recession in the US in 2020. To assess the mitigating impact of higher potential growth on the US recession, we use our macro-econometric trade model NiGEM to run a forecast of US GDP growth with the TFP trajectories of both scenario 1 and scenario 2 factored in. The results show that it will be very hard to avoid a recession in the US, even if the government were to launch the substantial supply-side stimulus incorporated in scenario 1 and 2 (Figure 7). However, the downturn would be substantially less deep: -0.8% cumulative in our baseline, -0.3% in scenario 1 and -0.1% in scenario 2. What is more important, the recovery from the bust would be much stronger in both scenarios compared to the baseline. Over the longer term, the differences in actual growth are equal to the already mentioned effects that apply to the supply side of the economy: 6¼ppts additional growth in scenario 1 compared to the baseline and 14ppts in scenario 2.

In this Special we argue that over the past administrations, US policymakers have shifted their focus too much to lifting short-term economic activity and boosting the stock market rather than stimulating the supply side of the US economy. This has resulted in a substantial slowdown of US productivity growth. The Trump administration is exacerbating this development by slashing budgets for science, innovation and education. Although generic tax cuts are providing relief in the short term, ongoing sluggish productivity growth is slowly eroding the core of the US economy. This will make the economy much more vulnerable to cyclical downturns in the long run. After all, if economic growth will continue to hover at low levels, only a modest headwind could push the economy into a recession.

We also claim that sluggish productivity development in the US is not an exogenous development, but something which is affected by the decisions of policymakers. All in all, economic policymaking is about incentives. A generic corporate tax cut, which was lowered from 35% to 21% under the TCJA, only partly translates in higher investment and has primarily boosted shareholder value. In contrast, an innovation and education agenda forces firms and public research bodies to allocate the funds to productivity-enhancing investments, but this policy route requires more patience, as the impact will take some years to materialize.

Our calculations show that fostering productivity growth by means of implementing a broad innovation, science and education agenda would lift US potential growth substantially. Investing the revenue losses of the Tax Cuts & Jobs Act of USD 1500bn in a program fostering public and private R&D would raise potential growth by more than 6ppts cumulatively compared to the baseline (up to 2030). An additional policy agenda focusing on intensifying investment in education on top of R&D stimulus could even raise potential GDP growth by 14ppts.

The upsides of such a policy shift would not be limited to solely higher potential growth. First, raising potential GDP growth also mitigates the negative impact of a potential US downturn. Second, fostering economic growth by means of innovation would raise competitiveness of the American corporate sector, which provides second-order effects in terms of job opportunities for US workers in the long run. Third, an innovation and science policy agenda could be targeted to boost research on tackling (global) societal challenges in the field of, e.g., climate change, nutrition and health, food and water security and sustainable agriculture, clean and efficient energy, smart green and integrated transport, cyber security and counterterrorism. Fourth, policies focusing on potential GDP growth have higher returns to the government in terms of tax receipts, so in the end government debt will be lower. This is (in terms of % GDP) amplified further by the higher level of GDP (denominator effect).

Lastly, the positive impact would stretch much further than US shores. It is well-known that countries can benefit from the others that are close to the technological frontier. This process is referred to as ‘technological catching-up’, and its impact is quite substantial. Indeed, over the past decades, US technologies and innovations reshaped every-day life across the globe, ranging from the laser, the internet, smartphones, personal computers to chemotherapy. Higher prosperity in other parts of the world due to US innovations leads to more export opportunities for US firms in the second round as well. Knowledge spillovers from US innovations in the past have been the result of decisions by policymakers in the US determined to provide the best education and take the lead in public research in combination with US firms focusing on outpacing their competitors by means of investment in R&D to deliver the best products and services. At the moment, it could even be argued that sluggish investment by the US in science, innovation and education is one of the main culprits behind the slowdown of global productivity growth. And from this context, it becomes even more important for the US presidential election campaign, which will kick off next year, to focus on the key aspects that will shape the future of the US and global economy.