Click here for a printer-friendly version of this article.
In his State of the Union address, President Obama used the word “compete” or its derivatives ten times. The remarks were delivered only a few weeks after a poll found that just one in five Americans think that the U.S. economy is the world’s strongest, compared to nearly half who picked China. The President, seeking to allay these concerns, focused on “winning the future” and then outlined a competitiveness agenda of increasing government investment and reforming corporate taxes. Despite Obama's rhetoric of competition among nations, only the tax proposal is likely to help America’s competitiveness.
Many conservatives jumped on the President’s use of “investment” as a euphemism for more spending. While government investment is government spending, it can contribute to economic growth. According to the Bureau of Economic Analysis, 20% of U.S. GDP comes from government investment and consumption. This is not the commonly cited measure of the absolute size of the government’s budget relative to the economy, but rather the actual contribution to output made by federal investments in the defense industry, state and local infrastructure projects, and other government outlays that go directly to acquiring goods and services. When the government pays to build a bridge, for example, the spending goes directly to the government investment account in the GDP calculation; when the government makes a transfer payment to a household, any resulting change in GDP comes from consumption expenditures, not from government.
Increasing government investment may seem like a good way to boost GDP, particularly when one looks at the scale of recent Chinese infrastructure spending and the high-quality of that nation’s airports and rail system. Columnist Tom Friedman makes the case for greater U.S. infrastructure spending by joking that the flight from Hong Kong to JFK airport in NY is “like going from the Jetsons to the Flintstones.” To compete with China, it is argued, the U.S. needs to increase infrastructure spending to ensure that it is on par with that of China.
China’s economy has benefited from massive government investment. This should come as no surprise given how poor the country was just 20 years ago. Large-scale infrastructure investment has always been a way to generate rapid economic growth in the short-run. It is important to remember that the first five-year plan of the Soviet Union was regarded by many (at the time) as a breakthrough in economic development. The plan dramatically modernized the country’s infrastructure through the construction of dams, railroads, canals, mines and factories, and dramatically increased industrial output of steel and iron. From 1928-1940, the Soviet economy doubled, with the total capital stock growing at 9% per year during that period. For decades, this experience led developmental economists to believe that rapid industrialization and protection for nascent industries was the surest path to higher standards of living.
As the Soviet Union later found out, the challenge is sustaining this development once the top-down planners have exhausted all of the obvious developmental projects. At a certain point on the economic development curve, the marginal benefits of incremental infrastructure spending begin to approach zero. So many “developing economies” never reach developed-country status because they lack vibrant private sectors to pick up the baton once the marginal benefits of government investment have diminished. Rich countries, like Japan that have pursued large-scale infrastructure spending to supplement the private sector have squandered huge amounts of resources in the process. Japan may have airports and railways that meet and surpass Friedman’s “Jetsons” test, but this has not allowed the Japanese economy to break free from a malaise that has lasted for the better parts of two decades. This should be obvious, as replacing an aging existing airport with a pristine, new all-glass terminal does nothing to directly increase the airport’s capacity to move people and goods. This form of national competition is based on aesthetics, rather than productive capacity, and distracts attention from the real competitive challenges the U.S. faces.
Rather than press for higher spending, the federal government should assist states and municipalities in reorienting their spending to rebuild the existing infrastructure. Instead of grandiose new airports, the many cities in the U.S. need more runways to allow for more flights. As explained in a recent e21 editorial, gross investment was equal to 26% of all state and local spending in 1950, but has declined to just 15% of all state and local spending since 1990. Rather than diverting more resources towards government investment, policymakers should improve the way current spending is distributed (or tax revenue is allocated). Money that now goes towards out-of-control compensation could be used to repave roads, repair bridges, straighten rails, and make other marginal improvements that actually would increase productivity.
The same is true for “high-technology” infrastructure projects like high-capacity internet and high-speed rail. Existing infrastructure often delays the adoption of new technology, but in ways that are rational and economical. For example, mobile phone penetration rates in countries that lacked a landline telephone infrastructure grew much faster than in the U.S. The marginal benefit of mobile phones is much greater if the alternative is no phone line, making the discrepant income-adjusted growth rates entirely reasonable. Similarly, at the end of 2009 there were only 76 million motor vehicles in China (population: 1.3 billion) compared to 246 million in the U.S. (population: 300 million). Much of China’s high-speed rail infrastructure development is for households that lack other means of transportation. Again, faster adoption is therefore rational. If the U.S. wanted to achieve similar growth in these areas, policymakers could impose taxes on the use of existing infrastructure, like gasoline excise taxes to discourage the use of cars for intercity passenger trips. This would speed adoption of new transportation technology, but not necessarily increase the country’s competitiveness.
Policymakers concerned about competition among nations need to ensure tax policies are conducive to business activity. To that end, we must raise our tax revenue more efficiently. The President correctly identified the corporate income tax as “rigged” and riddled with loopholes. Those loopholes make the effective tax rate corporations pay significantly lower than the 35% statutory rate. As a result, a revenue-neutral plan is likely to create as many winners as losers, as the Bush Administration found out when its Treasury Department researched the issue in 2007. Efforts to take the rate below 30% on a revenue-neutral basis generally require less generous depreciation allowances and other changes that could perversely increase marginal tax rates on new investment.
Corporate tax reform should be pursued, but pairing this agenda with other spending cuts would do more good by allowing for more ambitious reforms. Moreover, the President’s insistence on higher tax rates on individual income would not be wise given research showing that higher personal tax rates discourages entrepreneurship and new business creation.
Put simply, to reduce the need for more revenue, we must reduce spending. Indeed, the most depressing sign for U.S. competitiveness is not the age of its passenger-rail cars, but the decline in economic freedom. Ranked as a “mostly free” economy with large amounts of state intervention, the U.S. is now judged to be less free economically than a Nordic and socialist country like Denmark. Total U.S. government spending was 38.9% of GDP in 2010, and this is artificially low as a basis for comparison to other countries because it does not account for most health-care expenditures, which are categorized as government outlays in much of the rest of the world. When adding the $800 billion of private health insurance spending, adjusted U.S. government spending stood at 44.6% of GDP. This is slightly below Sweden’s 52.5% of GDP spending, but much higher than Canada’s 39.7% of GDP in government spending.
Although the President acceded to the moment of discontent by invoking competition, it should be no surprise that he did not embrace a true competitiveness agenda that would reduce the cost of government and empower the private sector. Left-leaning intellectuals have long abhorred a focus on competitiveness because they understand the way competition among national economies restrains the ability to enact their policy agenda. In 1994, just as the U.S. was about to enter a period of accelerating growth and unrivaled prosperity – thanks largely to the competitive force of innovation – Paul Krugman authored a famous essay in Foreign Affairs that ridiculed the notion that nations compete with one another. More significant than competition, Krugman argued, is productivity. Yet, it seems obvious that the more competitive the country’s economy and institutions, the more likely it would be to attract the financial and human capital necessary to drive productivity growth. And competitive institutions require low taxes, a regulatory environment that makes it easy to enter and exit markets, and a rule of law that protects investors from expropriation. This is especially true in contemporary times given the ease with which capital and knowledge of production processes can be transferred across borders.
When a country increases the cost of government, it becomes less competitive relative to neighbors that keep the cost of government low and predictable. The type of national competitiveness discussed in President Obama’s speech was as relevant to these issues as the Olympics. Competition among nations is real, but let us not get distracted from what it means and how it is inextricably linked to fiscal conditions.