Relevant and even prescient commentary on news, politics and the economy.

Backdating Options, APB 25, and FAS 123

Via Mark Thoma comes an interesting discussion from James Surowiecki:

The most common stock options are known as “at the money” options, which let you buy the company’s stock at the price that it had on the day of the grant. They’re valuable only if the stock price rises after you get them. The companies involved in the recent scandal were backdating options to a time when the stock price was lower, making them immediately lucrative. As it happens, companies are perfectly free to issue options priced below the current market: those are called “in the money” options, and they’re worth something right when they’re issued. (If you’re given an option with a strike price of ten dollars when today’s stock price is fifteen dollars, each option can yield an immediate profit of five dollars.) But there’s a rule that companies have to follow when they issue “in the money” options: they have to disclose it in their financial statements. The backdating companies broke this rule: they reported how many options they were issuing, but conveniently omitted the fact that they had been backdated … The bigger reason for choosing to backdate is to get around some bothersome accounting regulations. Until recently, the regulations distinguished, for no good reason, between in-the-money and at-the-money options. In-the-money options—but not at-the-money options – had to be recorded as an expense, which drove down reported earnings. Backdating allowed companies to reward employees with in-the-money options while getting the favorable accounting treatment of at-the-money options.

The “rule” was APB 25, which has been replaced by SFAS 123:

In 1993, FASB issued an exposure draft that would have required companies to report the value of stock option grants issued to employees as compensation expense in the year the grant was made. It was met with resounding opposition. Detractors claimed that the dramatic hit to earnings would have detrimental effects on competitiveness and innovation. The final regulation, SFAS 123, merely encouraged companies to adopt this reporting approach, while continuing to allow reporting under APB 25 rules so long as footnotes contained a pro forma presentation of earnings as if SFAS 123 had been adopted. The APB 25 rules required compensation expense to be reported only if the exercise price was less than the extant stock price at date of grant. In most cases, options are granted with an exercise price at or above the current stock price. The result was that most companies did not report stock option expense on the income statement.

APB 25 allowed companies to report the “intrinsic value” of options and omit the value derived from the “head I win, tail you lose” aspects of options, which could sizeable for volatile stocks. Backdating was a gimmick to hide even the intrinsic value of granting options. Yet another reason why APB 25 should have been discarded years ago. Which reminds me of yet another reason Joe Lieberman should not be in the Senate.

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Real Compensation – Still Below Where It Was Two Years Ago

Kash treats us to three things: (1) the latest on compensation from the BLS; (2) his own analysis and chart; and (3) a discussion from Rex Nuttig:

In the past year, employment costs are up 3.3%, the fastest year-over-gain in five quarters. It’s the first time compensation costs have risen faster than inflation in two years … A year ago, inflation-adjusted wages were down 2.3% year-over-year, but were up 1.1% in the past four quarters … Even though employment costs are at a two-year high, the increase has been modest by historic standards.

OK, the latter may have been a trick or perhaps that rock Charlie Brown usually got during Halloween. So he starts off with a nominal increase before he notes that the real wage increase for the past year was less than the real wage decrease for the year before. Translation: over the past two years, real wages have fallen by about 1.2%.

But the claim that employment costs are at a two-year high is just absurd. Why? Look at my chart which takes the September to September nominal increases in total compensation as well as wages and benefits and converts them to real changes. Real benefits barely increased during the period from September 2004 to September 2005 and then rose at the same modest rate as wages during the last year. Real compensation fell by 1.6% during the period from September 2004 to September 2005 and then rose by 1.2% over the past year. Excuse me – but how can one say that real compensation now is higher than it was two years ago?

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U.S. Motor Vehicle Production and Consumption

Tim Duy examines the controversy around the BEA advanced report for 2006QIII with respect to U.S. motor vehicle production with this illuminating follow-up:

Let’s disregard the price decline, and just switch to physical units. In the comments, spencer points out that auto and light truck sales rose from 16.17 to 16.63 million units in Q3. Did in fact those sales never really happen because the Big 3 cut domestic production? No – at least two channels can be operating. One, as Brad (and spencer) points out, is inventory depletion. Which gets to the point that although something may get counted as final sales in 3Q, that doesn’t mean it was actually produced in 3Q. It could have been counted as an inventory accumulation in a previous quarter, and is subtracted in the current quarter. If the BEA underestimated inventory draw for this quarter, they can fix it on a revision – nothing nefarious need be occurring. Moreover, just because a car is counted as a final sale in the US in 3Q does not mean it was PRODUCED in the US at all, in any quarter. In this case, the value is subtracted from GDP in the imports category. Note the large negative contribution due to rising imports

If we turn to the NIPA tables from BEA and go down to tables 7.24 through 7.26, we do see a reduction in the price index for motor vehicles as well as the fact that the reported nominal value of production did rise less slowly than the report real value. Final sales of domestic product also rose by more than motor vehicle output, that is, inventories did decline. But as far as net exports of motor vehicles, they declined during this quarter. But that only partially (and perhaps temporarily) reverses a long-term trend.

Kash got me thinking about the long-term as well as international trade as he traced the increase in real motor vehicle output since 1995 noting that some of this production may have come from U.S. based plants of companies such as Toyota.

I decided to plot final sales of domestic product (“production” abstracting from inventory swings) as well as the consumption of motor vehicles in the U.S. with the difference defined as net exports (NX) – all relative to GDP. My plot goes back to 1981 when net imports (net exports with the sign swithced) were less than 0.5% of GDP. Notice two things. Production and consumption both tend to be cyclical and the long-run tendency has been for net imports to rise as a share of GDP to around 1% recently. If we compare early 2001 to early 2000, we that consumption was higher at the tail end of the 1990’s boom than it was when President Reagan took the reigns from President Carter. Yet, production was about the same. During the last several years, both production and consumption have declined as a share of GDP, which is what one would expect if aggregate demand declined.

The bottom line is that while we are consuming as much as we were back in 1981 as far as motor vehicles as a share of GDP, we are purchasing more of those vehicles from abroad. So not only – as Kash suggests – has Ford & GM lost market share to the like of Toyota, even with Toyota opening plants in the U.S. we are producing less motor vehicles here as a percent of GDP than we were 25 years ago.

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Healthcare Costs and the Uninsured

I had a couple recent posts on healthcare costs – one showed that for whatever reason, healthcare costs tended to rise faster in the terms of Republican Presidents than when Democrats were President. The second one showed that the greater the government involvement in healthcare, the lower the increase in healthcare costs.

I decided to check one more thing. I’ve heard it said many times that the more uninsured people there are, the greater the healthcare expenditures for the rest of us. The idea is that the poor, by choosing not to have health insurance, end up not going in for healthcare until they’re really sick and thus costly to treat, and their healthcare costs get passed onto the rest of us with insurance. Despite the snark, the story makes sense to me, but I figured I’d check it. The data I used:

Cost of healthcare, 1960 – 2003
Population (NIPA Table 7.1)
Percentage of Americans with insurance from 1989 to 2005

The correlation between the percentage change in real healthcare costs per capita and the change in the percentage of insured Americans was -.31. So far so good for the story – as the percentage of uninsured rises, the percentage increase in real healthcare costs per capita also rises. I should probably have stopped here… I’ve had about 21 posts so far that have involved data, and this is the first time I recall getting anything resembling the conventional wisdom to crop up. But I was wondering…

Does one factor lead the other? For instance, do rising healthcare costs lead to fewer people with health insurance in later years? The following table shows the correlation between the change in the percentage of insured in any given year, and the % change in real expenditure per capita on healthcare in some previous year.

% ch real exp per cap t-1, ch in pct insured t_-0.20
% ch real exp per cap t-2, ch in pct insured t_-0.29
% ch real exp per cap t-3, ch in pct insured t_-0.43
% ch real exp per cap t-4, ch in pct insured t_-0.44
% ch real exp per cap t-5, ch in pct insured t_-0.29
% ch real exp per cap t-6, ch in pct insured t_-0.05

It seems that the greater the incrases in healthcare costs, the fewer people are insured some years (and some years seems to be mostly 3 or 4) down the line. As healthcare costs rise, so do insurance rates, and eventually fewer people buy it.

What about going the other way? The table below shows the correlation between the % change in real expenditures on healthcare per capita in any given year, and the change in the percentge of uninsured in some prevous years.

% ch real exp per cap t, ch in pct insured t-1_-0.16
% ch real exp per cap t, ch in pct insured t-2__0.37
% ch real exp per cap t, ch in pct insured t-3__0.69
% ch real exp per cap t, ch in pct insured t-4__0.28
% ch real exp per cap t, ch in pct insured t-5_-0.01
% ch real exp per cap t, ch in pct insured t-6__0.09

This is a bit more interesting…. it seems that if the percentage of Americans with health insurance goes up, a few years (3 seems to be a magic number today) later we see increases in healthcare costs.

Now, correlation is not causality, but note that the correlation between changes in the percentage of Americans with health insurance and the percentage change in real expenditures three years out is by far the larger (in absolute magnitude) than any other number in this post.

So what’s the mechanism? My guess… the more people get insurance, the more they want to use that insurance to get healthcare services, and rising demand raises prices.

Combining both parts of the story… prices (on healthcare, and then on insurance) rise, prompting people to drop insurance coverage some years later. The drop in insurance coverage leads to a slowdown in healthcare costs, and hence insurance costs, a few later. A drop in insurance costs leads to more people with insurance … Its not much data to work with, but for a guy like me who spent a lot of quality time with population ecology models, this looks an awful lot like a Lotka-Volterra system. What it doesn’t look like is the clean story about unwashed hordes of uninsured driving up the costs for the virtuous insured.

Update… I forgot to mention… as always, my spreadsheet is available to anyone who wants it.

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Fiscal Responsibility or Smoke & Mirrors?

AB reader ILSM directs our attention to a few tables from the OMB that give the illusion that Federal revenues will almost catch up with Federal expenditures by 2010. Before we get to the smoke and mirrors of these projections, a couple of items that have caught the attention of the Reality Based Community starting with some praise of Karl Rove from the Los Angeles Times including these goodies:

But the most significant element of Rove’s effort to help four-term Rep. Thomas M. Reynolds keep his job may have occurred behind closed doors, when the White House strategist met with a federal disaster relief official contemplating how to respond to the storm. Four days later, Reynolds announced that President Bush would authorize millions of dollars in federal disaster aid for the area … In Missouri, Sen. Jim Talent is struggling to retain a seat that is considered vital to maintaining the GOP’s Senate majority. Talent, whose mother died of breast cancer, has made support for fighting the disease an element in his campaign. Recently, Rove’s deputies arranged for First Lady Laura Bush to appear with Talent to promote Breast Cancer Awareness Month. Once a year, the National Park Service bathes the soaring Gateway Arch that dominates downtown St. Louis in pink light – the signature color of the breast cancer awareness campaign. This year, the pink lighting coincided with Laura Bush’s visit. The White House says it encouraged the action. Similarly, the Transportation Department, responding to White House prodding, dispatched the federal highway administrator to Columbus, Ohio, last week to announce grants for a transportation hub to facilitate moving freight among air, rail and highway carriers. The event was designed, an administration official said, to boost prospects for Rep. Deborah Pryce of Ohio, the No. 4 Republican in the House, who is trailing her opponent. And when environmentalists from the San Francisco Bay Area sharpened their attacks on Rep. Richard W. Pombo (R-Tracy), chairman of the House Resources Committee, the White House political office arranged for President Bush to stop in his district to sign legislation protecting wetlands – with Pombo standing by his side.

So when President Bush says we should spend taxpayers’ monies on priorities, you get the idea what he really means. But how to pay for all of this? Joe Galloway seems to have one form of fiscal restraint:

Oh yes. One other bit of news: the White House that says nothing is too good for our troops has turned its back on a plea by Army leaders for a $25 billion increase in its 2008 budget so it can carry out the missions the administration has assigned to it. The White House Office of Management and Budget rejected Army chief Gen. Peter J. Schoomaker’s extraordinary plea by for the additional funds to pay for repairing and replacing thousands of worn out and blown up tanks, Bradley fighting vehicles and Humvees.nInstead of the $25 billion that Schoomaker says the Army needs just to keep doing what it’s been doing with spit, adhesive tape and baling wire for the last five years, the Pentagon says the Army can have $7 billion.

Read the whole piece as Mr. Galloway seems to be a bit upset with the Commander-in-Chief.

But back to those OMB tables. It seems total Federal debt is expected to grow by 34% from 2006 to 2011 as compared to only a 30% increase in nominal GDP (combination of real GDP growth and inflation) so the OMB is forecasting that the debt to GDP ratio will continue to climb. And I thought they had the Federal deficit under control! Hmm. It must be the unified deficit that is forecasted to decline because of those Trust Fund surpluses. I see.

But is this notion that Federal spending, which was 20.8% of GDP, is projected to decline to only 19% of GDP by 2010 a credible forecast? Take a look at table 5.3, which reports the “growth in discretionary budget authority by major agency” from 2001 to 2006 and the projection for 2007. First of all, the reported 31% increase from 2001 to 2006, which represents a 5.6% per year increase, is odd given the fact that total Federal spending grew by an average 6.6% per year. But there lies my problem with reporting discretionary spending – you can hide a lot of spending increases by re-labeling something from the discretionary side to the mandatory side. Also notice that the OMB wants to claim a 5.2% per year average increase by pretending that nominal discretionary spending will only grow by 3.2%.

Some of the details are fascinating. For example, the OMB wants us to believe we are about to cut discretionary Federal education spending so that’s its cumulative growth over six years would be less than 36% (from $40.1 billion to $54.4 billion). The Bureau of Economic Analysis had total Federal spending at $47.3 billion in 2001 and at $70.1 billion as of 2005 for a 48% increase over just four years. Did this Administration massively increase “mandatory” education spending or is it planning to slash the education budget after all those years of bragging about its commitment to education. Don’t we voters deserve to know before we go to the polls?

Of course discretionary defense spending is projected to grow by another 6.9% according to this document. If there is some over/under contest, place my bet on the over. But fiscal conservatives might be elated to know that discretionary spending on agriculture will fall next year so its cumulative six year increase will be a paltry 2.5%. But again – something is amiss as the OMB is reporting agriculture spending just over $20 billion. But if we look at total spending on agriculture, it was $68 billion and had increased to almost $82 billion by 2005 according to this source. And this source puts 2006 spending on agriculture at $94.6 billion, which represents a 39% increase over 2001 spending levels. I guess handing out farm pork is another one of the President’s priorities.

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Michael Steele on Iraq: Blaming the Generals

I have tried to be kind to Meet The Press as Tim Russert has invited the candidates for six of the Senate seats to debate the issues but this morning’s show featuring Ben Cardin and Michael Steele was really disappointing on several levels. Those in Maryland who have seen suggestions that Michael Steele is the Democrat, don’t be confused as it’s Cardin who is the Democratic nominee. One indication that Mr. Steele is the Republican is how he answered this question:

MR. RUSSERT: You said it’s a mess. Did the Bush administration help create this mess?
LT. GOV. STEELE: I think that the Defense Department did not give the president the kind of strategy that he needed to prosecute this war.

Mr. Steele was trying to have it both ways. While he wants you to believe he is not a “Stay the Course” type, he has supported Bush to date. Maybe he doesn’t get how this works. The generals have offered all sorts of recommendations to improve our situations – as have many Democrats even as Mr. Steele tries to blame Mr. Cardin for our failures in Iraq. But Steele will not blame the President.

Steele was trying to have it both ways on many issues. Is he for or against affirmative action? Both.

Mr. Steele was asked where he would cut government spending and his answer was that we should but he could not give a specific answer. Russert did try by reminding Steele that he had supported President Bush’s call to slash Social Security benefits. But today he said he was against such cuts. And of course, Russert tried to spin it to suggest that Cardin was the one who wanted to cut Social Security benefits.

Steele apparently was for overturning Roe v. Wade before he was against it. Russert pressed by asking Steele about who he would have voted to place on the Supreme Court with Alito’s name being specifically mentioned during the discussion. Mr. Steele seemed surprised that a Senator actually had to deal with such issues.

While Cardin was more willing to give straight answer to the questions asked, quite frankly I wished he would have called Steele on his incessant misrepresentations of issues. And then we came to this line of questioning from Russert:

MR. RUSSERT: Mr. Cardin, you support abortion rights, also late-term abortions, or partial-birth abortions. Also, you voted against parental consent for abortion. Why shouldn’t a parent know that his or her daughter is having an abortion?
REP. CARDIN: First let me say that I am in favor of what is commonly known as pro-choice, to give a woman a right of choice and for government not interfering and there’s a — I don’t get comfort in listening to Mr. Steele’s response. And let me also point out, when he was asked specifically about the abortion issue, he said, “What does that have anything to do with the United States Senate? We don’t take that issue up.” And there have been many votes in the United States Senate that deal with a woman’s right of choice. Parental notification, to me, is something that should be — parents should be involved in their children. Absolutely. The problem is, you don’t want it to become an obstacle, particularly where there has been family abuse issues or where there’s been neglect in a family. You don’t want it used as a way of preventing a child from getting the necessary medical attention.
MR. RUSSERT: So a parent should not be notified?

Only a village idiot would honestly phrase the question this way. There is no law preventing parents and their kids from discussing this issue. The question at hand, which everyone likely knows is whether the government can insert its will over individual decisions. Assuming Tim Russert is not a village idiot, could someone tell me who within Karl Rove’s political machine put him up to this question? But look, how can we blame Tim Russert for being such a twit given we have known this for a long time. I blame the producers of Meet the Press for not finding a host for the show that could restore the integrity and news value it used to command.

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Congressman John Sweeney’s Economic Amnesia

Tim O’Brien covers Bill Clinton’s trip to Albany, New York as he is supporting Kirsten Gillibrand’s campaign to unseat John Sweeney. Clinton got a dig in at Sweeney with this:

Clinton also took a swipe at Sweeney for his 2001 trip to the Commonwealth of the Northern Mariana Islands. Sweeney has sought guidance from the House Ethics Committee on how he should handle the reporting of his 2001 trip to the Pacific islands in the company of a lobbyist hired by convicted Washington influence peddler Jack Abramoff. Sweeney has said he traveled to the islands with “the understanding” that the trip was paid for by the CNMI government. “We’ve got to forgive our Republicans for Abramoff because they all have Abramoff amnesia,” Clinton said. “They don’t remember any of it.”

Clinton and Sweeney seem to have different memories as to the economy and the Federal budget for the past 15 years or so:

Clinton said the Bush administration and Congress turned a $240 billion surplus he left into a $250 billion deficit. He criticized the GOP as a party that focused on tax cuts for a few over helping the working class … “The deficit is actually a result of a recession that began in his administration,” he contended. “We are exponentially paying down the deficit in an accelerated time frame.” Sweeney noted the Dow industrial average has passed 12,000, home ownership is at record highs, unemployment at record lows and 6.6 million new jobs have been created since the 9/11 terrorist attacks. “If the economy is the issue, we’re in good shape,” he said.

I guess Mr. Sweeney does not realize that the stock market today is still worth less in inflation-adjusted terms than it was in early 2000. And someone remind him that the recession started in early 2001. But he contradicts himself with the premise that the economy is currently in great shape as he also tries to blame a weak economy for the current deficit.

But let’s also compare real GDP and employment growth during Clinton’s 8 years versus Bush’s first 5.75 years. During Clinton’s years, real GDP grew by 32.7% or at a 3.6% per annum clip. Under Bush, the economy has grown by only 15.6%, which represents less than 2.6% per year.

As far as employment, it has not grown by 6.6 million since Bush took office. Try 3.1 million if we are using the payroll survey. Now under Clinton, employment grew by 23 million. I guess Congressman Sweeney doesn’t remember anything about the 1990’s.

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David Altig Redefines Core GDP

Before I discuss the latest from our conservative friend, let me congratulate Tony Snow for the funniest comment I’ve seen so far on yesterday’s disappointing news per real GDP:

“Everybody expected this. You have a combination of rising energy prices and also rising interest rates, and now you’ve seen a reverse on both,” said White House press secretary Tony Snow.

As the AP story noted, some private economists were forecasting 2.1% or 2.2% growth and we got a 1.6% growth. I never knew these private economists had a pro-Administration bias. But excuse me – did I miss Tony Snow’s more accurate forecast? Hat tip to Mark Kleiman.

We have had some fun with the National Review as to their various definitions of core GDP. As I try to follow what the National Review is trying to say, it goes something like this: net exports and government purchases don’t matter. But then they have at times defined core GDP as consumption plus all investment and at others as consumption plus business investment as if residential investment does not count. Which brings us to David’s latest:

Actually that 2.2% guess was higher than a lot of people were guessing – Larry Meyer’s Macroeconomic Advisers for example, had been projecting 1.8% and, frankly, 1.6% was better than I was expecting … The major reason for the sharp deceleration in growth was that the housing sector took over one percentage point out of growth … Basically, you really don’t have a weak economy if consumers are consuming, businesses are investing, exports are growing and imports are strong.

To be fair, David was quoting Joel Naroff, but he endorsed this quote. And David did find one forecaster who thought real GDP growth would be only 1.8%. Was Mr. Snow referring to David’s forecast? But let’s take a look at the numbers. Real GDP grew from $11,388.1 billion to $11432.9 billion for an increase equal to only $44.8 billion. But residential investment fell by $28 billion – so we forget about that, we can report an increase equal to $72.8 billion. Now I feel better.

But this strikes me as quite arbitrary. Why not include residential investment and exclude non-residential investment. By this definition of GDP, we see real GDP rising by only $17.6 billion. Whoops! Then again – why not exclude net exports since they fell by $15.7 billion. Of course, consistency would require that the core GDP crowd would have to exclude government purchases, which rose by $9.6 billion.

Update: AB readers have made a couple of requests. One is to note the story from Carlos Torres:

An unexpected increase in auto production last quarter was a statistical fluke that will be reversed, making current U.S. economic growth even weaker, according to a former Commerce Department economist. Last quarter’s annualized 26 percent increase in auto production shocked Joe Carson, now director of economic research at AllianceBernstein LP in New York. Without the gain, the economy would have grown at an annual rate of 0.9 percent, not the 1.6 percent the Commerce Department reported today.

The other gives me a chance of provide a couple of graphs showing the quarter-by-quarter noise evidenced when one presents various segments of aggregate demand growth. The following graphs are drawn from NIPA Table 1.1.1 of the National Economic Accounts. The first graph shows the even consumption demand and government purchase demand display a certain degree of volatility in terms of their growth rates. The second graph shows the components of fixed investment – nonresidential investment (NRI) and residential investment (RI). We often teach our students that investment demand growth tends to be volatile. The components individually tend to be even more volatile than the individual series, which is what one would expect if the two series were negatively correlated.

The weakness in the residential investment and auto production sectors will not automatically be offset by increases in business investment unless the Federal Reserve reverses the recent increase in interest rates as Brad DeLong recommends.

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Tax Rates, Tax Cuts, and the Growth of GDP per Capita, Again

Honestly, I’m tired about arguing about taxes. I wrote a few posts in the past on the topic, and other Angry Bears have done the same. No matter what data you post, there are always some people who insist that they’ve done some secret analysis (they don’t post their numbers or how they arrived at them) that shows that cutting taxes is always good for whatever ails the economy, and in particular, that cutting taxes creates growth.

Nobody argues that when tax rates are very high, cutting them will spur the economy. I also assume nobody reasonable argues that when tax rates are very low, cutting them will not boost the economy. (Will anyone work harder because their marginal rate dropped from 3% to 2%?) The question left unanswered, of course, is – what is “high” and what is “low” when it comes to tax rates.

If you look at data from 1950 to 2005, one thing stands out. If you split the sample in half, you find that the annual percentage increase in real GDP per capita from 1950 to 1977 was 3.1%, and from 1978 to 2005 was 2.4%, and yet the average highest (individual) marginal tax rate was 81% in the first half, and 43% in the second half.

But what of tax cuts themselves? Do they help? Sure, when taxes are too high, cutting them is going to boost growth. But again, the question arises… what is too high, and what is too low? So let’s look only at the second half of the sample, when the highest marginal rate ranged from 70% (1978, 1979) to 28% (1988 – 1990).

Below is a table showing the annual growth rate in real GDP per capita from 1978 to 2005, following decreases, increases, and no change in the tax rate. The first row shows the average growth rate in the year of a tax cut, tax hike, or no change. The second row shows the average yearly growth rate over two years following a tax cut, tax hike, or no change.

_________tax cut______tax hike______tax unchanged
1 year_______ 1.64 ______ 2.36 ______ 1.94
2 years______ 2.26 ______ 1.86 ______ 1.77
3 years______ 2.27 ______ 2.15 ______ 1.82
4 years______ 2.15 ______ 2.22 ______ 1.92
5 years______ 2.24 ______ 2.37 ______ 2.01
6 years______ 2.32 ______ 2.58 ______ 2.07
7 years______ 2.39 ______ 2.67 ______ 2.08
8 years______ 2.35 ______ 2.55 ______ 2.12

So what does this show? Years in which there was a tax hike showed faster than growth than years in which taxes remained unchanged, and years in which there was a tax cut brought up the rear. Over a period of two years… in the two years following a tax cut, growth rates were higher than under tax hikes or no change in taxes. In the two years following a tax cut, growth rates were higher than under tax hikes or no change in taxes. But… over a period of four years, five years, six years, seven years, and eight years, tax cuts resulted in slower growth rates than tax hikes.

Thus, two and three years after the fact, a tax cut outperformed a tax hike in the sample, but over longer periods of time, tax cuts did not result in higher growth rates. Using median yearly growth rates produces similar findings, as does starting in 1981, when Reagan took office.

It is important to remember – these results applied to data for the past 27 years or so. They may not apply in other times or places. But they do indicate that tax cuts led to slower, not faster growth rates, from 1978 to 2005.

Data Sources:
Real GDP per capita (NIPA Table 7.1)
Highest marginal tax rates

As always, my spreadsheets are available to anyone who wants them.

Update… Reader M Jed notes that use of plain averages is inappropriate for percentage growth rates. He is correct. This post was updated using geometric averages.

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Disappointing GDP Growth

The Bureau of Economic Analysis released its advanced estimate of real GDP growth for 2006QIII – and the bad news is that the economy’s growth rate appears to have slowed to only 1.6% per year.

Now consumption demand grew by 3.1% and government purchases grew by 2%. Exports growth was 6.5% offset by import growth at 7.8%. So why did overall growth fall short of expectations given the above moderately decent news. You guessed it – investment demand fell. Well, business investment was up but residential investment fell significantly.

Let’s be thankful that the Federal Reserve did not raise interest rates – and hope for better news for the fourth quarter (or perhaps the revised estimates won’t be as dismal).

Update: Cesar Conda claims the tax cuts are still working:

The Democrats and the mainstream media will no doubt say this is firm evidence that President Bush’s tax-cutting policies are starting to fail and that it’s time for a new policy direction. Critics also might blame the Federal Reserve for waiting too long to end its cycle of interest-rate hikes. But these criticisms will be wrong: The ongoing economic expansion is a direct result of the sound fiscal and monetary policies of the past six years, while the current slower pace of economic growth appears to be cyclical and temporary in nature. To begin, the housing market has cooled, which subtracts from GDP growth. However, no one expected the housing boom to continue. Additionally, the housing slowdown does not appear to be spreading to other parts of the economy (e.g., consumer spending continues to grow at a healthy pace), increased business construction is helping offset the decline in housing construction, and the housing decline itself may be ending: In September, housing starts increased and new single-family home sales rose 5.3 percent to 1.07 million (the second consecutive monthly increase) … A GDP report for one quarter is simply one quarter’s worth of data. A broad range of indicators over a longer time period provides a much more accurate picture of our economy: To wit, the U.S. economy grew 3.5 percent across the four quarters preceding the latest GDP data

Where to begin? Notice how Conda said the rise in business investment “is helping to offset” the fall in residential investment? Yes, overall investment demand FELL. OK, he’s right about this being only one quarter but how many times did we here these pseudo-economists crowding how large GDP growth based on one quarter’s information? Conda wants to talk about the last four quarters so he does not have to talk about the last six years – when GDP growth has averaged less than 2.5% per year. But the real howler is:

The ongoing economic expansion is a direct result of the sound fiscal and monetary policies of the past six years

I guess Conda does not realize that the FED has switched from easy monetary policy to tight monetary policy – in part to offset the fiscal insanity of Bush’s tax cuts.

Update II: CalculatedRisk makes a good point about the recent drop in residential investment by looking over the long-run:

Residential investment (RI) has now fallen to 5.7% of GDP from the peak of 6.3% in the second half of 2005. If RI falls back to the median level of the last 35 years (4.5% of GDP), the decline in RI has just started.

As his graph shows the run-up in the residential investment to GDP ratio over the past several years, I thought it would be interesting to include in a similar graph the ratio of non-residential investment (NRI) to GDP. While we hear all the yada, yada, yada about how this has been rising – its share of GDP is still far below where it was in 2000.

But here is what is interesting about the two series – their recent movements has been offsetting to some degree. OK, the rise in residential investment during the business investment slump did not avoid an overall decline in fixed investment as fixed investment relative to GDP fell from over 17% during 2000 to less than 15% for the period from mid-2002 to mid-2003. During the recovery, we saw both ratios rise to that fixed investment got back to being between 16.5% to 16.7% of GDP by end of 2005 and the first quarter of 2006. Since the end of 2005, however, the residential investment to GDP ratio has declined from 6.3% to 5.7% as CR suggests. There has rise been a rise in nonresidential investment as Mr. Conda suggests but overall fixed investment has declined as a share of GDP.

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