Yes, the United States is Competitive

Authors: Uri Dadush, William Shaw
Originally published by the Carnegie Endowment for International Peace

U.S. policymakers worry constantly about the nation’s declining competitiveness¹ —so much so that the theme dominated this year’s State of the Union Address. The country’s assumed inability to compete is blamed for everything from its structural current account deficit and declining number of manufacturing jobs to its rising debt levels and even its reduced influence in the world.

But the evidence suggests that the United States does not have a competitiveness problem: per-capita income is high and productivity in manufacturing is rising rapidly. Instead, its problem lies in spending. At its core, the perceived lack of U.S. competitiveness is the result of misguided fiscal policy, which contributes to low government and household savings and inefficient spending. Therefore, fiscal reforms that tilt incentives toward exporting more and importing less would help growth in the long run. On the other hand, a lower dollar or lower wages—traditional fixes for decreased competitiveness—would do little good.

It’s not competitiveness

Economists prefer to measure “competitiveness”—a murky term—through productivity, proxied by indicators such as per-capita income and output per hour². According to those indicators, the United States is in excellent competitive shape. At around $48,000, U.S. per-capita income is higher than that of all but a handful of countries, most of which are oil-rich economies. The supposedly declining U.S. manufacturing sector increased output per hour by 5 percent annually from 1990–2009, compared to an average of 3.4 percent in the other major, developed countries. And the United States tends to export relatively sophisticated, high-value-added products³, for which demand is growing and in which low-wage economies are less likely to compete.

Potential competitive handicaps—such as a rising dollar or higher inflation—are also unlikely to be responsible for the U.S. current account deficit, which deteriorated from $400 billion (4 percent of GDP) in 2001 to $700 billion (6 percent of GDP) in 2007. In fact, the dollar’s real effective exchange rate declined by 17 percent over the period. With that statistic in mind, it is puzzling that politicians worried about competitiveness pay so much attention to the dollar exchange rate.

As the chart below shows, the United States has lost export share to China and other emerging markets. That growth, however, reflects a one-time sea change in the policies of emerging markets (opening to the global economy and establishing sound conditions for growth), as discussed in Juggernaut: How Emerging Markets Are Reshaping Globalization. Moreover, as developing countries gain export share, their imports are also expanding, fueling the continued, rapid growth of world trade. There is little evidence of a long-term slowdown in U.S. export growth: the United States has maintained its export share relative to advanced countries, and the decline in its share against developing countries has been more than offset by the rapid growth of world trade.

There are, however, at least two concerns going forward about the U.S. ability to maintain its competitive edge: U.S. education and infrastructure. Despite spending an average of $14,000 annually per student—more than any other country spends—the United States ranks 31 in math and 22 in science out of 65 countries, including many developing countries. Moreover, after a long period of low investment, U.S. infrastructure is deteriorating. The American Society of Civil Engineers, for example, gave U.S. infrastructure a “D” in March 2009 and claimed that the country will require $2.2 trillion in infrastructure investment over the next five years—about twice the amount committed. This is only one indication that the government could be spending more efficiently.

America’s spending problem

Just as some high-earners live from paycheck to paycheck and some low-earners always have a nest egg to fall back on, the United States—a rich (productive) nation—is profligate, while some poor (unproductive) countries are parsimonious.

Before the Great Recession, U.S. household and government savings were deteriorating, fueling an unsustainable boom. In 2005, household savings plummeted to as low as 1.4 percent (compared to an OECD average of 4.4 percent and down from over 5 percent in the early 1990s). In 2007, the Congressional Budget Office (CBO) projected that debt held by the public would approach 200 percent of GDP within a generation. In other words, the fiscal deterioration occurred as the economy was expanding, and it continued for years.

This overspending was accompanied by a large deterioration in the current account deficit. Though the household savings rate has rebounded to over 5 percent since the crisis (but still lags the OECD average, now 7.3 percent) and the current account deficit narrowed to 2.7 percent of GDP during the recession in 2009, policy makers worry that the trade balance may widen again when the U.S. recovery accelerates.

Insofar as the U.S. structural current account deficit reflects inadequate savings—as it clearly does—reducing it is desirable. Doing so efficiently requires that policy makers focus on fiscal reforms that not only reduce the budget deficit directly but also make public spending more effective and nudge the private sector toward producing more exports and reducing imports.

Tax reform

Three types of tax reforms clearly meet these criteria: increased gasoline taxes, a value-added tax, and a phased-in elimination of the mortgage interest deduction.

The United States has held its federal gasoline tax at 18.4 cents per gallon since 1994 ⁴, while other OECD countries have instituted much higher rates⁵. Raising the U.S. gas tax would directly improve the fiscal deficit—raising the tax to only half the OECD average could generate approximately 1 percent of GDP⁶ —and it would help reduce the current account balance, as oil imports fall. Because the disposable income of consumers would decline, other imports and consumption could decrease as well. Over time, renewable energy sources, alternative means of commuting (including telecommuting), changes in residence or work location, and more efficient cars will mitigate the effect of the initial rise in gasoline prices. The gain in tax revenues will also be smaller as Americans adapt by consuming less gasoline⁷.

A value-added tax (VAT) could also reduce the fiscal and current account deficits. The CBO estimates that applying a 5 percent VAT to most goods and services in 2013 would raise $180 billion (1.2 percent of GDP) that year and $2.5 trillion through 2021 (1.4 percent of GDP over the period). Meanwhile, charging VAT on imports while rebating VAT payments to exporters, a universal practice, would strongly tilt incentives in favor of exporters. At the same time, introducing the VAT could increase the efficiency of the tax system and would require limited administrative resources for enforcement, as firms purchasing inputs have an incentive to ensure that sellers fully state their VAT payments. Finally, a VAT could increase household savings by taxing all consumption goods and allowing households to earn interest on savings free of VAT⁸.

The mortgage interest tax deduction, on the other hand, must be gradually eliminated to reduce the deficit. It will cost an estimated $100 billion in 2011 and artificially encourages spending on and investment in real estate, a highly volatile sector⁹. Eliminating the subsidy would help direct savings to more stable assets, reduce individuals’ reliance on household equity to finance consumption during booms, and improve income distribution (subsidizing home purchases disproportionally benefits the rich, who typically buy houses, over the poor, who typically rent). It would also free resources for investment in internationally-competing sectors.

Expenditure reforms

Reforms in government spending, particularly in healthcare, could also improve the trade balance indirectly. Health expenditures already account for close to one-fifth of government spending and are, by far, the fastest-growing segment. Yet U.S. health outcomes are disappointing. As shown in the chart, U.S. spending on health—public and private combined—is 50 percent higher per-capita than that of the next highest country, but the U.S. infant mortality rate, at 6.7 deaths per 1000 births, is higher than all OECD countries except Turkey and Mexico and life expectancy at age 65 is about the OECD average.

While high spending may reflect higher incomes, and poor health outcomes may be due to poorer lifestyle choices and higher pollution, less efficient procedures are clearly also responsible. One easy fix would be to allow the government to bargain for price reductions, but other solutions abound, even putting aside radical steps such as a single-payer system¹⁰. If reforms lowered healthcare spending only halfway toward the OECD average, nearly 3.6 percent of GDP could be saved. More efficient provision of healthcare would free up resources, some of which would be reallocated toward exports and import-competing sectors.

Defense spending also takes up about 20 percent of the budget. In 2010, the United States accounted for 43 percent of global defense spending (almost six times the number two defense spender, China) and equaled 4.7 percent of GDP (compared to 1 to 2.5 percent in Germany, France, and the United Kingdom). The United States has global responsibilities and, to some extent, the huge U.S. military establishment enables its allies to spend less. Nevertheless, given the huge resources it consumes, the effectiveness and efficiency of defense spending must be examined¹¹.

Conclusion

The United States does not suffer from low productivity or competitiveness. It does not need a lower dollar or to cut wages. Instead, inadequate government and household savings, misguided incentives, and inefficient public expenditures handicap the economy. A phased-in reform of the tax system and more efficient spending could not only increase national savings and reduce the structural current account deficit, but they could also raise the U.S. potential growth rate and improve the provision of essential public goods. These steps would help the United States become even more competitive in the years ahead.

1. See, for example, Podesta and others 2010 and NAS 2010.
2. Productivity is often defined either as labor productivity (output per worker or hour worked) or total factor productivity (a measure of the efficiency of all inputs to production).
3. In 2009, 23 percent of U.S. manufactured exports, for example, were high-technology exports, compared to the OECD average of 17.4 percent.
4. State taxes vary from 8 cents in Alaska to 47.7 cents in California.
5. The average tax rate on gasoline in the United States was 17.8 percent in September 2010, compared to an OECD average of 53 percent.
6. The CBO estimates that a 25 cent-per-gallon increase would raise slightly more than $25 billion a year. If this correspondence holds for larger hikes, raising the tax from an average (federal and state combined) of 50 cents per gallon to $1.75 would raise around $150 billion.
7. Other distributional policies could counterbalance the regressive impact of a gasoline tax (in 2009, gasoline expenditures equaled 9.3 percent of the lowest quintile’s after-tax income and only 2 percent of that of the highest quintile). A gasoline tax also would reduce U.S. vulnerability to supply interruptions, its reliance on the armed forces to safeguard supply from regions subject to political instability, and its contribution to climate change.
8. However, the VAT would not change the tradeoff between current and future consumption, and the impact of the after-tax return on savings is ambiguous due to substitution and income effects. The regressive impact of the VAT (since poor people save less than rich people) could be eased through a tax credit that falls as income rises, zero-rating (or lower-rating) some basic consumption goods, or earmarking a portion of revenues for social spending.
9. Other aspects of the tax system also favor home ownership. For example, home-use is not taxable, but renting involves a financial transaction that is subject to taxation. Subsidies channeled through Fannie Mae and Freddie Mac also encourage home ownership. Fannie and Freddie (along with other government programs) back about 90 percent of new housing loans, and PIMCO’s Bill Gross estimates that mortgage rates could be 3 percentage points higher if Fannie and Freddie were not implicitly backed by the government.
10. See “Bending the Curve: Effective Steps to Address Long-Term Health Care Spending Growth,” Brookings. Numerous issues are also discussed on healthaffairs.org; see, for example, Christina Bielaszka-DuVernay. 2011. “Improving Quality and Safety.” HealthAffairs.org.
11. At the same time, not all measures designed to increase savings or cut spending are worthwhile. Excessive reliance on spending cuts to reduce the fiscal deficit can further impair the provision of important public goods. Ostensible savings that cut or privatize Social Security and Medicare without making provisions for the aged and poor are profoundly inequitable.