Tim Pawlenty Is Right About 5% Growth

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Tim Pawlenty stirred up a hornets' nest when he called for setting a goal of 5% real economic growth. On the political left, Michael Ellinger of the liberal Center for American Progress commented, "It's patently ridiculous. It's not worth serious discussion." On the political right, Kevin Williamson had earlier declared on Larry Kudlow's TV show that believing in 5% growth was like believing in "magic unicorns".

The truth is that sustained, 5% real economic growth is not only realistic, it is necessary. Only a prolonged period of very fast economic growth will get unemployment down to a tolerable level in a reasonable length of time. Such a "growth spurt" is also needed to get the federal deficit and debt under control. To date, Pawlenty is the only presidential candidate who has put forward an explicit, quantitative goal for fast economic growth.

In April 2000, 67.3% of working-age adults were in the labor force and our unemployment rate was 3.8%. We had full employment. Unfortunately, the way that Obama's so-called "economic recovery" is going, the sun will explode before we see full employment again. If labor force participation in May 2011 had been 67.3%, the unemployment rate would have been reported at 13.2%, rather than 9.1%.

When the recession ended in June 2009, we were 12.5 million jobs short of full employment. Now, after two years of "recovery", the number is 15.3 million. Despite real GDP growth averaging 2.7% during Obama's recovery, we are losing ground with respect to full employment.

Real GDP per worker grew at an average annual rate of 2.96% during the first two years of the current economic recovery. This rate is high, but potentially sustainable. Real GDP per worker grew at a 2.91% average annual rate during the ten-year period ending in 1968.

If the growth of real GDP per worker were to continue at 3.0%, it would take us 11 years of 5% growth to get us back to full employment. Even if real GDP per worker were to slow to an average 2.0% annual increase from 2011 on, it would still take five years of 5% growth to reach full employment. Pawlenty seems to understand that we cannot wait decades to get Americans back to work.

As important as jobs are, they are not the whole story. We also need Pawlenty's 5% GDP growth to dig America out of the financial hole created by the "lost decade" of the 2000s.

The U.S. economy grew at an average annual real rate of 3.4% in the 1990s. This was slower than the 3.7% average from 1930 to 1990, but fast enough to get us to full employment in 2000. The economic growth of the 1990s also put the federal budget into surplus and bolstered the solvency of Social Security. In contrast, the 1.67% growth rate of the 2000s has left us where we are now.

It will take a asustained period of 5% real growth to get us out of this mess. If 5% growth commenced on January 1, 2012, it would take the U.S. until 2024 to recover financially. In other words, it would take 13 years of 5% real growth to catch us up to the GDP level that we would have attained by growing at 3.4% from 2000 on.

So, a sustained period of 5% economic growth is necessary. But is it doable? Yes, it is.

The economy as a whole grows the same way that an individual business grows: first you invest capital, then you hire workers, and then you produce output. Five percent real GDP growth is achievable because the U.S. economy produces a 50% annual return on nonresidential assets. In other words, adding $100 to nonresidential assets adds $50 to GDP. So, all we have to do to achieve 5% real growth is to get businesses to invest more.

The amount of additional capital investment that would be required to sustain 5% real growth is not daunting. Normally, the U.S. devotes about 15% of GDP to nonresidential capital investment. As a first approximation, we would have to increase this to about 18% of GDP to achieve 5% growth. However, the investment would have to be done by private businesses. Government-directed pork barrel "stimulus" produces nothing.

Our current policies could hardly be more hostile to investment. Our unstable dollar makes long-term projects very risky. Our corporate tax rate is the second highest in the world, and the compliance costs for this tax are larger than the revenues it produces. We tax inflation as a capital gain. We impose a death tax that forces the liquidation of businesses and farms. We massively subsidize residential investment, even though residential assets produce only about a 7% annual return in terms of GDP. We discourage business investment via a blizzard of constantly changing government regulations.

Ironically, this litany of horrors is actually good news. It means that all we have to do to get sustained 5% economic growth is to stop doing stupid things that discourage investment.

Pawlenty seems to understand that it is not in the federal government's interest to tax away a dollar that would otherwise be invested in nonresidential assets. This is because, on average, the Federal tax system captures about 18% of GDP. On the margin, a dollar collected in taxes produces at most a 2% real return for the Treasury via reduced interest costs. On the other hand, that same dollar invested in nonresidential assets produces a 9% real return for the Treasury (18% of the 50% GDP return produced by the assets).

You can't go broke by borrowing at 2% and investing the money at 9%, and neither can the Federal government. Pawlenty is correct when he says that his proposed tax cuts would more than pay for themselves. In fact, 5% economic growth will pay for whatever tax cuts are required to produce it.

Would Pawlenty's plan, as described in his speech, actually produce 5% growth? Very likely yes, although one element should be added, as discussed below.

Pawlenty's plan would increase capital investment in four ways. First, his 15% corporate income tax rate would increase after-tax returns. This would cause more projects to meet big companies' "hurdle rates". Second, the corporate income tax cut would make the U.S. much more competitive as a location for investments by multinational firms. Third, his elimination of the capital gains tax would boost venture capital funding of startups. And, fourth, lower taxes would mean faster growth for small businesses that must finance their expansion via retained earnings.

This having been said, eliminating the corporate income tax entirely would produce about four times the benefit of cutting the rate from 35% to 15%. That is because the corporate income tax has huge compliance costs, which companies (including startups) incur whether they are profitable or not.

Eliminating the capital gains tax entirely, as Pawlenty has proposed, should lead to rapid gains in employment, as well as GDP. All net job creation comes from companies less than five years old, and capitalgains are what motivate venture capitalists to fund startups.

Overall, Pawlenty's plan is good, but it would benefit from adding one more element. A stable, high-growth economy requires a stable dollar, and we don't have one right now. A successful president gets eight years in office, so it is illuminating to look at how "money" has impacted economic history over 8-year periods.

During the eight years ending in 1966, real GDP grew by an average of 5.13% per year. Unemployment declined by 56%, from 6.8% to 3.8%, and real GDP per worker increased by an average of 3.24% annually. This was the "golden age" of middle class prosperity. This boom was powered by the Kennedy tax cuts of the early 1960s, but it is not a coincidence that it occurred under the Bretton Woods monetary system, where the dollar was pegged to gold at $35/oz.

The best 8-year period of the post-Bretton Woods era ended in 2000. Real GDP increased at an average annual rate of 3.87%, and unemployment fell by 53%, from 7.5% to 4.0%. However, real GDP per worker increased by only an average of 2.01% annually, so middle-class income gains, while welcome, were not as robust as they were during the 1958 - 1966 period. It is important to note that, although the dollar was not completely stable during 1993 - 2000, it was rising-by 16% against major foreign currencies, and by 21% in terms of gold.

It is clear from the history from 1948 to the present that a strong dollar is essential to prosperity, and that a completely stable dollar is better still. Tim Pawlenty has put forth an important and courageous economic plan. As articulated, it would have an excellent chance of delivering on his goal of 5% economic growth. Add a stable dollar to the mix, and 5% growth would be assured.


Louis Woodhill (louis@woodhill.com), an engineer and software entrepreneur, and a RealClearMarkets contributor.  


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