Letter to the Speaker of the House of Representatives and the President of the Senate Transmitting the Annual Economic Report of the President

To the Speaker of the House of Representatives and the President of the Senate:

It is with great pride in the accomplishments of the American people that I present my eighth, and final, Economic Report of the President. When I took office 8 years ago there was widespread doubt concerning the ability and resolve of the United States to maintain its economic and political leadership of the Free World. Political events abroad seemed to demonstrate the impotence of American power, while economic events at home raised concerns about the vitality of our system. Throughout most of the 1970s inflation raged at unacceptably high rates, and unemployment moved upward. Stagflation, a name invented for the era, and malaise were the words used to describe America.

Today, it is as if the world were born anew. Those who doubted the resolve, and resilience, of the American people and economy doubt no more. The tide of history, which some skeptics saw as ebbing inevitably away from Western ideals of freedom of thought, expression, and enterprise, flows in our direction. By strengthening our military posture and reaffirming our commitment to the cause of freedom throughout the world, we have restored respect for America and have achieved the first arms control agreement in history to eliminate an entire class of nuclear missiles. And by reducing taxes and regulatory bureaucracy, we have unleashed the creative genius of ordinary Americans and ushered in an unparalleled period of peacetime prosperity. The world today is far safer, and more prosperous, than it was 8 years ago. And the America of today is, once again, brimming with self-confidence and a model for other countries to emulate. To be sure, there are challenges for the future, but I leave office confident that, with continued cooperation between the President and the Congress, America will meet these challenges and, in partnership with its allies, will continue to lead the world toward peace, prosperity, and freedom.

An Historical Perspective

Barely 40 years have passed since the end of World War II, but how the world has changed during that period. Man has walked on the Moon; products once unimagined are now commonplace; goods once considered luxuries are now necessities of life. Notwithstanding these enormous changes, the prime historical reality of this period has been the rivalry between two competing political and economic systems. One system operates by concentrating power in the hands of the few, by limiting personal freedoms, and by centralizing economic decisions. At its best, it is a system of state paternalism; at its worst, one of tyranny.

The other system believes that power emanates from the individual, not from the state; that the function of government is to serve, not dictate to, individuals. The great democracies recognize that political and economic freedom are indivisible; policies that threaten one of these freedoms inevitably undermine the other. These two divergent systems have vied, sometimes with words and sometimes with swords, for the hearts and minds of the rest of the world.

At the end of World War II the outcome of this competition was, to some, far from certain. Many intellectuals, looking back upon the experience of the depression in the interwar period, felt that the future was with communism. These people felt that capitalism, with its emphasis on the individual and decentralized decisionmaking, could not cope with the complexity of a modern economy. In the years that followed, some countries chose state planning and state ownership over the alleged chaos of the marketplace, while many more countries had this authoritarian system imposed upon them. Centralized control was especially attractive for many newly emerging economies, which felt themselves impoverished from, and were resentful of, their colonial experience. These countries turned inward, to highly regulated economies that shunned open markets and international trade as the path to prosperity, and instead sought self-sufficiency.

Today, few doubt which of these systems will emerge triumphant. Comparisons of economies with common cultures and people, such as North and South Korea, East and West Germany, or the People's Republic of China and Hong Kong or Taiwan, uniformly show that systems that emphasized individual initiative, open markets, and personal freedoms—as opposed to collective action—have prospered most. Developing economies have increasingly recognized the benefits of the market system as they have undertaken reforms to reduce the role of government and to increase the role of international trade. Most recently, this trend has even embraced the two largest proponents of state control, as first China and now the Soviet Union have reluctantly recognized that the true chains on individual fulfillment are an overbearing government that destroys motivation and freedom.

Viewed from the perspective of one who remembers well events of 40 years ago, the prosperity that we enjoy today is extraordinary. The economic growth experienced by countries that chose the path of economic and political freedom is virtually unparalleled in human history. This economic success is attributable to all nations that joined in pursuing market-oriented policies at home and in reducing barriers to trade among nations.

Americans can take a special pride in this postwar record. American aid to Western Europe and Japan helped rebuild those war-torn regions. America took the lead in fostering negotiations that reduced trade barriers and created international institutions that promoted financial stability and reconstruction. Open American markets not only benefited consumers at home, but also sped recovery abroad. And America took the lead in preserving the freedoms and prosperity we all enjoy. As Winston Churchill said in 1952: "What other nation in history, when it became supremely powerful, has had no thought of territorial aggrandizement, no ambition but to use its resources for the good of the world? I marvel at America's altruism, her sublime disinterestedness."

The Role of Government

As I said in my first Inaugural Address, "If we look to the answer as to why for so many years we achieved so much, prospered as no other people on Earth, it was because here in this land we unleashed the energy and individual genius of man to a greater extent than has ever been done before." The central role of government must be to nurture this genius, not to shackle it in a morass of regulations or to tax away the incentives for innovation.

This is not to deny that there are vital functions that a government must perform, but it must always do so in the least intrusive and costly fashion. The guiding philosophy of my Administration has been to leave to private initiative all functions that individuals can effectively perform for themselves, and when government action is necessary, to use the level of government closest to the community for all the public functions it can effectively handle. Federal Government action should be reserved only for those functions that require national attention. In this way government will least interfere with private incentives and will be most responsive to the wishes of the people it serves.

The Federal Government, of necessity, must provide for the national defense. Only through strength can we maintain peace and secure freedom and prosperity for ourselves and all free nations. But we must ensure that our defense money is spent wisely, not on pork-barrel projects, such as maintaining military bases that are no longer necessary. This Administration, through its words and its deeds, has shown its commitment to protecting the health and financial security of our elderly. Similarly, the government must provide a safety net for the Nation's poor, but is must do so in a way that promotes individual initiative. Too often, government programs, created with the best of intentions, serve to prolong, rather than eliminate, poverty.

There are some limited circumstances in which government regulation of private activity may be beneficial. Few would doubt that some rules are needed to protect the Nation's water and air from pollution. However, it is imperative that all such rules and regulations be based on sound economic principles that minimize the intrusion on private decisions. Whether well or poorly designed, whether aimed at worthy or dubious objectives, these rules have one thing in common: They "tax" and "spend" billions of dollars of private funds, unconstrained by public budget or appropriations controls.

The main role of government is to provide a stable economic environment that allows each individual to reach his or her full potential. Individuals and businesses must be able to make long-run plans confident that the government will not change the rules halfway through the game. Government's drain on the economy, both through its use of resources that could be used more productively by the private sector and through taxes that destroy individual incentives, must be minimized. This Administration's long-term view of fiscal policy, which abandoned the outmoded emphasis on fine-tuning the economy, has set the basis for the record peacetime expansion we currently enjoy. This policy, in conjunction with responsible monetary policy, has led to a sizable decrease in both unemployment rates and inflation over the past 8 years. I am pleased to say that my Administration is the first in more than a generation that can lay claim to this accomplishment.

The government's economic role in the international sphere should be similarly circumspect. It is the primary responsibility of governments to promote sound and stable financial markets that encourage international commerce and to reduce barriers to trade at home and abroad. Reducing these barriers will allow markets, not governments, to determine the goods that society produces. Too often policies designed to preserve jobs in one industry reduce competitiveness and employment in other industries. A creative, competitive America is the answer to a changing world, not trade wars that close doors, create greater barriers, and destroy millions of jobs. We should always remember: Protectionism is destructionism. America's jobs, America's growth, America's future depend on trade—trade that is free, open, and fair.

The Record of the Past 8 Years

In my first Inaugural Address I stated, "The economic ills we suffer have come upon us over several decades. They will not go away in days, weeks, or months, but they will go away." After a shaky start, necessitated by the sorry state of the economy in 1980, we now have a peacetime economy entering an unprecedented 7th year of expansion. The length, strength, and resilience of this expansion are ample testimony to the wisdom of the policies that we have pursued.

During this expansion, real GNP has risen by more than 4 percent a year, nearly double the growth rate of the previous 8 years. The growth in employment and jobs has been phenomenal; nearly 19 million nonagricultural jobs have been created during this period, with nearly 3.5 million new jobs created in the first 11 months of 1988. Furthermore, this remarkable expansion has benefited all segments of the population. While civilian employment has increased by more than 17 percent, Hispanic employment has grown by more than 45 percent, black employment by nearly 30 percent, and female employment by more than 20 percent. The decline in unemployment rates is equally dramatic—the overall unemployment rate has been cut in half, down to levels not seen in 14 years. And, assertions to the contrary, the jobs created are good ones; over 90 percent of the new jobs are full-time, and over 85 percent of these full-time jobs are in occupations in which average annual salaries exceed $20,000.

Unlike previous experiences, this expansion has been accomplished without simultaneously fueling inflation. The average inflation rate during this period, as measured by the GNP deflator, has been barely onethird the rate of inflation that prevailed in 1980. The scourge of inflation, which served as a hidden tax on the American people and diverted productive resources to unproductive uses, has been brought under control here and in our major trading partners. This, in turn, has led to a dramatic decline in interest rates, which, while still high by historic standards, are far lower than they were in January 1981. In short, we have achieved the objectives that eluded us during the 1970s—rapid economic growth and declining inflation rates.

This record has been achieved not through alchemy, but by using that good old-fashioned recipe of reducing the role of government. Too often the government has sought to solve problems best left to the private sector; and too often these solutions have had devastating side effects. We have at least learned that more government is not the solution to our problem; often it is the problem.

Our New Beginning has restored personal incentives through a series of tax reforms and tax cuts. These reforms have reduced the top Federal marginal income tax rate to less than one-half the level that prevailed when we took office and decreased tax liabilities at all income levels. The Tax Reform Act of 1986 improved efficiency by eliminating many tax preferences that distort private decision-making. By reducing tax rates and tax loopholes, we have encouraged people to make money the old-fashioned way—by producing goods and services that people want, not by finding new ways to avoid taxes. The tax reforms have increased equity as well, as an estimated 4 million low-income individuals and families have been removed from the income tax rolls by 1988. If imitation is the sincerest form of praise, then the fact that many other major industrial powers have also cut their tax rates is praise indeed.

These tax reforms, combined with regulatory reforms that will result in billions of dollars of saving over this decade, have helped spur productivity growth. Since 1981, manufacturing productivity has grown at an average annual rate exceeding 4 percent, triple the rate for the preceding 8 years and nearly 50 percent faster than that for the period 1948-73. This productivity growth, combined with exchange-rate changes, has led to a surge in U.S. exports that puts to rest the notion that U.S. industry is no longer competitive.

We have also made progress in reining in government expenditures, but much still needs to be done. We have reduced the rate of growth of Federal spending, and over the past 5 years government spending as a percent of GNP has fallen from 25.1 to 23.2 percent. Significant progress has also been made in reducing the budget deficit, both in absolute terms and as a percent of GNP, but further progress can be made only by reducing government spending. Tax increases would only threaten the enormous progress that has been made so far.

Our successes extend to the international sphere as well. The strong U.S. recovery, coupled with a weaker recovery abroad, helped create a sizable U.S. trade deficit. While the trade deficit has been significantly reduced during the past year as a result of our surging exports, it has served as an excuse for those seeking protection from foreign competition. Protectionism, like most forms of government intervention in the economy, serves only to enrich the few at the expense of the many. We have successfully resisted this protectionist pressure, while pursuing major trade liberalization efforts abroad.

The Israel-United States Free-Trade Agreement was the first such agreement entered into by the United States. The recently implemented Free-Trade Agreement with Canada represents an historic step forward for two staunch allies. In addition to creating the world's largest free-trade area between two countries and generating large benefits for both countries, it serves as a model of what can be accomplished in other negotiating forums. The United States remains committed to full multilateral liberalization, as reflected in the fact that we are the driving force behind the current Uruguay Round of multilateral negotiations under the General Agreement on Tariffs and Trade. While these negotiations are not scheduled to conclude until 1990, the results of the recent Mid-term Review indicate that they will result in significant reductions in trade barriers and a significant expansion in trade coverage.

Rather than succumbing to protectionist pressures at home, we have vigorously combatted unfair trade barriers abroad. This was the first Administration to seek, on its own initiative, changes in foreign trade practices that harmed American business. These policies have helped reduce foreign trade barriers and given American companies a chance to compete on equal terms.

The Challenges Ahead

As proud as I am of these and many other accomplishments, I will be the first to admit that the agenda is not yet completed. First, and foremost, is a need to reform the budget process and to bring Federal spending under control. The large budget deficit that this Nation faces is not a result of too few taxes, but too much spending. Strong economic growth and the base-broadening effect of tax reform have led to sizable increases in Federal receipts. According to current projections, these receipts will have increased by over $375 billion between fiscal years 1981 and 1989, but spending will have increased more rapidly—by more than $450 billion over this 8-year period. Projections indicate that Federal revenue will grow by more than $80 billion during the next fiscal year. All that is required to reduce the deficit is to halt, or moderate, the increase in expenditures.

Gramm-Rudman-Hollings is a first step toward bringing the deficit under control. However, further progress toward reform of the budget process is needed. Under current practice, funding for special-interest groups is combined with vital appropriations, leaving the President the choice between vetoing the entire package or accepting some funding that he knows is not in the national interest. To prevent this waste of taxpayers' money, the President needs what governors already have—a lineitem veto and enhanced rescission authority.

Moreover, the current budget process places no real restraint on congressional appropriations, because expanded spending on one program does not require reduced spending on other programs. Too often the temptation is to raise taxes, not lower spending. A law that requires a super majority of the Congress to approve waivers of spending limits or tax limits would help ensure that taxpayers' hard-earned dollars are spent wisely, and that the temptation to increase tax burdens is resisted. Furthermore, reform of government credit operations is required to limit new subsidies and to guarantee that the true costs of these measures are not hidden from public scrutiny. These reforms, together with the balanced budget amendment that I have repeatedly endorsed, would guarantee the fiscal prudence that is needed to sustain the dramatic expansion of the past 6 years. Limiting government expenditures would also help stimulate the private investment that is required to ensure that the next generation of Americans can look forward to the same increase in living standards that previous generations have enjoyed.

Despite the enormous progress we have already made in bringing down inflation, there is still work to be done. Inflation is a hidden, insidious way of taxing the American people. Price stability, not merely lowered inflation, is the key to maintaining the vigor of the American economy and the strong international role of the dollar. Stable, predictable monetary policy can provide the type of price stability that benefits not only our own economy, but also provides significant benefits to those developing countries that are so dependent upon us.

Perhaps most importantly, the challenge for the future is to maintain and expand upon the progress we have made in taking economic decisions away from the government and returning them to the private sector, where they properly belong. Governments are notoriously bad at identifying "industries of the future," and efforts to have the government formulate and implement industrial policy must be strongly resisted. For decades, government policies throughout the world have distorted agricultural production and trade. Adoption of our bold proposal to phase out these policies in the United States and other major producing countries would result in enormous efficiency gains. And, while major deregulatory gains have been made, much more can be accomplished. Reduced regulation of vital sectors, including transportation, energy, and financial industries, has led to significant increases in productivity and to sizable gains for consumers. Further deregulation of the financial sector can help preserve this country's position as the financial capital of the world. Finally, we must resist pressure to increase government requirements for mandated benefits. These programs, while well-intentioned, increase costs, reduce labor market flexibility, and reduce productivity. They undermine the competitiveness of American business and they ultimately hurt the very people they are supposed to benefit.

Conclusion

In 8 short years, we have reversed a 50-year trend of turning to the government for solutions. We have relearned what our Founding Fathers knew long ago—it is the people, not the government, who provide the vitality and creativity that make a great nation. Just as the first American Revolution, which began with the shot heard 'round the world, inspired people everywhere who dreamed of freedom, so has this second American revolution inspired changes throughout the world. The message that we brought to Washington—reduce government, reduce regulation, restore incentives-has been heard around the world.

I leave office secure in the knowledge that these policies have worked, and confident that this great Nation will continue to lead the way toward freedom and prosperity for all mankind.

RONALD REAGAN

The White House,

January 10, 1989.