Message to the Congress Transmitting the Annual Economic Report of the President

To the Congress of the United States:

In 1981, when I first assumed the duties of the Presidency, our Nation was suffering from declining productivity and the highest inflation in the postwar period—the legacy of years of government overspending, overtaxing, and overregulation.

We bent all of our efforts to correct these problems, not by unsustainable short-run measures, but by measures that would increase long-term growth without renewed inflation. We removed unnecessary regulations, cut taxes, and slowed the growth of Federal spending, freeing the private sector to develop markets, create jobs, and increase productivity. With conviction in our principles, with patience and hard work, we restored the economy to a condition of healthy growth without substantial inflation.

Although employment is now rising, business opportunities are expanding, and interest rates and inflation are under control, we cannot relax our economic vigilance. A return to the policies of excessive government spending and control that led to the economic "malaise" of the late seventies would quickly draw us back into that same disastrous pattern of inflation and recession. Now is the time to recommit ourselves to the policies that broke that awful pattern: policies of reduced Federal spending, lower tax rates, and less regulation to free the creative energy of our people and lead us to an even better economic future through strong and sustained economic growth.

Major Economic Developments 1981-1984

The Program for Economic Recovery that we initiated in February 1981 had four key elements:

• Budget reform to cut the rate of growth in Federal spending,

• Reductions in personal and business taxes,

• A far-reaching program of regulatory relief, and

• Restoration of a stable currency and a healthy financial market through sound monetary policy.

The success of this program is now obvious—the U.S. economy is experiencing the strongest recovery in 30 years:

• Real business fixed investment in plant and equipment is higher, relative to real gross national product, than at any time in the postwar period.

• Productivity growth in the business sector has averaged 2.2 percent since the fourth quarter of 1980, compared with a rate of less than 0.3 percent over the prior 4 years.

• The inflation rate is now about onethird the rate in 1980, and short-term interest rates are less than one-half their peak 1981 levels.

But the quantitative record alone does not tell the full story. Four years ago, there was a widespread and growing anxiety about the economy. Many thought that the Nation had entered a condition of permanent economic decline, and that we would have to live with permanent double-digit inflation unless we were willing to suffer massive long-term unemployment.

We did not share this pessimism. It was clear to us that the Nation's economic problems were not the product of the economic system, but of the onerous influence of government on that system. The creative potential of the American people, choosing their own economic futures, was more constrained than helped by the increasingly heavy hand of government. Nor did we share the negative views that a reduction of inflation would increase long-term unemployment; that economic growth, by itself, would increase inflation; and that the government had to protect a "fragile" market system by regulating off prices and interest rates.

The primary economic responsibility of the Federal Government is not to make choices for people, but to provide an environment in which people can make their own choices. The performance of the economy in the past 2 years under our Program for Economic Recovery fully justifies our faith in the Nation's basic economic health. In 1983 and 1984 the economy generated about 300,000 new jobs per month without an increase in inflation. Real gross national product increased 5.6 percent during 1984, and the unemployment rate declined from 8.1 percent to 7.1 percent. Inflation was steady at its lowest level in more than a decade, and most interest rates are now lower than a year ago. Yet while the U.S. economy grew rapidly in 1984, it maintains the potential for continued strong growth. The inventory/sales ratio is low by historical standards, and capacity utilization rates in most industries are well below prior peak rates.

Economic conditions in 1984 were more favorable than during the second year of a typical recovery, and we see none of the warning signs that usually precede the end of an expansion. The temporary showing of economic growth starting in July—reflecting the combination of a minor adjustment of consumer spending and inventories and little growth of the basic money supply-seems to have ended in November. These conditions, plus an expectation that the Federal Reserve System will maintain sufficient money growth, support our forecast that the present recovery will continue. The thriving venture capital market is financing a new American revolution of entrepreneurship and technological change. The American economy is once again the envy of the world.

The Economic Outlook

For the years 1985 through 1988, we assume real gross national product growth of 4 percent per year, slowing slightly in 1989-90. We know that economic recoveries have not been stable in either duration or magnitude, in part because monetary and fiscal policies have often been erratic. We may not be able to eliminate recessions entirely, but a sustained commitment to policies that promote long-term growth and stability can reduce their frequency and severity. Our forecast that the unemployment rate, the inflation rate, and interest rates will decline gradually in the years ahead reflects this commitment to sound, sustainable, and predictable policies.

The Task Ahead: A Program for Growth and Opportunity

Our 1981 Program for Economic Recovery was designed for the long run with priority attention to the major problems we faced at that time. Our second-term Program for Growth and Opportunity represents a continuation and expansion of the earlier program, with priority attention to the major problems we face in 1985 and beyond. Our objectives—economic growth, stability of the general price level, and increased individual economic opportunity-have not changed. Federal economic policy will continue to be guided by the four key elements of the earlier program. Our progress in solving the most important economic problems we inherited in 1981, however, has allowed us to refocus our attention on the remaining problems and to shift our priorities and resources toward their solution.

Several significant problems remain to be addressed. The rate of growth of Federal spending has been substantially reduced from the rate projected in the budget we inherited in fiscal 1981, but spending growth continues to outpace the economy. Spending too much has left us with a large budget deficit that must and will be reduced. In our efforts to reduce the deficit, we must not forget that the cause of the deficit is increased spending and insufficient growth, not decreased taxes. Federal tax receipts are now almost the same share of gross national product as in the late 1970s, even after the substantial reduction in tax rates that we initiated in 1981.

Another economic problem demanding resolution is unemployment and its effects on the Nation's workers and families. Despite significant progress, much remains to be done. More than 6 million more Americans are now employed than in January 1981, but the unemployment rate is still too high. We will not be satisfied until every American who wants a job is employed at a wage that reflects the market value of his or her skills. Another aspect of this problem is that the poverty rate remains stubbornly high, despite a strong recovery and a continued increase in government assistance. Also, although the inflation rate has been reduced substantially, it is still higher than during most of our peacetime history prior to 1965. We will not be satisfied until we have totally and permanently wrung inflation out of our economy.

Work also remains to be done in the areas of regulatory and monetary policy. Many Federal regulations still impose a substantial cost to the economy. In addition, we need to strengthen the commitment to a sound monetary policy that never again retards economic growth, or reaccelerates inflation.

Our trade deficit, another area of concern, has been caused in large part by a strong dollar. Investors around the world have bid up the dollar as they have become increasingly confident in our economy. That confidence is an asset and not a liability. However, the conditions that have led to the trade deficit have increased the obstacles faced by some important industries. Agriculture, one of our most productive export sectors, has been harmed by a combination of rigid and outdated Federal agricultural policies and subsidized foreign competition as well as by the strong dollar. Some of our import-competing industries, such as steel, have also been hurt by subsidized foreign competition and the strong dollar. In one respect the trade deficit is like the budget deficit; both are too large to be sustained, but there are both beneficial and detrimental ways to reduce them. Our goal is a system of free and fair trade in goods, services, and capital. We will work toward this goal through both bilateral and multilateral agreements.

Economic conditions during the past 4 years are best characterized as transitional—from a period of low productivity growth to a period of high productivity growth; from a period of high inflation and interest rates to a period of much lower inflation and interest rates; from a period of economic "malaise" to a period of economic opportunity. Our task is to consolidate and extend these gains.

Federal Spending and the Deficit

The rate of growth of Federal spending has been reduced from 14.8 percent in fiscal 1981 to an average rate of 9.1 percent in fiscal years 1982 through 1985. During this period, however, current dollar gross national product has increased at an average rate of 7.6 percent. The continued growth of the Federal spending share of gross national product and lost revenues from the recession are the main reasons we are now faced with such large Federal deficits.

The projected Federal deficits are much too large, and they must be reduced. As explained in the accompanying report, however, the economic consequences of reducing these deficits depend critically on how they are reduced. A sustained reduction of the growth of Federal spending will contribute to economic growth, while an increase in tax rates would constrain economic growth. Federal spending on many programs is far larger than necessary, and far larger than desired by most Americans.

My fiscal 1986 budget proposal will protect the social safety net and essential programs, such as defense, for which the Federal Government has a clear constitutional responsibility, and will reform or eliminate many programs that have proven ineffective or nonessential. With no resort to a tax increase, this budget will reduce the deficit to about 4 percent of gross national product in fiscal 1986 and to a steadily lower percentage in future years. Additional spending reductions will probably be necessary in future years to achieve a balanced budget by the end of the decade.

The problems of excessive spending and deficits are not new. In the absence of fundamental reform, they may recur again and again in the future. I therefore support two important measures—one to authorize the President to veto individual line items in comprehensive spending bills, and another to constrain the Federal authority to borrow or to increase spending in the absence of broad congressional support. These structural changes are not substitutes for the hard fiscal choices that will be necessary in 1985 and beyond, nor for the need to simplify our tax system to stimulate greater growth; but they are important to provide the mechanisms and discipline for longer term fiscal health.

The case for a line-item veto should by now be obvious. The Governors of 43 States have used this authority effectively, and such authority has only once been withdrawn, only later to be reinstated. For over a century, Presidents of both parties have requested such authority.

The proposed constitutional amendment providing for a balanced budget and a tax limitation would constrain the long-run growth of Federal spending and the national debt. In 1982 a proposed amendment to constrain Federal authority to spend and borrow was approved by more than twothirds of the Senate and by more than a majority of the House of Representatives; a balanced budget amendment has also been endorsed by the legislatures of 32 States. Approval of the proposed balanced budget/ tax limitation amendment would ensure that fiscal decisions by future Presidents and Members of Congress are more responsive to the broad interests of the American population.

Federal Taxation

The Economic Recovery Tax Act of 1981 was one of the most important accomplishments of my first term. Individual income tax rates were reduced by nearly 25 percent, effective tax rates on the income from new investment were substantially reduced, and beginning this year tax brackets are adjusted for inflation.

But more needs to be done. Personal tax rates should be reduced further to encourage stronger economic growth which, in itself, is our best tool for putting deficits on a steady downward path. Our tax system needs basic reform. It is extraordinarily complicated; it leads to substantial economic inefficiency; and it is widely perceived to be unfair.

At my request, the Treasury Department has developed a comprehensive proposal to simplify and reform the Federal tax system, one that for expected economic conditions would yield about the same revenues as the present system. This proposal, by substantially broadening the tax base, would permit a significant further reduction of marginal tax rates. Shortly, I will be submitting my own proposal for tax simplification, and will urge the Congress to give serious sustained attention to tax simplification—in order to enact a program that will increase fairness and stimulate future savings, investment, and growth.

Federal Regulation

We have made major efforts in the past 4 years to reduce and eliminate Federal regulation of economic activity. Executive Office review of new regulations was streamlined. Off prices were deregulated by Executive authority early in 1981. New legislation was approved to reduce regulation of banking and to largely eliminate regulation of interstate bus travel.

Regulatory reform, however, has been painfully slow. The Congress failed to approve our proposals to further deregulate banking and natural gas prices, and to reform the regulation of private pensions. In addition, the reauthorization of several major environmental laws has been delayed for several years.

I urge the Congress to consider further deregulation efforts in several areas. The experience with deregulation of oil prices makes clear that continued regulation of natural gas prices is not appropriate. Reform of nuclear licensing requirements also deserves attention. Further deregulation of the banking system should be paired with a major reform of the deposit insurance systems. Some changes in the single employer pension law and an increased premium are necessary to preserve the pension insurance system. We should also seriously consider eliminating the remaining Federal regulation of trucking and railroads. Finally, I remain hopeful that the Administration and the Congress can work together to reauthorize the major environmental laws in a way that serves our common environmental and economic goals.

Monetary Policy

The Constitution authorizes the Congress "To coin Money (and) regulate the Value thereof," and Congress has delegated this authority to the Federal Reserve System. The role of the executive branch is restricted to advising the Congress and the Federal Reserve about the conduct of monetary policy, and to nominating members of the Board of Governors as positions become vacant.

During my first term, the Federal Reserve reduced the rate of money growth relative to the high rates of the late 1970s. This change in policy, assisted by the related strong increase in the exchange value of the dollar, helped produce a substantial reduction of inflation and market interest rates. On occasion, however, the rate of money growth has been quite volatile, contributing to instability in interest rates and a decline in economic activity. The sharp reduction in money growth through mid-1982, for example, undoubtedly added to the length and severity of the 1981-1982 recession. And a similar reduction in money growth in the second half of 1984 contributed to the temporary slowing of economic growth late in the year.

We reaffirm our support for a sound monetary policy that contributes to strong, steady economic growth and price stability. Moreover, we expect to cooperate closely with the Federal Reserve in defining and carrying out a prudent and predictable monetary policy.

Conclusion

The Federal Government has only a few important economic responsibilities. Given a proper conduct of these important roles, additional Federal intervention is more often a part of the problem than a part of the solution. We should continue to reduce the many less-important economic activities of the Federal Government so that individuals, private institutions, and State and local governments will have more resources and more freedom to pursue their own interests. Good stewardship of our constitutional responsibilities and the creative energies of the American people will ensure a future of continued economic growth and opportunity.

RONALD REAGAN

February 5, 1985.