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

To the Congress of the United States:

The major economic objectives of my Administration from its beginning have been strong, sustainable, noninflationary economic growth and expanding economic opportunities for all Americans. To achieve these goals, we have pursued policies that are in the long-term best interest of the Nation.

The benefits of this approach are now clear. The economy has entered the fourth year of a robust expansion that has dramatically increased opportunities for all Americans. Millions of new jobs have been created. Investment opportunities have increased. Standards of living have risen. Moreover, this success has been accomplished without rekindling inflation.

We are committed to continuing and extending policies that encourage the private investment and innovation that are the foundation of this expansion. We continue to resist unnecessary increases in government spending and unwarranted interference in private markets. Sustained, strong economic growth depends critically on allowing the market system to function as freely as possible. Free markets provide proper incentives to work, save, and invest, and they ensure that the interests of consumers are served.

These basic principles were embodied in our 1981 Program for Economic Recovery and reaffirmed in the second-term Program for Growth and Opportunity. These programs do not offer "quick fixes" but rely on the inherent ability of the free market system to allocate resources efficiently and to generate economic prosperity. The fundamental responsibility of the Federal Government should be to provide a stable environment within which people can make economic decisions, not to make those decisions for them. To this end, our initial program involved four essential elements:

• Restrain the growth of Federal spending,

• Reduce personal and business taxes,

• Reduce regulatory excesses, and

• Encourage stable and moderate monetary growth.

The Current Expansion

The success of our policies is now apparent. Even though economic growth slowed a bit in 1985 compared with its strong performance in 1983 and 1984, the expansion has nonetheless proceeded at an encouraging pace. It is already 4 months longer in duration than the average peacetime expansion since World War II. If the expansion continues as expected throughout 1986, it will be the third longest in the postwar period.

This expansion has been characterized by unusually strong real business investment in plant and equipment due to our successful attack on inflation and to our tax policy, which stimulated investment. Real business investment has contributed nearly twice as much to real gross national product (GNP) growth in this expansion as it typically has in previous postwar expansions; as a share of real GNP, it is higher than at any other time in the postwar period. Stronger U.S. investment means not only a stronger economy today, but also higher productivity and the potential for faster growth in the future.

Strong employment growth is another outstanding feature of this recovery. Since the end of the last recession in November 1982, the U.S. economy has employed more than 9 million new workers. Furthermore, the unemployment rate fell from 10.6 percent in November 1982 to 6.9 percent in December 1985. Despite this dramatic improvement, however, we will not be satisfied until all American workers can find jobs at wages commensurate with their skills.

When we initiated our Program for Economic Recovery, we were confident that a resourceful, flexible economy, unencumbered by excessive governmental intervention, would create jobs. At the same time, we believed that restrained monetary growth would reduce inflation. Our optimism was justified. The rate of inflation is now less than one-third of the rate in 1980. During this expansion, inflation has maintained its lowest level in more than a decade despite the tremendous employment growth that the economy has generated. Reflecting in part the reduction in inflation, interest rates-especially long-term rates—have declined throughout 1985 and by the end of the year were at their lowest levels in 6 years.

Our success in reducing inflation came as a surprise to some. As inflation rose in the 1970s, some businesses and individuals incurred debt in order to purchase assets, expecting the income generated by these assets to rise with inflation while the real burden of servicing the debt decreased. With the decline in inflation, the real burden of debt servicing rose and the income generated by many assets fell. This combination of events has strained some U.S. financial institutions. Falling farm incomes have hampered the ability of some farmers to pay interest on their debt. Similarly, many less developed countries have had difficulty repaying loans from U.S. financial institutions. The stress that the undesirable rise in inflation and its desirable but unexpectedly rapid decline have imposed on the U.S. financial system emphasizes the importance of achieving and maintaining long-term price stability.

America's optimism concerning continued growth in economic opportunities is shared by businesses and individuals throughout the world. The United States has been and remains one of the few major immigrant-receiving countries, reflecting in part the economy's ability to generate economic opportunities. During the current expansion, profitable investment opportunities in the United States have also attracted foreign capital, helping to finance the rapid growth in investment. The inflow of foreign capital indicates a strong economy. As other nations continue to move toward market oriented policies and reduce excessive government spending, taxation, and structural rigidities, they too will generate increased investment opportunities, resulting in increased growth and stronger currencies as more capital flows into their economies.

The Economic Outlook

Many factors point to continuation of the current expansion. Economic conditions at the end of 1985 were more favorable than they were at the beginning of the year and are expected to improve further. Monetary growth during the past year has been sufficient to accommodate growth in the economy. The leading economic indicators have risen in 11 of the past 12 months. Inventories are relatively low, and as sales continue to expand, production should increase to replenish depleted inventories. Interest rates have continued their decline, promising to spur additional capital spending. Furthermore, the warning signals that typically precede the end of expansions have not been observed. Thus, we feel confident that the current expansion will continue through 1986.

We expect increased growth in real GNP of 4 percent in 1986, continuing throughout 1987 and 1988 and declining gradually in 1989-91 as the economy approaches its long-run real growth trend. Given the monetary and exchange rate developments during the past year, we anticipate a slight rise in inflation in 1986-87. However, if the Federal Reserve reaffirms its resolve to achieve price stability, a goal that I support without reservation, the downturn in inflation should resume in later years.

Changing events, including erratic monetary and fiscal policies, can bring any expansion to an abrupt and unexpected halt. Our projections for the longer term are premised on the assumption that stable economic policies will foster continued economic growth and will also provide the needed flexibility for the economy to respond to external disturbances. Our policy goals reflect this commitment to economic stability as the key contribution to sustained growth, stable prices, declining interest rates, and falling unemployment. The American people have a right to expect such results and, with the cooperation of the Congress and the Federal Reserve, we expect to continue to deliver them.

The Economic Role of Government

In formulating our program for healthy and continued economic expansion, we recognized the limited role that government properly plays. The Federal Government cannot provide prosperity or generate economic growth; it can only encourage private initiative, innovation, and entrepreneurial activity that produce economic opportunities. An overly active government actually hinders economic progress. Federal spending absorbs resources, many of which could be better used by the private sector. Excessive taxation distorts relative prices and relative rates of return. By arbitrarily reallocating resources, it inhibits the economy's ability to grow. Thus, the best way for government to promote economic growth is to provide a foundation of stable, predictable economic policies, and then to stand back and let the creative potential of the American people flourish.

The Federal Government has several definite responsibilities that my Administration continues to uphold. The first is to provide an adequate national defense. World peace and security require the United States, as the leader of the free world, to demonstrate its willingness and ability to defend its own national security and to contribute to the defense of its allies.

Furthermore, we will not ignore the less fortunate in this society. My Administration continues to provide an appropriate safety net to aid those individuals who need help. At the same time, we have worked to develop a strong, vibrant, opportunity-generating economy that can offer meaningful jobs to all who are able to work. The economic expansion has done much more to reduce poverty than any government transfer program. The significant decline in the percentage of the population in poverty in 1984 reflects both the success of our programs and the strength of the economy. Moreover, tax reform will benefit the working poor. My proposed tax reforms eliminate the Federal income tax burden of most working poor.

Finally, even though we believe that markets generally allocate resources most efficiently, there are a few special cases, such as air and water pollution, in which the market mechanism alone may be inadequate. In these instances, government intervention is necessary, but even here, it should be based on market principles. For example, the Environmental Protection Agency has approved arrangements that enable firms to earn credits for reducing emissions below the required limit, which they can sell to other firms facing higher costs of emission control. In this way, environmental quality is maintained and improved while the costs of compliance decline.

Control Federal Spending.—Fulfillment of these limited responsibilities, however, does not require the level or the rate of growth of Federal spending that the Nation has been experiencing. In spite of our efforts, spending remains excessive and has been the primary cause of the large budget deficit. Tax rate cuts did not generate this deficit; in fact, current tax receipts are as large a share of GNP as they were in the late 1970s, even after the reduction in tax rates that we initiated in 1981. The key to resolving the Federal budget deficit is to restrain unneeded spending. Spending, not the deficit, is the true indicator of the cost of government, because it measures the total economic resources diverted from the private sector. Excessive spending affects the economy in deleterious ways regardless of whether it is financed through taxation, borrowing, or even inflation. Private capital formation is reduced, resources are inefficiently allocated, and economic growth is slowed.

I applaud and support the newly enacted Balanced Budget and Emergency Deficit Control Act of 1985, known commonly as Gramm-Rudman-Hollings, as a way to work with the Congress to reduce Federal spending and the deficit. I intend to submit budgets in each of the coming years that satisfy the act's deficit targets, not by sacrificing the programs essential to the Nation, but by reforming or eliminating those programs that are ineffective or nonessential. I reject the notion of increased taxes. Higher taxes would only encourage more Federal spending and limit the economy's ability to grow.

Gramm-Rudman-Hollings accomplishes only part of our long-term objective of Federal fiscal responsibility. Properly applied, it will produce a balanced budget by 1991, but it does not guarantee a continued balanced budget thereafter. We must now direct our attention to a constitutional amendment providing for a permanently balanced budget. Together, these two measures will provide an orderly transition to a balanced budget, restrain future spending, and ensure that future fiscal decisions are prudent and responsive to the national interests. Accordingly, I continue to support strongly and to urge the adoption of a balanced-budget constitutional amendment. I also seek legislation that would authorize the President to veto individual line items in appropriations measures. Such authority is essential to ensure that only effective and essential government programs are funded.

Reform Taxes.—Over the years, successive modifications of the Federal tax code have resulted in a complex tax system that contains many loopholes and artificially encourages some types of activities at the expense of others. Furthermore, the inflation of the 1970s distorted the overall pattern of capital taxation and pushed personal incomes into ever-higher tax brackets, discouraging saving and investment. Our actions to reduce tax rates have corrected many of these distortions and inequities. Individual income tax rates have been reduced and indexed to the inflation rate; effective tax rates on new investment have been lowered substantially. Still, more must be done.

In May 1985, I submitted to the Congress a comprehensive reform of the tax code to make it simpler, fairer, and more conducive to economic growth. I proposed reducing marginal tax rates for individuals and businesses, broadening the tax base by eliminating the majority of existing loopholes, taxing different activities consistently so that resources are allocated on the basis of economic merit and not tax considerations, and compensating for or eliminating much of the remaining influence of inflation on effective tax rates on capital. Just before it recessed, the House of Representatives passed a tax reform bill that incorporated some of these principles. Despite substantive differences between my proposal and the House bill, I urged its passage to move the legislative process forward. We will now work with the Senate to generate a fair and simple tax code that is truly pro-family, projobs, and pro-growth.

Eliminate Counterproductive Regulation.—Tax reform is only one part of our goal to enable markets to function more efficiently in allocating resources. We have also worked hard to identify and remove government regulations that impede the operation of markets, inhibit competition, or impose unnecessary costs on firms and unnecessarily high prices on consumers. The regulation of domestic oil prices provides a good example of the deleterious economic effects that regulation can have as it distorts relative prices and prevents necessary adjustments. The results of my accelerating the deregulation of oil prices in January 1981 are now apparent. Oil imports 'have declined, and the Organization of Petroleum Exporting Countries has found it impossible to sustain its previous levels of high prices. In contrast, the natural gas market is still plagued by distortions induced by price controls. In 1983, we unsuccessfully urged the Congress to deregulate natural gas prices. We will again pursue legislation that would completely deregulate natural gas prices. In addition, we are proposing further deregulation of the trucking industry.

We will continue efforts to reduce government involvement in two particular sectors of the economy. First, the banking and credit system remains rife with regulations and loan guarantees that arbitrarily allocate credit and hamper the system's ability to adapt to changing economic conditions. While we must continue to protect the public against severe economic disturbances, we should allow financial institutions greater freedom in determining the composition of their assets and liabilities so that they can respond more flexibly to the changes they encounter.

Second, heavy government involvement also persists in many agricultural markets. Government policies, intended as solutions, have so distorted incentives that they have actually caused some of agriculture's current problems. The legislation that I proposed in 1985 was designed to return American agriculture gradually to a free market. The bill passed by the Congress in late 1985 contained some of my proposed reforms, but preserved some of the policies that now hamper agriculture. In particular, it maintained counterproductive government intervention in the dairy industry, mandated export subsidies, and continued costly distortions of the sugar market. We will continue to pursue further agricultural reform that lessens government involvement in these areas and increases opportunities for farmers to compete successfully in world markets.

Transfer Some Services to the Private Sector.—The Federal Government has increasingly sought to provide services that can be more efficiently provided by the private sector. To address this problem, I have established a working group to investigate which government functions could be effectively returned to the private sector. I have also included several initiatives in this area in the recently released budget. This strategy does not necessarily require eliminating services now provided by the government. Rather, it would make private alternatives available. Such a strategy ensures production of services that are demanded by consumers, not those chosen by government bureaucrats. It also leads to more efficient and lower cost production of those services, and often removes government-imposed restraints on competition.

Maintain Free and Fair Trade.—Our pursuit of unencumbered markets is not confined to the domestic economy. Our international trade policy rests firmly on the foundation of free and open markets. The benefits of free trade are well known: it generates more jobs, a more productive use of a nation's resources, more rapid innovation, and higher standards of living both for this Nation and its trading partners. While a unilateral commitment to free trade benefits the Nation, Americans gain even more when U.S. trading partners also open their markets. My Administration will actively pursue this goal. An important part of our trade program is to begin a new round of multilateral trade negotiations. Under the auspices of the General Agreement on Tariffs and Trade, we are seeking to engage U.S. trading partners in comprehensive negotiations that will generate freer trade, increased access for U.S. exports, and a stronger international trading system. To complement this initiative, we are continuing to explore the possibility of establishing bilateral free trade zones with some U.S. trading partners.

We do not blindly pursue free trade. We also strive to ensure that trade is fair by vigilantly enforcing current trade laws. Unfair trade practices abroad harm U.S. exporters as well as reduce standards of living worldwide; this is unacceptable. In an unprecedented move, I have asked the U.S. Trade Representative to initiate unfair trade practice investigations under Section 301 of the Trade Act of 1974. Such investigations are not intended to produce retaliatory action by the United States, but rather to achieve more open markets internationally. In this way, we hope to convey the message that a commitment to free and fair trade is a reciprocal obligation in this increasingly interrelated world trading community.

The large trade deficit that has evolved during the current expansion has subjected our free and fair trade policy to much criticism, especially from the Congress. During the past year, more than 300 pieces of protectionist legislation have been considered or proposed. While the conditions that have led to the trade deficit have adversely affected some U.S. industries, increased protectionism is not the solution. Protectionist measures will have little effect on the trade balance and will only decrease standards of living and inefficiently redistribute resources within the economy.

Our agreement with four other major industrialized nations in September 1985 was an important recognition that economic policy changes across countries (not only in the United States) are essential to correct trade imbalances worldwide and to realign currency values. To this end, we reaffirmed our commitment to continue efforts to reduce the Federal Government deficit by lowering spending as a share of GNP. We urged the Congress to enact Gramm-Rudman-Hollings to achieve that goal. America's trading partners, in turn, committed themselves to policies designed to foster increased internally generated economic growth and, hence, increased demand for U.S. exports. These policy objectives are important for less developed countries as well. Indeed, a central facet of the Secretary of the Treasury's recent initiatives to assist in resolving the debt-servicing problems of these countries is that they pursue policies to promote growth, reduce inflation, and secure balance of payments adjustment.

Conclusion

My Administration recognizes the responsibility of the Federal Government to promote economic growth and individual opportunity through policies that lead to maximum employment, production, and purchasing power. We intend to maintain this course with policies that continue to promote strong, sustainable, noninflationary growth and provide expanding economic opportunities for all. We shall continue to resist additional government involvement as a solution to short-term problems. Such involvement has been unsuccessful in the past and ultimately becomes part of the problem rather than part of the solution. With the cooperation and support of the Congress and the independent agencies, we will pursue the appropriate policies necessary to sustain the current expansion and to stabilize prices.

RONALD REAGAN

February 6, 1986