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The Story of the 1990s Economy

Joel Harris | 10/18/2010
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At an event last month, President Obama made a subtle and surprising connection when he linked the Clinton-era tax rates with the economic growth of the late 1990s. After discussing his plan to extend the Bush tax cuts on up to $250,000 in income, the President declared “[a]fter that, you’d go back to the rates that were in place when Bill Clinton was President – which I just want to remind everybody, at the time we had 22 million jobs created, much faster income and wage growth, the economy was humming pretty good.” A few weeks later The Economist captured the point more starkly: “On taxes, the administration points out that even allowing all the Bush tax cuts to expire would return tax rates only to what they were under Bill Clinton, which was hardly a terrible time for business.”

No one disputes the fact that the U.S. economy expanded significantly during the 1990s when the higher tax rates were in place, but this is a historical fact – not an argument. Reading between the lines, it appears the Administration is arguing it’s possible the economy could grow again if the top rate is reset to its Clinton-era level. But that doesn’t answer the question of whether or not, going forward, the economy is likely to grow at the higher rates, or what tax policies are most conducive to fostering economic growth in the future. To see this clearly, it’s worth taking a brief look at the actual engine of 1990s growth: improved productivity in information technology (IT) manufacturing and increased investment in IT equipment. The research examining the IT-led expansion from 1995-2000 shows it to be a unique and surprisingly unanticipated event that has no bearing on the tax decisions confronting Congress today.

First, it is important to recall the relatively poor performance of the U.S. economy in the early 1990s. From 1990-1995, real gross domestic product (GDP) grew at an average annual rate of just 2.4% per year (down from 4.3% real annual growth from 1983-1989), and multi-factor productivity gains – the most comprehensive measure of productivity – limped along at an average of 0.5% per year. (Productivity had slumped since the 1970s, despite the diffusion of personal computers. This led to Nobel laureate Robert Solow’s famous observation that “you can see the computer age everywhere but in the productivity statistics).

By the mid-1990s, some influential observers still foresaw no major productivity leaps, as a 2006 paper in the Federal Reserve Bank of St. Louis Review showed. For example, in the 1996 Economic Report of the President, President Clinton’s Council of Economic Advisors predicted that labor productivity, a key indicator of the impact of new technology on workers’ output, would continue to rise at roughly the level it had from 1973-1995.

However, all this changed in dramatic fashion. After a slight dip in 1995, GDP growth took off – averaging 4.3% a year in real terms from 1996-2000. Multi-factor productivity rose at an annual clip of 1.3% (over the 1995-2000 period), while labor productivity increased as well: a 2004 Brookings Institution study estimated that from 1995-2001 labor productivity grew at an average annual rate of 2.6% in services (a major source of overall improvements in workers’ efficiency) and 2.3% in manufacturing.

So what explains the productivity surge and the sharp rise in economic growth during the late 1990s? In a 2007 paper, a team of economists lead by Harvard’s Dale Jorgenson found the economic expansion was driven by efficiency increases in the production of IT, including computers, software and telecommunications components. Improvements in IT production “resulted in higher rates of decline in IT prices, stimulating decisions by firms, households, and governments to invest in IT equipment and software.”

But why was there a sudden improvement in the production of IT equipment in the mid-1990s? Jorgenson located the change in the semiconductor industry, a key source of components for computer chips. He noted that “[a] sharp acceleration in the rate of decline of semiconductor prices took place in 1994 and 1995 … as the semiconductor industry shifted from a three-year product cycle to a greatly accelerated two-year cycle.” Jorgenson argued elsewhere that the shortened product cycle was the result of competitive pressures in the semiconductor industry. In other words, a market-driven positive feedback loop was a central factor behind the 1990s expansion: competitive pressure drove production improvements in a key IT industry, leading to lower IT equipment prices and increased investment by businesses and consumers.

Other factors were certainly at play: research has also identified the role of organizational change and business process innovation in enabling firms to extract value from the new technologies they purchase. But there can be no doubt the roaring economy of the 1990s was due in large part to the impact of information technology on economic growth and productivity.

The story of the 1990s economy holds an important lesson for today’s tax debate, but it’s not the one the Administration intends by invoking it. While the Clinton-era expansion did indeed take place under higher tax taxes, it was largely due to crucial changes in IT production and investment that led to growth and once-in-a generation productivity gains. The lesson here is a basic but important one: the past doesn’t predict the future. If the Administration believes there are similar productivity gains on the horizon that will lift the U.S. economy out of its financial crisis-induced hangover, it should explicitly identify the source of these gains. Otherwise, the 1990s experience provides no guidance for what to do about the tax policy set to expire on January 1.

Joel Harris is a business consultant. He previously served as Policy Director to the Secretary of Commerce during the administration of George W. Bush.


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