Economic Report

of the President

Transmitted to the Congress

February 2005

together with
THE ANNUAL REPORT
of the
COUNCIL OF ECONOMIC ADVISERS

UNITED STATES GOVERNMENT PRINTING OFFICE

WASHINGTON : 2005

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Economic Report of the President | i

 C O N T E N T S

Page

ECONOMIC REPORT OF THE PRESIDENT............................................... 1

ANNUAL REPORT OF THE COUNCIL OF ECONOMIC ADVISERS*...... 7
CHAPTER 1. THE YEAR IN REVIEW AND THE YEARS AHEAD .............. 31
CHAPTER 2. EXPANSIONS PAST AND PRESENT ...................................... 49
CHAPTER 3. OPTIONS FOR TAX REFORM ................................................ 71
CHAPTER 4. IMMIGRATION ........................................................................ 93
CHAPTER 5. EXPANDING INDIVIDUAL CHOICE AND CONTROL...... 117
CHAPTER 6. INNOVATION AND THE INFORMATION ECONOMY ..... 135
CHAPTER 7. THE GLOBAL HIV/AIDS EPIDEMIC ..................................... 155
CHAPTER 8. MODERN INTERNATIONAL TRADE ................................... 173
APPENDIX A. REPORT TO THE PRESIDENT ON THE ACTIVITIES
OF THE COUNCIL OF ECONOMIC ADVISERS DURING 2004.............. 189
APPENDIX B. STATISTICAL TABLES RELATING TO INCOME,
EMPLOYMENT, AND PRODUCTION.......................................................... 201

* For a detailed table of contents of the Council’s Report, see page 11

Economic Report of the President | iii

 C H A P T E R 8

Modern International Trade

O pen markets and free trade raise living standards both at home and abroad.
The President’s policy of opening markets around the world is based on
this solid foundation. Yet, as international trade has grown in both volume and
scope, so too have concerns that old ideas about trade policies no longer apply
to today’s trade environment.
The key points in this chapter are:
• Free trade allows countries to mutually benefit from specializing in
producing products at which they are adept and then exchanging those
products. This rationale remains the same, even with advances in
technology and new types of trade.
• Foreign direct investment is playing an increasingly important role in
world trade, as companies invest across borders to gain skills, technology,
resources, and market access.
• The Administration has advanced multilateral, regional, and bilateral trade
agreements in order to open global markets. Lower trade barriers benefit
consumers worldwide and expand markets for America’s manufactured
goods, farm products, and services.

Free Trade: Beyond the Basics

The Administration’s pursuit of trade liberalization is based upon a long
history of intellectual support for free trade. Modern trade theory begins with
the nineteenth century’s David Ricardo. Ricardo’s central insight—his elegant
model of comparative advantage—is the starting point from which to explain
the gains from trade.
Ricardo’s model of comparative advantage addressed the question of how a
home country could compete with a foreign trading partner that is better at
producing everything. Ricardo showed that even if a foreign country could
produce each of two goods for less than the home country could (that is, the
foreign country has an absolute advantage in the production of the goods),
there could still be mutual gains from trading the two goods. The key to the
argument is that it is relative costs of production (comparative advantage) that
matter, not absolute advantage.
As an example of Ricardo’s theory of trade, consider a situation in which one
country requires two hours to produce a unit of each of two goods, while in a
second country it takes five hours to make Good One and ten hours to make

173
Good Two. In Ricardo’s simple model, the price of each good in the first
country before trade is one unit of the other good, because the two goods take
the same resources to produce. In the second country, Good Two would be
expected to cost twice as much as Good One, because it takes twice as much
labor to produce it. The first country has an absolute advantage in both goods,
but comparative advantage still provides a basis for trade. In this case, the
second country would gain from importing Good Two, which costs only half
as much in the other country (only one unit of Good One). The second
country would pay for these imports of Good Two by exporting Good One.
Similarly, the first country would import Good One, which in its trading
partner costs only one-half a unit of Good Two. It would pay for its imports
by exporting Good Two. In the end, world production rises as a result of trade,
and each country can consume more of both goods. This stylized example
illustrates that comparative advantage allows countries to gain when they
specialize in producing items in which they are relatively the most productive.
Critics do not usually argue that Ricardo’s theory of comparative advantage
is incorrect, but instead that it omits key aspects of trade that may undermine
the theory’s results and alter the consequent policy prescriptions. In basic
trade theory, for example, capital and labor do not move across borders
seeking the highest return. At least for capital, such movements are now
routine. Economic models that take into account both capital and labor
(Ricardo’s theory discussed only labor) show that countries as a whole still
gain from free trade. There are, however, differing impacts of trade on
different parts of the economy and the labor force. Policies aimed at
supporting individuals affected by trade are thus vital to ensuring that its
gains are widely shared. These policies are discussed later in the chapter.

Globalization and the Terms of Trade

Theoretical arguments showing the gains from trade compare a situation in
which a country is open to trade with one in which it is closed. The differ-
ences in production technology between a trading partner and the home
country mean that different prices prevail in the two countries before they
open their borders to trade. It is this difference in prices that allows both
countries to benefit from trade. With the advent of trade, a new price for
exchanging products will be reached, somewhere between the countries’ orig-
inal prices. This new price is known as the terms of trade. Each country gains
from opening when the terms of trade differs from the pre-trade price.
Over time, events in either country could change the terms of trade. Other
things equal, each country would prefer the price it receives for its export
good to increase, just as any merchant would wish to receive more for the
product he sells.

174 | Economic Report of the President

 After trade is opened, it is possible that changes in the world economy
could move the terms of trade in directions that benefit one country but not
the other. In this case, both countries would still be better off than they were
prior to trade, but one country would see its gains diminished. Such subse-
quent price changes could come from changes to the countries’ technologies
or from the discovery of natural resources, such as oil, that lead to changes in
production and trade patterns.
The possibility that a country could lose from global price changes is at the
heart of some recent critiques of globalization. One critique noted, for
example, that as China develops and becomes more similar to the United
States, the United States could be made worse off. There are two problems
with this critique. The typical view of globalization is that it is a phenomenon
marked by increased international economic integration. The critique above,
however, is of a situation in which development in China leads to less trade,
not more. If China and the United States have differences that allow for gains
from trade (for example, differences in technologies and productive capabili-
ties), removing those differences may reduce the amount of trade and thus
reduce the gains from that trade. The worst-case scenario in this situation
would be a complete elimination of trade. This is the opposite of the typical
concern that globalization involves an overly rapid pace of international
economic integration.
The second problem with the critique is that it ignores the ways in which
modern trade differs from Ricardo’s simple model. The advanced nations of
the world have substantially similar technology and factors of production, and
seemingly similar products such as automobiles and electronics are produced
in many countries, with substantial trade back and forth. This is at odds with
the simplest prediction of the Ricardian model, under which trade should
disappear once each country is able to make similar products at comparable
prices. Instead, the world has observed substantially increased trade since the
end of World War II. This reflects the fact that there are gains to intra-industry
trade, in which broadly similar products are traded in both directions between
nations (the United States both imports and exports computer components,
for example). Intra-industry trade reflects the advantages garnered by
consumers and firms from the increased number of varieties of similar prod-
ucts made available by trade, as well as the increased competition and higher
productivity spurred by trade. Given the historical experience that trade flows
have continued to increase between advanced economies even as production
technologies have become more similar, one would expect the potential for
mutually advantageous trade to remain even if China were to develop so
rapidly as to have similar technologies and prices as the United States.

Chapter 8 | 175
The Impact of Trade on Labor Markets
According to standard economic theory, the degree to which an economy
is open to trade affects the mix of jobs within an economy and can cause
dislocation in certain areas or industries, but has little impact on the overall
level of employment. The main influences on total employment are factors
such as the available workforce and the levels of interest rates, taxes, and regu-
lations that govern the labor market. Trade tends to lead a country to
specialize in producing goods and services at which it excels. Trade affects the
mix of jobs because workers and capital would be expected to shift away from
sectors in which they are less productive relative to foreign producers and
toward existing and new sectors. This would be expected to lead to higher
productivity and thus higher wages for workers.
The conclusion that free trade has little effect on the overall number of jobs
is borne out in data on the U.S. economy. If trade were a major determinant
of the Nation’s ability to maintain full employment, measures of the amount
of trade and the unemployment rate would move in tandem, but in fact, they
usually do not. The increase in imports as a percentage of gross domestic
product (GDP) over the past several decades has not led to any significant
trend in the overall unemployment rate (Chart 8-1). Indeed, over the past
decade, the U.S. economy has experienced historically low unemployment,
while exports and imports have grown considerably.

176 | Economic Report of the President

 Similar conclusions arise from examination of data on the trade or “current
account” balance (the broadest measure of the difference between exports and
imports of goods, services, and income flows). From 1960 to the third quarter
of 2004, the current account balance moved from a surplus of 0.5 percent of
GDP to a deficit of roughly 5.6 percent of GDP. Yet the average unemploy-
ment rate in 2004 was 5.5 percent, the same as the average unemployment
rate in 1960. Over this period, the U.S. economy gained more than
75 million jobs—an increase of roughly 140 percent. Increased trade has
neither inhibited overall job creation nor contributed to an increase in the
overall rate of unemployment.
That factors other than trade are the most important influences on the
labor market is of no consolation to a worker who loses a job because of
competition stemming from international trade. To assist people facing such
dislocation, the Administration has built upon and developed programs to
help workers acquire the skills needed to prosper in new jobs.
The Administration has proposed a reform of the overall workforce training
system to help Americans obtain marketable skills needed to compete for jobs
in emerging and innovative fields. The Administration recognizes that effec-
tive workforce training requires the cooperation of the private sector and
community colleges and has worked to nurture these partnerships through
the High Growth Job Training Initiative at the Department of Labor and
through the recently-enacted Community-based Job Training Grants.
In addition, the Administration has proposed the establishment of Personal
Reemployment Accounts, an innovative approach to worker retraining. With
these accounts, qualifying individuals who lose their jobs would receive an
account with funds that can be used for training and other services that best
fit their needs. Individuals who find new employment relatively quickly
would be eligible to keep the balance of their accounts as a cash reemploy-
ment bonus. The accounts would thus provide both support to unemployed
workers and an incentive to find new employment.
The Administration has also worked to enhance the long-standing Trade
Adjustment Assistance program, which provides training and income support
to workers directly hurt by import competition. As part of the Trade Act of
2002, eligibility was extended to workers indirectly affected by trade, such as
workers employed by firms that supply goods and services to industries
directly affected by trade competition. Benefits were enhanced to include a
health insurance tax credit and a wage supplement for older workers who
found new jobs that did not pay as well as their previous jobs. This assistance,
which will total $12 billion over 10 years, will ease the adjustment for
displaced workers and help them move into jobs for which their skills are
most in demand.

Chapter 8 | 177
The U.S. Advantage in Services Trade
This section considers the burgeoning trade in services. The performance
of U.S. service workers and firms has been particularly strong. The United
States exports more services than it imports, and this surplus has been
growing in recent years. Moreover, U.S. services exports tend to involve rela-
tively highly-skilled and highly-paid occupations, such as engineering,
financial services, or architectural services. While services trade may not have
been envisioned in the time of Ricardo, the principle of comparative advan-
tage holds. Any move toward economic isolationism would thus threaten the
competitive gains made by U.S. exporters while harming U.S. consumers and
firms that benefit from imports.
One prominent type of services trade is measured in the “business, profes-
sional, and technical services” category. This statistical category encompasses
advertising, telecommunications, computer and data processing services, and
accounting and legal services. The United States exports services when a U.S.
firm provides engineering or architectural services to partners in other coun-
tries. Annual U.S. exports in this category have grown by almost $25 billion
since 1989, compared to a $10 billion increase in imports over this period
(Chart 8-2). The growing trade surplus in this category is particularly striking
in light of the widening of the overall current account deficit. The existence
of a trade surplus suggests that the United States has a comparative advantage
in the international provision of tradable services.

178 | Economic Report of the President

 Ricardo’s theory that countries mutually gain from trade if they each
specialize in producing those items they could make relatively efficiently was
inspired by trade in goods. Given the difficulties of communication and
transportation in the nineteenth century, there would have been little point
in theorizing about trade in services.
In the modern global economy, however, services trade plays an important
role in international commerce and an especially positive one for the United
States. Advances in communication have made possible the increased trade in
services. These developments pose a challenge to industries that did not previ-
ously face foreign competition, though.
As noted above, the United States is good at the provision of services.
Expanded access to the broader international marketplace would be expected
only to further strengthen the U.S. advantage. The U.S. advantages in serv-
ices have fueled job gains both directly in firms that export services and
indirectly in firms that hire more workers in the United States as a result of
the efficiencies they gain through trade. One study of the effect of services
trade in the information technology sector found that it created over 90,000
net new jobs in the United States in 2003 and is expected to create 317,000
net new jobs by 2008. These new hires tend to be in positions requiring
relatively high levels of skills or creativity, such as software development.

Foreign Direct Investment: An Increasingly

Important Part of Trade
While the intellectual foundations behind free trade are unchanged, the
means by which goods are exchanged between countries have changed greatly
since the time of Ricardo. Goods are no longer simply produced in one place
using only that country’s resources and then sent off on ships to be unloaded
at a foreign port. Instead, many of the goods Americans enjoy today—whether
produced in the United States or abroad—are made with components from a
variety of sources.
Production of goods in this fashion is facilitated by foreign direct investment
(FDI). FDI occurs when an individual or firm buys a foreign company or
takes control of a sufficiently large portion of a foreign company (typically
10 percent or more of the target firm’s stock) that it can influence management
decisions. Greenfield FDI occurs when a company builds a plant abroad
from scratch (i.e., turns a “green field” into a factory), though this type of
investment is less common. FDI in turn gives rise to increased trade.
U.S. firms investing or setting up enterprises abroad can increase
opportunities for exporting their goods. Moreover, there is a good deal of
evidence suggesting that increased employment at the foreign subsidiaries of

Chapter 8 | 179
U.S. firms is associated with a corresponding increase in employment in the
U.S. parent company. Similarly, recent research shows that one dollar of
spending on capital investments abroad by U.S. firms is associated with an
additional 3.5 dollars of spending on capital investment at home. The avail-
able evidence thus suggests that, on the whole, overseas investment by U.S.
firms goes hand in hand with expansion at home.
Subsidiaries of foreign firms operating in the United States make important
positive contributions to the U.S. economy as well. These firms bring over
technology, techniques, and skills that in turn lead U.S. industries to be more
efficient. U.S. subsidiaries of foreign companies employed 5.4 million U.S.
workers in 2002, nearly 5 percent of total private-sector employment. This is
up from 3.9 million workers in 1992 (4.3 percent of total private employment
at that time).

The Global Supply Chain and FDI

The production of goods today can involve many firms in different
countries performing a variety of distinct functions to bring products to
market. A car made by an American company could include parts made by
firms in the United States, Japan, Canada, and other countries, and it might
be assembled in Canada or in Mexico. Producing this car could involve one
firm extracting and molding the steel for the chassis, another firm designing
and assembling interior components such as the seats and steering wheel, and
a third firm transporting cars to the showroom. Within these steps, the
production process could further involve a mix of domestic and imported
components. Likewise, a car produced by a foreign company could be made in
the United States and include a large share of components made here as well.
Firms invest in other countries for many reasons. One is that by investing
abroad, firms may be able to take advantage of resources that are unique to
the country in which the foreign business is located. Examples could be as
straightforward as the development of a mining project, which by necessity
must be undertaken where the natural resource is located, or the construction
of an aluminum smelter in a country with abundant deposits of bauxite, the
ore from which aluminum can be economically retrieved.
Firms might undertake foreign investment because it can be more cost-effective
to own a supplier rather than be one of the suppliers’ many customers. Once
the goods are produced, the domestic firm can use its distribution networks,
infrastructure, and knowledge about foreign tastes to export into new markets
as well as increase sales in existing markets. Firms might also invest in retailing
operations in other countries in order to exercise control over the sale of their
products. Moreover, some firms invest abroad to avoid the trade barriers and
transportation costs they might face if they produced in only one country for
export to the whole world.

180 | Economic Report of the President

 FDI spurs increased trade as firms move goods between parent companies
and their foreign affiliates. Foreign affiliates use the goods from the parent
company as both inputs to production and final goods to be sold through
their distribution networks. In 2002, 35 percent of total U.S. trade in goods
was accounted for by trade within components of firms with operations in
two or more countries. This includes the flow in both directions, between
U.S. companies and their majority-owed subsidiaries abroad, and between
majority-owned U.S. subsidiaries and their foreign parent companies.

How Inward FDI Strengthens Domestic Firms

Foreign direct investment into the United States by foreign firms can
increase the competitiveness of U.S. domestic firms. Studies suggest, for
example, that American auto firms were driven to produce higher-quality
and more fuel-efficient cars in the late 1970s and 1980s when foreign car
manufacturers began producing and selling cars in the United States.
Evidence also shows that foreign direct investment into the United States is
associated with the adoption of new technology, techniques, and skills by
locally-owned companies. The transfer of expertise can include skills in areas
such as operations, marketing, management, and organization; it can be espe-
cially important in sectors such as biotechnology in which research and
development activities play a prominent role. Such technology can “spill over”
to domestic customers and suppliers through a number of channels. Examples
would include when workers at a foreign subsidiary leave and find employ-
ment with local firms, when domestic customers incorporate the products of
these foreign firms into their supply chains, and when foreign firms provide
their U.S. suppliers with access to information or technology in order to
improve their own products’ quality and reliability. For example, one foreign
auto manufacturer in the United States recently shared with its U.S. steel
suppliers its innovations for producing stronger, rust-resistant steel. One
study estimates that such “spillovers” accounted for about 14 percent of the
productivity growth in U.S. manufacturing firms between 1987 and 1996.

Encouraging FDI
Many factors lead foreign firms to consider the United States when
deciding to invest abroad. These include a large pool of talented workers,
access to deep capital markets, a culture that supports innovation and risk-
taking, and a stable legal, political, and economic environment. Evidence
shows that countries prone to corruption, political instability, and having
private firms or industries taken over by the government are less likely to
receive foreign direct investment than countries that protect investor and
intellectual property rights. A recent study found that the United States was

Chapter 8 | 181
ranked the second-best country out of 145 in terms of ease of doing business,
just after New Zealand. In comparison, China was ranked the 42nd-best
place and India the 120th.
At home, the United States maintains an open and nondiscriminatory
policy toward investments made by foreign firms. With limited exceptions,
such as for national security reasons, the United States permits foreign invest-
ment in all sectors. The United States does not screen investments on size or
the companies’ country of origin, does not restrict FDI to involve establishing
only new facilities, and, with limited exceptions, does not have performance
requirements such as local content requirements or export quotas.

Achievements in Trade Negotiations

The Administration has pushed aggressively to open global markets to
trade. This has been done through multilateral talks under the auspices of the
World Trade Organization (WTO) and through agreements to liberalize trade
between the United States and various partners. The Administration has
worked to ensure that the benefits promised under the agreements are realized
for U.S. consumers, workers, manufacturers, farmers, and service providers.
At the same time, lower trade barriers benefit people in U.S. trading partner
countries. When U.S. trading partners do not fulfill their obligations, the
Administration has sought their compliance through a practical, problem-
solving approach. When that fails, however, the Administration has utilized
formal dispute-settlement mechanisms.
This section addresses the progress made in fostering global trade, which
provides mutual advantages to the United States and to all nations. The
section also discusses efforts to make sure that all nations live up to the agree-
ments they have signed. Because China has grown in importance as a U.S.
trading partner, this section begins with a discussion of U.S. trade with this
emerging economy. It then describes efforts to ensure the protection of intel-
lectual property rights. It concludes with a description of progress in the
negotiation of bilateral and multilateral trade agreements.

Trade with China

Prior to China’s accession to the WTO, exports from the People’s Republic
of China were granted access to the U.S. market on substantially similar terms
as exports from members of the WTO. This access, however, depended on an
annual Congressional vote to grant China “Normal Trading Relations” status
(also known as “Most Favored Nation” status). There were some exceptions to
China’s equal access, most notably in textiles and apparel. Because China was
not a member of the WTO, it was not subject to the sort of reciprocal

182 | Economic Report of the President

obligations to lower trade barriers that WTO members undertook in decades
of trade negotiations.
The Administration’s efforts to bring China into the WTO culminated in
China’s December 2001 accession. WTO membership offered China the
stability of Permanent Normal Trade Relations and access to the WTO’s rules-
based dispute-settlement mechanisms, but demanded of China extensive,
far-reaching, and often complex commitments to change its trade regime, at
all levels of government, and open its market to greater competition. China
committed to lower trade barriers in virtually every sector of the economy,
provide national treatment (treat imports on an equal basis with domestically-
produced goods), improve market access to goods and services imported from
the United States and other WTO members, and protect intellectual property
rights (IPR). In light of the state’s large role in the Chinese economy, China
also agreed to special rules regarding subsidies and the operation of state-
owned enterprises. In accepting China as a fellow WTO member, the United
States also secured a number of significant commitments from China that
protect U.S. interests during the period in which China implements its WTO
obligations. The United States in turn agreed to accord China the same
treatment it accords the other 146 members of the WTO.
That treatment includes a gradual liberalization of the market for textiles
and clothing. This is a sector that has been gradually transformed by advances
in technology and transportation, as well as by the opening of this sector
through trade agreements. Much of the world textile and apparel market had
been governed for decades by a global agreement that set bilateral quotas.
Those countries that were founding members of the WTO in the mid-1990s
agreed to liberalize textiles and apparel trade over the ensuing 10 years, a
process that culminated with the elimination of quotas on January 1, 2005.
Since China’s WTO accession, the Administration has worked to secure
access to China’s market for U.S. companies and their workers, farmers, and
service providers, as promised by China’s WTO membership, and to protect
U.S. rights within Chinese markets. Where possible, the Administration has
tried to resolve differences through negotiation. This approach has shown
concrete results; in April 2004, for example, meetings of the Joint
Commission on Commerce and Trade resolved seven potential WTO
disputes involving high-technology products, agriculture, and intellectual
property protection. When successful, this negotiated approach can deliver
more-immediate results than those available through the sometimes-
protracted legal procedures of a formal WTO dispute. When this pragmatic
approach has not produced prompt and effective results, however, the
Administration has also pursued dispute resolution under WTO procedures.
It filed the first-ever WTO case against China to address discriminatory tax
treatment of U.S. semiconductors in China. Within four months of the filing,

Chapter 8 | 183
the Chinese government agreed to eliminate the problematic tax program to
address U.S. concerns, resolving the dispute without lengthy litigation.
A central point of discussion with the Chinese has been about the benefits
of moving to a flexible, market-based exchange rate. The U.S. government
and organizations such as the International Monetary Fund (IMF) have
argued that the exchange rate should have greater flexibility. Greater flexibility
in China’s exchange rate would allow for smooth adjustments in international
accounts and would help protect China from the “boom-bust” economic
cycles of the past. Such a change poses a number of economic challenges. The
Department of the Treasury has been actively engaged with the Chinese in
working toward such a transition and has established a technical cooperation
program to address areas the Chinese view as impediments to greater flexi-
bility, leading to three missions in 2004 that covered currency risk
management, banking system best practices, and developing an exchange rate
futures market in China.
Amidst these changes in policy, trade between the United States and China
has been growing rapidly. For goods trade through November 2004, China
ranked as the third-largest trading partner of the United States. For most of
the period since China’s WTO accession, U.S. exports to China have been
growing at a rate faster than its imports from China (from 2002 to 2003, for
example, U.S. goods exports to China grew by 28 percent while imports from
China grew by 22 percent), but this export growth is occurring from a much
smaller base and so the bilateral trade deficit has grown. The growing bilateral
deficit has led to concerns in some circles about China’s rising prominence in
world trade. In fact, the data suggest that the increased imports from China
are largely coming at the expense of imports from other countries in the
Pacific Rim (Chart 8-3). This change is due in large part to China’s role as a
final assembly platform for exports for Asian manufacturing firms. The total
share of imports from the Pacific Rim has fallen from its recent high in the
mid-1990s. This helps to demonstrate why bilateral trade deficits have little
economic significance and why they are not a useful measure of the benefits
of a trading relationship; these bilateral measures can be driven by a realloca-
tion of trade among partners of the sort that is common in a world of
hundreds of trading nations.

Intellectual Property Rights

In 2004, the Administration launched a major initiative to protect intellectual
property rights. This initiative is called STOP! (for Strategy Targeting Organized
Piracy) and is the most comprehensive initiative ever advanced to combat trade
in pirated and counterfeit goods. The initiative is a government-wide effort to
empower American businesses to secure and enforce their intellectual property

184 | Economic Report of the President

rights in overseas markets, stop fakes at our borders, expose international pirates
and counterfeiters, keep global supply chains free of infringing goods, dismantle
criminal enterprises that steal America’s intellectual property, and reach out to
like-minded trading partners and build an international coalition to stop piracy
and counterfeiting worldwide. This initiative builds on the Administration’s
strong existing record of global enforcement and negotiation.
Such efforts are particularly important to the United States, which is a
major producer of innovative goods. Recordings, films, books, and software
are among the most successful U.S. exports. Property rights in general are
vital to the functioning of a market economy (see Chapter 5, Expanding
Individual Choice and Control). The enforcement of intellectual property
rights ensures that creators of innovative products capture the returns to their
efforts. This enforcement is vital as well to provide incentives to encourage
future innovation (see Chapter 7, The Global HIV/AIDS Epidemic). Empirical
studies have shown that improvements in a nation’s intellectual property
protection can lead to increased trade. These studies found the effect to be
particularly strong in goods that were easy to imitate, providing evidence that
theft of intellectual property displaces legitimate imports. One study found
that strengthened patent protection in large developing countries could
increase their imports by almost 10 percent.

Chapter 8 | 185
Trade Liberalization
Tariffs and other barriers to trade in developing countries are still much
higher than those in the United States, so there remains considerable scope for
lowering barriers both to benefit our trading partners and expand market
access for U.S. firms. Imposing barriers to trade means higher prices for
consumers and firms and a lower standard of living.
To dismantle these barriers and make the benefits of free trade available to
U.S. exporters, producers, and consumers, the Administration has pursued
trade agreements on several fronts. After intense diplomacy at meetings in
Geneva in July of last year, the United States achieved international agreement
on a framework for moving forward on the Doha Development Agenda of
WTO trade negotiations. These talks, which were launched in 2001 in Doha,
Qatar, have focused on measures that will especially benefit developing
nations, including the elimination of agricultural export subsidies. The
Administration has also pursued free trade agreements (FTAs) that set
modern rules for commerce, meet high standards of market access for goods,
and break new ground in areas such as services, e-commerce, intellectual
property protection, transparency and the effective enforcement of environ-
mental and labor laws. Agreements were concluded in 2004 with Australia,
Morocco, Bahrain, and with the participants in the Central American Free
Trade Agreement (CAFTA), including Costa Rica, El Salvador, Guatemala,
Honduras, Nicaragua, and the Dominican Republic. At the same time, the
United States continued negotiations with the five nations of the Southern
African Customs Union (Botswana, Lesotho, Namibia, South Africa, and
Swaziland) while launching new negotiations with Thailand, Panama, and the
Andean nations Colombia, Ecuador, and Peru. The President has also
announced to Congress his intention to begin FTA negotiations with the
United Arab Emirates and Oman.
Tariff reduction commitments negotiated in our bilateral FTAs in 2004
will save foreign consumers and businesses from paying higher prices for
imports and would be expected to spur increased productivity and thus higher
incomes in liberalizing countries. When combined with agreements already
negotiated by the Administration, partner countries accounting for almost
$50 billion in 2003 trade have committed to eventually eliminate tariffs on
almost all U.S. exports. Tariffs that averaged as high as 19.6 percent for U.S.
exports will be reduced to zero as a result of these agreements.
Opening markets expands opportunities for U.S. farmers, businesses, and
workers. An example of the benefits of open markets can be seen in the impact
of the recent trade agreement with Chile. Caterpillar Corporation manufac-
tures mining trucks in Decatur, Illinois, that it sells around the world. The
Escondida copper mine in Northern Chile—the largest copper mine in the

186 | Economic Report of the President

world—uses mining vehicles to move more than 350 million tons of material
per year. Before the free trade agreement with Chile went into effect in January,
Caterpillar's mining trucks were subject to tariffs of $60,000 or more. These
mining trucks now enter Chile duty-free, and have become Illinois’ biggest
export. In 2004, Caterpillar tripled its sales to Chile and added nearly 2,700
people to its U.S. payrolls.
The increase in market access for U.S. exports gained through trade diplomacy
is especially noteworthy because the United States enters these negotiations
with trade barriers that are very low. Central American nations, for example,
already had extensive access to the U.S. market through the Caribbean Basin
Initiative. Under the terms of the CAFTA, those countries are now making
reciprocal commitments to allow in U.S. goods and services.
Bilateral FTAs can also strengthen opportunities for progress in regional
and WTO negotiations. In his first term, the President made multilateral
trade negotiations a priority. In the second term, concluding multilateral
trade negotiations held under the auspices of the WTO will be a top priority
for the Administration. Under the President’s leadership, the United States
successfully led the effort to ensure that 2004 was not a “lost year” for the
Doha Development Agenda negotiations. Early in 2004, the United States
mounted an intensive effort to get the Doha negotiations on a practical track
toward success. U.S. negotiators pressed trading partners to narrow differ-
ences, establish key frameworks for detailed negotiations, and push forward
to reach an agreement that would foster increased economic growth, develop-
ment, and opportunity. The diplomatic effort focused on the key market
access areas of agriculture, industrial goods, and services; the effort in 2004
developed frameworks that will be built upon in moving forward with the
wider WTO agenda. At the end of July 2004, negotiations were successfully
put back on track. WTO ministers are scheduled to meet in Hong Kong,
China, at the end of 2005, to chart the final course for the negotiations.
To ensure continued U.S. global leadership on trade, two legislative steps
are necessary. First, Congress needs to reaffirm the United States’ commit-
ment to the WTO in its regular review. Second, Trade Promotion Authority
(TPA) must be renewed. TPA leaves the power to regulate international
commerce in the hands of the Congress. Under TPA, Congress agrees to
accept or reject an accord negotiated by the President without modification.
If TPA is not renewed, it will likely be difficult—if not impossible—to
achieve the kind of comprehensive benefits the Administration has already
negotiated in its free trade agreements to date. At stake are the substantial
gains that would come from a successful conclusion to the Doha talks. These
gains would accrue both to the United States and to all participants in the
global trading system.

Chapter 8 | 187
 Conclusion
The United States is the world’s leader in many ways and remains the
leading advocate for pro-growth policies around the world. Connecting the
world’s economies through trade provides economic benefits at home while
offering opportunities to other nations that are embracing economic reforms.
Peace and prosperity go hand in hand, each reinforcing the other. The
President's policies are designed to foster rising living standards at home,
while encouraging other nations to follow our lead.

188 | Economic Report of the President