BACKGROUND PAPER

An Analysis of the

Roth-Kemp Tax Cut Proposal

October 1978

Congress of the United States

Congressional Budget Office

Washington, D.C.
AN ANALYSIS OF THE

ROTH-KEMP TAX CUT PROPOSAL

Congress of the United States

Congressional Budget Office

For sale by the Superintendent of Documents, U.S. Government Printing Office

Washington, IXC. 20402

PREFACE

This report analyzes the tax cut proposed by Senator Roth

and Congressman Kemp (S. 1860 and H.R. 8333, respectively) which

provides for large cuts in income taxes phased in over three years. The report analyzes the Roth-Kemp proposal as it stands. Although

the bill itself does not include any provision for cuts in federal

spending, many proponents of the bill favor reductions in spending

as well. A brief discussion of the impact of tax cuts accompanied

by spending reductions is included in the last chapter of this

report.

The Congressional Budget Office prepared this study at the

request of Senator Bellmor. of the Senate Budget Committee. William

Beeman and James Annable were the principal authors and supervised

the study. Several members of CBO's Fiscal Analysis Division

contributed to the report, including: Nariman Behravesh, Gary

Bortz, George Iden, Yolanda Kodryzcki, Cornelia Motheral, Marvin

Phaup, Thyra Riley, Joan Schneider, and Stephen Zeller. Research

assistance was provided by Antoinette Gibbons, John Jacobson, and

Rebecca Summerville. The paper was typed by Debra Blagburn, Dorothy

Kornegay, and Marsha Mottesheard. Robert L. Faherty and Marion F. Houstoun edited the manuscript.

In keeping with CBO's mandate to provide objective analysis, this report contains no recommendations.

Alice M. Rivlin

Di rector

October 1978

i l l

CONTENTS

Page

PREFACE iii

SUMMARY ix

CHAPTER I. INTRODUCTION 1

CHAPTER II. THE RESPONSE OF AGGREGATE SUPPLY TO

LARGE TAX CUTS 7

Size of the Supply Response 7

The Response of Aggregate Supply to

Changed Incentives . . 9

Conclusion 21

CHAPTER III. AGGREGATE DEMAND AND ECONOMIC

GROWTH TARGETS 23

Capacity and Economic Trends 24

Expected Revenue Gains Because of the

Progressive Income Tax Structure and

Increases in Social Security Tax Rates . 27

The Problem of Commitment to Future

Tax Reductions: The Inflation Risk ... 31

Investment Spending 35

CHAPTER IV. ESTIMATES OF THE IMPACT OF ROTH-KEMP

TAX CUTS 37

The 1964 Tax Cut 37

Simulations With Three Macroeconomic

Models 38

The CBO Estimate 43

CHAPTER V. TAX REDUCTIONS ACCOMPANIED BY CUTS

IN SPENDING 49

Arguments for Spending Reductions .... 49

Conclusion 54

APPENDIX SUPPLY-SIDE MODELS 57

TABLES

Page

TABLE 1. INDIVIDUAL AND CORPORATE TAX REDUCTION UNDER

THE ROTH-KEMP BILL, 1979-1983 2

TABLE 2. INDIVIDUAL INCOME TAX REDUCTION UNDER THE

ROTH-KEMP BILL, WHEN FULLY EFFECTIVE, BY

INCOME CLASS AT 1978 INCOME LEVELS 3

TABLE 3. DISTRIBUTION OF INDIVIDUAL INCOME TAX RETURNS, CLASSIFIED BY HIGHEST MARGINAL RATE AT WHICH

TAX WAS COMPUTED, 1965 AND 1975 10

TABLE 4. ESTIMATES OF SUBSTITUTION AND INCOME EFFECTS

ON LABOR SUPPLY OF ADULTS IN ALL INCOME GROUPS

AND IN LOW-INCOME GROUPS—A SUMMARY OF RECENT

RESEARCH 15

TABLE 5. MEASURES OF LABOR-MARKET SLACK—UNEMPLOYMENT

RATES OF VARIOUS GROUPS FOR SELECTED YEARS . . 25

TABLE 6. MEASURES OF CAPACITY UTILIZATION FOR SELECTED

YEARS 26

TABLE 7. ADDITIONAL REVENUES BECAUSE OF INCOME TAX

PROGRESSIVITY, FISCAL YEARS 1979-1983 .... 28

TABLE 8. ADDITIONAL REVENUES BECAUSE OF SOCIAL SECURITY

TAX INCREASES, FISCAL YEARS 1979-1983 .... 31

TABLE 9. ALTERNATIVE PROJECTIONS OF THE ECONOMY WITHOUT

THE ROTH-KEMP TAX CUTS, CALENDAR YEARS

1979-1983 41

TABLE 10. ALTERNATIVE ESTIMATES OF THE INCREMENTAL

EFFECT OF THE ROTH-KEMP TAX CUTS, CALENDAR

YEARS 1979-1983 42

TABLE 11. ALTERNATIVE ESTIMATES OF TAX REFLOWS AS

A PERCENT OF GROSS REVENUE LOSS, CALENDAR

YEARS 1979-1983 43

VI
TABLES (cont.)

Page

TABLE 12. ESTIMATED INCREMENTAL ECONOMIC IMPACT OF

ROTH-KEMP TAX CUTS, FISCAL YEARS 1979-1983.

TABLE 13. EFFECTIVE TAX RATES FOR INDIVIDUALS FOR

SELECTED YEARS AND UNDER THE ROTH-KEMP

PROPOSAL

TABLE 14.

TABLE 15.

TABLE 16.

SPENDING AND TRANSFER REDUCTIONS SUFFICIENT

TO OFFSET FULLY THE IMPACT OF THE ROTH-KEMP

PROPOSAL ON THE RATE OF INFLATION (CPI) AND

ON THE FEDERAL GOVERNMENT DEFICIT

PROJECTIONS OF FEDERAL SPENDING AND CURRENT

DOLLAR GNP UNDER THE ROTH-KEMP PROPOSAL, WITH

ALTERNATIVE SPENDING ASSUMPTIONS, FISCAL

YEARS 1979-1983

NET INCREMENTAL IMPACT OF HALF THE SPENDING

REDUCTIONS NEEDED TO OFFSET FULLY THE IMPACT

OF THE ROTH-KEMP PROPOSAL ON THE RATE OF

INFLATION (CPI), FISCAL YEARS 1979-1983 . . .

45

50

52

53

55

FIGURE

FIGURE 1. LOW UNEMPLOYMENT AND WAGE INFLATION 33

VI I I
SUMMARY

THE ROTH-KEMP TAX REDUCTION PROPOSAL

The major provisions of the "Tax Reduction Act of 1978" (S.

1860 and H.R. 8333; the Roth-Kemp bill) are:

o A one-third cut in personal income tax rates, to be phased

in over three years;

o A 3 percentage point cut in the corporate income tax

rate, from 48 to 45 percent, likewise phased in over a

three-year period; and

o An increase in the corporate surtax exemption, from $50,000

to $100,000.

The Roth-Kemp proposal represents a commitment to a very large

tax cut over a period of three years. _]_/ Although the bill itself

does not include any provision to reduce federal spending, many

proponents of the bill favor such a reduction.

THE ESTIMATED IMPACT OF ROTH-KEMP ON THE ECONOMY

A key feature of the Roth-Kemp bill is the commitment to a

succession of large tax cuts, despite the uncertainty about

the future strength of the economy. Estimates of the economic

impact of these tax cuts depend, to a large extent, on the assumed

strength of the economy over the next five years without the tax

reduction. If the economy is strong, the added stimulus of the

Roth-Kemp tax cuts could be highly inflationary; however, if the

economy weakens, large tax cuts may be needed to maintain economic

growth.

V The Roth-Kemp tax cuts would average more than 4 percent of

Gross National Product (GNP) in 1982, the first full year

after the last cut goes into effect. By contrast, the large

Kennedy-Johnson tax cuts enacted in 1964 were about 2.2

percent of GNP in 1965.

IX

34-342 O - 78 - 2
CBO's assessment of the impact of Roth-Kemp is based on the

five-year economic projection adopted by the Senate and House

Budget Committees. Given that projection, it is estimated that

the proposed tax cuts would provide a large stimulus to economic

activity, although this effect would begin to wane by the end of

the five-year period (see Summary Table 1). By 1982, the unemployment rate would be 1.5 percentage points below its level without

the tax cut. These gains, however, would be won at the cost of a

substantial increase in the deficit and much higher inflation. The

sharp rise in aggregate demand would strain the total productive

capacity of the nation, with the unemployment rate falling well

below the 1973 boom level and production bottlenecks becoming

widespread. By fiscal year 1983, consumer prices would be rising

at an estimated rate 2.7 percentage points faster than without the

tax cut. Moreover, given the difficulty of achieving a 4 percent

unemployment rate because of demographic and structural changes

that have occurred in the labor market, this estimate of inflation

may be too low. In fiscal year 1983, the federal revenue loss

from the proposed tax cuts, after netting out revenue reflows

SUMMARY TABLE 1 . INCREMENTAL ECONOMIC IMPACT OF THE ROTH-KEMP TAX

CUTS, FISCAL YEARS 1979-1983

1979 1980 1981 1982 1983

Constant Dollar GNP

Growth Rate

(percentage points) 1.0 1.8 1.2 -0.2 -1.1

Inflation Rate

CPI (percentage points) b/ 0.1 0.2 1.0 1.7 2.7

Unemployment Rate

(percentage points) -0.1 -0.5 -1.2 -1.5 -1.3

Net Budget Cost

(billions of dollars) 16.0 38.4 64.4 74.8 79.1

a/ Difference from baseline projection.

Ib/ Fourth quarter to fourth quarter of fiscal years.
(the increase resulting from greater economic activity and infla- tion), is estimated to be nearly $80 billion. Moreover, inflation

rather than real growth generates the largest part of the revenue

ref1ows.

Roth-Kemp With Spending Cuts. The impact of the Roth-Kemp

proposal on inflation could be offset by reductions in federal

spending below the level that would exist if current policies were

continued. Some advocates of reduced federal spending argue that

the only way to achieve a major reduction in outlays is to commit

future growth in receipts to tax cuts. Otherwise, the growth in

receipts would be absorbed by increased spending. Indeed, some

proponents of Roth-Kemp have based their support on the assumption

that the proposed tax cuts would lead to large reductions in

federal spending. Others have proposed that an equally large tax

cut be phased in over a longer period and accompanied by reductions

in spending.

THE CASE FOR ROTH-KEEP WITHOUT SPENDING CUTS

Some who favor the Roth-Kemp bill reject the conventional

economic analysis that such tax reductions, without corresponding

cuts in spending, are likely to be inflationary. Their reasoning

is typically based on two arguments:

o Large tax cuts are needed to offset the depressing effects of the rising tax burden that results from

a progressive tax structure when combined with inflation

and productivity growth;

o Lower marginal tax rates would induce large increases in

hours worked, saving, and investment, causing total

productive capacity to expand sufficiently to absorb the

additional demand without inflationary bottlenecks.

Tax Revenue Growth

In the absence of changes in tax legislation, the growth in

federal income tax revenues generally exceeds the growth in income. This gap results from the progressive structure of the income tax

system; when money incomes rise, as a result of productivity growth

and inflation, they are taxed at higher rates, causing a drag on

the increase of disposable income. This dampening of the increase

XI

'IT
tends to slow total spending, which can lead to higher unemployment

and underutilized plant and equipment, as well as to some moderation in the rate of inflation.

Projections of the amount of revenue growth arising from

automatic increases in tax rates depend both upon the growth in

money income and the assumed response of tax rates to that growth.

CBO's estimates of the expected automatic tax revenue gains for

fiscal years 1979 through 1983 are presented in Summary Table 2. As can be seen, the increased revenue would reach $37 billion by

1981, the year of the last proposed tax rate reduction. Although

estimates of revenue loss resulting from the Roth-Kemp tax reductions vary, all show that the proposed tax cuts are much larger

than the expected increases in revenues resulting from the progressive tax structure. 2/

SUMMARY TABLE 2. ESTIMATED AUTOMATIC REVEMUE GAINS RESULTING

FROM INCOME TAX PROGRESSIVITY, FISCAL YEARS

1979-1983: IN BILLIONS OF DOLLARS

1979 1980 1981 1982 1983

Total Revenue

Because of

Because of

Gai

real

infl

ns

growth

ation

10.

3.

6.

1

8

3

21.

7.

14.

9

9

0

36

15

21

.9

.4

.5

55

23

31

.3

.5

.8

77.8

32.8

45.0

NOTE: It is assumed that equal amounts of real growth and inflation generate equal amounts of revenue.

2/ Using a tax model incorporating 50,000 representative returns,

the Roth-Kemp personal tax cuts are estimated to total about

$98 billion by 1981 and $lb5 billion by 1983.

XI I
Increased Supply

Some argue that the existing marginal tax rates have so

depressed incentives to work, save, and invest that a one-third cut

in tax rates would sharply increase the level of total economic

activity, perhaps by enough to make the tax reductions self- financing. This issue of the labor and saving response to changed

marginal tax rates is at the center of the debate about the

effects of the Roth-Kemp proposal. If individuals responded to

increased after-tax earnings by working significantly more hours

and by saving a significantly larger share of their income, then

the tax cuts would lead to greater real growth, more productive

capacity, and less inflation. On the other hand, if individuals

did not work significantly more hours or significantly increase

their saving, the result might well be spending increases in

excess of the growth in total capacity, leading to rapidly rising

prices.

It is estimated that Roth-Kemp will increase both the after- tax wage rate and the rate of return on saving by about 10 percent. If the Roth-Kemp tax cuts are to be self-financing, a 10 percent

rise in after-tax wages must lead to a greater than 10 percent

increase in the total number of hours worked. For example, a

single-earner family with an after-tax weekly income of $200 would

receive an additional $20. On average, out of 100 such families, the change must lead more than 10 previously not employed persons

to take full-time jobs, or lead existing earners to work more than

10 percent longer hours. Similarly, a 10 percent rise in the

after-tax rate of return on savings must lead to more than a 10

percent increase in saving.

The evidence indicates that this large a response to the

proposed tax cuts is most unlikely:

o Most studies of the labor response to changes in spendable

earnings have focused on the behavior of adult men and

have found little or no relationship between changes in

taxation and number of hours worked. Women, however, appear to be more sensitive to variations in marginal tax

rates. For the labor force as a whole, a 10 percent

increase in the disposable wage may lead to a 1 to

3 percent increase in hours worked—well below the more

than 10 percent response needed for the tax cuts to be

self-financing.

XI I I
o Most studies of the rate of interest and personal saving show either a very slight relationship or none at all. No study reports a saving response large enough to make

the Roth-Kemp tax cuts self-financing.

One shortcoming of these empirical studies is that the Roth- Kemp tax reductions are themselves larger than previously experi- enced; these findings may therefore underestimate the supply

response. But even if there were a sharp increase in total number

of hours worked and in saving, it is not reasonable to assume that

total productive capacity would increase quickly. Total demand can

increase rapidly in response to tax cuts. But major capital

projects take years to plan, design, finance, and put in place. Thus, even with a large labor and savings response, the Roth-Kemp

tax reductions would still risk widespread capacity shortages and

an acceleration of inflation, because the increase in total demand

is unlikely to be matched quickly by a corresponding increase in

plant and equipment.

CONCLUSION

The Roth-Kemp bill involves a considerable risk of accelerat- ing inflation. The factors giving rise to this risk are:

o The bill requires a commitment to large tax cuts over

the next three years, without a similar commitment to

constraints on spending; and

o Yet, the outlook for the strength of the economy during

this period is uncertain.

If the economy weakens substantially, tax cuts of the size

proposed in the Roth-Kemp bill might be appropriate in order to

achieve full employment. If nonfederal demands during the next

three years are strong, however, a one-third reduction in tax

rates—without a corresponding cut in spending—would fuel a sharp increase in total private spending, lead to labor scarcities and

other production bottlenecks, and result in a significant accele- ration of inflation.

XIV
CHAPTER I. INTRODUCTION

Although there is widespread support for a tax cut in 1979, the Congress has received sharply conflicting advice concerning the

specific nature of a tax reduction. A major issue is whether the

Congress should enact a one-time tax cut and await further economic

developments before considering another reduction, or whether it

should commit itself now to a series of large tax cuts over several

years. The latter course is proposed in the "Tax Reduction Act of

1978" (S. 1860 and H.R. 8333; the Roth-Kemp bill).

The major provisions of this bill are as follows:

o A one-third cut in personal income tax rates, to be phased

in over three years; !_/

o A 3 percentage point cut in the corporate tax rate, from

48 to 45 percent, also phased in over three years; and

o An increase in the corporate surtax exemption, from

$50,000 to $100,000.

The direct revenue loss from the tax cut before feedback—that

is, excluding the increased revenues stemming from new taxable

activity stimulated by the cut--is estimated to exceed $120 billion

when fully effective in 1981, with more than 90 percent of the loss

in personal tax revenues (see Table 1). The personal income tax cut

would be substantial for all income classes; nevertheless, the

percentage reduction would be largest for those in lower income

brackets, thereby increasing the progressivity of the personal

income tax structure (see Table 2). Effective personal income

tax rates, which would rise in the absence of a tax cut, would be

reduced to levels that prevailed in the early 1960s. In fact, the

Roth-Kemp tax reduction would approximately offset the combined

I/ The CBO analysis assumes that the first cut would be effective

January 1979.
TABLE 1. INDIVIDUAL AND CORPORATE TAX REDUCTION UNDER THE P.OTH- KEMP BILL, 1979-1983: IN BILLIONS OF DOLLARS a/

1979 1980 1981 1982 1983

Calendar Year

Individual 27.4 63.8 112.3 134.7 161.7

Corporate 4.0 6.6 9.6 10.5 11.5

Total 31.4 70.4 121.9 145.2 173.2

Fiscal Year

Individual 19.2 52.8 97.7 128.0 153.6

Corporate 1.8 5.2 8.0 10.1 11.0

Total 21.0 58.0 105.7 138.1 164.6

SOURCE: Joint Committee on Taxation.

a/ Assuming a January 1, 1979, effective date and change in

withholding. Compared with present law, assuming the extension

of expiring tax cuts.

increases in personal income and social security tax rates that

have occurred since 1970. 2/ The corporate tax rate reduction

would be much smaller. When the cut is fully phased in, the

effective tax rates on corporate income would be reduced by about 9

percent.

Although many supporters of a large tax cut favor a concomi- tant cut in spending, the Roth-Kemp proposal does not provide for

any reduction in spending. In fact, some advocates of the bill

assert that its objectives can be achieved without a cut in spend- ing.

2/ See Table 13 in Chapter V.
TABLE 2. INDIVIDUAL INCOME TAX REDUCTION UNDER THE ROTH-KEMP BILL, WHEN FULLY EFFECTIVE, BY INCOME CLASS AT 1978 INCOME

LEVELS a/

Expanded Income Class b/

Amount of

Reduction

(millions

of dollars)

Reduction

as a Percent

of Present

Tax

Percentage

Distribution

0 to $5,000

$5,000 to $10,000

$10,000 to $15,000

$15,000 to $20,000

$20,000 to $30,000

$30,000 to $50,000

$50,000 to $100,000

$100,000 and more

Total

312

3,902

6,946

9,019

15,944

13,638

8,034

7,182

54

46

41

37

36

35

33

27

64,977 d/ 35

c/

6

11

14

25

21

12

11

100

SOURCE: Joint Committee on Taxation.

£/ Compared with present law, which contains the temporary general

tax credit and earned income credit.

b/ Expanded income equals adjusted gross income plus minimum tax

preferences less investment interest to the extent of invest- ment income.

c/ Less than 0.5 percent.

d/ Total cost is less than that shown in Table 1 because of

different income assumptions.

34-342 O - 78 - i
Three major arguments have been put forward by advocates of

the Roth-Kemp tax cuts:

o Some contend that a substantial reduction in marginal tax

rates would increase incentives to work, save, and invest, which would provide such a large boost to production and

income that the tax cut would not increase the federal

deficit. Further, the effects on aggregate supply would be

so large that the tax cut would not be inflationary.

o A second group argues that the underlying strength of the

economy is not sufficient to sustain economic growth and

close the gap between actual and potential capacity, particularly in view of the upcoming increases in tax rates

arising from earlier social security legislation and the

combination of rising incomes and the progressive personal

income tax system. According to this view, the tax cuts

included in the First Concurrent Resolution on the Budget

for Fiscal Year 1979 were not large enough to achieve

growth at the rates advocated by the Administration and the

Congress.

o Finally, some advocates of reduced federal spending argue

that the only way to achieve a major reduction in outlays

is to commit future growth in receipts to tax cuts. Otherwise, it is argued, the growth in receipts would be

absorbed by increased spending, and tax rates would con- tinue to rise.

The Roth-Kemp tax cuts would be the largest tax cut within a

three-year period that has been enacted in recent history, ana it

would significantly alter overall economic activity for many years

to come. Each argument given in support of the proposal should

therefore be considered carefully.

Chapter II examines the theoretical and empirical bases for

the increased incentives argument. The second case for a large tax

cut—that it is needed to achieve some economic growth targets-- turns on questions regarding underlying strength of nonfederal

demands and the effect of the Roth-Kemp tax cuts on aggregate

demand. These issues are analyzed in Chapter III. Chapter IV

examines alternative estimates of the economic impact of Roth-Kemp

and describes the sources of uncertainty in such estimates.
The last argument for the tax cuts—fundamentally an argument

for a relatively smaller public sector—is an issue that can only

be resolved politically. Although resolution of this issue is

beyond the scope of economics, there is a significant risk in

attempting to reduce federal spending by committing future revenues

to tax cuts rather than by legislating a reduction in spending. For example, one possible outcome of this strategy would be that, despite the reduction in taxes, spending would not be reduced, and

the federal deficit would be greatly enlarged. If this occurred

when labor and capital were fully employed, the effect would be

accelerating inflation. Thus, some support a large tax cut, perhaps phased in over a longer period, provided it is accompanied

by a reduction in spending. In Chapter V, the economic impact of

this option of combining tax cuts and spending reductions is

examined.

CHAPTER II. THE RESPONSE OF AGGREGATE SUPPLY TO LARGE TAX CUTS

The Roth-Kemp tax reductions would change the incentives to

work, save, and invest. Some supporters of the bill have argued

that this change would substantially increase the productive

capacity of the nation. If so, it could sharply increase economic

growth without aggravating inflation.

This argument deserves careful consideration. Certainly, if

policymakers could be reasonably sure that the Roth-Kemp tax

reductions would lead to large increases in labor and capital, the

proposal would make good economic sense, even in an economy nearing

full-capacity production. ]_/ The central issue, then, is whether

a sufficiently large supply response would indeed occur.

This chapter reviews the available evidence on the supply

reaction to changed incentives. The review indicates that the

resulting changes in work effort and saving would fail--by a

considerable margin—to change the conclusion of conventional

economic analysis about Roth-Kemp. Briefly, if nonfederal demand

is strong during the next few years, the commitment to such large

tax cuts—without a similar commitment to corresponding constraints

on federal spending—would risk a substantial acceleration in

inflation as the economy encounters labor shortages, production

bottlenecks, and other capacity limitations. And recent experience

has shown how difficult it is to rid the economy of an infla- tionary momentum once it has begun. (This analysis is presented in

some detail in Chapter III.)

SIZE OF THE SUPPLY RESPONSE

This section briefly examines the size of the labor and saving

response needed to enable the Roth-Kemp reductions in tax rates to

be self-financing. Available evidence on the supply response to

changed price incentives will then be reviewed.

]_/ As used here, full capacity means the full utilization of

available resources at existing relative prices.
In order for the proposed tax cuts to pay for themselves, their impact on the economy would have to be so strong that the tax

revenues resulting from the increased economic activity would at

least equal the original revenue loss. It is estimated that the

Roth-Kemp tax cuts would reduce federal revenues by roughly $105

billion by fiscal year 1981. 2/ With the fully effective Roth-Kemp

tax rates, federal revenues would rise roughly 20 cents for each 1

dollar increase in the Gross National Product (GNP). 3/ Therefore, total national output would need to rise by about $525 billion-- five times the gross revenue loss--in order for the tax cuts to be

self-financing. This would be about a 20 percent addition to the

level of GNP expected by 1981.

Part of this 20 percent increment to total production could

result from reductions in the levels of unemployment and underuti- lized capital stock in the economy. As will be shown in Chapter

III, there is some slack in the economy today, but not a large

amount. Estimates provided by the Council of Economic Advisers

(CEA) indicate that actual output is currently about 4 to 5 percent

below potential production. 4Y If the same degree of excess

capacity were to exist in 1981, then GNP could expand by no more

than an additional 5 percent before encountering severe production

bottlenecks and rapidly accelerating inflation—unless productive

capacity increased as well.

2/ The estimate is provided by the Joint Economic Committee on

Taxation. For a discussion of the gross revenue loss of the

Roth-Kemp proposal, see Chapter IV.

3/ Inflation and real growth generated by increased demand

resulting from the tax cuts may cause the effective tax rate

to rise. This effect is ignored in order to focus on the

issue of supply response.

4_/ The CEA uses 4.9 percent unemployment to calculate poten- tial GNP. Many economists believe that the unemployment rate

at which inflation accelerates is higher than 4.9 percent; as

a result, they believe that the Council overstates the true

gap between actual and potential production. If a higher

unemployment figure is used, the results are less favorable to

Roth-Kemp.
Setting aside the problem of inflation, eliminating the

current level of economic slack may increase GNP by as much as 5

percent. Since a 20 percent increase in GNP attributable to the

tax cuts is necessary for Roth-Kemp to be self-financing, a 15

percent increase in total production must result from a greater

supply of production factors — labor and capital--induced by the

changed incentives. This is a very large response to tax cuts

that are estimated to increase disposable earnings 4 to 5 percent

on average and 8 to 10 percent at the margin.

Even under the generous assumptions of constant capital-output

and labor-output ratios, a lb percent rise in GNP would require

large increases in labor supply and personal saving. b_/ A 10

percent increase in the marginal after-tax real wage for workers

would have to result in more than a 10 percent increase in labor

supply. Similarly, a 10 percent increase in the marginal after-tax

real rate of return must induce greater than a 10 percent rise in

personal saving. As will be discussed in the remainder of this

chapter, such reactions are much higher than any estimates of the

actual responses of either labor or saving to changed wage or

interest rate incentives.

THE RESPONSE OF AGGREGATE SUPPLY TO CHANGED INCENTIVES

Taxpayers have been subject to higher marginal tax rates since

the mid-1960s. Table 3 presents the distribution of personal

income tax returns by tax bracket for 196b and 1975. These two

years are used because 1965 is the year in which the last general

reduction of marginal tax rates occurred, while 1975 is the most

recent year for which data are available. It can be seen, for

example, that fewer than one-fifth of all taxpayers had a marginal

5_/ These assumptions are quite generous. The available evidence

on production processes indicates that the response of

labor supply and saving—especially saving—would have to be

significantly greater than suggested in the text in order

for real GNP to rise by 15 percent. For empirical estimates

of labor-output and capital-output elasticities, see George H. Hildebrand and Ta-Chung Liu, Manufacturing Production Func- tions in the United States, 1957(CornellUniversityPress , 1965).
TABLE 3. DISTRIBUTION OF INDIVIDUAL INCOME TAX RETURNS, CLASSIFIED

BY HIGHEST MARGINAL RATE AT WHICH TAX WAS COMPUTED, 1965 AND

1975 a/

Percent

1965 1975

of Percent of

all taxable Cumulative al

Tax Bracket

14 Percent

15 Percent

16 Percent

17 to 18 Percent

19 to 20 Percent

21 to 24 Percent

25 to 29 Percent

30 to 39 Percent

40 to 49 Percent

50 to 59 Percent

60 to 69 Percent

returns percent

12.3

11.2

11.7

12.6

33.4

11.9

4.9

1.0

0.4

0.5

0.1

SOURCE: Donald Kiefer, Treasury Internal

dual Tax Returns

12.3

23.5

35.2

47.8

81.2

93.1

98.0

99.0

99.4

99.9

100.0

1 taxable

returns

6.6

5.2

6.1

6.7

22.2

24.2

20.3

6.3

1.3

0.9

0.3

Cumulative

percent

6.6

11.8

17.9

24.6

46.8

71.0

91.3

97.6

98.9

99.8

100.0

Library of Congress, and Department of the

Revenue Service, Statistics of Income, Indivi- (1965, 1975).

a/ The data in this table are for returns with taxable income.

10
rate greater than 20 percent in 1965, as compared with more than

half of all taxpayers a decade later.

This movement into higher marginal tax brackets has altered

the distribution of the tax burden. It cannot be concluded, however, from Table 3 alone that real economic growth has been

adversely affected. The impact of changed marginal tax rates on

the expansion of productive capacity depends on the response of

individuals to changes in marginal rewards.

The effect of changed incentives on total productive capacity

under the Roth-Kemp proposal would work through three major chan- nels, each of which is examined below:

o Increased take-home pay may make work more attractive

relative to leisure, resulting in a larger supply of

labor;

o Increased return on capital may make saving more attrac- tive relative to consumption and may increase the rate of

investment; and

o Lower tax rates may reduce tax avoidance through illegal

activities or tax shelters.

Labor Supply and Tax Incentives

A higher take-home wage would increase labor supply if most

persons responded by desiring to work more hours for pay or profit. On the other hand, if the increase in disposable income—which

would enable workers to maintain customary living standards with

fewer hours worked—led most workers to increase their leisure

activities at the expense of work, the supply of labor would

decrease.

Both types of response are limited by institutional arrange- ments governing the length of the workweek. Most wage earners have

little discretion over the number of hours they work, since this

is set by their employers. As a result, much of the labor-supply

11

34-342 O - 78 - 4
response to a changed take-home wage probably operates through

variations in the labor-force participation rate. In addition, discretionary overtime and "moonlighting" provide some opportuni- ties for varying the amount of time on the job. Self-employed

persons probably find it easiest to vary the number of hours they

work.

Evidence. Four types of evidence are available on the labor- supply response to changing wage incentives:

o The historical record on previous large personal income

tax cuts,

o Surveys of professional and high-income persons,

o Econometric analysis of the available data, and

o Income-support experiments.

Two recent episodes provide a historical record of the effects

on labor supply of changes in marginal tax rates. In 1964 and

1965, marginal tax rates were reduced by 20 to 30 percent. Later, effective in 1972, the maximum tax on labor earnings was lowered

from 71 to 50 percent. In neither of these cases is there evidence

of an unusual increase in the supply of labor.

A number of surveys of professional and high-income persons

have examined the effects of high marginal tax rates on hours of

work. For example, a study of British accountants and solicitors

(lawyers) found that there were almost as many respondents who felt

that the high marginal tax—a greater than 90 percent maximum rate

on earned income, as compared with the current 50 percent maximum

in the United States—led them to work longer hours, in order to

achieve their disposable income goals, as there were respondents

who felt that the high tax led them to work fewer hours. (>/ A

later study, also of British accountants and solicitors, found

6/ George F. Break, "Income Taxes and Incentives to Work," American Economic Review, vol. 47 (1957), pp. 529-49, as cited

in Theoretical and Empirical Aspects of the Effects of Taxa- tion on the Supply of Labor (Paris: Organization of Economic

Cooperation and Development, 1975) pp. 36-37.

12
stronger indications that high tax rates might reduce overall

hours, but the net reduction was still quite small. 7/ A 1964

survey of high-income individuals in the United States concluded

that about 6 percent of all members of high-income groups "plausibly" reported a work disincentive as a result of high marginal tax

rates. 8/ In each of these studies, the evidence of disincentives

from high tax rates was stronger for individuals with very high

incomes and for the self-employed than for others in the sample.

In general, the available survey evidence suggests that,

although high-income professionals and the self-employed may reduce

their labor supply as a result of high marginal tax rates, the net

reduction in hours worked is quite small. Without exception, such

surveys have found no indication of a major reduction in labor

supply of professional and high-income persons as a result of

income tax disincentives, even though many of the studies were

conducted in Britain, where the marginal income tax rates are

considerably higher than in the United States. Furthermore, since

the maximum tax on earnings would remain at 50 percent under the

Roth-Kemp proposal , there would be no impact on the labor supply of

groups in the highest income tax bracket.

Most estimates of the impact of changing tax rates on labor

supply are derived from the econometric analysis of the available

data. These studies may be divided into two groups: those on

broad demographic subgroups of the population cumulatively covering

all income groups and those on low-income groups.

It is generally agreed that the labor supply of all adult

males is largely unaffected by changes in marginal tax rates.

In most studies, both the substitution and the income effects are

7/ D. B. Fields and W. T. Stambury, "Income Taxes and Incentives

to Work: Some Additional Empirical Evidence," American Econo- mic Review, vol. 61 (1971), pp. 435-43, as cited in Theoretical and Empirical Aspects, pp. 46-48.

8/ James N. Morgan and others, "A Survey of Investment Manage- ment and Working Behavior Among High-Income Individuals," American Economic Review, vol. 55 (1965).

13
very close to zero. There is a much larger range of uncertainty

about the labor-supply response of all adult women to changes in

the take-home wage. The weight of the available evidence, however,

indicates that changes in the take-home wage do have a significant

impact on the labor-supply decisions of married women. For this

demographic group, a lowering of marginal tax rates, all other

things remaining the same, appears to lead to a greater number of

hours worked. ^/

The results of the negative income tax (N.I.T.) experiments,

which have been cited frequently as providing evidence on the

labor-supply response to variations in work incentives, are

summarized in the estimates given in Table 4 for low-income groups.

As can be seen, there is substantial uncertainty regarding the

response of low-income persons to changed wage rates; nevertheless, the evidence suggests that the net effect is relatively

small. In any case, the relevance of these findings to the laborsupply response from the Roth-Kemp tax reductions is limited.

Low-income persons would be relatively unaffected by the Roth-Kemp

changes because their income is taxed little under the federal

income tax system.

The overall impact. After reviewing the available empirical

evidence, CBO's best estimate is that hours worked would increase

if after-tax real wages went up, largely because of the reaction of

married women. The total net response, however, appears relatively

small. Perhaps a 1 to 3 percent increase in the labor supply would

result from a 10 percent rise in the disposable wage. As was noted

above, however, more than a 10 percent increase in labor supply

would be necessary for Roth-Kemp to be self-financing.

Saving and Tax Incentives

An increase in saving would follow a marginal tax cut if most

people responded to the opportunity for higher future returns by

9/ See, for example, Jane H. Leuthold, "The Effects of Taxation

on the Hours Worked by Married Women," Industrial and Labor

Relations Review, vol. 31 (July 1978) , p. 524.
TABLE 4. ESTIMATES OF SUBSTITUTION AND INCOME EFFECTS ON LABOR

SUPPLY OF ADULTS IN ALL INCOME GROUPS AND IN LOW-INCOME

GROUPS—A SUMMARY OF RECENT RESEARCH

Population Range of Substitution Range of Income

Group Elasticities a/ Elasticities b/

All Income Groups

Adult males 0 to 0.1 0 to -0.3

Adult females 0.1 to 2.5 -0.1 to -2.1

Low-Income Groups

Adult males 0.2 to 0.9 -0.1 to -0.9

Adult females 0.1 to 0.8 -0.1 to -1.0

a/ The "substitution elasticity" is a measure of the respon- siveness in the quantity of labor supplied to a small change in

the wage rate after taxes, with the level of the person's

income assumed constant. Roughly, it indicates the percent

change in labor supply for a 1 percent change in wage rates, holding income levels constant.

b/ The "income elasticity" is a measure of the responsiveness

in the quantity of labor supplied to a small change in real

(after-tax) incomes. Roughly, it indicates the percent change

in labor supply for a 1 percent change in real incomes.

SOURCES:

Orley Ashenfelter, and James Hickman, "Estimating Labor-Supply

Functions," in Glen G. Cain and Harold W. Watts, eds., Income

Maintenance and Labor Supply (Academic Press, 1973).

Michael J. Boskin, "The Economics of Labor Supply," in Income

Maintenance and Labor Supply.

Glen G. Cain and Harold W. Watts, "Toward a Synthesis of the

Evidence," in Income Maintenance and Labor Supply.

15
TABLE 4. (Continued)

Malcolm S. Cohen, Samuel A. Rea, Jr., and Robert I. Lerman, A

Micro Model of Labor Supply, Bureau of Labor Statistics Staff

Paper No.4 (1970).

Irwin Garfinkel, "On Estimating the Labor-Supply Effects of a

Negative Income Tax," in Income Maintenance and Labor Supply.

David Greenberg and Marvin Kosters, "Income Guarantees and the

Working Poor: The Effect of Income-Maintenance Programs on the

Hours of Work of Male Family Heads," in Income Maintenance and

Labor Supply.

C. Russell Hill, "The Determinants of Labor Supply for the Working

Urban Poor," in Income Maintenance and Labor Supply.

Edward S. Kalachek and Fredric Q. Raines, "Labor Supply of Low

Income Workers," in The President's Commission on Income

Maintenance Programs (1970).

Michael C. Keeley and others, The Labor Supply Effects and Costs of

Alternative Negative Income Tax Programs: Evidence from the

Seattle and Denver Income Maintenance Experiments (MenloPark ,

California: Stanford Research Institute, May 1977).

Marvin Kosters, "Effects of an Income Tax on Labor Supply," in

Arnold C. Harbenger and Martin J. Bailey, eds., The Taxation of Income From Capital (The Brookings Institution,

1969) .

Jane H. Leuthold, "The Effects of Taxation on the Hours Worked by

Married Women," Industrial and Labor Relations Review, vol. 31

(July 1978) , pp. 520-26.

Organization for Economic Cooperation and Development, Theoretical

and Empirical Aspects of the Effects of Taxation on the Supply

of Labor (Paris: OECD, 1975) .

Alfred Telia, Dorothy Telia, and Christopher Green, The Hours of

Work and Family Income Response to Negative Income Tax Plans

(Kalarnazoo, Michigan: W.E. Upjohn Institute for Employment

Research, 1971).

Finis Welch and Sherwin Rosen, "Labor Supply and Income Redistribution," Review of Economics and Statistics, vol. 53 (August

1971) , pp. 278-82.

16
saving more and consuming less. On the other hand, a tax reduction

could lead to decreased net saving because a smaller share of

disposable income would now be required to reach a given target

level of assets.

Evidence. As with labor supply, the question of the effect

of variations in the after-tax rate of return on the level of

saving is an empirical one. In 1974, Richard and Peggy Musgrave

summarized the empirical literature on this subject as follows: ". . . studies of the relationship between savings and the rate of

interest differ in their conclusion. Some hold that there is a

substantial negative relationship, while others attribute little

weight to the rate of interest in the consumption function." KJ/

The notion that the saving rate is essentially constant and

relatively unaffected by changes in the tax system, or by other

changes in the real after-tax rate of return on capital, has come

to be known as Denison's Law; until recently, it received wide- spread acceptance among economists. _]_]/

Michael Boskin recently drew renewed attention to this issue

by reporting his finding that: ".. . private saving is indeed

strongly affected by changes in the real after-tax rate of return. The estimated total (income plus substitution) interest elastici- ties of private saving cluster around 0.3 - 0.4." J2:/ This new

and somewhat surprising finding is only beginning to be reviewed

by the economics profession.

K)/ Richard A. Musgrave and Peggy B. Musgrave, Public Finance In

Theory and Practice (McGraw-Hill Book Company, 1973) , p. 478.

11/ Edward F. Denison, "A Note on Private Saving." Review of

Economics and Statistics, vol. 8 (1958), see also Paul A. David and John L. Scadding, "Private Savings: Ultraration- ality, Aggregation and 'Denison's Law,'" Journal of Political

Economy, vol. 82 (March/April 1974), pp. 225-49.

Michael J. Boskin, "Taxation, Savings, and the Rate of Inte- rest," Journal of Political Economy, vol. 86 (March/April

1978). His results suggests that a 10 percent rise in

the after-tax rate of return on saving would increase personal

saving by 3 to 4 percent.

17
A preliminary examination of Boskin's results, however, casts doubt on the relevance of his findings. His definition of

personal saving includes spending on consumers' durable goods, such

as automobiles and refrigerators; consequently, increased saving— when defined in this manner—does not necessarily make more funds

available for investment activities. Furthermore, the estimates

appear to have econometric problems that call their validity into question. 13/ In view of these problems, more work needs to

be done to demonstrate the validity of Boskin's results before they

can be accepted as an accurate description of actual behavior.

The overall impact. Boskin reports that a 10 percent increase

in the rate of return on saving would increase personal saving

between 3 and 4 percent. Although this estimate may be high for

the reasons noted above, it is still far below the saving increase

required to make the Roth-Kemp tax cuts self-financing. 14/

Even if that very large addition to saving was forthcoming, it is unlikely that the nation's capital stock could be increased

quickly. Major capital projects typically require several years to

plan, design, finance, and implement. Yet, while total capital

stock by its nature grows slowly in response to a tax cut, aggre- gate demand can increase quite quickly—reaching its full impact

13_/ Notably, there is a strong likelihood that the results are

distorted because the rate of inflation has been omitted

from the estimating equation and because of the particular

time period studied; there also appears to be substantial

serial correlation, which may be overstating the apparent

statistical significance of the impact of changes in the

interest rate on saving.

14/ It has been argued that the Roth-Kemp tax reductions, even if

not self-financing, would not be inflationary in a full- employment economy if the increase in saving resulting from

the higher after-tax rate of return would be sufficient to

offset the rise in the federal deficit. This does not seem

likely. Even using Boskin's high elasticity estimate, per- sonal saving would be only roughly $8 billion higher in 1983

in response to the increased after-tax rate of return—well

below the estimated increment to the budget deficit (see

Chapter IV).

18
within a few calendar quarters of the tax reduction. Since

the increase in total demand is not likely to be matched by rising

aggregate supply—at least not for a number of years—a commitment

to large tax cuts could lead to widespread shortages and could

accelerate the already rapid rate of inflation if nonfederal

demands are strong. J5/

Past experience suggests that the instability represented by accelerating inflation—and the consequent increased likelihood of

subsequent recession — raises business uncertainty about the

future and has a depressing effect on the expansion of the eco- nomy's capital stock. Thus, a commitment to large tax cuts with

spending unchanged might slow, rather than expand, the growth of

domestic productive capacity.

The Underground Economy and Tax Incentives

By definition, an underground or irregular economy is gene- rated by government laws and regulations. In particular, it

results largely from the following:

o Government prohibits certain activities; thus, the

underground economy provides goods and services not

otherwise available, such as illegal drugs and gambling.

o Government limits the employment of certain groups. For example, income penalties for taking wage employment

are imposed on those receiving social security or other

income-support payments; illegal aliens are not supposed

to be employed, and most employees must be paid at least

the statutary minimum wage. All of these laws create

inducements for working "off-the-books" —strictly for

cash, with no records kept.

jj>/ Data Resources, Inc. (DRI) estimates that under Roth-Kemp capacity utilization in industrial materials industries would

reach 93 percent by 1981 and would therefore be higher than in

1973—a year of widespread shortages and rapid inflation.

19

34-342 O - 78 - 5
Government taxes certain activities; for example, the

current income and social insurance tax systems provide

some inducement to work "off-the-books" in order to avoid

paying taxes altogether. The income tax system also

may reduce individual incentive to undertake additional

work within a tax period.

Evidence. In order to estimate the response of the irregular

economy to the Roth-Kemp tax reductions, three facts must be

determined:

o The size of the irregular economy,

o The proportion caused by taxation, and

0

 The degree to which these previously unreported activities

would be reduced in favor of taxable activity if marginal

tax rates were lower.

The evidence here—given the nature of the activity—is mostly

anecdotal and hardly provides grounds for strong conclusions

one way or the other. Unsystematic surveys indicate that most

"off-the-books" activity results from the prohibition of certain

activities, the limited employment opportunities of certain groups, and the opportunity to make cash transactions in order to avoid

paying taxes altogether; little of this casual evidence supports

the notion that lower marginal tax rates would significantly decrease the level of "off-the-books" activity. 16/ It seems

obvious that individuals who are involved in activities that carry

severe penalties—such as the sale of illegal drugs—would not

report such activities, no matter how low the tax rate.

See, for example, Louis Ferman, Louise Berndt, and Elaine

Selo, Analysis of the Irregular Economy: Cash Flow in the

Informal Sector (University of Michigan and Wayne State

University, Institute of Labor Relations, March 1978).

20
Overall Impact. There is no hard evidence on the probable

response of the irregular economy to a cut in marginal tax rates. Without such evidence, it is unknown to what extent the Roth-Kemp

tax cuts would cause activity to move from the irregular economy

into the tax base. 17/

CONCLUSION

The fundamental issue arising from a commitment to Roth-Kemp

tax cuts can be stated simply: Will the growth in productive

capacity induced by greater incentives to work, save, and invest be

large enough and rapid enough to prevent widespread shortages and

accelerated inflation? The available evidence provides no reason

for an optimistic answer to this question.

V7/ The increased allocational efficiency that would result from

reducing the attractiveness of legal tax shelters is also most

difficult to estimate.

21

CHAPTER III. AGGREGATE DEMAND AND ECONOMIC GROWTH TARGETS

Conventional macroeconomic analysis of fiscal policy effects

is largely, though not entirely, demand-oriented. _]_/ Greatly

simplified, the conventional analysis of the economic effects of

tax cuts can be characterized as follows:

o The primary stimulus to production and employment occurs

through increases in final private demands. Cuts in

personal income taxes increase disposable income and, over

time, add to consumer spending and saving. Similarly, business tax cuts spur business investment spending.

o The size of the overall impact on GNP depends on many

factors, such as the type of tax cut and the response of

monetary policy. For example, if monetary policy is fully

accommodative, and thus short-term interest rates are not

increased, the overall impact would be larger than if

interest rates were increased.

o The distribution of increased GNH between real output and

inflation depends largely on the amount of unemployment and

underutilized capital stock. In an underemployed economy, a tax cut tends to move real output toward capacity;

in a fully employed economy, however, a tax cut tends to

move the economy toward excess demand and higher prices. Personal income tax cuts do generate increased private

saving and investment, but changes in productive capacity

occur slowly relative to changes in demand.

o Some tax cuts have specialized effects on the composition

of output or on prices. For example, tax cuts in the form

of accelerated depreciation or an investment tax credit, which directly reduce the cost of capital goods, generate

relatively large investment spending.

V For a description of how changes in fiscal policy affect

economic activity, see Congressional Budget Office, Under- standing Fiscal Policy. Background Paper (April 1978).

23
o The net revenue loss is usually significantly less than the

gross loss because of the increased income and output—and

consequently the larger tax base—generated by the stimulus. Nevertheless, the increase in economic activity is

rarely large enough for the tax cuts to be self-financing.

Within this conventional framework, the major question about

the Roth-Kemp bill is: Would it result in an overheated economy?

In part, the answer depends on the degree of excess capacity in the

private sector and the impact of the budget on the economy without

such tax cuts. These issues are examined in this chapter along

with a brief discussion of the risk involved in the Roth-Kemp

commitment to future tax cuts.

CAPACITY AND ECONOMIC TRENDS

According to the conventional analysis outlined above, the

question whether a large tax cut would be consistent with Congres- sional targets for reducing inflation and maintaining real economic

growth depends largely on the degree of slack in the economy and

the outlook for final demands. Although there is always a great

deal of uncertainty in the economic outlook, it is instructive to

examine the Roth-Kemp proposal in light of the currently available

evidence.

Excess capacity in labor markets has been reduced signifi- cantly during the past year (see Table 5). Although the overall

unemployment rate is quite high by historical standards, it appears

less so when corrected for demographic changes. Unemployment rates

for married men are now at their 1972 levels; most analysts agree

that in 1973 the economy experienced significant excess demand. Measures of capacity utilization (shown in Table 6) are likewise

now around 1972 levels, again suggesting the possibility of high

levels of resource utilization in the following year.

Though there still seems to be some slack in the economy, it

has been declining rapidly. If economic growth were to slow in the

year ahead, slack would not be reduced; thus, there would be little

immediate danger that the first phase of Roth-Kemp would lead

2k
TABLE 5. MEASURES OF LABOR-MARKET SLACK — UNEMPLOYMENT RATES

OF VARIOUS GROUPS FOR SELECTED YEARS: IN PERCENTS

Aug. Aug.

1964 1966 1969 1972 1973 1977 1978

Total 5.2 3.8 3.5 5.6 4.9 7.0 5.9

Men, Aged

35-54 3.0 2.0 1.5 2.7 2.1 3.2 2.9

Married Men, Wife Present 2.8 1.9 1.5 2.8 2.3 3.5 2.8

Managers, Administrators 1.4 1.0 0.9 1.8 1.4 2.5 1.8

Craft and Kindred

Workers 4.2 2.8 2.0 4.3 3.7 5.5 4.4

SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.

to excess-demand inflation. 2/ Increasing the tax cut from $20

billion a year to, for example, $30 billion, with no compensating

cut in spending, would have a relatively small overall effect on

economic activity in the first year. (Depending on the type of tax

cut, the unemployment rate might be 0.1 percentage point lower and

inflation 0.1 percentage point higher by year-end.)

2/ CBO's most recent forecast for 1979 indicates that real eco- nomic growth will be in the 2.7 to 4.2 percent range during

the year, given a $20 billion annual rate tax cut in January ($15 billion for the fiscal year), federal outlays at $495

billion in fiscal year 1979, and a Federal Reserve monetary

policy that avoids a serious credit squeeze. Growth at the

upper end of this range could result in tight labor markets

during 1979 if recent low productivity growth persists. See

Congressional Budget Office, Inflation and Growth: The Economic

Policy Dilemma (July 1978).

25
TABLE 6. MEASURES OF CAPACITY UTILIZATION FOR SELECTED YEARS: IN

PERCENTS

Postwar Aug. Average 1964 1966 1969 1972 1973 1978

Capacity Utilization

Manufacturing 83 86 91 86 83 88 85

Primary processing 85 88 91 89 88 92 87

Vendor Performance a/ 51 63 73 65 63 88 65

Manufacturing

Overtime hours N.A. 3.1 3.9 3.6 3.4 3.8 3.5

N.A. = Not available.

SOURCES: Federal Reserve Board; U.S. Department of Commerce, Bureau of Economic Analysis; U.S. Department of Labor, Bureau of Labor Statistics.

ji/ Percent of purchasing agents reporting slower deliveries.

Some have argued that the present situation in labor markets

and in capacity utilization is much like that in 1964 and that a

tax reduction of similar relative magnitude (perhaps $45 billion at

an annual rate in today's economy) is therefore called for. But

the economic environment today is different from that in 1964, at

least in one important respect: the rate of inflation is much

higher and, perhaps because of institutional changes (such as the

widespread use of eost-of-living wage adjustments), the present

economy seems more prone to inflationary momentum than it was in

the 1960s. The risk of inflation generated by excessive fiscal

stimulus therefore seems to be greater today.

In any case, if economic growth is strong in the months

ahead, tight markets may be experienced by the end of 1979, and

a commitment to further tax cuts would be highly inflationary. Of

course, the extent of inflation is difficult to predict. The

26
third and last reduction provided by the Roth-Kemp proposal would

not be effective until 1981, and its economic impact would be

significant for several years thereafter. A complete macroeconomic

analysis of these tax cuts would therefore require a forecast of

the underlying strength of the economy for more than five years

ahead. Although CBO finds five-year trend projections useful for

budget planning purposes, it does not believe that the current

state of the art of economic forecasting permits a precise evalua- tion of the macroeconomic outcome of tax cuts that far in the

future. If there is a recession in, say, 1981, a large tax cut may be the antidote. On the other hand, if economic growth is strong, fiscal restraint to moderate the rise in demand and consequent

inflation may be appropriate. The economic environment cannot be

predicted with sufficient accuracy to design an optimal fiscal

policy three years in advance.

EXPECTE D REVENUE GAINS BECAUSE OF THE PROGRESSIVE INCOME TAX

STRUCTURE AND INCREASES IN SOCIAL SECURITY TAX RATES

Although the economic outlook is uncertain, it is clear

that, under current law, social security tax rates and, almost

certainly, personal income tax rates will increase and exert a

depressing effect on the economy. The increase in social security

taxes will result from existing legislation, which includes in- creases in both the tax rate and the wage base. The increase in

personal income tax rates will occur automatically as GNP grows

because, under the progressive income tax structure, increased

incomes are taxed at higher rates.

The automatic increase in personal income tax rates, due to

the combination of increasing money incomes and the progressive

income tax, slows the growth in spendable income relative to

before-tax income and acts as a drag on the economy. Generally, in the absence of legislated changes, the economic impact of

the automatic increase in the personal income tax burden is not

offset by automatic increases in federal spending. Considering the

effect of inflation alone on the relative behavior of federal

revenues and expenditures, historical evidence indicates that, for

a given amount of inflation, expenditures tend to increase at about

the same rate as prices while revenues grow considerably faster. 3/

Estimates of the responsiveness of personal income taxes to income

I/ See Congressional Budget Office, The Effects of Inflation

on Federal Expenditures, Background Paper (June 1976).

27
growth (that is, the income elasticity of personal income taxes)

indicate that these revenues grow about 50 percent faster than

total taxable personal income grows.

Tax cuts sufficient to offset increased revenues resulting

from the progressive income tax structure are sometimes advocated.

What amount would tax rates have to be cut to offset such increases? The precise answer depends upon projections of inflation and

real growth as well as upon estimates of the responsiveness of

personal income tax receipts to growth. Any estimate must be

regarded as a rough approximation, because the figures are significantly affected by these assumptions. The estimate shown in

Table 7 is based on the economic projections for the 1979-1983

period used by the Senate and House Budget Committees for the

second concurrent resolution and an assumed income elasticity of

1.5. Since inflation is projected to be higher than real economic

growth, most of the increased revenues result from inflation.

TABLE 7. ADDITIONAL REVENUES BECAUSE OF INCOME TAX PROGRESSIVITY,

FISCAL YEARS 1979-1983: IN BILLIONS OF DOLLARS

1979 1980 1981 1982 1983

Additional Revenues Because of Income Tax

Progressivity

Because of

Because of

a/

real

infl

growth

ati on

10.

3.

6.

1

8

3

21

7

14

.9

.9

.0

36

15

21

.9

.4

.5

55

23

31

.3

.5

.8

77.8

32.8

45.0

NOTE: Estimates of additional

year 1978.

revenues are made relative to fiscal

a/ Revenues above those that would be collected if the percent

increase in personal income tax revenues were equal to the

percent increase in taxable personal income. An elasticity of

1.5 is assumed.

28
The total increase in revenues resulting from the progressi- vity of the income tax is less than the revenue loss of the Roth- Kemp cuts, according to reasonable estimates. For fiscal year

1981, the year of the last rate reduction, the Joint Committee on

Taxation (JCT) estimates that the gross revenue loss resulting from

the personal tax cuts is about $98 billion; the revenue growth

resulting from progress!vity is roughly estimated to be about $37

billion that year. 4/ Although CBO believes that the $61 billion

difference suggested by these two estimates may be somewhat high, the actual gap is certainly substantial. Furthermore, it would not

be changed substantially by an assumption of higher inflation, as

some have suggested, since both estimates would be raised accord- ingly.

The contention that taxes should be cut sufficiently to

offset future automatic increases in personal income tax rates is

frequently based on issues not directly related to macroeconomic

policy. First, advocates of a smaller federal sector claim that, if anticipated automatic revenue increases are not committed to tax

cuts, the revenue gains will be absorbed by spending initiatives. Second, it is often argued that the increases in effective tax

4/ The magnitude of the Roth-Kemp tax cuts is a matter of contro- versy. Like the estimates of revenue growth due to progres- sivity, assumptions such as the level of economic activity and

the responsiveness of revenues to economic growth significantly

affect the estimated revenue loss. The JCT estimate of the

revenue loss is higher than most others but, because it is

based on the best available methodology, CBO has used this

estimate in its work. The estimate of the Joint Committee on

Taxation is based upon a tax model constructed from 50,000

sample returns. Most revenue forecasters believe this model

provides the most accurate estimate of direct revenue loss

(before feedback); in contrast, the crude estimates of the

direct revenue loss used in most large econometric model

simulations are substantially smaller as a result of the

structure of these models. In comparing the revenue loss due

to tax cuts and the increase in revenue due to progressivity, it is important that the economic assumptions be approximately

comparable in both calculations.

29
rates that occur because of inflation and without overt Congres- sional action are unfair and should be fully offset. 5/ These

arguments, in large part, involve conflicting value judgments that

can be resolved only through the political process.

Although pejorative connotations are often associated with the

automatic increase in income tax rates arising from progressivity, this should not always be the case when economic stabilization is a

matter of concern. For example, if there is a high risk that

the economy will become overheated, the automatic increase in tax

rates will work to slow the growth of aggregate demand and infla- tion. This passive increase in tax rates occurs immediately as

incomes rise. History suggests that legislated changes cannot

easily respond in such a timely fashion, principally because

increases in tax rates are difficult to enact.

An argument has also been made that income taxes should be

additionally cut to offset the legislated increase in social

security taxes, shown in Table 8. A cut of this kind would be more

stimulative than it first appears. The tax increases of the 1972

social security amendments may not represent an overall restrictive

burden because they were designed to adjust the maximum wage base

for inflation and growth (thus holding the rate constant) and to

finance increased benefits, which add to spendable income. The 1977

amendments, however, did increase effective tax rates, and they

were designed to improve long-term funding of social security

rather than to finance near-term increases in benefits. The effect

of the 1977 amendments is to reduce overall after-tax income and

economic activity; thus, only these amendments may have an overall

restrictive effect on economic activity.

5/ This could be done by indexing the tax system for inflation or

by periodic changes in the tax law. Sometimes there is confu- sion between an increase in revenues because of inflation and

an increase in tax rates because of inflation. An increased

burden arises only when the percentage increase in tax payments

exceeds the percentage increase in income—that is, when the

tax rates rise.

30
TABLE 8. ADDITIONAL REVENUES BECAUSE OF SOCIAL SECURITY TAX

INCREASES, FISCAL YEARS 1979-1983: IN BILLIONS OF DOLLARS

1979 1980 1981 1982 1983

Additional Revenues Because of

Social Security Legislation

1972 Amendments a/

1977 Amendments b/

4.6

1.3

3.3

10.7

1.7

9.0

22.8

6.2

16.6

32.0

8.6

23.4

34.9

9.4

25.5

a/ Joint Committee on Taxation, January 1978 estimates (adjusted

for fiscal year 1978 rather than fiscal year 1977 baseline).

b/ CBO, April 1978 estimates.

THE PROBLEM OF COMMITNENT TO FUTURE TAX REDUCTIONS:

THE INFLATION RISK

The Roth-Kemp tax bill would provide a major stimulus to the

economy, substantially more than the amount needed to offset

restrictive tax increases. From the viewpoint of economic policy- making, a major drawback of the proposal is its commitment to large

future tax reductions despite the great uncertainty regarding the

longer-run performance of the economy. This commitment reduces the

flexibility of fiscal policy and greatly increases the risk of

excess demand inflation relative to the risk of recession.

The Flexibility of Fiscal Policy

Politically, it has been more difficult to enact tax increases

to reduce excess demand than to cut taxes to boost economic acti- vity. At times, the easiest way to achieve a restrictive tax

policy is for the Congress to postpone tax cuts that would offset

the automatic increase in income tax rates arising from the inter- action of inflation and the progressive income tax structure.

Furthermore, spending programs cannot easily be used in place

31
of tax changes to achieve either a moderation or an increase in

total demand. A major difficulty with using spending programs to

achieve stabilization is the relatively long period required for

implementation. Whereas tax law changes can be implemented in a

few weeks (after enactment), spending programs frequently take

years to implement fully. Thus, the commitment to future tax cuts

could significantly reduce the flexibility of fiscal policy;

particularly, it could limit the Congress's ability to deal with a

situation that requires a restrictive tax policy, such as excess

demand inflation.

The Inflation Risk

How serious is the risk of inflation with the Roth-Kemp tax

reduction proposal? The answer depends largely on the future

strength of the economy and on the effect of the tax cuts. Fore- casts of the impact of the Roth-Kemp tax cuts by CBO and others

are presented in Chapter IV. Each of these forecasts shows a

substantial decline in the unemployment rate and an acceleration in

inflation because of excess demand. In some cases, the unemploy- ment rate is estimated to fall below 4 percent. Although the

estimates differ, there is consensus that low unemployment rates

generate inflation in the absence of substantial changes in the

structure of the labor market, in productivity, or in both.

Past experience indicates that a large reduction in unem- ployment would be highly inflationary. This is illustrated in

Figure 1. The top panel compares past and projected unemployment

rates with the "high-employment benchmark unemployment rate" of the

Council of Economic Advisers (CEA).6 y This high-employment

benchmark is an estimate of what the reported unemployment rate

would be in each year with high employment--that is, with the

degree of labor market tightness represented by the unemployment

rate of 4.0 percent in 1955. Because of demographic and other

changes, the high-employment benchmark has risen from 4.0 percent

in 1955 to 4.9 percent today; it is expected to decline gradually

in future years, as the "baby boom" generation moves out of the

high-unemployment years of youth.

6/ The CBO projection is shown in Chapter IV.

32
Figure 1.

LOW UNEMPLOYMENT AND WAGE INFLATION

Percent

8

7

6

5

4

3

i

0

10

9

8

Unemployment Rate

Projection

\ with

\ Roth-Kemp

x/

CEA High

Employment

Very Tight

Labor Markets

I I I I I I I I I I I I

Rate of Change in

Compensation per

Very Tight

Labor Marketsi i i i i i i i j i

'54 '56 '58 '60 '62 '64 '66 '68 70 '72 '74 '76 '78 '80 '82

Calendar Years

SOURCES: Actual unemployment rates and compensation per hour -- U.S. Department of

Labor, Bureau of Labor Statistics.

CEA high employment unemployment rate - Council of Economic Advisers.

Projection of unemployment rate with Roth-Kemp -- Congressional Budget Office.

33
The lower panel of the figure shows rates of change in labor

compensation per hour. In past years, compensation per hour

sharply increased when the unemployment rate fell to near the

benchmark rate--for example, in 1956 and 1973. When the unemploy- ment rate was held substantially below the benchmark rate for a

sustained period—in the years 1966 through 1969--there was a

sustained acceleration of labor cost. Compensation increases rose

from annual rates of around 4 percent in the early 1960s to rates

greater than 6 percent in the late 1960s and early 1970s, inter- rupted in 1972 by the imposition of price and wage controls.

On the basis of past experience, unemployment rates around

the CEA benchmark rate must be characterized as representing tight

labor markets, and rates below the benchmark rate (shaded area in

the figure) as representing very tight labor markets. The pro- jected unemployment rates shown in this figure fall well below the

CEA benchmark, suggesting that the Roth-Kemp tax cuts will generate

substantial wage inflation. ]_/

This is not to assert that the CEA rate represents the ir- reducible minimum of "frictional" unemployment in the U.S. economy. Clearly, it does not; lower rates are attainable, and they would

provide benefits to holders of the new jobs. But with exist- ing labor market institutions, "very tight" labor markets lead to

accelerating labor costs, which tend to be translated directly into

accelerating inflation. Tight labor markets are not the only

cause of accelerating inflation, as was abundantly demonstrated in

1974 and 1975, but the evidence strongly indicates that they can be

an important cause. 8/

7/ This projection, described in Chapter IV, is based on CBO's

estimate of the incremental effect of the Roth-Kemp tax cuts, given the economic baseline assumed in the five-year projection

used to mark up the Second Concurrent Resolution on the

Fiscal Year 1979 Budget.

8/ Inflation can be caused by restrictions of supply as well as

by excess demand. In the mid-1970s, inflation was increased by

a variety of supply-related factors, including the establish- ment of the oil cartel and a worldwide crop failure. Further- more, once inflation accelerates, it gathers (Continued)
The expansion of demand resulting from Roth-Kemp would in- crease utilization of capital as well as of labor. For example, estimates by DRI indicate that output increases would outstrip the

capacity increases resulting from the Roth-Kemp tax cuts, so that

by 1981 capacity utilization in the industrial materials industries

would average 93 percent for the year as a whole. S>/ This rate

would be even higher than that experienced in the inflationary 1973

boom period.

Thus, conventional analysis indicates that there is a serious

risk that the tax cuts would put upward pressure on prices by

tightening labor markets and by creating shortages of industrial

capacity. If past experience is a guide, the costs of ridding the

economy of a new burst of inflation would be high. Once inflation

gets started, it gathers momentum; substantial losses of employment

and output are needed to reduce inflation quickly.

INVESTNENT SPENDING

One of the benefits of the Roth-Kemp tax cuts is the stimulus

to business investment that would be provided by the cut in cor- porate income tax rates. The recovery of investment spending, since the 1974-1975 recession, has been disappointing, and most

analysts agree that a cut in business taxes is an effective way of

increasing investment.

The bill has nonetheless been criticized for providing only a

relatively small cut in business taxes. About 8 percent of the

revenue reduction is for corporations, as compared with the one- third corporate/two-thirds personal division frequently advocated. Furthermore, although this corporate tax reduction was proposed in

order to increase the supply of capital, most studies indicate

momentum—largely as a result of the widespread tendency to

link income adjustments to past price changes. This is the

mechanism underlying the continued rapid growth in labor

compensation in the mid-1970s, despite high joblessness during

and after the 1974-1975 recession.

The Data Resources Review of the U .$. Economy (Aigust 1978) , p. 13.

35
that increases in the investment tax credit or accelerated de- preciation are more effective instruments for this purpose. H)/

Indeed, the Roth-Kemp bill could adversely affect investment

spending if it results in an acceleration of inflation attributable

to excess demand. Inflation increases the cost of capital, it

increases the tax burden on economic profit because depreciation

relates to historical cost rather than replacement cost, and it may

also create considerable uncertainty regarding the profitability of

business ventures, thereby inhibiting investment spending.

Congressional Budget Office, The Economic Outlook (February

1978) , pp. 33-34.

36
CHAPTER IV. ESTIMATES OF THE IMPACT OF ROTH-KEMP TAX CUTS

Two general methods have been used to estimate the impact of

the Roth-Kemp tax cuts on the economy. The first involves a search

for a similar event in recent history and an analysis of its

aftermath; the second uses econometric models of the economy to

simulate the future under the assumption of enactment of the

bill.

THE 1964 TAX CUT

The tax reduction most similar to the Roth-Kemp bill is the

Kennedy-Johnson tax cut in 1964. It has been asserted that the

1964 tax rate reduction had very large supply effects and, as a

result, was self-financing. This assertion has been disputed by

the economists who designed that tax cut proposal.

The 1964 tax reduction was enacted to help close the estimated

5 percent gap between the actual and potential GNP that existed in

1963. Personal income taxes were cut from a range of 20 to 91

percent to a range of 14 to 71 percent in two stages, in 1964 and

1965. Withholding rates were reduced by the full amount in March

1964. The corporate income tax rate was reduced from 52 to 48

percent. Both of those changes were permanent.

The revenue loss (before feedback) from that personal income

tax reduction totaled nearly $12 billion when it reached its full

impact; the corporate tax reduction, $3 billion. The overall tax

cut amounted to about 2.2 percent of GNP; in today's economy, a

similar size cut would amount to about $45 billion to $50 billion.

In its 1964 Annual Report, the Council of Economic Advisers

estimated that this personal tax reduction would eventually add

about $18 billion to GNP. The corporate tax reduction, along with

the continued effects of the previously enacted investment tax

credit, was expected to add about $10 billion to $14 billion to

GNP. It has been argued recently that the 1964 tax cut had a

substantial effect on aggregate supply and that the overall results

37
were much larger than anticipated. These statements are generally based on the actual performance of the post-1964 economy. The

problem with this approach is that it neither isolates the impact

of the tax cut from other events, nor does it distinguish supply from demand effects. Many events occurring during this period-- such as the military build-up because of the Vietnam War—significantly affected the economy.

The 1964 tax cut has been studied by CBO and a number of

other analysts. Using three macrjoeconomic models, CBO estimated

that the personal income tax cut alone increased GNP by some $11

billion to $23 billion by 1966. I/ By 1967, three years after

passage of the bill, the unemployment rate had dropped to 3.8

percent, as contrasted with an estimated unemployment rate of about

4.5 percent without the tax cut. Tighter labor markets signifi- cantly affected inflation, increasing the price level by an esti- mated 1.4 to 2.2 percent above wh^t it would otherwise have been. According to this analysis, the impact of the corporate tax rate

cut was negligible, as compared wi-fh the personal tax cut.

None of the models used by CBO showed that the increased

economic activity generated by the tax cut raised revenues and

lowered countercyclical transfer Payments enough to make the tax

rate reductions self-financing, Jnstead, the models showed a net

increase in the federal deficit, aTter three years, of $5 billion

to $13 billion above the level in the no-tax-cut simulations. Although the estimates made by others also show considerable

variation, CBO is unaware of any Systematic study of the 1964 tax

cut that indicates that it was self-financing.

SIMULATIONS WITH THREE MACROECONOM|C MODELS

Policy simulations with laifge econometric models provide

an indication of the economic impact of the proposed tax cuts. The

estimated effects according to three quarterly models — those

I/ Congressional Budget Office, Understanding Fiscal Policy, Background Paper (April 1978), pp. 23-25.

38
of Data Resources, Inc. (DRI), Chase Econometric Associates,

Inc. (Chase), and MIT-Penn-SSRC (MPS)--are reported below. 2/

Since each of these models represents a somewhat different view of

the structure of the economy, a review of all three presents a

useful basis for assessing the impact of the tax cuts. It is

important to note, however, that the model simulations incorporated

numerous crucial assumptions and that these assumptions, which are

not the same in each model, flavor the results. Although many of

the assumptions are relatively innocuous when used in conjunction

with smaller tax cuts, they become important with a reduction of

the magnitude of Roth-Kemp.

The Gross Revenue Loss Assumptions

The first step in estimating the economic effects of a

tax cut is to determine the gross federal revenue loss (before

feedback). These estimates depend critically on projections of

taxable income in the absence of a tax cut and on the response of

personal tax receipts to growth in money incomes. High growth in

money income and high responsiveness lead to greater gross revenue

loss. In addition, as indicated in Chapter III, high responsiveness means that the tax structure will exert a more restrictive

influence on the economy as incomes rise.

The Joint Committee on Taxation (JCT) has estimated the

gross revenue loss that would result in calendar years 1979-1983

from the Roth-Kemp tax reductions (in billions of dollars):

Calendar Years

1979 1980 1981 1982 1983

Personal Tax

Revenue Loss 27.4 63.8 112.3 134.7 161.7

Corporate Tax

Revenue Loss 4.0 6.6 9.6 10.5 11.5

2/ The Wharton quarterly model, which CBO uses frequently, does

not have the capability to simulate beyond 1980 and was not

used in these exercises.

39
Given the uncertainty about the future growth of money income and

the responsiveness of tax revenues to this growth, estimates of the

gross revenue loss from Roth-Kemp can differ. As discussed in

Chapter III, CBO has traditionally used the JCT estimates of

revenue loss because they are derived from the best available

methodology. ^/

Other Assumptions

Other assumptions that significantly affect the outcome

of the simulations include the following: the overall baseline

economic scenario (that is, the performance of the economy without

the tax cut), the response of monetary policy, and the level of

federal spending. Although the simulations were adjusted for some

of the differences in assumptions, significant discrepancies

remained, especially in the rate of economic growth in the baseline

forecast (see Table 9).

Simulation Results

Estimates of the incremental impact of the Roth-Kemp tax

cuts (that is, the difference between the baseline and the tax cut

forecasts) are shown in Table 10. In a qualitative sense, the

three simulation results are quite similar. All show a substantial

reduction in unemployment and an acceleration in the rate of

inflation. Some significant differences in both the size and the

mix of the impact of Roth-Kemp, however, do arise. In the DRI

simulation, the jobless rate falls only slightly below b percent, while both Chase and MRS show the unemployment rate falling below

3/ The large econometric models produce estimates of gross

revenue loss from Roth-Kemp that are lower than the JCT

estimate. These models, however, assume a lower responsive- ness of tax revenues to income growth than is generally found

in empirical investigations of this relationship; large

econometric models therefore probably understate the true

gross revenue loss. In some cases, the low responsiveness

posited in the large models implies that a series of tax-rate

reductions are assumed to occur in the models' baseline

forecasts.
TABLE 9. ALTERNATIVE PROJECTIONS OF THE ECONOMY WITHOUT THE ROTH- KEMP TAX CUTS, CALENDAR YEARS 1979-1983: IN PERCENTS

Economic Variable 1979 1980 1981 1982 1983

Real Growth

DRI 3.0 4.7 3.1 2.5 3.4

MPS 3.0 5.2 4.7 2.2 N.A. Chase 1.9 2.7 2.7 3.4 3.5

Inflation

DRI 6.3 6.2 5.7 5.4 5.1

MPS 8.7 7.4 7.6 7.4 N.A. Chase 6.9 5.8 5.9 5.1 4.7

Unemployment

DRI

MPS

Chase

6.3

6.4

6.5

6.1

6.1

6.9

5.9

5.7

7.1

6.1

6.2

7.1

6.1

N.A.

6.9

N.A. = Not available.

4 percent. With unemployment rates below 4 percent—well below

what is generally regarded as full employment--the inflation impact

would be expected to be quite large in these simulations. In fact, this is the result in the MPS simulation, which shows the inflation

rate up more than 4 percentage points in both 1981 and 1982. By

contrast, the Chase simulation shows a relatively small effect on

prices, even less than in DRI, which shows a much higher labor- market slack.

In both the DRI and the MPS models, economic growth weakens

and unemployment rises by 1982 because of the stringent credit

conditions brought about by the increased inflation, the larger

federal deficit, and high interest rates. Unemployment continues

to decline in the Chase simulation through 1983. As can be seen, Chase shows a much more favorable outcome than the other two

models, partly because of its relatively weak baseline but also

because a more favorable trade-off between inflation and unem- ployment is implicit in that model.
TABLE 10. ALTERNATIVE ESTIMATES OF THE INCREMENTAL EFFECT OF THE

ROTH-KEMP TAX CUTS, CALENDAR YEARS 1979-1983

Economic Variable 1979

Difference from baseline in:

1980 1981 1982 1983

Real Growth

(billions of 1978 dollars)

DRI 11.1

MRS 19.3

Chase 10.3

Inflation

(percentage points)

DRI

MRS

Chase

Unemployment

(percentage points)

0.0

0.2

0.0

28.7

54.0

31.7

0.2

1.7

0.1

48.7

79.4

60.9

0.8

4.2

0.4

38.1

52.8

82.1

1.8

4.1

0.7

22.1

N.A.

89.4

1.3

N.A.

1.2

DRI

WPS

Chase

-0.2

-0.4

-0.2

-0.6

-1.3

-1.0

-1.0

-2.0

-2.1

-0.9

-1.8

-3.0

-0.5

N.A.

-3.4

N.A. = Not available.

Estimate of Feedback Effects

The various estimates of the increase in federal tax receipts

resulting from the growth in economic activity are shown in Table

11. The differences in feedback among these models are primarily the result of the different estimated effects of Roth-Kemp on

nominal GNP rather than the result of differences in the tax

structure. Their estimated feedback effects are therefore similar

when expressed as a percentage of nominal GNP effects. Although

these reflows do offset some of the direct costs of the Roth-Kemp proposal, the estimated increase of the federal deficit is still

very large in all three models.
TABLE 11. ALTERNATIVE ESTIMATES OF TAX REFLOWS AS A PERCENT OF

GROSS REVENUE LOSS, CALENDAR YEARS 1979-1983

1979 1980 1981 1982 1983

DRI

MRS

Chase

17.3

19.1

14.1

26.0

25.5

21.8

31.8

30.5

27.4

36.5

26.3

38.4

35.7

N.A.

44.9

N.A. = Not available.

THE CBO ESTIMATE

CBO has also estimated the impact of the Roth-Kemp tax cuts, relying to a large extent on consensus multipliers developed

previously and on experience with many models. 4/ But CBO's

confidence in such estimates decreases the further into the future

the estimates are projected ana the larger the tax cut is. The

Roth-Kemp reductions occur over a period of three years, and their

size is well beyond the normal range of postwar experience. Nevertheless, the CBO estimate appears to be fully consistent with

the most widely accepted evidence on the behavior of the economy.

CBO estimates that, by 1983, the Roth-Kemp tax cuts would

provide a large stimulus to economic output, driving the unemploy- ment rate down to nearly 4 percent. But this increase in economic

activity exceeds what is usually regarded as full capacity; there- fore, it would be achieved at the expense of much higher inflation

as well as a larger federal deficit.

4/ See Congressional Budget Office, The Multipliers Project

(August 1977).
With the Roth-Kemp tax cuts, the unemployment rate would be

substantially below the levels achieved since the beginning of this

decade—below even the 1973 boom rates. The economy would enter

a period of excess demand, which would place substantial upward

pressure on prices. CBO estimates that the incremental impact of

the Roth-Kemp proposal, shown in Table 12, would be to raise the

inflation rate by about 2.7 percentage points. Adjusting for the

fiscal stimulus already included in the five-year projection

adopted by the Budget Committee staffs, the inflation rate in 1983

would be nearly 2 percentage points above the five-year projection. Although this estimate of inflation is substantial, it may well be

low, given the demographic and structural changes that have occur- red in the labor market and the inflationary psychology evident in

the economy today.

CBO estimates that the deficit would be up sharply as a result

of the Roth-Kemp tax cuts, even after accounting for the substan- tial reflows produced by the increased GNP. Furthermore, a large

part of the revenue reflows would be generated by increased infla- tion brought about by Roth-Kemp, particularly in the later years.

The Assumed State of the Economy without the Tax Cuts

As indicated earlier, the ultimate effect of the Roth-Kemp tax

cuts depends to a great extent on the underlying strength of the

economy without the tax reduction. The inflation generated by the

tax cuts will depend heavily on the tightness of labor markets and

the utilization rate of plant and equipment. If nonfederal

demands were so strong that the economy reached full capacity

without a tax cut, then a tax reduction the size of Roth-Kemp would

generate extremely high rates of inflation. But, if the economy

were to weaken seriously without a tax cut, then the tax reduction

would produce a significant rise in real output and employment, and

the impact on inflation would be more moderate.

In order to maintain consistency with other budget estimates, the CBO estimate of the impact of the Roth-Kemp tax reductions uses

the economic baseline implicit in the five-year projections adopted
TABLE 12. ESTIMATED INCREMENTAL ECONOMIC IMPACT OF ROTH-KEMP

TAX CUTS, FISCAL YEARS 1979-1983: IN BILLIONS OF

DOLLARS a/

Current Dollar GNP

In dollars

Growth rate (percentage points) b/

Constant Dollar GNP

In dollars

Growth rate (percentage points) b/

Inflation Rate

(percentage points) b/

GNP deflator

CPI

Empl oyment

(thousands)

Unemployment Rate

(percentage points)

Direct Budget Cost

Net Budget Cost

1979

13.4

1.2

8.3

1.0

0.0

0.1

169

-0.1

21.0

16.0

1980

55.0

2.1

30.7

1.8

0.2

0.2

892

-0.5

58.0

38.4

1981

118.3

2.3

54.5

1.2

0.9

1.0

1,803

-1.2

105.7

64.4

1982

185.2

1.5

62.8

-0.2

1.6

1.7

2,257

-1.5

138.1

74.8

1983

253.7

1.5

53.3

-1.1

2.5

2.7

2,012

-1.3

164.6

79.1

a,/ Change from baseline projection.

b/ Fourth quarter to fourth quarter of fiscal years,
by the staffs of the Budget Committees. 5/ This five-year projec- tion has more growth, lower unemployment, but less inflation than

the baseline projections used in some other estimates of the

impact of Roth-Kemp.

Monetary Policy

The CBO estimate of the incremental effect of the Roth-Kemp

tax cuts assumes a rapid increase in the money supply—more rapid

than current Federal Reserve target rates. This assumption may not

be realistic. Growth in the basic money supply at such a rapid

rate—together with higher inflation, larger federal deficits, and lower unemployment—may well result in a more restrictive

monetary policy; if so, the incremental effects of Roth-Kemp would

be smaller.

Since tight credit markets are most detrimental to investment

activity, the combination of the Roth-Kemp tax cuts and a restric- tive monetary policy could retard the growth of productive capacity

and raise the jobless rate. Indeed, the DRI and MPS models fore- cast this scenario if the Roth-Kemp reductions are enacted.

The Effect of the Corporate Tax Rate Reduction

In earlier work prepared for the Budget Committees, CBO has

shown that there is substantial disagreement among macroeconomic

models regarding the size of the economic impact of changes in

The baseline projection was derived by removing the tax cuts

already (implicitly) in the five-year projection assuming

moderate growth in nonfederal demands and current policy

spending. The tax cuts were then applied to this weaker

baseline economy. As a result, the effect on the economic

assumptions adopted by the Budget Committees is smaller than

the overall incremental effect of the Roth-Kemp tax cuts.
corporate income taxes. 6>/ Given the present state of the art, it

is impossible to produce a consensus estimate of the effect of the

corporate tax cut included in the Roth-Kemp proposal. Neverthe- less, despite wide variations in estimates of economic effect, none

of the models show that corporate tax rate cuts are self-financing.

The Roth-Kemp tax cuts, however, are largely reductions in personal

income taxes, and there seems to be more agreement on the magnitude

of its effects on these taxes. The composition of the proposed tax

reductions therefore increases CBO's confidence in its assessment

of the overall impact of the Roth-Kemp proposal.

Longer-Term Effects

Some economists object to using econometric models, which

are greatly influenced by the cyclical behavior of the economy, to

analyze policy options over the longer term. More precisely, some

argue that the long-run supply effects from relative price changes

are not properly captured in such models.

It is possible that the longer-term consequences of fiscal

policy actions may be different from those suggested by the available models. At present, however, there is little evidence that the

macroeconomic models err significantly in this regard (see Appendix). Furthermore, it may be a mistake to assume that all of the

longer-term consequences of the proposed tax cuts are favorable.

Rapid inflation—a likely consequence of Roth-Kemp--would contri- bute to economic instability, and past experience has shown that

such instability can depress business fixed investment and slow the

growth of the nation's productive capacity.

6/ See Congressional Budget Office, The Economic Outlook (February 1978), pp. 47-49.

CHAPTER V. TAX REDUCTIONS ACCOMPANIED BY CUTS IN SPENDING

The Roth-Kemp proposal to reduce taxes does not include

any provision for a reduction in spending; therefore, CBO' s

estimate of the economic impact of the bill, presented in the

previous chapter, assumes spending would continue at levels set by

current policy. Many of the supporters of Roth-Kemp, however, advocate that it be accompanied by substantial reductions in

current-policy spending. The economic impact of a tax cut accom- panied by a reduction in spending would be very different from the

impact of a tax cut alone. For example, it should be possible to

design spending reductions in a way that would fully offset the

impact of the tax cut on inflation.

ARGUMENTS FOR SPENDING REDUCTIONS

Some advocates of reduced federal spending contend that the

only way that their goal can be achieved is to commit the nation to

tax cuts before the growth in future tax receipts is absorbed by increased spending programs. They observe that the effective tax

burden on individuals has risen substantially since the early

1960s. According to CBO estimates, the Roth-Kemp tax cuts would

reverse this trend (see Table 13).

This argument for tax cuts of the size proposed in the Roth- Kemp bill is essentially an argument for a smaller public sector. The question whether the electorate arid its representatives want

fewer public services is, however, largely a political--not econo- mic—matter, which will not be examined here. Nevertheless, some potential economic problems are associated with this type of

fiscal policy. In particular, there may be a substantial risk in

assuming that spending will be cut in response to tax cuts rather

than legislating a reduction. Despite the lower taxes, spending

may not be reduced; if not, a much larger federal deficit would

result. If this occurred when labor and capital were fully em- ployed, inflation would accelerate rapidly. Many proponents of a

Roth-Kemp size tax cut, therefore, believe that spending cuts

should also be mandated. In addition, some have proposed that
TABLE 13. EFFECTIVE TAX RATES FOR INDIVIDUALS FOR SELECTED YEARS

AND UNDER THE ROTH-KEMP PROPOSAL

Roth- 1960 1965 1970 1975 1977 Kemp a/

Personal income

taxes as a percent

of taxable personal

income b/ 11.3 10.4 12.3 11.3 12.5 10.5

Social insurance

taxes as a percent

of taxable personal

income b/

Total c/

2.5

13.8

2.7

13.1

3.9

16.2

4.7

16.1

4.7

17.3

5.5

16.0

a/ Projected for 1981, the first full year of the total tax cut.

t>/ Taxable personal income is defined as wages and salaries, proprietors' income, rental income, dividends, and personal

interest income.

£/ Components may not add to totals because of rounding.

the tax cut be phased in over a longer period of time or that the

reductions be backloaded—that is, made larger in later years—in

order to increase the likelihood of achieving corresponding reduc- tions in spending.

The Impact of Reductions in Spending

The size of the reduction in spending needed to offset the

inflationary impact of Roth-Kemp depends critically on the state

of the economy. If nonfederal demands are as strong as assumed

in the five-year projection adopted by the Budget Committees, very large spending cuts would be required to offset the infla- tionary effect of Roth-Kemp. If, on the other hand, the economy is

weaker than assumed in the projection, fewer spending cuts might

suffice. Similarly, if the tax cuts were phased in more slowly, the offsetting expenditure reductions could be smaller..

50
The categories in which federal spending is reduced would

also affect the size of the cut needed to offset the lower tax

rates. Reductions could be accomplished through changes in pur- chases of goods and services, transfers, grants, or through any

combination of these spending categories. A given change in federal

purchases is generally believed to affect the economy (in par- ticular, nominal GNP) more than corresponding changes in either

taxes or transfers. ]_/ The economic impact of reductions in grants

to state and local governments is highly variable, depending on the

type of program affected. The impact of a reduction in transfer

payments is roughly comparable to the impact of the same size

increase in personal income taxes. Consequently, if the spending

reductions were split equally between purchases and transfers, it

is estimated that these cuts would have to be approximately three- quarters the size of the direct costs of the tax cuts in order to

offset the letter's impact on nominal GNP and inflation. Since

changes in spending and personal income taxes affect the economy

with nearly equal speed, reductions in expenditures and tax rates

would have to be phased in concurrently.

Table 14 provides some rough indication of the size of the

spending cuts that would be necessary to offset the effect of

Roth-Kemp, if cuts were divided equally between purchases and

transfers. To offset fully the impact of Roth-Kemp on inflation, federal spending by fiscal year 1983 would have to be approxi- mately 20 percent less than under current law. If the impact of

Roth-Kemp on the federal deficit is to be offset completely, an

additional 10 percent reduction in expenditures would be needed. This latter course of action would lead to a weaker economy than

that predicted in the five-year projections adopted by the Budget

Committees.

V Congressional Budget Office, Understanding Fiscal Policy (April

1978), p. 14.

51
TABLE 14. SPENDING AND TRANSFER REDUCTIONS SUFFICIENT TO OFFSET

FULLY THE IMPACT OF THE ROTH-KEMP PROPOSAL ON THE RATE

OF INFLATION (CPI) AND ON THE FEDERAL GOVERNMENT

DEFICIT: IN BILLIONS OF DOLLARS

To Offset Fully the

Impact on Inflation

Fiscal Pur- Year chases

Trans- fers Total a/

To Offset Fully the

Impact on the Deficit

Pur- chases

Trans- fers Total a/

1979

1980

1981

1982

1983

7.1

20.9

37.4

51.8

73.7

7.1

20.9

37.4

51.8

73.7

14.1

41.7

74.7

103.6

147.4

12.8

35.2

63.8

86.4

112.3

12.8

35.2

63.8

86.4

112.3

25.6

70.4

127.6

172.7

224.5

a./ Components may not add to totals because of rounding.

Table 15 shows that the Roth-Kemp tax reduction proposal with

current-policy spending would decrease federal expenditures as

a proportion of total GNP. In fiscal year 1979, federal spending

would be somewhat less than 22 percent of GNP; five years later, it would be less than 20 percent. With spending cuts sufficient to

offset the effect of these tax cuts on prices, however, federal

spending would drop to around 17 percent of GNP in 1983. A cut in

spending sufficient to offset the effect of Roth-Kemp on the budget

deficit would reduce the federal share of GNP still further, to

about 15 percent.

Reductions of this magnitude in the federal sector, even when

introduced over a period of several years, could lead to some

serious economic consequences, which are not fully captured in the

standard multiplier analysis used to develop these estimates.

52
TABLE 15. PROJECTIONS OF FEDERAL SPENDING AND CURRENT-DOLLAR GNP

UNDER THE ROTH-KEMP PROPOSAL WITH ALTERNATIVE SPENDING

ASSUMPTIONS, FISCAL YEARS 1979-1983: IN BILLIONS OF

DOLLARS

1979 1980 1981 1982 1983

With Taxes Reduced

and Spending Projected at Current

Policy Levels

GNP 2,267.6 2,526.5 2,822.7 3,148.6 3,515.2

Total federal

spending 493.7 545.0 589.6 646.2 700.7

Share of GNP

(percent) 21.8 21.6 20.9 20.5 19.9

With Spending Reduced

to Offset the Increase

in the Rate of Infla- tion

GNP 2,254.2

Total federal

spending a/ 479.6

Share of GNP

(percent) 21.3

With Spending Reduced

to Offset the Increase

in the Federal Deficit

GNP 2,224.8

Total federal

spending a/ 468.1

Share of GNP

(percent) 20.9

2,471.5

503.3

20.4

2,432.4

474.6

19.5

2,704.4

514,9

19.0

2,625.0

462.0

17.6

2,963.4

542.6

18.3

2,852.6

473.5

16.6

3,261.5

553.3

17.0

3,117.8

476.2

15.3

a/ The reduction in spending simply reflects the assumed changes

in purchases and transfers shown in Table 14. Other budget

components, such as net interest, are assumed to be unchanged.

53
For example, if job creation programs were particularly hard hit, spending cuts might have larger than estimated effects on employ- ment. More important, there is considerable uncertainty about

how easily the economy would adjust to large changes in spending

programs.

Smaller reductions in spending to offset inflation could be

contemplated if the economy were weaker than projected or if the

tax cuts were phased in over a longer period. Furthermore, smaller

spending cuts could be enacted if the goal of neutralizing the

impact on the rate of inflation were relaxed. For example, Table

16 summarizes the economic impact of reductions in purchases and

transfers that are half the size of those in Table 14. As can be

seen, gains in constant dollar GNP would be more than half the

amount that would be realized with the Kemp-Roth tax reductions

alone, while the rate of inflation would be less than 1 percent

higher in 1983—significantly less than the incremental impact on

prices without spending cuts.

CONCLUSION

Full evaluation of any proposal for a broad-based change

in taxes involves analysis of such issues as its impact on the

distribution of income, the provision of public services, and the

effect on economic growth and inflation. But the question of the

desirability of the effects of Roth-Kemp on the distribution of

income and the size of the public sector is largely a political

question, which cannot be resolved by economic analysis. Thus, this paper has focused on the impact of the Roth-Kemp tax reduction

proposal on total production, employment, and inflation.

CBO estimates that a commitment to large future tax cuts, unaccompanied by spending reductions, involves a substantial risk

of accelerating inflation. Although the inflationary effect of

such large tax cuts could be mitigated by large reductions in

spending, achieving reductions of that size would be difficult, given the past history of federal spending programs.
TABLE 16. NET INCREMENTAL IMPACT OF HALF THE SPENDING REDUCTIONS

NEEDED TO OFFSET FULLY THE IMPACT OF THE ROTH-KEMP

PROPOSAL ON THE RATE OF INFLATION (CPI), FISCAL YEARS

1979-1983: IN BILLIONS OF DOLLARS

Economic Variable 1979 1980 1981 1982 1983

Change in Constant

Dollar GNP

Roth-Kemp (no spending cuts) a/ 8.3

Half the spending

cuts b/ 4.3

Change in Inflation Rate

(percentage points) c/

Roth-Kemp (no spending cuts) a/ 0.1

Half the spending

cuts b/ 0.1

Change in Unemployment

Rate (percentage points)

Roth-Kemp (no spend- ing cuts) a/ -0.1

Half the spending

cuts b/ -0.1

30.7 54.5 62.8 53.3

15.4 27.2 24.6 33.6

0.2 1.0 1.7 2.7

0.1 0.3 0.7 0.8

-0.5 -1.2 -1.5 -1.3

-0.3 -0.6 -0.8 -0.8

a/ See Table 13.

b/ See Table 15.

c/ Fourth quarter to fourth quarter of fiscal years.

55

APPENDIX
~rnr
APPENDIX. SUPPLY-SIDE MODELS

In Chapter III it was stated that most macroeconomic models of

the economy are primarily, though not entirely, oriented toward

analyzing changes in demand. This statement may be too strong. A letter from Otto Eckstein, included at the end of this appendix, describes the fairly extensive supply-side mechanisms in the DRI

model and provides some useful insights into the general issue of

supply-side effects.

In addition, a number of attempts have been made by others to

model the supply side of the economy, either by adding production- function and factor-supply equations to existing Keynesian models

or by constructing full-employment classical models of the economy. In particular, recent interest in how large tax cuts may affect

work-leisure decisions and the supply of savings has led to

attempts to construct models that explicitly consider the effects

of marginal taxes on the supplies of labor and capital. J/

The attempts to model the supply side of the economy generally have

encountered problems involving specification of the model equations

and difficulties in estimating the models once specified.

The full-employment equilibrium models appear to have some

potential for evaluating the long-run effect of changes in relative

prices, but little value in estimating effects of alternative

fiscal policies.on prices and employment. The U.S. economy has

been at full employment for only brief periods and, even if annual

data are used, one cannot assume that factor markets will clear in

that time interval. Thus, a model that can consider less than full

utilization of labor and capital should be used in the analysis

of the economic impact of alternative policies.

V For example, Norman Ture is developing a ful1-employment

equilibrium model, which is not yet available, to test the

effect of tax law changes on the supply of labor and capital.

59
DATA RESOU RCES, INC. ZS HARTWELL AVENUE • LEXINGTON • MASSACHUSETTS O2I73

6I7/ 86I-OI65

°Y°BLC

T

KSTEIN July 25, 1978

Ms. Alice Rivlin, Director

Congressional Budget Office

U.S. Congress

Washington, D.C. 20515

Dear Alice:

This is in reply to your request for a description of the supply effects, including

the tax influences, in the DRI model of the U.S. economy. Since the model is

an 800 simultaneous equation structure, a description of a market economy in

which, at least to a degree, everything depends on everything else, it is not a

simple task to summarize these effects. A full description would require a small

book, so this summary is inevitably incomplete. It should be read in combination with the 200-page model description which is a part of the model documentation

volume that we distributed late last year.

SUPPLY IN THE DRI MODEL OF THE U.S. ECONOMY

The supply effects in the model versions since 1974 can be classified under the

following headings:

1. The supply of materials, as reflected in the production-vendor performance-inventory-capacity equations;

2. The supply of financial capital, as reflected in the 200-equation flow- of-funds sector, which traces personal, business, government and foreign

saving through the financial system to the decisions of households and

nonf inancial corporations;

3. The supply of physical capital, as calculated for the stock of producers' durable equipment, nonresidential structures, residential structures and

household durables;

4. The supply of aggregate output, as measured through an aggregate

production function;

5. The supply of labor, as measured by participation rate equations which

relate the labor force to the working age population.

Supply of Materials

Because the DRI model takes the market approach, prices are the principal vehicle for supply conditions to affect the economy. A scarce supply of materials, such as steel, chemicals, oil, lumber, etc., is shown through high utilization rates,

which increase finished goods prices through the stage-of-processing price equa- tions. Besides the utilization effects, the model also contains a separate channel
for vendor performance, the well-known measure of delivery conditions in indus- trial markets. Poor vendor performance acts in the model to raise industrial

prices and to stimulate inventory hoarding.

In considering the determination of the supply of materials, processed materials

must be distinguished from raw materials. The supply of processed materials

is determined by the capacities of these industries. These capacities, in turn, are determined by the growth in capital stocks and by technology. An industry's

capital stock is determined from equations explaining the level of investment. The supply of raw materials is modeled through prices: agricultural commodities

and world oil are reflected in exogenous price variables; other raw materials

prices are endogenous, moved by the strength of demand, and on the supply side

by strike variables. It should be added that DRI's micro models, of numerous

industrial and agricultural commodities, do model the availability and costs of

supply very elaborately, and this work is an input to the materials forecasts in the macro model.

Supply of Finance

There are both price and quantity effects in the model. Flow-of-funds variables

move interest rates through the portfolio behavior of businesses, financial insti- tutions and individuals. Government deficits directly affect the interest rates

on government securities, and indirectly all interest rates. Quantity effects on

the financial side are also quite pervasive throughout the model. The mortgage

market, and therefore the housing industry, are moved in considerable part by

the quantity of personal saving that flows through the thrift institutions. The

volume of business investment in plant and equipment is affected by the quantity

of debt capital, particularly short-term debt capital that is already carried on

the business balance sheets. The volume of consumer spending on discretionary

items is affected by the quantity of consumer debt already outstanding, along

with the extent of household wealth and the size of the debt service burden in relation to income.

Supply of Physical Capital

These elements of supply have two principal roles in the model. First, spending

equations contain various stock-flow adjustment processes, with the size of the

physical stock in relation to current flows determining current outlays. The busi- ness investment equations, the demand for housing, and the demand for such con- sumer durables as automobiles fall into this category. Second, the supply of physical capital enters into the calculation of potential output through the aggregate

production function. Potential output, in turn, is a critical variable in the determination of the inflation rate via the unemployment-wage channel, and is a minor determinant of inflation as a secondary demand variable in some of the price

equations.

The supply of physical capital is calculated from investment and depreciation estimates, of course. The model has equations for investment in equipment, nonresidential construction, housing and consumer durables, and these are combined

with Department of Commerce estimates of depreciation rates to calculate the

respective capital stocks. In the case of automobiles an endogenous equation
determines the scrappage rate, since the economic situation of households clearly

is an important variable in determining the disappearance of old equipment from

the capital stock.

Supply of Labor

The supply of labor in the model is determined in two steps: the full employment

supply of labor is calculated outside of the model. Equations for the supply of

labor by sex and age rely on real wages, average real unemployment insurance

benefits, average real AFDC benefits, the ratio of young children to adults 25- W, military employment, national unemployment, married male unemployment

and time trends beginning in 1950 and 1965 to reflect sociological changes. These

equations are discussed in the recent book by Roger Brinner, Technology, Labor

and Economic Potential (DRI, 1978), pp. 34-65. The model's labor supply equation

draws heavily on this work.

The supply of labor has its largest impact on the model through unemployment, wages, unit labor costs and therefore prices. It also has a secondary effect through

the potential GNP channel directly into some prices. Employment in the model

is calculated in two ways: aggregate employment is derived from aggregate demand, and is contrasted with labor supply to calculate an estimate of the national unemploy- ment rate. This estimate is used as a check on the Okun's Law estimate of unemploy- ment which has proved to be the more statistically reliable calculation. The model

also estimates employment by industry, using production and productivity as the

explanatory variables. These industry employment calculations provide a check

on the national employment and unemployment estimates.

Supply Effects That Are Not Built into the Model Structure

While the supply matters in the model are quite elaborate and, in terms of equa- tion count, actually represent more than half of the total, perhaps it would aid

understanding to discuss two kinds of supply effects that are not presently in the

model. They are quantity constraints and multifactor production functions. In

the truly planned economy, the planning authority determines the production plan. The largest part of the planning activity consists of determining the production

requirements for materials and intermediate goods so they will be consistent and

will achieve the planned final product targets. At the theoretical level, the plan- ning authority may seek to optimize the production plan in terms of overall cost

or in terms of values attached to the end products. From the theoretical view- point, the proper model for this work is a linear or nonlinear programming model

in which the constraints are the production relationships and the supplies of basic

inputs including the capital stock.

The DRI model is not structured for a planned economy. The United States has

a market economy and the model must be built accordingly. The model is useful

as a planning tool only in terms of fiscal and monetary policy choices of the sort

that are made regularly by the government. For microeconomic planning, whether

by government or industry, the model can be a useful component of a fuller model- ing system, but it must be combined with micro models focussing on the particular

sectoral planning questions.
There are times when the U.S. economy experiences a greater planning ingredient. During the Arab oil embargo and during the period of the Nixon price controls

the normal workings of the market economy were partially suspended. A similar

situation exists today, to a lesser degree, in the energy field, with the government

attempting to regulate some prices and quantities. These situations pose a particu- lar challenge to modeling. On the one hand, a production planning model would

be grossly inappropriate for the United States since oil embargoes and price con- trols are anomalies in a market economy, and hopefully both rare and short-lived. On the other hand, it is impossible to program these situations into the model

because it is impossible to predict what particular sectors of the economy will

be affected at what particular moment in the future, and to define precisely what

questions will be asked and what policy levers will be available when the circum- stance finally develops.

The current answer to this planning challenge is to combine macro and micro

models. In the case of price controls, the models were very successful in calcu- lating their effectiveness and in estimating the temporary benefits to economic

performance from the reduced inflation rate. Neither the DRI model—-nor any

other system—was able to identify the shortages that developed through disrup- tions of production and diversion of materials into foreign markets. All that DRI

could do in that circumstance was to develop economic information systems that

could improve monitoring of what was going on. If controls were to return, the

probable shortages could now be calculated somewhat more precisely because

of the growth of micro models that could be simulated to estimate production

disruptions and diversions into uncontrolled markets.

In the case of energy, a problem likely to be with us for sometime, the answer

lies in developing elaborate systems which bridge the macro and the energy mod- els. DRI has a team actively working to make simultaneous solution of the macro

and energy models possible. The DRI macro model did well in identifying the

general inflationary impact of the energy crisis of 1973-74, but underestimated

the degree of disruption of consumer confidence and the degree of financial pres- sure that was created. The shortcomings in that episode were the main spur to

the elaboration of the model, including greater supply and financial effects, since

1974. The model is built quite precisely to take account of energy price effects

on the economy, but it is not yet, standing alone, able to sufficiently represent

the effects of disruption of supply, nor does it calculate the full effects of price

on conservation or productivity. Integration of the macro and energy models

will fill this gap.

The other important supply phenomenon which is not modeled sufficiently in the

current version of the DRI model is the multifactor aspect of production. Energy, and perhaps other materials, should be added to labor, capital and technology

in the aggregate production function. Further, the model should contain a produc- tion function of this type for each industry to calculate the effects of particular

price changes on the composition of production, the relative use of the different

factors of production and their productivity.
TAX EFFECTS AND SUPPLY

Because of the simultaneous nature of the 800-equation model, it is also somewhat

difficult to give a full and precise response to the question of tax effects on sup- ply. Before turning to your specific questions, let me review the tax issue in relation to the five aspects of supply discussed above.

Taxes and the Supply of Materials: Corporate taxation affects investment both

in the aggregate and by industry. Investment tax credits boost investment in

equipment, and lower corporate tax rates reduce the composite cost of capital

and augment cash flow. Consequently, lower taxes add to capacity, improve ven- dor performance and lower industrial prices, other things equal.

Taxes and the Supply of Finance: Corporate taxes affect cash flow, adding to

finance. The lower cost of capital boosts investment, partially offsetting the

extra business liquidity. There is also the extra demand for finance growing out

of the enlarged government deficit, but the model does not incorporate one-forone "crowding out." The crowding out coefficient varies from as low as 0.2 in periods of general slack and over-ample liquidity to near one in periods of extreme

credit stringency.

Personal tax reduction leads to an increase in personal saving which strengthens

the financial position of households. The personal saving largely flows into housing. Again the crowding out from the enlarged government deficit has to be considered. An exercise is reported below.

Taxes and the Supply of Physical Capital: Lower corporate taxes encourage in- vestment and the more rapid formation of physical capital. An exercise is re- ported below. Lower personal taxes also affect household capital formation, of

course.

Taxes and the Supply of Labor: The DRI model does not include a tax term in its supply of labor equation. Our statistical tests, as part of our general model

building work, did not disclose an identifiable impact. This may or may not be

due to the limited range of changes in the personal income tax in the postwar period, which is the basic interval for our analysis. Beyond our own limited work,

we also relied on the large body of research in the public finance field. The major empirical studies of the impact of income taxation on the supply of labor have

found quite mixed results: some individuals work harder if the tax burden is eased

and others work less because their aftertax income goals are achieved with less

effort. The best known studies are: Thomas H. Sanders, Effects of Taxation on Executives (Harvard University, Graduate School of Business Administration,

1951); George F. Break, "Income Taxes and Incentives to Work," American Economic Review, September 1957, pp. 529-549; Robin Barlow, Harvey E. Brazer, and James N. Morgan, Economic Behavior of the Affluent (Brookings Institution,

1966); and Daniel M. Holland, "The Effects of Taxation on Effort: Some Results

for Business Executives," National Tax Association, Proceedings of the Sixty- second Annual Conference on Taxation (1970), pp. 428-517. While these studies

analyze a broad range of experience, mainly in the United States and England, they have been largely confined to business executives and professionals. The

more recent studies of the effects of negative income taxes may be casting some
additional light on the relationship between work and taxation. I have not attempted

a systematic review of the negative income tax materials, but it is my impression

that the preponderant finding of the scholars is that the effects are small or non- existent. The last word has not been said on this subject, but what evidence there

is seems to be arguing against strong, measurable impacts of taxation on the sup- ply of labor.

Taxes and the Supply of Potential: Besides the capital input which is clearly en- hanced by lower taxes, and the supply of labor just discussed, the supply of potential depends on the rate of progress of factor productivity. The DRI model does

not contain a tax term in the productivity equations, nor in the aggregate produc- tion function, nor am I aware of any study that claims to have such a finding. But this is a matter which has not been studied sufficiently and is certainly worthy

of further work.

Let me now turn to your specific questions on taxation and supply.

1. Is the marginal personal tax rate included in the labor supply equation?

Answer: No, as discussed above.

2. What impact, if any, do personal taxes have on consumption-saving-investment

decisions?

Answer: A full model simulation is probably the best response to this question. Table 1 shows the impact of a personal tax reduction on the major dimensions

of the economy. A $10 billion personal tax reduction boosts consumption by an

almost equal amount four quarters later before the inflation effect destroys much

of the real benefit of stimulus. Personal saving is boosted by $6.4 billion in the

fourth quarter and $6.5 billion in the eighth quarter, and business fixed investment

is up by $1.1 billion and $2.1 billion. Housing is also aided because the extra per- sonal saving flows through the thrift institutions into the mortgage markets, and

because higher real income boosts demand.

3. How does the corporate profits tax rate affect capital accumulation?

Answer: A full model simulation again provides the clearest answer. Table 2

shows the impact of a $10 billion corporate tax cut. The statutory corporate

tax rate is cut by three percentage points and the investment tax credit is increased

by three percentage points. The cost of capital is reduced as a result, the service

burden ameliorated and total business fixed investment is given a sizeable boost. The general improved prosperity also serves to lift family incomes and consump- tion, of course. After a while, the stronger economy creates somewhat more

inflation and consequently some of the benefits are gradually lost. This occurs

despite the supply-boosting and productivity-enhancing effects of the extra capital accumulation.

4. How are long-run effects distinguished from short-run impacts?

Answer: The DRI model is designed to run well both in the short and long runs. The simulation properties are checked through a variety of exercises and we have

made numerous changes in the specifics of the equations to assure simulation

properties that are consistent with economic theory and general understanding.
Because the model is fully dynamic, with the lag structures obtained by careful

statistical work and built into the model, all effects have a time profile. In gen- eral, most things in the model take longer than the economic theorist would like

to believe, and this is one of the reasons why the model tends to show that eco- nomic policies rarely achieve quick results. At the moment, this is clearest in

connection with the dollar devaluation: the model calculates the "j curve" effect

to stretch out at least six quarters, with a cheaper dollar actually hurting our

balance of trade for at least two quarters. The model also shows that the initial

response to policies of stimulus is to boost quantity first, with the inflation damage

mainly appearing after year two. However, there are some quick inflation effects

in sensitive markets, such as some industrial materials and some food prices.

5. Can the models be applied to tax cuts much larger than those encountered

during sample periods?

Answer: The 196<f personal tax cut was a 17.5% reduction, while the corporate

cut was about 5%. Those cuts were simulated well by the DRI model. The current

proposals call for a 33% tax cut which is nearly twice as large. It is a judgemental

question whether the models would apply at that magnitude.

Arguing for the applicability of the models is the fact that a 33% reduction on

the personal income tax represents only a 17% reduction in the total tax burden. Further, the actual proposals now under consideration do not reduce the top mar- ginal tax rates on work at all. There is now a 50% ceiling on earned income and

I am not aware of any proposal to reduce it. Thus, it is only the rates below 50%

that would be changed as far as the income from work is concerned. The reduc- tion of income from dividends, interest and rent would be cut by about 30%, of

course. Arguing against the applicability of the large models is our limited know- ledge of the effects of the tax system on productivity and the inconclusive find- ings of the effects of taxation on the supply of labor. My judgement would be

that a 33% reduction in the personal income tax burden, following a 32.7% in- crease in that burden since 1965, is not enough to fall outside the range of applicability. The fact is that even the massive cuts now being proposed do not

go that much beyond the increases created by inflation and the rising burden of

government expenditure.

A point of "no applicability" can be reached, of course. A "Laffer curve" stretch- ing from a tax system which takes 100% of income to no taxes at all cannot be

traced out with a macro model. The 100% tax burden would represent either

a slave or a communist economy, or both. It would be governed by non-market

principles. The "no tax" point of the Laffer curve would also be hard to model

realistically since, without a government, our country would quickly fall prey

to the totalitarian forces loose in the world.

If you would like to pursue any of these matters further, please let me know.

I will also keep you posted on the work that DRI is doing to integrate further sup- ply effects, particularly in the energy field, and to dig more deeply into the ques- tions of taxation, productivity and labor supply.

Sincerely,

Q0T
TABLE 1

Impact of a $10 Billion Personal Tax Cut

The Economy

GNP

Consumption

Business Fixed Investment

Residential Construction

GNP

Consumption

Business Fixed Investment

Residential Construction

Inflation and Unemployment

GNP Deflator

Compensation Per Manhour

Unemployment Rate

Incomes

Disposable Income

Personal Savings

Savings Rate (Difference in Rate)

Aftertax Corporate Profits

Interest Rates

3-Month Treasury Bill Rate

Corporate New Issue Rate

Quarters After

Policy Change

4 6 8

(Billions of Dollars)

13.6 16.5 17.7 20.4

6.5 6.4 7.5 6.5

0.4 0.4 0.4 0.3 . 1.5 1.8 1.6 1.4

(Difference in Rate)

0.11 0.19 0.24 0.28

0.05 0.08 0.11 0.14

Federal Budget (Billions of Dollars)

Personal Taxes -9.5 -9.3 -9.5 -9.7

Total Receipts -8.0 -7.2 -7.6 -7.4

Surplus or Deficit (NIA) -7.9 -7.1 -7.8 -8.1

(- indicates a smaller surplus or a larger deficit)

Monetary policy assumed neutral, i.e. supply of

nonborrowed bank reserves left unchanged.

10

(Billions

7.

6.

0.

0.

8

9

5

6

11.

9.

1.

0.

,8

,8

,1

,8

(Billions of

5.

4.

0.

0.

0

6

3

3

6.

6.

0,

0,

.8

.0

,5

.4

of Dollars)

12.

9.

1.

0.

0

7

7

5

1972

5.

5.

0.

0.

9

3

7

1

14. 13.

2.

0.

,6

,3

,1

,3

16.

14.

2.

0.

3

9

1

1

Dollars)

6.

6.

0, -0,

.4

.8

.8

.1

6.

6.

0.

-0.

1

9

7

2

(Difference in Rate) — 0.1 0.1 0.1 0.1

0.1 0.2 0.1 0.1 0.1

-0.1 -0.2 -0.2 -0.2 -0.1

22.9

7.1

0.3

1.2

0.31

0.18

-9.9

-7.6

-8.8
TABLE 2 . Impact of a $10 Billion Corporate Tax Cut

The Economy

GNP

Consumption

Business Fixed Investment

Residential Construction

GNP

Consumption

Business Fixed Investment

Residential Construction

Business Incentives

Cost of Capital

Debt Service

Retained Earnings (billions of dollars)

Manufacturing Capacity

Nonfinancial Corporate Sector

Cash Flow

Physical Investment

Cost of Capital (percent difference)

Net Worth

Inflation and Unemployment

GNP Deflator

Compensation Per Manhour

Unemployment Rate

Incomes

Disposable Income

Personal Savings

Aftertax Corporate Profits

Interest Rates

3-Month Treasury Bill Rate

Corporate New Issue Rate

Quarters After

Policy Change

246 8

(Billions of Dollars)

3.4 7.3 13.2 18.7

0.8 2.0 3.9 6.1

0.9 3.9 7.9 11.3 — 0.1 0.1 -0.4

(Billions of 1972 Dollars)

2.0 4.2 7.1 9.1

0.5 1.2 2.0 2.8

0.5 2.3 4.5 6.2 — — — -0.3

(Percent Difference)

-2.8 -2.4 -2.0 -1.7

-5.8 -5.9 -5.7 -5.3

10.5 11.1 11.4 12.0 — 0.1 0.2 0.4

(Billions of Dollars)

8.8 9.2 9.6 10.6

2.3 4.5 7.9 10.9

-3.5 -3.1 -2.7 -2.4

7.0 10.5 13.4 16.0

(Difference in Rate) — 0.1 0.1 0.2 — 0.1 0.1 0.1 — -0.1 -0.2 -0.2

(Billions of Dollars)

1.6 3.8 7.5 11.2

0.9 1.7 3.5 4.7

11.0 12.3 13.4 14.8

(Difference in Rate)

0.04 0.09 0.19 0.33

0.03 0.03 0.08 0.14

(Billions of Dollars)

-9.5 -9.4 -9.9

-8.0 -6.5 -5.5

-8.0 -6.6 -5.9

Federal Budget

Corporate Taxes -9.7

Total Receipts -9.0

Surplus or Deficit (NIA) -9.0

(— indicates a smaller surplus or a larger deficit)

Three percentage point reduction in statutory corporate tax rate

from 48% to 45%. Three percentage point increase in the investment tax credit rate

from 10% to 13%. Monetary policy assumed neutral, i.e. supply of nonborrowed

reserves left unchanged.

10

22.5

8.6

13.6

-1.2

9.6

3.4

7.1

-0.8

-1.6

-4.3

11.8

0.8

11.0

12.2

-2.2

18.4

0.2

0.2

-0.2

14.9

5.6

15.4

0.44

0.20

-10.9

-5.2

-6.1

O