BACKGROUND PAPER

Understanding Fiscal Policy

April 1978

Congress of the United States

Congressional Budget Office

UNDERSTANDING FISCAL POLICY

The Congress of the United States

Congressional Budget Office

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

Washington, D.C. 20402

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PREFACE

Understanding Fiscal Policy attempts to explain the ways in

which federal budget policy affects employment, inflation,

and other dimensions of the economy. It analyzes how policy is

likely to work, and it traces the effects of three major past

policy changes. The study is written for the informed citizen,

not for the trained economist. It was prepared in response to

requests from Senator Edmund S. Muskie, Chairman of the Senate

Budget Committee, and Representative Thomas L. Ashley, Chairman

of the Task Force on Economic Policy of the House Budget Committee. In keeping with CBO's mandate to provide objective

analysis, this report offers no recommendations.

The principal author of the report was Frank de Leeuw,

former Assistant Director of CBO's Fiscal Analysis Division.

Nancy Morawetz, Helmut Wendel, Yolanda Kodrzycki, and Michael

Owen made important contributions. Alfred Fitt reviewed and

commented on a draft of the report. The manuscript was typed by

Marsha L. Mottesheard and Debra M. Blagburn and edited by Patricia H. Johnston; the figures were prepared under the supervision of Robert Bostick of the Congressional Research Service.

Alice M. Rivlin

Director

April 1978

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CONTENTS

PREFACE

SUMMARY

CHAPTER I.

CHAPTER II.

CHAPTER III.

CHAPTER IV.

INTRODUCTION

THE BASIC ECONOMIC FORCES AT WORK

Indirect Effects: Incentives to Work

Indirect Effects: Price Versus Quantity

THE NET OUTCOME: SOME EMPIRICAL ESTIMATES...

Models of the Economy and Fiscal Policy

The Impact of Some Past Major Federal

DESIGNING FISCAL POLICY

A Final Note

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FIGURES

Page

FIGURE 1. IMPACT OF A $10 BILLION STEP INCREASE IN

FEDERAL NON-DEFENSE PURCHASES, 1977 ECONOMIC

CONDITIONS 15

FIGURE 2. IMPACT OF $10 BILLION STEP CHANGES IN GOVERNMENT PURCHASES, PUBLIC SERVICE EMPLOYMENT, AND

PERSONAL TAXES: CBO MULTIPLIERS MODEL 17

FIGURE 3. DIRECT AND NET BUDGET COSTS OF $10 BILLION

STEP CHANGES IN GOVERNMENT PURCHASES, PUBLIC

SERVICE EMPLOYMENT, AND PERSONAL TAXES: CBO

MULTIPLIERS MODEL 19

FIGURE 4. THE MONETARY RESPONSE AND THE IMPACT OF A

$10 BILLION INCREASE IN FEDERAL PURCHASES 22

FIGURE 5. ECONOMIC EFFECTS OF THE 1964 PERSONAL TAX CUT.. 24

FIGURE 6. ECONOMIC EFFECTS OF THE TAX REDUCTION ACT

OF 1975 27

FIGURE 7. ECONOMIC EFFECTS OF THE 1969 CREDIT CRUNCH 28

FIGURE 8. CHANGES IN BUDGET SURPLUS OR DEFICIT, FOUR

MEASURES: NIPA, UNIFIED, FULL-EMPLOYMENT, AND

STANDARDIZED 35

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SUMMARY

How and by how much do fiscal policies affect general

economic activity? While there is continuing controversy about

the main theme of this study, there is also a steadily widening

area of agreement among most economists who have examined the

effects of fiscal policy. This report draws on the general

area of agreement and points out some of the uncertainties that

have not been resolved.

Promoting economic stability is a major objective of the

federal budget. Although fiscal policy—the process of designing

budget policy to promote that stability—is complex, in theory it

can be broken down into three elements:

o First, there must be a set of goals, desired levels of

unemployment, inflation, and so on, or at least directions in which it is hoped key indicators of these goals

will move.

o Secondly, there must be a baseline forecast, or some view

of how the economy will perform relative to the goals

under current fiscal policy.

o Finally, there must be some view as to the impact of

policy alternatives, or estimates of how the baseline

forecast, and hence nearness to the various goals, would

be affected if fiscal policy were changed in some way.

Equipped with information on these three matters, policymakers

can review and design budget alternatives from the point of view

of their effect on economic stability, as well as their impact on

the other objectives of the budget.

The Basic Economic Forces at Work

This study concentrates on the last of the three elements,

the impact of specific fiscal policies on the economy. Different

economic forces are unleashed when fiscal policy is changed.

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When the government finances additional construction outlays for

mass transportation, to take one example, a direct expansionary

effect occurs when people are hired and materials are purchased,

and a further respending effect occurs when the recipients of

these construction funds spend some of their new income on goods

and services. In contrast, a restrictive ("financing") effect

occurs when the higher federal deficit, resulting from the

construction grants, leads to more federal borrowing and higher

interest rates. Respending and financing effects are two of the

forces unleashed by an increase in federal spending. They are

not the only two.

Since these two effects work in opposite directions and

since there are other effects as well, it is perhaps not surprising that views differ on the net outcome of all the forces at

work. Even the respending effect is not a fixed proportion of

the initial outlay but varies with characteristics of those who

receive federal funds and, in the case of a tax cut, of those

whose after-tax income is increased.

The magnitude of the financing effects varies, depending on

the prevailing monetary policy. If monetary authorities were to

respond to a fiscal policy action by maintaining a predetermined

target path for the money supply, then interest rates would bear

the brunt of the adjustment to a fiscal change and could be a

significant influence working in the opposite direction from the

spending and respending effects. If, on the other hand, the

monetary authorities were to respond to an increase in federal

borrowing by neutralizing the effects on interest rates, or

keeping interest rates to some predetermined path, then the

financing effects of fiscal policy would be minimal. In this

case, however, the money supply would be expanding more rapidly

than under the first-mentioned monetary policy and some inflationary effects would be felt after a year or two. Probably the

most realistic assumption about monetary policy is in between

these two extremes, with fiscal policy permitted to have some

effect on both interest rates and the stock of money.

Still other forces are set in motion by a fiscal policy

change. For instance, a federal grant to promote public service

employment has its biggest economic effect if the program succeeds in creating jobs that would not have existed otherwise.

The effects are smaller if the federal funds serve merely to

finance wage payments that state and local governments would have

undertaken anyhow. Even in the case of displaced local funds,
however, the federal funds may continue to have effects since

they provide resources that can be used to cut state and local

taxes, avoid tax increases, or undertake other state and local

spending initiatives. If more federal borrowing leads only to

less state borrowing, however, the aggregate economic effects

will be tiny. To evaluate the economic effects of federal

grants, therefore, it is important to estimate the extent of

displacement of local funds for any particular program, w?iile

remembering that the federal spending that displaces specific

local outlays can still have a number of economic effects.

Among the least understood effects of fiscal policy are the

possible influences on personal incentives to work and to save.

Even at the theoretical level, there is no clear presumption that

the effects of moderate tax changes run in one direction or

another. For example, a 60-year-old worker with some pension

rights, when faced with an increase in taxes, might decide to

retire rather than work any longer at a reduced rate of take-home

pay. On the other hand, another worker could find that it was

harder to build up savings under higher taxes; and, if he wished

to reach some target level of savings before retiring, Vie might

decide to postpone his retirement because of the higher tax rate.

This ambiguity clouds the understanding of how tax rates affect

work effort.

A similar ambiguity complicates the direction of effect of

income taxes on the choice between saving and consumption.

Scattered empirical evidence suggests that moderate changes in

general tax rates would probably not have measurable effects on

these choices. Specific groups may, however, be quite sensitive

to major shifts in the incentives they encounter. Some welfare

recipients, for instance, could encounter a drastic change in the

work incentives they face under reform proposals, and might be

expected to react significantly to the change.

An important factor in any consideration of fiscal, policy

is that a change in total national spending is not necessarily a

change in output; it can be a change in prices instead. As a

rule, when resources are fully employed, additional spending

cannot increase total employment or capital use significantly,

but must instead serve to drive up prices. When there are large

unused quantities of resources, in contrast, additional spending

is likely to add to output, although prices may be affected as

well.

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Thus, in an economy with idle resources, a public works

project could have significant output effects, direct and indirect. The same project in a fully employed economy would

require bidding labor and materials away from other uses and in

the process drive up their prices. Dollars spent would still go

up, but for the economy as a whole, the rise would reflect higher

prices, not greater output. This example, however, is somewhat

oversimplified, since it does not allow for differences in

resource utilization by industry or for developments over time.

Thus, idle resources may be available when a public works project

is started, so that total output is initially increased, but

price effects may start to dominate sometime later while the

project is still underway.

Empirical Estimates of Net Outcome

It is possible to derive empirical estimates of the net

outcome of these basic economic forces. The estimates in this

paper are based mainly on econometric models of the economy

that incorporate statistical measurements of many facets of

economic behavior. The consensus of model results is that

changes in fiscal policy do have important aggregate economic

effects, although many policy changes pose trade-off problems—

improving some economic indicators but worsening others.

The models have a moderately favorable record in their

predictions in recent years. Over time spans of one to four

quarters ahead, they seem to do better than simple extrapolations

of the recent past. On the other hand, they have failed to give

clear signals of some of the major economic developments of the

1970s. The models could hardly have been expected to forecast

some of these events, such as the quadrupling of oil prices by

OPEC and its immediate aftermath. International oil prices are

among the "exogenous" variables that the models do not attempt to

explain but simply assume on the basis of best information

currently available.

The 1974-1975 decline in output and employment, on the other

hand, was not an exogenous variable, especially once the rise

in oil prices was an accomplished fact. Yet, the models by

and large forecast only moderate weakness rather than the worst

downturn of the last 30 years. Model builders have since changed

many equations so that they are sensitive to disturbances

from the supply side, in addition to those from the demand

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side. But it remains true that model forecasts—and indeed other

economic forecasts as well—should be used with a good deal

of caution.

The consensus of results among large econometric models is

that, given the state of the economy as of mid-1977, an increase

in the annual amount of federal spending on goods and services

would have a positive effect on current dollar GNP. In other

words, according to these models, forces leading to a positive

GNP impact outweigh forces leading to a negative impact. These

models all agree, furthermore, that the impact is smaller in the

first quarter or two than after several quarters have elapsed.

The peak effect on current dollar GNP implied by the models

occurs in the ninth quarter for one model and the twelfth quarter

for another model. These peak effects on GNP are about 1.4 to

2.9 times as large as the assumed increase in federal spending on

goods and services. Initially, most of the GNP effect takes the

form of higher real output rather than higher prices; but as time

passes, output effects diminish and price effects account for a

substantial portion of the GNP change.

When the effects of a personal income tax cut or an increase

in the public service employment program were tested, the direction of results on dollar GNP, real output, total employment, and

the general price level were similar to that obtained for an

increase in federal purchases of goods and services. The specific magnitudes and time pattern of these effects differed,

however.

The study also tested fiscal policy effects under different assumptions about the reactions of monetary policy. According

to the models, different monetary policy assumptions do not

result in greatly different outcomes in the first year, but the

results grow to be strikingly different in the second and third

years. Increases in current dollar GNP from a given fiscal

policy are sharply higher when monetary policy neutralizes the

impact of the fiscal change on short-term interest rates than

when monetary policy holds to a given money-supply growth rate

and allows interest rates to rise.

Fiscal policies not only affect the private economy, but

also have a "feedback" effect on the budget. After a few quarters have elapsed, an income tax cut of $10 billion per year is

likely to have a direct budget cost of only $4.5 to $6.5 billion.

The biggest single offset item is higher personal income tax

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receipts caused by the stimulative economic effects of the tax

cut. Other tax revenues also increase and outlays for unemployment insurance become smaller. These offsetting budgetary

effects of a tax cut or a spending increase, however, are generally not large enough to make the initial fiscal policy action

"sQlf-financing." In other words, the deficit does remain larger

following a general tax cut or spending increase than it would

have been without such fiscal actions.

An analysis of three major policy moves—the 1964 and

1975 tax cuts and the 1969 credit crunch—provided estimates

of their impact. One broad conclusion suggested by this review of

past events is that these major policy changes did have significant effects on GNP, employment, and prices. Another conclusion

is that other forces—movements in productivity, exports, the

lingering effects of policy actions of the past, to name a

few—are also of great importance, so that while policy moves of

the size actually undertaken in the last 15 years modify the

contours of economic developments, they do not drastically

reshape economic history. It would have taken more vigorous use

of policy instruments to alter completely the recent history of

unemployment or inflation in the United States.

Designing Fiscal Policy

There are a number of specific problems in designing fiscal

policy. One problem is to find a gauge, or indicator, that

measures the net effect of fiscal policy on the economy. The

budget deficit is a traditional indicator that is often used for

this purpose. This measure is unsatisfactory, however, because

it is so strongly influenced by developments in the economy that

may have little to do with fiscal policy. It cannot disentangle changes caused by shifts in fiscal policies from the

budget impact of other forces, such as monetary policy, changes

in world economic growth, or shifts in business and consumer

confidence. The so-called full-employment budget and some of

its variants that hold constant the measured path of economic

activity, therefore, are considered to be better indicators

of the underlying fiscal policies. There are, however, also

measurement problems with these approaches.

Since no single number is an adequate summary of all of the

important dimensions of fiscal policy, it is important to remain

aware of the special characteristics of the commonly used

instruments of stabilization policy. These include time lags,

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economic effects per dollar of budgetary change, and other

features of the main taxing and spending instruments available to

the Congress, such as income taxes, investment tax credits,

employment tax credits, transfer payments, and general revenue

sharing.

A review of the different fiscal instruments suggests that

changes in the various tax rates and various spending programs

have different effects on the economy; that many policy changes

pose trade-off problems; and that there remains a good deal of

uncertainty about the magnitude and, occasionally, about the

direction of the effect of a particular policy on a specific

economic indicator. Tax incentives to stimulate business investment, to cite one example, take a much longer time to affect

substantially employment and output than do changes in personal

income taxes; but, according to some (not all) estimates,

such incentives have exceptionally powerful effects per dollar of

foregone revenue when enough time has elapsed.

On the spending side, outlays for defense or health may well

have more impact per dollar than income tax changes. But, since

they frequently require continued and sustained funding to be

effective in accomplishing their primary purposes of maintaining

military strength or assuring health care, they are less amenable

to change for economic stabilization purposes. Other types

of spending, including some forms of income support and grant

programs for state and local governments, have recently undergone

rapid development as instruments of stabilization policy. Any

conclusions about their effects need to be reviewed and perhaps

modified as these new fiscal policy instruments continue to

evolve.

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CHAPTER I. INTRODUCTION

Promoting economic stability is a major objective of the

federal budget. Although fiscal policy—the process of designing

budget policy to promote stability—is complex, at an abstract

level it can be broken down into three elements. There must

first of all be a set of goals—desired levels of unemployment,

inflation, and so on, or at least directions in which it is

hoped key indicators of these goals will move. Secondly, there

must be a baseline forecast, or some view of how the economy will

perform relative to the goals under current fiscal policy.

Finally, there must be some view as to the impact of policy

alternatives, or estimates of how the baseline forecast, and

hence nearness to the various goals, would be affected if fiscal

policy were changed in some way. Equipped with information on

these three matters, policymakers can review and design budget

alternatives from the point of view of their effect on economic

stability, as well as their impact on the other objectives of the

budget.

This study concentrates on the last of the three elements,

the impact of specific fiscal policies on the economy. The

next chapter of the study discusses the major kinds of economic

force unleashed when fiscal policy is changed. When personal

tax rates are reduced, to take one example, an immediate expansionary effect occurs when some of the increase in take-home pay

is spent on goods and services. In contrast, a restrictive

effect occurs when the higher federal deficit, resulting from the

tax cut, leads to more federal borrowing and higher interest

rates. Respending effects and financing effects are two of the

forces unleashed by a reduction in tax rates. They are not the

only two.

Since these two effects work in opposite directions and

since there are other effects as well, it is perhaps not surprising that views differ on the net outcome of all the forces at

work. Following the chapter on basic forces is a section reviewing a number of estimates, based on econometric models of the

economy, of the net outcome of these forces. The consensus

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of the models is that changes in fiscal policy do have important

macroeconomic effects, although many policy changes pose tradeoff problems, improving some economic indicators but worsening

others.

The final chapter of the report discusses problems of

designing fiscal policy. It first reviews some measures of the

overall posture of fiscal policy, beginning with the federal

deficit. The deficit is criticized as being an unsuitable

measure of the impact of budget policy on the economy. A number

of alternative summary measures overcome some shortcomings of

the deficit, but still fall short of being a perfectly satisfactory measure of fiscal policy. The final section of the

chapter accordingly retreats from the search for an overall

indicator and goes back to a discussion of some of the advantages , drawbacks, and other special features of specific fiscal

policy instruments that the Congress can alter in pursuit of

economic stability.
CHAPTER II. THE BASIC ECONOMIC FORCES AT WORK

Any change in fiscal policy—a tax increase, a new spending

program, a change in the provisions of an income support program—sets in motion a number of forces whose effects spread

through the entire economy. This chapter explains what these

forces are and how they may be expected to influence household

and business behavior. The next chapter takes up the question of

how strong the various forces are and what the net effect of all

of them turns out to be.

DIRECT EFFECTS AND DISPLACEMENT

The story begins, of course, with the direct effects

of a budgetary action — the appropriation for a new dam, the

change in withholding rates to reflect a new provision in the

personal income tax laws, or the expansion of a federally funded

public service employment program. The first question to ask

about such a budgetary change is whether it is actually being

carried out according to the schedule envisioned in the legislation. As the federal spending shortfalls of recent years demonstrate, it is a mistake to assume that the translation from

legislation into direct effects is automatic and prompt or that

positive and negative discrepancies tend to balance out. In the

case of a tax change or an income-support program, budgetary

changes are usually translated into action quickly; but in the

case of federal purchases of goods or grants for specific projects, there are many instances of serious delays.

Even when federal spending programs appear on paper to

have been translated into action, it is necessary to ask another

basic question about the direct effects: namely, whether the

program outlays constitute an addition to total spending or

merely a change in sources of funds from nonfederal to federal.

The latter phenomenon is called displacement, and it raises

questions especially in connection with employment grants to

state and local governments (although they could be equally well

raised in connection with local public works grants). Some

studies of federal grants for state and local employment have

suggested that displacement is quite substantial—that many

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of the persons filling public service employment slots would have

been on local payrolls even without the federal program that pays

their salaries.

Even if displacement under a particular program is 100

percent, it would not be correct to conclude that the program has

no economic effects. Federal grants used to support local

programs increase the total financial resources of local governments (or other sponsors), and this increase will generally

lead to some change in economic behavior. Even if local governments "displace" public service employment money, the federal

funds provide resources that can be used to cut taxes or avoid

tax increases or to undertake (or avoid cutting back) other

spending programs. Moreover, if state and local governments were

to let their budget surpluses merely increase, such increases

would still serve to cancel any restrictive credit market effects

that are caused by the expanded federal deficit.

Since each of these uses of federal grants has its own

impact on the economy, it is important not to view displacement

as equivalent to nullifying the effects of federal grants.

Nevertheless, for evaluating the detailed impacts of employment

programs as compared to other kinds of budgetary change, displacement is an important concept to understand and to measure.

INDIRECT EFFECTS; RESPENDING

Once a spending or tax change is translated into action,

successive rounds of respending can greatly magnify the direct

effects. Persons hired under jobs programs, for example, will

use a large fraction of the money they receive to increase their

purchases of food, clothing, recreation, and other goods and

services. Contractors under public works projects will spend

much of the money they receive on materials and labor. The

income thus generated for the providers of these services can be

the basis of still more respending, including purchases of

machinery and plant as well as consumer goods, labor, and materials. Additional purchases of machinery and plant are likely not

only because business profits are increasing along with other

incomes, but also because businessmen are experiencing a boost in

orders that makes their existing capital stock appear less

adequate than before. The rounds of respending make it possible for the eventual effect of a budgetary change on total

national income to be much larger than the initial budgetary
change itself. In technical language, the "multiplier," or the

size of the change in total income relative to the size of the

initial budgetary change, can be greater than one.

Restrictive budgetary policies, of course, work in the

opposite direction. An increase in employee payroll taxes,

for example, can lead to reductions in dollars spent on food,

clothing, and so on, and set in motion a chain of contractions in

respending opposite in its effects to the expansionary chain just

described.

The example of a public employment program can be used

to illustrate some of the complexities in the respending process.

The initial recipients of the money will spend much of it; but

many of them may have been receiving unemployment compensation or

food stamps before they became employed. If so, the reduction in

unemployment benefits and food stamps offsets some of the spendable income paid under the employment program and thus reduces

the total effect of the program. The money that does get respent,

furthermore, shows up as incomes in a variety of forms—wages,

salaries, profits, interest, and rent. Since some of the respending is on imported rather than domestic goods, some of the

income generated is foreign rather than domestic. All these

different income sources can give rise to very different rates of

further respending on goods and services. Even if respending

effects were the only indirect impacts of fiscal policy, it would

be no easy task to work out the net result for total income,

employment, and prices.

INDIRECT EFFECTS: FINANCING

Credit-market or financing effects are another chain of

indirect effects following a fiscal policy action. An increase

in spending not paid for by an increase in revenue must entail a

higher deficit, which requires borrowing in private credit

markets. An increase in taxes not accompanied by higher spending,

in contrast, reduces the deficit, and leads to less federal

borrowing.

In many respects, financing effects are opposite from

direct effects. A spending increase or a tax cut usually leads

to tight credit markets and higher interest rates that, in turn,

reduce the values of outstanding bonds and make borrowing for new

investment more expensive. These changes tend to reduce the flow

of income and spending at the same time that respending effects

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tend to increase income. A spending reduction or tax increase

has opposite effects, easing credit markets and encouraging

spending.

It is at this point that fiscal policy interacts most

closely with monetary policy. Exactly what impact a change in

the deficit has on credit markets is quite sensitive to how the

monetary authorities respond. Through their control over banking, monetary authorities directly affect bank reserves and

indirectly affect the stock of money and interest rates. Monetary authorities can, thus, let fiscal changes affect interest

rates or they can take actions to neutralize this influence.

Similarly, they can permit fiscal policy to alter the growth path

of the money stock or they can neutralize this effect.

Monetary authorities cannot, however, offset all of the

effects of a change in federal borrowing. If they decide to

neutralize the effect of a higher deficit in pushing up interest

rates, then the only way they can do so is to supply enough

bank reserves so that these additional funds keep interest rates

from rising. In so doing, they will be expanding the money

supply. If they decide not to expand the money supply, then they

cannot prevent the rise in interest rates.

If monetary authorities respond to a change in federal

borrowing by neutralizing the effects on interest rates, or

keeping interest rates to some predetermined path—sometimes

known as "accommodating" the fiscal change—then the financing

effects of fiscal policy are at a minimum and do not seriously

reduce the spending and respending effects. If, instead, monetary authorities respond by maintaining a predetermined target

path for the money supply, then interest rates bear the brunt

of the adjustment to a fiscal change and can be a significant

influence working in the opposite direction from the spending

and respending effects. Probably the most realistic assumption

is in between these two extremes, with fiscal policy permitted to

have some impact on interest rates and some impact on the stock

of money.

There has been a lot of controversy about the importance

of direct and respending effects on the one hand, and financing

effects on the other. One way to characterize the debate between

"Keynesian" economists and "monetarist" economists is to say that

the former have tended to emphasize respending effects, while the

latter have tended to emphasize financing effects. At the
present time, the controversy between extremists in either camp

is dying down and a middle position is gaining ground. The

middle position recognizes the importance of financing effects

and monetary policy, especially over long periods of time, but

also grants an important influence on economic activity to

changes in the fiscal policy, at least in the short run.

INDIRECT EFFECTS; INCENTIVES TO WORK AND TO SAVE

Among the least understood effects of fiscal policy are

any influences on personal incentives to work and to save. Even

at the theoretical level, there is no clear presumption that

these effects run in one direction or another. To be sure,

extremely high tax rates—rates approaching 100 percent—will

almost certainly discourage productive effort, but for moderate

tax changes, the outcome is unclear. A moderate increase in

taxes could lead a 60-year-old worker with some pension rights to

decide to retire rather than work any longer at a reduced rate of

take-home pay. On the other hand, another worker could find that

it was harder to build up savings now that taxes were higher; and

if he wished to reach some target level of savings before retiring, the higher tax rate might make him postpone his retirement.

Higher tax rates, in other words, could make one perfectly

rational person work less and another perfectly rational person

work more.

The same ambiguity clouds the understanding of how rates

of return affect saving. A tax change that increased the

after-tax rate of return on personal saving could make individuals save more in order to reap the higher returns in the future;

but it could make other individuals save less because a smaller

amount of saving is now required to build up to any target level

of assets.

The importance of incentive effects is thus an empirical

question. The empirical evidence of the influence of taxes

on incentives is fairly skimpy; it includes one series of studies

of British professionals, and another series of studies of

lower-income American workers. The evidence suggests that

changing tax rates by a few percentage points—which corresponds

to the range of fiscal policy options usually considered—would

probably not have strong effects in either direction on overall

work effort or saving.

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While the overall incentive effects of moderate changes in

a broad tax rate may be small, specific groups may be quite

sensitive to major reforms of certain taxes or income-support

programs. Making unemployment insurance benefits taxable, for

example, could have a significant impact on the incentive to seek

a job for some of the insured unemployed. Some welfare reform

proposals would change the position of certain households from a

negative to a significantly positive incentive to work. Small

changes in work effort in the aggregate can imply major changes

for those most directly affected by these programs.

INDIRECT EFFECTS; PRICE VERSUS QUANTITY

A change in total spending or current dollar gross national

product (GNP) is not necessarily a change in output; it can be a

change in prices instead. As a general rule, when resources are

fully employed, additional spending cannot increase total employment or capital use significantly, but must instead serve to

drive up prices. When there are large unused quantities of

resources, in contrast, additional spending is likely to add to

output, although prices may be affected as well.

Thus, in an economy with idle resources, a public works

project could have significant output effects, direct and indirect. The same project in a fully employed economy would

require bidding labor and materials away from other uses and in

the process drive up their prices. Dollars spent would still go

up, but, for the economy as a whole, the rise would reflect

higher prices, not greater output.

The relationship between price effects and output effects

is not, however, as simple as the previous paragraph makes it

appear. Not only the aggregate quantity of idle resources, but

resource availability in specific industries and regions are

important. So is the time span under study; output effects tend

to take place before price effects. A public works project may

increase output at the time it is started but increase prices

enough to neutralize the output effect over a period of years

following its initiation.

Another kind of complexity in gauging the inflationary

effect of a policy change is that some policies directly cause
price changes that either reinforce or offset the price effects

operating through changes in the level of economic activity. An

increase in employer payroll taxes, for example, raises labor

costs directly, and this cost increase tends to lead to higher

prices. The respending effects in this case have an opposite

effects on prices, since higher taxes reduce private purchasing

power, and lead to lower prices. The direct, or price-raising

effects, take place fairly promptly,, but they will later be

offset, at least in part, by the indirect, or price-lowering

effects .

A pay raise for government employees, to take another

example, raises wage rates directly and may exert some upward

pressure on private wages and, thus, prices through this route.

Since a pay raise also entails more spending by government

employees, the direct price impact and the total spending impact

are in the same direction in this case, in contrast to the

payroll tax case.

26-845 O - 78 - 4

mumnr
Jill Jill.

CHAPTER III. THE NET OUTCOME: SOME EMPIRICAL ESTIMATES

There are by now more than a dozen statistical models of

the economy that attempt to capture in a set of equations the

forces, described in the previous chapter, that are set in

motion by a change in fiscal policy. The response of consumers

to a change in disposable income, the response of business

inventories to changes in sales, the response of interest rates

to a change in inflation rates, the response of wage rates to a

change in unemployment—these and many other relationships

are part of the models now commonly used to estimate the effects

of alternative economic policies.

This chapter begins with a simple account of how some of

these models of the economy work. It then summarizes what a

number of models say about a simple change in fiscal policy—a

one-step $10 billion per year increase in government purchases of

goods—under the economic conditions of early 1977. Finally,

it presents estimates of the impact of certain major economic

policy moves of the last 15 years.

MODELS OF THE ECONOMY AND FISCAL POLICY

What Econometric Models Do

The basic building-block of a statistical model of the

economy is an equation describing how one economic variable—

consumer spending, business profits, the unemployment rate,

industrial wholesale prices, or any one of hundreds of others—

responds to current and past movements in other economic variables. A very simple equation of this type, for example, would

be one which says that consumer spending this quarter is equal to

95 percent of household disposable income this quarter. A

slightly more complicated equation would be one that said consumer spending this quarter is equal to 50 percent of disposable

income this quarter plus 45 percent of disposable income last

quarter.

10
The typical equation of econometric models in common use

is based on detailed analysis of many interrelationships and

"lead-lag" _!_/ possibilities and is far, far more complicated than

these simple relationships. One of the leading models _2/,

for example, divides household consumption into 13 categories and

has a separate equation for each one. One typical equation

involves several explanatory variables including earned income,

government transfer payments to persons, and prices of different

categories of consumer goods. In addition to 13 equations explaining consumption, the model has 40 equations explaining

various categories of investment; 20 equations explaining how

total income is distributed among wages, proprietors' income,

profits, and other shares; 42 equations explaining prices; 36

equations -dealing with supplies and demands in the labor market;

18 equations dealing with borrowing, lending, and interest rates;

and many other equations covering various areas of economic

activity. In all, this model includes about 200 behavioral

equations.

A fundamental distinction running through this and other

econometric models is between "endogenous" variables, or those

items for which the model contains explanatory equations, and

"exogenous" variables, or those items for which the user of the

model simply determines values based on information outside the

model. Variables in the first or endogenous category include

consumption and other kinds of private spending, profits and

other forms of income, output, employment and unemployment,

market interest rates, and many others. Exogenous variables

include discretionary federal outlays such as defense spending or

public employment grants, tax rates, and key monetary policy

indicators—policy variables usually projected by users on the

basis of Administration and Congressional budgetary plans and

Federal Reserve monetary targets. Exogenous variables also

include indicators of the state of foreign economic activity and

demographic variables such as the size of the population in

different age groups.

_!/ Thus, orders for capital goods may be entered in an equation

for a whole sequence of previous quarters, each with a

different weight, to estimate acquisitions of new capital

equipment at a later point in time. In this case, the orders

"lead" and the acquisition of capital "lags".

_2_/ Wharton Econometric Forecasting Associates, Inc.

11

T~ll.lil III HIl!
To obtain a forecast from one of the models, it is necesary

to select values for all of the exogenous variables for as

far ahead as the prediction is to go, and then to solve all of

the equations of the model simultaneously to obtain values

for all of the endogenous variables. To predict economic events

in 1978, for example, it is necessary to make assumptions about

government spending, tax rates, Federal Reserve policy, and so on

through 1978 and then use these assumptions plus the equations of

the model to solve for consumption, GNP, profits, price levels,

and all the other variables. In practice, model users usually

adjust the initial model predictions, modifying judgmentally

those projection values which seem unreasonable, and re-solving

the entire system of equations subject to these modifications.

The models have a moderately favorable record in their

predictions in recent years. _3_/ Over time spans of one to

four quarters ahead, they seem to do better than simple extrapolations of the recent past. On the other hand, they have

failed to give clear signals of some of the major economic

developments of the 1970s. The models could hardly have been

expected to forecast some of these events, such as the quadrupling of oil prices by OPEC and its immediate aftermath.

International oil prices are among the "exogenous" variables

that the models do not attempt to explain but simply assume on

the basis of best information currently available.

The 1974-1975 decline in output and employment, on the other

hand, was not an "exogenous" variable, especially once the rise

in oil prices was an accomplished fact. Yet, the models by and

large forecast only moderate weakness rather than the worst

downturn of the last 30 years. Model builders have since changed

many equations so that they are sensitive to disturbances from

the supply side. But it: remains true that model forecasts—and

indeed other economic forecasts as well—should be used with a

good deal of caution.

_3/ See Stephen K. McNees, "An Evaluation of Economic Forecasts,"

New England Economic Review (November-December 1975).

12
The Impact of a Change in Federal Spending

Although most of the attention models receive centers on

their predictions rather than their implications for policy

alternatives, the very same procedures used to make predictions

can be used to derive the effects of policy changes. It is

simply necessary to solve a model twice, once with one set of

values of some exogenous variable and once with another set of

values—say, once with a current policy projection of spending _4/

for some public works grants and once with a higher (or lower)

level of spending for the same program. The difference between

the two solutions is the model's estimate of the impact of that

policy change on the economy. If running a model with one level

of public works grants (as well as values for all the other

exogenous variables) produces a projected value of GNP in 1978 of

$2100 billion, and raising the level of grants, but keeping all

the other exogenous variables the same, results in a GNP of $2105

billion, then the model implies that the impact of the change in

grants under consideration on current dollar GNP is to raise it

by $5 billion during calendar year 1978..

The same calculation can be made for a tax rate change, a

change in monetary policy, a change in the rate of growth of

foreign output, or any other exogenous change. The model will

estimate not only the effect on GNP but also the effect on

consumption, employment, federal revenues, profits, and all other

endogenous variables.

To get an impression of what four widely used models _5_/ have

to say about fiscal policy, it is helpful to consider first a

hypothetical, highly over-simplified fiscal operation consisting

_4/ Current policy spending projections assume all legislation

currently in effect remains unchanged.

_5/ Wharton Econometric Forecasting Assocates, Inc.; Data Resources, Inc. (DRI); M.I.T.-University of Pennsylvania-Social

Science Research Council (MPS) ; and Chase Econometric Associates, Inc.

13
of a $10 billion "step increase" in the annual-rate level of

federal purchases of nondefense goods that takes place in

mid-1977. Nondefense purchases, that is, rise by $10 billion

per year above some baseline projection and stay $10 billion

above the baseline thereafter. Note that such an abrupt shift to

a new spending level is unrealistic. Figure 1 shows the estimated impact of this spending increase on GNP, in both current

and constant dollars, employment, and prices, according to four

widely used models of the U.S. economy.

A number of features of the figure immediately invite

attention. All of the models predict that, given the state of

the economy as of mid-1977, such a spending increase would have

an overall positive effect on GNP. According to these models, in

other words, forces leading to a positive GNP impact outweigh

forces leading to a negative impact. These models all agree,

furthermore, that the impact is smaller in the first quarter or

two than after several quarters have elapsed. The peak effect on

current dollar GNP implied by the models ranges from a low of $14

billion in the ninth quarter for one model to a high of $29

billion in the twelfth quarter for another model. Since the

direct spending change is only $10 billion, this range implies a

range of peak multipliers from 1.4 to 2.9.

According to most of the models under review, the initial

impact of a this fiscal policy change is very largely on output

rather than prices. After a time, however, less and less of the

impact of this illustrative step increase goes to increase

output, and more and more of it goes to raise prices. According

to the models, the impact on real or constant dollar GNP reaches

its peak one to two years after the policy change, while price

impacts begin to build up in the second or third year. These

results were obtained when the policy change was started as of

mid-1977- The results would be changed if the initial conditions

in the economy had been quite different.

Policy Comparisons; Purchases of Goods, Public Employment,

and Personal Taxes

The GNP multipliers just presented for a change in federal

purchases of goods are not the same as the multipliers for

other changes in the federal budget. In the course of using a

number of econometric models, the Congressional Budget Office

14
Figure 1.

Impact of a $10 Billion Step Increase in Federal

Non-Defense Purchases, 1977 Economic Conditions

REAL GNP

Wharton

Chase

DRI

MPS

i i i I i i i I i i i i i i I i i i I i i i

4 8

Quarters

EMPLOYMENT

4 8

Quarters

PRICE LEVEL

800

-600

1400

o

200

0

I i i i I

10.5

-0.5

0 4 8 12 0 4 8

Quarters Quarters

SOURCE: CBO simulations based on the following models: DRI (Data Resources, Inc.), Wharton (Wharton Econometric Forecasting

Associates, Inc.), MPS (M.I.T. - University of Pennsylvania - Social Science Research Council), Chase (Chase Econometric

Associates, Inc.).

NOTE: Step changes begin in first quarter.

Records number of point changes in the index.
1

has had occasion to develop its own sets of GNP multipliers for

several different kinds of fiscal policy change. These multipliers are based on a careful analysis and comparison of five

econometric models; they discount some of the more questionable

elements in each model, while still maintaining consistency in

the treatment of different kinds of fiscal action. 6/

Figure 2 compares effects of several different policies

based on CBO's system of multipliers. The figure shows the

estimated impact not only of a rise in federal purchases of

goods, but also of a rise in federal spending on a "typical"

public employment program and of a cut in personal income taxes.

In each case, the policy is in the stylized form of a $10 billion

change in level beginning in mid-1977 and continuing thereafter.

(Once more, this abrupt shift to a new level is unrealistic in

the case of spending changes, although not in the case of tax

changes.) Because of the displacement estimates of 50 percent in

this analysis, the GNP multipliers for outlays on public service

employment turn out to be slightly smaller than the multipliers

for nondefense purchases. Still smaller are the estimated GNP

multipliers for a cut in personal taxes. Despite the displacement assumptions, however, employment effects are largest for

public employment; and these programs are estimated to be more

effective in stimulating jobs per dollar than federal purchases

or tax cuts.

For all three policies, real output effects dominate at

first and fade out later when price effects become increasingly

important. The public service employment option, which has

the largest employment impact, is also estimated to have the

greatest impact on prices. Price effects need not, however,

be proportional to employment effects—a public service employment program, for example., might minimize its price effects if it

were directed at hard-to-hire groups and so have less than

average impacts on wage rates. Some such targeting was assumed

in Figure 2.

The price-output pattern shown in the figure does not

apply even in broad outline to a program that has a direct

impact on the price level, such as a change in employer payroll

_6/ See Congressional Budget Office, The CBO Multipliers Project

(August 1977).

16
Figure 2.

Impact of $10 Billion Step Changes in Government Purchases,

Public Service Employment, and Personal Taxes:

CBO Multipliers Model

GNP REALGNP

/ Government Purchases

Public Service Employment

Personal Tax Cut

i i i I i i i I i i I

Quarters

EMPLOYMENT

4 8

Quarters

PRICE LEVEL

800

600

I

Oo

200

I I I

0 4 8

Quarters

NOTE: Step changes begin in first quarter.

3

 Records number of point changes in the index.

12 0 4 8

Quarters
taxes. An Increase in employer payroll taxes has a fairly

prompt upward effect on the price level because it adds to

business costs and hence to the price businesses charge in order

to cover costs. This cost-raising effect of higher payroll taxes

workes in the opposite direction from the indirect effects of the

policy, which are to restrain private demands and thereby reduce

pressures on prices. At first, according to the models, the

cost-raising effect is the stronger of the two forces and hence

higher payroll taxes add to prices. After two or three years,

however, it is much less clear which force predominates; higher

payroll taxes depress output but is is unclear what they do to

prices.

Gross and Net Budget Costs

All of the policy changes shown so far are in the stylized

form of a one-time $10 billion upward shift in spending or

downward shift in revenue levels. The direct budget cost

of these policies is $10 billion per year.

The net effect of these policies on the budget, however, is

less than $10 billion. The main reason is that, by causing

higher levels of real and current dollar GNP, the policies lead

to higher federal revenues. In addition, higher real GNP tends

to reduce outlays for income-support (transfer) programs such as

unemployment compensation. Offsetting these deficit-reducing

forces set in motion by a spending increase or a tax cut is the

fact that higher prices increase those federal outlays that are

tied to the price level, such as social security payments. The

net outcome of all of these forces is equal to the direct cost,

minus the induced increases in revenues, minus the induced

reduction in income-support outlays, plus the induced increase in

inflation-adjusted program outlays.

According to most estimates, these feedback effects from

revenue and income-support changes offset some but not all of the

direct cost of a standard fiscal operation. In the examples

shown in Figure 3, after a few quarters have elapsed, the revenue

and transfer "feedback" falls in the range of 35 to 55 percent of

the direct cost, leaving a net cost equal to 45 to 65 percent of

the direct cost. The biggest single offset item is higher personal income tax receipts. Other important items include payroll

taxes (employer and employee share), corporate profits taxes,

18
Figure 3.

Direct and Net Budget Costs of $10 Billion Step Changes in

Government Purchases, Public Service Employment, and

Personal Taxes: CBO Multipliers Model

INCREASE IN GOVERNMENT PURCHASES

0 4 8 12

Quarters

INCREASE IN PUBLIC SERVICE EMPLOYMENT

15

0 4 8 12

Quarters

REDUCTION IN PERSONAL TAXES

<D

*3

cc

10

a

0 I _ I

4 8

Quarters

12
.JULJLJLil _JL

and reduced outlays for unemployment insurance. Since these

feedbacks do not completely offset the initial fiscal change, a

final consequence of the fiscal policy action is a higher deficit

and higher interest payments on the debt.

It is helpful to decompose the feedback of revenues and

outlays from an expansionary fiscal policy change into two

parts. The first consideration is the multiplier effect of the

policy change on GNP. Thus, a $10 billion change in fiscal

policy that changes GNP by $20 billion has a multiplier of 2.

The second consideration is the average tax rate on GNP; if taxes

go up by $3 billion and transfers fall by $0.5 billion for every

$10 billion rise in GNP, then the tax-and-transfer-reduction rate

is 35 percent. The recapture of direct budget costs from an

expansionary fiscal policy is the product of these two ratios, or

the multiplier times the effective tax-and-transfer-reduction

rate. Thus, a $10 billion change in fiscal policy that causes

GNP to rise by $20 billion and thereby causes revenues to rise by

$6 billion and transfers to fall by $1 billion recaptures 70

percent of the direct cost. This 70 percent can be expressed as

the multiplier (2 in this case) times the effective tax-andtransf er-reduction rate (35 percent).

For policies that have multipliers ranging from 1.5 to

2.5 and an economy that has a marginal federal tax-and-transferreduction rate of 30 to 35 percent, the budget feedback is in

the range of 1.5 times 0.3 to 2.5 times 0.35, or roughly 0.45 to

0.87. As long as the budget feedback is less than 1.0, a policy

does not pay for itself in terms of its effect on the federal

deficit. In an economy with a tax-and-transfer-reduction rate of

0.3, it would require a multiplier of 3.33 or more for a policy

to pay for itself. The higher an economy's tax-transfer rate is,

the lower the size of its required multiplier; but higher tax

rates themselves tend to lower the size of actual GNP multipliers, since they reduce the amount of respending from a given

increase in incomes.

The consensus among econometric models is that standard

spending increases or across-the-board cuts in personal taxes do

not have effects on GNP high enough to be self-financing._?_/

T_l On this point, see also Herbert Stein, "The Dream of Balancing the Budget," The AEI Economist (November 1977), p. 6.

20
This consensus view is based on the assumption that monetary

policy permits interest rates to rise when fiscal policy expands—a key assumption that will be discussed below. Even under

this assumption, some models indicate that certain specialized

fiscal instruments, such as an investment tax credit adopted

under favorable circumstances, do have high enough multipliers to

"pay for themselves."

Fiscal Policy and Monetary Response

One characteristic of fiscal policy effects important to

keep in mind is the sensitivity to what is assumed about monetary

policy. As discussed earlier, the effects of a fiscal policy

change depend a great deal on whether monetary authorities use

their control over bank reserves to neutralize the impact of the

fiscal policy on interest rates, to neutralize the impact of the

policy on the money supply, or to follow some other strategy,

such as supplying the same level of bank reserves they would have

supplied in the absence of the policy. Figure 4 shows the

estimates, according to one model, of what difference the response of monetary authorities makes in the estimated effects of

the $10 billion one-step increase in federal purchases. _8/

The results are striking. A so-called "accommodating"

policy increasing bank reserves enough to neutralize the impact

of a fiscal change on short-term interest rates leads to high

multipliers--high enough, according to this model, for the

net budget cost of the program to be very close to zero. Initially, the lower interest rates resulting from this monetary

policy would stimulate housing and plant and equipment expenditures in particular. What was described in the first chapter of

this report as the financing effects of an expansionary fiscal

move are fully offset in this case, leaving respending effects

largely unchecked.

In sharp contrast, a policy of neutralizing the impact

of a fiscal change on the money supply cuts the current dollar

GNP multiplier to less than one and causes the real GNP and

employment effects to become negative by the end of three years.

8/ The estimates are based on the MPS model.

21

TTWT
Figure 4.

The Monetary Response and the Impact of a $10 Billion

Increase in Federal Purchases

REAL GNP

fo

tr

ro

I

Bill Rate Unchanged

Reserves Path Unchanged

— Money Supply Unchanged

i i i I i j i i i i I I i i i i i

4 8

Quarters

EMPLOYMENT

800

2 600

o

I 400

TO

o

200

1.5

PRICE LEVEL

1.0

S•o

0.5

0 4 8

Quarters

NOTE: Step changes begin in first quarter.

a

 Unborrowed reserves only.

b Records number of point changes in the index.

12 4 8

Quarters

12
For the case of maintaining the same level of bank reserves, j)/

as in the absence of the policy, the results are intermediate

between these two extreme cases. These intermediate results are

close to those shown for other models, that in fact generally

assume a monetary response of an unchanged supply of bank reserves rather than one of the two alternative extreme assumptions.

Clearly, any discussion of the impact of fiscal policy

is incomplete without an indication of what is assumed about

the response of monetary authorities. The discussion in this

report, like most of the econometric models, takes the supply of

bank reserves as an exogenous variable. This corresponds to

the assumption underlying the middle line in the panels of

Figure 4. Thus, when the path of bank reserves is held unchanged,

the results fall somewhere in between the assumptions of neutralizing the effect on interest rates (complete accommodation) on

the one hand, and neutralizing the effect on the money supply on

the other.

THE IMPACT OF SOME PAST MAJOR FEDERAL FISCAL POLICY MOVES

The step changes in fiscal policy discussed in the previous

section are much simpler than actual fiscal and monetary policy

moves of the last 15 years. This section reviews the estimated

effects of some of the major ones among these policies, beginning

with perhaps the most widely discussed of them, the cut in

personal income taxes in 1964. Intended explicitly to "get

the American economy moving," the cut amounted to 1.5 percent of

GNP, a fairly large change in the federal budget during peacetime.

The effects of that tax cut, according to Wharton and

DRI, are summarized in Figure 5. They are shown in the form of a

solid line depicting what actually happened to the economy (and

therefore including the effects of the tax cut) and dashed lines

showing each model's estimates of what would have happened to the

economy had there been no tax cut. The models clearly imply that

the tax cut did raise GNP. By the end of two years, the amount

of increase is variously estimated at $11 billion to $23 billion.

_£/ More precisely, unborrowed bank reserves.

23
.JUIiJIL

Figure 5.

Economic Effects of the 1964 Personal Tax Cut

GNP BUDGET SURPLUS OR DEFICIT (-), NIPA BASIS

20

4 8

Quarters

UNEMPLOYMENT RATE

o

«

S

65

0

80

75

Actual Historical Data

Without Tax Cut (Wharton Simulation)

Without Tax Cut (DRI Simulation)

Without Tax Cut (MPS Simulation) -

i i i I i i i I i i i i i i

4 8

Quarters

PRICE LEVEL

12 4 8

Quarters

INFLATION RATE

70

0

GNP Deflator, 1972 = 100

i i i I

§ 3

Percent Change from a Year Before, GNP Deflator

i I i I i i i i i i

0 4 8

Quarters

12 0 4 8

Quarters

12
The effect of the 1964 tax cut on the federal deficit

has been a matter of controversy. Some have claimed that the

tax cut provided so much economic stimulus that the increased

revenues and reduced income-support outlays resulting from

higher incomes more than offset the direct costs of the tax cut

in foregone revenues. According to the models, this was not the

case. The direct effect of the tax cut was to reduce revenues by

some $12 billion (annual rate) after the initial buildup. The

increase in output and later in prices produced by the tax cut,

according to the models, recaptured $3 to $9 billion of this

revenue at the end of two years. The result was a net increase

in the federal deficit of only about 25 to 75 percent of the full

$12 billion.

It is true that total revenues, unchanged from 1963 to

1964 (calendar years), rose by $9 billlion from 1964 to 1965

and by $18 billion and $8 billion, respectively, in the two

succeeding years. But most of this rise was due to economic

growth that would have taken place even without the tax cut. As

Figure 5 indicates, the gain in GNP from 1964 to 1967 was by no

means all or even mainly attributable to the tax cut. GNP rose

by $155 billion from the first quarter of 1964 to the first

quarter of 1967, and there is no model or economist who would

attribute all, or anything approaching all, of this increase to a

$12 billion cut in personal taxes.

Employment was also raised by the tax cut, and the unemployment rate lowered by nearly a percentage point. Toward the

end of the period, which corresponded to the years of high

capacity utilization at the peak of the Vietnam War, the actual

unemployment rate was below 4 percent, while the calculated rate

without the tax cut would have remained close to 4.5 percent.

The models estimate that this reduction in unemployment from an

already low level had significant effects on the overall price

level, raising it by 1.4 to 2.2 percent.

Results for the 1964 tax cut naturally invite a comparison

of the tax cut enacted during the 1975 recession and extended

in 1976. The 1975 cut was a complicated collection of changes

in the standard deduction, tax credits for each personal exemption as well as for low-income families, personal income tax

rebates, one-time payments to social security recipients, and

other features. Its direct size during 1975 was $18 billion.

According to the multipliers developed by CBO, the 1975 tax cut

had a peak effect on current dollar GNP of $30 billion (annual

25

inir
1

rate), more than the 1964 tax cut in dollar amount but less in

relation to the total size of the economy (see Figure 6) •

Employment effects of the two tax cuts were roughly the same—

very roughly three quarters of a million jobs in each case.

Most changes in federal spending, in contrast to tax

changes, have been dominated by goals other than economic

stabilization. Economic conditions have been a major impetus,

however, behind the recent growth in spending for public service

employment. Once allowance is made for displacement, the net job

creation due to the buildup of these programs has probably been

less than that due to the 1975 tax cut. While the number of jobs

created per dollar of spending has been relatively large, many

fewer budget dollars have been allocated to public service

employment than to the permanent tax change provisions of the

1975 legislation.

For comparison with these fiscal policy changes, it is

of interest to present estimated effects of at least one large

change in monetary policy; namely, the tightening of money

in 1969. In the second half of 1969, the annual growth rate of

the broadly defined money stock receded to below 1 percent,

while in the next year this growth rate was back to about 7

percent. It is possible .to ask the models what would have

happened to the economy had Federal Reserve open-market operations kept the growth rate of the broadly defined money supply at

no lower than 5 percent during 1969 and early 1970. Figure 7

shows the estimated results of this policy.

According to both models used for this simulation, avoiding

the 1969 runup of interest rates would have moderated significantly the rise in unemployment during the ensuing two years.

Instead of reaching a six percent rate, the models suggest that

unemployment would have gone no higher than five percent. One of

the two models indicates a substantial cost in terms of inflation—about 1.5 percentage points more on the inflation rate by

the end of the second year of the simulation. The other model

indicates almost no inflation effects—a surprising and not very

credible result, due perhaps to special difficulties in simulating this model during the late 1960s. This latter result

serves as a reminder that all of the foregoing model simulations

should be used with caution, perhaps especially those relating to

monetary policy.

26
Figure 6.

Economic Effects of the Tax Reduction Act of 1975

GNP

51800

<

1-I600

o

05

J

B

1400

90

BUDGET SURPLUS OR DEFICIT, (-), NIPA BASIS

-20 r

—— Actual Historical Data

Without 1975 Tax Cut

(CBO Simulation)

i i i I i i i I i i i

4 8

Quarters

EMPLOYMENT

I 86

84 -

J I i i I i i i < 0t_

12 0

UNEMPLOYMENT RATE

i i i I i i i

145

135

125

4 8

Quarters

PRICE LEVEL

GNP Deflator, 1972 = 100

i i i I i i i I i i i

4 8

Quarters

12

£ 8

o

S.

12 °0

4 8

Quarters

INFLATION RATE

12

Change from a Year Before, GNP Deflator

i i i I i i i

4 8

Quarters

12

F irn
Figure 7.

Economic Effects of the 1969 Credit Crunch

GNP

,1100

11000

o

"o

j 900

&

Actual Historical Data

.——No Credit Crunch

(Wharton Simulation) Sf.,

No Credit Crunch ../ X,

(DRI Simulation)^'*" ' '

j I I I I J I

BUDGET SURPLUS OR DEFICIT, (-), NIPA BASIS

20

1 10

I

«* 0

o

CO

-20

I I I I I I I

4 8

Quarters

UNEMPLOYMENT RATE

X

I

100

90

80

PRICE LEVEL

4 8

Quarters

INFLATION RATE

12

GNP Deflator, 1972 = 100

I I I I I I I I i

Percent Change from a Year Before, GNP Deflator

4 8

Quarters

12 4 8

Quarters

12
Three broad conclusions are suggested by this review of

some major fiscal and monetary policy actions. The first is that

policy moves within the range of recent experience do, as far as

one can tell, have significant impacts on GNP, employment, and

prices. The second is that other forces—movements in productivity, exports, the policy actions of the past, to name

a few—are also of great importance, so that while policy moves

of the size actually undertaken in the last 15 years modify the

contours of economic developments, they do not drastically

reshape economic history. It would have taken more vigorous use

of policy instruments to alter completely the recent history of

unemployment or inflation in the United States.

The final point is that very seldom is there an available

policy alternative all of whose impacts are clearly desirable.

Policies that have expanded the number of jobs have often

tended eventually to worsen the rate of inflation and to add to

the federal deficit. Policies that have reduced the deficit

have often tended to reduce the number of jobs as well. The

task of designing fiscal policy is not an easy one.

29

mm IF
JIIJL

CHAPTER IV. DESIGNING FISCAL POLICY

This study began by setting out a broad framework within

which fiscal policy is made, a framework including (a) setting

goals; (b) making a forecast of how close the economy will come

to these goals under some baseline assumption about fiscal

policy; and (c) developing estimates of the impact of changes in

policies on the forecast. The previous chapter looked at evidence relating to this third point—evidence about the effect of

fiscal policy on GNP, employment, inflation, and some other

economic aggregates. CBO found a general consensus that changes

in fiscal policy do have important macroeconomic effects; that

different fiscal instruments—various tax rates and spending

programs—have different effects on the economy; that many policy

changes pose trade-off problems, improving some economic indicators and worsening others; and that there remains a good deal

of uncertainty about the magnitude and, occasionally, about the

direction of the effect of a particular policy on a specific

economic indicator.

This chapter turns from reviewing the evidence to the

problems of designing actual fiscal policy. The first part of

the chapter reviews some of the overall measures of fiscal

policy—the federal deficit is the best known of these—and

their usefulness as a guide to making fiscal policy. The second

part discusses specific fiscal instruments—tax rebates, permanent tax cuts, employment programs, and others—and suggests some

of the special characteristics which affect the impact that each

of these instruments has on the economy.

SUMMARY MEASURES OF FISCAL POLICIES

The Unified Budget Deficit

The unified budget deficit, voted by the Congress in its

budget resolutions, is the best-known, single-number summary of

fiscal policy. The deficit has been very large in recent years—

$45 billion, $66 billion, and $45 billion in fiscal years 1975

through 1977, respectively, compared to an average of $14

billion in the earlier 1970s.

30
All too often, the unified budget deficit is taken to

suggest that fiscal policy has been enormously expansionary in

recent years. While it is essential for accounting purposes, the

unified deficit, unfortunately, is a very misleading indicator of

discretionary fiscal policy because it responds very sensitively

to changes in the economy that do not necessarily have anything

to do with fiscal policy. Most importantly, weakness or strength

in private demands and incomes cause revenues to fall or rise and

hence affect the unified budget deficit. Reinforcing this

tendency is the automatic response of income support programs,

such as unemployment insurance, to a deterioration or improvement

in economic activity. A severe recession causes the unified

budget deficit to rise not only because the fall in incomes

depresses revenues, but also because the fall in real incomes

increases payments for unemployment compensation, food stamps,

and other outlays. The recession of 1973-1975 and the subsequent

failure to close fully the gap between actual and potential

output that opened up at that time is the main cause of the large

unified budget deficits of recent years.

Federal outlays respond not only to changes in real income

but also to inflation. Some major federal programs—social

security is the most important—are tied automatically to the

rate of inflation, and certain other categories of outlays tend

to rise semi-automatically when prices go up. A boom, which

drives up the level of prices, thus increases outlays of certain

kinds as well as increasing revenues. If the outlay effect were

as large as the revenue effect, then the deficit would be unaffected; but in fact the revenue effect tends to be stronger

than the outlay effect. The main reason for this is that inflation drives households into higher income brackets and personal

income taxes consequently increase more than in proportion to

inflation. On balance, therefore, the deficit is reduced by a

general increase in prices.

What should the reaction be to a large change in the deficit

brought about not by Congressional action but by general economic

developments? Most economists would answer that changes of this

sort in the deficit are healthy developments. Reductions in the

deficit caused by a general boom in output and prices help to

curb the boom because higher tax collections and lower income

support outlays tend to curb private demands. An expansion in

the deficit during a recession is similarly a healthy development

since a fall in tax receipts and increases in income support

payments help to sustain demand and fight the recession.

31
.II III 1111

Automatic movements in the deficit should, according

to the conventional view, be welcomed and, if necessary, reinforced by deliberate policy changes. When a recession causes a

loss of revenues, that loss should not trigger an attempt to cut

back on spending to close the deficit, but on the contrary might

be the occasion for a further cut in taxes or an increase in

spending to reinforce the stabilizing effect on the private

economy of such changes in the federal deficit.

A key assumption underlying this conventional wisdom—and

one that obviously has not always applied in the 1970s—is

that movements in the rate of inflation are caused by changes

in aggregate demands, with high inflation rates accompanying

booms and low inflation rates accompanying recessions. In recent

years, there have been unfortunate experiences with bouts of

inflation originating from the supply side—from crop failures or

from the actions of a cartel in raising world oil prices—and

these have no necessary connection with a general boom in the

domestic economy. (In fact, they tend to depress economic

activity since they raise domestic prices without increasing

domestic real incomes.) Furthermore, the U.S. economy is now in

a period in which the momentum of past inflation seems to be the

dominant force accounting for current price rises. Under these

circumstances, it is not at all clear that automatic movements in

the unified budget deficit or surplus represent a healthy reaction that should be welcomed and possibly reinforced. The

conventional view of the significance of deficits is only partly

valid in today's economy. It remains true, however, that the

unified deficit is not a suitable single-number summary of

federal fiscal policy.

The National Income and Product Accounts Deficit

The principal drawback of the unified deficit as an indicator of fiscal policy is the one just mentioned—its sensitivity

to a whole host of developments in the private economy that have

no necessary connection with Congressional policy changes.

In addition, there are other shortcomings of the unified deficit.

One of them is the fact that it records taxes at the time the

money is collected, rather than at the time the liability is

incurred. In the case of corporations, the effect of taxes

on economic behavior appears to be more closely related to

taxes on a liability, or accrual, basis than to taxes on a cash

payment basis. Another problem with the unified budget deficit

is that certain financial transactions, such as oil leasing

on the Outer Continental Shelf and the direct lending activities

32
of government corporations, such as the Farmers Home Administration, are included in the unified deficit, although their effect

on the overall economy is much smaller per dollar than the impact

of general spending and tax receipts.

These conceptual shortcomings in the unified deficit from

the point of view of its economic impact are corrected by moving

from the unified budget deficit to the deficit as recorded

in the National Income and Product Accounts (NIPA) of the United

States. The NIPA deficit generally parallels movement in the

unified deficit but displays occasional differences because

of these timing and financial adjustments. For fiscal year 1977,

the NIPA deficit was $48 billion, compared to a unified deficit

of $45 billion. The NIPA deficit shares with the unified deficit

the sensitivity to a host of private economic changes that makes

it unsuitable as a single indicator of federal fiscal policy.

Refinements of the Surplus-Deficit Concept

Full-employment Budget. The full-employment budget was the

earliest attempt to correct the unified or NIPA budget for the

key difficulty—considered as an indicator of fiscal policy—of

responding to developments in the private economy. The method of

doing so is to express receipts and outlays not at their actual

historical value but at what they would be were the economy at

some standardized rate of unemployment. The rate of unemployment

chosen was usually 4 percent in the past, but full-employment

budget numbers now use somewhat higher rates for recent years.

As has often been pointed out, the full-employment budget

adjusts only for departures from a standard unemployment rate,

but not for changes in the rate of inflation. The full-employment budget remains quite sensitive to the rate of inflation, and

the complications arising from the varied sources of inflation

in recent years have made the interpretation of this fiscal

policy measure extremely difficult.

In addition, the full-employment budget has other defects

that require further adjustments. One difficulty is that this

budget evaluates discretionary changes in fiscal policy by the

effect that they would have at full employment (at least in

theory—in practice, this is often modified) rather than at

actual employment levels. Thus, enactment of an expansionary

33
program which would "trigger out" before the economy reached a

low rate of unemployment would in theory have no effect on the

full-employment budget, although it has an effect on the actual

economy•

Another problem with the full-employment budget is that,

like the actual budget, it weights each fiscal policy move

according to the number of dollars involved, and not according

to some measure of its impact on the economy. Thus, in spite

of the fact that corporate tax changes are generally viewed as

having smaller short-run effects on output and prices (per dollar

of tax) than personal income tax changes, the full-employment

budget gives the two types of changes equal weight.

Standardized Budget. A variation on the full-employment

budget, the so-called "standardized budget surplus," attempts to

correct for some of these defects. The standardized budget

surplus measures changes in discretionary programs at the actual

position of the economy, rather than at some hypothetical fullemployment rate. In doing so, it correctly includes policy

changes that have an impact at the time they are enacted but

would fade out before full employment. By restricting itself to

new discretionary policy actions, it also largely eliminates the

automatic effects of the rate of inflation on receipts and on

certain categories of expenditures. The standardized surplus

does not, however, make any change in the practice of using

budget cost, rather than some measure of budget impact on the

economy, as the yardstick for fiscal policy measurement.

Figure 8 compares the historical behavior of a number

of these measures of fiscal policy. The middle panel of the

figure shows actual GNP as a percent of potential GNP, as estimated by the Council of Economic Advisers, to indicate how fully

the economy's resources were used in each of the years from

1959 through 1977. The top panel of the figure shows two measures of the year-to-year change in the actual surplus or deficit,

the unified and the NIPA surplus or deficit. The figure shows

that in the three recession years of 1961, 1970, and 1975,

both measures fell sharply, largely because the fall in actual

as a percent of potential GNP had a depressing effect on revenues

and caused increases in outlays for income-support programs.

These moves toward larger deficits, as discussed earlier, were

healthy reactions to economic downturn, helping to cushion

34
Figure 8.

Changes in Budget Surplus or Deficit, Four

Measures: NIPA, Unified, Full-Employment, and Standardized

CHANGE IN BUDGET SURPLUS AS A PERCENT OF GNP

I I I i i i I I I I l

1960

GNP AS A PERCENT

1965

 Fiscal Year

 197°

1975

£ 95

90

3

2

1

0

-1

-2

-3

1960 1965 1970 1975

Fiscal Years

CHANGE IN BUDGET SURPLUS AS A PERCENT OF GNP

Full-Employment Budget

Standardized Budget

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

1960

NOTE: The middle panel is presented as a reference point for the top and bottom panels.

1965 1970

Fiscal Year

1975

i Tmniiir
I! II I

the shock to households and businesses. The figure indicates

that there were also many changes in the actual surplus or

deficit not caused by economic changes—the tax cuts of 1962 and

1964 and the Vietnam buildup, for example.

The bottom panel of Figure 8 shows two more refined measures of fiscal policy, changes in the full-employment budget and

changes in the standardized budget. Even these two measures fall

in the three recession years of 1961, 1970, and 1975, although

they fall much less than the actual surplus/deficit. The fact

they do fall indicates that not all of the actual deficit

increases of those years were automatic; there were some discretionary changes in an expansionary direction as well. More

striking, perhaps, is the significant increase in both measures

in the year preceding each of the three recessions. The figure

suggests that sharp fiscal changes in a restrictive direction

carry the danger of causing or hastening a recession.

The full-employment measure is persistently above the

standardized budget measure, and by an amount that tends to

increase over time. The principal reason is that the fullemployment budget includes automatic increases in taxes which

accompany inflation, while the standardized budget excludes

them. According to the full-employment budget, fiscal policy

has changed little since the 1975 tax cut; that conclusion

is actually the result of a near-offset between further expansionary moves by the Congress and automatic tax increases

due to inflation. The standardized budget includes the expansionary moves but omits the inflation-induced tax increases, and,

therefore, indicates that discretionary fiscal policy has been

expansionary since 1975.

In principle, one can go further than either of these

measures and weight the dollars in each element of fiscal change

according to some measure of influence on the economy. The

task is enormously difficult not only because there is no widespread consensus on the ultimate impact per dollar of each

instrument, but also because these effects build up over time

at varying rates. In spite of these obstacles, some economists

have attempted to construct measures of this sort. !_/

See, for example, Alan Blinder and Stephen Goldfeld, "New

Measures of Fiscal and Monetary Policy, 1958-73," American

Economic Review (December 1976), pp. 780-796.

36
Further experimentation with "weighted standardized surplus"

measures is likely to improve understanding of fiscal policy,

but this measure is probably too speculative to be an official

statistical series or to serve as an important policy guide. At

the present time, changes in both the full-employment budget and

the standardized budget provide guides to fiscal policy that are

more useful than the actual deficit, but there is no basic

substitute for separate analysis of changes in each important

fiscal instrument as the needs of the economy change and as new

policy proposals are developed.

SOME MAJOR FISCAL INSTRUMENTS

Since no single number is an adequate summary of all of the

important dimensions of fiscal policy, it is important to remain

aware of the special characteristics of the commonly used instruments of stabilization policy. Accordingly, this final section of

the study comments briefly on the time-lags, economic impact per

dollar, and other features of the main taxing and spending

instruments available to the Congress.

An ideal instrument of stabilization policy, if there were

one, would have at least four characteristics. It would first

of all be easy to implement as well as to remove or reverse

promptly. Secondly, it would have a favorable, or at least

minimally unfavorable, unemployment-inflation tradeoff—that is,

it could either be used to reduce unemployment with a minimal

effect on inflation, or be used to reduce inflation with very

little cost in extra unemployment. Thirdly, it would have

a favorable jobs/deficit tradeoff, requiring as small as possible

a net budget cost per job created. Finally, it would interfere

as little as possible with the efficiency of the private economy.

Although none of the common fiscal instruments has all

of these advantages, the list of advantages is a useful standard

against which to compare each instrument. It is not the only

standard to use, however, since many of the instruments have

major impacts on other goals besides stabilizing the economy.

Thus, payroll taxes have major effects on the status of the

social security funds and are raised in spite of rather than

because of their effects on inflation and unemployment. Similarly, payments to individuals have important effects on the

distribution of income, and public works programs have major

37

TUT
effects on selected local areas. The paragraphs below touch on

the other goals of some of the major budget instruments as

well as their effectiveness for general stabilization of the

economy. 21

The Individual Income Tax

Promptness is the great advantage of changes in the individual income tax for stabilizing the economy. At times,

the Congress has been able to work out a tax change bill within

two to four months, and the Treasury is able to translate a

completed action into changes in the take-home pay of millions of

Americans within weeks after enactment. Not only are income tax

changes prompt in taking effect, they are also easily reversible

from a technical point of view, although politically tax reductions are much more popular than tax increases, of course.

A rebate of income taxes is even more prompt than a permanent change in tax rates or deductions. A $10 billion rebate can

be paid out entirely within two or three months after enactment,

while the direct effects of a $10 billion annual change in

tax rates or deductions are generally spread out over a year.

There is widespread doubt, however, whether a rebate has nearly

as much impact on the economy per dollar of cost (gross or net

cost) as does the first year of a permanent cut in taxes. Many

economists view consumption decisions as influenced more by

long-run income prospects, which are affected by a permanent tax

cut but not a rebate, than by windfalls such as a one-time

rebate.

According to most analyses, even a permanent income tax

cut is a relatively expensive way of reducing unemployment in

terms of budget dollars (net or gross costs) per additional job.

As noted earlier in this study, the contention that a permanent

cut in individual income tax generates enough revenue so that its

net cost is zero is one which careful analysis does not support.

A somewhat similar discussion of fiscal instruments appears

in an earlier CBO report, Temporary Measures to Stimulate

Employment (September 1975).

38
Nor does a change in individual income taxes, according to

most analyses, have any special advantage in avoiding inflation.

A few dissenters from this view feel that low income taxes

increase the willingness of some persons to hold jobs or work

longer hours, and thereby lift the potential noninflationary

level of output of the economy; but this is not a widely held

position. Another aspect of the individual income tax that needs

to be considered is that proposals to change provisions inevitably raise distributional issues as well as macroeconomic ones.

Corporate Income Taxes

Like the personal income tax, the corporate income tax

can be changed promptly and—subject to the same political

constraints—can be reversed easily.

There is much less agreement about the economic impact

of the corporate income tax than there is about the personal

tax. One channel of influence is that the increased cash flow

accompanying a cut in business taxes may increase investment,

but this channel has not been found to be very important in

recent investment analyses. Some models of the economy translate

changes in the corporate income tax into movements in stock

prices, with significant effects on personal wealth and hence on

consumer spending. It is safe to say, however, that most changes

in the corporate income tax in the past have not been based on

any precise view of their economic impact, but rather on the

grounds of preserving equity between personal taxes and corporate

taxes.

Investment Tax Credits

A growing number of models of the economy find a powerful

GNP impact per dollar for the investment tax credit. Other

changes in the tax treatment of capital spending, such as

accelerated depreciation or inflation-adjusted depreciation,

should also have powerful effects if the investment tax credit

does, since they have similar effects on the after-tax return

on investment. Changes of this kind, furthermore, are easy to

enact and to implement. The investment tax credit has, in fact,

been varied a number of times since it was first introduced in

1962.

39

mr
..Mill IL!

Time lags in economic impact are the great shortcoming

of the investment tax credit as a stabilization device. Because

of the long lags involved in business investment decisions, it

may be a matter of a year or two before a change in the investment tax credit begins to have substantial effects on employment

and output. This is a contrast with the personal income tax

or with federal purchases, which may not reach their peak effects

for a year and a half, but which begin to have substantial

effects long before that.

A special effec t of the investment tax credit is that

it promotes an increase in the amount of capital per employee

and thus in the long run leads to a more capital-intensive

economy. According to some economists, this shift to more capital

per employee is accompanied by a shift in the demand for labor

from blue-collar to white-collar workers and frequently also by a

shift toward greater energy use. These possibilities need to

be considered along with the short-run macroeconomic impact

in assessing the value of this fiscal device.

Payroll Taxes

The employee share of the social security tax has macroeconomic impacts similar to those of the individual income tax.

Both taxes reduce take-home pay and thereby influence consumer

spending, and both taxes raise revenues and thereby reduce the

size of the deficit. Changes in both can be implemented promptly.

The incidence of the two taxes is quite different; a much

higher proportion of payroll taxes than income taxes is paid

by low-income workers, while a much higher proportion of income

taxes than payroll taxes is paid by middle- and high-income

households and property income recipients. This difference

in incidence could lead to a difference in overall impact if

the saving behavior of the rich differed greatly from the poor.

Contrary to most popular speculation, what facts there are

on saving by income class do not suggest large differences

in the proportion of lifetime income saved at the margin.

The way in which costs, prices, and incomes adjust to

changes in the employer share of payroll taxes—both social

security and unemployment insurance—is less understood. Most

40
analyses indicate that the principal initial impact is on business costs and prices. The higher prices that are set in response to an increase in employer payroll taxes reduce the real

value of wealth and cause higher interest rates, and thereby

depress real output and employment. Possibly there is another

type of depressing effect on output if the higher payroll taxes

were to cause employers to offer lower wages. According to this

analysis, in summary, raising the employer payroll tax worsens

both inflation and unemployment.

Why then has the payroll tax been raised so frequently?

Clearly, economic stabilization is not the reason; from the

point of view of stabilization goals, lowering payroll taxes

would be an advantageous move. Rather, the payroll tax has been

raised to maintain the solvency of the social insurance trust

funds in spite of effects on the general economy. This conflict

between the trust fund effects and the aggregate economic effects

of payroll taxes is one of the difficult dilemmas facing policymakers at the present time.

In some countries, temporary changes in value-added taxes _3/—similar to employer payroll taxes with respect to their

general impact on costs—are an important instrument of fiscal

policy. A temporary cut in an element of business costs can lead

to temporary price discounts, which should stimulate buying while

the temporary cut is in effect without any long-run impact on

prices. A temporary increase should have the reverse effect.

These are desirable features if fiscal policy is aiming to offset

a short-run disturbance in private spending. However, the use of

payroll taxes in this way has not been tried in this country.

Employment Tax Credits

The apparent success of the investment tax credit in stimulating business investment was one of the arguments in favor of a

similar approach to increasing employment by introducing an

A value added tax is a tax on the sales of a firm. A deduction is granted for the cost of purchases from other firms,

so that only the value added by each firm remains subject to

tax. Taxes paid by previous firms in the production chain on

capital goods purchased usually are refundable.

41

"TJimmr
employment tax credit. The latter tax credit can promote employment two different ways: (1) by encouraging a higher ratio

of labor to capital and other inputs for any given level of

output; and (2) by moderating pressures on prices while maintaining the earnings of workers, thus enabling workers to buy

more goods and stimulate, output and employment.

The first of these employment incentives is a long-run

proposition since, especially at a time of economic slack,

firms have a good deal of unused or under-used capital on hand

and hence have little immediate incentive to economize on the use

of capital. Moreover, the employment tax credit is likely to be

weaker in promoting labor-intensive production than the investment tax credit in helping capital intensity. The reason is that

capital goods are first purchased and then used for many years,

while labor is purchased at the time it is used. If an investment

tax credit is in effect, a firm knows it can lower its yearly

costs over the entire lifetime of a machine by taking the credit

on the initial purchase price. If an employment tax credit is in

effect, however, a firm can be sure of lowering its costs for

only the present year by taking the credit; there is a risk that

next year the employment tax credit could be terminated.

Many employment tax credit proposals involve a base level

of employment in each firm (say, last year's employment) with

employment credits extended only for workers hired in addition to

the base level of employment. If a given budget amount has been

allocated to employment tax credits, this approach clearly

allows a stronger incentive at the margin than if the available

funds had to be allocated over all existing and new employees.

Still, the base-level approach has its drawbacks. Some firms

would have expanded employment above the base even without the

incentive, and they get rewarded even if their behavior is

unaffected by the credit, while other firms need to retrench with

or without the employment credit, and they cannot be provided

with an incentive to retrench their workforce at a slower pace.

The difficulty in both cases is that no simple definition of the

employment base level is appropriate to all businesses.

The second macroeconomic channel of the employment tax

credit comes into play when the credit permits firms to reduce

prices; this channel might generate roughly as much new purchasing power as a personal tax reduction of equal budget cost.

There could also be the same effect on take-home pay as in the

case of a tax cut if labor were to succeed in bidding up wage

42
rates to acquire some of the subsidy rather than businesses

lowering prices. Still another possible outcome with more

uncertain results, is that business could increase its profits

rather than passing forward the subsidy in lower prices.

A generalized employment tax credit that would cover all new

and old jobs can be considered as the opposite of employer

payroll taxes. The one lowers a firm's employment costs while

the other raises them, both by amounts related to the firm's

employment or payroll. Employment tax credits are thus a

logical device for offsetting the macroeconomic impact of employer payroll taxes. It would take a substantial credit,

involving billions of dollars of foregone revenue, to offset

fully the sizable increases in social security payroll taxes in

prospect over the next few years.

Transfer Payments

From the point of view of impact on the economy, transfer

payments—social security payments, veterans' benefits, unemployment compensation, and other payments to individuals—are the

opposite of personal income taxes. An increase in social security payments adds to the money households have to spend and

adds to the deficit, while an increase in personal income taxes

reduces money households have to spend and reduces the federal

deficit. Like personal incomes taxes, transfer payments can be

changed promptly; however, there are very few actual instances of

reductions in transfer payments other than automatic ones caused

by a decline in the number of persons eligible. Decisions about

transfer payments, like decisions about taxes, have special power

to affect the incomes of particular groups—the retired, the

unemployed, and veterans, among others.

Probably most changes in transfer payments, like changes

in personal taxes, have less economic impact per dollar than

federal purchases of goods. Transfers need not be equivalent to

personal taxes in this respect if the persons directly affected

by a tax change have different spending-saving patterns from

those directly affected by transfer programs. Unemployed household heads, for example, probably spend a higher fraction of any

addition to their income than do employed household heads. It

follows that payments to unemployed household heads should

generate more GNP per dollar than a cut in taxes that is spread

43
among all taxpayers. There is, however, very little data useful

for measuring whether the difference is significant. Perhaps for

this reason, models of the economy generally do not allow for

such differentials.

Again like the income tax, most transfer programs respond

automatically to changes in economic conditions. A recession and

the accompanying rise in unemployment raises transfer payments;

unemployment compensation and welfare payments rise; and possibly, through changes in the number of early retirements,

social security benefits rise. These changes, like the drop in

revenues during a recession, illustrate the tendency of the

federal deficit to grow when the private economy weakens and

thereby to help cushion the impact of a recession.

In the case of a step-up in the rate of inflation the

response of transfer payments is also to increase—automatically

in the case of social security and semi-automatically in the case

of unemployment compensation which tends to be linked to recent

levels of wage rates. These responses succeed in protecting

the beneficiaries against inflation by preserving the real

purchasing power of old age payments and the real value of

unemployment insurance. At the same time, however, these responses add to total spending and hence increase the overall

inflationary pressure in the economy. The automatic response of

transfer payments to inflation is thus stabilizing from the point

of view of the individuals directly involved, but—unlike personal tax payments—is not stabilizing for the economy as a

whole.

General Revenue Sharing

General revenue sharing is another category of spending

that can be altered promptly in response to changes in economic

conditions. Whether prompt federal action in this case means

prompt economic impact, however, is less certain. It depends on

the speed with which state and local governments change their

spending and tax behavior in response to federal grants. What

evidence exists suggests that the state and local response is

slow, somewhat slower than the household response to a change

in take-home pay. A long lag in state and local responses

would make revenue sharing a less effective device for stabilizing the economy than some of the other fiscal instruments.

44
The entire system of federal grants has grown and changed very

rapidly in recent years, however, and the present lags may grow

smaller as states and localities become accustomed to dealing

with the newly evolving system*

The relatively recent innovation of countercyclical revenue

sharing links the total amount of outlays in this category

to the aggregate unemployment rate. It thereby provides some

automatic cushioning of the shock of a recession to states

and localities. To the extent that the state and local governments anticipate and hence respond promptly to these countercyclical grants, these grants also cushion the shock of a recession to the economy as a whole.

Public Service Employment Programs

An increasingly important instrument in recent stabilization

policy has been public service employment, almost all in the

forms of grants to state and local governments to support job

programs aimed at certain population groups.

Public service employment potentially can be a very powerful

creator of jobs per dollar spent. In most expansionary fiscal

moves, a relatively small proportion of the increase in national

income goes directly to the newly employed. A significant

proportion goes into increasing profits, another significant

proportion into increasing average hours of those already employed, and, at least under some circumstances, a significant

proportion to raising the wage level of those already employed.

Public service employment can reduce the fraction going into

higher profits and higher average hours and can focus on groups

of workers whose average wages are relatively low.

Public service employment programs will not achieve this

potential, however, if the rate of displacement—that is, substitution of federal for state and local money to pay for programs that would have been undertaken in any case—is very high

or if the lags in setting up local programs and hiring qualified

persons are long. Some investigators have reached pessimistic

conclusions about the impact of public service employment grants

because of pessimistic assumptions about these factors. The

estimates presented earlier in this report, based on less pessimistic assumptions, indicated high employment effects per

45
dollar of public service employment grants. All such conclusions

must be rated highly tentative at the present time because of the

rapid development and change in the public employment system.

Public service employment programs also can potentially

cause less price pressure per job created than other fiscal

instruments. They have this potential not only because the jobs

pay relatively low wages, but also because the programs can be

aimed at those groups with especially high unemployment rates.

This potential would not be realized, however, if a public

service employment program paid higher wages than the persons

directly affected could expect to receive in the labor market

under high-employment conditions. Again, it is much too early

for a final verdict on these rapidly changing programs.

Public Works

Public works is the new construction of public facilities

such as schools, hospitals, dams, sewage treatment plants, and

mass transportation structures. Like public service employment,

it has been a part of recent efforts to stimulate the economy.

Evidence supports two propositions about public works as

a fiscal instrument. First, it is relatively powerful per dollar

of direct budget cost. Like other federal purchases of goods, it

is more powerful in this respect, according to almost all models,

than general tax cuts or transfer payments. Secondly, there are

long lags in starting up or terminating public works projects.

Because of the long lags, it is probably a more appropriate

fiscal instrument when there appears to be a need for fiscal

stimulus or restraint extending several years into the future

than when the needs of the economy are known for only a short

period ahead. The lags are a disadvantage in using public works

to counter short-run swings in the private economy.

Other Federal Spending Programs

There are many types of federal expenditures that have

not been covered in the discussion so far. Usually, these

programs satisfy a very specific public need—such as defense,

aid to education, medical research, and health care delivery—so

that a rapid expansion and subsequent contraction of outlays,

46
which might serve the interest of stabilization policy, could

markedly reduce the effectiveness of these programs in meeting

their long-term goals. Often, the timing of these programs needs

to be designed carefully for technical reasons and they require

sustained long-term effort to yield benefits. For this reason,

outlays of this kind—say, for health care delivery—are less

amenable to countercyclical action than public works. The latter

consists of investment projects whose date of completion can be

altered without tremendous loss, since the finished investment is

likely to last for a long time and thus will render a continuous

stream of services once it is completed.

In sum, most spending programs outside the areas of cash

transfer payments, revenue sharing, public service employment,

and public works at either the local or federal level, are

difficult to organize as an instrument of stabilization policy.

This is not to say, however, that with careful planning and

attention, these other types of expenditures could not also be

utilized to help make government outlays a stabilizing tool.

Such an approach would require more than simply an appropriation

of funds; it would require careful follow-up on the speed and

efficiency with which funds are channeled into the private

economy, and perhaps authority to change the allocation of funds

if bottlenecks develop.

A FINAL NOTE

Fiscal policy instruments are evolving. Targeted public

service employment programs were unused in the 1950s and hardly

used in the 1960s. The investment tax credit dates back only a

decade and a half. Employment tax credits have barely been

tried. It is very likely that the future will bring continuing

innovations in the use of these and other policy instruments.

Not all of these measures will turn out to represent progress;

but if fiscal policy is to be made more effective, the way to

improvement lies through innovation and observing the consequences in a careful and unbiased manner.

Because fiscal policy is constantly evolving, the discussion

in this section of the report can be no more than a guide to the

instruments of fiscal policy as of 1977. In a few years there

may be enough changes in the characteristics of existing fiscal

instruments and enough development of new instruments so that

this section of the report is obsolete. That would be a highly

desirable development, if it meant an improvement in the power of

fiscal policy to stabilize the economy.

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