April 11, 1980

April 11, 1980 | Backgrounder on Economy

A Fiscal Approach to Inflation and Growth

(Archived document, may contain errors)

115 April 11 1980 A FISCAL APPROACH TO INFLATION AND GROWTH INTRODUCTION The virulence of inflation cannot be measured solely by changes in the consumer price index or tightened family budgets.

A subtle and more pernicious cost is the distortion which rising prices introduce into economic behavior. It is the latter which has caused consumer borrowinu to rise to un precedented levels savings to decline, and prodktivity to fali. The current preoccu pation with the short term portends serious economic difficulties for the future The deeply rooted pessimism about inflation and the concomi tant changes in behav.ior have complicated the already difficult task of combating inflation. The appropriate anti-inflation policy must not only reduce the rate of inflation but must also counter the bias against longer term considerations and economic growth MONETARY AND FISCAL POLIC IES The approach to our economic'ills should be two pronged.

Monetary policy should be directed at restricting the growth in nominal gross national product GNP Federal Reserve efforts to slow the growth in money supply; will, with a stable velocity of mone y, restrict the growth in either prices, output, or some combination of the two.

Fiscal policy should be used to promote the expansion of output or real GNP. A combination of federal spending cuts, tax reductions, and a budget surplus would restore both the incentives and the capacity of the private sector to invest and produce.

Large reductions in spending, with the resulting surplus, would relieve the Federal Reserve of the burden of financing federal 2 deficits without squeezing the private sector out of the money markets.

Given Federal Reserve Board Chairman Paul Voicker s avowed monetary course, an appropriate FY 1981 budget would limit federal outlays to $595.0 billion and revenues. to $597.6 billion. The fiscal plan would include a budget surplus o f $2.6 billion and a calendar year tax cut of $31 billion, to be divided between permanent indexation of individual income tax rates, accelerated depreciation, a more propitious treatment of savings, and repeal of President Carter's oil import fee Table 1 Fiscal Year 1981 Comparisons Revenues Outlays Tax Cut Surplus TAXES Carter House Budget Senate Budget Administration Commit tee Committee Alternative 628.0 613.8 623.0 597.6 611.5 611.8 612.9 595.0 16.5 2.0 10.1 2.6 10.3 20.5 President Carter's revised bu dget of March 1980 calls for federal revenues of $628.0 billion with no tax cut (Table 1).

The House and Senate Budget Committees have reported out budget resolutions with revenues of $613.8 billion and $623 billion respectively. In the House version, the $10.3 billion in oil import fee revenues would be set aside for a productivity-enhancing tax cut. In addition, the House Republicans plan to offer an alternative budget with a calendar year tax cut of $32 billion.

It should be noted that in none of the th ree proposals are federal revenues reduced below the level which would accrue assuming no legislative tax changes. All three versions assume that additional revenues ranging from $6 to $8 billion will result from withholding taxes on interest and cash man a gement policies I Revenues for FY 1981 should be $597.6 billion 9 billion below current service levels. This calculation is based on enactment of $10.2 billion in fiscal year 1981 cuts (Table 2 repeal of the oil import fee, and the appropriate rejection o f tax speed-up measures. The intent is to place as much of the total aggregate demand in the hands of the private sector as is possible. 3 Table 2 Fiscal Year 1981 Revenues billions of dollars HOUSE BUDGET COMMITTEE REVENUES minus cash management 2.6 minus withholding on interest 3.4 6.0 minus repeal of oil import fee 10.3 10.3 minus FY 1981 ta.x cuts (with 30% feedback Indexation 7.0 10-5-3 1.2 Savings 2.0 10.2 624.1 607.8 597.6 Indexation Permanent indexation of individual income tax rates for inflation i s a matter of both equity and efficiency support for the notion that, as inflation rises, the federal government makes more efficient use of expenditures than the taxpayer. Yet during an inflationary episode the unindexed tax system effectively increases t he real tax burden and shifts resources to the public sector There is no The unindexed tax system is inequitable because the effective tax increase has not been subjected to the legislative process.

Perhaps more importantly, the shift in resources associat ed with the present tax system creates inefficiencies. In accepting a level of taxes, consumers balance the value of the private consump tion foregone with the value of services provided by the government.

The unindexed tax system, by surreptiously shifti ng resources reduces the utility a consumer receives from a given level of income I security rollback, permanent indexation may contribute to wage demand restraint. Workers attempt to maximize not their nominal income .but rather the value of the goods an d services which that income will purchase. Aware that the progressive tax system will reduce the power of a pay increase which merely matches the rate of inflation, workers continuously must demand greater wage increases. Indexation, by eliminating the ta x system's real bite out of strictly nominal income increases, should permit workers to maintain the real value of their incomes with smaller wage increases. The Congressional Budget Office has calculated that the FY 1981 revenue loss attributable to index ation would be $10 billion.

Accelerated Depreciation Just as "bracket creep" has increased the effective individual income tax rates, the unindexed depreciation schedule has caused business taxes to rise. Profits, and hence income taxes, are 4 overstated b ecause the depreciation expenses are based on histori cal and not replacement costs. Martin Feldstein has calculated that, due to the inflation-induced variance between the two costs, 1977 profits were overstated by $35 billion Higher taxes and dividends paid out of overstated profits leave fewer resources available for investment. Slower investment translates into smaller productivity gains, less economic growth and a deterioration of U.S. competitiveness.

Rather than attempt to index the entire depreciation schedule a simpler alternative would be to establish an accelerated version.

The 10-5-3 principle embodied in the Capital Cost Recovery Act buildings would be written off in 10 years, tangible property such as machinery, in 5 years, and investment in automobiles and light duty trucks in 3 years) is one of several alternatives available.

The benefits of accelerated depreciation are appealing Table 3). Norman B. Ture, Inc in a study undertaken for the Nat ional Association of Manufacturers, has found that, the 10-5-3 Capital Recovery System will in 1983 provide an additional 370,000 jobs, expand GNP by $51 billion (in 1979 dollars) andincrease gross private domestic investment by $55 billion (in 1979 dolla rs).

The Treasury has estimated the first fiscal year cost of the Capital Cost Recovery Act at $1.7 billion, before feedback Table 3 10-5-3 Capital Recovery System Constant 1979 Dollar Projectiqns Increase or Decrease In Employment (thousands of full time equivalent employees 1980 1981 1982 1983 1984'1985 160 230 290 370 450 560 Annual Wage Rate $130 180 230 290 360 450 Gross National Product (billions Total Business Sector 21 30 .40 51 66 92 17 24 32 41 51 70 Gross Private Domestic Investment (billions To t al 11 30 42 55 61 34 Nonresidential 16 35 49 63 76 35 Consump tion (billions Federal Tax Revenues (billions Net of feedback Initial impact 5 Note: The figures are the differences between the estimated amount of the respective economic magnitudes under the tax change and under present law in each year.

Amounts shown in parentheses are decrease from present law in that year not from the preceding year under the tax change.

Source: Norman B. Ture, Inc NAM Savings The Capital Cost Recovery Act is designed to provide busi nesses with the internal resources for investment. External financing though equity or debt can be encouraged through more salutary tax treatment of personal savings.

On a secular scale, personal savings in the United States are substantially below such competitors as Japan or West Germany.

This long-term gap is exacerbated by inflation's short-term incentive to shift resources from savings to consumption. Rather than provide for future consumption in the traditional manner such as savings ac counts or share holdings, consumers invest in more exotic and less productive hedges, such as gold or antiques To encourage savings, changes in the tax system must increase the rate of return on marginal or additional savings. An exemption on the first $2 0 0 or $400 in interest or dividends, although it can certainly be advocated on equity grounds, will not cause anyone to increase the amount of savings beyond that necessary to achieve the entire exemption. Studies have indicated that these particular ceili ngs will induce little additional savings.

There have been several bills introduced this session designed to increase the marginal rate of return on savings. One proposal H.R. 6400, introduced by Representatives Clarence J. Brown (R-Ohio and John Rousselot (R-Calif.) and S. 2242 by Senator William V Roth (R-Del would separate the earned and unearned portions of income and apply the progressive tax rates to each. The top rate on savings income would be reduced from 70 to 50 percent. In addition, individuals with over 10,000 in preference income other than capital gains) would be ineligible for income splitting.

Under present law, a family of four, with wages of 25,400 and interest and dividend income of $4,400 would face a 32 percent tax against any increase in income. H.R. 6400, by splitting the incomes, would lower the tax liability of any additional savings by one half, to 16 percent. Michael Boskin of Stanford University has found that a one percent increase in the return on sayings will prompt an increa s e in savings of 0.3 to 0.4 percent 1. M. J. Boskin Taxation, Saving, and the Rate of Interest Journal'of Political Economy, Vol. 86, No. 2, Part 2 (April 19781, pp. S3-S27. 6 H.R. 6400 could be phased in over several years,.with possi ble first year costs of $2-3 billion Oil Import Fee The House Budget Committee has set aside the $10.3 billion in revenues expected from the oil import fee for a productivity- oriented tax cut. This action, however, would not lower the aggregate tax burden, but merely alter i t s composition. The proposal would finance the lower tax liabilities of the productive sector by assessing a tax against oil and gasoline consumers far'more efficacious policy would be to match the productivity tax cut with a reduction in ederal spending A SURPLUS The Fy 1981 surplus of $2.6 billion does not represent a reduction in aggregate demand, but rather a shift in resources toward the credit market. Instead of meeting the cash demands created by expiring federal debt through the issuance of more deb t , a surplus would permit a net debt retirement. In the credit markets this would make more resources available to the private sector SPENDING Federal spending should be reduced as EY 1981 revenues are reduced for two reasons. One a failure to cut spending will lead to a deficit Reserve to abandon its tight money policy and prevent the govern pent from crowding the private sector out of the capital markets thereby offsetting the investment inducements offered by the tax cuts. Secondly since the tax measures designed to stimulate investment and productivity will not immediately result in suffi cient supply increases the tax reduction unaccompanied by a cut in federal spending will create excess,demand and even greater inflationary pressures This would place g r eat pressure on the Federal The House Budget Committee outlined $16.5 billion in budget cuts in its reported resolution. This study adds another $21.9 billion See Appendix Although it is difficult to believe that Congress will, in one year, cut spending b y 38.4 billion or even $16.5 billion, the purpose of this exercise is to show what could be done To maximize the economic effects, the spending cuts should reduce many of the transfer programs now in effect ation and expansion of these programs has often c r eated disincen tives to employment. Of the $21.9 billion in outlays reductions recommended, xoughly 10 billion is drawn from transfer programs The prolifer Eugene J. McAllister Walker Fellow in Economics 7 APPENDIX 611.8 House Budget Committee FY 19.81 Ou tlays Offsetting outlay cuts are included in reductions below Gramm-Holt Amendment (Increase Defense Spending) 5.1 Reductions 21.9 Transfers Tax Unemployment Benefits 3.1.

Change in Trigger for Unemployment Insurance Extended Benefits 1.0 Modification of T rade Adjustment Assistance Modification in Federal Compensation Practices 0.150 0.49 3.5 Modification of Index for Federal Programs Including Social Security Overlap between Food Stamps School Lunches 1.18 Eliminate Certain G.I. Bill Benefits 0.70 User Ch a rges Coast' Guard User Charges Corps of Engineers User Charges Airports and Airways Large Airports Fees to Cover Costs of Food Product Inspections Reimbursement of Veterans Administration Reduce Subsidies for Maritime Industry Elimination of Solar Demonst r ations Eliminate Subsidies to U.S. Postal Service Fees for Outpatient Visits to Military Hospitals Federal Employment Reform Wage Board Pay System End Dual Federal Pay for Reservists Reduce Summer Youth Employment Eliminate Davis-Bacon Selective Cuts Rest r ucture College Student Loan Program Eliminate Impact Aid Limiting Federal Highway Aid Terminate Legal Services Corporation Reduce Support for Heal& Professions Progams Reduce Cultural and Recreational Support Excessive Department Overhead (Travel Equipmen t, etc 17.5% Cut in 17 Major Regulatory Agencies FY 1981 Outlays Cuts in excess of House Budget Committee actions 40 98 91 .10 31 20 13 85 .076 778 26 035 264 750 .40 25 20 25 05 326 3.9 47 595.0

About the Author

Related Issues: Economy