L. Scott Varner, of the Graduate School Staff, helped the program.

Terry Wells coordinated the operations of the seminar, and Dolores McDonagh provided administrative assistance.
Our deepest appreciation goes to the resource people who gave of their time and energy to prepare papers for this publication and to discuss them with seminar participants. Our thanks also to those seminar participants for their enthusiasm and insights.
All books published by the Graduate School Press are reviewed by the Graduate School's Committee on Publications, under the leader¬ ship of Peter A. Smith. Other members of the Committee are Theo¬ dora E. Carlson, James A. Horton, Hubert W. Kelley, Jr., Robert J. McKendry, and Julie N. Walker. Norma Harwood, Margaret Brown and Linda Coyle of the Graduate School staff provided invaluable help in preparing and printing the manuscript.
Reflecting upon his experience in the 1962 Critical Issues Seminar, participant Rollien Wells wrote in part;
"A single candle cannot light a hall,
But, multiplied, it pushes back the night.
Don't stop! This course can open wide the eyes,
Supply a thousand men with clearer visions To meet the issues of the world with wise Decisions."
As the Graduate School celebrates its 60th year of service to government, we hope that this effort, as well as others, may help government to deal better with the increasingly complex problems facing the U.S. and the world.
Edmund N. Fulker Director, Graduate School
IV
Critical Issues & Decisions
TABLE OF CONTENTS
Page
Introduction
Donald J. Senese . 1
The Integration of Demand and Supply Side Policies
Charles L. Schultze . 13
Commentary . 30
Putting the Supply and Demand Sides of Economics Together
Donald Paarlberg . 45
Commentary . 53
If Not Detente, Then What?
Robert L. Pfaltzgraff, Jr . 65
Commentary . 79
Of Men and Angels: A Search for Morality in the Constitution
Robert A. Goldwin . 89
Commentary . . . 108
The U.S. in the World Economy: Competitive Again
William H. Branson . 117
Commentary . 141
Bibliography
146
Critical Issues & Decisions
DONALD J.SENESE
Formerly Senior Research Associate with the Republican Study Committee, U.S. House of Representatives, Dr. Senese is now Assistant Secretary Designate for the Office of Educational Research and Im¬ provement, U.S. Department of Educa¬ tion.
From left to right: Editor Dr. Donald J. Senese, Dr. Edward N. Fulker, Director of the Graduate School, USDA and Dr. John B. Holden, Seminar Coordinator and former Director of the Graduate School, USDA confering on the seminar.
Critical Issues & Decisions
INTRODUCTION
One of the greatest challenges of governing is translating ideas into practice— into the day-to-day operation of government. The USDA Graduate School Program chronicled in these pages attempted in a modest way to do just that by bringing together government policymakers and economists who address with authority the wis¬ dom of supply-side economics. The seminar was particularly timely because in 1981 the United States is entering a new decade, and a national election has brought to power a Republican President (by a landslide), Republican control of the U.S. Senate for the first time in a quarter of a century, and significant Republican gains in the U.S. House of Representatives. Viewing the funda¬ mental differences in philosophy which separated the Democrat and Republican presidential nominees in the 1980 contest, many political prognosticators have heralded the 1980 election as the most significant shift in U.S. economic policy since the election of FDR to the presidency in 1932.
The problems the United States faces at the beginning of the 1980s are serious: double digit inflation, large unemployment, high interest rates, growing federal deficits, an expanding money supply, a low level of productivity, increased foreign competition that is worsening domestic economic conditions, and crises in various world "hot spots" that threaten world peace (e.g., the Persian Gulf, Latin America, Afghanistan, Poland, Southeast Asia). Can the Reagan Administration turn the tide? Can new programs and policies solve or at least ameliorate some of our more serious eco¬ nomic problems? Can the United States achieve increased produc¬ tivity, expanded employment, and lower inflation as it moves toward a stable economic policy? Can the United States gain the initiative in the world politics building its strength while maintaining peace? The answers will come not only from the elected officials but also, at least in part, from policymakers at all administrative levels of the Executive branch.
Dr. Donald J. Senese, Assistant Secretary Designate for the Office of Education¬ al Research and Improvement, U.S. Department of Education.
1
Critical Issues & Decisions
The economic program of the Reagan presidency has captured so much attention because it attempts to substitute a philosophy of economic growth (or supply-side economics) for the long-dominant New Deal-Great Society- Keynesian approach which relied heavily on the federal government to control the nation's economy. The Reagan Administration offers a comprehensive economic shift in emphasis away from the public towards the private sector of the economy by the following: (1) a substantia! reduction in federal expenditures of at least $40 billion in the Fiscal Year 82 budget and a downward shift in federal spending growth rates from 16 to 7 percent, to move toward a balanced federal budget, (2) a 3-year, 30 percent reduction in all individual income tax rates designed to restore incentives and renew economic growth, (3) a reduction in federal regulation, particularly those regulations which are excessively burdensome to the national economy and those affecting the key industrial sector, and (4) a movement toward a consistent and stable monetary policy. The philosophy motivating these goals found clear expression in the message sent to Congress by President Reagan:
This plan for national recovery represents a substantial break with past policy. The new policy is based on the premise that the people who make up the economy— workers, managers , savers , investors , buyers , and sellers— do not need the govern¬ ment to make reasoned and intelligent decisions about how best to organize and run their own lives. They continually adapt to best fit the current environment. The most appropriate role for government economic policy is to provide a stable and un¬ fettered environment in which private individuals can con¬ fidently plan and make appropriate decisions. The new re¬ covery plan is designed to bring all aspects of government policy a greater sense of purpose and consistency.
Central to the new policy is the view that expectations play an important role in determining economic activity , inflation , and interest rates. Decisions to work , save, spend and invest depend crucially on expectations regarding future government policies. Establishing an environment which ensures efficient and stable incentives for work, saving, and investment now and in the future is the cornerstone of the recovery plan. 1
2
Critical Issues & Decisions
The "past policy" from which this philosophy departs is that advocated by John Maynard Keynes in The General Theory of Employment , Interest and Money. Keynes believed that the central government, by a policy of stimulus and restraint, could smooth out the ups and downs of the economy and that government activity was needed to keep the economy operating at a level of prosperity for all. Despite Keynes' erudition the performance did not live up to the promise. In fact, government policies are not simply a choice between high inflation (and low unemployment) on one hand and low inflation (and high unemployment) on the other. The late 1960s and 1970s brought both high inflation and high unemploy¬ ment in a stagnating economy. Economists James Gwartney and Richard Stroup observe that just as Adam Smith set the stage for the free trade environment in the nineteenth century, so did the Keynes¬ ian macroeconomic thinking establish "the foundation for the poli¬ cies which provided us with the inflation, unemployment, and stagnation of the 1970s."2
Before the Reagan Administration embraced supply-side econom¬ ics, the foundation had been established by such luminaries as Professor Arthur Laffer of the University of California, journalist Jude Wanniski, and Congressman Jack Kemp of New York. Accord¬ ing to their approach, a tax cut would do more than just cut taxes and reduce government revenue; a tax cut could also be used to in¬ fluence certain desirable behavior. The Laffer Curve posits two rates that produce the same revenues. The task of political leaders, accord¬ ing to the theory, is to find that rate which maximizes income growth while allowing the distribution of income consistent with welfare.
The Laffer Curve has political as well as economic consequences. Wanniski believes that the Republican Party forgot this economic lesson (1) when it supported the the Smoot-Hawley Tariff in 1930, thus aggravating the severity of the Great Depression, and (2) later when President Eisenhower in 1953 opposed H.R. 1, which would have resulted in a 20 percent across the board tax cut in 1953. Thus, Wanniski reasons, the way for the Republican Party to grow is through embracing the Laffer Curve with a commitment to economic growth, not redistribution, and this political road will lead to a Republican renaissance.3 Congressman Jack Kemp views the challenge
3
Critical Issues & Decisions
of the 1980s as one of exciting the "vital qualities of human ingenu¬ ity and pressing ahead to gain the necessary tax and monetary re¬ forms which will premit growth."4 And political columnist David S. Broder has described the Reagan-Laffer-Wanniski-Kemp program as essentially a "new doctrine of growth and incentives, keyed to lowered tax rates and less regulation."5
In addition to the tax policy, the Reagan Administration program will involve government executives in another new role— the shift of the focus on certain current programs from the federal government to administration by the states via the "block grant" program. While making no claims that federal administration is automatically less efficient than state administration, the tacit thesis behind the program is that greater decision-making powers should be located close to the people who will be affected by the program.
The shift in decision-making power to state and local governments is an outgrowth of the ongoing debate in American society over the proper role of government. In writing an introduction to a book on the problems and recommended policies for the next decade, Hoover Institution scholars Peter Duignan and Alvin Rabushka note that the American political climate is turning away from the ortho¬ doxies of the 1960s and 1970s (dramatic growth in legislation, government regulation, public sector spending, and bold new policy initiatives in a host of social areas), while government in the 1980s is likely to remain more circumspect and less likely to spend beyond its fiscal means than in the past two decades.6 Professor James Q. Wilson has documented the harmful side effects of overregulation 7 Milton and Rose Friedman have espoused a number of new pro¬ posals promoting private sector involvement over public sector intervention.8 And two college economics professors, James T. Bennett and Manuel H. Johnson, advocate a greater reliance on the private rather than public sector to produce goods and services more efficiently.9
The Reagan Administration's foreign policy will enhance the role of the Defense Department and give a different orientation to the State Department. The outlines of new policies are clearly visible: a harder line against Soviet aggression; a renewal of ties with U.S. allies throughout the world; renewed efforts against internal terror¬ ism; a shift in the human rights policy which will balance it with
4
Critical Issues & Decisions
national security considerations; and especially a stronger national defense establishment as a preparation for any renewed arms limita¬ tion talks. Government executives will be dealing with these new policies at the Defense and State Departments, the Central Intelli¬ gence Agency, the Peace Corps, and U.S. embassies throughout the world. A post-Vietnam syndrome left the United States meek and timid in world affairs. The resolution of the Iranian hostage crisis, criticism of Soviet aggression (e.g., Afghanistan) and a renewed interest in combating terrorism and revolution in Latin America reflect certain new directions already in foreign policy. During the 1960s and 1970s there was a hostility toward the U.S. role in world affairs from the intellectual class and the media. A shift has taken place in public perceptions of the U.S. role— a shift which became evident during the 1980 presidential campaign. And a perceptive observer such as Commentary editor Norman Podhoretz views the shift as one away from a cult of appeasement to a "new national¬ ism," represented by a stronger defense establishment and agrowing concern with the increasing strength and hostile actions of nations like the Soviet Union.1 0
Will these ideas in domestic and foreign policies be incorporated into workable programs for the 1 980s? Only the actual events of the next few years will be able to answer that question decisively. Ac¬ cording to Peter Steinfels, intellectuals serve as advisors to office¬ holders and political candidates, write speeches, propose programs, draft legislation, and serve on special commissions. The mass media amplify ideas for a wider audience. Steinfels assigns two major tasks to these intellectuals: (1) they lend to officeholders their expertise in particular fields of public policy and work out the details of political measures, and (2) as the traffickers in society's symbols and values, they legitimize these ideas and policies. While noting that politics is the art of the possible, Steinfels warns against underestimating the crucial role that thinkers, writers, and artists have in defining for practical men just what is possible.1 1
Dr. Russell Kirk, whose 1953 work The Conservative Mind pro¬ vides a history of conservative thought, notes that in the United States and Britain it takes at least three decades for a body of convic¬ tions to be expressed, discussed, and incorporated into public policy. He dates the American intellectual renewal of conservative ideas to
5
Critical Issues & Decisions
1 2
about 1950. Herbert Stein notes that for years "big tax cuts, bal¬ anced budgets and indiscriminate references to getting government off our backs" have been a platform to get into office, but now conservatives will "have to discover what they want to stand on."13
The speakers in the "Critical Issues and Decisions for Govern¬ ment Executives" series represent a broad spectrum of expertise on public policy. The nature of supply-side economics has been described by two speakers: Dr. Charles T. Schultz and Dr. Don Paarlberg. Examining detente and alternatives to it constitutes the focus of the address by Dr. Robert L. Pfaltzgraff, Jr. The broader policy questions concerning our constitutional government are explored by Dr. Robert A. Goldwin. And finally an attempt to take a long-range look into the 1980s and the future beyond is provided by Dr. William Branson. Over 25 senior level government officials attended each session, asked questions, participated in the discus¬ sions, and then, breaking into separate teams, submitted commentary on each topic. That commentary is included in this book. A list of the participants, who brought a wide range of views and experience to this process, is also included. Hopefully, these senior-level officials will take the information and the spirit of the program back to their agencies.
This seminar sought to allow the participants to identify better the key social, economic, and political forces and problems, evaluate the implications of these forces and problems for governmental and private sector policy decisions, develop other strategies for dealing with the critical issues discussed in this seminar, and describe the complex interrelationships of the issues and thereby the difficulty of attempting to resolve them independently of one another.
The USDA Graduate School has conducted the "Critical Issues and Decisions" course previously and issued collections of these pro¬ ceedings in 1961, 1963, 1964, and 1967. This volume marks the twentieth anniversary of the series.
As we continue to observe and reflect on the Reagan Administra¬ tion, it is clear that this Administration has an operative Conservative philosophy and agenda which greatly influences its policies. President Reagan has made this clear in numerous statements, but particularly clear in his address to a gathering of his long-time supporters at the
6
Critical Issues & Decisions
Conservative Political Action Conference on March 20, 1981, at the Mayflower Hotel in Washington, D.C. The President related:
For whatever history does finally say about our cause , it must say: The conservative movement in twentieth century America held fast through hard and difficult years to its vision of the truth.
And history must also say that our victory , when it was achieved , was not so much a victory of politics as it was a victory of ideas , not so much a victory for any one man or party as it was a victory for a set of principles— principles that were pro¬ tected and nourished by a few unselfish Americans through many grim and heartbreaking defeats.
We have come to a turning point. We have a decision to make. Will we continue with yesterday's agenda and yesterday's failures, or will we assert our ideals and our standards, reaffirm our faith, and renew our purpose? This is a time for choosing. 1 4
Having abandoned "yesterday's agenda and yesterday's failures," will the Reagan conservatives successfully translate their ideas into realistic policies that will solve the problems to meet the challenges of the next decade? This book attempts to provide some guidelines in answering that question.
1 Henry Steele Commager, The Empire of Reason: How Europe Imagined and America Realized the Enlightenment, Garden City, New York: Anchor Press/Doubleday, 1978, p. XI.
o
James Gwartney and Richard Stroup, "The Creation of Economic Chaos: In¬ flation, Unemployment, and the Keynesian Revolution," The Intercol¬ legiate Review, 16 (Fall/Winter, 1980), No. 1, p. 3. An article which re¬ futes the Keynesian interpretation of the Great Depression as a breakdown of the old economic order built on free markets and competition can be found in Hans Sennholz's "The Great Depression: State-Caused Chaos,"
7
Critical Issues & Decisions
Perspectives on Public Policy by the Council for a Competitive Economy, reprinted from the April 1975 issue of The Freeman , published by the Foundation for Economic Education.
3Jude Wanniski, The Way the World Works, New York: Simon and Schuster, 1978, pp. XII, 301. Irving Kristol, a leading neoconservative, has called the book the "best economic primer since Adam Smith."
4Jack Kemp, An American Renaissance: A Strategy for the 1980s, New York: Harper and Row, 1979, p. 194.
5 David S. Broder, Changing of the Guard: Power and Leadership in America, New York: Simon and Schuster, 1980, p. 171. The supply-side approach is put in historic perspective by Tom Bethel I , "The Death of Keynes: Supply-Side Economics," National Review XII (December 30, 1980), No. 26, pp. 1560-1566.
6Peter Duignan and Alvin Rabushka, The United States in the 1980s, Stanford, California: Hoover Institution, Stanford University, 1980, pp. XIX, XXVIII.
7James Q. Wilson (Editor), The Politics of Regulation, New York: Basic Books Inc., 1980.
o
Milton and Rose Friedman, Free to Choose: A Personal Statement, New York: Harcourt Brace and Jovanovich, 1980.
9James T. Bennett and Manuel H. Johnson, Better Government at Half the Price: Private Production of Public Services, Ottawa, Illinois: Caroline House Publishers, Inc., 1981.
10Norman Podhoretz, The Present Danger, New York: Simon and Schuster, 1980, pp. 86-89.
11 Peter Steinfels, The Neoconservatives: The Men Who Are Changing America’s Politics, New York: Simon and Schuster, 1979, pp. 6-7. Steinfels presents some examples of how the legitimating process which creates an intellec¬ tual atmosphere occurs: "Daniel Bell writes a book and a syndicated columnist appropriates its theses for his Bicentennial musings. Irving Kristol derides a 'new class' of liberal intellectuals for its snobbish attitude
Critical Issues & Decisions
toward a business civilization, and Mobil Oil incorporates this idea in its public relations advertising. Alexander Bickel, Yale University Law School professor, writes an article on the failure of school integration in the North, and a White House aide refers to it twice in a 1970 memo to Nixon arguing that 'the second era of Re-Construction is over; the ship of integration is going down; it is not our ship. . .and we ought not to be aboard.' " Ibid., p. 6.
12Russell Kirk, The Conservative Movement: Then and Now, Washington, DC: The Heritage Foundation, 1980, pp. 2, 10.
1 3
Herbert Stein, "Economic Policy, Conservatively Speaking," Public Opinion, 4 (February /March 1981), No. 1, pp. 2-3.
14"A Tribute to the Conservative Movement," National Review XXXIII (April 17, 1981), No. 7, pp. 402-403.
9
Critical Issues & Decisions
CHARLES L. SCHULTZE
Senior Fellow at the Brookings Institu¬ tion. During President Carter's term. Dr. Schultze served as Chairman of the Coun¬ cil of Economic Advisors. He has also been Director of the U.S. Bureau of the Budget and taught economics at the University of Maryland and the Univer¬ sity of Indiana. Mr. Schultze is the author of many articles on economics and poli¬ tics.
From left to right: Albert J. Planagan, Director, Commerce Action Groups for the Near East, Department of Commerce; Neil B. Christianson, General Engineer (Logistics Specialist), U.S. Air Force; Dr. Clare I. Harris, Acting Associate Direc¬ tor, S&E, USDA/SEA; and Edward I. Reinsel, Agricultural Economist, USDA/ ESS. Not in picture: Robert F. Fagin, Director, Office of OMI, Department of Housing and Urban Development.
Critical Issues & Decisions
THE INTEGRATION OF DEMAND AND SUPPLY SIDE POLICIES* *
Charles L. Schultze
Economic policy must place greater emphasis on supply-oriented measures during the decade of the 1980s for a number of reasons. First, an increase in the growth of aggregate supply, and especially in the growth of productivity, can raise the growth of output and employment that is consistent with a steady reduction in inflation. Second, reducing this country's vulnerability to higher oil import bills will require a substantially increased investment in alternative energy sources over the next 10 years. Finally, even if inflation were not a problem, a speed-up in the lagging rate of productivity growth would be essential to maintain the historic advance in our standard of living.
The remainder of the chapter summarizes what has been happen¬ ing to productivity in the United States and briefly examines some of the reasons why the rate of productivity growth has declined. It also examines the need to increase the share of national resources allocated to capital formation and the Administration's response to that need. Finally, it discusses the relationship between demand- and supply-side policies and suggests how they must be integrated.
Advances in productivity are the foundation of advances in our standard of living. Increases in output per worker lead to increases in real income. Healthy increases in productivity can free the funds needed to improve the conditions of disadvantaged groups while lessening the need for sacrifice elsewhere. Thus, when productivity growth declines, these other advances are delayed. But expectations of a rising living standard persist. They perpetuate demands for real income gains which can no longer be met and which lead to in¬ flationary increases in wages and to growth in government spending.
Since the mid-1970s, the growth rate of labor productivity has been declining from its post-World War II highs. In recent years
Senior Fellow, The Brookings Institution, Washington, DC
* Excerpts from the Economic Report of the President, 1981
13
Critical Issues & Decisions
the decline has been so marked as to pose a major challenge to public policy. Because declining productivity growth brings with it prospects for slower improvement in our standard of living and contributes to inflation, a program to stimulate productivity growth must be a keystone of economic policy.
Table 1 summarizes the post-war history of growth in productiv¬ ity. The data show a gradual worsening of the productivity decline as time has passed, with the last few years showing sharp declines. While just-completed revisions of the data may change the magni¬ tude and timing of the slow down, its existence and its costliness are unarguable.
Table 1. Labor Productivity Growth, 1948-80
(Percent change per year)
Sector
1948 to
1 -
1965 to
1973 to
1978 IV to
1979 III to
1965
1973
1979
1979 IV
1980 III
Private business sector. . .
3.2
2.4
0.8
-0.9
-0.1
Nonfarm .
2.6
2.2
.6
-1.1
.1
Note: Data relate to output per hour for all persons. Source: Department of Labor, Bureau of Labor Statistics.
Some of the decline in productivity results from the way we measure it. In particular, productivity measurement counts as an in¬ put among the costs of governmental and private actions to ensure a cleaner environment, a healthier workplace, and safer consumer products, but it does not count the benefits of these actions as forms of output.
It is difficult to interpret measures of productivity such as those in Table 1 without first distinguishing between changes caused by the business cycle and changes caused by longer-term factors. Be¬ cause it is costly to hire or fire, businesses typically do not reduce their work force proportionally when demand slackens or increase it
14
Critical Issues & Decisions
proportionally when demand is expanding. Chart 1 presents the recent history of productivity growth after correction for these cyclical influences. As the chart vividly shows, productivity grew very slowly during most of the years since 1973 and on several occasions actually declined.
Chart 1. Productivity Adjusted for Cyclical Variation
1965 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80
Note: Data are for private nonfarm business. AM persons.
Source: Council of Economic Advisers.
It would not be surprising to discover that the slowdown has many causes. Measured productivity growth is a distillation of a number of changes and influences. Many researchers have been in agreement that a number of factors have contributed in roughly equal magnitude to the slowdown. These factors have been dis¬ cussed in past Reports. In addition to increased governmental regula¬ tions, particular attention has focused on increases in energy prices,
15
Critical Issues & Decisions
declines in the rate of growth of capital relative to labor, and de¬ creases in spending on research and development. But there has also been widespread agreement that a large portion of the slowdown has not yet been explained.
One of the causes of the decline in productivity growth has been the decline in growth of the capital stock relative to the labor force. Because a rising share of capital formation has been devoted to ad¬ justments to cope with higher energy prices and comply with en¬ vironmental and safety regulations, a diminishing fraction of in¬ vestment has been available to effect gains in productivity. Although these developments may not have been the primary causes of the productivity slowdown, increasing capital formation would never¬ theless be an effective way of reversing the slowdown. Many of the factors affecting productivity cannot be directly or immediately influenced by the government, but economic policy— especially tax policy— can influence the pace of capital formation.
As a rule, an increase in the amount of capital invested per worker is associated with an increase in output per worker, that is, in in¬ creased productivity.
There are two reasons for this. First, processes that generate more output per worker usually require more capital per worker, and second, increasing the ratio involves putting newer capital into place. The newer capital is likely to embody more advanced technology and will therefore increase the efficiency of the capital stock.
During the 1960s the capital-labor ratio grew at an average rate of about 3 percent per year; over the last 5 years, however, the ratio has remained roughly constant. This development has been due to both the slower growth in the capital stock and the more rapid growth in employment and hours worked (Table 2). The 1974-79 de¬ celeration in the growth of capital is somewhat at odds with the rough stability in the investment share of GNP over the same period and requires some explanation. A greater share of investment is now being spent on relatively short-lived assets. The ratio of investment in equipment to investment in nonresidential structures has increased in recent years. The result is that each dollar of gross investment now yields less net investment because the capital stock is depreciating more rapidly.
16
Critical issues & Decisions
Table 2. The Investment Share and Growth in the Capital-Labor Ratio
1949-1979
Real business fixed investment as percent of real GNP1
Percent change, average annual rate (end of year to end of year)
Period
Net capital stock (non-
o
residential)
Employ¬
ment3
Hours3
Capital
employ¬
ment
ratio
Capital
hours
ratio
1949-59
9.1
4.0
1.1
0.7
2.9
3.2
1959-69
9.8
4.6
1.6
1.2
3.0
3.3
1969-74
10.5
4.2
1.2
.5
2.9
3.7
1974-79
10.3
3.0
3.1
2.8
-.1
L
.2
Average annual i nvestment— GNP ratio, in percent.
2
Net fi xed nonresidential business capital, 1972 dollars, end of year.
3
For private business, all persons. End of year calculated as average of year's fourth quarter and following year's first quarter.
Sources: Department of Commerce (Bureau of Economic Analysis) and Department of Labor (Bureau of Labor Statistics).
To restore the growth of the capital stock per worker to that of the 1960s would require that the share of investment in GNP rise by at least 1 percentage point from its recent average of about 10.5 percent. Such a development should, at a minimum, restore the productivity growth lost from this source. Further improvement would require yet more investment.
Apart from the necessity of improving the productivity growth rate, there are other reasons why future economic policy should encourage increased investment. Last year's Report discussed these needs in detail. The average age of the capital stock at the end of 1979 was 7.1 years. This suggests that much of our plant and equip¬ ment was put in place when oil prices were much lower than they are now. Higher energy prices have shortened the service life of older and less energy-efficient capital and have made the speeding up of its replacement nationally beneficial. The magnitude of these in-
17
Critical Issues & Decisions
vestments is difficult to estimate, but it could represent another 1 percent of GNP per year.
Additional investment requirements arise from the need to con¬ tinue domestic production of oil, coal, and natural gas at sharply higher investment costs per unit of energy produced and to expand the investment devoted to alternative energy sources. Conservatively estimated, they amount to another. 5 percent of GNP.
During the late 1960s and early 1970s, before the first surge in oil prices, real business fixed investment averaged about 10.5 percent of GNP. In 1978-79, the investment share averaged slightly higher, around 10.75 percent, probably reflecting additional investment in the energy industries. On the basis of a rough judgment, continued investment of about 10.5 percent of GNP would meet the "normal" requirements of a moderately growing economy and hold the capital stock per worker approximately constant, as it has been in the past 5 years. But it would not provide for an expansion of capital per worker or for the nation's increased needs for energy investment.
Meeting these objectives will require much greater investment. Since the growth of aggregate demand and total GNP will be con¬ strained in the years immediately ahead by the need to reduce in¬ flation, the extra investment cannot come from additional GNP growth but will have to displace consumption or government spend¬ ing, the other major components of GNP. According to the estimates presented earlier, the share that investment takes in total output will have to rise substantially from a normally expected 10.5 percent or so to 12.5 or 13 percent, and the combined share of consump¬ tion and government spending will have to fall by a corresponding amount.
It is virtually certain that such a large increase in the investment share will not occur without deliberate government policies. The major elements of such a policy lie in a combination of federal tax measures and expenditure control. In the future, federal personal tax receipts will take a steadily increasing share of personal income as inflation pushes taxpayers into higher brackets. As oil prices are decontrolled, revenues will be transferred from purchasers— who will pay the higher prices— to the federal government through the wind¬ fall profits tax. For both of these reasons the ratio of taxes to GNP will tend to rise and the growth of consumption will fall. If federal
18
Critical Issues & Decisions
expenditures are controlled so that their share of GNP does not rise, periodic tax reductions will be possible. Indeed, they will be necessary to prevent even moderate economic growth from being choked off. If a sizable fraction of those tax reductions concentrates on encouraging investment rather than restoring the growth of con¬ sumption, the share of investment in GNP can be raised. Of course, if the share of federal expenditures in GNP is not merely stabilized but reduced, the room for increasing the investment share of GNP through investment-oriented tax cuts will be even larger.
Within this framework, tax reductions designed to increase the share of investment in GNP must meet two requirements: they must increase the demand for investment goods, and simultaneously they must increase saving, that is, they should not increase consumption. These two requirements are closely related, but they are not the same. There are a number of measures that might seek to increase saving but have little, if any, effect on the volume of business invest¬ ment. Forgoing tax cuts, letting effective tax rates increase, and creating a large federal budget surplus, for example, would appear to be one way of increasing national saving. Although such a policy would make possible a decline in interest rates, it would also create a substantial fiscal drag, reduce economic growth and private saving, and probably yield no increase in business investment spending. Conversely, measures that increase investment demand without making room for it with an increase in saving will yield an excessive growth in total demand and renewed inflationary pressure. Both aspects of the problem are important. Given the determinants of investment, what tax policies can best increase the demand for investment goods? What form of tax reductions is most likely to be channeled into saving rather than consumption?
Expectations about future growth are critical in determining the volume of investment demand for the economy as a whole. But the discussion above suggests that investment needs to increase by more than the amount that would be associated simply with a normal expansion of output. A number of factors influence the amount of capital that firms want to use to produce a given amount of output. Chief among them are the attractiveness of the return on capital investment compared with other uses of investors' funds, the per¬ ceived riskiness of corporate investment, and the cost and availability of capital.
19
Critical Issues & Decisions
The experience of recent years demonstrates the deleterious effects inflation can have on investment. High inflation rates increase the perceived riskiness of investment, and this increased uncertainty makes planning for future capita! needs more difficult. The informa¬ tion about relative demand that is contained in price changes be¬ comes clouded when inflation is high. In addition, increasing rates of inflation are ordinarily accompanied by the expectation of sharply higher interest rates and monetary stringency. The expected slowing of growth in demand reduces the incentive to add capacity.
But by far the most important effect of inflation on investment is its impact on tax accounting provisions and depreciation allow¬ ances. Depreciation is a cost of earning income from fixed capital assets. This cost is the reduced value of the asset due to use, aging, and obsolescence. The depreciation allowed for tax purposes is based on the historical cost of an asset. When inflation occurs, allowable depreciation is reduced relative to the cost of replacing the asset at today's price. Inflation therefore raises the tax on capital and reduces the rate of return on investment, and this problem worsens as the rate of inflation increases.
The inflation-induced increase in the tax on income from business plant and equipment is partly offset by the inflation-induced reduc¬ tion in the tax burden of borrowers. Firms are allowed to charge the full value of their interest payments against income, even though a portion of these higher interest payments amounts to the repayment of real capital to lenders. The effect on the return to investment of this "excess" deduction varies with the proportion of investment that is debt-financed. It also varies with the extent to which infla¬ tion is reflected in interest rates. Since an important part of invest¬ ment is not debt-financed, clearly inflation's tax-increasing impact on the value of depreciation allowances outweighs the tax-decreasing impact of excess deductions on the return to business investment.
Some have suggested that the inflation-induced distortion of tax depreciation could be corrected by indexing the value of existing business assets to allow replacement— rather than historical— cost depreciation. But indexing the value of assets would ignore the in¬ terest rate offset described in the paragraph above. Moreover, as with all indexing schemes, its administrative and accounting problems would be quite severe, and almost any simple index imaginable
20
Critical Issues & Decisions
would introduce distortions of its own. For these and other reasons, indexing is not an attractive means of correcting the inflation-in¬ duced distortion in depreciation allowances.
Policymakers have three principal measures to influence invest¬ ment through the tax system: changes in depreciation allowances, changes in the investment tax credit, and changes in the corporate income tax rate.
Since the effect of inflation in depressing the value of deprecia¬ tion is such an obvious factor in the recent decline in after-tax rates of return on capital assets, the liberalization of depreciation allow¬ ances is an attractive way to enhance investment. It not only pro¬ vides an overall incentive for investment but, if carefully designed, can also correct some of the distortions in investment that accom¬ pany inflation. Under proposals for accelerated depreciation, the allowable depreciation on capital assets would be increased. This would permit firms to write off their capital purchases faster. The changes would affect two determinants of business investment. First, they would increase the after-tax yield of capital investment and thus its attractiveness. Second, they would increase business cash flow and thereby supply a portion of the funds needed to finance additional investment.
Increases in the investment tax credit would have a similar impact on investment incentives. The investment tax credit reduces the pur¬ chase price of eligible equipment. It thus provides a direct incentive by raising net return and by increasing after-tax cash flow.
A reduction in corporate income tax rates, on the other hand, in¬ fluences investment by increasing after-tax profits. This tends to be a less effective stimulus to investment than either accelerated de¬ preciation or increases in the investment tax credit because it has a smaller impact on the net return from new purchases of capital assets. In addition, depreciation liberalization or an increased in¬ vestment tax credit are available to a firm only to the extent it invests, but a corporate tax reduction would be available whether investment is undertaken or not.
Any increase in the investment share of GNP must be accom¬ panied by a corresponding increase in the saving share of GNP. Total national saving comes from three sources: individuals save out of their personal income; businesses retain, and thereby save, some of
21
Critical Issues & Decisions
their profit income; and governments save when they run a budget surplus or dissave when they run a budget deficit. It is total national saving that supports total investment. A portion of saving flows into residential investment, investment in inventories, and net foreign investment. The remainder is available to finance business purchases of plant and equipment.
The federal government has many policy options for changing the level of national saving and thereby supporting a higher level of aggregate investment. But it is important to realize that no one sector works in isolation. A given sector's increase in saving may be par¬ tially or fully offset by another sector's dissaving.
Personal tax cuts designed to increase specific types of saving, such as an increase in the amount of tax-free interest from passbook savings accounts, are likely to be the least effective ways to increase total saving. They will increase the flow of saving into those in¬ struments whose after-tax returns have been raised, but they will do so primarily at the expense of those forms of household saving whose after-tax returns have not been raised. They will reshuffle personal saving but increase its amount very little.
General reductions in personal tax rates would increase personal income, an increase that would itself lead to higher saving. In addi¬ tion, the higher after-tax return on saving may induce still further increases in saving. This is more likely to occur if the personal tax cuts are directed at higher-income individuals who tend to save relatively more of their additional after-tax income. But there is substantial evidence that, in any case, the personal saving rate re¬ sponds very little to changes in rates of return or in the tax structure. A large part of the personal tax reduction would therefore go toward increasing consumption.
The most effective avenue accessible to the federal government to increase the volume of saving is to reduce taxes on business in¬ come. Cuts in business taxes would lower government saving, but a large part of the tax cut would flow into business saving. Business after-tax cash flow would be increased. In time, part of the increased cash flow would lead to higher corporate dividends. A very large part, however, would be allocated to an increase in retained earnings — i.e., saving. Evidence suggests, for example, that corporations save more than 50 cents from every additional dollar of after-tax in-
22
Critical Issues & Decisions
come. Furthermore, some portion of any dividend increase would find its way into personal saving. By contrast, giving the tax cut directly to households would have a smaller effect on saving be¬ cause households are likely to save a much smaller fraction of every dollar of additional disposable income.
It seems wise, then, to focus government efforts on the sector most likely to allocate a large part of any tax relief to saving- business. A business tax cut would result in relatively large saving, and incentives to expand investment demand would simultaneously improve. It is this approach that lies at the heart of the President's Economic Revitalization Program.
The Integration of Demand-Side and Supply-Side Policies
Tax reductions which induce additional saving and investment will contribute to faster productivity growth, and this in turn will help reduce inflation. A number of critical questions arise, however, about the appropriate type, magnitude, and timing of any tax re¬ ductions. First, what kind of an increase in productivity might reasonably be expected from investment-oriented tax cuts of various sizes, and what would be the associated reduction in inflation? Second, to what extent would the improvements in productivity and other supply-creating aspects of a tax reduction offset the in¬ crease in the aggregate demand they would cause? More generally, how would tax cuts aimed at increasing supply fit into the frame¬ work of fiscal restraint required to reduce inflation?
Although the effect on investment of a given loss of tax revenues would vary with the form of the reduction (accelerated depreciation, larger investment tax credit, or lower corporate income tax rates), the evidence suggests that each dollar of reduction in annual business taxes might, at the outside and after several years, generate slightly more than a dollar in business fixed investment. To increase invest¬ ment by 10 percent, a business tax reduction of at least $30 billion— or about 1 percent of GNP— would be necessary. This larger volume of investment, maintained from 1981 through 1985, would increase the capital stock by about 5 percent after allowing for depreciation. On the basis of the historical relationships between output and
23
Critical Issues & Decisions
capital, such an addition to the capital stock might generate a total increase in the level of productivity of at most 1.5 percent by 1985, or about 0.3 percent per year. In view of the declining rate of pro¬ ductivity growth which the nation has experienced in recent years, however, this small improvement would be significant.
Such a rise in the productivity growth rate would not be likely to induce a faster rise in money wage demands. Therefore, since the growth of unit labor costs equals the increase in compensation per hour minus the rate of growth in productivity, the faster productiv¬ ity growth rate should lead to a slower rise in costs and prices. In turn, a slower rise in prices would help to reduce the growth of wages, leading to a still further slowdown of inflation. All told, an investment-oriented tax cut amounting to about 1 percent of GNP might produce a 0.3 percentage point rise in productivity growth that would translate, after several years, into just over .5 percentage point reduction in the inflation rate.
Tax reductions have two principal effects. On the one hand, individuals and firms will buy more goods and services. As a tax cut is spent and respent throughout the economy, the resulting increase in nominal GNP will exceed the orignial tax cut. As a result of this multiplier process, aggregate demand will rise by more than the tax cut. But tax cuts also increase the supply of goods and services. Since lower tax rates allow individuals and firms to keep a larger fraction of their income after taxes, the lower rates affect incentives to work, to save, and to invest the savings, thus increasing potential GNP.
Although the magnitude of the multiplier varies according to the nature of the tax cut, aggregate demand typically rises by about twice the size of a reduction in taxes. Thus, a tax cut equal to 1 percent of GNP will increase aggregate demand by about 2 percent. To match the increase in demand, a 2 percent increase in supply would also be required. To the extent that its supply response is less than the additional demand it creates, any tax reduction adds to the pressures of demand on the rate of inflation.
But there are two ways in which such tax cuts can be made while demand is still restrained. First, tax reductions may offset increases in other taxes. As discussed earlier, inflation pushes taxpayers into higher tax brackets, so that the average effective tax rate— the ratio
24
Critical Issues & Decisions
of tax revenues to GNP— rises. Consumption is depressed and eco¬ nomic growth reduced. In the years ahead, periodic tax reductions will therefore be both possible and necessary to keep aggregate demand from falling. Second, a tax reduction accompanied by federal spending reductions of roughly the same magnitude will not change aggregate demand; hence, even if the supply response to a tax cut is smaller than the demand response, inflationary pres¬ sures will not be generated.
Thus, it is clear that the design and timing of supply-oriented tax cuts depend importantly on the specific relationship between the demand-side and supply-side responses. If such tax reductions fail to generate enough supply to offset the additional demand they create— and the evidence discussed below suggests that this is the case, particularly for personal tax reductions— they must then be integrated like any tax cut into policies of demand management.
A 10 percent reduction in marginal tax rates on individuals (ap¬ proximately a $30-b i 1 1 ion personal tax cut in 1981) would increase the total demand for goods and services by $60 billion, or 2 percent of GNP. It. could also lead to increase in individual work and saving in response to the lower tax rates and thereby increase potential GNP. How much of the increase in demand would be matched by such increases in supply?
The additional production that results from lowering taxes on labor income depends both on changes in the quantity of labor supplied (for instance, the total number of hours worked) and on changes in the average productivity of labor.
Higher after-tax wages make work more attractive. This en¬ courages new entrants to join the labor force and those already employed to work longer hours. Since after-tax incomes have risen, however, people can also afford to work less— to take longer vaca¬ tions or to shorten their workweeks. Whether the former effect would or would not exceed the latter effect is hard to predict. The preponderance of evidence suggests that for adult men the two effects approximately offset each other; that is, a cut in income taxes increases the supply of adult men in the work force only slightly, if at all. Women, on the other hand, and particulary married women, respond much more strongly to higher wages. In the past, the num¬ ber adult women in the work force may have increased by as much as
25
Critical Issues & Decisions
1 percent for every 1 percent increase in take-home pay. Although women are more responsive to changes in their wages than are men, men still outnumber women in the labor force and on the average earn substantially more. Therefore, a reduction in personal income tax rates would increase the total supply of labor only slightly.
Whether an increase in the labor supply would be accompanied by an increase in productivity is uncertain. While most business investment enhances productivity, an increase in the labor supply would not improve productivity unless it increased the average quality of work performed or the intensity of effort. Productivity might actually fall as the supply of labor increased if the additional labor supply consisted, on balance, of less skilled or less experi¬ enced workers.
On the other hand, some have argued that the increased supply of labor from high-income, high-productivity workers would out¬ weigh the increased supply from other workers, so that the average productivity of the labor force would rise. This could happen if high-productivity workers were more sensitive to a given percentage change in after-tax earnings, or if the tax reduction represented a larger percentage change in their take-home pay. Since high- income workers are a small fraction of the labor force, these in¬ fluences would have to be large to alter total productivity signifi¬ cantly. Studies of high-income workers generally do not find them much more responsive to equal percentage increases in after-tax income. However, a 10 percent across-the-board reduction in tax rates would also mean a larger percentage increase in the after-tax earnings for these workers because their households are in high marginal tax brackets. A 10 percent tax cut is, therefore, likely to produce a somewhat larger change in the supply of high-income workers. Still, even in high-income households it is in fact second- income earners— generally those who have lower productivity— who are apt to be the most responsive to lower tax rates.
Given these two opposing forces— the lack of experience of new workers and the possibility of a greater-than-average influx of higher- income workers— it seems unwise to assume that a personal tax cut will improve the average productivity of the labor force.
With all the relevant factors taken into account, the limited response of the supply of labor and of productivity to a 10 percent
26
Critical Issues & Decisions
reduction in personal income tax rates is likely to produce an in¬ crease in potential GNP of perhaps 0.2 percent to, at the most, 0.6 percent. This result follows in part from evidence suggesting that such a tax cut would induce an increase in labor supply between 0.3 and 1.0 percent. According to past relationships between labor and production, such an increase in labor supply would lead to the modest increase in potential GNP mentioned above.
A reduction in personal income tax rates increases both the in¬ come out of which an individual worker can save and the after-tax return to saving. It would also tend to discourage borrowing by re¬ ducing the value of the income tax deduction for interest payments. If the increases in personal saving find their way into additional business investment, productivity will rise.
Most empirical studies have concluded that changes in personal income tax rates would have only a small effect on personal saving. At best, a 10 percent reduction in tax rates would increase personal saving less than 3 percent. This means that the saving rate— the average share of personal saving in disposable income, which over the last 5 years has averaged 5.7 percent— would rise by no more than 0.2 percentage point. The additional saving would at most be equivalent to only about 0.2 percent of GNP.
Even if every dollar of personal saving that resulted from a 10 per¬ cent tax cut were invested in business plant and equipment— and some, in fact, would flow into housing— the effects on output and on productivity would be small. If the tax cut and the higher saving continued for 5 years, the additional saving and investment would increase potential GNP by less than 0.3 percent and lead to a neg¬ ligible increase in the annual rate of productivity growth.
This examination of likely responses thus suggests that even under the most optimistic circumstances, a 10 percent reduction in tax rates would not induce enough additional work, saving, or invest¬ ment to offset more than a fraction of the 2 percent increase in aggregate demand that would accompany the tax cut.
It was pointed out earlier that a tax cut that liberalized the busi¬ ness depreciation allowance or increased the investment tax credit could, after a time, have a fairly substantial effect on the nation's productive potential output by perhaps 1.5 percent over a 5-year period.
27
Critical issues & Decisions
This, however, would still be less than the 2 percent rise in ag¬ gregate demand that would also be generated. More importantly, the increase in demand would come relatively quickly, most of it within 1.5 to 2 years. The increase in supply, on the other hand, would occur very gradually. As a consequence, the tax cut would tend to increase demand pressures, especially in the years immedi¬ ately following it. While tax reductions that are effective in raising investment are essential in a long-term strategy to promote economic growth, business tax cuts, like personal tax cuts, must fit into an overall framework of fiscal restraint.
This analysis of the macroeconomic effects of federal tax reduc¬ tions suggests several conclusions for the development of fiscal policy:
First, specific investment-oriented tax reductions for business are likely to increase saving, investment, and productivity by a much more significant degree than cuts in personal income taxes.
Second, productivity-oriented tax reductions will yield improve¬ ments in the inflation rate that are helpful and significant, but still relatively modest if the underlying inflation rate is 10 percent.
Third, the supply response, while a critically important feature of any tax reduction, will be substantially less than the demand response, particularly in the short run.
Fourth, since reductions in both business and personal taxes will increase demand faster than supply, they must be designed and carried out in ways that are consistent with the demand restraint needed to reduce inflation.
It is sometimes alleged that the potentially inflationary effects of a large tax cut can be avoided if the Federal Reserve steadfastly pursues its goal of keeping the growth of the monetary aggregates within tight targets. But if taxes are reduced while the Federal Reserve pursues an unchanged monetary policy, aggregate demand will nevetheless increase, especially in the short run. The increase in demand will lead to a rise in interest rates that would dampen the increase in aggregate demand but not eliminate it. Additional inflationary pressure would then result.
A very large tax cut without the necessary spending cuts would lead to both an increase in inflation and a sharp rise in interest rates. Some, and perhaps all, of the stimulus to investment from tax
28
Critical Issues & Decisions
reductions would be undone by the higher interest rates and the greater uncertainty engendered by a new round of inflation.
Monetary restraint is absolutely essential to the reduction of in¬ flation. Tax measures focused on increasing supply can made a significant contribution. But there will be a continuing need for careful and prudent fiscal policies to restrain demand. In recent years the nation has come to appreciate the potential value of supply-oriented tax policies. In the process of learning some needed lessons about supply-side economics, however, the nation cannot afford to forget its hard-learned lessons about the need for demand- side restraint.
29
Critical Issues & Decisions
PUTTING THE SUPPLY AND DEMAND SIDES OF ECONOMICS TOGETHER
Commentary
There are different schools of thought about the effects of budget¬ ary and monetary policies on an economy. One, which we can call the demand side, stresses effects on purchasing power. Another, which we can call the supply side, stresses incentives to produce. Let us examine each of these in turn and focus on the likely con¬ sequences for prices and quantities.
An important economic problem is that, as public and private actions are taken to increase output, prices tend to increase. If we let P represent an index of the general price level, and Q an index of aggregate output/then the relationship between the price level and aggregate output may be represented on a graph:
Figure 1
The flat part of the graph suggests a range in which output can be increased without concern for inflation. This range, however, may be one in which unemployment is the paramount concern. As output increases, a range is reached in which inflation becomes a problem. This inflationary range may or may not include unemployment.
30
Critical Issues & Decisions
The upward sloping part of the graph reflects inflationary pres¬ sures in an economy approaching full employment of plant and labor force, at least in some sectors. Among the several structural factors which help to explain a rise in the general price level as out¬ put expands is wage rigidity. Wage levels tend to resist downward pressures. When relative prices change, wages may ratchet upwards, but they tend not to move down. Wage rigidity is partly explained by government policies put in place since World War II to expand the economy and to protect or bail out disadvantaged firms or in¬ dividuals. In addition, modern industry is simply not organized according to the textbook descriptions of a perfect market. Labor is a fixed asset that costs something to train and that a firm does not want to lose. Wage bargains, rather than competition, set rates. Product prices, too, are sluggish on the down side and tend to ratchet upward, given the rules by which firms operate in our complex economic system.
Our discussion of the demand and supply sides of economics will reflect different views about how an economy moves along the curve shown in Figure 1 and about how it shifts the curve to a different location. Let us take up the demand side first.
The demand side view of a tax cut is that it puts more purchasing power into the private sector. A rise in household and business in¬ comes after taxes increases spending as well as saving. The increase in demand for consumer and investor goods may call forth more production. But the economy may be in the range of Figure 1 in which it calls forth higher prices as well. An increase in govern¬ ment purchases instead of a tax cut has a similar expanding effect on the economy; the difference is that increased government spend¬ ing leads toward a relatively larger public sector, whereas decreased taxes lead toward a relatively larger private sector.
The initial increase in public and private spending resulting from an increased government deficit induces additional rounds of spend¬ ing through a process known as the multiplier effect. The recipient of the first round of spending saves some and respends the rest on a second round. That recipient respends some on a third round, and so on. Because some income is saved on each round, the successive rounds become smaller and smaller. The cumulative effect of indirect inducements to spend may be twice the initial increase in purchasing power.
31
Critical Issues & Decisions
If the money supply is held constant after a tax cut or spending increase, more of the existing supply is required for transactions and less remains for portfolio management. With a rising demand for money, interest rates rise. The rise in interest rates is a disincentive to consume or invest, and it limits the extent of the expansion in output. It also adds to costs of production and can put upward pressure on the general price level.
Hence, deficit spending (tax cuts or expenditure increases) needs to be accompanied by an accommodating easy monetary policy if the full output-increasing effects of the policy are to be realized. Similarly, if the economy is experiencing inflation (that is, if the economy is far to the right on the curve in Figure 1), then price increases can be moderated by budgetary surpluses (tax increases or expenditure cuts) and tight monetary policy (high interest rates). These curtail output while easing price pressures. If the government has budget deficits during a period of inflation and relies entirely on tight monetary policies to fight inflation, imbalances can occur.
The supply-side view of a tax cut is that it provides incentives to save and invest, to work, and to increase output. Higher disposable personal income from additional work encourages more full- and part-time entrants into the labor force and encourages additional effort from those who have jobs. Higher after-tax incomes to families encourage an increase in individual saving. Higher after-tax incomes to business induce investment, not only of the increase in cash flows but also of individual savings.
Supply-side incentives to increase investment, productivity and output are more sensitive to a change in marginal tax rates than to a change in average rates. Under a progressive tax system, the marginal rate is higher than the average rate for each individual taxpayer. A reduced average rate with no change at the margin can be affected, for example, by an increase in exemptions. This reduces the tax on existing income and investments, some of which adds to saving and to possible new investment, but it does not induce added work or investment to the extent that a reduction of the marginal tax rate would. In the extreme, a poll tax provides the greatest marginal inducement to invest because the additional tax on additional in¬ come is zero.
32
Critical Issues & Decisions
With little or no inflation, a tax cut will lead to increased output and employment by means of a move to the right along the flat part of the curve in the figure. With inflation, the increased incentive to produce will shift the upward sloping part of the curve so that addi¬ tional output, which can ease inflationary pressures, will be realized. The process of saving is not the same as that of investing. Supply- side economics attends to inducements to save and inducements to invest. The main policy instrument is a tax cut. The main route to limiting inflation is to induce more saving and investments which increase productivity and output, reduce costs, and limit upward pressure on prices.
Now, how do we put these two sides together? Clearly, a tax cut will produce a movement along the curve shown in the figure as well as a shift in the curve. The cut can encourage more demand; it can increase productivity and output; it can add to costs to the extent that higher interest rates are costs of production and consumption; and it can reduce costs to the extent that taxes are costs. Let us focus on the prospective shifts in supply and demand. If demand increases more than output does, inflationary pressures can be expected to increase, and if supply increases more than demand does, inflationary pressures will abate in response to a tax cut.
A tax cut amounting to 1 percent of aggregate income is likely, through the multiplier effect of demand-side economics, to induce a 2 percent increase in demand. If supply increases by more than 2 percent, there will be no abatement in inflationary pressures. If supply increases less than 2 percent, inflation will grow.
If one assumes diminishing returns, then the gains in productivity and output decrease as the level of investment increases. This seems to argue against the prospects of the supply effect of a tax cut's exceeding the demand effect. On the other hand, one could assume increasing returns and make a good case for the supply-side scenario. Hence, putting the two sides together turns out to be an empirical question— one for which we have very little data. Perhaps the best study of this is an econometric model which simulates the long¬ term supply response to a tax cut. This model estimates that if all of the tax cut were to go into investment, a 1 percent tax cut this year would be likely to induce an increase in supply of 1 to 1.5 percent, and this would be attained over a five-year period. This
33
Critical Issues & Decisions
suggests considerable inflationary pressures in the short run that become moderate but positive in the long run. If all of the tax cut were to provide work incentives instead of saving and investment incentives, supply might increase on the order of .5 percent. This includes incentives to join the labor force as well as to increase efforts of those with jobs. It supposes that marginal increments of added work will add less to output than the average output of all employment.
The conclusion is that any tax cut alone, when supply and demand side effects are both accounted for, will have more of a demand ef¬ fect than a supply effect. As long as the economy is close to capacity it will, therefore, be inflationary. To avoid this result, when there is inflation a tax cut must be accompanied by spending cuts. Further, since the government budget is now in deficit, spending cuts might better precede and/or exceed any tax cuts in order to reduce the degree of reliance on monetary policy to offset an inflationary budget deficit. Otherwise the money supply must be managed so as to maintain high interest rates, with their disincentives to invest and their additions to costs of production and consumption.
The U.S. economy still suffers high unemployment (7.5 percent), high inflation (10 percent), high interest rates (the prime rate is around 20 percent), a feeling that the private sector needs to grow relative to the public sector, and too much regulation in certain areas. Past policies have resulted in continuing budget deficits and high interests rates. Debate over economic policy has fed to proposals for:
1 . tax cuts,
2. spending cuts,
3. deregulation, and
4. high interest rates.
Both supply-siders and demand-siders tend to arrive at the same list. But they start from different assumptions, and they view the policies as achieving their results through different channels. More important, they differ on the degree, timing, and targets of deregu¬ lation or cutting.
34
Critical issues & Decisions
My own opinion is that too much emphasis on a tax cut— which is too soon, too large, and too long-run— will exacerbate inflation. Spending cuts need to come first and/or be larger. There is con¬ siderable room for debate on which programs should be cut and which deregulated. And there is a need to get the budget policy in order so' that interest rates— which, when they are too high, can be disincentives to invesment and sources of cost-push inflation- can be reduced.
Defense
The role of the Defense Department in economic policy for the 1980s should be that of a catalyst, a catalyst in the sense that ad¬ vanced technology in the design of new weapon systems needs to be introduced into American industry. This will require the acquisi¬ tion of new weapon systems which will motivate industry to make the capital investment in the equipment needed to produce the advanced technology.
The acquisition cycle is divided into five phases: initiation, valida¬ tion, development, production, deployment, and operation. During the past several years, defense acquisitions have stopped short of production. Stopping at production does not expose industry to the new technology nor does it induce industry to put up the capital to produce a yet-undemonstrated technology. Research which com¬ prises validation and development is indeed necessary to explore new initiatives, but research soon stagnates if the new initiatives are never demonstrated. Systems with advanced technology must be produced in quantity, must be supplied to operational units and must operate in an environment that simulates normal conditions before industry can see the public use for the technology. Two im¬ portant occurrences follow each other from the production of new advanced technology: more innovations come forth, and spinoff industries spring up to fill the demand for the new technology.
35
Critical issues & Decisions
In addition to providing national security, successful demonstra¬ tion of new technology, by a multiplier effect, triggers additional ideas for applying the technology in other fields. These new appli¬ cations expand the market for the technology further and trigger still more ideas for applying the new technology outside even those fields. In turn, spinoff enterprises spring up to supply and service the consumer goods that come from the new technology. These enterprises provide the tax revenue so essential to a healthy economy.
Supply-side economics recognizes the close relationship between advancing technology and the health of the economy. With more dollars for investment through favored tax cuts and with the stimu¬ lation of advanced technology by increased military spending, a new source of tax revenue can be expected. This revenue can then be used to balance the budget and provide for the welfare of the nation.
International Trade Issues
In implementing measures to increase domestic employment, productivity, and output, one must consider the impact of inter¬ national trade. Vigorous export performance can significantly contribute to achieving these goals. In the quarter century follow¬ ing World War II, the United States experienced significant trade surpluses. Both imports and exports expanded rapidly. This expan¬ sion enabled the U.S. economy to have access to cheaper raw materi¬ als and commodities, provided for employment growth, created capital for new investment, and contributed to a rising standard of living. Recent U.S. export performance, however, has been wanting. A trade deficit of $24 billion resulted in 1980 as exports totaled only $221 billion and imports $245 billion. This deficit followed record trade deficits in 1978 and 1979. In 1981, the deficit may be reduced by several billion dollars, although an increased deficit is also possible.
In the longer term, the outlook for continued improvement is uncertain. Key developments clouding U.S. export performance include anticipated slower growth rates for the major industrial countries and the erosion of price benefits gained from the dollar depreciation in the late 1970s. The U.S. faces growing competition from the more advanced LDC's such as Korea, Taiwan, and Mexico.
36
Critical issues & Decisions
As the U.S. economy accelerates in the 1980s, demand for foreign capital goods will also rise sharply. Moreover, rising personal in¬ comes should increase the demand for foreign consumer goods.
Foreign governments have taken a more aggressive position in sup¬ porting their exporting industries than the United States has. More¬ over, U.S. industry perceives the U.S. Government as having estab¬ lished significant disincentives to exporters, thereby undermining their efforts to expand exports and compete for major foreign project contracts.
The following are key U.S. Government export disincentives fre¬ quently mentioned by U.S. industry:
• Taxation of Americans working abroad . The United States, unlike other nations, significantly taxes the income of Americans working abroad. This raises the cost of employing Americans, thus leading to either higher price quotations by U.S. firms competing for foreign contracts or the substitution of lower-cost foreign labor in place of Americans.
• Extra-territorial application of U.S. antitrust laws. American industry believes these laws effectively prohibit joint actions in situations in which several firms could join in building on a multi¬ billion dollar development project.
• Foreign Corrupt Practices Act. Ambiguities in this law, as well as the inability of small and medium-sized firms to supervise directly the actions of their overseas agents, appear to be disin¬ centives to expanding the base of U.S. exporters. Only 10 percent of the firms with the potential to export are currently export¬ ing.
• U.S. Antiboycott Laws. The U.S. has three differing sets of anti¬ boycott laws administered by four different government agencies. Industry believes the confusion discourages exporters and recom¬ mends that it be resolved.
In addition to reducing disincentives, industry also perceives the need for additional U.S. export incentives. These include the need for expanded export financing to meet other governments' packages, especially on major project and capital equipment transactions. Tax benefits also come into debate, especially the role of the DISC program and the practice of not taxing the earnings remitted to the parent corporations in the U.S.
37
Critical Issues & Decisions
Another issue is pending legislation to permit the formation of export trading companies that would provide a full range of expert services to firms of any size. Such export trading companies would be an exception to the general principle of separation of banking and commerce.
These questions have to be addressed in the formulation of U.S. Government export policy in the 1980s if that policy is to com¬ plement domestic growth initiatives.
Housing and Urban Development
In this paper, I will focus on the subject of housing generally, as distinct from the more complex area of cities and urban development, which are vital parts of the HUD mission also. First, let us examine the conditions of housing from an economic standpoint.
Perhaps the most significant trait of housing in the economy is its high degree of sensitivity to inflation. Housing is thought to presage the turning of the economy by about six months on the up¬ turn side. It is immediately affected on the downside, though usually lowered starts of new units are not felt for about six months. In direct response to high interest there has been a 50 percent fa lloff in the volume of new starts this year over last year. Further, housing is highly dependent on savings and loans for its source of funds, if the Savings and Loans (S&L) do not have funds, then people cannot borrow money to purchase homes, and builders cannot borrow money to start construction.
Another condition affecting the housing industry is the long peri¬ od of time associated with the use of the funds. That is, an S&L lends money to a purchaser for 30 years. It hopes that the interest rate it charges reasonably reflects the conditions in the marketplace over the term of the loan. The rapidly rising costs of money in recent years, however, has left many S&Ls in dire straights, with millions of dollars of low-interest loans on their books. They are forced to pay more for money to lend than they are receiving for their port¬ folios. In December 1980, over half of this nation's S&L's were operating at a deficit.
Along with fewer housing starts come secondary effects felt by the related industries. There is less demand for lumber, household ap¬ pliances, and home furnishings.
38
Critical Issues & Decisions
The short supply of housing that results from this downturn has another effect of great significance. There is considerable latent demand in the marketplace. That is, people want single-family homes just as much as if the problems I have discussed did not exist. This demand pushes up prices for the available product. The federal tax policy encourages speculation by allowing equal write¬ offs for the investor and the resident. This drives prices up even further.
A final condition that bears mention is the leverage potential of real estate investment. Few, if any, sizable investments allow the opportunity for such high loan-to-value ratios as does housing. The advent of federal involvement in the housing industry since the thirties has made this possible. The result during inflationary times, however, is to make speculation and investment in real estate very attractive. The effects of this phenomenon as it relates to policy options for the federal government are discussed below.
Let us now turn to the national policy issues suggested by this discussion. This discussion will not deal with the broader issues of monetary and fiscal policy or the global impact of inflation. Generally, there are three areas of policy that are affected directly by this issue: tax policy, credit policy, and housing policy.
From a tax policy perspective, the nation needs to assess how much it wishes to encourage certain kinds of behavior at the expense of other uses of revenue. Specifically, I refer to the tax benefits to those who invest as opposed to those who simply own real estate. Local taxes, interest, depreciation, and other operating expenses are available to the residential, single-family investor. The point here is the utility in opportunity cost for the alternative use of the funds put into housing investment, as opposed to investments that add to the GNP more directly. Beyond the first home or a vacation proper¬ ty, the effect is to artifically bid up the price of an already inflated product. One could also question the view of depreciation for this type of investment in relation to similar investments. I refer hereto single-family investment only.
The sheer volume of funds required to support the housing indus¬ try raises the issue of credit policy. Flousing consumes huge sums of capital that are therefore not available for other uses. The federal government must address the question, when do these dollars reach a
39
Critical Issues & Decisions
point of diminishing returns as it relates to GNP as opposed to the next best alternative? Moreover, the federal government's assistance to this industry in the form of secondary financing, insurance, and loan guarantees means that it is competing in the commercial capital markets for credit. This in itself drives the price of money higher, assuming the Federal Reserve Board's restraints are maintained as they have been recently. To its credit, the federal government has moved in this area by establishing credit limits for various agencies. These limits have not yet had much effect, but that is more attributa¬ ble to the political process than to a lack of concern. Finally, there is the real issue of the long-term validity of the mortgage instrument. The fully amortized mortgage is of relatively recent vintage, dating back only to the thirties. What is the position of the federal govern¬ ment with respect to this vehicle for the loan?
I have saved the knottiest problem for the last. What is the housing policy for the 1980s? The central question is how to provide shelter for Americans in the current environment. The factors that bear on this issue are many. The post-war baby boom has entered the housing market looking for shelter like that in which they grew up. Addi¬ tionally, there is a much higher incidence of single heads of house¬ hold and singles generally coming to the housing market, with obvious effects on demand and prices.
I have focused on single-family dwellings almost exclusively here, but what about the housing needs of the poor and the elderly? This is primarily an issue of multifamily structures, but the policy issues for the federal government are substantially the same: How will this nation provide shelter for these large and growing segments of the population? I believe the central question for the federal government in the eighties is how it will react to the strongly held value of a single-family home and a plot of ground as the primary vehicle of shelter. This is a very inefficient form of shelter from an energy standpoint. Natural resources are an issue here, too, for surely housing requires far more materials when it is single-family-de¬ tached than other types. Moreover, the sprawl that accompanies this type of shelter has major implications for oil consumption and puts a great demand on local government to provide services.
In summary, the area of housing is significantly affected by inflation and government policy concerning inflation. At the same
40
Critical Issues & Decisions
time, housing is one of the most basic of human needs. How this nation and its government deal with changing values and others as old as the country in the face of significant problems of relatively recent origin will provide a major challenge for the eighties and beyond.
Senior-level executives working in the federal government should be aware of the implications of supply-side economics for specific departments and functions of the federal government. Depending on the orientation of the federal budget and cuts proposed, a shift in priorities will take place. Participants need to examine supply- side economics as an answer to our present economic problems and consider its impact on our defense, agriculture, and space programs.
41
Critical Issues & Decisions
DON PAARLBERG
Professor Emeritus, Purdue University and former Director, Agricultural Eco¬ nomics, Department of Agriculture. Dr. Paarlberg served as Special Assistant to the President and Food-for-Peace Coordi¬ nator from 1958-1961. He is the author of several books on economics and farm policy.
From left to right: Jack H. Armstrong, Deputy Administrator, USDA/ACS; Larry F. Thomasson, Assistant Administrator, USDA/Foreign Agricultural Services; Dr. Bruce Wald, Associate Director of Research, Naval Research Lab; and F. Dale Robertson, Supervisory Forester, Programs and Legislation, USDA/ Forest Service. Not in picture: Hugh H. Wilson, Director, Procurement Policy Division, NASA.
Critical Issues & Decisions
PUTTING THE SUPPLY AND DEMAND SIDES OF ECONOMICS TOGETHER
Don Paarlberg
What is called supply-side economics can be understood only in an historical context. Therefore, we make a brief excursion through that much-neglected field, the history of economic thought.
A controversy arose not long after the appearance of Adam Smith's Wealth of Nations (1776) as to whether the economic system was essentially benign or whether it was prone to malignancy in the form of overproduction, unemployment, and depression. A Frenchman, J. B. Say, said in 1803 that the system was benign. Fie put forth the proposition that the money laid out in the production of goods constituted the demand with which these goods could be purchased. Therefore, said he, there could be no general unemploy¬ ment, no large quantity of surplus goods, no large-scale depression. Small-scale maladjustment could occur, but nothing serious or pro¬ tracted. Say's principle was reduced to a simplified, understandable form: "Supply creates its own demand." This was economic ortho¬ doxy for more than a century.
But during the 1930s, we did have serious protracted depression and unemployment. Orthodox economics was without explanation or remedy. It is difficult from this point in history fully to realize the chaos that characterized the economic discipline during those terrible years. Flow prescribe for a situation which, according to the accepted theory, could not exist?
Into this vacuum rushed a new concept, produced by the eminent British economist, John Maynard Keynes. Keynes published his great work, The General Theory of Employment Interest and Money , in 1935. He threw out Say's law and developed a theoretical frame¬ work which showed that equilibrium could occur at much less than full employment. He showed that the economy could stagnate with much of its resources unused. The remedy, he said, was to inject income (demand) into the economy by deficit spending and easy
Professor Emeritus , Purdue University
45
Critical Issues & Decisions
monetary policy. This would stimulate the economy, putting idle men to work. In effect Keynes reversed Say's dictum; Keynes could be interpreted as saying that demand created its own supply. New demand (income), injected into the economy, would not be in¬ flationary so long as there were idle men and idle plants. If resources became fully used, any new increment of income would express it¬ self in inflation. If the economy became overheated, taxes should be increased, the money supply should be restricted, the excess demand should be siphoned off and equilibrium restored.
Keynesian thought soon replaced classical economics. The dis¬ cipline underwent the quickest and most comprehensive reform it had experienced in the 200 years of its existence. The Keynesian system was embraced by the Democrats, then in control of the White House and the Congress. It dominated the economic policies of the Democratic party from then until now.
It is easy to see why Keynesian economics triumphed. It had an explanation for the Depression, which classical economics lacked. It had a remedy, which classical economics also lacked. The remedy consisted of government action, the voting of benefits to constitu¬ ents without extracting taxes from them, which is the most appeal¬ ing proposition known to a politician.
The difficulty was thatthe politicians saw only one side of Keynes' prescription. They saw merit in injecting money into the income stream to stimulate the economy. But when the economy became overheated and inflation appeared, they were reluctant to raise taxes and extract money from the people. They took the attractive half of Keynes' proposition and ignored the other half. In this they were supported by many neo-Keynesian thinkers who loaned their influence to this distortion of the master's views. Had Keynes lived he would have been dismayed at this perversion.
Huge amounts of new money were injected into the income stream in the effort to goad the economy into superior performance. Deficit spending, and easy money were substituted for needed in¬ stitutional reform. Rather than deal with the obstacles to production imposed by particular interest groups (PIGS), the politicians poured out new increments of money. In the zeal to increase demand, pro¬ duction incentives were forgotten and investment in capital goods lagged. In the desire to generate government revenue with which to
46
Critical issues & Decisions
fund the demand-stimulating programs, taxes in the upper brackets were raised to very high levels. Like a much-flogged horse, the econ¬ omy began to stumble. The injections of new income, instead of putting resources to work, expended themselves in inflation. We then had— and have— inflation with resources less than fully used.
Keynesian theory can no more explain inflation with unused resources in today's world than classical economics could explain depression and unused resources coexisting during the 1930s. Say had been wrong: supply does not necessarily create its own demand. It now appears that Keynes' interpreters were also wrong: demand does not always create its own supply.
Pity the Council of Economic Advisers, who must recommend economic policy to the President. How can they do this when both the classical and the Keynesian concepts have shown them¬ selves unable to cope? It is as if a plant breeder were told to develop a new wheat, having just been told that the Mendelian principles of genetics were no longer valid.
In a sense, both Say and Keynes were right within their assump¬ tions. Say assumed that prices and wages would adjust to changing circumstances; the downfall of his theory resulted from institutional arrangements that prevented them from doing so. Keynes assumed that prices and wages had much rigidity and that government policy would be symmetrical: stimulation in slack times and restraint when the economy became overheated. Political failure to apply restraint discredited his system.
However people may disagree with this historical assessment, there is general consensus on the present state of the economy:
1. Unemployment is high by historical comparison, affecting seven percent of the labor force;
2. Our economic system is operating at a low level; our manufactur¬ ing plants are running at 75 percent of capacity;
3. Inflation is running at a double digit pace;
4. Efficiency, as measured by output per worker, is declining; and
5. The dollar is weaker than it was in international markets.
47
Critical Issues & Decisions
Clearly, this is an unsatisfactory situation. The demand of the public is that "something be done." A new Republican Administra¬ tion has been elected to "do something." The something they have chosen to do they call "supply-side economics."
What is supply-side economics? First, it is an overt rejection of Keynesian economics and, by inference, the economic concepts which have dominated the Democratic party. The Democrats were concerned primarily with the demand side of the economic system. Supply-side economics is in part a return to classical economics and to Say's principle. In some degree it is a synthesis of the old, the very old, and the new, the parts not being entirely consistent with each other. It has features which in the present setting are politically attractive: reduce the rate of governmental growth; cut taxes; reduce regulatory activity. It is presented with new nomenclature and new rhetoric. It is intended to give new hope that inflation can be re¬ strained and our economic performance improved.
The basic idea is that taxes have become so burdensome that they inhibit investment and enterprise. If taxes are reduced for entrepreneurial people, new plants will be built and new capital commitments will be made. The result will be greater efficiency and increased economic activity. This increased activity is expected to generate more taxes and so work toward a balanced budget. In other words, by cutting tax rates we generate more tax dollars. The plan is to reduce government costs by pruning off nonessential services and by curbing the particular interest groups. This, it is hoped, together with the added tax revenue resulting from greater economic activity, will in time permit the budget to be balanced and will curb the inflationary forces associated with deficits. All this will be associated with monetary policy which is on the tight side. And it is to be accompanied by relaxation of regulations which inhibit the entrepreneurial class. Fiscal and monetary policy are to team up, working together to get the economy going and to curb inflation.
There are two schools of thought as to how to get the economy straightened out. One is the shock treatment, to break the back of inflation by bold sudden strokes, involving a sharp cut in the money supply and sky-high interest rates, with acknowledged severe damage to exposed groups. The other involves "gradualism," to cool off
48
Critical Issues & Decisions
inflation and reduce inflationary expectations, to work toward a balanced budget, to restrain growth in the money supply, to relax government regulation, to provide incentives for saving and invest¬ ment, and to rebuild a feeling of self-reliance on the part of our citizens. Supply-side economics takes this gradual approach. It is not just a set of economic ideas; it is also a political concept.
Clearly what we have here is not an economic concept that is com¬ plete and internally consistent, as is classical economics or Keynesian economics. It is an amalgam. It is eclectic. In it are recognizable elements of the classical system and some unpurged remnants of Keynesian economics plus some elements that appear in neither of its predecessors. In addition, supply-side economics has political and social components. (Its adversaries would say "anti-social. ") If offered in the University, supply-side economics might be taught in the Economics Department, in the Department of Political Science, or in the School of Public Administration, or in all three. Presently it is not taught at all.
What are the prospects that supply-side economics might succeed? For that matter, what are the criteria for success? As the rhetoric rolls out, it appears that the new Administration's criteria are quali¬ tative as well quantitative. Apparently the attitudinal objectives are these: a new hope, a growing willingness to venture, greater self- reliance, and the belief that inflation can be slowed down. The quantitative objectives seem to be these: slowing inflation to a rate of 5 or 6 percent by 1984, balancing the federal budget by that year, lifting the real growth rate of the Gross National Product to 4 percent, and reducing unemployement from its 1980 level of 7 per¬ cent to something like 4 percent.
In considering the possibility that these objectives might be achieved or approached, we begin by examining the various parts of the package.
It is clear to this writer, and evidently also to large numbers of our citizens as well, that government is overgrown and that parts of it have been captured by the particular interest groups. That budget cutting is in order is agreed as a general proposition, though no one wants a cut in his program. The President's proposal is to cut approximately $49 billion from the Carter fiscal 1982 budget outlay of $739 billion. This is a 6 percent cut. Even if this entire
49
Critical Issues & Decisions
cut were made, which seems unlikely, budget outlays would still be some $40 billion or 5 percent above the 1981 budget. The impact involved in a reduction of this magnitude below the Carter budget may be very important psychologically, but it amounts to less than 2 percent of our Gross National Product. The proposed budget cuts appear to be wholesome from the standpoint of good govern¬ ment and would involve an improved benefit/cost ratio for govern¬ ment services. But the economic leverage seems insufficient to move us strongly toward the economic objectives, that is, unless the modest economic moves generate a sizable psychological change, as was the case when Keynesian economics was embraced 45 years ago.
What of the proposed tax cut? With inflation, the graduated income tax results in "bracket creep," moving people into higher tax rates even though their real incomes are no higher. Unless this is changed, government revenues will in time increase to such a point that they will take a disproportionate and unintended share of our effort. They will become confiscatory; the inhibiting effect on effort and investment which worries the supply-siders will become plain to all. Supply-siders contend that this has already happened. The availability of such enormous tax revenues would be an en¬ couragement to yet more government spending. So, to me, cutting taxes is desirable, though the appropriate amount, the nature, and the timing of the cut are not so clear.
The proposed tax cut is intended to reduce personal income taxes by 10 percent the first year and by an additional 10 percent in each of the two subsequent years. Even if this tax cut were made, 1982 federal revenues would still be $650 billion, 8 percent above their 1981 level. This constitutes a reduction of about 8 percent below what taxes otherwise would be. In speaking of the proposed 1982 tax cut, we are considering an amount equal to 2 percent of our Gross National Product.
The proposed tax cut is the most controversial part of the pack¬ age offered by the supply-siders, and it has the weakest theoretical underpinning.
The supply-siders want to shape the cut so that most of the benefits, in dollar terms, would go to the entrepreneurs who are among the more wealthy and who have been most hurt by punitive taxes and by bracket creep. The supply-siders' case rests on the
50
Critical Issues & Decisions
belief that these people, if relieved of burdensome taxes, will invest, innovate, and produce. They argue that the tax cut would stimulate the economy and so in time generate more revenue than does the slack economy at present high tax rates. They thus anticipant that the deficit would be reduced and that in time the budget would be balanced. The government would no longer have to go into the financial markets to borrow; the reduced demand for funds would cause the interest rate to fall. Thus lower tax rates stimulate invest¬ ment, which generates more tax dollars, which helps balance the budget, which reduces government demand for available funds, which lowers the interest rate and further encourages investment. While all this is going on, greater production and the balanced budget help reduce inflationary expectations. Stick beats dog, dog bites pig, pig jumps over the stile, and all get safely home.
Those who oppose the tax cut, generally those called liberals, point out that it would confer its least benefits on the poor. They also fear that a reduction in tax rates would reduce the pool from which benefits for the poor may be drawn. Further, they argue that a tax cut would have an early effect in reducing government income while such increased economic activity as would generate additional taxes would be a long time in coming. In the interim, they say, the deficit would increase and inflation would be the greater problem. Finally, they say that much of the increased spendable in¬ come available to the wealthy as a result of the tax cut would go for conspicuous consumption rather than for new capital equipment. They argue, on familiar Keynesian grounds, that tax cuts stimulate demand and are thus inflationary.
Opponents of supply-side economics, generally the liberals and the crypto-Keynesians, are embarrassed by one apparent fact. It was while we were acting out their scenario that the present malaise developed. Clearly, to prescribe more of the same would lack credi¬ bility. They are in the same circumstances as were the classical economists when the Great Depression struck. They are without explanation and without remedy. One would hope that their criti¬ cism of the new approach would therefore be modified.
In summary, as this writer sees it, what is called supply-side economics offers, in present and prospective circumstances, the best chance to break away from the spending, inflating, and regu-
51
Critical Issues & Decisions
lating syndrome that has characterized government activity for the past 50 years. Clearly it does not rest on a tidy piece of economic theory. Nor has it been tested. But considering the paucity of alter¬ natives, it has its merits. It has an articulate advocate in the President and a hopeful following among the people. These may be more important attributes than theoretical respectability.
Supply-side economics is a kind of Hegelian synthesis of the classi¬ cal thesis and the Keynesian antithesis. It is newly born, still not sure it has all its fingers and toes. Obviously it will need some nurture and disciplining if it survives infancy. An optimist— the writer— dares hope that it will avoid the reciprocal blindness of classical economics on the one hand and Keynesian economics on the other, the first of which contended that supply created its own demand and the other implying that demand creates its own supply. One hopes that we would read again the wise words of that great nineteenth-century English economist, Alfred Marshall, who told us that it was as use¬ less to contend which was the more important, supply or demand, as to argue about which blade of the scissors did the cutting.
52
Critical Issues & Decisions
Commentary
General Overview of Supply-Side Economics
Many different terms have been used to describe economics during the past century. They include the dismal science, the invisible hand, the allocation of scarce resources, and the free market. Economics as a system has been described by Adam Smith in his Wealth of Nations , J. B. Say in Say's Law , John Maynard Keynes in the General Theory of Employment Interest and Money , and many others of similar or lesser stature.
Politicians have generally recognized that most Americans vote their pocketbooks. For this reason, economics has played a large