the disappointing recovery - cbo
TRANSCRIPT
THE DISAPPOINTING RECOVERY
The Congress of the United StatesCongressional Budget Office
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PREFACE
The Disappointing Recovery is one of a series ofreports on the state of the economy issued periodicallyby the Congressional Budget Office. In keeping withCBO's mandate to provide nonpartisan analysis of policyoptions, the report contains no recommendations. It wasprepared by George Iden, Cornelia Motheral, Nancy Mora-wetz, Michael Owen, Mary Kay Plantes, David Rowe andother members of the Fiscal Analysis staff, under thedirection of Frank de Leeuw, and edited by Patricia H.Johnston.
Alice M. RivlinDirector
iii
TABLE OF CONTENTS
Preface iii
Summary ix
Chapter I. The Current Economic Situation 1
The Persisting Output Gap 3
The Role of the Federal Government 6
Inflation during the Recovery 7
Chapter II. The Outlook under Current Policy 11
Why Forecasts Have Worsened 13
Uncertainties in the Forecast 15
Chapter III. Policy Alternatives 17
Expansionary Fiscal Options 17
Estimated Economic Impacts 20
The Federal Deficit 26
Monetary Policy 27
v
TABLES
1. Economic Projections Based on Current Policy,1977-78 12
2. Expansionary Fiscal Options: Estimated BudgetCost and GNP Impact 23
3. Expansionary Fiscal Options: Estimated Employ-ment, Unemployment, and Inflation Impact 24
4. Illustrative Combinations of ExpansionaryFiscal Options 26
FIGURES
1. Indexes of Real GNP in Five Recession-RecoveryPeriods
2. Components of Real GNP in Recession andRecovery 4
3. Inflation in Recession and Recovery 8
VII
SUMMARY
The nation's output in recent quarters has fallenshort of what forecasters expected last spring andsummer. The report accompanying the Second ConcurrentResolution on the Fiscal Year 1977 Budget, passed inSeptember 1976, assumed that output would grow at a 5.5to 6.0 percent annual rate in 1976 and 1977 and thatthe unemployment rate would fall to 6.2 percent by theend of 1977. There now seems almost no chance of meetingthese output and unemployment assumptions under currentbudget policy. The Budget Committees are consequentlymoving to consider a third budget resolution for fiscalyear 1977 in advance of the initial budget resolution for1978.
The mid-1976 forecasts assumed that the exception-ally long and deep 1973-75 recession would be followed bya faster-than-average recovery that would make up some ofthe lost ground. In fact, recovery since the bottom ofthe recession has proceeded at about an average rate,with the result that unemployment remains unusually high.
In the absence of policy changes, CBO's forecastfor 1977 projects real output growth at 3.5 to 5.0 per-cent and an unemployment rate of 7.1 to 7.8 percent(7 to 7% million workers) by the end of the year. Evenby the end of 1978 the unemployment rate is projectedabove 6.5 percent. The rate of inflation is projectedat 4.5 to 6.0 percent for 1977, well below 1973-74 ratesbut little changed from more recent experience.
IX
81-174 O - 77 - 2
CURRENT-POLICY FORECAST
Economic Variables 1977 1978
Growth in constant-dollarGNP, fourth quarter to +3.5 to +5.0 +3.0 to +5.5fourth quarter (percent)
Unemployment rate, fourth 71 to 78 6.6 to 7.6quarter (percent)
Inflation rate, generalprice index (GNP deflator), +4.5 to +6.0 +4.0 to +6.0fourth quarter to fourthquarter (percent)
Changes in policy could move the economy closer toearlier assumptions about output and employment. Fivefiscal policy options are analyzed in the report:
• A $16 billion personal tax rebate paid out inthe third quarter of 1977;
• A $10 billion (annual rate) permanent reductionin personal taxes beginning in the third quarterof 1977;
• A $5 billion (annual rate) corporate tax re-duction beginning in the third quarter of 1977,divided between an increase in the investmenttax credit and a rate reduction;
• A $5 billion increase (annual rate) in counter-cyclical revenue sharing and public serviceemployment, the former beginning in the secondquarter of 1977 and the latter building graduallyduring the second half of 1977;
• A $6 billion authorization of public works pro-jects, with outlays rising slowly during 1977and 1978.
x
Estimated economic impacts of these policies are shownin the accompanying table.
Combinations of these options could add substantiallyto the number of jobs. Three illustrative policy com-binations analyzed in the report would add an estimated310,000, 610,000, and 920,000 jobs, respectively, by theend of 1977, and more in 1978. At present rates of un-employment and unused capacity, expansionary measureswould have relatively little effect on the rate ofinflation.
Expansionary fiscal policies would, however, entaila higher federal deficit. For fiscal year 1977, thedeficit, even in the absence of policy changes, is nowestimated at $54 to $58 billion, higher than the $50.6billion in the second Congressional resolution becauseof the weaker economy than was foreseen at the time.The three policy combinations analyzed in the reportwould add another $9 to $19 billion to the 1977 deficit.
XI
ESTIMATED IMPACTS OF EXPANSIONARY FISCAL POLICY OPTIONS
Unemployment Rate Inflation ImpactEmployment Impact Impact (percent- (percentage Net Budget Costc
(thousands of ad- age points re- points addi- (billions ofditional jobs) duced unemploy- tional infla- dollars)
ment) tion)Options
1977:4 1978:4 1977:4 1978:4 1980Fiscal FiscalYear Year1977 1978
1. $16 Billion Per-sonal Tax Rebate
500 170 -0.4 -0.1 0.0 +15 -3
2. $10 Billion Perman-ent Personal Tax 110Reduction
350 -0.1 -0.3 0.1 to 0.2 + 2 +7
$5 Billion BusinessTax Reduction
10 190 0 -0.1 0.1 to 0.2 + 1 +3
$5 Billion Increasein CountercyclicalRevenue Sharing andPublic ServiceEmployment
$6 Billion Authori-zation for Acceler-ated Public Works,Spending RisingSlowly to $3 BillionRate
260
40
410
140
-0.2 -0.3
0 -0.1
0.1 to 0.2
0.1
+ 1 +2
0 +1
a. The net budget cost of each option equals its direct spending increase or tax reductionminus the estimated higher revenues and lower income-support payments it causes.
CHAPTER'I THE CURRENT ECONOMIC SITUATION
The recession that occurred between late 1973 andearly 1975 was the sixth since World War II, It wasthe longest and deepest of the six, with national output(Gross National Product (GNP) in dollars of constantpurchasing power) falling by nearly 7 percent instead ofthe usual 1 to 3 percent. Deep recessions are oftenfollowed by sharp recoveries, and it appeared for a timeas if that would be the pattern in 1973-76. Instead, asFigure 1 shows, the recovery rate has been similar toearlier recovery rates, and the output gap below previouscycles which developed during the recession has per-sisted. It does not now seem at all likely that the eco-nomy under current fiscal policy will achieve a 5.5 to6.0 rate of growth of output or an unemployment rate of6.2 percent by the end of 1977, as assumed in framingCongressional resolutions in the fiscal year 1977 budget.
During the fall of 1976, economic news was espe-cially disappointing. Retail sales were sluggish, in-dustrial production declined in September and October,and the unemployment rate rose from 7.5 percent at mid-year to 7.9 percent in October and 8.1 percent in Novem-ber. Since then, the news has improved considerably.Retail sales rose strongly in November and were revisedupward for October. Production increased sharply inNovember. Leading indicators suggest further improve-ments in coming months, including a likely drop in theunemployment rate. The "pause" does not appear to beturning into a recession, as some feared it would.
But recent rapid rates of improvement are not likelyto be sustained either, if current fiscal and monetarypolicies are continued. In part at least, the recent in-creases represent recovery from the primary and secondaryeffects of the Ford strike and possibly from the effectsof earlier shortfalls in federal spending. These catch-up increases are likely to subside after the first monthsof 1977, without eliminating the substantial gap betweenrecent economic performance and average output behaviorduring previous recession-recovery periods.
Figure 1.INDEXES OF REAL GNP IN FIVE RECESSION-RECOVERY PERIODS(Business cycle peak = 100)
120
115
110
105
100
5 Quarters BusinessBefore CycleTrough Trough
5 QuartersAfterTrough
10 QuartersAfterTrough
15 QuartersAfterTrough
Even if this were a typical business cycle, thehistorical record would suggest some concern about itsdurability over the next two years. Figure 1 showsthat recovery has come to an end as early as two yearsafter the bottom of a recession and that only one of thefour previous recoveries lasted longer than 15 quartersafter the trough--an interval which would bring us tothe last quarter of 1978 in the current recovery. Theduration of previous recoveries thus warns us to lookfor signs of stagnation or recession by 1978.
THE PERSISTING OUTPUT GAP
Because of the severe 1973-75 recession followed byonly a normal recovery, by the sixth quarter of the re-covery output (real GNP) was only 2.4 percent above itsprevious peak level. Normally, the economy has been 6to 9 percent above its previous peak level by the sixthquarter of recovery, as can be observed in Chart 1. Thisshortfall of about 5 percent below a normal cyclical per-formance in real GNP will be referred to as the "outputgap." It has caused the unemployment rate to be morethan 2 percentage points higher than at a comparable stap-ein any of the previous postwar recoveries. It has alsocaused a large amount of unused plant and equipment, withconsequent losses in profits and in the growth of thenation's stock of capital.
Not all components of demand have contributed tothe current output gap. As the top panel of Figure 2shows, the unusually high rate of inventory liquidationin 1975 has been reversed and inventory investment wasat normal levels in the second and third quarters ofthis year. When sales turned sluggish in September andOctober, inventory/sales ratios rose somewhat, thoughthe rise was limited by prompt production adjustments.With the November recovery in sales, it appears likelythat inventories are not far out of line with sales.Inventory investment is likely to continue to be a neu-tral factor on balance, as in the middle stages of pre-vious cycles.
Figure 2.COMPONENTS OF REAL GNP IN RECESSION AND RECOVERY(Indexes, business cycle peak = 100, except forinventory investment)
Inventory Investment(as a percent of real GNP)
KEY
Average of four previouscycles1973:IV to date
-5 =5 Quarters before TroughT =Trough+5 =5 Quarters after Trough+10 =10 Quarters after Trough
+10
COMPONENTS OF REAL FINAL SALES
Consumer Durables130
120
110
100
90^ s
? !
x
r^lx^1
*• — -
^ "~
1
^ -~
14-5 T +5 +10
State & Local PurchasesIdU
120
110
100
50.? 1
— . •—_ J ^^^*
1
— — — —_
I
^ „ ^» — "*"
12-5 +5 +10
Housing Investment
L5u
100
. : r-5
^ ^ x
^
T
,-- '
1+5
<
+10 -5
Imports
IjU
120
110
100
9°.
/^^
h
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s — -
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12+5 +10
Nonresidential Fixed Investment
loll
120
110
ICC
so,
"̂f 1
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I?-5 +5 +10 -5
ExportsloU
120
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The source of the output gap, then, lies in finalsales. Figure 2 shows several strategic components ofreal (constant-dollar) final demand in the recent period,compared with average performance in the four previousrecession-recovery periods.
Consumer spending, by far the largest component ofGNP, is one of the sectors running below the level itwould have reached in an average postwar cycle. The gapis most marked in spending on durables--shown in thefigure—but is also apparent in spending on nondurables.The gap reflects stagnation of real income in recentyears rather than decisions by consumers to spend a lowerproportion of their incomes. The proportion of incomesspent, in fact, has been rising over the current reces-sion-recovery period. If it had not, the consumerspending gap would be even wider.
The output gap has been large in new housing invest-ment, with most of the gap in multifamily constructionrather than single-family building. Recent data showsome narrowing of the gap, and building permits and fin-ancial flows suggest that the improvement may continue.The longer-run prospects for multifamily housing remainmurky, however, with some of the recent strength re-flecting a speedup in federally subsidized activitiesthat may not be sustained.
Investment in plant and equipment (nonresidentialfixed investment) has been an important source of thegap and seems likely to continue so in the future. Earlythis autumn, private surveys of corporate spending planssuggested an increase in investment spending in 1977that would have partly closed the gap. However, theCommerce Department's more comprehensive survey, takenin late October and November, indicates that this plannedrise in real investment spending has been postponed ifnot cancelled, probably because of the recent leveling-off of capacity utilization at relatively low levels.In the first half of 1977, plant and equipment spendingin real terms is now anticipated to be little changedfrom the fourth quarter level of 1976.
81-174 O - 77 -3
Weak demands by state and local governments also con-tributed to the severity of the recession and the failureof output to rebound more sharply. The only time that therate of increase in state and local spending approachedprevious recovery rates was when federal grants were in-creasing rapidly in 1975. In early 1976, the flow offederal grants actually declined in current-dollar terms,as governments failed to pick up all the available money.Continued financial difficulties and voter and govern-mental caution have also contributed to slow growth inreal spending. In addition, one factor that used to con-tribute to steady growth in state and local spending--agrowing school population — is no longer present. Thesustained fall in the birth rate is now causing a declinein school populations.
Imports have a negative direct impact on GNP sincethey represent a channeling of demand to foreign ratherthan U.S. producers and are subtracted from exports incalculating the "net export" component of GNP. The lagin imports has thus helped to reduce the U.S. output gap.Some of the recent high growth in imports reflects stock-piling of oil in anticipation of the OPEC price increase,and import growth may therefore slow down in 1977.
Export demands have grown at a normal rate duringthe recovery so far. However, they are not expected toexpand at anything like the normal rate next year. Anyfurther rise in oil prices will limit the ability ofother oil-importing countries to buy U.S. goods. Further-more, the slowdown in recovery that has been occurringin other industrialized countries will, unless it issoon reversed, curtail their purchases from the UnitedStates.
THE ROLE OF THE FEDERAL GOVERNMENT
Federal fiscal policy mitigated the severity of therecession and contributed to the recovery, but somefederal actions may have added to instability in thepace of the recovery.
Real federal demands continued to grow as the reces-sion developed, in marked contrast to some earlier periods(after the end of the Korean and Vietnam wars) when fallingmilitary spending was a major cause of recessions. Sincethe bottom of the recession, federal spending (in constantdollars) has on balance continued to grow, but during 1976it fell significantly short of Congressional targets.This unexpected shortfall helps explain the economic lullwhich developed after the spring of 1976. If the short-fall ends and federal spending returns to the track setforth in Congressional budget resolutions, this will bea positive factor in the economic outlook for the monthsahead.
On the revenue side, inflation during 1973-74 in-creased the size of the tax burden and contributed tothe subsequent recession. In 1975, tax reductions re-stored private-sector real incomes and helped fuel therecovery; since that time, however, personal tax loadshave once again been rising faster than incomes.
Some of the tax reduction in 1975 consisted of arebate on 1974 personal income taxes and other one-timepayments. Though little of this money was spent in thequarter in which it was received, much of it appears tohave been spent by consumers in subsequent quarters.It thus provided a one-shot stimulus to the economyspread over several quarters. During the period of stim-ulus , growth rates were higher than they would have beenotherwise; but as the effects of the stimulus drew toan end, growth rates were lower than they would havebeen otherwise. The ending of the effects of the 1975rebates may be another factor in the 1976 economic lull.
INFLATION DURING THE RECOVERY
The rate of inflation has come down sharply duringthe current recovery. But as can been seen in Figure 3,inflation remains higher than at the same point in pre-vious recoveries.
Figure 3.INFLATION IN RECESSION AND RECOVERY(Percent Change From a Year Earlier in QuarterlyAverage Consumer Price Index)
14
12
10
8
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.976 j
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uarter ofated)
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jrage of thisvious cycle
7
-74
eesa
1
5 Quarters Business 5 Quarters 10 Quarters 15 QuartersBefore Cycle After After AfterTrough Trough Trough Trough Trough
4 —
a. Recession-recoveries of 1953-58, 1957-61, and 1959-64.
8
In the three recession-recovery periods of thefifties and early sixties, the behavior of the rate ofinflation (specifically, the rate of change from a yearearlier in the Consumer Price Index) was somewhat sim-ilar, and the average of the three is shown as the bot-tom line of the chart. From a rate of around 2 percentbefore the trough, inflation decelerated to near zeroduring the first year of recovery, and then rose grad-ually back to 2 percent. This line would probably showa little more acceleration after the first year of re-covery if it had not been for the guidelines beginningin 1962.
The middle line on the chart shows inflation duringthe recession of 1969-70 and up through the third quarterof 1974. Here, inflation started at a higher level butdeclined by about the usual amount during the firstthree quarters of recovery. With price and wage controlsinstituted in the third quarter of recovery, inflationdecelerated further for the next year and a half. Thencame the devastating acceleration of the 1972-74 period,in which high farm price increases, the ending of pricecontrols, depreciation of the dollar, materials bottle-necks, relatively high levels of output, and finallythe OPEC quadrupling of crude oil prices combined tocause the double-digit rates with which the 1973-76 re-cession and recovery period began.
The most recent period (starting with the businesscycle peak in the fourth quarter of 1973 and thereforeincluding the period at the end of the 1969-74 line) isshown as the solid line on the chart. Inflation accel-erated during the recession, reaching its peak rate of12 percent just before the cycle trough. The deceler-ation since then has been just as dramatic--considerablygreater than the normal deceleration during earlyrecovery.
The output gap and its attendant higher levelsof unemployment and excess capacity explain relativelylittle of this reduction in inflation, according to CBOcalculations. The principal factors in the decline ininflation have been the ending of the effects of the one-time shocks which hit the economy in 1972-74. Indeed,
two of the shocks have been partly reversed; farm priceshave been declining recently, and the value of thedollar relative to ten other major currencies is nowsignificantly higher than it was in early 1975.
10
CHAPTER II THE OUTLOOK UNDER CURRENT POLICY
In the absence of policy changes, the economy nowseems headed for a relatively modest 3.5 to 5.0 percentgrowth during 1977, with no acceleration in sight for1978. Growth in this range is likely to keep the un-employment rate above 7 percent during all of 1977 andabove 6.5 percent during 1978. The weak economy is alsolikely to raise the federal deficit in fiscal year 1977to the $54 to $58 billion range, even without any addi-tional fiscal stimulus. All these are significant de-partures from what was thought likely a few months agoand what was used in framing the Second Concurrent Re-solution on the Fiscal Year 1977 Budget.
This projection, shown in Table 1, rests on thefollowing principal assumptions:
• federal outlays recovering from the 1976 short-fall back to the path assumed in the secondconcurrent resolution;
• no changes in tax rates;
• monetary growth, as measured by the broadly de-fined money supply (M2>, near the upper end ofthe 7.5 to 10 percent range announced by theFederal Reserve, leading to little change inshort-term interest rates during 1977;
• increases in consumer food prices averaging 4percent per year;
• increases in wholesale fuel prices of 11 per-cent in 1977 and 8.5 percent in 1978;
• growth of about 3.5 percent per year in theconstant-dollar volume of U.S. exports.
11
TABLE 1. ECONOMIC PROJECTIONS BASED ON CURRENT POLICY, 1977-78
Economi
GNP (billions
GNP (billions
General Price1972 = 100)
Consumer Price
. Rates of Change (percent)L e v e l s => ^c Variables 1976:4 to 1977:4 to
1976:4 1977:4 1978:4 1977:4 1978:4
of current dollars) 1745 to 1755 1890 to 1950 2040 to 2170 8.0 to 11.0 7.0 to 11.5
of 1972 dollars) 1282 to 1287 1325 to 1350 1370 to 1420 3.5 to 5.0 3.0 to 5.5
Index (GNP deflator.136 to 137 142 to 145 148 to 154 4. 5 to 6.0 4.0 to 6.0
Index (1967 = 100) 173 to 174 181 to 184 188 to 195 4. 3 to 5. 8 3. 8 to 5. 8
Unemployment Rate (percentagepoints) 7.9 7.1 to 7.8 6.6 to 7.6
The forecast is based on a combination of statisti-cal models of the economy, recent information on keyvariables such as business capital spending plans andconsumer attitudes, and CBO staff judgment about key re-lationships such as inventory-sales ratios and householdsaving rates.
The projection implies a continuing rate of re-covery similar to the average rate from earlier reces-sions. Since the 1973-75 recession was exceptionallydeep, however, the projection also implies that the"output gap" between the current business cycle andearlier ones is likely to persist.
With excess capacity and high unemployment contin-uing, demand pressures do not seem likely to lead to areacceleration of inflation. Inflation is projected aswell below the double-digit levels of 1974 but littlechanged from the more modest rates of 1976, which turnedout somewhat below what most forecasters had expected.Wage increases are projected to decelerate slightlyduring the forecast period because of continuing highunemployment; but the deceleration is quite small, dueto the persistence of inflationary expectations and tothe process of catching up with earlier cost increases.Furthermore, the benefits of this deceleration are off-set by continuing price rises for oil and natural gas.
The increase in the deficit from the $50.6 billionof the second concurrent resolution to the $54 to $58billion now projected is due entirely to a weaker econ-omy. Personal income 2 percent below the assumption atthe time of the second concurrent resolution leads to areduction in individual tax revenues of some $3 billion.Corporate profits are now projected at about 6 percentbelow the second resolution assumption, causing a lossof about $3 billion in corporate tax revenues.
WHY FORECASTS HAVE WORSENED
Mid-1976 forecasts, including those prepared by theCongressional Budget Office, were significantly moreoptimistic than the current forecast. The earlier fore-casts projected an unemployment rate falling below 7
13
percent by late 1976 or early 1977, whereas it now seemslikely that in the absence of policy changes the unem-ployment rate will remain above 7 percent during 1977.Earlier forecasts projected growth rates above 5 percentin the second half of 1976 and during 1977, whereas thethird-quarter rate is now estimated at 3.9 percent, thefourth quarter rate does not promise much if any improve-ment, and average 1977 growth rates are projected at 3.5to 5.0 percent. Thus, actual growth in 1976 was lessthan forecast, and in addition the forecast growth for1977 has been revised downward.
Two developments that account for some of the errorin forecasting 1976 were the shortfall in federal spend-ing and the Ford strike. The federal shortfall was notclearly recognized at that time, partly because of lagsin information and partly because it was erroneouslyassumed that any shortfalls in the first half of 1976would be made up in the third quarter. Instead, therewas a shortfall during the third quarter as well. Thegap in federal spending below Congressional targets, in-cluding induced effects on consumer income and state andlocal government receipts, may have lowered the rate ofeconomic growth by roughly one percentage point (atannual rates) during the second and third quarters.
As for the Ford strike, the fact that the autocollective bargaining contract was about to be renegoti-ated was of course known at midyear. A strike, however,was not assumed. Even now it is not easy to measure thedirect and indirect effects of the strike on supply, de-mand, and production; but judging by the rebounds nowtaking place in auto and auto-related areas, theseeffects were considerable.
The downward revision in the forecasts for 1977follows, in part, from disappointing news during late1976. We cannot be sure why capital spending planshave been revised downward, but it seems likely that itis because of lower actual demands and utilization ratesExport demand forecasts have also been revised downward;the worldwide economic lull has lasted longer than wasanticipated at midyear, and in addition the ramifica-tions of a continuing large OPEC trade surplus do notappear to have been adequately factored into earlierforecasts.
14
The rise in the unemployment rate from 7.5 percentat mid-year to 7.9 percent in October and 8.1 percent inNovember was a surprise to nearly all forecasters. Laborforce growth in recent months has exceeded projections,reflecting accelerated growth in labor force participationby adult women. Also, much of the shortfall in federalgrants to state and local governments was in employment-intensive programs. Signs now point to a significant de-cline in unemployment in the months ahead; but it is dif-ficult to anticipate labor force and productivity develop-ments with any precision.
UNCERTAINTIES IN THE FORECAST
The current forecast could of course prove wrong,as mid-1976 forecasts proved to be. Demands could re-vive at a faster pace than projected, even withoutpolicy changes. Alternatively, demand could continueto weaken and cause a new recession.
What would be the signs that the economy is signi-ficantly weaker or stronger than the forecast? The un-employment rate is not the best indicator for this pur-pose, because over short periods of time its relation-ship to overall economic growth can be erratic. Onesensitive indicator would be revisions of investmentplans to be reported by the Commerce Department in mid-January and early March. If business spending on plantand equipment turns out significantly higher than therecent plans reported by the Commerce Department, thatwould be a sign that the economy may exceed the fore-cast summarized in Table 1, even without additionalpolicy actions. On the other hand, if the January andMarch reports bring significant downward revisions ininvestment plans, it is possible that the economy isheaded below the forecast.
Auto sales are another sensitive indicator. Theforecast summarized in Table 1 assumes a 10 to 11million unit auto sales year ahead. Currently, autosales statistics are still difficult to interpret be-cause of possible catch-up from sales losses during theFord strike. But if domestic and imported auto salesin February and March rise to a 12 million or higher
15
annual rate, that would be a sign that the economy issignificantly stronger than the forecast. On the otherhand, if total sales drop to an 8 million rate or lower,a weakening below the forecast could well lie ahead.
Finally, industrial production is forecast to riseat an annual rate of about 8 percent in the winter andspring, partly reflecting a continued rebound from theeffects of strikes. If the growth of industrial outputshould rise above a 10 percent annual rate from Decemberthrough March or April, that would indicate a stronger*economy than the forecast. Growth at an annual ratebelow 6 percent would indicate an economy more sluggishthan the forecast.
16
CHAPTER III POLICY ALTERNATIVES
In their reports on the Second Concurrent Resolu-tion on the Fiscal Year 1977 Budget, the House and SenateBudget Committees noted that there was growing uncer-tainty about the economic outlook which might call foradditional Congressional action. The Senate Committeereport stated that "the Committee is prepared to considera subsequent resolution early next year [1977] if theeconomic data received by then do not indicate that therecovery is proceeding satisfactorily."1 The HouseCommittee report contained similar language.
Since the recovery has not proceeded as projected,this report discusses fiscal policy changes that couldmove the economy closer to Congressional goals for out-put and unemployment. The possibilities include tempor-ary and/or permanent reductions in personal income taxes,tax cuts for businesses, increases in public employmentprograms, and stepped-up revenue sharing and publicworks. The discussion covers the impact of expansionarypolicies not only on output and employment but also oninflation and on the federal deficit.
EXPANSIONARY FISCAL OPTIONS
Personal Tax Reductions
A cut in personal income taxes can be enactedpromptly and can be put into effect soon after it is en-acted. There are many ways to reduce income tax pay-ments, including a one-time rebate, a reduction of taxrates, an increase in the standard deduction, an in-crease in the personal tax credit that was enacted in1975, and changes in a host of other provisions.
1. Report of the Committee on the Budget, United StatesSenate, to accompany S.Con.Res. 139, 94th Congress, 2ndsession, September 1976, p. 15.
17
From the point of view of stimulating economic ac-tivity, one important distinction is between a one-timerebate and a more permanent reduction. There are ofcourse intermediate possibilities, such as a series ofrebates or a rate reduction which phases out as unemploy-ment falls; but focusing on extremes is helpful in clar-ifying the advantages and drawbacks of different ap-proaches. A one-time rebate has the advantage of avoid-ing the need for long-term decisions about the structureof the tax system. Moreover, it does not sacrifice re-venue that might be needed in the future. On the otherhand, a temporary tax cut is probably less effective inreducing unemployment than a permanent tax cut of thesame size. A higher fraction of a temporary cut (howmuch higher is not at all settled among economists) islikely to be added to savings rather than be spent ongoods and services.
An additional difference is that a temporary cuttends to cause a temporary bulge in economic activityfollowed by a return to an earlier trend, while a per-manent cut tends to shift the level of economic activityupward for a long period. The rebates of 1975, for ex-ample, probably raised the economic growth rate duringlate 1975 and early 1976 but lowered the growth rate astheir impact waned in mid-1976. Except when such a one-time bulge is specifically desired, this characteristicargues for using a rebate in conjunction with otherpolicies whose impact builds up gradually as the effectsof the rebate fade away.
Business Tax Reductions
There is much less certainty about the effects onreal GNP and unemployment of a cut in business taxesthan there is about the effects of personal tax cuts.A reduction in the corporate tax rate is simple and canbe enacted promptly, but according to most studies itwould have relatively small short-run effects per dollarof foregone tax revenue. An increase in the investmenttax credit, also a simple change to enact, is generallythought to have a powerful effect on economic activity;but the effect may not be immediate. It might be
18
possible to speed up the response by making an increasein the investment tax credit temporary rather than per-manent, creating incentives to buy now rather than latter,
Other possibilities for reducing business taxes in-clude liberalization of depreciation allowances and anemployment tax credit. Higher depreciation allowancesare similar in their effects to an increased investmenttax credit, but probably more difficult to enact as atemporary change. An employment tax credit—a tax re-duction related to the level or change in a firm's em-ployment or payroll--reduces the cost of labor. A taxchange of this kind could help fight inflation as wellas stimulate economic activity. The quantitative impactof such a credit, however, is even less certain than thatof other business taxes.
Spending Increases
To create jobs quickly, larger federal purchasesare often more effective per dollar than tax reductions.Since a larger fraction of the stimulus goes into spend-ing rather than saving, there is more hiring in the yearor two following the increased purchases (but not neces-sarily in the long run).
An increase in purchases of goods and services,however, is more difficult to put into effect promptlythan a tax cut. Even a specifically antirecession pro-gram, such as public service employment, is limited bythe time it takes prime sponsors to organize useful pro-jects and hire workers. Acceleration of public works,another antirecession strategy, has been facilitated bythe development of a substantial backlog of relativelysmall-scale project applications; but there remains asubstantial time-lag between authorization and the bulkof spending for a typical proj ect.
Lags in federal spending need not be long in thecase of grants to state and local governments. Thespecial countercyclical revenue sharing provisions en-acted in 1976 distribute financial aid according to aformula that, like tax laws, could be increased easily
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and promptly. Since the formula is linked to unemploy-ment rates, increasing countercyclical aid does not com-mit funds in future years when unemployment rates arelower. To some extent, however, higher revenue sharingsimply shifts the problem of delays in spending from thefederal government to states and localities. The largerthe size of the revenue sharing program, the larger thenumber of states and localities that are likely to en-counter difficulties in spending the money promptly andusefully.
ESTIMATED ECONOMIC IMPACTS
To help the Congress in its deliberations aboutpossible policy changes for fiscal year 1977, this sec-tion presents estimated impacts of five fiscal policychanges on GNP, the number of jobs, the unemploymentrate, the rate of inflation, and the federal deficit.The estimated impacts are subject to large margins oferror, but a choice among fiscal options requires somenotion, however uncertain, of what their economic ef-fects are likely to be. The options presented are onesthat have been under active discussion recently. On thespending side, there are limits to the speed with whichoutlays can actually be increased, and these limits haveinfluenced the size of the spending options.
The five options are:
(1) A $16 billion personal tax rebate paid out inthe third quarter of 1977,through a retro-active increase in the personal tax creditplus a rebate for nontaxpayers such as mostsocial security recipients.
(2) A $10 billion (annual rate) permanent personaltax reduction beginning in the third quarterof 1977.A doubling of the personal tax cre-dit would be one way to reduce personal taxesby approximately $10 billion per year.
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(3) A $5 billion corporate tax reduction startingin the third quarter of 1977,consisting of anincrease of 3 percentage points in the invest-ment tax credit (costing approximately $3billion in direct foregone tax revenues) anda reduction of $2 billion through corporaterate changes.
(4) A $5 billion increase in countercyclical re-venue sharing and public service employmentduring 1977. The countercyclical revenue shar-ing formula enacted in 1976 would be doubledin the second quarter of 1977, retroactive tothe start of fiscal year 1977 (October 1976) .(Current outlays under the countercyclical re-venue sharing program are $1.3 billion peryear.) Budget authority for jobs funded byTitles II and VI of the Comprehensive Employmentand Training Act (CETA) would be increased bya $4 billion annual rate with outlays assumedto rise by a $2 billion rate in the thirdquarter of 1977 and build up to a $4 billionrate by the first quarter of 1978. (The fiscalyear 1977 budget authority available for CETATitles II and VI jobs is currently $1.7 bil-lion although the second concurrent resolutionincludes approximately $4.2 billion in budgetauthority for these programs.)
(5) A $6 billion authorization of public works pro-jects in the second quarter of 1977, with out-lays increasing by less than half a billion(annual rate) in the initial quarter and slowlyincreasing to a $3 billion annual rate by thesecond half of 1978. (Budget authority forcountercyclical public works in fiscal year1977 is currently $2 billion.)
The first two components, the personal tax rebateand the permanent personal tax reduction, have contrast-ing impacts. The direct budget cost of the rebate is$16 billion in fiscal year 1977 but zero in fiscal year1978, while the direct budget cost of the permanent re-duction rises from $3 billion in fiscal year 1977 (when
21
it is in place for only one quarter) to $10 billion infiscal year 1978. As Table 2 shows, this timing contrastcarries over to the estimated GNP impact, with the effectof the rebate fading out as the effect of the permanent:reduction builds up. Because of the fact that higher GNPproduces more revenues and reduces certain kinds of in-come assistance payments, the net budget costs shown inthe last columns of Table 2 are lower than the directbudget costs. Differences between direct costs and netcosts are fairly small in fiscal year 1977; but by fiscalyear 1978 the rebate is estimated to lower the federaldeficit by $3 billion, and the permanent cut to increaseit by only seven-tenths of the direct cost.
The remaining three options in the table, like thepermanent reduction in personal taxes, all have budgetcosts and GNP effects which increase from 1977 to 1978.The tax rebate thus complements all of the other programoptions in the table in the sense that combining a re-bate at some level with one or more of the other optionscan give a smoother pattern of economic effects than anyof the options by itself.
The effects of these options on employment and theunemployment rate, shown in Table 3, parallel the GNPeffects just discussed. The rebate is estimated to add500,000 jobs, worth a reduction of about 0.4 percentagepoints on the unemployment rate, by the fourth quarterof 1977, but only 170,000 jobs or a 0.1 percentage pointslower unemployment rate, by the end of 1978. These esti-mates are based on the assumption that three out of every10 new jobs are filled by someone joining or rejoiningthe labor force, with the remaining seven reducing thenumber of jobless already in the labor force.
The other options all have estimated employment ef-fects which build up from 1977 to 1978. Thus, each ofthese other options has estimated employment effectswhich, like its GNP impact, build up as those of the re-bate fade out.
The inflationary effects of these options, alsoshown in Table 3, are estimated to be fairly small.The rebate, because it is only a one-time payment, isestimated to have virtually no effect on the rate of
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TABLE 2. EXPANSIONARY FISCAL OPTIONS: ESTIMATED BUDGET COST AND GNP IMPACT(Billions of Current Dollars)
Direct Budget Cost GNP Impact (Actual Rate) Net Budget CostOptions py 19?7 FY 1978 1977:4 1978:4 FY 1977 FY 1978
1. $16 Billion Personal ,,,- n
Tax Rebate in 1977:3 +16 ° +15 + 8 +15 ~3
2. $10 Billion PersonalTax Reduction Starting + 3 +10 +8 +17 + 2 +7in 1977:3
3. $5 Billion CorporateTax Reduction Starting +1 +5 + 2 +10 +1 +3in 1977:3
4. $5 Billion Increase inCountercyclical RevenueSharing and Public Ser- + 2 + 5 +5 +9 +1 +2vice Employment Phasedin during 1977
5. $6 Billion Authoriza-tion for AcceleratedPublic Works, Spending 0 +3 +3 +7 0 +1Rising Slowly to $3Billion Rate
Note: The options are described in more detail in the text.
TABLE 3. EXPANSIONARY FISCAL OPTIONS: ESTIMATED EMPLOYMENT, UNEMPLOYMENT, AND INFLATIONIMPACT
Options
Impact onEmployment(thousands)
1977:4 1978:4
Impact onUnemployment Rate(percentage points)
1977:4 1978:4
Impact on Rate of Changeof Consumer Prices(percentage points)
1979:4 to 1980
1. $16 Billion PersonalTax Rebate in 1977:3
2. $10 Billion PersonalTax ReductionStarting in 1977;3
3. $5 Billion CorporateTax ReductionStarting in 1977:3
4. $5 Billion Increase inCountercyclical RevenueSharing and PublicService EmploymentPhased in during 1977
5. $6 Billion Authori-zation for AcceleratedPublic Works, SpendingRising Slowly to $3Billion Rate
500
110
10
260
40
170
350
190
410
140
-0.4
-0.1
-0,1
-0,3
-0.1
-0.2 -0.3
0 -0.1
0.0
0,1 to 0.2
0.1 to 0.2
0.1 to 0.2
0.1
Note: The options are described more fully in the text.
inflation. Each of the other options has an inflationaryeffect which builds gradually to an estimated 0.1 to 0.2percentage points by 1980.2 In other words, if inflationunder current policy were 4.5 percent in 1980, enactmentof one of the last four options would raise it to anestimated 4.6 to 4.7 percent. These estimates reflectthe view that expansionary policies at a time of substan-tial unemployment and excess capacity are much less in-flationary than these same policies would be in a high-employment economy.
Since there are numerous ways in which these optionsor fractions of them could be combined into an overallfiscal program, a discussion of combinations is neces-sarily limited to a few illustrations. One possibility,a relatively modest tax package, would consist of exactlyhalf of each of the first three options — the temporaryand permanent personal tax changes and the corporate taxreduction. The estimated effects of this and the othertwo fiscal policy packages are shown in Table 4. Thedirect budget cost of this package would be $10 billionin fiscal year 1977 and $8 billion in fiscal year 1978.The net budget cost, allowing for the effects of theeconomic stimulus on tax revenues and income supportoutlays, would be approximately $9 billion in fiscal year1977 and $4 billion in fiscal year 1978. The packagewould add an estimated 310,000 jobs by the fourth quarterof 1977, which would lower the unemployment rate by 0.25percentage points below the no-policy-change estimatesof 7.1 to 7.8 percent at the end of 1977. For the endof 1978, the corresponding figures are 355,000 jobs andagain 0.25 percentage points on the unemployment rate.The effect on inflation would be to add 0.1 to 0.2 per-centage points to the rate of price increase by 1980.
Somewhat larger economic stimulus would be providedby adding to the tax package just described the revenuesharing, public employment, and public works options inthe last two lines of Tables 2 and 3. This package wouldadd $12 billion in direct budget cost, or $10 billion
2. Estimates are based on a simplified two-equationwage-price model. A description is available from theFiscal Analysis Division, Congressional Budget Office.
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TABLE 4. ILLUSTRATIVE COMBINATIONS OF EXPANSIONARY FISCAL OPTIONS
Selected Impacts
Combination #1;Half of ThreeTax Options
Combination #2;#1 Plus Two
Spending Options
Combination #3;All Five Taxand SpendingOptions
1977 Impact:Direct Budget Cost, fiscalyear ($ billions)Net Budget Cost, fiscalyear ($ billions)Employment, 4th Quarter(thousands)
Unemployment Rate, 4thQuarter (percentage points)
1978 Impact;Direct Budget Cost, fiscalyear ($ billions)
Net Budget Cost, fiscalyear ($ billions)Employment, 4th Quarter(thousands)
Unemployment Rate, 4thQuarter (percentage points)
1980 Impact, Inflation Rate(Rate of change of consumerprices from 1979:4 to1980:4, percentage points)
+10
+9
+310
-0.25
+8
+4
+355
-0.25
+0.1 to 0.2
+12
+10
+610
-0.45
+16
+7
+905
-0.65
+0.3 to 0.5
+22
+19
+920
-0.70
+23
+10
+1260
-0.90
+0.4 to 0.7
after taking account of the GNP impact on taxes and in-come support payments, in fiscal year 1977. The corres-ponding figures for fiscal year 1978 would be $16 billiondirect cost and $7 billion net budget cost. Employmenteffects would add to an estimated 610,000 jobs at theend of 1977 and 905,000 at the end of 1978, lowering theunemployment rate 0.65 percentage points below the 6.6to 7.6 current policy estimate by the end of the latteryear. The estimated inflationary impact of this packagewould add 0.3 to 0.5 to the inflation rate by 1980.
Both of the illustrative packages just discussed in-clude only half of the tax reduction amounts on the firstthree lines of Tables 2 and 3. Still greater economicstimulus would be provided by simply adding all of theoptions in the tables, at full strength. The directbudget cost of this option would be $22 billion in fiscalyear 1977, with a net budget cost estimated at $19 bil-lion. In fiscal year 1978 the corresponding estimatesare $23 billion direct cost and $10 billion net cost.The estimated number of jobs created by this package is920,000 by the end of 1977 and 1,260,000 by the end of1978, lowering the unemployment rate by 0.9 percent be-low the current policy range of 6.6 to 7.6 for the latterperiod. The estimated impact on the 1980 rate of infla-tion ranges from a low of 0.4 percentage points to ahigh of 0.7 percentage points; in other words, if theno-policy-change inflation rate were 4.5 percent, thepackage consisting of all the options in Tables 2 and 3would raise it to an estimated 4.9 to 5.2 percent.
THE FEDERAL DEFICIT
The expansionary fiscal packages just describedwould lead to a higher federal deficit. Even with nochange in fiscal policy, the weaker economy than was ex-pected at the time of the second concurrent resolutionis likely to lead to a deficit of $54 to $58 billionrather than the $50.6 billion in the resolution. Thefirst of the three packages—half of each of the threetax cut options--would raise the estimate to $63 to $67billion. The second fiscal package would raise the esti-mate to $64 to $68 billion or about the same as the
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deficit in fiscal year 1976. The third option wouldraise the deficit to $73 to $77 billion.
The prospects for reducing the deficit over thelonger run depend on economic growth and on the policiesnecessary to achieve growth. In itself, economic growthreduces the deficit through increasing personal and busi-ness income and thereby increasing tax revenues. However,if high growth is achieved in part through tax reductionsand/or injections of government spending, the increasesin the deficit due to these measures may offset the de-ficit reduction flowing from higher growth.
We simply do not know which way these two effectswill balance out over the next few years. The long-termhistorical record suggests that an unemployment rate muchlower than the current one has often been compatible witha federal budget close to balance. At the present time,however, it appears likely that nonfederal demands inthe aggregate are sufficiently weak so that a high fed-eral deficit is required to obtain significant reductionsin unemployment.
MONETARY POLICY
How the Federal Reserve System reacts to changes infiscal policy has a major influence on policy impacts.The impact estimates just presented assume that monetaryauthorities do not change their open-market purchases orsales or the interest rate at which they lend to commer-cial banks in reaction to fiscal policy changes. Underthese circumstances, the expansionary fiscal moves de-scribed would lead to a modestly higher money supply and,for a time, to moderately higher short-term interestrates than a continuation of current fiscal policies.
If instead of the unchanged open-market policy as-sumed the Federal Reserve adhered strictly to a monetarygrowth path, then it would offset some of the effects ofexpansionary fiscal policy on economic growth and unem-ployment, and eventually on inflation as well. An in-crease in interest rates would be required to prevent
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higher money demands from calling forth a larger moneysupply, and higher interest rates would reduce privateborrowing and spending.
In contrast, if the Federal Reserve took steps tokeep interest rates from rising in response to fiscalpolicy moves, it would reenforce the expansionary impact.Growth would be higher and unemployment lower at first,and the inflation rate would eventually be higher. Thus,the way in which monetary policy reacts to fiscal policyhas important effects on the impact of fiscal policies.
Monetary policy has implications not only for unem-ployment and inflation but also for the composition ofoutput as divided among consumption, investment in capi-tal goods, and government services. Economic expansionachieved through monetary policy instead of fiscal policytends to reduce the proportion of output devoted to con-sumption and/or government and increase the proportiondevoted to investment in business capital and new housing,with favorable long-run effects on productivity and onthe quality of the housing stock. The federal deficitalso tends to be lower in an expansion achieved throughmonetary policy than in one fueled by fiscal policy.
While these effects would be viewed by many as fa-voring monetary expansion in preference to fiscal ex-pansion, there are disadvantages to monetary expansionas well. One disadvantage is that monetary policy oftenoperates with very long lags. As a result, an expansion-ary move large enough to have a sizable impact on theeconomy by 1977 and 1978 may well have a still largerimpact in later years, when the needs of the economy aremuch less certain.
Another disadvantage of using monetary policy forshort-run stabilization is that the economy appears tobe undergoing sizable shifts in the usual relationshipsamong money, interest rates, and incomes. The supply ofcurrency and checking accounts has grown by much lessthan GNP in the last two years, and yet short-terminterest rates have not been forced up as usually happens
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under these circumstances. Until these shifts are under-stood, there will be even more than the usual uncertaintyabout the effects of monetary policy on the economy. Atthe present time it is very difficult even to guess atthe degree of monetary expansion it would take to movethe economy back to Congressional goals and assumptionsfor output and unemployment.
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