EFFECT OF FISCAL POLICY ACTIONS ON SPENDING

Rather than looking at the composition of the tax cuts, I think there are two substantive objections to tax reduction that I should address. The first objection is premised on the view that fiscal policy actions, by which I mean Federal Government expenditure and tax policy, are ineffective in stimulating aggregate spending. This view is held not only by some academic economists, but also by important segments of the business and financial community. It is supported by various econometric studies which suggest that a planned Federal deficit, such as would occur with the proposed tax deduction, at first may stimulate spending, but over the course of approximately 1 year will have little or no net effect upon spending. This result is partly because private spending ultimately will be crowded out by rising interest rates generated when the Federal Government enters the money markets to finance the deficit. But there are also other reasons, including the contention that people or firms will cut back current spending to save for expected higher tax rates expected in the future to pay off that increased debt.

INFLUENCE OF MONETARY ACTIONS

Now, these statistical studies on the other hand conclude that monetary actions, that is manipulation of the Nation's money supply, do have a powerful influence on aggregate demand. It will not come as a great surprise to you that these studies support the monetarist view of macroeconomics.

In my view, these monetary studies contain serious weaknesses. I will not attempt here a technical discourse. However, I think it's interesting to report briefly the results of some work that my colleague, Professor Chang and I have carried out at the University of Tennessee. We believe that we have corrected for the weaknesses I mentioned above, and we find that fiscal actions, whether consisting of expenditure changes or tax changes, do indeed have a significant effect on spending. Further, and I'm speaking of private spending here, this effect is distributed over a fairly long period of time. It probably takes about 3 years before the effect of a tax action, for example, is more or less exhausted.

I hasten to add that in our model, monetary actions also are effective. On this point we do not differ with the monetarists.

FEDERAL DEFICIT

I also should point out that our work suggests that the actual deficit of the Federal Government would be even worse if we allowed the tax burden to rise and economic growth to slow. The reason is that tax receipts fall if income falls. Further, certain Federal expenditures, for example unemployment compensation, rise when income and the general level of economic activity falls.

SENSITIVE ECONOMIC REGIONS

Professor Chang and I have applied our model to the analysis of particular regions in the United States, and I think you'll find our results here of interest. They indicate that, as you might expect, the regional economy most sensitive to fiscal and monetary policy

actions is the Great Lakes region. This is due to the importance of durable goods manufacturing in such states as Ohio, Indiana, Illinois, and Michigan.

However, it may surprise you to learn that the second most sensitive region to national economic policy action is the Southeast. This sensitivity is due to the rapid industrialization of Southeastern States in the last 15 years or so.

RESTRICTIVE MONETARY AND FISCAL POLICY

An important implication of this, I believe, is that the so-called Sun Belt is in the same boat as the older industrialized areas of the northeast and midwest. For example, during the recession of 1973 to 1975, which was produced by restrictive monetary and fiscal policy, the much-publicized manufacturing growth of Southeastern States came to a complete halt. In fact, there was a substantial decline in manufacturing jobs. And in Tennessee we are just now returning to the level of manufacturing employment we enjoyed in 1973.

Turning to the northern tier States, our results suggest that much of the economic difficulty of these older industrialized areas is due to the restrictive national economic policies of 1973 and 1974 rather than to the loss of manufacturing plants to the Sun Belt.

TAX CUTS STIMULATE ECONOMIC ACTIVITY

Stated another way, our results suggest that all regions in the United States could enjoy growth if we did not find it necessary to periodically impose restrictive national economic policies. Some regions, of course, still would grow more rapidly than others.

So my conclusion is that both at the national level and regional level, there is strong evidence that contrary to the type of objections I am considering, tax cuts do stimulate economic activity.

CONSIDER COST OF REDUCING INFLATION

The second source, and the only other source of opposition to tax reduction that I wish to consider, is that made by those who contend that our first order of business should be to reduce the rate of inflation. I hope I won't be misunderstood here. I want to point out that it is definitely in our interest to reduce inflation. But I believe that we must consider the cost of reducing inflation, if this involves restrictive economic policy actions and slow economic growth.

SMALL GAINS REALIZED FROM REDUCING RATE OF INFLATION

On these grounds I believe that the benefits of reducing inflation through restrictive policy frequently are overstated. Here I want to be precise. I'm talking about those who object to tax reduction on the ground that it would be inflationary, because I believe that these observers are implicitly supporting a restrictive stance in our monetary and fiscal actions. My point is that we must then compare the cost of slow economic growth which would come about from restrictive actions with the gains to be realized from reducing inflation.

INVESTMENT SPENDING

On these grounds I believe that the gains from a reduced rate of inflation, if they require significantly slower real economic growth, are either illusory or very small. For example, an important cost of inflation alleged by some is that it is a cause of the disappointing capital investment performance in the current economic recovery. While there may be some basis to this, the beneficial effect of reduced inflation on investment spending must be compared to the fact that a major factor conducive to investment activity is the continued growth of income and spending. Numerous studies suggest that this accelerator effect may be the most important determinant of investment in new plants and equipment.

INFLATION VERSUS ECONOMIC GROWTH

If the fight against inflation requires slowdown in economic growth, it's likely investment would fall, not rise. And, incidentally, it is difficult to see how a restrictive policy which inhibits capital invstment spending will help fight inflation, for the smaller our investment now, the smaller our capital stock will be in the future, and the more difficult our battle against inflation in the future is likely to be.

INCENTIVE TO HOLD DOWN WAGE AND PRICE INCREASES

But where does this lead us? Do we meekly accept a 6 percent rate of inflation, or should we attempt to use some new policy instrument such as the tax cut reward system currently being suggested by Arthur Okun and others as an incentive for firms and workers to hold down wage and price increases? Although this plan has the attractive feature that it would attack the procedure whereby inflationary expectations have been incorporated into wage escalator clauses, there apparently exist serious questions as to its administrative feasibility.

ANTI-INFLATION AND MONETARY FISCAL POLICY APPROACH

In summary, then, while the effort to fight inflation is an extremely difficult one, the high cost and doubtful success of an antiinflation policy built solely upon restrictive monetary and fiscal policy should rule out the use of such policy. But that is exactly what we will get if the increase in tax burdens in 1978 is not offset. We must have tax reduction to avoid such a restrictive stance, and to insure continued real economic growth in 1978, 1979, and beyond.

Thank you.

Senator SASSER. Thank you very much, Dr. Garrison. I might state in passing that the Budget Committee will hold inflation hearings next Wednesday, and Dr. Arthur Okun, who you just mentioned, will be among the witnesses at that hearing.

Dr. Van Doorn Ooms indicates to me the staff of the Budget Committee would be very much interested in your study which you referred to, and if you would be kind enough to send that to the Committee staff, we would like very much to study it.

Dr. GARRISON. I would be happy to.

[Prepared statement of Dr. Charles B. Garrison follows:]

PREPARED Statement of DR. CHARLES B. GARRISON

TAX REDUCTION

Senator Sasser has requested that the witnesses here today address themselves to, among other topics, the appropriateness of the Administration's tax reduction proposals. I believe that tax reduction is indeed desirable, and even necessary, if the nation is to maintain an adequate rate of real economic growth over the next 2 or 3 years. In the absence of such tax reduction, we are in fact assured that tax burdens will rise due to higher Social Security taxes and higher effective personal income tax rates as nominal incomes rise. If we allow the tax burden to rise, a slowdown in spending and output growth is inevitable.

While the Administration's proposals for tax reduction apparently have obtained fairly widespread support, there exists important opposition. My approach today is to address the arguments of these opponents, for I believe that their anlaysis contains basic weaknesses which should be brought to the attention of policymakers. One source of opposition is among those who would prefer across-the-board personal income tax cuts rather than reduction aimed primarily at lower and middle income groups. This is an important issue, but I do not believe it is crucial; aggregate demand in the economy will be stimulated by either approach.

FISCAL POLICY ACTIONS INEFFECTIVE IN STIMULATING AGGREGATE SPENDING There are two substantive objections to tax reduction that I wish to address. The first objection is premised on the view that fiscal policy actions, including tax cuts, are ineffective in stimulating aggregate spending. This view is held not only by some academic economists but also by important segments of the business and financial community. It is supported by various econometric studies which suggest that a planned federal deficit (as would occur with a tax cut), may at first stimulate spending, but over the course of approximately one year will have little or no effect on spending. This is partly because private spending ultimately will be "crowded out" by rising interest rates generated when the federal government enters the credit markets to finance the deficit. But there also are other reasons, including the contention that people will cut back current spending to save for expected higher tax rates expected in the future to pay off the debt. These statistical studies, on the other hand, conclude that monetary actions have a powerful influence on aggregate demand. It will not come as a great surprise to you that these studies support the "monetarist" view of macroeconomics.

MONETARIST STUDIES HAVE SERIOUS WEAKNESSES

In my view these monetarist studies contain serious weaknesses. I will not attempt a technical discourse here; however, I think it is interesting to report briefly the results of some econometric work that my colleague Professor Chang and I have carried out at The University of Tennessee. We believe that we have corrected for the weaknesses I mentioned above, and we find that fiscal actions (whether consisting of expenditure changes or tax changes) do indeed have a significant effect on spending. Further, this effect is distributed over a fairly long period of time; it probably takes about three years before the effect is more or less exhausted. I hasten to add that in our model, monetary actions also are effective; on this point we do not differ with the monetarists.

RESTRICTIVE NATIONAL ECONOMIC POLICIES SLOWS GROWTH

Professor Chang and I also have applied our model to the analysis of particular regions within the United States. I think you will find our results here interesting. They indicate that, as you would expect, the regional economy most sensitive to fiscal policy actions is the Great Lakes. This is due to the importance of durable goods manufacturing in such states as Ohio, Indiana, Illinois, and Michigan. However, it may surprise you to learn that the second most sensistive region is the Southeast, of which Tennessee is a part. This sensitivity is due to the rapid industrialization of Tennessee and other Southeastern states in the last fifteen years or so. An important implication of this is that the so-called "Sunbelt" is in the same boat as the older industrialized areas of the Northeast and Midwest. During the recession of 1973 to 1975, which was produced by restrictive monetary and fiscal policy, the much-publicized manufacturing growth of Tennessee and similar states came to a complete halt. In fact, there was a substantial decline in manufacturing jobs, and in Tennessee we are just now returning to the level of manufacturing employment we enjoyed in 1973. Turning to the northern tier of states, our results suggest that the

economic difficulties of these older industrialized areas is due to the restrictive national economic policies of 1973 and 1974 rather than to the "loss" of manufacturing plants to the Sunbelt. Stated another way, all regions in the United States could enjoy growth if we did not find it desirable periodically to impose restrictive policies. Some regions, of course, still would grow more rapidly than others.

INFLATION

The second major source of opposition to tax reduction includes those who contend that our first order of business should be to reduce the rate of inflation. While it is in our interest to reduce inflation, I believe that the adverse effects of inflation frequently are overstated. More precisely, those who object to tax reduction on the grounds that it would be inflationary are implicitly supporting a restrictive stance in our monetary and fiscal actions. We must then compare the cost of slow economic growth with the gains to be realized from reducing inflation.

I believe that the gains from a reduced rate of inflation, if they require significantly slower real economic growth, are either illusory or very small. One benefit of reduced inflation currently cited is that the downward pressure on the dollar and our adverse trade balance could be eliminated. But it is likely that this effect would occur only if nominal GNP grows less rapidly in the United States than in other countries. Then our imports from such countries as Japan and West Germany might be reduced and our exports increased. But would this be worth the price? That is the question we should be asking.

SLOWS CAPITAL INVESTMENT

Another important cost of inflation alleged by some is that it is a cause of the disappointing capital investment performance in the current economic recovery. While there may be some basis to this, it is also true that a major factor conducive to investment activity is the continued growth of income and spending. Numerous studies suggest that this accelerator effect may be the most important determinant of investment in new plants and equipment. If the fight against inflation requires a slowdown in economic growth, it is likely that investment would fall, not rise. And, incidentally, it has always been difficult for me to see how a restrictive policy which inhibits capital investment will help to fight inflation, for the smaller our capital stock in the future, the more difficult our battle against inflation is likely to be. But where does this leave us? Do we meekly accept a 6 percent rate of inflation? Or should we attempt to use some new policy instrument, such as the tax cut reward system currently being suggested by Arthur Okun and others as an incentive for firms and workers to hold down wage and price increases? Although this plan has the attractive feature that it would attack the procedure whereby inflationary expectations have been incorporated into wage escalator clauses, there apparently exist serious questions as to its administrative feasibility.

In summary, while the effort to fight inflation is an extremely difficult one, the high cost and doubtful success of an anti-inflation policy built solely upon restrictive monetary and fiscal policy should rule out the use of such policy. But that is exactly what we will get if the increase in tax burdens in 1978 is not offset. We must have tax reduction to avoid such a restrictive stance and to ensure continued real economic growth in 1978, 1979, and beyond.

Senator SASSER. I think this might be an appropriate time to address some questions perhaps to the entire group here, and get responses from those of you who might wish to respond.

WAGE AND PRICE RESTRAINTS

The President has proposed a system of voluntary restraints by both business and labor to hold wages and prices down. Now, if this approach does not succeed, what other steps do you think the Federal Government might take to keep inflation down?

Dr. Garrison referred at the conclusion of his testimony to a system of tax incentives to control inflation, but you are worried about the administrative problem of that. If you would address yourselves for a few moments to that question, we'd like to get your responses.