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form of higher product prices. The extra $2.2 billion in costs represent about 0.2 percent of employee compensation in calendar 1977.

The proposed increase in the unemployment insurance tax would have a similar effect on costs. This proposed tax increase of $2.8 billion ($2.1 billion in fiscal 1977), will be paid entirely by employers and would raise labor costs by a full quarter of a percent.

The speed with which these cost increases would be transformed into price increases is uncertain. One recent study suggests that 75 percent of the increase would be passed on in the first year.

There is also some evidence that firms maintain their traditional profit margins on cost increases of this kind. If this is the case, the tong-run effect on prices could be greater than if the costs were simply passed through to consumers.

Ignoring the markup effect, the Gross National Product deflator would increase by 0.19 percent in calendar 1977 as a result of the proposed increases in payroll taxes and by more than 0.26 in the long run. The effect on the Consumer Price Index—a better measure of the cost of living-would be slightly larger.

The President's proposals to reduce corporate and personal income taxes may offset to some extent the effect on prices of the increases in payroll taxes. The evidence, however, does not suggest that this offset will be significant, at least in the short run.

PAY INCREASES FOR FEDERAL EMPLOYEES

The President has proposed to limit Federal pay increases to 5 percent in October 1976. Assuming that comparability requirements would call for an increase of about 8.5 percent by that date, and assuming further that restoration would have been made of the remaining 3.7 percent increase that was denied in October 1975, this proposal would keep Federal salaries $3.5 billion below the level they would otherwise attain.

Since Federal pay increases affect the Gross National Product deflator but not the Consumer Price Index, the effect of this proposal on the measured rate of inflation depends on which index is being used. No one's cost of living will be lower as a direct effect of the pay restraint. Yet the visibility of the Federal pay raise suggests that it may have a significant effect on other wage decisions. Thus the effect of pay restraint on the cost of living is indirect and its size is not estimated here. Its omission does not imply that the indirect effect would be insignificant.

The GNP deflator would be 0.19 percent lower if the President's proposal to restrict wage increase to 5 percent were adopted than with no pay restraints.

USER TAXES

The President has proposed to increase a wide variety of prices and taxes that are levied on the users of government facilities.

Postal rates would rise by $307 million more than if the subsidy to second-, third- and fourth-class mail were extended at current rates. The Postal Service has requested the extension.

1 Charles L. Schultze, "Falling Profits, Rising Margins and the Full Employment Profit Rate,” Brookings Papers on Economic Activity, 1975:2 pp. 449–469.

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Mass transit subsidies would be reduced. The President has proposed that only 50 percent of the funds provided to localities for mass transit aid in fiscal 1977 be used to subsidize fares. It is estimated that 90 percent of the $648 million requested for transit formula grants would have been used for fare subsidies without this restriction. Fares will be $258 million higher because of the restriction.

The sum of all user tax increases of this kind would be more than $700 million. If these costs were passed through to users with no markup, the GNP deflator would increase by 0.04 percent.

MEDICAL CARE

The President has proposed to limit the cost increases for medical care that can qualify for reimbursement under Medicare. Hospital cost increases of 7 percent and physician fee increases of 4 percent would be permitted. The proposed cost increases are about six percentage points less than their rate of increase in 1975. If, in the absence of the proposed controls, these prices would continue to increase at the higher 1975 rates during fiscal 1977, then the price reductions due to this proposal alone would be worth $1.18 billion in fiscal 1977. The budget message argues that total Medicare costs would be lower by $2.2 billion as a result of the entire Medicare proposal. The remaining budget savings would be due to a predicted reduction in utilization rates.

It is not clear whether this proposal would affect medical care costs in the rest of the economy since no controls are proposed for medical prices other than those to be reimbursed under Medicare.

It should be noted that this proposal differs from others that have been mentioned in that it involves direct controls over private prices. The other proposals concern changes in prices and costs that are already publicly determined.

Price controls on medical care were reasonably effective during the economic stabilization period of 1971 to 1974. Except for this period, hospital service costs have grown steadily relative to other prices for the last 20 years. The trend has been most evident since the enactment of Medicare and Medicaid in 1965. The table shows the abnormal behavior of prices in the medical care industry.

Table 1.-ANNUAL RATES OF COST INCREASE

Item

1969-71

ESP 1

1st half 1975

CPI..
Medical care.
Medical care services.
Semiprivate room.
Physician fees...

4. 6
6. 7
7. 6
13. 0
7. 4

6. 4 4. 3 4. 9 5. 7 4. 0

7. 5 12. 5 12. 8 15. 0 11. 6

1 Economic stabilization period.

* Other minor increases included in the $700 million are the imposition of $80 million of waterway user taxes and an increase in uranium prices that are charged to private utilities of $91 million.

While medical price increases were suppressed during the stabilization periods, institutional changes which would promote price reduction did not take root at that time. The measures employed by hospitals to restrain inflation were targeted toward short-term efficiencies: such as restraining employee salary increases, and freezing staffing ratios, rather than to more rational control of long-term costs. The exceptionally large increase in medical prices in 1975 was, in part, a realization of cost increases that had been suppressed during the economic stabilization period.

It should be noted that non-Federal medical care costs would not. fall, and could even be increased as a result of this proposal. This would happen if hospitals did not hold down costs and raised charges. to non-Medicare patients by enough to cover the cost increases for all patients. If the prices charged to non-Medicare patients are not affected by this proposal, it would reduce the GNP deflator by 0.06. percent.

GRANTS TO STATES

The reduction in grants to State and local government would have an uncertain effect on budget decisions in those jurisdictions. A part of the reduction could result in lower spending, and a part in higher taxes. If sales taxes, property taxes, or other excise taxes were increased, prices and costs would rise directly. The size of these tax increases has been estimated to be about one-third of the size of the reduction in general grants, and one-fourth the size of categorical grants. Thus an $8 billion reduction in grants would cause these taxes to rise by about $2.0 billion and would cause the deflator to increase by about 0.11 percent.

TOTAL INFLATIONARY EFFECT

Each of the proposals described above represents a request by the Administration that may be subject to controversy in the Congress. The proposals involve changes from current policy budget levels, from established procedures, or from prevailing prices that are being charged by government enterprises. Factors other than inflation, such as program efficiency, will also have to be considered.

The total direct effect on the GNP deflator of these proposals is estimated to be 0.68 percentage points as shown in Table 2. That is, this index would be higher by more than 0.68 percent if the inflationary option were chosen in every case than if the alternative were chosen. Since some of the Administration proposals would reduce prices, the net effect of the Administration's position would be to raise the deflator by about 0.14 percent, though the effect on private prices and costs. could be more than twice that. These estimates are summarized in the table below.

It should be noted that the indirect effect on costs could also be. substantial, though these estimates have been excluded from the table. Wage increases could moderate in the future, for example, if large price increases could be avoided in the shorter term. The Notes

3 Edward M. Gramlich and Harvey Galper, "State and Local Fiscal Behavior and Federal Grant Policy.” Brookings Papers on Economic Activity, 1973:1,

pp. 15–58.

72-678–76

to Table 2 below describe how the estimates were derived. Effects are shown for both the GNP deflator—which covers the entire economy including the government sector—and for the private sector alone.

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The estimates of the direct effect of lower taxes and prices on the price level were calculated as follows. For the GNP deflator, the dollar values of the proposed changes were divided by the level of GNP that is expected for the period. The GNP estimates are those provided in the President's budget. The payroll tax proposal would be effective January 1, 1977. It was divided by $1,890 billion, the projected level of GNP for calendar 1977. Other proposals were calculated under the assumption that they became effective on October 1, 1976. A GNP of $1,839 billion was used for these proposals, since that is the level of GNP projected for fiscal 1977.

The effects on the private cost of living were estimated by adjusting the GNP estimates for two factors. (1) Compensation of Federal employees was subtracted leaving an adjusted GNP of $1,770 billion for fiscal 1977 and $1,823 billion for calendar 1977. (2) Those prices not paid by the private sector-such as Federal salaries—were not included in the private cost of living.

B. DIRECT PRICE EFFECTS OF OTHER GOVERNMENT PROGRAMS

The proposals discussed above include only those changes from current policies that have been specifically proposed by the President. A wide range of additional options exist if Federal policy were to deliberately seek out price-reducing measures.

First, and most obvious, wherever an increase in prices has been proposed, decreases are an alternative to be considered. Payroll taxes, for example, can be reduced rather than increased and prices would then be pushed down rather than up.

Second, some additional budget proposals exist which could affect inflation but which do not involve direct controls over prices or costs. The President has proposed, for example, that $870 million worth of materials be sold from strategic military stockpiles. The sales would restrain increases in the prices of these materials by an undertermined amount.

Third, the budget also affects prices in many ways in areas where the President has not called for major changes. The list of changes above for which inflationary price tags have been estimated was selected because they require major budgetary decisions for fiscal 1977. The scheduled expiration of the telephone excise tax could be accelerated, for example. Interest subsidies for home buyers could be expanded. Subsidies could be increased for AmTrak or the Postal Service. Gasoline, tobacco, and alcohol taxes could be reduced.

Fourth, new budget options could be proposed that are specifically designed to cause prices to fall. Grants could be given to State and local government in exchange for reductions in sales taxes. These programs could be voluntary, though it is unlikely that any State would turn down a chance to reduce its own citizen's taxes, particularly if it thought that the Federal grants would be permanent. A $10 billion program of this kind would lower the Consumer Price Index by a full percentage point in its first year. The more broadly based GNP deflator would fall by less. The Consumer Price Index also has a larger effect on private wage decisions than the GNP deflator, so that the feedback from such price cuts on future wage decisions could be substantial.

Fifth, non-budgetary government programs can be used to change prices directly. The President has proposed that transportation regulations be changed so that shipping rates can fall. Natural gas and petroleum prices are determined in large part by the Federal Government. These prices have a substantial impact on the general price level. It has been estimated that the difference between the highest and lowest proposals for petroleum prices that were seriously considered in 1975 involved two full percentage points in the price index.

PRICES AND EFFICIENCY Prices serve an important purpose in guiding productive resources into those activities which are of greatest value in a free enterprise economy. The policy of direct cost reduction which has just been described would dull the effectiveness of the price system if the cuts were pushed too far, particularly if only a small number of products was involved. Prices fall when postal rates are cut, for example. But if postal rates are cut too far, the public would use the mail to a greater extent than they should. The Postal Service would then have to expand and the public benefits of the expansion would likely be less than the additional costs. Some feel that postal rates are already too low and that the subsidy should be ended.

For this reason it is best to concentrate major cost reductions on those taxes which have a general impact on all products. Cuts in the sales or the payroll tax, for example, would not distort private allocation decisions while lower postal rates might.

A dilemma arises in cases like that of natural gas where a higher price is needed in order to have consumers economize on its use. If however, the higher price cannot be offset by cuts in other publicly controlled prices, and if the higher price cannot be accompanied by more fiscal and monetary stimulus, then a rejection of the price increase can be considered on the grounds that it will add to both inflation and unemployment. The inefficiency caused by having workers idle should be

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