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weighed against

the inefficiency caused by having occasional shortages of natural gas. The impact on inflation of price increases of this kind is also an important criterion to consider.

In this regard, one must question the overriding importance of having employers pay for the unemployment compensation system, or for the use of the payroll tax to finance the Social Security System. Grants from general revenue may violate the principles of the systems. But this effect must be weighed against the adverse effect on inflation and unemployment of the payroll taxes that support these systems.

LONG-RUN EFFECT

These price policies will reduce the price level directly and therefore will reduce the rate of inflation in the short-run. But the price cuts are “one-shot” and will have no direct effect on future inflation rates unless they are repeated. The long-run effect of this policy depends on its effect on wage rates.

Historically, wage settlements have responded to changes in price inflation. If wage inflation were to moderate in response to the one-shot reduction in prices, then the long-run rate of inflation could be reduced. The lower wage inflation would reduce costs further leading to a further response of prices. The wage-price spiral would be partially unwound.

Even with a beneficial response from wages, direct price cuts should not be viewed as an alternative to responsible monetary and fiscal policies, but as complementary to them. The direct price cuts provide an opportunity to reduce the inflation rate permanently without changing the rate of real economic growth. If monetary and fiscal policies were not trimmed accordingly when full employment was approached, the economy would soon revert to its original, higher rate of inflation. In this regard, the price cuts provide an opportunity to adjust from our present inflationary situation to a less inflationary one, but they cannot, by themselves make the less inflationary situation permanent.

SUMMARY The budget has a major direct influence on prices. The rate of inflation could be reduced by a point or more through moderate changes in prices and costs that are directly under the control of the government. New programs could be devised to spread the effect of the direct price reductions more broadly and to increase the size of the general impact on prices without seriously distorting other program objectives. The reduction in inflation would be temporary unless monetary and fiscal policies were adjusted to take advantage of the possibility that would be created for a permanent reduction in inflation.

Minority Addendum
Fiscal policy and monetary policy interact with private
sector demands to determine the total demand for goods and
services, and the growth in that demand over time. The
growth in demand, together with the recent history of wage
and price increases, are the major determinants of the rate
of inflation at any point in time.

The growth in demand-as it affects prices and shapes the history of wage and price changes--becomes the dominant factor in determining the rate of inflation in the long run. The long run growth of demand is highly dependent on the rate of growth of the money supply. A major point of difference among economists is how quickly the current demand growth affects the rate of inflation. Some economists believe monetary and fiscal restraints on demand growth have more immediate effects on the rate of inflation.

The Budget Committee strongly affects the growth of total demand by recommending overall fiscal policy and by influencing monetary policy through fiscal policy and associated budget deficits.

III. The Effect of the Budget on Inflation and Unemployment

In this section, estimates of the impact of cost-cutting options on inflation and unemployment are discussed. The report concludes that reductions in directly controlled costs could reduce the unemployment rate more than would an income tax cut of the same budgetary cost. The lower rate of cost inflation would be partially offset by a higher rate of demand inflation that would result from the larger economic expansion. But the estimates indicate that the net effect would be to reduce inflation and unemployment at the same time. The resulting level of unemployment and inflation would depend on many other factors, the most important of which may be monetary policy. A. THE OUTLOOK

No one has been able to forecast prices very accurately, particularly in recent years when special inflationary factors other than the level of economic activity have been of such major importance. Another world oil price rise could change the standard forecast by several percentage points. A bad harvest due to drought in the Southern Plans would have a visible, but smaller impact. Barring unforeseen special circumstances of this kind, the outlook is roughly as follows.

UNDERLYING INFLATION

Wage increases appear to be stabilizing in the 7 to 9 percent range. After remaining relatively constant for almost 5 years, wage-inflation increased when wage and price controls were eliminated in April 1974. From a previous rate of about 6 percent per year, wage increases rose at a rate of more than 12 percent in late 1974 and early 1975. The worst of that surge appears to be over and a new rate in the 7 to 9 percent range has taken hold for the last several months. This is the assessment given to the Budget Committee by Secretary of Labor Usery in his testimony of February 26, 1976. Wage increases in that range would

normally be accompanied by price increases of about 6 to 7 percent. This appears to be the standard forecast for the next several years, and this report will use it as a measure of underlying inflation. This forecast assumes that the recovery will not be aborted by a low level of growth of the money supply.

DEMAND INFLATION

With unemployment rates in the 7 percent range and with utilization of plant in the 80 percent range, there can be no inflation due to excess aggregate demand. The demand for output will remain below the Nation's ability to produce for the next several years. Most of the inflation that occurs in that period will be due to factors other than demand. Slack demand should allow the overall inflation rate to decline and the pace of that decline will depend on the level of demand.

The Congressional Budget Office's (CBO) Five Year Budget Projections describes two alternative growth paths: (A) a path which averages 5 percent real growth between now and 1981 and (B) a 6percent path for the same period. No discussion of the policies needed to attain these paths is given. According to CBO, the rate of inflation should stabilize at about 6.6 percent per year along the fast path and gradually fall to 5 percent along the slow path.

The purpose of the two CBO growth paths is to point out the effect of economic assumptions on the budget projections. No discussions of the monetary or fiscal policies needed to attain these alternative paths is given. It appears that money growth substantially above the upper range of current Federal Reserve targets would be needed to meet these paths in the next few years. Despite the limitations of the two paths, they do permit a reasonable assessment of the impact on inflation of a more rapid rate of economic growth.

The inflation rate is higher along the fast path than it is on the slow path because resources are used more intensively. In particular, unemployment rates are lower and wage increases are higher along the fast path. This is due, in part, to the more rapid growth in the money supply that takes place along the fast growth path. The difference between the paths is displayed in the following table.

I NFLATION AND UNEMPLOYMENT ON THE 2 CBO GROWTH PATHS

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Between 1976 and 1981, the fast path would produce an unemployment rate that averages 1.4 points lower and an inflation rate that averages 1 point higher than the slow path. Note that inflation continues to decline under both paths, but not as quickly on the fast path. The total difference between the two paths amounts to an incredible $1,078 billion of GNP over the 6 years.

In short, the underlying inflation rate of 7 percent can be slowly reduced by gradually restraining demand, but with an enormous cost in terms of unemployment and production. The risk of an outbreak of demand inflation is minimal when resources are underutilized and growth rates are not excessive. Inflation does not accelerate even along the fast CBO growth path. Given the enormous cost of reducing demand inflation, it is important that all opportunities to reduce cost inflation be examined.

B. THE IMPACT OF AN INCOME TAX CUT ON INFLATION AND

UNEMPLOYMENT The CBO provided estimates for this report that a permanent cut in the personal income tax of $10 billion would reduce the unemployment rate by about 0.2 points within 2 years. The rate of inflation would be increased by less than 0.1 after 5 years as a result of the tax cut.

These estimates are consistent with estimates published elsewhere by CBO.

A rule of thumb that derives from this calculation is that for moderate changes in demand, the short-run effect on unemployment is about twice that on inflation. Every 0.2 percent that the unemployment rate falls is associated in the long run with an increase in the inflation rate of 0.1 percent. This rule of thumb is a useful guide when unemployment rates are in the 7-8 percent range. As unemployment rates fall, the inflationary impact will be larger than this rule suggests.

It should not be assumed from this estimate that inflation must increase if income taxes are cut. The 0.1 percent of inflation that would result from the income tax cut represents a change from what would otherwise take place. If inflation rates would otherwise fall by 0.5 percent, they would still fall with the enactment of a 10-billiondollar income tax cut, but only by 0.4 percent. Similarly, the reduction in the unemployment rate of 0.2 percent is in addition to the reduction that would take place without the cut.

The rule of thumb relating change in inflation to changes in unemployment permits us to calculate the cost of reducing inflation by restricting demand. At current levels of unemployment, an increase in the unemployment rate of 0.2 percent would be associated with a reduction in real GNP of about $9 billion. This would be associated with a reduction in the inflation rate of 0.1 percentage points. If this rule of thumb is valid for somewhat larger variations in demand, then the cost of reducing inflation by one full percentage point by restraining demand growth is 2 percent in unemployment and $90 billion in output. Cost reductions have a much smaller price tag as is shown below.

Longer-run benefits associated with a slower rate of inflation are difficult to quantify. They include the greater likelihood that restrictive policies which could induce recession will not be forthcoming at a later date.

1 See Congressional Budget Office, Recovery: How Far and How Fast? Congress of the United States, September 1975.

C. THE IMPACT ON INFLATION AND UNEMPLOYMENT OF DIRECT

CUTS IN COSTS

A reduction in the employer payroll tax would stimulate demand just as a reduction in the income tax would. This would tend to cause prices to rise. But the payroll tax is also a part of costs, and when costs fall, prices tend to fall as well. Which of these two effects is larger? That question is considered in this section.

The many different costs that could be cut directly by government would have very different impacts on inflation and unemployment. Their direct inflationary effect was described in Table 2. Their indirect effect depends on several other factors. (1) It depends on the speed with which firms pass through their cost changes to consumers. (2) It depends on whether changes in final prices get magnified by having an effect on future wage decisions. (3) It depends on the amount of funds that are transferred from the public to the private sector in order to bring about the reduction in costs. The different programs described above could differ in these three ways, and some of the differences are hard to predict. The effect of the cost reductions on unemployment will also vary with the same three factors.

The last factor is the easiest to identify. A transfer of funds from the public to the private sector has an effect on demand inflation and unemployment that is easily separated from the effect that derives directly from the price reductions listed in Table 2.

A payroll tax cut would provide funds to the private sector. So would an increase in the Postal subsidy, the mass transit subsidy, or a reduction in sales or excise taxes. The reduction in private prices that are regulated by the government, such as the trucking transport costs or natural gas prices, would not transfer any funds to the private sector. And the price controls on Medicare reimbursements and the wage controls on Federal employees would reduce the funds that are transferred to the private sector. The effects of the cost reductions on demand inflation vary directly with the amount of funds being transferred, and are about the same per dollar as the effects described above for the transfer of funds through a reduction in the income tax. That is, the aggregate demand pressure will be about the same whether the funds are transferred by reducing taxes or reducing prices. In some programs—such as the proposal to control Medicare costs-it should be noted that demand inflation and cost inflation are reduced at the same time.

CBO was asked to perform three different calculations to determine the effects on unemployment and inflation of different kinds of cost reductions (1) The effect of a payroll tax reduction was estimated under the assumption that a change in the employer tax would affect final prices as fast as would any other change in labor costs, (2) the effect of a direct reduction in consumer sales taxes was estimated under the assumption that this would have no subsequent impact on wage decisions; and (3), the same calculation was performed as in (2) except that it was assumed that future wage inflation would respond to the direct reduction in prices the way it has historically. All calculations were performed for a hypothetical $10 billion program. The effects for smaller programs can be estimated by reducing these figures proportionally.

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