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The effects of these hypothetical changes are summarized in Table 3. One striking result from the table is the power of cost reduction as an economic stimulus. Cost reduction would stimulate the economy in two ways. It would increase the number of dollars transferred from the government to the private sector by the same amount as the income tax cut. But since it would also lower prices, the purchasing power of all private incomes and assets would be increased. The impact of this second effect on unemployment would be quite powerful, according to the estimates provided. Direct price cuts are a powerful way to stimulate the economy and when unemployment rates are high, the price cuts are not offset in all cases by higher prices that result from the higher level of economic activity that takes place.
Table 3.- ESTIMATED EFFECT ON PRICE LEVEL AND UNEMPLOY
MENT OF VARIOUS PROGRAMS TO REDUCE PRIVATE COSTS
1 The figure reported in col. 3 is the estimated cumulative effect on prices over 5 years. It is not the estimated rate of inflation in the 5th year, but the sum of the inflation rates for the 5-year period.
Reductions in payroll taxes would work with a lag, but their final impact would be substantial. CBO estimates that 43 percent of a reduction in employer payroll taxes would be reflected in lower prices in the first year and 47 percent in the second year. After 5 years, this initial price reduction would be just offset by the inflationary effect of the expansion. Unemployment would fall by almost twice as much under this plan as it would if ordinary income taxes had been cut, however, The unemployment rate would be 0.4 lower after 2 years, compared to a reduction of 0.2 that would result from the $10 billion income tax cut. The strong possibility that cuts in employer payroll taxes could reduce unemployment twice as much as an equivalent cut in income taxes with the same effect on prices makes payroll tax cuts a policy worth serious study.
The numbers in Table 3 come from a model of inflation; a process that is not well understood. Therefore, the estimates must be evaluated with caution. Estimates of changes in inflation resulting from changes in policy, however, are more likely to be correct than estimates of the level of inflation (the level depending on other factors such as food harvests and OPEC oil prices.)
INFLATION AND UNEMPLOYMENT
Direct cost reduction was shown to be a powerful stimulus. Because of this, it would be dangerous to use this policy when unemployment rates were already low. Since the price cuts are a powerful stimulus, they would
create shortages if the economy were already at full employment. For this reason, the policy of cost reduction has not received much attention before. It would have been inappropriate to apply this policy to previous postwar inflations. It is the unique nature of the present inflation that makes this policy appropriate today.
The policy has been used before, however, Recently, France cut its value added tax in an attempt to reduce inflation without increasing unemployment. The United States does not have a similar Federal tax that could be cut at this time.
Most Federal excise taxes have already been eliminated. Many were reduced in 1965 in an effort to curb inflation. The others were reduced during the first term of the Nixon Administration for the same purpose. The economy was much closer to full employment in those years and thus the policy was less appropriate for reducing the inflation that was taking place then than it would be today.
Reductions in prices and costs controlled by the government offer a promising opportunity to reduce the unemployment rate without increasing the inflation rate. Most other sources of growth, whether public or private, would lead to more inflation than if the growth were stimulated by direct cost reduction by government. The only other source of growth that would have the same beneficial effect on inflation would come from price cuts in other economic sectors. If bountiful harvests caused food prices to fall or if problems within OPEC caused petroleum prices to fall, the economy would be stimulated and prices could fall at the same time. But with these special factors beyond government control, direct reductions in costs by government should be considered.
Through moderate changes in a variety of prices and costs that are directly controlled by the Federal Government, the inflation rate and the unemployment rate can be reduced at the same time. These constrictions must be balanced in the long run by reductions in the levels of monetary and fiscal stimuli if the reduction in inflation is to be maintained. The 1977 budget deliberations present an important opportunity to begin a policy of this kind.
THE INFLATION OF 1973–75
The simultaneous existence of inflation and unemployment makes the economic problem of the last few years a unique post-war experience. It was argued above that this unique situation calls for a policy of cost reduction on the part of government since such a policy can
attack inflation and unemployment at the same time. In order to
(a) the inflation was started in a few special sectors;
high by historical standards. It is always difficult to separate cause from effect when interpreting economic history. One plausible interpretation of the data is that the inflation was caused by a group of special factors that increased prices and costs in the sectors in question, and that it was not caused by an excessively stimulated economy. The increase in costs tended to drain purchasing power from the economy so that unemployment rose with the inflation rather than declining as it would if the inflation were due to too much demand.
While this interpretation is consistent with the data, it should be noted that price controls were in effect through much of the period, and that they provide an important qualification to any conclusions that are drawn. This problem is discussed further below.
THE COMPOSITION OF THE RECENT INFLATION
The data presented in Table 4 break down the inflation into several components—food, energy, imports, and mortgage interest costs—for each 6-month interval since late 1972. Inflation seemed to be under control in late 1972. Over the last 6 months of that year, the Consumer Price Index (CPI) increased at a rate of 3.71 percent per year. That was about two points lower than its level of 3 years before. The inflation was distributed relatively evenly over the various components of the index. Price controls were in effect and seemed to be working. The goal of the controls was to get the inflation rate below 3 percent and, for a few months in late 1972, this was accomplished.
The trouble began in early 1973, when prices of uncontrolled food and energy products began to increase at double-digit rates. While the rest of the economy did not experience this inflation, the average price level including food and energy rose at a rate of 8.2 percent as measured by the CPI. Within that average, the food component rose at a rate of 23.1 percent and the energy components rose at a rate of 11.4 percent. All other factors together rose at a rate below 4.3 percent.
In late 1973, the divergence among product prices was even more pronounced. The four special factors that are considered in this section-food, energy, mortgage interest costs, and imports--were responsible for more than 80 percent of the inflation during the last 6 months of that year despite the fact that they comprise only 40 percent of the index. Food prices went up at a 17-percent rate, energy prices at a 22-percent rate, mortgage interest costs at a 40-percent rate, and imports other than food and fuel at a 20-percent rate. All other prices-about 60 percent of the total index-increased at less than 4.5 percent. Despite the lack of a pervasive inflation, the CPI increased at a rate of 9.43 percent.
Table 4.-THE COMPOSITION OF THE PERCENT OF INFLATION
I. INFLATION OVER 6-MONTH INTERVALS EXPRESSED AT ANNUAL RATES
(a) The weights in Part III of the Table for food, energy, and mortgage interest costs reflect the relative importance of these sectors in the Consumer Price Index in December 1974 as reported by BLS. These weights change over time as inflation proceeds unevenly, and the figures in sections I and II reflect these changes.
(6) The energy index is the weighted sum of the separate CPI components for gasoline and motor oil, fuel oil and coal, and gas and electricity.
(c) The mortgage interest cost index is derived as the difference between the special CPI index excluding mortgage interest and the entire CPI, using the appropriate weights.
(d) The index for imports less food and fuel is derived from Table D of the September 1975 Survey of Current Business (p. 44). No separate import component appears in the CPI, so this index which depends on balance of payments data is used. Its weight of 0.04448 is the average ratio of non-food, non-fuel imports to GNP over this period. The weight is not varied over the different time periods in the table above.
The import index is not available for 1972, so there is no import index reported for the first two time periods in the table.
(e) The selection of data presented in the table represents one of many ways to separate the inflation rate into its various components. Another way is to use the GNP deflators. In principle, this would give a more accurate indication of the sources of inflation, but even the GNP data are not collected in such a way as to make the division a simple one.
The problem with the CPI is that the final components contain many intermediate products. The CPI for food, for example, measures retail food prices. But these prices include large costs for packaging, processing, and transportation.
There is a lot more than farm output in the CPI food index, and there is some reason to believe that these other factors were responsible for part of the recent increase in food prices.
On the other hand, energy is an input into most forms of production, so that much of the inflation that is reported in the table as taking place in the residual industries is really due to higher energy costs. Similarly, interest costs are much more important than indicated in the table since the table only measures mortgage interest costs.
In total, the special factors isloated in the table represent some over and under estimates of the importance of those factors. Other studies which use other data confirm the general pattern of the inflation described in the table.
In each of the highly inflationary sectors, special circumstances caused shortages of the commodities in question. Bad harvests worldwide and the emergency of Japan as a major world food customer greatly increased the demand for American food. The oil embargo cutoff a major U.S. source of petroleum and environmental restrictions caused low sulfer coal to sell at a premium. Import prices soared, particularly raw materials prices, as worldwide demand expanded at an unusually high rate. This was due partly to the growing importance of Japan as a raw materials customer and partly to the rare phenomenon of a simultaneous boom in all industrialized economies. There were also devaluations of the dollar which were responses to historical trends in costs and interest rates in the United States and abroad. Interest costs increased as the Federal Reserve attempted to halt the inflation by tightening the money supply.
These special circumstances were responsible for beginning the inflation the United States now experiences. Price increases were caused only in part by excess demand for output in the United States; excess demand worldwide contributed heavily to the pressure on prices. This combination of events would have caused an acceleration in the rate of inflation in the United States even if domestic demand had been restricted by monetary and fiscal policies. Even if these policies had restricted demand sufficiently to increase the rate of unemployment to 6 percent, rather than the 5 percent rate that prevailed, the special problem that caused food and fuel prices to rise would have increased the general price level. The size of the total increase would, however, have been somewhat smaller.
In 1974, the inflation rate began to spread from food, energy, imports, and mortgage interest rates to other sectors of the economy. Price controls were eliminated in April and wages started up. In the first 6 months of 1974, the CPI increased at a rate of 12.5 percent. The special factors still were causing an abnormal share of this inflationparticularly energy prices which increased at a rate of 43 percent—but the prices of the 60 percent of the index which had been stable until 1974 increased at a rate of 11.6 percent in the first 6 months of that year. The inflation which began in special, isolated sectors had begun to spread to the rest of the economy. By the last half of 1974, inflationary pressures were widespread. In the four special sectors, the inflation rate had fallen below 14 percent, while in the rest of the economy it was near 10 percent.
In the first half of 1975, the special factors had a lower rate of inflation than the rest of the economy. The total CPI increased at a rate of only 6.8 percent despite an inflation rate of 7.3 percent in all sectors except the four special ones. The data for all periods are presented in the table.