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Preface

This paper was prepared to aid the Senate Budget Committee in formulating the First Concurrent Resolution on the Budget for Fiscal Year 1977.

The paper was prepared by Donald Nichols and Edmond Haggart with the assistance of Karen Schubeck and Martin Asher of the Senate Budget Committee staff. Michael Owen and Frank deLeeuw of the Congressional Budget Office provided the econometric analyses.

EDMUND S. MUSKIE,

Chairman.

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GOVERNMENT POLICIES TO REDUCE

INFLATION

I. Summary

Fiscal policymakers are well aware of the short run trade-off between inflation and unemployment. The threat of renewed inflationary pressures is a deterrent to policies which would hasten the return to full employment and full production. In the present unusual circumstances when both unemployment and inflation are high, policies are needed which will cut prices and stimulate recovery simultaneously.

This paper suggests that policy opportunities of this kind are available through modest changes in the 1977 budget. Specifically, the President has proposed to change several prices and costs which are now directly controlled by the Federal Government. Some of his proposed changes would increase prices, such as the 0.3 percent increase in Federal social security payroll taxes and the increase in unemployment insurance taxes. Some proposed changes would lower prices, such as his proposals for Federal pay and Medicare cost control.

Taken together, these changes, upon which Congress must act this year, can reduce the general price level by more than one-half of 1 percent, compared with what would otherwise be. Additional opportunities for price cutting by the Federal Government could reduce prices by another one-half percent at least, without considering secondary effects of price reductions on wage rates.

These proposals also have an indirect effect on prices through their effect on economic activity. A cut in payroll taxes, for example, would reduce unit labor costs and therefore tend to reduce the rate of inflation; but it would also stimulate economic activity, and this would tend to cause prices to rise. Both effects are considered here. Inflation caused by direct changes in prices or costs is called cost inflation, while that caused by changes in economic activity is called demand inflation.

Section 1 examines the effect of some Federal policy options on cost inflation. Section 2 addresses the effect of these price-cutting options on demand inflation and compares their stimulative consequences with those caused by equivalent cuts of personal income taxes.

The price cutting options are shown to have a more favorable effect on both prices and jobs. The model used here suggests that there are feasible policies that will cut prices by eight-tenths percent in the first year and unemployment by over 0.4 percent in the second year. The disadvantages of using the price system in this fashion are noted.

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The options in this paper are considered independent from their effect on the Federal deficit. The conclusion is that cost cutting policies which would reduce Federal revenues by $10 billion have a more favorable impact on inflation and unemployment than, for example, a personal income tax cut which would reduce Federal revenues by the same amount. Moreover, it should be noted that a policy to reduce costs and inflation directly will permit adoption of more stimulative fiscal and monetary policies that will also reduce unemployment more quickly.*

II. Costs and Prices Under Direct Federal Control A. THE ADMINISTRATION'S BUDGET PROPOSALS FOR FISCAL 1977

The President's fiscal 1977 budget proposal suggests changes in many prices and costs. These are outlined here and an estimate of their impact on inflation is given.

PAYROLL TAXES

The President proposed that the social security payroll tax be increased by 0.3 percent on both employers and employees on January 1, 1977. This is estimated to yield $3.3 billion in fiscal 1977 (in the first 9 months of 1977), and $4.4 billion over the full year. That half of the tax which is paid by employers is an increase in labor costs, and in the short run these costs are usually passed on to consumers in the

* Minority footnote:

A strong word of caution is required about concluding that fiscal stimulus in addition to that resulting from these policies should be adopted. The favorable short-run effects of these policies on inflation does not mean it is safe to apply still more stimulus-to get back to the original inflation rate and benefit from doubly improved real growth. There are three reasons for this caution: (a) The quantitative reductions in the rate of inflation are rather

uncertain. This is merely a realization that the numbers are best estimates. If not increasing the unemployment payroll tax reduces the rate of inflation by 0.25 of a percentage point, this does not mean that added stimulus totaling a 0.25 increase in the inflation rate-by rule of thumb giving 0.5 added reduction in the unemployment rate-should be adopted. We can, however, safely conclude that adopting such a policy can be expected to produce at least as much real growth as tax reduction producing deficit of equal magnitude. In addition, the rate of inflation can be expected to be lower. A policy that would have similar effects and

was not mentioned in the paper is a wage tax credit. (6) The reduced rate of inflation resulting from use of policies that

influence prices directly may be only a short-run phenomenon; the longer-run effects on the rate of inflation will be considerably less, possibly zero. Therefore, to apply stimulus in addition to that provided by the direct price policy may well result in a higher

rate of inflation in the longer run. (c) The short-run trade-off between inflation and unemployment is not

constant throughout the possible range of unemployment rates and real growth rates. In general, the lower the unemployment rate or the more rapid the rate of real growth, the greater will be the increase in the rate of inflation from added budget/or monetary stimulus. Therefore, the added stimulus in addition to that provided by the direct price policies would affect that inflation rate more than it would in the absence of the direct price policies.

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