One of the arguments against the countercyclical policies of the past is that they fostered inflation by removing from business firms and workers the incentive to lower prices and wages during recessions in order to protect sales and jobs—why not just wait until the government pumps up demand again? In Britain Margaret Thatcher has put her countrymen and -women on notice that the only way they can restore the jobs and prosperity lost in the current slump is to disinflate. Her Majesty’s government will do nothing about it.
The same warning has been repeatedly issued in America by Chairman Paul Volcker of the Federal Reserve, who, unfortunately for the effectiveness of the warnings, does not quite command the same audience as a head of government. President Reagan has not made Volcker’s threat credible to those who determine wages and prices; instead he has undermined it by promising disinflation without tears, an instant spurt of rapid growth, falling unemployment, and declining inflation. Recently, it is true, his Treasury secretary has lapsed into old Keynesian “error,” urging the Fed to loosen up a bit to forestall incipient recession. On the other hand, the administration is not fine-tuning fiscal policy in an anti-recessionary direction. Instead, its current fine-turning is aimed in the other direction—it is trying like Hoover and Roosevelt in the early 1930s to offset the effects of the recession on the budget deficit by cutting the budget further. (However, recent statements by OMB director Stockman show awareness of the futility of aiming at specific budget deficits in a weakening economy.)
The renunciation of stabilization policy implies, if actually carried through, that the government no longer has meaningful goals for real economic variables—e.g., for employment and unemployment, national production and its growth. Of course, any political administration will publish its projections, scenarios, and hopes. But these will mean nothing if the government eschews measures to make them come true. The Thatcher and Reagan governments both say that they are providing a stable monetary and fiscal framework within which private enterprise and free markets will restore prosperity and non-inflationary growth. Another way to put it is that whatever economic outcomes private agents generate within the framework are by definition optimal. This is how the current chairman of the Council of Economic Advisers, Murray Weidenbaum, puts the case, even if his client doesn’t yet quite understand it that way.
Clearly this is a 180-degree reversal of the commitment of the Employment. Act of 1946, not to mention the Full Employment and Balanced Growth Act of 1978 (the “Humphrey-Hawkins Bill”). To be sure, employment goals have been slipping for a long time. The unemployment rate was 3 percent at the end of the Korean War, 4 percent at the peak of the boom in the mid-1950s when the Fed applied the brakes by raising interest rates, and 5 percent at the next cyclical peak in 1960. The Kennedy-Johnson administration officially adopted a full-employment goal of 4 percent unemployment, achieved it in 1965, and overachieved it during the Vietnam War. During the 1970s operational unemployment targets were not made explicit, but policy moves revealed implicit targets of 5 percent, then 6 percent, now probably 7 percent or more.
The slippage of course reflects the primacy given to the frustrating battle against inflation. But if and when the battle is won, I doubt that the Federal Reserve and the administration would risk reigniting inflation by relaxing the monetary screws enough to permit much reduction of unemployment from the 7 to 8 percent range. More likely they would settle for a resumption of normal sustainable real growth at prevailing rates of capital utilization, and would not provide financing for temporarily higher growth to absorb the slack created during the anti-inflationary fight. This scenario is, by the way, explicit in the projections of the UK Treasury.
In the US today macroeconomic policy and prospect are dominated by Federal Reserve monetary policy. The Reagan administration assigned disinflation to the Fed, chided the governors for past mistakes, and urged them to be tough. The Fed is being tough, and as Chairman Volcker has repeatedly made clear, proposes to be gradually but resolutely tougher every year until inflation rates are insignificantly different from zero. As Volcker and his colleagues appreciate much better than President Reagan and his associates, Federal Reserve money-supply policies will not allow room for real economic growth unless wage and price inflation melts by a point or two a year. Given the stubbornness of built-in wage and cost inflation, there is likely to be considerable economic pain and damage during a transition of several years.
The administration rejects on principle any direct wage and price policies, formal or informal, even diffuse persuasive appeals by the president. In their absence, the only mechanism by which monetary deceleration produces disinflation is by creating sufficient economic distress that workers and employees, desperate to protect jobs and solvency, settle for lower wage and price increases than those currently prevailing. We can see this process at work across the Atlantic, where midway in Mrs. Thatcher’s five-year term the record unemployment rates are in double digits while inflation rates are still in double digits but slowly declining.
A Thatcher scenario was not quite what the Reagan administration had in mind. The “supply-side” tax cuts were intended to unleash a surge of investment, enterprise, and productive effort. Supply-siders were impatient with traditional conservative orthodoxies that tax stimuli must wait for budget balance and disinflation. Exploiting the eager competition of both parties in Congress, they succeeded in promoting tax cuts that outdistanced the budget cuts of the redoubtable Mr. Stockman. But the tax bill only solidified the firm resolve of Mr. Volcker, and he is bound to win a fiscal–monetary tug-of-war. As the securities markets perceived, the situation is a Catch-22. Interest rates cannot be low enough to sustain expansion unless the economy is in recession.
I turn now to a second dimension of the counterrevolution, the distribution of income and wealth as affected by federal taxes and transfers.
Equality of opportunity has been an American ideal and an American excuse. The ideal of capitalism in a democracy is a fair race from an even start. Big prizes go to the swift, but all participants are rewarded—the more rewarded the faster everybody runs. True, economic and social outcomes are highly unequal. The excuses are that the racers all have the same opportunities and that differential prices generate even larger rewards for all participants.
Opportunities are actually far from equal. We Americans escaped the feudal castes of the Old World, but erected our own racial, religious, and ethnic barriers. Even as these are overcome, the hard fact remains that the children of parents of high economic and social status gain a head start—better education at home and school, better nutrition and medical care, as well as more gifts and bequests of worldly goods. To give children these advantages has indeed been traditionally a strong motivation for work, saving, and enterprise.
Wealth breeds wealth and poverty breeds poverty. Despite legendary examples of spectacular social mobility, the unequal outcomes of one generation are generally the unequal opportunities of the next. Here as in other democracies, governments have sought to arrest the momentum of inequality by free public education, social insurance, “war on poverty” measures, and progressive taxation.
The US budget and tax legislation of 1981 is a historic reversal of direction and purpose. Existing institutions, commitments, and “safety nets” can’t be rapidly dismantled, but the message is clear enough; inequality of opportunity is no longer a concern of the federal government.
The government has virtually abandoned all pretense of taxing transfers of wealth between generations. Capital gains on assets so transferred are excused from income tax, and now most of them will be free of estate and gift taxes as well. In the hasty competition of both parties for the favor of wealthy constituents, Congress casually liberalized these taxes without concern for unchecked dynastic wealth and inequality of opportunity.
Capital income, in contrast to wage income, is increasingly free of federal tax. Even before the 1981 tax law, the Treasury calculated that only one-third of capital income showed up as taxable personal income.* Taxable capital gains are seldom realized; when they are the top tax rate will now be only 20 percent. Deferment of tax on income saved for retirement, easily accessible via employer or do-it-yourself plans, effectively frees the returns of such saving from tax and generally moves the principal into a lower bracket. The new tax-exempt All Savers’ certificates carry no risk and beat the current inflation rate by several points.
The monetary–fiscal policies of the administration are, in fact, a recipe for high interest rates; the tax bill eases the pain for upper-bracket taxpayers, who can escape tax on interest receipts while claiming deductions for interest paid on mortgages, consumer debt, and other loans. The sophisticated rich know how, or know lawyers who know how, to combine depreciation and interest deductions with preferential capital gains rates to shelter salaries and self-employment incomes from taxation. Though many tears were shed in the successful effort to reduce those high-bracket taxes alleged to deter saving and investment, especially the 70 percent rate now abruptly lowered to 50 percent, few inhabitants of those brackets paid such taxes or will pay them now.
The government is a partner in business enterprise, and recent legislation impairs its equity—almost to the point where the Treasury’s share in investment costs and risks exceeds its share in prospective earnings. This is the result of combining greatly accelerated depreciation, “15-10-5-3,” with the investment tax credit—its value multiplied by leaseback arrangements—and interest deductions.
At the low end of the economic spectrum, federal efforts to bolster incomes and opportunities are being abandoned. As federal funds for welfare, food stamps, Medicaid, jobs and training, aid to education, and other residues of the war on poverty are reduced and combined into block grants, the beneficiaries will be at the mercy of local legislators and taxpayers. This process is just beginning. About $150 billion in 1984 tax revenues have been given away, and thanks to bracket indexing none will be recouped by inflation thereafter. The president has now donned his budget-balancing hat and presses Congress to redeem his promises by making budget cuts even greater than those enacted earlier this year. They won’t be found in defense, public-debt interest, or even in social security. There will be further cuts in social programs, more doses of the “new federalism” that devolves these responsibilities and their funding on to states and localities.
The Reagan economic program is advertised to cure inflation and unemployment, to revive productivity, investment, hard work, and thrift. It probably cannot achieve those wonderful results. What it is sure to do is to redistribute wealth, power, and opportunity to the wealthy and powerful and their heirs. If that is its principal outcome, the public will become considerably disenchanted.
Despite its free-market ideology, the administration has done little to dismantle regulations and subsidies that are costly, inefficient, and inflationary. Agricultural programs still not only subsidize producers but do so in ways that raise prices to consumers. Taxpayers, consumers, and shippers pay for our high-cost, noncompetitive merchant marine. The Carter administration deregulated airlines, but analogous measures for surface transport are stalled. The current administration is ready enough to liberalize or discontinue regulations of business when the opposing values are consumer protection or environmental conservation. It is by no means so devoted to market freedom, competition, and consumer interest as to challenge important business, labor, and farm constituencies. These politically sacred cows have been around a long time, and no other administrations have mustered the will or the power to kill them either. But an administration that claims a popular mandate for counter-revolution should not leave unscathed the most objectionable features of the old order.
The outlook for the American economy in the 1980s contains some bright spots and some dark prospects. On the bright side, it seems unlikely that the US and the world will be hit by external shocks of the magnitude of those of the 1970s. Though the present oil glut may not continue, Americans are now much better adapted to high oil prices and much better prepared to cope with future increases. To the extent that productivity and capital formation were held back in the 1970s by energy shocks and uncertainty about how to adapt to them, they should rebound in the 1980s.
On the dark side, the purely monetary cure for inflation can hold down the economy for half the decade, with capital formation discouraged either by high real interest rates, or by gloomy profit expectations, or both. The “new federalism,” as is only beginning to be realized, will have devastating effects on the finances of many state and local governments and on the services they render, especially to the poor. Meanwhile the tax cuts will be widening the gulf between the living standards of the rich and those of the poor, without the promised compensation in the conquest of stagflation. In the end, I think, a democratic polity will not tolerate in its government and central bank an economic strategy of indifference to the real state of the economy.
Eugene Steuerle, "Is Income from Capital Subject to Individual Income Taxation?" Office of Tax Analysis Paper 42, October 1980.↩
Eugene Steuerle, “Is Income from Capital Subject to Individual Income Taxation?” Office of Tax Analysis Paper 42, October 1980.↩