The final Economic Report of the Carter administration is a 357-page yellow caution flag waving at Ronald Reagan and his economic advisers.
Inflation worsened in 1980, and the underlying rate is now at least between 9 percent and 10 percent. Wages and benefits rose more rapidly despite the recession. Food and energy prices will be going up faster than prices generally for years to come, the report released today asserted.
These realities led President Carter to propose raising taxes this year and next rather than cutting them, while at the same time reducing real nondefense spending. This tight-fisted policy, in company with an equally stringent monetary policy, is intended to keep substantial slack in the economy and unemployment high in order to slow inflation.
But President-elect Reagan, not Carter, will be setting economic policy after tomorrow, and large personal and business tax cuts are at the head of his list of changes. Reagan also plans to cut federal spending. Neither the exact size nor the timing of the two groups of cuts has been set.
The Economic Report warned that large tax cuts not offset by spending cuts could lead to a surge in economic growth and inflation. "Because an increase in inflation once under way is so very hard to eliminate, an inflationary mistake takes much longer to reverse than its opposite," the report from the Council of Economic Advisers declares. "the risks that policymakers face are not symmetrical and, as a consequence, uncertainty must be resolved in favor of caution."
Sources close to the officials working on Reagan's policy package said that as the planners get more deeply into the details of where to cut the budget, there is new concern that Reagan may not be willing -- because of political realities -- to agree to spending cuts that are as large as the tax cuts or that can be made as quickly.
The incoming director of the Office of Management and Budget, David A. Stockman, promised the Senate Budget Committee during his confirmation hearing that the tax cuts would be largely offset on the spending side. Now, the sources said, there are indications Stockman is no longer sure that can be the case.
CEA Chairman Charles L. Schultze, at a briefing on the report, said cutting taxes in 1981 without also cutting spending would lead to an increase in the demand for goods and services -- which, under present circumstances, would generate more inflation.Faster economic growth, however, also could produce a collision with the Federal Reserve's tight restrictions on the availability of credit, with sharply higher interest rates quickly choking off the economic expansion.
In fact, Schultze conceded, the administration's own forecast of little or no growth in the first half of 1981 and about 3 1/2 percent rate of growth in GNP in the second half and throughout 1981 might not be consistent with the Fed's targets for limited increases in the money supply. Based on historic relationships of the growth of GNP and money, "You can make it, but you are on the edge" of what reasonably can be expected, he said.
After a meeting on Friday between Reagan and a number of advisers and members of his new cabinet, Stockman said the Carter forecast "is too optimistic" given the tax and spending policies the outgoing president recommended in his 1982 budget. With the policies Reagan will adopt, "We can have a much better economic forecast," Stockman said. The CEA report also included the following points
Setting targets for growth of the money supply "provides an invaluable tool to increase monetary discipline, to communicate Federal Reserve intentions, and to evaluate performance." But in a world subject to major and unpredictable changes, deviations from the targets may be necessary and should not be taken by the public to mean the Fed has abandoned its intention to curb inflation. Because of major changes in banking regulation this year, it will be particularly hard to set a proper monetary policy course.
Use of some form of an "incomes policy" can reduce the economic and social cost of trying to cut inflation by holding down the economy. The Carter administration's voluntary wage and price standards did reduce inflation while they were in effect. The most promising policy of this type for the future may be a tax-based incomes policy, or TIP, under which workers who accept pay increases below some set level would get income tax credits.
Trying to pick "winners" and "losers" among industries or within industries as part of a national industrial policy designed to foster faster growth and greater international competitiveness would not work because "it is presumptuous to assume that successful indentification of winning and losing industrial sectors is possible."
Rising exports have given the United States the strongest balance of payments position of any major industrial country, a position that is expected to continue to improve in 1981 despite continued increases in oil prices.As a result, the dollar should remain relatively strong in foreign exchange markets.
Much of the Economic Report is devoted to laying out how thoroughly inflation has become imbedded in the U.S. economy and how high the cost of rooting it out would be.
"Over the past 15 years, the underlying rate of inflation has risen from about 1 percent in the first half of the 1960s to 9 percent or 10 percent now," the report said. "The increase has not been steady. Instead, there have been three major episodes. Each period began with a sharp increase in the underlying rate and ended with the rate falling only part way to its original level."
The first jump came during the Vietnam war, and the second began in 1973 when world grain and oil prices shot upward. When the third occurred in 1979, the underlying rate of inflation was already between 6 percent and 7 percent, and the doubling of oil prices that year gave it another boost.
"The chief problem with respect to inflation is not the sporadic developments that generate inflationary impulses. Instead, it is the ratchet-like nature of the inflationary process which makes it resistant to downward pressures," the report said.
With the growing realization among business officials and workers that the government no longer would tolerate the frequent and often severe economic declines that preceded World War IIand that often produced falling wages and prices, a harsh form of discipline was lost. If wages and prices fell out of line with economic reality, the government could be trusted to change that reality by stimulating the economy.
Thus, the report said, "The rate of wage and price increase has become relatively insensitive to moderate degree of economic slack. As a consequence, the cost of the necessary restraint -- in terms of additional unemployment, idle capacity and lost income, production and investment -- would have (to be) extremely high" to return the economy to the level of inflation it was experiencing before an inflationary shock occurred.
"Downward wage and price rigidity makes the costs of reducting inflation through monetary and fiscal restraint quite large," the report continued. "It is difficult to estimate the costs with precision, but representative econometric studies suggest that reducing inflation by 1 percentage point would require a sacrifice of $100 billion in lost output (in 1980 prices) and a one-half-percentage-point rise in the unemployment rate over a period of about three years."
The report added that the costs might be smaller, but it is hard to be sure because "there has never been a period of sustained economic restraint in recent times . . ."
For 1981, the important point is that the incoming administration is not talking at all of sustained economic restraint. Rather, Reagan and his advisers argue that large tax cuts will provide such incentives to work, to save and to invest that the economy will become much more productive and much less inflation-prone.
The Economic Report agreed that a major increase in business investment is needed. It suggested than an increase from the recent average of about 10 1/2 percent of GNP to 12 1/2 percent or 13 percent will be required to improve productivity, retire equipment made obsolete by drastically higher energy prices and continue needed domestic production of oil, coal and natural gas.
"Since the growth of aggregate demand and total GNP will be constrained in the years immediately ahead by the need to reduce inflation, the extra investment cannot come from additional GNP growth but will have to displace consumption or government spending, the other major components of GNP," the report said.
However, such a large annual increase in investment -- 2 1/2 percent of GNP is now nearly $70 billion -- "will not be forthcoming without deliberate government policies. The major elements of such a policy lie in a combination of federal tax measures and expenditure control," it said.
The Reagan advisers would not quarrel with that sentiment, but are not considering either the combination of tax measures or expenditure control Carter's CEA believes is appropriate. The tax reductions should be "of a kind which concentrate on encouraging investment rather than restoring the growth of consumption . . ." the report asserted. Across-the-board personal income tax cuts, which Reagan will propose, will primarily increase consumption, not saving or investment, Schultze said at the briefing. To the extent government spending cuts offset such personal income tax cuts, one simply trades a form of government consumption for personal consumption with investment little affected, the CEA chairman added.
Both Carter and Reagan, on the other hand, have backed cutting business taxes by increasing depreciation allowances on capital investments. But the report cautioned that even here the payoff in terms of more productive economy will be slow.
"The evidence suggests that each dollar of reduction in annual business taxes might, at the outside and after several years, generate slightly more than a dollar in business fixed investment. To increase investment by 10 percent a business tax reduction of at least $30 billion -- or about 1 percent of GNP -- would be necessary. This larger volume of investment, maintained from 1981 through 1985 would increase the capital stock by about 5 percent after allowing for depreciation. On the basis of the historical relationships between output and capital, such an addition to the capital stock might generate a total increase in the level of productivity of at most 1 1/2 percent by 1985, or about 0.3 percent per year." And that, the report said, "would translate, after several years, to just over one-half percentage point reduction in the inflation rate."
If this analysis is correct, the business tax cuts planned by Reagan, which likely will not approach even $30 billion for several years, will not cut inflation very quickly.
The Economic Report went on to discuss the supply-side response to personal tax cuts. It said personal cuts would increase the total supply of labor only slightly because, although higher after-tax wages may induce some people to work more, the boost in take-home pay also will induce others to work less.
At the same time, a 10 percent reduction in rates would increase personal savings by no more than 3 percent, with the added savings equal to no more than about 0.2 percent of GNP. "If the tax cut and the higher saving continued for five years, the additional saving and investment would increase potential GNP by less than 0.3 percent and lead to a negligible increase in the annual rate of productivity growth," the report said.
A cut in personal taxes, however, would have a much quicker and much larger impact on total demand. "A 10 percent reduction in marginal tax rates on individuals (approximately a $30 billion personal tax cut in 1981) would increase the total demand for goods and services by $60 billion, or 2 percent of GNP," it continued.
The real rub, though, is timing. The increase in demand would come quickly, within one to two years. The increase in supply, on the other hand, would occur very gradually. The potential danger in the policies Reagan has in mind lies in the difference in timing, in Schultze's opinion. As his report put it, "In recent years the nation has come to appreciate the potential value of supply-oriented policies. In the process of learning some needed lessons about supply-side economics, however, the nation cannot afford to forget its hard-learned lessons about the need for demand-side restraint."