With the election over, President Reagan and his top aides and advisers will begin this week to address the difficult choices he must make to deliver on his promised reduction in future federal budget deficits and tax simplification.
A long-awaited report on tax reform from the Treasury Department won't reach Reagan until sometime next month, but the budget planning can't be postponed that long -- not if the fiscal 1986 budget is to get to Capitol Hill on time after the first of the year.
One key, unanswered question underlying the policy debate is the extent to which the changes in taxes, spending and monetary policies of the last four years may have improved the outlook for long-term growth of the American economy.
The consensus among most private economists is that there has been an improvement, but not a terribly large one. However, a minority of so-called supply-side economists maintain that a sea change has occurred and that the nation faces a rosy future with rapid increases in productivity lifting living standards and eventually eliminating the budget deficits.
Officials at Treasury, the Office of Management and Budget and the Council of Economic Advisers have given their own answer to this question by agreeing among themselve to continue to use the administration's long-term economic growth projections presented early this year. The official forecast for 1985 and 1986 and projections for later years will show about a 4 percent-per-year increase in the gross national product, adjusted for inflation, until unemployment approaches 5 1/2 percent. After that, it will show growth of about 3 1/2 percent a year.
"By and large, there is a consensus on that," said William Niskanen, a member of the Council of Economic Advisers. "We don't want there to be a debate over the forecast when the real issue is the policy."
The policy question, Niskanen added, is "how much we are going to take out of the deficit, how quickly, and how. All three of those issues are open."
Niskanen said emphatically that the nation has nothing to fear from rapid real growth if it goes hand in hand with stable or declining inflation. With more than a bit of understatement, he continued, "If somebody could give us a plausible reason for a higher number, there are lots of people who would be receptive to it. . . . But writing up the forecast doesn't achieve higher growth."
The administration has looked at the higher growth forecasts of Richard Rahn of the U.S. Chamber of Commerce and others and found nothing in them to explain why productivity should grow as rapidly as called for in those forecasts. For instance, in a forecast issued last week, Rahn showed real GNP rising The policy question is "how much we are going to take out of the deficit, how quickly, and how. All three of those issues are open." -- William Niskanen at a 5 percent rate or better beginning with the second quarter of 1985 and continuing through the end of his forecast period five quarters later. Productivity was forecast to rise 3.2 percent a year for the whole 1984-1986 period.
Rahn defended such projected productivity growth -- the linchpin of his forecast -- on the grounds that business capital investment is rising rapidly, that a "technological revolution" involving computers is under way and that an aging labor force is becoming steadily more skilled.
Rahn agreed that "hard evidence is lacking" that productivity growth will return to rates not seen consistently since the 1960s, but he nevertheless remains convinced that it will.
In contrast, a new set of long-term economic projections by Alan Greenspan, the former CEA chairman who heads Townsend-Greenspan & Co., shows real GNP rising 3.1 percent over the next decade, with labor productivity increasing 1.75 percent annually. Growing even that fast will require successful resolution of a number of potential problems, such as the questionable ability of many Third World nations to keep current on paying their debts to banks and governments in the industrial world, Greenspan said.
One reason that Greenspan thinks productivity growth will not be faster than that is the nature of the capital investment that has occurred in the last two years and that he expects to continue for some time to come. Although business investment in new plants and equipment, particularly equipment, has gone up very swiftly since the end of 1982, a large share of the investment has gone into items that have a relatively short expected useful life. That contrasts with the investment surge of the 1960s, when the average useful life of the additional capital stock was quite long.
The problem is that, the shorter the useful life of a machine or other item, the larger the annual charge for depreciation must be. In this case, depreciation is the actual economic depreciation -- the wearing out or the obsolescence of the machine -- not some form of accelerated depreciation used for tax purposes.
If the average useful life of additions to the nation's stock of productive capital gets steadily shorter, then the level of new investment must go up each year just to maintain a given level of capital stock. Indeed, Greenspan notes that the share of GNP going to gross business fixed investment has been rising more or less steadily since the early 1960s. And he projects that it will pass the 13 percent level early in the next decade, up from about 9.5 percent 20 years ago and 11.6 percent this year.
But at the same time, if both GNP and the level of gross business fixed investment are adjusted for depreciation, quite a different picture emerges, Greenspan says. Net business fixed investment as a share of net national product peaked at about 5 percent in 1966. Since then, each successive cyclical peak has been lower, and currently the share is about 3.4 percent and is projected to average less than 3 percent over the coming 10 years.
In other words, the money being spent on new equipment now, nearly two-thirds of the fixed investment total, is not buying capital goods that will last very long. This point is not apparent when comparisons are made among the strength of capital investment in this economic recovery and expansion and those that followed other post-World War II recessions.
Another relevant concern about investment several years from now is the nature of the tax stimulus that, by the estimation of virtually all economists, has been responsible for a substantial part of the big increases in business investment over the last two years.
John Makin, director of fiscal policy studies at the American Enterprise Institute, wrote in the November issue of the AEI Economist that the declines in interest rates since mid-1982, coupled with the 1981 business tax cuts, have had the effect of lowering the after-tax cost of investing.
"The difficulty emerges because, as past studies of investment response to such tax measures show, the antidote to high real interest rates wears off after two or three years," Makin said. "If the price of machinery falls, businesses want to add to the number of machines they own. That's investment. Once businesses have the desired number of machines, the new investment stops."
Concluded Makin, "If past history is any guide, that surge will not continue much longer. Meanwhile, user cost of capital is creeping back up instead of falling, as would be required to spark further investment."
Herbert Stein, another former CEA chairman, recently offered another caution in analyzing the rapid rise of investment from its recession lows. "This high rate of domestic private investment is mirrored by a high rate of foreign disinvestment," he wrote in the October AEI Economist. "Relative to GNP, we have been experiencing an unprecedented inflow of capital from abroad. Thus, while we have been building up capital in the United States at a rapid rate, we have been running down our capital owned abroad, or increasing our debts to the rest of the world, at a rapid rate.
"When these two developments, the increase of capital at home and the decrease of capital abroad, are combined, the increase in the capital owned by Americans has been a little smaller, in relation to GNP, than at this stage of earlier recoveries," Stein said.
The foreign disinvestment does not directly affect, say, productivity growth in the United States. But it does mean that the nation is committing itself in the future to spending a larger share of its domestic production abroad to pay the dividends and interest due on the massive inflow of foreign capital. Anthony M. Solomon, president of the Federal Reserve Bank of New York, declared in a recent speech that if present trends were to continue through the end of the decade, the United States would have to use about half of its expected annual increase in real GNP to make such payments.
If that happened, then that part of U.S. economic growth would not be available for investment, or for consumption, for that matter.
The CEA's Niskanen agrees that the administration's 4 percent forecast is higher than that of most private economists, and that it also is lower than what was achieved during the 1960s, a decade to which the supply siders point as a model and as evidence that such growth is achievable again for an extended period of time.
Niskanen says that the CEA's breakdown of prospective growth into the components of labor force growth, productivity gains and added use of presently idle productive capacity and idle workers has convinced him of the plausibility of the 4 percent forecast. He declined to release the annual average figures for productivity growth, but said they are higher than Greenspan's 1.75 percent and lower than the 2.3 percent achieved so far during the Reagan administration.
He also argues that the 1960s should not be used as a model for a forecast for the 1980s for two reasons. First, the expansion of the adult labor force will be about half a percentage point lower in coming years than it was in the '60s. Second, the latter part of that vigorous economic expansion was marked by the impact of the war in Vietnam, which helped boost output sharply, and by a surge in inflation.
So Niskanen and the other top administration policy makers do not intend to jack up projected growth rates to solve their budget dilemma. Instead, they plan to see how much spending can be cut.
"I think the president is entirely correct in how he has laid out his strategy: squeeze government spending to a level that has very broad public support," Niskanen said. "There is still a lot of money to be taken out of the budget over time. That's a wholly appropriate way to go. . . .
"Growth is clearly terribly important," he continued. "If we can grow our way out of the deficit, that's all well and good. After all, it is difficult to get this town to make hard choices. But the people who are saying that we can grow our way out of the problem, they are saying that we do not need to make any hard choices. I wish I believed that, but I don't," he said.
This week the president will get an updated look at some of those choices.