The annual report of the president's Council of Economic Advisers warned yesterday that, if federal spending is not cut sharply, taxes will have to be raised to bring down the budget deficit.
The report, which accompanied President Reagan's yearly economic report to Congress, indicated that the current strong economic expansion eventually would be undermined if the budget deficits are not trimmed in future years.
While stressing the need for action on the deficit, William Niskanen, the remaining member of the CEA, also emphasized the current health of the economy in testimony to the Joint Economic Committee.
Federal Reserve Board Chairman Paul A. Volcker, who followed Niskanen at the hearing, warned of the nation's swollen trade deficit as well as budget deficits, noting that the United States "is in the process of moving from the world's largest creditor to the world's largest debtor" and no longer can rely on foreign investment to help finance its deficit in international transactions.
The CEA report predicted that what so far has been the strongest economic expansion in 30 years will continue in 1985: The gross national product will grow 4 percent and consumer prices will go up 4.2 percent. Beyond this year, the CEA report projects continued healthy growth and declining inflation, interest rates and unemployment. But those projections are conditional on adoption of the proper government policies, including cutting federal spending and a predictable, moderate growth of the money supply.
Niskanen said one reason large deficits have been allowed to continue is that they have not produced the "apocalyptic" consequences, such as more inflation or a recession, of which some economists warned. The deficits "are better described as a slow-acting but potentially lethal cancer that must be dealt with sooner rather than later," Niskanen said.
The CEA report put it this way: "If the American people prefer that federal expenditures be restrained to about 20 percent of the gross national product, no increase in taxes is necessary; if they prefer the current share of about 24 percent, a substantial increase in tax receipts is necessary at some time."
And it explained, "Whatever the effects on the economy, the effects of the deficit on the federal budget are clear: Federal borrowing increases future interest payments that must be financed by either reducing future noninterest expenditures or increasing taxes."
Federal Reserve Chairman Paul A. Volcker, who followed Niskanen in testifying before the Joint Economic Committee, also pressed for action on the budget deficit. "Do as much as you can as soon as you can," Volcker urged. "I don't have any fear you will do too much."
Volcker questioned whether the $50 billion cut in spending proposed by President Reagan for fiscal 1986 is large enough to put the budget on an acceptable track. "That's just the first step," he said.
The Fed chairman added that for 1988 and later years, the deficits laid out in the Reagan budget "are extraordinarily large" for a period when the economy is projected to be operating essentially at full employment. In 1988, the deficit shown by Reagan -- $144 billion -- would be nearly 3 percent of GNP and the $107.5 billion deficit in 1989 still would be 2 percent. At that level, the deficit would absorb 20 to 25 percent of the nation's savings, he said.
Volcker also said he would prefer that the deficit be reduced by cutting spending, but he reiterated earlier statements that, "If you can't do it on the spending side, then do it on the revenue side."
Volcker also raised questions about the sustainability of the current situation the United States faces internationally. "Neither we nor other countries can expect growth to be maintained indefinitely on a shaky foundation of large and growing trade deficits, massive capital flows to the United States and accelerating international indebtedness," the Fed chairman said.
Meanwhile, President Reagan, in his annual economic report to Congress, said the administration expects "to cooperate closely with the Federal Reserve in defining and carrying out a prudent and predictable monetary policy," a statement some observers took as a mild threat, given suggestions by some administration officials that the board's independence be curtailed.
Niskanen told reporters that no proposals for exerting new controls over the central bank have been discussed by the Cabinet Council on Economic Policy.
The president noted that his new budget assumes steady economic growth through the end of the decade, although "we know that economic recoveries have not been stable in either duration or magnitude, in part, because monetary and fiscal policies have often been erratic."
And Reagan also declared, "We need to stengthen the commitment to a sound monetary policy that never again retards economic growth, or reaccelerates inflation." Asked by reporters if such a policy was, in fact, possible, Niskanen replied that both of the objectives "are not necessarily achievable all of the time."
Reagan said his own fiscal policy, despite record deficits, is properly aimed toward less spending and, eventually, with more cuts beyond those proposed this year, it will produce a balanced budget.
The CEA's report maintained in a chapter written by Niskanen that the economy would benefit the most if deficits were eliminated by cutting spending. Citing recent studies, the report said that the true cost of government spending to the economy is about 1 1/2 times the actual budget outlay.
Part of the added cost comes from tax payment and compliance activity by taxpayers and by government, and part arises from the misallocation of resources that occurs when government collects taxes and uses them directly or indirectly in ways other than the private sector would have, the report said.
In a striking departure from many past appraisals, the CEA report said that fiscal policy has little if any direct impact on GNP growth except in time of war. "The primary effects of the federal budget on the economy appear to operate through the 'supply side' of the economy by affecting incentives to work, save and invest, although this conclusion is controversial," it said.
Monetary policy determines how fast current-dollar GNP grows, while tax and spending policies can affect only the composition of the actual goods and services produced, the report continued.
More traditional Keynesian economists believe that fiscal policy can have much more direct impact on growth than that, particularly if there is unused productive capacity available in the economy. However, they, too, believe that growth of the money supply is a major factor in determining the rate of growth of current-dollar GNP.