Supply-Side Boom

The long-awaited tax cut is fueling the recovery-but dangers still lurk.

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Nineteen eighty-three marks the first year of what will come to be known as the "supply-side boom," set off by the policies known as Reaganomics. Last September my associate, Charles Kadlec, and I predicted that the recovery would begin in the first quarter of this year, as it has. While other forecasters were estimating a mere 2.8 percent increase in real gross national product for the year, we predicted 4 to 5 percent GNP growth, along with continued declines in interest rates and inflation less than five percent. Already, our forecasts seem unduly pessimistic.

What is propelling the boom is the long-awaited personal income tax rate cut that arrived on January 1. On that day, tax rates fell to 20 percent below their 1980 level and 10 percent below the level that prevailed during all of 1982. Married individuals filing a joint return, for example, will not enter the 25 percent tax bracket this year until their taxable income exceeds $24,600—$4,400 higher than for 1982. The 44 percent tax bracket will not be reached until taxable income exceeds $109,400—$23,800 higher than in 1982.

This change in tax rates is far more important to the economy than the literal change in withholding schedules that will occur on July 1. When the amount of taxes withheld declined by approximately 10 percent last July 1, net cash flow in the economy did not change. Since government spending was unchanged by the change in withholding, borrowing requirements rose dollar for dollar with the increase in take-home pay. The cash flowing into consumers' pockets by the lower withholdings was matched by the cash flowing back to the government to fund the increased deficit. The result: net cash flows to the economy were zero.

The key to the stimulative effect of the tax cut lies elsewhere—in increased incentives. Suppose, for example, that you are an employer, and consider how much more your employees would value their jobs if they could take home the full amount of what they cost the firm. Just as important, how many more individuals would be employed if they actually cost the firm what they now take home? As this tax wedge between what employees cost the firm and what they take home narrows, both parties are better off. More of the now lower-taxed activity takes place. As personal income tax rates decline, incentives to work and produce increase.

Tax policy, then, bodes well for recovery. Monetary policy is still a question. And lower energy prices will serve to complement the beneficial effects of the tax effects.

Since last year, the Federal Reserve's abandonment of targeting monetary aggregates has been accompanied by a steep decline in interest rates and a surge in money-growth rates. But the question for the future is, What will guide monetary policy?

For much of 1982 the Fed behaved as if its goal were to keep commodity price indices within a relatively narrow range. More recently, however, the Fed has lowered the discount rate several times even though commodity prices showed more erratic movements.

In response to our October 1982 article suggesting that the Fed was following an implicit price-stabilization rule, Chairman Paul Volcker pointed out the difficulty of focusing on commodity price indices at a time when many commodity prices have been severely depressed by the recession. Until the economy recovers, the Fed will have to monitor what Volcker calls "various indicators of inflationary pressures." The recent fall in the price of gold, decline in commodity price indices and long-term interest rates, and the strength of the dollar on foreign exchange markets all suggest continued success in the Federal Reserve's efforts to stabilize the price level.

In any case, the Fed's actions are circumscribed by price movements. For the Fed to err on the side of ease now could translate in short order into higher rates of inflation. Recent high rates of monetary growth are fine as long as commodity prices are generally stable. They indicate an increase in the demand for money that is part-and-parcel of growing confidence in the outlook for inflation and consequent reduction in interest rates. In this case, fast money growth is a sign of success.

If commodity prices begin to surge, however, this symptom of success turns with a vengeance into the escutcheon of failure. A sharp rise in commodity prices would signal a flight from money and a loss of confidence in monetary policy. Fast money growth under these circumstances would be highly inflationary.

Erring on the side of tightness has equally ominous implications for the economy. Refusing to accommodate today's demand for money balances would tend to drive commodity prices down and interest rates up. Wrenching the credit markets in this way would stifle the recovery, while the ensuing liquidity squeeze would clog the already overcrowded bankruptcy courts and unemployment offices across the country.

Beginning with US decontrol of oil prices in early 1981, competition has been the rule of the day in the energy business. Removing the United States from active participation in the cartel destroyed OPEC's ability to dictate prices in this country. OPEC has been losing market share in a shrinking market. World oil production has fallen and, along with it, OPEC's share of the oil market. With forecasts for oil prices now ranging from $10 to $30 per barrel and little chance for any significant advance for three to five years, the incentive for most of the world's energy producers is to pump oil, dig coal, and transport natural gas now while the price is high.

Conversely, consumers of energy have an incentive to defer energy consumption as long as possible. The implications of an increase in non-OPEC energy production and the continued decline in energy demand create tremendous downward pressure on oil prices. OPEC members are unable even to agree on lower production quotas, let alone to make them stick. As prices continue their decline, all net importers of energy (the United States, Europe, Japan, and most developing countries) will experience the equivalent of a tax cut. The same amount of work effort keeps the worker's house warmer in the winter and cooler in the summer and propels his car or recreational vehicle farther. The incentive to work and produce increases.

The road to growth is not without danger. Specific areas to watch include efforts to restrict trade; federal, state, and local tax increases; foreign government defaults; and foreign tax increases.

The meeting last fall of the nations who are party to the General Agreement on Tariffs and Trade could have provided a counterpoint to fend off growing protectionist pressures in the United States and abroad. The results, however, were quite different. Open warfare between the United States and Europe over agricultural subsidies was narrowly avoided at the meeting, but only because the United States backed off. The Europeans refused to discuss the nettlesome issue of agricultural subsidies or even to agree to future meetings to discuss their elimination. And they disavowed the final communique's commitment to resist new trade restrictions.

As a result, the GATT meeting's failure now threatens to become a rallying point for those who want a shoot-out over trade policy. Upon his return from the meeting, Senator Jesse Helms, among others, advocated countering the Europeans by releasing US surpluses of dairy products into world markets and stepping up export credits and other export subsidies for American agricultural products.

The sentiment for protectionism is also evident from the local-content amendment attached to the gasoline tax/highway bill passed in December. This amendment requires that materials used in the construction or repairs of highways and bridges be American-made when local or state governments so order. Such a requirement breaks the spirit, if not the letter, of the international trade agreements embodied in the GATT and sets a nasty precedent for US policy. The introduction in both houses of Congress of "domestic content" legislation, which would require foreign and domestic automakers to use specific percentages of US parts and labor in vehicles sold in the United States, provides further evidence of protectionist feeling in the Congress.

The apparent movement toward higher federal tax rates at the very time the economy turns toward growth brings into question the overall strength of the recovery. Ironically, the Social Security tax increases scheduled to begin in 1984, now sailing through Congress, improve the outlook for 1983. Just as lower tax rates in 1983 created incentives to postpone economic activity in 1982, higher Social Security taxes in 1984 will create incentives to shift production into 1983. But they will diminish growth in 1984 and beyond.

Tax increases at the state and local level also bode ill for the economy. Faced with a recession-induced decline in tax revenues, state after state has been raising tax rates. During 1982, for example, 21 states raised various taxes an estimated $2.93 billion. Only eight states reduced taxes by a total of just $50 million. Taken together, these tax changes are expected to increase state and local tax revenues for all 50 states by 1.2 percent.

Even such venerable low-tax states as New Hampshire and Florida joined the tax-increasing movement. Florida, for example, increased its sales tax a full percentage point, to 5 percent, though this move is supposed to allow local governments to reduce property taxes. High-tax states, including Michigan, Ohio, and Wisconsin, also were among the big tax increasers. In 1982 Ohio increased its top marginal personal income tax rate to 6.25 percent from 3.5 percent. Combined with increases in its corporate income and sales taxes, Ohio expects to raise $544 million. That follows $1.3 billion in tax increases during 1981.

Pressures to raise taxes during 1983 are on the rise. Large tax increases have been passed in New York City, Connecticut, New Jersey, and Indiana, while budgetary problems in California have led to enactment of a "stand-by" sales tax increase.

The danger of massive government defaults also dogs the outlook. From an economic point of view, the concerns are probably overstated. The capital of those banks that lent big to Mexico, Brazil, Argentina, and Eastern Europe et al. has been impaired already. What remains is simply accounting for the loss.

The fall in oil prices also will reduce the risk of massive default. To be sure, falling oil prices have impaired Mexico's ability to repay its loans. But the overriding focus on Mexico and other oil producers ignores the part of the United Nations that is not a member of the minority caucus known as OPEC. For every Mexico, there is a Brazil; for every Houston, a Detroit; for every Exxon, an International Harvester.

Absent a change in oil output, each oil-exporting country's loss is offset by an oil-importing country's gain. Mexico's oil exports of 1.5 million barrels a day, for example, are roughly equivalent to Brazil's oil imports. Holding output constant, only the distribution of wealth changes with a decline in the price of oil.

The breakdown of the OPEC cartel, however, suggests that oil output will increase. Let there be no mistake about it, a fall in the price of oil accompanied by an increase in oil production increases the total wealth—and therefore the strength—of the financial system.

Moreover, even the distributional effects of the decline in oil prices favor banks during the transition period. Of the seven nations with the largest net debt to banks—Argentina, Brazil, Chile, Mexico, Peru, the Philippines, and South Korea—six are oil importers whose creditworthiness will be enhanced by a decline in oil prices.

The real danger is that foreign government credits will become the basis of another inflationary surge. Fear of the default is being used to prompt the US and other governments to increase the monies available to bail out these governments. Agreement has been reached to increase the capital base of the International Monetary Fund by 50 percent through increased member quotas. The money will be used to help those countries most reckless in their own affairs. Creation of a super-fund would similarly reward countries for committing the last act of folly in order to qualify for the concessionary terms of a new loan. Congress will soon be deciding these issues.

Elsewhere in the world, fiscal policy is detracting from prospects for growth. In Germany, where unemployment last year exceeded 2 million for the first time since 1954, the government of Helmut Kohl raised the value added tax 1 percentage point, to 14 percent, for most products and to 7 percent from 6.5 percent on groceries, newspapers, magazines, and professional services. The tax increase will be effective in July. The goal is to narrow Germany's budget deficit; the result will be to increase its unemployment rate and social unrest. Tax rates in France also have gone up.

Meanwhile, the debt-servicing problems of many developing countries are opening the door for the International Monetary Fund's standard austerity package of currency devaluation, higher tax rates, and cutbacks in government spending. Implementation of such programs in Mexico, Brazil, Argentina and other countries will postpone recovery in these countries, as well.

Increases in the stock market indices in the eight major industrial countries—Canada, France, Germany, Italy, Japan, the Netherlands, Switzerland, and the United Kingdom—indicate that in spite of these tax increases, economic recovery will permeate these economies. Nonetheless, economic recovery in the United States will be dampened by the stagnation that now grips the rest of the world.

The failure of the GATT meeting, the financial problems of the developing countries, and continued high unemployment and slow economic growth in Europe and Japan seem to have provided the catalyst for serious consideration of a new monetary accord. In a speech before the GATT conference, French Foreign Trade Minister Michel Jobert questioned the value of the session without discussions of the international monetary situation. "It is paradoxical to concentrate on current trade tensions, while the real problems result from an unprecedented crisis in production," said Jobert. The source of these troubles was not the trading system, but "uncertainty provoked by erratic and incessant fluctuations in currency values."

Concerns over the financial problems of developing countries and the worldwide recession have led Felix G. Rohatyn—chairman of New York's Municipal Assistance Corporation, investment banker, and leading intellectual for the Democratic left—to nearly the same conclusion. Wrote Rohatyn in the December 5 edition of the New York Times Magazine:

For 25 years after World War II the international monetary system functioned as a result of the Bretton Woods agreements of 1944, which produced extraordinary growth and wealth throughout the world. Because it posed many problems, we have replaced this international system based on fixed exchange rates with a system based on floating rates, which poses even greater problems. The wild fluctuations in foreign exchange rates, speculative raids on individual currencies, the uncontrolled growth of the Eurodollar market—all have contributed to worldwide inflation and destabilization. Cooperation among America, Japan and Western Europe in an effort to synchronize economic policies geared to sound growth is now vital.

Against this backdrop, Treasury Secretary Donald Regan's call for discussions on stabilizing the international financial system signals a potential breakthrough in US international monetary policy. Reportedly, the US government is willing to consider all options, from a return to a gold standard to continuation of the present system.

A weakened OPEC can only add impetus toward a new international monetary system. Part of Regan's original support for the strong-dollar policy of the last two years was that an appreciating currency would lower the cost of raw-material imports, including oil. His comments were prescient. In the intervening two years, the foreign exchange value of the dollar has climbed 36.4 percent, commodity prices have fallen 20.9 percent, and OPEC's power over oil prices has been all but vanquished.

Though the chances of attaining a new international monetary agreement within the next year must be rated low, the broaching of the subject in advance of the 1984 elections bodes well for the outlook. Reinstatement of a system of fixed exchange rates inevitably will require institutionalization of a price rule. One of the key issues in restoring fixity is determination of which country intervenes in the event of divergence in the value of their currencies. Another issue is how to stabilize the price level throughout the monetary system. If the United States were to join the European Monetary System, the intervention issue would be settled by the complex calculations that govern that currency bloc. But price stability would not be guaranteed; under such a system, the rate of inflation would be determined by the weighted average of all participating countries.

Traditionally, price stability for the overall system has been warranted by using a commodity standard such as gold as a guide to monetary policy. Under such a system, if currency values diverge, the country with either a rising or falling nominal price level in terms of the commodity is required to intervene.

It is hard to overestimate the power of a well-conceived international monetary system to propel the world economy out of its current slump. Restoration of a stable price environment, both through time and across countries, would ignite a second historic rally in long-term bond markets. Moreover, by increasing investment horizons in both dimensions, such a change would launch a capital spending boom the likes of which would rival the experiences of the mid-1960s. (From 1964 to 1966, nonresidential fixed investment in constant dollars grew at an average annual rate of 13 percent.)

Thus, in spite of potential setbacks, 1983 appears to be the year a sustainable recovery will begin. The groundwork for a supply-side boom is in place. While the first year may produce a slightly slower-than-normal recovery, the distribution of potential growth patterns is skewed to the high end.

Recovery would serve to reinforce President Reagan's commitment to his program for economic growth. Good economic policies that had been implemented poorly, and with excessive slowness, are finally coming into existence.

Arthur Laffer is a professor of economics at the University of Southern California and a leading theorist of supply-side economics.

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