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SOME PROBLEM S IN O PTIM IZIN G T H E L E V E L OF PU B L IC E X P E N D IT U R E S Kenyon E. Poole, professor of economics, Northwestern University Sum m ary In this paper I should like to discuss a few of the problems that are met with in the determination of the optimum level of Federal expenditures, with particular reference to stable economic growth. I t may be useful to preface the more extended remarks with a brief summary of the major points th at will be covered in the text. I t seems to me th a t there is a tendency on the p art of many com mentators on the problem of Federal finance to be unduly pessimistic on the effectiveness of the budgetary process in holding Federal ex penditures to the level that makes a maximum contribution to aggre gate social welfare. In an age in which economic resources are still scarce, public information media can be counted upon to call atten tion to any really serious misallocation of resources between the public and the private sectors of the economy, or within the public sector. I t has to be conceded, of course, th at the complexities of the budgetary process, and the obstacles to making close calculations with respect to the relative social desirability of public and private spending pro grams, provide room for much difference of opinion on the effective ness with which our economic institutions allocate resources. W hat should not be conceded is the contention th at these difficulties make intelligent budgeting of resources for maximum social welfare an unattainable objective. In accordance with the relatively optimistic attitude adopted here toward the possibility of intelligent budgeting, two commonly held and widely divergent opinions are rejected. One is the view th at the secular rise in gross national product entitles the Federal Government to proceed with additional social-welfare programs on some kind of automatic basis, and the other is the frequently expressed view th at Federal expenditures are “too high,” or th at they have risen too rapidly. Both of these opinions beg the question by making tacit assumptions on which there is room for disagreement. I t is merely an assumption that government is entitled to share in any definite way in the annual increments to national product; but on the other hand it is to be expected th at as an economy grows, the absolute economic importance of government will grow with it. The job th at has to be done is to determine how fa r and in what directions government func tions should evolve when population, national output, and productiv ity are growing. By restricting the discussion of Federal spending to problems of economic growth, we exclude two types of programs. Day-to-day housekeeping expenditures, though both affecting and affected by economic growth, are not a prim ary consideration. Moreover, Fed 116 ECONOMIC GROWTH AND STABILITY 117 eral programs which may be definitely classed as social consumption are not directly relevant. A problem is posed in practice, however, in differentiating between programs which increase the capacity of the economy to produce goods and services (or to make progress in some broader sense), and those which merely contribute to current social consumption. The difficulty is, of course, that many programs have aspects of both. Examples which readily come to mind com prise most of the major Federal nonmilitary program s: Federal aid to schools, hospitals, residential construction, depressed areas, slum clearance, highways, aid to small business, social security, and the like. In passing judgment on the admissibility of particular programs we should be careful to distinguish between their social consumption aspects and their capacity for contributing to growth. Both are equally relevant to social w elfare; but it is necessary to face up to the implications of selecting a given ratio between the two objectives, and this involves taking a long look at every proposed program with this distinction in mind. This is an aspect of Federal budgeting which has not received sufficient attention in the past. A possible defect in our capacity for properly evaluating the net welfare contribution of Federal expenditures for economic develop ment stems from the fact that there is less resistance to spending pro grams that can be financed out of an automatic rise in tax receipts as national income rises than there is for programs that require a rise in tax rates. The reason is that public opinion seems to be fairly united on the view that tax rates, and especially income-tax progres sion, have reached (or surpassed) permissible peacetime limits. Im plicitly this means that the public believes that Federal spending lias already gone somewhat beyond the point at which its net marginal contribution to national welfare is negative. The effect is th at ade quate consideration may not always be given to the relative impetus to economic growth (and thus to an ultimate rise in the tax base and tax yields) of development programs that initially, at least, require a rise in tax rates. This disability is not a prohibition, however, and it therefore is of interest to consider 1 or 2 points th at bear on the effects on economic stability of a rise in Federal spending that is financed by a rise in tax rates. One point is the possibility th at destabilizing effects may arise out of an increasing divergence between the nominal and the actual incometax rate structure when already high nominal rates are increased. The higher rate schedule stimulates individuals and firms to seek a m ulti plication of exemptions, and the distortions caused by the varying suc cess of different groups may adversely affect investment. Another destabilizing effect of increased tax rates appears if increased excise tax rates, or increased rates of other taxes entering into cost of pro duction, result in a rise in the Consumer Price Index. The conse quences of increased tax rates are thus complex, and the particular mixture of inflationary and deflationary effects that is experienced de pends on circumstances. A discussion of the growth functions of Federal expenditure pro grams leads into the question of efficiency of Government operations. In this context efficiency is not closely related to the narrow concept of minimization of waste in Government offices, but is concerned with the question of the scope of Government functions, and the coordina 118 ECONOMIC GROWTH AND STABILITY tion of the objectives of the various Government agencies. In other words, concern is with the efficiency of resource utilization by the Gov ernment within the context of efficiency of resource utilization for the economy as a whole. I t is this broader concept of efficiency, rather than the narrow “office-manager” concept, th at ought to be used in determining the limits and judging the effectiveness of Government functions. Finally, this paper calls attention to an aspect of the impact of a high Federal spending floor on economic stability. To a significant extent the knowledge th at Federal spending is high, and will remain high, is a substitute for a large volume of liquid assets in providing a stimulus to private investment. So long as the monetary authority refrains from taking strong steps to discourage private borrowing, firms and individuals can borrow from banks (and thus create pur chasing power) with the certainty of a massive basic demand for prod ucts on the part of the Government. Thus an im portant contribution is made to investment for growth in the private sector; but in these circumstances the assurance of price stabiltiy appears to call for a more determined Federal Reserve policy than would be needed in the ab sence of the Government spending floor. In other words, there may be a bias toward optimism which might on occasion have to be counter acted in the interest of inflation control. I t can be argued th at inter est rate policy may therefore have to be supplemented with other types of control, particularly controls over investment through internal financing. T he P r e c o n d it io n or E f f e c t iv e B u d g e t in g The public finance theorist tells us that the cost of producing an additional unit of public goods is the sacrifice of real private con sumption or investment that is necessary to release the resources needed to give effect to the increase in public spending. In order to maximize social welfare, therefore, public expenditures should be pushed to the point at which the social satisfaction obtainable from an additional (or marginal) dollar spent on publicly produced goods no longer exceeds that of a dollar spent on privately produced goods.1 (Publicly produced goods are defined here in a broad sense, including not only government services, but also the net satisfactions derived from government transfer expenditures.) This concept is basic, and underlies the budgetary procedures in any political system. The principle is being applied whenever an intelligent decision is made, but it is qualified under rule by pressure groups if the wishes of the strong are accorded a heavier weight than those of the weak (for example, producers versus consumers). I t is true that we have an exceedingly difficult hurdle to surmount when we attempt to translate this marginal principle into practical action. 1 A t first blush one h esitates to sta te a proposition that would appear to be, in theory at least, so obvious. That there is nothing obvious about its practical political application is apparent from the manner in which (1) protagonists of increased provision of govern m ental welfare services simply assum e th a t the more of these services the economy pro duces, the greater the n et contribution to social welfare, and (2 ) exponents of Federal tax reduction assert that “expenditures have risen too rapidly and have reached too high a level.” In seeking the optimum level of public services in a m ainly free enterprise econ omy, th is is, of course, precisely the issue th at m ust be debated. The im plications of the problem can be clearly seen if one consults Governor Stevenson’s campaign statem ent en titled “A Program for the.T rue Economy : Where Is the Money Coming From ?” and tile com ments thereon by selected econom ists, Review of Econom ics and S tatistics, May 1957, pp. 134 fl., and the Committee for Econom ic Developm ent, T ax deduction and Tax Iteform— When and How, May 1957, pp. 10 ff. ECONOMIC GROWTH AND STABILITY 119 Developed by economic theorists for use in thinking about the optimi zation of public expenditures, it is subjected to severe criticism (pos sibly too severe criticism) by those who are experienced in the budgetary process and are impressed by the complexities of political decision making.2 (1) I t assumes substantial knowledge on the p art of the public of the available alternatives; (2) it supposes th at substitutions between public and private spending can be made in small enough units so that some attention is paid to the sacrifice in the consumption of private goods that must be made when gov ernment spending is increased; (3) it assumes that the welfare con tributions of alternative public expenditure programs are compar able; (4) it takes it for granted that the general public and its legislative representatives make a reasonably successful attempt to reconcile future social welfare with present social welfare; (5) it, assumes that account is taken of the fact that a particular objective, like growth or a welfare program, produces incidental adverse, social eifects, and that some government-produced goods hurt one group of individuals while benefiting others, or while benefiting society as a whole (for example, an airport in a residential a re a ): and (6) it assumes that it is not a fatal defect of decision-making that many individuals and groups favor or oppose on purely dog matic or sentimental grounds increases in the relative importance of Federal expenditures within the framework of aggregate spending. I f we consider these points in order, the practical difficulties come into focus at once, and not the least of them is the irreconcilability of opposed value judgments, upon which the economist has no special competence what ever to give an opinion. Thus, (1) no one has ever suggested a completely satisfactory means of providing the knowledge of alternatives that is needed to permit full weight to be given in our fiscal thinking to the public and private goods and services that must be forgone when a decision is taken to tax and to spend for a particular purpose; (2) even if such a tool were perfected, the fact that no price is too great to pay for adequate self-defense, for example, is an indication of the impossibility of making close, marginal calculations in Federal spending; (3) our ideas with respect to comparability of the satisfactions from alternative forms of public expenditure are fuzzy; (4) little success can be ex pected from an attempt to reconcile future with present social welfare so long as economists and others divide themselves neatly between those who believe we should encourage present consumption at the expense of present investment and future consumption and those who believe that we should do the reverse; 3 (5) surprisingly little attention 2 See, for example, Jesse Burkhead, Government Budgeting (Wiley, 1 9 5 6 )? pp. 42, 44, who sta tes that “Marginal social benefit and marginal social cost are attractive phrases, but they are devoid of explicit co n ten t;” and with respect to the allocation of public expendi tures, “A t the tim e when decisions are in process, m arginal theory provides no guidelines for the Allocation of public exp en d itu res/’ This statem ent appears to be rather extreme, since budget m aking and budget cutting are by no means alw ays across-the-board. 3 See the opposed testim ony of several prominent econom ists at the hearings before the Joint Economic Committee in June of this y e a r : F iscal P olicy Im plications of the Eco nomic Outlook and Budget Developments. Federal Reserve Board Chairman Martin has stated (Senate Finnnce Committee hearing, August 19 of this year) that present inflation ary pressures arise out of overspending and undersaving (and that the Federal Government may be the “chief offender” ). The counterargument would be that a high ratio of con sumption to income makes an invaluable contribution to full employment, which is itself indispensable to rapid capital form ation. But, again, it has been argued th at the rate of capital form ation in the fifties has been somewhat less than that of the tw enties, with the im plication th a t the saving-consum ption ratio m ight w ell be increased. When the question is raised whether the level of saving in the tw enties may have been too high to sustain fu ll employment, the elusiveness of th is whole issue becomes apparent. 120 ECONOMIC GROWTH AND STABILITY is ever paid to the long-term adverse welfare effects of public spending programs; and (6) to the extent th at individuals and groups have preconceptions and particularistic points of view, the conditions are lacking for an objective, socially oriented approach to welfare economics. All these obstacles to applying the marginal principle in order to ascertain the correct level and distribution of Federal expenditures are serious ones, and they stand out ominously in the dark shadows of the budgetary process. They have to be borne in mind when we are considering the net contribution th at can be made by Federal spending and taxing to the maintenance of the maximum rate of growth (assuming th a t we want to maximize growth) that is con sistent with the minimum acceptable degree of economic stability. Yet they are not insurmountable so long as the issues are debated in the full glare of publicity. Indeed, to take any other view would be to admit that public spending decisions are completely haphazard, and, despite all the shortcomings of the budgetary process, this is patently untrue. T he R ole or the F ederal G overnm ent in E c o n o m ic G row th In consonance with the terms of reference of these hearings, I shall lim it myself to a discussion of Federal expenditures for growth and stability. A t the same time, an adequate level of current maintenance expenditures and spending for protection is an indispensable prerequi site to growth, if not to stability, and both these types of expenditures are themselves dependent on the rate of growth. Consequently, they are likely to rise over the long run, and thus they are necessarily always under consideration, implicitly if not explicity. A t the outset it may be noted that a public spending policy aimed at encouraging growth exerts complex effects on economic stability. Federal expenditures on production factors place a floor under aggre gate demand, and, to that extent, reduce the danger of both cyclical downturns and secular stagnation. On the other hand, a concomitant of growth is a rise in the flow of goods and services, which, taken by itself, is a deflationary factor. The net effect cannot be easily foreseen very far in advance. Moreover, unless great care is taken in the choice and magnitude of governmental projects, the private sector may react adversely to increased competition for limited sup plies of savings and scarce resources. In contrast to the possible de flationary effects of government spending for growth are the infla tionary implications. The acceleration of rates of growth may pro vide the background for creeping inflation, and to avoid this a care ful balance needs to be kept between public and private investment programs. Moreover, there is always some danger th at the public may ultimately react to a lengthy period of creeping inflation by shifting into assets th at are believed to be inflation proof. I f this occurs, there is no guaranty th at the pace of inflation will not be great ly accelerated. I t is easy to approve, in general terms, any rise in aggregate spend ing th a t is expected to contribute to stable growth. The trick is to determine, of the expenditures that can be made for this purpose, w hat proportion should be undertaken by the Federal Government. This problem has roots th at are deep in the Nation’s history. I t will ECONOMIC GROWTH AND STABILITY 121 be recalled that Alexander Hamilton held to the view that growth would be stimulated if the National Government would take the lead in economic life, whereas his opponents divided themselves between two positions; (1) that the private sector could do the job best un aided by government except in essentials like protection of life and property, and (2) that the States, rather than the National Govern ment, should assume responsibility for certain risky and expensive developmental investment projects. In seeking to maximize growth, we must accept one im portant human characteristic. I t is a rare in dividual who concerns himself much that growth should be stable, provided only th at it is rapid. Feelings run strong, however, on the ratio in which the public and private sectors should share respon sibility for spending for grow th; and purely economic judgments are modified, and may at times even be submerged, by political philoso phies. The feeling is widespread that we are helpless in stemming the tide of Federal spending. But what is meant by this? Net budget expenditures, which were 15.3 percent of gross national product in fiscal 1949, after rising to 20.4 percent in fiscal 1953, had declined again to 16.1 percent by 1956. Gross national product has been rising steadily, while Federal spending has been subject to considerable fluctuations, prim arily in response to the m ilitary situation. Private spending has likewise been rising, however, and there is no a priori reason why a long-term rise in gross national product should not con sist, in part, of publicly produced goods and services. Indeed, it might be a contribution to clarity of thought if we ceased making regretful references to our inability to prevent a secular rise in Fed eral spending. Economic growth implies an expansion in the output of both public and private goods. I t is not impossible, moreover, that balanced growth may call for an increase in the ratio of public to private goods during certain phases of economic and political development. The latter statement receives support from the relatively sharp rise in State and local expenditures in recent years, much of which has been in direct re sponse to a public demand for new types of State and local serv ices. Many of them, like hospitals, highways, and standards of police protection, are at once cause and effect of economic growth. A similar point applies to some Federal expenditure programs. I t might be found, for example, that a rising proportion of Federal spending to gross national product would be justified by the need to react to the effects of growing international pressures which them selves are a corollary of growth of populations and of the expansion of economic aspirations of all nations. To the extent that this were true, a rising trend of Federal expenditures would be as much a result of growth as a cause of it. We may have to reckon with the possibility, as the expensiveness of national defense rises, that the ratio of Fed eral spending to national income will rise. R is in g G ross N a t io n a l P r o d u c t a s a J u s t if ic a t io n F ederal P rogram s for E xpanded A line of argument has often been set forth, and recently discussed by a symposium of economists, the acceptance of which would, indeed, greatly complicate the task of making an objective assessment of the 122 ECONOMIC GROWTH AND STABILITY relative satisfactions to be derived from public and private spending. This is the view (mentioned in footnote 1) that, even with present tax rates, prospective economic growth can be counted upon to finance automatically such desirable public services as medical and unem ployment insurance, a really adequate system of public education, slum clearance, the development of natural resources, and an expanded concept of old-age security. I f this argument is taken to mean only th at the automatic annual increase in Federal tax revenues can be counted upon to finance some rate of secular rise in Federal expendi tures, then it is not very interesting as a basis for establishing future spending policy. B ut if it is meant that we have some slack to play with in the budget, and that surely we can earmark a portion of the annual increment in national product for welfare purposes, or, in deed, for any particular objective, we are perilously close to being in the position of short circuiting the budgetary process. The essence of budgeting is to reexamine constantly the relative merits of the performance of functions by the public or private sector, as well as the merits of performance versus nonperformance of the function. Budgetary experience in this country runs strangely counter to the view that there is no problem to be faced in financing a planned secular increase in Federal welfare and other programs simply because at constant tax rates the total rise in Federal tax receipts over some period of years will be several times the total cost of the programs. I t is a matter of record th at revenues have not been, and are not now, adequate at present tax rates to finance all the programs th a t are urged upon (and by) the American people each year. Where, then, would we be if we went ahead and earmarked funds for an expansion of Federal programs ? The immediate answer would appear to be that either tax rates would have to be raised, or other spending programs would have to be curtailed. In fairness, however, this answer needs to be qualified. O f the Federal programs mentioned above, some contribute to eco nomic growth and some do not (or do so to a very minor extent). Those which do not (namely, all those which come under the rubric “the better life”) would be a deadweight charge on future budgets. But those which do facilitate growth also serve to enhance taxable capacity, and in some instances they may do so relatively to alternative programs undertaken in the private sector. I t seems imperative that the public should always be informed in advance of the cost to the Nation, in terms of foregone possibilities of growth, of an option in favor of a diversion of resources toward the better life. The voting appeal of liberalized social-security bene fits, for example, is very great. Therefore we need estimates of the cost to the private sector, in terms of taxes, that must be paid over the long term, taking account of increased revenue needs due to popu lation growth and to changes in the age distribution of the population. Moreover, account must be taken of the forms which demands for further elaboration of the good-life concept are likely to take, merely in consequence of the acceptance of initial and successive phases of the program. F or in accepting a program of this sort we are not only committing ourselves to the cost of foreseeable welfare and other government services. In addition, we are assuming responsibility for the automatic increases in the. cost of these programs that result e c o n o m ic grow th and 123 s t a b il it y from rapid population grow th; and we are advancing one step along the road toward the acceptance of at present unthought-of spending programs, since the achievement of one goal opens way for the struggle for another. I t is im portant to note that nothing in this discussion should be construed as representing basic opposition to an expansion of Federal spending programs intended to contribute to growth and long-term social welfare. We need a healthy competition between the public and private sectors for the privilege of implementing the investment de cisions that will optimize the utilization of resources at the disposal of the economy. Given the criteria of optimization, the test is rela tive efficiency, and there is no reason to advocate reduced expenditures merely because this permits a reduction in tax rates. B ut the good life ought not to be confused with economic development. We should be quite clear on the distinction between those Federal expenditures that can reasonably be considered to contribute to growth and those which are synonymous with consumption. This distinction is often obscure in the realm of public spending. Let us reject, therefore, the view that our dearest objective is always to strive to reduce Federal spending, however desirable judiciously spaced intermittent economy drives may be. On the contrary, we should be prepared to consider acceptance of an expansion of Federal programs when it can be established that they will make a greater contribution to desired growth, per dollar of expenditure, than would private investment programs. No purely genera 1discussion can enter into the manifold details that have to be sifted in giving effect to this judgment. One may simply state the belief that this is an area in which the planning principle, because of its obvious usefulness, should be acceptable to everyone. A t what point, for example, does invest ment in educational resources cease to contribute to growth and become a form of consumption? Remembering the serious political conse quences of “overeducation” in certain European countries during the interwar period, we may ask whether we do not need a detailed forecast of the economy’s future needs for trained personnel in order that intelligent decisions can be taken with respect to what the de sirable contribution of the Federal Government to education should be. (Similar exhaustive investigations ought to be made, and kept current, with respect to all long-range Federal programs.) I t is quite clear that productivity will be raised by improved standards of education only up to the point at which the working force is optimally distributed among job opportunities. Beyond that point educational expenditures become a form of luxury. This may be all to the good socially; but it will not necessarily contribute to growth. H ig h T ax R a tes as a n O b sta c le to E x pa n ded F ederal S p e n d in g I t is quite a step from the argument that a portion of the annual increment to real national income should always be earmarked for Federal spending to the view th at at some point positive steps may have to be taken to curtail the expansion of Federal programs. I f we look at economic growth alone as a criterion for Federal expenditure policy, we do not discover at the present moment any compelling argument in favor of the curtailment of Government spending. Notwithstanding some recent slowing down in productivity incre 124 ECONOMIC GROWTH AND STABILITY ments, there appears to be no serious dissatisfaction with the current rate of growth in real national product, nor with the p art played by the Federal Government in providing the basis for it.4 On the other hand, we must reckon with the eventuality that, taking into account the possibility of the need for a rise in m ilitary expenditures, the level of desirable Federal spending programs may rise sufficiently to call for higher tax rates. I f this were to occur it would be necessary to subtract from any contribution made by increased Federal expendi tures to economic growth the adverse effect that was produced on private investment and initiative by higher tax rates, and hence on the rate of growth in the private sector. _ A t the risk of repetition, it should be emphasized th at this problem is nonexistent to the extent that the rising tax base associated with rising gross national product provides each year an automatic increase in tax revenues. Under current tax rates? and with current annual increments to GNP, about $3 billion of additional revenues come auto matically into the Treasury each year. Only a portion of this, how ever, is available for programs designed to stimulate growth. Not only does this figure have to be deflated for a rising price level, but also account has to be taken of automatic increases in Federal spend ing under a wide variety of programs which are themselves a func tion of growth in population, for example, grants to States and local ities, highway programs, collection and analysis of statistics, services to agriculture and industry, and so on. Even when this is done, how ever, a modest residual is left which m ight be employed to finance new governmental programs without the aid of new taxes. But no one can predict for many years the cost of maintaining international political and m ilitary equilibrium, and it is therefore conceivable that m the light of urgent national defense projects desirable civil spend ing programs could not be financed solely out of automatic annual increments of tax revenues. D e s t a b il iz in g E ffects of I n creased T ax R ates I t is rather unlikely th at at present high income-tax rates public opinion would be favorable to tax increases even in order to finance growth programs that might ultimately contribute more to national income (and to the tax base) than would the private investment pro grams that would have to be sacrificed unless taxes on consumption were increased.5 Nevertheless it is of some interest to glance at a possible conse quence of any significant further rise in personal income tax rates. There is good reason to believe that pressure for exemptions and favorable tax rates under the income tax are some kind of a function of the severity of the nominal rate structure. I f this is so, then a further rise in income-tax rates would tend to shift the income-tax burden still further in the direction of those individuals and pro prietorships which are not in a position to benefit from such conces 4 Moreover, despite the large space devoted to the inflation problem in the press, there is so fa r little evidence th a t the public feels great concern over a gradually rising price level (though th is situation could change d rastically). On the contrary, m any policymakers show signs of being more fearful of temporary periods of declining prices than of a long term upward trend in prices. 6 It is hardly to be expected th at if tax-rate increases were found to be necessary, the income tax would be exempt. ECONOMIC GROWTH AND STABILITY 125 sions as percentage depletion, accelerated amortization, conversion of ordinary income into capital gains, and so on. Consequently, those who were unable to escape the effects of the higher nominal rates would invest less (because of higher marginal tax rates), and would,, moreover, have smaller after-tax incomes. B ut those who did man age to avoid being subject to the higher rates would have no incentive or capacity to increase investment (ignoring the income effects of the additional Federal spending). Consequently there would be a net adverse effect on that p art of economic growth that is accounted for by investment in the private sector.6 One argument in favor of holding any rise in Federal peacetime expenditures within the limits of the automatic increment of tax receipts determined by current rates of growth in gross nationl product is the difficulty of finding new revenue sources that are not destabiliz ing. As stated above, further rises in personal income-tax rates would probably have disincentive effects on those who are unable to escape the nominal rates. W ith respect to death taxes, there is scope for increased rates and lower exemptions, but this scope is limited. The other major alternatives, sales, and excise taxes, have a potentially serious defect if they are exploited during a period of creeping infla tion, or when there is a delicate balance in the economy between inflationary and deflationary forces. The Consumer Price Index of the Bureau of Labor Statistics, which is the index used in most wageescalator agreements, includes “sales taxes, retail excise taxes, customs duties, and all manufacturers’ and processors’ taxes passed on to the consumer.” Thus any increase in the rates or coverage of these taxes causes an automatic rise in the Consumer Price Index, and therefore in all wage rates either formally covered in escalator agreements or in practice tied to the cost of living in wage bargaining. The number of workers directly or indirectly covered under formal escalator agree ments (nearly 4 million at the present time) is of special significance, for there is no room for doubt that their hourly wages will increase in accordance with specified rises in the Consumer Price Index. A t the same time it is precisely during a period of rising prices that we find the maximum number of workers covered under escalator agree ments.7 In view of the fact that the two effects mentioned above tend to offset each other (higher income-tax rates are here viewed as defla tionary, and higher excise-tax rates as inflationary) it may be reason able to infer that some combination of rises in the rates of each tax could be found which would be reasonably neutral to inflation. An im portant difficulty, however, is the distortion caused by the mixture of unemployment and rising prices. Higher income-tax rates would tend to discourage output, while higher sales-tax rates would stimulate <6 A possible exception to th is statem ent may be of interest. If we start w ith a suffi ciently progressive rate structure in the higher brackets, the pressure for exem ptions and special treatm ent may be very great if income tax rates are raised still further. If th is is so, an increase in the nominal rate structure could actually result in a lessening of the tax burden on the higher-income groups. (T his is w hat would actually occur if a very high rate structure were to lead to the exemption of realized capital gains from the income tax.)i Conceivably the consequence m ight be a net increase in investm ent by them, since in the extreme case assumed here their after-tax incomes would be higher under the higher nominal tax rate structure. The practical application of th is case is probably unimpor* tant, but it serves to call attention to the nature of the economic effects of a high nominal income tax rate structure, which are usually ignored in favor of discussions of equity effects. 7 Moreover, the recent growing popularity of the longer term labor contract had already led to wider adoption of the clause even in advance of the price rise of 1956. 97735— 57— •— 10 126 ECONOMIC GROWTH AND STABILITY price and wage rises. The situation would be one of a mixture of rising prices and soft spots. The very evident confusion of economists in trying to explain economic trends in the circumstances of the past year or two, when a somewhat similar situation has developed for other reasons, is testimony to the obstacles which would face an attempt to prevent the appearance of destabilizing effects if substan tial additional tax revenue should come to be needed. There is, to be sure, an alternative tax which does not suffer from the “cost-inflationary” defect of sales taxes. This is a spending tax of the type proposed by the Treasury in 1942. This tax, levied at progressive rates on an individual’s spending, provides no mechanism whereby the tax shows up in the Consumer Price Index, and there fore contains no element of cost-push inflation.8 A t fixed rates, and with relatively low personal exemptions, this tax could be used to finance an increased amount of Federal investment expenditures with out disincentive effects on either private investment or personal con sumption. A Federal spending and tax policy could thus be evolved which would be consistent with both growth and price stability, though at a political cost. The cost would be a substantial increase in the role of government in the overall planning of resource use. But this eventuality is really implied anyhow in a fiscal program aimed simultaneously at growth and economic stability. A C r it e r io n of E f f ic ie n c y of G overnm ent S p e n d in g P rogram s I t is difficult to conceive of a discussion of government spending functions that omits reference to the question of economy and efficiency in Federal expenditures. The greater the efficiency with which gov ernment performs its services, the easier it becomes to gain public acceptance of the diversion of a given quantity of resources from p ri vate to public use. Unfortunately, as everyone knows, it is far from simple to compare efficiency in the private and public sectors. The efficiency of private enterprise is tested in terms of bankruptcies and declines in capital values th at are often associated with bargain pur chase by a more aggressive management group. No such objective market test is at hand for government services, and this fact not only complicates the problem of ascertaining the efficiency with which gov ernment agencies operate, but makes the public sector vulnerable to frivolous, along with the justified, charges of inefficiency. I t is often forgotten, moreover, th at it is no easy m atter to measure the efficiency of private enterprise. Furthermore, government action itself con tributes to the degree of efficiency th at is achieved by the private sector. Again, subsidies, favorable tax treatment, tariff protection, and the like may find legitimate support on one ground or another; yet they obviously widen the range within which inefficiency on the part of private management can conceal itself. I would contend that relative efficiency, in any narrow sense, does not provide much of a basis for helping us decide the proper scope of governmental func tions. In any event, each government agency ought to be glad to 8 It m ight be w orthwhile for Congress to reexamine the good and bad points of this tax in the ligh t of the growing im portance of wage cost-of-living clauses, and of the possibility th a t valorization clauses may som etime become increasingly popular in many types of contracts besides wage agreem ents (for example, ind^x bonds, variable annuities, escalated social security payments, etc.)- For a recent searching an alysis of th is tax see Nicholas Kaldor, An Expenditure Tax, George Allen and Unwin, Ltd., London, 1&55. 127 ECONOMIC GROWTH AND STABILITY subject itself to a periodic checkup on efficiency, and to report its progress in reducing cost per unit of output. In a broader sense, the question of efficiency borders on th a t of the determination of the limits of government functions. Here efficiency is conceived of, not in the technical sense of output per worker, but with respect to the form th at the long-term objectives of government programs ought to take in the light of forecasts of the future needs of the Nation. In other words, efficiency is conceived of in terms of output per unit of resources. In this area Congress might sponsor technical studies, perhaps undertaken by the staffs of appropriate joint committees, of the alternative short- and long-term objectives of major national welfare and other spending programs. This would give much-needed assistance to administrative agencies in making their self-evaluations, and would at the same time help to keep deci sions on the scope of government functions from being made on oppor tunistic grounds. Certainly these decisions are ultimately political ones; but holders of public office would clearly benefit from analyses made by technical experts, and important public spending issues would receive the benefit of timely clarification. One is struck with the need for maximum agility on the part of both government and private enterprise in making their decisions to devote resources to promising developmental projects, and in determining upon a method for shar ing responsibility for them. Any equilibrium between public and private spending plans must be tentative and subject to change. There is no room for dogma in allocating functions between government and private enterprise. We are engaged in a constant process of trial and error, and we can maximize the rate at which we learn, only if programs are constantly reassessed.9 T he I m pa ct or a H ig h F ederal S S p e n d in g F loor on E c o n o m ic t a b il it y Up to this point we have been primarily concerned with the question of the impact of Federal spending programs on growth. I t is nec essary also to take account of the ways in which the floor of Federal spending, as well as probable changes in Federal spending levels in response to fluctuations in income and employment, react upon spend ing in the private sector. The importance of doing this lies in the fact th a t the level of private investment spending (and through the mul tiplier, consumption spending) is partly, indeed significantly, deter mined by the fact that Federal spending is high, will remain high, and is likely to rise on the advent of any serious unemployment. The world situation assures a minimum Federal budget in the vicinity of $70 billion. Moreover, the great expansion of economic activity in recent years has necessitated a substantial rise in State and local pro grams ; and since these promise to continue to increase, private long term investment decisions are made in the light of knowledge that public demand for resources will rise secularly. I t is true that cut backs in Federal spending in the interest of economy add their weight to the soft spots caused by specific overproduction, inventory reduc tions, and lagging consumer demand. But even those who stress these 9 A case in point is the difficulty of coordinating the objectives o f different Federal agencies. For example, the Department of Agriculture is continually concerned w ith the problem of excess capacity in agriculture, while the Bureau of R eclam ation’s irrigation program obviously adds to it. 128 ECONOMIC GROWTH AND STABILITY phenomena, and who believe th at maintenance of expansion rates rather than the danger of inflation is the major economic problem facing this country today, would probably grant th at these adverse signs are prim arily structural and temporary in nature. A high floor under government spending has a direct effect on economic development. I t also has an indirect effect by way of its encouragement or discouragement to private investment spending. Provided that aggregate spending is not so high th a t interest rates are driven up to the point of discouraging private investment, a high level of government spending is a favorable sign for full employment and for the contribution of the private sector to rapid economic growth. Viewed in the broadest possible terms, one of the tasks of the Federal budgetary process is to take a position on the rate of p ri vate capital formation that is the optimum precondition of the desired rate of expansion of Federal (and State and local) developmental programs. Economic progress is maximized when the correct bal ance is struck between public and private spending programs. Permanent full employment (with no more than relatively minor recessions) in a free-enterprise economy is an achievable objective provided two hurdles can be surmounted. F irst, the private sec tor must be permanently convinced that the demand for resources for public use will rise indefinitely in response to growing demand for the kinds of programs that are best undertaken by government. In the public sector there is no important question of a lack of p u r chasing power; what has to be established is the reasonable certainty of a public desire for the expansion of governmental programs. Sec ond, some kind of procedure has to be worked out whereby competi tion between government and private enterprise for limited re sources is not allowed to lead to an inflationary situation th at is serious enough to be a prelude to crisis and possible collapse in the private sector. The problem is complicated by the fact th a t within the p ri vate sector itself specific overproduction and miscalculations are inte gral to the investment decision-making process, and serious deflation ary consequences can ensue if rapidly rising interest rates happen to coincide with inventory reductions and cutbacks resulting from tem porary overproduction. Any defects attributable to monetary and fiscal policy as instru ments of inflation control are magnified under circumstances of high level Federal spending and taxing, and particularly so under a philos ophy of assuring government its share m the secular rise in national product and in responsibility for rising national economic potential. The problem arises out of the fact th at while monetary and fiscal policy are suitable instruments for discouraging private spending, they are quite irrelevant to the control of Federal (though not, of course, State and local) spending.10 Sharp criticism has been directed 10 This is a worldwide phenomenon. Considerable com plaint has been voiced in a number of European countries that fear o f inflation leads governm ents to impose controls on private investm ent and consumption, w hile no sim ilarly effective instrum ents are at hand to curb am bitious public spending programs. One difficulty is th a t w hereas controls over the private sector can be made to operate more or less continuously, n ation al governm ents often tend to delay m oderating actio n w ith respect to their own spending programs u n til a serious international m onetary crisis has arisen. Some method needs to be evolved th at w ill encourage national governm ents to subm it to a more continuous regulation of spending pro gram s }n the ligh t o f w hat the governm ents them selves expect the private sector to accom plish* for economlcrgrowth and stab ility. -In-a word, the.ln stru m en ts of economic control a t the disposal o f free enterprise were developed prior to the appearance of national govern m ents as m assive users of economic resources, and are inadequate to cope w ith present-day problems. ECONOMIC GROWTH AND STABILITY 129 in recent months against a monetary policy th at is credited with being effective in stiffening the terms of borrowing to potential home owners, small and new business, and farmers. The Treasury’s difficul ties with debt financing are indeed well publicized; but while borrow ing problems discourage private investment and consumption spend ing, they do not enter into legislative spending decisions. This phe nomenon has been complained of in many countries, centrally con trolled and decentralized alike, in the postwar decade, and it appears to be part of the price that has to be paid for full employment. Recent discussion has called attention to a further complicating element in inflation control.11 Monetary policy is alleged to suffer from the serious defect that its major influence is exerted in restrict ing investment in the competitive sections of the market; big busi ness and oligopoly can utilize price policy and reinvested earnings as a defense against monetary control. In my judgment it is not necessary or desirable to carry too far the basically valid point that monetary policy can never be as important an instrument of control as it was thought to be in an era when the commercial banking system occupied a highly strategic position in the aggregate credit flow. Institutions have changed; they have not been swept away. The correct course would appear to be to forge supplementary politi cal institutional weapons that will assist in the control of investment by large enterprise and by the Federal Government. The dice are loaded in their favor in the struggle for scarce resources. Moreover, there is always the threat th at any sign of weakening on the part of the relatively competitive segment of the private sector of the econ omy will be taken as an invitation to government or big business to step in and fill the gap. There may be cogent reasons why further concentration of economic power in the hands of the Federal Govern ment and big business is desirable. But it would seem imperative at the earliest possible moment to establish ground rules which, if there is found to be an imbalance of power at the expense of the private sector, and specifically at the expense of new and small enterprise, make it possible and likely that steps will be quickly taken to redress it. 11 Cf., for example, J. K. Galbraith, Market Structure and Stabilization Policy, Review of Econom ics and S tatistics, May 1957, pt. V.
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