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EXECUTIVE
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EXECUTIVE OFFICE OF THE PRESIDENT

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T H E D IRECTOR
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May 11, 1966
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MEMORANDUM FOR THE PRESIDENT
Subject:

The effect of a Tax Increase

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In looking at the economic justification for a tax increase,
there are two major issues:
First
0 1 t^ best possible forecast of Government and private
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spending, will there be serious inflation without a tax
increase?
Second
Since even the best forecast is bound to be uncertain,
could a tax increase lead to recession if circumstances
changed — a settlement in Vietnam, for example?
1.
On the best current forecast, serious inflation is
almost certain unless taxes are raised.
We now estimate that Federal expenditures in FY 1967
may be $8 billion higher than shown in the January budget —
$121 billion rather than $112.8 billion. This assumes a
$6% billion increase in Defense spending* and a conservative
$1% billion Congressional add-on to Other programs.

The Defense estimates are our own and do not represent a
conclusion of Bob McNamara. We believe the estimates are
realistic — barring a quick settlement in Vietnam.

Nothing else sent to
C e n tra l F13.es as of



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The April Troika forecast, which assumed only a
$4 billion rise in Federal spending above January budget
estimates showed:
GNP rising by 8.5% during 1966
unemployment dropping to almost 2^% by mid 1967
"intense and mounting" price pressures.
With an $8 billion rise in Federal spending, the
forecast of inflationary problems is even more serious
GNP would rise by 9.3% over the next 12 months,
and unemployment would fall below 2^%
a true wage-price spiral would develop
the balance-of-payments drain could become highly
alarming
monetary tightness would surely increase, and there
would be the possibility of a serious liquidity
crisis in some areas, particularly among savings
and loan institutions.
In 1966 consumer prices will probably rise by more
than 3%. Some wage contracts are up for renewal this year
(the electrical workers, some telephone workers). In 1967 a
much larger number are open (autos, apparel, rubber, meat­
packing, food products).
With the $8 billion added expenditures and no tax
increase
.

prices will rise sharply in late 1966
there will be a severe labor shortage in late 1966
and early 1967.

Under these conditions wage settlements will be very
large. In turn this will guarantee continued sharp price
rises throughout 1967 and well into 1968 regardless, almost, of
whether there is a 1967 settlement in Vietnam.




2. Uncertainty over events in Vietnam is not sufficient
reason to prevent a tax increase.
On our best estimates, 1967 Defense expenditures will
be $64 billion compared to $54 billion this year. DOD will,
very soon, have to begin buying long lead-time items for use
in Vietnam in fiscal 1968. Even if a settlement is reached by
the end of this calendar year, a large part of the orders which
precede the 1967 expenditures will, nevertheless, already have
been made. Consequently, if the war continues for as little
as five to six months, the basic forecast made above would be
mainly correct — and a tax increase lasting at least through
early 1967 is justified.
The only situation, therefore, which might call into
question the wisdom of a tax increase is a cessation of hostil­
ities in the next five to six months. It will take at least a
month to prepare and enact a tax increase. We can always reverse
ourselves if a settlement is reached before the tax increase is
passed. Therefore the period of uncertainty is narrowed to four
or five months — i.e., the possibility that a settlement might
be reached between July and November or December.
In short, under almost every conceivable circumstance —
except a Vietnam settlement between July and November — a
decision to raise taxes at least for the remainder of this year
and early 1967 is clearly warranted. And even under that cir­
cumstance , the risks of serious inflation, in my view, far out­
weigh the dangers of having a tax increase extend a few months
past the date of a possible Vietnam settlement.
The effect of a 10% tax increase plus a suspension of the
investment credit and liberalized depreciation on buildings.
This tax package would:
1.

Hold down the Increase in consumer spending and also
indirectly slow investment in consumer goods industries.

2.

Directly reduce the increase in plant and equipment
spending.

3.

Reduce the inflationary demand, by mid 1967, to the
tune of $15 to $20 billion.




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4.

Thereby bring total demand more closely in line
with the growth in output.

5.

Reduce the rise in the CPI this year and the
severe labor shortage which would be facing us in
late 1966 and early 1967.

6.

As a consequence, hold down the size of wage
settlements in late 1966 and 1967, and, therefore,
sharply moderate the subsequent price inflation.

7.

Slow down the rise in imports which is hurting our
balance of payments.

8.

Have a more immediate psychological impact which
would
reduce the strain of excessive plant and equip­
ment orders immediately.
(If investors realized
that the credit would remain suspended for only
1 or 2 years, they would have a very strong
incentive to postpone investment projects till
then. When Vietnam hostilities ceased, a
reinstatement of the credit would be very use­
ful to get investment expansion going strongly
again.)
slow or stop speculative price increases
keep the monetary situation from becoming even
tighter and, among other things, make it much
easier to sell our financial assets
help avoid a really serious worsening of our
balance of payments in the coming months.

The combination of a 10% increase in corporate taxes and a
suspension of the investment credit and the suspension of
liberalized depreciation might well place a disproportionate
burden on business.




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Further study of this may well suggest a tax package which
has a somewhat smaller overall effect on business firms.




Charles L. Schultze
Director


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102