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THE I978 MIDYEAR REVIEW OF THE ECONOMY

HEARINGS
BEFORE THE

JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
NINETY-FIFTH CONGRESS
SECOND SESSION

PART 3
JULY 19, 20, AND 25, 1978

Printed for the use of the Joint Economic Committee

U.S. GOVERNMENT PRINTING OFFICE
37-250

WASHINGTON : 1979

For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington. D.C. 20402


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JOINT ECONOi\lIC COl\Il\IITTEE
(Created pursuant to sec. 5 (a) of Public Law 304, 79th Cong.)
RICHARD BOLLING, l\Ilssouri, Chairman
LLOYD BENTSEN, Texas, Vice Chairman
HOUSE OF REPRESENTATIVES
SENATE
HENRY S. REUSS, Wisconsin
JOHN SPARKMAN, Alabama
WILLIAJ\I S. MOORHEAD, Pennsylvania WILLIAM PROXMIRE, Wisconsin
LEE H. HAMILTON, Indiana
ABRAHAM RIBICOFF, Connecticut
GILLIS W. LONG, Louisiana
EDWARD l\I. KENNEDY, Massachusetts
P ARRJ<JN J. MITCHELL, Maryland
GEORGE McGOVERN, South Dakota
CLARENCE J. BROWN, Ohio
JACOB K. JAVITS, New York
GARRY BROWN, Michigan
WILLIAM V. ROTH, JR., Delaware
MARGARET l\I. HECKLER, l\Iassachusetts JAMES A. McCLURE, Idaho
JOHN H. ROUSSELOT, California
ORRIN G. HATCH, Utah
JOHN R. STARK, Executive Director


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CONTENTS
WITNESSES AND STATEMENTS
WEDNESDAY, JULY

19, 1978

International Adjustment I I
Reuss, Hon. Henry S., member of the Joint Economic Committee: Opening
statement______________________________________________________
Bergsten, Hon. C. Fred, Assistant Secretary of the Treasury for International Affairs____________________________________________________
Packer, Hon. Arnold H., Assistant Secretary of Labor for Policy, Evaluation and Research_______________________________________________
Whitman, Marina v. N., distinguished public service professor of economics,
Universiy of Pittsburgh, Pittsburgh, Pa____________________________
THURSDAY, JULY

'l'age

525

527
534
539

20, 1978

Inflation
Bolling, Hon. Richard, chairman of the Joint Economic Committee:
Opening statement _____ ~-________________________________________
Bosworth, Hon. Barry P., Director, Council on Wage and Price Stability__
Gordon, Robert J., professor of economics, Northwestern University, and
research associate, National Bureau of Economic Research____________
Pechman, Joseph A., director of economic studies, the Brookings Institution__________________________________________________________
Seidman, Laurence S., assistant professor of economics, the ·wharton
School, University of Pennsylvania, Philadelphia, Pa_________________
TUESDAY, JULY

571
572
596
606
611

25, 1978

JOINT SESSION OF Tl-IE SUBCOMMITTEE ON THE CITY OF THE HOUSE BANKING,
FINANCE AND URBAN AFFAIRS COMMITTEE AND THE JOINT ECONOMIC COMMITTEE

Local Distress, State Surpluses, Proposition 13: Prelude to Fiscal Crisis or New
Opportunities!
Reuss, Hon. Henry S., chairman of the Subcommittee on the City of the
House Banking, Finance and Urban Affairs Committee: Opening statement___________________________________________________________
Moorhead, Hon. William S., member of the Joint Economic Committee:
Opening statement _________________ ---,-__________________________
Javits, Hon. Jacob K., member of the Joint Economic Committee: Opening
statement______________________________________________________
Jacoby, Neil H., dean, Graduate School of Management, University of
California, Los Angeles___________________________________________
Duncan, Hon. Robert Blackford, a U.S. Representative in Congress from
the Third Congressional District of the State of Oregon______________
Boe, Hon. Jason, president of the Oregon State Senate and president of the
National Conference of State Legislatures (NCSL)___________________
Farber, Stephen B., director, National Governor's Association___________
Cooper, Fred F., county supervisor, Alameda County, CaliL _ __ __ __ __ ____
Kelly, Hon. Richard, a U.S. ReprPsentative in Congress from the Fifth
Congressional DiRtrict of the State of Florida _ _ __ __ __ __ __ __ __ __ __ __
Gramlich, Edward M., professor of economics, University of Michigan___


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640
640
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649
659
666
672
673

IV

Peterson, George E., director, Public Finance Program, the Urban Institute, Washington, D,C___________________________________________
Br;;ce, Herrington J., vice president, the Academy for Contemporary
roblems, Columbus, Ohio________________________________________
Greytak, David, the Center for Metropolitan Planning and Research
the Johns Ho'pkins University, and the Maxwell School of Publi~
Affairs, Syracuse University, Syracuse, N,Y________________________
Shannon, Hon. John, Assistant Director, Advisory Commission on Intergovernmental Relations________________________________________ _
:Fitch, Lyle C., president, Institute of Public Administration __________ - _

~age

677

687
713
729
738

SUBMISSIONS FOR THE RECORD
WEDNESDAY, JULY 19, 1978
:Bergsten, Ron. C. Fred:
Prepared statement ____ ------------------______________________
Response to additional written questions posed by Representative
Bolling_____________________________________________________
Packer, Hon. Arnold H.:
Prepared statement ________________ ------------________________
Whitman, Marina v. N.:
Prepared statement____________________________________________
Response to additional written questions posed by Representative
Bolling_____________________________________________________
THURSDAY, JULY

566
535
547
568

20, 1978

Bosworth, Hon. Barry P.:
Prepared statement____________________________________________
Gordon, Robert J.:
Prepared statement____________________________________________
Pechman, Joseph A.:
Prepared statement ________________ --------------------------__
Seidman, Laurence S. :
Prepared statement ____ --------------------------------------__
TUESDAY, JULY 25, 1978
Boe, Hon. Jason:
Bryc!~'tr.:;:!;;~!eJ.~nt___________________________________________ _

Prepared statement ____________________ -- -- -- ____ -- -- -- -- __ -- -Cooper,
Fred F.:
Prepared
statement ___________________________________________ _
Resolution adopted by the membership of the National Association of
July_____________
11, 1978, entitled
"Tax Reform and Responsible
Counties,
Government"
> _______________________________ _
Farber, Stephen B.:
Prepared statement with an attachment _________________________ _
Fitch, Lyle C.:
Prepared statement ___________________________________________ _
Gramlich,
Edward
M.: ___________________________________________ _
Prepared
statement
Greytak, David:
Prepared statement ________________ ---------------------------Jacoby,
Neil H.:
Prepared
statement ___________________________________________ _
Mc Govern, Hon. George:
Article entitled "Federal Tax Reform and Defense Cuts Are the Only
Answers," from the Los Angeles Times, July 2, 1978 ____________ _
Text of a speech entitled "A Vision of Positive Government" ______ _
Peterson, George E.:
Prepared statement .• _________________________________________ _
Shannon, Hon. John:
Prepared statement ____________________________________ ---- ___ _


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THE 1978 MIDYEAR REVIEW OF THE ECONOMY
WEDNESDAY, JULY 19, 1978

INTERNATIONAL ADJUSTMENT II

u

CONGRESS OF THE NITED S'l'ATES,
JOINT ECONOMIC CoMMITrEE,

Washington, D.0.
The committee met, pursuant to recess, at 10 a.m., in room 5110,
Dirksen Senate Office Building, Hon. Henry S. Reuss (member of the
committee) presiding.
Present: Representative Reuss and Senator J avits.
Also present: Richard F. Kaufman, assistant director-general counsel; Lloyd C. Atkinson, Thomas F. Dernburg, Kent H. Hughes, M.
Catherine Miller, and L. Douglas Lee, professional staff members;
Mark Borchelt, administrative assistant; and Charles H. Bradford,
Stephen J. Entin, and Robert H. Aten, minority professional staff
members.
Staff of Special Study on Economic Change present: Robert Ash
Wallace, research director; and Richard D. Bartel, economist.
OPENING STATEMENT OF REPRESENTATIVE REUSS

Representative REuss. Good morning.
The Joint Economic Committee will be in order for the second day
of its hearings devoted to the problems of balance of payments adjustment in our international monetary system. Yesterday the focus of
our attention was the problem 0£ world economic recovery 1and balance of payments adjustment under the present quasi-managed floating exchange rate system. The emphasis today will be on longer range
international monetary reform issues.
.
The Bretton Woods system of par values died with the widespread
adoption of floating exchange rates in 1973. The current international
monetary system, however, is not a cleanly floating exchange rate
regime.
As we look toward the future, toward reform of the international
monetary system, is a managed floating exchange rate system the best
we can hope for? Or would we be better advised to look toward a
:future characterized by cleanly floating exchange rates? What about
the rossibility of completely fixed rates, or some variant to the recently deceased Bretton Woods system?
If a managed floating system or some modified form is used, will
we not be plagued once again with precisely the same kind of problems


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526
that led to the downfall of Bretton vVoods in the first place~ Or have
we really learned the lesson of Bretton ·woods so that we can now
avoid those problems this time around?
·what sort of surveillance rules do you see being established in a
managed floating system? ·what is to stop individual countries from
manipulating exchange rates in pursuit of blatant "beggar-thy-neighbor" policies? How should the burden of adjustment be divided
between surplus and deficit countries? ,vhen, if ever, is it appropriate
to .correct for balance of payments disequilibria through the use of
domestic monetary and fiscal policies?
vVhat should be the future role of the dollar in our international
monetary system? "That about the role of SDffs? How would you
assess the prospects for monetary integration within the European
Community? Is this something the United States should encomage?
ould we lose or benefit from the establishment of such a common
currency?
Finally, what does the future hold with respect to the recycling of
surpluses? As yon know, the Honse passed the bill establishing a vVitteveen facility some months ago. Unfortunately, the Senate has not yet
acted on this.
In my judgment, the passage of this bill is important. First, it would
provide an important source of finance for those countries that are
especially burdened with oil-related deficits. Second, it would be an
important first step in the direction of establishing an efficient mechanism for the recycling of funds from surplus to deficit countries.
All of us have been amazed at the ease with which private banks
have stepped in to fill the gap and provide many of the financing
needs for countries with oil-related balance of payments deficits. Under
present circumstances is there any reason to believe the ,Vitteveen facility is inadequate as a supplemental source of funds? ·what other
recycling schemes ought we to be looking at in order to insure less
burdensome adjustments to an ever-changing world economy?
Those questions say quite a mouthful. You could write a book about
it, and we only have a couple of hours to go, but we couldn't have before
us a more distinguished or delightful panel of witnesses than we have
today.
I want to welcome 1\fr. Packer, Assistant Secretary of Labor for
Policy Evaluation and Research; Ms. mitman. who served with such
distinction here on the Council of Economic Advisers for years and is
now a distinguished public service professor of economics at
the University of Pittsburgh: and Mr. Bergsten, Assistant Secretary
of tlrn Treasury for International Affairs. I well remember the spirit
of attack which Mr. Bergsten as a private citizen used to be able to
make on governmental international monetary policy, and the valiant
defense of them which Ms. Whitman used to make. [Laughter.] Now
that the roles are exchanged, I welcome you to get even. So you are all
most welcome, and based, I guess, on alphabets, Fred Bergsten will be
first.
Yon all have very kindly submitted prepared statements, and without objection, they will be placed in full in the hearing record.
Representative REuss. 1\fr. Bergsten, please proceed.

,v


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.STATEMENT OF HON. C. FRED BERGSTEN, ASSISTANT SECRETARY OF THE TREASURY FOR INTERNATIONAL AFFAIRS
Mr. BERGSTEN. Thank you, Congressman Reuss.
In my prepared statement I put together a review of what we have
tried to do over the past 18 months in terms of our overall approach
to the international economic and financial problems that you mentioned. In light of the questions that you raised now in your opening
statement, what I might do is make a few comments on the international monetary aspect of those questions, and then if you care to
branch off into trade or develop other issues subsequently, we could
do so.
As you well know, Congressman Reuss, our focus, as well as the
focus of the new amendments to the Articles of Agreement of the
International Monetary Fund, has really been to look primarily to the
underlying economic conditions in individual countries rather than
focusing on changes in the system per se.
vVe do believe that the present system, relying primarily on more
flexible exchange rates, is the right basis for international monetary
arrangements. vVe share the view that you have suggested, that its evolution to provide better implementation of that system is called for,
and indeed we ourselves have made a number of proposals to at least
begin the process of developing an effective international surveillance
mechanism through which the IMF can carry out the responsibilities
handed to it under the 2d amendment to the IMF articles, which have
just come into effect on April 1 of this year.
vVe made those proposals at the interim committee meeting in Mexico City in late April. vVe are continuing to work on those in the
executive board of the IMF, and I am sure they will be further discussed at the annual meetings in the fall and subsequently.
But our focus has been on the underlying economics in all countries,
including our own. As we have faced the large disequilibria that continue to exist in the system, our own. deficit being one o:f the most
important, the surpluses in OPEC, Japan, Germany, and Switzerland,
on the other hand we have consistently and insistently sought policy
measures by each of those countries, ours included, that would reduce
those imbalances.
In our own case, of course, our focus has been the threefold one which
the President enunciated clearly, I think, in his speech back on
April 11. Namely, a broad effort to bring inflation down and under
control in this country. Second, a commitment which was reaffirmed
and strengthened in the summit communique this week to put into
effect a comprehensive U.S. energy program to cut our dependence on
oil imports; and, third, a comprehensive effort to expand U.S. exports
which we are now working on and putting into final shape for submission shortly to the President.
Our success in dealing with those items will, I think, be the fundamental determinant of whether we are successful in doing what we
from the U.S. standpoint can in bringing down our external imbalance
and bringing it back toward a more sustainable position;


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Now, obviously we have to focus on doing what we can, but at the
same time we have urged other countries, particularly surplus countries, to do what they can and must in order to achieve equilibrium from
their side.
Again, many of those steps were fully reflected in the summit communique of Monday of this week. Recommitments by both Germa1~y
and Japan to take the pressures necessary to achieve more rapid
economic growth there, and thereby reduce their own balance-of-payments surpluses; efforts by the Japanese-which we worked on, also,.
in the trade negotiations in Geneva-recently to open their market
further to imports from the United States and elsewhere, it cut their
trade surplus. In short, we have been workino- at all 'aspects of the
problem to get the surplus countries to reduce their imbalances, which
also contribute to the current difficulties in the international monetary and economic system.
On the OPEC side, we have, of course, consistently worked with
the OPEC countries, and through our own energy policy to try to.
hold down the world price of oil. This year it did remain stable, and
as a result, the OPEC surplus this year •has been cut dramatically,.
about in half, from around $36 billion last year to under $20 billion
this year.
This is probably the most dramatic change in the international
payments structure which has occurred since the increase in oil prices
in 1973. It does reduce one major source of imbalance in the system,.
ease the recycling and financial problems to which you have referred,
and since we think that for the foreseeable future that OPEC surplus.
is likely to continue on its downward trend, we would not imagine
that large new pr6blems would emerge from that particular source.
Indeed, now, the larger disequilibria are in the OECD world, our
own deficit ,and the surpluses particularly of Japan, but also to a
signifi0ant extent of Germany and Switzerland. Those 'are the fundamentals on which we are working. Beyond that are our efforts tostrengthen the monetary system itself.
The new amendments to the IMF articles retain the basic Bretton
Woods philosophy of international cooperation, and liberal trade and
payments arrangements. But it does move away from ·any effort to•
try to enforce stability on nations with an external mechanism, as the
Bretton Woods and the gold standard before had tried ,and failed.
Instead, it develops stabilities by sound underlying policies, which
we think is a more realistic and pragmatic approach. It does focus·
attention less <?n th~ symptoms of instability in the world economy,
such as conditions m the exchange markets, and more on the root
causes of instability, the pursuit of divergent and sometimes simply
inappropriate national policies by individual countries.
Now, under the new IMF articles, two basic obligations are placed'
on countries. First, each nation must endeavor to· direct its polices
toward orderly growth with reasonable price stability. Se.cond. each
nation must avoid manipulation of its exchange rate to avoid adjustment or gain unfair competitive advantage.
·
I might say, Congressman Reuss, in thinking on that, and on dis~
cussions we had when I was in a previous incarnation. something both
vou and I said 2 years ago proved all too right.. The fact. that tl1e
,faoanese, in the course of 1976, intervened too heavilv to keen the·
value of the yen from appreciating has really come home to ha1mt
us all. It was a major cause, we believe, of the very sharp ballooning·

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.of the Japanese surplus last year and again this year, with the normal
2-year time lag. Had the Japa,nese l,et that rate move toward a more
,equal level 2 years ago, their s,u:rplus now would be much less.
The second effect of that was when the yen started moving, as
it did, it moved rapidly and very far, thereby causing unneeded in:stabilities in the exchange market itself, excessive concern, and even in
Japan itself, because of the rapid change in its international competitive position.
But I think if we need empirical evidence as to the validity of relying on market mech-anisms to la.rg-ely determine .exchange rate relationships and the validity of this provi$ion in the new IMF articles
that countries should avoid manipulating e~ehange raws, we have the
proof right in front of us in what has happened m the last 2 years.
We remind our Japanese friends r-epeatedly of that, and urge that
the mistake not be allowed to reoccur in the future.
e know that no mo1'letary system can foree countries against
their will to adoptin.g economic 'a,nd financial policies. We do believe
those who seek refuge ht any automa,tic self-policing monetary system,
such as a return to Bretton Woods, are simply cha:smg sh&dows.
History shows that monetary stability and underlying eeooomic
·stability do tend to coexist, and to he mutually reinforcing-but that
the casuality runs primarily from underlying national stability to
the internationial arena rather than vfoe versa.
What we can do, and are trying to do, is to inerease the extent
to which nationa.l policies make a positive contribution. to international stability--and the degree to which the int.emational system
•contributes to oonstruetive m.ttional policies. German .and Japanese
growth policy is made by German and J,apanese authorities, but should
be made with a view to their global impact.
American ooonomie ,and energy poliey is mad~ by the Pre.sident
and the Congress, but must take their intern~tional .effects fully into
·account. The exchange markets give strong signals to all these authorities, and point to the costs of iTIJadequate action on ·all such issues.
Today's system provides the basis for this two~way interaction. All
of our efforts, su-ch as this week's summit, aim to operate it more
effectively. All of our efforts aim to make that system operate more
smoothlv.
I wouid be pleased to address your questions.
Renresent·ativs REuss. Thank you very much.
[The prepared statement of Mr. Bergsten follows :]

,v

Pil!J!:l'ABED STA'flEMENT OF HoN.

C.

FRED BERGSTEN

Interna,-tionai Eco1Wmic PoUery-Where We 8tmuJ,

I wellcome this opportuni~y to discuss with you longer term problems in the international ecou.omy. Far too often, the Congress .and the Executive Branch focus
solely on the short run. While this "fire-fighting" approach is inevitable to some
·extent. it is essential occasio.nally to step back and review the broader and longer
·term issues--and how our eountry is seeking to deal with them. The Garter Administration has been in office a year and a half, and it is thus particularly timely
·to review our international ec•momic policies.
Philosoph11

The Administration's philosophy centers on two basic factors:
(1) The need to maintain and strengthen an open trade and payments system;
·and
(2) The requirements of global economic interdependence.


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The Administration and, I believe, the Congress and the nation as well, place
basic reliance on the free market systems. The private market is the most efficient
way to allocate scarce resources at home and abroad, as long as it is truly free
of distortions due to governmental interference.
The free movement of goods, services and capital is essential to the efficient
functioning of the global economy. Only in this way can our citizens purchase
goods produced by the most efficient and lowest priced firms world wide, thus
minimizing the price level within our own borders. Only in this way can our producers have access to the widest possible market for their products, thus maximizing jobs for our workers.
But trade relations must be reciprocal. Goods must be allowed to move unencumbered out of the United States to other markets, as well as into the United
States. In many areas-far too many-the hard realities are that governments
are deeply involved in what should be basically private market decisions. For example, subsidies to domestic producers distort investment and trade flows. In
such cases it is incumbent upon the U.S. Government to undertake efforts to offset such distortions, both to defend our own producers and to try to deter others
from interfering in these markets themselves.
This is a basic tenet of our philosophy-"domestic" and "international" economic issues are inextricably linked. The pressures on governments to intervene
in private markets, in pursuit of their numerous policy objectives, is matched by
their increased dependence on external transactions. On the one hand, this adds
to the temptation to manipulate international flows. On the other hand, it compels
countries to play by the international rules if they are to avoid self-defeating retaliation or evaluation by other countries. Hence increased interdependence simultaneously produces centrifugal and centripetal forces as regards the maintenance
of an open world economy based largely on market principles.
Faced with this situation. the United States--to oversimplify for presentational
purposes-faces two basic choices : to fight or to join the trend toward increased
government involvement abroad. In practice, we will of course do some of both.
But our basic philosophy is to resist this trend in the hope and belief that the
market-oriented approach is both far superior and likely, over time, to prevail.
In many key instances-such as the adoption by most major countries of flexible
exchange rates, and the recent progres at Geneva in reducing tariffs and other
barriers to trade-there has recently been impressive evidence of the vitality of
the market approach, and the confidence of nations in it.
The maintenance of an open trading system produces essential support for
jobs abroad and jobs in the United States, both directly and through its effect
on the policies of others. A well functioning monetary system, sustained, noninflationary growth abroad, reasonably stable commodity prices, and healthy international competition are essential components of our fight against inflation
and unemployment.
Strategy

The strategy we have developed for converting philosophy into concrete results
is multi-faceted. We have operated simultaneously on a number of fronts: macroeconomic policies at home and abroad ; trade policy in general and the MTN
in particular, further improvement in the international monetary system; more
effective economic relationships between the industrialized and developing countries; and energy. Actions on each front are consistent with our basic approach:
each reinforces other elements in the overall strategy. The list of specific parts of
the entire program is rather long.
On macroeconomic policy, we have focused our domestic efforts on maintaining adequate growth, reducing unemployment, and controlling inflation. In discussions with our allies, we have pressed for accelerated growth wherever possible and for restraint where necessary due to domestic or external imbalances.
In pursuing the multilateral trade negotiations, we have pushed for maximum
tariff cuts, sought reductions in non-tariff barriers, supported a new internal trading framework, and argued for controls on subsidies and export credit competition.
In the monetary field, we have maintained our support for the system of flexible
exchange rates, emphasized the need to address fundamental imbalances in order
to restore international financial stability. increased efforts at exmmdin~ U.S.
exports to promote the strength and stability of the dollar, intervened in the exchange markets where necessary to counter disorderly conditions, proposed legiRlation for expanding IMF resources through the Witteveen Facility, sought a
better definition of the concept of IMF surveillance over the exchange rate sys-


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531
tern, and increased the availability of data on private bank lending to assess
.
more closely any risks involved in bank exposure in foreign countries.
We have had constant discussions with the developing conntries regardmg
commodity agreements, reduction of trade barriers, and a possible common fund,
and have expanded our own foreign assistance efforts considerably.
Finally, in the energy field, we have continuously pushed for a comprehen_si~e
National Energy Policy, worked actively with OPEC and other countries to llmit
the world price of oil, and pursued multilateral discussions on longer term energy
policies in the International Energy Agency.
Our ability to pursue these several initiatives successfully will be a major
factor in providing answers to the questions raised in your letter of invitation,
Mr. Chairman :
The evolution of the U.S. balance of payments will be determined largely by the
relationship between economic growth rates at home and abroad (in both the
industrialized and developing countries), by our success in controlling our own
rate of inflation and our appetite for oil imports, by our national export effort
and the willingness of other countries to reduce their barriers to imports.
The OPEC surplus, which will decline sharply this year to under $20 billion,
will turn largely on the evolution of demand for energy in this country and
abroad, our success in developing new sources of energy production around the
world, rates of economic growth, the stability of the international monetary system (because of its impact on decision-makers in the OPEC countries), and our
ability to work constructively together both with other oil-importing countries
and with the OPEC countries themselves in their efforts to develop their own
economies.
The debt problems of the developing countries will turn on the growth and
stability of the economies of the industrialized countries, the evolution of the
world price of oil, the willingness of a11 countries to maintain open markets for
LDC exports and to provide adequate flows of public and private capital in support of development, and the wisdom of the development policies which the developing countries adopt themselves.
This tabullation of our international economic policy efforts, and their implications, for some of the most important policy issues which we face, illustrates the
inter-relationships between our strategy and philosophy, the breadth of our
activity in the international economic area and the inextricable links between
"domestic" and "international" issues. I would like to discuss some of the more
directly international aspects of these actions in somewhat more detail.

International monetary system
Our basic approach to international monetary affairs centers on our approa('lJ.
to the domestic economy. It aims at the fundamentals of price stability and continued economic growth, and seeks as well to curb oil imports and expand U.S.
exports. The success of our international financial policy will ultimately be determined by our success in addressing these four basic issues.
Reinforcing this strategy are our efforts to strengthen the. operation of the
international monetary system itself. The system encompassed in the new Amendment to the IMF Articles of Agreement retains the basic Bretton Woods philosophy of cooperation and liberal trade and payments. But it moves away from
trying to force stability on nations through an external mechanism-as the gold
standard to an extreme degree, and the Bretton Woods system to a lesser degree
'
had tried but failed.
Instead, it aims at developing stability through the application of sound underlying economic and financial policies in individual countries. It is a more realistic
~ore pragmatic approach. It focuses ~t~ention less on the symptoms of instabilit;
m the world economy--.;;uch as condit10ns in the exchange markets-and more
on the root causes: the pursuit of diver,gent, and in some cases inappropriate
'
national policies by individual countries.
The main obligations placed on nations under the new IMF Articles are twofold. First, each nation must endeavor to direct its policies toward orderly
gr~wth wi!h reasonable price stability. Second, each nation must avoid maniplidat10n of its exchange rate to avoid adjustment or gain unfair competitive
advantage.
These are tough demands. The monetary system would function well if all nations f?llowed sensible poli~ies directed toward non-inflationary growth. and if
they did not tn· to rnamtam exchange rate~ at artificial levels. But we must
frankly acknowledge that neither the new monetary system, nor any conceiYahle


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532
alternative system, can force ;;;overeign nations against their will to adopt particular domestic economic and financial policies.
Those who seek refuge in an automatic self-policing m_o~etary system. '.1re
chasing shadows. History clearly ,;hows that monetary staln~1ty a~d underlymg
economic stability do tend to co-exist, and to be m~tually rei~forcmg-bu~ that
the causality runs primarily from underlying national stability to the mternational arena, rather than vice-versa.
.
'IVhat we can do and are trying to do, is to increase the extent to which national
policies make a ~sitive contribution to international stab~lity-a~d the d~ree
to which the international system contributes to constructive national policies.
German and Japanese growth policy is made by German and Japanese author:ities, but should be made with a view to their global impact. American econom~c
1tnd t'nergy policy is made by the President and the Congress, but ~ust take th~1r
international effects fully into account. The exchange markets give strong srguals to all these authorities, and point to the costs of inadequate action on all
sueh issues.
Today's system provides the basis for this two-way interaction ; all of our
efforts, such as this week's Summit, aim to operate it more effectively.
Trade relations

Perhaps in no other area has the Administration moved simultaneously on so
many fronts. The maintenance of an open and liberal trading system is a keystone of our international economi-c policit>s. In pursuit of this goal, we have
been actively involved in the MTN, including proposals for revitalizing the
GA'l'T; discussions on a wide variety of commodity issues; and the development
of positive adjustment programs.
In the recently completed h.lgh level di11cussion in Geneva on the MTN, we have
sought a new international trad,ing framework which will address a wide variety
of major problems : injurious import competition, government subsidization,
government procurement, the use of export controls, the role of the developing
countries, methods of dispute settlement. The new trade rules are needed to complement the new international monetary system of flexible exchange rates, by
updating the existing body of international rules to meet the demands of a rapidly changing international economy and providing a cooperative basis for addressing and resolving mutual problems. As in the monetary area, the new
trading framework must be flexible and recognize that the needs and problems
of domestic economies will differ among nations, yet provide acceptable guidelines and limitations upon national actions that interfere with trade flows.
In addition to these new codes and understandings, we also need to look
beyond the MTN-and to the need for improved mechanisms of cooperation in
trade among nations. We need to assure that trade problems can be addressed
and mutually resolved before they erupt in open conflict, To do so, we must inter
alia. expand the means and mechanisms for increasing participation by the more
advanced develloping nations (ADCs) in the global economy~both through improved consultation and rights, and through their acceptance of greater responsibilities in international trade.
Relation, wUh developing countries

Building better relationships with the developing world has been a primary
goal of this Administration. Our major instruments to that end are to provide
foreign assistance, conclude mutually beneficial commodity agreements where
appropriate, negotiate an effective financially sound Common Fund, and reduce
barriers to trade.
·
To assist the developing countries in meeting their development needs, we have
sought sharply increased levels of foreign assistance. To increase the effectiven~ss of our effort to eradicate the worst forms of poverty, we have targeted our
bilateral assistance on meeting basic needs-in agriculture, education and
health-of .the poorest. We have also encouraged the multifateral development
?anks to inc!-'8ase their emphasis on meeting basic human needs, while recognizmg the crucial role of these institutions in other areas, such as infrastructure
While a great deal still to be done, we can already see positive results from ou;
efforts-increases in_ health standards and life expectancy, 'better education systems, faster economic growth, and-in a number of countries-declines in the
rate of population growth.
The fiscal year 1979 Appropriations Bill for foreign assistance and related
programs is now before the Congress for floor action. The bill has been extensively
cu~ i1;1 Committee, and further cuts are threatened on the floor. Moreover, appropnatrons for the multilateral banks are severely threatened by possible restric-


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tive atnendments--on ~lther country or commodity grounds. The banks cannot
accept any funds with such restrictions attached, so such am<:n.dme_nts wou~d
severely UT!dermine our continued participation in them-a participation that is
vital to our nation's economic and political interests. I urge your support for
the amounts recommended by the Appropriations Committee, and ask your help
in averting tbe adoption of restrictive amendments.
.
In the wake of the massive economic dislocations brought about by the ~nl
crisis, the establishment of a cohesive set of polici<:s dealing with com_modity
prices has been a major aim of our development policy. Over the _p3:st eight<:en
months, we have sought to develop a comprehensive approach to this issue yrhich
can provide substantial benefits to both consumers_ and producers of primary
commodities in the United States and in other countries.
.
That policy seeks to integrate domestic and international elements into a smgle,
eoherent approach. In so doing, it has focussed on five policy instruments:
International commodity agreements between producers and consumers, to
reduce excessive price volatility in world commodity markets. We have neg?ti.ailled a sugar agreement, agreed to contribute to the buffer stock of the tm
agreement, laid the basis for negotiating natural rubber and whea~ a~reements,
seriously considered the possibilities of a copper agreement, and. indicated our
willingness to participate in a renegotiation of the cocoa agreement.
A common fund which, by poolling the financial resources of individual commodity agreements, would provide for adequate financing of agreements while
reducing the budgetary burden on individual governments.
Promotion of increased productive capacity abroad for key raw materials
throug:h greater activity by the World Bank, the regional development banks,
and our own Overseas Private Investment Corporation (OPIC).
A strategic stockpile policy based on revised strategic objectives and implemented in ways which are consistent with our national and international economic goals.
Support for the stabilization of export earnings of producing countries through
the Compensatory ~'inance Facility of the International Monetary Fund.
A key component of U.S. policy toward the developing nations is general trade
relations. Their need for access to our markets for manufactured products comes
at a difficult time, because our own unemployment. remains too high and our
trade deficit has reached record proportions.
Nevertheless we must recognize that these countries are large and growing
markets for our exports. We believe that open trading arrangements are very
much in the interests of the United States-to minimize inflation, to create millions of export and import•reUtted jobs and to avoid the imposition of non-trade
restrictions in other countries. The Administration has therefore resisted proposals for wide-ranging curbs on U.S. imports from the developing (and other)
countries, as an essential element of our approach to the developing countries.
In addition, the Multilateral Trade Negotiations seek to further reduce barriers
to international trade, particularly for products sold by the developing countries.
OoncluBion

Given this long ,and complex shopping 1Lst, one cannot expect instant results.
In some areas, our strategy has already produced significant successes. In others
there is movement in the right direction. In still otiher,s, we have recorded les~
progress :so far.
In any event, it is clear that much work remains to be done if we are to maintain an open interna,tional economic system in today's interdependent world.
First and foremost, we must have congressional action on energy.
Second, we must move forward to complete tihe MTN and develop a new
international trading framework.
Third, we need to develop guidelines for IMF surveillance of exchange rates as
a prerequisite for a smoothily operating international monetary system.
Fourth, we need to develop a means for more effectively rincluding the ADCs
in the international system. They are fast becoming important actors but they
are not yet active in many of the major internation:al institutiorus wh~re .global
problems are discussed.
Progress in all of these areas is necessary in our continued pursuit of economic
and political gains for botih the United States and the world economy as a whol-e.
I greatly welcome this opportunity to discuss the whole range of matters with
you.

Representative REuss. Mr. Packer.


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STATEMENT OF HON. ARNOLD H. PACKER, ASSISTANT SECRETARY OF LABOR FOR POLICY, EVALUATION AND RESEARCH
Mr. PACKER. Thank yon, Congressman Reuss.
I will :follow the pattern Mr. Bergsten has begun o:f summarizing
the prepared statement. It is a privilege to be here and talk about this
complicated problem in which the daTiiger is not imminent. These kinds
o:f problems a:re the ones that the democracies tend to ignore-the
ones that are complicated and not in a crisis proportion.
The problem I see is really not in terms of imbalances in the financial
markets, as Mr. Bergsten has said. I look at a world in which there
are substantial unmet needs and substantial unutilized resources. 1Vhen
I see that sort o:f a situation, I :feel that there must be some better
solution than to let those needs go unmet and the resources remain idle.
I point to the 16 million unemployed in the OECD countries as an
indication o:f the idle resources.
Apparently, we have idle financial resources; I say they are idle and
the recycling has not bt'en success:ful, because i:f it had been suocess:ful, we would have :full employment throughout the OECD world.
The recycling may have maintained the financial stability, but it has
not balanced saving-s and investment a,t a level to provide for full
employment. This, m my judgment, is the test o:f adequate recycling.
vVe do see tihese other problems of balance o:f payments and so forth.
However, one has to wonder whether investment is balanced in the
world. Manufacturing capacity in steel and other commodities is in
excess. Yet, we see investment moving in those directions, while investment in energy and :food seems to be going less rapidly than one would
hope.
The concern is that the :fundamental solutions to these imbalances
take a long time, and i:f one waits until the crisis is evident, it usually
is too late to undertake the necessary long-term action.
I compliment the committee :for deal~ng with the longer term problems, something that the body politic in '\Vashington frequently doesn't
have time to do.
It seems unusual, in a sense, :for someone :from the Labor Department
to be here discussing international economics. I hope that is the beginning of a trend o:f greater involvement in international matters by the
Department and, perhaps more importantly, by the labor movement
itsel:f. I sometimes believe that international economic policy matters
are not dealt with properly because the discussion o:f exchange rat('B
and disequilibria do not seem at the hea1t o:f the public's concern or
political interests.
In the labor movement, employment and prices are the key data. Yet,
we all know from the work tluit vou and the committee ham done that
employment and prices, in :fact, are partially determined by what
happens in the international sphere. In recent years, this has been particularly true :for the United States.
I want to point out that the AFL-CIO has spoken out on the forei 1gn
aid appropriation, particularly, the World Bank portion, and has
wTitten a letter to all Membt'rs o:f Congress expressing their support.
I think that is a ~epart1~re. from their previous policy and, I hope, part
of a trend that will contmue.
My testimony goes on to indicate some figures about the slowinO' o:f
world economic growth. I. will just recite one or two figures that ;ere
not in the testimony, but -;truck me as being significant.

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In Japan, manufacturing hours grew at a 2.2-percent rate between
1960 and 1973. After 1973 they dropped at a 3-percent rate. Germany
experienced stable manufacturing hours bet:Veen 1960 and 1973, ~ut
has declined at a 4.5-percent annual rate smce 1973. So somethmg
happened in 1973 that has not yet been solved.
As has been pointed out many times, the problem is that the substantial increases in oil prices and the imbalances that turned up as
surpluses of funds were not invested in employment-producing activities. Investments in land or in Treasury bills are clearly a place to
put your money, but they don't directly produce employment. If the
Federal Reserve has a domestic target, these inflows of foreign moneys
do not do what monetarists think they do in terms of creating full employment. Again, I point out the fact that the OECD world does not
have full employment, and this suggests to me that the monetarists
view is clearly not accurate.
Some observers think there is an imminent crisis. I don't think that
the system is on the brink of failure, but I do believe we have the beginning of something that could be a problem. As I point out in my prepared statement, most of the world's problems had been around for
many years in a manageable state before they got out of control. The
rise of fascism in the 1930's or the Vietnam war are a good examples. I
think we have a situation in which the south countries in the northsouth dialog are doing without, whne we have the richer countries saying their desire to constime has diminished. One would hope that this
would be an opportunity to do something for the poorer countries, but,
in fact, it turns out to be a problem.
1Ve all hope now that the richer countries will consume more so that
the rest of us can go to work. It seems to me that, even here, one can
desire a more optimal solution.
The solution that I point to in my prepared statement uses the
orld Bank or other international financial institutions and transfers
idle resources-whether they be in the OPEC c01mtries or in Japan or
Germany-to places where purchasing power will be created. Appropriate places would be primarily the developing countries; either the
more advanced developing countries or the poorer ones. This will lead
to balanced investment in the sectors of the world that lack developed
r{\Sources, including energy, agriculture, infrastructure, and raw
materials.
I would be happy Congressman Reuss, to try to answer any questions you have. Thank you:
Representative REuss. Thank you, Mr. Packer.
[The prepared statement of Mr. Packer follows:]
1

,v

PREPARED STATEMENT OF HON. ARNOLD H. PACKER

It is a privilege to be here this morning to testify on this important subject. It
may seem unusual for a representative of the Labor Department to be discussing
international economics. However, I hope that it is just the beginning of a trend
towards greater involvement in international matters by .both the Labor Department and the labor movement. It is noteworthy that the AFL-CIO has spoken
out quite strongly on the foreign aid appropriation, particularly the World Bank
portion.
U.S. FULL EMPLOYMENT AND THE INTERNATIONAL ECONOMY

The observation that we are all part of one interdependent world has become
inescapable. The Labor Department, the labor movement, and, increasingly, the
general public are now aware that domestic policy ol1jeetives cannot be achieved
unless the world economy is healthy. The U.S. economy is increasingly dependent

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on the level of international economic activity. Last year, for example, U.~. imports were greater than all ~usiness fixed inv~stn_1ent in t~e U.S. and twice. as
large as residential construct10n. Roughly one m eight jobs m the manuf~cturmg
sector can be attributed to exports. ]'urthermore, these export-related Jobs are
typically high wage and high productivity jobs.
.
.
. .
While the relative size of the e:iqxirt sector of our economy is qmte sigmficant,.
its rate of growth has tapered off considerably in the last few years. Our economy
would be much stronger without the sluggishness of the export sector. I would
point out that developing country's share of U.S. exports is growing. In thetwenty years prior to 19·,3, real exports grew from 3.8% of r~l GNP to 7.1%.
If the strong 1953--1973 growth in exports had continued over the last four years,
GNP would now ibe $22 billion higher and the Federal deficit $5 billion lower.
Economic distress in the rest of the world encourages foreign countries to increase their exports to the U.S. and to reduce their imports of goods which they
themselves can produce. It also encourages them to export surplus labor. The·
U.S. economy is vulnerable to imported surplus labor, particularly in the form
of undocumented workers,. and this problem appears to be worsening. While no
hard data on this issue exists, the flow of surplus labor to the U.S. shows little
sign of slowing down. "\Ve believe that undocumented workers now account for a
substantial portion of the labor force in certain markets and segments of industry. Faced with economic stagnation, low wages, and sometimes politically repressive situations, workers from other countries see the U.S. labor market as an
extremely attractive alternative. Hundreds of thousands of undocumented workers enter the U.S. annually.
Meanwhile, several European nations which used to welcome "guest workers''
from other .parts of the continent no longer face labor shortages. In the near
future the drop in airline fares could possibly increase the flow of undocumented
workers to the U.S. and make it relatively inexpensive for potential emigrants
from Asia, Africa, and the rest of the less developed world to pl.ace new strains on
the U.S. labor market.
The interest of the Labor Department and the labor movement in the health
of the international economy has heightened, because we can no longer maintain
strong economic growth ourselves unless the rest of the world economy is also
growing. If economic stagnation persists in foreign countries, it will be difficult
to achieve the goals of the Humphrey-Hawkins Bfill. If we are to attain these
essential goals on schedule, we must strive to build a stronger world economy.
THE PARADOX OF INTERNATIONAL IMBALANCE

Until 1973, the economic interdependence of the United States and the rest of
the world grew at a slow and steady pace. The sudden quadrupling of energy
prices following the oil embargo made all Americans aware of our increased economic vulnerability and the need to maintain a strong international economic
order. But, if the economic imbalance which followed the dramatic events of 1973
persist, they will slow the return to a healthy world economy.
The symptoms of the imbalance are numerous. Within the United States, it
ha,: become more difficult to reconcile full employment and a balanced budget.
The dollar is falling on the international currency markets, while the trade deficit
continues to assume astronomical proportions. Since December of 1975. the dollar
has depreciated 22 percent in terms of the yen and 34 percent in terms of the
D-Mark. Nominal net exports declined from a $20.3 billion surplus for 1975 to a
$23.7 billion deficit in the first quarter of this year. U.S•. industries face increasingly stiff competition from imports, while our export growth is slowing. Real
exports grew at a 6.7 percent annual rate between 1954 and 1974. They dropped
in 1975, recovered in 1976 but grew only 1.8 percent in 1977,
The symptoms are clear on an international level, as well. Much of the industrialized world faces persistent high unemployment. There is the potential for
political instability. Once again we are hearing the call for increased protectionism among the industrialized countries. In few areas is the imbalance as evident
as it is in the uneven growth pat.terns of some poorer countries. In many nations
in Asia and Africa, real growth is only 2 percent per year, while population
growth is 2.6 percent. On a per capita basis, GNP is dropping in these countries.
In 1975 Africa imported 2¾ times as much food as it did in 1970. However, last
year the average African had less to eat than he did in 1970. These nations have.
in the past, emphasized manufacturing and urban development at the expense of
agriculture and rural development. This approach led to excess capacity in the


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light manufacturing industries and in basic industries such as steel and autos.
Meanwhile agricultural development proceeded at a pace insufficient to meet
world food'needs. Too much effort was often spent on developing energy-intensiYe
and capital-intensive industries, while too little effort was spent on developing
energy and water resources.
Some observers believe that this situation will worsen before it improves. Senator Javits has expressed concern that the world financial system will be unalJle
to tolerate the continuation of the current situation. Recent work by ProfessorRonald Muller at American University supports Senator Javits' thesis. While we
continue to believe that the financial system possesses the necessary resiliency
to cope with these problems, we do not discount the views of those who take a
more pessimistic approach. Moreover, the Administration's view is based upon
the continuation of the domestic recovery and a resumption of growth in the
Organization for Economic Co-operation and Devellopment (OEOD) countries..
The world now has an opportunity to prevent the next crisis-worldwide economic stagnation. Most emergencies give ample warning, if only the world's leaders are attuned to the signals. The rise of fascism, bringing with it the seeds of
World War II, was apparent at a time when it could easily have been contained.
Vietnam was brewing for at least a decade before it reached the proportions which
tore the nation apart. Future historians may look back upon the latter half of
this decade as yet another instance when the symptoms of an ensuing problem,
were ignored, letting the problem grow into a crisis of unmanageable proportions.
Currently, the seeds of the next crisis may be visible. An international imbalance of savings and investment started with the unused Organization of
Petroleum Exporting Countries (OPEC) surplus (which resulted from the
quadrupling of energy prices). More recently, this problem has been intensified
by the large surpluses held by other industrialized nations. As a result, many
countries including our own, must run budget deficits in order to compensate for
the purchasing power which is being siphoned off by the underutilization of trade
surpluses.
Four years after the increase in oil prices, most industrialized countries are
desperately trying to earn the· foreign exchange necessary to pay for oil
imports. This attempt has generated considerable pressure to promote exports·
in both rich and poor countries.
While some countries can eliminate their current account deficits some of the
time, deficit countries cannot do so simultaneously as long as the oil-exporters
and a handful of industrial nations remain heavily in surplus. In the last few
years, the deficit has moved from one group of countries to another as different
nations accept an extraordinary share of the imbalance. But, since no country can
sustain this7;axing burden for long, there is a tendency to try to shift the hot
potato to someone else.
In 1974 and 1975, developing nations bore most of the deficit caused by the rise
in oil prices. In 1974, the non-oil exporting developing countries ran a $24.5 billion deficit on current account. In 1975, their deficit on current account was $40.0•
billion. The comparable 1975 figure for the OECD nations was only $6.3 billion.
This could not continue for long since there were limits to how much debt these
countries could finance without raising fears of possible default.
Recently, the United States picked up the burden of a massive deficit. Our 1977
deficit on current account was $18 billion. The previous year's deficit was only $1.4
billion, and in 1975 we ran a surplus of $11.6 billion. In large measure, last year's
deficit occurred because our imports grew while our export growth diminished.
The deficit, in turn, contributed the recent decline in the dollar and triggered further inflationary problems. Additionally, the combination of high unemployment
and a sizeable trade deficit has made protectionism seem more attractive.
Worldwide, we face the classic Keynesian situation where desired savings
exceeds investment. The imbalance between savings and investment within individual countries stems from a failure to make up for OPEC surpluses in terms of
effective demand. Deficits induced by the higher costs of imported oil have made
industrialized democracies extremely cautious in effecting policies to offset these
imbalances.
If investors were sufficiently confident and were able to obtain bank loam; at
low enough interest rates, private investment might rise by enough to replace the
purchasing power lost through oil imports. But, this is not the prevailing situation. Quite simply, under currel!t interest rates, investment will not rise enough
to match desired savings. Similarly, governments could replace lost purchasing
power through full employment budget deficits. However,. again, most govern37-250-79--2


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ments appear unwilling to take this risk. Instead, as Secretary Marshall noted
before the Empire Club in Toronto, "the industrial world leaders are uncomfortably balal!cing the political costs of budget deficits against those of high
unemployment.''
A major problem is the recycling of OPEC trade surpluses into effective demand.
With the industrial countries fearful of such stimulation because of a possible
rekindling of inflation, actions should be taken to channel these resources to
balanced development in, less developed countries. Currently, many investors in
the OPEC and industrialized countries holding surplus funds are reluctant to
increase their investments in less developed countries because of the risk which
they perceive. However, by providing some mechanism, such as greatly expanding
the lendir.g capacity of international financial institutions, such rechanneling of
these funds could be made possible.
POTENTIAL SOLUTION

A number of observers have indicated such a possible solution. l\Iost recently,
the OECD ministerial meetings noted that "increased investment in developing
countries would contribute to sustained and more balanced economic growth as
well as enhancing development in the countries concerned." The analysis divides
the world into three sets of actors. One is the large surplus countries-certain OPEC
natior,s, European surplus nations, and Japan. The second set is composed of the
deficit industrial countries of the OECD, and the third is the developing world.
The surplus nations are clearly unable or unwilling to consume all they can
afford. It is ironic that the lack of consumption by rich provides-within the current institutior,al framework-not an opportunity but a problem. The deficit
industrial countries-and the United States is a good example-are consuming
or importing more than they are producing or exporting. In some cases, this is not
what they would wish to do. The imbalances in world financial flows have created
a situation, in which continued trade imbalances seem unavoidable.
Only an expansion of international export markets would be able to eliminate
these deficits. For the United States, an expansion in export markets could mean
increases in real output, employment, and productivity, ar.d reductions in both
the trade and budget deficits. We could eliminate much of the federal deficit and
one of the real causes of inflation-the continuing decline of the dollar in the
world currency markets.
Current investmer.t efforts in the developing nations often center too much on
"showcase" projects such as steel mills or on investments with a short term
payoff such as textile mills. In general, this approach has no long run benefit for
the countries. Private investors are currently unwilling to take the risk of investing in long run projects which enhance the infrastructure and lead to long run
growth. Aid should continue to be directed towards projects which will expand
the agricultural sector. There are few developing nations which would not benefit
from rural cooperatives, and agricultural extension services which help to introduce more advanced agricultural technologies. Industrial aid should be tailored
towards the recipients' special resources. Some nations could generate cheap
hydroelectricity. Solar energy projects would be useful in desert areas. But these
projects are all long term-the immediate return will be too small and the risk
too great to interest private investors.
What is needed is a great expansion of the lending capacity of the international final!cial institutions which would make development loans to the Jess
developed world. These can only be made through an unprecedented degree of
cooperation between the industrialized nations and the OPEC countries.
To be most effective, these development loans should emphasize agriculture,
water, and er.ergy production. Increased agricultural productivity, and rural
nonfarm development in the less developed world would slow migration from
rural to urban areas, pave the way for an increasing standard of living, and
avoid serious food shortages. These loans should not be intended to impose
Western norms on the developing world. Rather, they should be designed to help
each country choose its own formula for balanced growth.
'The World Bank, its soft loan window (IDA), and regional development banks
are the main financial institutions- that cal!i make these loans. It is essential that
the industrial world and the OPEC nations recognize their common interest in
expanding world demand.
My message is simple. .As a result of various ecol!omic forces, we face a situation where <'ertain nations are running large trade surpluses which they are
unable to channel back into productive investment. This has led to a reduction in


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effective world demand, and we have had to compensate by ru:cning large budget
deficits. If we can, through international financial institutions, find a productive
way to use the idle trade surpluses, we can restore the purchasing power which
has been siphoned away. In this manner, we can help restore robust economic
growth to the industrial nations and pave the way for meaningful economic
development in many poor countries.
If we fail to act promptly, we could face major, worldwide economic stagnation
in the coming decades. We must act now, with an unprecedented degree of international cooperation, in order to avoid this next crisis.

Representative REuss. Ms. "Thitman.
STATEMENT OF MARINA v. N. WHITMAN, DISTINGUISHED PUBLIC SERVICE PROFESSOR OF ECONOMICS, UNIVERSITY OF
PITTSBURGH, PITTSBURGH, PA.
Ms. ,vHITl\IAN. Thank you, Congressman Reuss. I, too, am very
glad to have this opportunity to talk about the international adjustment process and the international monetary system. I hate to disappoint you, but it doesn't sound as if Mr. Bergsten and I are going
to have much to fight about.
Representative REuss. ,vell, do the best you can. [Laughter.]
~fs. ,vHITl\IAN. I will do the best I can. ,vhen I started teaching
this subject of international economics in the early 1960's, we told the
students that the international monetary system should be evaluated
in terms of its performance in providing three fundamental necessities: Adjustment, liquidity, and confidence. Despite the cataclysmic
changes that the system has undergone in the intervening years, these
three terms still offer convenient categories into which to group my
comments about the present performance of the system.
Let me begin with the international adjustment process. The behavior of exchange rates over the last year or so poses something of a
puzzle. On the one hand, the instability of these rates, and particularly
the precipitous decline of the dollar, are widely regarded as one of the
primary problems of the international economy, destroying confidence,
disrupting financial markets, interfering with investment decisions
and acting as a drag on economic growth. We hear that all the time .
.At the same time, the United States has developed unprecedentedly
large deficits on trade and current account, deficits that show no sign
of abating. Viewed as an instrument of external adjustment, one
might be £empted to conclude that, far from being excessive, the depreciation of the dollar hasn't gone far enough. I guess it is lucky that
I am now at the University of Pittsburgh and not in the Government,
or the dollar would take another plunge on the basis of that statement.
But things are not all that simple. For one thing, we are talking
about different exchange rates. Investment and financial markets are
dominated by the relationship between the dollar and two or three
other major currencies. Here the shifts have indeed been large: Over
the past year, the dollar has fallen by roughly 15 percent against the
German mark, and by about 25 percent against the Japanese yen and
the Swiss franc. Measured against a wider group of currencies, on the
trade-weighted basis that is a more appropriate measure for gaginginternational competitiveness, the depreci3:tion of the _dollar has_ b~en
7.5 percent----and in real ter~s, that 1s, ad1usted for differences m rnflation rates, it has been less than half of that.


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Even more surprising is the fact that the dollar's value today, in.,
effective terms, is only about 2 percent below where it stood in midFebruary 1973, just after the second formal dollar devaluation that
marked the beginning of the era of managed floating. The reason, of
course, is something that Mr. Bergsten talked a bit about, too, that in
between there was a significant appreciation of the dollar, caused at
least partly, and perhaps substantially, by the very heavy intervention by other countries, and certainly by the Japanese, in the exchange
markets.
I think the picture is also blurred by the fact that changes in exchange rates appear to exert their effects on international competitiveness and trade flows with substantial lags of up to 2 years or more.
Thus, the main impact on trade flows of the dollar's decline over the
past year presumably lies ahead. In fact, a recent study by the International Monetary Fund staff estimates that, by 1980, there should be
a beneficial impact on the U.S. current-account balance of nearly $7
billion stemming from changes in relative prices-that is 1 exchange
rate changes adjusted for domestic inflation differenti als-that havenot yet exerted their impact on trade flmvs. I hope they are right.
So, whether the value of the dollar has dropped too far, not enough,
or just the right ,amount vis-a-vis other leading currencies, is a question neither I nor anyone else can answer with any degree of certainty.
Certainly any American living or touring abroad can tell that, in
purchasing-power-parity terms, the dollar is undervalued; that is, that
at present rates of exchange it will buy you considerably more in
Kansas City, ·washington, or even New York than it will in Munich,,
Zurich, or Tokyo.
The trouble with this sort of comparison is that, while over very
long periods of time such purchasing-power-parity relationships appear to hold up pretty well, in the short and medium runs exchange·
rates have to clear financial as well as commodity markets, to reflect
capital flows as well as trade flows, and to adjust for differences in
energy production and consumption, degree of export-orientation, differences in real growth rates, and a whole lot of other factors in addition to changes in relative price levels and rates of inflation.
In addition, exchange markets, like the stock market, take account
not only of the past and the present, but of the future as well, or at
least of expectations regarding it. It is increasingly apparent that in
the United States inflation is accelerating, which in the three "strong
currency" countries it appears to be stable or declining.
I believe that present exchange rates incorporate this anticipated
widening of this gap. If we are dismayed-as we should be-by the
visions of the future reflected in exchange market behavior, we woulct
be better advised to seek effective policies to alter those expectations
than to cavil against the markets that mirror them. No one has ever
succeeded in averting bad news by killing-or beating up-the messenger who brings it.
The fundamental uncertainty regarding the criteria by which exchange rate relationships should be judged make the IMF's post-Jamaica responsibility for surveillance over exchange rate policies as,
difficult as it is vitally important. And it is vitally important, because
obviously there is no such thing as an exchange ·rate completely free·
of Government intervention. Most countries today still peg their currencies, and those that don't are certainly managing their rates. The·


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541
central banks of some five or six industrialized countries ha,ve bought
more than $40 billion in 1977 and the first quarter of 1978, mainly in
order to dampen the appreciation of their own currencies.
Furth~rmorn, as the IMF's Executive Board has recognized, there
are many instrument5 other than direct intervention that a country can
use to manipulate its exchangera.te to its own advantage and the disadvantage of others, including official borrowing or lending on international capital markets, the use of controls on current or capitaloccount transa,ctions, or changes in the mix of monetary and fiscal
policy used for dome~ic stabilization purposes.
The fact is, of course, there are no principles defining what constitutes sooia1ly acceptable behavior in these areas, any more than there
are concrete means to distinguish appropriate from inappropriate exchange rates. But the fact that no such criteria have been deffloped
should be reason for support rather than criticism or abandonment
of the IMF's e.tforts to carry out its surveillance mandate.
In addition to the conceptual uncertainty surrounding these issues,
the IMF faces the in~vitable constraints felt by an intel'national
agency attempting to impinge on sovereign nations in the exercise of
legitimate-if not always constructive-instruments of national economic policy.
Inevitably the IMF must move slowly in this area, bu.ilding precedents gradually and on a case-by-case basis, through the consultative
process. The :fact that th~re are no general standttrd.s for acceptable
behavior does; not mean that the Fund cannot gradually evolve procedures for earmarking unacceptable behavior in particular instances,
any more than the inability to find a general definition of beauty means
that we cannot get a consensus on when it is absent, particularly in
~xtreme cases. It is essential that the United States give firm support
to the International Monetary Fund as it struggles to evolve effective
techniques for exchange rate surveillance in a world of man:aged
floating.
I don't mean to say, of course, that exchange rates are the alpha
and the omega of the adjustment process. They are not. This is partly
because, as I have already mentioned, they are far more completely
free to equilibrate the balance 0£ payments. It is also becau:se, even
if they were complooely "unmanaged/' exchan~ rates alone could not,
especially in a world of high intemational capital mobility, guarantee
the achievement o:f stable and acceptable current account positions,
insulate 'a country against external economic disturbances, or
prevent the international transmission and magnification of economic disturbances.
Recognizing the need for complementary measures to promote external adjustment in an environment o:f stable world economic growth,
the United States has for some time joined the OECD and various
other intemational agenci-es in urging that those countries with low
rates of inflation and strong external positions take a leading role in
stimulating and maintaining world economic recovery.
But, of the three countries originally envisaged as "locomotive
f'conomies" or "engines of recovery," the United States has run up
ag-afost both inflation and bfdance~o£-pavments ('<)nstr1tints of itR own,
while Germany and Japan insist that fear of rekindling inflationary
pressures and structural problems that limit the effectiveness of meas-


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ures to stimulate domestic demand severely constrain their abilityand their willingness-to do more along these lines.
So there has been something of an impasse on the "locomotive"
issue. This is not the place for an exhaustive evaluation of the locomotive strategy or its successor, the so-called convoy approach, which
would spread the responsibility for stimulating global recovery more
widely to include such countries as France, Itialy, and the United
Kingdom, whose inflation rates and balance-of-payments positions
have recently shown substantial improvement.
Let me confine myself to two brief comments, recognizing that, even
as I make them, the subject may have once again become a bone of contention at the Bonn summit discussions.
First, the tremendous uncertainty that currently prevails regarding
the impact of the traditional tools of aggregate demand policy in an
environment of persistent stagflation lies at the root of the problem.
Until some general consensus on this critical issue emerges, and until
some reliable ways are found to sustain or stimulate real growth
while restraining inflation, divergent national views and preferences
are bound to stand in the way of further progress on the international
coordination of macroeconomic policies.
The second point is that, while appropriate demand-management
policies in the leading industrialized countries, and particularly in the
leading surplus countries, are clearly essential to global economic recovery and real growth-which has been faltering badly outside of
the Unit~d States-we should not expect too much of changes in real
growth rate differentials among the industrialized countries as a means
of eliminating balance of payments disequilibria.
Specifically, a recent OECD study and one by the International
Monetary Fund estimated that demand-stimulating programs in other
countries sufficient to eliminate entirely the present growth gap differential-that is, differences in the size of the discrepancy between actual
and potential growth rates-between the United States and other industrialized countries would result in an improvement in the U.S.
balance on current acoount of less than $5 billion.
They get estimates that would range between $2 and $5 billion in
our current account position by 1980, clearly not insignificant, but by
no means the major solution to the problem.
Another issue, of course, is the development of an effective U.S.
energy policy, which has been viewed as essential to the health of our
economy and a balanced external position. More recently, attention has
turned also toward the development of export promotion policies in a
nation that has traditionally regarded foreign markets rather casually.
This latest policy development has drawn added support from the
trade data for the first 4 months of 1978, a period during which oil imports actually decline significantly, nonpetroleum imports soared and
nonagricultural exports rose very modestly indeed. This pattern suggests that broader issues of trade competitiveness, rather than simply
the petroleum import question, may underlie our deteriorating current
account position.
The trials and tribulations of U.S. energy legislation are too well
known to the members of this committee to require any recapitulation
here, while concrete details of a proposed export policy are not yet
known. So I will confine myself, once again, to a couple of brief ob-


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servations. One is that, quite apart from the delays inherent in the
political processes of a democracy, it is highly unlikely that either our
energy or our export promotion policies, in thei~ final for~, -W:ill set
in motion structural changes sharp enough to brmg about s1gmficant
changes in the U.S. trade and current account positions over the next
couple of years.
"'\iVhile firm action in either or both of these areas would doubtless
bring about a significant temporary firming of the dollar, via effects
on expectations, we should not count on such developments to make a
major contribution to the payments adjustment process in the immediate future, although I think they are important for the longer run.
The second point is to caution against taking actions in either of
these areas that can be justified solely on balance-of-payments grounds.
If we find it politically infeasible to allow U.S. petroleum prices to rise
rapidly to world levels, then alternative means of stimulating domestic
production and discouraging consumption make sense as second-best
policies. And, of course, we should, as part of our export promotioi1
effort, encourage basic research and development, stimulate innovation
and productivity increases, improve information about potential export markets, and clear away obstructionist governmental regulations
that reduce competitiveness without bestowing commensurate social
benefits. But such actions would be desirable at any time, the fact that
our trade deficit may provide the essential political catalyst notwithstanding.
The point is that we should not allow concern about our external
position to lead us into actions that would otherwise be economically
unjustifiable. Back in the 1960's, when the increasing overvaluation of
the dollar appeared difficult or impossible to correct directly, one could
perhaps make an intellectually respectable argument for such behavior.
But today, when our exchange rate is much freer to move to equilibrate
our external position, we are only fooling ourselves if we attempt to
reduce our current account deficit or shore up the dollar by taking
actions that would not make sense if we were in surplus or the dollar
were not under downward pressure.
The fact is that, despite widespread opinion to the contrary, there is
nothing magical about exports that makes a dollar's worth of additional demand originating in foreign markets any less inflationary, or
more employment-creating, than a dollar's worth arising from increased domestic consumption, investment or government spending.
In fact, increased exports, like defense spending, may fuel domestic
inflation by adding to domestic income without adding to the supply
of goods available in this country to spend it on. Increased investment,
on the other hand, adds to productive capacity and thus helps to
counteract inflationary pressures over the longer term. The solution to
the stagflation problem does not lie in artificial subsidization of exports
or restriction of imports.
This brings me, inevitably, to the question of trade policy. These
hearings are not directed toward that issue, and I won't say very much
about it. But there is no way to separate trade policv from considerations of the adiustment process. It is always attempting to resnond
to external deficits or currency weakness by imposing tariffs or
quantitative restrictions on imports, and it is quite possible that such
measures would have the desired effect in the short run.


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Fortunately, U.S. policymakers have on the whole stood firm against
pressures for increased protectionism. Such measures would not solve
,either our externa.l or our internal economic problems in the long run.
On the contrary, at a time when policymakers are searching intensely
for ways to improve the currently unattractive tradeoft' between inflation and unemployment, trade liberalization offers such a way, and
they are very rare and hard to find.
Now the Geneva participants have reached a "framework o:f under-standing" to eschew protectionism as the solution to current economic
problems, it is incumbent upon the major industrialized nations in
general, and upon those in strong surplus positions in particular, to
move ahead in fleshing out this general agreement with concrete actions as regards both agriculture and manufactured goods. The effectiveness of exchange rate adjustments in reducing the trade deficit
of the United States and the surpluses of Germany and Japan depends
heavily on how free tra.de is to respond to changes in price relation-ships. For the United States, export promotion and expanded market
access---,...in both directions-must go hand in hand.
Finally, and most crucially, thel'e is the issue of inflation. Not only
has this country's inflation been running at a significantly higher rate
than in the leading strong currency countries, but the indications are
that this gap is inc1-easing and will continue to increase in the near
future. As I mentioned, I believe that exchange markets are already
reflecting this outlook and will continue to do so until there is a solid
basis for a cha11i:,oe in e~pectations.
In recent months, as our unemployment rate has dropped and inflationary pressures have aceelerttted, tt stronger anti-inflationary
stance h3:s been emerging in the United States. Whether these moves
prove adequate to reverse the acceleration of price increases remains
to he seen. Obviously, we just don't k®w. In any event, their :full force
is more likely to be felt in 1979, and beyond, than in 1978.
The question seems to be whether we can stop the inflation without
throwing ourselves into a recession. For the long run, however, our
performance as regards inflation remains the key factor in the performance of our balance of payments and our exchange rate. If we can
regain our superior performance vis-a-vis other leading industrialized
·countries in this regard, not only will our international competitiveness and our current account position improve, but the dollar is likely
to strengthen even in anticipation of these developments.
I -f we continue to inflate faster than the strong currency countries,
and there are no solid reasons to expect a narrowing o:f this gap, our
trade and payments positions will remain weak and the doHar will
continue under persistent downward pressure.
Let me turn now to international liquidity, leaving the wjustment
process for the moment. The question of whether global reserves are
inadequate or redundant, and what should be done about it has receded
into the backg-round. There are good reasons £or this development.
First, with the steady expansion of international capital markets and
increased borrowing by official or semiofficial agen<\ies for balance of
payments purposes, the distinction between owned reserves and borrowing capacity has substantially eroded. Internationally, as domestica1ly, the line between cash and credit has become steadily fuzzier
us new forms of the latter have become an increasingly good substitute for the former.


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Even more important in defusing the liquidity issue has been the
shift in the exchange rate regime. The concern with global liquidity
management came to the forefront in an area of pegged exchange rates
and was nurtured by the explosive creation of dollar reserves in the
waning days of the Bretton Woods system. Under the old rules of
the game, countries acquired-or surrendered-foreign exchange reserved in the course of exchange market intervention undertaken to
fulfill their parity obligations under the IMF Articles of Agreement.
Under managed floating there is what might be termed consumer
sovereignty; countries that accumulate reserves do so voluntarily.
They have the alternative of allowing exchange rate changes to clear
the market for foreign exchange without the political difficulties associated with official revaluations or devaluations under the Bretton
1Voods system.
Certainly the need for reserves has not disappeared, but I think the
issue has become less significant under the present exchange rate regime. I think that is also true with respect to the composition of reserves, or more accurately, controlling the instability caused by shifts
from one reserve asset to another.
Shifts obviously can and do occur under the new system. There has
been some diversification away from dollars since 1973, and there probably will continue to be some diversification. How far it goes on depends, I think, on the question of relative inflation rates, and how fast
different currencies lose purchasing power. But the existence of a continuously '.functioning adjustment mechanism that can prevent the
buildup of cumulative disequilibria and thereby eliminate the threat
of large, discontinuous changes in rates among major currencies should
help to :forestall sudden, destabilizing shifts in the composition of reserve assets.
This does not mean, of course, that all the issues relating to international liquidity have been satisfactorily resolved. The question of
whether gold has actually been effectively demonetized or not remains
somewhat up in the air, although it has receded into the background
for the time being. Certainly, the Jamaica agreement's stated objective
of making the SDR the principal reserve asset of the system has gone
nowhere at all so :far.
My own feeling is that it may be time to consider the possibility 0£
a new allocation of SDR's, not so much because there is any clear-cut
need' for additional international reserves at the moment as to support
and enhance the authority of the International Monetary Fund. They
need all the support they can get at the moment.
Even more important, however, is that .the Fund be endowed with
additional capacity to provide conditional liquidity, funds whose availability is predicated upon the borrowing countries taking actions that
will :facilitate adjustment of their payments imbalances.
In this connection, it is imperative that the long-delayed legislation
needed to permit U.S. participation in, and thus activation of, the $11
billion Witteveen :facility be promptly enacted. I think it is also important that during the IMF's seventh review of quotas, currently
underway, we should also take account of the :fact that only i:f it has
adequate resources can the IMF perform effectively its role o:f supervising and encouraging the elimination of external disequilibria and
the stabilization o:f domestic economic conditions that must underlie
a.ny durable stability o:f payments positions and exchange markets.


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Unfortunately, an adequate capacity to lend can enhance the IMF's
authority only over deficit countries, which is only half of the picture.
Pressure on surplus countries to play their role in eliminating payments disequilibria can only come from the gradual development of
effective and acceptable criteria and instruments for the surve-illance
of policies bearing on exchange rates, which I have already talked
about.
Finally, there are a number of questions that bear on the dollar's
role as a reserve currency. In the days of Bretton Woods, a great deal
of rhetoric was expended in debating whether this reserve currency
role represented a "unique burden" or an "exhorbitant privilege." Although, for a variety of reasons I have detailed elsewhere, I expect the
dollar to continue as the world's major reserve asset for the foreseeable
future, it seems to me that the move to managed floating has greatly
reduced both the exhorbitant "privilege" and the unique "burden"
associated with that role.
On the one hand, other countries need no longer accumulate unwanted dollars in fulfilling their parity obligations under the IMF
Articles of Agreement, thereby enabling this country to run what
some regarded as a "deficit without tears." On the other hand, the
United States is no longer constrained by the dollar's special position
from allowing its exchange rate to move in order to alleviate disequilibria in its external position.
In light of this situation, it seems to me that our attitude as regards
developments likely to affect the dollar's reserve currency role should
be relatively relaxed and 1ow key. I myself am not convinced, at this
moment, that an asset-substitution account in the IMF, which would
exchange some portion of official dollar reserves for SD R's is likely to
prove either necessary or sufficient to eliminate instability in the dollar
txchange market. But if other countries feel strongly that such a facility is desirable, and would provide them with the reassurance required to make their own behavior as regards trade liberalization or
demand-management policy more forthcoming, I think we should
ngree to a thorough and intensive joint evaluation of concrete proposals along these lines.
Of more immediate concern. inst now, is how tlw United States
should respond to the recent EEC agreement to work toward an expanded "snake"-a joint float of their currencies vis-a-vis the doJlar
supported by a pool of reserves amounting to perhaps $50 billion. Obviously, any detailed response on the part of the United States would
be premature, since no one yet knows the details of the plan, and I susped that includes the participants themselves at the moment.
It would be easv to detail manv obstacles that confront any such
plan, and it ·would almost certainly require the Germans to modify
their insistence on strictly limiting any reserve currency role for the
deutsc1rn mark. a position that has so far tended to dampen the appreciation of that currency. But these are properly the concerns of the
Europeans.
Onr legitimate concrrn should be assurance, as the plans procee,d,
that this latest step in European economic unification should be fundamentally liberal and internationalist rather than inward looking and
mercantilistic in thrust. Beyond that, we should think twice--or three
timrs-before abandoning the position of interested and sympathetic
snectator for that of active participant in what is bound to be a complex and difficult evolution.

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Finally, there is the question of confidence, the most mysterious and
elusive ingredient of an effectively functioning international monetary system.
I am afraid I have no magic solutions to offer in this area. Yes, close
consultation and coordination among central banks as regards exchange market intervention to counter disorderly market conditions
can be helpful in avoiding confusion and misunderstanding and promoting good feeling among the major industrialized countries. But
we should have learned :from recent experience not to expect too much
:from such intervention: unprecedented sums have been J;>Oured into
exchange markets during the past 18 months or so in ultimately unsuccessful efforts to dampen currency movements. In £act, I would
agree with Mr. Bergsten's comments that they may have only made
things worse.
And, yes, Government officials should avoid, insofar as it is humanly
possible, rattling supersensitive exchange markets by comments that
lend themselves to exaggeration or misinterpretation. But except in
the very short nm, it is the behavior of economies, not the words of
policymakers, that will determine the behavior of financial markets,
including exchange markets.
I suspect that confidence, like happiness, is seldom achieved when
sought directly, but is most likely to be reached as byproduct of the
pursuit of other goals. The key elements in any U.S. contribution to
stabilization of currency markets, the facilitation of international
trade and investment, and thus the promotion of stability and growth
in the world economy, are three: The avoidance of protectionismincluding manipulation of exchange rates as well as restrictive trade
policies-both at home and abroad; the establishment of an effective
anti-inflationary stance that will eliminate or reverse the unfavorable
differential in inflation rates between the United States and the strong
currency countries; and the development of a sensible energy policy,
which means eliminating, by direct or indirect means, the stimulus to
energy consumption and the discouragement of domestic production,
at least relative to other industrialized nations, that are implicit in
our present policies.
I will be glad to answer questions.
Representative REuss. Thank you, Ms. Whitman.
[The prepared statement of Ms. "Whitman follows:]
PREPARED STATE:!.IENT OF MARINA V.

N. WHITMAN

I appreciate this opportunity to participate in the midyear hearings of the
.Joint Economic Committee, and specifically to make some comments on the
operation of the international adjustment process and the international monetary
system.
When I started teaching international economics in the early 1960's, we told
our students that the international monetary system should be evaluated in
terms of its performance in providing three fundamental necessities: adjustment,
liquidity, and confidence. Despite the cataclysmic changes that the system has
undergone in the intervening years, these three terms still ofl'er convenient categories into which to group my comments about the present performance of the
system.
THE ADJUSTMENT PROCESS : EXCHANGE RATES

Let me begin with the international adjustment process. The behavior of exC'hange rates over the last year or so poses something of a puzzle. On the one hand,
the instability of these rates, and particularly the precipitous decline of the
dollar, are widely regarded as one of the primary problems of the international

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economy, destroying confidence, disrupting financial markets, interfering with:
investment decisions and acting as a drag on economic growth. At the same time,
the United States has developed unprecedently large deficits on trade and current
account, deficits that show no sign of abating. Viewed as an instrument of external adjustment, one might be tempted to conclude that, far from being excessive, the depreciatioh of the dollar hasn't gone far enough.
It's a good thing I'm currently a college Professor, rather than a government
official; otherwise that last comment would doubtless cause another plunge of
the dollar on international markets. Let me hasten to add, though, that things
aren't at all that simple. First of all, there is more than one exchange rate
involved. Investment and financial markets are dominated l:)y the relationship
between the dollar and two or three other major currencies. Here the shifts
have indeed been large: over the past year, the dollar has fallen by roughly 15
percent against the German mark, and by about 25 percent against the Japanese
yen and the Swiss franc. Measured against a wider group of currencies, on the
trade-weighted basis that is a more appropriate measure for gauging international competitiveness, the depreciation of the dollar has been 7½ percent (and
in real terms, that is, adjusted for differences in inflation rates, it has been less
than half of that). Even more surp,rising is the fact that the dollar's value today,
in effective terms, is only about 2 percent below where it stood in mid•February
1973, just after the second formal dollar devaluation that marked the beginning of the era of managed floating. Perhaps these-differences help to account for
a puzzling ambivalence on the part of observers who decry the instability of floating rates. ,vhen pressed, many of them note that the exchange-rate changes that
have taken place so far (that is, up to the date on which they are speaking
or writing) appear to be on the whole justified, but that any further changes
would ··be economically unwarranted, financially disastrous, and the result of
.speculative excesses.
The picture is also blurred by the fact that changes in exchange rates appear
to exert their effects on international competitiveness and trade flows with substantial lags of up to two years or more. Thus, the main impact on trade flows
of the dollar's decline over the past year presumably lies ahead. Indeed. a recent study by the International Monetary Fund Staff estimates that, by 1980,
there should be a beneficial impact on the U.S. current-account balance of nearly
$7 billion stemming from changes in relative prices (that is, exchange-rate
changes adjusted for domestic inflation differentials) that have not yet exerted
their impact on trade flows.
Whether the value of the dollar has dropped too far, not enough, or just the·
right amount vis a vis other leading currencies is a question neither I nor anyone
else can answer with any degree of certainty. Certainly, any American living or
tourning abroad can tell that, in purchasing-power-parity terms, the dollar is
undervalued, that is, that at present rates of exchange. it will buy you considerably more in Kansas City or Washington or even New York than it will in Munich
or Zurich or Tokyo. The trouble with this sort of comparison is that, while over
very long periods of time such purchasing-power-parity relationships appear to
hold up pretty well, in the short and medinm runs exchange rates have to clear
financial as well as commodity markets, to reflect capital as well as trade flowfl,
and to adjust for differences in energy production and consumption, degree of
export-orientation, differences in real growth rates, and a whole host of other
factors in addition to changes in relative price levels and rates of inflation.
In addition, exchange markets, like the stock market, take account not only
of the past and the present but of the future as well. or at least of expectations
regarding it. It is increasingly apparent that in the United States inflation is
accelerating. While in the three "strong currency" countries it appears to be
stable or declining. I believe that present rates incorporate this anticipated widening of this gap. If we are dismayed-as we should be:.......by the visions of the future
reflected in exchange-market behavior, we would be better advised to seek effective policies to alter those expectations than to cavil against the markets that
mirror them. No one has ever succeeded in averting bad news by killing-or
beating up~the me11senger who brings it.
The flmdamental uncertainty regarding the criteria by which exchange-rate
relationships should be judged makes the IMF's post-Jamaica responsibility for
surveillance over exchange-rate policies as difficult as it is vitally important. For
there is-and can be-no such thing as an exchange rate free of government intervention. The vast majority of countries today still peg their rates to some currency or to a basket of them. And, even among the floaters, that floating is heavily


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managed, as attested to by the fact that the central banks of some five or six
industrialized nations together purchased more than $40 billion in 1977 and
the first quarter of 1978, mainly in order to dampen the appreciation of their own
currencies.
Furthermore, as the IMF's Executive Board has recognized, there are many
instruments other than direct intervention that a country can use to manipulate
its exchange rate to its own advantage and the disadvantage of others, including
official borrowing or lending on international capital markets, the use of controls
•on current or capital-account transactions, or changes in the mix of monetary
and fiscal policy used for domestic stabilization purposes.
The fact is, of course, there are no principles defining what constitutes socially
.acceptable behavior in these areas, any more than there are concrete means to
-distinguish appropriate from inappropriate exchange rates. But the fact that
no such criteria have been developed should be reason for support rather than
criticism of the IMF's efforts to carry out its surveillance mandate. In addition
to the conceptual uncertainty surrounding these issues, the IMF faces the
inevitable constraints felt by an international agency attempting to impinge
on sovereign nations in the exercises of legitimate-if not always constructive-instruments of national economic policy. Inevitably, the IMF must move slowly
in. this area, building precedents gradually and on a case-by-case basis, through
the consultative process. The fact that there are no general standards for accept,able behavior does not mean that the Fund cannot gradually evolve procedures
for earmarking unacceptable behavior in particular instances, any more than the
inability to find a general definition of beauty means that we cannot get a consensus on when it is absent, particularly in extreme cases. It is essential that the
United States give fl.rm support to the International Monetary Fund as it struggles to evolve effective techniques for exchange-rate surveillance in a world of
managed floating.
THE ADJUSTMENT PROCESS: GROWTH, ENEBGY, TBADE, A.ND INFI.ATION

Exchange rates are not, of course, the alpha and the omega of the payments
·adjustment process. This is partly because, as I have already mentioned, they
are far from .completely free to equilibrate the balance of payments. It is also
because, even if they were completely "unmanaged," exchange rates alone could
not, especially in a world of high international capital mobility, guarantee the
achievement of stable and acceptable current-account position!!, insulate a country
against external economic disturbances, or prevent the international transmission
.and magnification of economic disturbances.
Recognizing the need for complementary measures to promote external adjustment in an environment of stable world economic growth, the United States
has for some time joined the OECD and various international agencies in urging
that those countries with low rates .of inflation and strong external positions
take a leading role in stimulating and maintaining world economic recovery. But,
,of the three countries originally envisaged as "locomotive econoi;nies" or "engines
·of, recovery," the United States has run up against both inflation and balance-ofpayments contraints of its own, while Germany and Japan insist that fear of
rekindling inflationary pressures and structural problems that limit the effectiveness of measures to stimulate domestic demand severely constrain their abilityand their willingness-to do more along these lines.
This is not the place for an exhaustive evaluation of the locomotive strategy
or its successor, the so-called convoy approach, which would spread the responsibility for stimulating global recovery more widely to include such countries as
France, Italy, and the United Kingdom, whose inflation rates and balance-of-payments positions have recently shown substantial improv.ement. Let me confine
myself to two brief comments, recognizing that, even as I make them, the
subject may have once again become a bone of contention at the Bonn summit
di.scussions. First, the tremendous uncertainty that currently prevails regarding
the impact of the traditional tools of aggregate demand policy in an environment
-of persistent stagflation lies at the root of the problem. Until some general consensus on this critical issue emerges, and until reliable ways are found to sustain
-0:r stimulate real growth while restraining inflation, divergent national views and
preferences are bound to stand in the way of further progress on the international
•coordination of macroeconomic policies.
The second point is that, while appropriate. demand-management polici_es in
the leading industrialized countries are clearly essential to global economic
recovery and real growth (which has beeri faltering badly outside of the United


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States), we should not expect too much of changes in real growth rate differentials among the industrialized countries as a means of eliminating balance-ofc
payments disequilibtia. Specifically, a recent OECD study estimated that demandstimulating programs in other countries sufficient to eliminate entirely the present "growth gap differential" (that is, differences in the size of the discrepancy
between actual and potential growth rates) between the United States and
other industrialized countries would result in an improvement in the U.S. balance
on current account of less than $5 billion. A similar exercise by the IMF staffusing somewhat different assumptions-yielded an estimated improvement of
only $2 billion by 1980.
Ever since OPEC changed the face of the world petroleum market in 197374, .the development of an effective U.S. energy policy has been regarded as essential to the health of the American economy. When our current account moved
sharply into deficit and the dollar came under sustained downward pressure
during 1977, such a policy, leading to a reduction in oil imports, was seen as the
key to improvement in our external position as well. More recently, attention has
turned also toward the development of export-promotion policies in a nation that
has traditionally regarded foreign markets rather casually. This latest policy
development has drawn added support from the trade data for the first four
months of 1978, a period during which oil imports actually decline significantly,
non-petroleum imports soared and nonagricultural exports rose very modestly
indeed. This pattern suggests that broader issues of trade competitiveness, rather
than simply the petroleum-import question, may underlie our deteriorating current account position.
The trials and tribulations of U.S. energy legislation are too well known to the
members of this committee to require any recapitulation here, while concrete
details of a proposed export policy are not yet known. So I will confine myself,
once again, to a couple of brief observations. One is that, quite apart from the
delays ..inherent in the political processes of a democracy, it is highly unlikely
that either our energy or our export-promotion policies· in their final form will
set in motion structural changes sharp enough to bring about significant changes
in the U.S. trade and current-acco\lnt positions over the next couple of years.
While firm action in either or both of these areas woul'd doubtless bring about a
significant temporary firming of the dollar, via effects on expectations, we should
not count on such developments to make a major contribution to the payments
adjustment process in the immediate future, nor to provide sustained support to
the dollar in the absence of other developments.
The second point is to cant.ion against taking actions in either of these areas
that can be 'justified solely on balance-of-payments grounds. If we find it politically
infeasible to allow ·U.S. petroleum prices to rise rapidly to world levels, then
alternative means of stimulating domestic production and discouraging consumption make sense as second-best policies. And of course we should, as part of our
export-promotion effort, encourage basic research and development, stimulate•
innovation and productivity increases, improve information about potential export markets, and clear away obstructionist government regulations that reduce•
competitiveness without bestowing commensurate social benefits.. But such actions would be desirable at any time, the fact that our trade deficit may provide•
the essential political catalyst notwithstanding.
The point is that we should not allow concern about our external position to,
lead Uli into actions that would otherwise be economic11lly unjustifiable. Back in
the 1000s, .w.I~en th«:l growing oyervaluatio.n of. the dollar appeared difficult or·
impossible to correct directly, one could perhaps make an intellectually .respectable argument for such behavior. But today, when our exchange rate is much
freer to move to equilibrate our external position, we are only fooling ourselves,
if we attempt to reduce our current-account deficit or shore up the dollar hy taking
actions that would not make sense of we were in surplus or the dollar were not
under downward pressure.
The fact is that, despite widespread opinion to the contrary, there is nothing
magical about exports that makes a dollar's worth of additional .demand originating in foreign markets any less inflationary, or more employment-creating,
than a dollar's worth arising from increased domestic consumption, investment.
or government spending. ( In fact, increased exports, like. defense spending, may
feel domestic inflation by,adding to domestic income without adding to the supply
of goo,dR~vailable to spend it on. Increased investment, on the other hand, adds
to j}r()'ductive capacity 'and thus' helps to contraet fotfl.ationary pressures over the
long;eF. term.) The solution to the stagflation problem does not lie in artificial
sub!Jidiza-fiorr of exl)Qrts-or restriction of imports.


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Such considerations bring me, inevitably, to the question of trade policy. These
hearings are not directed toward that issue and, as I write, no one knows what
will emerge from the Geneva negotiations or the sumit discussions. But there is
no way to separate trade policy from considerations of the adjustment process.
It is always tempting to respond to external deficits or currency weakness by
imposing tariffs or quantitative restrictions on imports, and it is quite possible
that such measures would have the desired effect in the short run. Fortunately,
U.S. policymakers have on the whole stood firm against pressures for increased
protection. Such measures would not solve either our external or our internal
economic problems in the long run. On the contrary, at a time when policymakers
are searching intensely for ways to improve the currently unattractive trade-off
between inflation and unemployment, trade liberalization offers such a way. Now
that the Geneva participants have reached a "framework of understanding"
to eschew protectionism as the solution to current economic problems, it is incumbent upon .the major industrialized nations in general, and upon those in strong
surplus positions in particular, to move ahead in fleshing out this general agreemenLwith concrete.actions as regards both agriculture and manufactured goods.
The effectiveness of exchange rate adjustments in reducing the trade deficit of
the United States and the surpluses of Germany and Japan depends heavily on
hovi free trade is to respond to changes in price relationships. For the United
States, export-promotion and expanded market access (in both directions) must
go hand in hand.
Finally, and most crucially, there is the issue of inflation. Not only has this
country's inflation been running at a significantly higher rate than in the leading
strong-currency countries, but the indications are that this gap is increasing and
will continue to increase in the near future. As I mentioned, I believe that exchange markets are already reflecting this outlook and will continue to do so untiLthere is a .solid. basis for. a change in expectations .. In recent months, as our
unemployment rate has dropped ·and inflatfonary' pressures. have accelerated,
a stronger anti-inflationary stance has been emerging. in the United States.
Monetary and fiscal policy have taken a less stimulative turn, the Administration appears to have scaled down somewhat its real-growth target for 1978,
and an intensified anti-inflation jawboning effort has been placed in Charge of
one of the nation's most skilled and successful practitioners of the art.
W"hether these moves prove adequate to reverse the acceleration of price
increases .remains to be seen .. In any eve11t, their full force is more likely
to be felt in 1979 and beyond than in 1978. For the long tun, however, our l)(lrformance as regards inflation remains the key factor in the performance of
our balance of payments and our exchange rate. If we can regain our superior
performance vis-a-vis other leading industrialized countries in this regard, not
only will our international competitiveness and our current account position improve, but the dollar is likely to strengthen even in anticipation of these devel
opments. If we continue to inflate faster than the strong-currency countries,
and there are no solid reasons to expect a narrowing of this gap, our trade and
payments positions will remain weak and the dollar will continue under persistent downward pressure, perhaps ipterrupted by brief :flurries of strength in
response to news headlines on central-bank interventions, flurries that will serve
to increase the apparent instability of exchange markets without altering the
underlying. trend in rates.
0

INTERNATIONAL RESERVES: QUANTITY AND COMPOSITION

As regards international liquidity, the question of whether international re:a;erves are in the aggregate either inadequate or redundant and, if so, what should
he done about it has somewhat receded into the background. There are good
reasons for this development. First, with the steady expansion of international
capital markets and increased borrowing by official or semi-official agencies for
balance of payments purposes, the distinction between owned reserves and borrowing capacity has substantially eroded. Internationally, as domestically, the
line between cash and credit has become steadily fuzzier as new forms of the
latter have become an increasingly good substitute for the former.
Even more important in defusing the liquidity issue has been the shift in
the exchange-rate regime, The concern with global liquidity management came
to the forefront in an era of pegged 'exchange rates· and was nurtured, by the iexplosive creation of dollar reserves in the waning days of the Bretton Woods system. Under the old rules of the game, countries acquired ( or surrendered) foreignexchange reserves in the course of exchange-market intervention undertaken


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to fulfill their parity obligations under the IMF Articles of Agreement. Under
managed floating, there is what might be termed consumer sovereignty: countries
that accumulate reserves do so voluntarily. They have the alternative of allowing exchange-rate changes to clear the market for foreign exchange without the
political difficulties associated with official revaluations or devaluations under the
Bretton ·woods system. Floating today is managed, not free, and a need for international reserves remains, but the change in the exchange-rate regime has
substantially reduced the problem of controlling the global volume of liquidity.
The change from pegged rates to managed floating has also reduced the urgency of the related problem of controlling reserve composition or, more accurately, the potential for instability created by shifts among reserve assets in a
multiple-reserve system. Shifts can and do occur under the new system as
well; significant diversification away from dollars in favor of other currencies
apparently took place during the early years of managed floating. Nor is such
asset-diversification necessarily a thing of the past; the rate at which it continues to take place will certainly be affected, among other things, by our old
bugaboo, inflation differentials-that is, differences among the rates at which
different currencies lose purchasing power. But the existence of a continuouslyfunctioning adjustment mechanism that can prevent the buildup of cumulative
disequilibria and thereby eliminate the threat of large, discontinuous changes
in rates among major currencies should help to forestall sudden, destabilizing
shifts in the composition of reserve assets.
This does not mean, of course, that all the issues relating to international
liquidity have been s11-tisfactorily resolved. The question of whether gold has
actually been effectively demonetized or not remains somewhat up in the air,
although it bas receded into the background for the time being. Certainly, the
Jamaica Agreement's stated objective of making the SDR the principle reserve
asset of the system has gone nowhere at all, nor is it likely to in the foreseeable
future. My own feeling is that it may be time to consider the possibility of a
new allocation of SDRs, not so much because there is any clear-cut need for additional international reserves at the moment as to support and enhance the
authority of the International Monetary Fund.
Even more important, however, is that the Fund be endowed with additional
capacity to provide conditional liquidity, funds whose availability is predicated
upon the borrowing countries' taking actions that will facilitate adjustment
of their payments imbalances. In this connection, it is imperative that the longdelayed legislation needed to permit U.S. participation in, and thus activation
of, the $11 billion "Witteveen facility" be promptly enacted. The position taken
by the United States during the IMF's. Seventh Review of Quotas, currently
underway, should also take account of the fact that only if it has adequate
resources can the IMF perform effectively its role of supervising and encouraging the elimination of external disequilibria and the stabilization of domestic
economic conditions that must underlie any durable stability of payments positions and exchange markets. Unfortunately, an adequate capacity to lend can enhance the IMF's authority only over deficit countries, which is only half of the
picture. Pressure on surplus countries to play their role in eliminating payments
disequilibria, essential if the adjustment process is to work symmetrically and
equitably, can only come from the gradual development of effective and acceptable criteria and instruments for the surveillance of policies bearing on exchange
rates, discussed earlier.
Finally, there are a number of questions· that bear on the dollar's role as a
reserve currency. In the days of Bretton Woods, a great deal of rhetoric was
expended in debating whether this reRerve,currency role represented a unique burden or an exorbitant privilege. Although, for a variety of reasons I have detailed elsewhere, I expect the dollar to continue as the world's major reserve
asset for the foreseeable future, it seems to me that the move to managed floating has greatlv reduced hoth the "privilege" and the "burden" associated with
that role. On the on!" hand. other countries need no longer accumulate unwanted
dollars in fulfilling their parity obligations under the IMF Articles of Agreement,
thereby enabling this country to run what some regarded as a "deficit without
tears"; on the other. the United States is no longer constrained by the dollar's
special position from allowing its exchange rate to move in order to alleviate disequilibrium in its external position.
In the liirht of thiR Rituation. it s!'ems to me that our attitude as regards developments likely to affect the .dollar's reserve-currency role should be relatively
relaxed and low key. I personally am not convinced at this moment. that the
establishment of a so-called substitution account facility in the IMF, intended


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to "sterilize" some portion of dollar reserves via special issues of SDRs, as
recently proposed by the IMF's Managing Director, is likely to prove either
necessary or sufficent to eliminate instability in the dollar exchange market. But
if other countries feel strongly that such a facility is desirable, and would
provide them with the reassurance required, to make their own behavior as
regards trade liberalization or demand-management policy more forthcoming, I
think we should agree to a thorough and intensive joint evaluation of concrete
proposals along these lines.
Of more immediate concern just now is how the United States should respond to the recent EEC agreement to work toward an expanded "snake"-a
joint float of their currencies vis a vis the dollar supported by a pool of reserves
amounting to perhaps $50 billion. Obviously, any detailed response on the part
of the United States would be premature, since no one yet knows the details of
the plan, including the prospective participants themselves. It would be easy
to detail many obstacles that confront any such plan, and it would almost certainly require the Germans to modify their insistence on strictly limiting any
reserve-currency role for the Deutsche mark, a position that has so far tended to
dampen the appreciation of that currency. But these are properly the concerns
of the Europeans.
Our legitimate concern should be assurance, as the plans proceed, that this
latest step in European economic unification should be fundamentally liberal
and internationalist rather than inward-looking and mercantilistic in thrust.
Beyond that, we should think twice-or three times-before abandoning the
position of interested and sympathetic spectator for that of active participant
in What is bound to be a complex and difficult evolution.
RESTORING CONFIDENCE: A MATTER OF FUNDAMENTALS

I ,come finally to the question of confidence, the most mysterious and elusive
of the three ingredients of an effectively-functioning international monetary
sJ·stem. I'm afraid I have no magic solutions to offer in this area. Yes, close
consultation and coordination among central banks as regards exchange-market
intervention to counter disorderly market conditions can be helpful in avoiding
confusion and misunderstanding and promoting good feeling among the major
industrialized countries. But we should have learned from recent experience not
to expect too much from such intervention: unprecedented sums have been
poured into exchange markets during the past 18 months or so in ultimately
unsuccessful efforts to dampen currency movements. And it has proved extraordinarily difficult to distinguish, ex ante, between speculative excesses and the pnll
of market forces. It is not that currency markets, left to themselves, are models
of stability so much. as that central bankers and government officials do not
seem to be endowed with any special prescience in discerning the shape of the
future. And, yes, government officials should avoid, insofar as it is humanly
possible, rattling super-sensitive exchange markets by comments that lend themselves to exaggeration or misinterpretation. BuJ, except in the very short run. it is
the behavior of economies, not the words of policymakers, that will determine
the behavior of financial markets, including exchange markets.
I suspect that confidence, like happiness, is seldom achieved when sought
directly, but is most likely to be reached as a byproduct of the pursuit of other
goals. The key elements in any U.S. contribution to stabilization of currency
markets, the facilitation of international trade and investment, and thus the
promotion of stability and growth in the world economy, are three: the avoidance of protectionism (including manipulation of exchange rates as well as
restrictive trade policies) both at home and abroad, the establishment of an
effective anti-inflationary stance tb.at will eliminate or reverse the unfavorable
differential in inflation rates between the United States and the strong-currency
countries, and the development of a sensible energy policy, which means eliminating, by direct or indirect means, the stimulus to energy consumption and the
discouragement of domestic production, at least relative to other industrialized
nations, that are implicit in our present policies.
There is nothing new or surprising in this litany, and you may be weary of
hearing the obvious once again. But it is far from a counsel of despair. For all
the problems and uncertainties that beset us, the United States possesses a
remarkable array of economic strengths. We have the richest endowment of
natural resources, the stablest political climate, the sturdiest economic recovery
and the most attractive environment for investment among the major industrialized nations. What we must do is find more effective ways of putting these assets
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to work in accomplishing the tasks I have just outlined, accomplishments that
hold the key, not only to restoring confidence in the international monetary
system, but to ensuring the stability and growth of our own and the world
economy.

Representative REuss. Thank you all, on the panel, for truly
excellent presentations today.
I have lots of questions, starting with the matter of the energy
policy, which our witnesses have alluded to several times. You have
said, in effect, that no energy policy now on the legislative agenda is
going to produce wonders in the less than 2 years anyway, but that it
is a very important psychological hangup with all our dollar trading
partners.
I agree with both facets of that statement. That being true, wouldn't
it seem to you to make sense, and others have been arguing for some
time, for the administration to get-you have to have a package of
five, and take the three or four elements of the five-point packageget Congress to enact energy legislation, and with a little skill this
would be done in a couple of weeks.
This could be called energy package No. 1, admittedly imperfect,
but it allows us to do something in the way of home insulation, conversion of factories from oil and gas to coal, reform of utility rates,
and probably partial deregulation of natural gas.
Take that which has been agreed on in conference at least, :forget
about the very controversial, very inflationary $5 billion a year wellhead tax, and either make that part 2, or the second energy package,
or try to evolve some method which less exclusively rations, which is
what any overall tax or price increase does.
Would we be better off going with what we have instead of endlessly dragging this thing out? Congress has been the principal culprit, but this could all be solved very quickly. In my conversations
with foreign central bankers and finance ministers it is that they don't
mind Canadian rollover with incremental crisis, and would be satisfied
with an energy package.
Ms. WHITMAN. This is getting off into tactics, and I am not the
appropriate person to make comments, particularly since I have been
off in China for the last month. I think what does disturb me a little
about that is that, as compared to the original notions of what would
constitute an effective energy package that most economists dreamed
up, the administration's five-part package is already a very much
reduced and trimmed-down and compromised-out kind of thing.
I think many of the major aspects dropped out long ago, as I suppose might have been expected, because the truth is that any proposal
which makes a sudden change in energy production and consumption
is also going to cause a sufficiently sharp structural wrench so that
the country will probably not tolerate. it. There is the problem you
referred to, again, that any measure-like a wellhead tax-which takes
what I think is the ultimately necessary step of adjusting U.S. prices
toward world prices, is in the short run bound to be inflationary.
I agree with you that foreign observers might not be terribly
fussy at the present moment about what kind of package they got.
I think we would get a short-term favorable effect on exchange rates if
any significant pieces of energy legislation passed. What troubles me
is that I am afraid we would also get a backlash effect later. That is,
·we would get, certainly, a strengthening of the dollar when this
legislation passed. H, however, as a result of that legislation, we did

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not get much change in the energy picture in the United States, I
think that would be reflected in a backlash, and I am not sure there
is any greater percentage in buying a short-term appreciation of the
dollar now which would later be reversed. That, it seems to me, would
only contribute to instability on the exchange markets.
Now, petroleum imports into this country appear to be dropping at
the moment. If we were lucky enough to latch onto a trend that was
happening anyway and then say, "Look what happened as the result of
the legislation we passed," that would be terrific, but I think it is pretty
chancy.
Representative REuss. Mr. Packer, not so long ago I wrote our
trade negotiator, Mr. Strauss, a letter in which I suggested there
be added to trade negotiations on tariffs ,and nontariff barriers the
general concept, at least, of envil'onmental controls and other controls, the idea being that the host of environmental laws and similar
laws does unquesHonably add to American costs, and that it should
at least be put on the agenda of future trade negotiations that these
are legitimate subjects to talk about with Korea and Taiwan, Nigeria,
and other countries, which ought to be thinking about clean air and
water and better conditions in factories if they aspire to the fruiti.
of freer trade.
I got back a reasonably smpathetic response. The difficulties
such an approach are obvious, but what is your feeling about the
inclusion on the overall agenda of the international trade discussions
items like that which are usually looked upon as purely domestic?
Mr. PACKER. If you had written your letter to the Secretary of
Labor, you would have gotten a very enthusiastic response, partially
because it is not our responsibility to impose those requirements.
[Laughter.]
It is something the Secretary has spoken about many times, international fair labor standards and the inappropriateness of export
-of our cancer problem to some other countries.
Representative REuss. Has he included environment in there? I
am aware of the fact he has talked about factory conditions.
Mr. PACKER. And the health situation, and I do not know whether
he has spoken to the environmental conditions themselves. I think
that is a somewhat more complicated problem, but, if those environment-al factors arerelated to health, as opposed to esthetic values, thm
I think his position would be sympathetic to that, too.
Representative REuss. What we do by our domestic legislation by
wav of the ozone, let us say, could be of some use to noninhabitants
oft he North American Continent.
Mr. PACKER. That is correct.
Representative REUSS. So I would think we have a perfect right to
put that on the docket, and I encourage yonr department to give the
trade negotiating department of government all the help you can on
that.
.
Ms. Whitman, in your discussion of IMF progress on developing
rules for the surveillance of exchange rate policies, you quite reasonably pointed out that coutries get very sophisticated about how they
cut corners on exchange rate policies.
In fact, 2 years ago our Japanese friends were doing it very crudely
by dumping yen and buying dollars, ,and thus establishing trade patterns which still make their contribution to our country's '"oes, but

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then, as you pointed out, there are many other ways of skinning a cat,
mternational borrowing practices> and so on.
My question is this: 8ince the IMF, to its credit, in its bilateral
team negotiations with countries, including mighty ones like the
United Kingdom a couple of years ago, isn't the least bit loathe to
get quite specific about internal methods, why should it not be equally
ready to take quite a wide vision and look at everything a country
may do that could discombobulate the international exchange market 1
Ms. WHITMAN. I think they can and they should.
My guess is that they may aleady he beginning to do that. I think
it is one of the characteristics of the process by which they operate
that much of what they do may not be made public. I would expect
that at least their initial efforts to negotiate bilaterally with particular countries on the appropriateness of their general policies which
:have a major effect on exchange rates would be private and that it
would be only in extreme cases, where the negotiations have really gone
very badly and the IMF is very exasperated, that they will start to
go public. And I suspect that lots of us may have to spend lots of
time reading closely between the lines of those annual country reports
that the IMF puts out to see if they are subtly slapping anyone's hand.
I would expect that publicity regarding this activity would come
fairly late in the game.
·
The problem with trying to generalize the IMF's behavior regarding Great Britain is one I referred to in my testimony, and. that is with
major defa.lit countries the IMF does have a particular clout. It controls, either directly or indirectly, significant amounts of access to
capital markets. It doesn't have that particular bit of clout with
surplus countries, which I think makes a kind of jawboning, i:f yon
like, moral pressure through the consultation process and through
bringing to bear a certain amount of multilateral pressute at appropriate moments, all the more critical.
I don't think it is an impossible thing to do. But, ·as I say, the
IMF doesn't have a commensurate weapon on the surplus side corresponding to its influence over access to financial markets by deficit
cmintries.
But I don't think that that means they can't develop somP, especially if they get .substantial and outspoken support from the leading
industrialized countries i~ _carrying out this effort, which obviously
means the tough proposition that one has to accept their advice
g-raciously even when it affects you and not the other g-uy and, given
the political processes in democracies, that will clearly· be possible
sometimes only to a limited extent.
Mr. BERGSTEN. C,ongressman Reuss, to reinforce what Ms. W'hitman
Raid, certainlv in its consultation with eotmtries, whether in the context of a stabilization proqram or just in the annual view-su<'h ns
I chaired for the United States just a couple of months a.o-o for this
year-the Fund cert'ainly does oonsider the whole range of economic
policy measures includin~ trade policy, export credit policies, the
whole range of measures that do indirectly, as weH as directly, ,affect
t,hfl exchange rate.
Now, in an effort to do what I think you are sugge~in~, CornrresR-.
man Reuss, one of the proposals we have made toward the evolution
of th-is new surveillance process is preciselv for thP, Fund to prepare
reports on individual countries and how their policies are affecting

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the overall international adjustment process, and to consider the possibility of publishing •those reports, whicl?- would be a means _by wh_ich
Fund influence could be brought to bear in a broader sense, mcludmg
on surplus countries.
That is something we very much have in mind. We put it on the
table as an item for discussion as we work with the other IMF countries now to evolve the surveillance mechanism, and we think it might
be a useful part of that process.
Representative REuss. That sounds like an excellent idea, and I am
going to have the staff take a look at the Freedom of Information Act
and see if we can't get hold of those reports, whether you decide to
publish them or not. That may be one way of saving your :face and
getting the message, too. [Laughter. J
On the economic summit, since it seems to be that-well, it may not
have been earth-shaking, but nothing bad was said. I think it went in
a constructive direction. But let me ask, perhaps Mr. Bergsten: ·what
reason is there to think that there is going to be more rapid growth in
:Europe and Japan after this latest round of affirmative commitments
than there has been in the past when commitments have also been made
and honored in the breach 1
Mr. BERGSTEN. Let me say, Congressman, that we were already expecting in the second half of this yea.r and into 1979 some substantial
pickup in growth rates rubroad, both in Europe and in Japan, thereby
bringing into better balance growth rates between our country and the
rest of the OECD, which should contribute to a more balanced interna,tional economic and financial situation.
What I think did emerge from the summit was a very strong reaffirmation on the part of Japan that it intends to meet its growth,.
target for this fiscal year. Prime Minister Fukuda explicitly noted that
he will be making a decision in August or September as to whetheradditional measures are needed to move Japan toward that target. I:
think that makes much more sense than had been the case before
the ,Tapanese commitment to take action, if needed, to achieve its
target.
In the case of Germany, Chancellor Schmidt really for the first time
said publicly that as a contribution to the international situation he
would be, by the end of August, proposing to his legislative bodies a
rather substantial stimulus program in Germany to try to boost their
growth rate and contribute to a better international economic
equilibrium.
Now, one can always, of course, question what the end results of
such commitments and measures are going to be, and we all know too
well that none of us can simply turn the dial and achieve the economic
results we want, whether in terms of growth or inflation. So in that
sense we all have to be modest in our expectations and hold the judO'~
ment until we see what the results are.
But I think th_e _summit did add speci~city, and in the case of Ge_rmany a new. dec1s1on to what had prev1<?usly been on the agenda m
terms of ma1~r efforts by the two most important surplus countries
to add to their growth rates during the year and therefore add to
better balance in the world economy.
I would say it is a significant step forward. We certainly hope the
results would be as those countries intend. We know they can't assure
the bottom line, but I think it is a very significant indication of will-


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ingness for them to ma~e ~ecisions that move in t!ie _right direction,
and in a context where it is clearly done, at least m important part,
for purposes 0£ better international economic I:>alai:ce.
.
.
Representative REuss. There are, of course, strmuh and stimuli; and
one serve one purpose well, and some serve another purpose.
Talking to Germans of various persurusions ~n recent_ months, the
thing that Germany seems to them to need most is a ihousrng program,
housmg for reasons not completely different from our own housing
industry. It has about ground to a halt, and publicly stimulated housing in the cities seems to be a real need for a country which is otherwise affluent.
Thus, if you get an indirect macroeconomic stimulus by doing a
microeconomic thing by helping housing, that is a good way for Germany to help itself and the world all together.
On the other hand, I suppose a German direct tax cut might be 0£
more benefit internationally to this country and perhaps some other
deficit countries because it would enable us to sell the Germall!S more
imports.
Do we get into stimuli evaluation discussions at any level with the
Germans, or is that considered verboten?
Mr. BERGSTEN. No, it is not verboten. We have active discussions
with them, both 0£ the array of measures we are thinking about taking
internally here both for macroeconomic reasons and sector policies,
such as energy, and discuss with them the various measures they have
in mind.
I think we do recognize that it is basically up to them, as to the J apanese, or any other country, and certainly ourselves, to make the decisions as to how most effectively to achieve the overall objective for
international purposes, and we would certainly not try to suggest to
them how best they should do it.
But we do have active discussions. We share experiences in te,rms 0£
reactions to tax cuts, reactions to Government expenditure programs,
how they may work out both substantively and psychologically, and
I think all of our countries have benefited a great deal by that interchange.
It 1s up to them, obviously, as to what measures they take. Every
outsider has legitimate base to comment on in terms of the net result,
the country's balance-of-payments position, and what it contributes
to the international scene.
Representative REuss. Senator Javits.
Senator ,TAvrTs. Thank you, Congressman Reuss. I have just come
from a meeting with the President about the summit, ,and for me, it
was interesting to learn that the most decisive action taken at the
summit had nothing to do with economics. Instead, it had to do with
terrorism. And I think that decision is characteristic 0£ the summit.
I believe the President, considering the atmosphere and his own
attributions, did very well personally, but I don't think the summit
went as well. Of course, it is high time that the civilized world declared
itself in an effective way to be against terrorism. I say that, like any
consensus at a time when boldness is required, the summit bypassed
all the bold things in favor of the safe course 0£ retreading old ground;
£or example, what growth rate is Japan going to have, what growth
rate is Germany going to have, and what we are going to do about
these inside deals on trade and so on.


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This is what we face, Mr. Bergsten, and I want to discuss it a little
more and then ask you a question about it.
At this summit, I gather that there was a real gearing up for the
next one. This was really stage one, but the next summit, from what
we can see now, should be concerned with very specific contributions
to growth.
As Mr. Packer properly says in his presentation, which I have read,
I have some doubts that the world is going to be able to wait for the
next summit before acting, for it may be headed for a serious recession or depression, which may overtake us in the 1978-79 period, instead of politely waiting for the 1979-80 period.
I hope we can avoid that dread event.
Mr. Bergsten, I want to discuss with you the possibility of gearing
up-it takes at least a year's time-for a massive effort toward investment and development on a major world scale that will expand
markets and materially accelerate the process of development, especially for the middle level developing countries, which you call the
ADC's. I would hope we would be joined in some way by the Soviet
Union and her associated countries.
I notice you refer to such a possibility in your prepared statement,
where you speak of commodity agreements, reduction of trade barriers, a common fund, and expanded foreign assistance, and also where
you deal with the net balance of. payments problems of the developing countries-a very serious matter in view of the fact that our banks
are very heavily loaned up to the developing countries.
Would you discuss the attitude of the Department of the Treasury
respecting these matters to which I have referred?
Mr. BERGSTEN. I think we ·would not foresee a recession or anything
approaching a depression on the horizon either in 1978 or 1979. Nevertheless, we share your view that investment levels are inadequate both
in this country and around the world, and that new measures need to
be adopted wherever possible in order to rectify that situation.
You have noticed, I am sure, that there are several references in the
summit communique to that need, and specifically to the advanced developing countries.
Indeed, two or three paragraphs of the summit communique itself
refer specifically to that body of countries as important and growing
participants in the trading system, as countries who need increased
help through the multilateral development banks, not concessional
finance, but World Bank type of lending, and a very clear statement
by tJhe summit governments that they will support replenishment of
the panks' abilities to make those loans on the necessary scale, and
also explicitly, and I am citing from paragraph 26 of that communique, "encourage governmental and private cofinancing of development projects with the banks."
So I think on that, Senator, we are very much on the same wavelen,g-th.
The problem has re~lly, as you well know, been a practical one of
how much support congresses and parliaments around the world
have been prepared to provide to that process.
Now, l\fr. Packer in his testimony this morning has proposed a
rather dramatic program, somewhat akin, I think, to your own
proposal, Senator, of a vast expansion in the financial flows to the


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developing countries, particularly the more advanced developing countries, through institutions such as the World Bank.
We face, however, at the same time, a reluctance here in the Congress t-0 provide not only the full amount of the rather modest appropriation sought thi.s year by the administration, but threats of massive cuts in that and, indeed, that has delayed the bill coming to tho
House floor for the last several weeks.
The need does seem to be clear. The effective utilization of the
money seems to be assured by the proven track record of the banks, and
what it seems to me that we need to do is all work more effectively,
and I would certainly include the administration within that directive, to sell the case and make clear how we need not only to provide
the full funding that is now available but, as the communique agreed,
on the part of all seven countries, further capital to be channeled
in this effective mechanism to places where it can be used mor0
effectively.
So I think we are in agreement with you on the basic approach
needed. The question is how to get it done.
Senator JAVITS. I appreciate what you say, and I agree with you.
I come now to Ms. Whitman, if I may, and I like what you say
in the last part of your prepared statement about confidence.
Confidence, like leadership, is not created; it is induced.
I want to examine briefly various states of confidence and their
effects on the world. Consider a world in which the Peace Corps would
be again a cause for ideology. We would have a lively world economy
in which there would be an accelerated effort to develop. to grow. to
expand, to create, and to produce. Such a world would be one in
which people could look ahead to the future and feel something
good is going to happen in the world.
Do yon find that true now i And what do you attribute the absence
of it. to. if you do not~
Ms. W:rIIT'\fAN. I think, as you say, Senator. there are "animal
. spirits." as Keynes called them, or whatever it is; I think they are
very important. I think if there were expectations of that kind of
growth and dynamism in the world economy, yes, we would have a
much better framework for the specific things we were talking about.
I think we don't have that now. I think what we have is massive
uncertainty. If anything. there is a tendencv to look at the world
situation as worse than it is, or to ::mticipate the worst, which, of
course, one never can prove won't happen.
It is easf to point to some of the reasons. Clearlv. we know that the
vast shakeup caused by OPEC. and the very real chanl!eS in income
and wea]th positions. in countries' terms of trade. t'ansed a big- sho<'k.
We had a maior recession. No country in the world has been 'terriblv
successful, although the degree of snecess cliffors. in full recovery
from the recession without exacerbation of inflation: we have <'ertain lv done the best on the recoverv side. In fact. most other industrialized countries haven't gone anvwhere in recoverv.
Ry the same token. we 'haYe done the, worst on 'the inflation side,
certainly in terms of the direction that inflation is going.
In that process. I suspect we do tend to overlook some of the
economic strengths that work in our favor. I didn't talk about these


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orally, but I did mention them in the last paragraph o:f my prepared
.statement.
Senator J AVITS. Yes, I read it.
Ms. WHITMAN. I do thing we have some major things going for
us in this country. We have the mo~t stable political climate in t~e
world, and the best recovery-that 1s a relative statement, but still
it is true. We have the best climate for investment, surprising as that
may sound. I am not at all convinced that the picture is so bleak. We
have a lot of important unsolved problems and, as is always true, the
only really important problems are the ones you haven't solved yet
and that is still true.
I think there is a breakdown o:f what used to be a consensus in
the economics profession as to how we can manage these twin problems of inflation and unemployment.
I don't know any better than anybody else does whether we are
in the grip of something more than just a cyclical problem and
whether, indeed, there is some more longrun slowing down of world
growth going on or not. One can find lots of reasons to adduce on
either side.
I think, by the way, that one of the bright sides that is a bit overlooked is how much better many of the developing countries have done
in pulling out of the oil crisis and recession than the industrialized
-countries.
Again, there are individual less-developed countries that clearly have
terrible problems still, but if you look at the overall picture, those
,countries have done m11ch better in terms of maintaining or increasing
rates of growth than the industrialized countries have, and they have
done it at a time when the cards were stacked against them in the sense
that the industrialized countries, which normally provide their largest
markets, were themselves growing very slowly.
For people who worry, as so many of us did so intensively in the
1960's, about the increasmg income gap between the rich and the poor
-countries, this kind of performance has its very encouraging side. If
they have done so well now, how much better might they do if the
industrialized countries could recover some of their own momentum.
That means, at the same time, that we have to accept certain implications. They are going to increasingly become effective competitors with
us in a wide range of areas. If we are unwilling to accept that, we will
-cut off and severely interrupt their economic momentum.
Senator JAVITS. Ms. Whitman, one great achievement or breakthrough for American business is that the price of real estate is the
highest on a street that is occupied by competing stores. Another is
the proposition that, if A wins, it doesn't mean B loses. A third point
is the effects of mutual ownership and limited corporate liability.
These are the brilliance of the American system which contribute to
our domestic confidence.
·we don't need to emphasize how inadequate we are. Some of us have
spent a lifetime trying to get people to understand the strengths of
the American system, sometimes with meager results.
l would like to ask you this: Assume that this summit is undistinguished, as it really is; if it is used as a springboard so that the next
-summit may redeem many of these assurances, such as those regarding
the more advanced developing countries, and I read from the summit


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communique, we renewed our pledge "to support the replenishment of
the multilateral development banks' resources and agreed to encourage
governmental and private cofinancing; of development project with
these banks." Moreover, we urged "the developing countries to cooperate with them in creating a good investment clim~te, and a~equ~te
protection of foreign investment in order to let private foreign 1~vestment play its effective role in generating economic growth ~nd m
stimulating the transfer of technology." The developed countries reaffirmed "their commitment to continue actively the negotiations on
the Common Fund, to conclude individual commodity agreements, and
to complete studies of various ways of stabilizing the export earnings
of the developing countries."
I:f we started to carry out all these assurances, you think they would
make an important contribution to confidence i
Ms. WHITMAN. Wow ! Yes ; that is a very long list and, while I
might take issue with some items on that list, clearly, if we could make
substantial progress on all those fronts, that would be a major achieve~
ment and would have a tremendous impact on confidence.
Those are all ongoing efforts. We are not starting from scratch on
any one of them. It is a question of how far we can go. I think we have
to remember, too, the interrelations among them. It is important to
shore up the multilateral lending institutions, but all that can come
to grief unless we make sure, at the same time, that the policies of both
the industrialized countries and the developing countries themselves
are such as to allow them to develop economic dynamism so that they
can pay the loans back.
We will only make the situation worse if we increase funding facilities without at the same time insuring that our policies and the policie~
of the developing countries themselves are appropriate to assure their
generating the means of repayment.
Senator J AVITS. I take my text from what you said, and I understand
that because it has been our attitude.
I would like to turn to labor. Although I realize neither of you is a
Secretary, both of you are influential people testifying before us, and
we will call your bosses to tell them the same thing.
I would like to ask you two things, one each.
The inhibition about markets-that is, letting their goods in, as Ms.
Whitman mentioned quite properly-is that it will take away the jobs
of American workers. This requires two things: One, a rerationalizing
of our economy-we can't make simplistic things forever and live in a
peaceful world, and second and critical, it means, Mr. Packer, that we
have to be showing our people that we are acquiring markets. I:f you
look at the trade figures and see how trade has grown-when I first
came here, we talked about $50 billion in exports and imports. Now the
figure is well over $200 billion, and that is not all a result of inflation.
Inflation is high, but it is a very different problem.
I gather, and this is a conservative estimate, that 67 million American workers engage in exports, a number which far exceeds that for
those who are harmed by imports.
I think it is a grave failure of your department not to marshal those
figures and have their voices be as loud as that of the guy who wants
to exclude everything and says "to hell with tomorrow:" I am very
serious about this.


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If I may say to you Mr. Bergsten, I suggest to you that as a society
we are very bashful .about our aid, and that is what is in the craw of
our people here on the hill.
l have been a Congressman and Senator for a long time. The United
States does very well when you add the private flow of dollars to the
public flow, particularly when you add in such activities as OPIC and
the Ex-Im Bank. Moreover, the connection is strong between these
U.S. activities abroad and counterpart American activity, including
the stock exchanges and various banks, all yielding increased U.S. employment resulting from export activity and U.S. dollar flows abroad.
The New York Clearinghouse Association has proposed bringing a
free trade zone for banking into New York City. I am all for it. You
know its justification? Four to five thousand jobs.
It is not that New York City is going to be richer, but it is that we
are going to increase jobs available in New York City.
In addition, I think we are much too inhibited about laying it on the
line as to what we mean by the international financing of our institutions. Some seem to think the funds are sent from heaven. I expect that
20 percent or more .of the total funds required is our natural proportion, and that the money is mostly raised right here in U.S. financial
markets. If we don't like it, we could shut those financial markets down.
I beg you to tell your people that those nations we assist will take
the money, even if we tell them it is from us. They won't be that
insulted.
Gentlemen, I am all-fired-up about this matter because I see the
opportunity, and I see how it should be moved.
I would appreciate any comment.
Mr. BERGSTEN. If I might respond on the.last point, Senator,it does
fall to me in this administration to handle our negotiations on contributions to the development banks, as you know, and I can assure
you that neither I nor my compatriots are at all bashful in making
clear the. major.contributions the United States continues to make to
every one of these institutions and thereby try to wield an effedive
U.S. role.
But the problem emerges when we do not make good on our pledges.
This is really what the issue comes down to. We neither should nor
need be bashful in terms of our past role and what we have pledged in
each of these institutional arrangements, but when we fail to make
good on the pledges that have been worked out in consultation with.
the Congress, based on full authorization with the Congress, and we
lag over 2 years-as we now are in ARDA, and as we lagged over a
year in the Witteveen facility-and then our position is weakened and
our ability to take credit for what you quite rightly say we have done
and continue to plan to do is weakened very badly.
Now, I am talking to the converted here. It is not, as you know, a.
criticism of you. You have been one of the major supporters, indeed
fathers, of this whole effort; but our international credibility, our a;bility to get credit for what we have done over the years and are trying
to do now is badly jeopardized when we fail to come through on our
pledges and actually play our fair-share role. That is the problem as I
see it.
If we can get that on track, then we can work together and go many
steps ahead, as you suggested, but we have to get up-to-date first on our
past problems.

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Representative REuss. I will come to that in a moment after Mr.
Packer has a chance to comment.
Mr. PACKER. I think you are right about the export situation. I did
some lobbying myself on the Witteveen facility in the House. It was
unusual for somebody from the Labor Department to give a damn,
frankly, about the Witteveen facility. To most domestically oriented
people, it is just another aid operation, and nobody understands what
1t is about. We have problems with the World Bank getting tied up
with proposition 13. Adding money to the World Bank will reduce the
Federal deficit, not increase 1t.
The question of the World Bank appropriations seems more to
swing on whether World Bank officials fly the Concorde or get paid
too much rather than what is really at stake.
We have been trying with the labor movement, and Mr. Meany
wrote to each Member of the House and Senate asking for support on
foreign aid and the World Bank. I think all of us have not been successful in making the real issues clear to domestic political interests.
There is so much at stake here-there are jobs in exports, that balance
aipqng the developing countries is in our interest, not because of the
goodness of our hearts becaµse it bothers us that people starve to death
while Americans are on dieil,-which it should. American full employment, and the Humphrey-Hawkins bill, are unachievable, in my judgment, if we have 16 million unemployed in the OECD world. We have
a whole host of impediments.
I compliment you for your long efforts, as yet not fully successful,
in making domestically oriented politicians and policymakers in the
body politic concerned about the impacts of international affairs. Our
own inflation and unemployment performance to a great extent depend
on being able to separate proposition 13 from the amount of money
that is going to be given to the World Bank.
I don't think people in general understand that that appropriation
for the World Bank does not add to outlays and does not add to the
deficit. The question of why we should help poor countries when we
can't rebuild our cities is an irrelevant question. We are using other
peoples' money to do the work elsewhere, and the results of these activities will give us the revenues that will allow us to rebuild the cities.
It is not a trade-off.
Senator J Avrrs. I certainly appreciate that statement.
I would like to finish, if I may, by saying to Mr. Bergsten that I
think one of the weaknesses about the presentation of the Fund to the
Congress has been the idea that we pledged the honor of the United
States, and we have.to keep that pledge to preserve our honor.
That is a very weak argument around here. A much more persuasive
argument is that the Fund is excellent business.
We have to lay it on the line that the Fund will be an aid to business
and employment, prove it, and forget about the fact that we made a
pledge and that our honor is at stake. As I just said, that is a very
weak argument, as has been demonstrated before.
Thank you, Congressman Reuss.
Representative REuss. Thank you, Senator. I welcomed your philosophical discussion with Ms. Whitman about confidence. It is true,
and you have been pointing this out for some time in many speeches,
that the world and this country lack confidence at the moment. There
has been increasing alienation between groups. In our cities, there are


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vast groups of young people without any prospect of a job, who turn
to crime and drugs, who cause endless social upheaval. There has been
a breakdown in the confidence of the people in leaders in Government,
in labor, business, and every place else.
I recall, just 1,000 years ago, in 978, the same sort of thing was going
on. Everyone believed that the world was going to end in the yea:r
1000. That was the apocalyptic date, and the world was infested with
.masterless men in the forests and the city streets, robbing everybody
and with disaffection between the monks and the theologians and the
rest of the people, and with the general breakdown of confidenre
in leaders, the system where everybody knew his place in life had
.broken down; and then, to everyone's surprise, along came the year
1000, and the world did not come to an end.
In fact, it led to a revival of culture and to religion and to tn~
Renaissance, the Reformation, the building of the city, and all kinds
of good things.
Therefore, I think the three of us can aline ourselves to the side of
_those who do not feel the world will come to an end in the year 2000,
and if we play our cards right in the next 22 years, we can a;vofrf tha;t
possibility.
I would have one question of Mr. Bergsten, who, a few years ago, was
arguing very persuasively that the dollar overhang system eould be
solved through some sort of a substitution account whereby unwanted
dollars could be turned in for SDR's, and, as a matter of faet, I was
singing the same song myself.
Are you still as persuaded that there is that kind of a need for consolidating the dollar overhang by some sort of a sub.stitution account 1
Mr. BERGSTEN. Well, Congressman, I really made that argument in
the concept of the fixed exchange rate system, and also in the context
of proposed reform in a basically fixed exchange rate system, where
I argued, and would argue now, that the United Stateswouldbeunabie
to take on ,any kind of asset convertibility in a world where there was
remaining a huge dollar overhang. That would simply put nJl impossible strain on any level of U.S. reserves.
Now that we have moved to a system of more flexible exchange rates,
I think one has to look at overhang in ,a somewhat different light. I
basicaJly would agree with what Ms. Whitman was saying earlier on
that, with one modification, and without using the term "overhang."
I think it is true that the existence of a large outstanding stock of
dollars around the world may add to the degree of fluctuation in exchange rates in both directions. In a period when the underlying U.S.
situation is strong, for whatever reason, as occurred in 1975, the existence of the key currency role of the dollar may mean inflows into the
dollar which might carry it on the upside beyond the level that is
justified by underlying competitive conditions.
Indeed, it is our view that the nppreciation of the dollar that did
occur in 1975 and early 1976, which came at a time, incidentally, when
U.S. inflation rates were a little higher than those of our main competitors, did have a competitive disadvantage to the United States,
which explains an important part of the deterioration in your external
accounts between 1975 and 1977.
It is our judgment that somewhere on the order of $5 to $10 biJlion
of that total swing, which is perhaps as much as a quartfil" of it, does


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566
derive from the excessive rate of appreciation of the dollar back in
1975, which hurt our competitive position.
On tJhe other side, when you get an underlying'situation where the
dollar is under pressure on the downside, the fact that .there is a large
outstanding stock of dollar balances around the world does provide a
source from which selling can occur, portfolio diversification, which
may push the dollar rate lower than might be justified by the underlying economics.
But with that ca,veat, I would say under a srstem of flexible rates ,any
problem Qf the dollar overhang is of a much d1fferent nature than 'it was
in the past, and I would not put it on the front burner as a problem at
this point.
' --·"
· Representative REuss. I agree with you both. I am not even sure
your caveat is all that necessary, because I bet if you could not put in a
substitution account, and one-half of the floating dollars got substituted, I bet the financial writer would still be writing about this terrible
overhang and its imminent danger to the world monetary system.
Thank you.
We have kept you much too long. You 'have made a memorable contribution to our semiannual review, and I am sure Senator Javits will
join with me. I am going to lobby in our semiannual report for a
heavy emphasis on international economics.
Senator JAVITS. As good business. [Laughter.]
Representative REuss. Thank you all very much. The hearing is
recessed.
[Whereupon, at 11 :50 a.m., the committee recessed, to reconvene at
9 :30 a.m., Thursday, July 20, 1978.]
[The following written questions and answers were subsequently
supplied for the record :]
RESPONSE OF HON. C. FRED BERGSTEN TO ADDITIONAL WRITTEN QUESTIONS POSED
BY REPRESENTATIVE BOLLING
CONGilESS OF THE UNITED STATES,
JOINT ECONOMIC COMMITTEE,
Washington, D.O., July 31, 1978.

Hon. C. FRED BERGSTEN,
A -~-~istant Secretary for International Affairs,
U.S. Department of the Treasury,
WasMngton, D.O.
DEAR MR. BERGSTEN: On behalf of the Joint Economic Committee I wish to·thank
you most sincerely for taking time from your busy schedule to participate in the
hearings that comprise an essential part of the Committee's 1978 Midyear Review
of the economy. Your testimony is an important part of the record and will be of
substantial assistance to the Committee.
I am sorry that my schedule did not enable me to attend the hearing on July
19, and I apologize to you for my absence.
In order to complete the record, I would very much appreciate a written response to the following questions:
U) How would you assess the prospects for monetary integration within the
'European community? ·would the U.S. benefit or lose from the establishme,1t of a
common European currency? Would the establishment of a common European
currency be beneficial from the point of view of the operation of our international
monetary system? Would our payments system to more or less stable? What would
happen to the position of the dollar as a reserve currency?
(2) With respect to the question of surveillance, does there not exist the danger
that a set of rules of conduct will be established that could cause the Bretton
\Voods syRtem to be resurrected de facto? How do we protect ourselves from such
an eventuality?


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Copies of the hearings and our Midyear Report will be sent to you as soon as
they are available.
Thank you again.
Sincerely,
RICHARD BOLLING, Ohairman.

DEPARTMENT OF THE

TREASURY,

Washington, D.O., August 22, 1978.

Hon. RICHARD BOLLING,
Chairman, Joint Eoonomio Oommittee, Congress of the United- States, Washington, D.O.

DEAR MB. CHAmMAN: This is in reply to your letter of July 31 in which you
posed some questions concerning recent proposals for closer monetary integration
i,n the European Community and concerning surveillance in the International
Monetary Fund. I hope that the answers contained in the attachment will help to
,complete the record.s of the Joint Economic Committee's 1978 Midyear Review
of the economy.
It was a pleasure appearing before the Committee on July 19.
,Sincerely,
C. FRED BERGSTEN,
Assistant Secretary.

Enclosure.
Question 1. How would you assess the prospects for monetary integration within the European Community? Would the U.S. benefit or lose from the establishment of a common European currency? W·ould the establishment of a common
European currency be beneficial from the point of view of the operation of the
international monetary system? Would our payments system be µiore or less
stable? What would happen to the position of the dollar as a reserve currency?
Answer. In their summit meeting in Bremen on July 6-7 the EC chiefs of state
.and government stated that closer monetary cooperation leading to a zone of
monetary stability in Europe was a highly desirable objective. The Chancellor of
the Federal Republic of Germany and the President of France presented the
:broad outline of a plan to create such a monetary zone. The EC leaders agreed
that this plan should be used as a point of departure for further study.
The main elements of the German-French proposal include:
Exchange rate arrangements that limit fluctuations among European curren,cies. They also would establish a coordinated EC exchange rate policy vis-a-vis
the dollar.
Pooling of a portion of European gold and dollar reserves to help finance intervention in the exchange market.
Expanded lending of EC currencies on conditions designed to encourage the
harmonization of economic policies.
Creation of a European reserve asset (the European Currency Unit) to be
11sed in official EC transactions.
Following instructions given at the Bremen summit; EC Finance·Ministers met
-0n July 24 to develop guidelines for a study to be completed by October 31, with
a view toward adoption of decisions on any new monetary commitments at the
11ext EC summit meeting on December 4-5.
Since specific EC monetary proposals have not yet been agreed to, it is premature for the U.S. to.attempt any assessment of the impact of new EC arrangements. The main areas of interest have to do with the effects of possible EC
arrangements on: (1) world economic growth, (2) the effectiveness of the international adjustment process and (3) the international monetary system.
The United States has long supported the objective of the economic unity of
Europe. Close monetary cooperation may be an important part of this process. It
is our hope that any new EC arrangements will be designed to promote economic
growth in the world as a whole. We could not, of course, support a plan which
prevented the dollar exchange rate from responding to underlying economic and
financial factors. We will wish to be certain that any new arrangements will be
·administered in full conformity with the revised Articles of Agreement of the
IMF and in close consultation and cooperation with the monetary authorities of
<_>ther countries. W~ welcome.the commitment of the EC countries, as expressed
1n the Bonn Summit commumque, to consult fully with us as their thinking-on the
issues develops.
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The monetary cooperation plans being studied in tl;te EC are not immediately
aimed at creation of a common currency in the strict sense,. They do envisage
creation of a new European reserve asset (the European Currency Unit) to be
used in official EC transactions. It may well be that a European Currency Unit, ill
time, will come to play a prominent role in the international monetary system as.
a consequence of EC efforts to achieve greater economic harmonization and exchange rate stability within the Community. Such a development, provided it
were compatible with the broad interests of a smoothly functioning, efficient
world monetary system, should not be a source of concern.
•Question 2. With respect to the question of surveillance, does there not exist
the danger that a set of rules of conduct will he established that could cause
the Bretton Woods system to be resurrected de facto? How do we protect ourselves from such an eventuality?
Answer. I do not believe that IMF surveillance poses a danger of a return to
the. rigidities of the Bretton Woods system. Quite the contrary. The.amended Il\IF
Articles and surveillance represent a marked departure from the approach underlying the par value provisions of the Bretton Woods system. The new arrangements recognize that exchange rate stability can only be achieved through policies
that promote underlying economic and financial sta.bility; and that exchange rate
movements play an important role in balance of payments adjustment.
The new IMF Articles provide countries with freedom of choice in adopting exchange rate arrapgements best suited to their needs, provided that the member
meets its general IMF obligations. Most importantly, the Articles enjoin countries to avoid manipulating their exchange rates to prevent effective balance of
payments adjustment or gain unfair competitive advantage. This new obligation
says in effect, that prevention of exchange rate change, in either direction, can
be· undesirable and harmful, just as "competitive devaluation" was considered
undesirable in the Bretton Woods system.
The amended Articles contain legal safeguards which will enable the U.S.
to 'protect itself against the adoption of exchange arrangements detrimental to
its interest. Although explicit provision is made for future IMF determination
that international economic conditions permits the introduction of a wid.espread
system based on stable hut adjustable par values, an 85 percent majority vote
is required. The U.S., with about 20 percent of IMF voting power,,would have a
controlling vote in such a determination, and par value arrangements adopted
.nuder the· amended Articles would provide for substantially greater flexibility
than the Bretton Woods system.
The principles and procedures for IMF surveillance are intended to help assure that the obligations contained in the new Articles are. fulfilled. IMF surYeillance will provide an improved means for the U.S. to protect its interests
from the exchange rate practices and policies of other countries. Most impor.tantly, surveillance will apply symmetrically to surplus and deficit countries,
whereas the Bretton Woods system tended to focus largely on the practices of
,deficit countries. Efforts to prevent exchange rate changes, in either direction,
will be examined. When intervening in the foreign exchange markets, countries
are required to take account of the interests of other members including. the interPsts of the countriPs in whose currency they intervene.
Neither the U.S. nor any other country can realistically ·expect total freedom
of exchange rate behavior. The IMF Articles and surveillance recognize that exc-hange rates are of legitimate interest to the entire international community.
They provide members with greater flexibility and freedom in exchange rate
matters, while ensuring that the interests of the international community
are protected. The U.S. believes that the legal framework contained in the
amended Articles and IMF surveillance provide an efl:ective means of safeguarding its interests in exchange rate matters.
RESPONSE OF MARINA V.

N.

WHITMAN TO ADDITIONAL WRITTEN QUESTIONS POSED
BY REPBESENTATIVE :BOLIJNG
CONGRESS OF THE UNITED STATES,
JOINT ECONOMIC COMMITTl<;E,

Washington, D.O., July 27, 1978.
N. WHITMAN,
Department of li1conomicB, University of Pittsburgh,
Pittsburgh, Pa.
}\fa, MARINA V.

DEAB Ms. WHITMAN: On behalf of the J'oint Economic Committee I wish to
thank you most sincerely for taking time from your busy schedule to participate
in the hearings that comprise an essential part of the Committee's 1978 Midyear

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Review of the economy. Your testimony is an important part of the record and
will be of substantial assistance to the Committee.
I am sorry that my schedule did not ena\Jle me to attend the hearing on July
19, and I apologize to you for my absence.
In order to complete the record, I would very much appreciate a written response to the following questions :
(1) How would you assess the prospects for monetary integration within the
European community? Would the U.S. benefit or lose from the establishment of a
common European currency? Would the establishment of a common European
currency be beneficial from the point of view of the operation of our international
monetary system? ·would our payments system be more or less stable? What
would happen to the position of the dollar as a reserve currency?
(2) With respect to the question of surveillance, does there not exist the danger that a set of rules of conduct will be established that could cause the Bretton ,voods system to be resurrected de facto'! How do we protect ourselves from
such an eventuality?
Copies of the hearings and our Midyear Report will be sent to you as soon as
they are available.
Thank you again.
Sincerely,
RICHARD BOLLING, Chairman.
UNIVERSITY OF PITTSBURGH,
FACULTY OF ARTS AND SCIENCES,
Pittsburgh, Pa., August,, 1978.

Hon. RICHARD BOLLING,
Chairman, Joint Economic Committee,
U.S. Congress, Washington, D.O.

DEAR MR. BOLLING: Thank you for your letter of 27 July. Let me respond briefly
to the questions you posed there.
1. As regards European monetary integration, several such attempts have been
made in recent years, and all of the previous ones have foundered on the complexities of monetary integration among sovereign nations with very different
economies, inflation rates, and stabilization goals. Whether this time will be
difl'~rent it is too early to say, but I hope I may be forgiven a certain cautious
skepticism. The probabilities are likely to be affected, however, by the performance of the U.S. economy and the dollar; the worse these do, the more urgency
the Europeans are likely to feel regarding their own monetary integration, and
vice versa.
As I said in my testimony, I believe it would be premature to try to evaluate
the costs and benefits to the United States of a p~an whose details are not yet
known, even to the participants. Our major concern should be that such a plan
be market-oriented and internationalist in orientation, rather than restrictive
and mercantilist, and that it not be used as a mechanism for exchange-rate manipulation unfavorable to the United States or to nonmember countries in general. Depending on the details of how it is operated, such a scheme might ( or
might not) reduce somewhat the reserve-currency role of the dollar, but I think
the . dollar would remain the single most important medium for international
reserves in any case.
2. There is always some danger that rules of conduct regarding exchange-rate
surveillance could, become the vehicle for a restoration of pegged rates and a
chronically overvalued dollar. The danger can be minimized, I believe, by making
sure that the guidelines regarding exchange-rate policy be "permissive" rather
than "prescriptive." That is, they should define the conditions under which direct
or indirect intervention in exchange markets is ( or is not) permissible, rather
than when it is recommended or required. It seems to me that the IMF's actions
so far in this area have been on the whole in the right direction, but it is a difficult issue, and one on which precedents will have to be developed slowly, gradually, on a case-by-case basis.
Yours sincerely,
MARINA v. N. WHITMAN.

37-250-79--4


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THE 1978 MIDYEAR REVIEW OF THE ECONOMY
THURSDAY, JULY 20, 1978

INFLATION

CONGRESS OF THE u NITED STATES,
JOINT EcoNoMIC CoMMITI'EE,
Washington., D.O.
The committee met, pursuant to recess, at 9 :30 a.m., in room 2168,
Rayburn House Office Building, Hon. Richard Bolling ( chairman of
the committee) presiding.
Present: Representatives Bolling, Long, and Brown of Ohio; and
Senators McGovern and Javits.
Also present: John R. Stark, executive director; Lloyd C. Atkinson,
Thomas F. Dernburg, Kent H. Hughes, M. Catherine Miller, and L.
Douglas Lee, professional staff members; and Charles H. Bradford,
Stephen J. Entin, Mark R. Policinski, and Robert H. Aten, minority
professional staff members.
OPENING STATEMENT

OF

REPRESENTATIVE BOLLING, CHAIRMAN

Representative BoLLING. The committee will come to order.
Several public officials, including Chairman Miller of the Federal
Reserve, have declared inflation to be public economic enemy No. 1.
I agree that inflation is a very serious problem, but I want everyone
to remember that past fights against inflation have usually stalled
the economy and produced enormous and unconsrionable costs in terms
of lost proo.uetion··an:d employment. 'In :fact, the more recent of these
episodes caused great pain and misery without even producing the
benefit of a significant reduction in inflation.
We are still paying the price :for the misguided policies of the 1970's.
Capital spending has now been subnormal for over 3 years. The result
is that we have now virtually no productivity growth so that any wage
increase almost immediately translates itself into higher unit labor
costs and prices.
As its central theme, the 1977 midyear report of the Joint Economic Committee emphasized that inflation is the most serious obstacle to the attainment of full employment and of rapid and sustained
economic growth. The report cited a number of reasons, but certainly
the most important was that inflation paralyzes economic policy measures. If anything, the message of that report is even more relevant today than it was a year ago.
Our first witness, Mr. Barry Bosworth, Director of the Council on
\Yage and Price Stability, has in his public statements echoed the


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warnings of the Joint Economic Committee. Mr. Bosworth and· this
committee, therefore, start from a common base.
The most important question that we shall be attempting to answer
today is whether it is possible to slow our rapid and apparently accelera~ing inflation without once again pushing the economy in
recession.
As I interpret the purposes of the Council on w· age and Price Stability and the administration's deceleration program, they are to provide ways of slowing inflation without using the harsh restrictive
monetary fiscal medicine that has brought about the recessions of the
past.
We will, therefore, want to explore with Mr. Bosworth whether the
deceleration program stands much of a chance of success. "\Ve will also
value his opinion of what additional authority he needs to make the
battle against inflation a successful one.
We will want to know, in short, what we in the Congress can do to
help him in the struggle against inflation.
Welcome to the hearing of the Joint Economic Committee, Mr. Bosworth. Please proceed as you wish.

STATEMENT OF HON. BARRY P. BOSWORTH, DIRECTOR, COUNCIL
ON WAGE AND PRICE STABILITY
Mr. BoswoRTH. Thank you, Mr. Chairman.
I have a prepared statement which I would like to submit for the
record.
Representative BOLLING. Without objection, it will be included in
the hearing record.
Mr. BoswoRTH. What I would like to do is take a £ew minutes to
summarize for you the current status of inflation from my perspective, I'll refer to the tables in my prepared statement.
It is very clear that if our e:fforts are currently aimed at slowing
inflation, we are not making progress. In fact, we are headed in the
wrong direction.
In the first 5 months this year, the consumer price increase has
reached a 10-percent annual rate of inflation. However, there are some
special circumstances which took place in the first part of the year
that we should properly adjust for.
First, food prices have increased so far this year at an annual rate
of nearly 20 percent at the consumer level. This rate of food price
inflation is even more rapid than the explosive food prices in 1972 and
1973. It is primarily reflected at the farm level, where the farm value
of the consumer food dollar increased in the first 5 months of the year
at a 50-percent rate of inflation.
While a few months ago people were worrying about depressed
incomes for the farmers, this year should turn the farm situation
around dramatically.
If you look at the bottom of the table on domestically produced
farm products, you'll see that domestically produced products at the
retail level are rising at a 23-percent annual rate. Farm values are up
at a 50-percent rate, and the food margin is rising at about 7.5 percent
a year, about the same rate of inflation as in the industrial sector.
Our main problems in the food area have been the well-known shortages of meat. In addition, heavy rainfalls on the west coast completely
disru-pted the fruit and vegetable crops and drove those prices up,.

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and there have been substantial increases in every other component of
the consumer food dollar.
Thankfully, I think we can look forward in the remainder of the
year to a dramatic improvement in the food area.
First, I think the speculative mood in the livestock area has now
broken. Livestock prices appear to have stabilized in a range that appears relatively reasonable both from the perspective of the consumer
and from the perspective of the farmer. Therefore, for the rest of the
year we will not be experiencing a continuation of the sharp livestock
price increases.
As new crops have been planted, there has been a substantial decline
in vegetable and fruit prices. That has not yet beell reflected in the
Consumer Price Index, but we should see substantial moderation in
food prices in the next one and the ones to follow.
I think the only major problem we have in the food area is the proposal before the Congress for an increase in sugar prices and the support levels of those.
Otherwise, the current situation should be sharply distinguished
from what happened in 1972-73. Food prices went up dramatically in
thdirst part of this year, but we are not in a situation that could lead
to a continuation of this trend, because we do not have the same sort of
problem we did in grains.
We have a very plentiful supply of grains. Unless there is a sharp
increase in grain prices that under.pills any increase in consumer food
prices, I don't think it will continue for the rest of the year.
In addition, there have been rather dramatic increases in a couple
of other areas in the first part of the year. First, the shift of the Federal
ll:eserve Board toward a tighter and more restrictive monetary policy
has rapidly driven up home financing charges. There has been an
increase In taxes, too. There has been an annual increase of 20 percent
in inflation in the first 5 months of the year in taxes. There, too, we can
]ook forward to a substantial leveling out over the last.half of. the year.
Finally, a rather peculiar area in the Consumer Price Index is a rapid
upward movement in the price of used cars. In terms of trying to
:anticipate where we are going for the rest of the year, it is more realistic to look at the rate of inflation that excludes these highly erratic
-components.
You can see the annual rate of inflation in what w-e might can the
industrial components of the Consumer Price Index is runnmg,ata,bout
6.5 to 7 percent annually. While that is not 10 percent it is an acceleration from the 6 percent annual rate of inflation that we have had in the
prior 2½ years.
I think the conclusion is unavoidable that-at least thus far this
year-the basic underlying forces driving the inflation rate are beginning to accelerate. They have been particularly dramatic in those three
areas I cited: Housing costs and food prices have been the.two major
components responsible £on this.
I think the same story tums out to be true for the wholesale price
index. At the wholesale level there has been an acceleration 0£ the
basic rate of industrial price increases--a:fter exclusion of food prices
and other erratic components-of about a percent a year.
Finally, on the wage side, the same picture comes through. What had
been a fairly steady rate of wage inflation of about 7 percent a year for
hourly earnings has become 8 percent.

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In the last year, the average hourly earnings index shows wage earn.
ings are up a little over 8 percent. Certainly the minimum wage
increase in January contributed substantially to that increase. Tirnt
will not continue in the rest of the year.
Yet I think an overall review of the wage index shows indisputably
that there has been an equal amount of acceleration on the wage side.. ,
A third factor, a long-lasting one, I think, is that in the first quarter
of this year productivity, instead of increasing as it normally does,
actually fell very sharply. Many of us attributed this drop in productivity to cold weather and the coal strike and assumed it would rebotmq'
in the second part of the year. However, the decline in the unemployment rate in the last couple of months and the modest growth in aggregate demand suggests that the productivity slowdown is of more longlasting concern and is not just the result of the coal strike and cold
weather.
It now appears that, even with reasonably good economic growtll',
we may see almost no improvement in productivity for the year as' a
whole. That leaves no room for improvement in the real incomes of the
average American workers.
With this sort of a framework and background of where we stand,.
if you look at the actual rate of increases of prices and wages, we arenot making any progress in trying to keep the inflation down.
I will, then, look at the program that the administration has put
forth to try to summarize the maior focus of it and discuss where our
major problems lie. First of all, I think the conclusion has to be inescapable that the Federal Government and the State and local governments to a lesser extent must bear considerable responsibility for the
actions th:'at they have taken in recent decades that have directly contributed to the rate of inflation.
I don't think those actions have been that the Federal Government
has tried to create too many jobs. I agree wholeheartedly with the
opening statement of the chairman that attempts to end inflation in
this country by throwing people out of work are going to be :far too
costly.
What we are trying to do is to find ways of slowing inflation without
throwing millions of people out of work. I would point out to you that
we have come to the conclusion that it would take a million people out
of work :for at lea:st 2 years for every percentage point that you could
take off the inflation rate.
A million people out of work implies $75 billion loss in the GNP, and
those costs mean if you try to get down to an acceptable range, the
country would have to return to the double-digit unemployment rate$'
if we relied on that mechanism.
·
I think the Government contributes to the inflation in a :far more
direct :fashion. It continues inflation through tax policy and regulatory
actions and it contributes to inflation through its attempts to respond
to individuals and special interest groups, through trade restrictions:
to protect them against foreign competition, to try to guarantee minimum wage and minimum prices for those specific groups.
It is the magnitude of these sorts of activities that has become a ver.y
considerable :force in inflation, and that is different :from the 1960's. I
pointed out that in 1978, £or example, the increase in the minimum
wage, the increase in thi:l social security taxes, and in the increase in the


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'

575
unemployment compensation are estimated to add nearly three-quarters of a peroentage point to the inflation rate.
We estimate tlie Fede:ralregulatory activities are currently adding
an additional three-quarters of 1 percent annually to the inflation rate.
Something in the magnitude of about 1½ percent on inflation has currently been traced to governmental activities. Many of these activities, particularly the regulatory ones, have substantial benefits but
we can't ignore the fact that they are adding to the inflation problem,
and we do face a serious tradeoff in that area.
We have tried to get business groups to try to follow a policy of limiting their individual price increases to a rate of increase in 1978 of
less than the average of the last 2 years. But looking at the wholesale
price index, there is an inescapable conclusion that most business firms,
are· raising prices at a rate that would not allow them to meet that
objective.
,
· We have contacted firms to .ask them what actions they mean to
take in the last half of the year.
We have had difficulties in trying to make the anti-inflation program
be effective for the wage area. I believe the greatest problem in the
wage area is that it is a little absurd to ask the average American
worker to hold back on wage increases when he has been getting 7 or 8
percent and he looks out and sees other people getting 9 and 10 percent annua,l wage increases.
, Before we can expect much from the average American workers, we·
must find a way to bring wage increases for those people in the industrial core of the economy back in line with everyone else's. As long as
this highly visible labor force continues to obtain wage increases substantially above the average worker, we cannot expect the average
worker to cooperate.
I think thus far our program has not obtained the full cooperation·.
of organized labor, and I understand their concern. A worker is being
asked to sign a multiyear labor agreement with no assurances that
inflation will decelerate. On the other side the businessman says, "Yes~
I am willing to cooperate with the program." But if it doesn't work out
in the next 30 days, he can raise his prices.
I .think there are some means to try to equalize the risk for the
American workers. In the large industrial contracts that risk is really
not there to the extent they claim it is, because they do have cost~ofliving escalator contracts. They don't protect them 100 percent, buttoa substantial degree.
At this time when we are trying to reduce inflation, people can negotiate contracts for a shorter period of time. The 3-year labor contract is something we can move away from.
·
At the same time I think the administration realizes that some further action will possibly have to be taken and some modification ofthe
program will have to be made. We are in the process of exploring a
lot of different alternatives tha.t have been proposed both publicly
and privately to see what we can do to get some additional cooperation
on the part of individua.ls in the private sector.
I am more impressed, I think, with the response of our own Government. I think there is a sharp increase in awareness by the Congress
and the administration of the inflationary impact of Government actions. Many people in the Government are trying to find a way to deal
with some of the,se problems.

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I think our difficulties now lie primarily in the private sector in
terms of getting some fonn of response.
At present, if you look at the Consumer Price Index, the extent of
the success we have had indicates it has been a little bit limited.
Representative BOLLING. Thank you very much.
[The prepared statement of Mr. Bosworth follows:]
PREPARED STATEMENT OF HON. BARRY P. BOSWORTH

Mr. Chairman and members of the committee, I am.happy to have the opPortunity to appear before you today. We. share 11 common goal-'-reducing the rate·
of inflation. All of us are deeply aware that finding a solution to the inflation
problem is vital to the nation's economic future.
All of the recent figures indicate that we are not doing very well. Despite our
efforts so far, the rate of inflation is increasing. I do not think, however, that
the outlook is nearly as grim as the statistics of recent months suggest. They
show inflation running at an annual rate of about 10 percent. Quite obviously
we are not going to end the year on a note as sour as this. For 1978 the figure
probably will be about 7 percent. While it is true that this is the wrong direction,
inflation is not running rampant.
I have attached some tahles showing recent inflation trends.
During the balance of this year we expect considerable improvement. We especlally•anticipate sharp moderations in food·prices which were responsible·for
most of the large increases we experienced earlier this year. Already fresh vegetable prices have come down and I think the large increases in meat prices are
behind us, with a more stable level of prices for the remainder of the year.
Beyond the second half of this year the outlook is far less certain. Much
depends on the effectiveness of our anti-inflation program.
There has been criticism that this program so far has not produced any tangible
results, and without question there remains a good deal of skepticism about its
voluntary nature. But we did not expect the deceleration program to produce
immediate improvement in a situation that has worsened for more than a decade.
We have not sought a quick fix. The objective is to get a gradual but sustained
improvement over the next few years. The multi-year nature of many of our
wage and price contracts does not make it feasible for a voluntary program to
achieve dramatic results in a short time period.
But I believe it is too early to conclude that this nation c11,nnot solve its inflation
problems through cooperative efforts or that we must again put the country
through the,aggregate demand restraint wringer with millions more out of work.
The.President announced the concept of the deceleration efl'ort last Januacry,and
theli further implemented it with a number of positive steps of which you are all
aware in April.
You have requested my asse><sment of the President's anti-inflation program.
As I have indicated already. !think it is far too soon to expect major results.
From the outset we were aware that it would take some timl' simply to make a
modest start. But I will have to concede that the clock is ticking. I honestly do
not fl'el that we have a lot of time left.
I think, however. that any assessment of what has been done so far must be
viPwed in terms of the alternatives.
Tberf' is no question that the amount of fiscal stimulus could be reduced to the
point that inflation would end. You could hold down the money supply growth to
a<'hieve the very same result. But let's be honest about what we are talking about.
~ince no businessman sets prices by the size of the budget deficit and no one
clpmands wag-e il!creases because they feel the money supply is rising too fast,
what we really mean is cut government spending, cut production, throw a few
rnHlion more pf'ople 011t of work in hDpes they will quit a1-1king for wag-e increllses.
I agreP that we could end inflation by this old-fashioned demand rPstraint. Rut
let's not fool ourselves. The price, in termi, of human coi,ts, would be enormously
hig-b. The best economic estimates are that it would take an additional one millilin
1m1>mployed for two years just to bring down the rate of inflation one percentag-e
point. In my opinion, that is an unacceptably hi~ price tag. We do not have an
inflation cam:ied by excef'lf'l dPmand and it cannot be halted by creating an even
farg-er oool of the unemnloyed. And I don't sPe any convincing evidence now that
df'mand presnres threaten new inflationary influf'n<>es.
There was a time when ju~t a little air!!rPgate clPrnand restraint applied through
fiscal or monetary policy achieved results. But this is no longer true. We have


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undergone a number of structural changes in our economy-such as the reduction
of competition both in labor and .in pricing markets and the growth of governmerit .lnvolvement-that have markedly altered our options. The fear of'.uuemplayment and lost sales as incentives to hold dowI!J wage and price increases
haB become relatively ineffective for several major sectors of the economy.
,There is, of course, another option-wage and price controls. But they are
simply not applicable to the kind of inflation we have today. Controls.are shol't
term solutions to emergency situations. And this is not what we have. Inflation
has been a problem for us and all other industrial democratic nations for several
decades. The use of controls on a sustained basis would cause distortions and
inequities and would not address the fundamental structural problems. The Admil!istration has said repeatedly and emphatically that it rejects this approach.
One very basic reason is that we just don't know how to operate controls. Thel'e
are millions of prices in this country and when you try to set them from Washington, you inevitably make serious mistakes that ultimately lead to bottlenecks and
distortions. And when you try to set wage rates in Washington I think you run
the risk of creating basic changes in our political structure. The political activity
of labor and business would concentrate primarily on persuading the government
to approve their higher wages and prices.
In between these two extremes there is very little. We have been looking at
some new incentive ideas that are loosely lumped together as Tax Incentive Plans ..
I believe that these options should be fully explored because they appear to
address the problem of insufficient incentives for the individual firm and worker
to exercise restraint in their wage and price decisior..s. But there are serions
·administrative problems. The idea certainly is well worth e·xploring. Significant
progress has been made in identifying and solving these problems, but we do not
yet have a version of such an ince11tive approach that is a viable option.
At present we have identified the major areas in which our anti-inflation efforts
will need to concentrate and we have tried to develop for both business and labor
reasonable guidelines for non-inflationary wage and price decisions.
The program has four major parts. First, the Administration recognizes that
the Federal government itself is an important contributor to inflation.
The Administration is committed to working with Congress to maintain a
responsible long-run budgetary policy that balances concern for sustained economic growth with a determination to avoid excessive surges in aggregate
demand relative to, supply. The President has reduced the size of the proposed
tax cut to avoid excessive demand stimulation and has indicated that he will
veto budget bills that exceed his requested levels.
In other areas the President has strengthened the review and analysis of the
government regulatory process in an attempt to simplify regulations and assure
that their objectives are achieved in the mo~t cost-effective manner. It is reliably
estimated that government regulations add about three quarters of a percer..t
a.nnually to the rate of inflation.
The President as well has frozen the salaries of the White House senior sbiff
and has recommended a 5.5 percent ceiling on this year's Federal white collar pay
raise. He has ordered the Executive branch to reduce where possible the purchases of goods and services where prices are rising rapidly.
But while the Federal government must do its share, it alone cannot solve the
problem. Cooperation of the private sector is vitally needed.
The anti-inflation program is based on the premise that deceleration must
be achieved in every market. To reach this goal individual industries are being
asked to limit price increases to less than the average over the last two years.
The objectve, as well, is to assure that there is no widening of profit margins.
Several individual firms already have pledged to meet this deceleration target
and we are continuing a full schedule of meetings to persuade others to do the
same. In this effort I am working closely with Robe~t Strauss, the President's
special counselor for inflation.
We adopted a standard for price behavior that ref2rs to the cumulative ma!?nitude of price increases for the year 1978 as a whole in order to avoid encouraging
a multitude of small price increases for which we did not have resources for
analysis, and to encourage firms to be responsible for their own cost increases
rather than accepting a pass-through of costs as adequate justification for price
increases.
One consequence of that policy has bePn that we have not had a basis on which
to comment with respect to many pricing actions in the first half of the year.
During the next six months, however, many industries will be approaching the
deceleration target that we expect them to meet. I anticipate that we will need to


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expand the Council's activities in that area over the next few months. On the
hasis of price developments through June, for example, we have begun a process
of contacting these firms in industries with price increases approaching the
deceleration objective to inquire as to what actions they contemplate taking
during the remainder of the year in order to achieve the objective. If they cannot
d() so, we would like to obtain a detailed explanation of the factors responsible
accelerating inflation in this industry.
The third part of the program involves gaining labor support. A moderation
,of prices can be sustained only if there is an equal reduction in the magnitude
of average wage increases.
Quite candidly we have not done very well here. A lot of this probably is
m.v fault. Perhaps I did not explain the labor side of the program well enough
and did not address myself adequately to some· special problems labor has with a
voluntary program.
It is a lot easier for business to make a price commitment than it is for labor to
make a wage commitment. If inflation fails to moderate, businessmen can simply
pull out any time and raise prices. But labor contracts are in effect for two or
three years.
.
So there has to be an understanding that the working man will be protected
if the cost of living continues to rise.
I think there are equitable means of handling this problem. Many major
labor agreements contain cost of living escalator provisions. Alternatively, they
could choose to negotiate shorter-term contracts or to include provisions for annual wage reopeners. But our problem has been that, in the name of protection
ag?in1>t inflat~on, some labor groups have obtained wage increases far inEµ:cess of
the ,average American worker. These increases also exceed producti-'l'ity gains
plus increases in the cost of living. We cannot continue this trend toward a dual
labor market where the wages of one group rise far more rapidly than those
-0f the average worker. Nor can we ask the average worker to participate in the
anti-inflation effort by restraining his wage increases when the gains of others
are so much greater.
Both on the labor side and the price side the voluntary deceleration program
provides for flexibility to meet specific problems and situations. This is what
distinguishes it from a rigid guidepost approach. The program expects more from
those industries and those workers who have done very well in recent years.
And it understands that it will have to accept less from those who have done
poorly.
'\Ve recognize, for instance, that firms that lowered their price-cost margins
during the recession will experience a rise in those margins as demand strength-ens. The program is not designed to penalize those firms who have in the past
Yaried prices in response to market conditions. By the same token there should
he flexibility to allow for uncontrollable mandated costs from government programs such as payroll tax increases, regulatory actions, tax changes and import~d
raw materials.
On the other side, it is absolutely true that the average American worker has
not fared well because of inflation. This does not apply, however, to those workers
in the central industrial core of our society. They have been receiving gains of
about 10 percent annually. If we are really going to do anything about inflation,
thef<e groups must begin to moderate their gains and bring them back in line with
the 7 percent average of the rest of the economy.
The final part of the program deals with those sections of the economy that
present special inflation problems. These include medical care, food, transportation and housing. In general the rate of price increases in these sectors has
comdstently exceeded the economy-wide average.
There is before Congress a hospital cost containment bill that was designed
to provide significant relief in this area. But it seems now to have almost no
<>hance of passage. Recently the Council on Wage and Price Stability met with
repreRentatives from the American Medical Association in an effort to persuade
individual doctors to hold down their rate of fee increase, which has been
ac<'elerating much faRter than the general rate of inflation.
In the final analy,lis, I cannot guarantee you that the course we are following
will do the job. And it might not he the best approach. But so far, given the optiomi. no one has been able to come up with a better one. And God knows we have
tried.
This Administration is serious. And it is committed. It will do all in its power
to mRke the program work. But success or failure really depends on cooperation
from both business and labor.


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All I can guarantee you is that if we fail, the Federal Reserve will not tolerate
another long spell of rising inflation. The result will be an end to the economic
expansion and a subsequent recession with absolutely no guarantee that we will
emerge from it in any better shape in terms of inflationary pressures.
ALTERNATIVE MEASURES OF PRICE INFLATION
December
1977 relative
Annual changes'
importance - - - - - - - - - - Percent change
(percentage)
1976
1977
year to date 2
Consumer Price Index: a
All items ______________________________________ _
Food _____________ -- ____________ • _________ _
Energy._ ••• _••• __ •• __ •• _. __ •• __ • _____ • ___ _
Home finance, insurance, and taxes __________ _
Used cars ____ ._. __ •• _. ____________________ _
Other items .•• ____________________________ _
HighHousing
inflation___________
components:
• ______________ • ____________ _

100. 0
17. 7

8. 6
9. 2
3.0

61. 5

43. 9
Medical care ____ . ___________ .. ______ .. ________ _
5. 0
Food. ______ ._. _______________________________ _
17. 7
Consumer food prices:
Away from home _______________________________ ,
5. 5
At home_______________________________________
12. 2
Domestically produced farm food:•
Retail value ••• ___________________________ ._. ____ •• __________ •
Farm value ______ •••• ______________ . ___ •• _____ ••. -- •• -- - •• -- - •
lmp~!~i:~il margin _______________ •• ____ •• ___ ••••• _____ ••••• __ _

Wholesale Price Index:
Finished goods .••• ________________ •• ____ •• ____ _
Producer____ ••• ___ •• ____ ••• ____ • ___ ••• __ •••
Consumer__ ••• __________ ••• ___ •• _________ ••
Consumer less food ________________________ _
Intermediate less food •••• ____ •• _. __ •• __________ •
Crude less food ____ • _________________ •• _. ______ _

41. 2
12. 2
29.0
18. 7
45.5

4. 0

.6
6.9
I. 6
19. 0
6.1

4.8

6.8
8. 0
7. 2
11. 2
-4.1
6. 2

10.0
18. 7
7.4
19. 3
14. 0
6. 7

5.4
10.1
.6

7.6
8.8
8. 0

10. 8
8. 7
18. 7

-.9

6.1

8.0
8. 0

11. 6
2. 21

-3.2
-10.6
2.1
15. 9

5.1
4.3
5.6
25. 7

23.0
50. 9
7. 5
NA

3.3
6.4
2.1
4. 9
6.4
13. 5

6.6
7.2
6.4
6.1
6.4
11.4

10.5
8.3
11.1
7.9
7. 7
14.0

' December over December of prior year.
2 CPI figures show December to May changes, WPI figures show December to June changes. All figures are seasonally
adjusted at annual rates.
8 CPI for all urban consumers.
• Domestically produced farm food comprises 100 percent of consumer food at home. Relative importance of the components of this group are: Retail food, JOO percent, farm value, 41 percent; and farm-retail margin, 59 percent.
Source: U.S. Department of Labor and U.S. Department of Agriculture.
ALTERNATIVE MEASURES OF EMPLOYMENT COST
Average annual percentage
change
1967-77

1976-77,

December
1977 to
June 1978 2

June 1977 to
June 1978

6. 9
7.1

7.6
7. 2

9. 4
8. 3

8.4
8. 2

1977: IV to
1978: I 2

1977: I to
1978: I

13. 2
-3.3
17. 0
0
-11.9

9.1
.9
8. 2
1. 4
I. 9

Private nonfarm sector:
Average hourly earnings_________________________
Hourly earnings index___________________________

Hourly compensation (all persons)____________________
Labor productivity___________________________________
Unitjlabor costs_____________________________________
Real .wages, average hourly earnings___________________
Real!spendable earnings'----------------------------

7. 7
I. 6
6. 0
•8
•3

8.9
3.0
5. 7
2.9
2.2

1 Average annual percentage change 1975 IV to 1977 IV.
' Seasonally adjusted at annual rates.
' Real spendable weekly earnings of a worker with 3 dependents.

Source: Bureau of Labor Statistics.

Representative BoLI,ING. Senator Javits, I understand you have a
time problem, so I will be glad to recognize you first.
Senator J AVITS. Thank you.
Mr. Bosworth, I came especially this morning because I wanted
very much to hear the administration's position in this matter.


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Do you expect your particular areas of activity to be changed, modified, or intensified; or do you look forward to carrying on, as you
have indioo.ted in your four-step administration program, pretty much
.
.
. .
.
as you have in the past? .
Mr. BoswoRTH. After 3 months of really mtens1ve act1v1ty with
respect to the inflation issue, I would not say that we are happy. I
would say the aid.ministration has been placing a great deal more stress
on the inflation issue since the President's speech in April.
We have provided the framework where we should constantly be
considering some additional measures consistent with it to firm it up.
We are well aware of the fact that we have problems, particularly wit,h
labor, where our original proJ?OSals did not go over well, and we will
have to consider some alternatives. And we are.
However, we don't anticipate any dramatic changes in the near
future.
Senator ,TAvrTs. Do you feel you have the authority to make whatever recommendations you believe should be made in order to cushion
inflation? For example, in your prepared statement, you say that fresh
vegetable prices have come down, and the large increases in meat prices
are behind us.
Now, the meat price problem is susceptible to the impact of imports.
Imports can be increased or decreased, by executive branch actionr
and have been.
In your opinion, do you have the power to make recommendations
to the President and to make public those recommendations-for example, that imports should be increased if you feel that large incresUses
in meat prices turn out not to be behind us?
Mr. BoswoRTH. Yes, although I would point out we did make that
recommendation 2 months ago and the President did increase the
amount of imports. The difficulty you face on the import side is that
the situation in the United States is largely duplicated in the world
market. There is a worldwide shortage of meat products, and the opportunity to expand meat products was limited to the actions that the
President took to import 200 million additional pounds for the rest
of the year.
There is not a lot of meat out there in the world market just waiting
to come into the United States.
In addition,, we know that meat prices were almost absurdly low a
year ago. At that price level, the American hoof producer was going
bankrupt. It was around $40 a hundredweight on the Omaha market.
1:Vhen it started to get up to $55, that was more reasonable.
However, when it started to get to the rate of $60 or $65, we got
concerned. I don't think we could take many more actions to moderate
meat price increases for the remainder of 'the year, but I think they
have stabilized, the speculative elements has largely gone.
Senator ,L<\VITS. What I had in mind is the fact that when we allow
imoorts, they have a moderating effect on meat prices; however, the
fact that we make it possible doesn't mean we will obtain the extra
meat economically.
The other question I wanted to ask vou is to what extent would
more effective consumer advice from the Department of Agriculture
help yon to stabilize prices? This has been a much debated question
for years, and I myself have discussed it. I have never been given


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a really satisfactory explanation as to why we don't have topflight
,consumer services. vVe leave it to consumer advisers hired by NBC and
CBS and so on to tell us that this morning's calf brains is a good buy.
If you are in business to moderate prices, why can't the U.S. GovA:irnment, as a matter of national policy, give the consumer the break
which would come from authoritative advice? The Government could
say; "We don't think you ought to buy beef today because all you are
.doing is hurting yourselves," or "We think you should buy now be.cause there is too much beef around."
Mr. BoswoRTH. I don't think too many people would want to take
the job of saying we shouldn't buy beef. I said that a couple of months
.a,go, and sometimes I regret I did. '11here are two sides to every story.
There are beef producers who think the price is way too low and
should be higher. But we have addressed the question more broadly
with advice to consumers about purchases, and Ms. Peterson of the
·white House is actively trying to put forth a program they are working on to develop a more effective food information program for
.consumers.
Senator .J.\VITS. Could you send me a memorandum about the ideas
you have discussed with Ms. Peterson? Often I find they die in the
bureaucracy before we find out they were aborning.
Mr. BoswonTn. Y <'S.
Senator ,JAvrTs. The last question I have for you is on the issue of
J)roductivity. I notice your discussion of tax incentives to stabilize
prices. I am interested, and I look at it very sympathetically and
,cardully. But isn't it a fact that we are "in the cellar" in productivity
.among the leading 10 industrial countries and the cost of domestically
·manufactured goods, therefore, is higher than it should be? This is
very inhibiting in terms of supply and stable prices, and even to meet
:foreign competition. In foreign competition, we are bested materially,
,especially by the Japanese, and not always on what ought to be strictly
~conomic grounds.
Chairman Bolling, with my strong urging, asked the committee to
investigate the American industrial plant, and we have found it is
beroming obsolescent.
,
Wouldn't it be within your jurisdiction to make recommendations
for and to urge a ma:jor productivity drive in this country~
Mr. BoswoRTH. Our productivitY. does put us in the ceUar. A 1percent slowdown may not seem hke mu~h of a decrease, but when
you think of it ·as a third of our annual growth, it certainly is alarming.
Senator J AvrTs. ,vhen you say "a third," do you mean over the
_yearst
Mr. Boswowrn. In the fifties and sixties, we were getting a :3-percent
grmvth. E,arlier t:his year, we were down to· 2 percent. Given the
events of the first half of this year; we are even more worried that
in the private nonfarm sector productivity may be as low as a percent
-and a half.
That would be less than half the rate we were getting a decade ago,
and it is causing serious concern.
The JEC published a study about a year and a half ago, and one
-0f the things they very dramatically pointed out is the complexity
o_f ~he issue and the difficulty of even trying to explain this producb v1ty slowdown.


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!'he Council on Wag:e and Price Stability publis~ed ~ report e~rlier
tlus year where we tried to look at the common md1cat10ns, hke a
shift in workers' age and sex, but they did not appear to hold up.
There has been a slowdown in capital formation, but it came after
1974, well after the productivity slowdown first began. So, while I
am sure it is a contributing factor, it is not a complete explanation.
As we look at productivity, one thing that increasingly worries us
is the Federal regulatory area, and the complexity of the regul,ations
that we are overlaying on top of the industrial system.
In a study by Mr. Ed Denison of the Brookings Institution, he fmtnd
that Federal regulations have a minor influence on productivity. The
delays in licensmg requests and the costs of some of these programs;
after all, if you want to improve the environment, you have the
outlays, and they don't show up as wage increases, and don't show
up in profit margins.
That is the cost, so to speak, with the benefits being the improvement of the environment. We think a lot of those costs are excessivelv
high.
•
But the administration proposed some rather substantial increases
for investment, increases in the investment tax credit, and a cut in the
corporate tax rate at the beginning of the year. I don't think we are
going to get the measures through Congress this year, unfortunately.
We have another productivity study going on now, where we are
looking at individual increases rather than the overall economy. I
don't know why productivity growth has been so slow in this country
in the last decade. I just don't have the explanation, and I don't think
the President or anybody else has a full accounting of it.
Senator JAVITS. Mr. Bosworth, my time is up. I think with all
you have given us--pleas, confessions, and avoidance-I cannot see
anything except that this administration has failed. I don't accuse
this one booause it is a Democratic administration. Rather, as was tri-1e
of others, this administration has failed to launch a national productivity drive and awaken our people in a vivid way-not by studies,
because they don't register-to the erosion of American strength and
ooonomic capability and to the resulting drop in productivity.
Although one opportunity for increased productivity results from
the necessary ,automation of American business, I rather suspect that
one of the biggest ,problems ·is the mora,Ie.of American workers. I
strongly commend to you-I am not finding fault with you-that
one of the greatest things you officials could do is to leap into this
field with both feet. The heart of the matter is here-not in what vou
are called upon to do-but rather in what you can do to affect price
levels.
Thank you, Mr. Chairman.
Representative BoLLING. Thank you, Senator.
Congressman Long.
Representative LoNG. Thank you, Mr. Chairman.
Mr. Bosworth, we are happy to have you with us today. If I understood you correctly, you feel that those of us in Government are
making some progress, at least with respect to our attitude toward
inflation. You seem to feel that we are at least beginning to understand the problemi and a,re beginning to take some steps to try to
reduce the effect of infl,ation, and that the same is not necessarily true
of the private sector.


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Is that correct ~
Mr. BoswoRTH. In terms of attitude, I guess we could say yes.
Representative LoNo. I wonder if perhaps one of the reasons for
that might be tlrat we can control and understand our own attitudes,
but that we thave little control over attitudes, because we have some
degree of control in the private sector, or P.ractically none.
At this time, though, we find Chairman Miller proclaiming inflation
to be public enemy No. 1, and we find you, and my friend Bob Strauss,
trumpeting the inflation alarm. The fact that you have seen some
results in the Government sector and not in the private sector may
perhaps mean that what you are doing is counterproductive, and that
it is causing, or hardening, the inflationary expectations on the part
of the private sector.
What is your reaction to this criticism?
Mr. BoswoRTH. I think that is a real possibility. It isn't the statements we have made that have upset the public about inflation. I think
it is what has actually happened.
The price increases this year are a very real phenomena. But, for
example, I'm often told that by highlighting the major union labor
contraJCts and pointing to them, you harden their attitudes and ma:ke
them dig in even more, so they are even more reluctant.
The only answer to that is to keep quite. But when we did so, the
contracts were very large. Now that we are talking about them,,the
contracts are very large.
I think the first step in this is to get people to recognize the severity
of the problem; it isn't going to go away overnight. The cost of doing
that may be in the early stages that in fact you lead people to
anticipate-Representative LoNG. In effect, a self-fulfilling prophecy?
Mr. BoswoRTH. Yes, and also in this area are people's concerns
about controls. In the last few months I think we have been successful
in calming them down; at least when I talk to businessmen and labor
leaders, they take us seriously when we say, no, we are not going
to go to controls, and you should not worry about that.
So any sort of speculative activities of that kind have, I think, been
largely calmed.
Representative LoNG. What do you think of Senator Javits' suggestion about a major productivity drive in the United States?
He had to leave and didn't give yon an opportunity to comment
on it, and I just wondered what your views on it were.
Mr. BoswoRTH. I think that productivity is a major part of the
inflation problem, and yes, we would like to have a drive for improved
productivity, but the problem is that we had better know what to tell
people to do. The problem is that we don't know why productivity has
slowed down.
If we asked people to improve productivity, they would say, "How?"
Representative LoNG. The Senator believes a substantial part of
the difficulty might be a morale problem in the United States, and that
to some degree could be corrected. Do yon feel the morale problem of
the American worker is a substantial part of the problem?
Mr. BoswoRTH. No. The people who use the measure of worker
morale try to see whether it has deteriorated. In some industries, workers have never liked their jobs, but productivity has gone up. If you


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say there is room to improve productivity in the area, of work rule
changes and the like, that does lie in people's discretion, hut the problem doesn't seem to be any worse than it was a decade ago.
In my view, there are things that could be done in that area, but
they are not the reason that the rate of growth of productivity has
slowed down so dramatically in the past decade.
·Representative I.JONG. What is your educated guess on that?
Mr. BoswoRTH. My educated guess is that it is government regulations. We have made it so much more difficult to create new plants
as opposed to modernizing or updating. One of the things I found
most striking is the sharp dropoff in. new greenfield sites in American
industry, the building of a brand new plant from scratch.
vVe have been looking at productivity in individual industries. We
have found, for example, that the opportunity to improve productivity
in the steel industry from a completely new plant is an order of
magniture greater than the opportunity to improve productivity in
a given plant. They get into the problems that under the new technology, the flow of the materials in the old plant is backward.
You can't lay out the assembly line in. the old plant in a more
efficient fashion. A lot of that goes to the tremendous difficulties of ever
getting approval, particularly within the environmental area, for a
new plant.
W:ith all the license requests that they have to get, it delays things
and mcreases the risk, you have to plan further ahead.
I think that is part of it. I think the second major factor has been
the fact that this economy has been on a roller coaster for the past
decade. Whenever we have a boom, everybody switches and worries
about inflation; and then we go into a recession., and everybody gets
upset about the unemployment rate.
With that type of up-and-down behavior of the economy, no businessman can make an intelligent decision about what future output
requirements will be.
A lot of the mistakes have been made because people have wrongly
anticipated the magnitude of demands made on their industry, and a
lot of resources have been misallocated because of the performance
of the overall economy.
That is compared to the 1960's, where we had a slow but sustained
increase in economic activity. Then, people could make much better
projections of what their investment needs were going to be.
The fundamental reason we are not getting more investments today
is that nobody believes the expansion will continue. They know inflation is accelerating, and the Federal Government is restricting, and
we are headed for a recession. So, they reason, "I don't need to build
a new plant now." I would say that factor and government regulations
lie behind it, not shifts in the age and sex composition of the labor
force.
Representative LONG. Some of these regulations have been moderated, some quite recently, as you well know. Do you ~hink they have
been moderated to any extent that is measurable, or will become measurable. as a counterirritant, so that the regulations will allow productivity to rise again?
Mr. BoswoRTH. I don't think they have to be moderated. The problem isn't that we have been asked to improve the environment too
much. The problem is the way we are going about doing it.


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The problem is caused by the bureaucratic system, the licensing
requirements, administrative procedures, and· noneconomic decisions
that we are forcing people to·make to get to goalswhi<!,h, when.looked
at in an economic perspective, are reasonable. The regulators need an
understanding of the economic impacts of what they &re doing.
In that area, in the last year there has been a change in attitude on
the part of the regulatory agencies. They are making much better
efforts than th~y were before.
I think the Congress could do more by writing into the laws specific:
requirements. sayin~ this is the intent of Congress. Some regulators
-say, "9ongress di~n t want us to look at the economic impact." I~ would
help 1f you put m the laws that they have to be cost-efi'ootlve. By
doing that you could streamline the whole process, speed it up, and,
uot have the negative effect on productivity.
Representative LoNG. I was thinking the same thing. I think as
regulators gain more experience with the problems that regulations
have helped to create they 'fill make some changes in recognizing
the economic i_mpact, and in many instances, the utter absurdity of
what their regulations reQuire.
Thank you, Mr. Chairman.
Representative BoLLING. Senator McGovern.
Senator McGOVERN: Mr. Bosworth-, it is said frequently, and I gather
this has also been said by you, that one of the major factors in the inflation problem is farm prices.
.
I am at a loss to understand that, because when we talk with farm
people and go over their prices as well as their costs, they make a pretty
compelling case that prices are too low.
You know the city was filled with farmers here earlier this year
who convinced.a good many Members of Congress that farm prices were
too low, as over against the cost of production.
What evidence is there thatfarm prices are out of1ine?
Mr. BoswoRTH. First of all, if you ask me what has contributed to
inflation, my answer doesn't have a value judgment about whether the
price increase was justified or unjustified. Look at the rate of inflation,
and see what prices are going up rapidly. Food prices have been a problem, because they are rising at over twice the rate of every other price.
Now, the question is, whether that is necessary or desirable for other
reasons.
Senator McGOVERN. What is causing the increase in food prices?
Mr. BoswoRTH. The factors I went over at the beginning of my testimony were concerned with the large increase in meat prices. Then I
pointed out the current inflation in food prices has been heavily driven
by this increase in meat prices.
If you look at the wholesale level, livestock prices were about $40 a
hundredweight last year.
They were abnormally low, and they had to come back up, if the
herds were going, to be maintained and rebuilt over the next few years.
That is still inflation. When the prices went up from $40 per hundredweight to $55 or $60 a hundredweight, they were rising a dollar
every couple of da.ys, and that is wlien we took action;
They have now stabilized in the area of $55 a hundredweight, which
seem.<¾ to he reasonable; .
Senator MoGbVEru.. Would it be accurate,to say, in order to get at
the heart of the problem, that a year ago farm prices were too low, inl,,;1
duding cattle prices.
87-250--79-5


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Mr. BoswoRTH. From an economic point of view, yes.
Senator McGOVERN. In order for a producer to at least regain 4is
cost of production, his prices had to go up.
.
Mr. BoswoRTH. Even when the new farm bill went into effect, grain
prices were allowed to rise, so, from an economic perspective, some of
those rises are in line with costs.
Senator McGOVERN. So the remedy for those who are concerned about
controlling inflation, and I assume that includes all of us, does not
point in the direction of a deliberate effort to lower farm prices?
Mr. BoswoRTH. I think the focus on farm prices should not be that
they are too high or too low, but that they are erratic. From the first
hal£ of the year, they exploded up at a 50-percent annual rate of inflation. '\V'e should be trying to provide some continuity and stability.
I think that the new farm bill passed last fall by Congress was a
minor step in that direction, because the fundamental pinning of food
price inflation is grain prices.
What the Congress has moved to do is to establish a stabilization
reserve to make sure prices don't go exploding upward too rapidly.
Then you set a minimum price based on the cost of production, just
variable costs, and that is reasonable.
So prices are free to fluctuate within that band, but they can't drop
below it, and they can't go above it. That seems to me a reasonable,
approach.
Now, if we had stabilized like this in 1973 and 1974, we wouldn't
have the meat ~hortage_Problem toda)'.'. It may strike you as a long way
back to go, but 1t really 1s the explanat10n for why meat prices are going
up so much today.
The sharp rises in me!l-t prices in 1973-74 touched off a consumer boycott. They stopped buymg. The market broke, and the meat producers
panicked and started over a 3-year period to unload their herds. They
finally ran the herd down, and then they moved to rebuild the herds.
Thus less meat will come to market and the prices will have to rise
again.
I think the answer to that is not to say that we want them either low
or high, but we want a level, and government policy should focus on
making sure they don't fluctuate too much in the short run.
Senator McGOVERN. I agree basically with what you are saying. I
certainly recognize the fact that the cattle cycle runs for several years
at a time.
.
It does seem to me, though, that there are times when the administration's actions ignore that.
For example, the recent decision to open up beef import quotas: To
people engaging in the production of livestock, who are trying to recover, now, over the next 2 or 3 or 4 years from the unsatisfactory
prices they have received for the last 2 or :3 years, they see a move likethat as a punishment to their efforts to rebuild their herds.
How could they interpret it differently?
Mr. BoswoRTH. I have found beef producers' attitudes towards meat
imports are irrational. Meat imports in this country are 7 percent of
beef production, and a couple of percent of overall meat consumption.
'\V'hat the administration did was raise the level slightly.
There is no way that could have a dramatic real impact on prices.
Senator McGOVERN. Doesn't it have an important psychological
effect 1


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Mr. BoswoRTH. It signaled a change in policy that broke the
speculative boom. The prices gradually went irom $40 a hundred~
weight to $55. That is not an unreasonable price.
Then they started to move very dramatically up into the midsixties
range for no apparent reason. It looked like more pure speculation in
the market.
.
I£ this had continued and had been passed through to the retail level,
I think the farmers should have worried about consumer boycotts and
rebellion against those prices and a repeat of what happened in 1973
and 1974.
·
What the administration did was take an action which in the long
run can hardly do anything to prices. It broke speculation on prices;
they fell sharply, then they recovered, and they are now in the range of
$55 a hundredweight, and are stable.
·
It seems to· m·e that we stopped the speculative boom that would
have done nobody any good. Now the market is trying to operate, and
200 million pounds of imports is not going to hurt the American
farmer. It isn't even the right type of meat. It is hamburger and lean
meat that goes into McDonald-type hamburgers, not the type of meat
produced by the American farmer.
I think he worries about something that has almost nothing to do
with what his own returns are going to be and-Senator McGOVERN. I disagree with you on being the wrong kind of
meat. We probably should be eating more of this lean, grass-fed beef.
[Laughter.]
Mr. BoswoRTH. I expected somebody from the Dakotas to say that.
Senator McGOVERN. No; that isn't my concern. Our producers produced the corn-fed fat beef that we call "choice beef." I would prefer,
for health reasons, that we produce and consume leaner meat. I recognize, Mr. Bosworth, what you say is true. A couple of hundred pounds
of beef in itself is not going to break the American market.
It is questionable whether we are going to get those imports anyway; but it certainly has a psychological impact on the market ·just at
the time when producers appeared to be recovering from the long,
painful losses that they had suffered in recent years.
·
That is the only point ram making.
Mr: BoswoRTH. The price did come back up again.
Senator McGOVERN. I'm sorry, I missed your response.
Mr. BoswoRTH. The price did come baick up. The low prices lasted
about 2 weeks, when it overshot. It is back up.
The farmers were upset about 10 or 14 days after the aiction, but
then the prices recovered, and came to that reasonable range again.
Senator McGOVERN. I certainly agree with the point you.make about
the grain prices being crucial to what happens to meat prices. I do
hope we can be more successful, both in establishing reserve policies
that will stabilize grain prices and in holding the prices at a more
equitable level. It just makes no sense at all for the United States,
Canada, Australia, and Argentina-four countries that are producing
85 percent of all the grain that moves in international markets-to
scl,l,grain below-tµe cost of production, because they don't coope:rate
in terms of the reasonable price.
They are undercutting each other.


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I'd like to pursue another matter, Mr. Bosworth. If you have gone
into this, don't repeat the answer, but I have been very much interested
in Mr. Okun's argument-Arthur Okun's proposal-to use the .tax
structure as a means of tamping down inflation, provide Jtax conces~
sions to industries and to workers who agree to hold the line on wage
and price increases.
Have you discussed that matter this morning 1
Mr. BoswoRTH. No, we have not. I think it is fair to say that I a.m
very interested in it as well, and so are several other people in the
-administration. We have spent quite a. bit of time in the past year
looking fairly intensively at different forms of tax incentive type
programs.
,ve have now narrowed it down to two basic problems with two
different types of programs we have evaluated.
First are the administrative problems; and, quite frankly, we ha.ve
not solved them. Even though the idea is an interesting one, there ar0
still enough of the administrative difficulties so that we can't yet come
up here and say, "Here is a plan you might look at, and it is a,ll
worked out."
However, we have solved quite a few of these administrative problems. Over the next few months, I hope we can work on answers to
the rest of the problems. Then we could say, "If somebody wanted to
do this, tihis is what a plan would look like in detail."
The other problem is whether or not it will have any impact. There
are some questions about whether or not there would be much impact
from taxes, but I do think the basic idea is a good one.
I£ you are sa:ving that there has be~n a reduction in the degroo of
competition in the economy today to the extent that the fear of losing
one's job doesn't hold down on wage incre&ses and the fear of loss of
sales doesn't hold down prices, and you have a conrentrated labor and
producer market, then the idea of putting in some other play like
throwing- people out of work and trying to make the risk of unemployment higher is not a good one. Let's, instead, put in some other incentive that makes it more in a person's interest to hold back on wa.ge
increases.
It sounds like a good idea. The problem is, if you look at it and
work out an economically rational plan, it isn't much of an incentive.
Suppose we put $10 billion out there. A $10 billion tax cut. On wages,
the effoot of the relative impact would be about a half of a percentage
point.
The worker faces a trade-off, to take the wage increase and reduce
it by half a percent every year into the future. So if he takes a cut
in the magnitude of his wage increase, you are going to lower his income every year all the way up.
The present discounted value of that income swing, even with a high
discount rate, is probably seven or eight times, if there is no wage cut,
and he compares that to a little tax cut in the first ye&r, which he
doesn't get thereafter. It is not a verv powerful incentive to induce
somebody to ¢ve up t!he sure tJhing of a wage increase that they a.re
going to be a,ble to koop forever. And you are coming bftek and saying,
"You have a tax return for 1 year."
8mator McGOVERN. He gets the prospect of lower priees.
Mr. BoswoRTH. That is true, but the individual says, "If I do it on
my own, nothing will happen to prices."


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If everybody says, "I would be willing to hold down on my wage
inereases jf pr1oos would come down. However, even if I do it, nobodi!
else will do it, and prices won't come down," this program still wouldn t
increase his expectations that others will do the same thing.
The problem is that individuals on wages are completely independent of what is going to happen to prices.
Senator McGoVERN. The problem is that voluntary restraints don't
work very well.
Mr. BoswoRTH. That is the problem we have today. We talk to individuals and say, "Why don't you hold back on your wage increases f'
And they say, "Nobody else is going to do it."
Other proposals have the same problem. We are at the stage where
we haven't quite made up our minds. All I am trying to point out is
that there are some pros and cons to these things, and they don't look
to me like they are a magical solution that will eliminate inflation
problems. However, they still may have a high enough value to be
worth trying.
·
We are trying to put out specific versions. We have fully discussed
the incentive effects, and the budget loss.
Representative BOLLING. You said earlier, Mr. Bosworth, that you
had been successful or relatively successful in convincing people that
we are not going to go to wage and price controls, and I think it is
important for the sake of the record that you discuss that a little bit
more; why, overall, wage and price controls, which I oppose for my
own reasons, which stem not from anything .Political but the experience
of having to deal with the legislation durmg the Korean war when
nobody else seemed to be interested in touching it with a 10-foot pole,
and not feeling we had a very good experience with it even in th:tt
situation.
What are your reasons for feeling that we should not have on the
shelf, let us say, a standby wage and pricelaw1
Mr. BoswoRTH. Let me just take the issue of the controls themselves
without going to standby.
Representative BoLLING. All right.
Mr. BoswoRTH. First, I think there is a major <;l.ifference now, compared to 1971. In 1971 you had a lot more support from the people
you were going to control, and, if you are going to have opposition to
controls from the very group of people you are going to try to control, they are going to fight it every step of the way. So you are going
to have even more difficulties than we had that time; and at that time
the outcome was not very promising.
Second, I would diagnose the fundamental inflation problem as one
of changes in modern industrial economies, and the basic industrial
structure of them, which is a permanent, longrun problem.
Inflation is not something that has been with us for a few years, that
we solved once and can make it go away again. Controls can be used
for a short period of time, and then people find a way to get around
them. Then Governmelllt bureaucrats make mistakes.
It is awfully damned hard to figure out what the right wage or price
should be, and we do begin over time to distort the structure, and we
get involved in shortages and black markets and things like that. So
you run into a lot of difficulties.
Third, as I mentioned earlier, the tax incentive program has some
administrative problems, but controls have even more administrative

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problems. Just trying to measure price increases is not an easy thing.
They change the quality of the product, and they introduce new prodllcts, and how do you link them?
So there are an amazing number of administrative difficulties in
trying to keep track of what people are doing that we don't believe we
can solve. I don't think we could find a way, in effect, to really administer price controls.
Wage controls raises lots of political problems. If people thought
Washington, D.C., was going to determine wages, then the whole game
would shift here. It would be a negotiation between labor groups and
the Federal Government, and I don't think that is a good trend.
Representative BOLLING. In effect, the last thing that you didn't say,
but implied it, is that you really corrupt the society if you propose to
have controls over a long period of time.
The incentive is to find a way around the controls, and when that is
compounded by the economic distortion and inevitable failure of administration-not overall failure, but partial failure of administration-you tend to force the society to corrupt itself.
I think that probably almost surely happened in World War II, but
nobody has made that study, and I don't know that the material would
be available now if you wanted to.
Mr. BoswoRTH. We know that black markets became quite a problem
in w·orld War II. We know they are quite a problem in other countries
that do have price controls. You simply substitute standing in a longer
line for a higher price.
Representative BoLLING. Then a similar problem, the program we
have been trying to get through the Congress on energy is obviously
very inflationary. The argument is made by some who oppose that
program that we ought to have rationing. I will leave out the standby.
1V-hat is the relationship between rationing as an instrument of price
control?
Mr. BoswoRTH. It is a system o:f price controls, using something other
than the price mechanism to try to allocate resources. I think, if we had
another oil embargo, we could make a case for rationing. In a very
short period of time of an embargo, you don't like to use prices alone
to determine who is going to get a scarce commodity. But over a long
period of time you have to worry about allocating.
Representative BOLLING. The same set of problems.
Mr. BoswoRTH. Yes, you'd have the same set of problems as in price
control.
Representative BOLLING. You discussed the impact of regulation and
the administration of regulations on the economy. I suppose it is really
too late to make it worthwhile to raise the question. But, has a thorough
look been taken at the different approaches that are always possible
in dealing with similar situations, the environmental situation over11JH You can approach it by regulation, or you can approach it by
incentives or disincentives.
Has any serious work been done on that, a comparison of the approaches?
Mr. BoswoRTH. There are some academic studies, particularly in the
pollution abatement area, which put forth specific proposals about how
incentive programs, for example, a tax program. would actually work.
It is not feasible in all cases. If you pursue either approach to the
extreme, you can get situations in which neither will work. But I think

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we should place much greater reliance on incentives. We have current
ones. One that we are debating right now is air rights, and it's a big
mess.
In areas where they do not moot the standards, you have to sell off
the rights. How do you do that?
It is like owning land. If you have the right to build a plant in an
area, the pollution right is the same thing as owning land. The policy
has been to give it away to first come, first served; 20 years from now,
it is something like $50 billion in rights.
Representative BOLLING. $50 billion?
Mr. BoswoRTH. Yes. Now, you are going to hand those out by administrative needs i I think that route is fraught with corruption and
the otential :for scandal. Who is going to get it first?
I in a city you want to come to you can a:ff ord to build only one
plant, what plant is going to be built i
We know of a situation where somebody wants to build a steel plant.
In order to do that, you need a public utility to supply more energy.
You can't build both. Right now the public utility has the air rights,
but if you don't build the steel plant, you don't get the public utility.
But if the steel company got the air rights, they wouldn't have power
to run their plant. Are you going to let EPA hand them out to
whomever-Representative BoLLING. After we find a saint to administer it.
Mr. BoswoRTH. Yes; and since you won't find a saint to administer
it, I worry about the potential implications of such systems.
Why don't we set up a market i You could sell off these air rights.
You could take them to the highest bidder, the industry that needs it
the most. You can have local authorities, if you like, planning the direction they want to go, but you can't hand these things out willy-nilly,
first come, first served.
They are going to have an enormous impact on regional distribution
of industrial production in this country.
Representative Bolling. Thank you.
One of the things that worried me aibout deceleration in the beginning was that it seemed too simple.
Mr. BoswoRTH. It hasn't been simJ?le.
Representative BoLLING. I know 1t hasn't been simple in terms of
your relationship to it, but isn't it as you implied~and I don't have
any desire to put words in your mouth-but I think you implied in
some of the discussion, isn't it so simple that it has, in effect, left the
question where it is almost inevitable that the people who get the
highest wage increases continue to get them. The people who have the
most market power over prices continue to have whatever you want
to call it, the most market power. Is there some modification or variation that would be betted
Mr. BoswoRTH. Well, to tell you how we arrive at it, what we were
originally after was some way to have an objective on the price side.
If you go back to the 1960 guideposts, for example, they were just a
standard for wages. On the price side they didn't say anything. Business passed through cost increases. A concept of cost passthrough, we
think, is very inflationary. The businessman can raise his prices with
no incentive to hold down on costs, and particularly no incentive to
improve productivity.

f


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So what we were after was a standard of price behavior independent of that. We. obviously couldn't go through industry by industry
and just pull a standard out of a hat, because every industry has different rates of •productivity increases and different rates of cost increases~
What we did instead was to go back to the last 2 years of stable economic recovery, 1976 and 1977, where you could see the dependence on
energy price increases and on labor oosts, et cetera. So the way to arrive at a reasonably sound price increase for individual industries was
to use the average of the last 2 years as a starting point.
We could have used a longer time, but we didn't want to take 197!>
because that was a recession year, and we didn't wantto go back before,
the oil embargo because it didn't reflect the differences between industries and the importance of fuel supply.
So we said that the price increases in 1978 relative to the averages,
of the past 2 years was not an unreasonable industry-by-industry
standard.
The problem comes up, as you point out, on the labor side. Deceleration makes no sense, applied on a wage-by-wage basis, because it says
the guys who have been getting 10 percent wage increases get 9.5 or 9
percent, and people who have been getting 2 percent get 1 or 1.5
percent.
We modified that. We said, "No; what we seek on the wage side is.
that realistically there must be much greater deceleration by those
people who have been getting wage increases above the average."
So, in recent months we haven't really done or said anything about
people :whose wage increases have been below the average.
We have been seeking to bring the people with large wage increases.
back in line with what everybody else is getting. Tha.t means the major union round of negotiations. It means the mdustries in the large
mdustrial core of the economy which are highly concentrated with
not much competition. In many cases they have trade restrictions to,
make sure that they don't have to face up to foreign competition, and
the regulated sector of the economy has the ICC and that type of
regulation.
We focused on tho.se wage increases, to bring them back in line with
the average. Somehow or other we have to bring these disparate wage
increases back in line. We cannot continue the trend of the last half
decade, which is the enormous disparity in terms of increases in wages.
Some groups are getting 10 percent more a year, and others almost
nothing. It will give you a dual economy.
Representative BoLLING. Don't we already have a dual economy?
Mr. BoswoRTH. I think to some extent 1t has gotten to the point:
where the relative wage differentialsRepresentative BoLLING. We also have an economy beneath the regular economy which must be related to the people we lose in the census
and ·the number of people working off book. I don't know anything·
about it.
Mr. BoswoRTH. That is a different thing. The distinction you can
make today is between income gains in the so-called noncompetitive·
industrial area compared to the wage gains in the more competitive·
sectors. Look, for example, at a steelworker compared to an apparel'
worker. The steelworker has had 10 percent a year, and the apparel'
workers are down around 3 or 4 percent a year.


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Representative BOLLING. You picked an interesting industry,. be.cause, if that is an industry tha~ is not competitive abroad-Mr. BoswoRTH. Which one~
Representative BOLLING. Steel.
Mr. BoswoRTH. But it is protected from competition.
Representative BOLLING. But you get all these skews and they are
multiplied by other skews, and the mability to com~te with other
-countries' steel production. It is not only unreal, it is unsane."
I am ~rtainly not blaming it on you. I have been around a lot longer
than you have, and I am probably more at fault than you are. But I
want to pursue two aspects of this. Since 1971, there has been a doubling in the automatic effect, because I understand that 60 percent of
workers covered by major labor contracts have an automatic cost-ofliving clause today, where in 1971 there were only 28 percent.
I don't know how those figures come out in bodies, in numbers, but
they must be relatively close to double.
Now, that situation has gotten substantially worse, and this merely
substantiates the point that you have been making, but how do we
deal with it i
Mr. BoswoRTH. Well, first of all, on the cost-of-living contracts, I
think you can argue that two ways. One is that you can't expect workers to sign 3-year contracts today for small wage increases just because
somebody tells them, "1Vell, the Government is going to lower the
rate of inflation."
I have heard that line before, and the Government hasn't done it
'before. There are two conditions workers need : One is to get protection from inflation. If they don't, they will just assume that the rate
of inflation will not come down, and they will negotiate a 10-percent
fixed wage increase. That is what is happening in the cement industry,
the petroleum industry, and the paper industry.
At least the cost-of-living escalator gives rise to the possibility that,
if inflation moderates, so will the wage increases. But the problem we
face is that the extent of this coverage is very uneven. Some workers
have it, and some don't, and by pure accident in 1973-74, when nobody anticipated those fuel price increases, those workers who had
cost-of-living escalators saw their wage increases carried up into the
double-digit level, while other people were held down to the historical
rate of wage increases they had been receiving.
That opened up a big difference between wage increases that continues today.
So, I feel two ways about cost-of-living escalators. To some extent
they can be helpful because, if you are moderating prices, wages will
.come down in steps. On the other hand, i£ inflation accelerates, they
add to the problems, because they force the wages up as prices go up
and keep the spiral going.
I think the more important problem is that some have them and
some do not. Under that situation we are developing a spread in the
wage structure that others are trying to catch upto.
Representative BOLLING. One more question for me.
,vhat about the case of setting specific guides such as those of President Kennedy. which is applicable to today's conditions 1
Mr. BoswoRTH. I think there are elements 0£ the 1960 guideposts that
-are applicable today. If you take the 2-per.cent growth, and some


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adjustment for the cost o:f living, it might work. I:f we want to get the
rate of inflation down, however, you can't· get 100 percent compensation :for the cost of living, because that keeps everything going up.
But some o:f the very best escalators in labor contracts call for about
80 percent of compensation. Under that, you can derive a general wage
standard that takes account of productivity growth, makes an allowance for inflation, but says we want to get it down so we won't go the
full amount of the past rate of inflation. You could put out a guidebook.
The difficulty we have is that there could be no exception to that
standard if we put it out. Think of the conflict you are going to run
into in the major unions. They are getting 10 percent and we would
be putting out a number that, if we did it, would be close to the average
rate of wage increases, somewhere around 7 or 8 percent. So this protected group opposes such an idea.
Representative BOLLING. Thank you very much.
Senator McGovern.
Senator McGOVERN. One further question on wage.and price controls.
Mr. Gordon Ganule said the other day that every public survey he
has seen in recent years shows the clear majority of the American
people favor wage and price controls.
That, of course, puts the majority of the public in opposition to
what I gather the strong majority of the professional economists, and
most of us in politics think, but I have thought more and more in the
last year or so that everything else we have talked about in terms o:f
controlling inflation turns out not to work very well.
With all due respect to the points that have been made about the
shortcomings of the 1971-72 period when we were under wage and
price controls, and some of the corruption that developed in the Korean
war and during vVorld War II, it seems to me a pretty good case can
be made that they weren't failures entirely, that, on balance, they
accomplished more in protecting the American consumer and stabilizing the American economy than anything else that was proposed as
an alternative.
·what is your reaction to the recommendations of Mr. Galbraith and
others, and studies made for this committee by economists, indicating
that you might have greater success with wage and price controls i:f
they were confined to the so-called monopoly industries, the larger,
more concentrated industries?
It strikes me that that kind o:f system might have some merit.
Mr. BoswoRTH. w·en, I think part of it is that people always favor
controls in the abstract, but before you put them in, they assume they
are going to apply to somebody else. The support :falls off quite rapidly when controls are in.
I do tend to agree that controls were not a complete :failure in 1971
or 1972. The circumstances changed so dramatically. They were put in
in an economy with excess capacity and administered price inflation.
Then you had a commodity food shortage that drove up prices. So
they were outrun by events.
I guess I can understand the :frustration and, quite :frankly, I have
never heard an economist who ever convinced me that he had a solution to the inflation problem. I think it does lie with the institutional
structure o:f a modern industrial economy.

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We are not that competitive anymore, but we obviously can't go
back being a competitive society of small farmers either.
The difficulties I have with controls is that I believe inflation is a.
long-term problem, and I don't see how the controls can be applied
any longer than a short period of time before you find out that the
bureaucracy of the Federal Government would do just as bad a job
as the bureaucracy of big business and big unions.
Senator McGOVERN. The motives are certainly different.
Mr. BoswoRTH. I think everybody has good motives.
Senator McGOVERN. I am not sure they do. I think you have a situation today where you have great concentrations of economic power in
corporate board rooms where the fundamental objective is to maximize
profits. That is not necessarily an evil impulse, but it certainly ought
to be different than' the impulse of the public servant whose purpose
ought to be to protect the public, and not to maximize profit.
Can't we find people who are fair enough in terms of recognizing
that industry and)abor are entitled to a fair run, but also the public is
entitled to something?
vVhy is it so difficult to find people to administer a program of wage
and price controls equitably ?
Mr. BoswoRTH. Partly, I think, because fairness is in the eye of the
beholder.
If we had a universal definition of :fairness, that would be all right,
but we don't. If you set prices too low, there would be no expansion
and you'd have shortages. What would you do then?
Senator McGOVERN. We could make adjustments. If you have a
board that is setting wage and price controls, presumably changes
could be made. There are changes made by the industry price setters,
too. Maybe they lose their jobs if they make too many mistakes. The
same thing could happen to people in the Government.
Representative BOLLING. Would the Senator yield?
My own experience has been that very fine people do what everybody does. They get a vested interest in their own thing, and very fine
people in the Government do the same thing that people in industry
and labor do. They get so committed to their own mistakes that they
are in concrete, and the dilemma is, and I think perhaps this point is
proved by those who still tend to :favor wage and price controls.
Most of them in the economic field are people who worked with that
at one time or other, and I think they naturally :feel that they did a good
job, and there is nothing wrong with that. Even Mr. Nixon was
involved in that.
Senator McGovERN. I always thought that was one of the more sensible things he did. [Laughter.]
Representative BOLLING. Relatively speaking.
Senator McGOVERN. That is correct. [Laughter.] I don't see the evidence that it was a :failure. I think there may have been some :failure
in the-Mr. BoswoRTH. But even when the controls were put on in 1971 and
1972, people said, "These are temporary, and we are going to ·work to
structural changes so that in the :future we don't have inflation problems." And theii when they w~re asked, "vVhat structural changes?"_;;
they came up empty-handed.
Certainly, if those controls had contimied a couple more years in~
relatively smooth world, they would have run into some distortion

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problems. In retrospect, we can look at industries today where we have
problems, and we see their problems started in that period of controls.
The aluminum industry was one. Today we have a capacity shortage.
You can't correct that easily. You must remember that the decision to
build a new plant takes 10 years from the time they decide to do it until
the time that the plant is operating. It is not that easy to correct the
mistakes. We can't make a mistake and correct it today and tomorrow
the costs are gone.
Instead, you set off very long-term trends. You held down food
prices, as you were pointing out, in 1973, and it turned out to be very
costly.
Representative BOLLING. 1Ve are about to run out of time in any
event.
I want to express my gratitude to you, Mr. Bosworth. I have enjoyed
this session as I have enjoyed few dealing with this subject.
1Vith that, we will recessJhe hearing of the committee, to reconvene
in a minute or two.
[ A brief recess was taken.]
Representative BOLLING. The committee will be in order.
Our Joint Economic Committee hearing on the subject of inflation
continues with a very distinguished panel of experts, Mr. Robert Gordon and Mr. Joseph Pechman have provided excellent counsel and
guidance for the committee in the past, and Mr. Seidman's innovative
ideas on inflation control will, I am sure, cause us to seek his assistance
again in the future.
The ,Toint Economic Committee wants to stop inflation, but wants
to do this without slowing the growth in production and employment.
W'hat we want from you quite simply is the magic formula for accomplishing this miracle.
Specifically, we would value your counsel on the following issue.
Can we control inflation without excessive monetary and fiscal
restraints? Is the President's deceleration program adequate and is it
workable, and will a tax-based incomes policy succeed in slowing
inflation, and can such a program be designed in such a way that makes
it politi~ally feasible and acceptable?
If we can't stop inflation, which is the impression I have been getting
from recent hearings, should we try to make it less painful and destructive on indexing?
Before I go on, I will say that I will have to leave somewhat early.
If Congressman Long is here, he will preside. I also have Mr. Dernburg of the staff to take the Chair.
I will now ask you to begin your testimony. Let us proceed in alphabetical oraer. Mr. Gordon, will you please be.gin.

STATEMENT OF ROBERT J'. GORDON, PROFESSOR OF ECONOMICS,
NORTHWESTERN UNIVERSITY, AND RESEARCH ASSOCIATE,
NATI0NAL BUREAU OF ECONOMIC RESEARCH
Mr. GoRDON. Thank you.
It is a pleasure to 1:ie here. My approach takes a general view of
what is wrong; and what the problem is.
The acceleration of inflation during the last half of 1978 has made a
mockery not just of the administration's own forecasts, but all the private forecasters who make their living from making predictions.

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I looked at a forecast made only 3 months ago which said that the
·CPI would grow at 6 percent in the second quarter, in contrast to the
9 percent which in fact occurred. It is a situation reminiscent of 1973
in that much of the problem is an unexpected rise in food prices. If you
break down the CPI at an annual rate between November and May,
an 8.9 percent total rate of inflation would have been 7.5 percent if food
prices had grown at the average of all the commodities. But that 7.5
inflation of nonfood items still represents an acceleration of a full
percentage point versus the year prior to last November.
So you see we have had an acceleration which is not due just to food
problems.
Now, the inflationary surprise in 1978 highlights two unfavorable
structural changes that have taken place in the economy in the last 5
years, one of which is well known and one of which has received little
comment.
The first, which has received little comment, and· which is little
understood, is the longrun price deterioration in the price perform•
ance of the food industry. Between 1947 and 1971 food prices went up
at a rate one-fourth slower than nonfood prices, but since 1971 up
through May 1978 food prices have gone up 50 percent faster than
nonfood prices.
Now, the second structural change is much better known, and ~Ir.
Bosworth referred to it this morning, and that is that long-term productivity growth has slowed far more than anyone would have imagined 2 years ago.
From 1972 to 1978 productivity grew fully a full perc0ntage point
slower than it had in the previous 15 years. The implications of this
are dire and serious. First of all, it means a given rate of wage rate
translates into faster price increases. It means the economy is growing
slower, and Federal revenues will grow more slowly.
Finally, it explains a reversal, which is quite surprising to me. Since
last summer I thought, looking at the future over the next 2 years,
we were likely to run into a shortage of plant capacity before ,rn ran
into a shortage of skilled workers. In fact, production has grown
slowly over the last year and employment has grown by leaps and
bounds. As a result we are closer to a shortage of skilled workers and
there has been virtually no change in capacity utilization.
In normal business cycle recoveries industrial production grows
about three times as fast as employment. In this past year, industrial
production has crept ahead of employment by only a hair. This is a
sign of the peculiar nature of this recovery, and also a sign of the
slowdown in productivity growth to which I referred earlier.
Now, why is the United States stuck with such an inflation problem
which not only fails to improve on schedule, but grows worse? I will
refer in passing to the fact that Germany and Japan, since 1975, seem
to have been able to solve a problem which we have failed to solve,
and I think one way to focus our question on future policy is to ask:
What are their secrets?
One standard answer is to start ont and say that everything is due
to overexpansive aggregate demand policy. That is. Federal deficits
have been too high and monetary growth has been too rapid. This is
too easy an answer to the puzzle.
·
If low unemployment in the late 1960's and again in 1973 are respon•
sible foc gettiE.g us into this mess, and responsible for the acceleration

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of inflation, then why did high unemployment for 1975 and 1977 not
slow inflation down.? In fact, we had 31 straight months when unemployment was above 7 .percent, and yet there was no permanent deceleration of inflation during that period.
Well, my answer is that prices are determined by two blades of
scissors, not just demand, but also supply. The demand forces determine the growth in total spending, total dollar GNP. Supply forces
determine how that is divided between inflation and changes in real
output.
When we look back over the last 5 years, we have had exactly a 10percent annual growth in total spending; that is, total dollar GNP
,has grown at a 10-percent rate per year for 5 years on average.
How has that been divided up between real output growth and inflation? All we have achieved is 2.4 percent real output growth. The
remainder has gone in higher prices. So the great dilemma of antiinflation policy is not only that the average division between output
:and prices has been so unfavorable, but the short-run impact of slowing down spending tends to fall heavily on output with very little response in prices.
If we had a different supply system in which a 100-percent slowdown
in spending went into prices, then a cure for inflation would be a
breeze. It could be handled entirely by the Federal Reserve.
The supply process in the United States is crucial, not only in designing an inflationary :policy, but in understanding disagreements
among economists. Inflat10n would be purely a demand problem, and
monetarists would be right, if 100 percent of any slowdown in expenditure went into a slowdown in prices, but monetarists would not be
right if zero percent went into a slowdown in prices and all went into a
slowdown of real output and employment.
Now, supply forces; that is, all the things that determine how much
businessmen charge to produce a given amount of output, and how
much workers insist on to go to work instead of striking, those supply
forces give us a partial answer to the puzzle I pose. That is, why did
inflation accelerate, but then refuse to slow down?
We have had a continuous increase in the cost of production due to
things other than just excessive aggregate demand. These were relatively minor before 1972, and have become very important since then.
So let's enumerate the sources of what I call supply shifts or supply
shocks in order to understand what has happened and try to see how
we might counteract them, or design favorable supply shifts instead
of having to put up with negative supply shifts.
I have four categories, the first of which is taxes. Increases in tax
rates raise the wedge between the price the consumer pays at the supermarket and the amount of money that is left over out of total purchases for workers to take home after all taxes and deductions have
been paid; this includes the sales tax, excise and customs duties, payroll taxes, corporate income taxes, and personal income taxes.
Now, these things•don't all have the same effect on prices. Empirical research indicates that sales taxes which directly affect prices,
as well as customs duties and payroll taxes, have a bigger effect on the
price level than the corporate income tax or the personal income tax.
We have had major increases in payroll taxes, as we all know, in the
last decade, which are a major culprit in continuing to push up the rate
of inflation, both when we had excessive demand and when we had in
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sufficient demand.. The most important tax of all was the OPEC price
increase which had exactly the same effect. It takes out money which
the consumer pays, but is not available to the worker to take home in
terms of aftertax income.
The second category is price-raising legislation. Here I noted some
omissions in Mr. Bosworth's catechism-all the things the present administration has done to raise prices. We have a large number of
candidates for criticism in this category, ranging from farm price sup~
ports, environmental legislation, the OSHA situation, and if we have
an energy: plan which terminates price controls on oil, that would be
price-raising legislation, although as I will point out later such
legislation has beneficial side effects that make it desirable in any
case.
Mr. Edward Denison, Mr. Pechman's colleague at Brookings, has
quantified part of this type of legislation. He claims that environmental, occupational, and health legislation, plus the rise in crime in
the United States, taken together by 1975, will reduce our long-term
productivity growth rate by a full ha1£ a percentage point. In other
words, half the mystery which you posed as a question to Mr. Bosworth
earlier is in the area of Government regulations.
Now, of course, this also means that if we have a continuous increase in wages, firms are going to have to raise prices faster than
without that legislation, because their workers are increasing their
output at a slower rate.
Something else is obvious also, and that is that if workers continue
to demand higher wage increases, in a way they are casting their vote,
saying that environmental and safety legislation is not giving them a
payoff that is worth the cost to the employer.
Someone should ask Gallup and Harris to run a poll to find out how
much people are willing to pay on their automobiles, on their steel,
on everything that they buy in order to have the high level of environmental quality which we are enjoying now compared to a decade ago.
Next we have, as the third category, the consequences of the depreciating dollar. This doesn't just raise the price of imported goods, but
contributes to rises in farm prices, because farm products are exported,
and Germans can buy more American products when the dollar appreciates and that raises the demand for farm products.
Also competing goods go up in price. One knows if Datsun and
Toyota raise prices, the Ford Pinto and the Chevette can't be far
behind.
Finally, we have labor market institutions which are a problem
which has received very little attention, although I notice in his discussion Mr. Bosworth kept coming back to these institutions. The major difference between the United States and other countries is our 3year wage accounts with staggered expiration dates. If we ha,d 1-year
contracts with a common expiration date, there would be room for a
deal as happens in some countries between the unions and the central
banks.
Unions could be told:l'You cooperate and you can have your jobs;
bnt if you don't cooperate, you lose them." And we will make this
decision all at one time.
Of course, now no single union has anything to gain by moderation.
Prices are being pushed up continuously. A wage slow-down by any


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si11gle union wUl have only a negligible effect on the cost of _living.
This unfortunate featn:re of U.S. labor markets helps to explam how
other countries ·have achieved greater success in holding down·the inflation rate. Demand growth has been translated into more moderate
price increases in these countries.
·While debates on anti-inflation policy always start out with monetary ~rowth !lnd the Jfederal bu?,get, I wo~ld pu~ this i1!- a ca~egory of
solutions which hold httle promise for dealmg with the mflation problem if we rely on them alone.
With the une:x;pected decline in unemployment over the past year
and the sluggishness in growth and GNP, certainly caution is advised.
On the monetary side, a delicate balance must be maintained in
order to sustain modest real output growth without an actual recession~
a task made more difficult by the contradictory signals that have been
given out by the rapid growth in M-1 and the sluggish growth in M2 over the past half year.
I found in a study that M-2 was a much better predictor o:f spending powth than M-1 than in the 1970's, and so the excessive concentration in the media on M-1 might :force the Fed into more restriction
than is desirable.
There are more solutions which lack promise, but, first, I would
like to make a couple o:f comments on the Federal deficit which, despite postponement of the administration's tax cut program and the
reduction of its size, still, according to the most recent calculations
I have seen, leaves us with an increase in the :full-employment deficit
in 1979 as compared to 1978.
In the first place, the :full-employment deficit is severely understated,
because it is calculated on the assumption that we can achieve a 4.9
employment rate and that potential output is faster than it is. So the
figures in terms of budget projections for next year are unrealistic.
In contrast, I think it would be desirable to have a steady shrinkage in the :full-emplo:yment deficit, to help encourage a shift in capital
market funds toward mvestment.
More important for fiscal policy, however, is the composition of
that expenditure and those taxes. Are they the kind of expenditure
which deal with our employment and inflation problems? Are they the
kind of taxes which can raise prices, or those which tend to have a
smaller effect on prices? Those are the important things to be considered, and we will get back to those in terms of the recommendations.
First, let's look at two proposals, one of the great interest in this
morning's testimony, to curing or helping to deal with the inflation
problem, and that is, first of all, jawboning; and, second of all, taxbased income policy. Attempting to slow down inflation with jawboning is like trying to hold back a tiaal wave with a toothpick.
Unions have every incentive to try to achieve higher wage increases
in the next negotiations, not lower rates. Wage claims are being pushed
up by Government measures, payroll tax increases, .increases in the
minimum wage, :farm price supports and import restrictions as well as
by the rapid reduction of unemployment itself, which increases labor's
bargaining power.
"Beoause of the U.S. system o:f staggered long-term wage contracts,
no one union or labor group will be willing to be a sacrificial lamb to
help out in the struggle of the administration's jawboning effort. Tax-


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base4 income~ policy has been of grea~ interest to some of the ~e~bers
ofth1s committee and staff, and certamly some of the people s1ttmg at
this table, but so far the economics profession shows no indication to
jump on the bandwagon.
If you think about the plan that Mr. Seidman is going to tell you
about in some detail, on the one hand, the firms that have already
negotiated wage increases would find that they would have an increase
in their taxes, and they would. try to recoup some of this by higher
prices. The tax wedge could be raised, and would lead to faster inflation. At best, there would be no impact.
In the second place, those firms that are currently negotiating and
trying to resist the unions are going to find themselves faced with the
greater likelihood of strikes, because the unions have no incentives. All
the J?enalty or reward goes to the employer.
Fmally, I think if prices don't go up as a result of these increa~d
taxes which will surely come as a result of the penalties, we would have
a decline in investment, something which we scarcely need now in light
of the productivity problem.
The alternative would be to bribe workers with tax rebates. This
would achieve some moderation, I think, particularly in the low-wage
workers who fall within the ceiling, but remember that any kind of
carrot scheme or any kind of bribe to workers costs Federal money,
and I ask as my simple reaction to this idea, why not spend the Federal
money where we know it will do good in holding down inflation; that
is, postponing or holding down payroll tax increases~
There are areas that hold promise. I will mention some that are
politically. feasible and others that are politically more controversial.
In the first place, the scheduled increases in the minimum wage
scheduled for January 1979 and January 1980 should be postponed.
Better yet, we should have a two-tier system of minimum wages which
exempts workers under a certain age.
The administration seems to have lost the favor of the unions anyway, so why not take this time when George Meany is mad at the
administration to push through something George Meany despises,
and that is a two-tier minimum wage.
The second proposal is that scheduled increases in social security
taxes be postponed. I believe that the total is $16 billion in social security taxes, which are scheduled now for 1980 as opposed to 1978.
Rather than just postponing them, better yet would be to shift the
funding of some major portion of the social security system into general revenues. This 1s based on the results of research, which is not
definitive, but suggests that payroll taxes have a greater impact on
prices than personal income taxes.
So why not just lessen inflationary cuts in taxes?
Third I think we should have more discussion, something to his
credit, that Mr. Okun proposed back in the era of the oil increase,
that we should bribe States to cut their State sales taxes. We know
those are taxes which have an immediate impact on the consumer price
index, and would benefit the inflation process doubly. because holding
down the CPI holds down wages through the cost-of-living escalators.
Next, we have the problem of environmental protection and occupational and safety administration, and I think here the comments made
earlier this morning about bureaucracy are very apt. I think that bu37-250-79-6


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reaucrats in these agencies have to promulgate some rulings in order to
extend and maintain their own power base, with very little place fur
the American people to come in and say how much of this priceraising regulation they really want.
The politicians should realize that interference in the price system
through higher taxes or minimum wages don't involve taking money
from Peter to pay Paul. That is, we lose because there is a tax situation
that interferes with the freedom of workers and prices.
Low income levels and inadequate steel attainments could be a factor with income supplements or negative income tax and manpower
training programs.
I have gone on too long, and let me stress the last section of the prepared statement. All of the measures I am suggesting deal with inflation through the supply side, and will take time to have an effect. They
will have only a gradual effect.
As prices are lowered, it takes waiting for the next wage negotiations for those price reductions to get into wages.
vVe will have to live with a high rate of inflation for a long time,
and there are a number o:f things that the Government should be doing. I said the same thing in the summer of 1971. To help this economy
live with inflation, and particularly the small savers and the people
who stand to lose the most, we should have index tax brackets and
exemptions, as in Canada. vVe should exempt from taxation capital
gains due to inflation, and the interest income on that portion o:f interest rate which is due to inflation.
vVe should not allow people to deduct from their income tax the
portion of the interest rate they pay on their borrowings, which is
due to inflation, and as well, the Government should issue an index
bond. These measures, taken together, will not cure inflation, but they
would cause dramatic increases in the :funds available for productive
investment and would end some o:f the distortions that contribute to
inflation and have sapped the Nation's potential for growth in the
last 5 years.
Representative LoNo [presiding]. Thank you.
[The prepared statement of Mr. Gordon follows:]
PREPARED STATEMENT OF ROBERT

J.

GORDON

Aggregate Supply and the Inffotion Process
Another inflationary surprise

The acceleration of inflation during the first half of 1978 has made a mockery
of earlier forecasts not just of Administration economists, but of all the private
forecasters who make their living from their predictions. As recently as three
months ago, one of the leading private firms forecast an increase in the CPI in
the second quarter at an annual rate of just 6 percent, in contrast to the 10.4
percent rate which actually occurred between February and May.
The recent surprise is reminiscent of 1973, in that much of the problem stems
from an unexpected upsurge in food prices. The 8.9 annual rate of increase in
the CPI in the six months through May would have been a more moderate 7.5
percent if food price increases had equaled the average of other goods and services. But even this lower figure represents an acceleration from the 6.4 percent
rate for non-food items observed during the preceding year.
The inflation surprise of 1978 highlights two unfavorable structural changes
which have come about in the past decade. First, the notorious volatility of food
prices is well known, as is the lamentable inability of even the best private forecasting firms to predict their twists and turns. Less noticed is a long-term deterioration in the price performance of the food industry, including both farmers


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.and the farm-to-market, chain:. between 1947 and 1971 food prices increased at
,a rate about one-quarter slower than nonfood prices. But from 1971 through the
;J)resent, food prices have risen 5()percent faster than nonfood prices.
The second long-term structural change is better known. The over-all rate of
long-term productivity growth in the U.S. has slowed down in recent years more
than anyone had imagined would occur. The productivity growth !'ate in the peri,od since 1972 has fallen a full percentage point short of the rate experienced' in
the decade and a half .prior to 1972. This means that any giYen rate of wage in.crease translates into faster increases in labor cost and prices, and that the
_growth rate ,of potential real GNP is slower than previously thought. The rapid
decline in unemployment during the past 12 months, a period during which the
annual growth rate of actual real GNP has been only 4.4 percent, is the counterpart of the inflationary deterioration of America's productivity performance.
Lagging productivity has created another surprise. A year ago it looked as if
the present expansion might run into bottlenecks of industrial capacity before
.any labor shortages emerged,
But in the last year industrial production has barely grown faster than employment, in contrast to the 1970-73 expansion when industrial production grew
.at a rate three times faster than employment. As a result, we find ourselves with
unemployment rates for skilled workers which have fallen close to the tightness
'.Zone, while capacity utilization has barely changed since last summer.
.Sources of the present inff,ation: Dema,nd and supply

Why is the U.S. economy stuck with such an intractible inflation problem,
which not only fails to improve on schedule, but has actually grown worse? The
standard answer is to blame overexpansionary aggregate demand policy : federal
deficits which are too high, and money supply growth rates which are too rapid.
But this too-easy answer presents a puzzle: if low unemployment rates in 1966.69 and 1973 caused inflation to accelerate, why did high unemployment rates in
1975--77 not contribute to a marked deceleration in inflation? Why, after 31
,straight months of unemployment above 7 percent, did we fail to achieve a
·
permanent deceleration of inflation?
The answer is that prices are determined by two blades of a scissors, not just
.demand but also supply. Demand forces determine how fast total spending can
rise.
But supply forces determines how that spending g,rowth is divided between
inflation and increases in real GNP. Only by studying the supply side can we
understand why the 10.0 annual rate of nominal GNP growth achieved by
.demand expansion over the past five years have been translated into only 2.4
percent annual growth in real output, leaving 7.6 percent remaining· as the
·average rate of infla;tion.1
Tille great dilemma of anti-inflation policy i<s not only that the average division
between output and prices !has been so unfavorable, but tJhat the short-run impact
.of any attempt to slow down demand growth tends to be a decline in output with
very little response of prices. With a different supply mechanism, in which 100
percent of •any expenditure change was •immediately reflected in prices, the ending of inflation would be a breeze and could be handled entirely by an expendi. ture slowdown.
An understanding of the peculiarities of the supply process in the U.S. is
.crucial not only in designing an effective anti-inflationary policy, but also in
assessing disagreements au:nong economicsts. Monetarists who claim that inflatwn
is a demand problem wbose only solution is slower monetary growth would be
,abso1utely right if 100 .percent of ex;penditure changes went directly into prices,
but not if zero percent went into prices and 100 percent into output changes. It is
the lack of responsiveness of price change to monetary tightness and other demand
:measures which make the monetarist prescription inadequate and forces consideration of supplemental measures.
The role of supply forces provides an answer to the puzzle posed earlier-why
did low unemployment in 1966-69 and 1973 cawse inflation ,to ,speed up, yet high
unemployment in 1975-77 fail to achieve a deceleration? The answer is that
adverse supply forces worked continuously and independently of demand policy
to push up the inflation rate, with a relatively minor contr,ilmtion in ,the late
1960s and a very major contrilm:tion since 1972. If we begin by enumerating
,.these. sources of "supply shift," which ha:ve raised tJhe pr,i£e level indapendentiy:
1

Annual compound growth rates between 1973: Q2 and 1978: Q2.


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of demand pressure, we can simultaneously identify ,the anti-inffation mee.sures
whlich will make a contribution under present circumstances, and those which
will not be effective. All of the following are adverse supply factors which raise
the aggregate price level which firms and workers require to be willing to produce
a given level of real GNP :
1. Ta/lJes. An increase in any tax rate inserts an additional "wedge" between
the price the consumer pay,s to the firm, and the amount the firm has left over
to contribute to the take-home pay of workers. Sales, excise, payroll, corporate
income, and personal income taxes, as well as customs duties, are all pa,rt of lbhe
"tax wedge". Empirical researoh suggests that indirect sales, excise, customs,
and payroll taxes have a greater impact on consumer prices than direct income
taxes, and also isolates payroll itax increases over the past decade as a major
source of upward pressure on the overall price level. The increase in oil prices
achieved by the OPEC cartel was, however, the most important single "tax"
imposed on the U.S. consumer.
2. Price-raising legislation. Under this category fall numerous measuresarm price supports, environmental protection, OSHA, and the minimum wage.
'J'he termination of oil price controls, which previously held down prices, as proposed in recent energy legi,slation, falls into this category. Edward Denison has
estimated that environmental, occupational, and health legislation, together with
a worsening of the crime problem, contributed by 1975 about half a percentage
point of the slowdown in secular productivity growth.
3. The depreciation of the dollar raises the prices of imports and many ex.ports,
especially farm products, but also boosts the prices of closely competitive goods.
When Datsun ,and Toyota are forced by the cheaper dollar to raise .prices, one
knows that the Ohevette and Ford Pinto wm not be far behind. The effective
exchange rate of the dollar has declined by fully 6 percent in the past year,
adding an additional source of the inflationary surprise of 1978.
4. Labor-market Institutions. A major difference between the U.S. and some
other countries is our institution in many industries of three-year labor contracts with staggered expiration dates. If we had one-year contracts with a
common expiration date, there would be room for a "deal" between the unions
and the Federal Reserve-a dirPct trade of jobs for a wage deceleration.
But now, no one union has anything to gain by moderation. Prices are being
pushed up by all of the previous agreements, which set a standard for emulation,
and a wage hold-down by any single union will have only a negligible effect on
its own cost of living. This unfortunate feature of U.S. labor markets helps to
explain why other countries, particularly Japan and Germany, have achieved
greater succPss in slowing down their inflation rate. Monetary tightness and
slow demand growth have been ,translated into more moderate wage and price
increases to a greater extent in those countries than in the U.S.
Proposed solutions which lack promise

Debates on anti-inflation policy always begin with monetary growth and the
Federal budget. With the unexpected decline in unemployment over the past
year. and the corresponding sluggishness of growth in potential GNP, caution is
advised. On the monetary side a delicate balance must be maintained >in order to
sustain modest real output growth without an actual ,recession, a task which is
being made even more diflkult by the contradictory signals being given by rapid
growth in Ml and sluggish growth in M2 over the past half-year. During the
1970'1s M2 has been a more reliable predictor of GNP than Ml, leading to concern that the current excessive concentration on Ml will cause too much
restriction.
Current administration proposals will lead to ,an increase in 1979 in an already
excessive (and understated) full-employment Federal deficit, rather than thP
steady shrinkage in that deficit which ii;, appropriate at tMs stage in the busine~s
cycle, and which is desirable to help shift capital market funds toward fixed
investment. Even more important is the composi.tion of ex.penditure and tax
changes which are approved ; below we ,shall outline an agenda of changes which
not only are anti-inflationary in impact, hut whioh will help people live more
comfort,ably with t,he inflation w,h,lch remains.
·
Many economists have expressed an endorsement of, or a.t least an interest in,
ei.tber jawboning or tax-based incomes ,policy as potential solutions to the inftation dilemma. Attemvting to slow down Inflation with jawboning, however. is like
trying to hold back a tidal wave with a toothpick. Unions have every incentive
to try to achieve higher rates of wage increase in the next round of negotiations,
not lower rates a,s the Administration is trying unrealistically to achieve. Wage


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claims are being pushed up by government measures, particularly payroll tax
increases, minimum wage boosts, farm price supports, and import restrictions, as
well as by the r111pid reduction in unemployment itself. Because of the U.S. system
of staggered long-term wage contracts, no one union or labor group will be willing
to ·1,e a sacrificial lamb and to suffer a reduction in its real income to help out a
struggling Admintstration jawboning effort.
Ta-x:-based incomes policy (TIP) has been of great interest to some members
of this committee and its staff, but so far the economics profession has shown no
inclination to jump on the TIP bandwagon. One version of TIP, the WallichWeintraub plan, would tax firms which negotiated wage increases above some
norm. This would raise the "tax wedge" and lead to faster inflation as firms attempted to recoup lost net profits. At best there would be no impact. The Okun
alternative would bribe workers through tax rebates to accept lower wage increases. This would achieve some moderation. particularly among the low-wage
workers who fall beneath Okun's ceiling and find it to their advantage to accept
his offer, but only at the expense of monstrous administrative problems and an
increase in the Federal deficit. The money spent on Okun's scheme could be much
better used to reduce payroll taxes, and my guess is that the impact on inflation
per Federal budget dollar would be considerably greater with a payroll tax reduction. Further, the staggered nature of U.S. wage contracts might cause the
scheme to boomerang. Coal miners and others who have already achieved high
wage increases would suffer major increases in income taxes if penalties were imposed for above-norm wage increases; the miners might then try at the next round
to recoup the unexpected loss in real after-tax income.
Solutions which hold promise

The U.S. inflation problem has been aggravated by adverse supply shifts. Government policy should henceforth devote its main thrust to creating favorable
supply shifts which reduce the tax wedge between market prices and after•tax
labor income. Most obvious of these shifts would be postponement of scheduled
increases in the minimum wage and in payroll taxes. Present Administration
plans to cut personal income taxes should be redrafted to channel the funds to the
payroll tax, which most research shows to have a greater impact on inflation.
The use of growing Federal income tax revenues to bribe states to cut their
sales taxes, rather than using the same dollars to cut Federal income tax rates,
should be given much more active consideration. Further, politicians should realize that the bureaucracies at EPA and OSHA have developed a life of their own
and have begun to promulgate tough rulings in order to extend and solidify their
own power base. They will have to be forced by Congress to tone down their goals
and postpone their timetables. Gallup and Harris should be asked to poll the
American people on environmental, safety, and health legislation-is it worth
continuing to increase the tightness of regulations at the cost of slower productivity growth, slower output growth, and faster inflation?
Politicians should realize that interference in the price system through higher
taxes or minimum wages does not just involve taking money from Peter to pay
Paul, but imposes on both Pi>ter and Panl a so-called "dead-weight loss." That Is,
society loses just because there is a tax or regulation which interferes with the
free workings of the price system. If the problem is inadequate income for farmers. or for workers who have low skill levels. there are better solutions than inflationary wages and price supports. Low income levels and inadequate skill attainments can be attacked directly with income supplements, a negative income
tax. and manpower training programs, none of which have the same direct priceraising impact.
International events influence domestic inflation. The failure to pass energy
legislation has contributed to the decline in the dollar in the past year. Those
Congressmen trying to protect the American consumer by opposing increases in
domestic energy prices to the world level have in effect robbed the American consumer by forcing him to pay the higher prices of imports and goods competing
with imports as a result of the depreciation of the dollar. Attempts to patch up the
U.S. trade problem by imposing tariff's or quotas on goods other than oil have also
contributed to inflation by raising domestic prices.
Living with inflation through government reforms

The philosophy stressed here ls to eneourage favorable shifts in supply. As they
bike ei'l'ect, the growth of the money supply and of aggregate demand can be
slowed. But this approach will moderate inflation only gradually. In the meantime the American economy needs a host of reform measures to help it "live with


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inflation," and to counteract the adverse effects of inflation which sap consumers.
incomes and which distort investment and saving decisions. Tax exemptions and
brackets should be indexed to the CPI, as in Canada. The government should issue
an indexed bond to help small savers keep up with inflation. Illusory capital
gains due to inflation should be exempt from taxation, a far more constructiveproposal than the present hatchet-like movement to cut capital-gains taxes across
the board. Savers should be exempt from taxation on the injlation component of
their nominal interest return, and borrowers should not be allowed to deduct
the inflation component or their interest payments. These measures, taken
together, would cause a dramatic increase in the funds available for productive
investment, and would end some of the distortions which have contributed to,
inflation and sapped the nation's potential for growth in the past five years,

Representative LoNG. Mr. Pechman.
STATEMENT OF JOSEPH A. PECHMAN, DIRECTOR OF ECONOMIC:
STUDIES, THE BROOKINGS INSTITUTION

Mr. PECIIllfAN. I will also summarize my prepared statement, Congressman.
Representative LoNG. ·without objection, your prepared statement
will also be made part of the record.
Mr. PECHllfAN. Recently, the Brookings Institution had a meeting
of its panel on economic activity, at which botJh of these gentlemen,
Mr. Robert Gordon and Mr. Lawrence Seidman, were present. The
mooting provided a thorough review of anti-inflation policies and gave
a great deal of prominence to some of the things Mr. Gordon has said
on the supply side: In addition it provided what was, I think the first
thorough discussion of tax-based incomes policies, which had been
sadly missing, until now.
I have ,a copy of the published volume. I know the staff is familiar
with it, and I hope they will at least read the summary by the editors,
Mr. Arthur Okum and Mr. George Perry, who did a very good job in
organizing and chairing the meeting.
I am very sympathetic to the idea of incomes policies. I wish I
could be enthusiastic about tax-based incomes policies because they
seem, at least in theory, to provide a solution which voluntary or other
means don't seem to give. However, I am a tax expert, and I view
tax proposals very seriously when they are recommended.
After having my arm twisted by my colleagues at Brookings and
bv Mr. Seidman, I regret to say that I have concluded that tax policies
of this kind are not practical, and I urge Congress to look at them
carefully before adopting them.
As Mr. Gordon said, there are two types of proposals. There is a
penalty and a carrot approach. The penalty approach is exemplified
by the Wallich-Weintraub proposal, which would provide for an
increase in the corporate tax rate or some other penalty for firms th::tt
give higher than 'average or guideline wage increases to employees.
Mr. Okun recognizes that it is very difficult to apply penalties of
this sort, and so he has turned it airound and suggested, "why not
reward people if they do the right thing?"
I must say that Mr. Okun's proposal is attractive, but on reflection
it turns out to be quite impractical. The members of the Brookings
panel, in distinguishing between the two ·approaches, concluded that
the penalty approach is more practical than the carrot approach, and
I will say more ,about that later.


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Let me go to the specific problems: First,.co:verage. I leafed through
the various Statistics of Income provided' by the .Internal Revenue
Service for the year 1975, and found that there are at least 13 million
employing entities in this country. Most of those entities are very
small : Farmers, small businessmen, corner grocers, druggists, and
so on. It is very difficult for me to imagine a policy which would
apply penalties or, for that matter, carrots on the basis of average,
or changes, in average wages.
Aside from keepmg records, which might be a burden on those
people, the fact of the matter is that employment in many of these
firms is episodic. I doubt whether you wouM want to differentiate between smaH businesses which have very substanti'al changes in the
composition of their labor force over the period of a year, and because of these changes would have changes in average wage rates that
have absolutely no relationship to the changes in the wage rates that
are given to a particular employee. FOT example, suppose the corner
drugstore replaces a couple of teenage youngsters who work part
time with a full-time worker who is much more qualified to do the
work in that drugstore. You might find that even though that particular worker did not get any more than a 6-percent increase over
his earnings in the prior year· in another firm, the average wage increase for this particular firm turned out to be higher than 6 percent.
I don't think anybody would ever want to penalize such a firm or
would want to deny it ,a subsidy.
For that reason, under the carrot approach, you would have to
7ive the subsidy to all of the small businesses right off the bat. Under
the penalty approach, you probably would want to simply exempt most
of the firms in the United States and limit your tax-based incomes
policy to,the top 500 or 1,000 or 2,000 firms. The authors of the penalty
approach recognize this, and I think they still would support the
penalty approach on this ground alone.
Now, another thing that my economist friends, who are nontax
experts, :fail to appredate is that the eoonomic unit that bargains for
or makes deals with employers on wages is very different from the
tax-paying unit that appears on tax returns.
What you would have to do is somehow make rules which would
permit the employer to translate what he does in practice in the
wage field onto a tax return. To give you an example, suppose you
have a multiproduct firm with offices and subsidiary corporations located all over the country.
This firm now files a consolidated return. In many cases the large
firms also file consolidated returns with branches and with subsidiaries
abr0ttd. Let's omit the :foreign employment problem, which is tough
enough, but let's think about the Pxecutives of this firm trying to
dec'irle what its policy would be with respect to wages in the war
1979 if the tax-based incomes policy were to be put into effect :for that
year.
It would have to know or evaluate what the prospects :for wage
changes ,are in every one of the myriad of categories that it has. and
somehow or other make a decision as to whether it will or will not
be able to rE>sist wage increnses or provide lower wage. increasE>s undE>r
n <'arrot approach with respect to all these particular units. Frank]v,
I just don't see how this can be done, and if businessmen do come to


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Congress and say that they would be overinvolved by the problem, I
think they a.re right.
Now, Mr. Okun compounds the problem. I think it is bad enough
to do it retrospectively after the year is over a.nd the firm has all
the records, but Mr. Okun's plan is prospective. He would ask all
employers to make a decision with respect to wages in the calend•ar
year 1979 in the month or months right before 1979 opens. I am not
talking about the problem of simply reporting man~hours, which
I think for these particular firms would be surmounta,ble.
I know of no large firm that would be able to oome to a,n agreement
or to some sort of underste,nding with all of the trade unions that it
negotiates with in such a short period. I regret to say that my friends
have not come to grips with this particular practical problem.
I also would like to add the fact that there 8Jre some difficult problems even if the business managers feel they could somehow make such
decisions. In a complex dynamIC economy, many changes occur during
a particular year which make comparisons of a,nything about the firm
from yea,r to year extremely difficult and hazardous. This is called in
tax language "The excess profits tax problem."
We have had a number of excess profit taxes in the United States
during wartime. We confine it to wartime, because most people agree
than an excess profits tax is very difficult. The fact of the matter is that
every time we have tried to compare profits during a particular year
with profits in some sort of base period, Congress has recognized the
fact that changes occur which have nothing t~ do with the particular
tax purpose, and therefore they provide alternative methods of calculating excess profits.
There are numerous mergers and spinoffs, and what-have-you. I
don't think the Congress is ready to consider all of the problems that
would arise if you wanted to tax as normal wage increases or provide
subsidies to below-normal wage increases.
I give an example in my prepared statement. Some economists have
suggested that, with new firms, you could use as a base the average
earnings in particular occupations as estimated by the Department
of Labor. I doubt that anybody would accept the rather gross statistics
that the Bureau of Labor Statistics have on average wages. They could
not possibly be applied to any one firm in this country for purposes of
taxation.
Finally, with respect to the timing of either the penalty or the subsidy, obviously the subsidy would be prospective, and I have already
indicated the problems there. The penalty would be retrospective, and
there I think the problem is that most firms, if they are asked about
this, I could really say that there might be too many prices at the end
of the year that would subject them to penalties which they did not expect.
For example, it is conceivable that a firm-suppose the guideline is
6 percent-after the year is over finds that its average wage has risen
above _the 6-percent guideline, and yet every employee in the firm got
wage mcreases of 6 percent or less. That can occur because the firm
happened to employ during that year relatively more high wage workers than it did the prior year. I can assure you that, if that ever happened, this firm, and others like it, would be coming to Congress for a
relief provision simply to prevent an injustice from being done.


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In brief, excess profits taxation is difficult, and that is why it is
limited to wartime situations.
In conclusion, while I am sympathetic to the objective of these policies, I would like to caution the Congress that it is a difficult approach,
and in m;y view has not been thought out well enough to be implemented within the foreseeable future.
Thank you.
Representative LoNG. Thank you very much, Mr. Pechman.
[The prepared statement of Mr. Pechman follows:]
PREPARED STATEMENT OF JOSEPH

A.

PECHMAN 1

Problems of Implementing Tax-Based Incomes Policies

As inflation has become more and more serious, it has become fashionable to
talk about tax-based incomes policies as a possible device to moderate it. I am
very sympathetic to the idea of an incomes policy, but I find it difficult to see
how a tax-based incomes policy can be implemented. The problems were thoroughly
explored at the April 1978 meeting of the Brookings Panel of Economic Activity. I
urge the committee to review the papers and proceedings of this conference
(Brookings Papel".S on Economic Activity, 2: 1978). My remarks this morning are
based on a comment I made at the conference.
Coverage

About 13 million firms filed federal tax returns in 1975, including 10.9 million
sole proprietorships, 1.1 million partnerships, and 2.0 COl".POrations. In addition,
there were 0.5 million returns of nonprofit organizations and over 78,000 governmental units. Most of the business firms had no employees, many report no net income, and all but a relatively small number of large businesses keep personnel
records. Yet, if a tax penalty or tax subsidy is to be designed, the law must be
explicit about how every one of these units is to be treated.
A penalty would be easier to administer than a subsidy, because it would be
possible to limit the penalty to large firms. But this should not be meant to imply
that the problems of a penalty can be overlooked. As I shall indicate below, I am
not p(;!rsuaded that it is feasible to measure average wage changes for all economic units in a manner that would be satisfactory for a tax-based wage penalty
or subsidy.
As for the subsidy approach, I assume that we would not ask the average
farmer, or the average corner drugstore owner, or most self-employed professionals who have a few employees, to report manhours on a tax return. Moreover,
with only a few employees, many firms might be denied a subsidy if they happened to shift to higher paid workers. To avoid the problems that the small firms
would haye, the wage subsidy would probably be given to all employees in such
establishments and to the owners of these establishments as well. This is not
fatal for the wage subsidy plan on administrative grounds, but it would mean that
a substantial fraction; if not a majority, of all workers would get the subsidy
whether they conformed with the wage guideline or not.
The economic unit

The unit for tax accounting purposes is a legal entity which, in our complex
economy, often bears little relationship to the unit which enters into wage bargains with their employees. Large corporations generally fl.le consolidated returns that include the operating results of many, but not necessarily, all of their
subsidiaries. So far a;i wages are concerned, the branches or subsidiaries of a
large firm in this country often bear no relationship to one another or to the parent
firm. Accordingly, the rules would have to be flexible enough to permit the unit
of calculation to be relevant to the wage setting process. Under wage controls, thebusiness firms themselves made this decision and I assume the control agency
could modify that decision if it was deemed necessary. But for purposes of a waµ:e
subsidy or penalty, definite rules would have to be set out either in the legislation
or in the regulations so that labor and management knew exactly what wage bargains they were dealing with. However, I am not aware of any usable guides on
how such rules can be written.
• Director of !\COnomle studies. the Brooklna:s Institution. The views expressed are m:r
own and do not reflect those or the officers, trust~es, and other statt members of the Brookings Institution.


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It would be necessary to prescribe other rules to make inter-year wage compari•
sons for new firms, mergers, spinoffs, sales of facilities, changes in product mix,
and other types of abnormal situations in which the wage data would not accurately reflect changes in average wages. This is what is referred to in tax
language as "the excess profits tax problem" : that is, the problem of estimating
the tax base when it depends upon events and conditions in two or more adjacent
years. The decisions made for the excess profits taxes in the United States were
the subject of extensive and time-consuming litigation every time the tax was
used, and no one on the government or the business side was ever satisfied. I can
imagine a. set of arbitrary rules that economists or tax administrators might
agree to, but Congress would find it difficult to accept such rules. (One example:
it has been suggested that, for new firms, a base year wage structure might be
constructed from averages for other firms in the same industry. But the only
data of this type that do exist are those of the Bureau of Labor Statistics and
they could not possibly be applied to a particular firm.) In the end, the legislation would be complex and, li~e the excess profits tax, would impose unforeseen
costs on business which would lead to further legislation and litigation to moderate such costs.
Timing of penalty or subsidy

From an administrative or compliance standpoint, it would be much easier to
impose a penalty or provide a subsidy after the end of the accounting period. If
the proposal is for a penalty based on profits it should be possible to rely on the
business firms to take the penalty into account in its wage decisions.
Just the opposite is true for a subsidy to workers accepting a wage increase
below the guideline percentage. To appeal to workers to accept the constraint, the
subsidy must be prospective and must be incorporated in the current tax withholding tables so that the workers will have immediate tangible evidence that
their disposable income will not be impaired by the policy. (Two sets of withholding tables would. be required, but this is only a minor complication compared
to others.)
The basic problem is that labor and management would find it extremely difficult to incorporate a prospective subsidy in their wage bargaining and, inci•
dentally, to come to an agreement in a few weeks before the beginning of each
year. Unless the bargaining unit were coterminous with the unit for determining
the subsidy, no worker or group of workers would know whether the deal they
made will actually trigger the subsidy until negotiations are completed with
the other bargaining units in the same firm. Management would have the same
problems: how can it be sure that the construction workers will accept a wage
increase that, together with. the agreement with coal miners, will trigger a
subsidy to both groups?
I conclude that a retrospective penalty on profits ·based on wage changes is
feasible. For prospective subsidies to workers, there are numerous pitfalls and
I frankly do not see how they can overcome to the satisfaction of labor and
management.
Prioes
The original tax-based incomes policies were to increase profits taxes of firms
with excessive wage increases, so that prices were not involved at all. Others
have ~uggested that, to be even handed, it would be necessary to provide penalties against firms with above average price increases. Unfortunately, any kind
of tax penalty or subsidy that depends upon a change in average prices of particular firms is simply impractical. All of the problems of constructing price indexes
would emerge-treatment of new products, quality change, measurement of
costs to be passed through, etc.-and there is really no solution to most of them.
I leave it to the Committee to judge whether a tax-based incomes policy can be
applied to wages and not to prices.
Controls 1Jersus tax-based incomes polioies
I believe it is not productive to argue whether tax-based incomes policies are
another form of controls or not. The question is which approach is feasible, and
what are their relative costs.
It is true that a tax-based incomes policy can be disregarded by any firm and
Its workers if they wish. But the rules and regulations must •be written to be
sure that all economic units in the country understand them and make their
decisions accordingly. Even if it is agreed that some of the rules must be arbitrary, I .doubt that it will qe..possible to arrive at such arbitrary rules through
the tax legislative process as we know it today;


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Under controls, Co.ngress avoids the hard decisions and lets the controlling
,agency make the arbitrary rules. One reason controls seem to be more accept.able than tax penalties or subsidies is that relatively few firms are ever involved
in disputes under controls, whereas a tax penalty or a subsidy would apply to
,an or a large number of firms and the perceived hardships and disputes Will be
numerous. Both devices lead to capricious results, but I am at a loss to understand why their proponents believe that tax-based incomes policies would be
:more acceptable to labor, management, the public and Congress.

Representative LoNG. Mr. Seidman.
:STATEMENT OF LAURENCE S. SEIDMAN, ASSISTANT PROFESSOR
OF ECONOMICS, THE WHARTON SCHOOL, UNIVERSITY OF PENNSYLVANIA, PHILADELPHIA, PA.

Mr. SEIDMAN. Congressman Long, in the interest of time I will be
.reading only part of my prepared statement.
During the past 4 years I have been engaged in research concerning
the theory and design of a tax-based incomes volicy (TIP). I recently
presented a paper on tax-based incomes policies at the Brookings conference devoted to that subject.
The aim of TIP is not to place blame on labor or business, but to
permanently restructure financial incentives so that the outcome is
best for the public, labor, and business.
I offer this package tentatively to serve as a concrete starting point,
:and as a basis for my analysis this morning. The TIP package consists of three parts: Wages, prices, and profits. I will consider each in
turn.
When I say wages, I really mean compensation, including salaries,
fringe benefits, and executive pay. Incidentally, I mean the salaries
of university professors, as well as the wages of factory workers.
Economic theory, econometric evidence and commonsense all strongly
support the conclusion that a smaller wage increase, and therefore
a smaller unit cost increase, will result in a smaller price increase.
Today, the average annual wage increase is 8 percent, but because
the trend growth rate of productivity-out per man-hour is only 2
percent-and varies little from this figure-the average unit cost in-crease is 6 percent. Our basic inflation rate, therefore, is 6 percent.
The best way to predict the inflation rate is to observe the average
wage settlement and subtract 2 percent £or the productivity growth
rnte.
The only way to bring the inflation rate down to zero percent is
to stop the advance of unit labor costs by gradually reducing the
grQwth rate of wages from its current 8 percent down to 2 percent,
the growth rate of productivity.
Suppose TIP sets, as its initial target, a wage inflation rate of
'6 percent-instead of the current 8 percent-and a price inflation rate
of 4 percent, instead of the current 6 percent. Then TIP might consist
of the following two incentives.
The first. employer incentive. A firm that grants a wage increase
in excess of 6 percent would receive a surcharge on its income tax for
that year in proportion to the size of the excess. If it grants less
than 6 percent, it would enjoy a proportionate tax cut. If it grants
'6 percent, its tax rate would remain at the base; currently 48 percent
for many corporations. For example, if a firm grants 7 percent, and-


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the TIP multiplier is 6, its tax rate would rise to 54 percent. If it
grants 8 percent, its tax rate would rise to 60 percent.
The second, employee incentive. Employees at a firm that grants
an average wage increase in excess of 6 percent would receive a tax
increase for that year in proportion to the size of the excess. If the
firm grants less than 6 percent, they would enjoy a proportionate
tax cut. If it grants 6 percent, their tax rate would remain at the base.
The penalty or reward would depend only on the average wage increase at the firm, so that individual promotion is not discouraged.
One method of implementing the employee incentive would be to
use the income tax withholding system. If the firm grants a wage
increase in excess of 6 percent, it would be required to raise the
actual withholding rate, yet employees would only be credited the
standard rate on their W-2 forms.
Symmetrically, if a firm grants less than 6 percent, it would be
required to reduce the actual withholding rate, yet employees would
be credited the standard rate on their W-2 forms. In this way, the
incentive would be fully implemented by the employer, so that there
is no additional compliance burden on individual employees. But on
each paycheck, and on the W-2 form, employees would be informed
of the TIP surcharge or credit, so they would know the penalty or
reward that has resulted from the wage increase at the firm.
It is crucial to understand how these TIP incentives differ fundamentally from controls. For both incentives, the tax penalty for exceeding 6 percent must be stiff, but not prohibitive, for either the
employer or employees. Where market forces, and the special conditions of the firm or industry, call for a relative wage increase, it is
essential that the firm still be able to exceed 6 percent, though by
less than it would have without TIP.
For,example, suppose firm A faces a sharp rise in product demand,
and thus a labor shortage, while firm B faces a decline in demand,
and thus a labor surplus. Without TIP, A might grant 9 percent
and B, 7 percent, for an average of 8 percent. With TIP, A might
grant 7 percent, and B, 5 percent, for an average of 6 percent.
TIP would not replace the market forces working on each firm,
and would not prevent the relative wage increase required by A to
attract additional labor. Both A and B would be free to set their
wage increase without having to seek regulatory approval.
Now contrast the situation of A and B under controls. Under controls, all firms would be prohibited from exceeding the wage target
of 6 percent, unless a firm could prove to a regulatory board that
it deserved special treatment. Under TIP, the employer and employees at firm A, through collective bargaining, would be free to
set a 7-percent wage increase, and accept the tax penalty.
Under controls, the employer and employees at A would not be
free to arrive at their own decision. They would have to submit their
case to a reguiatory board. Their collective bargaining agreement
would in effect require Government approval.
The outcome would not depend on their own assessment of the
particular situation in their industry, but on the assessment of a
board reviewing a large volume of cases, a board which would
therefore be far less informed about the merits of their case.


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The appeal process under controls would be time consuming, costly,
frustrating, and inefficient. TIP would entirely avoid this regulatory
interference in collective bargaining decisions. It would preserve the
freedom of business and labor at each firm to make their own decisions.
TIP di:ffers from controls exactly as the il).vestment tax credit and
accelerated depreciation differ from Government controls over each
firm's investment. Like these tax incentives, TIP would change the
profitability of particular firm decisions. But each firm would lie free
to respond as it wishes, without seeking approval from regulators
or regulations. The IRS would investigate a sample of firms accord•
ing to its usual procedure.
Let me pause here to reply to Mr. Pechman's comments. I have
great respect for him, and he has raised important and practical
problems which require careful consideration. But we have to keep
the practical problems in perspective.
Suppose today we were considering enacting for the first time an
income tax on individuals and corporations. I have no doubt that if
Mr. Pechman were assigned the task of assessing potential practical
problems, he could leave us quite discouraged by asking the very same
questions he asks concerning TIP. For example, who would be covered
under the income tax? All mdividuals or households? All businesses?
Could small businesses provide adequate records and be expected to
comply.
How would business income be measured? Surely there should be an
allowance for depreciation of capital, but there is no actual transac•
tion. Rules would have to be developed for determining asset lives.
Would only straight-line depreciation be allowed? Again, would we
expeet small business to comply?
For individuals, what about capital gains~ When they accrue, or
when realized? What about artificial gains due to inflation? Capital
gains would depend on events in 2 adjacent years. What about the im•
puted rental income of home owners? For business, what would be the
eDonomic unit. For large conglomerate firms? How would subsidiaries
be treated? What would be the timing of tax payment on the income
tax Y·what about rules for withholding and estimated taxes? If there
are underwithholdings, won't taxpayers object when they make up the
difference? And so on.
My point is not that TIP is immune from difficulties. Rather, I am
arguing that it would be premature to allow a listing of problems to
prevent serious consideration. We must proceed to the next stage,
drafting legislation, and attempting to write IRS regulations and cir•
eulate these to tax and collective bargaining experts.
Our income tax to this day has significant unsolved practical problems, and yet it has been the centerpiece of our tax system. The work
ability of TIP must not be judged against a mythical ideal tax, but
against the other highly imperfect, yet tolerably, feasible taxes that
now exist.
The above TIP package contains both an employer and employee
incentive, and combines both penalty and reward. I want to emphasize
that in my view the most crucial ingredient in the package is the in•
.come tax penalty on the employer, the original Weintrau'b-Wallich
:incentive. In a technical paper that will be appearing in the next issue


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o:f the Brookings Papers on Economic Activity, I present the economic
theory and econometric evidence that I believe leads to this conclusion. I will briefly summarize the central argument.
An employer can ignore the opportunity to earn a tax cut; and employees can ignore either the penalty or reward, provided the penalty
is not prohibitive. An employer, however, cannot afford to ignore the
imposition o:f a stiff tax surcharge on its income tax.
I:f the TIP package, together with proper monetary and fiscal policy, succeeds in reducing wage inflation to 6 percent, and price inflation to 4 percent, then the dividing line between penalty and reward
under TIP should be lowered to 4 percent, and ultimately-after several years-to 2 percent, the average growth rate o:f labor produc;tivity,
and therefore the rate required to keep inflation near zero.
As disinflation steadily occurs, the unemployment rate can gradu:;i,lly
be brought down perhaps to near 4 percent. Econometric evidence
suggests that without TIP a 4-percent unemployment rate would cause
wage and price inflation to gradually accelerate, so that 4 percent
could not be maintained. ·with a permanent TIP, exerting permanent
downward pressure on wage increases, it should be possible to keep
wage increases equal to productivity growth at a 4-percent unemployment rate.
The monetary growth rate prescribed by monetarist economists
would then be essential, on average, to maintain 4 percent unemployment and near zero percent inflation. It will be easier :for the Federal
Reserve to gradually reduce the monetary growth rate to its target
i:f tbe :full employment budget is brought approximately into balance,
so that pressure on interest rates :from fiscal policy is reduced.
At first glance, it might seem natural to suggest tax incentives :for
price increases, just as TIP provides tax incentives :for wage increases.
Tax incentives :for price increases, however, are almost certainly administratively unfeasible. Most firms make a variety o:f products, with
a variety of quality levels. It is extremely difficult to distinguish a price
change :from a quality change.
Fortunately, tax incentives on prices are unnecessary. As explained
earlier, theory and evidence strongly suggest that prices are tied to unit
costs, and a decline in the growth rate o:f unit costs will automaticallv
bring down the growth rate o:f prices. Nevertheless, labor deserves insurance.
I would, therefore, suggest that "real wage insurance," first proposed
by Mr. Okun in 1974, be included in the TIP package. Suppose wage·
inflation declines :from 8 percent to 6 percent in the initial year under
TIP, but price inflation declines :from 6 percent to only 5 percentalthough theory and evidence expect a decline to 4 percent-then Cong-ress would authorize in advance compensatory tax cuts :for employees
to make up the difference.
These tax cuts could be vaded with the wage increase at each firm,
so that those who exercised greatest wage restraint would receive the·
largest tax cut. The expected cost to the Treasury o:f real wage insurance is·zero, because the decline in price inflation should automatically·
match the decline in wage inflation. Nevertheless, it is iqi.porta,11t to
guarantee protection. Real waue insurance shi;ml<l be enacted as part
of the TIP package, so that the compensatory tax cuts would be assured in advance.


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As in the case of prices, tax incentives for profit restraint at each
firm would have harmful effects. The firm's incentive to improve its
efficiency, from which consumers ultimately benefit, could be weakened
by reducing the profit reward. The practical experience with the excess profits tax has not been encouraging.
Fortunately, as in the case of prices, tax incentives on profits are,
unnecessary. As long as price inflation stays approximately equal to
unit labor cost inflation, the ratio of capital income to la:bor income
must remain fairly constant. If price inflation declines 2 percent when
unit labor cost inflation declines 2 percent, then unit profit inflation
must decline 2 percent. Nevertheless, labor deserves insurance.
I would, therefore, suggest that the following proposal, offered by
Mrs. Lawrence Klein and Vijaya Duggal of "Wharton Econometric
Forecasting Associates at the University of Pennsylvania, deserves
careful consideration. According to their proposal, if the ratio of
after-tax profit to labor income for the whole corporate sector rises
above some threshold when wage inflation declines, then the base corporate tax rate can be raised equally for all firms to keep the ratio at
the threshold for that year.
To reassure labor, this adjustment can be enacted in advance and
made automatic. It should be emphasized that their proposal would
not attempt to define and tax "excess" profit at each individual firm.
Only the ratio for the whole corporate sector-or economv-would be
of .copcern. Their proposal would, therefore, avoid the difficulties of
past excess profit taxes.
In conclusion, I would recommend that a tax-based incomes policy
should be adopted. TIP, together with monetary and fiscal restraint,
can reduce inflation and unemployment simultaneously and permanentlv. Labor, business, and the general public would, therefore, all
benefit greatly from TIP.
Thank you.
Representative LoNG. Thank you :for a provocative statement.
[The prepared statement of Mr. Seidman follows:]
PREPARED STATEMENT OF LAURENCE S. SEIDMAN

A Tam-Based Incomes Policy

My name is Larry Seidman. I am an Assistant Professor of Economics at the
,vharton School, University of Penrn;ylvania. During the last four years, I have
heen engaged in research concerning the theory and design of a tax-based incomes
policy [TIP). I recently presented a paper on tax-based income policies at
the Brookings Conference devoted to that subject.
This morning. I want to explain why I believe a tax-based incomes policy should
he adopted. and offer specific suggestions for its design. A permanent tax-based
incomes policy [TIP) complemented by proper monetary and fiscal policy, offers
tlie prospect of permanently reducing both inflation and unemployment. Moreover,
I believe it is the only policy that will enable us to reduce inflation and unemployment simultaneously. Labor, business, and the general public would therefore benefit greatly from a tax-based incomes policy.
TIP is fully compatible with our market economy, its institutions. In contrast
to Pither persuasion or controls-the two traditional methods of incomes policyTIP. would harness the instrµment. that has proved its effecth•eness in our mark-rt;~~imqmy: financiaffo.ce,itives. Business and labor would remain free to bargaiirwlleetil\'e}y,·and·weigh ·theparticulai'"features of their own situation against
the TIP incentive, arrivdng at. the wage and price decisions they regard as best,
without government interference.
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It must be emphasized that TIP does not seek to blame labor or business for
inflation. Employees, or their unions, who seek higher wages and salar~ef! to
catch-up with inflation, to stay ahead of it, or to improve their standard of hvmg,
are simply reacting to protect their own self-in~erest, exactly a~ man~ements
do when they seek profits. Since labor is respondmg to the same mcentlves that
drive all economic agents in our economy, fault-finding is unjustified. Similarly,
when 1business firms grant wage increases in excess of productivity increases,
and pass the higher unit costs on to consumers through higher prices, they are
protecting their own interest in response to the constraints they face. The aim of
TIP is no to place blame on labor, or business, but to permanently restructure
financial incentives so that the outcome is best for the public, labor, and business.
The logic of TIP can be simply explained. When the average firm grants, and
its employees receive a wage increase in excess of its productivity increase, the
result is an increase' in its unit cost, which the firm must cover by raising its
price. This behavior imposes a cost on society in either of two forms. If monetary
and fiscal rpolicy accommodate such wage-price behavior, the social cost takes
the form of inflation. If monetary and fiscal policy tries to combat such behavior,
the social cost takes the form of unemployment and recession.
Yet today neither the employer nor employees hav,~ an incentive to take this
external social cost into account when their own wage increase is set. Many
economists would diagnose this as a standard "externality" problem, and therefore recommend the standard remedy: "internalize the externaUty." The employer and employees at each firm should bear a private cost whenever they impose a social cost, in the form of higher inflation or unemployment, on the rest of
society. They should either incur a financial penalty, or forego a financial reward,
when they engage in such behavior. The aim of TIP is to provide such a financial
incentive.
Even advocates of TIP have not yet agreed on the best design. Today, I want
to set out tentatively a TIP package that promii-es to restrain wages, prices, and
;profits. It combines elements from the original employer TIP, first proposed by
Drs. Henry Wallich and Sidney Weintraub in 1971; and the recent employeremployee package suggested by Dr. Arthur Okun. Moreover, it contains specific
guarantees and protections for labor concerning prices and profits, similar to
those that have been offered by Dr. Okun, and Drs. Lawrence Klein and Vijaya
Duggal, among others. I offer this package tentatively, to serve as a concrete
starting point, and as a basis for my analysis this morning. The TIP package
consists of three parts: wages, prices, and profits. I will consider each in turn.
WAGES

When I say "wages" I really mean compensation, including salaries, fringe
benefits, and executive pay. Incidentally, I mean the salaries of university professors, as well as the wages of factory workers. Economic theory, econometric
evidence, and common sense all strongly support the conclusion that a smaller
wage increase, and therefore, a smaller unit cost increase, will result in a similar
price increase. Today, the average annual wage increase is 8 percent; but because
the trend growth rate of productivity-output per manhour-is only 2 percent ( and
varies little from this figure), the average unit cost increase is 6 percent. Our
basic inflation rate, therefore, is 6 percent.
The best way to ,predict the inflation rate is to observe the average wage settlement and subtract 2 percent-the productivity growth rate. Table 1 shows that
over the last thirty years in this country, in most years the• inflation rate has
been approximately equal to the dilference between the average wage increase
and the average productivity increase. For example, in the early 1960's, the average wage increase was 4 percent, the average productivity increase was 3 percent. and the inflation rate was 1 percent. This rule of thumb is one of the most
stwble empirical relalti:onships in economics. There is no mystery about this. Every
business must cover an increase in its unit cost by raising its price. Moreover,
the degree of competition in each industry-whether high or low-establishes a
specific relationship between unit cost, and the price firms charge, so that price
and unit costs move together. Both theory and empirical evidence strongly reject the view that sustained price increases can occur without accompanying increases in unit labor costs. Today, unit labor costs are raising 6 percent per year,
and therefore, so are prices. The only way to bring the inflation rate down to· O
percent is t,o stop the advance of unit labor costs, by gradually reducing the
growth rate of wages from its current 8 percent down, to 2 percent, the growth
rate of productivity.


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TABLE 1.-PRICE-UNIT LABOR COST RELATIONSHIP
[Percent change from the previous period]
Year
1948
---- ---------- -_. --------------1949 ________________
______________________________
____ -- -- ______ _
1950 ______________________________________________ _
1951 ________ -- _________ -- _____ -- __________ -- ______ _
1952 ______________ • ___ •••• _. __ • __ •• ___ • __ • _____ ••• _
1953 ______________________________________________ _
1954 ______________________________________________ _
1955______________________________________________ _
1956 ______________________________________________ _
1957
-- -------------- _•----- __
1958-------_________-------• _____ • -____
___ -- ___ •______
_. _.--__--• __
1959 ____ -- -- ___ ••••• _. -- _. _. _- -- _-•.• -•. -- _- _•.• --.
1960________
-- -- -- -- _-- ----- ----- --- -- -- -- --- -- -- --_
1961_
_____________________________________________
1962______________________________________________ _
1963______________________________________________
________ -- -- -- ------ -- -- -- ------ -- -- --- ---- - --._
1964
1955________ -------- -- -- ----- _-- -- ---- -- -- -- -- -- -- _
1966____ -- -- _. _. _. _--.• _•• -- -- •.•• _••• __ •.. __ . ____ _
1967
--- _· -- -- ---- -- _-- _. _---- --- -- _-- -- -- _
_
1968--------______________________________________________
1969
-- -- • _. ___ •• __ •••• _. _•• __ • ___ • ___ •• ___ --- --_
1970____
______________________________________________
1971_ _____________________________________________ _
1972
-- • _•• _. _. _. ___ • _. _•• _. _•• -- •.•. _-. -.. -- _.•_
1973.••.
______________________________________________
197 4___ • _. _. ___ • _______ • __________________________ _
1975 ·------- -- -- -- ---------- -- -- ---------- ---------

Output per Compensation
hour
per hour
3. 1
3.6
6.1
2. 4
2. 2
2.1
1. 8
3.4
-.3
2. 3
3.1
3. 2
.7
3. 4
4. 1
3.1
3. 6

2. 6

3. 1
I. 7

2.6
-.4
.6
3.4
3. 4
2.0
-2.4
1, 9

8. 9
3.1
5. 5
8.8
5. 5
5. 7
3.2
3.5
5.9
5.7
3. 7
4.6
3.9
3:3
4.2
3.6
4.8
3. 6
6. 2
5. 7
7.4
6. 7
6.8
6. 8
6. 2
7. 8
9. 5
18.9

Unit labor
costs

Implicit price
deflator

5. 6
-.5
-.6
6. 3
3.2
3. 6
1. 3
.1
6.2
3.4

6.6

.6

1. 3
3.2
-.1
0

•5
1. 2
1.0
3.0
3. 9
4. 7
7.1
6.1
3. 3
2. 7
5. 7
12.2
18.0

1.0
1. 7
6.8
.1.7
2.2
!. 6
2.1
3.2
3. 5
1.0
2.2
1. 6

.8
1. 5
I. 3
1. 3
1. 7

2. 8
3.1
4. 1
4. 7
4.9
4. 7
3.1
4.2
10.1
t 9. 9

Projected by Bureau of Labor Statistics.
Note: All data are for the private, nonfarm economy.
Source: Bureau of Labor Statistics, Department of Labor. Presented in table B-31 (p. 207), The Economic Report of the
President, January 1976,
1

Suppose TIP sets as its initial target a wage inflation rate of 6 percent (instead of the current 8 percent), and a price inflation rate of 4 percent (instead
of the current 6 percent). Then TIP might consist of the following two incentives.
(.A) Employer incentive

A firm that grants a wage increase in excess of 6 percent would receive a surcharge on its income tax for thalt year in proportion to rthe size of the excess. If
it grants less than 6 percent, it would enjoy a proportionate tax cut; if it grants
6 percent, its tax rate would remain at the base (currently 48 percent for many
corporations). For example, if a firm grants 7 percent, and the TIP multiplier is
6, its tax rate would rise to 54 percent; if it grants 8 percent, its tax rate would
rise to 60 percent.
(B) Employee incentive

Employees at a firm that grants an average wage increase in excess of 6 percent
would receive a tax increase for that year in propo11tion to the size of the excess.
If the firm grants less th,an 6 percent, they would enjoy a proportionate tax cut:
if it grants 6 percent, their tax rate would remain at ,the base. The penalty or reward would depend only on the average wage increase at the firm, so that individual promotion is not discouraged.
One method of implementing the employee incentive would be to use the income tax withholding system. If the firm grants a wage increase in excess of 6
percent, it would be required to raise the actual withholding rate; yet employees
would only ,be credited ·the standard rate on their W-2 forms. Symmetrically, if
the firm grants less than 6 percent, it would be required to reduce the actual
withholding rate; yet employees would be credited the standard rate on their
W-2 forms. In this way, the incentive would be fully implemented by the employer, so that there is no additional compliance burden on individual employees.
But on each paycheck, and on the W-2 form, employees would be informed of
the TIP surcharge or credit, so they would know the penalty or reward that has
resulted from the wage increase at the firm.
It is crucial to understand how these TIP incentives differ fundamentally from
controls. For both incentives, the tax penalty for exceeding 6 percent must be
37-250-79--7


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stiff, but not prohibitive, for eitJller the employer or employees. Where market
forces, and the special conditions of the firm or industry, call for a relative wage
increase, it is essential that the firm still be able to exceed 6 percent, though by
less than it would have without TIP.
For example, suppose firtn A faces a sharp rise in product demand, and thus
a labor shortage; while fit.ID B faces a decline in demand, and thus a labor surplus. Without TIP, A might grant 9 percent, and B, 7 percent, for an average of 8
percent. With TIP, A might grant 7 percent, and B, 5 percent, for an average of
6 percent. TIP would not replace the market forces working on each firm, and
would not prevent the relative wage increase required by A to attract additional
labor. Both A and B would be free to set their wage increase without having to
seek regulatory approval.
Now contrast the situation of A and B under controls. Under controls, all
firms would be prohibited from exooeding the wage target of 6 percent, unless a
firm could prove to a regulatory board thait it deserved special treatment. Under
TIP, the employer and employees at firm A, through collective bargaining, would
be free to set a 7 percent wage increase, and accept the tax penalty. Under controls, the employer and employees at A would not ·be free to arrive wt their own
decision. They would have to submit their case to a reg,ulatory ,board. Their collective bargaining agreement would in effect require government approval. The
outcome would not depend on their own assessment of the pavticular situation
in their industry, but on the assessment of a board reviewing a large volume of
cases-a board which would therefore be tar less informed about the merits of
their case. 'l'he appeal process under controls would be time-consuming, costly,
frustrating, and inefficiernt. TIP would entirely avoid this regulatory interference
in collective bargaining decisions. It would preserve the freedom of business and
labor at each firm to make their own decisions.
Dr. Henry Wallich, a respected conservative, has written:
"The essence of TIP is that it differs fundamentally from the usual kind of
wage and price controls. Business and labor are free to bargain for any wage
increase they choose. Only the weight of market forces is changed, with the
tax doing the weighting."
TIP differs from controls exactly as the investment tax credit and accelerated
depreciation differ from government controls over each firm's investment. Like
these tax incentives, TIP would change the profitability of particular firm
decisions. But each firm would be free to respond as it wishes, without seeking
approval from regulators or regulations. The IRS would investigate a sample
of firms according to its usual procedure.
TIP would complicate the tax code. But so do the investment tax credit and
accelerated depreciation. For example, IRS must develop service lives for many
classes of assets, often requiring arbitrary judgments. Businessmen clearly do
not regard such tax incentives as controls. Despite their complexity, these
incentives leave each firm free to make its own decisions. It cannot be overemphasized that TIP is a tax incentive, to which firms can respond as they wish.
The practical difficulties of implementing TIP have nothing to do with controls,
or the interference by government in the decisions of business and labor. Instead,
they are exactly analogous to those encountered with accelerated depreciation.
IRS must carefully draw up rules that firms must follow in computing their tax
liability. Under TIP, IRS will have to define how the wage increase, including
contributions to fringe benefits, is to be computed for tax purposes.
The most serious technical problems that have been raised against some versions of TIP can be completely avoided if TIP is properly designed. For example,
the question has been raised: Whose estimate of the cost of a labor contract
will be accepted1 This problem, however, disappears if TIP is based on the labor
expenses actually paid by the firm in a given year, rather than attempting to
estimate what the negotiated contract implies. Tax liabilities are based on actual
income earned, not on a forecast of prospective income. What must be grasped
is that TIP is a tax incentive, and should be implemented according to standard
principles of taxation, not according to the methods of controls.
Moreover, if a firm actually pays 9 percent more per manhour this year
than last, it should not matter how much of this is the base wage, a cost-of-living
adjustment, or a contribution to health or life insurance, or pensions. The
important fact is that actual total labor expense per manhour has increased 9 percent; this is what counts for the firm's costs, pricing, and inflation, and is therefore the basis on which TIP should be computed.
The most valid objections have been raised against a TIP that would provide
penalties or rewards based on prices or profit margins. These objections will be


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·reviewed later. A TIP that provides incentives for wages only a'1'oids tliese
problems. Later, I will show how prices and profits cart ba testrli.i:titd M:ectfveli
without direct tax incentives.
In summary, TIP differs fundamentally from controls. Indeed, in my '1'iew
TIP is our best hope for avoiding controls.
The above TIP package contains both an employer and employee incentive and
combines both penalty. and reward. I want to emphasize that in tny view', the
most crucial ingredient in the package is the income tax penalty on the eiilployer-the original Weintraub-Wallich incentive. In a t~hnical paper that will
be appearing in the next issue of the Brookings Papers on Economic Activity, I
present the economic theory and econometric evidence that I believe leads to this
conclusion. I will briefly summarize the central argument.
An employer can ignore the opportunity to earn a tax cut; and employees
can ignore either the penalty or reward, provided the penalty is not prohibitive.
An employer, however, cannot afford to ignore the impoSition of a stiff tax
surcharge on its income tax. In the above TIP package, the employe't incurs a tax
penalty if he grants a wage increase above the 6 percent target. Suppose instead,
under a reward-only TIP, he were offered a tax cut for reducing his wage
increase below today's average of 8 percent-but his tax rate would remain 48
percent if he grants 8 percent or higher. It is possible that the opportunity for
a tax cut will induce him to reduce his wage increase below 8 percent. But if
he does not, he will be no worse off than he is today. It is therefore uncertain
whether he will respond. Suppose under the penalty proposed in the above
package, his tax rate would rise to 60 percent if he grants 8 percent ( 6 perceu tage
points for eaeh 1 percent excess). If he insists on granting 8, he will be significantly worse off.
In my view, there is significant econometric evidence that when the profit
rate declines below normal, business firms grant below-normal wage increases,
reflecting their reduced ability-to-pay. '.l'he income tax penalty would threaten
a squeeze in after-tax profit if the firm grants the same wage inctease. 'l'he
evidence suggests that this threat would cause 1nallagetne1Hs to stiffen their
resistance and reduce the wage increase towards the target to avoid the potential
after-tax profit squeeze.
It must be emphasized that if firms respond to the pOtlltttial penalty by
reducing the wage increase to the TIP target, their tax rate will remain unchanged, and no after-tax profit decline will actually occur. A central feature of
the employer penalty TIP, in contrast to an increase in the ordinary corporate
tax rate, is that it can threaten a profit squeeze if firms fail to respond; but will
not cause an actual one if firms respond as expected.
In response to this argument, the following question can be raised: Is it possible that firms will ignore penalty-TIP, grants 8 percent, accept the tax increase, but pass on the higher. tax cost to consumers through higher prices,
thereby avoiding a decline in their after-tax profit? Let me explain why thil!I
possibility will not undermine penalty-TIP.
Since the tax penalty is on the income tax of the firm, in effect "IRS gt)e'S
last." First, the firm raises its price, hoping to increase its before-tax profit
enough to offset the '!.'IP tax increase. Then, IRS taxes a fraction of this groSl!
profit. If the TIP penalty multiplier is made stiff enough, the firm will be uoob!e
to avoid an after-tax profit decline if it grants 8 percent, no matter how great
its market power. For example, if the TIP multiplier is 6, so that the firm's tax
rate increases from 48 percent to 60 percent, the firm would have to be able to
raise its before-tax profit by 30 percent to avoid a decline in after-tax profit
(without TIP, the firm would keep 52 percent, which is 30 percent greater than
the 40 percent it would keep under TIP if it grants 8 percent). If the multiplier
were 13, so that the firm's tax rate increases from 48 percent to 74 percent, the
firm would have to possess the ability to double its before-tax profit to avoid
a decline in its after-tax profit (since it keeps 52 percent without TIP, but
26 percent with TIP if it grants 8 percent). Finally, if the TIP multiplier were
26, so that the firm's tax rate increases from 48 percent to 100 percent, ft would
be literally impossible for the firm, no matter how great its monopoly power, to
avoid an after-tax profit squeeze if it grants 8 percent. Of course, so extreme
a TIP multiplier is neither desirable nor necessary. The extreme example is
given to illustrate that, regardless of the degree of oligopoly power of the firm,
there is a TIP penalty stiff enough to force the firm to respond by reducing itll
wage increase.
· Even if it is understood that raising prices cannot fully protect the :firm, it May
be asked: Won't firms try to cover part of the tax cost by rais-mg prlce, an4 won't


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this w~rsen inflation? The answer is as follows. As long as the average 1irm re•
duces its wage increase to the target, the average tax rate will remain at the base
(today, 48 percent for most corporations), and there will be no tax increase to
~ass on. Suppose, pessimistically, that the average firm exceeds the target, and
mcurs a tax increase. The result will at worst be a one-time increase in the average firm's mark-up, and price. Once the price is adjusted to the higher tax rate,
price will again follow unit labor cost. The pass-on can only occur once, because
the tax rate will at worst only increl\se once. Thus, even under the worst scenario,
_penalty-TIP will soon permanently bring down the inflation rate.
Moreover, it is far from certain that firms can raise prices and before-tax profits
;Significantly in response to TIP. Even under industry-wide collective bargaining,
where the firms are large oligopolists, import competition may limit the ability
to raise gross profit by raising price. It is therefore important that if TIP is in,troduced, firms clearly understand that the government will refuse to protect
,them from import competition if they ignore TIP, grant a wage increase above
the target, and try to pass on the tax cost through higher prices.
The shifting problem just described will not undermine TIP if the penalty is
on the income tax, because in effect, "IRS goes last," after the firm tries to raise
its gross profit by raising price. If the penalty were on the payroll tax of the
firm, in effect IRS would "go first," and the shifting problem would be more serious. After paying the tax, according to the size of its wage bill, the firm could
then try to maintain its after-tax profit by raising price. There would be no guar~
an tee that the firm would suffer an after-tax profit squeeze if it granted 8 percent.
The version of TIP that would disallow excess wages as a deduction when the
firm computes its tax liability can be shown to be equivalent to a payroll tax
surcharge. Because it is less vulnerable to the shifting problem, the income tax
surcharge is preferable to the deduction disallowance.
In summary, the threat of an income tax penalty will force firms to respond by
"digging in" at a lower wage increase in order to avoid an after-tax profit squeeze.
Today, the average firm "digs in" at 8 percent. If the TIP target is 6 percent, the
average firm will "dig in" with the same intensity at 6 percent.
The employer penalty is most readily applied to the private, profit sector. I
would suggest, however, that the penalty should also be applied to large firms in
the non-profit sector, such as universities, to the regulated sector, and to state
and local governments. For the latter, general revenue sharing could ,be reduced
the larger the wage increase. Both equity and efficiency require as broad a coverage for TIP as is consistent with administrative feasibility. In light of the cost
of compliance and administration, small firms might be given the option of inclusion or exclusion from TIP.
Some of my colleagues who have suggested tax rewards, instead of penalties,
agree with my conclusion that the employer income tax penalty is likely to be the
strongest, and most reliable ingredient in a TIP package. They have settled for a
tax reward because they fear that the patient will refuse to accept stronger medicine, and that you will not have the political courage to enact a tax penalty.
Our anti-inflation policy has suffered from an unwillingness to recommend anything that may be temporarily unpleasant to the patient. The result of this timidity has been that the disease has grown worse, and the patient feels worse than
before. The time has come to recognize that the best medicine does not always
taste best. It is understandable that the patient seeks to avoid unpleasant medicine. It is the responsibility of the physician, however, to prescribe what will
work.
Your willingness to enact an employer tax penalty will not only provide the key
ingredient for reducing inflation. It will do more to reduce the expectation of
higher inflation than any other single action you can take. The public is justifiably alarmed when it observes political leaders and policy-makers "running
for cover" when some one complains that he will refuse to consider any medicine
with an unpleasant taste. What is required is a TIP package, containing penalties
as well as rewards, together with monetary and fiscal restraint, to restore public confidence, reduce the expected inflation rate, and begin to wind down the actual inflation rate without subjecting the economy to a severe recession.
If the TIP package, together with proper monetary and fiscal policy, succeeds
in reducing wage inflation to 6 percent, and price inflation to 4 percent, then the
dividing line between penalty and reward under TIP should be lowered to 4
percent, and ultimately (after several years) to 2 percent, the average growth
rate of labor productivity, and therefore, the rate required to keep inflation near
zero.
Ae disinflation steadily occurs, the unemployment rate can gradually be brought
down perhaps to near 4 percent. Econometric evidence suggests that without TIP,


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a 4 percent unemployment rate would cause wage and price inflation to gradually,
accelerate, so that 4 percent could not be maintained. With a permanent TIP,
exerting permanent downward pressure on wage increases, it should be possible
to keep wage increases equal to productivity growth at a 4 percent unemployment
rate.
My own analysis suggests that a permanent TIP would cause a significant
structural change in the economy. TIP would permanently reduce the nonaccelerating-inflation rate of unemployment (NAIRU) of the economy-from perhaps 6 percent to 4 percent. It would then become possible to run the economy at
4 percent, instead of 6 percent, without generating a rise in the inflation rate.
This reduction in the NAIRU would yield large social benefits each year. According to Okun's Law (a 1 percent reduction in unemployment yields a 3 percent in.;
crease in real GNP), if the economy can be run at a 4 percent unemployment rate,.
real (inflation-adjusted) GNP, labor income, private investment, and profits, will
all be 6 percent higher each year than if the unemployment rate were 6 percent.
The monetary growth rate prescribed by monetarist economists would then be
essential, on average, to maintain 4 percent unemployment (the new NAIRU under TIP), and near O percent inflation. It will be easier for the Federal Reserve
to gradually reduce the monetary growth rate to its target if the full employmen~
budget is brought approximately into balance, so that pressure on interest rates
from fiscal policy is reduced. Thus, TIP is a complement to, not a substitute for,
responsible monetary and fiscal policy. Of course, periodic disturbances will move
the economy away from its targets, and flexible, countercyclical monetary and
fiscal policy will remain necessary. Nevertheless, a permanent TIP should sig•
niflcantly reduce the frequency, and degree, of stagflation in our economy.
Why can't we use monetary and fiscal discipline alone? Why must we also
adopt TIP? Monetary and fiscal discipline, if applied long enough, and severely
enough, can eventually cause enough unemployment and low profits to reduce
wage increases, until cost increases, and therefore price increases. Those who
advocate a balanced budget and slow monetary growth as a substitute for TIP
seldom indicate, specifically, the process by which wage increases are eventually
to be brought into line with productivity increases. They leave the impression
that there is a mysterious link between such discipline, and prices firms set.
But firms will raise prices as long as unit costs increase ; and unit costs will
increase as long as wage increases exceed productivity increases. So the issue
becomes: How can we bring down the growth in wages?
Monetary and fiscal restraint, alone, can only do it in one way: By causing
a severe enough recession. This is precisely the policy that was tried in 1974 and
early 1975. Tight monetary and fiscal policy helped cause a sharp decline in
aggregate demand, and the most severe recession since the 1930's. The impact on
wage inflation, and therefore, price inflation, was meager. Wage in,flation was
reduced from just above 10 percent to 8 percent; therefore, price inflation declined
no further than 6 percent. Despite the loss to our society of billions of dollars
worth of output, the inflation rate declined only a few percentage points to 6
percent. Sole reliance on monetary and fiscal discipline is not a new approach
waiting to be put to the test. It was just tried, with dismal results. Let advocates
of discipline-only tell us what went wrong in 1974 when their experiment was
attempted. How long, and severe, a recession do they recommend to bring down
the inflation rate?
This traditional method of reducing wage inflation is indirect, ineffective, and
enormously harmful. TIP provides a direct incentive to reduce wage increases,
and therefore, cost increases and price increases, instead of relying on a severe
recession to do it. Monetary and fiscal discipline are then required to reinforce
TIP, so that its disinflation effect is permanent. It is true that TIP cannot
succeed in the absence of monetary and fiscal restraint. But who asserts that it
can? The real choice is between TIP plus monetary and fiscal restraint ; vs.
monetary and fiscal restraint alone. The choice is therefore between reducing
inflation and unmployment together; vs. reducing inflation through high, prolonged unemployment.
Moreover, even if restraint, after years of recession, eventually brings down
the inflation rate, it will not change the NAIRU-the unemployment rate required to keep the inflation rate from accelerating. We would have to accept an
unemployment rate of 6 percent or higher to prevent a rise in the inflation rate.
Thus, the traditional approach asks us to endure years of high unemployment
to reduce inflation, and a permanent unemployment rate of perhaps 6 percent
in order to maintain low inflation. In contrast, TIP offers the prospect of reducing the NAIRU perhaps to 4 percent. Thus, in the longer run, the choice is


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b_etween running .the economy a.t a 4 percent unempfof:m~nt ta:te without inflation, vs. running the economy at a 6 percent unemployment rate without inflation.
TIP therefore deserves to be regarded as an anti-i;memployment, as well as antiinflation policy.
PRICES AND PROFITS

At first glance, it might seem natural to suggest tax incentives for price
increases, just as TIP provides tax incentives for wage increases. Tax incentives
for price increases, however, are almost certainly administratively unfeasible.
Most firms make a variety of products, with a variety of quality levels. It is
extremely difficult to distinguish a price change from a quality change.
The key practical distinction between wages and prices is that the manhour~
the unit of labor input-is well defined, while the unit of output is not. To
compute the wage, total compensation can be divided by total manhours, where
the latter can in principle be measured unambiguously. Price is revenue per unit
of fixed output; but the latter is not well defined. For example, support McDonald's keeps the nominal price of a Big Mac constant, but somewhat reduces
the quantity of beef, while changing the sauce. Has the true price of a Big Mac
increased? Similiarly, suppose it keeps the quantity of beef the same, but improves its quality, and also improves the quality of the sauce. If it raises the
nominal price of a Big Mac a dime, is this a price increase, or simply a quality
improvement? If it were regarded as a price increase under a tax incentive,
quality improvements would be discouraged.
Furthermore, a guidepost for prices is less justified than for wages. Although
wage increases are not identical for all firms, most increases are not too far
from the average, because labor mobility and perceptions of equity force most
wage increases to stay close to the general pattern. Wide disparities in productivity change, however, across firms-caused by diverse rates of technological innovation and capital formation-cause wide disparities in unit cost changes, and
therefore, price changes. Although the average price increased 6 percent in 1977,
some prices were cut sharply, while others increased sharply. These disparities
serve a vital function. They signal consumers where costs are falling, and where
costs are rising, so that consumers are encouraged to shift towards products
with falling costs, and away from products with rising costs.
Fortunately, tax incentives on prices are unnecessary. As explained earlier,
theory and evidence strongly ,Suggest that prices are tied to unit costs, and a
decline in the growth rate of unit costs will automatically bring down the growth
rate of prices. Nevertheless, labor deserves insurance. I would therefore suggest
that "real wage insurance," first proposed by Dr. Okun in 1974, be included in
the TIP package. Suppose wage inflation declines from 8 percent to 6 percent
in the initial year under TIP, but price inflation declines from 6 percent to only
5 percent (although theory and evidence expect a decline to 4 percent). Then
Congress would authorize in advance compensatory tax cuts for employees to
make up the difference. These tax cuts could be integrated with employee-TIP,
and implemented through withholding at each finn. Moreover, the withholding
tax cut could be varied with the wage increase at each firm, so that those who
exercised greatest wage restraint would receive the largest tax cut. The expected
cost to the Treasury of real wage insurance is zero, because the decline in price
inflation should automatically match the decline in wage inflation. Nevertheless,
it is important to guarantee protection. Real wage insurance should be enacted
as part of the TIP package, so that the compensatory tax cuts would be
assured in advance.
As in the case of prices, tax incentives for profit restraint at each firm would
have harmful effects. The firm's incentive to improve its efficiency, from which
consumers ultimately benefit, could be weakened by reducing the profit reward
The practical experience with the excess profits tax has not been encouraging.
Fortunately, as in the case of prices, tax incentives on profits are Jinnecessary.
As long as price inflation stays approximately equal to unit labor cost inflation.
the ratio of capital income to labor income must remain fairly constant; if
price inflation declines 2 pereeut when unit labor cost inf!.ation declines 2 percent,
then unit profit inflation must decline 2 percent. Neverless, labor deserves insurance. I would therfore suggest that the following prpposal, offered by Drs.
Lawrence Klein an(l Vijaya Duggal of Wharton Econometric Forecasting Associates at the University of Pennsylvania, deserves cal'e-ful consideration. According to their ,proposal, if the ratio of after-tax profit to labor income for the
whole corporate sector rises above some threshold when wage inflation declines,
then the base crporate tax rate can be raised equally for all firms to keep the
ratio at the threshold for that year. To reassure labor, this adjustment can be

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enacted in advance and made automatic. It should be emphasized that their
proposal would not attempt to define and tax "ex~s" profit J.t ~ individual
firm. Only the ,ratio for the whole corporate ,l!eetor ( or economy.) would be of
concern. TJ;ieir proposal would therefore avoid the difficulties of past excess
profit taxes.
CONCLUSIONS AND RECOMMENDATIONS

A tax-based incomes policy (TIP) should be adopted. TIP together with
monetary and fiscal restraint can reduce inflation and unemployment simultaneously and permanently. Labor, business, and the general public would therefore
all benefit greatly from TIP.
(2) TIP differs fundamentally from controls. It would harness tlle instniment
that has proved its effectiveness in our market economy : financial incentives.
It would leave business and labor free to make their own decisions without
government interference.
(3) The employer and employees at a firm that grants a Wl;l.ge increase above
the TIP target should both incur a tax penalty ; the employer and employees at a
firm that grants a wage increase below the target should both receive a tax
reward. The tax penalties must be stifl', but not prohibitive. Where market
forces, and the special conditions of the firm or industry, call .for a :relative
wage increase, it is essential that the firm .still be able to exceed the TIP
target, though by less than it would have without TIP.
( 4) The most crucial ingredient in the TIP package is the income tax penalty
on the employer who grants a wage increase above the target. It is most likely
to be effective. The best medicine does not always taste best.
( 5) Although TIP focuses on wage increases, .this does not mean that employees
(or their unions) who seek wage increases in excess of productivity increases, or
employers who grant such increases, should be blamed for inflation. Both labor
and business are trying to.protect their own position in•response to the incentives
they now confront. The aim of TIP is not to place blame, but to restructure
incentives, so that the outcom.e is best for labor, b'Q.siness, and the public.
(6) Economic theory and econometric evidence strongly suggest that the price
inflation rate approximately equals the wage inflation rate minus the productivity growth rate (2 percent). Thus, if TIP reduces the .wage inflation rate
gradually to 2 percent, it will automatically reduce the inflation rate to zero.
Tax incentives for prices or profits are therefore unnecessary. Moreover, they
would have harmful effects.
(7) Labor should be protected by "real wage insurance," which would guarantee automatic tax cuts for employees if the decline in price ,.inflation fails to
match the decline in wage inflation for the whole econol)ly; .and .possibly by an
automatic upward adjustment of the corporate income tax rate for all firms
should profit il!:flation fail to decline with wage inflation.
(8) A permanent TIP may be able to reduce the non,accelerating-inflation
rate of unemployment [NAIRU] of the economy. If so, it would be,possibleto run
the economy at perhaps a 4 percent unemployment rate without caush1g a rise in
the inflation rate. TIP should therefore be regarded as an anti-unemployment, as
well as an anti-inflation policy.
(1)

Representative LoNa. What is your thinking about the administrative feasibility o:f a plan such as this, Mr. Gordon i
Mr. ,GoRDoN. I would de:fer to Mr. Pechman on administrative details, since that is something he has done a lot 0£ thinking about and
I haven't. I wCiluld perhaps perform some service by emphasizing the
points that he made that I think are the most important.
The first is the possibility o:f having a carrot .or rewards scheme
without giving it to everyone. 0£ course, the small firm will holler
bloody murder i:f it isn't given a subsidy.
Second, the penalty schemes. I think those are perhaps imt1,ginable
i:f you do it after the fact, as he said, But then the horse is out the barn
door, because as I emphasized in my statemE1nt, we are stuck with the
3-year wage contracts. That is a unique problem we have.
What good is it going to <ilo i£ a firm finally figi.xres out in 1980 that
its wages went up too much in 1979 and it has to.pay a big taxi It has


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already negotiated its 10-percent wage increase, which Mr. Bosworth
objected to so strongly. So what? All it is left with is a higher tax bill.
What is that ·going to do? Two things in some combination.
It will try to recoup that through higher prices, or the profits will
be squeezed and will have an effect on investment. Using Mr: Seidman's
own scheme and numbers, he makes the penalty sound pretty modest
by giving an example of a firm which, with a 6-percent norm, actually
negotiates a 7-percent agreement.
What happens with the coal mining firm that already is stuck with
a 3-year agreement with a 10-percent average rate of wage increases?
His corporate income tax goes up from 48 to 72 percent; 72 percent is
a wartime type of confiscation, and it is bound to cause a crisis in coal
mining or raise coal prices, and I suspect it would mainly raise coal
prices.
I think this is something Mr. Seidman's scheme continually evades,
because of a hope that when the coal miners come up next time and
they see the poor struggling coal mining firm, which has been forced
to pay a 72-percent tax rate the last time, they are going to feel sorry
for it and they .are going to be very modest.
They are going to be modest after the teamsters got 10 percent and
the railroad workers got 10 percent and the auto workers got 10.5
percent? I don't think that is the way the world works.
The unions are looking at what the last guy got, and it is the
staggered set of wage contracts. One guy expires in March and the
next guy who expires in May is trying to get as much as the guy who
expires in March. That is one of the reasons our inflation is so hard to
slow down. It would create a revolution if Congress tried to do something about that.
That is where the heart of the problem lies, and we might as "·ell
put it on the table and begin to grapple with that. I h.ate to say this,
because it is conventional in political circles. We always say we have
big business and big labor, but the consequences of Mr. Bosworth's
testimony this morning-his problem is big labor, finding a way to
get labor to slow down its wage demands.
Mr. PECHMAN. I didn't know my friend, Mr. Gordon, had latent
abilities as a tax expert. It is clear that his analytical abilities in these
areas are very good.
I did want to respond to what Mr. Seidman said about the analogy
between the tax-based incomes policy and the income tax. Unfortunately, the analogy is just not correct, The analogy should be to a tax
based upon events that occurred in two different years, and that is a
very different thing.
I:f you had asked me in 1913 whether the United States should
introduce an excess income tax, I would have said "no," but I would
have said that an income tax based on a single year would have been
possible.
As I indicated before, in the case of excess profits taxation, we have
done it during wartime and every time it was used, it was agreed that
it was messy. The litigation extended over a period of 20 or 25 years
after World War II, and perhaps over 10 years in the Korean war. I
wasinthe Treasury Department at that time, and wetried hard to fake
care of the .abnormal cases. However, the litigation extended for a long
time after the Korean war.


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Another example of £his a pp roach was a proposal to provide a carrot
for firms that had a larger amount of investment than the amount of
investment in the base period. Congress rejected that out of hand in
the early 1960's even though economists were unanimous in saying that
a differential investment credit would be more effective than a flat
credit.
The only part of the income tax that I can remember that relates to
2 different years was the capital gains tax, and the committee will recognize right away that that part of the code is the most complicated
and has given us the most headaches.
Most economists would say that the realization principle that is
used for capital gains taxation is wrong, that what you should do is
base the tax upon changes in the value of assets between two periods of
time. Every country in the world has rejected that approach on simple
practical grounds, because it is extremely difficult to value assets
between two periods of time, and even if you could, you wouldn't want
to impose atax, because there would be a payment problem.
So if you want analogies, you should take the correct analogies. I
submit to you that, ·on the basis of the history of taxation in this
country and abroad, experience does suggest that this kind of approach
is extremely difficult to implement.
Representative LONG. Mr. Seidman, you have stimulated some
thought, as I cari see, through the economic circles. Do you have anything you would like to add at this time 1
Mr. SEIDMAN. Let me briefly respond, first, to what Mr. Pechman
said.
·
I agree with hiS' point about the two separate events and the 21 different year comparisons involved, but most of his statement involved
the other reasons I was addressing. If you look back on his statement,
the first issue was coverage. That would have been an issue if we wern
issue under the income tax.
The second is the economic unit. That would be an issue under the
income tax. Timing the penalty or subsidy. That would have been an
issue under the income tax.
So a good part of the problems he is raising-I think they are important problems-would al.so be problems if we were sitting here contemplating whether we should enact an income tax. Only one of the
problems h~ is raising is different, although not completely different,
because there is the analogy of capital gains.
Again, I am not a tax expert. My only point is this : Up to this point,
there is not unanimity of the tax experts who have looked at this. Richard Slitor, who did a careful study of TIP at the request of Henry Wallich, came to much more positive conclusions, concerning the feasibility, and I would urge you to read his comments in the Brookings
volume on TIP.
Emily Sunley and Larry Dildine at the Treasury raised a number of
problems. I don't know if you would say they are more positive or less
positive than you. I think it depends on which part. What we need is to
go further. We must go to the next stage of having legislation drafted,
to write regulations, and have a larger sample of tax and collective
b,argaining experts, begin to scrutinize the points and see.
The only point I am making is that the accumulation of a list of
potential problems should not let us become overly discouraged. There


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are few taxes that we have enacted that you couldn't have gotten prematurely discouraged about as well. That is my only point.
With respect to Mr. Gordon, the first point is on the phasing in.
There is certainly no consensus among advocates of TIP to apply the
tax rate to previously negotiated deferred wage increases if we began
TIP at the beginning of the next year: Obviously we have to think
carefully of the phase-in problem and what do you do about contracts
already negotiated, but certainly I am sure most advocates of TIP
would not say that you should simply impose a tax penalty on them
because they had already negotiated the contract and then let them
have to bear that high penalty.
So we need to think about the phase-in, and not assume that that is
what we would do.
Also, the other implication you draw that puzzles me is that, certainly, the penalty version of Weintraub-Wallich does not depend on
unions feeling sorry for management's profit squeeze.
My basic view is that the clash of the push of labor and the resistance
of management determines the wage outcome. Today that average
comes out at 8 percent. There are very few workers who do not believe
sincerely that they deserve more than what they get, and they press for
more and would like to have more.
At some point management's resfatance, because of the consequence
for after-tax profit, becomes greater than the push for labor and some
equilibrium point is reached. Today the average is 8 percent.
What the TIP penalty is trying to do is make the point where management digs in, and became, say, 6 percent, instead of 8 to change·
the push-resistance balance point. But it surely does not depend on
saying that workers are now supposed to feel sorry for management.
If we depended on that, it wouldn't work.
Representative LONG. Congressman Brown.
Representative BROWN of Ohio. Thank you, Congressman Long.
I am impressed with a couple of suggestions made by Mr. Gordon,.
and I want to pursue those.
You talked about the cost of regulation. Mr. Bosworth talked about
the cost of regulation. We have had some figures presented to the,
committee by Mr. Murray Weidenbaum where he quantified the cost
of regulation in total dollar amounts. They may be debatable, and
they may or may not be close to the mark, but they represent the first
definitive study on the subject.
The question is, what kinds of supply-side impacts would be made
in terms of termination in some of these regulations or even holding·
the line in the development of regulations? Do you have any figures
or statistics on that?
Mr. GORDON. Yes., I can give you a specific exampl,e of the kind of·
research that needs to be done on a broader scale. This is in the area
of _how much regulation has increased the I cost of operating·
automobiles.
Now, the figures, as I read them in the press, Mr. Weidenbaum referred to the extra devices required by the Government to be placed
on an automobile. There is .something else that turns out to be even.
more important over the last 10 years that has been done to the automobile by Government regulations, and that is the lost fuel economy·
of antipollution regulations.


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Now, we have done a study of the whole question of gasoline economy from 1949 to the present, and we found out something that is
really hidden in the statistics entirely. That is, it looks, in the crude
data, like gasoline mileage didn't improve at all between the late 1940's
and the late 1960's. That is because cars were getting bigger.
If you correct for the quality of automobiles, we had an almost 30~
percent improvement in fuel economy, and then almost a 20-percent
decline as the antipollution laws took effect.
,
If you take the difference between what we coqld achieve and what
we did achieve, it turns out to be $300 per automobile, and that iS'
more than the BLS figures for the actual cost of devices placed on the
automobiles.
'
Now, we have a wh_ole new set of regulations essentially trying to
counteract that by trymg to force the cars to become smaller. The fact
is that that is a measurable cost, and something that could be undone
by loosening the regulations. I am not saying we don't need regulations, but I think the American public has no idea of the operating
costs and the capital costs in the case of the automobile that is being
imposed on them.
I think the choice put to them is that the error you have enjoyed,
and it is a very hard question to ask, is, is it worth that much? w·ould
you vote for-well, we know that diminishing returns are reached at
the wells. Each dollar produces less and less in the form of better air
as you tighten regulations.
So maybe only 80 percent effective regulations instead of 99 percent effective would give you a tremendous payoff. It would come out
in improved gas mileage, and so forth. That would go right into the
CPI in the year it happened.
.
Representative BROWN of Ohio. Would you have any suggestions
as to specific legislative approaches that might be taken in this area?
Mr. GORDON. I think there has been a lot of testimony by economists
dating back to the economic summit in the fall of 1974 when Mr.
Houthakker had his 41 points, which I thought of as Martin Luther
nailing the theses on the door of Congress.
Since I have a particular interest in the airline industry, I have
been astonished to see how airline executives, who thought the demand
elasticity £or air travel was very low, suddenly found the Government
:forcing them to reduce fares and putting a gold mine in their hands.
This kind of effect of creating a more competitive economy, which
economists are all lecturing Congress about, could go info numerous
other areas, whether it is truck transportation or maritime transportation.
You have to realize you have lobbies down in the corridor that have
something to lose and the whole competitive economy, the consumerat-large has something to gain, but they are not out there in the
corridors.
I wanted to stress one more thing which I think I said briefly in
the testimony. I£ you look at the energy bill, for instance, there are a
number of Congressmen who are against raising prices because they
worry that that would aggravate in~at~on. Look at how much inflation has been aggravated by the declme m the dollar. The turnaround
in. the dollar that would occur with an energy plan that cuts .consumption will give us a bonus in the slower increase in the price of
imports.


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I was reading an advertisement by the Government of Japan in
Business Week magazine, and they point out their GNP in real terms
has gone up more than ours has, and yet they are using no more
energy now than they were in 1973. That is, of course, because they
have allowed the price to go up with world prices, whereas we have
not.
Representative BROWN of Ohio. I want to pursue a comment Mr.
Gordon made, and I am having difficulty finding it here, about the
fact that we have had very low productivity increases, and in recent
years employment has gone up without a substantial increase in productivity. I don't find the statement.
Representative L{rnG. That is the essence of the statement.
Mr. GORDON. Yes.
Representative BROWN of Ohio. My question is: How do you pnt that
together with the political-Mr. GORDON. You are referring to the structural change that I said
was better known?
Representrutive BROWN of Ohio. Yes. Industrial production grew at
a rate three times faster than employment in 1970-73, but currently
we are improving our production not as fast as employment.
Mr. GoRDON. Over the last 12 months production has gone up 5 percent and employment has gone up 4 percent. So it has barely stayed
ahead.
Representative BROWN of Ohio. ,v-hat do you do with that when we
still seem to have more unemployment than we like? There is a political
difficulty in suggesting that we ought to put a premium on improving
the productivity of plants by tax incentives or real cost depreciation
systems, or enhancing savings at a time when we have unemployment.
Mr. PECHMAN. It indicates thait public policy should bend in the
direction of stimulating additional productivity. I am not sanguine
about-Representative BROWN of Ohio. Even at the cost of increased unemployment? Wouldn't that result in increased unemployment? Or
would it?
Mr. PEcHMAN. No; not if your demand policies are geared to provide enough demand for the workers. I don't fear productivity. After
all, if productivity rises-Representative BROWN of Ohio. But if we have increased productivity, aren't we likely to wind up with more goods than we ha.ve demand for?
Mr. PECHMAN. Not if aggregate monetary and fiscal policies are
geared to clearing the shelves at the higher production level. Theimportant point you are raising is whether we now should use tax policy
?r any other policy to promote increased productivity and more
mvestment.
The answer is yes. I don't think there is .any economist who would
disagree that in the next tax bill, and I do hope you will have a tax
bill this year-Representative BROWN of Ohio. That could be said about so many
bills. [Laughter.]
l\fr: PECHMAN [contin~ingJ .. And that a substantial portion of the
tax bill should go to busmess m the form of rate cuts or investment
credits to promote investment.


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I 'am. still a little conservative, I must say, about the proposa~ that
has been made to index taxes. It is the same story that ~ mentioned
{larlier. Indexing the tax system means tl~at you ,~,re trymg to undo
something that happened between two periods of time, and, once you
get into that area, you are in a morass. .
.
.
.
Take the question, for example, of mdexu1;g capital gams. If you
did that, you would be generatmg real losses m 1!1-any cases whe!'e the
t-axpayer reports a nominal gain. A taxpayer might report a $.:>0,000
capital O'ain which in the end might turn out to be a real loss of
$25,000. Wh~t do you do with that $25,000?
Representative BROWN of Ohio. Please explain that to me.
Mr. PECHMAN. Well, suppose he bought the asset for $100,000 and
sold it for $150,000. That is a nominal capital gain of $50,000. Suppose
in the same ,period prices increased 75 percent, so that the real co~t
of the asset was $175,000. So his real gain is negative; actually, it 1s
minus $25,000. One would think the answer is that we should not tax:
the $50,000 gain. But what do we do with the losses i
There are many other taxpayers in the system who report gains and.
have real losses. Take the saving and loan depositor who has been
receiving a 5-percent rate of return on his deposits in a period when
inflation is 7 percent. He has been taxable on the 5 percent in full, yet
he had a real loss averaging 2 percent a year.
Representative BROWN of Ohio. You might even mention the steel
industry, which had shown a nominal profit for some years, although
its plants has deteriorated.
Mr. PECHMAN. That is right. That is a comparable situation.
The point is that, trying to a<ljust part of the system, as some people
want to do-say adjust for capital gains alone, or provide some measure of replacement costs for depreciation-is not the answer, be~ause
you will create a great many more inequities that will come back to
haunt you.
..
I thmk t,he answer is either stick with the present system and try
to combat inflation. That is my preferred answer. Alternatively, if you
go to the full indexing system, you will incur the many admirnstrative
problems.
Representative BROWN of Ohio. But you mentioned the administrative problems in your testimony, and I was impressed with the point
that the administrative problems are just overwhelming.
Mr. PECHMAN. I agree, and I also think the administrative prob,
lems of indexing are very difficult.
Representative BROWN of Ohio. I get teirribly concerned about the
fact that we now have two categories of natural gas and in the proposed natural gas pricing arrangements there will be 23 different categories of natural gas, and I don't have a gas well in my district. I don't
know what Congressman Long here has. He must get hysterical.
How is the Federal Government going to determine all those different thin 1gs?
Mr. PECHMAN. I agree that the sooner we get out of regulated prices,
the better. But there is a probrem with how to get them from here
to the!e, as. I indicated in my discussion of the problem of how to
get to mdexmg.
~epresenfative BROWN of Ohio. Let me pursue that, and I am not
tr;nng to entrap you, but, if we don't regulate prices of commodities,


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and we don't regulate prices of labor, and we don't in effect regulate
the taxes through indexing-and I think tax indexing is a form of
regulation of taxes-then the Federal Government is saying that you
keep your taxes down there where they belong; there seems to be no
other solution.
Mr. PECHMAN. There are only two solutions, and I think the economists are agreed on that. One solution is simply to run a tight enough
monetary fiscal policy and put the economy through a wringer to inhibit demand and pay no attention to how much unemployment you
create, but wring the infi'ation out of the system.
There ,a;re ~ple who honestly believe that it would be better to run
an ecoll'Omy with 8 or 9 or 10 percent unemployment for 5 years than
to keep unemployment down at 6 percent and have a 7-percent inflation.
Rep,resentative BROWN of Ohio, Can I throw in a paragraph there t
It occurs to me that that is ,a little bit like what Mr. Seidman
has proposed, be~use what he has said is that we are not going to
inhibit demand iby holding the money supply down. We are going
to, if they get a 7_-percent increase, but should they only have a 6-percent increase-we 1are going to take it away from them in taxes. I
think it has something.of the same impact, doesn't it 1
Mr. PECHMAN. Mr. Seidman's proposal comes in the class of the
second alternative, which is also difficult and unpalatable to many
poople; that is, to do something about the wage- and price-setting
process.
If we had oompetition in industry and labor markets, the effect of
the first policy would be more immediate, and you wouldn't have to
go through the course I refer to to stop inflation.
The people who believe the second point of view argue that the cost
of stopping inflation by traditional methods is just too high and, therefore, would somehow get into the wage and price setting pl"OCess so
that I,abor and business conduct their affairs in the public interest,
which would wind down the wages and prices. These are the two
alternatives.
Representative BROWN of Ohio. You had me all excitE:'d, because
I thought you were ,going to give me a solution, and you ?"ave me two
rulternatives, both of which seem to be unacceptable, and I am now
de0:ressed •again.
Mr. PECHMAN. I regret it, but the two alternatives are depressing.
Representative BROWN of Ohio. You don't think there are any
other alternatives 1
Mr. PECIJMAN. No.
Representative LoNG. Which one would vou choose ?
Mr. PEcHl\!AN. I would choose general income policies which wonld
not be tax based.
Mr. GoRDON. I think mv statement state,c; alternatives three nnd four,
which I think should be laid out on the table for some discussion.
At a given s.mount of demand we can produce the wedge of taxes
and other things which will :force up prices in relation to what the
worker gets. Tlhat is the minimum wage, payroll taxes, regulations,
and the other thin~ I mentioned.
The final thing is that I don't think any of these three alternatives
f,w dealing with inflation demanding restriction, conkols, or sunplyside measurement is going to have an immediate drastic effect. We are
not going to go from 7 percent inflation this year to 2 percent inflation

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this year. We might go from 7 to 6.5 to 6 percent. That is still a 6percent inflation that the small saver has to cope with.
Representative BROWN of Ohio. In the same way that we don't
jump from 3 percent inflation to 100 percent inflation. We jump from
3 to 10, and then we get used to 10, and then we jump to something
else. Is that what yoµ are suggesting? Does it work the same way going
downasupi
Mr. GoRDON. l think I suggested why we have found ourselves with
7 percent, whereas in 1970 or 19'71 we had 5 percent, and that is
cumulative-Representative BROWN of Ohio. And we put on wage and price
controls to cure 5 percent and wound up with 7 percent.
Mr. Gol!DON. That is right.
Representative BROWN of Ohio. We cured 5 percent, ,anyway.
Mr. GoRDON. I have seen almost 10 studies on wage and price controls which agree with the conclusion I reached as early as 1972, which
is that price oontrols squeeezd profits temporarily and the moment
they were lifted, prices oame back to where they would have been.
Anyway, to get back to the train of thought, if we are going to be
stuck with the 6 percent, I think there is every reason to go into the
areas of liying with ii\flation which I mentioned, and I do not think
that the ,administrati,ve obstacles of simply upgrading the exceptions
and the tax brackets with CPI are onerous at all. They are already
doing it in Canada.
The ques~ion :of caI?ital g~ins is tougher, beea~se, as Mr. Pech~~n
says, any kind of capital gams taxes have some of the same •admimstrative problems.
I was thinking how you oould write a tax: rule to prevent me from
deducting e:11 my interest payments, or the portion that is due to the
increase in the oost of livmg. In other words, I go out and borrow,
nnd buy now boos.use things wottld oost m.ore next. year, because the
Federal Governme:nt encourages me to do that. That 1s, encourages
borrowing and discourages saving.
We could start out as an approxim&tion by letting people deduct
onlv half of the amount they boTI'Ow. That would be better than doing
nothing.
Representative BROWN of Ohio. H I had a 4-percent mortgage on
my h011se, or 5¾ percent on my house, versus the guy who has a 10.5pel'Cent mortgage on his house-Mr. GoRDON. You al'e making a killing and he is not.
Representative BROWN of Ohio. But he gets a bigger tax: break
than I do.
Mr. GoRDON. That is right; but you have essentially a windfall
which now is oot 'being taxed at all.
Representative BROWN of Ohio. You mentioned alternatives three
and :four!
·
l\fr. GoRDON;. _Thr_ee is dealing wit~ inflation directly by trying to
reduce cost-ra1smg items, both those mtroduced by the Federal Gove.rnment and those that are not, particularly t·axes that are inflationary,
like the payroll tax, minimum wage, and so on. That is what I call
supply-side solutions to the inflation problem.
Representative BROWN of Ohio. In other words, don't raise the minimum wage and don't add to social security taxes.


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Mr. GoRDON. And what I said before you came in, that .the timid,
politically acceptable solution is to. postpone the increases for 1 year.
The second is that I said ignore George Meany and have a two-tier
system and get rid 0£ the minimum wage f,or,peqple under 25.
The fourth category is living with inflation. That is the fact-let's
realize nothing is going-to work immediately an.d let's try to minimize
the burden and impact on society in terms of reduced investment and
.
.
the reduced savings.
That is where the indexing comes in, and it includes an indexed
bond, by the way.
Representative BROWN of Ohio. I thought you might come up with
a fifth choice, or maybe I have mistaken this in three and four, and
that is to provide some long-range stimulation for greater production
of goods which, you know, in the old Henry Ford sense, we seem to
have lost track of. That is, build a better mousetrap and the world will
beat a path to your door. Instead of raising the automobile prices 8
or 10 percent a year to keep up with inflation, we should encourage investment in cost-saving techniques, because it reduces tlie price.
That seems to me to be a lost art in this country, and perhaps abroad.
I am not sure.
Is there anything cheaper than it used to be?
Mr. GORDON. Let me tie this together a little bit and show how
a number of these measures can deal with productivity, which is the
.
direct method of coping with inflation.
The entire regulation discussion means that a steel firm is putting
money into smokestacks and filters which could be put into more pro.
ductive steelmaking.
Mr. Bosworth mentioned this morning, at about 10 :30, that he was
struck by the fact tllat there were virtually no "greenfield," as he
called th.em, investment projects going on, people setting up new steel
plants, which is the best way to increase produttivity.
Representative BuowN of Ohio. In this country that is not happening. It is happening in other places.
Mr. GoRI>oN, That is part of the problem. The reason it is not happening comes from two sources. We were doing it 10 years ago. Why
not now?
In the first place, the tax system itself has ~reated these distortions
which we referred to that means that firms are being taxed on a phony
basis. Your steelmaking firms would have made losses in the years if
they had had true inflation costs and depreciation.
Representative BROWN of Ohio. Or if they had, getting to the subject
of jawboning, from every President from Eisenhower right on
through-Mr. GoRDON. That is true. I am against any controls and jawboning.
·
I think you end up with distortions.
Th~ Government h~s made it expensive to build a new steel plant.
That 1s the second pomt. You put that together, and the uncertainty,
the worry about whether controls are going to be put on, that makes
steel presidents say no, whereas otherwise they might say yes.
Representative BROWN of Ohio. I just came from a hearin()' on
nuclear powerplant licensing. In the testimony, it was conceded to be
10 ~o 12 years from the tim~ you decide you are_ going to build a plant
un.til you get a plant on hne, and that has killed nuclear power in
this country because of the economics of it. A utility cannot afford to


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carry that financing for that long and pass it onto its consumers, because it does not work out economically.
In fact, the recent figures are not 10 to 12 years, but between 12 and
16 years. It seems to be getting worse.
Mr. GoRDON. If I could interject there.
Living in Chicago, where almost half of the electricity comes from
nuclear power, we have been beneficiaries on two occasions, and we
looked at the problems of New York and felt somewhat smug, and we
looked at the problems of Ohio and felt somewhat superior. We had a
certain built-in capacity which is not heavily resource using, which fortunately was built at the low prices of years ago. It is too bad that we
have this very strong political movement in this country that is antinuclear. That is not my specialty.
.
Representative BROWN of Ohio. Would you make a brief reply, Mr.
Seidman and Mr. Pechman?
Mr. SEIDMAN. I agree with the way Mr. Pechman ch11,racterizes the
choices as being fundamentally two.
Three and four, that Mr. Gordon puts forward, let's look at them.
No. 4 is living with inflation.
Representative BROWN of Ohio. But our country has, :for years and
years, with some aberrational jumps and some low points, lived with
3-percent inflation. Is that much different from living with a 10-percent inflation, or 40-percent inflation?
You know, it strikes me that it is a little like Bernard Shaw's conversation with the actress. It is not really what you are; you are just
haggling· about the price. We have lived with inflation in the past at
3 percent. It seemed not to be oppressive. Couldn't we live with 7 or
l0percent?
Mr. SEIDMAN. Sure. We may have to if we don't do something about
it.
My only point is that policies to reduce inflation, there are basically
two choices.
As a matter o:f fact, some o:f the fine studies that Mr. Gordon.himself
has done on the relation .of prices and wages reinforce this general
empirical relationship. If you have wages going up at 8 percent a
year, but productivity going up 2 percent, then unit labor costs are
going to rise 6 percent, and there is no business that can avoid raising
its price 6 percent to cover it.
You have got to get wage increases down to the level o:f the increase
in output per worker, or you are not going to be able to get inflation
under control. It is one of the necessary conditions.
I am not saying it is the only thing to fight inflation, but it is central.
It is key.
Representative BRowN·of Ohio. Now you have answered why we
can't live with 7- to 10-percent inflation. We could live with it if we
had a 7-percent increase m productivity.
Mr. SEIDMAN. Which we are not going to have.
Representative BROWN of Ohio. Or maybe we could live with a 2percent increase in productivity and a 7-percent increase in inflation
if nobody else had a higher productivity rate than we do. But, if somebody else does, then we get impacted by their ability to produce more
rapidly than we, and tend to lose our employment to them. Is that
right?
37-250-70-8


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Mr. SEIDMAN. Let me repeat my point. My point is.that if we have
money wage increases, wage and salary, and I am talkmgabout executives and university professors, as well as factory workers, at a rate of
8 percent, when we are only producing in real terms 2 percent more
per year, then what hapl?ens is that the unit costs go up by the difference, 6 percent, and busmessmen will raise prices to cover that, and
we will have an inflation rate of 6 percent, which is basically describing the current situation.
·
There is no way that we can get the inflation rate down unless we
bring wage and salary incooases down into line with productivity
increases, which are roughly in the neighborhood of 2 percent. If
we can get productivity increases up to 3 percent, then we would only
have to bring it down to 3; but basically the question is how do we
bring it down to get it into line.
There are only two ways. Mr. Pechman said you can slow the whole
"conomy dowtJ. by tight mo:netary and fiscal policy, ft>r .example, throw
enough people out of work and lower profits so that workers won't
press as hard for wage increases and businesses won't be able to afford
to give them.
The strategy of zero-balanced budget a,nd tight monetary policy
alone must work that way.
If you press any of the economists advocating that course, they will
<'Oncede that the scenario requires a rise in unemployment which they
feel will be temporary, but when pressed will admit is could be 4 or 5
years.
The only other althernativ-e would be an incomes policy. There are
only three kinds of incomes policies. One is voluntary persuasion. The
current administration policy is that. The other extreme is controls.
Representative BROWN of Ohio. Curing inflation with the jawbone
of Mr. Strauss?
Mr. SEIDMAN. That is ri~ht.
The intermediate one, the one I am suggestin~. is to use tax incentives. That is the on:ly approach to incomes policy that hasn't been
tried yet. It is more . flexible than controls on the one hand, but tougher
than persuasion on the other.
Mr. Peehman is right. There are practical proMems with a tax ineenti:ve approach, buUihere are also great difficulties with the other two.
Persuasion doesn't have the teeth to work; and controls, on the other
hand, have all the rigidities and administrative difficulty that I say are
much greater than under a tax-based inoomes,polfoy.
As Mr. Okun said, we don't arrive at TIP because we think it is a
perfect, beautiful policy. We support it beca:use it is the least worst
of all the other feasible alternatives.
Representative BROWN of Ohio. But why would you ignore the
other side of the problem i I feel obliged to raise a question which
I am sure Senator J avits would raise if he were here. That is, why
don't you increase prgductivity i
That seems to me to be the other side of the problem that you say
is unaddressable. One of the things we worried about at the end of
World War II was that we didn't have the jobs for all the men and
women who were co!ll~ng out of service, and suddenly we realized that
we had the productivity and the pent-up demand, and when they all
came out of the service, instead of making jeeps, they were making
Chevrolets.

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It seems to me that if you have that productivity increase through
the capacity to get investment into modernization of plant, which we
talked about a minute ago, that you would then have the jobs for the
young, the blacks, and the people who are now not employed. You
could also say to the working man, "More power to you. Ask for more
money next year because we will be producing more and will be able
to give you more money next year."
Mr. SEIDMAN. One reason you have had such p<>or productivity performance is that because of the concern about mffation we have used
tight monetary and fiscal policy several times in the last decade to slow
the economy down.
Representative BoowN of Ohio. Maybe that was a mistak,e.
Mr. SEIDMAN. No, I think given the lack of an effective incomes
policy, there was no other choice.
Representative BROWN of Ohio. The Germans haven't had this problem because the Germans have had a savings rate much higher than
ours. Therefore, they have stimulated the produetion of more goods,
more efficiently, by the fact that they had high savings and therefore
a high investment in the increase of plant and capacity.
Mr. SEIDMAN. Everybody is for increasing plant and capacity and
productivity, but there is no one who thinks you can get our productivity growth rate up to 8 percent, which is the growth rate of wages
and salaries.
Even in the 1960's, when we were doing much better, we were growing 3 percent in productivity per year.
Representative BRow:N" of Ohio. I understand that our.productivity
has been as high as 5 percent. Is that right 1
:Mr. PECHMAN. No.
Mr. GoRDON. Only in cyclicalrecovery.
~Ir. SEIDMAN. Let's do the things we can to raise productivity, but
let's not use that as a convenient escape from the problem. It is politically easy to say, "Let's raise productivity." It is politically difficult to
say, "Let us restrain our wage and salary increases to get them into
line with whatever productivity we have been able to achieve."
We can't ignore that difficult issue by trying to focus on the thing
that is popular.
Representative BROWN of Ohio. Let me go back to Henry Ford.
When you had an inflation rate of, say, 3 percent, and the cost of the
automobile is going down, didn't you have a rather peculiar circumstance there because you had productivity in that industry at a rate
in excess, certainly, of 3 percent 1
Mr. GoRDON. The cost of IBM computers has gone down 20 percent over the past few years'.
Representative BROWN of Ohio. But the industry created the-Mr. GoRDON. That allows them to cut prices even if their wages are
going up with Mr. Seidman's 8 percent.
Representative LONG. Gentlemen, we have about 2 minutes.
Mr. GoRDON. The third solution, which Mr. Seidman is attempting
to rule out, comes very neatly into his own numbers. With his 8-percent wage increases and his 2-percent productivity, he gets 6-percent
inflation. If we get productivity up to 2.5, inflation goes to 5.5 percent.
Next year, the workers would have their wages held down by the
contracts. The inflation will slow down gradually.
If the employer gets a payroll tax cut, he can raise prices less.

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Congressman Brown, you came in late so you missed a reference I
made to Germany which is of some interest to you, and why they were·
able to hold down their inflation and slow it down by tight monetary
policy, and we weren't.
The big difference between the two countries does not have to do·
with the high savings rate, but rather with the labor market institutions, where they have renegotiation of contracts every year; and, if
we could have all the unions of this country come into a room with
Chairman Miller of the Federal Reserve and work out a deal once
a year where labor is going to promise them stability-Representative BROWN of Ohio. The difference is that Germans accept productivity advancement and modernization of plants.
:Mr. GoRDoN. .And lower wages.
R~presentative LoNG. Gentlemen, thank you for a provocative dis-cuss10n.
The hearing is recessed.
[Whereupon, at 12 :53 p.m., the committee recessed, to reconvene at.
9 :30 a.m., Tuesday, July 25, 1978.]


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THE 1978 MIDYEAR REVIEW OF THE ECONOMY
TUESDAY, JULY 25, 1978

LOCAL DISTRESS, STATE SURPLUSES, PROPOSITION 13: PRELUDE
TO FISCAL CRISIS OR NEW OPPORTUNITIES!'

CONGRESS OF THE UNITED STATES,
·SUBCOMMITTEE ON THE CITY OF THE HOUSE BANKING,
FINANCE AND URBAN AFFAIRS COMMITTEE
AND THE JOINT ECONOMIC COMMITTEE,
W(l,8hington,D.O.
The committees met, pursuant to recess, at 9 :35 a.m., in room 2128,
Rayburn House Office Building. Hon. Henry S. Reuss ( chairman,
House Subcommittee on the City) and Hon. William S. Moorhead
(member of the Joint Economic Committee) copresiding.
Present :from the Subcommittee on the City: Representatives Reuss,
Eattison, Cavanaugh, Mattox, Watkins, Kelly, McKinney, and Fenwick. Present from the Joint Economic Committee: Representatives
:Moorhead and Long; and Senators McGovern and J a vits.
Joint Economic Committee staff present: Deborah N orelli Matz
and Paul B. Manchester, professional staff members; Louis C. Krauthoff II, assistant director; Allen Stone, assistant to Senator McGovern;
and Charles H. Bradford and Mark R. Policinski, minority profe'Ssional staff members.
OPENING STATEJirENT oF REPRESENTATIVE REuss, CoPRESII>ING
Representative REuss .. Good morning. The joint session of the Joint
Economic Committee and the Subcommittee on the City of the House
Committee on Banking, Finance and Urban Affairs will be in order for
its consideration of "After Proposition 13, What?"
I am honored to be joined by Representative William S. Moorhead
of Pennsylvania, who will share with me the chairmanship of today's
joint hearing. We have until noon, or a little after noon, today, to do
an awful lot of work, so I want to get right to it.
The, antitax sentiment that surfaced recently in California is sweeping across the Nation posing challenges to Government at all levels.
The message from Proposition 13--opinion polls, and the campaign
that brought President Carter to the White House-is that Americans
want to halt wasteful and ineffective programs. ·
Economizing, as the President has discovered, is easier said than
done. The fat and frills decried by some, are defended by others as
essential. So what services to cut or which agencies to consolidate are
tough decisions, and taxpayers need more credible and persuasive
(637)

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llxplanations of the trade-offs. Yet the choice is clear: Officials must
find orderly ways to cut costs, or await the day when irate citizens impose crude and insensitive instruments of their own.
·
The prospects aren't all dismal. Some States use their revenues to
provide local tax relief. A number have made property taxes more
acceptable through such devices as circuitbreakers and abatements
for rehabilitation.
When the library in the California town of Ojai was slated to be shut
down recently for lack of funds, citizens rallied with volunteer staffing
and donations. This approach may have limited applicability, but it
indicates the resourcefulness and creativity of Americans tJhat communities can capitalize on.
1Ve two committees are meeting today, concluding the .Toint Economic Committee's Midyear Revie,w of the Economy. When Congressman Moorhead and I learned that we were separately planning to
touch on closely related issues, we agreed, in the spirit of economy and
efficiency to combine forces.
I'm happy that Representative Moorhead will be cochairing this,
hearing.
Today's hearing comprises three panels of witnesses. The first wilf
discuss the rationale of measures such as Proposition 13 and how they
will affect cities, counties, and the States.
The second will examine the fiscal status of State and local governments, how extensive their surpluses are, and what it implies.
The third will look at the prospects for curbing local government
spending, developing new revenue sources, and devising more efficient
governmental structures.
Tomorrow, the Subcommittee on the City meets again to focus on
local government productivity and how to cut costs without sacrificing
essential services. Further hearings and reports on these vital issues
will be scheduled in the months •ahead.
The first panel will focus on the subjects of why the taxpayers are in
revolt, and what are the consequences for local g-overnment and their
citizens. The panel consists of Professor Neil H. Jacoby of the Graduate School of Management at UCLA, and a former and m~ected member of the Council of Economic Advisers: the Honorable Jason Boer
president of the Oregon State Senate and National Conference of State
Legislatures; SM-phen B. Farber, who is director of the National
Governors' Association; and Fred F. Cooper, county supervisor of
Alameda County, Calif.
Congressman Moorhead, would you like to make an opening statement now i Or would you like to wait until the seoond panel 1
RepresentativP MooRHEAD. Thank you, Mr. Ohairman, I would like
to procood now, if I may.
·
OPENING STATEMENT OF REPRESENTATIVE

MooRHEAD,

CoPIU,SIDING

First, I would like to thank you for the courtesy you have extended
us in ioining forces.
It is fortunate thn:t we both serve on the ,Toint Economic Committee
and the House Banking, Finance and Urban Affairs Committee, of
which you are, of course, the chairman. There is a slightly different
thrust to these studies of our respective subcommittees, but I would


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agree with you, Mr. Chairman, there is so much overlap that we would
have to call some of the witnesses twice if we held separate hearings.
The focus of the Joint Economic Committee's hearings is the fiscal
condition of State and local governments. The future of many State
and local governments is at a critical threshold. I have seen estimates
that in 1978 direct aid, as a percent of own-source general revenue, will
be on the order o:f 53 percent in Philadelphia, 60 percent in Cleveland,
and 58 percent in Phoenix, and as high as 76 percent in Detroit.
More than 40 months into the recovery, many localities are still :faced
with reduced levels of employment, reduced capital expenditures, and
great reliance on Federal aid.
Those chronically ill municipalities have experienced reductions in
employment and population which have resulted in declining revenue
bases.
The situation is further exacerbated by a capital stock which is in
disrepair. Unfortunately, the list of such problem localities is all too
long. At the same time-and this is our dilemma-the National Income
Account data indicating large surpluses in the State and local sectors
tend to reorient the focus of national attention away from the problems
1

of fiscal distress.

The media, in particular, have used the surplus to suggest that
municipal fiscal strains are now part of history; that we can turn our
attention to other national problems.
I regret that I cannot share in this opinion. The NIA data indicate that in 1977, the State and local sector had a surplus of $29 billion. I am extremely concerned about what this surplus really means.
Can the mere existence of a surplus be equated with a healthy local
economy? Are the surpluses widespread? Are local units of government
in surplus States sharing its wealth?
I hope the witnesses today-particularly in the second panel--can
shed some light on these important questions.
In the coming months, we in Congress wiH begin to consider a host
of intergovernmental assistance proposals. This task is never easy, but
at this point in time it is particularly difficult because of the confusion
the State and local government budget surplus data has generated.
Congress will have to grapple witJh and ultimately decide whether
States themselves should be eligible :for additional assistance. Or
should it, in foot, be required to assist their own localities? And moreover, whether Federal fiscal assistance should be eontinued; and, if so,
what form it should t:ake.
I hope that the testimony today will help to clarify the fiscal needs
of our municipalities, as well as the meaning and extent of the budget
surp1uR.
I believe that these ioint hearings oan be of great benefit to future
considerations of the Congress:
Thank you, Mr. Chairman.
RApmsentative REuss. Thank vou, Congressman Moorhead.
We are privileged to have with us a distinguished member of the
Joint Economic Committee from the other body, Senator Jacob K.
Javits. Would you like to make an opening statement, Senafod
Senator JAVITS. Yes, I would, Mr. Chairman. Thank you for the
privilege.


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OPENING STATEMENT OF SENATOR JAVITS
First, Mr. Chairman, I thoroughly approve of the joint hearings, and

I compliment the Chair, the chairman of the Joint Economic Committee, and Representative Moorhead, your cochairman, for arranging
this hearing.
It seems to me that you are serving a very critical purpose here. That
is-and perhaps I am coining a word-to "demythify" Proposition 13,
I don:t think the voters of the United States have lost their marbles.
They gave us a message, but they didn't intend to dismantle the
-country.
And I think that it is critically important that this be put into focus:
that we share our problems with the people.
My own city of New York, for example, we'll literally collapse from
lack of maintenance if you try to apply any standard of what the
citizen wants to pay in taxes relative to what it takes to pay for his desired level of mmtenance of city facilities, when those costs are compared with what it costs to pay for his home and an environment which
he and his family can live a reasonable life.
So I think you are performing a great service, within the limits
of our other problems, and in the Senate I will do my utmost to
participate.
I thank you very much.
Representative REuss. Thank you, Senator.
Are there other members ,vho at this time would like to make an
initial statement i If not, let's straightaway get to work.
AH the witnesses have turned in compendious and very helpful
prepared statements, and under the rule and without objection they
will be printed in full in the record.
That will enable the witnesses to proceed in their own way, either
elaborating, magnifying, or whatever suits them best.
We will hear first :from Mr. Neil H. Jacoby, of the University of
California Graduate School of Management.
l\fr. Jacoby.

STA'l'EMENT OF NEIL H. JACOBY, DEAN, GRADUATE SCHOOL OF
MANAGEMENT, UNIVERSITY OF CALIFORNIA, LOS ANGELES
Mr. JACOBY. Thank you, Mr. Chairman.
You have invited me to speak about the meaning of California's
Proposition 13, and the legal limits on government spending in
general.
I should like to take the brief time allotted, if I may, to elaborate
brip,-fly on five points.
.
·
First, that there is a systemic bias toward, or structural flaw in
our democratic political system that leads to overspending by government, in the strict sense that the total of government spending is
more than the citizens would approve if they had a chance to vote
on the total.
Second, that the two major causes of this bias are: Pressure-group
politics and unbalanced collective bargaining, with the increasingly
nowerful public employees' unions. And these are, I think, causes of
increasing strength and power.


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My third point is that effective legal limits on spending can help
to correct the bias by giving people a chance to vote on aggregate
spending, by making collective bargaining with public employee
unions less unbalanced, by simulating market pressures on government for efficiency, that is to say, we have lacked, in the field of
government, pressures for efficiency which the market brings to bear
on business. Spending limits can function as a substitute. I believe
these points are all borne out by the experience of California, so
far, with Proposition 13.
My fourth point is that the long-run effects of Proposition 13
spending limits in California will prove to be favorable. They are and
will produce, in California, economic expansion, with less inflation.
What is even more important, they have, I think, revived the faith
of the people in the democratic process; giving them a feeling that
they can effectively participate in and control their government. There
has been no special sacrifice visited on the poor. In fact, their private
job opportunities are being, and will be enhanced.
Which leads me to my fifth point: That we need, now, limits on
Federal spending to stimulate investment and to re.store world confidence in the dollar, which is, as we see in the morning press, continuing to hemorrhage in value.
e need to strike a decisive blow
against inflation.
Let me now just comment briefly on each of these points.
It is clear that our political processes contain a strong systemic
bias toward overspending by government. The basic causes of this,
I believe, are numerous, but two factors stand out: The first is
pressure-group politics. Our political representatives naturally respond to the strong demands of small groups for spending programs
that benefit them greatly, because those demands are only weakly
opposed by the majority who benefit little, or not at all.
Every spending proposal has a small group of organized supporters,
and a large and inarticulate group of unorganized opponents. The
payoff to the politician of meeting the demands of the,strong minority outweighs the political cost of fl.outing the will of the weak
majority.
Add to this the familiar phenomenon of "log rolling" for reciprocal
political benefits, and it is easy to understand why spending mounts
ever higher, even though the majority of voters, including members
of favored pressure groups, would oppose a higher total if given
a chance.
Without a legal limit on aggregate government spending, the public
is never able to vote directly on the total size of the budget.
The second favor is unbalanced collective bargaining by powerful
unions of public employees. The case of New York City is illustrative.
To Ol)erate in the public interest, collective bargaining requires
approximately equal bargaining power on both sides of the table.
In business, the union's power to strike is opposed by management's
imperative to hold down costs and stay competitive in the market.
This make for tough bargaining. The manager who fails loses his job.
In government, history shows that politicians normally accede to
the demands of employee unions because a docile electorate shoulders
the higher cost of government, and there is no competitive market
to penalize the manager of a high-cost government. Hence, unbalanced


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bargaining power has become a central cause of overspending by
government.
Now, effective legal limits on spending can, I believe, help to eure
this serious fault in the political process. It does give the people a
chance to decide how large their government should be in relation to
the private sector; it increases the bargaining power of the public official; and it simulates market pressures for efficiency that operateiin the
business field.
In the private sector, as I have noted, market competition forces the
business firm to stay reasonably efficient if it is to survive. In the public sector, th.ere is no counterpart to the market to compel public officials to engage in housecleaning. And for some 40 years, public spending at all levels has grown almost continuously, and there has never
been an occasion to houseclean.
Meanwhile, budgets have become laden with unnecessary positions1
spending programs continue after they are obsolete, there is no pressure to modernize methods and equipment, civil service rules protect
the inefficient while foreclosing rewards to the efficient, and the evidence shows that productivity, motivation, and morale in the public
sector are low.
I think California's experience under Proposition 13 shows that a
legal limit on government spending can be a substitute for the market
in forcing efficiency.
What has happened in California was that tough priority-setting
decisions that had been avoided for many years by public officials,
while revenues were rising, began to be made. Unfilled and unnecessary jobs were struck out of budgets; marginal and obsolete programs
were eliminated; moratoria were put on hiring and on increases in pay
and benefits; and to date, less than 9,000 government employees have
been laid off, although it had been predicted that 45,000 would lose
their jobs.
California governments will cut their spending about 10 percent
under budgeted levels during this fiscal year. Now this leaves about an
equal amount of economizing for future years, assuming no new taxes,
which Governor Brown has said he will not approve.
Because public budgets in California have been expanding 10 percent or more a year, adjustment to Proposition 13 merely means stopping government's growth for about 2 years. It has not meant massive
layoffs as were earlier predicted.
The long-run effects of Proposition 13 will be salutory. And I may
point to the fact that the Congressional Budget Office has confirmed
my own forecast: That Proposition 13 will have a positive effect upon
California employment and income in 1980 and beyond, and will reduce inflation by cutting housing costs, which,is a material factor in
the Consumer Price Index.
Now let me come to the lesson for the Federal Government. I think
the California experience, to date, indicates that legal limits on government spending would be beneficial in all American States, but most
of all they are needed in Federal Government.
The persistenoo of a $50 billion Federal deficit in an economy now
close to full employment is a root cause of inflation and doIIar depreciation. Ending infl.atien is our primary national problem, and it calls
for bold action, now, on the fiscal front as well as on the energy front.


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The imperative need, I believe, is to end the Federal deficit by cutting spending. That will release savings now used to finance government for productive investment in the private sector, and by restoring
confidence in the dollar it will induce an inflow of foreign investment.
I commend the anti-inflationary proposals of Federal Reserve
Chairman G. William Miller, who proposed to cut the deficit from an
estimated $50 billion in the present fiscal year to $30 billion in fiscal
1980, to $17 billion in fiscal 1981, to zero in fiscal 1982; and over the
same period, he would cut Federal spending from 22 to 20 percent of
the gross national product.
These spending limits that I suggest-which Chairman Miller suggested-are liberal. California governments are cutting spending by
10 percent in 1 year; whereas, we are proposing here a IO-percent cut
over 3 years. Nor does 10 percent, by any means, measure the amount
o:f fat on the body politic. We have estimates that there is 20-percent
:fat in California government;
I propose, gentlemen, that these limits be written into law by a
joint resolution o:f the Congress; and that that resolution would mandate a proportional cutback o:f all Federal programs whenever the
total exceeded the prescribed limits.
I believe that Proposition 13-type effects would soon follow. The
opportunities for billion dollar savings, without sacrifice o:f national
security or essential services, are legion.
Examples are food stamps, farm subsidies, pork barrel water projects, redundant military bases, and nonproductive Health, Education,
and W el:fare programs.
HEW itsel:f recently acknowledged $7 billion o:f discovered annual
waste through fraud, and I suggest there must be twice as much
through maladministration.
The expansionary eft'ects o:f a congressional action o:f this kind I believe would be dramatic. Private investment would boom. Confidence
in the dollar would surge upward around the world. I :fear most foreigners think we've lost control o:f our fiscal affairs. Interest rates would
stay at moderate levels, encouraging housing and other private investment. The inflation that is undermining American society and weakening our economy would be brought under control. And what is more
important is the shaken confidence o:f Americans in their Government
would be restored.
Mr. Chairman, the times call :for decisive action.
Thank you very much.
Representative REUSS. Thank you, Mr.Jacoby.
[The prepared statement o:f Mr.Jacoby :follows:]
PREPARED STATEMENT OF NEIL

H.

,JACOBY

Oalifornia Proposition 13 and Legal Limits on Government Spending

You have invited my commenits on the causes and probable effects of Proposition 13, which was overwhelmingly approved by the voters of California laRt
,June 6th. It immediately cut property taxes by 60 percent and total state-andlocal revenues by 21 percent, and it rigorously limits the future growth of property tax revenues. Governor Brown .and the California Legislature 1mbsequently
agreed that the $6.5 billion state surplus should be allocated to the local governments to ease the burdens of adjustment, that there should not be any new state
taxes, and that the State government should share with the local governments
the tasks of fiscal austerity. Proposition 13 is now reducing State-and-local spend-


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ing in California. It is functioning as an effective legal limit on government expenditµres. Such an explicit limit is likely to be adopted by the voters of California_
next November.
THE SYSTEMIC BIAS TOWARD GOVERNMENTAL OVERSPENDING

Events of recent years have demonstrated that legal limits on government
spending are needed to correct the bias toward overspending in our political sys-tern. Government spending has boomed. It is shocking that, after three years of
economic expansion, the federal government continues to run an estimated $50to $60 billion annual deficit. Powerful public employees unions have exacted pa~·
levels that much exceed those in the private sector for equivalent jobs. 'l'hey have
gained retirement benefits that threaten the solvency of our governments. Government spending at all levels is excessive; in the federal government it seems to
be out of control.
It is now clear that our political processes contain a strong, systemic bias toward overspendi;ng by government. They do not produce an optimum allocation
of income as between governmental and private expenditures. Californians voted
for Proposition 13 because they believe they are getting smaller benefits from themarginal dollars collected from them and spent by government than they would
derive from the opportunity to spend those dollars themselves. They are, convinced that government is trying to do too much; and what it is doing is done
inefficiently.
What are the basic causes of systemic overspending by governments? Although
the reasons are numerous, two factors stand out: pressure group politics and un-balanced collective bargaining in the public sector.
PRESSURE GROUP POLITICS

Democratic governments generally suffer from a disease that can be fatal if
not checked. Total government spending expands irrationally as a result of "pressure group" politics. Our political representatives naturally respond to the strong
demands of small groups for spending programs that benefit them greatly, because
those demands are only weakly opposed by the majority who benefit little, or not
at all. Every spending proposal has a small group of organized supporters aud
a large and inarticulate group of unorganized opponents. The payoff to the politician of meeting the demands of the strong minority outweighs the political costs of
flouting the will of the weak majority. Add to this the familiar phenomenon of
"log rolling" for reciprocal political benefit, and it is easy to understand why
spending mounts ever higher, even though the majority of voters-including
members of favored pressure groups-would oppose a higher total if given n
chance. Without a legal limit on aggregate government spending, the public is
never able to vote directly on the total size of the public budget.
UNBALANCED COLLECTIVE BARGAINING

The second important factor in explaining the systemic bias toward governmental overspending is unbalanced collective bargaining by powerful unions of
public employees. As the case of New York City illustrates, excessive pay and
benefits for public employees has emerged as a dominant cause of municipal fiscal
distress. The problem of unfunded pension oblig-ations looms menacingly over
our heads. Public employees unions have wrested excessive compensation from
public officials through the collective bargaining process, on threats of slow-downs,
"sick-outs" and strikes.
One must question the validity of transferring to the public sector-where employees already enjoy the job security of civil service-the institutions used in
the private sector to determine wages, hours and fringe benefits. To operate in the
public interest, collective bargaining requires approximately equal bargaining
power on both sides of the table, In business, the union's power to strike is opposed by management's imperative to hold down costs and to stay competitin'
in the market. This makes for tough bargaining. The manager who fails loses
his job. In government, history shows that politicians normally accede to the
demands of employee unions, because a docile electorate shoulders the higher
costs and there is no competitive market to penalize the manager of a high-cost
government. Pay and benefits for employees make up the bulk of government
expenditures. Hence, unbalanced bargaining power has become a central cause
of government' over-spending.


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EFFECTIVE LEGAL LIMITS CAN REDUCE THE OVER-SPENDING BIAS

Effective le.gal limits on government spending can help to cure defects in the
,political process. Such limits give the people a chance to decide how large their
government should be in relation to the private sector. The people can determine
·what proportion of their income should purchase public goods and services, and
what part should remain for private allocation. As a result, incomes are allocated
more effectively. The benefits derived by the public from a given level of income
increase.
Effective legal limits on government spending also increase the bargaining
power of public officials. As has been observed, "There is no way in which the
politicians could be pursuaded to stand up to (public employees') unions without
something like Proposition 13 to provide the necessary backbonP.." 1 It put their
political futures on the line.
Legal limits on government spending must be effective if they are to correct
the overspending bias. They must actually reduce the budgeted growth of gov·ernment spending. Merely nominal formulae for limiting expenditures, that do not
compel public officials to take economizing actions, are worse than nothing. California voters decisively rejected Proposition 8 at the last election. It would have
limited the annual percentage increase in State government spending to the inflation rate plus 1.2 times the percentage increase in California income--a formula
that would have permited the State to grow as fast as it had been growing.
Although the politicians and bureaucrats feel comfortable with this limit the
people did not. Two-to-one, they endorsed Proposition 13 instead.
The reason why the legal limitation on government spending in California took
the form that it did was that California has been over-zealous in taxing and
spending. Furthermore, it has been collecting 50 percent more property tax revenue than the nationwide average percentage. It has used this revenue to finance
welfare medical and school costs, as well as the costs of property-related services.
Over-reliance on property taxation, combined with booming assessed valuations
of property a.s a result of inflation, was threatening the ability of many citizenS-:both owners or renters-to keep their homes. Any democratic government that
threatens the tenure of people in their homes is courting disaster. Proposition 13
therefore killed two birds with one stone: It stabilized property taxes at a reasonable and predictable level, and it forced state and local governments to economize.
States that now tax property moderately do not need Proposition 13. Butall states
share with California the problem of streamlining governments that have grown
fat.and flabby during years of rising revenues. They do need legal limits on government spending.
}::FFEOTIVE SPENDING LIMITS SIMU~ATE MARKET PRESSURES FOR EFFICIENCY

History teaches that all human organizations need to "clean house" periodically-to streamline their organizations and processes-in order to stay vital and
f'fficient. Over time, organizations tend to accumulate deadwood personnel, obsolete programs, out-moded methods and unproductive expenditures. In the private
sector, market competition forces the business firm to stay reasonably efficient if
it is to survive. A firm with slack management loses market share and profitability, and new management comes in to eliminate unproductive products, plants and
personnel, and to restore efficiency. Remedial action is'usually swift and certain.
because the alternative is bankruptcy.
In the public sector, there is no counterpart to the competitive market to compel public officials to engage in house cleaning. For more than forty years-since
Franklin Roosevelt's New Deal-government spending has risen almost continuously. Public officials have grown accustomed to an ever richer diet of revenue to .finance more public spending. They have never had to clean house. Meanwhile, governmental manpower has become redundant. Budgets are laden with
unnecessary positions. Spending programs continue long after they have become
obsolete. There is no pressure to modernize methods and equipment. The bureaucracy opposes labor-saving changes. Civil i;,ervice rules protect the inefficient while
foreclosing rewards to the efficient. The evidence shows that productivity, motivation and morale in the public sector are abysmally low.
Effective legal limits on government spending can be a substitute in the public
sector for the market competition that enforces efficiency in the private sector.
1

Irving Kristo! in the Wall Street Journal, June 28, 1978.


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California's experien~e Uhder Proposition 13 offers convincing proof of this proposition. Faced for the first time in their political careers with the prospect of less
money to finance public services, California's public officials at first reacted with
a dismay that approached panic. They predicted "chaos," announced "doomsday"
budgets, proposed massive layoffs of government employees, and threatened
drastic cuts in essential public services. Initially, none proposed that spending
sh()uld be trimmed by higher productivity and tighter managemPnt. Years of disuse had attenuated their capacities for economizing.
Soon, howpver, hard necessity worked to rejuvenate these capacities. The
tough, priority-setting decisions that had been avoided in the years of "easy
come" began to be made. Unfilled and unnecessary jobs were struck out of budgets.
Marginal and obsolPte programs were eliminated. Moratoria were put on hiring
and on increases in pay and benefits. More efficient methods were introduced.
Hitherto unknown surpluses and reserve funds were discovered. To date, less than
9,000 government employees have been laid off, although it had been predicted
that 450,000 would lose their jobs. No essential public service has been eliminated. More than one public official has told me privately : "Proposition 13 is the
best thing that has happened in this state in years. We can now get rid of waste
that was politically impossible to eliminate before. We can say "no" to the pressure groups."
California's adjustment to the sharp revenue cuts of Proposition 13 is not over.
The house-cleaning process will continue for several years. Overall, California
governments will cut spending 10 percent under budgeted levels during this fiscal
year. This leaves an equal amount of economizing for future years, assuming no
new taxes. Because their budgets have been expanding 10 percent a year, adjusting to Proposition 13 merely means stopping government's growth for two years.
Meanwhile, Governor Brown has appointed a Commission on Government Reform
composed of 11 prominent citizens from various walks of life to recommend
efficiency-promoting reforms in the organization and in the revenue and expenditure structures of the state. He has expressed the wish to make California government "a model for the nation."
LONG-RUN EFFECTS OF PROPOSITION 13

How will Proposition 13 affect California in the long run? Let us first dispose
of adverse criticisms that have been made of the measure-social, political and
economic.
Throughout the nation the measure has been attacked by the Liberal Left. To
this group it is an article of faith that America's social salvation lies in an everexpanding government. They interpreted the overwhelming public support of
Proposition 13 as a signal that the public would no longer tolerate rising government spending. Predictably, their reaction to this unexpected change in public
sentiment bordered on the hysterical.
Senator George McGovern insulted two-thirds of California voters by describing their action as "degrading hedonism" which was "motivated by racism" and
which would impose heavy burdens on the poor.2 Professor J. K. Galbraith described Proposition 13 as a "disguised attack on the poor."• Henry Fairlie, a
British journalist, branded it "an irresponsible use of the initiative," which he
wrote has been "peculiarly the brainchild of the Western states with their primitive fascination with the forms of democracy."• Adverse economic consequences
have also been predicted. Business Week stated that "Californians have threatened the strength and stability of the boom, and have raised serious-doubts about
the state's ability to accommodate future growth."•
Not one of these criticisms is valid. The effort to distort Californians' legitimate complaints about governmental inefficiency and inequitable property taxation into racism and class warfare is reprehensible. It comes with, poor grace
from the Senator of a state which spends only $20 per $1,000 of pers.onal income
on public welfare, versus an average of $25 by the nation and· $33 by "hedonistic"
Californians! Proposition 13 has not caused any essential public serv:ice to be
curtailed, nor any legitimate welfare payment to be cut.
• See Los Angeles Times, July 2, 1978.
• See Los Angeles Times, July 9. 1978.
• §_ee Los Angeles Times, July 2, 1978.
• nuslness Week, July 17, 1978, p. 54.


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Mr. Fairlie should be reminded that it was not their "primitive fascination''
with the referendum that leci Californiarrs to support Proposition 13. It was the
failur,e of the California legisl~tll4'e for th.tee years to resolve the problem of property taxation which was threatening peoples' ability to keep their homes while
mountainous surplui;;es wete piling up in the State treasury. The referendum
bridged a breakd-0wn in representative g-0vernmerit.
The doleful economic predictions of Busir..ess Week have been contradicted by
the Congressional Budg~t Office and by Chase Econometric Associates. Both
agencies confirmed my own forecast that Proposition 13 will have a positive effect
upon the California and national economies in 1980 and beyorrd, and will reduce
inflation.• It will prolong and expand the present level of construction in California, with all of the multiplier effects this irrdustry has upon income and
,employment. No investor in residential real estate, no businessman seeking to
build a factory, warehouse, office building, hotel or shopping center, will ignore
the inducement of California's stabilized low-rate property tax. It has raised the
prospective rate of return to investmerrt. Both economic theory and history demonstrate the powerful influence of higher prospective rates of return upon the
volume of investment.
If tax reduction by a state really produced economic recession and unemployment, then the road to prosperity must be ever-higher taxes ! Economic reasonirrg
that leads to such an absurd result must be rejected. The stimulative economic
effects of a tax reduction are well established.
The political and social effects of Proposition 13 may prove to be even more
beneficial than its economic consequences. Californians feel that they have
recovered control of their goverrrment. They have a revived faith in democracy.
They feel more secure in their homes. Proposition 13 has put in motion changes
that are making California a better state. It is bringing more efficient government, more equitable taxation, less social tension, and an improved climate for
business.
PROPOSED FEDERAL SPENDING LIMITS

The California experience indicates that legal limits on government spending
would be beneficial in all American states. Most of all, however, spending limits
are needed in the federal government. The persistence of huge federal budget
deficits, in an economy now close to full employment, is a root cause of inflation
and dollar depreciation. Ending inflation calls for bold actions on many fronts.
But the imperative need is to end the federal deficit by cutting spending. This
will release savings now used to finance government for productive investment in
the private sector. By restoring confidence in the dollar, it will induce an inflow
of foreign investment. At this time the U.S. economy would benefit far more from
spending reduction arrd budget balance than from tax reduction.
The anti-inflationary proposals of Federal Reserve Chairman G. William Miller
merit strong endorsement. He proposed to cut the deficit from $50 billion in fiscal
1979, to $30 billion in fiscal1980, to $17 billion in fiscal 1981 to zero in fiscal 1982.
Over the same period, he would cut federal spendil!g from 22 percent to 20 percent
of the GNP.'
These spending limits are liberal. California governments are cutting spending
by 10 percent in one year, whereas we propose a 10 perecnt cut in federal spending over three years. Nor does 10 percent by any mear..s measure the amount of fat
on the body politic. Nathan Shapell, Chairman of California's "Little Hoover"
Commission on Government Economy and Efficiency, has evidence that California government sperrding can be cut at least 20 percent without impairing any
essential service. Who will contend that the margin of fat in federal government is
less?
Why not write these limits into law by a joint resolution of the Congress? The
resolution would mandate a proportional cutback of all federal programs wher..ever the total exceeded the legl),l limits. Proposition 13-type effects would soon
follow. Opportunities for billion-dollar savings without sacrifice of national security or essential 'services are legion. Examples are food stamps, farm subsidies.
pork-barrel water projects, redundarrt military bases, and unproductive HEW
programs. HEW itself recently acknowledged $7 billions of annual waste.
The expansionary effeets of such an action would be dramatic. Private investment would boom. Confidence in the dollar would surge upward around the world.
Los Angeles Times, July, 7, 1978. Wall Street Journal, July 12, 1978.
• Reported by Time, July 17, 1978, p. 62.

8


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Interest rates would stay at moderate levels, encouraging housing and other
private investment. The inflation that is undermining American society and
weakening our economy would be brought under control. The shaken confidence
of Americans in their government would be restored. The times call for decisive
action. Political cynics may say this proposal is visionary. I would remind them
of the words in the Scriptures--:"Where there is no vision, the people perish."

Representative REuss. We are fortunate in having with us in the
hearing room Representative Robert Blackford Duncan of the Third
Congressional District of the State of Oregon.
Congressman, we would be honored to have you introduce your
colleague, State Senator Jason Boe.
STATEMENT OF HON. ROBERT BLACKFORD DUNCAN, A U.S. REPRESENTATIVE IN CONGRESS FROM THE THIRD CONGRESSIONAL
DISTRICT OF THE STATE OF OREGON
Representative DUNCAN. Messrs. Chairmen, Senator, and members
of the committees, I know that those on the House side at least are
aware of the total and complete modesty with which those of us from
the State of Oregon view the accomplishments of our State and of our
favorite sons.
Accordingly, it is an honor for me today to be able to introduce one
o:f our Oregonians who has been honored and whose abilities have
been recognized by his election to president of the National Conference on State Legislatures.
Senator Boe and I have known each other for many years. We have
campaigned up and down the Umpqua River, Mapleton, Reedsport.
\Ve have been up at the Florence. I have known 1nm since before he
got in the State legislature where he quickly distinguished himself,
moved into a leadership position in the House of Representatives;
moved over to the Senate; was elected president of the Senate after
one term; and has since been successively reelected three times.
That is an unprecedented event in the State of Oregon. Jason and
his supporters attribute it to be a recognition of brains and diligence
and hard work and ability; some of his detractors attribute it to the
irrationality which some of us in the House of Representatives-with
apologies, Senator Javits-sometimes attribute to the actions of the
Senate whether at the State or the Federal level.
I count myself as one of Mr. Boe's friends. I'm not sure what he is
going to tell you today. Perhaps he will tell you to cut Federal spending, but increase aid to the States. If he says that, I know that he will
say much more and I commend to you what he says.
I'm honored to be able to introduce him as he participates in this
panel. I'm a former member of the legislature; I was a former member
of the Counsel on Intergovernmental Relations; I'm one who believes
strongly in the federal system.
I commend the committees for inviting this testimony and the testimony of the panel to the committee.
Thank you.
Representative REuss. Thank you, Congressman Duncan.
Senator Boe, with a Golden Fleece Award like that you may proceed. \Ve are grateful to have you here.


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STATEMENT OF HON. JASON :BOE, PRESIDENT OF THE OREGON
STATE SENATE AND PRESIDENT OF THE NATIONAL CONFERENCE OF STATE LEGISLATURES (NCSL)
Senator BoE. Mr. Chairman, I have lied about Congressman Duncan for years, and it is only fair he return the honor today.
[Laughter.]
Mr. Chairman and Cochairman, Senator Javits, members of the
;EJouse Subcommittee on the City, and Joint Economic Committee, it
1s a pleasure to appear before you to discuss the impact of proposition
13 and the structure of fiscal federalism in our country today.
I serve as the president of the Oregon Senate. I am also president
of the National Conference of State Legislatures, the NCSL, which is
the official representative of the country's 7,600 State legislators and
their staffs, now representing all 50 of the States.
NCSL works to help lawmakers meet the challenges of our complex
federal system through a variety of State and State-Federal services
provided by our headquarters office in Denver and our State-Federal
relations office in Washington, D.C.
The NCSL, for those of you ·who are not familiar with it, is a nonpartisan organization funded by the States and governed by a 43member executive committee. "\Ve have three basic objectives:
One: To improve the quality and effectiveness of State legislatures.
Two: To assure States a strong, cohesive voice in the Federal decisionmaking process.
Three: To foster interstate communication and cooperation.
I have been asked to speak today about the effects of the taxpayer
revolt on State and local governments. I believe the causPs of the taxpayer revolt extend far beyond State boundaries. I believe those of
you at this table-and the rest of your colleagues in Congress-must
assume at least a large part of the responsibility for the passage of
proposition 13 in California.
To further qualify my statement, just recently an identical copy of
the Jarvis-Gann proposition, only with a 1-percent limitation, it contains a l½~percent limitation, but other than that, is a Xerox copy of
Jarvis-Gann, was recently placed on the November ballot through
the initiative process requiring only 63,000 signatures, but it went on
the ballot with well over 200,000 signatures of Oregonians.
So while we are looking at California, I want you to remember that
we in Oregon are facing some of the same problems, and perhaps some
of the same opportunities that are presented by proposition 13.
I believe that the taxpayer revolt is a loaded gun, and that loaded
gun is pointed directly at Congress. The first bullet has hit local governments, and the second bullet may hit State government. But the
Federal Government is the ultimate target, and I believe that the third
bullet is already on its way toward Washington, D.C.
Unless you act, and act quickly, the voters will not only take the matter out of our hands, but out of your hands. And I must tell you it is
my considered opinion, Mr. Chairman-and this is a complete reversal
of an opinion I have held for many years-that I firmly believe that
within the next 5 years, we will see a constitutional convention called

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in this United States. I firmly believe that. I did not, but I do now, because the mood of the people out there is to grab hold and grab hold
wherever they can. As they see the initiative referendum process working in the 23 States that have that today, there is going to be increased
pressure on those rest of the States that do not have the initiaive refer.
end um to move in that direction.
And that is happening right now. There will be over 6,000 State leg•
islators up for election or reelection this year. Every one of those legislators are going to have the finger pointed at them saying "Where do
you stand on Jarvis-Gann?" And I suspect you and your colleagues
who are up for reelection this year, and those m the Senate who are up
this year, are going to be asked that same question, and you are going
to be having to respond to those same types of questions.
We in the State legislatures are at the battlefront of the war on high
taxes, and we have been so for many years.
Let me go now into the effect on State governments. In the Califor~
nia situation and possibly the Oregon situation, the passage of proposition 13 has attracted widespread popular attention. It reminds us once
again that most people believe in the American tra,dition of limited
government c1,nd that when government becomes too expensive or too
luxurious for public taste, voters can find ways to send a message to
their elected officials about scaling back government outlays and
programs.
The California legislature was able to temper the effects of proposition 13 through quick, decisive action. But most of the rest of the States
don't have the large budget surpluses that were available in California.
I'll let Mr. Farber, representing the Governors Association, go into
the fallacy of some of your statisticians in the Federal Government who
have been claiming that there is a $36 billion surplus out there, and
we'll commend to you an article from the Wall Stroot Journal this
morning pointing out the fallacies of some of your statisticians' basic
assumptions.
But most of the States don't have the large surpluses that were available in the State of California. The passage of a measure like proposi•
tion 13 would result in immediate and widespread financial hardships
in almost all other States.
The 1-year emergency relief plan devised by the Ca1ifornia legislature makes effective use of that State's $5 billion surplus, since over
$4.4 billion of that surplus is returned to provide relief to that State's
counties, cities and school districts.
But I would hasten to add that there are many States like Oregon
who have used whatever resources they have to develop homeowner
and renter property tax relief programs. And, by the way, one of the
great faults with Jarvis-Gann among other things, is the fact that the
renter is absolutely left out. In California today they are in the throes
of coming to grips with that by some voluntary rental controls or roll•
back of rentals which in my opinion are not going to be terribly successful, and will be for a limited time only.
The 1-year emergency relief plan devised by the California Legislature does make good use of their money. Among the special provisions
in the relief plan in California are State assumption of tl1e county
public assistance costs and the like. Other significant aspects of the California legislation include the provision that most cities and counties


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will operate at 80 percent of the previous budget levels, and the provision that most school units will have about 85 to 91 percent of last year's
expenditures, which may mean that regular programs will not suffer if
certain extracurricular and summer programs are reduced in schoo]
budgets.
Delegation of greater authority to California counties to allocate
over $125 million annually, and assurance that cities and counties maintain such essential services as police and fire protection at levels existing prior to Proposition 13 were included.
All State legislatures are going to be watching California closely
over the next few years, and also in Oregon, if it passes, as it appear&
that it might-to see the long-term impacts of Proposition 13. It is
apparent the California legislature has been largely suocessful in meeting many of the measures' immediate challenges. But the real effects of
the Jarvis-Gann meat-ax approach to tax reform might not be known
for several years.
I don't think anybody, no matter how distinguished they are as economists, can ultimately see what the ultimate effect of Proposition 13:
may be when the surpluses have dried up and are no longer available. I
believe that the California legislature was right in not looking to Congress for a Federal ''bailout". I don't believe that many States, if any,.
will· look for Federal assistance should measures like Proposition ,13
make it on the ballot.
They :i,re not looking to fill the sock up from outside sources·. They
are lookmg for ways to cut, cut severely, and cut all types of waste. I
want to give just a brief history on State limits on spending.
Proposition 13 is the latest in a rather long and extensive history of
State limitations on local government budgets beginning in the 19:30's
when citizens were seeking relief from depression troubles, and again
in the late 1960's and early 1970's when they felt the strain from rising
property taxes and continuing in 1978 because of the increases in all
forms of taxes.
I'll skip through a good deal of this because I know your time as
well as ours is somewhat limited.
Let me point out that despite the tremendous publicity given to
Proposition 13, most States have had considerable experience with
limitations on State and local spending, that the States are acutely
aware of the fiscal prob1ems of the property value inflation and are
moving almost universally to develop property tax assessment and
relief programs to reduce the burdens of rising taxes.
It is c1ear to me that Proposition 13 is ushering in an era of fiscal
restraint for State and local governments throughout the country.
This is a new era of fiscal prudence that I think will produce several
maior events in State financial policies in the years ahead.
States will continue to experiment with several imposed limits on
State and local spending rather than have such limits approved
through popular initiative.
Tennessee's recent enactment of the constitutional limit on increases
in State spending, and the various types of fiscal limits that other
States have imposed on local school districts in the course· of school
finance reform are ample indication that legislatures often need little
prodding to curtail State and local spending, especially dming these
times of double-digit-inflation.


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As I said earlier, Congress must assume certain responsibilities as
a result of the taxpayers' revolt. I don't make this statement lightly.
I sincerely believe that much of the anger behind the taxpayers' revolt
is aimed at inflation, and is aimed at Federal spending practices that
appear to be fueling this inflation.
Forty-eight of the 50 States operate on a balanced budget, by constitutional mandate. We cannot print additional money or operate on
a deficit. This is wise, and the Congress would do well to follow the
lead of the States in this matter.
My home State of Oregon is just one of the many States that have
passed a resolution calling for a constitutional convention to require
the Federal Government to live within a Federal budget except in
times of war or true national fiscal emergencies.
The voters view your current $51 billion deficit as one of the main
reasons for today's skyrocketing costs and they appear to be right.
Mr. Chairman, I am going to have the rest of my testimony entered
in the record, but in conclusion, let me state, Proposition 13 has provided both State and Federal governments with what I think is a
rare opportunity. With all the bad things that can be said about it, it
has provided State and Federal governments with a rare opportunity
to reassess the structure of fiscal federalism in this country.
Both the Federal and State governments will have to better balance
their revenue and expenditure structures. The State and Federal governments most certainly will have to address the impact of continued
Federal deficits, and their impact on inflation. They will have to apply
the same scrutiny to the economic impact of their regulations, and
other preemptive measures that unduly raise the cost of government.
"\Ve in the States are terribly concerned with the increasing intrusion
of the Federal bureaucracy in literally, by bureaucratic edict, ripping
pages from the State lawbooks of every single State in this Nation,
not by an act of Congress duly signed by the President of the United
States and enacted into law, but bv bureaucratic edict from the Federal Trade Commission, from the ·Federal Communications Commission, and others who are without the benefit of passage by Congress.,
writing, rewriting, and ripping up State laws in all 50 States today as
we sit here.
This is a dangerous thing, and I must communicate to vou the concerns of the States with regard to what is happening on tliis level. The
Federal Trade Commission, gentlemen, and ladies, is your responsibility. They are an ann of the Congress, and you must watch them
carefully. As both the Fr,deral and State governments begin to revise
their fiscal policies, in light of Proposition 13, we must 'have a more
constructive and fruitful dialog between the State legislatures and the
Congress on such matters as the Federal tax reform, welfare revisions,
general revenue sharing, and regulation reform.
As president of the Oregon Senate and president of the National
Conferences of State Lei;rislatures, I will assure you that State legislatures will help in steering a course of fiscal prudence for this Nation's intergovernmental fiscal system .
. I u~ge_ the members of this comT?ittee, an~ your colleagues, to do
likewise m order to assure the American pubhc that their Government
is o~~ that can responsibly live up to the challenges and to the opportumties that are presented to us today by Proposition 13.


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Thank you very much.
Representative REuss. Thank you very much, Senator Boe.
[The prepared statement of Mr. Boe follows:]
PREPARED STATEMENT OF HON. JASON BOE

Proposition 13 ana the Future of FiscaZ Feaeralism
INTRODUCTION

Chai11IUan Reuss and Chairman Moorhead and distinguished members of the
House Subcommittee on the City and ,tihe Joint Economic Committee, it is a
pleasure to ,appear before you today to discuss the impact of Pro,position 13 on
the structure of Fiscal Federalism in our country today.
My name is Jason Boe, and I serve as the President of the Oregon Senate
I am also the President of the National Conference of State Legislatures (NCSL)
which is the official representative of the country's 7,600 state legislators and
their staffs. NCSL works ,to help lawmakers meet the challenges of 01Ur complex:
federal system through a variety of state and state-Federal services provided by
our headquarters office in Denver and our state-federial rele,tions office in Wash•
ington, D.C.
The NCSL is a non-partisan organization funded by the s.tates and governed
by a 43 member executive committee. NCSL ha,s three basic objectives:
To improve tile quality and effectiveness of State legislatures.
To ,assure States a strong, cohesive voice in ,tbe Federal decisiO'll-making
process.
To foster interstate communication and cooperation.
I have been asked to speak rtoday about the effects of the taxpayer revolt Oil
State and local governments. But I believe the causes of the tax,picyer revolt,
extend far beyond State boundaries. I believe those of you at the table-and therest of your colleagues in Congress-must assume a large part of the iresponsihi1ity for the passage of Proposition 13 in California. I beldeve the taxpayer
revolt is a loaded gun pointed directly a.t Congress. The fil'st ,bullet has hit local
governments and the second bullet may hit Starte government. But the Federal
Government is the ultimate target, and the third bullet ,is already on its way to
W,ashington, D.C. unless you aot-and act quickly-the votel'IS will take the
matter completely out of your hands.
State legislatures are at the battle front of the war on high taxes-and have
been for many years.
PROPOSITION 13: ITS EFFECT ON STATE GOVE!RNMENTS

The California situation.-The passage of P,roposLtion 13 in California has
attracted widespread popular attention. It reminds ,us once again that most people
believe in the American tradition of limited government and that when government becomes too expensive or too luxurious for public taste, voters can find
ways to send a message to their elected officials about scaling back government
outlays and programs.
The California legislature was able to temper the effects of Proiposition 13
through quick, decisive action. But most of the rest of the S1Ja:tes don't have the
large budget surpluses that were available dn Oalifornia. The passage of a
measure like Proposition 13 would result in immedia,te and widespread financial
hard,ships in almost all other States.
The l()ne year emergency relief plans devised by the California legislature
makes effective use of the State's $5 billion sur:plus since over $4.4 billion of that
surplus is returned to provide relief to that State's counties, cities and school
districts.
Among 1:ib.e special prov1sions in the relief plan 11:re : State assm:ruption of the
county public assistance, the subordination of prev-iously independent special
districts to their respective counties, and a freeze on State employee salaries
and benefits for ,public welfare recipients.
Othere significant aspects of the California leg,i,sla.tion include:
Provtsion that most cities and counties will operate at 80 peirCent of previous
•budget levels.
Prov_ision .tha~ most school units will have about 85-91 percent of last year
expend1tures whwh may mean that regular programs will not suffer if certain
extracurricular and summar programs are reduced in school budgets.


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Delegation of greater authority to California counties to allocate over $125
million annually for the operation ,of special districts within their jurisdiction.
Assurance that cities and counties maintain such essential services as police
and fire protection at levels existing prior to Proposition 13.
All State legislatures will be watching California closely over the next few
years to see the long-term impacts of Proposition 13. It is apparent fue California legislature has been largely successful in meeting many of the measures'
immediate challenges. But the real effects of the Jarvis-Gann meat ax approach
to tax refomn might not be known for several years.
The California legislature wa.s rigiht in not looking ,to Congress for a Federal
"Bail-,out". I don't · believe that many states-if any-will look •for Federal
assistance should measures like Proposition 13 make it on the ballot. You in
Congress have your own responsibilities in this siuta,tion, and I w:ill get to them
.shortly.
State limits on spending: A brief history.-Proposition 13 is the latest development in ,a rather long and extensive history of st,a:te limitation of local government budgets, beginning :in the 1930's, when citizens were seeking relief from
depression troubles, and aga,in the late 1960',s and early 1970's when they felt
the strain from rising property taxes, and continuing in 1978 because olf the in•
<!reases in all forms of taxes.
Over the last decade the impetus for states to play a more extensive role in
local fiscal affairs has been derived from the following factors :
( 1) A greater public demand for property tax relief.
(2) Court-mandated upgrading of assessment practices to encourage equalization.
(3) The assumption of an increasing share of state/local expenditures responsibilities by the state.
,( 4) An effort by the state to control and equalize school district expenditures.
'The use of property tax and expenditure limitations originated in the late 19th
,century. Nine states had such limitations before 1940. Since 1970, fourteen states
,and the District of Columbia have enacted some form of tax and/or expenditures
limitations.
Currently state tax and expenditure controls on local governments are directed
primarily at limiting the use of property taxes in an effort to bring •relief to
the taxpayers in the state.
The two most common tax relief methods used by states to effect a decrease
in citizen property tax burdens are homestead exemptions and circuit-breaker
programs. A homestead exemption reduces the assessed value of a property by
a specific dollar amount. A circuit-breaker program extends a rebate or credit
to families whose property tax exceeds a state determined percentage of the
family's income. Circuit-breaker programs are usually administered through the
.,state. income tax system but can be administered separately.
Doth programs have generally been targeted to elderly or disabled homeowners
:and renters; however, within the last two years several states have revised
,eligibility requirements so that a larger number and a broader range of their
taxpayers are eligible to receive some relief. Indeed, state appropriations for
circuit-breaker reached close to $1 billion in FY 1977. This is not an indication of
the growing concern among the states about ever increasing property taxes and
the citizen responses to these increases.
Finally, since 1976 five states have passed tax or expenditure limitation legis1ation to check the growth in state spending. Eight states deliberated on sucb
·measures in their 1978 sessions. At least six states are attempting to get such
legislation on the ballot in their states this fall. Many other states are actively
involved in drafting legislation on these matters for consideration in the near
future. As more citizens in each state continue to express their concern about
-the rising costs of services and ever increasing property taxes, legislatures will
.continue to respond promptly, but responsibly.
Sohooi finance pressures.-Part of this strain from rising property taxes has
:been reflected in the widening gaps in local spending for public education. Sev-eral state courts in the 1970's mandated that education outlays could not depend
directly on real estate values unless states equalized the yield from local prop.erty tax effort. Laws prohibiting uncontrolled local spending have, therefore,
·been put on the books over the last decade.
State limits on local school operating budgets are common to every region of
the country, with exception of the northeast. No New England state except
'.Maine imposes limitations on local education budget authority (see table 1).


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Elsewhere in the northeast, the only statewide controls on school budgets are
confined to Pennsylvania, with New York and New Jersey applying limits only
to large cities.
Limits are generally imposed in three ways : On property tax rates, property
tax levies, and expenditures. Rate limits are used in 26 states; levy limits in
6; and expenditure controls in 4. Rate limits set the maximum percentage of the
local property tax base that may be used annually for school revenues; although
the real meaning of the rate limits depends in part, however, upon whether state
property assessment practices are standardized. While rate limits are the most
popular form of budget control, levy and expenditure controls have been increasingly accepted. School districts are permitted to raise local tax revenues equal
only to a lump sum pupil or percentage amount. In states with expenditure limits,
school districts are permitted to increase their expenditures annually by a legislatively determined percentage; expenditure limits can also function on a lumpsum basis that permits each school district to increase its outlays only by a certain dollar amount for each pupil.
Although only very sparse information on actual fiscal results have been documented, the evidence indicates that State controls on local budgetary authority
have minimally affected education. States which limit local school district expenditures spend an amount comparable to schools in States without limits. Likewise, States with limits raise approximately the same share of educational revenues from local sources as do States without limits. Moreover, there is insufficient evidence conclusively to support the finding that expenditure limitations
depress educational quality.
But, limits have had these effects: States rely less on the local property tax
as. a source of educational revenue, and especially so when limits are part of
major reform in school finance legislation. Limits often assist low-wealth, lowexpenditure districts which can justify budget increases that would otherwise
be suppressed in the name of holding down rit-ling educational costs.
Federal aid polices and spending Zimits.-Increased Federal funds, together
with increased latitude in the use of these funds, can undermine State legislative
control of expenditures. Federal funds now make up an average of 21 percent of
States' budgets, for a fiscal year 1978 total of $80 million on its official civilian
payroll. These persons include the swelling numbers of workers who receive indirect Federal monies through Government contracts, research grants and Federal
matching payments for local government officials. Indeed, State executive agencies often use Federal grants to support programs and functions which the legislature has expressly denied budgetary authority. Thus, the State's responsibility
for sound fiscal planning and management is critically at stake.
Scant consideration has been given to the fit between Federal and State programs. For example, some States which have enacted school finance reform laws,
consider Federal impact and payments as part of the basic State aid coJ1tribution
to local school finance budgets. Yet, for the most part, Federal and State-local
monies operate independently. Often the Federal Government provides marginal
monies for educational programs the later become major State-local fiscal
burdens. In the absence of general aid support, this burden strains the ability of
a State to adequately fund its own equalizing general aid formula.
Additional problems will be generated when States which may pass spending
limits find difficulty in meeting Federal requirements prohibiting supplanting
of State monies. Whether California will be able to meet this requirement after
current State surpluses dry up, remains to be seen. Because States passing
limits may not be able to maintain outlays in the long run, many programs,
particularly disadvantaged and bilingual education and manpower programs may
be severely jeopardized.
At this point, it is fair to point out that despite the tremendous publicity
giYen Proposition 13 :
Most States have had considerable experience with limitations on State and
lo<'al spending.
States are acutely aware of the fiscal problems of property value inflation and
are moving almost universally to develop property assessment and relief programs that will reduce the burden of rising taxes.
Considerable unrest with rising State and local taxes must in part be laid at
the door of the Federal Government which bas contributed to the expansion of
the State-local sector through the increases in Federal aid, particularly categotical aid which promotes higher State-local spending.


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FUTURE STATE RESPONSES TO PROPOSITION 13

It is clear to me that Proposition 13 is ushering in an era of fiscal restraint
for State and local governments throughout the country. This new era of fiscal
prudence, I think, will produce several major developments in State finance
policy in the years ahead.
First, States will continue to experiment with self-imposed limits on State
and local spending rather than have such limits imposed through popular inititive. Tennessee's recent enactment of a constitutional limit on increases in State
spending and the various sorts of fiscal limits that States have imposed on local
school districts in the course of school finance reform are ample indication that
the legislature often needs little prodding to curtail State and local spending,
especially during these times of double digit inflation.
In a related vein, States are also examining their revenue structures quite
closely to determine ways in which they can be made more equitable during
these troubled times. Colorado, for example, has recently indexed its income
tax to prevent undue fiscal surpluses during times of inflation. Several States
cut various taxes during this current year (see table 2). The Arizona legislature
recently enacted a constitutional amendment which will be submitted to the
voters which will limit tax revenue to 7 percent of income. Similar proposals on
limiting revenues have recently been enacted in New Jersey and will be considered in upcoming legislative sessions in such diverse States as Maine, Florida,
Minnesota, and Pennsylvania. Tax limitation legislation will be a major item in
upcoming legislative sessions.
In that context, let me remind this committee that State governments moved
vigorously in this past session of the legislature to make many important changes
in a variety of State-local fiscal policies. For example:
Seventeen States adopted or expanded their property tax circuit-breaker or
homestead exemptions.
Ten States either made major cuts in their State taxes or enacted major exemtpions in their broad-gauged taxes (see table 2).
A large number of States are conducting comprehensive iterim studies of their
overall State-local tax structure to develop new policies aimed at reducing Statelocal tax burdens or making them more equitable for businesses and individuals.
'.Finally, States are increasingly active in scrutinizing Federal aid in their own
budgets. More and more States are following Pennsylvania's lead in reappropriating Federal aid in their own budget. Thirty-seven States have developed regulation review capabilities that may ultimately be applied to analysis of Federal
regulations that increase State and local governmental costs. In these two areas
and many others, it is clear that State governments are going to examine the
terms and conditions of the Federal aid dollar more closely than ever before
to prevent against distortions of State taxing and spending policies. It most
certainly means that State legislatures throughout the country will be promoting
the concept of having the Federal Government deliver more of. their intergovernmental aid through general revenue-sharing and block grants that give broad
State discretion in allocating Federal aid.
PROPOSITION 13; THE FEDERAL ROLE

As I said earlier, Congress must assume certain responsibilities as a result of
the taxpayer revolt. I do not make this statement lightly. I sincerely believe that
much of the anger behind the taxpayer revolt is aimed at inflation and the Federal spending practices that are fueling inflation.
Most States operate on a balanced budget. We cannot print additional money
or operate on a deficit. This is wise, and Congress would do well to follow the lead
of the States in this matter.
My home State of Oregon is just one of many States that have passed a
resolution calling for a constitutional convention to require the Federal Government to live with a balanced budget, except in times of war or true national fiscal
emergencies. The voters view your current 51 billion dollar deficit as one of the
main reasons for today's skyrocketing costs-and they are right.
But the quick, across the board budget cuts now being considered by Congress
are not appropriate. The House recently voted to cut 6.4 billion dollars from
-.arious appropriations bills. This move tremendously increased the power of the
executive branch by giving the President the final responsibility to determine
which programs get trimmed. It is Congress' responsibility to prioritize spend-


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Ing and determine where cuts are to be made-and to do otherwise is just
plain "chicken."
Congress would do well to take a 'long, hard look at all existing Federal programs. Whether this is accomplished through a formal "sunset" review or a less
formal Ways and Means Committee review is up to you. But Congress had better
find some effective way to cut waste and eliminate outdated programs before
the voters find a way to do it themselves-as they did in California.
I believe the issue of Federal preemption is central to understanding the origins
of the taxpayer revolt. Congress must take a closer look at the mounting economic costs of Federal Government regulation.
One of the President's inflation counselors, Dr. Barry Bosworth, has indicated
to the NCSL that increasing Federal regulations in the environmental and occupational health area may be costing this country as much as $100 billion per
year-an amount that may be considerably in excess of the benefits of such
regulations. Moreover, these regulations may be adding nearly a full percent
to the current inflation rate.
In the same context, the Federal Government must consider the cost of the
various mandates and preemptive Federal regulations that are increasingly
being issued from Washington. The Vocational Rehabilitation Act of 1973,
for example, may cost State and local governments as much as $9 billion to
implement. Not one cent of Federal money is yet forthcoming to help meet this
mandate. Mandating programs without the promise of some fiscal support to
implement a program is an outmoded notion. More and more States, such as my
own State of Oregon, are developing policies that will provide local governments
with adequate support for any State mandated program. The Federal Government should follow the lead of progressive States in this field.
Congress should also take a close look at the manner i11 which it sends funds
to the States. Legislatures are going to need budget flexibility to meet the wishes
of the voters. General revenue sharing dollars are a must, and I would urge
that the administration and Congress even now reaffirm its commitment to
early passage of general revenue sharing in the 1980 session of Congress.
.
Unconditional general revenue sharing represents one of the most fundamental changes in the operation of our Federal fiscal system. With a minimum
of strings and with due regard for the budget responsibilities of State and local
govel'Ilment, the program has provided welcome assistance for State and local
governments in the past several years. This program should be continued and
expanded in 1980. Any cutbacks or conditions placed on the program will undon btedly be opposed by State and local governments and their national organizations such as NCSL. Therefore, to preserve comity among all levels of Government, we will appreciate your early support in revenue-sharing renewal.
CONCLUSION

In conclusion. let me state that Proposition 13 has provided both State and
Federal Governments with a rare opportunity to reassess the structure of Fiscal federalism in this country.
Both State and Federal governments will have to better balance their revenue
and expenditure structures. The Federal government most certainly will have to
address the impact of continued Federal deficits and their impact on inflation;
they will have to apply the same scrutiny to the economic impact of their regulations and other preemptive measures that unduly raise the cost of government.
States will be revising their revenue structures to create more fiscal equity for
the business and individual taxpayer. They will also be continually analyzing
their many local aid programs to prevent undue disruption in essential local
public services and to prevent overreliance on the local property tax.
As both levels of government begin to revise their fiscal policies in light of
Proposition 13, we must have a more constructive and fruitful dialogue between
state legislatures and the congress on such matters as Federal Tax Reform,
wt>lfare revisions, general revenue sharing, and regulation reform. As president
of the Oregon Senate and the president. of the National Conference of State
Legislatures (NCSL) you may be assured that state legislatures will help in
stf>ering a course of fiscal prudence for this nation's intergovernmental fiscal
system. I urge members of this committee and your other colleagues to do likewise
in order to assure the American public that their government is one that can
rE>;;11oni,ibly live up to the many challenges brought about by Proposition 13.
'f•hank you.


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TABLE 1.-STATE LIMITS ON SCHOOL DISTRICT OPERATING BUDGETS, 1976
Limit coverage

Limit imposed onState

Limit in
force

Millage

Expend/
levy

Universal

Classified

Partial

Refer•
endum
override
possible

New England:

Connecticut. •••.•.•....••••••••••.•.•..•.••.•.....•.........•..•.••.•••••••••.••.•..•.•...•

~:~~:ctiiisetts······. x.......... x.........···· ·· ······. x ......... ························

~~:ci~T~:~~ire.==::::::::::::::::::::::=:::::::::=::::::::::::::::::::=::::::::::::::::::::
Vermont. ••..•.•.••••••••.••......•.•..•.•.••....•. -· •-•· •······· •··· ·· ·· •· ···· ·· ·· •· •· ·--·
Mideast:
Delaware....•••.•....••••••••••••.•..•...•..............••.....•.••.•.•..••...•..•...•....•
Maryland_ •• _•.........•••••.•.••.••...•.........................••.••.•.••........•.••....

~=:

{'::rS:!:==:::::: ~
Sout~!:s~~ylvania ••.•.•• X

Q
x

=:::::::::::::::::::::::::::=:=:=:::

Q

........................ x
............
~~t~~~;;··········. x.......... x.................................. x.....................
~:;:~~-············ ~
• X ••••••••• ·-····-·····. X ••••••••• ·x·········::::::::::::
Ken_t~cky •••••.•••• X

~!~it;~;

•.....•.•.•• X

X

~
X
X

••....•.•.•••••.......••

Q.......... ~......... :: :: :: :: ::::.~.........·x·.... ····:::: ::::::::

tri~~== :: :: •
South Carolina •..•....•....•..••••••.••...••..•....•••••...••.•••...••••..•.••.••.••.•....••

~1il~~~::;nia ••••... · x ·········· x ········· ............ · x ·····-···........................
Great Lakes:
Illinois ..•....•.•••• X
X
....•.•••••.•...•••.•.•. X
..•...•.•...
Indiana .••••.•..•.. X
•.......•.•. X
X
•.............•.....•...
Michigan ...•.•.•.•. X
X
•.•...••.... X
··············-·--···-··
O~io... 0 • • • • • • • • • • • X
X
•.•..••••••• X
•...•....•.•..•.........
Wisconsin .......... X
••••.••.•..• X
X
-·····-········---·--··Plains:
Iowa •••••••..•..•. X
••.......•.• X
...•.•..•..• X
•...........
Kansas ••••...•.... X
••.......... X
...•.......• X
........... .
M!nnes~ta ..•....... X
•••••••••.•• X
•••••••••••. X
·---·-······
Missouri ..........• X
X
............ X
.....•.•................
Nebraska •••..•.... X
X
•••...•••••••••••••.•••• X
X
North Dakota...•... X
X
•••••••••••••••••••.•••• X
-··-·--·····
South Dakota....... X
X
..•.......•.....•.•....• X
•...........
Southwest:
Arizona ......••••.• X
......•.•... X
X
•..••.•.•••...•..•......
New Mexico .•.•..• ~ X
X
•••..•.•.•.• X
·················-··-·-Oklahoma .......... X
X
••••.••••••• X
•••••••••••••••••••••.••
Texas .............. X
X
••.••••••••••••••••••••• X
••.••••••.••
Rocky Mountains:
Colorado......•.••• X
•••••••••••• X
X
•••••••••••• X
Idaho .........•.... X
X
•..••••••••• X
••••.••.••••••••••••••••
Montana ••...••.•.. X
X
...........• X
....•...................
Utah ..•..•.•....... X
··---·····-·-··········· X
........... .
X
Wyoming••......... X
X
-·········•··-···•······ X
••......•..•
Far West:
Alaska ...•..•..•.•. X
X
••.••••••••••••••••••••••••••••••••• X
~:~ii\nia. -········. X •••••••••••••••••••.•• X ••••••••.•••••••••.••• x ········· ............
Nevada •••.••••..•. X
X
•••••••••••• X
•••.•.••••••••••••••••••
Oregon ••.•.•....•. X
•••.•••••••• X
X
•••••.•••.•••••.•••••.•.
Washington ..••.•••. X
X
•••••••••••• X
•.....................•.
Source: See appendix A.


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X
X
X
X

X
X
X

X
X
X

659
TABLE 2.-SELECTED STATE TAX ACTIONS, 1978

State

State tax cuts/revisions

State tax exemptions

State spending limits

Circuitbreaker/
homestead
exemptions

California._-------------··--··-·--··----·-·-··-······-·-·-·-··-·-···· Proposition 13 ••• ·--·-·- X
Colorado ____ ·-·-·---- Indexation of state in•
come tax.
Connecticut •• ·-···-·· Elderly recipients of SSI
can receive direct
grant in refund of
utility and rent bills
paid.
•.•. -· ·-.• -· ·- ____ ·- __ .• --·--· ----·-··-· ·--· •••• X
Idaho .. _.• -·--·· ••••• ·-·-·--··- __ ·-·· .•.••••• ______ .. -· __________________ --·- ____ -·__________ X
IIii nois._. ·- ____________ •• ______ •• ____ •• __________ ---- __ -· ________ .. -- -- -- --·- -· -- -- -- -- -- -- -- X
Indiana ____________________ --·-----·-·-·----· Increased income limits
on property tax ex•
emptions for elderly. ·------···-···--·-----·- X
Iowa_ •.• ·------·------·-----------·--·-·····-·-·-- __ -----·------·---·----------------·---- -- X
Kansas ... _-----·-- __ --·------·----------·-··----·-··----·-----·---·-------···------·-·-·-··· X
Maine·---------·-·-· Reduced personal income tax rates.
---·-·------·---·-·-·------·------···-·-··----·- X
Ma 'YI and. _• _______ ·-·-•. -- -- -- -- ____ ·----··· ____ ·- __ -- -- -- __ -- -- -- -··--- -·--·--- -··· -· -· -- -· X
Massachusetts---·-·-·-----·-·-------·--·-·-·· Extended income limits
on income tax exemp·
tions;
···-···-·-······------··
Michigan .. _______________ ·- __ -· ____ -· ____ •• ··-- __________
-· __ --·---·-·-••
---· -- ----·- -- -- -- -- X
Minnesota ...• ________ Reduced State income
tax rates.
··-·--•• __ -······--··· •• __ ·--····- --·-··---- -···
Mississippi _______ • __ • Doubled standard deduc•
tion allowable.
•• ·-·· •••• -····-•• ·-·- __ .• ____ -· -··-•.•• --··--··
Nebraska. __ -·- --·· __ .• ______ •• __ •...•• __ ••••.• __ •• ·--··-•••. ____ ..•• __ .. -· .• ·- __ -· ·-·- __ ·- __ X
New Jersey ....• ·- ____ ·- ______ .•..•. __ ·-·- •. -·-· .• -· .. -· •••• -·-·-· •••••• --·-·-•. -··-·--· .• -- -- X
New Mexico.·---··--- Reduced State sales tax
ra~--------------------------------------New York ______ ·--·-· Reduced State income
tax rates, increased
investment tax credit,
increased amount
standard deduction
allowable,
•••.... _. -·-··-···-·-··-----·---------··-·---·· K
Rhode Island.-·-·-·-·-·-· -- •• -- •• --·- ____ •• ____ -··- -··- -· -····-·····-•• --·--···--·--··· •••••• X
South Dakota •.... ____ Increased property and
sales tax refunds for
elderly and disabled. ··---···--·--····-·--···-----·--------···-·-···· X
Tennessee._ •• -·-·······-·-···-·············-··-··-·················· Limited state spending
to the rate of economic growth in state. K
Vermont ••••••••••••• Repealed State income
surtax.

------------------------X

Representative REuss. Our next witness is Mr. Stephen B. Farber.
STATEMENT OF STEPHEN B. FARBER, DIRECTOR, NATIONAL
GOVERNOR'S ASSOCIATION

Mr. FARBER. Chairman Reuss and Mr. Cochairman Moorhead, members of the House Subcommittee on the City, and the Joint Economic
Com,mittee, it is a great pleasure for me to appear before you today


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on behalf of the National Governors' Association, the policy instrument of the Nation's Governors.
Your hearings today are timely and important. The issues which
you are examining require less heat and more light. These hearings
can help achieve this result.
My prepared statement, which you have seen, addresses several questions that are of fundamental importance to the debate over tax and
-expenditure limitations. One key question is the extent to which State
assistance to local governments has increased to enable those governments to restrict growth of their local property taxes.
Our analysis at the National Governors' Association shows that
State support of local governments now totals $73 billion and has
virtually doubled in the last 12 years even after the impact of inflation
is discounted.
Two-thirds of all State revenues go to support local governments.
State discretionary grants to local governments have increased twice as
fast as overall State aid. As a result local property taxes have steadily
declined both ao; a percentage of State and local revenues and as
pcrcentgc of personal income.
During the past 12 years State assistance to local governments in
welfare has grown by 450 percent; in revenue sharing, by 409 percent;
in education, by 240 percent; in highways, by 103 percent; and in
health and hospitals, by 259 percent.
I would like to emphasize the growth in revenue sharing, 409 percent, because we strongly believe that the Federal Government would
also be making more effective use of its funds through continued and
expanded use of mechanisms for revenue sharing.
Sometimes in Washington, D.C., Mr. Chairman, the magnitud-e and
the significance of State assistance to local governments are underestimnted. But I can assure you that in the capitals of all the 50 States,
both State and local officials have a full appreciation of the meaning of
the 873 bmion figure that I quoted, a figure that looms even larger in
importance when tax and expenditure limitations are discussed or
projected.
A second key question deals wHh actions States have taken, and are
taking, to limit taxes and expenditures. On the tax side, almost every
State has acted in the past 3 years to limit $tate and/or local taxpayer
liability through increased credits, deductions, or exemptions. gtate
circuithreakcr programs, for example, now operate in 30 States.
In 1977. they returned $932 million to just over 5 million households
for an average rebate of $184. On the expenditure side, tax exPenditure limits of different kinds have been set in Tennessee, New Jersey,
Colorado, and Michigan, and they are pending in other States.
In short, Mr. Chairman, the past several years have seen extensive
StaJe action to limit taxes and expenditures.
The need now, as States consider new approaches in the wake of the
passage of proposition 13, is for programs that are well considered and
precisely targeted.
A third key question deals with the impact of tax limitation efforts
on the State and national economies, and on the delivery of services.
Yon are iamiliar with the recently completed CBO analysis of the effects of proposition 13. That report is sobering in its conclusions.
Whether or not one fully agrees with the report's conclusions, the


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message, it seems to me, is quite clear: We must all insist on knowing
the full jmpact of programs to limit taxes and expenditures on the
economy of the States and of the Nation, and on the delivery of services, befo1·e and not after they are adopted.
The question to which my statement devotes the most substantial
attention, Mr. Chairman, is the actual fiscal condition of the States.
There has been widespread, and I believe quite damaging, error and
confusion on this question, and these hearings can perform a great
service by helping to set the record straight so that sound and wellinformed public policy can be made.
The prevailing myth in some quartters is that there is a massive
surplus in the States in the range of $30 billion.
Cochairman Moorhead alluded to these figures in his opening presentation. I'm glad that you did, Mr. Cochairman, because it's time
to nail hard, and nail precisely, what the facts are.
The reality, as opposed to the myth, of the State surplus, or more
accurately, the States' general fund operating balance, is quite different. The $30 billion figure often heard is actually a combination of
what the Commerce Department calls "social insurance funds," and
"other funds" for both State and local governments.
The social insurance or pension funds are not available to State
and local governments to pay their operating costs. Yet these funds
currently represent nearly two-thirds of the so-called surplus.
The aggregate State government general fund operating balance, as
of the first quarter of 1978, was projected at $6 billion by our best
analysjs, and that figure reflects sound budgeting practices.
During the first quarter of 1978, local governments, as opposed to
State governments, appeared to have an operatjng balance of approxi-.
mately the same size as State governments; that is, in the range of
$6 billion. These are data that we have compiled painstakingly with
the excellent assistance of the National Association of State Budget
Officers.
The aggregate State operating balance represents less than 6 percent of the operating budgets of all States. Sound budgeting experienre
suggests that such a contingency fund is necessary to offset unexpected
emergencies or financial difficulties, and in all of the States which you
represent, Mr. Chairman and members of the subcommittee and committees, you know that these emergencies, whether floods or disasters
of other kinds, or fiscal difficulties, can and do arise and must be
budgeted for.
The bulk of the aggregate State operating balance is found in just
a few States, and in those States, such as California, where Governor
Brown and the legislature have acted decisively to deal with the
impact of proposition 13, the balances have already been largely
committed.
The fact is that most States-such as New Jersey, Mrs. Fenwick,
which has a $23 million surplus in a massive State budget-have a
modest or marginal balance at the very best.
In short, the reality of the State financial situation is significantly
different from the myth. The surplus, as Barron's magazine concluded
in its May issue of this year, is "vanishing," and "phantom."
The aggregate operating balance for State governments is about
$6 billion, or one-fifth of the commonly cited $30 billion figure, and


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it is projected to be proportionately smaller, perhaps 30 percent
smaller, by the end of fiscal year 1979.
The balances in most States are small, and represent sound financial
management, and far from acting as a drain on the economy, these
balances will either be returned to citizens to reduce property taxes, or
reinvested in economic growth.
This morning's Wall Street Journal, on page 3, has this leadline:
"U.S. Finds State, Local Budget Surpluses Evaporating, Trims Third,
Period Estimate."
I commend this excellent story to your attention. The impact of this
information on the tax limitation debate and on fiscal federalism cannot be overstated.
Misinformation on the fiscal condition of the States could well confuse, and even inflame, the tax limitation debate. And as the night follows the day, inaccurate data will lead to unsound public policy.
It is frankly high time to consign the myth of the massive State surplus to the oblivion it deserves. As Gov. William G. Milliken, chairman
of the National Governors' Association, has said, "Anyone who claims
that there are massive State surpluses is not familiar with the facts."
As the administration and Congress consider the fiscal 1980 Federal
budget, and as you examine the longer-term issues, such as continued
State participation in general revenue sharing, it is extremely important for options to be considered, and decisions made, on the basis
of the reality, not the myth of the States' fiscal condition.
It is time to note with precision the tremendous growth in State
assistance to local governments, and the enormous size of that assistance, and time to note as well, with equal precision the fact and not
the fiction about the States' fiscal condition.
Finally, Mr. Chairman, it seems to me that on this question, as on
the others I have just discussed, the stakes for responsible government,
and for fiscal federalism, are extremely high.
The National Governors' Association will continue to address all
these questions, just as fully and forthrightly as we can. We look forward to a continued close working relationship with the administration, and with the Congress, in this effort.
Thank you.
Representative REuss. Thank you very much, Mr. Farber.
[The prepared statement of Mr. Farber, with an attachment, follows:]
PREPARED STATEMENT OF STEPHEN

B.

FARBER

Chairman Reuss, Cochairman Moorhead, and members of the House Subcommitee on the City and the Joint Economic Committee, I appreciate the opportunity to appear before you today on behalf of the National Governors' Association,
the policy instrument of the Nation's Governors.
Your hearings on efforts to limit taxes and expenditures, and their implications for fiscal federalism, are timely and important. Since the passage of Proposition 13 on June 6 by the voters of California, taxpayers and public officials in
every State have been grappling hard with the problems and the opportunities
created !by efforts to limit taxes and expenditures. The issues involved are in
great need of less heat and more light. These hearings can help develop the sound
and relia:ble base of information required for a better informed consideration of
the issues.
In my statement today I would like to address four fundamental questions:
1. What is the actual fiscal condition of the States?
2. What constructive steps have states taken in the past, and are they now
taking, to provide greater financial assistance to their local governments?


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3. What constructive steps have states taken in the past, and are they now taking, to limit taxes and expenditures?
4. What effects will tax limitation efforts have on the state and national economies and on the delivery of services?
The first question-what is the actual fiscal condition of the states?-is of crucial importance. I regret to say that there is widespread error and confusion on
this point--despite the best efforts of the National Governors' Association, the
Nationnl Conference of State Legislatures, the National Association of State
Budget Officers, and others-and it is high time to set the record straight.
Notwithstanding the data contained in the NGA-NASBO Fiscal Survey of the
States, the prevailing myth in some quarters is that there is a massive "surplus"
in the states in the range of $30 billion. This figure has been taken out of context
from the President's Economic Report of last January and from the national income and product accounts of the Commerce Department's Survey of Current
Business which have preceded and followed it.
The reality, as opposed to the myth, of the state "surplus"-or more accurately,
the states' general fund operating balance-is quite different.
First, the general fund operating balance of State and local governments is not
30 billion. The $30 billion figure is actU'ally a combination of what the Commerce
Department calls "social insurance funds" and "other funds." The President's
Economic Report notes that "a large part of the aggregate surplus represents
accumulations of pension funds for the 13 million emplovees of State and local
go,·ernments." The social insurance funds are not available to state and local
governments to pay operating costs.
The most recent figures from the Commerce Department-for the first quarter
of 1978----show $19.9 billion in "social insurance funds" and $11.5 billion in "other
funds". These figures are significant for at least two reasons. First, they reflect
the increasing efforts by State and local governments during the past three years
to put their pension funds in order. Second, they show that of the total Statelocal "surplus", nearly two-thirds is unrelated to the current State-local fiscal
condition as measured by operating balances.
Second, even the "other funds" category is misleading he<'ause i't in<'ludes a
significant amount of restricted revenues-for highways, parks. and other purposes-not available for general fund expenditures. The aggregate state government general fund operating balance, as of the first quarter of 1978. was projected
at six billion dollars, and reflects sound budgeting practices. Commer<'e Department figures reletased in May indicate that the local share of "other funds" has
generally been larger than the Staite share ,since 1970. In 1976, for example. "other
funds" for local governments were $2.6 billion and for State governments, $1.2
billion. During the first quarter of 1978 local governments appeared to have an
operating balance of approximately the same size as State governments-that is,
in the range of $6 billion.
The aggregate state operating balance represents less than 6 percent of the
aggregate operating budgets of all States. Sound budgeting experience suggests
that such a contingency is necessary to offset unexpected emergencies or financial
difficulties. The 6 percent aggregate figure represents a slimmer margin for
emergencies than many States normally seek to budget. Moreover, since nearly
every State is required by its constitution or statutes to have a balanced budget.
such opemting balances are imperative.
Thil"d, the bulk of the aggregate State opera,ting balance is found in just a few
states, and in those States-such as California, where Governor Brown and the
legislature have acted decisively to deial wi,th the impact of Proposition 13-the
balances have already been largely committed. Most States have very modest or
marginal balances. The balances reflect strong economies in energy- and foodproducing States, the effects of more progressive revenue systems in an improving national economy, and inflation-induced revenue growth.
Fourth, the States' fiscal 1979 budgets will further reduce current balances. A
substantial percentage of the balances which are reported by the States in our
surveys will be spent in the fiscal year which began in most states on July 1. A
preliminary survey of 29 States indicates that by the end of fiscal year 1979, next
June 30, operating balances will decline to four to five percent of general fund
expenditures. The revenues will be used to support property tax relief programs,
recession-delayed projects, inflation-caused cost increases for labor and materials,
and hard-pressed local governments. Also requiring increased State financial support will be such needs as underfunded pension liabilities. equalization of school
support, services for the handicapped, and maintenance and upgrading of the public infrastructure.


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These demands will put existing balances quickly and efficiently back in,to the
State economies. Moreover, far from acting as a "drain" on the economy-as the
President's Economic Report suggests---these resources will enable States to supplement Federal efl'ovts to further expand economic growth.
In short, the reality of State finances is significantly different from the myth.
The surplus, as Barron's Magazine concluded in its May isSl\le, is "vanishing" and
"phantom." The aggregate operating balance for State governments is about $6
billion, or one-fifth of the commonly cited $30 billion figure, and is projected to be
proportionately smaller-perhaps by 30 percent-by the end of fiscal year 1979.
The balances in most States are small and represent sound financial management.
And far from acting as •a drain on 1the economy, these balances will be either returned to citizens to reduce property taxes or re-invested in economic growth and
development.
It is imperative that the current misunderstanding of State fiscal datl:a be
clarified. We have urged Chairman Schultze of the Council of Economic Advisers
to work wtth us to improve reporting and data collection techniques for State
government finances and to incorporate these data into the federal budget reports
and the annual Economic Report of the President. And because many Federal
policy makers have seemed to interpret the State-local "surplus" figure in the
national income and product accounts as the definitive measure of the fiscal condition of State and local governments, we have urged Secretary Kreps to include
in the Survey of Current Business a short explanation of the "surplus" figure and
its limitations as an indicator of fiscal condition. A copy of our letter to Secretary
Kreps is attached for the record.
The impact of this information on the tax limitation debate, and on fiscal federalism. cannot be overstated. Misinformation on the fiscal condition of the States
could well confuse, and perhaps even inflame, the •tax limitation debate. And as
the night follows the day, inaccurate data will lead to unsound public policy. It
is frankly high time to consign the myth of the massive State surplus to the oblivion it deserves. As Governor WiUiam G. Milliken, Chairman of the National
Governors' Association, has said, "Any one who claims that there are massive
state surpluses is not familiar wLth the facts."
As the Administration and Congress consider the fiscal year 1980 Federal
budget and examine longer-term issues, such as continued state participation
in general revenue sharing, it is extremely important for options to be cons1dered and decisions made on the basis of the reality-not the myth-of the
States' fl.seal condition.
Let me turn briefly to the three other fundamental questions before these
hearings.
The first question is what constructive steps have States taken in the past,
and are they now taking, to provide greater financial assisance to their local
governments? Precise information about this increased State assistance, which
has helped to restrict the growth of property taxes, is essential to informed
debate over tax limitation strategies.
A report just completed · by the NGA Center for Poli.cy Research entitled
Allocation of State Funds to Local Jurisdictions ilndicates that State support
of local governments now totals $73 billion and has virtually doubled' in the
last 12 years, even after the impact of inflation is discounted. The report a[so
shows that two-thirds of all State revenues go to support local governments
and that State discretionary grants to locaJ governmens have increased twice
as fast as overall State aid. As a result local property taxes have steadilv
declined both as a percentage of total State-local revenues and as a percenta,;e
of personal income.
"'
During the past twelve years, the report shows, state assistance to lOCitl
governments _in welfa~ has grown by 450 percent; in revenue sharing, by
409 percent; m education, where many States have acted dramatically to overhaul their school finance systems, by 240 percent; in highways by 103 percent•
and in health •and hospitals, by 259 percent.
'
'
A related and equally important question is what constructive steps have
States taken. in the past, and are they now taking, to limit taxes and expennitures? On the tax side, almost every State has acted in the past three years to
limit state and/or local taxpayer liability through increased credits deductions
or exemptions. State circuit breaker programs for example now operate in 30
States and in 1977 returned $932 million-an !~crease of 108,percent over 197i..to just over five million households-an ifncrease of 68 percent over 1974-for
an average rebate of $184. On the expenditure side, tax expenditure- limits of
different kinds have been set in Tennessee, New Jersey Colorado and Michigan
and are pending in other States.
'
'


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In short the past several years have seen extensive state action to limit
taxes and ~xpenditures. The need now, as States consider new approaches _in the
wake of the passage of Proposition 13, is for proposals that are well considered
and precisely targeted. To assist in this effort the NGA Center of Policy Research,
in response to a suggstion made by Governor Ella Grasso and at the request of
Governor Milliken, will serve as a clearinghouse to advise Governors on different
approaches to tax and expenditure limitation and their impact on services.
A finaJl question of basic importance is what effects will tax limitation efforts
have on the State and national economies and on the delivery of services. The
Congressional Budget Office has just completed a report on the impact of Proposition 13 on the national economy, Federal revenues, and Federal expenditures.
That report is sobering and instructive. It argues that Proposition 13 will cause
an employment loss of about 60,000 jobs by the end of 1978; a reduction in the
national Consumer Price Index of 0.2 percent by the end of 1978 and 0.4 percent
by mid-1980; an increase in Federal revenues of $600 million in fiscal year
1979 and $900 million in fiscal year 1980; and a potential reduction in California's
participation in Federal grant programs that have matching requirements, particularly in welfare, employment and training, education, and transit. The
report further argues that "if such actions spread to a significant number of
States, the impact on the Nation's economy and the Federal budget could become
significant. Unless the reductions in taxes are at least twice as large as the
accompanying slowdown or cut in expenditures, the net effect is likely to be a
slowdown in economic activity and employment growth."
Whether or not one fully agrees with the report's data and conclusions, the
message here is clear. We must insist on knowing the full impact of prOipOsals
to limit taxes and expenditures on the economy of the States and the Nation,
and on the delivery of services, before, not after, they are adopted.
On this question, as on the others I have discussed, the stakes-for responsible
government and for fiscal federalism-are extremely high. The National GoYernors' Association will continue to address these questions as fully and forthrightly as we can. We look forward to a continued close working relationship
with the Administration and Congress in this effort.
Attachment.
NATIONAL GOVERNORS' ASSOCIATION,
Washington, D.O., July 24, 1918.

Hon. JUANITA M. KREPS,
Secretary of Commerce,
Washington, D.O.

DEAR MADAM SECRETARY: As you may know, the National Governors' Association and National Oonference of State Legislatures have expressed concern on
several occasions about what appears to be a widespread misunderstanding of
the meaning of the state-local "surplus" figure reflected in the national income
and product accounts prepared by the Commerce Departments' Bureau of
Economic Analysis. Enclosed are some of the materials in which we have conveyed our concerns to members of the Administration, Congress, and the press.
Regrettably, the misunderstanding has persisted despite our efforts, and it
appears to have the potential to influence public policy. This letter is to ask your
assistance in a small matter that could go a [ong way toward clearing1 up this
misunderstanding.
The heart of the problem is that many federal decision-makers have interpreted the state-local "surplus" figure in the national income and product accounts as the definitive measure of the fiscal condition of state and local governments. We are sure· that your economists would agree that the national
income and product accounts were not intended to measure the absolute- fiscal
condition of state and [ocal governments and that they should not be used for
this purpose.
We believe that it would be helpful if the Commerce Department would publish
in the Survey of Current Business a short explanation of the precise meaning
of the SUTl'[)lus figure and of its limitations as an indicator of fi~al condition.
B:v way of example, the following language addresses the main points w'ith
regardto the figure's limitations:
The size of state and ,local government surpluses, as reflected in the national
income and product accounts, has attracted significant public attention in reC'ent
months. The followlJ.ng technical points should be kept in mind in interpreting
this statistic:
1. The national income and product accounts are not a definitive measure of
the fiscal condition of state and local governments. The accounts measure flows
37-250-79--10


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.among_ sectors of the economy that generate income or product. The accounts thus
provide income and expense information hut do not show stllte and local government balance sheets, which would be neces~ary to make informed judgments
.about fiscal condition. The accounts do not show, for example, the debt position
of state and local governments nor do they reflect the condition of assets with
regard to maintenance and replacement.
2.. Tjle accounts cover more than 80,000 governments, and aggregate trends can
,mask,contrary conditions for even a majority of these governments.
3. The accounts show the net flow of social insurance funds as part of the
state-local surplus although these funds are not available to state and local gov·ernmepts to pay operating costs.
4. Tpe vast majority of state and local governments are required by constitutional provision or statute to operate on a balanced budget and are prohibited
from borrowing to meet operating costs. In these governments, the ability to
•deal with contingencies may dictate the deliberate budgeting of a surplus.
5. A significant portion of state and local revenues is restricted by constitutional provision or statute to specific and narrow uses and is therefore not rele~-ant to the fiscal condition of state and local government general operating funds.
6.· The size of the state-local surplus as reflected in the national' income and
product accounts may be influenced by changes in the rate at which state and
local governments spend for capital construction. These changes may be caused
1w external factorrs not significantly related to the fiscal condition of the governments.
An explanation along these lines in the highly respected Survey of Current
Bmdness would help ensure that the state-local surplus figure is not misunderstood and would therefore contribute to better-informed public policy.
Sincerely,
WILLIAM G. MILLIKEN,
Governor of Michigan;
Chairman, National Governors' Association.
JASON BOE,

President, Oregon Senate;
President, National Conference of State Legfalatures.

Representative REuss. We will now hear :from Mr. Fred F. Cooper.

STATEMENT OF FRED F. COOPER, COUNTY SUPERVISOR, ALAMEDA
COUNTY, CALIF.
Mr. CooPER. Thank you, Mr. Chairman. I would like to, o:f course,
refer to my prepared statement as well, as I have submitted a resolution adopted by the National Association of Counties at their annual
convention in Atlanta 2 weeks ago today.
Representative REuss. ,vithout objection, those will be included in
the record at the end of your oral statement.
Mr. CooPER. In my prepared statement, I attempted to look at what
I see as some of the reasons for passage of Proposition 13 in California. I am a county supervisor in Alameda County, which has a
population of 1.1 million people. It is across the bay, east of San
Francisco, has 13 cities running :from the core urban cities of Berkeley
and Oakland in the north to suburban cities of Freemont, Livermore,
and Pleasanton in the south.
So we have both the urban and the suburban problems, and are, of
course, at the core of the problem of Proposition 13, the problems and
the solution.
I think one of the key factors that I think has been overlooked in
passage of Proposition 13 and the reason why voters-many votersseem to be angry with Government is that for 30 years. in the forties,
~-ftics, and_ sixties, we had inflation, but we still ha~ peo_ple's purchasmg power mcrease. In the past 5 years, the pnrchasmg power has been
eroded, and we are continuing to have inflation, but people's purchasing power does not keep up.

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I think Congress needs to look at the impact of the actions of th~
Arab oil countnes and the impact of the environmental and consumer
movements on purchasing power in this country.
Those three things have all substantially increased the cost of goods
and services in the country without adding anything to the value of
the goods and services, and I think have resulted in the purchasing
power of many people being eroded.
Inflation, of course, is a contributing factor, but as I have indicated,
we have had inflation for a number of years without purchasing power
being diminished. And when people see their purchasing power eroding, they look for somebody to blame. They tend to blame the unions,
business, and now these days, following Watergate, it is big government, and I think it is important to focus on the reasons for the eroeion of purchasing power and get people to understand better what is
hnppening.
Obviously, when they get angry, they look for something to do
something about; the property tax with Proposition 13 gave them that
opportunity to express their dissatisfaction and cut at least one major
cost item that they could have an impact on. Another major factor is
mandates to local government passed without providing the funds.
Those mandates come from the Congress, they come from the State
legislature, they come from the courts.
I have outlined in my prepared statement some of the mandates
from the courts, some of the mandates from the Congress, and some
of the mandates from the State legislators that our county has to live
with that increase in our costs, that require us to increase our property
tax much faster than just the cost of living, and it seems to me that
Congress needs to look at the effect of those mandates, and some of
them come from Jaws you pass and are implemented by regulation.
As I pointed out in my prepared statement, the same newspapers
and television stations and voters complain about Alameda County
increasing the property tax 1½ years ago, and they were also reporting disabled people sitting in Senator Cranston's office in San Francisco, and coming back to Washington and asking that Secretary
Califano adopt regulations, and those regulations resulted in costs
of $10 to $20 million. They are based on the law you passed, based
on the law Secretary Califano signed.
Everybody was in favor of them 1½ years ago, and nobody looked
at the cost, and now we in local government are being blamed for
the fact that to implement those regulations takes money. And we
are being blamed for the fact that you have imposed those regulations on us without giving us a dime to fund the cost. And, I think
you need to look at some way of requiring economic impact statements
when you adopt regulations, and when you adopt legislation that has
an impact on local government.
Finally in my prepared statement, I point out that California has
rejected three similar propositions to Proposition 13 over the past
15 years, and this one was passed even though three prior ones had
been rejected.
I think two key factors that resulted in the passage of the fourth
one, when three had been rejected were: One, the substantial increase
in the market value of single-family homes, partly due to inflation, and
partly clue to the environmental and no-growth movements that have
resulted in the assessed valuation of the average home in California

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doubling over the past 5 years, and has resulted in a substantial shift
of the property tax burden from commercial and industrial property
to homeowner.
The second factor that did not exist when California rejected similar·
programs three times previously was the substantial State budget surplus-which has passed $5 billion-and, of course, a substantial amount
of that budget surplus was accumulated by the State passing on costs
to local government through regulations and through State legislation without providing the dollars.
So, at the same time the State legislature and the Governor have
increased the property tax through mandates, they have been accumulating a substantial surplus, and their inability to keep their
commitments which they have been making for 2 years to use thesurplus to fund some property tax relief for the homeowners also
added to people's anger, and by the time they adopted the program
under the threat of Proposition 13, the voters had lost confidence
in their sincerity.
So those two factors did exist this year in California. They do not
necessarily exist throughout the rest of the country, but they doexplain to at least a great extent the reason why Proposition 13 passed
when three prior measures failed.
I think Congress could assist the States by studying the impact
of the environmental movement on increased cost of housing, bylooking at what is happening to the purchasing power in this conntrv, and helping people understand what is happening before you
adopt the mandates, and you might leave it open to the possibility
of requiring that whenever you insist on expenditures through your
laws or regulations that we do something new, or we expand the
program, that to send the money on to fund them.
Local government in California, through the passage of Proposition 13, has become almost totally dependent upon the State and·
Federal Governments for the funds with which to operate. This
erosion of local control over local government is a dangerous thing·
because it will result in the inabilitv of local officials to adjust local
programs to meet local needs, it will mean that only programs approved in Sacramento and Washington will be funded. and it means
that the most vital decisions for local government will be made by
State and Federal employees adopting a,nd modifyinl{ regula.tinns
in Sacramento and Washington, rather than by people responsible
to their local voters.
That is the real danger of Proposition 1 ~, anrl if that is true
throughout the country, local government throughout the country
will become less and less responsive to the local voters.
Thank you.
RepresentativeREuss. Thankvou. Mr. Cooper.
fThe nrepared statement of Mr. Cooner, to.cretlier with a resolution
adopted by the National Association of Counties, follows:]
PREPARED STATEMENT OF FRED F. COOPER

Members of the subcommittee: I appreciate this opportunity to appear and·
testify before you on what I see as some of the causes for the passage of Proposition 13 in California and several of the problems that led to its passage.
Perhaps the biggest single factor is the fact that the cost of local government, and county government in particular, is going up faster than the cost of·
living at the same time that individual taxpayers see their purchasing power-


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-eroded away through actions of the Arab oil countries, the consumer movement
and the environmental movement. While we have had thirty years of inflation,
throughout most of that period people's purchasing power has increased more
rapidly than their expenses, but in the last.Jive years that has not been the case.
People see thei-r purchasing power each ye!r being reduced, they look for some-0ne to blame, and the tendency is to blame labor unions and business for raising
prices, and to complain about property tax going up rapidly since it is one thing
where they have ,some control. I do not think adequate attention has been paid
to the fact that a major portion of the erosion in purchasing power is due to
,actions of the Arab oil countries, the environmental movement, and the consumer
movement since all three result in our having to pay higher prices for products
without the products being improved or being made more valuable in any way.
P(lrhaps your committee can focus on the erosion of purchasing power in this
,country and the basic causes, since inflation is often blamed, but inflation in the
1950's and 1960's did not result in lower purchasing power.
A more direct cause of voter dissatisfaction with the property tax is the fact
that it goes up substantially faster than the cost of living. Partly this is due to
the fact the cost of some things that counties purchase go up faster than the
•cost of living, particularly utilities and gasoline due to the oil crisis. But of
,course higher oil prices are built into the cost of every item of goods and services
purchased by counties just as substantially higher medical costs are built into the
price of every item of goods and services. Every time yon go to a grocery store and
buy a bag of potatoes you are contributing to the medical care of the grocer and
his staff, the people who process and deliver the items, etc. Higher medical care
-costs should be added to my previous discussion of increased costs from Arab oil
-countries, and the consumer and environmental movements.
A major factor causing the county property tax to increase much faster than
the cost of living is governmental mandates. These include the United States
·Congress, the California legislature. and both state and federal courts as follows:
J. The average length of a felony trial in Alameda County has tripled in the past
fifteen years, from just over two days to over eight days. Mostly the increased
length is due to decisions of the United States Supreme Court, and a substantial
.amount is due to decisions of the California Supreme Court, which require the
courts to provide attorneys, provide time for hearings on a great many different
things such as search and seizure, past records of police officers, di-scovery of
•evidence, etc. The increased length of trials requires more judges, more district
attorneys, more public defenders, more clerks, more courtrooms, etc.
2. Mandates by the federal government increase local costs. Passage by Congres.s
,of unemployment insurance is increasing our costs, and even though the Fair
Labor Standards Act application to local government was suspended by the
·Supreme Court, many jurisdictions including my own are continuing through
1abor negotiations to apply portions of that act to county operations at higher
,costs. The adoption by HEW of regulations for the disabled and handicapped a
year and a half ago will eventually result in increased cost to local government,
probably more than one-half in the schools, of $10 billion to $20 billion. In this
:area it is significant that the same taxpayers and newspapers that are criticizing
local government in California for the high property tax were, a year and a half
ago, quite sympathetic to the demonstrations by handicapped people in Senator
'Cranston's office in California and in Washington, when they were asking Secretary Califano to sign the regulations. The same people who urged that. the
regulations be signed are now complaining about having to pay the cost. It mhrht
be useful to require an "economic impact report" before Congress passes legislation affecting local government, and before federal agencies adopt regulations
that require changes in the operations of local governments.
3. A large portion of the increase(J property tax for Alameda County has been
due to mandates by the legislature of the State of California. We have been re-quired to fund increasing amounts each year for Medi-Cal, AFDC, and adult
welfare. State law and state regulations frequently require improvements and
-expansions in county programs, without supplying any funds. At the same time,
when the State provides partial funding for local programs the State frequently
provides no cost of living increase in their share of the program. For example,
the state bas been paying the same $95 per month for the care of juveniles in
juvenile camps since 1953, leaving the county to pick up all increases in costs over
the past 25 years.
I believe the above listed factors of reduced purchasing power and increased
mandates by the courts and the state and federal governments apply fairly uniformly throughout the country. although I Ruspect that the state mandates are
1ees of a problem in states with low overall tax rates than they are in California.

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I would urge the Congress to look at the erosion of purchasing power over thepast several years associated with the oil crisis, and the consumer and environ~
mental movements, and to consider some sort of economic impact report on locar
government whenever Congress, or state legislatures, or the courts, mandate newprograms or mandate improvements fo existing programs.
If we look specifically at California and Proposition 13 we need to recall that
over the past fifteen years the voters in California have rejected three similar·
measures to proposition 13--two proposed by the former Assessor of Los Angeles
County and one proposed by former Governor Ronald Reagan.
It is my feeling that three factors existed in 1978 that were not present when·
the voters rejected the three similar measures previously as follows :
1. The erosion of purchasing power on the part of most people has gotten most
severe in the past two or three years, and results in frustration since inadequate·
attention has been paid to the problem and inadequate explanations given. People
get frustrated when their purchasing power goes down, but the frustration is·
compounded by the fact that they are not sure who to blame, and is compounded·
further when they see their taxes increasing rapidly to provide additional services·
and benefits to p~ople whom they feel are not carrying their full weight. So far,
that frust·ration has not extended to dramatic increases in the Social Security tax
to fund· dramatically increased benefits to senior citizens, but unless there is
better public understanding of what is happening I think we can anticipate in the
next few years the same frustration directed at senior citizens as is presently
directed at recipients of welfare.
2. The cost of housing, and particularly single family housing, haR <louhled in
California in the past five years. This seems to be partly due to general inflation.
and partly due to the environmental movement, which has kept the ,supply of·
housing down at the same time the demand has increa,sed, thereby causing market
values to sky-rocket. Since property tax assesim1ents are based on market value,.
the assessment of the average home has doubled over five years and therefore evell'
with the same tax rate the amount of tax being paid has doubled. Because single·
family homes increase in market value much faster than commercial and industrial property, this has resulted in a shift of part of the property taxes from commercial and industrial properties to homeowners. It should be noted that theopinion polls in California show equal numbers of people against Proposition 13 as
those in favor of it up through March of this year. When the increased assess-ments came out in April, public opinion shifted dramatically in favor of the
proposition.
3. The other major factor present this year in California that was not present
previously was the fact that the State was sitting on a budget surplus of $3 to,
$4 billion at the same time that the State legislature and Governor were unable·
to provide the property ..tax relief that they had been promising for more than a
yea·r'. Voter frustration •increased as the taxes went up, as dramatically higherassessment notices were sent out in April, and yet the legislature and Governorwere unable to keep their promises to distribute the surplus to solve the problem,.
at least until some time after Proposition 13 qualified. The fact that the legislature finally passed an alternative measure some months after Proposition 13
qualified for the ballot made many voters feel that the legislatJure would not
have done anything except under the threat of Proposition 13. It is, of course,
significant that subSJtantial portions of the State surplus were developed as a
result of state mandates by both the legi,slature and administrative mandates
from the Governor that increased the property tax. If, instead of accumulatinga large surplus, the State had used the money to fund the many mandates tolocal government which increased property tax and to provide adequate funding
for the State's share of partnership programs, the property tax would not have
increased so dramatically and Proposition 13 might not have passed.
Congress could assist the states by studying state surpluses, by studying the
impacts of the environmental movement on increased cost of housing, by attempting to help control inflation in housing costs, and by encouraging the use of state
surpluses to fund state mandates, thereby reducing the need to increase local
property taxes.
Local government in California, through the passage of Proposition 13, has
become almost totally dependent upon the state and federal governments for
the funds with which to operate. This erosion of local control over local government is a dangerous thing because it will result in the inability of local officials to
adjust local programs to meet local needs, it will mean that only programs approved in Sacramento and Washington· will be funded, and it means that the
most vital decisions for local government will be made by state and federal employees adopting and modifying regulations in Sacramento and Washington►
rather than by people responsible to their local voters.

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[Resolution adopted by the membership of NACo, the National Association of Counties,
July 11, 1978, iu Washington, D.C.]
TAX REFORM AND RESPONSIBLE GOVERNMENT

Be it Resolved, upon the initiative of President William 0. Beach, that NACo
adopts the following statement on tax reform and responsible government, to
have the effect of a resolution:
The adoption of Proposition 13 in the state of California constitutes a confirmation from the voters of that state of what has been a NACo position of
longstanding-that the property tax levels at the local level are often intolerable,
and the property tax itself has been asked to carry far too many of our governmental burdens. In addition to the traditional property-related services, it also
now often must pay for our expensive modern educational systems, health and
social services, and many other programs. Too often this over-loading of the
property tax is not the result of votes by local elected officials, but rather than
mandates of Federal and state government. NACo has long held that the major
burden of property taxes frequently arises from l'ederal and State policies
mandating the conduct and financing of ]federal and State programs from local
resources principally, and in many cases exclusively, from the property tax.
NACo is acutely aware of the public concern and reaction to the crushing
burdens of property taxes placed upon property owners not only in California,
but elsewhere in the nation. We support the roll-back of property taxes if they
reach confiscatory levels, and the adoption of property tax levels which accurately
reflect the costs to local governments to provide essential local governmental
services.
While the implementation of such roll-backs may, in many cases, cause initial
severe economic and programmatic dislocations, a direct result of such implementation can be to put into clear public perspective the impact of Federal and
state mandate programs and policies upon the local governments' principal
source of revenue--the property tax.
NACo calls upon the President, the Congress and each state's executive and
legislative leaderships to recognize the clear and compelling principle of the
need for equitable reallocation of cost burden sharing now placed upon the property tax used by many of our nation's counties and other local governments.
NACo further calls upon Federal and state governmental leadership to review,
with sensitivity to the unacceptable tax burdens of all kinds upon the people of
this nation, all aspects of governmental spending to reduce waste, duplication and
unnecessary governmental spending-an objective which NACo and its individual
members have long advocated, and to which we re-commit ourselves.
In order to more clearly re-state where NACo and its member counties stand,
we hereby rededicate ourselves to the following long-held principles and
objectives:
Delivery to the best of our abilities a wide variety of important and essential
public services to our citizens, including vital human services to the poor, aged,
disabled, mentally and physically ill and those otherwise disadvantaged who are
least able to care for themselves ;
Operation of the delivery of those services with the confines of a balanced
budget that the taxpayers can afford ;
Maintenance of a vigilant watch in order to maintain only essential positions in
county.government and otherwise to eliminate all unnecessary expenditures from
our public budgets ;
Continuing efforts to increase efficiency and productivity of both management
and the rank and file of county employees ; and
Fair and equitable administration of the property tax, together with all other
local taxes.
We also, individually and as a national organization, pledge our best efforts,
in cooperation with our state associations of counties and our fellow state, city
and Federal officials, to encourage and work at all levels of government:
To resist all state and Federal mandates to local government unless there is a
provision for funding by the state of Federal government; and
To control inflation, by vigorously urging the President and Congress to balance
the Federal budget at the earliest possible date and we pledge to assume our
share of that responsibility.
Finally, we pledge ourselves to the following specific actions and commitments:
Establish priorities
In the interests of economy, we ask each of our twelve steering committees to
establish priorities among their various functional areas. We ask the Board of
Directors to establish priorities among those submitted by the committees. Fi
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nally, we as the policymaking membership pledge ourselves to the difficult but
necessary task of developing each year an American County Platform which
combines a balance of necessary programs and fiscal responsibility.
In establishing priorities, we ask each of our steering committees to give
full consideration to actions in their respective subject areas which are calculated to increase economy and efficiency by such devices as caps· on medical
expenses, removing much of health and welfare costs from the property tax base,
and bring Federal, State and local regulations to a minimum.
Maintain NAOo's tam revolt action center

Provide factual information to public officials, media and the citizens in general, on the various methods and devices for tax reform and expenditure control. In particular, we will endeavor to better educate voters on the real problems
concerning the property tax, the roll of mandated programs in driving the property taxes to often near confiscatory levels, and the need for basic tax spending
reforms at the state and Federal levels.
Strengthen NAOo's new county center

Top association priority should be given to the New County Center, which
provides information to the public officials and citizens in general on ways and
means of improving county administration, finance management, planning, organization, staffing, budgeting and public reporting. Special emphasis should be
placed upon the following: consolidations of elimination of special authorities
and districts; functional consolidations; joint governmental contracting; voluntary regional cooperation; increased management and labor productivity; and
improved general public administration.
Provide Federal budget input

At the earliest date, the leadership of NACo should meet with the director of
the Office of Management and Budget and the Congressional Budget Committees
to determine a responsible county role in aiding the President and the Congress
in determining Federal budget priorities and limits.
Improve financial management

NACo will continue to help county governments improve their financial management practices. Our Tax and Finance Conference in Los Angeles, September 18-20, 1978, will focus on tax reform activities and fiscal management.
Urge tax and welfare reform

Funding of welfare and certain health costs from the property tax is a major
concern to citizens and is strongly opposed by NAOO. All efforts should be made
to secure Federal action to remove these costly items from the property tax.

Representative REuss. In order to conserve time, cochairman
Moorhead and I have suggested that the next three witnesses, consisting of Mr. Edward Gramlich, of the University of Michigan, Public
Finance Director George Peterson of the Urban Institute, and Herrington Bryce of the Academy for Contemporary Problems, take their
seats at the table so that after their testimony, we may examine the first
eight witnesses, and withhold the final three witnesses until later.
So, if you three gentlemen will jnst remain at ease where yoh are,
we will hear thesf\ three witnesses I have j.ust named.
Representative KELLY. Mr. Chairman, I have a brief statement
that I would like to make at this time, if the committee has no
objection.
Representative REuss. Of course, Congressman.

STATEMENT OF HON. RICHARD KELLY, A U.S. REPRESENTATIVE
IN CONGRESS FROM THE FIFTH CONGRESSIONAL DISTRICT OF
THE STATE OF FLORIDA
Representative KELLY. Mr. Chairman, and Mr. Cochairman, Proposition 13 represents government by volunteers, where the people en
masse have turned away from their duly elected officials-the constitu-


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tional government-and have looked to volunteers to lead them and to
establish government that is satisfactory to the public.
Recently, a poll in my district showed that the Congress of the
United States has a minus-51 job rating, which means that the rest of
the people, 49 percent, either didn't have an opinion, or thought Congress was doing all right. But I think that accommodation of these
two considerations indicates a very serious significance regarding
Proposition 13.
Mr. Chairman, the threat that is being made by the elected officialdom is that if the people try any shenanigans like Proposition 13,
that there is going to be reprisals, massive layoffs among the publ~c
employees; that a lot of people are going to get fired, and pllhhc
services are going to be reduced. But nowhere does there seem to be any
suggestion that government, as a matter of economy, might cut salaries
as a way of retaining employment of everybody and also maintaining the level of public service.
The other suggestion seems to be that, well, we will just shift the
burden of spending :from local governments to the Federal Government, and in that way some miracle will be wrought. Of course, that is
just going to shift the burden on the taxpayers from one pocket to
anothRr, and really will not accomplish anything.
So I see merit in two major areas: the idea o:f cutting salaries and
trying to cause government officials who are elected, according to our
constitutional processes, to start :functioning in the way that Proposition rn suggests that thev should, rather than run the risk of chaos
in our Nation and destruction of our constitutional form of governmen~ by forcing the people to turn to volunteers rather than the estahhshed government.
Representative REuss. Thank 'Vou Congressman Kelly.
Congressman Moorehead will introduce our next panel.
Representative MOOREHEAD. Thank you, Mr. Chairman.
The leadoff witness, for panel No. 2 before the .Toint Economic Committee and the Subcommittee on the City, is Mr. Edward M. Gramlich.

STATEMENT OF EDWARD M. GRAMLICH, PROFESSOR OF
ECONOMICS, UNIVERSITY OF :MICHIGAN

Mr. GRAMLICH. Thank you, Mr. Chairman and committee members.
I have a statement of about five or six pages here, which I will submit
for the record. What I would like to do is just make five points that
I ma:ke in the statement much more briefly than I do there.
As Congressman Moorhead said, we are addressing in this panel
the question of the high current-day national income account data
and the State and local budget surplus, and what it means.
The first point is a :factual point. Is the surplus really all that it is
cracked up to be: there are a couple of reasons whv it is not. The first
is that, as Mr. Farber in particular mentioned earlier, one really must
deal separatelv with the pension :fund surplus. In the latest :full-year
numbers that I have available, the overall surplus o:f $29 billion, $15.5
was pension :funds, so that the appropriate general government surplus is more like $13 billion.
There are a lot o:f reasons why the pension fund surplus doesn't
mean anything about even the financial health of pension :funds. Cer-


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tainly it is true that the money is not available -for general government
purposes and must be left out of these kinds o-f discussions.
Now, even the general government surplus of $14 billion has increased $20 billion in the past 2 years. There has been a sharp turnaround even in that number. So a second question that I deal with in
my testimony is what has caused that. Basically, there are three
causes:
The first is that there has been a very sharp drop in State and local
construction that accounts -for about one-third in the change in surplus. There are a number o-f fairly, at this point, m:vsterious, reasons
:for that. I have some thoughts about that, but I didn't go into them in
mvtestimonv.
'In any case, the construction budget is again not part of the operating budget o-f most State and local governments. So probably a better
number to focus on is more like the $13 billion change in the operating
surolus over the past 2 years.
Now, what has caused that? I think that you can attribute that
mainl:v to two sources. The first is that the agg:regate economy has recovered sharply from the recession of 1975, and in the. recession of
1 n75 State and local budgets were in a precarious budgetary situation.
TJ1ev have recovered now because the economv has recovered.
That is a welcome improvement. We shouldn't regret it, and we
probably shouldn't change our views about aiding State and local
governments because that has happened.
The second thing is that there has been an increase in some Fedf'ral
grants in the past 2 years, mostly in CETA grants. Many people feel
that there is a lot of so-called displacement with CETA, and if that
is so, that could also explain at least some of the rise in the operating
budget surplus in the past 2 years.
Now, the next point refers to the composition of the surplus. Is it
held by State governments, or is it held by local governments e One
thing that I should say this morning is that anybody who talks about
this is talking in a little bit of a factual vacuum, because as· a matter
of fact we don't have very good figures in the most recent period
which governments have the surplus.
The Department of Commerce has just published a breakdown of
the State and local accounts between the State governments and local
{rOvernments through 1976. These figures don't cover 1977, which is
the year when a lot of the chanQ'e in the surplus has taken place.
So it is very hard to tell at this point where the surplus actually is,
by State governments or local governments. But if you look at the i976
numbers, what you find is that, indeed, the State governments have
n,eeived a little bit more of the year-to-year change, but that the
State government budgets are always more cyclical than local government budgets. If you compare the budget position now with the 1960's,
that in fact local governments are doing slightly better now than they
were in the 1960's, and State governments are doing the same or a
little bit worse.
So, while it is true that State governments have received a little more
of the latest rise in the surplus than local governments, local govern-


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ments have received some and local governments are still better off
relative to the 1960's.
It is very hard to go beyond that and talk about individual governments.
Now, the next point is the relevance that these surpluses for overall
macropolicy. These surpluses are saving in the overall national ac,counts: They are revenues that are not met by expenditures. This does
mean that other things being equal it is going to be harder :for the
Federal Government to cut its own budget deficit without causing an
increase in unemployment.
And it may be that, as some o:f the speakers have said this morning,
it is a top priority £or the Federal budget to come more into balance.
But what is liable to happen is either the State surpluses, State and
local surpluses, will disappear more rapidly than they otherwise would
have, or we will observe a worsening m unemployment. I think those
risk in the Federal budget policy should be confronted directly.
The final point regards the relevance o:f these surpluses £or longer
term, questions about Federal grant policy, aiding urban governments,
or aiding various :functions at the State and local levels. And there I
think the answer is that the revelance is not much; that is, that one
can look at Commerce numbers and observe these numbers bouncing
about always, and there are good reasons £or the rise in the surplus in
recent 6mes.
The surplus probably has a very high transitory component---it
certainly always has-and i:f you are considering more permanent
things such as, let's say, aid to urban governments or supporting
various rncial goods such as antipollution expenditures, or roadbuildhig, or whatever, those decisions ought to be made on more permanent,
longer run grounds. You should not be observing a State and local
surplus which bounces up and down according to short-term changes in
income and, also, in the Federal grant policy.
Thank you.
Representative MOORHEAD. Thank you, Mr. Gramlich.
[The prepared statement o:f Mr. Gramlich :follows:]
PREPARED STATEMENT OF EDWARD

M. GRAMLICH

State and LocaZ Budget BurpZitses and FederaZ Grant PoZicies

Thank you for inviting me to testify this morning. In my remarks, I'd
like to focus on an astounding fact that is lately affecting fiscal and grant policy
<decisions: the $29 billion budget surplus run by state and local governments in
1977. How can this number be true when we keep reading of urban fiscal crises?
What will happen to it? What does it mean for federal fiscal policy and federal
grant policy? Why should there be yet more aid from the biggest debtor government, the federal government, to those large creditor state and local governments?
Before getting into the substance, a brief look at the facts. The aggregate
state and local surplus, the number that is causing all the commotion, is given
in,the left column of table 1. There it can be seen that this surplus never exceeded
'$4 billion before 1972, took a brief rise in 1972-73, fell back down in 1974-75, and
lately bas soared back to $29.2 billion by 1977. What is going on?


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TABLE 1.-STATE AND LOCAL BUDGET SURPLUS, NATIONAL INCOME ACCOUNTS BASIS
[In billions of current dollars)

Calendar year

Overall
surplus

Less: Pension
fund surplus

1960_·-·····-·--·--·---··-·
0.1
196L __ ·-·-·--·----·------·
-. 4
1962............. ----······
.5
1963-......................
.5
1964.......................
1. 0
1965.................. _.................. _.
1966_......................
.5
1967.......................
-I. I
1968..... _.................
.3
1969···---·······-···---···
2.1
1970... _...................
2. 8
197L ..........•.... ·---··
3. 7
1972.......................
13. 7
1973..·-·-·······-·········
13. 0
1974_·············-········
7. 6
1975.......................
5. 9
1976..·-·-·······-·········
18. 4
1977.......................
29. 2

2. 3
2.4

2.6
2. 8
3. 2
3.4
4.0
4. 8
5. 3
5.9
6. 8
7. 5
8. 1
8.9
10. 5
12.1
14. 5
15.5

Equals: General
government
surplus

-2.2
-2.8
-2.1
-2.4
-2.2
-3.4
-3.5
-5.9
-5.0
-3.7
-4.0
-3.8
5.6
4.1
-2.9
-6.2
3.9
13. 7

Plus: Net
capital items

6.2
6. 9
7. 0
7.4
7. 7
9.2
10. 5
12. 7
14. 0
14.1
12. 3

13. 3
13. 3
13. 7
16. 5
15.1
10. 4
8.9

Equals:
Operating
budget surplus

4. 0
4.1
4.9
5.0

5. 5
5.8
7.0
6. 8
9.0
lOA
8.3
9. 5
18. 9
17. 8
13. 6
8. 9

14. 3
22.6

Source: Survey of Current Business, various July issues.

A first thing that is going on is that this overall number, recorded in the national income accounts statistics of the Department of Commerce, includes the
surpluses of employee's retirement funds. For macroeconomic purposes this saving is relevant, and does imply that the federal government must dissave more
to maintain a high level of overall spending demand. But in trying to examine
the financial health of state and local governments, it should be recognized that
pension funds must run a surplus to pay for larger pensions for greater numbers
of employees in future years. Whether the surplus is large enough to maintain
the ac_tu,arial standing of the funds is still questionable-many observers think
not. B_ut whether it is or is not, at least this component of the surplus is not
availa.!Jlr for normal governmental operations, must be deducted and leaves the
small~r general government surplus in the third column. To be sure, it has still
risen almost $20 billion in two years time, but $13.7 billion is less dramatic than
$29.2 billion.
A second thing that is going on is that even the general government surplus
does not measure the true operating budget for most states and localities because
it includes capital expenditures. The fourth column in the Table gives the ad•
justments necessary to go from total budgets to current operating budgetsconstruction expenditures are not considered expenditures and are added back,
debt retirement (a better proxy for how much capital is "used up") is deducted,
and grants for construction deducted. Since normally net capital expenditures
as so :defined are positive, the operating surplus in the fifth column is always
more positive than the general government number. Perhaps more relevantly,
however, we should focus on the change in this value, and there we see that the
change is less dramatic than before because of a recent mysterious drop in
construction that has caused at least part of the recent rise in the NIA surplus.
A last factual question is to inquire into the breakdown of this surplus or its
change into that received by states and localities. Because certain necessary data
are not yet published, we cannot do this for 1977, but we can for 1976, and there
we find that states have received slightly more of the recent rise than localities.
But not much more: localities have shared in the recent improvement too. More•
over, state budgets are recently more cyclical than localities, and their recent
gains in surpluses merely restores losses in the recession of 1975. If we were to
compare the average fiscal position in the seventies with that in the sixties, locali•
ties ar_~ the governments that are doing better.
The result of all these adjustments is then to take much of the pizzazz out of
the recent changes in the state and local surplus. Not only is a realistic indication of the fiscal health of state and local governments not as high as the gross
NIA number, but its recent change is also less dramatic-only $13.7 from the low
point in 1975 to the high point in 1977. This is a change, and perhaps a welcome
indication that things are better for state and local governments, but certainly
not as much to get excited about.


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Since even the adjusted surplus shows a recent rise, we might inquire further
ahout what it means. Basically the surplus records changes in the stock of buffer
assets possessed by state and local governments, and as say income rises, in the
short run governments are likely to put much of this change into their stocks and
run a temporary surplus. As time goes on, this behavior makes less and less
sense, because once stocks get built to a sufficient level, there is no point in further
!iaving. So over the cycle the surplus will rise temporarily in an upswing, fall
temporarily in a downswing, and average out to some normal level over time. A
t,rief look at the numbers in either column three or column five indicates strong
traces· of this behavior over the seventies. The surplus was up in good years
1972, 1973, 1976, 1977 and down in bad years 1974, 1975. An ironic side effect of
thiR is· that if the recently passed Jarvis Amendment can be interpreted as forcing the State of California to get rid of its surplus, that is exactly what past
relationships say the state would have done anyways (even as far as saying it
would mainly result in tax reductions).
,Economic fluctuations are only one of the causes of possible changes in the
suri:llus, however: the other might be federal aid. Just as in the short run a rise
in income might pad surpluses before there are inclinations or plans to. spend
the m(mey, so might also be the case for federal aid. In some statistical work I
l1ave done on state and local budgets I have indeed found this to be the case.
With general revenue sharing, I find that only one-third of the money is used
for. expenditure increases or tax reduction after one year and about sixty percent after two years-broadly in agreement with some studies commissioned by
the Treasury. If there is displacement of public service employment grants, the
Fame will be true-much of this money will not result in higher expenditures or
lower taxes, but will simply be saved by local governments. Hence an additional
reason for changes in the surplus is changes in federal aid policy, with big rises
in the early years of general revenue sharing (1972-73) and CETA (1975-76).
It seems to me that the lessons that can be drawn from all; this are as follows:
(a) At least part of the level and change in the state and local surpluses are
illusory, caused by pension fund surpluses and by a mysterious drop in construction.
(b) In any case the surplus always moves about in an erratic manner in the
short rnn, rising when income rises and aid is increaijed, and falling in the reverse
situations. We should expect some a,bnormal ·surpfuses right now, and we can
al~o exnect they will disappear in a year or so, even without Jarvis Amendments.
( c) The high surpluses are relevant for macro policy. State and local governments are Raving, and the federal government must dissave accordingly to maintain spending demands. This is one reason why it is now difficult to cut the federal deficit without generating unemployment.
(d) The high surpluses may or may not be relevant for grant policy. If the aim
of grant policy is to stimulate the overall economy in a recession, the surplus
changes. impede this aim because they imply that the grant money will riot_ get
spent. But if the aim of grant policy is a more permanent one of counteracting
the economic decline of certain areas, transitory changes in the budget surplus
are not very relevant and certairily not sufficient reason to limit the •aid.

Representative MooRHEAD. The two committees would now like to
hear from Mr. George E. Peterson, director of public finance, the
Urban Institute, Washington, D.C.
Mr. Peterson.
STATEMENT OF GEORGE E. PETERSON, DIRECTOR, PUBLIC FINANCE
PROGRAM, THE URBAN INSTITUTE, WASHINGTON, D.C.

Mr. PETERSON. Thank you very much, Mr. Cochairman. I have been
nsked to concentrate on the current fiscal condition of the large cities
especially those that are fiscal~y distressed. In my prepared statement;
J :follow recent developments m seven of those cities, Boston Buffalo
Cleveland, Detroit, Newark, Philadelphia, and Pittsburgh, ~hich 2 o;
a years ago appeared to be in nearly as precarious a financial position
as New York City.


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The financial recovery of these cities has been impressive. Although
their long:term tax base prospects have not improved greatly, most
have recovered from immediate financial strain; this fact changes the
character of the choices to be made about Federal aid policy.
I would like to emphasize five themes in my paper which I think
relate closely to the comments of the other panelists.
First, there is now underway a fundamental reversal of city spending, employment, and wage trends. Until 1975, city government spending had increased steadily year in and year out relative to the gross
national product as illustrated by the charts on the right hand side of
the room. This trend has now come to a halt. Congressman Kelly mentioned public sector wages. "\Vages in the majority of large cities in fact
have declined in real terms during the last 3 years, in some cities quit.e
substantially.
In this sense, Proposition 13 is a confirmation rather than a harbinger of the movement to restrain public spending. Viewing this
period a decade from now, the last 3 years may well stand out for halting the postwar trend of persistent growth in the share of national out'...
put spent by State and local government.
This reversal has been most visible in the older cities. During the d.ecade preceding 1975 the Nation's older cities, those that were losing pop.a.
ulation, jobs, and tax base, not only spent more per capita than other:
cities, had more public employees per thousand residents, and paid
igher wages to those employees, but all of these costs of public sector
operations were growing more rapidly than elsewhere and had been
growing more rapidly for the past decade.
Table 1 of my prepared statement shows how greatly things have
changed since 1974. Since'1974, public sector wages in those cities losing
population have grown at about one-half the rate of wages in other
cities. Public employment actually has declined in these cities at a
faster rate than population has been lost, with a consequent decline in
the number of workers per thousand residents, especially if you exclude
Federal employment trainees.
These trends are in sharp contrast to those visible in the newer, more
prosperous cities.
In short, we are in the midst of a strong reversal of fiscal course.
Budget difficulties have forced the large cities to cut back on their historic spending growth.
1Second, I would like to call your attention to the nature of the cities'
budget adjustments and the role of tax limitations in shaping those
adjustments.
Table 2 of my prepared statement shows how different have been the
reactions of different cities to local fiscal pressure. In Boston, Philadelphia, and Pittsburgh, the adjustments were made almost entirelv
through tax increases. Some of those have been very large indeed. Philadelphia increased its property tax rate by 66 percent, and its wage and
income tax rate by 30 percent.
Boston increased its property tax rate by 28 percent and Pittsburgh
had to reinstitute its wage and income tax.
In Newark, there was a very large municipal tax rate increase which,
fortunately for the city was offset by the State taking over a large
share of scli.ool costs, making possible school tax reductions.


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Detroit-the city with perhaps the greatest exposure to cyclical
downturn-responded more quickly to the cyclical rebound in the local:
economy, which was franslated through the cyclically sensitive jncome·
tax base into a strong recovery in local revenues.
I might add that Detroit was very greatly assisted by State countercyclical aid programs as well as Federal aid programs.
'I1here are two other cities, Buffalo and Cleveland, which tried tobalance their budgets almost solely through expenditure reductions,
with virtually no tax increases and little outside aid except :for the
standard Federal aid programs. I think it is interesting to look at the
reasons for these differences of response.
_
Buffalo is subject to a strict limit on its rate of property taxation. It
has been at or near the maximum of that tax ceiling for some time, and
thus unable to increase local taxes; In £act the State courts recently'
ruled unconstitutional State legislation allowing property tax rates
imposed for pension payments to be excepted from the state,vide 2-peL"cent tax rate limitation established by the New York State constitution. As a result the city has had to cut back severely on its rate of property taxation.
Cleveland has one of the most severe voting requirements £or authorization of tax rate increases in the country. Cleveland has been unable
to secure. voter approval :for property tax increases either for general
city government or £or its schools.
One point comes through clearly from these adjustments, and that
is just how difficult it is £or cities to balance their budgets solely by
restraining expenditures.
Cleveland and Pittsburgh have made as great an effort at spending
cutbacks as can reasonably be expected. ClevGland's public employment is down by 16 percent in the course of 3 years. Real wages also.
have declined. But these spending reductions have not been sufficient
to balance local budgets.
One of the reasons :for this I have illustrated in table 3 of my prepared statement, which compares the costs of current service delivery
with the fixed costs of a labor force that are unresponsive to reductions
in current services.
You can see tha~ over the 5 years covered in the table, which were
5 years of very heavy inflation, Pittsburgh trimmed its labor force by
20 percent, more than 2,000 employees, and was able to lb.old its to¼l
current service costs to an increase of 11 percent. Yet, its contributions
to pension costs increased by over 120 percent. The city's cost of other
fringe benefits increased by a total of 170 percent.
The point simply is that in these cities where population and tax
base are declining rapidly, it is extraordinarily difficult to make commensurate reductions in public sector budgets because of the fixed nature of many of the costs of city government. Moreover, even reductions of 20 and 25 percent in the labor force may not suffice to balance
the local budget.
Local tax rate increases have been a central ingredient of the fiscal
adjustment of financially distressed cities where these adjustments
have been successful. A prohibition against tax rate increases through
imposition of new tax limitations, I think, would be very traumatic to
these cities, as it would remove the most disciplined option for restoring budget balance.


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I might add that, in :fact where these limitations have been in effect,
such as in Buffalo and Cleveland, one response has been to go deeper
into debt as the cities have borrowed to cover their fixed costs.
Third, let me comment on the surplus situation. These cities, too,
have had substantial surpluses in fiscal 1977, and 1978. But I think it
is important to see how current annual surpluses take on a quite different meaning in the context of recent budgetary history.
You can see from tables 4 and 5 in my prepared statement that
each of these cities went very deeply into the red in 1975 and 1976:
Philadelphia to the tune of $78 million in 1 year; Detroit $35 million ; and Boston $60 million. In :fact each of these cities went so :far
jnto deficit during the 1975 and 1976 fiscal years that they entirely
depleted their balances on accumulated account, creating cumulative
deficits as well, which had to be covered by the issuance of short-term
debt.
State constitutions require that the cities generate surpluses in sub- ·
sequent years to restore their cumulative budget position. Concentrating solely on the surpluses generated in 1977 and 1978 without
comparing these with the deficit positions which the cities have inherited and which they are now liquidating is, I believe, to misread the
message of the surpluses. It is one thing to compile a surplus on top
of a sound fiscal position; it is something quite different to generate
a current account surplus that permits repayment of the debt issued
to cover previous operating deficits.
The restoration of cash liquidity was just as important to the cities
in normalizing their budgetary circumstances as the restoration of
liquidity was to the private corporate sector, which was also recovering from the recession and where the first priority for almost all corporations was to liquidate the massive debt increases incurred during
the recession in order to restore a sound financial basis.
Let me also mention two uncertainties that lie ahead and that complicate further the surplus interpretation. It was noted that many of
these surpluses are being held in pension funds. Despite that :fact, almost all large city pension funds are seriously underfunded at this
time, relative to the obligations that the :future carries.
Two of these cities in this sample are on a virtual pay-as-you-go
basis of pension funding. It has been estimated by auditors that
Pittsburgh and Boston would have to approximately triple their current pension fund contributions to :fully :fund their outstanding pension obligations over a 40-year period. As the cities move toward :fuller


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funding of their pensions, we can count on incurring larger surpluses
on cash account in pension funds. It will became a matter of severe
public policy how those funds should be invested, and how the cash
surpluses should be interpreted.
The final point I wanted to mention is related to the downturn in
capital construction. One thing that has been happening in addition
to the change in cash surplus is under-investment in the existing
capital stock of several of these older cities, which has had the effect
of depreciating the assets the cities have accumulated in the past.
The drop in maintenance and repair expenditures in several of the
older cities has been on the order of 30 and 40 percent. In fact, what
appears to be a cash surplus may be an indirect conversion of physical capital to cash, by letting that capital run down in order to save
on maintenance, repair, and replacement costs.
Thank you.
Representative MooRHEAD. Thank you very much, Mr. Peterson.
[The prepared statement of Mr. Peterson follows:]
PREPARED STATEMENT OF GEORGE

E.

PETERSON

Fiscally Distressed Cities: What is Happening to Themt

The fiscal condition of cities has been a major source of Federal policy. con•
cern for the last three years. New York City's financial distress reawakened
public officials to the risks involved in managing cities during national recession
and local economic decline. Much of recent federal domestic legislation, adopted
or proposed, has aimed at strengthening the fiscal capacity of cities or at lessening their fiscal exposure to weak local economic conditions.
This paper tracks recent fiscal events in seven of the nation's most fiscally
distressed cities: Boston, Buffalo, Cleveland, Detroit, Newark, Philadelphia,
and Pittsburgh. The fiscal strain on these cities is reflected in Figure 1, which
shows the interest costs paid for municipal borrowing relative to Moody's AAA
bond index. With New York, these cities possessed the highest perceived risk
and interest rate premiums during the capital market disruptions of 1975-76.
The rank ordering of presently perceived fiscal distress has changed substantially from that shown in Figure 1. Detroit, which is 1975 was regarded
by the bond market as financially troubled in the same degreeas New YorkJJity,
has largely recovered its equilibrium. Cleveland, which appeared in relatively
sound fiscal condition in 1975, now faces the greatest financial disarray. The
events that produced these divergent paths reveal a good deal about the signs of
fiscal health in urban governments.
In general, American cities have experienced a strong fiscal i'ecovery· since
1975, · assisted by recovery of their local tax bases, federal aid programs, and
local expenditure restraint. Many· cities continue to face long term prospects of
tax base stagnation, but immediate financial difficulties are limited to a handful
of dties, such as Cleveland, which have failed to take vigorous measures to
close their budgetary gaps.
·

37-250-79--11

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Figure 1

YIELD Otl 1984 GENERAL OilllGATION BONDS OF DIFHREilT CITIES
RELATIVE TO THE MOODY'S Aaa MUi:ICIP Al BOND INDEX, 1975 Ai:D 1976
225

200

1975 1975

175

150

125

75

50
25

Source:

L. Brwne ar.d R. Syron, "Big City Bonds after New York, n ~
England Economic Review (J.976), Chart 2, P• 3.

EXPENDITURE CUTBACKS AND TAX RATE INCREASES

In a long term perspective, the cities' fiscal problems emerged largely because
the cities were slow to cut back expenditure commitments in line with population losses and local tax base declines. Budgetary difficulties have given a
powerful impetus to spend restraint. For the quarter century ending in 1975,
local public spending rose year in and year out relative to national product, but
during the present economic recovery city expenditures have grown at a much
slower rate than national output. Cities suffering economic and po{'Ulation
decline have taken the lead in restraining expenditures. In this sense Proposition 13 seems a confirmation rather than a harbinger of a new attitude in the
state-local sector. Viewed a decade from now, the last three years may well
stand out for halting the post-war trend of persistent growth in the share of
national output spent by state and local governments.
Table 1 shows the convergence that is now occurring within city government
finances. In 1973-74, the per capita public expenditures of the nation's older
cities-those losing population and jobs-were far higher than other cities', as
were the number of city government employees per resident and public sector
wages. The expenditure gaps between "declining" and "growing" cities had
been widening steadily for the past decade. Since 1974 this trend has reversed.
Comparable Census data are available only through fiscal year 1976, but local
financial reports show that the trends toward convergence of spending, employment and wages have persisted, even strengthened, in the last two years. As
might be expected, the budgetary pressure on older cities has proved to he
an effective spending limitation.


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TABLE !.-SPENDING, EMPLOYMENT AriD WAGE TRENDS, LARGE CITIES (1"974-76)
[In percent)

population 1

Large cities
growing in
population in
1960-70, now
declining•

+37
+s
+30

+20

Large cities
gaining

Item
Growth in per capita spending• ______________________________ _
Growth in noneducational city employment, per 1,000 residents __
Growth in average monthly wage, noneducational employees ____ _

+31
+3

Large cities
losing
population•
+24
-1

+15

1 Hooolulu, Houston, Jacksonville, Memphis, Phonenix, San Antonio, and San Diego.
'Columbus, Dallas, Denver, Indianapolis, Kansas City, and Los Angeles .
.• Baltimore, Boston, Buffalo, Chicago, Cincinnati, Cleveland, Detroit, Milwaukee, New Orleans, New York, Philadelphia,
Pittsburgh, St. Louis, San Francisco, and Seattle.
• Excludes education and welfare, functions not provided by many of the cities.
Source: Bureau of the Census, City Finances and City Employment, selected years.

Local fax rate increases also have played an important role in restoring
financial solvency to the fiscally troubled cities. Talble 2 shows the tax rate and
revenue adjustments made by the seven cities reviewed in this paper. As is clear
from the ta-ble, different cities have relied to different degree on local revenue
increases to restore budgetary balance. Philadelphia, Boston, and Pittsburgh have
depended heavily on tax hikes. Newark, New Jersey, also has financed its municipal revenue needs through steep tax increases, though H was able to substitute municipal millage rates for school millage rates as the result of the school
tax relief enacted under New Jersey's new school finance arrangements. Detroit
was grea,Uy aided during the recession 'by the adoption of new state aid programs. Since 1976, Detroit's economic base has rebounded vigorously. Indeed,
Detroit's fiscal troubles, more clearly than those of any other city, were largely
cyclical in nature. The exposure of the city's automotiYe industry to recession
was compounded 'by Detroit's heavy use of the cyclically sensitive municipal income tax. In fiscal 1975, income tax revenues fell some $14 million, or 13 percent,
short of •projected levels. Fortunately for the city, the income tax 'base responded
with equal alacrity to the economic upturn. In fiscal 19-77 and 1978, the city
underestimated income tax receipts by a total of almost $22 million. The countercyclical assistance programs of both the federal government and the State of
Michigan were able to srnoothe out these violent fluctuations.
Cleveland and Buffalo present a different picture. Both have attempted to
react to budgetary pressure almost solely through expenditure reductions, in part
because of limitations on their ability to raise taxes.
TABLE 2.-CHANGES IN LOCAL TAX RATES AND LOCAL REVENUE COLLECTIONS
(FISCAL 1975 TO FISCAL 1977)
[In percent)

City 2overnment
Boston _________________ -_-- -- -- -- -- -- ---- -- --- --- -- -- -- -- Buffalo ________________ --- ___ - ---- -- ---- ----- - -------- -- --Cleveland ________________________________ -- --- ____________ _
Detroit _______ -------- -- ---- _: _----- ---- -- ---- -- -------- -- Newark _________ -- -- -- --- --- -- -- -- -- -- -- -- -- ---- -- -- --- --- Philadelphia ______________ - -- -- -- ---- -- -- -- ---- -- -- -- -- -- -- Pittsbur2h ____ -- - - -- --- --- -- -- -- -- -- -- -- ---- -- -- ---- -- -- -- -

Wage and
Property
tax rate income tax rate
(')
(')

0

0
0
0

+23
1+101
+66
0

t No tax.
'Property tax rate decreased by 12 percent in fiscal 1978.
• Larrely offset by reductions in school tax financed by State of New Jersey,
• Newly installed.
Source: Local financial reports.


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+28

2+s

+30

(')

Total locally
collectedl
revenues.
+1s,
+s.
+sa
+s
1+51

+11

+2&

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ARE FURTHER TAX OR EXPENDITURE LIMITATIONS ON DISTRESSED CITIES DESIRABLE?'

Further tax or expenditure limitations are desirable only if it is thought the
adjustments of distressed cities to their long run budget constraints are occurring
too slowly. To impose a new set of tax or spending ceilings would in many cases
require more rapid reversals of policy than the cities can handle. Without ac:
cumulated balances to cushion their adjustments, cities would have to translate
such limitations into immediate layoffs or (what is more likely) new 'borrowing
to cover their revenue losses.
An examination of the record of tax and spending restraints in cities laboring
under fiscal strain shows some of the undesirable effects these can have. The
New York State courts recently ruled unconstitutional state legislation allowing
property tax rates imposed for pension payments to be excepted from the statewide 2 percent tax rate limitation on true property values. As a res1Ht, Buffalo
was forced to cut its property tax millage from 87.03 in FY 1977-78 to 75.60 in
FY 1978-79. In order to balance its budget on a cash basis, the city borrowed
$11.5 million from the state. However, the city is hoping the state eventually will
treat this sum as an advance aid payment. Should the loan terms be enforced,
Buffalo will find itself in severe financial trouble as it is forced to make back
payments plus finance continuing pension obligations from a severely limited taxing authority. Buffalo faces this financial predicament despite the fact that twice
in the last three years the New Year State retirement systems, to which Buffalo
belongs, have sharply reduced pension benefits for new pubUc employees. Constitutional restrictions prevent the city or state from reducing benefits for existing
employees. Hence, the possibiliities for effecting economies are sharply
circumscribed.
Cleveland is another city which finds itself in financial difficulty, in part bemuse the city is prevented from balancing its budget through tax rate increases
without voter approval. Between 1973 and 1976 Cleveland ,cut its city labor
force by 16 percent, t'.he largest reduction of any big city in the country. It has
J!educed real wages for public sector workers. And it has su1bstituted federally
supported CE'TA workers for locally paid workers, at one time using almost all
of Hs ·CETA slots for police and sanitation personnel. Nonetheless, the city's exJ)enditure reductions have not been sufficient to balance its budget. Withouit the
ability to raise taxes, Cleveland has gone deeper and deeper into debt. It now
faces probably the most difficult fiscal circumstances of any American city. The
city is under court order to pay some $16 million for past acquisition of electricity
for resale through its municipal utility, but cannot secure voter approval for a
new tax levy or court authorization to raise the funds through a bond issue. The
city has added to its short term debt to finance its other cash requirements, much
as New York City did prior to its .financial crisis, 'but now the bonds and other
public bondholderl'! have refused 'to purchase further debt. The city has temporarily staved ofl' financial crisis by arranging for its water system to buy the
city's short term debt issues. Cleveland's school system also has been accumulating short term debt, finally forcing the state to take over operation of 'Cleveland's
schools after voters refused to authorize the tax hikes necessary for repayment.
In short, tax rate increases have been an essential ingredient of the fiscal
adjustments of recently distressed cities, where these have 'been undertaken
1!111.Ccessfully. The fiscal problems of these cities have been so great that it is
impracticable to expect them to restore sound financial condition through expenditure reductions alone.
1

1

FIXED COSTS

The difficulties that cities face in reducing budgetary outlays are illustrated
by the experience of Pittsburgh. Pittsburgh was perhaps the first city to attempt
to cut back its public sector operations in full proportion to its population loss.
Between 1960 and 1975 Pittsburgh lost nearly one-third its population, declining
from 677,000 population to 459,000.
The city since 1970 has reduced public employment at a much faster rate
than population loss. Between ·1969 ·and 1975 full time equivalent employment
was reduced from 7,595 to 5,5,57. Real public sector wage levels over the same
period dropped by 14 percent, one of the sharpest declines for any big city. These
economies enabled the city to hold the line on taxes and even to eliminate the
local wage and earnings tax for a period.


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The fixed costs in municipal operations, however, make it difficult to achieve
budgetary savings commensurate with employment reductions. Table 3 illustrates
some of ,t.he obstacles to budget cutting. Although Pittsburgh was able to restrain
current libor service costs far below the rate of inflation over the period 197075, it could not control other personnel costs, including the costs of severance pay,
pensions, and oth~ benefits to employees who were laid off. New York City's
recent spending illustrates the same difficulty : though the city's work force
has been greatly reduced, the inflexible costs of debt servicing and pension contributions have scarcely altered their upward course. The nature of these costs
sets severe limits to the spending reduction it is feasible to ask large cities to
make.
TABLE 3.-EXPENDITURE GROWTH FOR WAGES AND BENEFITS, PITTSBURGH, 1970-75
[In thousands]
Growth

Year
Item
Current service costs:
Public safety_________________________________________________
Public works_________________________________________________
Parks and recreation__________________________________________
Library______________________________________________________
Land and buildings____________________________________________
Supplies ______ , ____ __ ______ ___ ___ ____ ______ __ __ ___ __ ____ ___ _

1970

1975

(percent)

$32, 641. 6
16,607.9
5,947.7
l, 976. 5
2,315.8
271. 8

$34, 044. 8
16,537.7
6,156.9
2, 443. 5
2,404.3
4, 490. 0

_____________ _
_____________ _
_____________ _
_____________ _
_____________ _
_____________ _

- -59,-781.
- 4- - -11.-Z
66,472.-2 - - -+

TotaL ______ __ _____ _____ __ ____ __ _____ ___ __ __________ __ __ ___
Benefits:
City contribution to pension funds_______________________________
Other fringe benefits (workman's compensation, hospitalization,
group insurance and severance pay)___________________________
TotaL __________ ____ ________________ __ __ __ __ ______ __ __ _____

3,151.0

7,144.0

2,074.8
5, 225. 8

7,305.5 --------------

+126.7

------- - - - -+176.5
-14,449.5

Source: Annual financial statements for Pittsburgh, Pa., 1970, 1975.
SURPLUSES

An operating surplus also presents a different appearance in cities under severe
fiscal pressure than it does elsewhere. Surpluses in fiscal in accord with legal
requirements. Indeed, the necessity of counterbalancing past operating deficits
with current year surpluses is a large measure of the fiscal discipline imposed
by the budgetary process. Tables 4-6 show the annual and accumulated balance
positions of the several cities. Tables 4 and 6 present local operating results as
reported by the cities themselves; Table 5 converts local accounts to a uniform
proforma basis, which recognizes only recurring revenues and restates revenues
and expenditures on a consistent basis. Each of the cities can be seen to have
gone into the red at some point during the recession, and most faced negative
accumulated balances at the end of 1975 or 1976, which were subsequently offset
by operating surpluses. Restated on a pro forma basis, Cleveland's accounts
show it to be the only city with a steadily worsening financial position throughout
this period. The city's operating deficits were hidden from public view by extraordinary revenues realized from asset sales and by transfers from the cash balances of enterprise accounts.
With the single exception of Pittsburgh, the cities also entered fiscal 1977
with unrestricted cash deficits. The value of short term debt outstanding exceeded
local cash reserves held in other than restricted pension fund or bond fund accounts. These cash deficits reached as high as 50 percent of annual general expenditures in Cleveland. Their presence made it imperative for cities to roll over
their short term debt, yet made access to the bond market difficult. The restoration of liquidity therfore was as immediate a financial priority to these cities.
and as important to their future fiscal prospects, as was the restoration of liquidity to the private corporate sector during the recovery from the recession. All
of the cities except Buffalo (and Cleveland on a pro forma basis) have now
eliminated their accumulated deficit balances. The only city which failed to
make progress on its accumulated balances through current account surplusesCleveland-now finds itself in a perilous financial predicament.


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TABLE 4.-GENERAL FUND OPERATING SURPLUSES (DEFICITS) AS REPORTED BY 6 CITIES
(In millions of doHars)
Fiscal years endingDec. 30, 1974 to Dec. 30, 1975 to
June 30, 1975
June 30, 1976

City
Detroit ____________________________________ _
Newark •• _______________ • _________________ _
Philadelphia ______ • ________________________ •
Boston _____ • __ • ___________ ._._._ •• _._ •• ___ •
Buffalo •••• --------·-----·-·----·----- ____ _
Cleveland.····-·-·--------------··------ __ _

Dec. 30, 1976 to
June 30, 1977

(22. 7)
51. 5
(5. 6)
6. 2
(77. 8)
64.3
(12. 6)
24. 8
..16 -------------···
.3

(35. 6)
9. 7
(27. 6)
.7
(5. 8)
.2

Dec. 30, 19n to
June 30, 1978
I
1

3. 5

(.1)
NA
NA
NA

•o

t Estimated.
• Budgeted.

Source: Local financial reports and bond prospectuses.
TABLE 5,-PRO FORMA GENERAL FUND OPERATING RESULTS
(In millions of dollars)
Fiscal years ending-

City
Detroit. • _________________ •• ______ _
Newark ____________ •• __ • ______ • ___ _

Philadelphia ________ ._. ___ ••• __ ••• __
Boston ___________________________ _
Buffalo •• _________________________ _
Cleveland. ___________ • ______ • ___ • __

Dec. 30, 1974 to
June 30, 1975
(35. 6)
(4. 7)
(27. 6)
(9.1)
(12. 6)
. 02

Dec. 30, 1975 to
June 30, 1976

Dec. 30, 1976 to
June 30, 1977

Dec. 30, 1977 to
June 30, 1978

(22.7)
51.5
3.5
(6.6)
8.2
tl.1
(77. 8)
(64. 4)
NA
(60. 2)
24. 8
NA
1. 4 -----------------------------------(3. 4)
(8. 8)
• (16. 8)

1 Estimated.
• Budgeted.

TABLE 6,-ACCUMULATED GENERAL FUND BALANCES (DEflCITS) END OF FISCAL 1975 OR 1976, AS REPORTED

City

Oetrait____ •. ______ .•. _...... ____ •.•• ____ • ________________________________ • ____ •

Newark •• _•• ____ •• ____ • _______________________________________________________ _
Philadelphia ••••••••• _____ ._. __ • ___________________ •• ________________________ •••
Boston •••••••••••• ___ ._. _________ • _________ • _____________ • ____ •• ___ ._ •• _•• _._ ••
Buffalo ••••••••• __________ •• _____ • ________ ._. ____________ •• ________ • ____ • _____ •
Cleveland •••••••••••••• __ •••••• __ •••• ___________ • __ ••••• ____ •••• __ •••••••••••••

Fund Balance

Year

(36. 9)
1976
(19.3)
1975
(87. 8)
1976
NA •••••••••••..•
(20. 5)
1976
.1
1976

Capital investment
Capital spending, particularly spending on repair and maintenance of existing
capital facilities, has borne the brunt of fiscal adjustment in a number of financially hard pressed cities. Several of the older cities operating under fiscal pressure have had spectacular reductions in their capital spending-Buffalo trimmed
its capital budget by one-third in 1976 and more in 1977. New York reduced total
city capital spending by more than half, some $800 million ; while Pittsburgh cut
back capital outlays by almost 20 percent. Hardest hit in each case were general
improvements to the city infrastructure systems. In several instances, cities were
shut out of the municipal capital market for an exended period of time, causing
their bond fund reserves to dwindle and impairing their ability to finance capital
improvements.
Because of the difficulties they have encountered in raising local revenues or
issuing general obligation bonds, many of the older cities have become deeply
dependent upon federal aid programs to pay for their capital budgets, especially
that portion devoted to general improvements. No less than 80 percent of Newark's
capital budget in 1978 will be financed by federal emergency local public works
funds, as well as 65 percent of the capital budget of Pittsburgh, 30 percent of
the public construction contracts issued by New York City and 43 percent of St.
Louis' total capital spending.
It is difficult to get a firm grasp on the postponed maintenance, repair and capital spending of cities. The last several months also have brought sharp recovery


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to capital expenditures. But the danger persists that in bringing their budgets into
balance cities will try to squeeze savings from their capital stock.
IMPLICATIONS FOR FEDERAL AID PROGRAMS

In many respects the greatest risk attending city finances at present is the fate
of the temporary federal aid programs that have helped cities resist fiscal pressure. The enabling legislation for both CETA and antirecession fiscal assistance
expires on September 30, 1978. The local public works program already has terminated, though a sizable proportion of the funds remain to be spent by local recipients. All three programs have successor legislation current!y pending before Congress.
Our review suggests the following conclusions for future federal assistance
toward large, "distressed" cities:
(a) From the standpoint of financial condition, relatively few cities need extra
help at this juncture. City finances have strengthened considerably in the last 24
months; those cities that remain in weak financial shape find themselves in that
predicament largely because of local management decisions. It would be undesirable to remove the pressure on city budgets altogether through external assistance, since this pressure has been primarily responsible for promoting the spending restraint that seems in the cities' own best long term interests.
(b) The simultaneous elimination of CETA, countercyclical revenue sharing,
and Local Public Works aid undoubtedly would disrupt city budgets. The first
two programs in 1977 accounted for approximately 16 percent of the general operating budgets of the cities in our sample. Although CETA funds now are used
largely to support district employment programs, rather than to pay for ordinary municipal services personnel, loss of these funds would require large scale
adjustments in local service delivery and tax rates. Elimination of local public
works assistance would, with some delay, depress city capital spending.
(c) In choosing the right mix of urban aid for the future, the federal government would do well to look beyond financial difficulties to the long run tax base
deteri<lration of the cities. The most important studies in tax base equalization
have been taken by state governments, through school aid formulas and urban aid
packages which compensate cities for their special costs of service provisions.
The cities' recovery from the financial pressure of 1974-76 is now nearly complete.
Some of the temporary federal aid programs adopted to cope with this pressure
can begin to be eliminated. In devising long term fiscal al!ISistance for the cities,
Congress should look to a fresh partnership with the states, so that federal aid
is used to encourage permanent state initiatives at sustaining the tax capacity of
urban areas.

Representative MooRHEAD. The committees would now like to hear
:from Mr. Herrington J. Bryce, vice president, the Academy for Contemporary Problems.

STATEMENT OF HERRINGTON 1. :BRYCE, VICE PRESIDENT, THE
ACADEMY FOR CONTEMPORARY PROBLEMS, COLUMBUS, OHIO
Mr. BRYCE. Thank you very much. Mr. Cochairman, and members
of the committees. I have a prepared statement which deals with the
fiscal problems of smaller cities as requested b:v the committees. That
prepared statement also attempts to distinguish between some of the
fiscal trends in the declining small cities and in metropolitan and nonmetropolitan small cities.
I would prefer, however, not to read the testimony but to give just
a brief oral statement which highlights these two points made in my
written version.
I think, first of all, it is rather important that we appreciate the
fact that small cities account for a very significant part of the general
expenditures of all cities and also £or the ca.pita! spending of all cities.
Small cities, depe~ding upon how they are defined, account for anywhere from one-third to 40 percent of the general expenditures of all
cities.

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Consequently, they have important impact on the resource ~llo:ation
of cities in general, and the tmth is that they have a very s1gmficant
impact on our ability to deal with cyclical crises and resource
allocation.
In addition to their relative importance in the spending of citi~s
in general, I think that the most important feature of these expenditures is the significant rise in dependency of small cities on the Federal
Government.
I have looked at particularly a very short period, 1969 through 1976
which, of course, embraces two recessions, and during that period of
time the small cities which I have looked at increased their dependency
on the Federal Government by over 800 percent. This was almost twice
as much as cities in general.
Now, John Shannon, from whom I think you will hear later, has
looked at some annual rates of increases in small cities during the
period of 1965 through 1972 and I think his figures show that among
small cities, that rate of increase in dependency was even higher than
it was £or the most of our cities with the exception of the six or so
cities over 1 million in population. But I wish to underline my particular finding that looks at it in the short period, which shows an
increase of over 800 percent.
Now, there are any number of ways in which one might lookat that
figure. First of all, I think it does imply some serious kinds of problems concerning local initiatives. I think, however, that if the current
trends continue with respect to how citizens embrace the possibilities
of putting a cap on local expenditures or local government revenues,
we can except that that dependency will rise and probably rise rather
sharply in the near future. That rise will occur as well i£ we accept,
which I do, the position of our previous speakers which indicated that
the State surplus is one which is probably, one, overestimated_; and,
two, transitorv.
The dependency, however, is not a11 that had. First of all, I wish
to call your attention to the fact that in a sense, part of the dependency
reflects a tendency on the part of the Federal Government to finance
some of its mandated costs which arise when the Federal Government
requires local action by way of regulations such as through EPA; part
of the dependency is reflected in the transfer funds from the Federal
Government to local governments which permits the local government,
small cities in this particular case, to meet those requirements.
The second part of the dependency reflects on the part of the Federal <;tovernment i~s willingness to deal with cyclical crises. Clearly
that 1s the case with some programs; clearly that is the case with
CETA, and other such programs.
·
Now, that is not bad because what it does is it reduces the fiscal
strain that smaller cities would ex,perience had there not been those
transfers available.
A third part of the dependency must be viewed as a voluntary act
on the part of the local government. There are many programs, £or
example, community development block grants, in which ,a local government has the option of participati11i~. My own figures have shown
that among the small cities I have looked at over 84 percent of them


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applied to participate in the community development block grant
program.
.
The point is that dependency reflects in t~i~ sens~ an expression on
the pai,t of many local governments to participate m the.se programs
e:ven though the price the Federal Government might impose is not
to them a very comfortable one.
It is widely acknowledged that many of our small cities find it very
difficult to deal with some of the specific. regulations and specific requirements of Federal programs. The point is, however, that should
the ·Federal Government transfers to these cities decrease, given the
current trends to put a ca:p on looal on government revenues, we can
expect a significant fiscal crisis, I believe, in many small cities.
I wish to stop here, Mr. Coohairman, and refer the committee back
to my prepared statement.
Representative MOORHEAD. Thank you.
Without objection the prepared statements of all the members of
panel 2 will be made a part of the record.
[The prepared statement of Mr. Bryce follows:]
PREPARED STATEMENT OF HERRINGTON

J.

BRYCE 1

CURRENT TRENDS IN FINANCING SMALLER CITIES

This testimony looks at the recent fiscal trends in small cities-generally those
ranging in size from 25,000 to 50,000 although in particular circumstances it also
considers cities 50,000 to 100,000. It looks at various types of expenditures and
revenue sources and compares the experiences of growing and declining cities
and of metropolitan and nonmetropolitan cities, as was requested by this Committee.
The period of comparison is relatively short, 1969-70 through 1975-76, a
period which embraces two recessions and during which the Consumer Price Index and Producers Prices rose by approximately 55.6 percent. A problem of looking at any jurisdictional group over time by size class is that over very long
periods of time some cities enter and others leave the group so that the composition of the group is not constant. The period being used in this testimony is
sufficiently short such that we do not have major changes in the composition of
what we refer to as small cities.
General empenditurea
By 1975-76, general expenditures in cities 25,000 to 50,000 (small cities as
defined in this testimony) exceeded $13.4 billion or 25 percent of the total general
expenditures of all cities combined. Thus, while small, these cities have a significant impact on the demand for goods and services among jurisdictions.
The three major expenditure categories among small cities are in police,
sewerage and sanitation and highways. Each takes roughly 14 percent of their
general expenditures. The lower proportion of the municipal budget going to
education in smaller cities as compared to all cities combined is not to be misconstrued. The latter figure contains the effects of those few large cities which
conduct their own educational systems. Education in other cities is frequently
the responsibility of independent school districts.
Table 1 also shows that a much larger proportion of the budgets in small
cities goes to highways. This, too, is not to be misconstrued. The total mileage
~hich falls within the loca_l government system in rural areas alone, for example,
is nearly three and a half times as great as the mileage in cities.•
1 This testimony Is drawn from a study on small cities which this author is conducting for
the _Joint Center for Political Studies. The study Is funded in part by National Science Foundat10n grant ERS74-21286 and assistance from the Charles F. Kettering Foundation
/National Urban Policy Roundtable whkh Is coordinated by the Academy for Contemporary
Problems). I am grateful for the assistance of Barbara Buhl, Avra Rapton and Shirley Lee
The views expressed In this paper are strictly those of the author and do not necessarily
reflp~t the views of any of the organizations mentioned or their sponsors.
• U.S. Department of Transportation. "Hli!hway Statistics: Summary to 1975" (Washington, D.C., U.S. Government Printing Office, 1976) p. 211.


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Over the period, two of the functions in which expenditures have risen f~ste~t
among small cities are police and park and recreation. In both cases, the rJ.Se is
greater than explainable simply in terms of inflation.
The crime rate among cities 25,000 to 50,000 grew six times as fast between 197S
and 1976 as it did in all cities taken as a whole and much faster than all big cities
except the six cities which have over a million people. In fact, many of the middle-sized cities (those 250,000 to 1 million in population) had a decline in crime
during this period. The crime rates rose especially fast among the nonsuburban
cities (25,000 to 50,000 in population). It was two and half times as fast among
those cities as it was among suburban cities.•
The rapid rise in spending on park and recreational services is to be viewed
more than as a measure to provide amenities for present residents. Among many
small cities the major attraction to visitors as well as prospective newcomers is
in the area of park and recreational facilities.
CapitaZ ea:pend.itures

Capital expenditures increased among small cities by a greater amount than
among cities as a whole. In 1975-76, capital expenditures among these small
jurisdictions amounted to $3 billion-roughly a third of the capital outlays of
all cities. This is a significant portion of the capital programs of municipal
governments.
Just under 50 percent of the capital outlays in small cities go to two functions-highways (23.1 percent) and sewerage and sanitation (24.2 percent).
These two areas are also the two most emphasized in the capital improvement
programs in cities in general. It should be noted, however, that while among
cit_ies as a whole there has been a dramatic shift in capita/I. formation in housing
and urban renewal to sewerage, such has not been the case in small cities. Housing and urban renewal remain small proportions of the latter's budget and the
proportion going to sewerage has remained reasonably stable between 1970-76.
Table 2 shows that although hospital and public buildings together account
for less than 10 percent of the tota/1 capital spending by small cities, they are the
two fastest growing areas of such spending.
The expenditure on sewerage is particularly important in podnting to a theme
(fiscal dependency) which will be discussed in this testimony in a later section.
The relative importance of sewerage is related to the fact that this is one
of the most common functions discharged directly by small city governments.•
,vaste disposal is also an important tool for controlling and managing growth.
But a significant part of the allocation of resources to this function relates to
the imposition of federal requirements as well as the availability of federal
dollars obtained through HUD's Community Development Block Grant, the
Farmers Home Administration, the Environmental Protection Agency, and to
some extent, the Department of Commerce.
Borrowing
Among small cities, the financing of a capital project might occur through a
variety of means such as the use of reserves, special assessments, grants, loans
and borrowing.
Given the rapid rate of growth of population in small cities, capital expenditures are important in providing new or improved infrastructure. Thus, we
find in Table 8 that growing small cities (those 50,000 to 100.000 in population)
spend a larger percentage of their budgets on cap'ltal items than do declining
cities. Forty-one percent of the growing compared to 23 percent of the declining
small cities allocate at least a fourth of their annual expenditures to capital
programs. Further, as Table 4 shows, growing cities are more likely to have
a larger debt outstanding than declining cities. Nearly one half (48 percent)
of the growing compared to only 30 percent of the declini.ng cities have a gross
outstanding debt of at least $25 million.
It is frequently more common that declining small cities guarantee their debt
instruments with the full faith, credit and taxing powers •of the jurisdiction.
• Federal Bureau of Investigation, "Uniformed Crime Report" (Washington, D.C., U.S.
Government Printing Office. 1976) pp. 146-149.
• Herrington J. Bryce, "Planning Smaller Cities" (Lexington Books : forthcoming 1978),
ch. IV.


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Sixty percent of growl~ cities as compared to only 49 percent of declining
cities had 25 percent or more of their outstanding debt not guaranteed. See
'.l'able 5. Heavy dependence on g:uaranteed debt implies greater exposure to voter
referenda. It ls also troublesome since the tax base which secures the loan is by
implication either declining or growing more slowly in declining cities.
Partly reflecting this fact, the Moody rating of the general oblligaUon bonds
of declining cities is slightly less favorable than it is for growing cities. Ratings
are shown in Tables 6 and 7. Some 81 percent of the growing cities had bond
ratings of A or better compared to 72 percent of the declining cities. What is
most striking, however, is that declill!ingi cities are not significantly more likely
to be unrated than growing cities. Roughly 18 percent of the declining cities
and 13 percent of the growing are unrated. Admittedly, rating is on[y one factor
which affects the mark~tability of a debt instrument."
Among small cities there is also a difference between the capital programs
ef metropolitan as contrasted with nonmetropolitan cities. Some 44 percent of
no:wnetropolitan small cities allocated at least 25 percent of their annual expenditures to capital programs as compared to 30 percent of metropolitan cities. This
reflects the fact that nonmetropolitan cities are more likely than their suburban
counterparts to be directly responsible for the provision of basic services.•
Tables.
Accordingly, small cities in the metropolitan areas tend to have a smaller
debt outstanding than do their nonmetropoUtan counterparts. Only 35 ,percent
of metropolitan cities, but 55 percent of nonmetropdlitan cities had an outstanding debt of $10 million or more. But nonmetropolitan cities were lesa Jikely
to back their debt with the full fa!ith and credit of the municipality. Thus, 61
percent of nonmetropolitan cities had at least 25 percent of their outstanding
debt nonguaranteed. Tables 9 and 10.
As shown in Table 6, it is not clear (at least among cities ranging, in size
of 25 to 50 thousand) that bond ratings are decisively lower among nonmetropolitan cities.
Revenues and dependency

Looking at the revenue patterns in Tables 11 and 12 reveals the declining
importance of the property tax as a source of revenues among small cities.
Nevertheless, this tax remains the major source of all general reevnues deriYed.
by these cities.
On the other hand, intergovernmental transfers have increased. Like all cities-,.
small cities stim get proportionately more of their intergovernmental aid from
the.state government. But the increase in the flow of funds from the federal'
government to small cities is spectacular. This aid has increased by over 800>
percent (twice the mte of increase of all cities taken together) in the short
period ranging from 1970 to 1976. Table 13.
Table 14 helps us to look at this dependency as it relates to growing and de•
dining cities and as it relates to those cities in metropolitan as opposed to those
in nonmetropolitan areas. It also shows that dependency is greater among nonmetropolitan cities. Just over half of the metropolitan cities (52 percent) obtained 75 percent or more of their general revenues from their own source compared to 31 percent of nonmetropolitan cities. The data do show as well that
growing cities rely more heavily on their own source of revenues than declining
cities do. Forty-three percent of the growing cities compared to 32 percent of
declining cities obtain 75 percent or more of their revenuPs from their own so11rcP.
The heavy reliance on outside sources while making the local government less
vulnerable to the displeasure of local taxpayers does reduce local initiatives!
Another consequence of this increase in dependency is the heavy administra•
tive burden which has been placed on these small cities. It is reported bv mnny
of them. for example, that the mo,;t difficult task they have in discharging the
responsibilities of the Community Development Block Grant is in completing the
6 For a ~IRcusslon of the marketabil!ty of debt Instruments of small cities, See J"ohn E.
fetPrsen. 'The Borrowing Costs of Small Cities" In Herrington .T. Bry<'e (ed.) "Small Cities
m Transition: The Dynamics of Growth and Decline" (Cambridge, Massachusetts, Ballinger. 1977), pp. Mo-368.
• Herrington J". Bryce, op. cit.
7 For an additional vle;iy- of the dependency phenomenon amonir small cities. see J"ohn
Sh:mnon and J"ohn Ross. Cities: Their Increasing Dependence on State and Federal Aid,"
In Herrington J". Bryce (ed.) "Small Cities," pp. 189-208.


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692
financial and administrative paperwork." Partly as a consequence of the federal
flemands on the administrative and financial components of these governments,
their expenditures on financial administration more than doubled between 1969
and 1976. Admittedly, part of this increase is financed by the federal government
which permits the use of some fraction of program funds for administrative
C!OStS.
CONCLUSIONS

We make a serious error in not giving adequate attention to the role of small
cities in determining the overall economic ·behavior of cities in general; Small
cities account for a significant part of the expenditures of city governments.
Consequently, as a group, they have a significant impact on resource allocation.
But size is not an exclusive determinant of the economic behavior of cities;
therefore, we have shown in this testimony some significant differences between
11;mall cities depending upon their metropolitan or growth status.
Perhaps the most outstanding feature of the recent fiscal trend in small cities
is their growing dependence on the federal government. This trend is not all
negative. To some extent it represents partial federal financing of expenditures
mandated by the federal government. In some respects, as is true of the various
countercyclical measures, it represents federal intervention to relieve fiscal and
economic .pressures on small cities. Hence, my own study has shown that 75
percent of small cities have relied on CETA to offset the employment impact
of the recession. It is also true that part of the fiscal dependency reflects a voluntary action on the part of local governments to participate in federal pro~rams which are optional. My own study shows that over 85 percent of small
cities applied for participation in the Community Development Block Grant
Program.• The implication is that in spite of the "price" that the federal government .extracts for participation by small cities in programs and in spite of
the negative side effects of this intervention, the overwhelming majority of
small cities would be fiscally hurt by the termination of these programs.
TABLE !.-GENERAL EXPENDITURES OF CITIES, BY CITY SIZE AND TYPE OF EXPENDITURE, PERCENT
DISTRIBUTION, 1975-76

[Dollar amounts in millions)

General expenditure.................................
Capita I outlay.:.................................
other general expenditure........................
General expenditure:
Education......................................

All cities

Cities with
population
of 25,000
to 49,999

All cities
(percent)

Cities with
population
of 25,000
to 49,999
(percent)

$54,425

$13,465

100. 0

100. 0

45,113

10,426

82. 9

77. 4

7,610
4, ,45
4,544
3,462
€, 015
3,257
5,557
2,558
!, 525
€84
912
!, 611
934
2,863
8,828

!, 246
!, 886

14. 0

9. 3
1~

------------------,--17.1
22. 6
3,040
9,312

~~g~~a!!1tare..................................
Hospitals and. health.............................
Police ....•.•..•.............. _._._._. __ .• _.___
Fire...........................................
Sewerage and sanitation.........................
Parks and recreation............................
Housing and urban renewal......................
libraries.... ..........•.•.....•...•.•....••...
Financial administration.........................
General control.................................
General public buildings.........................
Interest on debt................................
Other..........................................

69
690
!, 827
953
2,009
766
160
196
321
597
329
573
!, 842

~: ~
6. 4

11. 1

6. O

10. 2

4. 7
2. 8
I. 3
I. 7
3. 0
I. 7
4. 9
16. 2

g

5.1
13. 6

7. I

14. 9

5. 7
1. 2
1. 5
2. 4
4. 4
2. 4
4. 3
13. 7

Source: Academy for Contemporary Problems Staff from data in U.S. Department of Commerce, "City Government
Finances in 1975-76" (Washington, D.C., U.S. Government Printing Office, 1977) p. 7.
• The Department of Housing and Urban Development, "Community Development Block
Grant Programs, Second Annual Report" (Washington, D.C., U.S. Government Prlnj;ing
Office) p. 10. Approximately 10 l)€rcent of connty program costs in CDBG were federal
paperwork, and 5 percent of municipal program costs resulted from federal paperwork requirements. See Timothy D. Mead, "Impact of Federal Paperwork on State And Local Governments: An Assessment." Report to the Commission on Federal Paperwork, July 15, 1977,
pp. 48-53, 69-72.
• See Herrington J. Bryce, "Planning Smaller Cities," op. cit., chs. VII and VIII.


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693
TABLE 2.-CAPITAL OUTLAYS FOR SELECTED ITEMS, BY CITY SIZE, PERCENT DISTRIBUTION AND PERCENT
CHANGE, 1975-76

Selected items, 1975-76
Total capital outlay for general expenditure. ______________________ •
Selected
items:__________________
Education
Highways _________________ •
Hospitals__________________ •
Sewerage __________________
Housing and urban renewal..
Public buildings _____________

Percent change

Percent distribution

Dollars (millions)

All cities

25,000 to
49,999

All cities

25,0QOlto
49,999

3,040

100. 0

100. 0

66. 6

85.4

134
702
lll
737
85
157

7. 2
19. 3
2. 2
24. 7
6. 8
4. 0

4.4
23. l
3. 7
24. 2
2. 8
5. 2

21. 9
61. I
88. 2
160. 6
--9.2
129.4

94.2
87. 7
270.0
100.8
25.8
157.4

All cities

25,000 to
49,999

9,312
669
I, 801
207
2,296
633
374

Source: Academy for Contemporary Problems Staff from data in U.S. Department of Commerce, "City Government
Finances in 1975-76," (Washington, D.C., U.S. Government Printing Office, 1977) p. 7.
TABLE 3.-PERCENT OF GENERAL EXPENDITURE ALLOCATED TO CAPITAL OUTLAY FOR CITIES WITH 1970
POPULATION OF 50,000 TO 100,000, FISCAL YEAR 1975-76 (BY DECLINING OR INCREASING POPULATION, 1970-75)
Percent for capital outlay
All
·cities

25 to 49

Under 25

50 to 74

75 to 100

Total (number) _______________________

230

157

65

8

0

Declining _________________________
Stable or increasing _______________

118
112

91
66

22
43

5
3

8

Total (percent)_. _____________________
Declining _________________________
Stable or increasing _______________

100. 0
100. 0
100. 0

68. 3
77. I
58. 9

28. 3
18.6
38; 4

3. 5
4. 2
2. 7

0
0

Total (percent) ____ , ____ -,------ ______

100. 0

100. 0

100. 0

100. 0

Declining _________________________
Stable or increasing _______________

51. 3
48. 7

58. 0
42. 0

33.8
66. 2

62. 5
37. 5

I

0

----------------------------------------

Source: Academy for Contemporary Problems Staff from data in Barbara H. Grouby and Mary A. Schellinger, Profiles

lo! Individual Cities, In "The Municipal Year Book 1978" (Washington, D.C., International City Management Associatioo
1978), pp. 3-44.

TABLE 4.-BOND RATINGS OF CITIES WITH 1970 POPULATION OF 50,000 TO 100,000 BY DECLINING OR INCREASING
POPULATION, 1970-75
All cities
(number)
Total. •.... _•• ____________ •
Declining ______________
Stable or increasing _____

230
118
112

Bond rating (percent of cities)
Aaa

Aa

Al

A

Baal

Baa

NA

3. 5

2.6. I
25. 4
26. 8

24. 8

22. 2
20. 3
24. I

4. 3
5.1
3.6

3.'5
5. 1
1. 8

15. 7
17.8
13.4

4. 2
2. 7

2t.. 0

27. 7

Source: Academy for Contemporary Problems Staff from data in Barbara H. Grouby and Mary A. Schellinger, Profiles of
Individual Cities, in "The Municipal Year Book 1978" (Washington, D.C., International City Management Association,
1978), pp. 3-44.
TABLE 5.-PERCENT OF GROSS OUTSTANDING DEBT WHICH IS NONGUARANTEED FOR CITIES WITH 1970 POPULATION OF 50.000 TO 100,000, FISCAL YEAR 1975-76 (BY DECLINING OR INCREASING POPULATION, 1970-75)
Percent nonguaranteed
All cities

Under 25

Total (number). _______ •••••••••••••
Declining _________________ •••••
Stable or increasing _____________

230
118
112

Total (percent)._ •• _________________
Declining. ____________________ •
Stable or increasing ___ • _________

100. 0
100. 0
100. 0

25 to 49

50 to 74

75 to 100

NA

41

54

37

34

64

18
23

25
29

18
19

15
19

42
22

17. 8
15. 3
20. 5

23. 5
21.2
25. 9

16. I
15. 3
17. 0

14. 8
12. 7
17. 0

27.8
35.6
19. 6

S_o~rce: Aca_demy f~f Contem~orary Problems Staff tr,om data_ in Barbara H. Groubx and M_ary A. Schtllinger, Profiles of
lnd1v1dual C1t1es, in. The Municipal Year Book 1978 (Washington, D.C., International City Management Association,
1978), pp. 3-44,


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694
TABLE 6.-BOND RATINGS OF CITIES WITH 1970 POPULATION OF 25,000 TO 50,000, BY METROPOUfAHNONMETROPOLITAN STATUS
Bond ratings
All
Cities
Total (number) _____________________

Aaa

Aa

Al

A

Baal

Baa

93

92

114

16

30

1
4

56
38

57
35

70
44

8
8

16
14

1
0

10
30

1.1
.4
2. 3

20. 6
20. l
22.0

20. 4
20. 4
20.2

25.2
25. 1
25.4

3. 5
2. 9
4. 6

6. 6
5. 7
8.1

.2
.4
0

22. 3
25.1
17. 3

452

Metropolitan ____________________
Nonmetropolitan ________________

279
173
Total (percent) _____________________
100. 0
Metropolitan __ • ______ ._. _______ • 100. 0
Nonmetropolitan ________________ 100.0

NA

Ba

101

Source: Academy for Contemporary Problems Staff from data in Barbara H. Grouby and Mary A. Schellinger, Profiles
~f Individual Cities, in "The Municipal Year Book 1978" (Washington, D.C., International City Management Association
1978), pp. 3-44.
TABLE 7.-GROSS OUTSTANDING DEBT FOR CITIES WITH 1970 POPULATION OF 50,000 TO 100,000, FISCAL YEAR
1975-76 (BY DECLINING OR INCREASING POPULATION, 1970-75)
Gross outstanding debt (thousands of dollars)
All
cities

!, 000 10,000 25,000 50,000 100,000 150,000
to
to
to
to
to 200, COO
to
9,999 24,999 49,999 99,999 149,999 199, 999 and over

Under 100 to
100
999

Total (number) ___________

230

5

5

46

84

60

24

4

Declining _____________
Stable or increasing_ ••

118
112

5
0

3
2

25
21

49
35

25
35

10
14

1
3

0
1

0

Total (percent) ___________ JOO. 0
Deel ining. ______ •• ____ 100. 0
Stable or increasing •• _ 100.0

2. 2
4. 2
0

2. 2
2. 5
1. 8

20. 0
21. 2
18. 8

36. 5
41. 5
31. 2

26.1
21. 2
31. 2

JO. 4
8. 5
12. 5

1.7
.8
2. 7

0. 4
0
.9

0.4
0
.9

1

Source: Academy for Contemporary Problems Staff from data in Barbara H. Grouby and Mary A. Schellinger, Profiles of
Individual Cities, in "The Municipal Year Book 1978" (Washington, D.C., International City Management Association,
1971!), PR· 3-44.
TABLE 8.-PERCENT OF GENERAL EXPENDITURES ALLOCATED TO CAPITAL PROJECTS, FOR CITIES WITH 1970
POPULATION OF 25,000 TO 50,000, FISCAL YEAR 1975-76 (BY METROPOLITAN STATUS)
Percent for capital projects
All cities

Under 25

25 to 49

50 to 74

75 to 100

NA

Total (number) ________________ •• ___

452

284

121

25

15

7

Metropolitan ••••• _______________
Nonmetropolitan ___ •• ___________

279
173

188
96

57

14
1

6

64

14
11

Total (percent) ___ • ______________ •• _
Metropolitan._. _________ •• ___ •• _
Nonmetropolitan. _______________

100.0
100.0
100. 0

62. 8
67.4
55. 5

26. 8
20.4
37.0

5. 5
5.0
6. 4

3. 3
5.0
.6

1.5
2.2
.6

1

Source: Academy for Contemporary Problems Staff from data in Barbara H. Groub_y and Mary A. Schellinger, Profiles
of Individual Cities, in "The Municipal Year Book 1978" (Washington, D.C., International City Management Association,
1978), pp. 3-44,
TABLE 9.-GROSS OUTSTANDING DEBT FOR CITIES WITH 1970 POPULATION OF 25,000 TO 50,000, FISCAL YEAR
1975-76 (BY METROPOLITAN-NONMETROPOLITAN STATUS)
Gross outstanding debt (thousands of dollars)
All
cities

Under
100

452

4

Total (number). _____
Metropolitan _____
Nonm·etropolitan _

100
to
999

1,000
to
9,999

10,000
to
24,999

25,000
to
49,999

50,000
to
99,999

100,000
to
149,999

150,000
to
199,999

200,000
and
over

NA

30

210

148

36

7

2

0

0

15

16
20

6
1

0
0

0
0

8.0
5. 7
11.6

1.5
2. 2
.6

279
173

4
0

29
1

135
76

75
73

Total (percent) •• ____ 100. 0
Metropolitan····- 100. 0
Nonmetropolitan_ 100. 0

0.9
1. 4

6.6
10. 4
.6

46. 5
48. 4
43. 9

32. 7
26. 9
42. 2

0

0. 4 --·-·--··-··-·-··• 4 ··--·----······-·• 6 --------·-·-·-·---

13
1

--3. 3
4. 7
.6

Source: Academy for Contemporary Problems Staff from data in Barbara H. Grouby and Mary A. Schellinger, Profiles
of Individual Cities, in "The Municipal Year Book, 1978" (Washington, D.C., International City Management Association,
1978), pp. 3-44,


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695
TABLE 10.-PERCENT OF GROSS OUTSTANDING DEBT WHICH IS NONGUARANTEED FOR CITIES WITH 1970 POPU•
LATION OF 25,000 TO 50,000, FISCAL YEAR 1975-76 (BY METROPOLITAN AND NONMETROPOLITAN STATUS)
Percent nonguaranteed
All cities

Under 25

25 to 49

50 to 74

75 to 100

NA

Total (number) •••••••••••••••••••••

452

95

77

65

94

121

Metropolitan •••••••••••••.•••••
Nonmetropolitan ••••••••••••.•••

279
173

61
34

46
31

36
29

48
46

88
33

Total (percent) •••••••••••••••••••••
M£tropolitan ..•.••••••••••••••••
Non metropolitan ••••••••••••••••

100.0
100. 0
100.0

21. 0
21. 9
19. 7

17. 0
16. 5
17. 9

14.4
12. 9
16. 8

20.8
17. 2
26.6

26. 8
31. 5
19. I

Source: Academy for Contemporary Problems Staff from data in Barbara H. Grouby and Mary A. Schellinger, Profiles of
Individual Cities, in "The Municipal Year Book 1978" (Washington, D.C., International City Management Association,
1978), pp. 3-44.
TABLE IL-GENERAL REVENUE OF CITIES, BY CITY SIZE, ANO TYPE OF REVENUE ANO PERCENT DISTRIBUTION,
1969-70
[Dollar amounts in millions)

All
cities

Cities with
population of
25,000 to
49,999

All
cities
(percent)

Cities with
popijlation of
25,000 to
49,999
(percent)

$26,621

$6,270

100.0

100.0

State..........•.•...•.•.•.......•.........
Federal. ..................•...............•

6,173

Local .•....................................

I,~~~

1,066

23. 2
5. 0

17. 0
2.9

From, own saurces...............................

18, 715

70.3

78.4

General revenue....................................

---------------7,906
I, 356
29. 7

From Government sources........................

rn~
==============
1.5

4,914

---------------13,647
3,193
51. 3
---------------Property...................................
9,127
2,346
34.3

Taxes..........................................

Sates......................................
Other......................................
Current charges.............................
Misc6llaneous..... .•. .. ...... ••• •. .• •. .• .. .

21.6

1.7

50.9

2, 422
2, 098

494
352

9. I
7.9

37.4
7.9
5.6

I, 955

712

7.3

JG. I
U.4

==============
3, 113
I, 010
11. 7

Source: Academy for Contemporary Problems Staff from data in U.S. Department of Commerce, "City Finances in 196970" (Washington, D.C.," U.S. Government Printing Office, 1977) p. 7.
TABLE 12.-GENERAL REVENUE Of CITIES, BY CITY SIZE, AND TYPE OF REVENUE AND
PERCENT DISTRIBUTION, 1975-76
[Dollar amounts in millions)

All cities

Cities with
population
of 25,000
to 49,999

All cities
(percent)

Cities with
population
of 25,000
to 49,999
(percent)

General revenue .........•...•.•..............•.....

$55,341

$13,839

100. 0

100.0

From Government sources .............•.........

22,234

4,635

40.2

33. 5

State ..............................•.....•.
Federal .•..........................•.•.....
Local. ......•..............................

13,772
7,442
I, 021

2,595
I, 656
383

24.9
13. 4
1.8

18. 8
12. 0
2.8

From own sources ........................•...•.

33, 107

9,205

59. 8

611. 5

Taxes .•..•..............................•.

23,336

5,850

42.2

42.3

Prope rt y•..................•...........
Sales •...•.............................
Other................................. .

5,109
4,063

I, 262
677

9.2
7. 3

9.1
4.9

~~;~:n~~~i~~~--·:::::: :: :,: :::::::::::::::::

3,611

!, 269

6. 5

9.2

------------------14,165
3,912
25.6
28. 3

==================
6, 161
2,086
II.I
15.1

Source: Academy for Contemporary Problems Staff from d1ta in U.S. Department of Commerce, "City Governmut,
Finances in 1975-76," (Washington, O.C., U.S. Government Printing Office, 1977), p. 7.


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696
TABLE 13.-PERCENTAGE CHANGE IN REVENUES BYTYPE BETWEEN FISCAL 1969-70 and FISCAL 1975-76

All cities

City population of
25,000 to 49,999

107. 9
181. 2
123. l
456. 6
157. 8
76. 9
71. 0
55. 2
ll0.9
97. 3
97. 9
84. 7

110. 7
241. 8
143. 4
820.0
251. 4
87. 3
83.2
66.8
155. 5
92. 3
106. 5
78. 2

56. 9
112. 6

59.9
ll8.4

General revenue ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
From Government sources •••••••••••••••••••••••••••••••••••••••••••••••
State ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Federal ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Local ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
From own sources ••••••••••••••••••••••••••••••••••••••••••••••••••••••
Taxes ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Property •••••• o ••••••••••••••••••••••••••••••••••••••••••••••••
Sales ••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Other••••••••••••••••••••••••••••••••••••••••••••••••••••••••••
Current charges •••••••••••••••••••••••••••••••••••• ···- •••••••••••••
Miscellaneous ••••••••••••••••••••••••••••••••••••••••••••••••••••••
Utility revenue:

tit~; ~fi~~y:::::::::::::::::::::::::::::::::::::::::::::::::::::::::::

Source: Academy for Contemporary Problems Staff from data in U.S. Department of Commerce, "City Government
Finances in 1975-76," (Washington, D.C., U.S. Government Printing Office, 1977) p. 7,
TABLE 14.-PERCENT OF GENERAL REVENUE FROM OWN SOURCES FOR CITIES WITH 1970 POPULATION OF 25,000
TO 50,000, FISCAL YEAR 1975-76 (BY METROPOLITAN STATUS)

All
cities

Percent from own sources
Under 25

25 to 49

50 to 74

75 to 100

NA

Total (number) •••••••••••••••••••••

452

38

2ll

198

4

Metropolitan ••••••••••••••••••••
Nonmetropolitan ••••••••••••••••

279
173

1
0

15
23

ll6
95

144
54

3
1

Total (percent) •••••••••••••••••••••
Metropolitan •••••••••••••••••••
Nonmetropolitan ••••••••••••••••

100. 0
100. 0
100.0

0.2
.4
0

8. 4
5. 4
13. 3

46. 7
41. 6
54. 9

43.8
51. 6
31. 2

o. 9
I. I

.6

Source: Academy for Contemporary Problems Staff from data in Barbara H. Grouby and Mary A. Schellinger, Profiles of
Individual Cities, in "The Municipal Yeu Book 1978" (Washington, D.C., International City Management Association.
1978), pp. 3-44.
TABLE 15.-PERCENT OF GENERAL REVENUE FROM OWN SOURCES FOR CITIES WITH 1970 POPULATION OF
50,000 TO 100,000, FISCAL YEAR 1975-76 (BY DECLINING OR INCREASING POPULATION, 1970-75)
Percent from own sources
All cities

Under 25

25 lo 49

50 to 74

Total (number) •••••••••••••••••

230

2

13

129

86

Declining.•••.••••••••••••••••••••••••
Stable or increasing •••••••••••••••••••

118
112

8
5

71
58

38
48

75 to JOO

Total (percent) •••••••••••••••••

100. 0

0. 9

5. 7

56. J

37.4

Declining•••••••••••••••••••••••••••••
Stable or increasing •••••••••••••••••••

100. 0
100. 0

8
9

6. 8
4. 5

60. 2
51. 8

32. 2
42. 9

Total (percent) •••••••••••••••••

100. 0

100. 0

100. 0

100. 0

100. 0

Declining..•.••.••••••••••••••••••••••
Stable or increasing •••••••••••••••••••

51.3
48. 7

50.0
50. 0

61. 5
38. 5

55. 0
45. 0

44. 2
55. 8

Source: Academy for Contemporary Problems Staff from data in Barbara H. Grouby and Mary A. Schellinger, Profiles

of Individual Cities, in "The Municipal Year Book 1978" (Washington, D.C., International City Management Association,
1978), pp. 3--44.

Representative MOORHEAD. Mr. Chairman.
Representative REuss. I think, Cochairman Moorhead, it would be
expeditious and fair, if it is all right with every member of the committee if we now withheld the third panel of three sterling witnesses,
and that we eight members at the table, under the 5-minute rule, proceeded to examine the eight witnesses that we have had before us.


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We then will hear from the second panel in 30 minutes and start in
the questioning on the part of members of the committee where we left
off. Is there any objection to that procedure?
If not, let me start out. Mr. Jacoby, yours like the others was a
fascinating paper. One is struck by the fact that here the Federal
Government has been giving $2 billion or more a year in general revenue sharing to the States. California somehow or other ends up with
$5 billion of do-re-mi which, mythological or not, seems to be of a
nature that can be returned now to localities and some of the taxpayers.
Tax assessments and tax rates on homes did go up frightfully in
your State, as who knows better than you? How did this all come
about? Could not some light be thrown on this by the action of the
smallish community of Petaluma, where the city fathers said,
Look, we are tired of taxing existing homeowners to provide free or subsidized
streets, highways, sewer extensions, water extensions and utilities, to new subdivisions whose speculator-developers are then able to sell for less than would
be the case had they paid the full price, which results in a tax burden being
loaded on the poor souls who got there first, for which they get no visible
benefit.

I am not suggesting that is the whole story but there is this tremendous population boom you had in California and with your climate
and fine country, I can understand why you had it. Couldn't that be
part of this ghastly problem which Jarvis-Gann finally made contact
with?
Mr. JACOBY. Chairman Reuss, I think the answer is yes, it certainly
had a great deal to do with it. I believe that in interpreting the proposition 13 episode in California one must bear in mind that California
had been backward in reforming its State and local revenue system to
reduce reliance on property taxation.
The State was increasingly relying on property taxes to finance not
only so-called property-related services, street maintenance, lighting,
sewers, water, and police and fire protection, but also the increasingly
expensive people-related services, recreation, welfare, and health and
education.
Just to give you a figure, in 1977 the best estimate I have been able
to make of the cost of property-related services in California was $3.9
billion, but the State and local governments were collecting $11 billion
from property owners and this figure was simply skyrocketing as inflation and speculation was driving up the prices of homes and other
real estate.
So that the pinch on the local property owner who was unfairly bearing the burden that ought to be shared more generally combined with
the buildup of the State surplus to create a political problem that apparently the California Legislature was unable to solve.
~or 3 years the surplus built up while the legislature struggled with
var10us formulae for reducing property taxes that everybody agreed
were excessive and were threatening the continued tenure of people
in their homes. With 3 percent average State property tax rate and
homes that had been selling for $40,000 a few years ago now selling
for $125,000, you can see now the burden was simply unbearable for
the elderly, and for the poor.
So that the State was faced with this political problem of utilizing
the surplus to cut property· taxes and it brought forth a number of
37-250-79-12


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formulae that were unsatisfactory and after 3 years it appeared to
the people that the legislative process had broken down and here I
would like to comment on the question raised by Mr. Kelly. He asked
quite properly whether California~s government was not taken over by
volunteers. ,ven, yes, but this is true whenever the initiative and referendum is utilized and I think more than half the States provide for
the initiative and referendum in cases where the legislative process
has failed to produce a solution.
So the people in this case produced their own solution, some 5 million people who voted for Proposition 13.
I don't see this as a flaw in our democracy. I think it is unfortunate
that the legislative process did not produce a solution, but I think it
is fortunate that we do have a safety valve in the referendum and
initiative where legislative action fails as it did in California.
But that is now part of the past history. Another question raised by
Representative Kelly was whether cuts in salaries to government
employees, instead of firing them, might not serve to make an adjustment that is desirable.
en, as I pointed out in my prepared statement, one of the adjustments to Proposition 13 in California was a moratorium on all State
and local hiring and on pay increases. No local government could get
any State subvention unless it followed the rule of the State. The
State was the fiscal disciplinarian for local governments. So we have
had a freeze and will have a freeze this year on local government pay
increases, benefit increases and hiring which will go a very long way
toward reducing the cost of government in Califomia by the 10 percent that I referred to in my paper.
Representative REuss. Thank you very much, Mr. Jacoby. My
time has expired.
Congressman Moorhead.
Representative MOORHEAD. Thank you, Mr. Chairman.
I am well a ware that there has been some criticism of the National
Income Account figures. Isn't it the situation, however, that the figures
are correct and that it is the use of these figures for purposes for which
they were not intended that causes the difficulty, Mr. Gramlich?
Mr. GRAllfLICH. That is exactly right. The Department of Commerce gets the national accounts budgets by just adding up the accounts of various sectors of the economy in conventional ways and
those surpluses really are there, but you are exactly right in saying
that the interpretations is what is in question. In my prepared statement I tried to distinguish between the interpretation for macroeconomic purposes where it really is saving, from an interpretation on
Federal aid policy which should be determined in longer run, on the
longer run basis and where the surplus is not particularly relevant.
Representative MooRHEAD. Mr. Peterson, you have painted a rather
positive picture of the fiscal recovery of our cities. Isn't there a distinction, however, between what I ,votild call the basic economic recovery, that is, recovery of the tax base through job and population
increases and the fiscal recovery?
Mr. PETERSON. Yes, I would like to draw three distinctions in fact.
One is the strict financial condition of the cities, whether there is
significant jeopardy of a financial crisis. I think the answer to that

,v


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question, with the exception o:f one or two cities, most conspicuously
Cleveland, is: No, the finances are in rather sound shape now and have
recovered well.
The second question involves the longer term fiscal condition of the
cities, which I would measure primarily by their tax bases, their ability
to raise funds from their own tax base. On that account you cannot be
very sanguine. Most of these cities have staggering tax bases, some of
them have had declining tax bases in the face of rapid inflation. Their
abi]ity to provide for themselves, through their own taxable resources
is slight and deteriorating, which makes a case for some kind of permanent assistance, I think, from other levels of government. This
assistance should be designed, however, to equalize tax capacity, to
enhance their ability to purchase services themselves, to stimulate
additional local spending.
The third level of consideration is the economic base of the cities.
This is partiallv related to their fiscal capacity over the long run, but
also an independent concern.
On that score we have greatly varying trends at this point. Some
cities have shown signs of more than cyclical recovery. Others have not.
The Federal Government quite properly is directing much of its
attention to stimulating investment in those cities that have not been
able to recover economically.
RepresentatiYe MooRHEAD. There is an interesting difference between Mr. Bryce's prepared statement and yours, Mr. Peterson. You
state in your prepared statement that capital spending- referring
mostly to the large cities-on repair and maintenance has borne the
brunt of fiscal adjustment. On the other hand, Mr. Bryce, you report
that smaller cities have actually increased their capital expenditures.
Can you gentlemen give me a reason why the smaller cities go one
way and the larger cities go the other way?
Mr. BRYCE. Yes. First of all, I would like to point out that many of
the smaller cities did begin to experience the effects of the recession
much later than some of the larger cities. I think my figures, in one of
the reports I have done, show something like 60 percent of the smaller
citiPs have postponed some amount o-f their capital programs.
I think that there are a couple of things; one is that to some extent
l\fr. Peterson's figure, I believe, might take into account some of the
effects' of increases in prices.
M v figures do as well to some extent. Some of the differences might
just be an adjustment figure. I do not want to give the impression, as I
said in the first part of this statement, that smaller cities were not also
affected. Around 60 percent of them did reduce capital expenditures.
To some extent increases in capital expenditures were also aided by
some of the intergovernmental transfers. Take the community development bloc grant, for example, a very large proportion of those small
citiPs which used discretionary funds used those funds for sewer and
sanitation.
Again to underline the point, that increases in capital expenditures
by many of these cities during this particular period of time was enabled in part by Federal Government transfers.
Mr., PETF.RSON. I would like to make one comment. In the broa,d picture, over the last decade, capital spending by State and local govern-


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ments, as a whole, has been down quite sharply; it has been down very
severely in the past :few years. In the last :few years the local public
works programs have it percolated through the economy.
One particular handicap that these fiscally distressed large cities
:faced was that they were unable to gain access to the bond market during 1975 to 1976. That inability to borrow had consequences in the succeeding years as they drew down their capital :funds and had no cash
with which to invest in capital stock. Certainly :for individual cities
that has been o:f primary performance.
Representative REuss. The time o:f the gentleman has expired.
Congressman Kelly.
Representative KELLY. Thank you, Mr. Chairman.
Mr. Jacoby, I would like to ask you, are the property taxes in New
York about the same, more or less than they are in California?
Mr. JACOBY; I really lack the information to answer that. I can say
that the overall average property tax in California be:fore the Proposition 13 was 2.8 percent o:f market value.
Representative KELLY. Does anyone on the panel know? Are the
property taxes higher or lower in New York?
Mr. PETERSON. They have been moderately lower.
Representative KELLY. Who?
Mr. PETERSON. Massachusetts and New Jersey lead the country, yes.
Representative FENWICK. What did you say?
Mr. PETERSON. Massachusetts and New Jersey have had the highest
rates followed at some distance by California.
Representative KELLY. Then the situation seems to be that we then
play a sort o:f cynical game in this whole business o:f government as it
is presently being operated. New York City pays the highest taxes in
the United States o:f America when everything is considered. California doesn't pay taxes that are as high. Yet they have revolted.
So the game is :for the political establishment, the government as it
now exists, to milk the .public and the economy, in a way that it doesn't
sting so that the public's attention will be called to it. And i:f they can
milk the public a great deal and sting them a little, then that is ~uccess:ful government under. the present-day criteria. So in New York the
P<?lit~cians are just more successful at this game o:f milking without
stmgmg because they get more and create less discomfort among the
public.
Is that a fair description of what we are about?
Mr. CooPER. No, no, it is not.
~fr. JACOBY. May I ~omment, sir?
I am not intimately :familiar with the New Xork fiscal situation, but
I would like to comment on California's. I think it is important to recognize that California has relied :far more heavily on property taxation
.for its total to finance State and local services than has the average
State. It is also important to recognize that we are relatively a high tax
State. A recent study shows that the overall tax burden in California
ranks only a:fter Alaska and· New York and a margin behind New
York is notvery large.
vVe also have relied very heavily on property taxes.
Representative KELLY. That is the point I was making, that the mistake there was not how much you milked the cow, but that you were
not careful about it. And you just pulled the wrong thing.
Mr. CooPER. Congressman--


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Mr. JACOBY, I thinkwEl pulled thedghtplug, sir.
Mr. CooPER. Speaking af:l someone who has to deal .with the voters at
the local level, I disagree with your comment about milking the public:
The public wants the service, but does not want to pay for it. When we
closed our libraries temporarily, the public came in and said "we voted
for 13, but we didn't mean for libraries to be closed~ vVe want you to
close welfare, because we are not getting welfare benefits."
You know, everybody sees their service as the bone and somebody
else's service as the fat.
Representative KELLY. Let me ask you this then. In New York City,
in order to accomplish some economy they reduced the number of people that were working by over 25 percent, but yet reduced the cost of
maintaining the services by only 1 percent;
,
Now, I think the public is really getting flimflammed in this whole
operation.
Mr. COOPER. The µublic wants to be flimflammed, generally.
Representative KELLY. It could be that one person came into the library and said that, but the whole public didn't come into the library
,and say that and probably does not share any such view.
But let me ask you this: Isn't it a truth that there are an awful lot of
things that the Gc,>Vernment itself is doing that increase the costs of
,doing business for all ·local governments like. the Davis-Bacon Act!
Isn't that just an arbitrary imposition of inefficiency and excessive
-costs on local government i
Mr. CooPER. Congressman, I continually go to Sacramento and
"Washington and face the same problem with the legislation, fair labor
'Standards and unemployment insurance, or something else comes up
and I say, "Look, we don't need this. We have put unemployment insurance into our labor agreements," for example. Alameda County doesn't
need this legislation. But you can point to a thousand counties ln this
•country that are not doing a competent job; So you get horrible
•examples.
You are going to have the same thing on pensions, we are 80 perce.nt
"funded and we are going toward 100 percent. But you can dig up a lot
-of local jurisdictions in this country that are practically zero funded.
On the other hand, General Motors is $10 billion underfunded. It is
11ardly unique to the public sector to be underfunded in pensions. But
tlwre are other solutions to that.
Representative REuss. The time of the gentleman has expired.
Representative KELLY. Mr. Chairman, I would like to review and
-extend the remarks that I made in the record earli~r.
Representative REuss. Is there objection? Hearing none, the gentlemnn will be permitted to extend his remarks.
Mr. CooPER. Can I comment on one thing Mr. Kelly commented on
-earlier because I am directly involved in this? My county has laid off
more public employees since 13 than any other jurisdiction in California because we are concerned if we don't lay off 10 percent this year,
we will have to lay off 20 percent next year, which will be impossible.
Ten percent is difficult after you spend 7 years trying to be more
effil'ient.
But when you talk about cutting salaries, it is true we have a salary
freeze for 1 year, but you do that for 2 years, no pay increases. You are


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going to-or if you start cutting salaries, you are goi_!_lg to lose the com~
petent people. They are going to go to private industry where they can
getthese decent salaries.
The same people that come in to me and say, "Cut those management
salaries" are the same ones who bitch about the way I administer the
programs. Yet you want to cut salaries, get rid of the competent people,
have them go to private industry and have a higher percentage of
incompetent people on your staff managing programs under civil service and they are going to have the justification to say "This is impossible, close the whole thing down."
You cannot cut salaries. You know, we are generally 10 to 20 percent
below the Federal Government. A fair number of our people can grt
comparable jobs in t.he FPderal Government. If you want to- cut your
salaries and say we should also, I would be happy to go along with
that. Then at ]east I have a chance of keeping some of those competent
people on my staff.
How do you keep competent people and not pay comparable
salaries1
Representative REUSS. The time of the gentleman has expired.
Representative KELLY. Pay less welfare.
Representative REuss. The Chair will point out that Senator Boe
must leave within the next 10 or 15 minutes. Therefore if there are any
questions addressable to him, I would serve notice to the committee.
Congressman Pattison.
Representative PATTISON. Mr. Jacoby, you point out the systemic
bias toward Government overspending due to both unbalanced collective bargaining and the pressure group politics. I don't think we could
disagree with that.
Isn't there also a corresponding bias, a systemic bias when you are
actually cutting the budget or keeping budgets from going up at a local
level, a bias against maintenance and against capital expenditures,
because they are the easiest things to cut. For instance, not fixing your
sewer or not fixing your water system, because it is very hard to go out
to the public and say :
Look what I have done. I have spent so much money maintaining the water
system or maintaining the sewer system. As long as the water keeps coming out
and the toilets keep flushing, nobody really cares.

Consequently, you defer maintenance, as with the railroad experience. Because of the pressure group politics, you keep some of the more
visi?~e things that people demand and you ultimately get yourself in a
pos1t10n where your bridges fall down, your sewers collapse, your
water system :fails. Then :von have a.n enormously expensive capital
project which you cannot fund and you then come to the next level of
government or two levels up, and then end up with that situation.
With a spending limitation such as Proposition 13, don't we simply
run that risk of what you might call irresponsible government, or government that doesn't feel the same market disciplines that you might
feel in a business?
Mr. ,JAcoBY. I don't fePl that it is a very great risk. My observation
has been that where the people feel the need of Rome capital asset or
some maintenance expenditure, they will vote for it.


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Representative PATTISON. If, in fact, you should spend, say 10 percent of your value of your sewer on maintaining it, so that you do it a
little bit every year, people really don't feel the need for that much. I
have never had anybody come to me and say "We really have to maintain these bridges;" It is when they fall down that people £eel this
need.
Mr. JACOBY. Well, they usually have to be impressed with the need
by some untoward event, I agree. But where there is a felt need by the
public, the public will spend the money.
For exampie, in my own city of Los An.geles, the public has turned
down bond issues for new schools for some years. They don't be] ieve
they are needed and I think the figure,; show that many of our schools
are only half used. They are not needed.
. .
.
On the other hand, the people voted for a $30 milhon commumcations network for the police because they believe, they felt the need for
better law enforcement.
I think that we can trust the people to make wise decisions as to
how to allocate their incomes as between public goods and private
goods, but don't overestimate their information. You give them the
information. You will get a rational judgment from them.
Representative PATrISON. It seems to me that what you are saying
is, that you can trust the people in the area of maintenance and capital,
but that you can't trust the people through their representatives, and
I assume you are still talking through representative for maintenance
and capital. You can't trust them to resist the special interest, local
pressure group politics or the collective-bargaining pressures.
Where can I decide to trust the people i
Mr. JACOBY. We are talking about the vulnerability of the representative in a democratic government to the blandishments of special
pressure groups. I am not saying he is a bad man, he is just as good
as the rest of us, but his interest is in being reelected and he finds that
his strategy is more successful if he caters to the interest of the special
pressure group rather than to the general public interest group.
Representative PATTISON. I agree with that. I understand those
pressures, I feel them all the time. ·
Each group wants their piece of the pie and they want to take it out
of somebody else's piece of the pie. We understand that. Wbat I am
trying to find out is the flip side of that-and apparently you don't
agree with it-that as to the same lack of pressures. When it comes
to doing the difficult things that are invisible, the long-term things,
fixing a jail is not something that too many people go out and campaign on.
I haven't heard anybody campaign on that basis or very rarely. So
that fixing a jail, fixmg sewers, or fixing water systems that seem to
be working well is also the flip side of that lack of pressure, and then
you make the same kind of irresponsible decision.
Mr. JACOBY. Well, as I say, if the public is informed of the need for
maintenance of public facilities, I believe they will vote for it. There
is no evidence that our public facilities overall are undermaintained
that I am a ware of.
Representative REuss. The time of the gentleman has expired.
Senator McGovern.


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Senator McGOVERN. Mr. Jacoby, I wonder if you-could turn to your
prepared statement..
There you say, and I quote:
Senator George McGovern insulted two-thirds of California voters by describing their actions as "degrading hedonism" which was "motivated by racism" and
which would impose heavy -burdens on the poor.

In all due respects, Mr. Jacoby, I never made any such statement.
Now, I notice you have footnoted your remarks to the July 2 issue of
the Los Angeles Times; is that correct i
Mr; JACOBY. That is correct.
Senator McGOVERN. I would like to read just two or three parngraphs from that article in the Los Angeles Times of July 2, which I
authorized:
The roots of the California tax revolt expressed in the passage of Proposition
13 began growing long ago in the soil of an inflation fertilized by the escalation
of the Vietnam War and irrigated by the continuing a.rms race with the Soviet
Union.
The media have placed too much emphasis on a recent remark I made suggesting that while the tax revolt articulated a profound and legitimate anger, it
also had undertones of racism. Certainly, black and other minorities will suffer.
disproportionately from the cutbacks imposed on California by the passage of
P.roposition 13. But I do not believe that the majority of voters was expressing
racial resentment.
·
As inflated property valuations and the increasing• cost of living on all fronts
leaped out of control, property owners finally saw' an:opportunity to react against
taxes, inflation and ineffective government-all at once.
But it seems to me that there are far better ways than Proposition 13 to make
taxes lower and fairer for everyone.
The trouble is that Proposition 13 offers relief to the majority by reducing
services vital to the minority and by creating new tax advantages for corporate
landowners.

Mr. Chairman. I ask unanimous consent that the full text of this
article from the July 2 issue of the Los Angeles Times be printed in
the record.
Representative REuss. Without objection.
[The article referred to follows:]
[From the Los Angeles Times, July 2, 1978)
FEDERAL TAX REFORM AND DEFENSE CUTS ARE THE ONLY ANSWERS

(By George McGovern)

1

The roots of the California tax. revolt expressed in the passage of Proposition
13 began growing long ago in the soil of an inflation fertilized by t_he escalation
of the Vietnam War and irrigated by the continuing arms race with the Soviet
lJnion.
The media have placed too much emphasis on a recent remark I made suggesting that while the tax revolt articulated a profound and legitimate anger, it
also had undertones of racism. Certainly, blacks and other minorities will suffer
disproportionately from the cutbacks imposed on California by the passage of
Proposition 13. But I do not believe that the majority of voters were expressing
racial resentment.
As inflated property valuations and the increasing cost of living on all fronts
leaped out of control, property owners finally saw an opportunity to react against
taxes, inflation and ineffective government-all at once.
But it seems to me that there are far better ways than Proposition 13 to make
taxes lower and fairer for everyone.
1 GPor!!'P McGovern. a DemocrAt. IR the senior Senator from South Dakota. He was his
-party's 1972 presidential standard-hearer.


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The trouble is that Proposition 13 offers relief to the majority by reducing
services vital to the minority and by creating new tax advantages for corporate
landowners. Two-thirds of the proposition's tax relief will go to commercial
property, much of it owned by out-of-state interests, rather than to California
homeowners.
·
Beyond this, the tax cut is so sweeping that once the temporary state surplus.
provided by inflation is exhausted, public services of all kinds-police and fire
protection, education and recreation, sanitation and medical care, family assistance and mental health-may have to be slashed sharply. The Jarvis formula
may turn out to be the fiscal equivalent of the neutron bomb-a device that preserves property while destroying people.
Californians voted. for Proposition 13 because they had no better choice that
could both reduce unfair taxes and preserve essential services. But in view of
the underlying causes that contributed to that action, I suggest the alternative
steps of lowering federal spending on defense and eliminating both national and'
state tax loopholes currently available to corporations. These steps could lighten
the tax burden on our citizenry and slow the ravages of inflation-not only in
California, but also throughout the nation,
Much of the inflation and rising governmental costs that have driven up property valuations and taxes of all kinds originated with the cost of the Vietnam
War. That war accelerated rapidly after 1965 with no tax increases to pay for·
it and no effective price and wage restraints to limit inflation.
The ultimate cost of the war to the American taxpayer, including veterans•·
benefits and debt-carrying charges, will approximate $500 billion. That is a wartax of $10,000 on each American household over approximately 10 years.
Nor is the Vietnam War the only factor still with us. Since the end of that struggle, the arms race has been speeding up rather than slowing down. Annual U.S.
arms outlays have now skyrocketed to a current annual level of $126 billion.
In recent years we have squandered $51 billion on a useless, antiballistic missile complex in North Dakota, now abandoned; we spent nearly $5 billion on the·
B-1 bomber before abandoning that project as unneeded. We have spent tens of
billions of doliars on the MIRV (multiple independently targeted re-entry vehicles) missile system, which the Russians are now matching. This would not be
happening if a prohibition against MIRVs had been included in the first SALT
treaty, signed in 1972.
Now a summit round of Strategic Arms Limitation Talks is pending with theSovi.et Union. Should they fail or be substantially postponed, we will continue to•
pile another $75 billion in extra arms spending onto the backs of American taxpayers during the next five years.
Congress is about to force $2.5 billion nuclear aircraft carrier on an Administration which insists tha,t the carrier is unnecessary for national security. Although the Soviet Union and the United States both have enough nuclear fire
power to pulverize each other many times over-no matter which side strikes·
first-we are pushing ahead on plans for ,a costly new mobile missile system on
railroad tracks, plus a vast array of cruise missiles. The Soviets will doubtless
follow suit.
Former Defense Department official Townsend Hoopes and former I>eputy
CIA Director Hevbert Scoville have contended that the United States could save
$30. billion over the next four years in non-nuclear military forces-without
reducing our military effectiveness or our power to deter conventional war. Add
to that the $75 billion which a successful SALT II agreement co11ld save over
the next five years, and it becomes clear that such savings could not only reduce
government expenditures, deficits and taxes, but in doing so, could also dampen
the fires of inflation.
Beyond all this, there are ways to make taxes fairer for everyone-ways I first
proposed in 1972. At that time I urged that some of the loopholes in our federal
tax laws be closed, estimating the consequent savings at $28 billion, It was my
suggestion that these savings be returned to the states and earmarked for property-tax relief-a proposal that would have cut California's property taxes in
half.
On March 21, 1972, I told the Senate: "The American people are angry with a
tax system which has become increasingly unjust and which places an enormous
burden on property owners,. It is no exaggeration to say that we face a full
fledged tax revolt. While the President and the Congress would have to decide·
on the use of revenues resulting from tax reform, I believe that we must place
a high priority on their allocation for the purpose of reducing the property tax ...


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Six years later, after Proposition 13, it is even more urgent to eliminate loopholes in the federal tax code and pass the savings on in the form .of tax relief
and strengthened public services.
Economist Arthur Okun of the Brookings Institution has suggested a further
measure which would use federal tax reduction to fight inflation rather than aggravating it. Instead of offering President Carter's suggested broad tax cut of
$20 billion to corporations and individuals, he favors making a major part of this
reduction available to those businesses and their employees who agree to hold
down prices and wages.
Economist Robert Eisner of Northwestern Universi<ty has suggested other helpful tax revisions. He advocates a phaseout of the present 10 percent investment
tax credit for corporations, which would save the U.S. treasury $15 billion annually-savings that could help finance ei,ther a tax credit or subsidy to employers
for 50 percent of the cost of hiring and training Americans now without jobs.
Second, Eisner supports ene.ing all payroll taxes for workers under age 20.
H Proposition 13 was indeed a cry for help, then that help mrust be constructive
and swift, as well as targeted directly at those whose pain is greatest. The combination of prudent savings in our swollen arms budget, plus federal tax reform
based on common sense and designed to make our williest tax-avoiders bear their
share of the load, would serve us well.

Senator McGov1mN. Even on the bases of what I read, Mr. ,Jacoby,
I wonder how you draw the conclusion you did by my analysis of
proposition 13?
Those phrases that you used don't appear at all in the July 2 issue
of the Los Angeles Times.
l\fr. JACOBY. I believe the article you have quoted was a second
speech you made, which succeeded your initial speech in which these
comments that I quoted were made, sir.
Senator McGOVERN. It is the only one that appeared in the July 2
issue of the Los Angeles Times.
Mr. JACOBY. I will get the other citation.
Senator McGOVERN. Let me read you the other citation, then. It
comes from a speech delivered here in Washington on J1me 17 before
the Americans for Democratic Action annual convention in which
I addressed• at considerable length a much larger problem that proposition 13, which is the whole question of the priorities of the Nation
and the fairness of our tax system as a whole.
Now, this is the only place in that eight-page, single-spaces speech
where any reference to racism is mar le. It is all in about three sentences
and this is what I said: "And in conscience some final words must be
said. While the tax revolt expresses profound and legitimate anger,
it also has undertones of racism''; a newsweekly quoted on California
voter, and I quote: "It is those social services that annoy me, social
services for the colored, the Mexican, and so forth."
"Sixty percent of the employees may be laid off in Los Angeles are
members of minority groups."
Now, frankly, Mr. ,Jacobv, I regret having mentioned, even in passing, that, while it was by
means a causal factor, there were elements
of racism involved, especially in the results of proposition 13.
The reason I regret putting it in is that not that it isn't true, but
the fact that you and some of the news media had seen fit to lift that
ont of context and to use it as the interpretation of what I was trying
to sav about the essential unfairness of much of our total tax structure
in this country.
l\fr .•TAcoBY. If I may share a word in reply, Senator McGovern.
It was not my purpose to pillory you, but to _rather critici.ze a rather
wide Jy expressed view among the so-called liberal establishment of


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the country that the excessive burdens of property taxes in California
and the very high cost of the inefficient government we are running,
which led to proposition 13 should be explained by an effort to place
burdens on the poor or on racial minorities. This is not the case.
Representative REUSS. That will also take care, I believe, of Mr.
Jacoby's request, because that second McGovern speech is the one
that you at least partially referred to. Is that not so?
Mr. JACOBY. I think the first comment was also relevant. I should
have cited that as well, and I am sorry I omitted that reference. But
I believe it is true that the expressions of "racial overtones" and the
expression of "degrading- hedonism" were used by you, Senator.
Senator MoG◊vERN. Minor trace elements, Mr. Jacoby. They were
not the central thrust of my remarks at all. I am not suggesting you
:are trying to be unfair but I have made a real effort, including the
article that I wrote for the ,July 2d issue of the Los Angeles Times,
to clarify what I thought was an unfortunate distortion of my position,
and what does puzzle me slightly is that you quoted that clarification
but used the language from the initial statement.
I just repeat again that I agree with you, that that is not a fair
statement and I never made any such statements.
Mr. Chairman, since my time is up, I ask unanimous consent that
the full text of the earlier speech of June 17 also be made a part of the
1·ecord.
Representative REuss. "Without objection, it will be made a part of
the record.
Mr. JACOBY. I appreciate your effort to clear it up and I certainly
·wish to say there are no hard feelings on my part, sir.
Senator McGOVERN. Well, I feel the same way.
Representative REUSS. I thank you both very much.
[The text of the speech referred to by Senator McGovern follows:]
A VISION OF POSITIVE GovER,NMEN'T

(Remarks by Senator George McGovern (D.-S.D.) before the Americans for
Democratic Action Annual Convention, Washington, D.C., June 17, 1978)
We meet in a month when liberals are supposed to be in hiding. California
has voted overwhelmingly to approve Proposition 13. In New Jersey, a rightwing extremist has taken a Senate nomination by pledging to cut taxes and to
gut government. In Ohio, a general rejection of bond issues may close down
schools in Columbus and Cleveland. Across the country politicians are chasing
and fanning the popular whirlwind. They are seeking a mandate to govern by
runn~g against government itself.
So first of all let me affirm that I continue to <be a liberal-a believer in
dynamic government unafraid to set important goals and to persist in their
achievement. I still believe that social justice and peace among nations are
the defining endeavors of our democracy. I do not concede that the New Deal
and the United Nations are out of date. I do not intend, in the words of Edmund
Burke, "to take up or lay down a great political system for the convenience of
thP hour."
Expedient politicians have reversed Burke's standards of integrity: apparently
they are not in office "to support (their) opinion of the public good"; but they
"form (their) opinion in order to get into (office), or to continue in it." Candielates who sowed the wind with anti-government slogans are reaping the whirlwind. It should come as no surprise that citizens who hear government denounced
as feckless will decide that the futility is not worth their tax dollars. If Franklin
Roosevelt had assailed the needy and the old as shiftless and thriftless, could
he have passed unemployment compensation, rural electrification and social
F:ecurity?


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Today politics is being malpracticed as tactics, not leadership. Timid officia~s
are repeating and reinforcing a despair of democracy. Last January the President himself announced that the state of the union was one of powerle_ssness:that "government cannot. solve our problems ... define our vision ... eliminatepoverty ... or reduce inflation .... "
In the past, in success and in adversity, the Democratic Party has stood.
proudly for the possibility of progress. Woodrow Wilson sought a New Freedom
at home and peace through law •abroad; Franklin Roosevelt brought a New Deal;
Harry Truman fought for a Fair Deal; John and Robert Kennedy opened a NewFrontier; Lyndon Johnson and Hubert Humphrey dreamed of a Great Society;
and even in the crushing defeat of 1972,. we tried to call America home to its
founding ideals. We have not come this far to settle now for no deal. We are not
Americans for Democratic inaction.
Let us insist that government can, and must, solve problems-that it can, and
must, eliminate poverty and reduce inflation-that it can, and must set goals and
define a vision for the nation. For it is as true now as it was when Franklin
Roosevelt quoted it in his inaugural address that "where there is .no vision, the·
people perish." The danger is not the immediate death oft.he system, but a steady
decline of its capacity and credibility. And people literally do perish in the process.
Bad diets, bad housing, and bad health care do take human lives. Abused children
and battered wives do suffer and die. Dangerous poorly policed neighborhoods dokill people. Black.sand other minorities on average do die four years sooner than
whites; thousands of senior citizens do lose the will to live out a neglected old.
age. And there is a death of hope among Americans of every race and age whomust live out lesser lives in a lesser land. Beyond all of this maybe the death
of our planet if we do not soon curb the arms madness.
A clear vision of a better country cannot offer mere abstractions and disconnected echoes of the latest opinion polls. It asks not just for efficient government;
it asks efficient at what. It depends not just on preaching love, compassion and!
competence-but on achieving results. For faith without works is empty.
But the conventional cynicism replies that the liberal faith will not workthat we should not try to move forward because the Great Society failed. I am
tired of hearing that myth from the politicians and officials who urged the war
that diminished the Great Society. They were not skeptical of government then.
They believed the American government could work its will-in an Asian jungle.
They were wrong. The final price of their error will total $400 billion for the
fighting and its aftermath. It was the greatest single instance of government
waste in any nation's history. That is when the taxpayers should have revolted.
Three weeks of the Vietnam .war at its height cost m.ore than the highest budget
of the war on poverty for an entire year.
Because all the firepower finally proved to be powerless, because it could notdestroy enough villages in order to "save" Vietnam, does not mean that we are
helpless to save our own cities by saving them, or to prevent needless malnutrition
an_d illness, or to correct unemployment throµgh job opportunities, or to reduce
poverty through welfare reform, or to harass the sum and .convert waste matterto energy. Government can do what is possible domestically.,...,,.but not if it purst,es
a wasteful, se1f-defeating military glob_alism.
·
There is a fatal inconsistency in the nihilism of th.e new right that government
is only good for tax write-offs and costly new weapons. Their Senate npminee in
New Jersey emphasizes two issues-,--a 30 percent reduction in federal taxes and
an American withdrawal from the SALT talks. He scorns the "free-spending" of
government, but he would spend freely for tens of billions of dollars of extra
megatons. How would the bill be paid? What programs would be slashed?
It is time to challenge the simplistic hypocrisies of the new right.
·
If government has the money to bail out Lockheed and Penn Central, why is it
powerless to help ol<ler people, neglected children and average Americans-including those with black skin?
If government has billions for nuclear power plants, why does it lack the resources to develop solar power instead?
If government can find billions to dig .13-mile underground tracks for intercontinental missiles, why can't it restore railways and city transit instead?
In 1976 we were pledged a decrease of five billion to· seven billion dollars in
military waste; since then, we have had an increase of twenty billion. And recently we have been invited to the brink of a new cold war. We have heard no
convincing rationale that current events in Africa outweigh the fundamental,
mutual interest of America and Russia in ending the arms race before it ends all


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of us. But we have heard bombastic implications that who backed the Katanga
rebels is a more urgent concern than .SALT. Rather than proving that our leaders
are tough enough, official overreaction to such minor events may convince the
public than any SALT agreement that can be negotiated will be a bad one. How
senseless it would be to hazard Armageddon for Shaba Province.
The real spendthrifts are the hardline hawks whose "worst case" nightmares
are burdening the taxpayer, inflating our economy and jeopardizing the peace.
The signing of ,sALT I in 1972 has saved us $15 billion in a needless ABM. The
loss of SALT II would cost us $75 billion over the next five years-ten times the
total property tax cut in California under Proposition 13. The arms race fuels
the .fires of inflation and the tax revolt. To ·be anti-waste is to lbe anti-war. In
1972, I urged military economies and tax reform to finance property tax relief.
·we were six years ahead of Howard Jarvis-and we explained how to pay the
bill fairly. Today the fault for the heavy burden of unfair taxes rests not on
liberal programs, but on needless war, a reckless arms race and an unjust tax
system designed and continued by selfish special interests.
Instead voters are offered a degrading hedonism that tells that to ask what
they can take from the needy-and conceals the fact ,that in effect they also will
take necessities from themselves. Television commercials reassured Californians
that local governments could lose revenues without losing essential services.
Voters in surveys believed tha t enough frills could be eliminated. Now it turns
out that the friHs include police and firefighters; that entire school systems may
be shut down; that even if they open, clas-s sizes will soar as high as 170 pupils;
and that 225,000 employees probably will be laid off-"Which will raise state spending .for unemployment compensation and welfare. Tax dollars will be shifted:
they will pay employees less to do nothing rather than enough to provide services.
Ironically, two-thirds of the tax relief will enrich corporations and corporate
landowners-many of them absentee owners thousands of miles from California.
The homeowners knew it; but they believed that to get a fair break for themselves, they had to give that boon to the corporations. Property 'taxes in California were fifty percent above the national average. State officials had piled up
a five billion dollar surplus. They were proud of it: they cited it as evidence that
they could cut government down to size. And they fought over it; they delayed
even minor property tax reform. So people who literally were being taxed out
of their homes were so frustrated that they followed a pied piper-a paid lolbbyist
for the real estate industry.
'Politicians looking to ride or ride out the whirlwind of Proposition 13 cannot
see or shape a vision of tax justice. They have become instant economizers and
flailing taxcutters in the storm. The panic is nonpartisan. In New York, a Democratic officials has suggested an a:t'bitrary ceiling on the number of state employees that would force tens of thousands out of work; he did not say what
services would be slashed. In the same state the Republican candidate for
Governor proposed a constitutional amendment to limit local taxes ; according
to an aide, he left it deliberately vague.
Here in· Washington, officeholders 'have been busy compounding the deeper•
causes and the worst inequities of the ·tax revolt. The President. resurrected his
promise of a balanced budget by 1981, while simultaneously calling for a tax cut
and an even bigger Pentagon budget. 'That combination ~·m bring economic
trouble if he really means it and disillusion if he does not. A Congress that has
spurned even meager reform of federal taxes has rushed to cut the budget at
least a little. Intent on not offending the powerful, the House of Representatives
attacked the weak. It voted down $22·5 million to remove architectural barriers
to the handica:pPed. What a spectacle the majority made of themselves: after
raising the Pentagon's billions, they pinched a relative pittance for the halt, the
lame, and the blind.
Was this one of those wasteful programs which will not work? Are we sbort
of the materials and designs to build ramps? Nothing could more vividly expose
the character of the assault on domestic government. A convenient arrogance
of powerlessness comforts the comfortable: they would give less for what others
need.
But even the comfortable would be in trouble if the whirlwind reached too far.
John Kennedy's warning is ·still true that if we cannot help the many who are
poor we cannot save the few who are rich.
It took Vietnam to teach the ihard itesson that the American government in
arms is not all-powerful. Will it take the domestic equivalent of that defeat to
show the government in fiscal chains and our society in 'bondage? The new right
figures that they can follow the tax rerolt all the way into the White House.


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And in rthis illiberal hour, the rest of us are advised to trim our sails, tame our
conscience, borr;ow the passing rhetoric, and gratefully accept a leadership of
style over substance.
How can we continue to advocate government as the employer of last resort
when the voters are making it rthe unemployer of immediate resort? We do so
because it is right. We do so because we still believe in the decency of the
American people. We believe that they prefer a government that is both efficient
and compassionate. But if they do not have that alternative, then they, like the
citizens of California, may pick a government whose only virtue is that it has
been cheapened-not merely in finance, ·but in principle. The new right can exploit frustration; timid candidates may be swept along in the tide. But liberals
can offer a steady vision of taxes that are lower for the majority and fairer for
everyone. We can offer the vision of a society committed to a fuller justice for
all citizens. ·we can and we must demand an end to the arms race as the condition of our prosperity and our survival.
First, we can provide tax relief through tax reform and the reduction of
military waste. Billions of dollars are lost in unjustified tax loopholes; there
are billions of dollars to be saved in completing the SALT talks.
Second, we can offer additional tax relief that simultaneously controls inflation. Rather than cutting corporate taxes willy-nilly as now proposed we should,
as Arthur Okun recommends, offer tax rebates to businesses and their employees who practice price and wage restraints.
By contrast, present anti-inflation policy saps the economy of $100 billion
of output. The policy raises unemployment and the costs of welfare and unemployment compensation. Economists are now warning of an imminent recession.
To invite it in order to control inflation, to make unemployment a secondary
concern, in Republican economics that did not work before. It is failing again as
inflation soars into double digits.
As Roosevelt once said: "We are poor indeed if this nation cannot afford to
lift from every recess of American life the dread fear of the unemployed that
they are not needed in this world." Are we so poor now that 6 or 7 percent
unemployment has become the moral equivalent of full employment? Fifteen
years ago a 4 percent rate was just a temporary goal. Is a level far higher now
to become a permanent condition?
Third, we can offer financial relief by enacting programs instead of dismantling government. A common sense program af nutrition education and
preventive health care could cut the nation's medical bill by one-fourth and
1,rohahly more.
Similarly government intervention in energy could prevent excessive price
increases. The Administration apparently will welcome any energy program now,
including deregulation of natural gas. Government is not working when the
averai;re family's gas bill will rise $2,000 over the next seven years. Government is not working when the moral equivalent of war becomes the functional
equivalent of surrender to the oil monopoly. Instead of an energy policy that
seeks com:ervation through higher prices and higher oil taxes, we should he
pressing hard for alternative, renewable sources of energy and more economical
transportation.
How ironic it is to see the new rightists piously protesting every public endeavor that costs anything, then eagerly advocating natural gas legislation
that will transfer $60 billion from people's pockets to private boardrooms.
In truth the tax revolt is an accident that happened to their ideology. 'fhey
nre not a1rninst wastf•: they are 1mti-1wvernment. good or bad, except when
it is paying for B---1 bombers or neutron hombs. Their loyalty is not to hardpres11ed taxpayers, but to the ideology of McKinley, Harding and Hoover.
I know that it is not politic to oppose that ideology now-that Proposition 13
in California haR stirred a panic Pven more serious than the Cubans in Africa.
But the redeeming purpose of politics is to explain. to educate. to take risks
for a conviction-in short, to lead. I also know that no matter who leads us,
the political journey from the vision to the reality will not be an easy onP.
I believe that Jimmy Carter is a dedicated, conscientious man who longs to he
a good President. I well know that the problems that now afflict the nation are
not the results of a single presidency and no single President will end this time
of troubles. Wilson and Roosevelt lost their share of congressional and judicial
struggles. But what counted was that they fought another day, and then another,
for their conceptions of how government could and should work. And they


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held a vision of greatness constantly before the American people. A President
reaps disawroval not because he is set back in a cause that is right, but when
he is lukewarm in a course that is confused.
We elect leaders to set goals and solve problems, not to plead that they are
insoluble. And in the final analysis, their leadership must be a moral one. I
do not mean the morali-sm of insubstantial pieties or dreary self-righteousness.
:Moral leadership does not tell us how good we are, but how we can do better.
It touches conscience as well as self-interest.
And in conscience, some final words must be said. While the tax revolt
expresses profound and legitimate anger, it also has undertones of racism.
Crime was, and is, a legitimate issue; but in the last decade, law and order
became a code word. So it could be with tax relief. A news weekly quoted
one California voter: "It's those social services that annoy . . . me-social
services for the colored, the Mexican, and so forth." Sixty percent of the
employees who may be laid off in Los Angeles are members of minority groups.
It is unfashionable now to worry about the poor and minorities and to
defend the idea that they, too, deserve an opportunity. Perhaps property taxpayers ought to remember, if only for a moment, how many of them would
never have owned a home without a government loan and a mortgage tax
write-off. To give up on government now, to turn our backs on those who have
been left behind, to decide that all we can do is keer, our own share, is to give
up on our own best instincts. It is un-American; it is unacceptable.
At stake is whether America will become a parcel of geography drained of
ideals, a collection of selfish, competing economic persons whose highest purpose is the bottom line. We worry about defending our nation as a physical
entity; we must also defend it as a source of justice and mercy. National
security includes the condition of our national spirit as much as the size of
our nuclear arsenal. The gravest threat today is not a foreign adversary, but
an enemy within. That enemy is not a conspiracy or a fifth column ; it is inside
ourselves and among our leaders. It is the sense of futility. It is the dulled
conscience. It is the lost vision.
'l'hose of us who have ,seen the liberal vision have an obligation to nurture it.
,ve must insist tha;t this latest revolution against taxation need not overthrow
the first, best traditions of that earlier revolution for "the unalienable rights" of
all people.
,ve must speak for those who have no voice.
We must stand for those who have nolobhy.
,ve must be strong for those who are weak.
We must demand fairness for those to whom life has been unfair.
We must take,the road that leads to peace.
We must not be ashamed to care or ,afr,aid to he liberal. For in this month
when we are supposed to be hid·ing, a montih that comes 10 years after Robert
Kennedy's death, we still refuse to see ,thing,s as they are ,and assume fuat they
have to be; we continue to dream tihing,s <that never were--{lnd to say "why not."

Representative REuss. Senator Boe has to leave. Congresswoman
Fenwick has a question to ask him.
I recognize the gentlela.dy from New ,Terscy.
Representative FENWICK. I woncler if yon could comment on the
feelings of or express an opinion given by :Mr. Gramlich about unemployment as a result of this proposition 13.
I would like to say that I don't think that that feeling of impatience
or "rage" ae:ainst government, and what it imposes on people, is found
only in California. It is found aJI o\·er the Nation, and I think it is
increasing.
But, could you comment on the unemployment aspect of that?
Senator BoE. Yes, I believe that there i" no onestion in my mind that
the ultimate effect of proposition 13 will be -decreased employment,
pt1,rticularly in schools. When we are talking about property taxes,
we are talking about education.


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In the State of Oregon, we are not too far different than most of the
rest of your States, 75 cents of every property tax dollar goos to the
support of education, K through 12 or K through community college
of education.
Representative FENWICK. Right.
Senator BoE. That is what we are talking ·about, where I think where
\,he stringent unemployment aspects are going to ha,ppen.
Representative FENWICK. "'\Vhat do you mea!1 by "unemployment
aspects"? Do you mean through teachers thrut will be unemployed?
Senator BoE. Certainly.
Of you average school budget, 80 percent is salaries. So, if there is
going to be cuts in funding, there will be cuts in education •and your
pupil-te,acher ratio will increase from 1 to 25 kids to 1 to 40 kids. It is
the only way the budget can be balanced.
Representative FENWICK. But, isn't it also true that some of the
education budget is spent for programs like the summer lunch program? According to Congresswoman Holtzman, this produ<led a handsome profit in 10 weeks of $1 million in her district?
There are elements which have nothing to do with education and
are extremely burdensome and expensive, and maybe those could be
eliminated, which would be discontinued, which would not result in
unemployment but denial to that enterprising gentlemen of his $1 million profit?
Senator BoE. This is perhaps correct. Goodness knows, we, in the
State legislatures are faced witJh the same problems on a smaller scale
than· you are.
You can go through the Federal budget, Mr. Proxmire, our distinguished gentleman in the Senate does it regularly and points out that
some of the interesting things that some of the things that the Congress
budgets for around it, and throughout the Federal budget.
I do have to leave and I want to leave this witJh you i:f I can. I think
that to voters, the most dangerous thing about this is the fact that there
is goin~ to, be a backlash, a voter baddash, somewhere between 4 and 8
years down the track, if this goes on, as the way I see it.
The reason for that is this : Your property taxes, -under this, ate
rolled back to 1975-76 with a 2-percent incremental increase. But if the
property sells, then the assessor comes and ,assesses at the new true
cash value.
Statistics tell us nationally that homes sell for three times in 20
years. That means every 6-pius years, homes resell. They will then be
reassessed at true cash value.
.
Senator McGovern mentioned two-thirds of property taxes are paid
now by income-producing properties. So we have two-thirds here and
one-third for the homes.
As those homes sell-because Southern Pacific does not sell their
railroad and utilities don't sell their utilities, and apartment owners
don't too often sell their apa,rtments, so the present relationship of twothirds, one third within 6 to 8 years is going to be this way-homes ,are
going to be picking up two-thirds and income-producing properties
are down to about a third.
Now, we, in t!he States really only have one way to tap income from
business, and that is through the property tax. Oregon's oorpora.tion
excise tax is 7 percent. We cannot get more because the Feds have


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already preempted us with the 49 percent or 48 percent or whatever
the rate is now.
Representative FENWICK. Right.
Senator BoE. The States simply have to keep that corporate excise
tax down to a reasonable level for competitive reasons as well as others.
So the property tax is really the only way that we have a chance of
business supporting local public services.
Representative Fl!:NWICK. Right.
Senator BoE. vVhen homeowners begin to realize what has happened
in this shift, then, I am prepared to predict that there will be a voter
reaction that will make Jarvis-Gann look like a picnic and the brunt
of it is going to be felt by the business community.
They can wave their checks and say, "Look, we contributed against
Jarvis-Gann," like they did in the California Manufacturer's Association meeting, and the public will say, "To heck with that; we are
going to get you, now."
I think that is one of the greatest dangers that we have at this time,
and so far I have heard no answers to that from my colleagues here.
Representative FENWICK. I will tell you may answer but my time
has expired.
We are addicted to spending down here. That is the truth. Never
was an effort made to reduce the increase in the budget from 11 to 9
percent and it was turned down by the House of Representatives.
Just that alone explains what has happened to the deficit, to the
people's rage. They cannot seem to control it. We are addicted to
spending. It is work. We are all here and that is it.
Representative REuss. I must call the gentlelady's attention to the
four excellent display charts which show that our addiction, while considerable, is of a Quaalude nature compared with other levels of gov'0rnment. [Laughter.]
Representative FENWICK. Look at CETA and all, but look at the
revenues as a percentage of Government expenditures, the blue; look
at the Federal spending over there.
Rpresentative REuss. Senator Boe, thank you for giving us your
time. We are most grateful to you. Now, I think, under the rule, we
will start right out in the questioning after the next panel with Congressman Cavanaugh and Congressman McKinney, who have not yet
been heard from.
We would like to hear from the final panel. Professor Greytak,
would you lead off? Of course, the other witnesses will stay, if you
would, 'for further questions.

:STATEMENT OF DAVID GREYTAK, THE CENTER FOR METROPOLITAN PLANNING AND RESEARCH, THE J'OHNS HOPKINS UNIVERSITY, AND THE MAXWELL SCHOOL OF PUBLIC AFFAIRS, SYRACUSE UNIVERSITY, SYRACUSE, N.Y.
Mr. GREYTAK. Mr. Chairman and members of the committee.
I have a prepared statement which I would like to submit for the
record, but which I would like to partially summarize at this point.
Representative REuss. As with all statements, it will be received in
-full into the record.
37-250-79-13


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Mr. GREYTAK. Let me begin by noting that expenditures of State
and local governments prior to 1974 increased less than 10 percent
before 1974. They have increased at a rate in excess of 14 percent after
1974.
Over the previous decade, the per capita State and local government
expenditures increased by fully 250 percent, a sizable increase by any
measure.
Three types of explanations are given for this growth.
First there is the demand-side explanation. Here the argument goes
that a large population of growing incomes demand more public services and therefore larger levels of public expenditures.
The second is the cost-side explanation. Here the argument is simply
that the success of public employee bargaining and inflation have increased the costs of providing any level of public services.
The third argument is an "inefficiency" argument and states that
because of mismanagement and/or low productivity the public sector has become increasingly costly.
Actually it's likely that elements of all three of these explanations
have been operative. However, an understanding of the relative importance of these three are essential for they hold very different prospects for future growth in expenditures and therefore have different
implications for differing types of goals.
If mismanagement is at the root of the problem, then reorganization, new technology, and innovation can hold forth promise for expenditure control.
If the explanation lies in growing demand, then declining schoolage population and a decline in the dependent populations, which will
accompany economic recovery, hold some promise for future relief.
If cost pressures result principally in public emplovee unionization
and inflation, a continuation of both of these implies that there is
little, rP1ief in sight.
,vith regard to the demand-sidP argument, the data would seem to
indicate that growing service needs cannot account for much of the
growth in public State and local government expenditures.
In fact, although expenditures have grown at accelerated rates recently, population in general has not.
More to the point, the reins on employment growth at all levels of
government-at the State level and all levels of local government as
well-have been growing increasingly tight since 1973. This is particul~-r:ly t_h~ case for employment in education, and employment by
m1m1c1 paht1es.
In fact, municipal employment in 1976 stood at a level below that
of 1973. As a result of the wide differences in expenditures and employ~ent growt~ rates per capita. ~tate and local government expenditures have mcreased at 5 to 7 times the rate of per capita State and
local government employment in recent years.
The reading of the data implies that little of the growth in State
and local government can be attributed to increasing demands and
growing service levels.


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The situation is quite different in the case o:f the cost cycle. Although
State and local governments have been able to put the brakes on
employment, though the record is much different in employee compensation, average wage and salary compensation for State and local
employees has continually increased, but since 1972 it has increased at
rates somewhat greater than in the previous decade.
Fringe benefits and other supplemental expenditures per employee
also have increased at rapid rates-12 to 15 percent per year during
the last 5 years-and in 1976 the average fringe benefit cost per State
and local government employee stood at a level of about $1,850.
As high as this figure is, it is probably an understatement of the
true cost of wages-salary supplement. There are strong reasons to
believe that many of the State and local government pension funds
are underfunded, and full funding would inflate that figure even more.
Even if the full cost of pension programs were included, the true
cost of fringe packages still would be understated, for employees receive substantial benefits in the form of paid vacation, holidays, sick
leave and the like.
When the costs of these are included, the ratio of fringe benefits to
pay for hours worked jumps quite sharply.
For uniform services of local government, for example, the rate is
in the range of 46 to 47 percent. For other local government employees
the range is slightly lower but still at about 40 percent.
As high as these costs are, there are reasons to believe that they will
continue to increase.
I
As the full effects of the recent social security legislation and the
movement towatd fuller funding of State and local government pensions materialize, they will increase.
Inflation is another important factor and one mentioned by many.
Although it affects all sectors of the economy, its impact on State and
local governments is difficult to determine as none of the generally
available price indexes is appropriate for application in the public
sector.
Under the sponsorship of the National Science Foundation, the
metropolitan studies program of Syracuse University has developed
a set of indexes for State and local governments which measure inflation's impact on their expenditures and their tax bases.
These indexes clearly reveal the susceptibility of governments to
inflation. They indicate that, if State and local governments had
simply absorbed price increases of goods and services they purchased
from the private sector, while compensating employees in transfer
payments for only the increases in the cost of living, their expenditures would have increased by about 22 percent during the "5-year
period 1967 to 1972, a period of moderate price increases.
During the 2-year period of double-digit inflation, 1972-74, inflation
pressures on State and local government expenditures exceeded that
of the previous 5 years as a whole. That is, inflation may have increased
the cost of State and local governments by as much a.s 2i :percent in.
just 2 years.


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The decline in the rate of inflation after 1974 is refleoted in the lower
rate of oost increases for State and local governments, roughly 12 percent between 1974 and 1976.
An analysis based on these data reported in my prepared statement
indicates that fully two-thirds of the growth of local government expenditures between 1972 and 1976 can likely be attributed to inflation
alone.
Alternatively, only about 21 percent of local government expenditures can be attributed to the increase in the number of local government employees. Clearly local governments have had little room to increase the amounts of goods and services they purchase from the
private sector or increase the real income of their employees.
It is also possible to calculate the impact of inflation on tax bases
and, to be fair, this must be done. These calculations indicate that inflation has led to an increase in the nominal values of many tax bases.
Indeed, between 1974 and 1976, the purchasing power of the tax bases
of many local governments wa;s reestablished at 1972 levels.
Still, there remains the question of whether local governments were
able to capture the inflation-induced increases in the nominal values
of their tax bases. For some taxes, such as those on retail sales and incomes, changes in tax bases are immediately translated into revenues.
For others, particularly the property tax, these changes must be measured before they can be realized. In those jurisdictions where reassessments are prompt and accurate, the effects of inflation on property
tax revenues will be captured quite quickly. California is one State
where reassessments are regular and accurate.
The implication is that, for 7 years, inflation increased expenditures more than tax revenues. Then, between 1974 and 1976, a reversal
occurred. It does not take much of an imagination to envision the
plight of local officials. Conditioned by the experience of the previous
7 years, any budgetary slack which occurred after 1974 was a surprise.
Uncertainty as to the permanence of newly found sources of revenues
no doubt precluded the sharing with taxpayers what might be just a
one-time shot of relief from the pressures of inflation on public budgets. Such circumstances lead to tax burden increases unacoompanied
by service level expansion, and this obviously is the fuel for tax revolt.
The implication of this analysis, and I will summarize quite quickly,
is that increasing cost due primarily to inflation rather than growing
demands is largely responsible for the recent increases in State and
local government expenditures. This being the case, the inevitable
conclusion is that the fight against inflation must be the single most
important element in any program to restrain increases in State and
local government expenditures and tax burdens.
There are other possibilities for restraining growth in the expenditures and tax burdens of State and local governments.
In particular, care must be taken not to follow the oourse which
simply shifts the burdens of local government operations from local
taxpayers to State taxpayers with no reduction in combined State and
local government tax burdens. This may be a likely outcome of the
imposition of property tax limits, State assumption of the financial


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responsibility £or what had been local £unctions and increases in State
transfers to local governments.
As has been mentioned by earlier witnesses here, there are also
serious local control and equity issues related to the above-mentioned
and other policy alternatives. Many 0£ these are discussed: in my submitted statement. In the interest of time, I will not pursue them at
this point.
Thank you.
Representative REuss. Thank you, Mr. Greytak.
[The prepared statement of Mr. Greytak follows:]
PREPARED STATEMENT OF DAVID GREYTAK

The Increasing Costs of Local Governments: Underlying Causes and Policy
Considerations
INTRODUCTION

The development of serious policies for effective control of local government
expenditure growth requires not only a knowledge of the factors underlying
the growth in the cost of local government, but equally an understanding of the
consequences of the available policy options. These topics have been of increasing
concern to public policy analysts and researchers. Still, a consensus has yet to
be achieved as to the exact nature of the problem, let alone the appropriate policy
response. The purpose here is to examine in a general way, a number of the
factors related to the growth in the local public sector and to consider some of
the problems associated with some of the more popular policy alternatives. It
should be emphasized at the outset that the available evidence about the cost
and expenditures of local governments is sufficient to support only those conclusions which are of a general nature. More explicit statements would require
detailed analysis of local government fiscal documents. Given the limitations of
the general available information about the operations and costs of local governments, any conclusions, including those stated herein, must be considered as
tentative.
PART I

Growth in e(JJpenditures

Expenditures of state and local governments, both in total and those in support of current operations, have grown at a substantial pace during the last
decade (Table 1). The rate of growth in these expenditures, however, has been
higher in the 1973-76 period than in the previous five years, 1967-1972. The increase in the rates of expenditure growth is quite sharp, as both total expenditures and current operating expenditures have grown at annual rates in excesl!I
of fourteen percent since 1974, while prior to that date their growth rate was
generally less than ten percent. This rapid growth in expenditures, in combination with fairly slow growth in population, has resulted in an increase in per
capita expenditures from $539 in 1967 to $1422 in 1976, an increase in excess of
250 percent. As was the case with total expenditures, the annual average rates
of increase in per capita expenditures indicate that their growth has accelerated
during recent years.
A number of possible explanations of the growth in expenditures exist. On.
the one hand, it may be argued that expenditure increases are largely due to
expansion of service levels; that, as total population, the number of school-aged
children, and the number of dependent poor increase. the need for public sector
activity also grows. Alternatively, there is the cost side argument. Simply stated,
the success of public employee unions, coupled with inflation, has driven up the
cost of providing any given level of service. Finally, there is the efficiency argument; that, because of mismanagement and low productivity, the bureaucracy has become increasingly costly.
·
Most likely, some combination of the elements of all three explanations has
been operative. However, some idea of the relative importance of the three is
essential, for they hold very different proB{>ects for future growth in expenditures.


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TMLE 1.-GROWTH IN STATE AND LOCAL GOVERNMENT EXPENDITURES AND GROWTH IN PER CAPITA STATE
AND LOCAL GOVERNMENT EXPENDITURES, SELECTED YEARS, 1967-76
[Dollar amounts in millions)
General
Total
State and local government direct expenditures:
1967 --- _-- -- _----- __ -- -- -- --- --- -- -- -- _------- _
1972 ____ ----- _-- _______ --- -- -- _---- _-- ---- _-- -1973 ____ -- -- -- --- -- -- ___ -- -- -- _-- _-- __ -- -- -- _-1974 ______ -- --- ___ -- -- -- ______ -- -- -- -- __ -- -- -- _
1975 ___ -- --- -- __ -- -- ________ -- -- _-- _-- -- ___ -- __
1976 ____ ----- __ -- _-- -- -- _-- ___ -- -- -- -- -- ---- _--

72

Per capita

Current
opera/~i~I

Employees
per 10,000
population

$106,675
188,825
205, 195
226,032
266, 483
305,268

$539. 14
906. 80
977. 81
I, 069. 27
I, 250. 38
I, 422. 11

$68,248
125,630
138,974
154,810
180,976
204,976

378
444
456
466
478
475

10. 0
8. 7
10.1
17. 9
14. 6

9.1
7. 8
9.1
16. 9
13. 7

10. 17
10. 5
II. 6
16. 5
12. 9

2. 7
2. 7
2.2
2.5
-.01

==============

A'verf~il ual growth rates (percent): _______________ _

1972-73 _____ ---- -- --- ___ -- -- ___ ----- -- _--- -- --1973-74 ______ --- -- ______ -- _--- -- -- ------ -- ___ -1974-75 _____ -- -- --- _____ -- -- -- ----- --- -- ----- -1975-76 _____ -- -- ---- -- -- -- -- -- __ ---------- -- -- _

Source: U.S. Bureau of the Census, Governmental Finances, Selected years, 1967-76, U.S. Government Printing Office,
Washington, D.C.; and U.S. Bureau of the Census, Public Employment in 1976, series GE 76 No. I, U.S. Government Printing
Office, Washington, D.C., 1977.

If the problem is one of mismanagement, then reorganization and/or the
adoption of new technology and innovation procedures would imply the possibility
of expenditure control. If growing service explanations are appropriate, then
the anticipated decline in school-age population and any decline in the size
of the dependent population which accompanies growth in the economy should
provide some relief. Alternatively, if cost pressures are the principal cause of
growth,J;he the outlook is for continued expenditure growth.
Demand considerations

An obvious question to be posed when confronted with such rapid growth
in expenditures is whether it has been a response to increased service needs. As
is well known, the search for the answer to such a question is a maze of pitfalls,
arising out of the difficulties and complications associated with the measurement of public output and service levels.1 However, the extent to which service
level increases have accompanied expenditure growth can be evaluated in ways
that are rough and crude, but which can be taken as indicative.•
Despite the fact that the pace of growth in state and local government expenditures has stepped up during the last few years, rates of public employment growth have continually declined during this decade (Table 2). Since
1973, the reins appear to have been drawn increasingly tight on educational
employment by all levels of government, and on total employment by municipalities. In fact, employment growth has all but ceased since 1973. The case is even
more extreme for municipalities. In this case, employment reductions in 1976
offset the growth of the two previous years and, in 1976, the municipal full-time
equivalent employment level was below that of 1973.
1 These problems have been discussed in the context of case study evaluation of local government productivity and performance in David Greytak, Donald Phares, and Elaine Morley,
"Municipal Output and Performance In New York City" (Lexington Books, 1975).
2 For a detailed case study account of the relation between expenditure, service levels, and
productivity, see Jesse Burkhead and John P. Ross, "Productivity in the Local Government
Sector" (Lexington: D. C. Heath and Company, 1974).


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TABLE 2.-EMPLOYMENT (FULL TIME EQUIVALENT) OF STATE AND LOCAL GOVERNMENT, 1962-76
[In thousands!
Local Municipalities

Education

1962................................
5,958
1,478
4,480
I, 486
2,029
1972.................................
9,237
2,487
6, 750
2, 109
7,031
1973...• ••·•··•· ...•..•. _........• ·-9, 578
2, 547
7, 199
2,127
1974...• ···- .......•. ·-· ••••..•.•. ··9, 852
2, 653
2, 142
7,354
1975.................................
10,098
2,744
2, 107
7,407
1976......••..........•.••.••.•..•.••===l=O~,2=06===~2,=79=9=========
Average annual growth rates (percent):
4.2
3.2
1962-72..•••••.....•.... -· ......•
4. 5
5. 3
4.2
1972-73...•..•.....•.......... ··3. 7
2.4
3. 9
2.4
2. 9
4. 2
.9
1973-74...•..••.. ··•·•·· .. ·- ....•
.7
1974-75 ..•••.•....•.....•...... -·
2. 2
2.5
3.4
.7
-1.7
2.0
1975-76...••. ···--· .........••.•.
I.I

2,730
4,585
4,751
4,901
4,952
5,003

State and local

State

9.1
3.6
3. 2
.1
.1

Source: U.S. Bureau of the Census, Public Employment in 1976, table 2.

It could be argued that the decline in municipal employment reflects just
the substantial employment rollback which has occurred in New York City.
However, the record for large cities shows that employment reductions have
occurred in a number of cities during recent years. In 1976, half of the twenty
largest cities reportedly cut back the number of employees on their payrolls.•
The case is similar with state and local government employment. .Although state
and local government employment has continually increased, the rate of growth
in per capita employment has been at a much lower rate, in the neighborhood
of two to three percent, than that in expenditures. In fact, per capita employment declined in 1976 despite the increase in expenditures. In addition, expenditures for current operations have increased more slowly than total expenditures
since 1974. whereas in previous years the reverse was the case. The implication
is that state and local government expenditures for labor and other services
directly related to the provision of public services account for a smaller share
of total expenditures than had been the case in the recent past. To the extent
that service levels are closely related to employment and expenditures for current operations, these differences in rates of increase can be taken as an indication that factors other than expansion of current service levels account for an
increasing share of the growth in state and local government expenditures.•
Whether this trend can be related to the growing importance of state governments, whose share of total state and local expenditures increased from 37.2
percent in 1967 to 40.8 percent in 1976, is an interesting, but at this point unanswerable, question.
Of course, it could be that, because of increased productivity, public sector
employment growth understates the increase in service levels. However, it is
doubtful that the technology and efficiency of governmental operations have
changed sufficiently to allow a service level increase commensurate with growth
in per capita expenditures. Given the contrast between the patterns of growth
• Roy Bahl et al., "The Outlook for City Fiscal Performance in Declining Regions" (Syracuse, N.Y.: Metropolitan Studies Program, Syracuse University, April 5, 1978).
• Other than current operation expenditures, total direct expenditures includes capital out•
lays, interest on debt, insurance benefits and repayments, and assistance and subsidies. Of
these, changes in the latter are likely to be closely related to changes in service levels, 1.e.,
welfare payments. However, the share of State and local direct expenditures which assist•
ance and subsidies accounts for has declined since 1971.


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in state and local government expenditures and employment, the association
between increasing expenditures and employment additions seems weak at best.
Moreover, the implication that government expenditures and costs of operation
have increased more rapidly than levels of service seems inescapable.• As will
be discussed later, state and local government employment additions themselves
can be held accountable for a relatively small part of expenditure growth.
Cost considerations
Although state and local governments apparently have been able to put the
brake on employment growth, the record is much different when it comes to
employee compensation. Indeed, the average wage rates of state and local government employees have increased regularly since 1967 (Table 3). However, since
1972, they have increased at rates which exceed the rate for the previous ten
years. This would seem to lend credibility to the many accusations about excessive pay rates for state and local government employees. In fact, state and local
government wage rates have been above the average industry level for some time.
However, since 1973, the difference has been continually eroded as private sector
wage rates increased at a greater rate than those in the state and local government sector. Alternately, the gap between federal civilian and state and local
government wage rates has narrowed since 1972. Thus, while the case for excessive state and local government pay rate increases is questioned by comparison
with private sector pay rates, it garners strength in a comparison with federal
civilian pay rate increases.
TABLE 3.-AVERAGE ANNUAL WAGES AND SALARIES PER FULL TIME EQUIVALENT EMPLOYEE BY"
INll'UStRY, 1972-76 1

1962_•••.. _.•. _. _•• _. _••••••••• _. _•..•••. _.....• -· .•...•.•.•.... _
1972 ..• ·---·· .••••. ··-·· ...•.•...•...•.•........................•
1973... •····-············-·····-·································
1974..••....•.•.•••. ·-········-· ·•··•• .•... _...•. ··-···· ·- ·-· ···1975..•• ·------·--- .••.••.•••.•..•.. ·-·-···· .....•...•••.• ·-····.
1976....•• --- • _.•. -- •••.•••.•• -- •.• _.• _•.• -- . _. _••..••• ·--. _-- ·-.

Private
industry

Federal
civilian

State and
local
government

$5,082
8,590
9,106
9,832
10,690
II, 486

$6, 239
12,679
13, 497
14, 112
15, 195
16, 201

$5,017
8, 9\6
9,505
10,063'
10,862
11, 572·

5. 4
6. 0

7. 4
6. 5
4. 6
7. 7
6.6

5.9
6.6
5. 9
7.9'
6.5

Avera~e annual growth rates (percent):

1962-72... - .•. _•• _...• _•••.••.. _•••• _. _.••.•.•• _. _.••• ·- •••.•
1972-73.•• - ...•. ·- ••.• _...•• _•••.•.•.•.... ·- •.•••• _•...••....
1973-7 4... - •• _·- •. _•• _. _•• _•....••.•...•..•• _.•.••• -· .. _•.•. _
197 4-75 ... _... _. ·- •. _·-- .• ·- _..••••• -- •.• _.•.•.•..•. ·-....•.•
1975-76... - •••.•••••..•.•. ·- ..• _••.......• _•• - .•...•. _.•••.•.

8.0
8. 7
7.4

Calendar years.
Source: U.S. Department of Commerce, Office of Business Economics, The National Income and Product
Accounts ol the United States, 1929-1965, tables 6.2 and 6.4.
t

Wages and salaries are not the only components of employee compensation..
Indeed, they are not even the fastest growing component. Fringe benefits and"
supplements such as pensions, health and hospital insurance, and social security coverage add considerably to employee costs (Table 4). Since 1971, thesecosts have grown quite rapidly in the private and federal civilian sectors (about
66 and 87 percent, respectively), as well as in the state and the local government
sector ( 66 percent). Although wage and salary supplements in the federal
sector have been and continue to be quite large, the advantage of private over·
state and local government employees has declined slightly since 1972. Still,
in 1976, the cost of supplements averaged about $1848 per employee in the
state and local government sector. This is a significant amount, i.e., about 16·
percent of average earndngs.
The fact that pensions and fringe qenefits have been growing more rapidly
than total payroll outlays implies that governments have been more willing toprovide increases in supplement and fringe packages than they have been
• Slmllar conclusions have been drawn from case studies of city and State governments.
See Roy W. Bahl, "The Long Term Fiscal Outlook for New York State" (Syracuse, N.Y. ~
Metropolitan Studies Program, Syracuse University, mlmeo,. n.d.) ; and David Greytak,
"Status and Prospects for Maryland's Public and Private Sectors" (Baltimore, Md.: Centeifor Metropolitan Planning and Research, the Johns Hopkins University, occasional papei-.
February 1978).


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to grant wage and salary increases. Or it could be that employees have bargained more actively for fringe benefits than for wage and salary !increments.
Whichever the case may be, the data are consistent with the hypothesis that,
rather than grant highly visible and immediately payable wage increments,
state and local governments have provided compensation increases which have
low public visibility and whose full cost may not appear on the public ledger
for some time.
TABLE 4.-AVERAGE ANNUAL SUPPLEMENTS TO WAGES AND SALARIES PER FULL TIME EQUIVALENT EMPLOYEE
BY INDUSTRY, 1962-761
Private
industry

Federal State and local
industry
government

$482
1, 150
1,331
1,485
1, 706
1,904

$1, 4 7
l, 689
2,006
2,442
2,809

9.1
15. 7
11.6
14. 9
11.6

12. 8
18. 8
21.7
15. 0

~)

(')

$431
1,110
l, 248
1,437
l, 619
1,848
9.9
12. 4
15. l
12.1
14. l

1 Calendar years.
Data are not available.

2

Source: U.S. Department of Commerce, Office of Business Economics, the National Income and Product Accounts of
the United States, 1929--65, tables 6.4 and 6.7.

Moreover, there is serious question as to whether levels of pension expenditures reflect the true cost of these programs. Indeed, the pension systems to
which a number of state and local government employees belong are funded
on a pay-as-you-go basis.• A more appropriate means of financing pension plans
is through full funding. In this case, the employer sets aside funds which, when
invested, are sufficient to cover the claim on future benefits that employees
accumulate during their working lives. Indeed. most pension plans in the public
sector claim to be of the fully funded rather than of the pay-as-you-go variety.
Still, there are strong reasons to believe that even these are under funded. 7 If
indeed this is the case, state and local expenditures have not increased sufficiently to cover their full obligations. Moreover, those governments which have
underfunded pension plans wiil, at some later date, be faced with sharply increased employee pension costs, even with no increases in employment, pay
rates, or benefit packages.
Be that as it may, even if the cost of fully funded pension plans were to be
included in the figure of supplements, the true cost of fringe benefits would
be understated. In all sectors of the economy, employees receive substantial
fringe benefits in the form of paid vacations, holidays, sick leave, and the like.
When the cost of these is added to that of wage and salary supplements, fringe
henefit cost relative to pay for actual hours worked jumps dramatically (Table
5). The ratio of fringe cost to pay for hours worked is particularly high for
police, 46.8 percent, and fire, 47.2 percent. The ratio for sanitation, 43.3 percent,
is a good bit lower, but still 10 percent above that for other general municipal
employees, 39.37 percent, which aligns closely with the private sectors of the
economy.
Whether there is an appropriate relation between the full cost of fringe and
supplements and pay for hours worked is not at issue here, nor is the question of
whether these costs should be equated within the public sector or between the
•For example, Pittsburgh, Seattle, Indianapolis, and Washington, D.C., are among the
major cities which use pay-as-you-go financing.
"Labor-Maagement Relations Service of the National Leagne of Cities. U.S. Conference
of Mayors, National Association of Counties. "First National Survey of Employee Benefits
for Full Time Personnel of U.S. Municipalities," Special Report: A Spotlight on City
Emnloyee Benefits (Washing-ton, D.C. : Labor Management Relations Service. n.d.) : Thomas
P. Bleakney, "Retirement SYistems for Public Emplovees" (Homewood, Ill. : Richard D.
Irwin, Inc., 1972) : and Advisory Commission on intergovernmental Relntlons, "City
Financial Emergencies: The Intergovernmental Dimension" (Washington, D.C.: U.S. Gov•
ernment Printing Ofllce, 1978).


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public and private sectors. Rather, for present purposes, the point is that
fringes and supplements account for a substantial share of government expenditures. Moreover, that share appears to be increasing even faster than average
salaries.
The social security element of the fringe package is deserving of special note.
Currently, about 70 percent of state and local government employees work for
jurisdictions which participate in social security. As a result of recent legislation, the social security tax rate and the level of earnings subject to the tax are
being increased in a stepwise fashion over a number of years. There can be
no doubt that this will increase the employee compensation costs of state and
local governments.
TABLE 5.-ANNUAL PAY FOR HOURS WORKED AND EMPLOYER COST FOR FRINGE BENEFITS, EMPLOYEES
OF SELECTED MUNICIPALITIES AND ALL PRIVATE INDUSTRY, 1973 AND 1975

Annual pay for hours worked
Amount

Police •••.••• ___ •••••••••••
Fire __ •••• ____ •••• _••• _••••
Sanitation ______ •••••• _. __ ••
Other general municipal
employees _______ ••••••••
All private industry __________
All manufacturing industry ___
All nonmanufacturing industry_ ••.••••••••••••••••••

Employer cost of fringe benefits

Fringe benefit cost
as a percentage of
pay for hours
worked

1975

Percentage
change,
1973-75

1973

1975

1973

1975

Percentage
chanre,
1973-75

Amount

$9, 170
8,973
6,868

$10,699
10,194
8, £32

16. 7
13. 6
19. 9

$3,878
3,969
2, 737

$5,002
4,812
3,567

29.0
30. 2
30. 3

42. 3
41. 2
39. 9

46. 8
47. 2
43. 3

7,409
8,167
8,092

8, 182
9,318
9, 126

10. 4
14. 1
12. 8

2, 730
3,007
2,907

3,215
3, 713
3,651

17. 8
23. 5
25.6

36. 8
36. 8
35. 9

39. 3
39. 8
40.0

8,238

9,571

16. 2

3, 151

3,799

20. 6

38.2

39. 7

1973

Source: Edward H. Friend and Albert Pike, Ill, 1975 National Survey of Employee Benefits for Full-Time Personnel of
U.S. Municipalities, Washington, D.C.: Labor Management Relations Service of the National League of Cities, 1977, pp.
48 and 49.

lnfiation

Although widely recognized as a factor underlying cost increases in all sectors
of the economy, the impact of inflation on state and local governments is difficult
to calculate from generally available price indexes. Under the sponsorship of the
National Science Foundation, the Metropolitan Studies Program at the Maxwell
School of Syracuse University has developed a set of inflation indexes which
measures inflation's impact on both expenditures and revenues.• These indexes
have been calculated for the periods 1967-72, 1972-74, and 1974-76 (Table 67).
Examination of these indexes reveals the susceptibility of government eX'I)enditures to inflationary pressure. For example, during the 1967-72 period, the
rates of price increases were relatively modest, but sufficient to increase the costs
of the goods and services purchased by state and local governments by slightly
more than five percent per year, or roughly by 22 to 23 percent over the five-year
period. During the 1972-74 period, inflation hit the double digit level, and
resulted in a two-year increase in prices paid by state and local governments of
25 percent. The decline in the rate of inflation between 1974 and 1976 is reflected
by a lower rate of increase in the prices paid by government. Still, over the twoyear period, the indexes indicate that inflation boosted prices paid by governments by 12 percent.
Over the whole ten-year span, the prices of the goods and services purchased
by local governments increased by a full seventy-five percent. That is to say
that, if state and local governments did no more than absorb price and cost of
living increases while holding service levels constant, the cost of the services
provided in 1967 would be seventy-five percent greater in 1976. Note, however,
the major part of these cost increases has occurred in the post-1972 period.
8 David Greytak and Bernard J'ump, "Inflation and local Government Expenditures and
Revenues: Method and Case ·Studies," "Public Finance Quarterly 5," No. 8 (J'uly 1977) ;
and "The E1fects of Inflation on State and Local Government Finances, 1976-1974." (Syra~"""· N.Y.: Metropolitan Studies Program, Syracuse University, Occasional Paper No. 25,
1975).


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TABLE 6.-INFLATION INDEXES FOR STATE AND LOCAL GOVERNMENT REVENUES, EXPENDITURES BY TYPE OF
GOVERNMENT, SELECTED PERIODS, 1967-72
Expenditure indexes

Revenue indexes

1967-72

1972-74

1974-76

1967-72

1972-74

1974-76

122. 6
122. 7
122. 9
122.1
123. 7
121. 8
123. 0

125. 4
125. 4
125. 4
125. 6
125. 0
125. 7
125. 2

112. 2
112.0
112. 1
li2. 6
110. 7
113. 4
112. 0

115.2
127. 7
123. 7
130.0
132. 2
114. 8
112.2

116. 6
116.7
115. 4
114.8
119.2
113. 3
116.9

110.0
114. 2
113.3
113. 9
116. 4
109.6
110. 9

States. ____________________________
Counties. __________________________
Municipalities. _____________________
Townships _________________________
School districts _____________________
Special districts _____________________
All State and locaL _________________

Source: Inflation indexes computed using methods and datl sources noted in David Greytak and Bernard Jump, "The
Effects of Inflation on State and Local Government Finances, 1967-1974," Syracuse, N.Y.: Metropoliten Studies Program,
Syracuse University, 1975); and Roy Bahl et al., "The Outlook for City Fiscal Performance," Syracuse, N.Y.: Metropolitan
Studies Program, Syracuse University, 1978.
TABLE 7.-SELECTED DATA RELATED TO THE GROWTH IN STATE AND LOCAL GOVERNMENT EXPENDITURES BY
SOURCE, 1972-76
State
Total expenditure growth (millions) 1 _______________________________ _
Growth index ____________________________________________________ _
Inflation index ___________________________________________________ _
Percent of expenditure growth due to inflation _______________________ _
Percent of expenditure growth due to employment increase. __________ _
1

$28,385
152. 30
140. 80
42. 81
15. 89

Local State and local
$50,379
150. 57
139. 87
67. 94
21. 23

$78,757
151. 05
140. 18
64.09
19. 30

Excludes intergovernmental expenditures.

Source: See table 6.

As indicated in Table 7, over the period 1972-76, the prices of goods and
i;:ervices purchased by state and local governments increased by roughly forty
percent. That is to say that, if state and local governments had done no more
than absorb the price increases on the goods and services they purchase from
the private sector, while maintaining the real value of the compensation paid
to their employees and transfer recipients, their cost would have increased by
about forty percent between 1972 and 1976. However, the earlier discussion
implies that state and local governments did not hold employment and real wage
rates constanlt. Still, the data in Table 7 indicate that only a relatively small
proportion of state, 15.9 percent, and local, 21.2 percent, expenditure increases
can be attributed to additions to their work force. Alternatively, a large proportion of expenditure increases, fully two-1thirds for local governments and 43
percent for state governments, can be attributed to inflation." There can be
little doubt that inflation has been a major factor underlying the increasing
cos:t of state and, more particularly, local governments.10
Inflation is also important on the revenue side of the government ledger, for
inflation affeds the monetary values of propery, retail sales, and personal and
corporate income as well as other components of the state and local tax base.
However, none of the generally available price indexes provides an appropriate
measure of 'the extent to which price increases have affected tax bases and tax
revenues. Inflation indexes for state and local government revenue systems have
been developed and implemented as part of the project mentioned earlier
(Table 6).
An examination of these indexes indicates a number of interesting findings.
First, there is a good deal of variability in the extenJt to which inflation impacts
• The share of expenditure incl'.eases not associated with inflation or employment growth
can be attributed to increased purchases of goods and services from the private market,
increases in the real value of employee and transfer recipient compensation, and increased
numbers of transfer recipients.
10 In an earlier analysis of the 19,67-72 period, these proportions were reversed; I.e.,
employment accounted for the major share of expenditure growth, while only about twent:,
percent of cost increases could be attributed to inflation. See Greytak and Jump, "The Ell:ects
of Inflation on State and Local Gove:rnment Finances • • •," op. cit.


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on the revenue systems of various types of governments. For example, infl.ation
appears to have a greater revenue potential for counties and school districts, while
state systems appear Ito be somewhat less responsive. Second, during the 1972-74
period of double digit rates of price increases, inflation had a greater effect
on expenditures than on revenues, although in the period 1974-76, the dampening of inflation did allow inflation induced increases in revenues to nearly match
inflation generated expenditure increases.
Perhaps a more illustrative way to depict this effect is to consider the effect
of inflation on the purchasing power of government tax bases (Table 8). This
analysis clearly identifies the strain which has been placed on local governments by inflation. The purchasing power of state and local tax bases fell by
about 8.5 percent between 1967 and 1972, and by another 7.6 percent between
1972 and 1976. Given this erosion in tax bases, lf:here can be little doubt that
inflation has been a major source of fiscal strain to state and local governments.
However, during the period 1972-74, when price increases were at double digit
rates, inflation reduced the purchasing power of state and local government
tax bases to 93.3 percent of itheir 1972 level. Between 1974 and 1976, inflationary
pressures declined such that purchasing power of the combined state and local
tax base was eroded only slightly, i.e., by one percent. However, it must be
noted that, between 1974 and 1976, when inflation really hit the land and housing markets, those governments heavily dependent on property taxes (municipalities, townships, and school districts) experienced an increase in the purchasing power of their tax bases. For no level of government was this incre!lse
sufficient to offset the purchasing power loss tbey had experienced since 1967.
However, between 1974 and 1976, inflation so enhanced the tax bases of school
districts that, by 1976, the purchasing power of their tax bases had been
re-established at 1972 levels. No other level of government has been so fortunate.
What these data portray is the susceptibility of state and local governments
to inflation. Moreover, !they imply that inflation impacts on governments depend
critically on the structure of their tax system and the pattern of price increases.
For surely, if property values had not so greatly inflated between 1974 and 1976.
property tax dependent governmen'ts (municipalities, towmihips, and school di~triets) would not have experienced the increases in tax base purchasing power
they did.
TABLE 8.-PURCHASING POWER INDEXES FOR STATE AND LOCAL GOVERNMENT
REVENUE BASES, SELECTED PERIODS, 1967-761

States ____________________________________________ _
~ouun~~ii~~lities_ •• __________________________________ _
Townships ________________________________________ _
School districts
-------------------------·- ______ __
Special
districts...
____________________________________
All State and local._ ... ____________________________ _

1967-72

1972-74

1974--76

1972-76

90. 59
92. 43
91. 39
92. 51
94. 32
89. 89
91. 54

92. 98
93. 06
92. 03
91. 40
95. 36
90. 14
93. 30

98. 04
98. 04
101. 03

91.12
94. 88
92. 96
92. 37
100. 00
87.16
92. 44

101. 11

105. 15
96. 64
99. 00

• Excludes intergovernmental aid.
Source: See table 6.

There remains the question of whether these governments were able to realize
the increase in tax base purchasing power which occurred between 1974 and
1976. Realization of the changes in tax base purchasing power requires a tax
structure capable of capturing as revenues inflation-indueed increases in the
nominal values of tax bases, while maintaining compensation constant in rPal
terms.11 Realization of tax base expansion, whether due to inflation or not,
essentially is automatic in the case of those taxes whose bases are defined in·
nominal terms, e.g., retail sales, personal income, and corporate income. Alternately, realization of the revenue potential of tax base expansion of those taxes whose
bases must be measured is not automatic. The property tax is most representative of this type of tax. Reassessment lags are common, and sug.gest that the
indexes and the analysis based on them would overstate effects of inflation on
:11 For e.n expanded discussion of these considerations, see De.vl.d Gre:vte.k and Berne.rd'
Jump, "The Impact of lnfle.tlon on the Expenditures and Revenues of Six Local Governments, 1971-1979" (Syracuse, N.Y.: Metropolitan Studies Program, Sy~e.cuse University,_
Occasional Paper, December 1971!).


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tax revenues. However, in those jurisdictions where reassessments are frequent, base changes are quickly translated into revenues if tax rates do not
decrease. One state in which prompt and accurate reassessment is the rule is
California. This being the case, the analysis here suggests that the actual purchasing power of the local government, although declining between 1972 and
1974, increased markedly between 1974 and 1976.
The implication, of course, is that, for a period of at least seven years
(1967-74), the pressure of inflation for expenditure increases exceeded that
on the expansion of nominal tax bases. Then suddenly, between 1974 and
1976, a reversal occurred and the inflation-induced expansion in nominal tax
base and, because of timely and accurate tax reassessment, tax renvues was
greater than that for expenditures. In such a situation, it does not take much
imagination to envision the plight of public officials. Conditioned by the experience of the past seven years, the budgetary slack produced by inflation
between 1974 and 1976 was a surprise, and, no doubt, a welcome one. However,
uncertainty as to the permanence of the newly emergent source of revenue
growth most likely precluded either the adaption of new expenditure commitments via tax cuts, or the sharing of what might be a one-time shot of relief
from the longer term pressures of inflation on public budgets. Such circumstances
lead to tax burden increases unaccompanied by service level expansion, and
they are fuel for tax revolt.
PART II

PubUc policy

There are at least three objectives which should guide public policy directed
toward the control of local government cost increases. The first is the equity
objective, i.e., to improve or at least not reduce the absolute or relative real
income and living circumstances of the poor and disadvantaged. Proposals to
cut local government service levels under this objective require close scrutiny
and evaluation, for reductions in the major local government programs (police,
fire, sanitation, and education) are likely to fall particularly on the poor and
disadvantaged.
A second, or efficiency, objective of public policies should be to improve the
management capabilities of local governments. Here, federal and state programs
of technical assistance, improvements in financial management, programs of
longer term facilities and fiscal planning, better coordination among governments, coordination of state and federal grant programs, and improved reporting and monitoring of all programs are all part of reforms that might improve
the management capabilities of local governments.
A third objective should be the maintenance of local control over local expenditure decisions. This extends beyond the simple one man, one vote notion of local
government. Rather, it refers to the ability of locally elected officials, first, to
perceive the expenditure needs and preferences of their citizenry and then to
move toward the satisfaction of them without undue interference from higher
levels of government. In part, this requires that local officials be informed of
and responsive to the desires of their constituents and the circumstances surrounding their lives. It also dictates a careful evaluation of federal and state
mandated programs, as well as aid programs which are designed to promote
priorities set above the local level.
In fact, the equity objective is the one which should dominate in the consideration of policy options. If the concept of expenditure control is to have substance,
it argues for a realignment of expenditures consistent with the needs of local
governments' clientele. In a real sense, it means excessive and unessential service
must be cut back and the cost of increases of the necessary activities of local
governments restrained. Since such a large part of the services and programs
provided by local governments, especially education and police and fire protection, is of greater importance to the poor than to the rich, and since access
to private market alternatives is greater among the non-poor, expenditure control
means achieving the equity objective with a smaller share of local income.
The substance of the management and productivity objective is efficiency in
the use of public resources to achieve public ends. In this sense, it is an objective
which is subservient to the others. However, administrative and management
reorganization have the appealing characteristic of being relatively inexpensive,
although their success is difficult to evaluate.


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Polioy options and problems

If tlle pattern of past behavior of those governments which have attempted!
to reduce costs is indicative of what the future holds, then reductions in local
government employment levels can be anticipated. Reduction in public employment levels, however, unless accompanied by major increases in employee·
productivity, will lead to reductions in the quantity or quality of public services.
This alternative raises serious equity questions, since the economically disadvantaged are among the major beneficiaries of the local public services, particularly in central cities.
:Moreover, this alternative must confront the resistance of public employee
organizations to reductions in their numbers. While the fact that some cities and.
their unions apparently have been able to negotiate employment reductions, thepotential for really major deductions is limited, for major service reductions
are likely to accelerate the decline of at least some cities by aggravating their
fiscal problems.
Alternatively, non-labor expenditures may be cut with little or no immediately
perceptible impact on the quality of public services. In particular, capital ex-penditures for the maintenance and repair of public capital may be curtailed.
The efficacy of such a move is indeed questionable for such a policy does not
eliminate expenditures in a real sense, but rather simply defers them to a later
date. Moreover, the deterioration of public facilities such as streets, bridges,.
schools, sanitation facilities, and the like may lead to outmovement of business
and industry, as well as upper income populations. This, too, may result in complicating rather than relieving city fiscal problems, although this may not occur
immediately.
Another often advocated alternative for reducing the scope of local government
is that of shifting responsibility to higher levels of government. This is most
often 1-mggested in regard to courts, some aspects of education, finance, welfare,
and health and hospital programs, as well as some administrative operations,
e.g., property assessment. 'l'his alternative must confront a set of equity questions
which are not always recognized. For, if states are to adopt the financial responsihilities for programs currently funded out of local revenues, then states will
either have to cut back expenditures on other programs or raise additional taxes.
State adoption of locl_!l programs, if financed by reducing expenditures on programs of primary benefits to the economically disadvantaged, are unpalatable on
equity grounds. Alternatively, state assumptions financed by new state revenues
may have adverse income distribution consequences. For example, if the state
relies on sales taxes rather than on progressive income taxes, the aggregate tax
burden on the poor will likely increase.'"
Additional intergovernmental aid is often recommended as a means of reducing the local expenditure requirements associated with the services and
activities of local governments. If intergovernmental aid money is fully substituted for local money, the serious issue is the same as that confronting state
assumption of programs, i.e., the implications for the tax burdens of the poor.
On these grounds, federal aid would seem_ preferable to state aid because of the
greater progressivity of its tax system. Perhaps the more serious issuP, which
strikes at the heart of the argument for intergovernmental aid, has to do with the
question of whethPr such aid 8Ubstitutes for or ~timnlates 1lw Pxpenditures of
recipients. Although this question has bPen subjected to a great deal of research,
a definitive answer has not been produced as yet. However, in collaboration with
the Advisory Commission on Intergovernmental Relations, the Metropolitan
Studies Program of the Maxwell School has recently completed a review of the
evidence and rm analy,ds of the snh~titntion-stimulatioTJ (Jne~tion of a wiilP variety
of state and federal aid programs.'• Their findings, while not lending themselves
to a single unqualifiPd evaluation, strongly indicate that aid has generated increased local expenditures rather than reducing them. Whether the current
dis;;atisfaction with the operation of the loeal puhlic se<'tor wonlrl be sufficient
to make local officials see additional aid monies as a means of dollar for dollar
12 Roy W. Bahl and Walter Vogt, "State and Regional Government Financing of Urban
Pnbllc Services." in A. K. Campbell and R. Bahl (eds.), "State and Local Government·
The Political Economy of Reform" (New York: The J;'ree Press, 1976), pp. 96-126.
·
13 Adwsory Commission on Intergovernmental Relations, "Federal Grants: Their Eft'eets
on St11;te-L-Ocal Expe~dltnres, Employment Levels. Wage Rates," A-61 (Washington, D.C. :
U.S. Government Prmting Office, 1977) ; and "The States and Intergovernmental Aids•
A-59 (Washington, D.C.: U.S. Government Printing Office, February, 1977).
'


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tax reductions rather than providing the budgetary slack for additional expenditures is a question which cannot now be answered.
l<'inally, with regard to intergovernmental aid, there is the issue of whether
programmatic aid leads to the provision of the types of service which are most
desired by the constituents of local governments. lf one takes the statements of
the officials whose responsibility it is to implement state and federal aid programs
at the local level as indicative of popular sentiment, then the efficacy of current
aid programs is que:stionable. Generally, local officials are close to unanimous
in the opinion that expenditure restrictions associated with aid programs mitigate
their ability to provide the types and levels of service in conformity with local
preferences and priorities.1' Thus, many aid programs are in conflict with the
oojectives of local control.
To many, however, this may not constitute a legitimate issue, for many aid
programs have as their purpose the provision of services which, if left to local
dh,cretion, would not be provided; or, if provided, would be at level:,; not consistent with the preference of the broader society. While there can be little doubt
that reduction or elimination of many of the expenditure restrictions associated
with aid programs would accommodate the objectives of local control, there
remains the question of their consistency with other objectives. As to efficiency,
one would guess that restrictions and their monitoring generate a good deal of
accounting and paperwork. If relieved of these encumbrances, some reduction in
the costs of local government management could occur. However, it is unlikely
that such savings would be sizable.
State and federal dictates as to types and levels of local expenditures extend
far beyond aid programs. Mandates necessitating local expenditures are common,
and extend from state safety specifications dictating the number and position
of traffic lights to conventions governing property tax collections."'
These, too, may be deemed necessary and appropriate for social achievement,
with benefits to broader society. As there is little known about the actual cost
implications of such mandates, little can be said about the magnitude of local
expenditure reductions which could be associated with the elimination of or
compensation for state or federal mandated expenditures. ·what can be said,
however, is that full reimbur:sement of the cost of local activities which are the
results of state and federal mandates would relieve local governments of the
associated financial burdens. It is difficult to identify the amounts of money that
would be involved, for so little is known about the fiscal implications of mandating.
Per-haps the policy most often associated with attempts to restrain expenditure
growth involves employment and wage freezes. In light of the labor intensity of
local governments and the importance of labor cost in their budgets, such policies
would seem appropriate. However, in addition to their unpopularity among employees and their bargaining agents, the effectiveness of employment and wage
freezes depends on a number of factors. Indeed, it is possible that, even with
employment or wage freezes, the number of public workers and/or their compensation rates may increase. Unless lids are placed on the number of actual
employees rather than authorized positions, the actual government workforce
can continue to grow as budgeted, but vacant positions are filled. Similarly, wage
freezes may not eliminate labor cost increases, even if they are accompanied by
no growth in the local government employment. This is so for wage freezes generally but do not apply to such things as seniority and cost of living raises, which
are incorporated in salary scales and employment contracts. While theise considerations question the efficacy of employment and wage freezes, there are other
equally important considerations.
Employment and wage rate freezes, particularly those of the across the
board variety, can interfere with the efficiency and local control objectiYes. On
efficiency grounds, it can be argued that freezes preclude or make difficult the
allocation of new resources, and perhaps the reallocation of existing public money
to high priority activities or functions. The inefficiency is, of course, that government resources will not be allocated in a manner which conforms with public
"Advisory Commission on Intergovernmental Relations.
,. The local ,government cost -implications of state and -fedeiral mandates 1s an area in
which our knowledge 1s vastly deficient. Initial study, of this topic bas been undertaken by
the Advisory Commission on Intergovernmental Relations, "Tax Lids and Expenditure
l\ian~tes: 'l'he Ca11e.for-Fiscal·Falr Play," Intergovernment.u P.eraputwe 8, No. 3 (Summer
1977) : 7-12. -F-or a list, of state mandates alfectin,g .local .governments in one state, see
Connecticut Conference of Mnnleipallties, "State Mandates to Cities and Towns' (New
Haven, Conn.: CCM, mlmeo, March 1976).


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priorities. Beyond this, policies which preclude or make difficult shift of public
monies among local government activities may violate the equity objective.
This would occur when priorities dictate that additional money be allocated to
activities which are of particular benefit to the low income or needy population.
Limits on expenditures need not be the across the board variety. 'l'here are
a variety of limits which could, in effect, limit the aggregate budget and/or its
growth and provide the flexibility to accommodate the equity, efficiency, and
local control objectives.
The most common alternatives to limits placed on eX,Peinditures are those
placed on revenues. Local tax and revenue limits have a long history, although
their effectiveness as a means of expenditure control is not a matter of certitude.
However, the Advisory Commission on Intergovernmental Relations recently
reported research findings which indicate that local taxes are associated with
lower local expenditures from own sources.16 However, the bulk of evidence suggests that local tax limits have no effect on total state and local expenditures.
The implication is that, to the extent that local tax limits are restraining taxation and spending by local governments, the state government adopts additional
expenditure responsibilities. Whether a greater state role in combined state-local
spending accommodates the equity objective is a serious question. A greater degree of progressivity in state tax systems does not guarantee that equity improvements in financing will be achieved by state financing. It is the source of finance
for the expenditures in question which must be examined. The presumption is
that financing out of a progressive state income tax would be equitable, while use
of a sales tax would probably have inequitable effects." Equity issues aside, state
financing raises the issue of local control for if state control accompanies state
financing, then tax limits run contrary to the local control objective.
Within the class of actions which attempt to achieve expenditure control
indirectly by limiting revenues are full disclosure restrictions. Generally, these
restrictions require a public hearing and a vote by public officials whenever property tax is to be levied at a rate above some previously specified rate.18 Such procedures closely conform to the objective of local control. Since they do not in and
of themselves have equity implications or hamper the efficiency of local government operation, this type of restriction would seem to be quite appealing.
CONCLUDING COMMENTS

Many of the possibilities for local goverinment ex,penditure reduction involveactivities which would reduce either service levels or local responsibility for the
financing of service. The recent experience of California. as well as that of New
York City, would suggest that state governments, however reluctant they may be,
will be involved in any major attempts to cut local government expenditures.
Whether this involves state aid increases or state adoptiO!ll of local expenditure
responsibilities, the implication is for a shift of tax burden from local to state
taxpayers without any clear guarantee of a reduction in combined state and
local tax burdens. Whether shifts in tax burdens are sufficient to dampen the
forces of taxpayer revolt is a matter of speculation. If they are not, then the
search for ways to cut the costs, or at least restrain cost increases, of state and
local governments will gain force. The analysis of the factors related to the increasing cost of government has identified the growth in average employee costs
as a major contributor to increases in the cost of government activities. However.
despite the fairly large increases in employee compensation, the data reported
hereiin indicate that wage rate increments in large part serve to offset increases
in costs of living. In fact, inflation alone may have contributed more to the
growth in local government expenditures than all other factors combined. Clearly
short of major service cuts, little relief from increasing costs of government ca~
be expected unless the federal goverinment is more effective in its fight against
inflation,
:re Advisory Commission on Intergovernmental Relations "State Limitations on Local
Taxes and Expenditures," A-64 (Washington, D.C.: u.s'. Government Printing Office•
February 1977).
17 Although there Is llttle question about the e9ulty lmpllcatlone of Income vs sales
taxation. the general presumption of the regressiv1ty of the local property tax has been
subjected to serious questioning. If In fact the property tax ts pro~resslve, then the degree
of :rogresslvlty of local as well as state taxes would need to be considered.
Most commonly, these procedures are required whenever the property tax Is to be
set at a rate which would yield revenues greater than the r.rev1ous year's revenues or in
'
some cases, a specified amount greater than the previous year e revenues.


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Representative REuss. Now, the widely respected A~sistant Director
of the Advisory Council for Intergovernmental Relations, the Honorable John Shannon.

STATEMENT OF HON. 10HN SHANNON, ASSISTANT DIRECTOR, ADVISORY COMMISSION ON INTERGOVERNMENTAL RELATIONS
Mr. SHANNON. Thank you, Mr. Chairman, and members of the two
.
.
committees involved in thi& hearing.
I have been asked to concentrate on the local tax s1tuat1on, property
tax, and cetrain other related issues, and that part of my prepared
statement from page 14 on, I will summarize.
Actually there are two questions that I hope to answer for the
committee.
First: Does it still make political and econoffi:ic sen~e to _retai_n the
property tax as a major source of local revenue m an mflat1on-ridden
economyi
Despite obviou& defects and a very poor public image, the prope~ty
tax has significant political and fiscal virtues. First, it is the one ma1or
revenue source directly available to local government and, therefore,
serves as the traditional defense against fiscal centralization.
Second, it is the only major tax that can recapture for the comnmnity the property values created by the community.
Third, it has a high visibility and it can work in the direction of
greater public accountability.
But beyond these three con&iderations there is an inescapable element
of fiscal realism-the Nation's local governments will not quickly come
up with an acceptable substitute for this powerful $65 billion revenue
producer.
That figure alone is more than the gross national product of most
of the members of the United Nations. We are talking about a revenue
instrument that produces more than the individual income tax and the
sales tax of the State levels combined.
In view of the con&ervative mood of the country, it is also not likely
that many State legislative bodies will. be willing to solve the loeal
property tax 1;>roblem hy granting broad discretion to focal gove1mments to levy mcome and sales taxes or by quickly relieving the local
property tax of all responsibility for the financing of school-s.
State legislators are much more likely to use their surplus funds to
grant tax reli~f to property owners rather than work out fi&cal relief
strategies for local governments. The State-financed plans af aid to
property owners will take a variety of forms, and we are seeing it now.
Expanded circuitbreakers, State reimbursement for partiarl homestead exemptions or tax. rebates for part of the school taxes-part, not
all, of the school taxes borne by homemvners. Th,e1re is•a ma.j-0r propa&ition under consideration in Tex.as on tJ1at latten point r:irght now.
. Because State takeov.e~ of local school costs is an extremeiy e,x,pens1ve venture, we are not hkely to see many dramatic breakthrou1.rhs on
this fro~t immediately. It is happening over time, but it is going to be
slow gomg.
.For. all of these reasons, prudent public policy would dictate the
adoption of measures at the State level, designed to conserve the
37-250-79-14


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730
local property tax by reducing as much as possible the high irritant
content of this levy.
Well, what is the ACIR prescription for keeping the irritant level
of the property tax to tolerable levels, particularly during periods of
inflation?
Our first prescription-and we think all of these need to be worked
together-is a uniform system for administering the property tax.
For a market value appraisal of all taxable property, you need professional appraisers, strong supervision of local assessors, and the
preparation and disclosure of assessment ratio findings to enable taxpayers to judge the fairness of their assessments. But that all goes
under the traditional rubric of assessment reform.
Second, and this is very important, is a truth-in-property taxation
process, along the lines of the Florida plan, that will enable taxpayers
to fix political responsibility for higher property taxes without placing fiscal shackles on local government.
In my prepared statement I go into some detail explaining the Florida plan. Basically there has to be a rollback of rates roughly commensurate with the increase in the base unless the local spending
authorities go through a very rigorous full-disclosu_re process so that
the taxpayer knows that it's the school board, the city council, or the
county board that is responsible for that tax increase and not the
assessor.
The third element in this five-item protection program is a Statefinanced circuit breaker to shield homeowners and renters with low
and fixed income from property tax overload situations. And, again,
in my prepared statement I describe why we do consider the circuit
breaker the instrument of choice for Q"ranting taxpayer relief.
The :fourth-and this bears on the Federal policymakers as well as
StatP-is an intergovernmental "fairp]av" policy. When the State
mandates additional expenditure responsibilities on local government,
it should be prepared to help finance the added expenditure burden.
1V"hen a State mandates a partial or complete exemption from th0
]oral property tax. such as a partial homestead exemption, it should
reimburse the localities for revenue loss, and this £airplay concept also
makes good sense at the Federal level.
And the fifth would be a tax utilization philosophy that recognizes
that the best property tax is a moderate tax. As with any other tax,
the heavier it becomes, the less obvious its virtues, the more glaring its
defects.·
In my view. a moderate pronnty tax would fall into the 1 to l.!'i
percent of market value range. Beyond 1.5 percent of market value, the
a_mber warning light turns on, and beyond 2 percent, certainly the red
light flashes.
If a State at least gradually can assume the full cost of welfare and
medicaid and at least 65 percent of the cost of local schooli,. it will
probably be able to hold property tax levels below the 2 percent level.
A map 1 in my prepared statement gives FHA effective rates back
in 1975. 'T'here has bPPn son1p f'hange sinf'e then. but basir:i]lv tlw pif'ture is that the Southern States have moderate rates, the Northern
States are close to 1 percent or abovP. In thP casp of ~fassachusetts.
thP effediYP rate is bv far and. awav the highest; it is 3.26 percent. So
that on a home of $100,000 in 1975 the property tax was $3,260.
1

See Mr. Shannon's prepared statement, p. 737.


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There is room for guarded optimism. Many legislators may find that
this five-point reform program more acceptable than the radical
surgery alternative prescribed by Drs. Jarvis and Gann. I:f this
turns out to be the case, June 6, 1978-proposition 13 day-will also
become a red letter day in the long and troubled history of the local
property tax.
Thank you very much.
[The prepared statement of Mr. Shannon follows:]
PREPARED STATEMENT OF HON. JOHN SHANNON

After Jarvis-A 'l'ough Reappraisal of State-Local Finance

Shock waves of increasing intensity have jolted the state-local finance sector
during the last four years. If their severity could be measured on a scale of 1 to
10, then the 1975 New York City crisis might register a Richter-type reading
of 5, the 1974-1976 recession about 8, and the 1978 California tax revolt almost 10.
While the first two shocks-the New York City crisis and the recessionstrengthened the hands of the fiscal conservatives, the California tax revolt
provided them with a four-point action program for slowing down the growth
of state and local government.
A J[assive Local Property Ta;c Rollback.-Because property cannot be taxed
at more than 1 percent of its estimated 1975--1976 market value, this necessitated a property tax cut of approximately $7 billion.
A Partial Property Tam Assessment Freeze.-No property tax assessment
ca·n be increased in any one year by more than 2 percent unless that property
is ~old, at which time it can be reassessed on the basis of its market value.
Vent Tight Constitutional Restrictions on Local Revenue Raisers.-After

July 1, 1978 no tax can be increased or a new tax imposed without the approval
of two-thirds of the qualified voters.
Fairly Tight Constit'lttional Rc8trictions on Stcttc Hc1Jen11c Raisers.-Xo additional state taxes can be imposed unless approved by at least two-thirds of the
total membership of both the Senate arid the House.
Proposition 13 raises several hard questions for state and local policymakers.
First, does the ,Jarvis approaeh for controlling the growth of public spending represent the wave of the future"?' It is highly unlikely that many states could
replicate all of the factors that gave such strong support for the massiYe · rollback in lqcal property taxes. California had a $5.5 billion surplus to C'nshion
the initial shock of the local property tax rollback. This extraordinary surplus,
together with a well above average property tax bnrden, a high and rising
fiscal blood pressure· reading, a strong populist tradition, and an unusually
rapid growth in residential property values in South California all combined to give explosive support for Proposition 13.
It ,;hould also be noted that the partial assessment freeze fairly bristleR with
equity and uniformity issues-not many states are likely to enter this legal
thicket.
·while huge local property tax rollbacks or partial asse1ssment freezes appear
unlikely in most other states, the strong support for Proposition 13 will certainly hurry history along on three fronts.
1. More Restriction.~ on Local TctJJ cmd Spending Powers.-Since 1970 at least
14 states have placed restrictions on the power of local officials to raise property
taxes (Table 1).
/?. More Restrictions on Stetfe Tam and Spending Power8.-Since 1976 New
Jersey, Michigan, Colorado, Tennessee. and now California have taken ni.rious
restrictiYe actions to check the growth of state spending (Table 2).
3. Greater Support for Home Owner Property TaJJ Relief.-Proposals calling
for expanded circuitbreakers, split rollR. larger homestPad exemptions. and tax
deferrals will compete even more intensively for state legislative support.
Second, is it possible to moderate state expenditure growth rates without
placing fiscal shackles on state legislative bodies? Two considerations give this
question an urgency that cannot he denied. First, there is clear evidence that
an increasing number of citizens no longer want the state-local sector to keep
growing at a faster clip than the g-rowth in their own income. Ever since ·world
,var II all systems have been "go" for the Nation';:; largest growth industry.


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GROWTH OF THE STATE•LOCAL SECTOR, 1948-77
[State-local expenditures and taxes as a percent of State personal income!
State.local
direct general expenditures (percent)
Total

Fiscal year
1948 ...••••••• · ••••••••·••••••••••
1958 ....• •••••••·•••••••••••••••••
1968 ....•••••••••••••••••••••.••••
1976 .....••••••••••••.••..•••••••••
1977 estimate •••...••••..•.•••..•••

From own
funds (excluding
Federal aid)

9.32

12. 93
16. 38
20.32
20. 75

I

State•local Exhibit: Stale•local
tax revenue
employees ptr
(percent)
10,000 population

8. 34
11. 53
13.64
15.
16. 05

7. 03
8. 85
10, 81
12. 47
12.87

90

1

240

298
396

475
485

• Based on population including Armed Forces overseas.
2 This 1976-77 slight increase varies from an earlier ACIR finding of a slight decrease in the relation of State and local
spendini to gross national product. This tabulation used census data, fiscal year, and personal income. The earlier analysis
used national income accounts, calendar year, and gross national product.
Source: ACIR staff computations based on U.S. Bureau of the Census. Governments Divisions various reports, and staff
estimates.
TABLE !.-STATE LIMITATIONS ON LOCAL GOVERNMENT POWER TO RAISE PROPERTY TAX REVrNUE, 1977
[Key to abbreviations: C-<:ounties; M-municipalities; S-school districts (in some States school districts have no in•
dependent taxing authority or depend on county aovernment for taxes, in which case the IHllits on the in~evendent
general government impact on school districts.)]

State

No
limitations

Full disclosure of
effect of assessment
increases on
Property tax
property tax rate 1 rate limitation•

ProP.erty tax levy
limitation• (levy
equals rate times
tax base)

Expe"diture
limitation

Alabama ••.•..•.............•....•.•••.•.........•.•.•. CMS 1•••••••••••••••••••••••••••••.
Alaska ..•....•............•...••.•.•.•••.•.••.••••...•. M...•••.•.•.•• M(1973) ••.•..••..•
Arizona ....•.......................•.•.•.•.....•...•.•• M. _.........•. CM .•....•••...•... S.
Arkansas ..•.•......•..............•••••.••.•.........•• CMS •..•.........•.•.....•••......•
California ..•.•.•.•...........•.•.•..••.•.•.••.•..•••••• CMS'··· ••••..••.•...•....••.•....•
Colorado •..•.•.•...•........••...•.•••••.•.•..•..•••••••..••.•..••••••. CMS •••...••......•
Connecticut. .•••...•. M..........•.••••.••••••..•.........•••....•.•..•.•........••.......
Delaware....•........ MS ....•.•.....•......•.•...•..•. C•..••.••.•....•••.•.••...••••.•..•
District of Columbia................. M(1975) .............................•.•..........•....

~:f;~·- · · · . . . . . . . .· · · .~:~9;~;]0).........

g~~

•.........................···::

Idaho ..••...••...•..•..•..••.....•.•..•..•••.•...•••..• CMS••.•.•.•.•.•..••••.•••.•.••••••
Illinois .•••••.•.•.•.•...•..•.....••.•.•••••.••...••.•.•. CMS •.••.•••.•.•.•..••.•.•..••...••

~]~ii(~::::::::::::::::::::::::::::::::::::::::::: l~I:::::::::::: g~}WJJ:;: ~~:? s.
=

~:~~!~h~setts::::::: :•:M::::::::::. CM (1977).:: :::: :: :::::::::::::::: :::: :::::::::: ::::::: S

~r:::::: : : ::: : : : : ;:-~~:: : : : 1§: :::::::::_: o:•~:: : : :
Nevada .•.••.•.•••...•.•.•.•.••.••.•.•••••..••.•••••.•• CMS••••••••••••••••••.•.•...•.•...

~==
~~r;cr~ ::::::: M:::::::::::::::::::::::::::::::· cMS • ::::::::::::::::::::::::::::· CM
New York •••.••..•..••.•.•.•.•..••.•...•.•.•••.•...•.•• CMS ••.•••••..••••.•••...•••••.••••

(1976),

North Carolina •.•••.....•.•••...•••••••••••.•••.••.••.•• CM .•••••••••••.••.•••.•.•..••.•.••
North Dakota ••••••••••••••••••••••••••••••••••••••••••• CMS •••••••••••••••••••••••••••••••
Ohio......•.••••.•••.•.•....•.•.••.•.•••••.•••••••.•.•• CMS••.•••••...•••..••...•••.•.•.•.
Oklahoma.•.••••••••.•.•......••••.•.••••••••••..•••••• CMS 1•••••• ' ••••.••••••••••••••••••
Oregon ....•••••...•.•.•.••...•..•.•.•...•..••.•••.••••••...•••.•.••••. CMS • .•••...•...••

:~~d!Y/:~~t::::::::·

M_-_-:: : : : : : : : : :::::::: : : : : : : : : ::·.CMS:::::::::::::::::::::::::::::.:
South Carolina ...••..• CM .•..•..••••.•••.•.•••.••••.••. S.••.•••.•.•••.•...•.•••••.•...•..•
South Dakota .•..••..•......•.•.•.•••.•••••.••••••••.••• CMS ••••.•.•••.•.•.•.•••••••.•.•..•
+:~~:ssee ..: :::::::::.CM:::::::::: :::::::::::::::::::·CMS,.:::::::::::::::::::::::::::::
Utah ....••..••.•.••.........••.•......•.•••••.•..•.•••• CMS •.••.•.•••.•.•.•...•••••.•.•.•.
Vermont. .•.•••••..•. M....•.•.••.•.......•.•.•.•.•••••••••••••••.•.•.•.••••..•.•.•...•...

i:!f~%~~ra························~~.<!:?~!.......... g:~ !··········.cM 0911> •····=::::

~~•~~~~~~· ............•........................ ·········cMS i ........... CMS (1975) ..••..•.

, Under a full disclosure procedure, a property tax rate is established that will provide a levy equal to the previous
years when a_pplied to som_e percentage of the curre~t year's tax base. In prd~r ~o increase the levy above the amount
derived by using the established rate the local aovermn11 board must advertise its intent to set a hiaher rate hold public
hearings, and thereafter approve, the higher rate by vote of the board.
'
• Property tax rate limitation sets a maximum rate that may be applied against the assessed value of properjy
• Levy _limitation places a maximum on the amount of revenue that can be raised by the property tax (e.g., 10s· percent
of the pnor year levy).
• Restriction Is constitutional.


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TABLE 2.-RECENT STATE RESTRICTIONS ON STATE TAX/SPENDING POWERS
Type of restriction and year of
enactment
State

Constitutiona I

Colorado ____________________________ _

Remarks

Statutory

19n Allows a 7 percent iooreasa in a,neralfund spending with an
additional 4 percent to reserve fund. Amounts over 11
percent refunded to taxpayers.

1978 Indexation of the State personal income tax to prevent inMichigan ____________________________ _

New Jersey__________________________
Tennessee __________ _

California, __________ _

flation from pushilll! tallpayers into higher tax brackerts.
1977 Budget stabilization fund provided. Amounts in excess of
2 percent of adjusted personal income multiplied by previous year general pur11ose revenue to determine amount
to be de~osited in budget stabilization fund. Withdrawals
are provided if there is a decrease in adjusted personal

1976

income.

Spending increase limited to increase in the State personal
income (Federal series). Increase of between 9 and JO
percent for this year.
1978 ________________ Spending increase limited to growth in the economy. Increase approximately 11 percent this year. Provisions for
full or shared costs for mandated programs to local
governments.

1978_ ------ -- -- -- _--

Proposition 13 (Jarvis-Gann), by constitutio1T8I revision, provides that any changes in State taxes enacted for the
purpose of increasing revenues must be imposed by an act pass8d by not less than ¾ of all members elected to each
of the 2 houses of the legislature, except that no new ad valorem taxes on real property or sales or transaction taxes on
the sales of real property may be imposed.
1

Note: Legislation restricting State spending powers by either constitutional or statutory means fs under a consideration
in the following States: Arizona, Florid!, Georgia, Hawaii, Idaho, 111:aois, Iowa, Maine, Maryland, Massachusetts,
Minnesota, Missouri, Ohio, South Dakota, rexas, Utah, Virginia, Washington, and Wisconsin.
Source: ACI R staff compilation, June 9, 1978.

Second, there is also evidence to suggest that a part of this growth rate can
be traced to imperfections in our system for holding elected officials clearly accountable for the growth in taxes and expenditures-imperfections that become
more serious during inflation in these ways :
Unlegislated Tare Rate Increases.-Inflation subtly pushes taxpay'ers into
higher federal and state income tax brackets.
1

The Diffusion and Misdirection of Political Responsibility for Higher Local
Property Tarces.-Is the taxpayer to blame the assessor, the school board, the city

council, or the county board for his tax increase?
Diffusion and Misdirection of Political Responsibility for New Spending
Programs.-In many instances, Congress takes the political credit for enacting

a new program (such as the Safe Drinking Water Act) while mandating the
additional expenditure requirements on states and localities. Similarly, state
legislatur'es often mandate new services or the upgrading of the wages and
pension benefits of local employees and force the added· expenditure requirements on local governments. There is also the frequent case in which one legislature will take political credit for the enactment of a hew program but leave
to the next legislature the task of funding it.
In order to remove these imperfections from the political marketplace, the
political accountability of elect'ed officials must be strengthened. By so doing,
expenditure growth rates can be slowed down without doing violence to the
concepts of representative government, majority rule, and fiscal flexibility•
Examples of this strengthened accountability approach can be found on both
the tax and expenditure sides of the fiscal equation.
A good example of strengthening political accountability for expenditure decisions is the 1978 Tennessee constitutional amendment that restricts state spending to the growth in the state economy. The state legislature can exceed this
limit by a simple majority vote, provided it follows a full disclosure procedure.
This amendment also directed the state legislature (a) to at least partially
reimburse local governmentF< for state expenditure mandates, and (b) to fully
fund the first-year cost of all new state programs. In effect, then, it directs the
state legislature to put its money where its mouth is.
The state of Colorado strengthened political accountability when it indexed
the personal income tax this year so as to prevent inflation from pushing taxpayers into higher tax brackets. Similarly, Arizona passed a law indexing its
deductions, credits, and exemptions. The ACIR has recommended this action on
the grounds that higher income tax rates should result from overt state legislative action rather than as the silent consequences of inflation.


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734
Admittedly, these various means for focusing a sharper spotlight on tax and
expenditure decisions will come under attack from the hard line fiscal conservatives as very "weak tea." Underpinning their objectives is the firm conviction that elected representatives can no longer say "no" to all the various
pressure groups-that their backbones must be stiffened by replacing a simple
majority requirement with a constitutional provision that calls for two-thirds
majority approval as the prerequisite for either the enactment of new taxes or a
decision to raise expenditures significantty. In effect, this hard line approach
gives the conservative minority a veto power over all major tax or expenditure
decisions. It, of course, completely undercuts the concepts of representative
government, majority rule, and fiscal flexibility-the Jarvis prescription.
A policy of strengthening political accountability will also come under fire
from the left side of the political spectrum. Liberals are apt to oppose some of
these policies in the grounds that they represent a foot in the door for the fiscal
conservatives. Many liberals believe that the public sector is still undernourished,
particularly in those program areas that are of most concern to the poor and
minority groups. Thus, in their judgment, tax and expenditure questions should
be resolved in favor or meeting these urgent public needs-not in figuring out
.new ways to slow down the growth in state and local government.
Confronted with these conflicting demands and philosophies, many policymakers will opt for the middle course--that of slowing down expenditure growth
rates by strengthening the political accountability of elected officials.
Third, when is a state justified in imposing a tight, permanent, lid on local
property tax authorities? In the judgment of the Advisory Commission, the
state is justified in adopting a permanent, tight lid policy only if the state is
willing to provide adequate financial compensation to local governments. The
tighter the lid, the more persuasive the case for a new source of local revenue.
Adequate compensation could take the form of a major new source of tax revenue
for local governments or the enactment of a substantial state program of unconditional aid to localities.
Without this compensatory action, the trend toward fiscal centralization will
become even more dramatic. This centralizing tendency was clearly underscored
by our findings-while state lids on local levies reduced property tax levels, this
effect was offset by higher state taxes.
Fourth, can state policymakers prevent locally elected officials from reaping
inflation "windfalls" from rapidly rising property tax assessments without
imposing arbitrary tax and/or spending lids on localities? This issue becomes
especially acute during periods of inflation when property values generally and
residential property values in particular rise at a faster clip than the income of
the property owner.
In many cases, local legislative bodies fail to cut back their property tax rates
roughly commensurate with a substantial hike in the tax assessment base. Thus
the assessor-not the local spender111-is mistakenly blamed for the resultant increase in the property tax load.
Florida has resolved this property tax windfall issue and thereby helped to
moder-ate the growth in local spending through the adoption of a "truth-in-taxation" procedure--rather than through the imposition of arbitrary lids on local
fiscal action. The author of this pioneering legislation, State Representative Carl
0,gden of Florida, recently described the full disclosure procedure:


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"Every year, the tax appraisers reassess homes in light of current market
values, which generally are higher than the year before. The tax rate is then
1·educed, so as to generate no additional revenue from the reassessment. The only
•fudge factor' is new construction, which can be taxed outside the normal rolls
for the first year.
"If last year's revenues plus the fudge factor aren't enough for this year's
public expenditures, the taxing unit-for example, the city council-has to put the
following quarter-page ad into the local newspaper of largest circulation : 'The
City Council proposes to increase your property taxes. Hearings will be held on
,(such-and-such a date).'
"Lest you overlook the ad, it must be surrounded by thick biack border.
"If after the public hearing, the council goes ahead and raises taxes, another
black-bordered, quarter-page ad must be placed: 'The City Council has voted to
raise your property taxes. Hearings will be held ( on such-and-such a date).' After
tlie second set of hearings, there's another vote. Only then can taxes actually be
increased." 1
While such a procedure may appear restrictive to many local officials, it nevertheless permits them to raise rates as high as they want by a simple majority
vote. In effect, local officials have as much fiscal leeway as ,they want to exerdse-provided they're willing to accept full responsibility for their decision to
.raise taxes.
Fifth, what is the instrument of choice for providing property tax relief to
home owners? In the judgment of the Advisory Commission, a state-financed
"circuit-breaker" gets the nod. Three considerations support this judg1J11ent.
First, the circuit-breaker can provide tax relief to those who need it most
at a lower cm;t than the homestead exemption. If the objective is to relieve residential property taxes that are unduly burdensome, the circuit-breaker can provide more meaningful relief at less cost. It targets relief dollars to those most in
·need of relief-those who are carrying extraordinary tax loads in relation to
family income.
Second, in contrast to homel!ltead exemptions, renters as well as home owners
·can be given relief under circuit-breakers. On the assumption that landlords
pass on a good share of their ,property taxes to renters in the form of higher
rents, the majority of circuit-breaker states designate some percentage of rent
as a property tax equivalent which enters the circuitbreaker calculation in
exactly the same manner as owners' tax payments.
Third, the circuit-breaker is less likely to encounter legal obstacles than the
·homestead exemption or the "split roll." Because of uniformity provisions, a
constitutional amendment appears to be a prerequisite in many states for homestead exemptions on proposals to tax business property more heavily than resi·dential property. By contrast, because the circuit-breaker can grant relief from
residential property taxes without adjusting tax assessments or tax liability,
the courts have consistently held that the circuit-breaker does not violate state
constitutional uniformity provisions.
Our latest survey reveals a sharp increase in state reliance on circuit-breakers.
In 1977, 30 states paid out almost ,'jil billion in circuit-breaker relief to five million
householders---contrasted to $500 million in tax relief payments to three million
:householders in 1974 (Table 3).
1

The Washington Post, June 19, 1978, p. D10.


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TABLE 3.-COSJS AND PARTICIPATION RATES OF STATE PROPERTY TAX CIRCUIT-BREAKER PROGRAMS: FISCAL
YEARS 1974 AND 1977'

Total cost of
programs
(thousands)
State
Arizona ________________
Arkansas _______________

California_______________
__ -··-·------Colorado
Connecticut _____________

Number of claimants

1974

1977

(')

$7, 762
676
95,000
11.003
24, 754
600
4,200
4,000
100,000
844
9,600
8,824
4,347
20,808
275,582
134,200
7,008
1,350
l, 500

$166
61,000
2,355
6, 193

('~
~~s~fil_~~-:~1-~~~~~:::::
('
1,871
Idaho-----·-----------·
Illinois
_________________
21,950
Indiana ________________
l, 800
Iowa ___________________
2,540
Kansas _________________
3,149
Maine _________________
1,974
Marl'and _______________
(')
Mic ,igan _______________ 129,000
Minnesota ______________ 10,010
Missouri_ ______________
4,709
Nevada ________________
80
New Mexico ____________
(8)
New York ______________
(3)
North Dakota ___________
35
Ohio ___________________
33,000
Oklahoma ______________
Oregon _________________ 70, 7~•)
0
Pennsylvania _______ --·· 56, 100
(')
Rhode
Island•---------South Dakota ___________
(')
Utah ___________________
~•)
Vermont_ ______________
4, 7 1
West Virginia ___________
166
Wisconsin. _____________ 35,411

(').

1,198
44,614
357
74, 140
58,918
12
1,487
950
7,670
18
48,139

Average cost
per claimant

Cost per capita

1974

1977

1974

1977

1974

1977

(•)

38,619
8,916
440,000
58,'875
101, 574
6,000

$59Sl

$200. 19
75. 76
215. 91
187. 00
243. 70
100. 00

('~

201. 98
86. 41
317. 05

$0. 0
2. 96
. 96
2.10

$3. 45
. 36
4. 25
4. 20
7. 96
. 87
4.65
4. 67
8.85

2,798
302,000
27,251
19,533
(')
(')

15,924
144,-647
44,000
37,000
31,307
18,468
(')

810,000
110,000
58,031
l, 994
(')
(3)

5,052
264,300
(')

509,000
410,000
(3)

~:~

16,400
8,529
189, 521

(')

17,323
405,000
28,665
83,800
62,955
20, 7.26
83,863
1,234,800
857,277
56,260
10,560
40,000
('~

9, 96
329,462
4,159
502, 575
413,974
249
15,095
10,000
36, 516
l, 265
234,201

(')
(')

117. 49
151. 74
40. 90
68. 64
100. 58
146. 56
159.<;>5
91. 00
81. 14
40. 12
(')
(•~

70. 0
124. 86
(')

138. 95
136. 82
(')
(•~
(•

288. 47
19. 46
186. 84

Total (21 States in
197 4, 29 States
plus District of
Columbia in
147. 97
1977) 6 _. -------· 446,970 949,561 3,020, 755 5, 112, 738
Percentage increase _______________
69. 3 ---------112. 4 ------------

(')

231. 00
250. 00
29 45
114. 56
140. 17
209. 10
248. 12
223. 18
156. 54
124. 57
127. 84
37. 50
120.<;>0
135. 42
85. 93
147. 52
142. 32
51. 92
98. 51
95.00
210. 05
13. 94
205. 55

185. 72

(')

<'l

2. 4
I. 95
. 33
I. 26
I. 38
1. 92
(')

14. 26
2.56

,98
.14
(')

.~)5
3.20
31.<;>8
4. 71
(')
(')
(3)

10.19
.09

7. 75

4. 41

25. 5 ---------·

• l&

3. 34
3. 84
4. 06
5. 03
30. 24
33. 94
I. 46
2.20
1. 26
(')

1. 86

4.26
.13
31. 20
4. 99
. 01
2.17
. 75
16. 08
. 01
10. 31

6. 90
56. 5

• For several States data are for other than year indicated,see appendix table 6.
• Not available; new program for lear indicated.
• No circuit-breaker program in 1 74.
• New program, data are for period Jan. 1 throu~h Al,'· 10.
• Excludes the following new programs for which ala was not available: 1974-Arizona, District of Columbia, and
Oklahoma; 1977-New York.
Soufce: Appendix table6.

Sixth, does it make political and economic sense to retain the property tax as
a major source of local revenue in an inflation ridden economy? Despite obvious
defects and poor public image, the property tax has significant political and
fiscal virtues. First, it is the one major revenue source directly available to local
government and therefore serves as the traditional. defense against fiscal centralization. Second, it is the only major tax that can recapture for the community
the property values created by the community. Third, its high visibility works
in favor of greater public accountability.
Beyond these three considerations there is the inescapable element of fiscal
realism-the Nation's local governments will not quickly come up with an
acceptable substitute for this powerful $65 billion revenue producer.
In view of the current conservative mood of the country, it is not likely that
many state legislative bodies will be willing to solve the local property tax
problem by granting broad new discretion to local governments to levy income
and sales taxes. The legislators are far more likely to support proposals granting fiscal relief to taxpayers than to local governments.
'l'he state financed relief will come in a variety of forms- expanded circuitbreakers, state reimbursement for partial homestead exemptions, or tax rebates
for part of the school taxes borne by property owners.
Because state "takeove~: of local school costs is an extremely expensive venture, we are also not likely to see many dramatic breakthroughs on this front.


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737
Prudent public policy, therefore, would dictate the adoption of measures
designed to reduce the irritant content of the property tax levy.
Seventh, what is the AOIR prescription for keeping the irritant level of local
property taxes at tolerable levels--particularly during periods of inflation?
1. A uniform system for administering the property tax marked by:
(a) market value appraisal of all taxable property;
( b) professional appraisers ;
(c) either strong state supervision of local assessors or state administration of the tax assessment system ;
(d) the preparation and disclosure of assessment ratio findings to enable
taxpayers to judge the fairness of their assessments.•
2. A "truth in property taxation" process along the lines of the Florida plan
that will enable taxpayers to fix political responsibility for higher property
taxes without placing fiscal shackles on local government.•
3. A state-finance circuit-breaker system to shield home owners and renters
with low and fixed income from property tax overload situations.•
4. An intergovernmental "fair play" policy. When the state mandates additional
expenditure responsibilities on local government, it should be prepared to help
finance the added expenditure burden. When a state mandates a partial or
complete exemption, from the local property tax (i.e., homestead exemption), it
should reimburse the localities for the revenue loss.'
5. A tax utilization philosophy that recognizes the best property tax ls a
moderate property tax. As with a11'.y other tax, the heavier it becomes the less
obvious are its virtues and the more glaring are its defects. In my view, a
moderate property tax should fall in the 1 to 1.5 percent of market value range.
Beyond 1.5 percent of market value the amber warning light tuTns on-beyond 2
percent the red danger light flashes. If a state assumes the full cost of welfare
and medicaid and at least 65 percent of the cost of l-0cal schools, it will probably
be able to hold local property tax levels below 2 percent of market value (See
map).
There is room for guarded optimism. Legislators in many states may find this
five point reform program more acceptable than the radical s\ugery alternative
prescribed by Doctors Jarvis and Gann. If this turns out to be the case, June 6,
197~Proposition 13 Day-will also become a red letter day in the long and
troubled history of the property tax.
AVERAGE EFFECTIVE PROPERTY TAX RATES. EXISTING SINGLE FAMILY HOMES WITH
FHA-INSURED MOR1GAGES, IIY STATE, 1975

I 60

1.53

?.14
1.12
2.50
1.99

1

ss

1.56

2.06
'll!,., ',vP 1;i, •;oil,.•~ !hi' 0"'•~•.'11;,qr.
1· ,, ,.,. ,,,.,,.,,,. •~ " '

,,.e ,.,_,,~et-·

"""'Pl <.o•n1...,:,.~ ht ACIII !>ll'I h0'" c,1•1 C!lf•?.1,11,,•1 ,1 ll S ('!1:0,111•
n,,:nl t,I •'"U'4f>Q ;r,:i U•~ar Ut~"10~"'"'1 I e.-le1,)I ll<,u~,n9
i\,J,.,.,• •,l•;o•,<J••. t-,•,1n.1<:"l'•1:1•t l•,f,.,r .1•,o•• ~,~It'••~ ~,. <;.o<,1n,
OJl,I I •• ~t.,k~ ,II>,!. S· ·,•rr .. ~ Afl•,IS ,,,, ._:11.1•,1•.:e••l'<CJ ot
Fl/II V.,e,4:1(.NIS (l'ICfl/1 ~o•C/tJII :IJJrl)I, ,9,;~

• ACIR, "The Role of the States tn Strengthening the Propercy Tax," A-17, reissued
1976. ACIR has drafted suggested legislation to Implement these recommendations.
• ACIR, "State Limitations on Local Taxes & Expenditures," A-64, 1977• ..lCIR haa
drafted suggested legislation to Implement this recommendation.
• ACIR, "Property Tax Circuit-Breakers: Current Status and PoUc,i Issues," M-17,
1975. ACIR has drafted suggested legislation to Implement this recommendation.
• ACIR, "State ·Mandating of Local E>xpenditures," forthcoming report. ACIR has
drafted suggested legislation to Implement this recommendation.


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738
Representative MooRHEAD. The two committees would now like to
hear from Mr. Lyle C. Fitch, president o:f the Institute of PublicAdministration.
STATEMENT OF LYLE C. FITCH, PRESIDENT, INSTITUTE OF PUBLIC
ADMINISTRATION

Mr. FrTCH. Mr. Chairman and members o:f the two committees,
I have filed a prepared statement with the committees which says
"Better Government or :Less Government-the Response to Taxpayer Revolt." I would like to summarize the major points of that
statement.
The first point :follows Mr. Greytak in its emphasis on inflation in
~tate and local government costs and the role o:f inflation in precipitatmg the taxpayer revolt. In brief, what has happened in the last 20
years is that the unit cost o:f goods and services purchased by local
governments in order to provide public services, unit costs have increased by some 189 percent compared with an increase in the cost
o:f consumer goods and services of something.I like 104 percent. So
there has been a dramatic inflation and the cost o:f the inflation going
into the State and local government process, compared with the cost
of consumer goods.
Second, the amount of resources used by State and local govern ments, per capita increased by 100 percent in the last two decades.
In other words, State and local governments are now using twice the
amount of resources :for each man, woman, and child that they did
two decades ago.
Now I doubt if many taxpayers are getting double the services.
On the contrary, we have seen services declining with the result of
increasing school dropouts, more traffic conjes6on, dirtier streets,
worsening public transportation. rise in delinquency, and the rest.
There are many reasons -for the rise in per capita costs and some
of them do reflect increased services. But being a battered old public
administrator, I conclude that there was a substantial drop in productivity of State and local government services industries and that
the average citizen is not wrong in concluding that he is getting relatively less from his taxes than from most other purchases that he
makes.
0-f course this is what the antigovernment people of whom I do not
connt myself one have been telling us all alonQ".
We next have to consider whether the eating up of the heating up
of the taxpayer revolt can return to good account in providin.q: better
government as opposed to merely cutting services arnl having less
government because of the -fact that government re-forms usually
resnlt whE'n the money runs ont or when the machinery bPcomes
glaringly inadequate or when the exis6ng power structure gets into
difficulty because o-f corruption or misma?agement.
.
.
There are two main approaches which I would hke to mention
_
briefly. The first is structural and administrative overhaul.
There is a long and lengthy agenda o-f structural procedural reforms. Most of them have long been advocated by your di~tinguished·
chairman, Congressman Reuss, and I won't go mto tlus. But the
greater structural deficiencies are in the large urban areas where


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Federal Reserve Bank of St. Louis

739
government is a thicket o:f municipalities, regional agencies, and
special districts, counties, all o:f which are incomprehensible to most
stages.
Ten years ao-o the Committee £or Economic Development noted
that there wer~ 80 000 local governments in the United States, most
o:f which were too ;mall to function efficiently. The CED thought the
country would be much better off with only one-tenth_ o:f that number.
·with local governments large enough to opera~e efficiently. Ho,:·ever,
I have always had some reservations about cu~tmg back so drastically
because structural reform and paraphernalia by themselves dont
assure good performance. New York City is the case o:f a government
with all the paraphernalia o:f modern administration. It was the first
and is still the largest metropolitan consolidation with well-staffed
planning and personnel agencies. It has a strong executive equipped
with professional assistttnts and it has gone through periodic charter
revision to keep the system up to date. But all o:f this doesn't ½eep
the city from getting into a horrendous financial pickle, mamly
through skyrocketing costs financed by short-term borrowing. "\Ye
have had tax and debt Jimits, but these aie circumvented with connivance and assent o:f the State government, the cities' elected officials~
the public employee unions, and the banks; all o:f which stood to gain
in the short run by the city's financial irresponsibility.
I, therefore, suggest that the main problem of many governments
is not an adequate size by arteriosclerosis of the bureaucracy arnl the
lack of incentives for economizing. Government agencies by nature
are more interested in organizational growths, status, and power than
service improvements and economical functioning. I think this is one
thing we have to keep hammering at.
The second thing tmvgrd improving government costs is through
productivity which implies nroviding more government services and
more relevant services, with less resources. A raise in productivity involves overcoming a lot of negative factors, using crude and effective
management: and supervision, lack of employee incentives. and hostilitv o:f employee organizations to the very notion of prodnctivitv. It
also involves puttin.ir .o-reater ernnlrnsis on a number of nositive fadors,
in?luding e-reater utilization o:f technology, more effertive iob analvsis. overhanling antiqnatecl civil service systems, and introducingbetter definitions of agency objectives and measures o:f performance.
01_1 a still_ higher p1ane pro<lnctivity means modifying those notions
o:f hierarchical control and devising new patterns of organizational
structure and new incentive systems :for executive superrisors and
street level workers. Such things are especially difficult to achieve
when programs are being cut back and workers are being ]aid off.
"\V-hen layoffs are by se~iority, t~ere is no relationship between quality
~nd per_formance and Job security. New methods, new machines, and
mnovat10ns cannot be financed when money is ti£?:ht.
But in conclusion, I think that the taxpayer revolts manifested bv
Proposition 13 and less drastic measures can accelerate the pace of
q-oyer1.1ment improvement. Both structural improvement and productivity improvement depend on strong political leadership which can
mohilize and su~tain support from citizens, business and taxpayer
groups, awl other constituencies. But the payoff is long run, not short


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Federal Reserve Bank of St. Louis

740
run, and this is a heavy handicap £or elected officials where horizons extend only until the next election.
Continued interest is most likely centered on officials dependent on
the number of votes which can be garnered by vigorously sponsoring
Government reform, which is a grubby business at best. The Federal
and State governments can lend a hand by putting their own grant programs in better order and making judicious use of the power of the
purchases to promote structural reform and encourage productivity.
Finally, how can taxpayer resistance constructively affect government expenditures in the short run~ I would say mainly by flashing the "go slow" signals to officials, legislators, and emI?loyee unions.
As Governor Carey of New York put the matter in his maugural address in January 1975, "The days of wine and roses are over."
The great danger is that cataclysms like Proposition 13 will lead to
drastic expenditure reductions which wipe out the amenities of urban
existence beginning with parks, recreation, libraries, and the arts. This
leads me to say that crash economy programs, like crash diets, are
almost invariably ineffective; they usually damage the patient, they
are painful, and are soon abandoned. Truly effective government economizing, like weight reduetion, requires laying out a well-balanced
diet and sticking to it.
Thank you.
Representative REuss. Thank you very much, Mr. Fitch.
[The prepared statement of Mr. Fitch follows:]
PREPARED STATEMENT OF LYLE

C.

FITCH

Better Government or Less Governmentr-The Response to TaJJpayer Revozt
WHY TAXPAYERS REVOLT-THE COST EXPLOSION

Whether Proposition 13 is a highwater mark or only an interim marker in
the conltemporary American tax revolt, it clearly calls for greater effort than
we have seen to date to check government expenditures and taxation. California
voters opted for an absolute reduction of property taxes while making it difficult to replace them with increased stalte or local nonproperty taxes. It is less
clear that they opted for reduced services, but many seem to have felt that
the cost of public services has been outrunning benefits, implying that lthe extra
bang is not worth the extra buck.
The revolt has been gathering steam for years, of course, with many communities vetoing increases in school and other budgets, and several states pultting
new limits on state-1ocal expenditures and taxes. For example, New Jersey two
years ago tied state expenditure increases to the growth in New Jersey stalte
income payments, and put a 5-percent limit on annual increases in local government budgets. Tennessee is moving to put similar restrictions into the sltate
constitution. More or less draconian measures are being urged on many other
states.'
How account for the whopping increase in state-local government expenditures
in lthe postwar period? Professor Greytak has discussed the factors accounting
for recent increases in government expenditures. I want to emphasize two
points which bear on what I will say later.
1. In the twenty-year period 1957-77, the unit cost of state-local government
increased 179 percent compared with an increase of 108 percent in the price
,of goods and services purchased by consumers.• This was in large part due to
the fact that average wages of state and local government employees more than
1 "States Vie to Cu?lb Tues, Spending." Oongreadonai Quarterir,, J"ul7 8, 1978, pp.
1727-80.
• The indices refel'l'ed to are the Gross National Product deflators for state and local
government and consumer goods and services, liloonomlo B611ort of the President, 1978,
TallleB-4.


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741
trebled. Contrary to the claims of public employee unions, the average wage of
state-local government employees sltarted higher and rose faster than the average
wage in the private sector rmtil the early 1970s when taxpayer resistance began
stiffening and the increase rate slowed to approximately the pace of private•
sector wage increases.•
2. Adjusting for inflation and for population increases, we find that per capita
real expenditures on state-local government services approximately doubled.
This datum measures the amount of manpower and other resources which state
and local governments bought in order to provide public services.
To complete the picture, transfer expenditures, mainly welfare and related
grants, went from $4.8 billion to $20 billion.
The most significant fact is that the per capita real cost of state and local
government doubled. Other things being equal, the quality and quantity of public
services-government outputs-also should have doubled, to match' the increase
in input. But while it is impossible to measure the quantity of government outputs,
let alone the quality, I see little reason to believe that per capita output rose
by anything like 100 percent. On the contrary, many indicators point to a decline
in the quality and quantity of amenities affected by public services as evidenced
by increasing school drovouts, growing traffic congestion, worsening public
transportation, dirtier streets, deteriorating housing stock, and other indicationiJ
of declining public-sector effectiveness.
Granted that for several reasons the real cost and difficulty of providing some
types of public services did increase, particularly in central cities which bad to
take care of increasing proportions of low-income groups in need _9f special
education, social and other services. Nonetheless, it is difficult to escape the
conclusion, which is supported by special studies of several limited areas,' that
productivity of state and local government service industries declined sub~tantially over the period. Averages are deceptive, and we can expect great variation
in the performance of state and local governments. But the average citizen of
many states and localities is not wrong in thinking he is getting less from his
tax dollar. Parallel data from the federal government, on the other hand, indicate
moderate increases in productivity and this indication is borne out by reports
of the federal government's Joint ]'inancial Management Improvement Program.
Meanwhile, inflation and declining productivity in the economy at large frustrated taxpayers by whittling away their purchasing power. The weekly wage
of the average private-sector worker bought less in 1977 than in 1969, and this
is true of wages in most occupational sectors. The purchasing power of per capita
disposable income (income after taxes) was lower in 1974 and 1975 than in
1973, and modest increases in 1976 and 1977 barely made up the gap. In other
words, per capita purchasing power in 1973 approximately equalled the average
of the following four years.
To cap the climax, the eruption of the Watergate scandals created an atmosphere of distress in national government which overflowed into state and local
governments. This, added to inflation and depletion of purchasing power and
the soaring costs of state-local government, contributed to the growing taxpayer
revolt by giving plausibility to the conservative credo that government has gotten
out of hand.
Financial brinksmanskip
Fiscal emergencies are nothing new to state and local governments. In pal'ticular, large cities in the midwest and east such as Cleveland, Detroit, St. Louis,
Philadelphia, and Newark have been living for years in a state of financial
desperation stemming partly from economic decline and partly from taxpayer
resistance.
Responses to revenue shortfalls come more or less in the following order:
1. Position freezes and vacancy contl:ols, and suspension of travel allowances
and transportation and other perquisites of higher-level employees. Position
freezes are economy by happenstance since they fall wherever vacancies happen
to occur. Economizing out on executive perquisites may strike at needless ex• The averages conceal a great diversity among governments and among employee

groups. In some states and cities publlc employee compensation still lags behind that of

comparable jobs In the private sector, in others', public pay rates have exceeded private.
Usually this situation is found in the mass-employee occupations, though in a few .cases
middle-and higher-leTel occupations have outrun lower.
• John P. Ross and Jesse Burkhead, "Productivity in the Local Government Sector," Lexington Books, 1974; David Greytak, Donald Phares and Elaine Morie,-, "Municipal Output
and Performance in New York City," LeJCington Books, 11118.


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742
penditures but may also reduce employee effectiveness and deter professional
development, and thereby increase the difficulty of recruiting management talent.
2. Reductions in force. These are usually in order of seniority, striking the
younger and more vigorous employees and the minority groups who are particularly dependent on public employment because they have fewer privatesector opportunities. Many people laid off will draw unemployment compensation and eventually public assistance, so that the net effect is to shift the cost
of maintaining them to other pockets while wasting whatever contributions
they might have made if employed." Layoffs may be across-the-board or may
reflect a considered set of priorities in which basic services such as police, fire,
sanitation and health are favored at the expense of amenities such as libraries,
parks and recreation, school enrichment programs, and the arts.
3. Top ·administrators and legislators, who are usually most careful about
new programs, will give more attention to ongoing ones and will comb over old
progra!lls in search of places to cut, even though they do not go all the way
with zero-base budgeting. Managers may uncover opportunities for genuine
economies or may employ the old trick of cutting services whose loss will be
most conspicuous and keenly felt, but this has dangers since it is likely to be
exposed by unsympathetic sources-the party out of power, the media, or
sharp-eyed civic organizations. Alert agency heads will draw upon program
planning and budgeting techniques, better to justify their program requests.
In governments which have long been strapped for funds, however, there is
little room for reordering priorities and savings through administrative reform
because existing agencies ana ongmng programs have survived the harsh political test of survival of the fittest. The budget-making process of one such government has been described as follows:
"There is loose talk to the effect that budgetmaking involves resources allocation. So far as the few American cities we know are concerned, we believe
this rumor to be unfounded. . . . Since cities are in a financial straitjacket
and officials can make only small changes in their budgets, the rationale for resource allocation is not entirely clear."•
4. All expenditures that can possibly be deferred will be, particularly maintenance expenditures and capital outlays. Hard-pressed city and county governments have already been doing this for years; consequently vast amounts of
deferred maintenance are accumulating, with water and sewer mains falling
apart, streets filled with potholes, and deterioration of highways and bridges
to .the point where they have to be closed. Bridges are an especially serinm-1
problem in cities which depend heavily on them, such as New York and
Pittsburgh.
5. Since a major cost-increasing factor in many jurisdictions has been large
wage and pension <increases, one of the most important effects of taxpayer
resistance may be to stiffen resistance to pay any fringe benefit increases while
tempering union demands .. It is unfair to blame unions alone for kiting labor
cost>', however, since management has to agree to settlements. New York City
got into trouble because its management not only agreed to impossible settlements but borrowed money to pay the bills until the city's credit was gone.

How to economize
In eonsidning how to hold down government costs, taxpayers need to determine whether they want less government or better government, or perhaps
both. A distinction must be drawn between the 1mti-government people who
want government cut back on ideological grounds, and those who have conduded that government is simply wasteful and dnefl'ective and need to be
assured that it can perform better. I think that results of recent polls show
that a majority of protesting taxpayerfl are in the latter group; they simply
have concluded that they are not getting their money's worth and are demanding tax reductions even if this means giving up some overpriced services. The
fact that RO many single out welfare is probably a result of seeing their own
aspirations frustrated by inflation and the economy's mediocre performance.
Government reforms commonly result when the money runs out, or when
exi~ting machinery becomes glaringly inadequate, or when the existing power
"Federal CETA grants have made It possible for states and localities to avert some of this
waste.
• ~rno](] .T. l\feltsner and Aaron Wlldavsky. "Leave City Budgeting Alone!" In John P.
Creeme. ed .. "Financing the l\fetropolis," Sage Publications, 1970, p. 311.


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Federal Reserve Bank of St. Louis

743
structure gets into trouble because of conspicuous incompetence or corruption.
The contempo_rary taxl!ayer revolt and financial troubles of many local governments m:i:i: give_ new impetus to government improvement through structural
and admimstrative reform and to more rigorous cost controls as an alternative
to drastic cutbacks in public services.
Lagging capacities of State and local governments

In_ discussing whether the taxpayer revolt can be put to good account in improvmg state-local government, I will look first at existing deficiencies and the
agenda for reform.
State governments have come some distance in the last decade since the
Committee for Economic Development complained (in 1967) that many of them
lacked the requisite organizational and administrative tools for effective performance,1 and the Advisory Commission on Intergovernment al Relations noted
(in 1970) that most state governments are on the verge of losing control over
mounting problems of central-city deterioration and the rapid growth of metropoli4tn areas.• To mention a few areas of improvement :
Stat~s have proceeded with a standard agenda of administrative reform, including departmental restructuring, strengthening of accounting and budgeting, etc;. ; taken over functions formerly performed by local governments ; in
creased grants to local governments; established agencies which furnish information and technical assistance to local governments; passed enabling legislation for intergovernment al service agreements, regional organization, service
transfers to county governments, etc. On the debit side they have yielded to
pressure from local government employee groups, piling costs on local governments ·in violation of home rule principles; harpooned municipal administrative and planning reforms; further complicated local government structure by
creating new special districts and substate regional agencies; and engaged in
other disorderly conduct. But most conspicuous have been their sins of omission-not moving faster to tidy their own houses ; rescue their faltering cities ;
and prune their local government jungles. It should be noted, however, that without local support and cooperation state governments are limited in what they
can do, particularly in the strong home rule states.
As for local governments, the Committee for Economic Development in 1966
noted the following deficiencies, most of which are still around.
Very few local units are large enough-in population, area, or taxable resources-to apply modern methods in solving current and future problems, Even
the largest cities find their major problems insoluble because of limits on their
geographic areas, their taxable resources, and their legal powers.
Overlapping layers of local government abound-municip alities, townships,
school districts, special districts-which in certain areas may number ten or
more. They may all have power to tax the same land, but frequently no one
has the power to deal with specific urban problems, or to coordinate related
activities.
Public control of local governments is ineffective or sporadic, and public
interest in local politics is tepid. Contributing factors are the confusion resulting from the many-layered system, profusion of elective o_ffices without policy
significance, and increasing mobility of the population.
Most units are characterized by weak policy-making and antiquated administrative machinery. Organizational concepts considered axiomatic in American
business firms are unrecognized or disregarded in most local governments.
The administrative process is handicapped by low prestige of municipal service, low pay scales of administrative and executive personnel, ~nd lack of knowledge and appreciation on the part of elected officials and legislators of professional qualifications."
Structural reform

A OED policy paper drafted by Dr. Alan K. Campbell, present Civil ~ervice
Commission chairman advocated two-tier metropolitan government with region-wide jurisdiction~ performing functions which for various reasons need
to be handled on a metropolitan scale, and community jurisdiction performing
• "Mollernizing State Government," 1967.
8 ACIR. "Federalism in 1!170," 12th Annual Report, p. 7.
• CED. "Modernizing Local Government," 1966.


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community-scale functions.1° Subsequent ACIR reports have explored at length
the various functions and sub-functions appropriate for each level. 11
The concept of metropolitan jurisdictions-to administer and coordinate
metropolitan-scale functions and to equalize the financial burdens of providing
urban services-has been around for some decades without having made any
great impact on the American governmental system. New York City's consolidation, which occurred in 1898, is still the only example of consolidation on a grand
scale. Other metropolitan organization has been on a much less ambitious scale,
with a dozen or so county-city consolidations, mainly in the south, and expansion of city boundaries through annexation in states which permit this solution;
multi-purpose regional organizations in Seattle and Portland, and the wellpublicized Twin Cities Metropolitan Council. County governments have in-.
creasingly taken over and coordinated large-scale functions and are the handiest
solution where they are big enough, but in many metropolitan areas functions
spill over county boundaries and in some areas over state boundaries.

Purposes of metropolitan organization
There are three main purposes: (1) scale economies involving functions
which can be performed most cheaply, or performed at all, only by metropolitanwide agencies; (2) coordination of metropolitan functions; and (3) fiscal
equity which involves sharing tax burdens of services which benefit both city
suburbs, and of special services required by low-income disadvantaged groups.
Scale economies are most adequately achieved of the three purposes, usually
by single-fJlnction special districts or authorities, of which there are now some
8,000 in the country's metropolitan areas.
Coordination of metropolitan functions is much less adequate because of the
penchant for special districts. Some coordination is achieved through the
numerous councils of governments (COGS) and federal requirements for grant
application review ( commonly handled by the COGS), but most COGS have little
muscle beyond their review powers and correspondingly little control of the
policies of their member jurisdictions or of the special districts. The ACIR
has recommended the creation of umbrella multijurisdictional organizatione
(UMJOs) as a means of improving coordination.""
Equalization of fiscal burdens, the third main objective of metropolitan organization, is usually desired by the central cities but almost everywhere opposed
by most suburibs. It is more amenable to alternative solutions than are the
other objectives, since state and/or federal governments can assume the cost of
providing welfare benefits and special services to low-income groups who congregate in central cities and older suburbs.
Another and separate problem is the continuance in some areas of many
general-purpose municipal gov,ernments which are too small to perform efficiently or adequately the functions assigned to them. The solution of combining small units into larger ones, or into metropolitan general governments, has
never taken hold in the United States (except in the instances noted above)
for several reasons. One is the attachment of residents to their own communities and their fear of domination by larger entities. Another is the people's
choice principle, particularly admired by economists, of maintaining a number
of jurisdictions with different amounts and kinds of services in order to provide
a variety of choices to urban residents. A third is the principle of neighborhood
or community control, which argues for smaller jurisdictions as a mean!! of
giving residents a larger voice in the decisions that affect them.
There are two other obstacles to metropolitan consolidation, less justifiable
but still politically potent. The first is a fear of racial integration on the part
of suburban whites, primarily concerned with the impact on property values, and
central-city blacks who fear that black dispersal would diminish their political
power. The second obstacle is officials of small municipalities who resist the idea
of displacement and possible unemployment which would result from consolidation.

Bottom-up reform
The CED'S second proposed reform is based on the premise that units of
government wherever possible should be small enough to enable residents to
1° Committee for Economic Development, "Reorganizing Government in Metropolitan
A•eas," 1970.
11 Advisory Commission on Intergovernmental Relations, "Government Functions and
Processes: 'Local and Area Wide;" Substate Regionalism and the Federal System. vol. 4;
.A-45. 1974: also. "Improving Urhan Amnlca: a Challenge to Federalism," M-107, 1976.
u .ACIR, "Improving Urban America," Chapter 4.


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have some voice and control. This version of "maximum feasible participation"
applies to a variety of services which may appropriately be handled by small to
medium sized units. "Voice and control" might include the power to allocate
part of all of the funds available for public services in the community, and the
power to implement such decisions by hiring personnel, purchasing materials,
and making contracts, and the power to sign checks-in short, the budgetaryexpenditure powers ordinarily exercized by municipal general governments.
There are several arguments for such decentralization, including the public-choice
principle and the participation principle-previously noted in the discussion of
consolidation.
Also there is an administrative efficiency argument which holds that giving a
community greater control over suppliers through the power to hire, fire and
make contracts will compel a bureaucracy to pay attention to clients' needs and
serve them more effectively.
Though I am not unsympathetic with these objectives, I have always wondered
why deconsolidating existing urban governments should produce any better
results than the already-existing small suburban governments whose members,
particularly the poor ones, are not models of administrative competence, however much beloved by their residents. I am also bothered by the fact that in
most experiments with decentralization I have observed, the decentralized units
have failed to improve services regardless of their other achievements. Decentralization in New York City's educational system was followed by an
accelerated decline of pupil performance, a sharp increase in administrative
costs, and in most districts minimal involvement in communities.
I would certainly agree that the urban poor generally, and large-city poor
minority groups in particular, should be more involved with public decisions that
affect them. But there are less drastic mechanisms for achieving participation,
including community councils which are consulted on development plans, service
priorities, and similar matters; neighborhood service centers to make health,
welfare and other services more readily accessible to clients with regard to both
hours and locations; and devices for improving communication between neighborhoods and central agency administrators. Even such relatively simple measures
have not been exploited by most cities, although an increasing number are moving
to improve communication and access, including access to services.
One difficulty is defining "communities." Sometimes they already exist but
more often they do not. Annmarie Hauck Walsh has observed that:
"Power never did reside in general population groups within the neighborhoods
of our large cities, and it remains to be seen if there is any sense of community
in most of them. Their image of neighborhood power has cultural roots in our
ideology, namely our yearning for a town-meeting society, but it has little place
in urban political history." 28
The ta1Cp<JIJler revolt and structuraZ reform

Can action on the long agenda of needed structural reforms be accelerated by
taxpayer revolts? I think it can be, but only if there is forceful political leader•
ship to mobilize taxpayer support. California's governor, as part of the response
to Proposition 13, appointed a commission to consider the state's basic condition,
including its economy and governmental organization. Already there have been
some significant changes in state intergovernmental relations as a result of the
fiscal rescue effort designed by the governor in cooperation with a select legislative committee and passed by the legislature. These changes include:
A state takeover of county welfare, food stamps and health functions.
Allocation to counties of funds for special districts and authorities, which
makes these units dependent on locally elected county officials. This may pave
the way for creation of multipurpose authorities, which may in turn achieve
better coordination and reduce overhead costs.
City authorization to raise charges and impose new charges, which may lead
to greater use of public pricing-an objective advocated by many economists."
In addition, the diminished fiscal capacity of local government and increased
dependence on the state will inevitably trigger other moves, including moves
required for maximum utilization of federal grant programs.
A degree of preference to poor districts il'l allocating school funds, continuing
the state's grad;uai adjustment to the Serrano decision reqniring more equitable
access to school :finance resources.
"What Priee Decentralization In New York?" "New York City Almanac." June 1972.
"See Selma Mushkin, "Public Prices for Public Products," The Urban Institute, 1972.
37-250-79--15

13


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The most significant single effect of Proposition 13 has been the shift in finan•
cial and other powers to the state government in what traditionally has been a
strong home-rule state.
New York State also moved strongly to rescue several of its faltering cities
from financial collapse, most prominently the Big Apple. When New York City
proved unable to handle its own finances and required outside help to get the
budget under control, the state created the Emergen~y Financial Control Board
with wide powers over city •budgeting, including the authority to review financial plans and modifications, contracts and proposed borrowing for conformity
with the long-term objective of restoring a balanced budget. The EFCB was an
important structural change which now seems likely to endure indefinitely,
though it is hotly opposed by the city employee unions. 15
The New York State intervention wa,s an emergency measure, not concerned
with government organization or managerial structure. But many other things
have been going on, including increased financial assistance to local governments,
including New York City. The governor also set in motion the latest round of
New York City charter reforms which culminated in the adoption, in 1975, of
a new city charter designed in part to correct the management deficiencies which
had led the city to the verge of bankruptcy. Thus far, however, the new charter
changes have made little difference in the way the city actually operates or iP its
management structure.
Another interesting organizational innovation prompted by financial desperation was creation of the Metropolitan Transportation Authority, which in 1967
put under one organizational roof the city's subway and bus agencies, the New
York commuter rail services, and the Triborough Bridge and Tunnel Authority.
The basic purpose of the consolidation was to enable the use of the Triborough
Authority's surplus revenues, derived from auto tolls, to meet transit and commuter rail deficits. As a management organization, however the MTA has been
ineffective; it lacks even the information for managerial supervision. Operations.
long-term planning, budgeting and policy coordination are still largely in the
hands of individual agencies which were brought together in the consolidation.
Without going into more detail, I will jump to a conclusion about structural
changes which involve established organizations: they usually take a long time
in gestation and winning approval. and a long time for effective implementation.
Government reorganization. whether toward metropolitan consolidation or deconsolidation of existing government, is not calculated to produce savings in
the short run. Metropolitan consolidation has been primarily a means of spending more money more efficiently, not of spending less money. It ordinarily concerns regional water, sewage dh,posal. air pollution eontrol, transportation and,
more reeently, manpower programs, eeonomic development, and health programs.
Most of these involve raising expenditure levels to meet needs not previously met
or, in many cases, not even recognized.
IN QUEST OF PRODUCTIVITY

Despite the fact that governments have fallen far short of meeting organizational and other standards which most of the experts tell us are needed for
effeetive performanee, many state and local governments have marle some progress
in the last two decades, a few have mane eonsirlerahle progress. Notwithstanding, productivity seems to have deelined. as measured by results. But are the indifferent results attributable merely to the faet that the difficulty of the problems
increased so greatly that they couldn't be handled as well even by doubling the
resourees employed? I think not. for we ean identify a number of other faetors
assoeiated with productivity deeline.
1. The considerable amount of manpower going to make up for improvt>ment
in working conditions: shorter work wet>ks. lighter work loads, increased vaeation time and work breaks, more siek leave, et eetera.
2. The eontinued deterioration in many state and loeal governments of technical, professional and managerial positions, three occupational groups which
generally are not protected by strong unions, by adequate civil serviee structures
or by political constituencies.
15 The State also created the Municipal Assistance Corporation (MAC) to serve as a surrogate borrower for the city, MAC obligations are backed by a first claim on city sales tax
revenues.


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3 The continued degeneration of civil service and merit systems into inst~ume~ts for protecting mediocrity and defying administr:ative control, ~endencies
which are strengthened by the increasing power of pubhc emplo_yee umons.
4. Whereas capital-intensive industry, notably ma1;1ufacturmg, of!'Sets such
productivity-reducing factors by providing worker~ _with more ma~hm~ power,
in goverm,nent, which is labor-intensive, opportumties for mechamzation have
been more limited and existing ones tend to be smothered by featherbeds.
5. The anti-poverty programs of the 1960s encouraged the creation of new
organizations--community action age_n~ies, concentrated e~ployment progra1;11s,
neighborhood service centers, model cities programs, etc.-m many cases outside
the established political and administrative framework. In _t~e process, oldfashioned notions of organization, management, and accountab1hty we:it largely
down the drain and many cities are still repairing the damage.
6. The most important fact that elected officials and lei;islat,ors tend ~o be
more interested in inputs-jobs, franchises, contracts-than m outputs---0ehvery
of goods and services. Dominance of output interests leads naturally to rising
government costs and deteriorating government outputs.
I continue to be impressed by the multiplicity of demands on the public sector.
One of the greatest impediments to economy in government is that the interests
of those who want economical and efficient public services frequently clash with
the interests of those who want jobs and contracts, union expansion and
security welfare and other direct grants, and other rewards of political influence.
These c~nflicts tend to be greatest in heterogeneous jurisdictions, particularly the
large cities with heavy concentrations of poor minorities. Smaller and mediumsized cities, dominated by middle-class interests, tend to put greater streses on
services, good management and productivity.
Chances of cost reduction through productivity

Like the abominable snowman, productivity in state and local governments
has a devoted body of faithful believers, while skeptics believe it is largely
mythical.
Views and hopes for the potential of achieving productivity for the public
sector in general and state-local governments in particular span the spectrum. At
one end is the view that the service industries, including public service, are
inherently resistant to productivity measures-a view that is based on rather
superficial examples such as services of barbers, musicians, and like occupations.
At the other end is the view that the service industries are an undeveloped
frontier of productivity, and that there have already been enormous gains; for
example, recordings and electronic transmission enormously multiply the listeners
served by musicians and musical ensembles; home kitchens have become heavily
mechanized; earth-moving equipmefllt has replaced the pick and shovel; and so
on. More pertinent to government paper and data processing are the computer
and word processing revol.utions. 1•
In the opinion of management enthusiasts, equally significant _potentials lie in
management improvement with the main emphasis on planning, goal setting,
program development, program monitoring and evaluation, continuing appraisal
of employee performance and accountability, reiterative use of information for
program improvement, and responsiveness to changing client needs.
My own appraisal of the potential runs somewhat along the following lines.
In some cases agencies faced with loss of funds may accept the challenge and
finds ways of maintaining their level of services as by improving procedureR or
redeploying personnel, or redefining the services. But more basic programs to
get at the root causes of low productivity, involving subtle changes in trchniques,
attitudes, communication. worker-supervisor relationships. and incentive structures, cannot he developed and implemented under a fiscal gun. Programs are
being cut back and workers are being laid off, when tensions and resentment
are usually high, and workers are preoccupied with fear of the pink slip and
the falling axe. Even where the layoffs go largely by seniority, there is no relationship between quality of performance and continuance on the job, and correspondingly little incentive for extra effort. It is difficult to increase personnel
productivity by machine power if there is no money to purcha,se and install
machines and go through the necessary period of breaking in and adjustment
which usually attends any innovation that involves a change in routine. Training and executive development programs are likely to be prm1ed, and short16

Si>P Theodore Li>avitt, "Management and the Post Industrial Society," The Public

Interest, Summer 1976.


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handed agencies ordinarily must spend all of their time dealing with exigencies
of the moment and have little left over for devising more effective means of
operation.
Back to management

"The gloomy account of a low-productivity service economy," Leavitt obser,es,
"is rooted in an almost wanton disregard of the historical role and future possibilities of the managerial arts for improving labor productivity." 17
'l'here is a familiar litany of management deficiencies which includes: lack of
a progressive management philosophy, lack of provision for an effective administrative class in the civil service, too few management positions, erosion of
management authority and effectiveness through expansion of collective bargaining; a long-standing lack of adequate CO!llpensation for managerial positions;
lack of incentive for and bureaucratic obstacles to productivity innovations; inflexible and inappropriate civil service regulations. However, productivity problems cannot be solved simply by enlisting a corps of trained management pe,Jple
and handing them authority to "manage." To begin with, government bureaucracies, particularly the more professionalized ones, resist outside control whether
from chief executives, citizens boards or legislatures, as "political interference"
with their functions and prerogatives.
Moreover, management control, particularly in large public-sector organizations, is limited by the fact that the actual work is done by the "foot soldier out
on his own on the beat, on the garbage truck, or in the classroom," so that "urban
bureaucracies have precious little administrative control over service delivery
at the crucial point of contact between city and citizens. 18 In such a context,
productivity is at best a gossamer concept, much easier to damage than to
improve.
Management experts, particularly those with business or engineering orientations, put great stress on defininig and measuring outputs. My own obsen·ation is that unless handled very carefully they will likely be seen as aspersions
on professional integrity, or threats to employee security or working conditions.
Moreover, as I have previously stressed, outputs of many government activitie.,,
cannot be closely defined and the objectives of government activities are frequently vague and conflicting.""
'.1.'he attitude of workers toward productivity in sOIIIle degree reflects the attitude of the top executives who in turn take their cues from public attitudes.
Unless business and citizen groups show an active interest in productivity, it is
likely to have low priority and the expert personnel required will be crowded
out by patronage requirements."'
The public employee unions have been suspicious of productivity, which ls at
odds with the traditional goal of more pay for less work and which implies
stretchouts, work quotas, and management snooping. Such biases may be softened by relating productivity to compensation gains and making cost-of-living
adjustments dependent on demonstrated "productivity savings." But such measurements tend to degenerate into a mere numbers game unless they are carefully supervised and audited from the outside. In any case, they run into the
fll!llliliar difficulty of measuring public-sector productivity.
In some cases, a :fiscal crunch can help avert ,productivity losses by easing
pressure for employee benefits which reduce working time. However, it should
not be imagined, as naive consultants sometimes do, that productivity can be
increased by eliminating benefits already won, such as holidays, training and
vacation time, and so on; once ha'.ving become imbedded in the system, productivity-defeating benefits are almost impossible to dislodge. New York's mayor
rediscovered this fact during the wage negotiations in the spring of 1978 when
he insisted on "givebacks" in return for wage increases, and lost the argument.
On ,the other hand, skillful and persistent bargaining, can obtain important concessions--for example, the Seattle transit system has obtained union agree\Illent
to use part-time workers to handle rush hour shifts ; a similar limited conces11 Ibtd., p. 71.
1 • Douglas Yates, "Service Delivery and the Political Order," In Wlllls D. Hawley and
David Rogers, eds., Improving the Quality of Urban Management, Sage Publications, 1974.
p. 219.
19 Asron Wildavsky. New York AjJairs, Spring 1977.
.. The poverty-prone minority groups pay little attention.to productivity Issues; although
they suffer from poor services they ascribe them to the discriminatory system rather than tolow output-Input ratioA. Their leaders tend to be more concerned with jobs and status symbols than with service Improvement.


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sion was obtained by the New York City transit system. This one innovation
could significantly reduce costs of the labor-intensive transit industry.
A major problem of state and local government labor negotiations is that
government representatives tend to regard themselves as mediators between
workers and taxpayers rather than as negotiators. Until recently the rewards
of meeting employee demands and of avoiding strikes and other job actions have
been perceived to outweigh taxpayer protests. Stiffened taxpayer resistance is
changing this attitude, but the responses vary. California has imposed a wage
freeze on state employees, and local governments 1must follow suit. In New York
City, the unions hung tough, fortified by the city's continued dependence on pension funds as a source of financing. Despite an ostensible wage freeze, employees
have continued receiving cost-of-living adjustments (COLAS) plus substantial
increases in the 1978 round of wage negotiations.21
Outs-ille support for productivity

State and federal governments can help the cause by measures to encourage
productivity in lower-level governments and judicious use of the grant system
for this purpose. The Committee for Economic Development has recommended
"that state governments establish and enforce minimum standards for local
government budgeting, accounting, and performance and reporlting systems that
would provide data on the level, quality, results, and costs of services. . . . where
enforcement [of data requirements] proves difficult, states could require compliance as a condition for receiving state grants." Also, "State governmen:ts
should provide financial assistance to local governments for the purpose of
developing and implementing performance measures, experimenting with or
implementing techniques or programs that have the greatest likelihood of success, and underltaking other programs that would improve productivity."
As for the federal government, "we recommend that federal grants, including
revenue sharing, block grants, and categorical programs be redesigned to encourage improvements in the structure and internal management of state and
local governments that will enhance productivi!ty." ••
In considering upcoming legislation for Federal grant reform, the Congress
should also keep in mind last year's complaint of the National Governors'
Conference that:
"Congress continues to legislate more narrow and special purpose programs
ll'hich, added to hundreds of existing programs, lead directly to an unmanageable maze of conflicting regulations and requirements. '.fhese impediments
unnecessarily divert state and federal resources to paperwork and other overhead which should be used for services. Programs are often poorly drafted and
passed without a clear understanding of their impact on state and local budgets
or administrative structures. Federal, state and local program administrators
cannot make rational budgetary or administrative decisions, recipients cannot
understand what is expected of them, and the public is irate over government's
inal!ility :to be responsible.
"The Ninety-Third Congress passed 'landmark legislation' to reform the way
in which it dealt with the budget. . . . The same principle must now be extended
to the process by which programs are created, amended and extended. The
intergovernmental process cannot be effectively managed until it is simplified
and categorized; the creeping recategorization of existing block grants must be
reversed." 23
Obviously there is a lot of ground to be plowed, and higher-level governments
which dispense program funds should be sticking closer to the plow. It should
he noted, however, lthat program evaluation as a basis for continued funding
has many problems which go beyond performance measurement. Once programs
have been launched, personnel hired, managers selected, and money begins
flowing, the shutting off of funds because management is sloppy or federal
or state directives are not followed is like taking a lamb chop away from a
21 In principle, the cost-of-living adjustments were to be based on productivity improve•
ments formulated through joint labor-management committees on productivity. Although
there seem to have been a few genuine instances of productivity improvement, few observers
believe that they are in any way commensurate with the cost of the COLAS. In fact, one
union whose members claim substantial productivity Increases is demanding a special
wage increase in recognition thereof, over and above the COLAS and increases granted to
other city workers.
""Improving Productivity In State and Local Government," 1976, pp. 70-1, 75.
23 '"Federal Roadblocks to Efficient State Government," an agenda for intergovernmental
reform, National Governors Conference. February 1977.


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bungry wolf or trying to fire a civil servant for poor work. Funding agencies
may conclude that the struggle is not worthwhile and go on tolerating indifferent
performance and misfeasance. Or they may he caught between a rock and a
hard place with the continued dangers, on one hand, of vengeful congressmen
seeking Ito reduce appropriaUons if their constituents have been damaged by
strict supervision and, on the other, danger that the GAO will conduct a management audit and produce a damaging report.
To reiterate a previous point, however, productivity is not an emergency
measure but the result of continuous attitude and process which will help avoid
emergencies. A recent study of productivity programs put the point thusly:
"Previous expi:>rience with crash programs to improve decision systems overnight have been disillusioning. A productivity program may best evolve naturallY'
out of continuing attention to improving the overall management of state government, beginning with a few carefully selected targets of opportunity, where
opposition would not be likely to destroy the effort, where significant results are
anticipated, where activities are most susceptible to measurement, and within
the limitations of available staff."""
Epilogne: Congressman Rcnss's reform program and what happened to the Bi{!
Apple

Congressman Henry Reuss, a long-term advocate of government modernization,
wanted to use federal grants as incentives to improve st:J.te-local government
machinery. The list of criteria included in the Reuss-Humphrey bill, for example,
included personnel reform, overhauling state and local fiscal systems according
to long-accepted principles, liberalizing municipal annexation powers, authorizing
city-county consolidation, intergovernmental contracts, metropolitan councils of
government, metropolitan study commissions and planning agencies, and making
local governments more responsible and democratic by decentralizing power and
function1i back to the neighborhoods.
Recent experience has emphasized that these are essential but not sufficient
conditions. New York City long ago adopted most of them. It was the country's
first and largest metropolitan government; it has most of the formal apparatus
of good government, including well-staffed planning, budgeting, and personnel
administration ; has put through three charter reform1i in the last forty years
(the last in 1975), and has launched productivity drives which attracted national
attention. But it managed to get into a horrendous financial pickle from which it
has not yet extricated itself. Underlying the city's problems were its economic
decline, the arteriosclerosis of its elephantine bureaucracy, the number and
range of services it tried to maintain, and low productivity. The immediate cause,
however, was simply bad management and a refusal to recognize that city expenditures could not indefinitely continue risin.g at an annual rate twice that
of revenue increases. In the period 1971-76, debt service and pension costs alone
ab,:orbed three-fourths of the increasp,: in city-financed expenditures. By 1976
these two categoriell amounted to some 56 percent of the city's total revenues from
its own sources.
The city's fiscal streamlining included the familiar moves previously mentioned, including laying ofl' employees, paring services and reducing maintenance. And like a football club owner changing coaches it mounted nPw productivity drives. Productivity gains offer the .only hopP of contrtining the cost of
government, and we are always driven back to it, even though it is often difficult
to measure or even define, lacks political sex appeal, and requires the patience
of .Job.
But we have to keep hammering away.

Representative REuss. Now, the very patient Congressman
Cavanaugh.
Representative CAVANAUGH. Thank you, Mr. Chairman. I want
to commend the chairman and cochairman of these committees for
the excel1ent panel you have C"onvene<l. It has been a remarkable nlncn-.
tion for me an<l I think we run the gamut of opinion on tax revolt and
reform expressions.
,
"_Ediwr .T. Cra!'e, Bernard F. Lentz. :r. :\f. Shnfrit•. State Government Productivity: the
en1·,ronment for impro11ement. Praeger Publishers, 1976.


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And Mr. Fitch, you are an appropriate anchor, I think, to this
panel. You have quite articulately drawn together many of the conflicts which this issue presents us. I think that the dichotomy between Mr. Jacoby and Mr. Cooper is the most dramatic that we are
presented with.
Mr. Cooper, you seem to indicate that you saw in the vote for
Proposition 13 no demand from the public for less government and
less services; and in fact seem to indicate the contrary, that there is an
ever-increasing demand and a more sophisticated demand for ,government services, in an ever-widening array of human activities. But
what you see is an erosion of local control and an increased demand for
Federal spending to provide those services.
1 would have to say that there have been strong indications to support your contention. We received a resolution from the Los Angeles
City Council urging a continuation of Federal funding and matching
grants and a change in the criteria. Immediately after the vote. the
Governor of California made that same expression to the President. And I would presume that after the State surplus is dissipated-after the first year-that the California congressional dele,gation is going to be under increasing pressure to approach the Congress
on the basis of replacing those local funds with Federal revenues in
order to continue the services.
Mr. Jacoby, on the other hand, you seem to express that it was a
demand not for reduced taxes, but an educated demand for less services. I think that brings me to the following point. What are those
services? It does get back to some extent to Senator McGovern's prob_;
lem. Were the people of California-and I know they have cut back
some library services--did they feel that their library services were
excessive? Did they :feel that they had too much road b_uilding?
Did they feel that they had too many parks, or that expenditures on
parks and recreation have been extravagant and beyond what they
desired for their recreational purposes 1
I notice that in education, the summer school and extracurricular
athletic programs have been reduced. Were those intelligently
understood and anticipated consequences by the people of California;
did they determine that summer school or extracurricular recreational
athletic programs were excessive and unwanted uses of their tax
money?
In 'those particular categories, which are some of the implic~tions
o:f Proposition 13, were those valid an<'l inte1li,gent iudgments ancl
anticipations made by the people of California? Is that what they
wanted1
Mr. JACOBY. I think you misinterpreted my earlier remarks. In my
view-and I think I was a rather close observer of the whole Proposition 13 episode-the overwhelming vote o:f the public Proposition 13
may be attributed not to a rejection of governmental services that were
being performed, but to a belief that, as Mr. Fitch has pointed out,
they were being inefficiently performed.
Every study that I am aware o:f has shown that productivity in
the public sector-that is actual output of service-is low compared to
thP nrivate sector.
Representative CAVANAUGH. I would like to examine that because
you seem extremely supportive of the consequences of Proposition 13,


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Mr.JACOBY. Yes,sir.
Representative CAVANAUGH. In education, it is my understanding
that summer school activities have been curtailed in most school
districts.
Mr. JACOBY. I believe that is true.
Representative CAVANAUGH. Now, my question is: Was that an unintended consequence? Did the people expect they could get the same
level and quality of education for their children, including summer
school, with this reduction in taxes? If that is true, it would be my
interpretation that the implementation of Proposition 13 is not going as intended. Is that a correct interpretation?
Mr. JACOBY. No, I think not. I cannot, of course, tell you what
all the people of California believed about the great coterie of services. I can say this, that the people of California have seen the
cost of education soar upward in terms of amounts spent for pupilyear while the quality of education has gone down.
I think they are asking themselves the question, is more money tlie
answer?
As far as summer school is concerned, a number of school districts
have eliminated it and voluntary efforts have been made by parent
groups to get together to form summer school groups.
But there has been no general cutback in educational outlay of
California. The Los Angeles School District, which initially terminated-30,000 teachers, has rehired them all and is now advertising
in two adjoining States of Arizona and New Mexico for 1,800 additional teachers. So there has been no general cutback in education.
Mr. CooPER. I would like to comment. People did not vote for 13
in a mass or a block. There are about five different groups that voted
for 13 for five different reasons.
Some people were upset with the schools' feeling that they do
not get their money's worth out of the schools. On the other hand,
many of those same people will object when the law goes into effect
that says: "Your kid doesn't leave the sixth grade until he passes
-certain tests." The same people that will object that the schools are
not adequate will also want their kid promoted every year regardless of how well he does.
The services that are being cut, however, are those not mandated
by law. We are mandated in the county by law to provide the courts,
the jails, welfare, hospitals and clinic, public health, and police and
fire services, so that means when you have to cut, the cuts come in
things that are not mandated by law, mental health, service to the
aging, disabled, social services.
Now that may change. The legislature added some this year, but
they may add more next year. But if you have to cut 10 percent and
you can't cut certain programs because they are mandated by law,
then you are stuck with cutting the others.
·when you run public opinion polls in California, there is only one
service, that about 50 percent want cut. That is welfare. Yet Congress
and the State legislature set the eligibility requirements and benefit
levels, and the legislature says: If we cut the staffing too much and
make too many mistakes, they will charge us for 100 percent of the
-extra mistakes."


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So it is one of the programs that cannot be cut at all. But 48 percent
of the people in California want to cut that.
The next most popular program for cutting is support of chambers
of commerce, which only 20 percent of the people of California want
cut.
So it is not a conscious thing and you know some people voted for
Proposition 13. There was a woman who said: I will use the money I
save to go to Europe. That was her idea. Others said I want to send a
message to Sacramento and this is the only game in town.
Representative CAVANAUGH. Of course, I understand that and we
all agree with that, there was no referendum on services. But the
problems it presents to us in the decisioninaking process is we will
have to make those and we will have to make them in the public
interest.
Mr. CooPER. Everything will have to be cut.
Representative CAVANAUGH. My problem with Mr. Jacoby is he
doesn't seem to address that.
Mr. COOPER. Many people wanted everything cut. I presented
messages to the chairman from my constituents, that some of the
people said that. Others said other things.
Representative REuss. Mr. McKinney.
Representative McKINNEY. Gentleman, this is a little bit like covering the globe on a bicycle in 1 day. I must say I enjoyed your testimony and I will read it. I would just like to add to the discussion
going on. I find people don't want less services; I find people want
more.
For instance, I am continually being told, particularly by senior
citizens. "We cannot afford inflation today, but mcrease our pensions."
But I find many people who are angry at government, but this. is
the only ball game in town. All you have to do is ask anyone about a
simple little trivia of government-any type of local licensing their
doing or getting their car registered-the people are irritated by all
of those things. They don't see government being delivered to them.
Yet they see their taxes going up and up.
The real message here is that the Government has got to be runwhich it is not being done now in many cases-for the people that
pay for it. I constantly have walked into the Federal building where
I have my office and find an old lady crying in the hallway. I said,
"Why are you crying?" and she said: "The girl gave me these forms
and I cannot understand them. I don't read English very well."
So I look the little old lady in to the Social Security clerk and I
said, "What is the problem?" And she said. "Well, just fill in these
forms." I said, ""\iVho do you work for?" She said, "I work for the
Social Security Administration."
I said, "You do not; you work for this lady. So fill out the forms
for her."
But that was absolutely untold. The supervisor came over and asked
why I was interfering. I said, "Bec:tuse you people in th~,s,place work
for the taxpayer; you don't work to abuse the taxpayer.
I could go on and on and on on thiB subject forever. T want.ed to ask
a couple of technical questions, Mr. Peterson. One of the thmgs that
bothers me about the surplus figures I see in the local and State
government is: Do you have any iden of how many of that quote-


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unquote surplus is really depreciation on what we would call a depreciation loss in business or what is deferred maintenance, things
that are just not being done?
Mr. PETERSON. vVell-Representative McKINNEY. Just because the pressure is on to show
a surplus so the State and local government are ignoring the truth
that the bridge has to be painted every 2 years?
Mr. PETERSON. We don't know the answer to that question presently.
e in the Urban Institute are in fact engaged in a study which we
hope will produce an answer to that question, but we do know that
the number in some cities is substantial. A sizable part 0£ the apparent
surplus is being taken out 0£ assets through depreciation.
I might add that locally reported surpluses are in any event highly
inexact figures. H you look at almost any city which is laboring under
hard fiscal circumstances and start to scrutinize its accounts, you will
find some ingenuity in moving cash back and forth to affect the
reported budget balance.
Let me cite two alarming trends. One is that almost all 0£ the large
cities under fiscal strain are transferring large sums from enterprise
accounts which have been used in the past to provide water. sewer
services and so forth, and which provide the principal source 0£ funding £or capital investment in those £unctions, to cover operating deficits
under their general fonds. This has accPlerated greatly.
Second, several 0£ the cities, Cleveland the most conspicuous example, are not just undermaintaining, but selling off their physical
assets and using the profits to close their current account deficits.
Cleveland sold its sewer system and covered its operating deficits £or
3 years. It now has suburban land np for sale that the city had the foresight to buy in the 19th century. They have been renegotiating the sale
0£ their electricity generating system £or the last couple years.
This is an extreme example, but on a lesser scale it is found in several 0£ the cities ; they are unloading their assets to get cash to cover
operating deficits.
Representative McKrxNEY. I was going to say that I sit on the
Audit Commission, and we have a tendency to move money around,
too.
Mr. COOPER. I would like to point out, our yearend balance in my
county is $16 million. That is 4 percent 0£ our annual budget. vVe can't
go into that; that is a contingency fund. But what seems to be overlooked is that, i£ Proposition 13 had not passed, this coming fiscal
year we would analyze, we would prepare a budget, we would say,
"All right, we need $180 million; we will carry over $16 million from
last year, so that means we only have to raise property tax to the tune 0£
$164 million."
·
Now, you know, it isn't like the surplus is passed out as a dividend;
it go~s into your next year's budget, and it's taken into account, and
the bigger the surplus, the £ewer property tax dollars yon levy. That
is the standard way we operate, and I wmild assume most jurisdictions
operate that way.
0£ course, we do have special funds £or capital improvements or
various things that in an emergency you can raise, and a lot 0£ juris<lictions do tnat.

,v


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Representative McKrxKEY. The best examples are Cleveland and
Boston, New York, or Washington, D.C., that their auditing system is
so poor that they cannot operate in the cool way you suggest, which is
one of the underlying things that bothers me.
You read today that we have a $112 billion bill facing us on fixing
the highway system we have not finished building yet. I wonder what's
going on at the-I guess my time is up.
Representative FENWICK. May I make a comment?
Representative REuss. The time of Mr. McKinney is up.
I recognize the gentlelady from New Jersey.
Representative FENWICK. ·what is driving people crazy, are the
questions Mr. Fitch and Professor Jacoby have addressed themselves
to. People know, because Ws in the papers daily, that business can
make a profit of picking up the garbage at the doorstep of 29 percent
of the pickup cost. Why don't we do it? Because we are frozen into
arrangements that are more expensive. Nine people are employed by
the municipality in place of the five employed by private business,
and still the business is not only making a profit but they are paying
taxes, also.
We haven't got the courage, those of us in politics. Let's face it.
I was on my borough council, and in my State legislature, too. We
haven't got the courage to come out and do what needs to be done and
this is what I think Proposition 13 is trying to tell us. Let's face up
to the real issues.
Mr. CooPER. And now with the lack of funds, for example, we just
hired a private firm to administer our hospitals.
Representative REuss. Cochairman Moorhead.
Representative MoomIEAD. Thank you, Mr. Chairman.
First, Mr. Jacoby, you proposed Federal spending limits and ultimately cuts in spending. One of the things that the committee is
looking into is intergovernmental relationships. Would you recommend cutting sue!-\ transfer payments from the Federal Government
to the State and local govern:ri1ents as revenue sharing, CETA, and
similar programs?
·
Mr. JACOBY. Yes; I don't think any item of the Federal budget
should be exempt from an effort to find opportunities for saving. I
think that there is a lot of water in these Federal grants. In :fact,
I saw a study recently by an academic economist, I have not looked
at it, but I merely cite it. I am not sure how solidly it is based, but his
contention is that nearly one-half of the people holding CETA jobs
are not qualified for them under the Federal standard. That is being
misused an~ abused by many local governments; it has not been adequately audited by the Federal Government, and apparently a great
deal of waste is occurring in this one program, which you mentioned.
You can go down the whole list of Federal grants."! am sure you
will find equal opportunities for either doing them more efficiently
or perhaps where the ontput doesn't justify the input, for eliminating
them.
Representative MooRHEAD. So general revenue sharing where there
is no auditing, that would be a prime candidate for reduction in Federal expenditures?
Mr. ,TAcoBY. Yes, I would think so, sir.


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Representative MooRHEAD. Just to get the panel working here, Mr.
Bryce, in your testimony you said that small cities have become more
dependent on the Federal Government in recent years. Do you share
Mr. Jacoby's_ feeling that we can cut back on Federal transfers to
smaller cities ~
Mr. BRYCE. I think we can cut back almost anything that we choose
to cut back. And, having said that, I really do intend to emphasize
what I think is a far easier statement to make than to implement. As
I listened to individuals comment about the inefficiency of government,
and compare that with businesses, a number of things go through my
mind.
First of all, I do agree there is inefficiency in government. But there
is also inefficiency in business.
Businesses also have losses; so I don't know why we must malign
those governments in particular for having that problem.
·
Most of the businesses which are in some of these cities are reasonably small in comparison with the local government. Many of them do
not produce products which are as complex or as difficult to assess, or
as difficult to provide to their consumers.
So, whereas I might conclude that there is some amount of inefficiency, I think it's an oversimplification to assume that simply because
some businesses work well, and many of them I want to say, simply do
not work all that well, that we ought to expect the same thing of local
governments.
I would like to use your question to make one other statement. and
that is I would like to go back to your earlier question to me about
capital spending, and I would like to make two other points.
As I listened to Mr. Peterson make his reply, two things went
through my mind. One is that it is true that, as he pointed out, that
there has been a general trend in the aga;regate spending of State and
local governments with respect to capital programs. I was not referring
to the aggregate spending; I was referring particularly to small cities.
The second thing, as he does suggest, there has been a question of
difficulty of acquiring capital in the capital markets for some of these
localities.
I would like to underscore one point, and that is that one of the
significant differences between financing capital programs in large
cities and financing capital programs in small cities is that many small
cities do not rely as much on the capital markets as the larger cities do.
It is a very common thing to find in manv smaller cities that although
they do have the authority to borrow. thev finance capital programs
either through reserves, as was implied earlier by one of the panelists,
or they do it through grants or through other means.
Representative MOORHEAD. Mr. Peterson, can large cities get along
with reduced Federal transfer payments~
Mr. PETERSON. I would like to answer that Question in two steps.
First, I think that in designing Federal programs that we are beyond
the stage where we need the temporary pragmmc: or 11rban assistance designPd to relieve financfal strain. Both the CETA le2:islntion
and the antirecession fiscaJ assistance Je2:islntion R.re scheiln led £or
expiration September 30, and the focal public works portion 0£ the
public works bill has expired. I think this is a good opportunity to


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turn one's attention from short term fiscal sustenance to the design
of more permanent programs by beginning to phaseout some of
those temporary ones.
Second, I believe that in any discussion of the cost implications of
Federal grant programs that more attention has to be given to the
structure of aid programs and their implications for local public
sector prices. In a sense it is quite deceptive to speak of inflation at
the State and local level as if prices were beyond Government control.
A good deal of the increase in State and local costs has been increasing in relative prices-public sector wages, for example-and capital costs that have increased beyond the national inflation rate. Fed.:
eral grant-in-aid programs have contributed to that price inflation
by lowering the cost to local governments o:f acquiring certain kinds
o:f services. I think there has been a direct linkage between State
and local wage levels and the prices paid for goods and services, and
the design of aid programs. Until very recently Federal aid programs were designed to stimulate spending and often had the effect of
raising prices, as well.
The original purpose of general revenue sharing, in fact, was to
stimulate State and local spending to make sure that State and local
spending increased as a portion of gross national product.
We have come a long way in the last decade in our perception o:f
that issue. We now want to restrain State-local spending, where possible. It is therefore important to design Federal grant programs, not
to deliberately stimulate spending, but to be sure the expenditure impacts are not captured simply in price increases.
Repi·esentative MooRHEAD. I wonder if Mr. Gramlich would care to
comment.
I think it is a very significant statement made that we should be
changing our emphasis from fiscal relief measures to more targeted
economic development measures if we stay in the business of assisting localities at all.
Mr. GRAMLICH. I agree with that. I don't have too much to add,
except for one other point. That is that a lot of the temporary measures that Mr. Peterson was referring to were things passed as part
of the economic stimulus package of 1976. Measures expressly designed
to stimulate the economy by changing the spending of local governments. And I think that the people who have looked at the success of
that effort-including others, as well as myself-have found in general that there wasn't that much spending that was stimulative.
I think that one can conclude that, if you are interested in stimulating the economy-which you have to be from time to time-that the
best way to do that is by direct income tax cuts and increases, and not
by grants through local governments. That is not an effective way to
alter the national economy.
Representative MOORHEAD. Thank you, Mr. Chairman.
Representative REuss. Thank you, Congressman Moorhead.
The one overriding conclusion I draw from this enormously interesting discussion is that, while the immediate bolt of lightning from
Proposition 13 fell on the heads of local government, there is enough
sin to go around at the State and Federal level, too, and that the problems we are talking about are really the problems of our Federal


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structure, and thus an approach like that taken by the Joint Economic
Committee and the Subcommittee on the City, which doesn't try to
distinguish too much between levels of government, but tries to look
at the total of what has been done, seems to me to be the direction in
which we have to go, and I congratulate each one of you for pursuing
the problems before us in that light.
It's been an extremely helpful session. vVe could go on for a long
time, but we have been working hard for more than 3 hours.
I want to thank you and thank Congressman Moorhead for his
generosity in agreeing to cochair this joint session.
The Subcommittee on the City will convene here at 9 :30 a.m. tomorrow morning for a continuation of these hearings.
[Whereupon, at 12 :43 p.m., the joint hearing adjourned, subject
to the call of the Chair.]


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