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Federal Reserve Bank of Minneapolis 1979 Annual Report










Contents
A b o u t T h is I s s u e ....................................................................... iii
T h e T ax-C u t I ll u s i o n ..............................................................

1

1 979 O p erating H ig h lig h ts .................................................. 10
Statem en t of C o n d itio n ......................................................... 12
Earnings and E x p e n se s/V o lu m e of O p e r a tio n s . . . .

13

D irectors and O f f ic e r s ............................................................ 14


ii


About This Issue
During 1979 the Federal Reserve System tried to slow
the growth of money, and in 1980 it has renewed its
commitment to this task. Slowing the growth of money is
a necessary step for fighting inflation, but as our 1978
Annual Report explained, the Fed cannot do the job of
fighting inflation by itself. Monetary policy must be
supported by appropriate fiscal policy.
The lead article in this year's Annual Report discusses
one aspect of fiscal policy that has often appeared in the
news in recent months: the possibility of cutting taxes.
Although a real tax cut would be appealing, this is not an
option that the proponents of cutting taxes usually
present. In fact, most of the tax cuts that are usually offered
would result in higher budget deficits and higher
inflation. This amounts to replacing direct taxes with an
inflation tax. If fighting inflation is vital and urgent, as
we strongly believe, then such tax cuts would be a step
backwards.




Of course, if federal government expenditures were
reduced along with taxes, budget deficits and inflation
would not necessarily be pushed higher. In this case, we
would have a real cut in taxes — which could well be good
for the economy. Unfortunately, a substantial cut in
government expenditures seems very elusive.
In the second part of this report, the Minneapolis
Federal Reserve Bank's success in lowering unit costs and
raising productivity is documented. Although it may
not greatly affect inflation, we are extremely pleased to
report this performance. It is noteworthy that the Bank
was able to cut its unit costs significantly in spite of high
inflation.

'McJ fl. LjjA.
Mark H. Willes
President
Federal Reserve Bank of Minneapolis




Federal Reserve Bank of Minneapolis 1979 Annual Report

L\A- LiUJ*
A tax cut is often touted as the magical solution to our
economic problems, but a tax cut is not always what it
seems. Most proposals for cutting taxes would not reduce
government expenditures one bit. They are like the
magician's trick of sawing in half the lady in the box. There
is a great deal of hoopla while something appears to be cut,
but when it is all over, nothing much has changed.
In fact, most of the commonly heard proposals for
cutting taxes would not lower the real tax bu rden— they
would probably increase it. A reduction in taxes without a
corresponding reduction in government expenditures
would merely increase our reliance on deficit spending.
This would cause further inflation and make our
economic performance deteriorate. Because of these
hidden costs, a tax cut could easily be concealing an
increase in the real tax burden.

The Real Tax Burden
The real tax burden is the amount of resources — goods
and services — that the government removes from the
private sector. Government expenditures account for the
major part of the real tax burden. When the government
spends for investment, transfer programs, consumption,
or anything else, it buys labor, expertise, raw materials,
land, buildings, and so forth. Since all these resources are
in limited supply, the private sector must give them up
when the government buys them. The real tax burden is
not what the Internal Revenue Service collects; it is what
the private sector gives up to government.



A smaller, but still significant, part of the real tax burden
consists of the resources that are consumed incidentally
because of the government's taxation policy. These
resources are removed from the private sector but never
go to any government purpose. They are simply lost —not
because of ineptness or corruption, but because every tax
causes some resources to be wasted. These lost resources,
sometimes called deadweight loss, include collection costs:
the legislative time devoted to tax laws, the expenses of tax
courts, and the costs of running the IRS. They also include
the productive time or material that is wasted as
individuals, legally and illegally, try to minimize their
taxes. Together, these lost resources and government
expenditures com pose the real tax burden.
Most of the proposals for cutting taxes would not
reduce the real tax burden, despite the claims of the newly
popular supply-side theories. They would reduce neither
expenditures nor the amount of wasted resources. They
would merely reduce tax revenues — but reducing tax
revenues does not mean that government hires fewer
people, buys fewer buildings, or owns and controls
fewer resources of any other kind. In fact, it could easily
mean that government owns and controls the same
resources and runs larger budget deficits.

Deficits and Inflation
Because most proposals for tax cuts are not coupled with
any reduction in government expenditures or dead­
weight loss, they would have to increase the federal

1

Increasing federal debt is a way to conceal taxes,
not a way to reduce them . . .

budget deficit. In effect, they would replace explicit taxes
like the income tax with greater deficits.
A shift from explicit taxes to deficits does not lower the
real tax burden, whatever else it may do. Increasing
federal debt is a way to conceal taxes, not a way to reduce
them. If the accumulated debt is going to be paid off in the
future, a shift to deficits could indeed postpone taxes for a
while. But the taxes must eventually be paid back with
interest.
If, on the contrary, the accumulated debt is not going to
be paid off in the future, then a shift to deficits merely
makes taxes less visible. Currently, it seems safe to assume
that the United States governm ent will not pay off its
debt. Since the 1960s it has not done so, and it appears to
have no intention of doing so. Congress and the
administration have sought to balance the budget only
when there is full employment, only at the peaks of the
business cycle. They are clearly saying that the budget on
average will be in deficit. The longer they follow this
policy, the greater the total federal debt will be.
When the federal government runs a deficit, it simply
prints and sells more bonds. Federal bonds are nothing
more than an alternative form of currency — they are
promises to deliver currency in the future. Like currency,
these bonds are pieces of paper backed by nothing
tangible; they are fiat paper. Like currency, they are a debt
that the government never promises to retire. They are,
in all essentials, a part of our ever-expanding money
supply. W hen the government has no intention of retiring
its debt, there is little difference between currency and
bonds; both are money.
In this circumstance, any increase in the deficit is an
inflation tax. As is well understood, government can cause
inflation by printing more money. W hen m ore paper is
pursuing the same amount of goods, it takes more paper
to buy each good. The value of the paper declines; the
price of goods goes up. Obviously, this is inflation.
What is not often acknowledged, though, is that this is
also a tax. W hen the governm ent prints more paper, the
government benefits and the private sector pays.
Government can print paper for virtually nothing and
use it to pay consultants' salaries, to construct buildings, or


2


to acquire other real resources from the private sector.
The private sector then has more paper and fewer goods.
By printing paper, government is able to obtain a larger
share of the available goods, just as if it were taxing its
citizens more. An increase in federal paper — currency or
bonds — is thus really an inflation tax.
The data support the contention that deficits are a
means of levying an inflation tax. In recent years, higher
inflation has accompanied higher deficits. The accumu­
lated federal budget deficit (the stock of interest-bearing
and noninterest-bearing federal government debt) has
expanded much faster in the 1970s than in the 1960s. In
the 1960s, when the deficit grew slowly, the rate of
inflation was very moderate, as Figure 1 shows. In the
more debt-burdened 1970s, in contrast, inflation aver­
aged about 7 percent per year.

Some Excuses for Deficits
The total federal debt has been increasing; this is the
indisputable consequence of our repeated annual deficits.
Som e economists, however, claim that the increase in
federal deficits cannot explain the increase in inflation.
They have two main lines of argument to explain why
deficits in the 1970s have not been large enough to cause
inflation to accelerate. Both of their arguments are off
the mark.
They claim, first, that federal deficits are partly offset
by state and local government surpluses. On the surface
this claim may look plausible, because surpluses and
deficits are simply opposite sides of the same thing. A
deficit adds to the amount of bonds a particular
government has issued; a surplus lowers the amount. But
federal deficits cannot simply be added to state and local
surpluses. They are not equivalent, and adding them is
like adding apples and oranges.
Deficits from state and local governments are funda­
mentally different from those from the federal govern­
ment. Unlike the federal government, state and local
governments back their bonds with the promise to tax
people. They must repay their debts or go into bank-

When the government prints more fiat paper,
the government benefits and the private sector pays

Fig u re 1
H ig h er inflation has accom p an ied h ig h er deficits —
Average Annual Growth (%) in Federal Governm ent Debt
and the Consum er Price Index in the Last Two Decades

19 7 0 s

*N ot including D ecem b er 1979.
Sou rces:

Federal R eserve Board o f G overnors,
U S. D epartm ents of C o m m erce and Labor

ruptcy. Because their bonds are backed, they have no
effect on the amount of unbacked debt — fiat paper —
in circulation. This means that they have nothing to do
with inflation, for only fiat paper causes inflation.
The surpluses of state and local governments are also
quite unlike those of the federal government. State and
local surpluses simply reduce the amount of backed
bonds. They do not reduce federal debt. They do not
reduce the amount of fiat paper in circulation. They do not



reduce the money supply. And they do not reduce
citizens' tax obligations to the federal government.
Adding today's federal deficit to state and local surpluses,
like adding apples to oranges, does not make sense; it
makes fruit cocktail.
The second argument that some economists use to
explain why federal deficits have not been growing fast
enough to cause an increase in inflation is that federal
deficits have not grown in relation to the size of the
economy. More specifically, they claim that when the
accumulated federal debt is computed as a percentage of
the gross national product, it has actually declined in the
1970s. Therefore, they argue, deficits can't explain the
higher inflation rates of the 1970s.
Their calculation, however, is meaningless. They
mistakenly use the figures for nominal GNP to represent
the size of the economy, figures that include the effects of
inflation. Nominal GNP is equal to the price level
multiplied by real GNP, the amount of goods and services
that the country produces. As a result, nominal GNP can
increase merely because of inflation. Real GNP, in
contrast, can increase only when people work more,
when firms invest more, or when productivity increases.
To determine if deficits are large in relation to the size of
the economy, it is necessary to use figures for real GNP,
figures that are not adulterated by inflation.
To see why it is meaningless to calculate federal debt as
a percentage of nominal GNP, consider what happens to
this percentage under an extreme assumption: that
federal debt is the sole cause of inflation. Under this
assumption, suppose that federal debt doubles during a
certain period. What happens? The price level doubles,
which is to say the rate of inflation is 100 percent. Nominal
GN P likewise doubles, supposing that output remains
the same. But despite the rapid rate of inflation, federal
debt as a percentage of nominal GN P remains exactly the
same as it was, because both figures have simply doubled.
The conclusion is inescapable: Computing federal debt as
a percentage of nominal GN P is irrelevant for determin­
ing if debt growth causes inflation. Even if debt growth
were the sole cause of inflation, this computation could
not detect it.

3




Figure 2
— ev en w h en th e scale o f th e eco n o m y is co n sid ered

*N o t including D ecem b er 1979.
Sou rces:

Federal R eserve Board o f G ov ern ors, U.S. D epartm ents of C o m m erce and Labor

Inflation is never neutral.
It is a real tax that lowers real output,
even when it is fully anticipated . . .

To compare the size of the federal debt with the size of
the economy, the economy must be represented by the
quantity of real goods that the country produces. That is,
real GNP, not nominal GNP, is the relevant measure.
W hen the amount of federal debt is computed as a
percentage of real GNP, the claim that increases in federal
debt are closely related to inflation cannot be easily
dismissed. (See Figure 2.) From 1959 to 1969, when
inflation was low, federal government debt as a
percentage of real G N P dropped slightly. From 1969 to
1978, when inflation was high, it nearly doubled. Even
when the scale of the economy is considered, federal debt
in the inflationary decade of the 1970s has grown more
rapidly than in the relatively stable 1960s.
A tax cut that reduces revenues and increases deficits,
therefore, would merely substitute the inflation tax for
explicit taxes. It would not lower the amount taxpayers
relinquish to the government.

I h c Costs o f Inflation
Why, then, has the inflation tax been used so extensively?
Congress has apparently found it easier to legislate
inflation than to increase direct taxes, because many
prominent economic models erroneously imply that
inflation isn't a serious hardship. In these models, inflation
has no econom ic costs — it does not reduce output.
Although most economists would agree that a highly
unpredictable rate of inflation makes planning more hitand-miss and increases the odds of making damaging
econom ic decisions, their models typically do not reveal
these costs. In most models, in fact, inflation is neutral, its
costs negligible.
Keynesian models, for instance, imply not only that
inflation is costless, but that it has tremendous benefits. In
these models it is possible to raise output and employ­
ment indefinitely simply by raising inflation. On average,
in Keynesian models, inflation makes the economy
perform better. Monetarist models also imply that the cost
of inflation is low, although not as low as in Keynesian
models. In monetarist models the cost of inflation is zero,



because higher prices have no effect on real output. When
inflation is fully anticipated, wages, incomes, prices, and
interest rates all go up in unison and no one is really
harmed. When inflation is not anticipated, it causes some
redistribution of income from creditors to debtors, but
one person's losses are balanced by another's gains, so the
economy as a whole is unaffected. In these models, that is,
inflation produces no deadweight loss — no wasted
resources of any sort.
But inflation is never neutral. It is a real tax that lowers
real output, even when it is fully anticipated.
The inflation tax lowers output — or, in other words,
lowers real income — because it produces a high
deadweight loss. Inflation gives people incentives to use
their time and physical goods in less productive ways. It
encourages them to use their resources in ways they
wouldn't dream of if more explicit taxes replaced the
inflation tax.
It does this by making money less desirable as a means
of exchange and a store of value. Inflation can be defined
as the rate of increase in the price level or as the rate of
decline in the value of each unit of fiat paper. By either
definition, when inflation accelerates, the real rate of
return on currency and outstanding federal bonds falls.
This begins a chain reaction. When the rate of return on
money falls, more real resources — physical goods that
would otherwise be used to produce something — are
devoted to cash management techniques. A lot of labor,
computers, and office space, for instance, are now being
used to allow individuals to substitute interest-bearing
assets for idle cash.
When resources are diverted to nonproductive uses —
when a steel company finds it necessary to hire someone
to minimize its cash holdings instead of someone who
produces steel — the rates of return on capital should fall.
Sure enough, they have fallen as deficits have increased
and inflation has accelerated in the 1970s. Although
individuals find it in their own best interests to hold less
money when inflation rises, substituting productive
capital for money is wasteful for the economy as a whole.
A lower return on capital is not the only problem
related to deficit financing and the subsequent inflation

5

Most of the frequently proposed tax cuts
are misleading and potentially harmful . .

F ig u re 3
L o w er retu rn s and slo w er g row th in th e inflationary '7 0 s
1970s
Average Annual
Rate of Return (%)
on Capital

Average Annual Grow th (%) in

Real GNP

Capital
per W orker

7
*1 9 7 0 -7 8
So u rces:

Federal R eserve Board o f G ov ern ors, U.S. D epartm ents o f C o m m erce and Labor

tax, as Figure 3 shows. As the return on capital has
fallen, business has becom e more reluctant to add to its
capital stock. Because of this, workers have been forced to
work with less capital than they otherwise would — they
use fewer or older machines, for example. As a result, they
have not produced as much as they could have. Thus,
productivity and total output have both grown more
slowly than they would have. The data, in short, are
consistent with the view that the greater inflation taxes of
the 1970s have caused a decline in the real rate of return
on capital, a decline in the rate of capital accumulation,
a decline in productivity growth, and a decline in overall
economic growth.
Some of this slower growth might be blamed on greater

6


uncertainty about inflation or government policy. How­
ever, even if this uncertainty could be eliminated, inflation
would still have large costs. The inflation tax has been
allowed to becom e very high and do a lot of damage to the
economy.*
‘ So m e have argued that the deterioration in econ om ic perform ance
in the 1970s is due to h igher energy prices. But even w h en the rise in the
relative price of energy was m odest, as it was from 1970 to 1978, econ om ic
perform an ce was hardly exem plary. O v er this period the energy subindex of
the con su m er price index rose at an average annual rate o f 8.7 p ercent — only
m odestly faster than the total CPI, w hich rose at an average annual rate of 6.6
percent. W hen the period from 1970 to 1978 is com p ared to the 1960s, the
econ o m ic p erform an ce of the 1970s still looks p oo r. It is doubtful, then, that
energy prices can explain the deterioration of econ om ic p erform an ce in the
1970s.

If policymakers were made aware
of the uncertainty surrounding economic forecasts,
they would have to be much more cautious . . .

Popular Tax-Cut Proposals
Most of the frequently proposed tax cuts amount to using
explicit taxes less and the inflation tax more, since they
would almost certainly lower tax revenues and increase
deficits. They are thus misleading and potentially
harmful.
One type of tax cut that has been proposed with slight
variations over the last several years is the antirecession
tax cut. It is designed to lower tax rates in general so that
tax revenues fall. Its advocates admit that it would increase
inflation, but they claim that the cost of the extra inflation
would be trivial compared to the benefits. As prices rise,
their argument goes, workers on inflexible contracts
could not receive compensating raises so that their real, or
inflation-adjusted, wages would fall. Because of the lower
real wages, employers would demand more labor and
output would increase. The supposed result of the
antirecession tax cut, then, is a slight increase in inflation
and substantially m ore employment and output.
This kind of reasoning got us into the economic swamp
we're in now. It is wrong for at least three reasons.
First, it is wrong because it assumes that people can
be repeatedly fooled by a policy of cutting taxes whenever
an econom ic downturn appears. It assumes not that
people make random errors in guessing about the
economic future, but that they make systematic errors that
government policy can exploit to make them better off
in spite of themselves. This assumption is not well
founded. The best current theories suggest that people
cannot be so easily fooled and that government is not so
omnipotent. W hen employers and employees are
concerned about real wages and both foresee an increase
in prices, then nominal wages rise. This offsets the price
increases and keeps employment and output from rising.
The reasoning behind the antirecession tax cut is
wrong, secondly, because it relies on only half of what the
advocates' econom ic models predict. Advocates of this
kind of tax cut emphasize that it could produce some
temporary gain in employment or output, but they ignore
another prediction from the same models: the prediction



that this gain will soon be completely wiped out. After a
few years, we will be left only with higher inflation. The
advocates say"buy now"and forget to mention"pay later."
The reasoning of the advocates of the antirecession tax
cut is wrong, thirdly, because it ignores the uncertainty of
their models. W hen the advocates announce that their
models predict, say, - 1 percent real growth for the year
ahead, they fail to note that the models really predict a
range of economic outcomes. With reasonable confi­
dence they can say only that econom ic growth will turn
out to be between something like - 5 percent and + 3
percent, a range so wide as to be of little value for
determining the impact of a tax cut. So when economists
forecast, for example, that a $25 billion tax cut will add
1 percentage point to real growth, the implied certainty of
their forecast is ludicrous. If policymakers were made
aware of the uncertainty surrounding econom ic forecasts,
they would have to be much more cautious about
recommending an antirecession tax cut.
The most basic problem with the antirecession tax cut,
though, is the familiar one. It would create higher
inflation, and inflation is not free. Such a tax cut would be
costly.
Another common proposal for a tax cut is the incentive
tax cut. It is designed to lower a specific tax rate, such as
the payroll tax rate or the business tax rate, in order to
provide incentives for individuals to produce m ore or
invest more. Incentive tax cuts, however, would quickly
cause larger deficits and m ore inflation. This would
probably take away m ore incentives than it would
provide. Lowering a specific tax rate would lower the
deadweight loss caused by that specific tax — the amount
of legislative time, lawyers' fees, office space, and other
resources consumed by that tax. But it would simul­
taneously increase the deadweight loss caused by
inflation— the erosion of people's savings, the weakening
of bond markets, the obstacles to establishing long-term
contracts, and so on. The incentives provided by the right
hand would be taken away by the left, and with a
vengeance.
Some economists and editorialists contend that tax
rates can be cut without losing tax revenues. It is much

7

The Uncertainties of the Laffer Effect
The one hope that a cut in tax rates will increase tax
revenues is the"Laffer effect/' but this is a slim hope at
best. It depends on the assumption that people will work
significantly more when their after-tax wages rise or that
they will invest significantly more when their after-tax
profit or rate of return rises.
The presumed relationship of tax rates and tax
revenues for a particular tax, like the payroll tax or the
business tax, is shown in the chart below. As this chart
indicates, when tax rates fall to zero, revenue falls to
zero. When tax rates rise to 100 percent, revenue also
falls to zero, because people have no incentive to work.
Between these two extremes lies the tax rate that will
produce the maximum revenue for this particular tax,
rate C . No one knows what this rate is.It could be close to
the middle or close to one of the extremes. Furthermore,
no one knows the shape of the curve. It could have
irregularities that do not appear on this simple chart.
The Laffer curve

T ax R ates

The Laffer effect depends on two conditions which
are highly uncertain and unlikely. First, for any given
tax, the current tax rate must be beyond the point of
maximum revenue — that is, the tax rate must be higher
than rate C. If tax rates were cut from E to D, for instance,
revenues would rise. However, since no one knows
where the point of maximum revenue is, no one can be
sure that the Laffer effect will occur. If the tax rate were
below rate C, a cut in rates would not raise revenues. If
rates were cut from B to A, for example, tax revenues
would fall.


8


The second crucial condition that must be met for
the Laffer effect to work is that the tax cut must not
be too large. Even if we assume that the tax rate is
above rate C, the Laffer effect won't work unless it is
cut just enough to bring revenues closer to the point
of maximum revenue, but not much beyond it.
Lowering tax rates from E to D or from D to C, for
example, would increase revenues. But lowering them
from D to B would make revenues fall. Since no one
knows the shape of the curve or the location of the
point of maximum revenue, it would be very difficult
to cut tax rates correctly. Perhaps just a small change
in rates would carry us all the way from E to A.
If the tax rate is now higher than the point of
maximum revenue and if the rate were cut just the right
amount, the Laffer effect would work— lower tax rates
would produce higher tax revenues. Both conditions,
though, are extremely uncertain.
Worse, they seem very unlikely, judging from what
little evidence is available. For the payroll tax cut to
succeed, people must work significantly more when
their real after-tax wages rise, because only then
could a cut in tax rates fail to reduce tax revenues. If
payroll taxes were assessed at a lower rate and people
worked the same amount or less, tax revenues
obviously would fall. Recent data, in fact, suggest that
people do not work more when their real after-tax
wages rise. If any generalizations can be made, people
seem to work less and enjoy more leisure when their
real wages rise. In recent years, at least, when real
wages have gone up, people have worked less.
Similarly, for the business tax cut to raise tax
revenues, firms must invest significantly more when
their real after-tax return rises and output must increase
significantly in response to the added investment.
Output must increase enough so that the initial decrease
in taxes is offset. For example, if a tax on business output
is lowered from 50 to 45 percent, then output would
have to increase more than 10 percent to make up for
lost tax revenues. But even the proponents of the
business tax cut concede that an increase in tax revenues
is highly unlikely. They admit that tax revenues would
probably drop.
Since there is a good chance that a cut in tax rates
would ultimately lower tax revenues, experimenting
with such a cut would be to risk making our high
inflation rates even higher and our large budget deficits
even larger. The uncertainties of the Laffer effect seem
far too great to justify such a risk.

Let there be a tax cut —
but let it be the real thing

more likely, however, that a cut in tax rates would lower
revenues. (See opposite page: "The Uncertainties of the
Laffer Effect.")
Neither of the two main versions of the incentive tax
cut is likely to succeed. One version, the payroll tax cut, is a
plan to reduce the payroll taxes that employers pay on
every worker. This, it is supposed, would lower the cost of
labor. Businesses would respond by hiring more workers,
the additional workers would generate more output and,
as this additional output reached the market, prices would
tend to be lower.
If the payroll tax cut really worked this way, then we
should eliminate all payroll taxes. This, supposedly,
would increase employment even further. Perhaps we
should even offer businesses a large tax rebate for every
employee hired. If the rebate were large enough, this
would supposedly stop inflation altogether. The payroll
tax cut, of course, would not work like this, because
government can't just give away money it does not have. If
government really wants to lower payroll taxes, it has to
reduce its expenditures or raise other taxes to make up
for lost revenues. But then the tax cut might create jobs in
one sector by eliminating them in another.
Of course, government could finance the payroll tax
cut with more fiat paper, more unbacked debt. And unless
it should undergo the most spectacular conversion since
Paul went to Damascus, that is what it would do. If the
government printed more fiat paper, we would, of course,
have more inflation. Labor would doubtlessly recognize
this, as it has in the past, and would immediately demand
higher wages. Then, the payroll tax cut would only
transform a tax levied on employers into an inflation tax
levied on everyone. Because of higher inflation, the
promised increase in output would fail to materialize.
Another version of the incentive tax cut, the business tax
cut, is a plan to encourage investment. The argument for
this plan is that a cut in business taxes will increase
profitability and, hence, the return on capital. Business
will then be motivated to invest more, and the increase in
capital will generate more output and lower prices. The
plan, however, has the crucial weakness of the other taxcut proposals. If government does not raise tax revenues



through another source, the business tax cut will create
higher inflation. The cost of the higher inflation would
offset the benefit of lower taxes so that business would not
be motivated to invest in m ore capital or increase its
output.
Proponents of both the payroll tax cut and the business
tax cut are correct in one regard: the tax structure does
change incentives to work or invest. But they overlook a
basic point. The real tax burden is the amount of resources
government removes directly or indirectly from the
private sector. If governm ent does not lower expendi­
tures, a cut in any particular tax will be offset by increases
in other taxes, especially the inflation tax. There are two
ladies in the magician's box — two types of taxes — not
just one. While the obvious taxes may appear to be cut, the
hidden taxes are increased.
The proposed tax cuts, however, are not just slick
stagecraft. They are not merely pleasant illusions that
leave everything unchanged. They do change things —
and not necessarily for the better. As they replace direct
taxes with the less efficient inflation tax, they cause
resources to be needlessly wasted. While pretending to
saw the lady in half, the magician destroys a lot of boxes.
There is every reason to believe that people would be
better off if government used the inflation tax less, since
inflation is so wasteful and harms the econom y in so many
ways.
A tax cut could be worthwhile if it were an honest tax
cut — that is, if governm ent truly took fewer resources
from the private sector. To do this in any significant way,
of course, it would have to reduce expenditures, devise a
more efficient tax structure, or both. So let there be a tax
cut — but let it be the real thing and not merely a
magician's illusion.
This article w as prepared by Preston }. Miller, A ssistant
Vice President, with assistance from Alan Struthers, Jr.,
Editor, both o f the Research Department o f the Federal
Reserve Bank o f M inneapolis.

9

During 1979, operating performance at the Federal
Reserve Bank of Minneapolis reflected a continuation
of five-year trends in expense control, unit cost and
productivity improvement, and growth in output. Also,
a great deal of planning and preparation took place for
significant technological changes in the Bank's opera­
tions. Ninth District 1979 total operating expenses of
$29.7 million represented an increase of only 5.6 percent
over 1978 levels in spite of a 9.6 percent increase in
measured output.
As the accompanying charts illustrate, five-year
expense, productivity, and unit cost trends have com ­
pared quite favorably with standard economic indicators
for both the Federal Reserve Bank of Minneapolis and the
Federal Reserve System as a whole. Over the five-year
period of 1974 through 1979, total operating expenses
(Chart 1) have increased at an average annual rate of 6.8
percent for the Federal Reserve System and 4.7 percent
for the Federal Reserve Bank of Minneapolis. Over the
same five-year period, measurable outputs (Chart 2) have
increased at an annual rate of approximately 7.0 percent
for both the System and the Minneapolis Bank.
Unit cost performance over this period (Chart 3) has
been very strong as 1979 unit costs are 3.2 percent below
.1974 levels for the System and 18.2 percent below 1974
levels for the Minneapolis Bank. These compare to a 44.1
percent increase in the GN P price deflator, which is a
measure of general price level changes.
Increases in labor productivity (Chart 4) have been a
primary contributor to the unit cost performance.
Productivity has increased at an average annual rate of 9.6
percent for the System since 1974 and 7.8 percent per year
for the Minneapolis Bank. These increases compare to an
annual average increase in productivity for the nonfarm
business sector of 1.25 percent over the last five years.


10


In addition to the continued strong performance
results, 1979 was also a year of preparation for operations
in the new decade. The Federal Reserve Bank of M innea­
polis planned for major technological changes in its
operations as well as contributed to System efforts on
membership, access, and pricing issues. In the operations
area, Check Department is in the process of implementing
and testing a new generation of faster and larger capacity
reader/sorters; these are expected to be fully operational
by the third quarter of 1980. This new equipment will
increase peak processing capacity by 25 to 30 percent and
substantially reduce reject and jam rates. Delivery delays
on the new sorters resulted in a shortage of processing
capacity during the fourth quarter of 1979 and necessi­
tated an increase in staff levels to accommodate a larger
than expected growth in check volume. This contributed
to the first annual increase in staff size for the Bank as a
whole since 1975 (Chart 5).
Planning also took place in 1979 on the installation of
new high speed currency processing equipment in the
Money Department. This equipment, which is scheduled
to be installed during the first half of 1980, will combine
individual note fitness sorting, counterfeit detection and
on-line destruction of unfit notes to improve sorting
efficiency and costs.
Preparations were also under way this past year for
several externally precipitated changes in the Bank's
operations, including a new System long-range auto­
mation program, a new nationwide Federal Reserve
communication system, and planning for potential
changes due to membership, access, and pricing
legislation.

Chart 4

Labor
Productivity
1974 = 100

Ninth
District

Chart 5

130

\
Ninth
District

120

mploymen
1 9 7 4 = 100

110

100

150
GNP Price
Deflator

140
130
120

110

100

90
Ninth
District

80




I

75

76

77

78

11

Statement of Condition

(In thousands)

December 31

1979

1978

ASSETS
Gold Certificate A ccount..............................................................
Interdistrict Settlement F u n d .....................................................
Special Drawing Rights Certificate A ccount...........................
C oin.......................................................................................................
Loans to M ember B a n k s ..............................................................
Securities:
Federal Agency Obligations.................................................
U.S. Government Securities.................................................

$ 231,534
(765,306)
32,000
16,741
31,440
182,625
2,585,043

Total Secu rities.........................................................................

$2,767,668 $2,816,740

Cash Items in Process of Collection..........................................
Prem ises and Equipment —
Less: Depreciation of $9,538 and $8,217...........................
Other A s s e t s .....................................................................................
Total A ssets................................................................................

$ 231,177
(435,146)
28,000
11,182
10,250
'
189,477
2,627,263

994,364

802,060

30,644
156,101

30,992
101,654

$3,495,186

$3,596,909

Federal Reserve N o tes...................................................................
Deposits:
Reserve Accounts.....................................................................
U.S. Treasury — General A ccou nt......................................
Foreign.........................................................................................
Other D ep o sits.........................................................................

$1,908,623

$1,854,810

675,326
175,017
9,568
21,508

866,328
182,605
6,081
7,638

Total D eposits............................................................................

$ 881,419

$1,062,652

Deferred Availability Cash Ite m s...............................................
Other Liabilities................................................................................

571,747
60,885

559,983
51,384

Total Liabilities.........................................................................

$3,422,674

$3,528,829

$

36,256
36,256

$

34,040
34,040

Total Capital A cco u n ts..........................................................

$

72,512

$

68,080

Total Liabilities and Capital Accounts...............................

$3,495,186

LIABILITIES

CAPITAL ACCOUNTS
Capital Paid I n ..................................................................................
S u rp lu s................................................................................................


12


$3,596,909

'

Earnings and Expenses

(in thousands)

For the Year Ended December 31

1979

1978

CURRENT EARNINGS
Interest on Loans to Member B a n k s ........................................
Interest on U.S. Government Securities
and Federal Agency O blig atio n s............................................
All Other E arn in g s.........................................................................

$

6,356

$

2,379

226,908
2,300

200,243
377

$235,564

$202,999

Salaries and Other Ben efits..........................................................
$ 17,516
Postage and Expressage................................................................
3,238
Telephone and Telegrap h.............................................................................572
Printing and Supplies.....................................................................
1,041
Real Estate T axes..............................................................................
1,325
Furniture and Operating Equipment —
Rentals, Depreciation, M aintenance........................................
1,672
Depreciation — Bank P rem ises................................................... .................873
U tilities.................................................................................................................466
Other Operating E x p e n se s ..........................................................
2,010
Federal Reserve C urrency............................................................
993

$ 16,299
3,135
585
944
1,521

Total Current E arn in gs..........................................................

CURRENT EXPENSES

1,505
873
489
1,815
992

Total Current Expenses..........................................................

$ 29,706

$28,158

Less Expenses Reimbursed or Recovered...............................

2,409

1,942

Net E x p e n se s............................................................................

$ 27,297

$ 26,216

CURRENT NET EARNINGS .....................................................

$208,267
(3,621)

$176,783
(18,252)

1,593
2,121
198,716

1,596
1,921
151,704

Net Profit (or L oss).........................................................................
Less:
Assessment for Expenses of Board of G overn ors.............
Dividends P a id ..............................................................................
Payments to U.S. T rea su ry ........................................................
Transferred to S u r p lu s ..........................................................

$

2,216

$

3,310

SURPLUS ACCOUNT
Surplus, January 1 ............................................................................
Transferred to Surplus — as above............................................

$34,040
2,216

$30,730
3,310

Surplus, Decem ber 3 1 ...................................................................

$36,256

$34,040

Volume of Operations*
Number
For the Year Ended December 31
Loans to M ember Banks......................
Currency Received and Verified. . . .
Coin Received and C o u n ted .............
Checks Handled, T o ta l........................
Collection Items H a n d le d ..................
Issues, Redemptions, Exchanges
of U.S. Government Securities . . . .
Securities Held in Safekeeping.........
Transfer of F u n d s ..................................

1979
157
352
770
.3

1,904
million
million
million
million

9.8 million
520,955
1,133,182

Dollar Amount
1979
1978

1978
148
637
718
.3

987
million
million
million
million

9.2 million
523,772
1,001,192

$

2.4 billion
1.4 billion
65 million
281 billion
.5 billion
99.4 billion
2.7 billion
1.169 trillion

$ 1.4
1.3
87
263
.5

billion
billion
million
billion
billion

81.1 billion
2.5 billion
941 billion

^M inneapolis and H elena com bined




13

Directors of the Federal Reserve Bank of Minneapolis
Terms expire December 31 of indicated year

January 1980

Stephen F. Keating
Chairman and Federal Reserve Agent
William G. Phillips
Deputy Chairman

CLASS A

CLASS B

CLASS C

Elected by Member Banks

Elected by Member Banks

Appointed by Board of Governors

Jam es H. Smaby (1980)
President
Com m ercial National Bank & Trust Co.
Iron Mountain, Michigan

Donald P. Helgeson (1980)
Vice President and Secretary
Jack Frost, Inc.
St. Cloud, Minnesota

Stephen F. Keating (1980)
Vice Chairman
Honeywell, Inc.
Minneapolis, Minnesota

Zane G. Murfitt (1981)
President
Flint C reek Valley Bank
Philipsburg, Montana

Russell G. Cleary (1981)
Chairman and President
G. Heileman Brewing Co., Inc.
La Crosse, Wisconsin

William G. Phillips (1981)
Chairman
International Multifoods
Minneapolis, Minnesota

Henry N. Ness (1982)
Senior Vice President
The Fargo National Bank & Trust Co.
Fargo, North Dakota

Joe F. Kirby (1982)
Chairman
Western Surety Company
Sioux Falls, South Dakota

Sister G enerose Gervais (1982)
Administrator
Saint Mary's Hospital
Rochester, Minnesota

Member of Federal Advisory Council
Clarence G. Frame (1980)
President
First National Bank
St. Paul, M innesota

Directors of the Helena Branch
Patricia P. Douglas
Chairman
Norris E. Hanford
Vice Chairman

Appointed by Board of Directors
FRB o f Minneapolis

Appointed by Board of Governors

Harry W. Newlon (1980)
President
First National Bank
Bozem an, Montana

Patricia P. Douglas (1980)
Vice President-Fiscal Affairs
University of Montana
Missoula, Montana

Jase O. N orsw orthy (1980)
President
The N R G C om pany
Billings, M ontana

Norris E. Hanford (1981)
Wheat and Barley Operator
Fort Benton, Montana

Lynn D. G robel (1981)
President
First National Bank
Glasgow, Montana

14


Officers of the Federal Reserve Bank of Minneapolis
January 1980
Mark H. Willes
President
Thomas E. Gainor
First Vice President

Senior Vice Presidents

Vice Presidents

Assistant Vice Presidents

Melvin L. Burstein
Senior Vice President
and G eneral Counsel

John P. Danforth
Vice President and
Director of Research

Sheldon L. Azine
Assistant Vice President
and Assistant Counsel

Leonard W. Fernelius
Senior Vice President

Lester G. Gable
Vice President

James U. Brooks
Assistant Vice President

John A. MacDonald
Senior Vice President

Gary P. Hanson
Vice President

Marilyn L. Brown
Assistant Vice President

Ruth A Reister
Assistant Vice President
and Secretary

Bruce J. Hedblom
Vice President

Richard K. Einan
Assistant Vice President

Arthur J. Rolnick
Assistant Vice President

Douglas R. Hellweg
Vice President

Phil C. G erber
Assistant Vice President

Charles L. Shrom off
Assistant Vice President

Howard L. Knous
Vice President
and G eneral Auditor

Richard C. Heiber
Assistant Vice President

C olleen K. Strand
Assistant Vice President

William B. Holm
Assistant Vice President

Joseph R. Vogel
C hief Examiner




David R. McDonald
Vice President
Clarence W. Nelson
Vice President

Ronald E. Kaatz
Assistant Vice President
Preston J. Miller
Assistant Vice President

Ronald O. Hostad
Assistant Vice President

James R. Taylor
Vice President
Robert W. W orcester
Vice President

Officers of the Helena Branch
Betty J. Lindstrom
Vice President

G. Randall Fraser
Assistant Vice President
Robert F. McNellis
Assistant Vice President

15