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MAY 22 AND 23, 1978

Printed for the use of the
Committee on Banking, Housing, and Urban Affairs

29-775 O


WILLIAM PROXMIRE, Wisconsin, Chairman
EDWARD W. BROOKE, Massachusetts
THOMAS J. McINTYRE, New Hampshire
H. JOHN HEINZ III, Pennsylvania
ROBERT MORGAN, North Carolina

KENNETH A. MCLEAN, Staff Director

JEREMIAH S. BUCKLEY, Minority Staff Director
STEVEN M. ROBERTS, Chief Economist


Opening statement of Senator Proxmire
Opening statement of Senator Brooke
Opening statement of Senator Schmitt
Henry C. Wallich, member, Board of Governors, Federal Reserve System.
Arthur M. Okun, Brookings Institution
David M. Lilly, former member, Board of Governors, Federal Reserve
Emil M. Sunley, Deputy Assistant Secretary for Tax Analysis, Department
of the Treasury




Ambassador Robert Strauss, Special Representative for Trade Negotiations



Barry P. Bosworth, Director, Council on Wage and Price Stability
Albert Rees, Princeton University, Economics Department
Sidney Weintraub, University of Pennsylvania, Economics Department-Laurence S. Seidman, University of Pennsylvania, Economics Department-



Burns Arthur F., statement submitted to committee entitled "Memorandum on Inflation"
Federal Reserve System, report prepared for the Board of Governors of the
the Federal Reserve System by Richard E. Slitor entitled, "Tax-Based
Incomes Policy: Technical and Administrative Aspects"
Library of Congress research paper by Edward Knight on "Inflation and
Government Policy"
Questionnaire, letter and list of individuals mailed April 26, 1978
Responses to questionnaire on Tax-Based Incomes Policies:
American Enterprise Institute, William Fellner, Sterling Professor
of Economics Emeritus, Yale University
Brookings panel on Economic Activity, comments of Alan Greenspan.
Brookings seminar, Alba P. Lerner
Carnegie-Mellon University, Allan H. Meltzer
Center for the Study of American Business, Murry L. Weidenbaum,
Federal Reserve Bank of Minneapolis:
Mark H. Willes, president
Preston Miller, associate director of research
Federal Reserve Bank of New York, Paul A. Volcker, president
Financial Analysts Journal, March-April 1977, by Walter S. McConnell
and Stephen D. Leit
Institute for Social Research, University of Michigan, F. Thomas
Juster, director
Richard Eaton Slitor, economic consultant
University of Chicago, Frederic S. Mishkin, Department of EconomicsThe Financial Analysts Federation, statement prepared for the Federation
by Walter McConnell, senior vice president and director of Wertheim
& Co
"The Return of the Profit Rate to the Wage Equation," by Lawrence S.
Seidman, discussion paper No. 363, August 1977
Statement of Gary Hart, U.S. Senator from the Stste of Colorado




U.S. deficit as percent of GNP
Relationship between money, U.S. Government debt and prices
The WCM Theory: The double-edged demand and cost blades
Price-unit labor cost relationship
Wage equations
Distributed lags for equation (1-M)
Examples of the effects of TIP on a corporation's profits


MONDAY, MAY 22, 1978

Washington, B.C.
The committee met at 10:05 a.m. in room 5302, Dirksen Senate
Office Building, Senator William Proxmire (chairman of the committee) presiding.
Present: Senators Proxmire, Sparkman, and Schmitt.

The CHAIRMAN. The committee will come to order.
Today we begin 2 days of oversight hearings on inflation and new
ways to reduce inflation.
There is a growing consensus that inflation is our No. 1 economic
problem. During the first 4 months of this year the rate of inflation
accelerated to a 12-percent annual rate, and recent estimates of the
underlying rate of inflation have been raised from 6 to 7 percent or
more. There is no way to deny any longer that we are caught in a
vicious inflationary spiral with wage and price inflation feeding on
each other.
About 1 month ago President Carter announced his anti-inflation
program which is based primarily on voluntary efforts to hold down
prices and wages. There has been some support for the President's
programs but there has also been clear and strong opposition to it by
organized labor. About 2 weeks ago even though he was willing to
recognize the inflation problem George Meany would not agree to
support the President's request for restraint. Yet it is obvious that if
the President's anti-inflation program is to work, everyone—the administration, the Congress, the Federal Reserve, business, and labor—
must make a commitment to short-circuit the inflationary spiral.
It has become increasingly clear that the monetary and fiscal policies that could reduce inflation to an acceptable level are politically
unachievable. I found that out 2 weeks ago when the Senate wouldn't
reduce spending by $25 or even $5 billion as I recommended. Also,
the Federal Reserve has repeatedly told this committee that it needs
help in fighting inflation so that monetary policy does not have to create a situation where credit is excessively tight and interest rates
Everyone agrees that wage and price controls won't work and
shouldn't be used. There is no interest at all in using wage and price
controls in this committee and there shouldn't be.


So what are we left with to combat inflation beyond a hope that
everyone will volunteer for the President's fight against inflation?
Well, the reason that these hearings are being held is that we have
been told by some eminent economists that there is a new approach to
reducing inflation that deserves to be given serious consideration.
This approach would use the Federal tax system to provide incentives to business and labor to comply with disinflationary guideposts.
No blame would be assigned to either business or labor for creating
inflation by the proposed programs, and furthermore, compliance
with the guideposts would be voluntary with the tax incentives providing the inducement to hold to the guidelines. These incentives
would be similar to the incentives provided by the investment tax
credit which is already part of the tax system.

Senator SCHMITT. The Carter administration's activities become
more disturbing as time goes on, and there is a continuing impression
that the President blames the country rather than Government for
our economic problems.
The President's influence on economic monetary policy is through
fiscal, and other policy recommendations to Congress, and through
moral persuasion. Frankly, in the eyes of this Senator, both the
policy recommendations and the moral persuasion are inadequate.
One shot tax cuts without spending cuts and the magnitude of the
recently imposed coal settlement are only the most recent examples of
this administration's lack of fiscal leadership.
The Carter administration seems to have recognized that inflation
must be reduced, but many of the policies supported by the administration will significantly increase the rate of inflation:
One: New social security taxes for 1978 will add $6.8 billion to employers payroll costs. Over the next decade, the total increase in social
security taxes will amount to $113 billion for employers and the same
amount for employees, according to the House Ways and Means
Two: Proposed energy taxes will mean higher fuel costs for utilities, industry, and consumers. According to testimony given by
Treasury Secretary Blumenthal before the House Ways and Means
Committee, under the Carter energy plan, if enacted as proposed, the
American people would have faced almost $177 billion in new taxes
by 1985.
Three: For the businessman and consumer alike, the cost compliance with Federal regulations and their attendant paperwork represent purely inflationary costs. The cost of federally generated regulations and the attendant paperwork add $102.7 billion in inflationary
pressure according to a recent study by Murray Weidenbaum prepared for the Joint Economic Committee.
It is clear that the most critical economic problems facing us
domestically and internationally are government created inflation,
declining productivity, unemployment, and overregulation of the
economy. Although the symptoms of these problems reinforce each
other, there are gradual common sense solutions to each problem. If

we begin to solve these problems, and show some patience as solutions
begin to take effect, the- symptoms will begin to recede.
Let me once again suggest the following "common sense" approaches to these four problems. These approaches should be thought
of as an interrelated package of scheduling goals rather than absolute

Our 5-year fiscal policy should (1) Reduce the net Federal deficit
by $10 billion per year; (2) permanently reduce taxes on the productive portions of our economy by $10 biliion per year, and (3) reduce
the rate of growth of the Federal budget by 2 percent per year.
The Federal funds rate should be held below 7 percent so that the
credit market can stabilize and related pressures toward a recession
can be reduced or eliminated.
Monetary policy should reduce the gap between the quarterly averaged growth of Mt and the quarterly averaged growth rate of real
GNP by 0.5 percent per year until rough equality is reached.
Congress should allow for graduated mortgage rates to reduce any
short-term adverse effects of possible increased interest rates as a
consequence of tighter money growth.
Management and labor policy in the private sector must jointly
bear the burdens of reducing demands for price and wage increases
as a strong incentive for the Government to also show restraint.

Tax policy should establish annual permanent decreases in personal
and business taxes which will (1) Encourage small business development and hiring; (2) create increased long-term demand, and (3)
create investment in increased labor-intensive productions.
Congress should gradually increase the incentives for able-bodied
persons on welfare to sock private sector employment or training for
future private sector employment.
Monetary policy should be one of restraint so that business and investment confidence can contribute directly to the creation of private
sector jobs.
Federal tax policy should be one of general reduction so that the
bottom rungs of the economic ladder to success are restored for unemployed youth and for those with dreams of starting their own

Regulatory and tax policy should create incentives for production
and efficient use of our vast domestic resources of oil, natural gas,
coal, uranium, geothermal and solar energy so that energy costs can
be driven down by competition and increased domestic supply.
The administration and the congressional majority do not understand that the high cost of energy is caused by Federal regulation
that prevents the increases in domestic production that can break
the back of the OPEC cartel.
It is not caused by too little energy regulation and taxation.

The guarantee of a free market price structure for new domestic
oil and natural gas would rapidly begin the discovery and production
of a resource base of at least 300 billion barrels of oil and 700 trillion
cubic feet of natural gas. That would provide several decades of supply while we develop alternatives as fast as we can but without the
threat to national security we now face.

Federal regulatory policy must be streamlined so that Congress can
review major regulatory programs for their economic, judicial, and
paperwork impacts on the economy. I have introduced the Regulation
Reduction and Congressional Control Act of 1978, S. 2011, which
would accomplish this aim.
I hope that during these hearings on anti-inflationary proposals,
this committee will give its primary attention to the major source of
inflationary pressure in our economy: The Federal Government.
It is a simple fact that every first-year student of economics learns,
"As the supply of a commodity increases, its price, or value, declines." That is just what the Government has done with the dollar.
By putting too many dollars into circulation, the value of each of
them has been diminished. It is pointless to call upon the rest of the
country to forego the pay increases that will allow them to keep up
with the declining value of the dollar. We must address ourselves to
ending inflation through changes in Federal policies instead.
The CHAIRMAN. We are honored today to have some of the economists who first recommended the new tax-based, anti-inflation policies here to give us their views on inflation and to explain how their
proposals would work toward reducing inflation.
Our witnesses today will appear as a panel. They are the Honorable Henry Wallich, a member of the Board of txovernors of the
Federal Reserve System; Dr. Arthur Okun, a senior fellow at the
Brookings Institution and former Chairman of the Council of Economic Advisors; Mr. David Lilly, who has recently been a member
of the Federal Reserve Board and who will soon take on the responsibilities of dean of the business school at the University of Minnesota;
and Mr. Emil Sunley, Deputy Assistant Secretary of the Treasury
for Tax Analysis.
I would like to ask our witnesses to come forward if they would
and I would like to ask our witnesses to limit their oral statements if
they would to 10 minutes if possible. There will be a light—I hope
you can see it—right in front of me here. The green light will go on
for 9 minutes, then a yellow caution light for 1 minute, and then the
red light suggests that your 10 minutes are up.
Governor Wallich, go right ahead, sir.

Mr. WALLICH. Thank you, Mr. Chairman.
[Complete statement follows:]

Statement by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System

I am pleased to present before this distinguished Committee
my personal views on the subject of tax-based incomes policies (TIP).
Among the several versions of TIP that have been under discussion,
my testimony will focus on the approach colloquially referred to
as the "stick approach," on which Professor Sidney Weintraub of
the University of Pennsylvania and I have collaborated since 1971.
The stick version of TIP seeks to restrain inflation by imposing
a tax on employers granting excessive wage increases.
interference with the forces of the market:

There is no

employers who, for some

reason, wish to raise wages substantially, can do so; TIP, therefore,
in no way involves wage and price controls.
Various other forms of TIP have been proposed, especially
the "carrot" approach, which rewards employers and employees for
maintaining moderation in wage increases.

A few conrients on the

differences between the two approaches will be made later in this

I would like to stress, however, that what counts at

this time is the general principle rather than the specifics.


needs to be examined now is whether any form of TIP can contribute
to restraining inflation, rather than whether one or the other version
may be preferable.
If other well-functioning weapons against inflation were
readily available, there would be no need to discuss TIP.

It is

because the orthodox methods work slowly that leads me to believe
that a device such as TIP, despite its obvious inconveniences,
deserves consideration at this time.

Fiscal and monetary policy, the orthodox weapons against
inflation, so far have not been successful in winding it down.


does not mean that they would be without effect in the long run.


do I believe that the cost of applying them, measured against realistic
alternatives, would be as high as is sometimes believed.

The alternative

to successfully combating inflation is not a constant rate of inflation.
We do not have the choice between doing something about inflation and
leaving it alone.

Left alone, it will accelerate.

This tendency

results from the fact that inflation increases the degree of uncertainty with which all participants in the market must cope.


business, labor, borrowers, lenders will all tend to inject mounting
insurance premia into their wage, price, and interest rate behavior
to guard against the contingency of higher inflation.


itself tends to generate accelerating inflation unless effectively

Accelerating inflation, however, means sure recession

sooner or later.

The cost of letting inflation run, therefore, is

higher than even a costly form of restraining it.
TIP, moreover, should not be viewed as an outright alternative
to monetary and fiscal restraint.

In 1971, wage and price controls

were viewed as such an alternative, and fiscal and monetary policy
accordingly turned expansive.

I do not believe that TIP could

offset the consequences of excessively expansive monetary and fiscal

Some restraint by use of these traditional tools will continue

to be needed.

Nevertheless, an appropriate combination of TIP and
the standard tools of fiscal and monetary policy offers great
promise for the longer run, once the present inflation has been
wound down.

TIP, continuously employed, would exert continuous

restraint on wages and prices.

This means that fiscal and monetary

policies could be somewhat more expansionary once reasonable price
stability has been restored.

TIP would tend to reduce the "noninfla-

tionary rate of unemployment."

Whatever the level of unemployment

consistent with reasonable price stability (or a constant rate of
inflation), the restraints imposed by TIP would tend to make it
somewhat lower.

Fuller utilization of resources and larger output

would thus become possible.

The payoff to a successful effort to

wind down inflation would thus become very large over time.

Distinctive Features of Carrot and Stick Approach
Both approaches rest on the well documented fact that
prices follow wages.

Numerous researchers have arrived at that

At the same time, of course, prices influence wages,

although the relationship is less close.

There are other cost

factors that often are claimed to be responsible for inflation high profits, high interest rates, monopolistic practices, high
prices of food, of oil, and the depreciation of the dollar.


at times each of these does exert an effect, the main factor governing

prices nevertheless is wages.

With about 75 per cent of national

income representing compensation of labor, it could not be otherwise.

All other elements, although at times possibly significant,

are bound to be small by comparison.
means restraint of prices.

Therefore, restraint of wages

Labor does not lose from wage restraint.

Whatever it gives up in the form of higher wage increases, it can
expect to get back in the form of lower price increases.
Such unchanging real wage gains as wages and prices
decelerate is all that the stick approach offers.

The carrot

approach offers that, plus the benefits from a tax bonus.


stick approach operates by shifting the balance of bargaining
power between management and labor.

The carrot approach breaks

into the wage-price cycle by providing a tax bonus for wage earners


and possibly price setters -- conditional on wage and price restraint.
There are further differences inherent in the two approaches.
One difference is implicit in the fact that adherence to a carrot
scheme can be made voluntary but also would probably have to be
made universally accessible.

The stick approach would have to be

mandatory but could be limited to a group of the largest firms.
Another difference would result if the carrot approach were so
formulated as to require meeting a wage guideline accurately on
penalty of losing the carrot.

The stick approach proposes the

penalty to be scaled to the degree of overshooting of the guideline.

Finally there is the fact that tnanka tQ it 3 voluntary character
and availability of a reward the carrot approach should be more
readily acceptable while the stick approach avoids a revenue loss
and may even yield additional revenues.
Form of Tax Under Stick Approach
A penalty in the form of an increase in the corporate income
tax rate, equal to some multiple of the excess of a wage increase over
a guideline, is one of several options.

It would have the advantage

of relative difficulty of shifting the burden to consumers.

It would

have the disadvantage, on the other hand, of uneven impact as between
capital intensive and labor intensive firms.

Also, it would not be

applicable to firms with losses, although such firms are perhaps
less likely to grant excessive wage increases.

The difficulty of

applying an incomes tax penalty to unincorporated business, nonprofit
institutions, and governments, would not weigh heavily if TIP is
applied only to a limited group of large corporations.
Disallowance of an excess wage increase for corporate tax
purposes would be a second option.

It has the advantage of simplicity

and of having been on the statute books on prior occasions.

Its main

disadvantage is greater shiftability.
A payroll tax offers a third option.

Against the advantage

of simplicity of administration stands the fact that it appears to
penalize labor when the purpose of the tax is to exert pressure on

1/ These and many other technical aspects are examined by Richard E.
Slitor in a report, "Tax-Based Incomes Policy: Technical and Administrative
Aspects," prepared for the Board of Governors of the Federal Reserve System.

The Guideline
The setting of a guideline for nonexcessive wage increases
is not as critical a decision within the TIP framework as is sometimes argued.

The consequences of a relatively high guideline can

be compensated by more severe penalties for overshooting.


likelihood that a relatively low guideline will be frequently overshot can be compensated by a more moderate penalty.

The concern

that a guideline will become the minimum rather than the maximum
should be largely allayed by the favorable effects of a guideline on
wage setting in smaller firms, unincorporated businesses, and other
employers that probably would not be covered.

The guideline should

embody the well-known principle that nationwide rather than industry
or firm-wide productivity gains are the proper standard for wage increases.
The guideline would be the sum of this long-term nationwide productivity
trend and an amount, such as perhaps one-half of the going rate of
inflation, that would allow for the fact that inflation must be wound
down gradually rather than overnight.

At the present time, this sum

might be 5.5 per cent, reflecting 2 per cent for productivity and 3.5
per cent for inflation.

The guideline would have to be reset periodically,

perhaps annually, at lower levels ideally, until wage increases equal
productivity gains.
If prices follow wages, as can be expected, labor would
not suffer from accepting a moderate guideline even if, at the
original rate of inflation, this guideline seemed to leave no room for
real wage increases.

As inflation decelerates, real wage gains will

be restored to their normal level, i.e., on average equal to average
productivity gains.

Costing the Wage Increase
To establish the tax consequences of overshooting the
wage guideline, exact costing of a bargaining agreement including
all types of fringes, is necessary.

This requires measuring the

total increase in compensation, including pensions, medical benefits,
cost-of-living adjustments, improvements in working conditions,
and others.

It also becomes necessary to determine the increase

per employee, or per hour worked, or per hour worked in each
differently paid employee category.

In all probability, the best

approach would be an index of increases covering all employee
categories, weighted by hours worked.
For both types of calculation -- total increase in compensation,
and the per cent increase for a given firm -- there are well established

The Internal Revenue Service continually has to deal

with the question of what constitutes compensation and what does not.
From the experience of the Council on Wage and Price Stability and
before it that of the Pay Board, which administered wage controls
during Phase Two, the problems involved in costing out a percentage
increase are familiar.

They are not simple, but they would yield

to careful writing of regulations.

The task would be made easier

if the number of firm3 to be covered is limited.

It would be eased

also by the fact that small differences between taxpayers and the
IRS would have only small consequences in terms of the penalty
to be assessed under a graduated penalty scheme.
If a surcharge on the corporate income tax is employed
as the tax "stick," the unit for which the wage increase must be
computed clearly must be the parent corporation, rather than
particular subsidiaries or plants.

This means that a number of

bargaining units may be involved, with different wage settlements.
The fact that in such a situation management would be impelled by
TIP to resist all wage increase demands, both high and low, is not a
disadvantage, however.

Wage restraint, to the extent possible, should

be applied with equal strength at all margins.

Conceptually, TIP can be applied to all employers, including
unincorporated business, nonprofit institutions, and governments.
Penalties other than the corporate income tax would, of course, have
to be employed for some of these.

In practice, limiting applicability

to the largest thousand or two thousand firms seems preferable from
an administrative point of view.

The largest one thousand firms alone

cover about 26 per cent of all nongovernmental payroll employees.
These firms also are the pattern setters for wages so long as the
economy is not overheating.

The existence of a guideline should help

uncovered employers restrain the demands confronting them.

Narrow coverage would reduce a number of troublesome
administrative problems.

Among these are problems of new firms,

and of merging or splitting firms.
One possible defect is inherent in narrower coverage.
The closeness of the relation of prices and wages may diminish if
coverage is incomplete.

A loosening of this linkage could, of

course, occur in special circumstances.

A manner of dealing with

it is outlined in the next section.

Restraining an Increase in Profits
In terms of nationwide averages, prices move with wages.
Under some circumstances, the link may loosen. Some of these instances
are not capable of being remedied.

For instance, a decline in

productivity, a rise in oil prices, and the consequences of a drop in
the dollar, are "real" phenomena which affect the availability of

They are bound to affect real wages.

This is not the case,

however, of a loosening of the linkage of wages and prices that is
reflected in a change in profit margins.

In the unlikely event that

deceleration of wages should fail to be followed by deceleration of
prices without any of the above noted factors being present, profit
margins would widen.

The share of profits in GNP, in that event,

would rise as a consequence of wage restraint.
This contingency could be guarded against by changing the
corporate profits tax rate in such a way as to restore the after-tax

29-775 O - 78 - 2

share of profits to its previous level.

In order to eliminate the

influence of purely cyclical factors, some benchmark for the profit
share based on historical relationships might be established.

A tax

designed to hold profits down to this share could be regarded as an
"excess profits tax" on the profits of the entire corporate sector.
It would fall on corporations with high and low earnings.

It would

probably have a very moderate impact, thereby avoiding the familiar
drawbacks of an excess profits tax geared to. the profits of particular

Given the close historical link between wages and

prices, this "corporate sector excess profits tax" probably would
rarely, if ever, be triggered.

But its existence would serve as a

protection against an adverse shift in the distribution of income.

Neither the penalty tax on excess wage increases nor the
"corporate sector excess profits tax" are intended to raise revenue
although they may do so.

Any revenue that does accrue could be

employed to reduce income taxes.

The amounts raised by the penalty

tax depend, of course, on the level at which the guideline would
be set and on the penalty rate on overshooting these guidelines.
The objectives in setting rates should be not the raising of revenue,
but the optimal functioning of TIP.

That completes my testimony.
The CHAIRMAN. Thank you very much, Dr. Wallich.
Dr. Okun.
Mr. OKUX. Thank you, Mr. Chairman.
[Complete statement follows:]

Statement by Arthur M. Okun*
Senior Fellow, Brookings Institution
before the
Committee on Banking, Housing,
and Urban Affairs
U.S. Senate
May 22, 1978

I am a proponent of a tax-based incomes policy, not because that
policy is beautiful, but because it is a lot less ugly than alternative
policy strategies.

Under present policies, inflation is proceeding at a

pace that is unacceptable to the American people; it is not unwinding but
rather tending to step up; it is not susceptible to any efficient cure
from either fiscal-monetary restraint or price-wage controls.

The Preamble to TIP
Despite persistent excess supplies for more than three years, our
economy is suffering from

an entrenched price-wage spiral with a 6-percent

rate of price increase and an 8-percent rate of pay increase.

And although

the rate of price increase has been reasonably steady and well-predicted,
inflation remains public enemy //I in the eyes of the
of the American public.

overwhelming majority

Currently inflation seems to be moving a bit above

the 6-percent plateau, reflecting an inevitable catch-up of nonunion wages

*The views expressed are my own and are not necessarily those of
the officers, trustees, or other staff members of The Brookings Institution.

and the consequences of several cost-raising measures taken by the
Inflation could be slowed down once more by recession, as it

during 1974-75.

But fighting inflation by curbing demand at a time

when it is not being caused by excess demand is absurdly inefficient.
It is like burning down the house to roast the pig.

A wide variety of

statistical estimates that I know agree that, under current conditions,
a reduction of 1 percent in nominal GNP for 1979 would cost between 0.85
and 0.95 of a percentage point of production and save only between .05
and .15 of a percentage point in inflation.

In their discussions on

fiscal policy, the Administration and Congress show that they are not
willing to pay that price; while in its decisions on monetary policy,
the Federal Reserve apparently considers it essential to pay that price.
Hence, the nation is facing the serious risk that fiscal policy and
monetary policy may be on a collision course.

In light of all these

unfavorable circumstances, I simply cannot see a realistic happy ending
to the present scenario of policy.
The momentum of inflation must be stopped —

without another

bloodletting of jobs and investment like that of 1974-75 and without a
return to the brittle and distorting controls of 1971-72.

The same

opinion surveys that record the American people's antipathy toward
Inflation also reveal their basic support for a mutual deescalation of
wages and prices.

But because this is a decentralized economy, no single

group of private decisionmakers can stop the spiral on its own.

On the

contrary, firms and unions must run ever faster to protect themselves from
higher costs being imposed on them.

The spiral can be broken only with

the help of a collective, social decision.

Tax-based incomes policy (TIP) is a way of pursuing mutual

It is not tried and true; but the present scenario has

been tried and found sadly wanting.

It is not a substitute for lower

rates of monetary growth and lower federal deficits as a remedy for
inflation, but it is a way to make possible the necessary slowdown of
money growth and turnaround of fiscal

stimulus without the enormous

economic and social costs of recession.

An Outline of a Reward Tip on Wages
I speak as the inventor of the reward TIP; the original, basicmodel TIP produced by Henry Wallich and Sidney Weintraub relies on a
stick, and I sought to convert it to a carrot.

I see some distinct

advantages and disadvantages in each of the two approaches.

But, most

of all,I believe that either of them could work effectively, and that
both belong among the options from which the Congress might ultimately
select an efficient cure for stagflation.
My thinking about how a reward TIP might best be implemented has
evolved during the past six months in light of constructive criticisms
and probing inquiries that I
some more.

have received; and I expect it to change

But let me outline my current thoughts on the main features

of that program.

To begin with, I would like the legislation implementing

a reward-TIP for wages to be enacted for a three-year period, with the
understanding that the ceiling on the wage increase that qualifies for
the reward and the size of the tax credit would be determined annually
by the Congress.

I would hope to be able to declare victory and let

TIP expire after the three-year period, but I would like to hold open
the possibility of renewal.
As I envision it, forms would be sent to all employers in the

nation on October 1 in the year prior to the initiation of TIP, asking
them to enlist in the program.

To participate at that time, the firm

would have to pledge to limit the average pay increase for its workers
in the next year to no more than 6 percent.

Pay would be defined as

wages plus private fringe benefits, and the definition of fringes would
be spelled out in detail.

The pledge would leave the firm free to grant

promotions and merit raises of any size to individual workers so long as
its overall average increase in pay was within the limit.
By participating, the firm would qualify all its employees for a
tax reduction during the year ahead equal to 1% percent of their wage
and salary income up to some level, say $20,000.

For most workers, that

tax credit would be the equivalent of a raise a little bigger than 2
percent (before-tax).
with a 6-percent raise

In other words, the worker would be better off
and the tax credit in combination, than with an

8-percent raise and no tax cut.

The credit would then be subtracted

in calculating the worker's withholding tax, in effect offsetting a
portion of the present payroll tax.
The firm would also be asked to state in the initial form how it
intended to measure its units of employment for the two consecutive years
for example, as total person-hours or as full-time equivalent employees.
.It would also be asked to specify how it planned to calculate its
average wage increase —

for example, simply by using the totality of

all pay and all workers, or by weighting increases for distinct
occupational groups, plants, subsidiaries, or the like.

Once the firm

made these decisions, it would be required to stick with them for the

next tax year.
I believe that workers would strongly prefer getting the bonus
right from the beginning of the year in their take-home paychecks,
and that is why I emphasize advance commitments by firms to participate.
But some firms may be unable to predict their wage increases in advance
or might become unable to keep wages on target under some contingencies
they might encounter during the calendar year.
Hence, I think that firms should be given an option to fill out
the form, displaying an interest in the program without making a commitment; they would hold open the possibility of qualifying their workers
for refunds after the year ends, if they meet the wage limit.


contrast to those firms that delay their decision, any firm that makes
an advance commitment must take the responsibility of fulfilling its
pledge and must assume the full liability for any subsequent determination
that the reduction in withholding taxes from workers was unjustified.
For carrying those responsibilities, the firms that sign up in advance
(not those that only qualify ex post) should receive some reward for
themselves —

perhaps one-fourth of the amount that is rebated to

their workers through withholding.
Thus, the key features of the plan can be summarized as follows:

A qualified worker receives an anti-inflationary tax credit

equal to 14 percent of his wage or salary income up to $20,000 —
equivalent to an extra raise of 2+ percent (before-tax).

A worker becomes qualified when his employer either:
A. Pledges in advance that the overall average pay increase
for the year will not exceed 6 percent (and then the worker
gets the credit in take-home pay through reduced withholding); or

B. Reports on its tax return, ex post, that its average pay
increase for the year in fact did not exceed 6 percent
(and then the worker gets a tax refund).

A firm that enlists in advance (as in 2A above) receives for

itself a tax credit equal to one-fourth the total reduction in withholding
taxes granted to its workers.
Under present circumstances, I would expect the overwhelming
majority of nonunion employers to enlist in the program, with virtually
all governmental units and nonprofit institutions leading the parade.
Employees would be informed that they would receive tax credits, and, I
would expect, most would be assured by the firms that, if their relative
wage position should fall behind during the course of the program, it
would be subsequently restored.
though probably only a minority —

I would expect a significant fraction —
of unionized firms to particpate

during the initial year of the program.

In fact, the size of

the pay increases scheduled for the second year and third year of many
existing three-year contracts would make participation worthwhile to
the workers.

Indeed, a substantial fraction of union contracts average

less than 8 percent over the life of the contract, even though the
average is apparently above 9 percent.

As a rough guess, I would

expect that about two-thirds of all workers would be enrolled in the

If the Congress could afford to make the rebate 2 or 2*5 percent

rather than 1*5, that figure might be raised to 80 or 90 percent.
Firms will want to participate in a reward TIP because —
only because —


the tax credit to their workers would help them to slow

down wages; and that is the basic guarantee that the program would be

effectively anti-inflationary.
want —

I would expect —

and, indeed, I would

the average wage slowdown to be somewhat smaller than the tax

credit so that labor is initially made better off, as well as gaining
additional benefits from the subsequent slowdown of prices.

I would

also expect generally favorable effects from the recognition and the
expectation of the deceleration of inflation.
Surely, the slowdown of wages in general will affect union contracts;
the influence of relative wages works both ways —
sectors as well as the reverse.

from nonunion to union

Moreover, the deceleration in consumer

prices stemming from the slowdown in wages would automatically have
further favorable anti-inflationary effects through cost-of-living
escalator clauses.
During the second and third years of the program, I would expect
an increasing fraction of union workers to be enrolled in it.


participation requires an implicit understanding with employers that,
at the end of the program, any group that has fallen behind in relative
wages would require some compensatory catch-up.

But with broad participation,

such adjustments would largely serve to restrain those who did not join
up, rather than to compensate those who did.
At the end of each year, employers who qualified their workers for
the credit (either by advance pledge or by ex post action) would fill


a supplemental form on their income taxes, totalling wages and all other
deducted expenses that are classified as pay, and then dividing that
total pay by the number of employment units (say, full-time equivalent
workers or total manhours).

The calculation would be made for the

latest year and for the base year, to show that the 6-percent standard
had been met.

There would be no monitoring, investigating, or approval or
notification of any wage change during the course of the year.


auditing of tax returns would be the sole technique of enforcement, just
as it is now for all provisions of the income tax.

In these respects,

all types of TIP contrast sharply with controls: no private behavior is
prohibited, and no advance approval from the government is required.
If a firm has an acute labor shortage and really needs to raise
wages by 12 percent to get the added workers it can profitably use,
clearly it should and would stay out of the program.

That firm and its

workers should then recognize that, in all fairness, they are not entitled
to an anti-inflationary tax credit.

Analogously, in the case of the

investment tax credit, a firm that does not need more equipment is
not obliged to invest; but neither does it have any justified
complaint about not receiving a tax reward.

Some Features of Alternative Proposals
The advantages and disadvantages of various approaches form an
interesting balance sheet:
Revenue costs.

The most obvious disadvantage of the reward-TIP

relative to the penalty TIP is that the reward costs federal revenue, and
that is a significant matter.

Secondly, the reward approach must be universal; the tax

reductions must be available to employees of the corner grocer and the
county sheriff's office as well as to those of major corporations.


penalty approach, on the other hand, can be confined to large firms which
may be viewed as the pacesetters in the determination of wages.

At a

Brookings conference last month that covered this range of subjects,
many participants viewed the opportunity for selectivity as a major

advantage of the penalty approach, particularly because it avoided the
problems of record-keeping, informing, and auditing for very small firms.
In my personal judgment, however, that is not a decisive matter.
Small firms are now offered the opportunity of qualifying for the investment tax credit, the employment tax credit, capital gains advantages,
deductible travel and entertainment expenses, and all of the other complex
tax-minimizing provisions of the income tax.

And all of these provisions

are enforced solely through the low probability of subsequent audit of

But if the Congress should feel that an onerous burden would

be placed on tiny firms, then enterprises with, say, less than twenty
employees (as well as brand new firms operating in their initial year)
could be given a special exemption, enabling them to qualify their
workers for the tax credit simply by signing a pledge to adhere to the
anti-inflationary spirit of the program.

Any sensible employer would

convert that into some slowdown of wages.
Special situations.

Like any tax incentive program, any newly

enacted TIP will run into some special situations that
be regarded as "inequities."

can reasonably

For example, some firm may have granted

no pay increases at all in the preceding year, and its workers might well
feel that they deserve the elbow room to catch up.

Alternatively, another

firm might have raised pay by 10 percent on September 1 of the preceding
year; that alone would push up the calendar-year average increase of
the next year above the 6 percent hurdle, even if no further pay
increases were awarded during that calendar year.

No manageable set

of provisions can "fix up" such special problems.

If these are inequities,

they are surely far less serious than the inequities imposed by stagflation.
The Congress would have to accept some imperfections to ensure an
administratively feasible and economically effective program.


suspect that such a course would be more acceptable if the victims
of "special situations" are merely deprived of rewards rather than subjected to penalties.

In the history of tax legislation, "grandfather

clauses" have been typical for newly stiffened rules, but not for new
benefits, like the investment or employment tax credits.

So this

difference is another advantage of the reward approach.
In a somewhat related manner, the reward approach builds in a better
incentive for compliance by making employers liable for any unwarranted
rebates of taxation to their workers.

Firms are much less likely to

risk IRS punishment for unjustified claims that benefit workers directly
than for minimization or avoidance to shave their own liability for

In the penalty approach, firms that pay higher taxes

because of large wage increases may conceivably pass on the tax penalty
to their customers in the form of even higher prices.

I do not view the

pass-through as an overwhelming problem, but it is avoided by the reward
Fairness to workers.

Both the reward and the penalty TIP apply

leverage directly to wages rather than to prices.
needs to be clearly understood.

That aspect of TIP

Every TIP proponent knows that labor has

not been the villain in the present inflation and that wages are not out
of line on the high side.

The reason for focusing on wages is quite

According to a vast body of statistical evidence, a slowdown

in wages is fully and reliably translated, after a reasonably short lag,

into a slowdown of prices.

The evidence on the conversion of price

slowdowns into wage slowdowns is much less clear.

Some studies suggest

that a 1 percentage point slowdown in prices will slow wages by only
0.2 percentage point, while others give answers as high as 0.9.
the problem is that economists just don't know.


If we were sure that

a price slowdown would generate a prompt and substantial wage slowdown,
we could break the spiral by a direct attack on consumer prices


for example, a federal program to "buy out" state sales taxes (or to
slash ,federal payroll taxes on employers).

I think those steps are

well worth taking, but I do not have the faith in their effectiveness
to rely entirely on them.
At least in part, wage inflation must be the direct target of
any effective TIP,

With a reward TIP, I do not see a substantive equity

problem: the average take-home pay of workers would probably be increased
a little initially, even before they benefit from a slowdown of price
With the penalty approach, there is a problem of ensuring fairness
to workers.

They would be better off before long, and would be far better

off than they would be if inflation speeds up or if it is curbed by

But they are not immediately indemnified for the initial

slowdown of wages that is being induced by the tax penalty.

As some see

a penalty TIP, it requires workers (and only workers) to ante up for
the deal, so to speak.

Henry Wallich and Sidney Weintraub have been

sensitive to such criticisms and have suggested added provisions
achieve equity —


like a contingent tax on any shift of income to profits.

Problems of this sort are most relevant in the first year of
a penalty TIP, since the statistical evidence warns that it takes a little
while for a wage slowdown to be translated fully into a price slowdown.
It could help to combine the stick on excessive wage increases with a
general carrot for all wage earners in that year —

e.g. by enacting an

income-tax cut for low and middle income families or, even better, a cut
in federal payroll taxes on workers, or, best of all, a federal grant
program to induce cuts in state sales taxes.

A Price Restraint Credit?
In the search for still greater evenhandedness, I suggested last
fall that a tax reward (perhaps a discount on income taxes) might be
offered to those businesses that limited to 4 percent their price increases
on a value-added basis (that is, above and beyond increased costs of
purchased materials, energy, and supplies).

On this proposal, the

criticisms that I have received from my professional colleagues have
generally been more adverse and, to me, more persuasive than those on
the wage reward TIP.

I was searching for symmetry, but

the economy has

a basic asymmetry: it is much harder to measure increases in product
prices than increases in wages.

New products, quality changes, and

widely varied types of output complicate the calculation.

I now believe

that a price reward can be incorporated into the program J^f the Congress
insists that the burden of proof rests on any claimant for such a tax
credit —

that the firm is responsible to develop the kind of systematic

price indexes that would justify its deduction.

But my critics would

emphasize that such an accounting task would be Inherently less difficult
for large manufacturing firms, airlines, communications companies, and
utilities than for small enterprises.

Frankly, I never expected much additional benefit in slowing
inflation from the price reward, but felt that the forging of a social
compact would be enhanced by treating wages and prices symmetrically.


however, I am concerned that a provision that was intended to reassure
workers might turn out to bestow tax cuts arbitrarily on big business.
At this point, I would

not advocate a tax credit for price restraint.

In summary, TIP requires much more discussion and a major educational
effort; and this committee deserves our gratitude for promoting that

Clearly, the basic current controversy is not among alter-

native forms of TIP.

Rather, it is between slowing the wage-price spiral

by some form of TIP or other innovative cost-reducing strategy, on the one
hand, and the hideous alternatives of letting inflation rip, fighting
it by recession, or suppressing it by wage-price controls, on the other.
The need to lick stagflation cooperatively and sensibly is the biggest
economic challenge facing our nation, and also one of the biggest
challenges to our democratic political process.


The CHAIRMAN. Thank you very much, Dr. Okun.
Governor Lilly.

Mr. LILLY. Senators, I have submitted a statement in writing
The CHAIRMAN. Without objection, all these statements will be
printed in full in the record and if you would like to summarize it
would be appreciated.
Mr. LILLY. All right. I will abstract the important parts.
[Complete statement follows:]

29-775 O - 78 - 3

Testimony by David Lilly
before Senate Banking Committee
May 22, 1978

It Is a pleasure to be here to testify before this distinguished
committee on the problem of controlling Inflation In our economy.

I am

speaking today as a private citizen who is concerned about this problem.
As a private citizen, I have been simultaneously amazed and dismayed by
the new anti-inflation proposals.

I am amazed by the ingenuity of the

designers of new policies like TIP, but I am dismayed because I believe
most of the new policies are directed at the wrong sector of the economy.
My experience as a businessman and as a member of the Federal Reserve
Board has persuaded me that the federal government plays a major role in
determining the price level and its rate of change.
It is this view—that the government plays a primary role in
creating inflation—that I wish to emphasize today.

The Importance of

determining the cause of inflation is, of course, obvious in designing a
solution to our inflation problem.

For if inflation Is indeed caused

mainly by.the federal government, and If our policies designed to contain inflation are directed mainly at the private sector, these programs
will have little chance of success and may even be counterproductive.
There are two ways principally that the government has contributed
to our inflation problem:

through stimulative fiscal policies and their

accompanying large federal deficits; and through impediments to market
performance resulting from overzealous use of the regulatory apparatus.


Fiscal Policy and Inflation

The tendency for the government to run large budget deficits
has increased dramatically in the last decade.

As you can see from

Chart 1, the federal government actually ran a small surplus on an
average in the 1950s.

In the 1960s the average deficit was about 3/10

of 1 percent of GNP, or in 1970 dollars, about $5 billion per year.


deficit has averaged little over 2 percent of GNP, or about $40 billion
per year, in the current decade.
Not surprisingly the rate of inflation in the U.S. has ratcheted
upward during the last three decades as shown in the next chart.
average rate of inflation in the 1950s was 2.3 percent.
the average inflation rate moved up to 3.1 percent.


In the 1960s

In the current

decade the inflation rate has averaged 5.6 percent.
Another way of looking at the same relationship is through the
correspondence between the level of outstanding U.S. government debt and
the price level.

Shown in the next chart is the consumer price index

and the outstanding stock of interest bearing U.S. government debt.
outstanding stock of narrowly defined money, Ml, is also shown.


As you

can see, the relationship between the price level and the outstanding
stock of U.S. government debt is amazingly close, particularly over the
last ten years.

Over this period the rate of growth of consumer prices

as accelerated rather dramatically from its trend growth of the 1950s
and the first half of the 60s; and the same time, the level of U.S.
government debt has increased at about the same rate.

In fact, the

relationship between the consumer price level and the stock of outstanding U.S. government debt is much closer than the relationship between
the price level and the narrowly defined money stock.
I don't have a very precise theory of how the government
deficit—or what is essentially the same thing, changes in the outstanding stock of the U.S. government securities—contributes to the rate of


However, I think we all understand that a larger deficit

means greater aggregate demand in the economy.

And greater aggregate

demand tends to push up prices as businessmen are forced to utilize
plant and equipment more intensively or to hire less cost-efficient
resources in order to meet the enlarged demand.

Even without a precise

theory linking government deficits with the price level, I think the
evidence shown in Chart 2 is so clear and so striking that we must take
very seriously the possibility that large government deficits contribute
significantly to inflation.
If large deficits cause inflation, then the solution to our
inflation problem seems clear, though it may be painful.

In order to

reduce the rate of inflation we need to shrink the federal deficit.
This, of course, would require that strong decisive actions be taken and
that parts of budget be cut that would arouse the anger of certain
special interest groups.

But if we are truly convinced that the infla-

tion problem must be solved, these decisive steps must be taken.



In addition to fiscal policy the federal government has
contributed to the inflation problem by passing laws that alter the
structure of markets in ways which produce higher prices.

All of these

policies were chosen in order to achieve very worthwhile objectives but
I would guess their potential effects on inflation received, in most
cases, only a very cursory examination during the decision-making
The laws to which I refer contribute to inflation in one of
two ways.

Either they raise a price directly or they limit the ability

of the economy to absorb an increase in the price of some factor of

Direct Setting of Prices
The government and its agencies fuel inflation by raising the
prices of certain goods and services directly.

Either these goods and

services are consumed directly by the public or they are used in producing goods which are later consumed.

In either case the public ulti-

mately pays a higher price for the goods and services it uses.
Examples of increases in government-controlled prices are not
hard to find.

The recent increase in the minimum wage received opposi-

tion from economists of all political persuasions, though not enough to
defeat or postpone it.

Increases in agricultural price supports also

fuel inflation, and I strongly urge the gentlemen on this committee to
show restraint when they are asked to vote on a future proposal.
Curiously enough, the government conrrlbuts to the inflation
problem not only by raising prices but also by just keeping controlled
prices constant.

In the field of transportation, I would argue regula-

tion keeps prices too high and restricts entry into the markets for air,
land, and water transport.

This effectively forestalls competition that

could bring the price of these goods and services down in the absence of
some time.

Such a situation has existed in the airline industry for
It is well known that unregulated intrastate airfares in

Texas and California are roughly half the regulated fares.


could help bring other fares down as well.
Another example of the benefits to be derived by decreasing
such regulation is provided by experience with the shipment of frozen
poultry and frozen fruits and vegetables in the 1950s.

The commodities

were added to the list of agricultural commodities whose shipment was
exempt from l.C.C. control.

A Department of Agriculture study of this

limited deregulation concluded that there were two basic effects:


cost of shipping these goods declined (approximately 30 percent for
poultry and 20 percent for fruit) and shippers reported that the quality
of service for these commodities improved.
Even when government regulation keeps a price too low, it can
contribute to inflation.

A good case can be made that the maintenance

of a very low price on natural gas discourages exploration, prevents
growth in supply, and prevents natural gas from competing with foreign

Discouraging this potential competition makes it harder to

decrease our dependence on foreign oil whose price is rising and, hence,
makes the inflationary impact of that price rise greater than it would
be if energy users had more opportunity to switch away from the more
expensive fuel.

Limiting the Economy's Flexibility
The previous example of competition between fuels might be
used equally well as an illustration of how government regulation limits
the economy's ability to adjust and to absorb increases in the costs of
factors of production.
As a businessman, I can assure you that a rise in the cost of
a factor of production is not viewed by business as an excuse to increase1
the price to consumers and widen the profit margin.

Rather my experience

in the private sector has been that a rise in the price of a key input
almost inevitably leads to a decline in profit.

With the price of one

input higher than it used to be, we try to redesign our product to
maintain quality but use less of the more expensive material than

We may also respond by restructuring our production process

to produce the same product, in a less costly v/uy.
In any case, the emphasis is on minimizing the effect on the
quality and price of our product.

Rarely can a producer even consider

the option of passing the entire increase along to the consumer.


competitors (domestic and foreign) are usually ready and able to undertake
any cost-saving alteration a producer might be tempted to forego.
Uhen, as a result of government regulatory restriction, producers
are discouraged or prohibited from making such adjustments, the consumer
is the loser.

The price increase the consumer faces is higher than it

would have been in the absence of regulatory constraints.
Examples of this kind of situation abound.


standards raise the cost of mining coal for fuel and the cost of adapting existing facilities to burning cheap, yet polluting coal.


limits industry's ability to shift away from cleaner burning petroleum
whose price is rising rapidly.

The producer's higher costs will be

reflected in the price the consumer pays.

Building codes and work rules

in the construction industry and environmental standards for construction produce similar effects.

Protection of domestic industries from

foreign competition by the use of trade restrictions can also have the
effect of increasing the inflationary impact of cost rises in those
This list could be extended as 1'n sure you are all aware, but
my point has, I hope, been made.

With the growth of regulation (and I

don't feel I need to document that), the economy is less able to absorb
a rise in the price of a factor of production.
In pointing out the inflationary consequences of these and
other regulatory policies, I do not mean to imply that they are all bad
policies which should be repealed.

But I do claim that in many cases,

the laws have been drafted and enforced with little attention to their
inflationary consequences.

Approached with this additional considera-

tion in mind, these programs can and should be tailored and modified to

minimize their inflationary impact while attaining their other goods.
(In November of 1977, I submitted to Vice-President Mondale some of my
suggestions of how this might be done.)


Policy Options

My policy preferences flow directly from my belief that rises
in the general level of prices should be attributed to government actions
Instead of private actions.

Let us first consider the policies that I

(and large part of the economics profession) say won't help the economy.

Policies That Won't Help
Several policies currently under discussion (or in use!) will
not help the economy towards better health because they are directed at
the symptoms of the disease not at the root cause.
Wage and price controls are misdirected at the private sector
and woulJ provide little help to the economy.

Controls procede from the •

view that inflation grows out of the greed of wqrkers and the greed of
employers, a view I strenuously dispute.
There is no doubt that the CPI could be held down temporarily
by controls, but the bulk of professional economic opinion agrees that
this cure for inflation is worse than the disease itself.

The real

resource cost from delaying the kinds of adjustments the private sector
is forced to make when relative prices change outweighs the gains from
temporarily forestalling a general price rise.

And we must add to this

the costs of administration which arc usually substantial.

In my read-

ing, I find that economists vastly different ideological and political
stripe find agreement on this point.

Only when inflation really starts

to heat up do a few economists start to reevaluatc history until they
conclude eventually that controls (usually in some slightly new form)
are worth a try.

Tax-based Incomes Policies have received a lot of attention at
these hearings are, it is claimed, a new and better form of controls.
These proposals are still directed at the private sector only this time
with the belief that inflation is caused by the greed of workers and the
timidity of employers.

I do not share either half of that belief.

TIP is presented as a mild form of wage-price controls.


agree that, as such, it will probably deliver less of the good effects
of controls, and I fear it will deliver as much or more of the bad
effects of more general controls.
TIP could have some good effect.

It could effectively limit

the growth of wages and to some extent the growth of prices.


the bad effects would, I think, outweigh the ^ood by at least as great a
margin as they do for complete controls.
The bad effects may be very groat because TIP may produce evew
greater distortions than standard controls and will also be very costly
to enforce.
First, it is argued that TIP will create fewer distortions
than standard controls by allowing market forces to help allocate

Yet since TIP acts as tax on only a single factor, labor,

the action of those market forces may indeed push the allocation of
resouces in the wrong direction.

Making labor relatively more expensive

to firms will encourage them to substitute machines for workers wherever
possible and reward those who do so with actual

This could

create distortions far worse than those caused by general controls on
all inputs which do not provide such encouragement.
SeconJ, TIP ir> often portrayed as being less costly to administer
than norc goiu ral controls, but I feel the admin u;t rat. i.v<» costs would

still bo substantial.

I prepared a short list of administrative questions

which I think have not, as of the date these hearings, been adequately
Since TIP would be adjoined to the corporate income tax, how
would unincorporated businesses and nonprofit institutions be treated?
How would the program be applied to new firms with no past records of
salary expenses?

How would TIP be applied to salary increases based on

previously negotiated contracts?

Couldn't TIP be evaded by granting

"promotions" ta employees receiving above-guideline pay increases?
Couldn't payments "in kind," such as longer lunch breaks and vacations,
be used to evade the program?
with work contracted out?
be handled?

How would TIP handle costs associated

How would demands for "catch up" wage increases

Might not the aluminum workers argue that a large pay

increase would be required in their next contract to preserve comparability with steel workers who received a large settlement in 1977?
In short, if costs of more general controls cutweigh their
benefits, it is ray feeling TIP does not offer a decrease in costs or an
increase in benefits sufficient to swing the balance in favor of intervention.

A Policy That Will Help
*If, as I believe, the cause of inflation is the spending and
regulatory behavior of the federal government, changing that behavior is
the only real solution to the inflation problem.
The first order of business for a government intent on stopping
inflation should be to cut the budget deficit.

Only by slowing the

growth of government debt can we slow the growth of the price level in a
fundamental nondistorting way.

This reduction of the deficit will have the largest effect on
the economy if it is perceived by the public as the first stop of a
continuing program of fiscal restraint.

If such a reduction, say for

fiscal 1979, is viewed as a one-time experiment to be followed by controls if prices don't slow, it is almost surely doomed to failure.


must abandon the sequence of "quick fixes" for a slower and surer regimen.
The task facing a Congress seeking to implement such a policy
is indeed a formidable one.

It will involve hard political choices,

either denying the demands of various deserving special interests or
abandoning a general tax cut which many people are already anticipating.
But, if you can ignore the short-term political pressure that such a
policy would generate in order to attain the long-term good that such a
policy would deliver, you will i>e acting in a tradition of principle for
which the Senate has been deservedly revered.


U.S. Deficit as % of GNP

+ .1



Relationship Between Money,
U.S. Government Debt and Prices



(1967 = 100)

800 r


700 \




500 \


400 \









50 51 52 53 54 65 56 67 £8 5G 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77


The CHAIRMAN. Thank you, Governor Lilly.
Mr. Sunley.

Mr. SUNLEY. Thank you, Mr. Chairman.
I am most pleased to be here. There are comments that I will be
making today that are very similar
The CHAIRMAN. Before you came in—incidentally, your statement
will be printed in full in the record. It's a substantial statement. The
lights here—the green is 9 minutes, the yellow is 1 minute, and then
the red goes on.
Mr. SUNLEY. Fine. The statement I'm making today is very similar
in content to a paper that Larry Dildine of the Treasury and I prepared for a recent Brookings conference, so not only will there some
day be published the statement of this hearing today, but a much
longer statement that Larry Dildine and I wrote will be published in
the Brookings papers.
I will address my remarks here to the administrative problems of
a tax-based incomes policy. A workable scheme must permit the
Internal Revenue Service and businesses to determine the amount of
tax benefit or penalty that a firm qualifies for or is subject to. As one
might expect, finding solutions to the administrative problems often
involves tradeoffs with features that would otherwise be desirable on
economic or political grounds.
[Complete statement follows:]

Expected at 10:00 a.m.
May 22, 19 78
Mr. Chairman and Members of this Distinguished Committee:
I am pleased to appear today to discuss with you the
potential for use of tax incentives to hold down wage and
price increases. These imaginative proposals have recently
been receiving increasing attention and I am happy to see
that this Committee is giving them a thorough hearing.
I will address my remarks here to the administrative
problems of tax-based incomes policies, such as those put
forth by Arthur Okun and by Henry Wallich and Sidney Weintraub.
A workable scheme must permit the Internal Revenue Service
and businesses to determine the amount of tax benefit or
penalty that a firm qualifies for or is subject to. As one
might expect, finding solutions to the administrative
problems often involves trade-offs with features that would
otherwise be desirable on economic or political grounds.
Preliminary Observations
The administrative problems of implementing a tax-based
incomes policy depend crucially on five initial design
decisions. First, the scheme may impose tax penalties on
firms granting excessive wage or price increases, or it may
provide tax reductions for firms or workers restraining
price or wage increases. If the stick approach is taken;
that is, penalties are imposed, then unincorporated businesses
and small firms, which often employ only rudimentary accounting,
can be excluded from the program. Limiting the penalties to
larger corporations would greatly reduce administrative
problems without seriously impacting the effectiveness of
the program.

The carrot approach is politically attractive because
it could probably provide tax reductions directly for
workers as well as employers if wages did not rise above the
threshold amount. But, providing tax reductions for workers
raises some vexing administrative problems. Firms would
have to inform workers on the W-2 Form that they qualify for
the. tax break, or, following Okun's suggestion, they might
adjust withholding in anticipation of qualifying for the tax
break. If on audit it is found that the workers did not
qualify, the Internal Revenue Service would have to collect
from the firm, leaving the tax break for the workers intact.
This solution is practical, but it seems to suggest that
employees are responsible for successful wage restraint,
while companies are to blame for any failure.
Furthermore, it would not be desirable to deny small
business taxpayers and their employees the rewards for good
behavior. A program that has universal coverage of all
taxpayers would be much more costly to administer than one
that covers only larger corporations. I conclude, therefore, that the stick approach involving penalties on firms
is to be preferred on administrative grounds to the carrot
approach involving tax breaks for workers.
The second initial decision with important administrative
implications is whether the rewards and penalties apply over
the full range of possible wage and price changes, such as
under the program proposed by Laurence Seidman, or whether
they depend on the firm remaining above or below a threshold
or hurdle. Under a continuous program, higher prices and
wages reduce the rewards or increase the penalties according
to some formula. Continuous incentives are more efficient
but also would require that for every firm the exact increase
in wages or prices must be known.
In the hurdle approach, the rewards and penalties
depend simply on whether a firm's wage increases are below,
say, 5 percent per year. In this approach, IRS enforcement
efforts can be concentrated on firms that are near the
hurdle. Consequently, the hurdle approach is more attractive
on administrative grounds.

Whether the program is a temporary or permanent one is
the third initial design decision. If a tax penalty is
imposed for only one year it is likely to have very arbitrary
effects among firms depending on when they customarily raise
wages and prices. Complicated intra-year adjustments
annualizing wage and price increases occurring during the
year may be needed to reduce the arbitrariness of the
program. Also, special rules or exceptions may be needed
for multi-year contracts that provide future wage or price
increases. A temporary program may result in firms and
workers agreeing to compensatory wage increases or bonuses
to be paid after TIP expires. The best way to avoid this
problem is to indicate initially that a temporary program
may very well be extended if it is successful in moderating
The fourth initial decision is whether the basic
accounting unit for wage and price increases should be the
plant, the corporate entity, or the conglomerate. In the
case of a tax-based incomes policy applying only to wages,
the basic accounting unit could also be the bargaining unit,
or class of workers.
By far the simplest arrangement for administration is
to have the basic accounting unit be the group of related
corporations that file a consolidated tax return, and to
have the basic time period be the accounting period of that
group. Some corporations may be on a calendar year time
period, and others on a fiscal year.
If the TIP penalties or rewards are to be applied
directly to tax liabilities of employess, it may also be
necessary to apply them to each bargaining unit or broad
class of employees. Otherwise, one group of employees may
be penalized for the greater demands or stronger market
positions of another union or class of workers.
The fifth initial design decision is to specify the
nature of the TIP penalty or reward. Most TIP proposals
have been cast in terms of changes in the rate of the income
tax. Thus, the Okun proposal would rebate a percentage of
the income tax for firms and employees of firms that pass
the hurdle, while Wallich and Weintraub propose a surtax on
income for firms that fail the hurdle. Laurence Seidman has
suggested a variable system with rebates for firms that do
better than a specified standard and a surtax for those that
do worse.

29-775 O - 78 - 4

However, an economic case may be made for tying a wage
restraint to the Federal payroll taxes. A payroll tax
variant of TIP would then be directly related to a measure
of labor cost rather than to capital income. Some approach
other than altering the income tax rate should be proposed,
if it is deemed important that businesses be subject to TIP,
regardless of the amount of income tax currently paid. In
1973, 56 percent of corporate taxpayers paid no Federal
income tax. A TIP that alters the income tax rate for the
current tax year would have no consequence for such firms.
The most easily administered type of TIP incentive that
would also apply to deficit companies is a credit or surcharge
applied to one of the payroll tax bases. These incentives
could be defined as additional income tax liabilities or
credits so as not to affect the trust funds.
Having settled on (1) carrot or stick, (2) a hurdle or
continuous formula, (3) temporary or permanent, and upon (4)
the level of consolidation, and (5) the type of penalty or
reward, any TIP program must specify rules to determine the
extent of wage increases. If price increases are to be
explicitly treated, these must also be defined. In each
case, there are problems of defining the prior year base and
measuring the increase over the base. The administrative
problems are considerable, particularly in the case of
prices, unless simplified procedures are adopted. These
procedures would be somewhat arbitrary and could distort
business decisions such as the choice between debt and
equity or the choice between money wages and fringe benefits.
The Measurement of Wage Increases
A comprehensive measure of pay increases would include
all elements of labor compensation that can be reasonably
valued in dollars. That is, the numerator of the hourly
wage rate would be the sum of money wages and salaries,
including overtime; the accruals of pension rights; profit
sharing and other incentive awards; contributions to annuities
and group insurance; commissions; bonuses, and any other
valuable compensation. The denominator would be the annual
total of manhours worked. Such a thoroughgoing definition
of wages is desirable unless there is some reason to promote
the substitution of nonwage benefits for money wages.

All of the practical problems of measuring nonwage
compensation are already encountered in defining and administering the income tax. For employees, the incentives to
seek substitution of certain tax-exempt or unreported
nonwage benefits such as reduced-rate merchandise or companypaid insurance already exists. For corporations, there is a
strong incentive to avoid understatement of deductible labor
costs since these directly reduce corporate tax liability;
but, in many cases, fringe benefits that are not reported as
income by employees are deductible to employers as business
Under a hurdle-type TIP program, the payoff at the
margin for reducing measured pay increases by increasing
benefits that are not recognized as compensation may be very
large. For some versions of TIP, if the wage hurdle is set
at 6 percent, any device that allows a firm to reduce the
measured increase from 6.1 percent will result in a tax rate
reduction (or avoidance of a rate increase) on the entire
income of the firm. Because of this "notch", firms that are
near the margin of target wage increases would have very
strong inducement to underreport increases in compensation,
even if the average rate of the TIP penalties or rewards is
small. A similar potential notch problem would exist on the
price side of TIP.
Adjustments and Exceptions
One set of wage measurement issues thus involves
defining enforceable rules for measuring accruals of pensions
and unfunded insurance benefits, for measuring the value of
employee fringe benefits, and for estimating hours worked
for those on salary or commissions. Another set of wage
measurement issues is the adjustment of gross increases in
hourly compensation for such considerations as year-to-year
variations in the amount of overtime, changes in the skills
mix, changes in the average length of service, explicit
escalator clauses, and incentive awards.
Equity would suggest that a firm with above-average
overtime in the current year should not be penalized under a
TIP. This would require that an adjustment for overtime be
made in both the base period and for the current year. Many
firms, however, would not have records to support the amount
of overtime pay in the base period.

It may also be unfair to penalize a firm for pay
increases that result from adding more highly skilled
employees, or for rewarding employees who complete training
programs or surpass quotas. To the extent that employee
incentive awards, increases for length of service, and
promotions are intended to reflect increased productivity,
these changes in compensation are already allowed for in
setting the wage increase hurdle. But firms in a cyclical
downturn may be caught by TIP if layoffs are mainly lowerskill, lower-pay employees. Actual shifts in the mix of
employment toward higher-paid classes will, of course, be
penalized if TIP is based only on the change in aggregate
hourly compensation.
TIP could also provide an incentive for firms to
contract out for high-wage labor services. Suppose, for
example, that a small construction firm, consisting of 5
laborers and 2 engineers, wishes to hire an additional
engineer. Under a straight hourly wage hurdle with no
adjustment for classes of workers, hiring the engineer
outright could cause the firm to fail the TIP hurdle.
Hiring the additional engineer as a consultant would allow
the firm to qualify unless there were regulations to count
consultants as employees.
During the 1971-72 wage controls, the meaning of the
term "wage increase" was rather narrowly construed to mean
increases in the regular compensation, not including overtime and bonuses, for a given job held by employees with the
same length of service and quality of performance. This
concept requires the specification of an index to adjust
"compensation per hour" for changes in job definitions,
longevity, and the mix of skills.
A wage index could take the form of a weighted average
of hourly wages in each job classification or grade. But
the specification of such an index adds significantly to the
compliance and aministrative burden as compared to a simple
average hourly wage measure. It also puts heavy reliance on
the job classification system of business organizations. If
the coverage of the TIP program is to be nearly universal,
most small employers would need to invent a classification
system and all employers would be tempted to bend their
classification systems to help achieve the specified standard.
The promotion of a relatively high-paid secretary to administrative assistant can reduce the average wage in each

category, giving the appearance of wage reductions. Such
promotions would give more room for pay increases within
grades without encountering the TIP penalty or foregoing the
TIP reward.
The worst injustices resulting from shifts in the
employment mix may be accommodated, without adding greatly
to administrative burden, if a calculation of the average
increase in hourly compensation defined to include all types
of compensation, were made separately for certain broad and
recognizable classes, such as (1) hourly rated employees,
(2) salaried and commissioned employees, and (3) corporate
officers or partners. The increase in these classes could
then be averaged using the number of full-time equivalent
employees of each class in the base period as weights.
Finally, Congress would need to decide whether exceptions
should be allowed for low-wage employees and, especially,
for wage increases mandated by increases in the minimum
wage. Again, exceptions of this type that are attractive on
equity grounds will complicate administration and compliance.
The Measurement of Price Increases
Extending a tax-based incomes program to prices would
increase the administrative problems severalfold. In the
case of wages, there is a basic unit of labor, a man-hour,
which can be adequately defined. Total compensation,
somehow defined, can then be divided by total man-hours to
obtain compensation per man hour.
In the case of prices there is not a basic unit of
output. Thus it is not possible to divide total sales
revenue by total units of output to obtain price per unit of
output. Instead, a price index must be created for each
covered firm. This is not a simple task, when there are
some companies, such as Dow Chemical, that produce over
100,000 separate products.
What makes matters even more difficult is that a firm
may have raised its price only because it was passing
through an increase in the cost of purchased materials.
Allowing a pass-through of cost increases is a simple
concept, but it does raise a number of issues, particularly
as to just what costs are going to be passed through and how
purchased materials are to be priced. In general, firms
should be permitted to pass-through costs of inputs if the

firm is a price taker. However, if the firm has some
control over the price of the input, pass-through should not
be permitted. But this would be a very tough judgment to
make in developing a TIP program, and the rules would
inevitably be more appropriate for some taxpayers than for
To determine whether there has been a price increase
net of costs of materials, i.e., a value added price increase,
the firm must know last year's prices of purchased materials
and output. Last year's price of a product very likely will
be a weighted average of the prices at which the product was
sold during the previous year, and special rules may be
required for temporary special allowances offered during the
base period. The firm would then measure this year's value
added using last year's prices and compare that with this
year's value added measured using this year's prices. • In
short, the firm would construct a value added price index
using this year's quantity weights for both outputs and
purchased materials. Constructing such an index would raise
all the traditional problems involved in constructing a
price index.
The first problem in developing a value added price
index is to define by statute or regulation what is a
product or an input. For example, how many kinds of automobiles does General Motors sell in one year or how many
kinds of steel does Bethlehem Steel produce? In the case of
a drug store, are felt tipped pens different from ball point
pens? Just what is a separate product or input would have
to be defined with sufficient clarity that the firm and the
Internal Revenue. Service can easily compute the value added
price index.
Closely related to the problem of new products is the
problem of quality changes. This year's automobile is
different from last year's. Some adjustment would have to
be made for product improvement such as disc brakes, safety
equipment, and more durable bumpers. Again, the statute or
the regulations would have to provide specific rules for
quality improvements that both businesses and IRS agents can
easily follow.
An additional problem with constructing an index is
that the base period may not be a "normal" year. Companies
whose base period prices or wages were abnormally low will
seek an exception or special relief. For example, the major

firms in the steel industry raised prices just before the
August 15, 1971 freeze. These firms thus had a high base
period price. The smaller firms in the steel industry had
not raised prices. These firms, as a result, were doubly
penalized since they purchase raw steel from the majors and
sell finished products in the same market as the majors.
The problems of measuring average price increases arose
during Phase II and later phases of the economic stabilization
program. Unfortunately, the experience during the economic
stabilization program gives little guidance for administration
of a tax-based incomes policy since little auditing of
company reports was ever done. Firms were essentially on an
honor system, and the Cost of Living Council generally
accepted the reports as filed.
I conclude that computing a value added price index for
each firm would involve considerable complexity for business.
There is no easy way to define what are separate products or
inputs or to handle new products, quality improvements, and
the various issues surrounding cost pass through. Sampling
techniques could ease the administrative burdens for large
business but would be beyond the capabilities of a small
retail firm with many different products. If it is desirable
to apply a tax-based incomes policy to prices, consideration
should be given to a scheme that does not involve the
construction of an index.
Profit Margin Test
During wage and price controls, a profit margin limitation
was employed as a supplemental device to allowable cost pass
through. It was assumed that a firm that had not increased
its profit margin; i.e., the ratio of profits to sales, had
not increased its prices excessively.
A profit margin limitation would solve many of the
problems of a value added price index. No special rules
would be required for new products or quality improvements.
All costs could be passed through including increases in
wages. Presumably, a parallel portion of the tax-based
incomes policy would provide a brake on excessive wage
Firms would, however, have an incentive to increase
expenditures for advertising and R&D so as to shrink profit
margins. Unless the test was applied to gross profit
margins, that is, profits before debt service, firms would

have an incentive to substitute debt for equity financing.
Base-year problems would also remain, though they would be
mitigated since the base period could be an average of
several prior years and not just the immediate proceeding
year. Special exceptions would have to be made for losses
or very low profits in the base year. One possibility would
be for the government to publish minimum profit margins for
specific industries based on industry averages.
The major advantage of a profit margin limitation is
that the Internal Revenue Service could much more easily
administer it. Sales revenue and profits, either net or
gross, are concepts with which the Service has had long
Like any excess profits test, a profit margin limitation
would be a penalty on efficiency. It would also penalize
industries that are becoming more capital intensive. But,
if some form of price controls are regarded as a necessary
complement to a TIP for wages, the profit margin limitation
is the most tractable version.
Special Rules and Exceptions
A tax-based incomes policy applying either to wages or
prices may require a number of special rules relating to
exports, coverage of particular industries, and corporate
mergers and other reorganizations.
The objective of a tax-based incomes policy is to hold
down domestic wages and prices. There is, however, no
particular policy reason to be concerned about export price
increases. Thus, firms should probably be permitted or
required to disaggregate exports in determining the value
added price increase or the gross profit margin. This would
require special regulations to allocate certain costs and
As indicated at the beginning of my testimony, if a
tax-based incomes policy provides tax benefits, all business
taxpayers and even nonprofit organizations would want to be
permitted to participate. If, however, tax penalties are to
be provided, a number of exclusions that would greatly
simplify the administrative complexities would be possible.
An effective tax-based incomes policy could exclude new
firms, unincorporated businesses, small corporations, and
certain industries. There are very substantial administrative
advantages to such exclusions.

Determining base period prices and wages would be a
considerable burden on new firms, if they are included in
the tax-based incomes policy. If the firm began midway
through the year, an intra-year adjustment might also be
If anything more than the most perfunctory auditing
were to be contemplated for small firms, the sheer magnitude
of necessary paper work for firms and for the IRS argues
against including them. Precisely this kind of paper work
burden was encountered in administering Phase II controls,
and this was eventually accommodated by the exemption of
most firms having fewer than 60 employees.
Small firms are most likely to make use of the potential
for contracting out in order to avoid the apparent wage
increase from adding or replacing high-paid workers. Also,
small corporations present significant opportunities to
reduce salaries and increase corporate taxable income when
the owners are also employees. This is particularly true
when a small corporation is subject to only the 20 or 22
percent corporate tax rate.
In general, the proportion of cases for which some
special relief from the rules may be needed is probably much
larger for small firms. Large changes in skill mix, changes
in the amount of overtime, and other such potentially
variable elements in the calculation of the wage increase
would be more likely where small firms are involved. Exempting
the smaller firms would also exclude most sectors of the
economy, such as agriculture and small retailing, where
wages and prices are the most market sensitive. Excluding
unincorporated businesses and Subchapter S corporations from
TIP would avoid the necessity for special rules to distinguish
labor compensation in the earnings of partners, proprietors,
and shareholders that are active in management.
I conclude that tax-based incomes policies would
involve significant administrative problems for the IRS and
compliance problems for businesses. These problems can be
reduced to a manageable size if the scheme is applied only
to business taxpayers, limited to wages, if the hurdle
approach is adopted, and if it does not apply to small
companies. The administrative and compliance problems,
however, still would be significant.

There would be a strong incentive for firms near the
hurdle to pass the test by substituting forms of compensation
that are not included or are under valued in the wage index.
Experience with wage measurement problems under the income
tax suggests that opportunities for substituting forms of
compensation that understate the true increase in labor cost
cannot be fully closed off. Establishing the base period
wage level is an added problem. Adjustments are required
for firms that reorganize or add major new activities.
Further adjustments may be demanded for year-to-year changes
in the skills mix, overtime pay, or wage increases mandated
by low or prior contracts.
If a parallel price restraint program is adopted, there
are strong administrative reasons for preferring a profit
margin limitation rather than an explicit price index.
The remaining administrative and compliance problems
must be weighted against the expected gains from a tax-based
incomes policy in moderating wage and price increases.



The CHAIRMAN. Thank you, Mr. Sunley.
I want to thank all of you gentlemen very much. This is, as we
said, a terribly perplexing, frustrating problem. I think Dr. Okun
put it well when he indicated that we have to look at these as the
least worst or the least ugly alternatives and there's no option that's
good. Obviously, if there were, we would put it into effect.
I'd like to start off by asking each of you gentlemen to comment, if
you could, on the President's program as he announced it so far.
As T understand it, even if TIP went forward with full vigor and
the Congress adopted it and passed it, it would not go into effect
probably for iy 2 or 2 years and, therefore, we would be faced in the
immediate future with a problem of what we can do with what we
President Carter's anti-inflation program was announced about a
month ago. It consisted of the following, brought up to date in view
of his present attitude on the deficit: (1) a pledge to hold the fiscal
year 1979 budget deficit to $50 billion and to veto any bills that
threaten a larger deficit; (2) a limit of raises for 3A miliion Federal
civilian workers and military personnel to ?>.!) or 6.5 percent recently
budgeted; also, the salaries of 2.300 political appointees were frozen
and letters were sent to all Governors and mayors asking them to
hold down pay of the State and city employees; (3) a vow to reduce
the burden of Federal regulations on business; (4) a request that
labor and industry bring wage and price increases below the average
of the past 2 years, and the President also called on high executives
to freeze their own salaries and bonuses; (5) help us to meet with
executives of certain industries to formulate goals for wage and price
boosts—and as we know, Robert Strauss, who was appointed Special
Counselor on Inflation, will appear this afternoon as a witness before
this committee.
A recent column in the Washington Post commented on this and
I'd like to know whether this would be your view. The President's
reliance on totally voluntary restraints and the waggling of Strauss'
jawbone is likely to produce little more than a temporary euphoria.
It is clear, as President Carter himself said at last week's press conference, that the present inflation is a product of a self-maintaining
spiral of wages and prices. Something dramatic is needed to break
the cycle and it is doubtful that even Bob Strauss can do it by himself in the face of a stubborn 7 percent inflation rate.
Mr. WALLICI-I. Mr. Chairman, holding down the deficit is certainly
an important first step. I would prefer, however, a more dramatic
move in that direction: a reduction in the proposed tax cut to an
amount no larger than that required to offset the inflationary push
into higher tax brackets. I would estimate that to be no more than
$5 or $10 billion.
The CHAIRMAN. By that, you mean $5 or $10 billion below the $19.5
billion that is the President's request ?
Mr. WALLTCII. A tax cut of $5 or $10 billion is what I had in mind.
The CIIATRMAX. Instead of the $19.5 billion?
The CHAIRMAN. I see.

Thank vou.


Mr. WALLICII. Pressuring labor and business to decelerate wage and
price increases has the appeal of being very logical; that is, smaller
wage and price increases each year will eventually lead to reasonable
price stability. Although I think it is too early to say that the President's anti-inflation program is likely to be only partially effective, we
must bear in mind that ours is a very competitive society in which
people in their official capacity as union leaders and leaders of businesses cannot do what they might be willing to do as individuals;
that is, to make a sacrifice for the common good. So, while I wish
this program well, I do not think we should rely wholly on it. The
same applies to the approach described by Ambassador Strauss.
I fear that the forces of accelerating inflation are staring us in the
face and that if we do not do something more intensive than the
President has proposed so far, we may find that inflation will further
The CHAIRMAN. Dr. Okun, how do you feel about the President's
proposed anti-inflation program ?
Mr. OKUN. I think the President took an important step in the
right direction when he introduced that program last month. I wish
he had done it a year ago, frankly.
To me, he showed for the first time that he's willing to stand firm
and take some political heat from interest groups ranging from
Federal workers to farmers to business and labor and to environmentalists on timber cutting in order to pursue a course of containment of the inflation rate.
I was also pleased that he has explicitly committed himself to a
voluntary price and wage restraint program with some jawboning.
The evidence of the 1960's indicates that there were benefits from that
type of program before it was overwhelmed by the tides of excessive
demand. I think it's well worth doing.
I rather regret that the President and the administration have
fought so hard and apparently seem to have defeated, at least at this
stage, any tax-cutting in the form of rolling back the payroll tax,
which is clearly an inflationary tax. I think that the form of the tax
cut is much more important than whether the size of the tax cut is
$10 billion or $20 billion. There's much more opportunity for fighting
inflation by adjusting the form of the tax cut to be cost reducing
than by adjusting the size to change the amount of total pressure on
aggregate demand.
My understanding, as I look at the economic indicators, is that we
are still not facing an excess demand inflation and I don't think a
major reduction in the deficit is at all a sensible, efficient medicine for
an inflation that is not excess demand. It's just saying let's slow down
the economy.
Mr. Lilly said he doesn't have a precise theory of the link between
deficits and inflation. I guess none of us really do, but to believe that
there's something magic about Federal dollars being spent or being
returned to citizens in the form of tax cuts that makes it inherently
more inflationary than private spending is something that just strains
my credibility.
At this point I don't think the right answer to inflation is any
major change in fiscal policy. All things considered, I guess it's two
cheers for the April program. It's better than what we had before,


but as your quotation from the Post and as Henry Wallich's summary pointed out, I don't think we can rely on it entirely asr a cure.
That is precisely why we have to act well ahead and why w e should
proceed to have further discussion and legislative consideration of
The CHAIRMAN. Governor Lilly.
Mr. LILLY. Well, I think the program is fine. I agree with Dr.
Okun, it's too bad it didn't start a year ago or even prior to that,
I am more concerned that there be follow-through. I disagree with
Dr. Okun, as you know, on the impact of the deficit, however, I do
agree with him on the cost-raising actions and I certainly agree that
if there is to be a tax cut it should become in the form of decreased
payroll taxes rather than just decreasing the income tax.
So I would like to see the program—I endorse the program. I
would like to see a follow-through and a further decrease in the
budget deficit in the years following and I'd like to further see as
part of the program that any cost-raising action by the Government
be offset by a cost-cutting action. This could require—as I have
recommended before—that an inflationary impact statement accompany any new legislation or increase in funding by the Congress.
The CHAIRMAN. Mr. Sunley.
Mr. SUNLEY. Thank you, Mr. Chairman.
President Carter, as you know, reduced the size of the proposed income tax reduction from $25 billion to $20 billion in response really
to the somewhat higher levels of inflation that we were fighting in the
first part of this year than what the administration and private forecasters had expected.
I think we need to recognize at this lower level of $20 billion the
portion that will be going to individuals in 1979 will not offset fully
the social security tax increases or the impact of inflation on pushing
taxpayers up into higher tax brackets which was alluded to by Governor Wallich. So I think with the size of the tax cut the President
is now proposing it is important that we enact that cut.
With respect to social security tax cuts instead of income tax cuts,
it was the administration's view—and I think now borne out after
the consideration in the House—that it was very difficult to do anything this year other than putting a small bandaid on the problem
without raising very fundamental issues, and that, of course, is what
happened in the Ways and Means Committee. It appeared that it was
impossible to get 19 votes for any one proposal for cutting social
security taxes for 1979, even though there were 19 votes in favor of
cutting social security taxes as a general principle. But the fundamental issues raised in terms of where did the general financing go,
did it go into the health insurance fund, the disability trust fund or
maybe spewed into all three, could not be resolved in that Committee.
The Administration believes, and I believe, we should not do a quick
fix on social security. Instead, income tax cuts can be adopted that
would at least offset the impact of the increased social security taxes
for each family up through the median income level.
The CHAIRMAN. Thank you.
Senator Schmitt.
Senator SCIIMITT. Thank you very much, Mr. Chairman.


We have had a lot of interesting testimony and a large number of
understatements. With Governor Lilly maybe being the understatement of the morning, that we must take very seriously the possibility that large government deficits contribute significantly to inflation.
Certainly I realize what you're saying. I don't think that anybody
can really seriously question that the Government deficits don't have
a very significant impact on inflation. I guess the question is: can
we do anything about it? And that's where we tend to have our
The tax-based incomes policy seems to me to be a classic example
of "Potomac fever" and that the Government can do anything
whether it's necessary or not and in this case it seems to me an effort
to relieve the conscience of those who won't take the kind of actions
necessary to reduce the Federal deficit.
Mr. Sunley's testimony indicates very clearly that T I P is going to
be a bureaucratic dream" and a taxpayers' nightmare, no matter how
we structure it, whether we leave small business out or not. It reminds
me, Mr. Chairman, to paraphrase an old Army adage which could be
applied to the economy, that if it begins to move, tax it; if it doesn't
move, regulate it; and if it's too big to regulate, break it up. And I
have a feeling that's exactly what this Government has been trying to
do for at least a decade if not longer.
I just don't see how we could ever implement a program such as
this, first of all, in a pragmatic way. Secondly, if we don't also
take the basic steps that are required to eliminate the basic inflationary pressures that exist in our economy, if we don't begin to gradually reduce that Federal deficit, if we don't begin to gradually reduce
the tax burden on the American taxpayer and business, then we must
also realize that it is that deficit which creates the pressures on the
Federal Reserve System to increase the money supply.
And your chart, Mr. Lilly, I think is a very real chart. Whether
you can come up with a theory or not, we have had enough time now
to see those trends and they are very clearly coupled, the linkage is
very obvious. I think it's very obvious what we have to do.
Now I would ask you gentlemen, don't you think that it is possible
to set up a schedule of economic goals, not specific goals but schedules,
where we begin to reduce the tax burden by say $10 billion a year in
a permanent fashion ? In this way would we begin to reduce the annual
deficits by about $10 billion a year and simultaneously reduce the rate
of growth of the money supply by about half a percent until we come
into balance with the rate of growth of the GNP ? Mr. Lilly, would
you like to comment first?
Mr. LILLY. I can't do that math in my head and I'm not sure
Senator SCHMITT. Well, I just threw something out.
Mr. LILLY. But I certainly would agree generally.
Senator SCHMITT. The coupling of those kind of factors
Mr. LILLY. I would certainly agree.
Senator SCHMITT. Mr. Okun?
Mr. OKUN. I do not agree, Mr. Schmitt. I spent my professional
life studying the relationship between fiscal and monetary policy and
the performance of the economy, both production and inflation, and

nothing I know tells me that a change in the deficit or in monetary
policy will have an effect on inflation.
Senator SCIIMITT. YOU aren't impressed by that diagram, Mr.
Senator SCHMITT. DO you
Mr. OKUX. Yes, I have an

have an explanation for it?
explanation for it very definitely. If you
cover up the last period until 1970 you don't find a very remarkable
correlation between the CPI and U.S. debt. I think you do find that
the Vietnam experience was a classical case of an overheated economy where the deficit played a major role. What happened the last 2
years is that we created a recession because we had too much inflation.
The recession forced us to have very high Federal deficits. So the
direction of causation is exactly the reverse. It's the rapid inflation
that created the recession that led to very large Federal deficits.
There's such a difficulty in communication on this issue. I wish we
could understand each other better. As I see it, the only way in
which you can say that we would have been better off in the last 2
years with a lower federal deficit and lower money growth is if you
believe the economy has grown too fast. If you believe we should
have had a longer, deeper recession and a slower recovery, I understand what you're saying, and then I'm prepared to tell you how
painful that would have been. But everything I know tells me that
Federal dollars behave like any other dollars. They go into people's
hands whether they're Government expenditures or whether they
take the form of tax cuts, and people decide what to do with them. If
the economy has a lot of slack those dollars create more production
and more employment and very little added inflation. If you're talking about a major cut in the deficit or a major reduction in money
growth today you're talking about getting rid of inflation by causing
another recession.
I have studied every analysis that I could lay my hands on in the
literature of the relationship between total spending and inflation
and, as I report in my testimony, the most optimistic one that I could
find says that cutting back a dollar of GNP in 1979 by cutting the
deficit or cutting money growth will save no more than 15 cents worth
of inflation and will lose 85 cents of real production. I call that burning down the house to roast the pig.
If we're going to ask is it worth paying that price
Senator SCIIMITT. Don't you think you're in a minority with that
kind of analysis?
Mr. OKUN. I'm not in the minority. Indeed I don't know anybody
in the economics profession who has done a study
Senator SCI-IMTTT. YOU think you can continue to pump $60 billion
a year into the economy without any commensurate increase in the
production of goods and services and not have an inflationary
pressure ?
Mr. OKUX. That's precisely the point. That would become dangerous when it has created enough production of goods and services so
that we're fully using our resources. We're close to that point now, a
lot closer than we wore a year or two or three ago. We had plenty of
slack in this economy by my standards in 1975 and 1976. The real


question is what is there about the price and wage making process
that does not convert slack and excess supply into disinflation.
The fundamental problem is in the price and wage setting process
and T I P is a way of dealing with fundamentals.
Senator SCIIMITT. Mr. Okun, you don't think that the price and
wage increases are a direct reflection of the inflation? Do you think
they are generally inflationary, to have wage and price increases ?
Mr. OKUN. I think that the price and wage decisions are clearly
influenced by what has been happening to inflation. That's precisely
the way we became entrenched in a price-wage spiral. We have been
having that much inflation. There's no obvious reason to expect it to
go away. People have to protect themselves and in the process wage
earners have become accustomed to something like 8 percent in wage
increases. When they get 8 percent, price makers need 6 percent to
cover their costs and it's precisely that spiral which had been
Senator SCHMITT. YOU propose then that we begin to cut prices
and wages, and that somehow inflation is going to go away. Also that
there will be sufficient profit margins both for the wa^e earners and
business that the ecnomy can contitnue to operate—inflation at 6 percent and limiting wage increases to something like 3 percent?
Mr. OKUN. My proposal is 6 percent. I'm proposing to provide a
tax credit for wage earners in those firms that pledge to hold wage
increases to 6 percent. I'm not looking for a major change. I don't
think we can get a major change. I don't think you can stop inflation
dead in its tracks because you create a major inequity problem with
respect to people who just got their price and wage increases recently
and those that came into the new program. I think it's got to be
Senator SCIIMTTT. SO, under vour basic economic philosophy, we
could have any size Federal deficit and it would not be inflationary?
Mr. OKUN. I hope I didn't give that impression at all.
Senator SCIIMITT. $60 billion is not inflationary according to you.
$100 billion presumably would not be also.
Mr. OKUN. That's not the case at all.
Senator SCIIMITT. Where can we go to then? Obviously, you are
satisfied with $60 billion.
Mr. OKUN. NO, I'm not. That's not my figure, sir.
Senator SCIIMITT. Well, that's where we are and you're saying
that's not inflationary. I'm a geologist. I'm not an economist. And
out in the real world of geology when you deal with mineral deposit economics you have to live with the real world. You can't live
with what Washington tells you economics is. You have to live with
what that mineral deposit tells you what economics is. You're telling me that $60 billion is not an'inflationary budget, a deficit of $60
billion is not an inflationary budget. There's nobody in this country
that I've run into who's paying taxes for that budget that believes
you, but that's what you said here this morning.
Mr. OKUN. The question of what deficit becomes inflationary is a
question of at what point does the economy go too fast and get overheated. We should be able to agree that tnat's the question. There is
no magic by which a deficit gets into prices or wages. It gets into

prices and wages because of what it does to demand and supply. You
can have bad taxes that discourage supply. You can have bad expenditures. If you don't have an overheated economy, then the deficit
isn't inflationary. The reason we have had to have $45 and $50 billion deficits—I don't think we've hit $60 billion yet and I don't think
we will—in recent years is because we dropped this economy over a
cliff in 1974 and it has needed Federal support to get back. If we
didn't have the tax cuts we had in 1975 and 1976, we'd still have
8 percent unemployment rates and we'd still have capital spending
down where it was then.
It is precisely because the economy has been hit by inflation—by
monetary restraints in the face of the oil and the food explosion in
1974 and 1975—that there's no way of getting back to a balanced
budget soon. No economist I know will tell you that you could
quickly reduce that deficit from $60 billion to zero without causing
a recession. There's a good deal of question about whether the deficit
ought to be $50 billion or $40 billion, it shouldn't be $20 billion and
it shouldn't be zero.
Senator SCIIMITT. My question to you, sir, was, don't you think
we should decrease by $10 billion a year now that we're supposedly
coming out of this recession ?
Mr. OKUN. I think that's a reasonable path to be on once we get
the economy back to health.
Senator SCIIMITT. The economy is strong. You said so yourself.
We have been coming out of the recession far too slowly, but we are
coming out. We are employing all the new people by the numbers
that are coming into the labor market. The unemployment rate, even
by the Labor Department's figures, is decreasing, even though they are
inflated. I think most people now are agreeing that those numbers
are inflated. So when do we start to reduce the deficit?
Mr. Chairman, I'm over my time. I will pursue this later.
Mr. OKUN. I'm sorry that I'm prolonging the dialog, but I think
this is a crucial issue, Senator.
The CHAIRMAN. Let me get back briefly to TIP. I want to congratulate both of you gentlemen for taking this initiative. It's very,
very welcome. It's always hard to come into something that's new
and different and far-reaching. You obviously are going to encounter a lot of opposition and I know you realized that when you
made the proposal, but I think it has great merit of being something
that could work. It does go to the heart of a big element of the inflation problem which is the wage-price spiral, the momentum of
inflation. The fact is that once you get inflation built into the system
it's the hardest thing in the world to overcome it.
Let me ask you first, Dr. Okun, was I right or wrong in assuming
that this would not go into effect for iy2 or maybe 2 years? What's
your assumption on that?
Mr. OKUN. I suppose that's a realistic assumption. In principle,
there's still a tax bill before the Congress this year and the tax cut
could take the form of a T I P to go into effect in January 1979.
There's nothing that requires more prolonged advance work. It is
the problem of building a consensus, building an understanding, and
quite frankly, we don't have it right now.

29-775 O - 78 - 5


The CHAIRMAN. SO you acknowledge you don't have it. Do you
agree with that, Dr. Wallich, that there's not sufficient consensus
now for Congress to enact this so it could go into effect in 1979?
Mr. WALLICH. I think that is true. I think progress is being made
on that front.
The CHAIRMAN. What evidence is there that progress is being
made on that point ?
Mr. WALLICH. The growing interest in TIP. T I P is not being sold
on the basis that it is an attractive innovation. T I P commends itself
because all alternatives seem to be
The CHAIRMAN. YOU say "growing interest." Who do you mean?
Are there people in business and labor and Government and so forth
who are beginning to call out for it, indicating they will support it?
Mr. WALLICH. I think there are, without imputing it to anybody
in particular. Certainly the amount of public attention that it has
received has mounted very rapidly.
The CHAIRMAN. IS there any prospect that it could be tried on a
pilot basis? I think many people feel that it's too complicated, that
it wouldn't work for one reason or another. Mr. Sunley has given
some administration objections to it. Do you think that would be possible? Would that help to build either a consensus or a recognition
that we have to try something else?
Mr. WALLICH. The relationship of wages and prices make that
rather difficult. If wages slowed down across the Nation, then prices
would slow down; but one couldn't hope, for instance, to slow down
wages in one industry or in one area of the country. It wouldn't
have the proper effect on prices, in which case it would just cause
unappropriate pressure on wages.
The CHAIRMAN. Why couldn't it be workable in a particular industry? After all, the carrot approach—you'd have the advantages
for the people that took part in that industry. You possibly could
have some reflection on what would happen to the price in that industry. Do you think that has any merit. Dr. Okun, or do you have
to have this on a comprehensive nationwide basis?
Mr. OKUN. I think the only issue there would be whether you
could justify, in terms of equity and the politics of the situation,
singling out that industry as a beneficiary of a reward or
The CHAIRMAN. What you need, of course, is a leadership in both
the industry and labor unions who would say "Let's try it. We're
going to give it a shot." Maybe the automobile industry or maybe
some other area where you've got people who might have the imagination and the understanding to do it.
Mr. OKUN. I think that would be very worthwhile. At a perhaps
less ambitious level of not actually putting the program into practice
on a pilot basis but of trying to simulate its workings, there has
been some expression of interest by an economic development council
in the Baltimore area. They have shown some interest in trying to
see whether firms might consider what set of rules they could easily
implement, how they could handle it, what administrative problems
they would see within the firm, trying to guess how they might
react, and whether some of the loopholes and compliance problems
that have been mentioned would look serious or trivial in their
judgment. I think something like that would be valuable.


The CHAIRMAN. Governor Lilly, let me ask you—I think Senator
Schmitt has taken a very strong position. It does reflect the views
of many Members of Congress and many people in business and the
public generally, but at this stage in the business cycle when you have
6 percent unemployment, when you have 82 percent capacity operation, 18 percent vacancy in capacity, when you have no evident shortages, I do favor, as you may know, reducing the budget and reducing
taxes too because I think the Government is growing too fast, it's
too big, too awkward and too wasteful, but I frankly am not sure—
and I would tend to agree with Dr. Okun, that that would not be an
answer to our inflation problem necessarily because, as I say, I
would reduce both spending and taxing at the same time. The fiscal
effect might be a washout.
At any rate, on the assumption that Congress is going to go ahead
and have at least a $50 billion deficit, how do you feel about TIP as
an option, if that's all you have, unless you can suggest something
Mr. LILLY. Well, I think what you're doing is treating the symptom rather than the cause. If you have a longer range program in
The CHAIRMAN. DO you still maintain, in spite of what Dr. Okun
has so eloquently argued, that the present deficit is the cause of the
inflation ?
Mr. LILLY. I think that the present deficit certainly has something
to do with the present inflation.
The CHAIRMAN. What does it have to do with it right now, recognizing the deficit we had in 1968 and 1969 was a cause of inflation,
recognizing it could be a cause a year from now if we continue to
have unemployment drop and we move down to say 90 percent capacity utilization ?
Mr. LILLY. Well, Senator, first of all, let me say that I do not
believe that we should try and remove the whole deficit immediately.
I think this is going to take a very long time.
The CHAIRMAN. My question is, if we don't move faster—say
Congress is going to stay and take a realistic position that a $50
billion deficit—maybe we shouldn't do it but we're going to do it—
then would you feel it might be practical to try it?
Mr. LILLY. Then I think you have to move to controls of some
kind and I would prefer T I P to wage and price controls.
The CHAIRMAN. Why do you call TIP controls? It's not controls
in the sense of mandating a particular wage or price. People are
still free to do what they want. The tax system is just an incentive.
Mr. LILLY. They are very persuasive guidelines and they are designed to control the rate of increase in wages.
The CHAIRMAN. Well, maybe they are persuasive in that they
might work, but what's wrong with that? You're not mandating
business or labor to agree for that matter.
Mr. LILLY. Well, as I say, I would prefer T I P to wage and price
controls, given the situation where we seem unable to do anything
about the basic causes of inflation. And I might interject here that I
think we may be very close to the top of this particular cycle and we


have a higher percentage of the adult population in the country employed than we have ever had in our history.
The CHAIRMAN. That's right, of the whole population.
Mr. LILLY. Of the adult population.
The CHAIRMAN. The work force is so big, it's exploded so much
that we now have—people 16 years old or older are the only people
who are measured according to testimony we had last month before
the Joint Economic Committee.
Let me ask you, Mr. Sunley, I'm not sure from your conclusion
whether you would flatly reject T I P or not. You indicated a lot of
difficulties with it. You indicated the cost seemed to make it unworkable. Does that mean that you would not accept it or does that
mean that if inflation continued—and you seem to have a realistic
appreciation of the tough political obstacles in the way of meeting
inflation any other way—would you consider this as an option?
Mr. SUNLEY. Yes, I would. I think what I conclude in my statement, Mr. Chairman, is that T I P does involve some serious administrative problems for the IRS and the IRS is not looking for a new
program to administer. T I P does involve some serious compliance
problems for firms. But, there are versions of T I P which involve
considerably less administrative and compliance problems.
For example, you can hold it down to only the large firms, if you
apply it only to wages
The CHAIRMAN. That's pretty much the way it was presented by
Mr. Wallich and Mr. Okun. They didn't mean to cover every one of
the 5 million firms in the country by any means.
Mr. SUNLEY. That's the direction T I P has been moving, that's
quite clear, in the public discussion. I think what you then need to
weigh, and I was not trying to do this in my testimony, is the benefits from moderating wage and price increases that you could achieve
through T I P compared to those costs which we will try to minimize
in a carefully designed T I P program. Presumably, T I P would allow
you to further reduce the level of unemployment or, at any given
level of unemployment, have a lower rate of increase in prices.
It's clear to me that if the choice is between T I P and wage and
price controls, we should give T I P a try. But the President's program may be adequate, and it's clear that we aren't at this point
ready to move T I P into place. Nobody has done a legislative draft
of it. Several of us have looked very carefully at what we think are
the administrative problems, but sometimes you don't discover what
all the problems are until you start to draft the legislation. So I
think T I P is one of those options that deserves continued study.
The CHAIRMAN. Would you submit for the committee for the
record the studies that have been done ? You say several people have
made studies. We'd like to have everything you've got over there
on this.
Mr. SUNLEY. I would be glad to submit the paper that Larry
Dildine and I did for Brookings and there was an interesting paper
done for Henry Wallich. If it is public I will be glad to submit it.
Mr. WALLICH. I will supply that, Mr. Chairman.
[Governor Wallich subsequently provided the Committee with the
report prepared for the Board of Governors of the Federal Reserve

System by Kichard E. Slitor, "Tax-Based Incomes Policy: Technical and Administrative Aspects."]
The CHAIRMAN. My time is up.
Senator SCIIMITT. Mr. Chairman, there's a recent Library of Congress research paper by Mr. Edward Knight on inflation and Government policy which covers a number of these items. I think it might be
useful, if it's not already in our record, to have that inserted in the
record also.
The CHAIRMAN. Without objection, it will be inserted in the
[Both papers are reprinted as follows:]



April 7, 1978

The ongoing discussion of tax-based incomes policies (TIP)
makes desirable a thorough examination of the technical aspects of
these proposals from the viewpoint of the tax administrator. The
report transmitted herewith seeks to contribute to meeting this need.
Its author is Richard E. Slitor, Economic Consultant, former member
of the Treasury's Tax Analysis Staff in charge of corporate income
The report covers the technical aspects of a TIP, based
mainly on Wallich-Weintraub lines, but also examines other versions
of the penalty or "stick" approach. In summary form it deals with
variants of the "carrot" approach and with combinations of the two
approaches. The body of the report is preceded by a 10-page
executive summary.
Slitor*s views are entirely his own and do not represent
those of the Federal Reserve Board nor even in all cases my own.
His report was financed by the Federal Reserve Board in connection
with my ongoing work and Congressional testimony on TIP.

Henry C. Wallich


A Report Prepared for the
Board of Governors of the Federal Reserve System

Richard E. Slitor
Economic Consultant
9000 Burning Tree Road
Bethesda, Maryland 20034
March 20, 1978


Executive Summary


Introduc tion

Scope of the analysis


Technical particulars examined

Basic tax design options

Form of the tax

Adjustment of the regularly applicable income tax



Illustrative formulas



Problems and difficulties
(1) Discrimination against equity capital




Inapproprlateness of base of penalty tax
adjustment: economic and equity aspects









Debt financing, leveraging, and



Small business and unincorporated


Coordination of corporate and
individual tax adjustments



(f) Deficit companies



Low shiftability of corporate income
tax adjustment


Damage to investment


- ii 2. Disallowance of excess wage deductions


a. Conceptual compatability with existing
disallowance of illegal payments


b. How it would work


(1) Basic penalty effects
(2) Possible additional penalty effects


(3) Possible scaling factor


c. Problems and difficulties


(1) Non-taxable because unprofitable firms


(2) Tax haven industries


(3) Variation of penalty effect with applicable
tax rate


d. Quantitative comparison of approaches
(1) Incremental or marginal impact


(2) '^Effective" rate effects


3. Special penalty tax on excess compensation





a. Excise tax on inflationary excess compensation


"Carrot versus stick" and variant TIP plans ....


a. Considerations raised by the generic tax
carrot plan
b. Okun proposal for tax relief for price-wage


c. Seidman plan for business payroll tax
decreases for wage increases below norm ....


d. Abba P. Lerner anti-stagflation package


B. Area of application



1. Unincorporated enterprise


a. Blanket exemption




Size exemption

- iii -




Corporate area



Design options



Universal corporate application



Universal corporate application subject to
small business exemption



Application of TIP to large corporations only



Subchapter S (tax optional) corporations ...



"Deficit" corporations



Technical problems of exemption


(1) Notch problem
(2) Multiple incorporation and other business


Duration of TIP penalty



One year only approach



Cumulative excess or carryover approach



Further problems in the carryover approach


Fixed period of years


Definitional and measurement matters





Definition and measurement of wages/salaries/compensation and increases thereof



Identification and valuation of compensation items



Deferred compensation and deferred pay increases



Allocation of group-type compensation among different components of the work force



Convenience of employer rule



Travel, entertainment, personal expenses of
employees, gifts, and similar items


Exclusion of non-domestic compensation



7. Measurement of certain elements of wage increase




Valuation of compensation other than in cash


- iv B. Measurement of excess compensation for TIP purposes
1. Brief review of alternatives


a. Reliance solely on percentage pay increase
in union wage settlements


b. Wage bill


c. Overall annual average pay per employee ....


d. Weighted average or indexing procedures ...
(1) Illustration and analysis of alternative


(2) What the results show


(3) Highlights of Treasury staff study of 1970


(4) Apportionment of non-directly allocable
employee-benefit costs


(a) What the illustration shows about
apportionment factors


(b) Sidelight on choice of averaging


(5) Treatment of overtime pay


(a) BLS-ECI Index
(b) Treasury staff study of 1970



(c) Should overtime be neutralized as
a TIP factor?




1. Indexation vs. average rate of compensation
2. Would actual indexation be appropriate in applying




a. Structuring


b. Roundaboutness


c. Cumulative or carryover approach
d. Interplay of "long-play" tax and carryover



- V 3.

Some official compensation indexes





BLS compensation indexes emphasizing
measurement of change


Employee classification issue


c. Lessons drawn
Methods of pay increase measurement followed in past
episodes of wage stabilization



"Costing out" collective bargaining settlements



Compensation per manhour



Employment Cost Index (ECI)


Definition of the taxpayer unit


1. Controlled corporate groups



Importance in the economy


Potential anomalies and inequalities: TIP



tax shelters



Labor-management s trategy



Interplay with form of tax


e. Discrimination depending upon consolidation
versus non-consolidation



Possible mandatory consolidation



Separate filing for TIP purposes



Conglomerate problem



Changes of corporate ownership of affiliates ...



Foreign subsidiaries and branches









c. Western Hemisphere trade corporations



Constructive taxable income from related
foreign corporations


- vi -


Timing problems

Start-up and transition problems



Effective date of plan



Pre-existing contracts and "catch-up" settlements



Start-up data requirements



New companies



Defunct companies



Coordination of guideline determination,
excess compensation calculation, and timing
of tax payment


(1) Prompt availability of guideline standard





Current TIP tax payment


(a) Avoiding lagged and perverse timing


Integrating TIP with income tax
current payment system


Evaluation and constructive solution



Simplified operation in start-up year



New companies



Making non-conterminous wage contract and tax
years compatible
Relief for predetermined pay increases and
catch-up wage settlements




Proration of guidelines for "straddle"





Specific problems of administration and economic impact



Tax avoidance and evasion



Concealment of fringe benefits



Upgrading of employees


- vii -

3. Fictitious overtime and manipulation of differential shift pay





Corporate reorganizations and transfers into new


Sale or transfer of a subsidiary between multicorporate groups (or acquisition of independent


Switches of employment to "deficit" subsidiaries


7. Contracting out


Relief from hardship


1. Renewal of multi-year contracts including a
"first year catch-up" increase


2. New labor classifications



Upward drift in the skill mix



"Tandem relationship"/catch-up problem


5. COIA adjustments


Inter-firm, inter-industry, and inter-regional
compe titive pay adjustments



Undesirable economic impacts:

export of jobs



Accounting problems of small business
Problems of precise and detailed articulation of


standards and procedures


Appendix A:
A Primer of Index Number Construction for TIP




Base period consideration

B. Alternate methods of constructing wage index numbers



Aggregative wage index numbers




Simple or "unweighted" aggregates

- viii -

2. Weighted aggregates



Base period quantities as weights



Given (current year) quantities used as weights



Average of total quantities of base and given
(current) years used as weights


Average together the quantities for all (or
selected typical) years covered by the index


Highest common factor used as weight




f. Average of two different weignted index
measures (usually employing geometric mean)
g. Weighting bias criticisms

Averages of wage (price) relatives

Usefulness of weighted average of wage relatives
method vs• aggregative method
Appendix B:




Definition of TIP taxpayer unit in the case of multicorporate entities: effects of separate and consolidated
reporting due to interplay of labor skill mix and index



Effects on excess compensation



Effects on TIP tax liabilities



TIP plan design and taxpayer choice problems



Tentative conclusions




Overview of content


1. Basic tax design options



Definition and measurement issues



Specific problems of tax avoidance and evasion,
hardship, and adverse economic impact




Form of tax



Area of application


D • Duration of tax



Measurement of compensation



Determination of excess compensation



Definition of the TIP taxpayer unit



Timing problems



Specific problems of administration and economic impact


- s-i -


Overview of content
This report analyzes the technical and administrative aspects

of proposals for a tax-based Incomes policy (TIP) under several basic
topical headings:
1. Basic tax design options
This covers the issue of the form of the tax penalty on excess
wage settlements (adjustment of income tax rate, disallowance of excess
wage deductions, and other alternatives); the scope or coverage of the
tax in terms of type and size of business organization; and the duration
of application of the penalty tax, once incurred.

Definition and measurement issues
This topic includes:
-- the achievement of a suitably comprehensive definition of
compensation which would capture both the standard forms of
fringe benefits and more novel or exotic forms, more difficult
to identify, measure, and attribute
— the measurement of the average percentage increases in rates
of compensation in the current year over the preceding year (or
other specified base) for purposes of determining the excess of
compensation increases over the guideline standard; this to be
done either by averaging the percentage increases among different
labor categories or by equivalent "indexation"
— the definition of the taxpayer unit in an economy characterized
by frequently changing multicorporate aggregations with different
degrees of common control, frequently "conglomerate" in character,
embracing quite distinct industrial classifications or lines of
industrial activity with possibly disparate wage classifications
and experience, and
— a variety of timing problems, including the start-up of TIP
with reference to a pre-TIP compensation base, the treatment of
new firms, the handling of catch-up wage settlements, the

29-775 O - 78 - 6

- S-ii -

coordination of TIP tax penalty and the inflationary behavior
which triggered it, and similar matters.

Specific problems of tax avoidance and evasion, hardship, and
adverse economic impact
This discussion partially overlaps other portions of the

report but stresses constructive solutions.

It includes:

-- various tax avoidance and tax evasion routes and appropriate
methods of closing these avenues of concealment or escape
-- some possible hardship situations and suggested methods of
providing relief
— possible undesirable economic impacts such as the transfer
of operations outside the U.S. by direct or indirect means
(e.g., import of product components, resulting in "export of
Highlights of these various discussion areas are set forth

Form of TIP tax
With respect to the form of the TIP tax, the report (1) rates

an adjustment of the general corporate or individual income tax rather
low since it tends to (a) impose penalties on a net income base not
closely related to the excess compensation and (b) to discriminate
against capital intensive businesses.

(2) Disallowance of excess

compensation as income tax deductions would avoid distortions due
to variations in capital intensiveness but, in common with the rate
adjustment approach, would be at least partially ineffective as a wage
settlement restraint in the case of businesses without net taxable income.
While the deficit business area may not be regarded as criticially
important to TIP, it cannot be overlooked.

(3) An alternative form

- S-iii -

of TIP tax penalty applicable directly and separately to determine
excess compensation may be appropriate to assure universal industrial
coverage without regard to net taxable income or loss status.
The report is inclined to be concerned with TIP approaches
which leave deficit companies unscathed. With this as a standard,
the adjustment of income tax rate approach rates low; the disallowance
of deduction method somewhat higher -- since it would affect loss
carryovers, a matter of importance to any but the most chronic loss
companies; and a direct tax on the compensation excess as such, still

However, considerations of shiftability and the adverse

semantics and public relations of proposing to tax wages as such
rather than profits tend to argue against the latter.
The report observes that TIP may take the form of rewarding
conformity with wage guidelines, thus indirectly penalizing firms
paying excess compensation by denying them otherwise available tax
reduction (Okun approach).

This approach would involve no special

technical problems except that unless appropriately devised it may
involve indirect tax penalties on capital intensiveness, differentially
high penalties on very profitable firms, or blind spots with respect
to tax haven or non-taxable operations of the same types encountered
in formulating direct tax penalties.
C. Area of application
With respect to the area or scope of application of TIP,
the report recognizes the appeal of excluding all but a few thousand
large corporations in order to focus on major wage settlements and

- S-iv -

contain its compliance and administrative burden. However, any
specific size test appropriate for some industries marked by concentration in large units would be inappropriate in covering the action in
others where numerous relatively small firms account for the bulk of
the business. Construction, trucking, and to some extent retail trade
are industries in which relatively small firms predominate and union
wage settlements are important to national incomes policy.
The report examines other technical questions of scope such
as the treatment of unincorporated businesses and subchapter S (tax
option) corporations, and point out workable methods of including them,
if that should be desired.

Duration of tax
The report considers the relative merits and technical

problems associated with applying the TIP penalty for (1) one year
only, (2) for a fixed multi-year period, or (3) for a lengthy or
indefinite period.

It concludes that lengthy periods of cumulative

build-up of TIP tax penalties stemming from various historic layers
of excess compensation would be complex and burdensome.

It suggests,

however, that some extended duration or cumulation with carryovers of
good or bad wage settlement experience would be practicable and desirable
to exert continuous pressure towards conformity with non-inflationary
compensation policies and to provide equity for lumpy or irregular wage

- S-v -


Measurement of compensation
As the report points out, the definition and measurement

of compensation for TIP purposes involves two steps:
— the definition and measurement of total compensation per
se, involving the identification and valuation of the whole
range of fringe benefits and wage supplements among classes
of employees, and
— the allocation and apportionment of these compensation
benefits among classes of employees.
Fringe benefit measurement may require alertness and thorough
"costing-out" of wage settlements and compensation increases of all

The report points out that this is not a novel operation.

Labor Department (BLS) statistics-gathering functions already provide
precedents for this step.
Compensation items, such as use of recreational or medical
facilities, which may not be directly aHocable to classes of employees
for purposes of calculating a weighted average rate of increase in
compensation (discussed in the next paragraph) may be apportioned according
to total compensation or other apportionment factor.

Determination of excess compensation
The determination of excess compensation for TIP purposes

on a reasonable basis involves the calculation of the average percentage
pay increase.

The report demonstrates that crude unweighted averages

would be unsuitable. A fair and accurate measure of pay increase would
involve employee classes.

Reasonable personnel classifications would

be provided by statute and refined by regulations pursuant to the
statutory directive.

The analysis indicates that a relatively few

- S-vi -

categories would serve TIP purposes, although classification might
need to be adapted to the varying complexity of the skill mix and
compensation hierarchy in different industries.
As the report indicates, calculation of weighted average
percentage increases in the rate of compensation involves a policy
choice among averaging methods.
The report examines and illustrates various methods of
weighting and averaging for purposes of calculating the over-all
average pay increase percentage to be compared with the guideline in
arriving at the excess compensation on which the TIP tax penalty would
be based.

The calculation of average rates of pay increase is equivalent

to an indexation procedure.

The report demonstrates that in typical

compensation increase situations different well-designed methods of pay
increase averaging or indexation yield closely similar results.
As background for the whole question of measuring average
rates of pay increase, the report provides an appendix (Appendix A)
in the form of a primer on index number construction for TIP. The
computation is not conceptually complex or laborious.

Definition of the TIP taxpayer unit
The report takes up the various problems of defining the

taxpayer unit for TIP purposes in an economy characterized by multicorporate enterprises, many of them industrially conglomerate in

(1) While the income taxpayer unit would be the unit for

purposes of asserting ultimate TIP" tax liability, a smaller component
unit might be designated for purposes of calculating a particular excess

- S-vii -

of compensation over the guideline level. Separate excesses might
then be assembled algebraically for purposes of the over-all TIP tax

(2) The mechanical alternative would be to combine all intra-

firm components in making the final determination of the average percentage
pay increase and comparing it with the guideline figure.


divisions or even separate plant units are conceivable for purposes
of calculating percentage changes in the average rate of pay.


the report is concerned chiefly with the choice between separate and
consolidated reporting, and year-to-year continuity and consistency,
in the case of the multicorporate business entity, for purposes of
computing the overall average percentage increase in pay rates.
In general, the resulting overall TIP liability would be
larger if there are any "unused" margins of below-guideline compensation to be offset against excesses within the more comprehensively
defined unit.

However, this generalization would not hold if TIP

compensation excesses were taxed as part of the regular income tax
(either via rate adjustment or via disallowance of deductions).


reason for the latter point is that segregation of TIP compensation
excesses in "component" units or sub-units without taxable income would
offer obvious TIP tax-saving opportunities.
A second appendix to the report (Appendix B) deals briefly
with TIP tax disparities which may result from separate vs. combined
reporting of affiliated corporations due to various technical factors.
This appendix suggests the need for further more detailed study of this
aspect, including the relative merits of different averaging or index

- S-vtti -

The report tends to favor a simplifying but equitable combination approach:
— a comprehensive TIP tax which would be payable by deficit
as well as net profit business units, and
-- a comprehensive, consistent year-to-year definition of the
TIP taxpayer unit.
The report gives specific attention to the treatment of
foreign business operations, including parallel TIP treatment of
foreign subsidiaries and foreign branches.

Timing problems
A frequently raised issue in the design and operation of a

TIP initiative involves a whole range of technical questions relating

"timing," including start-up and similar transition matters such

as new companies, defunct companies, treatment of pre-existing contracts,
catch-up settlements, coordination of tax and wage contract years,
timing of TIP tax payment, and provision for current payment.


report examines these matters in some detail, finds many of them less
than serious, and offers constructive solutions for others.

Specific problems of administration and economic impact
Finally, the report canvasses an extensive miscellany of

problems of:

tax avoidance and evasion


hardship situations


undesirable economic impacts


TIP tax accounting for small business

-- preicse and up-to-date formulation and regulatory statement
of standards and procedures.

- S-tx -

The emphasis in this round-up is on evaluating the weight
of suggested problems and suggesting constructive solutions.

Discussions public and private will confront a number of arguments, chiefly technical, partially economic in character, to the effect
that the TIP plan will involve all the problems of
— an incremental tax with complex measurement of an excess over
a base
— a non-revenue, regulatory measure, susceptible to neglect by
tax administrators in partially unconscious sympathy with business,
labor, or other popular resistance to such a measure
— a measure which calls upon an "overburdened" Internal Revenue
Service to carry out "extraneous" duties in the field of monitoring
economic stabilization efforts
— a plan which appears to interpose tax burdens on generosity to
A systematic canvass of numerous technical issues, such as
that conducted in this report, tends to overemphasize the range and
complexity of possible problem areas encountered by the TIP plan.
Actually, TIP is less complex and less prone to distortion and
inequity than an excess profits tax.

Its so-called base period or

base period abnormality problems are minor compared with those of an
historic-base type excess profits tax.

It does not entail the incentives

to waste characteristic of excess profits tax. TIP is no more "regulatory"
and possibly simpler than the interest equalization tax of 1967-74 and
a variety of environmental tax plans such as the government tax initiative
to curb sulfur emissions.

- S-x -

TIP is practicable and workable in a number of variant

Like most tax measures it would benefit from careful design

at a number of policy option points. However, it presents a classic
case of policy determination where perfection is the enemy of the best;
the best, of the good.


I. Introduction
This report is concerned with the practical aspects
of a tax-based incomes policy (TIP) designed to curb the
wage-price spiral by applying a stabilizing tax incentive
to the process of wage determination.

A. Scope of the analysis
A number of economists have supported the TIP approach
in the form of a tax on wage increases in excess of a specified
non-inflationary, productivity standard.

Such a tax has been

the subject of discussions in the financial press and economic

These discussions have been concerned chiefly

with the economic theory and rationale of the TIP plan.


have dealt only in a very limited and cursory manner with the "
practical tasks and problems of its detailed design, implementation, and administration.
This report deals almost exclusively with these
important practical questions.

It represents a pioneer effort

in exploring technical and administrative problems and alternative solutions -- the "nitty-gritty" of developing an effective TIP model and making it work.

- 2 -

B. Technical particulars examined
The analysis first examines a number of basic tax
design options that are critical in shaping the framework of

the form of the tax, its scope of application, the

duration of a given tax penalty on excess wages, and
related matters.
It then proceeds to deal with key definitional and
measurement questions:

the definition and measurement of

wages/salaries, the determination of the taxable excess over
the non-inflationary standard, the definition of the taxpayer unit, and a group of "timing" problems ranging from
start-up and transition questions to the possibility of perverse timing of tax payment based on ex post tax determination.
The remaining sections of the report reviev a series
of specific problems of administration and economic impact of
the plan, including possible tax avoidance and evasion devices
and the economic consequences of certain adaptive mechanisms
that might arise under TIP.
The report concludes with a short section devoted
to rough estimates of the administrative-compliance costs of
TIP in the light of proposed and historic analogues.

II. Basic tax design options
The basic concept of TIP involves the application
of a tax disincentive or penalty to firms involved in wage
increases which exceed a specified non-inflationary standard.



In the language of the Council of Economic Advisers enunciating
the principle guideposts:
"The general guide for noninflationary wage behavior
is that the rate of increase in wage rates (including
fringe benefits) in each industry be equal to the trend
rate of over-all productivity increase. General acceptance of this guide would maintain stability of labor
cost per unit of output for the economy as a whole —
though not of course for individual industries."^
The 1962 CEA statement also described a companion general
guide for non-inflationary price behavior, as well as specific
modifications of the general guides for non-inflationary


and price behavior depending upon particular industry conditions.-^
In lieu of the general sanction of public opinion
and government pressure relied upon in supporting the guideposts of the early 1960's, TIP would apply a specific tax related quantitatively to specific amounts of excess wages reflecting the extent of inflationary wage behavior.

Leaving aside

for the moment the related questions of excess wage measurement, the first major design questions which arise are:
— What form would the tax take?

How would it operate?

A. Form of the tax
Several alternative forms of tax disincentive
immediately suggest themselves, with their particular sets

^Economic Report of the President, 1962, p.. 189.
-'Ibid. See also John Sheahan, The Wage-Price Guideposts,
The Brookings Institution, Washington: 1967, pp. 14-16"^


of advantages and disadvantages.

These basic tax design

options and their variants include:

(l) adjustment of the

regularly applicable corporate (or individual income tax,
(2) disallowance of part or all of excess wages as an income
tax deduction, and (3) special penalty tax on excess wages,
including use of a special gross income, turnover, or valueadded tax which would in effect single out excess wages.

1. Adjustment of the regularly applicable income tax rates
One major option would be an upward adjustment of
the regularly applicable corporation (or individual) income
tax rates for employers paying wage increases in excess of
the non inflationary standard.

This adjustment might con-

sist of a fixed number of percentage points regardless of the
extent of the excess or might vary porportionately with the
proportionate excess. Such an approach was originally suggested by the originators of the TIP plan, Professor Sidney
Weintraub and Dr. Henry C. Wallich, now a member of the Board
of Governors of the Federal Reserve System.

In the words of

Dr. Wallich:
"Under our tax-based incomes policy (TIP), a businessman considering an 8 percent wage increase (at a
time when labor productivity increase was less) would
find that this would raise his tax from 48 percent to
60, 70, or 80 percent. The exact amount would depend
on the degree to which the wage increase exceeded a
wage guideline to be set by the government.11-^
This method of corporate tax adjustment for those

^Henry C. Wallich, "TIP vs Wage-Price Curbs", Journal of
Commerce, August 15, 1977.

- 5 -

paying excess wages was also tentatively linked with an adjustment of the general corporate income tax rate on all corporations to make sure that profit levels generally would not
"benefit inappropriately from TIP."-' This auxiliary feature
would be designed to make the plan fairer and more acceptable
to labor, which might otherwise be concerned that the restraint
on wages achieved by TIP would be reflected in a general rise
in profits.

The auxiliary adjustment in the general corporate

rate might thus be set at a level which would keep the aftertax share of profits in national income at some historic benchmark such as the 6 percent of GNP prevailing in the prosperous
There are various ways of making the increase in
the income tax more or less proportional to the excess of the
wage increase over the guidepost or non-inflationary standard.
The factor of proportionality could be anything from less than
unity to a multiple of 2, 3, or more.
It may be desirable to have a minimum percentage
penalty, in terms of the corporate tax rate, for any excess
of wage increases over the non-inflationary norm, however

Large excesses, on the other hand, which in some cases

a company may not be able to avoid, should not be penalized
so heavily as to wipe out profit altogether.-'

-'Memorandum "Guidepost Tax" by Henry C. Wallich, dated
December 29, 1970.

- 6 -

a. Illustrative formulas
One possible formulation of the adjustment or
penalty addition to the regularly applicable income tax
rates would be:
Formula (l) A = (I - G) ~ , where
A = percentage adjustment,
I = actual percentage increase in employer's
average rate of compensation, and
G = guideline or non-infjationary standard
percentage increase.-'
Under this formulation

if the guideline (G) was .05 (5 percent)

and the actual percentage increase (I) was .10 (10 percent),
the calculation of A would be (.10 - .05) ^ | = .05 x 2 = .10
or 10 percent.
The adjustment factor A as calculated above might
be taken as a penalty addition of the equivalent number of
percentage points to the regularly applicable income tax rate.
Or it might be used as an adjustment factor or coefficient to
be multiplied by the applicable income tax.

The adjustment

factor calculated and used as described here might be made
subject to a further "'scaling factor"—'which would either
heighten or tone down the sensitivity of the penalty adjustment to a given spread between I and G.

—' A penalty tax formula of this type was selected as "probably
the simplest ," in a Treasury memorandum on the subject.
"An Income Tax Deterrent to Inflationary Wage Settlements,"
by Seymour Fiekovsky, dated December 2, 1970.
^The £ factor in formula (1) is itself a scaling factor which
heightens the sensitivity of the penalty to increases in th«
excess of I over G.


The values of the penalty under this formulation •
and selected variant applications are illustrated below for
a range of values of I, assuming G to be .05.





Formula (l) and variants

A multiplied
by a scaling
factor of:

Values in columns (2) - (4)
multiplied by .48 corporate
tax rate

































































Another, simpler formulation, which eliminates
the scaling factor measured by the ratio of I to G
employed in Formula (l) would be:
Formula (2) A = I - G.
Under this simplified formulation, the penalty
addition would be equal to the spread between the actual and
the guideline percentage increase in the average compensation

Thus, if the actual percentage increase (1) was .10

29-775 O - 78 - 7

- 8 -

and the guideline (G) .05, the penalty addition would be .05
as against .10 under formula (l). Again, the penalty as thus
calculated could be multiplied by a scaling factor as desired,
or applied as a coefficient with or without a scaling factor
to be multiplied times the applicable income tax rate.


resulting values of the penalty are illustrated in the table





Formula (2) and variants

Multiplied by a
scaling factor of:

Values in columns (2)-(4)
multiplied by .48 corporate
tax rate

































































As indicated by the foregoing exploration of alternative tax formulas, virtually any level of penalty tax and
any degree of progression or sensitivity to the proportionate
excess of I over G may be obtained by formula construction.


Formula (l), it will be noted, tends to impose extremelysevere penalties for large excesses of I over G unless these
effects are toned down by a scaling factor and/or multiplied
by the tax rate.

These extreme penalty impacts reflect in

large part the operation of the implicit scaling factor — in
Formula (1).

This multiplies the absolute spread between

I and G by a ratio reflecting the proportionate difference
between I and G.

This multiplier effect is avoided under

Formula (2).
Under any of these formulations or their variants
a minimum or maximum limitation might be appropriate for
reasons previously indicated.

b. Problems and difficulties
Apart from the minor technical problems involved in
achieving a satisfactory level and responsiveness of the
penalty, the application of the deterrent through an adjustment of income tax rates involves serious problems of equity
and economic impact.

These problems stem from the fact that

while the penalty rate under the income tax adjustment
approach is geared to the extent of the excess wages, the
actual base of the added tax is not the excess compensation
but the net income of the business.

(1) Discrimination against equity capital intensiveness
A basic defect in the method of applying the

- io -

deterrent tax to a base, consisting of the taxable net income
of the firm is the substantive discrimination against firms
and industries which tend to be equity capital intensive.
This discrimination tends to be perverse in relation to the
objective of penalizing inflationary compensation increases
since, for a given value-added contribution, the less equity
capital intensive operation tends to have greater wage and
salary payments and therefore greater inflationary impact
while the more equity capital intensive operation has less labor
costs relative to value added and therefore smaller inflation potential
from labor compensation increases. Moreover, this discrimination would tend to encourage debt financing as a means of
supporting capital intensiveness but reduce the equity capital returns on which the computation of the tax penalty for
excess wage/salary increases is based.
These discriminatory impacts on equity capital
intensive operations are illustrated below.


Equity capital intensive discrimination
Equity Adjustment
capital to corporawage
return tion income
tax = 10 percent of net

Firm or

value added













Wages and

^Assumed to be 5 percent of wages and salaries


In the above simplified illustration, if the average
percentage excess of compensation increases over the manufacturing norm is the same for both A and B, triggering the
same 10 percent added tax on earnings, B would pay four times
as great a penalty as A, due to its greater capital intensiveness.

This would occur in spite of the fact that a compensa-

tion increase of, say, 10 percent which was 5 percent in
excess of the guideline would represent inflationary infusion
into the economy which was 50 percent greater for A than for
B (4.5*3=1.5).

(2) Inappropriateness of base of penalty tax adjustment;
economic and equity aspects

The fact that the rate of the tax adjustment is
geared to the degree of transgression of the guideline may be
nullified if the base of the tax adjustment, net income, is
small or non-existent, or it may be blown out of proportion
if the wage bill is low, but business net income is large due
to the contribution of capital or other non-wage factors in
the production process.
under this approach

Moreover, the anti-inflation penalty

is tied to the technical characteristics

and vagaries of the definition of the net income base.


reduces the uniformity and reliability of the proposed restraint
on inflationary wage revisions.

Wage settlements in industries

- 12 which might be critical in cost-push inflationary situations
would not be well covered by the income tax adjustment


building operation (rental real estate, such

as residential, office, or commercial facilities where liberal
depreciation wiped out most or all of net income and operation was
combined with calculation of basic rental income).

b. Equity
The equity and therefore the acceptability of the
plan are also involved.

Taxable business income often departs

from conventional measures of income, chiefly as a result of
incentive measures built into the definition of the tax base.
These differences frequently relate to the allowances for
capital recovery, particularly depreciation and depletion!
Capital gains are also involved.

In addition to the mineral

industries, agriculture, timber, and real estate, there are others
with large outlays on depreciable assets subject to accelerated

and favorable depreciation rates under the guideline. Asset

Depreciation Range (ADR) System and Class Life System (CLS).—'
The impact of incentive allowances under the income
tax produce tax liability effects which are sometimes viewed
as conflicting with commonsense equity standards.

But, what-

ever their acceptability under the regular income tax, the
extension of these incentive-justified differentials to the
special realm of TIP would be especially dubious from the
standpoint of equity as well as comprehensive effectiveness
in discouraging inflationary wage settlements.

—'For a brief summary of the present depreciation structure
and its historical developments see 1975 Depreciation Guide.
e Clearing House, para. 1, pp. 7-8.,

- 13 -

c. Debt financing, leveraging, and leasing
The income tax adjustment penalty approach would
penalize capital intensive industries, other things being equal.
However, capital intensiveness might be offset by heavy debt
financing, reflecting either established financial practices
of the firm or industry or special efforts on the part of
the firm or industry to increase their debt-equity ratios, and
by leasing rather than owning capital assets.
The corporate income tax structure particularly is
now biassed in favor of debt as against equity financing.


income tax adjustment approach would accentuate this bias,
including the leasing aspects, possibly quite strongly in a
situation in which substantial tax penalties attached to wage
settlements which the affected industries could not otherwise

(d) Small business and unincorporated enterprise
The penalty adjustment to income tax rates would
involve a number of special problems in its application to
small corporate enterprise and to unincorporated enterprises.
In the case of small corporations, in which taxable
net earnings are sometimes kept small by payment of salaries
to owner-officers and sometimes artificially increased by
keeping salaries of owner-officers low (so as to enhance
retained earnings suoject only to a sinrjio low corporate tax


rate), the penalty adjustment approach would have erratic
results and stimulate reorientation of corporate salary
policy vis a vis owner-officers.
In the case of unincorporated businesses, including
proprietorships, partnerships, and Subchapter S corporations
electing to be taxed like partnerships, the penalty tax adjustment approach would apparently require special sets of rules,
including the imputation of proprietors' wages and salaries,
limitations on partners* and corporate officers' compensation,
and the allocation of the TIP penalty tax liability to partners
and electing shareholders.-^

e. Coordination of corporate and individual tax adjustments
If the penalty tax adjustment were purely additive,
that is, consisted of an addition of a calculated number of
percentage points to otherwise applicable corporate or income
tax rates, it would be uniform, regardless of the income level
or the form of business organization of the taxpayer. Uniformity might involve policy issues, but little technical

Special attention might need to be given in for-

mulating any limitation required to avoid a confiscatory combination of tax and penalty tax.
If the penalty tax adjustment were applied as a
percentage of

the applicable corporate or individual tax

rate, the penalty would vary as between individuals and corporations and would depend upon the income level and tax .

p. 10.

- 15 bracket.

Highly diverse penalties would thus result for cor-

porations large and small and for individuals in varying tax

Different penalties would apply to different part-

ners in the same enterprise, depending upon their over-all
income position.

Again policy issues would predominate, but

attention would have to be given to designing limitations to
avoid confiscatory impacts.

f. Deficit companies
One of the problems which the income adjustment
approach would share to some extent with its nearest competitor,
the disallowance of excess wage deductions, is its ineffectiveness in readhing enterprises with no current net earnings.
The corporate population embraces a substantial
group, including some large and even giant enterprises, which
have no net income for tax purposes, owing to business and
economic circumstances as well as special features of the tax

In 1974, for example, out of a total of 1,978,059 active

corporation returns, 1,224,131 or 61.9 percent reported net

Thus, 753,928 or 38.1 percent had no net income.^

Some of the latter group circulate in and out of the
deficit category.

Some are new enterprises not yet having

attained a net profits position.
ness, about to fade out.

Others are declining busi-

Still others may be in a chronic

deficit posture but may continue in business for a protracted
period particularly if their cash flow position is positive,
although capital recovery allowances wipe out an overall net
profi t.
ics of Income l°74, Preliminary, Corporation Income Tax
Returns, Department of the Treasury, Internal Revenue Service,
Publication 159 (1-77). Table 1. n. 4.

- 16 -

g. Low shiftabilitv of corporate income tax adjustment
As part of the corporate (and individual) income tax,
the penalty adjustment for excess compensation would be difficult to shift in the short run.

The tax is assessed on

profits, but the level of assessment is geared to employment
and payroll events.

Still, the selective, uncertain, and

aleatory nature of the adjustment would make it difficult to
shift, possibly more so than the regular corporate tax itself.
This would mean that the burden of penalty adjustment would tend to
rest upon the owners of the business in the short run.

This general-

ization has to be qualified in light of the possibility of a general
price increasing reaction by business to the hazards of a Tip penalty.
By contrast a TIP penalty tax based on payrolls (as has been
suggested by some) would tend to be incorporated in the costs
determining the marginal cost curve and also be reflected in
mark-up pricing in the short run.
In the longer run, during which capital investment
could adjust to the existence of TIP, equity capital exposed
to the hazard of penalty-subject wage settlements would move
out of the more hazardous into less exposed areas.
ital would tend to be diverted from them.

New cap-

These capital

adjustments or flows in response to the potential penalty tax
would lower rates of return in less exposed type of investment
and increase them in corporate equities in some proportion to
the perceived degree of exposure to the chance of incurring
the added tax.
In some terminologies, the neo-classic capital
adjustment mechanism just described would be called shifting.


In others, stress would be placed upon the absorption of the
added tax by capital generally, rather than on the differential
which would be developed as a result of the tax between pretax rates of return in corporate equities and other forms of

h. Damage to investment
Because of the damage the tax penalty might do to
the whole investment process, in which corporate equity of
highly "exposed" types would play a complementary role vis a
vis other types of investment, investment as a whole may sag
(and therefore income and saving) unless this negative element
were counteracted or compensated by other, investment-stimulating measures in the fiscal, monetary, or other arsenals of
macro-economic expansionist techniques.

xHow the damage done

by the income tax rate adjustment would compare with that
under alternative tax forms will be examined later.

2. Disallowance of excess wage deductions
An alternative which appears to be technically and
economically superior to the rate adjustment approach is one
which would disallow deductions for excess employee compensation for purposes of computing taxable income.

a. Conceptual compatibility with existing disallowance of
illegal p-ymer.ts
This approach would be in the tradition of past and

- 18 -

present income tax sanctions on deduction of payments of any
kind in contravention of law or sound public policy
Section 162 of the Internal Revenue Code, which sets
forth the basic general provisions for the allowance as a
deduction of all the ordinary

and necessary trade or business

expenses, including reasonable salaries or other compensation
for personal services, incurred in carrying on any trade or
business also contains specific prohibitions against the
deduction of "illegal bribes, kickbacks and other illegal payments"-^ Related general provisions deny deductions for fines
and penalties.-^
In denying status as deductible business expenses
for fines and penalties paid to a government for the violation
of any law, the Congress has codified the position of the courts
in this area.
Under the provisions of sec. 162(c) any bribe or
illegal kickback paid to a public official or government
employee is nondeductible.

This prohibition includes payments

to foreign government officials and employees if the payment
would be unlawful under the laws of the United States if
applicable to such payment or recipient.
No deduction is allowed for any payment made directly
or indirectly to any person if the payment is an illegal bribe,
illegal kickback, or other illegal payment under any law of
the United States or any State, provided such State law is
enforced, which subjects the payor to a criminal penalty or

^IRC sees. 162 (c) (1) and (2).
^ I R C sec. 162 (f) .

- 19 -

the loss of license or privilege to engage in a trade or business.

In any proceeding involving the issue of whether a pay-

ment is an illegal bribe, illegal kickback, or other illegal
payment, the burden of proof is placed upon the Commissioner
to the same extent as under IRC sec. 7454 concerning the burden of proof when the issue relates to fraud.—* -*

b. How it would work

(1) Basic penalty effects
If this approach were implemented with a straightforward disallowance of all excess compensation, without regard
to the degree of excess, the resulting basic penalty would vary
with the applicable bracket rate of tax, as follows:


bracket rate

Penalty per $1,000 of
excess compensation

Income 0-25,000


Income 25,000-50,000



Income over 50,000



Lowest applicable rate
above 0 bracket



Top bracket rate




* 14 percent bracket is actually less than $1,000 Wide.
^ I R C sec. I62(e) (2)
-^The summary contained in this paragraph borrows in part from
Federal Tax Return Manual 1977, Corrjuerce Clearing House, para.
2440, p.2420.

20 -

(2) Possible additional penalty effects
In addition to the penalty involved in loss of
deductions under the regular individual and corporate income tax rates, for which illustrative calculations are
shown above, tax penalties might arise under other individual corporate levies based on income in the absence of
explicit statutory directives limiting these ancillary effects
of the disallowance of excess compensation.

The major examples

A disallowance of deductions increasing taxable
income might, other things being equal, increase some individuals1 self-employment tax on business and partnership

For 1977, the self-employment tax is imposed at a

rate of 7.9 percent on the first $16,500 of self-employment
income; for 1978, the rate is 8.1 percent on the first $17,700.
The loss of $1,000 of deductions for excess wages would increase self-employment tax by an additional $79 at 1977
levels and $81 at 1978 levels.
Corporations subject to the accumulated earnings tax
might incur substantial additional penalties from the increase
in income due to the disallowance of excess wages, as indicated here.

- 21 -

Accumulated earnings tax


First $100,000 above
$150,000 accumulated
earnings credit


Over $100,000


Penalty per $1,000 of
additional income due to
excess wage disallowance


(3) Possible scaling factor
The amount of excess wages disallowed in computing
taxable income might be made equal to the entire excess wage,
as previously illustrated.

Or, if that penalty were deemed

too severe, a fractional disallowance might be provided, i.e.,
50 percent, 40 percent, or 25 percent, or less of the excess

This modification would reduce the penalty for a corpo-

ration in the 48 percent bracket as follows:
Fractional disallowance

Penalty per $1,000 of excess









Similarly, the percentage of excess wages denied
deductibility might be made to vary with the degree of excessiveness.

The following scales A and B serve to illustrate

this variant:

- 22 -

Amount of wages equal to specified
percentage above guideline

Percent disallowed
Scale A
Scale B

First one percent





















Seventh to tenth

• 80


Above the tenth


Above the fifteenth


It would be possible to provide a disallowance in
excess of 100 percent, but questions of equity and even
legality would arise.

c. Problems and difficulties
The disallowance of deductions approach would be
subject to some of the weaknesses of the penalty adjustment
of rates previously discussed.

(1) Non-taxable because unprofitable firms
It would fail to reach firms (and possibly whole
industries) which had substantial chronic operating losses
and were not in position to utilize loss carrybacks or carryovers.

In some cases, firms which showed zero or negative

earnings after ordinary deductions would be made taxable on

- 23 -

earnings reflecting a portion of excess compensation as a
result of its disallowance.

Or their loss carrybacks {or

carryforwards) would be reduced with resulting tax detriment.
However, the effectiveness of the plan would be reduced to
the extent that unprofitable firms are considered a significant portion of the compensation-push inflation problem.

(2) Tax haven industries
Like the rate adjustment approach, but in somewhat
lesser degree, the disallowance of deductions method would be
ineffective and uneven in its approach because of the significant areas of the economy receiving favorable capital recovery
allowance and other incentive provisions.

There woulc. be

some differences in favor of the disallovance of deductions
method since it would not uniformly favor businesses with relatively low taxable income bases as would the rate adjustment

If the tax-favored firm or industry had zero or

merely low earnings, the disallowance of deductions would be
fully reflected in the new tax base-.

Even if there were exist-

ing operating losses for tax purposes, the disallowance of
excess wage deductions might eliminate? the loss and be reflected
partially in the new positive earnings position, so the disallowance would have marginal

incentive impact.

£ven if there was

a current net operating loss but past years' income was available for application of operating loss carrybacks, the disallowance of deductions method would immediately reduce these
tax benefits to firms trancross irv,: I ho r.on inflationary co^pensati

29-775 O - 78 - 8

- 24 -

(3) Variation of penalty effects with applicable tax rate
The disallowance of deductions approach would produce a wide variety of tax penalties, varying with the applicable tax bracket of the particular taxpayer, as shown in the
preceding tabular analysis.

The question is raised whether

this particular structure of resulting tax penalties is in
accordance with the concept and purposes of the plan.


structure would be progressive or adjusted in accordance with
taxable capacity as gauged by the tax rate schedules of past

It is not unreasonable to suggest that a struc-

ture of penalties bearing a uniform relationship to existing
tax burdens Js prima facie fair as well as in keeping with the
spirit and the practical effect of legislative and judicial
sanctions of the past on payments determined to be illegal
and in contravention of sound public policy.

On the other

hand, in some situations fairly steep penalties on excess compensation might be needed to make the TIP plan effective, and
these would not be implemented by a disallowance of deductions
under a 14 percent rate (starting rate for individuals) or a
20 to 22 percent rate (rate for sraall corporations).

(d) Quantitative ccnoarison of approaches
It is worthwhile to compare the penalty rate adjustment and the d L.sallowance of deduction approaches in terms of
their dollar burden effects.

Without makinc; a lengthy or

detailed analysis it is possible to cjnin useful perspective
from the Ifollov/ina iliu.-iLrciL.i ve calculation.*.

- 25 -

(1) Incremental or marginal impact
The disallowance of deductions approach produces a
simple, readily predictable impact, increasing the tax bill
by an amount equal to the applicable maryinal or bracket tax
rate times the disallowed excess compensation.

The adjust-

ment of rate approach produces a less predictable impact on
tax liability since the net income for the year is involved
in the determination.

the following relationships:

1) Formula A=(I-G) — without further scaling factor for
the adjustment approach
2) Straightforward disallowance of excess compensation
under a 48 percent corporate tax rate for the deduction
disallowance approach
3) T-.10
4) Gross receipts
Other expenses
Net income before tax prior to
disallowance of excess compensation
Excess compensation

= 10,000
= 5.667
= 2,733



—' G percent of qross receipts = average for all manufacturing in 1974.
-Ain'jed on J=.l0 relative to G=.05 Tor one entire year;
6061 x 1.1 = 6,607, 6061 x 1.05 = 636-1, and 6667 - 6?64 = 303.
The increase in tax under the adjustment of rate
approach would be + 60, i.e., 10 percent of net income and
19.8 percent of the excess compensation.
The increase in tax u.yjer tho di:;allovaricr.» cf deduction

- 26 -

approach would be about $145, for a corporation subject to the
top rate, i.e., 48 percent of the excess compensation and 24 percent of net income as computed prior to the disallowance.
L'nlcs: scaled up substantially, the adjustment of
tax would produce a lower dollar tax effect than the disallowance of deductions.

The difference between 48 percent

of the excess compensation and 19.8 percent would be marked.

(2) "Effective" rate effect
The comparative effective rate effect depends of
course upon the net earnings position of the taxpayer.


the circumstances assumed here, the formula adjustment would
increase the effective tax rate on net income (as computed
prior to any disallowance of deductions) by 10 percent versus
24 percent under the disallowance approach.
Since the dollar effect under the stated assumption
is 2.42 times greater under the disallowance approach than
under the rate adjustment method, the impact is also 2.42
times greater in terms of both an increment of the excess
compensation and an increment in the effective corporate tax
rate on net earnings.

3. Special penalty tax on excess co:?
To deal vith so~.e of the characteristics of the
previously outlined approaches which may be considered unsatisfactory, alternatives are available that would *


— apply a penalty tax to buaineso^s paying excess compensation regardless of thuir net earnings position
— assess the penalty on a "predictable" flat rate or
scheduled basis not affected by not earnings, capital
intensivones:-;, applicable income tax rate, or other
"extraneous" factor.-:


Excise tax on inflationary excess compensation
One method would be to impose an excise tax,

regulatory in character and in the spirit of the eaualization tax (in effect from July 19, 1963 through . une
30, 1974), on compensation payments in excess of the noninflationary guideline standard.
The interest equalization tax was originally
enacted under the Interest Equalization Tax Act (P.L. 88563) Sept. 2, 196-1 and extended by subsequent laws.
It was designed to tax acquisitions of certain foreign
securities in order to equalize costs of longer term
financing in the United States and in markets abroad,
and thus to aid the ration's balance-of-payments position by restraining the demand on our capital market
from other industrialized c o u n t r i e s . ^
The rate could be set at the desired level
or levels and could bo made to be varied, a:s was the
interest equjli/.ation exci:;o tax by trie i resident pursuant
—'Tor .;u •:.:?. ~iry oT provisions dnd purpo.-.c.i, sr-o 1;) /.) ." .., .
Excise 'lax . '.:ic-::, Ca.:.,;ci:co Clear irvj nuu^c, p^ra^. 125J-

- 28 -

to Executive Order.-'

This approach would avoid the in-

accessibility of deficit businesses, if that was desired.
It could be made applicable to orcjcini nations not subject
to income tax.


Implementation of penalty through a special gross

income type tax
Another method of applying a tax penalty on
excess compensation in a way that would be neutral with
respect to net profitability, capital'intensivity, or
equity-debt ratio, would be to impose a gross income
tax which would permit the deduction of all cost and
capital return items except excess compensation.


effect, the tax base of the special gross income tax
would be excess compensation.
The base of the special gross income tax would
(1) Gross receipts from all sources as now defined for
income tax purposes adjusted dov.nv/ard by the amount of
net income, if any, or upward by the amount of net operating losses, if any, less
(2) All deduction itcr.?; nov; allowed for income tax purposes, except corr.pen.iat.ion in PXCGJ:; of the non-inflationary nuidolino .standard.
This would accomplish the same substantive
result as the excise tax on excess compensation, but
would incorporate the tax penalty directly into the








- 29 -

compliance and administrative procedures of the income

On the negative side, this approach might appear

to follow an involved, roundabout

subterfuge in order

to accomplish the san-.e result as an excise approach.
Questions of semantics and public attitudes are important in the development and presentation of such a gross
income tax since it might well arouse the anxieties and
controversies associated with a potential broad-based
tax whether of the gross receipts, turnover, or valueadded type.
On the question of shiftability, it would appear
that the existence of either an excise tax on excess compensation or a "gross" income tax which single out such
excess would have about the same "long-term" effects
on prices, wages, capital investment behavior, and equity
investment returns as the income tax approaches previously
discussed, subject to certain qualifications:
tax here would be more uniform and predictable;

the penalty

not exclude deficit companies as would both income tax

and would not reward debt financing as would

the rate adjustment approach in particular.
Certainty and comprehensiveness or universality miqht seem to facilitate? shifting.

However, the

fact that the Lax penalty on excess compensation would
presumably not be universal and possibly quite limited,
variable, and even spotty in it. a application would militate anairist. the tr ic;ceri nq of systematic :->!ii ftinc, mechanises.

The greater uniformity and "fairness" of c: penalty

- 30 -

based on excess compensation regardless of net earnings,
capital intensivity, and debt-equity ratio might do less
damage to equity investment than other options.
The application of the penalty on excess compensation to deficit companies is a significant consideration here.

The "exemption"

of deficit businesses has

been tentatively treated as a kind of technical defect
in the previous discussion.

However, it may be argued

that (1) deficit organizations are a less important factor in inflationary wage settlements, (2) taxing them
when they are forced to accept such wage settlements
smacks of hitting them when they are down and being
forced further downward, and (3) shiftability is possibly
reduced if this exempt

area is retained in the economy.

It may also be persuasively argued that the chief danger
that the penalty tax (in whatever form) will be shifted
forward into higher prices is the reaction to it by
large oligopolistic corporations with market power


they feel can be exploited further in the new situation
posed by an extensive if not universal tax cost factor.

4. "Carrot versus stick" and variant TIP plans
An alternative to the tax penalty for excess
compansation payments is an approach which would extend
a tax bonus for guideline compliance,


one variant would

business tax reduction for business generally but deny

part or ail of the reduction to those who did not comply with

guidelines, and possibly in proportion to

- 31 -

the degree of non-compliance.

Other variant "carrot" approaches

would offer a specific bonus (tax relief) only for firms observing restraint in their wage policies.

This approach could be

implemented effectively only in a fiscal environment of tax

Otherwise it would call for additional taxes to

pay for the bonus program.

A number of plans of this type are

cited in the following section.

a. Considerations raised by the generic tax carrot plan
In general, the question of the carrot versus the
stick approach to fiscal incentives for wage restraint presents
several aspects reviewed briefly below.
1) The*> are problems in providing a general tax cut
large enough to make a sufficient carrot to reward noninflationary wage behavior.
2) In contrast with the TIP penalty as proposed by Wallich
and Weintraub, which would be graded smoothly according
to the deqree of excessiveness in the wage settlement,
the carrot or bonus approach as generally advanced is an
"all or nothing" affair. Large amounts of potential tax
reduction would ride upon small differences of opinion or
3) While a grading-in system would moderate the impact on
small excesses, it would leave a weak disincentive or
deterrent to larSe inflationary excesses.
in examining those questions i" is important to btar
in mind some of the typical relationships between wages/salaries
and employee compensation generally, on the one hand, and corporate profits and a tax reduction thereon, on the other.
In 19 75, total corporate income subject to tax for
all active corporations was roughly $145 billion, or nearly
-^Differences in the guideline, at the bargaining table, in the
carrot plan design, and/or in the tax administrator's determination.

- 3la -

5 percent of total corporate receipts of $3,196 billion, of
which $2,962 billion were classified as business receipts.
Total payroll was approximately $523 billion or 17.65 percent
of business receipts.

Wage supplements amounted to about

$90 billion or 3 percent of business receipts.

Thus total

employee compensation amounted to about $613 billion or some
20.7 percent of total business receipts.-' -^
Within this set of relationships, a tax reduction of
3 percentage points across the board in the corporate rate,
equivalent to a reduction of 6*. percent for larger corporations
and 15 percent for the smallest, would lose about $4.35 billion
of revenue at 1975 levels.

At the higher profit levels likely

to prevail in 1978-79 the revenue cost would be in the vicinity
of $5 to ;;(, billion.
The 3 percentage point tax reduction (which would be
taken away in the event of non-conformity with the guideline

^ D a t a on payroll and supplements obtained from Bureau of Labor
Statistics, U.S. Department of Labor. Corporate income and
receipts data shown here are from Statistics of Income 1975
Preliminary, Department of the Treasury, Internal Revenue Service,
Publication 159 (1-78), Table, 1, p. 9.
-'While wages constitute about 75 percent of the national income,
they represent a much smaller percentage of the total receipts of
businesses, owing to the1 substantial volume of interbusiness
transactions which have the familiar effect of increasing total
costs and total receipts relative to the value added of a particular
business or aggregate of businesses. In many large businesses the
ratio of wages and employee compensation to business receipts is
higher than the 20.7 percent figure developed here for all active
corporations in 1975. For example, in 1977 employee compensation
for General Motors Corporation was 33.5 percent of sales; for
General Electric Company the figure was 37.4 percent. For unincorporated businesses as reported in Statistics of Income 1974,
Business Income Tax Returns, payroll and wage supplements averaged
9.4 percent of sales for sole proprieorships and 11.8 percent for

- 31b -

under the typical carrot plan) would thus amount to about 0.7
percent of employee compensation including various wage supplements and employee benefits (4.35 • 613) or .83 percent of
wages/salaries (4.35 *• 523), assuming 1975 aggregate relationships.
If the entire penalty in the form of denial of the
3 percentage point corporate rate reduction were regarded as
focussed on a l percent excess compensation figure, it would
amount to a crushing 71 percent of the offending compensation

(4.35 • 6.13 or 1 percent of 613) again assuming the

relationships observed in tho aggregate corporate data for 1975.
The degree of severity would vary with the amount of the excess,
rising to astronomical percentage figures for very small excess
compensation increases above the guideline.
These considerations point up the fact that some kind
of grading-in system would seem required under the carrot or
bonus system to make its impact more "gradual" rather than an
"all or nothing" matter.
One crude method would be to phase out the bonus on
a schedule such as the following:
Percentage points

Percent of

above guideline

tax bonus allowed

Above 0, less than 1






Above 3


- 3lc -

Such a schedule would ameliorate some of the crudities,
discontinuities, and "notch" effects of the bonus approach, but
it would still leave sizeable amounts of bonus at stake at the
various breaking points.

Narrower brackets would reduce the

amount of bonus at stake for each bracket boundary but would
increase the number of boundaries at which an abrupt change
A smoother, more gradual phase-out of the bonus would
be possible.

Thus a formula might be applied which would reduce

the bonus by a percentage equal to the ratio of the number of
percentage points (calculated to several decimal places) by
which compensation increases exceeded the guideline to, say,
3, thus wiping out the bonus at an 8 percent wage increase in
relation to a 5 percent guideline.

This would apply a constant

penalty equal to 23.65 percent of the excess compensation.


23.65 percent is equal to 4.35 • 18.39 where 4.35 represents
a tax bonus of 3 percent of corporate profits of 145 and 18.39
equals 3 percent of compensation of 613 on the basis of the
1975 aggregate relationships outlined earlier.^
Above the 8 percent wage increase or 3 percent excess
compensation point, the bonus would be a constant amount equal
to the assumed percentage points of tax on corporate profits.
It would thus become a decreasing percentage of excess earnings
as the excess increased above that point. The incremental penalty: zero.
By contrast with this "loss of bonus" behavior, the
Wallich-Weintraub TIP approach would continue to increase the
penalty on inflationary wage increases, making the penalty
1/ The 23.65 percent incremental penalty rate calculated here
compares with a 48 percent incremental penalty under the
deduction disallowance method for a large corporation. For
a corporation with total employee compensation equal to, say,
41.3 percent of recipts or twice as high in relation to profits as
assumed here, the carrot plan penalty would be half that shown hen

- 31d -

greater the larger the excess up to any desired designated
The essential problem of adjusting the incentive involved in the tax bonus or carrot approach as generally proposed, even with a smooth phase-out, is that it hinges upon
allowing or not allowing a fixed reward.

Once the carrot was

taken away, there would be no further proportioning of the
disincentive to inflationary wage excesses to the extent of
the excess. Indeed, the incremental loss of bonus would be zero.
The carrot approach involves granting tax reduction
to a presumptive majority of businesses conforming with the
noninflationary guideline.

This involves massive tax reductions.

The minority of non-conformers with the guideline would receive
a smaller tax reduction or no tax reduction.
losing the bonus would lack incrementa lity
boundary of the phase-out zone.

The penalty of
above the upper

The penalty would be made

steeper for the offending minority only at the cost of further
costly tax reductions for the majority.

b. Okun proposal for tax relief for price-wage restraint
Arthur >i. Okun has, as part of a larger antistagflation package, proposed a tax relief incentive for
workers and businessmen who enlist in a cooperative antiinflationary effort.

In its wage restraint aspects the Okun

plan would grant businesses pledging, at the beginning of 1978,
to hold the average rate of wage increase below 6 percent a

- 3le -

tax rebate equal to 5 percent of its income tax liabilities on
domestic operating profits.

Participating employees would also

be rewarded in the form of a rebate of 1*2 percent of wage or
salary incomes up to $225 per person.

The revenue cost of this

feature of the plan is estimated at up to $15 billion annually.—'
This plan would involve the usual problems and burdens of measuring wage increases relative to a guideline, discussed later in this report.

It would involve very wide

application of the measurement process.

Considerable accuracy

would be required at the 6 percent margin.

un this measurement

would ride a potentially universal tax rebate both for business
and participating employees who established satisfactory (below
the b percent norm) wage behavior.

1-ricing behavior would

also be a factor in qualifying for the rebate.

c. Seidman plan for business payroll tax decreases for wage
increases below norm
Lawrence S. Seidnan has proposed progressive rebates
on the payroll tax -- the greater, the further the average
wage increase is below the norm.

This would enhance the effi-

ciency of the 'vallich-We intraub Tit- plan by providing a marginal incentive discouraging all wage increases, not just
those penetrating the guideline ceiling, according to its proponents.
The administrative-compliance aspects peculiar to
this plan would be similar to those of the Lkun proposal

-^Arthur M. Okun (Senior fellow, The Brookings Institution),
"The Great Stagflation Swamp", Address before the ticonomic
Club of Chicago, Oct. 6, 1977, pp. 17-18.

- 32 -

since all business would be required to measure wage restraint success.

Great accuracy would be required in

measuring wage increases not merely for those in the vicinity
of the norm but for all businesses in establishing the amount
of the payroll tax rebate.

The plan would not incrementally

discourage wage increases once the guideline ceiling was
breached by a firm.-^

-'See description of Seidman plan in Abba P. Lerner,
"Stagflation - Its Cause and Cure", Challenge, Vol. 20,
No. 4, Sept.-Oct. 1977) p. 17.

- 33 -


Abba P. Lerner anti-staqf]ation package!/
Lerner has proposed (as an intellectually

second choice to

sale of wage-increase permits in the

manner of plans for the auctioning off of licenses to
pollute) a package plan limited to the thousand largest
corporation including

these features:

— a ."consolidation" of the Wallich-tfeintraub plan
and the Seidman proposal which would give each participating corporation a lump sum grant, possibly in the form
of tax reduction, less a tax/charge per unit of every
wage increase. There would be no need for a norm for
measuring excess wages. The intent would be to make
the plan revenue neutral by balancing grants and taxes/
— t h e arant (or tax relief) as well as the tax/charge
to be based not on net profits but on a previous wage bill;
— t h e tax/charge to be geared proportionally to the
average wage rate increase times the base figure. The
exact formula required for the tax/charge is not furnished
by Lerner.
This complex plan would involve calculations
of all wage rate increases for the thousand largest corporations only.

The duration of the charge/tax like that

of the grant in any year would be limited to that year

The procedure would be

plated annually.

A formidable estimating task would be required
to balance grants and tax/charge levels and to adjust
these figures annually.

Lcrr.or cst.i maces that owing

Lo the limitation of the plan to a relatively few large

-'See Abba F. Lerner "Stagflation - Its Cause and Cure"
Challenge, previously cited, pp. l-l-l1.) especial lv pp.

- 34 -

corporations administration costs would bo only "a few
million dollars" annually (versus a national product
gain in the tens of billions of dollars).



Denying income tax rate reduction to non-compliers with v/age guidelines would present the same characteristics and teclinical problems as the penalty upward adjustment of rates previously discussed.

It would

superimpose new special technical problems associated
with a dual level of tax rates which would entail a
differential against non-compliers.

Future tax rate

adjustments up and down would have to take into consideration means of maintaining or altering as desired the
original differential penalty on non-compliance.


Area of application
One of the critical policy decisions to te

made in the design of TIP is its area of application.
This area would be defined (or limited) chiefly in terms
of type and size of business organization.
The practical issues (decisions on which technical
and administrative problems are involved) seem to boil down
to the followinc;:
(1) Should t'-ropuic L'.oryhi jr: pa r triers hi p.-j bo exempted
from the tax penalty or\ non-compliance with compensation
guidelines? i:ow should suhchaptcr a corporations be treated?
(2) Should da exclusion or •I'xcr-.-.ption based on size (income level, r.oL vcrth, a:;octs, nu-r.her of employees, sales,
or othnr character is tic) 1x3 applied to otherwise eligible
V u 3 i :K- S S categories V

9-775 O - 78 - 9

- 35 -

(3) Should the scope of the tax be limited to domestic
activities of enterprises?
(4) Should "new" firms - defined either as genuinely
newly organized or as inclusive of "new" combinations
of preexistinq firms or their assets - be temporarily
excluded or given special treatment tantamount to temporary exemption?
(5) Should "tax-exempt" or non-profit organizations be
included in some form of penalty or ncn-compliance with
anti-inflationary wage guidelines?
Technical and adminstrative factors enter into
the decisions on these issues in two ways:
—the practical implementation of an exemption
—the technical and administrative problems avoided
by creating an exempt area or demanding attention if
no exemption is created.

1. Unincorporated enterprise
There are those who contend that there would
be "no logical basis for distinguishing categories of
business tax payers who might be exempted from the additional tax".

Also, it is contended that "Size class-

ifications always end up being highly arbitrary and discriminatory between fims in different markets whether
the criterion is total assets, net worth, or numbers of

And there? would be unintentional ambiguity

introduced by yxe^.ptinq proprietorships and partnerships
when approximately 300,000 corporations qualify under

- 30 -

Subchapter S and elect to be taxed as partnerships".^/


Blanket exemption
There is however considerable economic and

administrative logic in exempting unincorporated enterprises.
Their role is small in tho process of compensation-push
inflation reflecting wage increases in excess of productivity gains pressed upon large, strategically positioned
corporate employers by powerful labor unions.
role in wage increases is largely passive.


The applica-

tion of the tax to them would chiefly be in the interest
of uniformity and equity.

Avoidance of an area of wage

settlement free of the proposed tax restraint which might
exert upward pressure on the labor market for penaltytax subject corporate employers might be a pertinent
Exemption of unincorporated enterprise would
involve little or no adirunstrative complication and would
save a substantial a-nount of administrative and compliance cost with little sacrifice of overall effectiveness
of TIP.
The acLniniatra'civc? saving would bo chiefly in

": t sr.o'JlO !:*.• notod th-;L at l")7 • l e v e l s thr?ro
v:ero"~^3n,';i. : ,-;rl:.i.'li-f1 o'iall • .u:•;i:ica3 c o r p o r a t i o n return:-;,
:«"orrc 1120 :> y ol '.;hich lfi3,lGl rp;rjrt:c! not i n c o m e t o t a l 1 i no abon t -5.7 hi 11 ion . S t-a t i s t i c^s n " ' :icc:no 1 '•) 1A ,
F r e l LT.inary, C-,i.-porj t i ori •ncc~<i iax /iotiir.-.j, x p a r L-.ient
of t':io T r c a ^ i w
•.• ^•.•\"..T.LIG S e r v i c e , I ubl i c a t i u n
159 ( 1 - 7 7 ; VV.M-J J, p . \ :.

- 37 -

the form of the cost of designing, printing, distributing, procession, monitoring, and tabulating the special
tax forms or schedules.

It seems likely that there would

be relatively fev; cases of compensation increases above
the guideline norm in the unincorporated business area,
oxcept in severe inflationary spirals completely beyond
the control of small employers.

Actual audit of border-

line or actual cases involving penalty tax would probably
be minimal in this area, except under severe inflation.
The costs or cost savings involved, probably in the order
of $ 5

million would probably not be significantly

different under any of the four alternative forms of penalty
tax discussed earlier.
The economic and administrative magnitudes
involved in blanketing out the unincorporated enterprise
sector are evidenced by the following key figures.
For 1974, these


— 1 0 , 8 7 3 , 3 2 2 p r o p r i e t o r s h i p s in all i n d u s t r i e s w i t h
n e t p r o f i t s (less l o s s e s ) of ^ 4 5 . 9 b i l l i o n
— 7 , 0 9 5 , 6 6 6 p r o p r i e t o r s h i p s in n o n f a r m i n d u s t r i e s
w i t h n e t p r o f i t s (less l o s s e s ) of -.39.0 b i l l i o n
— 1 , 0 6 2 , 2 6 8 p a r t n e r s h i p s with 4,620,^39 p a r t n e r s
(an a v e r a g e of 4 1/3 p a r t n e r s per rir;n) iri all i n d u s t r i e s
w i t h not p r o f i t (loss lo:7s) o r $>o.9 b i l l i o n
— 9 5 2 , 6 5 5 p a r t n e r s h i p s w i t h 4,298,129 partners (an average
oi 4'j p a r t n e r s per firm) in nanftiri:! inciustricis w i t h n e t
p r o f i t (less loss) of ^7.3 b i l l i o n
• ^ D c t a tnkon :rcM SjLaJ^sJt_i_c_:j._of lr'Hi-_.. L^LLlt ~"us;in(???s
incurve Tax Ho t u r n s , JO.'.O i rofjric-Lor::..i;js •~nci i artr.crahips,
DenarLnc-.t of tho Trca:.i:r", J:H^riuU xevcr.uo J>i. rvii:e,
;"uV.lica-_l«n. -:3S (7-77! Jw'.-.y^ ;, \.l <>.r.C '2.1, TP- • <";nd ^J-q-

- 38 -

Average profits (less losses) per firm awi
per partner were as follovs:
All industries
Nonfarm industries

* 4217

Per firm
$ 8345

All industries
Nonfann industries

I er partner
$ 1919

Payroll constitutes a considerably smaller
percentage of the receipts of unincorporated enterprise
than in the case of corporations.

The following percent-

age calculations for sole proprietorships and partnerships highlight the facts:
fercent of
(dollar amounts in thousands)
Sole Proprietorships
All industries
M l industries

; 328,262,352

* 30,733,400











While exactly cov.parable tax data are not available for
corporations, Commerce data shov that in the

P^st 30

years or so total compensation of employees of noniinancial
corporate business has ranged around 62 to 67 percent
of the gross domestic product of this particular


sector .-^ii.-noiovees1 share oi national incone rose to
-'Goe, for i.'X.vr
..^•rj.-.r-.- !')7G, i


- 30 -

three-fourths in the 1070's from the two-thirds level prevailing in the period 1035-C8.

The 0 to 12 percent payroll

ratio to business receipts of noncorporate business cited
above based on tax return data is not exactly comparable,
since the wage component of interbusiness sales is excluded.
But even making an approximate adjustment for this difference,
it is evident that employee compensation is a smaller percentage of product for noncorporate enterprise.


owner service income is a factor in this differential.
rihile the majority of sole proprietorships are small,
they include a substantial area of sizeable operations.


the partnership area, the scope of business operations with
sizeable net profit is still more important, as summarized in
the follov/ing size distributions.-'

—* Data taken frot*. statistics of Tnco-nc V)1A, Business Income
Tax lie turns, previously cited, lablou 1. L> and 2.3, pp. 96
and 145.

- 40 -

Sole proprietorships 1074
Size of adjusted
gross income

Number of

Returns with or
without adjusted
gross income, total 10,873,822


Net profit
(less loss)






$1 - 5,000




5,000 - 10,000




10,000 - 20,000




20,000 - 50,000




50,000 - 100,000




100,000 - 500,000













Returns with adjusted gross income, total

500,000 - 1,000,000
1,000,000 and over
Returns with no
adjusted gross

Except in size class column dollar amounts in thousands.

- 41 -

Partnerships 1974
Size of business receipts

Number of



Net profit
(less loss)





Under $5,000, total





No receipts reported









5.000 - 10,000





10,000 - 25,000





25,000 - 50,000





50,000 - 100,000





100,000 - 200,000





200,000 - 500,000





500,000 - 1,000,000





1,000,000 - 2,000,000





2,000,000 - 5,000,000





5,000,000 - 10,000,000










$1 - 5,000

10,000,000 and over

Except in size class column, dollar amounts in thousands.
In light of the abpve datA .showing a considerable
area of sizeable business operations in the unincorporated
enterprise area, and an appreciable "overlap" of unincorporated and corporate enterprise in the small and mediumsized business area, it is difficult to accept a blanket
exemption for sole proprietorships and partnerships.

- 42 -

A specific exemption of unincorporated enterprise
income of about $10,000 before the additional tax is applied
has been suggested, on the grounds that


income is always gross of the proprietor's own service income.
This is apparently intended as a technical adjustment of the penalty
tax base of the unincorporated enterprise or its owners to bring
it into comparability with that of the owner-officer salary
net figure for corporations.

It is not intended as a size

exemption for proprietorships and partnerships as such.

b. Size exemption
To avoid a blanket non-corporate exemption with its discr:
lriatory sweeping aside of a considerable area of small and medium
sized business comparable with corresponding corporate operations, and yet to save the compliance and administrative
burden associated with the penalty tax reporting and processing procedures for numerous truly small farm and commercial
enterprises, it seems dosirable to consider an exemption fea•ture, applicable to corporate and unincorporated enterprises

This exemption ;v, iqht bo based on payroll business

receipts or similar qrorss measure of size of operations.
The exact level of the exemption would need to be 5sr?t on the
basis of detailed study in the light of policy objectives,
including coordination with the related exemption in the corporate enterprise area.

- 43 -

2. Corporate area

a. Design options
In the corporate area there are several design
options with respect to coverage in which administrative and
compliance burdens are a determining factor.
One possibility is to limit the penalty on excess
compensation to large corporations only.

This would remove

the numerous returns reflecting both compliance costs and
substantial processing activity with a relatively small payoff in terms of penalty tax and anti-inflationary restraint.
This approach would be reasonably consistent with a blanket
exemption for unincorporated business.
Another variant would be to apply the penalty tax
to corporations generally v;ith a small business exemption.
Depending in part on the level of the small business exemption,
this might be substantially consistent conceptually with a
blanket exemption for unincorporated enterprise.

If, how-

ever, the exemption were set quite low for corporations,
this might call for applying the penalty tax system consisently to unincorporated businesses above the specified exemption level in tor.r.s of receipts, payroll, or other measure
of operations size.

Otherwise the disparity in treatment

between overlapping large propriotor.^iips and partnerships
on the ono hand and snail or medium-sized corporations would
be conspicuous and a potential factor in inducing tax-inspired

- 44 -

A third possibility would be universal corporate
area of application.

This would entail maximum compliance

and administrative implementation and processing costs, particularly if it dictated, as it would tend to do, similar
universal application to large and small unincorporated

b. Universal corporate application
Universal corporate application- would bring within
the ambit of the penalty tax administration and compliance
procedures some 1,978,059 active corporations, based on preliminary 1974 Statistics of Income data.

Of this total, some

1,153,292 or 58.3 percent would have assets under £100,000.
Some 1,521,645 or 76.9 percent would have assets under

The 58.3 percent with assets under $ 100,000 in 1974

accounted for total net income (less deficit) of about £851.7
million or less than T-Q °- ! percent of the £146 billion
total net income reported by corporations in that year.


76.9 percent with assets under £250,000 in 1974 accounted for
total net income of about £4.1 billion or 2.8 percent of the
$146 billion total for all corporations in 1974.

c. universal corporate application .sub joe t to s.r.all business

As the foreqoinc; sizo distribution data indicate,
a small bjfinor.s oxor.ipl ion could ho •.-,rc>viood in the- covp-.rztc-

- 45 -

area which would remove some 58 to 77 percent of the corporate
population from the application of the excess wage penalty

This would effectuate very substantial

and administrative cost savings.


This could be done at a

cost in terms of the potential base and comprehensiveness of
the anti-inflationary restraint which would be only a small
fraction of the total potential.

The —

of 1 percent to 2.8

percent figure just cited as the smaller corporations 1


of the total net income (less loss) almost certainly overstates the significance of the exemption in terms of the
area of active contribution to inflationary


A small business exemption would provide only a
partial justification on equity grounds for a blanket exemption of unincorporated business.

A better balance between

the corporate and unincorporated sectors wculd probably be
struck by applying a similar exemption to both.

d. Application of: Til' to large corporations only
Very large savings of compliance and administrative
cost could be obtained if the? TIP plan was restricted to
large corporations only.

The exemption of rill but large or

very large corporations in implementing Tli could thus capitalize on (1) tho familiar, pervasive factor of economic
concentration and (2) the .ipparently <.;t rcvceciic role of large,
especially giant, corporation..-: it! the? v.wce negotiation process
in r-.inv if i\nv rr.or.t i n-iv--r_ rial cv. fev.-ri!'?:?.

- 46 -

In 1974, 1759 corporations with assets of
$250 million or more accounted for:
— 4 6 . 3 percent of the total receipts of all active
— 6 4 . 3 percent of the total assets
— 6 3 . 8 percent of the total net income (less deficit)
— 6 3 . 2 percent of the total corporate income tax
before credits
— 8 4 . 3 percent of the total corporate additonal
tax for tax preferences
— 9 7 . 3 percent of the total foreign tax credit
— 6 5 . 7 percent of the total investment credit
— 7 4 . 3 percent of total dividend distribution (other
than in stock) to stockholders.!/
These 1759 corporations constituted less than 9/100
of 1 percent of all active corporations filing 1974
corporate income tax returns.
The aggregate coverage of these giants in
terms of most business measures is impressive.

If the

degree and pattern of concentration were uniform in
all major industrial classifications, it would be a
simple matter to establish a uniform exception based
on receipts, assets payroll, or similar-



an exemption could exclude hundreds of thousands of
smaller corporations and stake the implementation of

— The scrips of rerccnU.iRs prt.-sonted lie re arc computed
fron*. da La a p p e a r i n g in S l:-. L i s L i c F; •)." I p. co:ne 1 •") 7 4 , P r e l i m i n a r y , C o r p o r a t i o n I \ i-r.i .OLiir;;.;, i>»p:irt-".:ent
of the? L're/.^ury, .. nternai. .icvcuue .,c.-''vico, i ublicacicr.
159 ( 1 - 7 7 ; T.ibi-- 3, p . •.-,.

- 47 -

TIP on a relative handful (loss than 2000) of corporate
giants accounting for two-thirds or more of the corporate

sector, which in turn accounts for 86.8 percent

of the total receipts of all U.S. business enterprise
as of 1974.1/
The degree of concentration varies, however,
and the conditioning described by the aggregate data
do not prevail in a number of industries in which wage
settlements play an important role in the macroeconomy.
Thus degree of concentration characteristic of the corporate

aggregate does not prevail in the following major

industrial divisions:
1) Agriculture, forestry, and fishing,
2) Construction,
3) Wholesale and retail trade, and
4) Services
Moreover, the pattern of distribution of receipts and
other measures of activity by asset size in these major
industry divisions is such that an exemption in the
interest of compliance/administrative economics would
have to qo at least as low as J> 1,000, 000 assets, and
—'Compiled arrJ computed from Statistics of Income 1074,
previously cited, as follows:
Sole proprietorships

Total receipts (billions)
* 3059.1


- 48 -

considerably lower in most cases, to achieve TIP coverage for two-thirds of business receipts (and presumably
compensation payments).
Unless, therefore, the plan were to jettison
effective coverage of these industrial categories and
focus chiefly on mining, manufacturing, transport and
public utilities, and the financial sector, it would
be impossible to achieve acceptable coverage with a
uniform exemption geared to exclude all corporations
except those in the giant or near-giant size class.
The following set of calculations, based on 1974 Statistics
of Income data, indicate the varying asset size exemption levels required to include two-thirds of corporate
receipts in the four relatively non-concentrated major
industrial decisions, with associated figures in numbers
and percentages of exempted corporations.

forestry, and

Approximate exemption level, based
on asset size,
needed for tvothirds coverace
of receipts


$ 396,000







Wholesale and
retail trade








Source: Calculated vitr, roiKr!i ir.terprc t.a tions from
as:>oL sii'.G din tr Lbuti Oiiu :"or all active corporation
return:-"., •<! ••;.t_i-rLr-_.v.(-l_. . o £ Ll'JH • "il ll'li !» - - e ] i - u n a r y , t r e a s u r y
I'd'j 1 U!->1 i c \ i l U . . l • :J f \ 1 - ~ I J
.«."..:• J , ry.;m > ' ! - l 5 .


- 49 -

These figures are merely illustrative.


ther variations in the pattern of concentration would
emerge from finer analysis.

The difficulties these

data point up do not, however, conclusively veto any
attempt to introduce into T1F an exemption designed to
save compliance and administrative costs for government
and numerous smaller businesses.

These difficulties,

together with the consideration that a problem of inflationary compensation push may in fact exist in areas
of so-called small business, suggest that the exemption
approach calls for close study in formulating a detailed
TIP proposal.


Subchapter S (tax option) corporations
The design of TIP with respect to area of

application, particularly if consideration is given to
excluding sole proprietorships and partnerships, must
confront the issue of what to do v:ith subchapter


corporations, vhich elect, pursuant to the provisions
of Internal Revenue Code sections 1371 - 1379, to file
on Form 1120-5 and receive partnership-like treatment
for themselves and their stockholders.
These corporations do not pay corporate income
tax on their income, but instead have their shareholders
pay taxes on it, even though the income is not actually
distributed to the shareholders.
hov.'ever, a. subchapter S

Unlike a partnership,

corporation is not treated

- 50 -

as a conduit for Lax purposes.

That is, individual

items of income and deduction are not as a general rule
passed through to the shareholders so as to retain the
same character in the hands of the shareholders as they
had in the hands of the corporation.

Instead, taxable

income is computed at the corporate level in about the
same way as it is for corporations generally.

The share-

holders are then taxed directly on the taxable income
(or loss) thus attributed to them, whether or not the
corporation actually makes any distribution of funds
to them.
One exception to the "no conduit" rule just

the net capital gain of Subchapter S corpo-

rations . is attributed to them and is treated as longterm capital gain of individuals on their individual
income tax returns.-*
In 1974, there were 330,418 returns of active
small business corporation on Form 1120-S, O f which
193,161 or 53.5 percent reported net income.
receipts of subchapter


S corporations in 1974 amounted

to $122.4 billion, of which ^98.6 billion was received
by those v/ith net income.

Total net income (less defi-

cit of this croup of corporations ar.iounted to about
$3.6 billion, representing about 2:: percent of the net

-'The preceding summary relies upon 1977 LT. S. Master
Tax Guice, Cor.v.ercc Clearing House, para. 24-i, pp. 91-92.

29-775 O - 78 - 10

- 51 -

income (less deficit) of all corporations but nevertheless a substantial area of corporate business operation.
To exclude this area of partnership-like
tax entities as an ancillary feature of an exemption
of unincorporated business would seem to go too far
in weakening the coverage of TIP as part of an attempt
to achieve uniform treatment of actual and "tax-option"

If both unincorporated and corporate

business were treated alike under TIP, the issue would
automatically be resolved. The only remaining issue,
a minor one, would be how to apply the income tax rate
adjustment approach in the case of subchapter S corporations and their shareholders.

The presumption would

be that they would be taxed like partnerships - at the
owner level under the applicable individual income tax.


"Deficit" corporations
FrOiTi time to time in the preceding discussion,

references have been made to the issue raised by "deficit"

It would seem that exclusion of these

enterprises fro:n the application of Til- would weaken
the effective scope of the anti-inflationary wage restraint.
On the other hand, it might SOGT, like hitting_a loss
corporation when it was down to impose a TIF penalty
on top of an inflationary wage increase thrust upon
it by force:.: fccyond its control.

- 52 Deficit corporations in 1974 numbered 753,92 0
out of a total active corporate population of 1,978,059,
or 38.1 percent.

Their net losses totalled about $24.4

their total receipts were about :?43fj.7 or

14.3 percent of the $3059.1 billion corporate total.
Exclusion of such a largo business sector for the effective scope of TIP, either by an explicit exemption based on net
income or by an implicit exemption based on use of a tax penalty
related to net taxable income would seem objectionable
On balance, it would seem that consideration
would need to be given reaching the deficit group more
effectively than by disallowing deductions which had
repercussions in reducing their loss carrybacks and

If this were done, however, the tax would

have to be based on excess wages directly or a gross
income equivalent.

Tachnical problems of exemption
The narrowing of the scope of TIP through an

outright exemption based on size characteristics raises
certain technical problems.
(1) N'otch problem
One is the notch problem:

the triggering of

a tax creator than, ana po.^ibly a large multiple of, a .s'iaii size? increment basod on recoipLs,
G a m m a s , assets, or si:;iiLar ::oasurr which puts tho

^Comparable data for 1975: deficit corporations numbered 795,534
Net lossei Tf th° H ? ' a C t l V G c o r P ° " t i o n s numbering 2,021,778
d e f l c
^ group were $26.4 billion; total receipts

- 53 -

firm within the ambit of TIP.

The usual remedy for a

notch problem of this type would be to limit the penalty
tax to some fraction of the increment in size that triggered the tax.

Without such a remedy, the forewarned

business will go through various tax-pressured contortions to keep under the critical size limit, including
refusing business, shifting business, contracting out
in lieu of employment, and business reorganization.

(2) Multiple incorporation and other business reorganization
Business response to an exemption based on
either size or form of organization would include:
—split-ups and multiple incorporation to keep under the critical size and avoid TIP
—disincorporation to take advantage of an exemption
of unincorporated business
These problems argue both for (1) avoiding
an exemption or keeping it small to minimize the feasible and significant area of TIP avoidance and (2) developing safeguards against TIP avoidance through obvious
maneuvers, as discussed later in this report.


Duration of TIP penalty

The formulation of Til- immediately raises the

How long should t.he additional tax triggered

- 54 -

by excess compensation in a particular year persist,
in the absence of any obvious correction of the excess
payment position?
For example, suppose a business increases its
wages by an average of, say, 7 percent in year 1, when
the noninflationary guideline is 5 percent, and continues
the 7 percent increase into years 2 and 3 on top of
annual new increases equal to the guideline percentage
in the subsequent years. Should the TIP penalty apply
only in year 1 and the slate be wiped clean in year
2 and subsequent periods?

Or should the TIP penalty

be continued as long as the cumulative wage increases
over the period since the inception of TIP are in excess
of the cumulative total of the noninflationary guideline

Cr should the penalty tax be made sub-

ject to some arbitrary cut-off period of, say, 2, 3,
or 5 years application following the initial excess
compensation arrangement?
The payment of excess wages may be regarded
as a one-tine transgression against stability and thus
taxed only in tho first year or first full year.


tion beyond that may ho recorded as punitive, since
inflation becomes a fait accompli nfter the initial
creation of the excess.

Cn the other hand, it may be

contended that tho tax hojps contain inflation once
the wane increase has occurred and removal of the tax

- 55 -

after the first year may lead to further inflationary release of purchasing power.
Beyond a few years, however, it may be held
that it would be best to let bygones be bygones.


of cumulative penalty taxes would favor "new"

businesses which could start with a clean slate, and
compel discontinuance of older heavily burdened operations.
The mechanics of alternative approaches to
"duration" are examined under the headings that follow.


One year only approach
The simplest approach might at first glance

appear to be to impose the TIP penalty for one year
only, i.e., the year for vhich averace compensation increases over the preceding (base) year were determined
to be in excess of the applicable non-inflationary guideline standard.

To illustrate in simplest terms, suppose

the guideline for the year 1979 permitted an average
compensation increase of 5 percent in 1979 over 1978.
If an employer's wages were $1,000,000 in 1978 and
$1,070,000 in 1979, and the $1,070,000 was found to
represent an increase of 7 percent over the prior year
bast?, the excess of $1,070,000 over 1,050,000 or >20,000
would be subject to the annual penalty tax.l/

-^In this simplified illustration, the actual wage bill
for 1073 is treated as Lhe base- from which the 7 percent
av2r?.<::ri vac-o incroac;r? in 1070 is measured.
Lnio relationship l-joLi.rcn Ll;o' c^r i-'.vit ?*".:'• prior yc\;r v.^;o Lilli.-,
wouId :ioi nocu:•;3..;:' i ] y e:.i s L .

- 56 -

In the following year 1980, if actual wages
are again increased 7 percent as compared with a 5 percent guideline, the new excess wage figure would become
$21,400 (.02 x 1,070,000, i.e. 1.07 x 1,070,000 ninus
1.05 x 1,070,000 or 1,144,900 - 1,123,500).
The $20,000 excess of 1979 in effect would
be expunged from the record as far as the computation
of the excess wage tax base in 1980 is concerned.
This would simplify record-keeping but weaken the pressure on chronic transgressors of the guideline.


this approach would tend to impose a relatively mild
annual penalty based on the current year excess, even
though the employer had a cumulative build-up of wage
increases in excess of the non-inflationary norm far
greater than the current year TIP penalty tax base.


Cumulative? excess or carryover approach
To bring continuing pressure in proportion to

the employer's cumulative excess of wage increases over
the guideline standard, a cumulative approach might
be followed which would carry forward the excess in one
year to be added to the excess if any in the succeedino
year or years, until corrected or expunged by the terms
of the TIP penalty tax plan.
The cumulative approach is illustrated and
compared with the annual approach in the following simplified exa.-iple.

This example a^surues a continuing

- 57 -

7 percent annual increase in the average vage rate,
as aginst a 5 percent guideline.

For purpose of clari-

fying the continuity of developments the actual wage
bill for one year is treated as equal to the base wage
in computing the excess compensation in the following
years, a condition which would not necessarily prevail.

Illustration 1. Comparison of cumulative and annual
approaches, assuming constant annual rate of excess
over guideline^/
Employer experience

1079 •



$ 1,000,000

$ 1,050,000

$ 1,102,500









67,41 il

Excess wages,
annual basis





Difference between cumulative
and annual basis



21 ,000

44, 520

Excess wages,
cumulative basis

—'Guideline = 5 percent; average annual percentage rate of wage increases
= 7 percent; average annual rate of excess over guideline = 2 percent.

Suppose that the pattern of wage'increases
in excesn of guideline was interrupted.

The cumulative

system would give the e.v.ployor credit for this improvement
in his status as illustrated below.

- 58 -

Illustration 2. Operation of cumulative excess approach
when excess over guideline in early years is followed
by conformity or reversed.
(5 percent)
Excess wages,
annual basis











1.123.5OO 1 /

1,179,67s 2 /


Excess wages



^Increase 5 percent over 1979.
^Increase 5 percent over 1980.
—' Increase about 3 percent over 1981 (actual percentage
increase required to eliminate TIP tax penalty under
cumulative approach = 3.03736 percent).

Under the cumulative approach and the circumstances assumed in Illustration 2, mere conformity with
the guideline in 1982 would not have purged the employer
of any TIP tax liability in that year.

Rather the ex-

cess would have been $23153, i.e. ($1,179,675 x 1.05
or $1,238,659

minus $1,215,506)• It will be noted that

mere conformity following a pericd of excess vage payments
continues the excess wage base, increased by the annual
growth rate of the wage bill.

Thus the $22,050 excess

under the cumulative approach shown in Illustration 2
for 1981 is 1.05 tiroes tho >21,000 excess for 1980.
Similarly, the? 523,153 excess for 19?2 cited above


- 59 -

under an alternative assumption for 1982 would be 1.05
times the $22,050 excess for 1981.
This formulation of the cumulative approach
would bring continuing pressure for the employer who
has exceeded the guideline in prior years not only to
get into conformity on a current basis but also to dip
below the guideline rate of increase sufficiently to
wipe out the excess established in a prior year as now
increased in dollar terms by the overall rate of growth
in compensation.
It is assumed that the design of the cumulative
approach would not permit negative TIP tax bases to develop,
as might mathematically occur if the cumulative rate of
wage increase fell below the cumulative guideline level,
and that such a "negative" could not be applied to recoup TIP tax liability previously incurred in years of

However, a year in which wage increases-were

below the guideline, possibly producing a technical
negative, might be used as a carryforward to be
credited in a future year in which the wage increase,
exceeded the current guideline, possibly as a result of
a catch-up type of wacje adjustment.
The carryforward of credit for restrained wage
behavior would automatically occur under the cumulative
approach as outlined.

This operation of the carryforward

effect under the cumulative approach las compared with
tho annual basis approach vith no carryforward) is shown
in illustration 3 helow..

- 60 -

Illustration 3. Carryforward of credit for below guideline increases against years of excess.
C5 percent)

$ 1,000,000

E.nployer experience


Excess wages,
annual basis
Excess wages,
cumulative basis




$ 1,102,500







*^3 percent increase over 1978.
^ 7 percent increase over 1979.

As Illustration 3 demonstrates, the payment of
a 7 percent increase in wages in 1980 following a 3 percent increase in 1979 would result in a substantial TIP
tax base

under the annual method in 1980 and prevent

TIP tax penalty in that year under the facts assumed.
Provision could be made for a limited carryover under the
annual method to prevent the apparent hardship in catchup wage settlements.
The complexity of the cumulative approach,
particularly over a considerable period of years under
the system in which trio identity of particular employers
may be altered in various ways, would be substantial.
Labor groups would of course particularly
oppose a carryforward feature of the plan which had the

- 61 -

effect of additional encouragement to employers to go below the
guideline in order to wipe out a previous record of above-guideline
wage payments and their continuing tax penalty effects .
One possible variant of the cumulative approach
would entail a periodic wipeout of prior guideline experience, permitting the employer and employees to start
anew without the complexities and overhanging pressures
of prior above guideline or below guideline wage settlement experience.


Further problems in the carryover approach
It should be borne in mind that the operation

of the cumulative basis or carryover approach as illustrated
in the preceding section is substantially simplified
by the use of a continuing wage bill on which the sequence
of assumed wage increases takes effect and no other growth
changes occur.

In practice, the wage bill will reflect

growth or decline due to causes other than
or inflation.


Under these conditions, the cumulative

or carryover process v/ould take the form of accumulating
and carrying over percentages or index figures reflecting
excess wage experience of the past.
Should these percentages representing


excess vacjc experience of the past be applied to the
current wa^e bill ;:iUiout adjustment?
ceptually r.ppoaliiyj;

This may be con-

iL \;ouid involve applying an x

- 62 percent excess wage

determination to wage layers which

may be much larger (or smaller) due to expansion (or decline) of the business or the economic sector of which
it is a part.

Thus a portion of the TIF penalty tax

originating in a wage settlement involving, say, $50,000
excess wages in 1978 may be applied to a much larger
amount 5 years or more later.
This may be

harmonious with the economic logic

of penalizing inflated wage rate increases for a lengthy
if not indefinite period, including all the growth element
in the current wage.

But it may be difficult to .justify

to the ordinary observer who perceives a TIF penalty
tax applied to a determined percentage of a wage bill
jf $2 million, for example, in 1983 when
the original wage bill from which the penalty arose a.mounted tc only $1,000,000.

With growth due to all fac-

tors of 15 percent annually a TIF penalty tax of, say,
$50,000 based on a 1979 noncompliance becomes $100,5 68 five
years later in 1934 at a 15 percent annual growth rate
(compouded annually);
growth rate;

$124,416 at a 20 percent annual

and v224,202 at a 35 percent annual growth

This effect vould "-:o further compounded if there

were intervening inflationary vacjo increases embodied
in the expansion process above

guideline in the years

1930 - 1984.
Some might question the propriety of a policy of applying a TIF penalty originating in an excess wage settlement in,
say, m 7 9 to the wages of an addition to the firm's staff in, say,

"Layering" or separate treatment of different vintages of

an expanding staff would be complex.

- 63 Technical problems associated with a cumulative computation under an indexing procedure are mentioned in connection
with that topic in a later section of this report.


Fixed period of years
In the interest of simplification, achieving

more impact than a 1-year penalty only, but keeping the
combined TIP penalty tax within more moderate limits
than under the cumulative method, a compromise approach
is possible which would continue the penalty tax liability
arising from a particular year for, say, 3 years, then
drop that portion of the TIP penalty assessment.
This would result in a gradual build up of the
penalty from a 1-year assessment in year 1 to a 3-year
assessment in year 3.

Thereafter a now year of assessment

would be added each year and an old year dropped.


3-year wage experience span upon which the current combined penalty would be based would be a moving period,
reflecting the wage settlement experiences relative to
the guidelines over the most recent prior three years.
Two different acproaches are possible in applying a fixed period of years technique.

The simplest would

subject the excess v/acjes as determined in year 1 to the
TIP penalty tax for the next 3 (or whatever) number of years.
In effect, this would merely triple the tax for one year
and spread it over a 3-year period.

The base in years

2 and 3 would not change in response to expansion or
contraction of the previously dcterrained layer of excess

- 64 -

The other would be to apply the penalty tax
in the same ways as under the cumulative approach but
terminate the inclusion in the tax base with resnect to
any particular layer of excess wages after 3 years.
The TIP penalty
two alternative 3-year


base or "measure" under

period approaches are illustrated

below over a 4-year build-up period.


Wage bill
Excers wages

Year 2


.Year 3


Year 4


(1) Simplified
3-year period



(2) Cumulative
3-year cut-off



32,700 .
52,70c 17

12.000- ,



72,0Q0 27


of $1,000,000 (from year 1) plus 3% of $1,090,000.

-/year 2 total plus l.i of $1,200,000.
-/year 2 and year 3 components of year 3 total plus
nil percent of yGar 4 v.-acr: bill .

plus 3 or So cf $1,090,000.

^ 2 plus 3 plus 1 or 6.^ of ?1,200,000.
--^3 plus 1 plus 0 or 4;.. of yl,300,000.

The impact of the Til- penalty tax under the

- 65 -

fixed period method would bo amplified as compared with
a one-year only method.

The 3-year method would be milder

than full cumulation but would tend, other things being
equal, to call for a lower tax rate than under the one-year
only methoct.
The question is posed whether the prospect of
3 years of application of a lower penalty rate would
be as effective a deterrent to excessive wage increases
as a higher rate of a single year's duration.

Would it

stimulate closing of business operations to escape the overhanging TIP tax burden?
The additonal penalty imposed under the threeyears* duration system is less certain, although prospectively greater in

a firm with a growing wage bill, un-

der the cumulative system shown as Alternative 2 in the
preceding illustration in which excess wage layers are
"elastic" portions of the changing wage bill.


Definitional and measurement matters
This section discusses a number of central

problems and issues involved in the definition and mea.surraent of the TIP tax base and taxable unit.


Definition and measurement of wages/salaries/com-

pensation and increases thereof
The definition of compensation and its various components would be expected to be comprehensive in
order to v;ard off obvious escape hatches fro:,; the TIP

Those definitional questions nnd tV.e related com-

pliance and adniniotraLive tasks confront virtually all
forms of the Til approach, including fiio:.e which (like

- 66 -

the Abba P. Lerner package) impose taxes on all wage
increases without regard to excessiveness in relation
to any norm.


Identification and valuation of compensation ite:ns
The definition and valuation of wages/salaries/

compensation should include, in the absence of policy
considerations to the contrary, not only money compensation payments and conventional payments in kind, but
the whole range of presently known and potential new
wage supplements and fringe benefits.

The various pay

components and factors which are to be varied and changes
in which may contribute to increases in compensation
rates would include, but not necessarily be limited to:
—pension and retirement benefits
—health, dental, and legal service or insurance
— l i f e insurance
— p a i d vacations
—recreational facilites and travel
--in-house food services
—deferred compensation and deferred pay increases
--commuter travel or other transportation or moving allowances
—commission and piece rate compensation or bonus
and incentive pay arrangements
—profit sharing benefits

29-775 O - 78 - 11


--bargain purchase of stock, commodities, or services
—guaranteed wage arrangements
— s h o r t e r work periods
—improvement in the work environment and working
conditions, and
— o t h e r compensation-equivalent or hard-to-value
employee benefits.
Some of these items might prove difficult
to measure and subject to considerable controversy.
Specialized study and detailed regulations might be required for their valuation.
Conceptual problems would arise in the approach
to certain items, such as deferred compensation or deferred pay increases.


Deferred compensation and deferred pay increases
Deferred compensation valued at its present

discounted value might be regarded as current pay.
Its receipt would not swell tho flow of current compensation dollars, but it would affect the employee's attitude and spending-saving inclinations towards current
Deferred pay increases differ in character
from deferred compensation in that they do not becon.e
owing to the employees until work is performed in a later
period in vhicb tho increases become effective.


theless, they may take the place of current pay increases
anc. loocen irp spending ny O'l/.io'/X's in anticipation

- 68 -

of future improvement in their earnings status.

If the

TIP tax penalty plan were to operate for an indefinite
period, the deferred pay increases would be taken account
of, in any event, when actually received.

Thus, on

balance, while the prescription would seem to be that
deferred compensation should be currently recognized at
present discounted

value, deferred pay increases should

be recognized as part of the compensation measure only
when they actually materialize as current pay.


Allocation of group-type compensation among different

components of the work force
In cases where group benefits,presumably measured on the basis of cost to the employer, are not
directly attributable to a particular category of labor,
some allocation or apportionment would need to be provided in calculating weighted average rates of wagesalary-compensation


This apportionment

might be based, for example, on the ratio of other,
directly allocabie pay for that class of employees to
the total.

Gr an initial npportion-.ent on such basis

might be modified in the light of the actual experience
in the sharing of the flow of the employee benefits.
Since the calculation of average rates of pay
increase is a vital factor in doterming conformity with
guidelines and the dcc;ree of excess, if any, specific
attention would need to be niven to this question in

- G9 -

the detailed formulation and implementation of TIP.
This might call for specific statutory guidance and
specific statutory delegation of regulation-making authority to spell out detailed provisions for allocation
and apportionment of benefits among employee classes.


Convenience of employer rule
The pressures of a TIP penalty tax system may

bring into question sor.e of the existing rules for determining

taxable compensation, or their applicability

for purposes of TIP.
One example is the existing provision that
the value of meals and lodging furnished for the convenience of the employer is not income if, in the case
of meals, they are furnished on the business premises
of the employer and if, in the case of lodging, the employee is required to accept the lodging on the business
premises of the employer as a condition of his employment.^

Escape from TIP via the "convenience of employer"

rule is a possibility that would need to be dealt with.


Travel, nntortair.nent. personal expenses of employ-

ees, gifts, and similar items
The v/hole complex of present provisions relating to the deductibility to the employer and status in

—'Internal £cvenue Code see. 119

- 70 -

the hands of the employee of travel and entertainment
expenditures, club dues, local travel, other personal
expenses, gifts, and other items may need to be reexamined
for purposes of measuring compensation under TIP.
Items now excluded from the definition of compensation to employees might need to be treated as
compensation for TIP purposes.

Excessive salaries,

not now deductable by the employer but taxable to_the
employee as something else, might need to be examined
in the light of TIP.

Present rules excluding from tax-

able compensation the cost of the first $50,00 of group
term life insurance might call for review for TIP purposes.
The status of interest-free loans to employees
in connection with fixed, periodic bonus payments, for
example, would need to be explored, since the benefit
from such loans is apparently not now considered taxable gain and offers a route for paying employees taxfree incentive compensation.^
Present rules permitting some bargain purchases to be treated as gifts or good will promotional
expenses, not compensation, also would require review
for TIP purposes.^
This brief treatment illustrates possible

•^3ee 1977 i'!l Tci:: .toturn Manual, Co.iuncrce Clearing
House, para. 73?, pp. 70S-7U9.
^ A b i d . , para. 733, p. 709.

- 71 -

technical problems.

Full examination of this area is

beyond the scope of this report.


Exclusion of non-do:nestic compensation
Since the scope of TIF would presumably be

limited to domestic activites of enterprisesi


rules would need to be developed for the segregation of
wages, salaries, and other compensation related to domestic
and foreign activities.

These definitional rules would

need to be consistent with the determination, of U.S.
or domestic net income to which the TIP tax penalty
would apply under some formulations of the plan.


Measurement of certain elements of v/acre increase
The preceding list illustrates problems of

achieving comprehensiveness in identifying and measuring

allocating certain items among work force

categories, and dealing with low-visibility types of
compensation increase.

3efore moving on to the key

question of calculating average rate of pay increase
by indexation or otherwise, brief attention should be
given to questions of valuation of certain types of
compensation or increases in compensation.


Valuation or" cor.petisjtion other than in cash
I'ho qenoral rule of the tax law is that where

services .-. m

T.nid Co r in •,i"OD?|ptv, t-.iiO fnir market value

- 72 -

at the timo of receipt must bo included in the employee's
gross income.

A note received in payment for services,

and not merely as security for such payment, comes within
this r u l e . ^
From the employee's standpoint, rental value
of living quarters and fair market value of meals are
the measure of these forms of compensation in kind
(now excluded fiom the employee's gross income if furnished
for the convenience of the employer).

It is the cost

to the employer, however,' not the value which is deductible by him as a business expense.-'

This technical

disparity would need to be handled in the determination
of wage levels and wage increases.
If deferred compensation were treated as a
current compensation increase, valuation would presumably be on a present discounted value basis, as indicated

The weight thrust upon the rate of discount

used and related calculation procedures by Til would
call for precise specifications.
Similar problems arise in the measurement
of compensation increases involving acturial estimates,
forecasts of retirement experience,

- ' S t ? o 1_977___L^_.jj_._ jLiJ_s_tcr_JJUL-iiiiiis0.»
Hou s o , " p . i r a . 7 24", pp . ' ? ~G - ?. 2 7 .

pension fund earnings



S' '7r\zi H n t u r n >'.nnu-->l, Commerce
c a m . 2 - i l i , p . 2 h)-..».


- 73 -

and similar factors

As has been pointed out by a proponent

of TIP, these questions are gradually ironed out in the
process of wage negotiations.

The "two sides' inter-

pretations of the cost of a given claim or offer frequently diverge widely" in the early stages.


the settlement is reached, the differing interpretations
tend to be closer and often are in agreement.


theless, these calculations contain a high degree of

They may involve assumptions as to future

labor turnover, retirements, incidence, and cost of illnesss, pension fund performance, and the like.


may be adequate for purposes of policing the verdicts
of the Pay Board.

Typically, they are not adequate

as a basis for assessments of a surtax which must be capable
of being audited and if necessary taken to court".-'


Measurement of excess compensation for TIP purposes
A basic task, in the measurement of excess com-

pensation for TIP purposes is the determination of the
percentage incre'ase in the average rate of compensation.
This percentage :aay then be compared with the guideline
percentage (presumably reflecting the nationwide average j.
increase in labor productivity) to determine conformity
or non-conformity with the non inflationary norm and
the extent the employer's departure (above or below)



^ .See i i o n r y C. .,>.ll i c h , "I has,e I I and t h e l - r o p o s a l
7or a Ta:< \. r i c n L c 6 Iricur.ys
. , > I i c y ' ' , J^iy.icv of -aocig.1
'Jl c o r icr;; / . V o l . ..!.'•.', \"o . 1 ;.vic. rc:h ! 'J7I!, , p . vj.

- 74 -


the noninflationary norm.
This discussion takes the determination of

the guideline percentage as given, i.e. determined


on the basis of nationwide data measuring the increase
in later productivity, essentially the rate of growth
of real output per person-hour or other unit of labor

It is therefore concerned almost entirely with

the procedure for measuring the particular employer's
average percentage increase in rates of compensation.


13rief review of alternatives
The following review of alternative methods

of measuring average rates of pay increase includes
a' number which are obviously crude or defective, chiefly
as a step in clarifying the problems and defects which
the more refined procedures are designed to avoid.


Reliance solclv on percentage pay increase in union

wage settlements
ThQ simplest although not necessarily the crudest approach would be possible if the I'll penalty tax
were confined to excessive ;/age settlements tetveen
labor unions and typically lar^o employers.

The cal-

culation of the percentage increase in pay in these
settlements could bo refined and subjected to standardizing definitions and rules.

The excess of the percentage

increase ever a r/uidoline standard could be fed

- 75 into the profits penalty tax formula, with technical
adjustments called for where the compensation segment
involved was only a part of the work force;

used in

determining and scaling the disallowance of deductions;


used in identifying and measuring the base of a special
excise or payroll tax on excess pay increases.

If the

wage settlement involved only one category of workers,
the TIP penalty tax would then be confined to this category of pay or corresponding portion of profits.


would be made for increases under multi-year as against
annual contracts.


Wage bill
The calculation of percentage pay increases

based on the overall change in the wage bill from one
year to another is the simplest and crudest technique.
It would work well only in situations where the
work force remained the same in numbers and composition
from one year to another.

Where growth (or decline)

occurred in the work force, the percentage increase
in pay would be correspondingly overstated (or understated).

Similarly, the wage bill method vould fail

to take account of changes in the skill and pay rate
mix, which would distort the result and invite tax avoidance by manipulation of the skill r.iix within the firm.


Cvernll average annual pay per cmnloveo
Another me?sure of average pay increase -

one sug-* ^otcd by i ro:t-5;:;or ..^int. r<j':b - vuu'id ho b.i^cd

- 76 -

on the percentage chanqe from one year to another in
the annual payroll (wage bill) divided by the number
of employees, or possibly by the number of man hours.
This would avoid the crudities and distortions in the
wage bill or total payroll method described above due
to failure to take account of increases in the number
of employees or similar measure of labor input,


ever, relying as it does on an unweighted average wage
or salary, this method would register the effect of an
increase in the proportion of more skilled to less
skilled employees as an average pay increase;

of an

increase in the less skilled relatively to the more
skilled, as an average pay decrease factor.
The result would be an obvious distortion, unintended inequities and penalties on "irms employing an
increased proportion of skilled workers, and "invitations to tax avoidance by manipulationg the nu:nber of
employees and the rr.ix of skills (and therefore of average
wage levels) within the firm's labor force."-'


.Veicjhted average or inocxip.' procedures
The only exact, and fair r.is_rtii.-jci vould bo Lc-

measure the average annual percentage in oay
on the basis of tvi avcracje of co'.r.por.sation increases
in appropriate o.r.pluyoe or co:iper.:-.ation categories,

'..'allicb "I'IJ.'!5-:O i. i zr.c, L:v . ro-^.^il :"•.•; r .0 ..:•:•: :.r I T M'.OCI

- 77 -

appropriately weighted by man hours or other suitable
units of labor input.-1-'
an indexing procedure

This approach is tantamount to
Zxcept for whatever additional

complication is involved in pay and labor categorization
and the related weighting procedure, this correct approach
is no more complex for the standpoint of administration
and compliance than the crude unweighted average annual
pay method, described under the preceding heading.
The labor category, labor input, and wage data
for this weighted average or indexing method is available or could readily be obtained by a rearrangement
of cost data the taxpayer must prepare for income and
payroll tax purposes and for its own payroll purposes.
The procedure may seem laborious on a startup basis.

Initial problems of classification on a con-

sistent basis would arise and cull for administrative

However, once in operation with the as-

sistance of automatic and electronic payroll accounting
methods it should not 1x2 unduly burdensome for business
to prepare or fcr the government to monitor and audit.

Some analysts, observe that:
"any specific *..ny of measuring the firm's
a v o r a c o Wcir-e vv.'jid u n d o u b t e d l y leave? • l o o p h o l c c ' o v c!cn>'."L-'i_o si-ic e f i e c L s .
If Ll:e indox
v-ore sivply t'r.o firm's L-»Lai ' w ^ ' h i l l 'or
the ye-ar divided hy its ,-;vonf!P lobour force
durir.c; the? y e a r
t'l'.c fir.r :".i-;h» s h i f t ivs
skil L'mi :•: Lovarc;.-; l-;.-.::?r p:iid vorUorr., s i n c e
by rc'.ucint.. t"-o avc-ranc «•«.•;;:• t::is v.oulc) or.^bje
it to re i ;o V.-J.-.Q^ ,,il .,.:- v i L h o u t i n c u r iriri tax. .-ut t;:c li.^ -;.-.-.i.?i.-:Lre:i.:b oi;t.;c:ost.ion
of -in ii»c'o:: onnrc. atcd
froni. scpciT'ito \-;\</a

- 73 -

indice.s for separatf skill classes m m !,ht induce spurious upgrading of workers".^/

(1) Illustration and analysis of alternative measures
Alternative weighted average procedures are
compared with each other and vith the cruder measures
of percentage changes in compensation in the accompanying Tables 1 and 2 ,-J
Table 1 sets forth an example of a firm's experience in terns of total pay, labor input, and average pay, broken dovn by four different employee categories (hourly paid personnel and salaried:


technical-professional, and executive) for each of 3

The table thus provides an illustrative analysis

of the measure rent of chances from year I to year 2
(an expansionary

period vith substantial pay increases)

and from year \>. to year 3 (marked by contraction and
a reduction in rote of pay increase).
T a M e 2 summarizes the percentage pay increases,
by employee for year 2 over year 1 and for
year 3 over yor.r 2 showr. in 'Lable 1 and gives the results
of different methods especially weighting procedures,
in c.ilcuLnt-ir.:.; avo r.ico pcM-cr'titaqo pay increases.


convor:ionce of, the average pay calculatioiio in '.'able 2 arc repeated in the lover Lank of
Table 1 .
- .-'"I-urn .'oi: ..•'.. i t:- .1!"..-: .: : c". \-.\ L-'; '.or\= .;. " i : .^ f " - ; x o "

- 78 -

indices for separate? skill classes mi^ht induce spurious upgrading of workers".^/

(1) Illustration and analysis of alternative? measures
Alternative weighted average procedures are
compared with each other and with the cruder measures
of percentage changes in compensation in the accompanying Tables 1 and 2 .-y
Table 1 sets forth an example of a firm's experience in tenns of total pay, labor input, and average pay, broken down by four different employee categories (hourly paid personnel and salaried:


technical-professional, and executive) for each of 3

The table thus provides an illustrative analysis

of the measure r.ent of changes from year I to year 2
(an expansionary

period with substantial pay increases)

and from year ?. bo year 3 (marked by contraction and
a reduction in rote of pay increase?).
Table 2 summarizes the percentage pay increases,
by employee category for year 2 over year 1 and for
year 3 over yrv.r 2 shov/r. in Table 1 and gives the results
of different r.iothods especially weighting procedures,
in calculnt: iiiij averaco percentage pay increases.


convenience of reference, the average? pay calculations in '.'able 2 are repeated in the lower oanJ; of
Table 1.
- .-'"'uri-i .:ot •v.itr. .">:*.<: .-. i c'.i-.i rii lor 1 ..'.;. " 1 : . ^ f":.-.x O P
\ n r t h \.o:is::d


•::J~~i: m y ,

p . I*-.,



Table 1. Illustration of selected alternative methods
of determining average rates of compensation increaf;o
Year 0
Year 1
of employ" Total pay Employee Ave pay Total pay Evnpioyec Ayr* pay ToLal pay
(? thovi) yrs (hi*.;) per yr
(*> thou)
yrs (hrs) por /r
('? Li:ou)

Year 2
:.,i.iplo)c r .\v^
yrs (in:;) f-.r

ou:• 1y paid p o r -


4 50


1 0 , ?.-;•. =3
5 r >,000
3 3.3GC



S e l e c t e d p e r c e n t a g e changes i n given y e a r over p r e c e d i n g
ot = 'l payroll
nl.->i :i!.::.:'-':r of c .^Ictyc years
vc r r- -o ;-••?. y po r r •: p 1 Pyr o
vc r••*.'_:'•• i.,icror.r-;c .in pay o r 4 c l a s s e s of employees:
1. I'MV^lviitou nvcr.-irjc
J.irV- r-;juiv.-jlo:il;
2. AwrcKjC '.."ar;o r c - l a t i v e s \;ciy'ited
L-)L.-'l pay, year
Tndc:-: ocfiiiviTlmit

3. Avcrnre wnic'iiLod hy nuvp.ber of
employee? precodinn year
Indo;: equivalent





100. or:
u . 01
1 0 0 . 01

For further detail on pay rate changes in this example and additional u l t c r n n U \
methods of determining average increases, sec Table 2.

- 80 -

Table 2
Percentage pay increases by class of employees
(shown in Table 1 example)
tonether Kith
Surrjnary of results under alternative index methods
pay increase
year 1 over year 0

Class of employees

pay increase
year 2 over ys?ar 1

Hourly paid personnel




1. Average pay all employees
Index equivalent









106. 75

110. 00

6. 92

3. 71

106. 9?

110. 39

Average of four classes of
2. Unweighted


Index equivalent
3. Average of relatives
weighted by total pay,
current year
In^ex equivalent
A, Avorr/'C of rrlativss
-.vci^'hiieri '•;;/ employee
years ,
cur rent year

6 .91

J.rvV:: oquiva lent (i^:ii:-chc
Av.irc -:<o of r•olJtivcs
ted 'ov o..,r?loycc
rii:;(.;, y e
Tr.r»o:•: r?:;ui\"ci

100 .91

3. 685
11C. 35


C . 91

3 .CO
133 . 0''.
3 .C9

»"•.-:; u i v c. 1 •."-•." t

110 .85

- 30A -

Table 2 continued

-lass of employees

pay increase
year 1 over year 0

7. "True" Paasche*/

pay increase
year 2 over year 1





Current vear quantity
8. "True" L a s p e y r e s ^
3ase year quantity weights




^ N o t e : Percentage change numbers for all alternatives except
"true" Paasche and Laspeyres methods are, as indicated, calculated
for current year over preceding year. Corresponding index figures
are constructed by "chaining" back to year 0. True Paasche and
Laspeyres age;rear.Live index calculations with the year 0 base,
without, "chaining," ^ire shov.Ti for comparison. The Fisher's Ideal
Index is the sane, due to rounding, whether computed on the basis
of the Paasche-Laspeyres-type numbers or on the basis of the "true"

- 81 -

For purpose of obtaining a common denominator
in computing pay per employee and the weighted averages
based on amount of labor in the current year, preceding
year, or both, hours of hourly paid employees were converted into employee years on the basis of 2000 hours =
1 employee year.-^
The calculations underlying the results shown
in Tables 1 and 2 abstract from two technical problems
discussed later under separate headings:

(1) apportion-

ment of the costs of not specifically allocable employee
benefits, and (more important) (2) the treatment of


(2) What the results show
From a technical standpoint, all the weighted
average systems of calculating the average percentage
increase in compensation rates give similar results
both in the expansion and contraction years.

In addition,

since there was no marked change in the distribution
of the work force the four employee classifications,
the average pay per employee (once favored by Wcintraub)
performed reasonably veil in alir;n...ont vith the more
refined vrieghteel averages.

iiven the unweighted average

produced a result approximately in lino vith that of the
3 standard •.•:ciqhtinq systc-v.s and the n-ore recherche.1
Fisher's Ideal Index for the expansion year, taut it

--'CCO:; hours as.-u;\o;; ?50 v;or':i::c: clay.-, of ci~ht l.ourc
in the year.

29-775 O - 78 - 12

- 82 -

foil down in overresponding to the negative change
for one employee category


and the v?ry low increase for another (supervisory), not
untypical events of a contraction year.
The results shown wore, understandably


properly, governed primarily by the pay experience of the
hourly paid personnel, who accounted for the bulk of
the payroll (90 percent in year 1) and an even higher percent
(94 percent) of the number of employee years, factors
used as weights.
Over-all, the averaging system seems reliable
as a measuring device.

The choice among averaging or

weighting systems would not seem to be a critical issue.
The average percentage pay rise would not be especially
difficult to compute once the data were assembled and

The data assemblage and organization tasks

do not seem burdensome.

(3) Highlights of Treasury staff study <->- 1970
A Treasury staff study on the subject in 1970
wont through the various operations involved in the
deterr.i nation of a co-nponsa ti on incc-x for purposes of
a TIP approach.

The Treasury study procedure assumed

only 2 categories of employees:

hourly paid personnel

- 83 -

and salaried personnel.

It concluded that the determina-

tion of a suitable compensation index would then call
for "four parts or schedules in any given return":
one (i\) for the determination of hourly compensation
of hourly paid personnel;

one (»i) for the determination

of per salaried personnel compensation;

one (C) for

allocating non-directly allocable compensation deductions
between the salaried and hourly paid personnel;


one (D) for calculation of the compensation index.
The Treasury staff illustration of "Schedule A" for
hourly paid personnel took. 2 half pages of typescript,
i.e., U page each for the current year and the preceding
year (together the equivalent of about 1 full pace).
The illustration of Schedule H on salaried employees
for the 2 years involved called for

' typescript pages,

each about 1/2 pane» and less than 1 full page together.
The other two schedules C, and D, required about 1/3
of a typescript page oach or loss than 1 full page altogether
The greater length of "Schedule A" for hourly paid
personnel as compared with the others was attributable to
the distinction between regular hours and overtime hours
vorked and thr? calculation of" a regular ti-.v.e equivalent
of overtir.-.r; at a 3 to 2 ratio .issun;i.rig tiir.c and a;iehalf for overtime, together with the uppertio:rr.cnt
of non-dirr-ctly ,il loca-il e benefit cu.-it.:. (the latter
a procedure, is also called for in the processing of the
salarirv.l i".'r.;onne] r;ehec!i]e' .

- 84 -

The Treasury staff study determined the compensation index by means of a weighted average of the

pay increases for hourly paid and salaried

personnel, the weighting being based on the total compensation of each broad category of personnel as a percent of the total compensation (payroll, "fringes", and
all employee benefit costs for which the employer would
take income tax deductions).
There is no indication in the Treasury staff
study of 1970 that the procedure would be infeasible,
unduly burdensome, or impracticable.

This would seem

to include the mechanics of data gathering and processing
and related compliance tasks by the firm, such as the
apportionment of non-directly allocable benefit costs
and merging of regular tine and overtime compensation

All apportionment and weighting procedures in

the Treasury study v/erc based upon the ratio of compensation (or allocable compensation) for the particular
employee clnsr.ification and the total compensation
(or allocrifclG compensation.),

other vreiyhts or apportion-

ment factors w r e not entertained.
Th:) re^iu 11 i n~ average percentage increase
in corrrponr.ation v..-s terr.eci the finr.'s "cor.po.-isation
index", ar.d this index V.MS to be conpared with the
guideline? ini'e:: in determining the Til- penalty tax.—
As vill be pointed out 1-iLor in this report., percentage
rosultirn.-. ti.v.e


- 85 -

Other Treasury staff work on the subject of TIP
of the period 1970-71 seems to have been concerned primarily with the economic concept and effects of Til ,
including the economic aspects of design options.
Specific attention, however, was given to:
— t h e preferability of the deduction-disallowance
method over a penalty adjustment of income tax rates
— t h e scope of the TIP tax
—"miscellaneous measurement" problems, i.e., the
need for a reasonalble index construction procedure,
and timing problems in the introduction and transitional
phases of Til-.

(4) Apportionment of non-directly allocable sxploveebenefit costs
The calculation of alternative measures of
average pay increases illustrated in Tables 1 and 2
Eibove assumed that the compensation figures fed into
the calculation included all fringe benefits and wage
supplements, including directly allocable to the
employee classificaLion used in the averaging system.
The attribution o" iteus not directly allocable to particular employee categories necessarily involves an
apportionment procedure.

- 80 -

The non-directly allocablo items, like others, are to be
generally measured by the income tax deductions taken by the
employer For these items.

In some exceptional cases, part of

the compensation element may be reflected in values for which
there is no current cost deduction counterpart, a point dis-»
cussed briefly under a subsequent heading.
The chief technical issue in the apportionment of
non-directly allocable items is the selection of the basis
of apportionment, i.e., the apportionment factors.

The Treasury

staff work on this subject relied solely on the ratio of the
sum of the hourly pay or salary plus directly allocable compensation employment benefit costs for a particular employee
category to the corresponding total for all employee categories.
This would tend to assign more of the non-directly allocable
items to the more highly paid classifications and loss to the
lower-pay groups.

An obvious alternative vould be to appor-

tion on tho basis of nvmbcrs of employees (or calculated
employee years where the group includes a numerous changing
population due to labor turnover).
It should to recalled that tho choice of method
does not affect the income Lax of the employee, .so no conventional question of tax procjressivi ty vs. rcgrcsoivity is involved.

..hat is involved is the detorminaLion of the average

annual percentage pay increase for the firm, affecting its
TIT liability.

Apportioning would tend to increase TIL lia-

bility if it attributed more to an employee group with a

- 87 -

large percentage pay increase and decrease TIP liability if
it attributed more to a group with a low percentage pay
increase in a particular year.
The mechanics and impact considerations of alternative apportionment bases are illustrated by the following.
We start with the situation shown below.
"Compensation structure and changes,
excluding non-directly allocable items
Classes of employees

Year 1

Year 2

Total compensation--' Number
Amount rercent dist.

Hourly paid













Technical-professional 3




















Total compensation-^
Amount Percent dist.


-'Total compensation excluding non-directly allocablt? items equal to
$40 thousand in year 1 and $50 thousand in year 2.
The revised pay structure including the non-directly
allocable items under tvo alternative apportionment procedures
for the two years is shown bclov.

- 88 A. Apportionment based on t o t a l compensation
Year 1
Allocable \ T on-directly


Year 2
Allocable Non-directly


Hourly paid






945. 85







78. 20







88. 65







104. 30








B. Apportionment based on numbers of employees
Year 1
Allocable Non-directly



Year 2


Hourly paid





44 .39

951. 39






2 .80

77. 80






1 .87

86. 87







100. 94







C. Apportionment based o m
Total compensation
Average Average
Year 1 Year 2

Number of employees
Year 1
Year 2

Hourly paid


















17,067 -











10, -100






Avsraao per cv?n tare
increase i o ! l :
r :
. r.v:ci, '-.i.c-1 iiver.K ^
..•|'L'.:il.o.-i :.<y t c t ; . i co:. : .'.n:•• a t i OA C\J r r::-u t y•_• n r
.••:.•'i<..:.;.(-d ' y r.^T'ccr ^L
•T^iployocs, c u r r e n t y o a r

0 . -1 36

. 9.499

- 89 -

(a) What the illustration shows about apportionment factors
As this series of illustrative calculations shows,
the apportionment of non-directly allocable employee benefit
costs on the basis of numbers of employees may produce minor
but appreciable differences in impact on average rate of pay
increase as compared with apportionment based on total compensation.

Under the not untypical circumstances assumed in

these illustrations, apportionment by numbers increased the
percentage pay increase in the- hourly paid category more than
apportionment by total compensation.

An opposite effect

occurred in the higher paid classes where numbers do not weigh
as heavily as total compensation.

As a result, the weighted

average pay increase percentage vas slightly higher under the
numbers apportionment method, whether the weighting was by total
compensation or by numbers of employees.

Dy contrast, the

unweighted average percentage pay increase vas lower by isina
numbers apportionment, because this apportionment, reduced percentage increases for the highly paid categories more in terms
of percentage points than it increased the percentage increase
for the hourly paid.
It may be argued that whether the non-directly allocable benefit costs shoul I :.c ,apportioned among employee categories on the basis o" nu..i'c:-r.:j o.r tr.ployoos or on the bo5;i.s
of total compensation should depend in on the nature of
the bor.efit, when it was intended for, .-'ho eje tu it, arid whose
cor.ipen.ic> tic; r: is implicitly criiia ice:.! by it.

If the benefit

ton-'s to bo qre^tor f:..-t- hi-.,::]-' c:.\lcy^r3, the i:o::.:c;b\!tion formula

- 90 -

seem more in accord with the facts.

If the benefit goes

more to the rank and file, the numbers formula would seem

If benefits seem clearly greater for a partic-

ular category than any practicable formula would apportion to it,
some allocation on the basis of facts and circumstances may
be called for, the remainder being subject to formula apportionment.

Perhaps different types of benefits should be

apportioned by different formulas, although that would complicate the applicable rules and procedures.
In any event, the above illustration shows that
some potential tax effects ride upon the method of apportioning the non-directly allocable, and the merits and demerits
of the options need to bo considered.

(b) Sidelight on choice of averaging method
The lengthy illustration also serves to bring out
another more basic point relating to the relative effects of
the averaging method.

Under the set of facts and circumstances

assumed here, unlike those of Tables 1 and 2, there is a substantial disparity between the average -percentage increase
in pay as computed under the compensation weighting and number of employees weighting system.
This disparity results I"rc.;\ the vide? differences
between the percentage pay increase for hourly paid personnel,
in particular, and the increases for the technical-professional
and executive categories.

Under a veianting system based on

numbers the high ?ercenti.r;c ccKporisatiriii riser, fnr t-x- les:^

- 91 -

numerous but higher-paid categories were reflected less in the
weighted average than under the compensation weighting system.
It is evident that the choice of weighted average
as between numbers and compensation weighting may have very
substantial tax consequences.

The numbers weighting system isi

— more favorable than compensation weighting to businesses with relatively high executive pay increases (or
in an economic environment in which such increases
predominate) and
— less favorable than compensation weighting to businesses with relatively high pay rises for the majority
of workers and lower percentage increases for rel-atively
few but highly paid executive and near-executive personnel
(or in an economic environment in which the latter pattern predominates).

(5) Treatment of overtime pay
One of the neglected issues in the detailed formulation of the TIP tax penalty is how overtime pay is to be
handled in the numerator and denominator of the fraction which
determines average pay for a given classification of employees.

(a) 3LS - ECI Index
Overtime pay is excluded fro:n the me a sure mo nL of
changes in the price of labor in the Employment Cost Index
developed by the Bureau of Labor Statistics.

This index measures

only "straicjht-line" hourly earnings, including production
bonuses, commissions, and cost-of-livinq allowances, but
excluding premium payments for overtime, weekend, and latc- s n ift

- 92 -

work, also payments in kind, room and board, and

(b) Treasury staff study of 1970
Of more direct interest as a "precedent" for TIP
design is a method followed in illustrating the Wallich TIP
plan in the Treasury staff study of 1970.

The Treasury

procedure is highlighted in pertinent

part below:

Hourly paid personnel

Year 1

Year 2

A. Total hourly wage pay



b. Regular hours worked



c. Overtime hours worked



d. Regular hour equivalent of overtime (time + -2 assumed)



e. Total "regular" hours worked



f. Hourly wage



g. Non-wage "deductions" allocable
to hourly paid personnel



h. Non-wage "deductions" per
employee hour









i. Non-directly allocable deductions apportioned to hourly paid
j. Apportioned waqe equivalent per
employee hour
k. Total hourly compensation

-^DLS Handbook of Methods, U. 3. Dept. of Labor, Bureau of Labor
Statistic.i, 197u, I.ullclin 1910, p. 134.

- 93 -

(c) Should overtime be neutralizecl as a TTF factor?
The treatment illustrated above removes overtime
as a factor influencing hourly wage rates unless there is a
change in the role of overtime allowance.

An increase in the

amount of overtime worked is offset by the adjustment in "regular" hours.

This treatment would substantially remove higher

wage bills and higher annual rates of pay due to increases in
overtime worked from the application of TIP.

Conversely, it

would remove a decline in the prevalence of overtime as a factor decreasing effective rates of annual pay.

By using total

compensation, including dollars received for overtime, as a
weighting factor attached to the "muted" percentage change
in the hourly wage rate, the method illustrated compounds its
effect in toning down possible application of TIP in a strongly
expanding labor market.
The percentage increase in work pay in a situation
involving increased overtime under different methods of calculation are illustrated below.
Year 1
Regular hours worked
Cvertime* hours


Year 2

Percentage increas'
Yoar 2 over year .




Total actual hours




Total hours equivalent for pay




Hourly pay
TrJtal p.ny



A\OI:;.K;O cay per hour :.c:-cually



Averaoo pay per "regular" hour as
cor.:3Ut?d in Treasury ."i curly




- 94 -

The absence of TIP penalty on overtime as a payincrease factor may seem fair or only properly generous to
the employer who pays a fixed schedule of rising hourly rates
with expanded operations.

On the other hand, a TIP penalty

on substantial amounts of overtime raising pay above productivity-matching levels may help increase the number of
employed persons and decrease unemployment by spreading the
hours of work.

In a situation in which a real labor scarcity

existed, the TIP penalty on overtime might be a disincentive
to the expansion of the effective labor supply.


creates more goods and services but at a somewhat higher marginal cost; while this is one aspect of a shortage situation,
the price of goods and services involved would rise ie.:s-- with
the supply created by overtime than in its absence.

C. Indexation
This section briefly examines the question of the
merits of indexation vs. more direct methods of calculating
the average rate of compensation increases.

It reviews some

standard statistical procedures for measuring compensation levels
and changes.-^

1. Indexation vs. average rat<? of compensation increase

the preceding discussion, the calculation of

average rates of increase in employee compensation for a firm
and indexation have been used almost interchangeably (subject
to a footnote caveat that there is a technical difference?) .

- 93 -

"Si?wi£r of .speaking is understandable since a mere technicality is involved.

The Treasury study of 1970 referred

to the Calculation of a compensation-weightod average of percentage increases in pay for hourly paid and salaried employees
over the preceding year as indexation.

The Eureau of Labor

Statistics currently publishes its Employment Cost Index



quarterly percentage changes rather than in index form to
avoid confusion caused by shifts of the reference base as the
index is expanded in scope.""

The BLS expects to publish

these data in index form when the expansion is complete.


ECI is described as "a fixed employment, base-weighted average"
of changes in the rate of compensation expressed as a relative
of average rates in a reference base period."-^
The familiar fact is that an index number is a
figure which reflects the relative change, if any, of prices,
wages, costs or other variable between one period of time and
another, referencc-d to a time period selected as the base,
to which is usually assigned the index number 100.
average percentage increases in compensation are

Thus, if

by a consistent, reasonable method from year to year, they
are easily translatable into actual index form to a specified
base year as follows:

^1'T.S Mo:isuro~ o: •'To.-irn:i.-:v.tion, U. S. Jopt. o~ Labor, Lureau of
Statistics, 1977, I.ullutin 1(>1I, p. 74.

- 96 -

Year 1

Year 2

Year 3

Year 4




Average percentage
change in compensation over preceding
Corresponding index
(year 1=100)



Year 5


111 . 2 8 ^ 117.96


Indexes are usually computed only for large aggregates such as general price or wage levels, but they may be
employed by a particular firm.

The chances that classifica-

tion problems and any weighting system other than current
year quantities or compensation totals may need to be periodically revised are greater for a particular firm, particularly
a small or medium-sized one>

than for the economy.

2. Would actual indexation be appropriate in applying TIP?

a. Structuring
Indexation in the liberal sense would not seem to
provide any more "discipline", uniformity, or structuring in
the compliance procedures of the firm than a prescribed system of calculating the average percentage increase in rates
of pay in the current year over the preceding year.

b. Roundaboutness
The calculation of the average percentage increase

- 97 in compensation rates would directly provide the figure which
the firm would compare with the guideline (or feed into a
tax penalty formula) to determine TIP liability.

If the

procedure first involved calculation of an index number
referenced to a remote initial year base for
the firm, the average percentage increase in compensation
rates would then have to be derived from the index by the
familiar translating procedure illustrated below.

The index

would then seem to be merely a superfluous step, making for
a less convenient, roundabout procedure for getting the practical operating result* unless of course the base year was moved
forward each year, so that the reference base was always the
preceding year.

Derived percentage increase in
compensation rates for current year over preceding

Year 1

Year 2

Year 3





7- /


An index number such as the consumer price index
which is used for various purposes involving historical perspective cind lonq-rarigo comparisons benveen periods calls for
referencing to an historical base- period.

This increases its

understanddbility and convenience for most users.


in the case of ir.ipleir.cntiny Til-f trie Jocus is primarily on
the current year percentage- increase in compensation rates

29-775 O - 78 - 13

- 98 -

which is to be compared with a conceptually compatible annual
percentage rise in labor productivity furnished to the taxpayer.

c. Cumulative or carryover approach
Special considerations may arise in the implementation of a cumulative or carryover approach (as distinguished
from the annual approach) in determining the application of
a TIP tax penalty.

If the TIP tax was based solely on one

year's excess compensation (presumably then to apply for a
year or period of years) without regard to the excess compensation experience of other, preceding or succeeding, years,
there would be no apparent need for the historical perspective or running record that an index number affords.-^ If,
however, the TIP tax liability is to take account of previous
or subsequent years 1 as veil as the current year's experience,
would this make a difference?

Would the record provided by

actual indexation be more useful than the equivalent information provided by the series of annual compensation rate
increases (which are after all an alternative to, and the raw
material for, a true index).
Suppose, for example, the TIP specifications called
for the carryover of below-guiaeline pay increase experience
for 3 years, in order to reliovo wage catch-up adjustments in
a particular year that merely made up for several prior years
of no increase or low rate o_ increase caused by an outmoded
3-year contract (or whatever).

The pay rate increase percentages

^ iX;_-.; ti. or. o ' L;n.» Til pon-ilty L«-ir. is ossonLi.'il ly distinct I run;,
and inrj.--p ••rl;.oni_ -C, t'r.c. . -z^ciCiciLicn yiL'.i r.'Qc.rd uo accumulation
or f.v.rr\ J/: r •..•iir.::\ na.i L O Ho vi^ii cr'jciii: i::c; ciflfir.". for i-irioi."
y t? -j r

fv > 1 ci •: . o i c 1 •:? 1 i >\c

\:c\ z\ n


- 99 -

for a 4 year period for a particular firm relative to the
guideline are shown in the first bank of the tabular presentation below.
Application of a cumulative guideline and a compensation index for
the firm is shown in the second bank.


Average percentage increase
in compensation rates over
preceding year















Compensation index to
year base=l00





Cumulative guideline
expressed as index









The 3-year carryover of unused guideline leeway
would permit the firm to be exempt from TIP liability in year 4
because the cumulative deficiency of -5 percent for the years
1-3 (-l» -2, -2) would offset the excess of 5 percent in year A.
Would the availability of a conventional index number make the
implementation of the carryover principle any easier?
answer seems to be no.


The carryover would be effectuated

essentially by adding up algebraically the annual figures for
"Excess" (guideline minus firm's average percentage increase
in pay rates).

- 99a -

If the index number were the starting point
for implementing the carryover, it would merely have to be
translated bade into annual percentage figures for the average
pay rate rise.

Cr the ceiling on pay rises in year 4, for

example, would have to be expressed in terms of a cumulative
rise in the firings index over the period beginning with the
earliest carryover year (year 1 ) . The latter procedure would
seem to be somevhat cur.\bersor;.e and less understandable than
the annual rate method.

It would also give slightly different

numerical results since the result of compounding growth rates
which add up to a given sum will vary with their order of occurrence.

- ioo -

d. Interplay of "long-play TIP penalty tax and carryover principle
How would an index serve under more complex carryover
and tax duration rules?

Although duration of TIP tax and the

carryover principle are essentially separate concepts, there
would be an important interplay if the TIP specification, for
example, called for a long or indefinite duration of tax with
respect to a'layer of excess arising in a particular year and
also a carryover of credit for years when wage increases were
below the guideline,

Assume the following sequence of com-

pensation increases in relation to guideline standards:

Year 1 Year 2 Year 3 Year 4
Finr^s percentage increase










Excess for year





Cumulative excess
(TIP penalty tax base)

In the circumstances shown above, the firm would
incur TIP penalty to.:-: based on an excess of l percent or payroll in year 1; 2 percent, in year 2; 2 percent aoain, in
year 3.

In year A its current below-guideline vaco expedience

of 2 would wipe out the previous cumulative excess of 2 and
exempt itrro:'i TIP tax in year 4 (and thereafter ur.uil a new


excess developed.
The same experience, applying cumulative guideline
and compensation indexes is shown below:
Year 1

Year 2

Year 3

Year 4

Firm's compensation index





Guideline (cumulative,
expressed as index)
Excess (cumu. a t i vo )


2 .11



Again, there seems to bo no particular advantage in
the case of a true index figure as against a cumulation of
successive annual disparities, positive or negative, between
the firn^s average percentage pay rise and the guideline.
This brief analysis illustrates the operation
of a possible set of TIP specifications the policy


of which go beyond the compliance and administrative merits
of indexation versus simple annual measurements of percentage
pay rate increases.

One effect of these specifications is

relief for catch-up vage settlements.

The other is both (a) relief

from continued duration of a "long-play" TIP tai-c penalty based on
cumulative alignment of wage policy with guideline objectives and
(b) continuing pressure on the firm which has exceeded the guideline not merely to get in line with the current guideline but also
to compensate for past excesses with below-guideline wage adjustments.

- 101a -

3. Some official compensation indexes
A review of possible methods of computing average
percentage increases in pay rates or constructing index numbers
is outside the scope of this report.

The selection of the

TIP specification in this regard would call for a review of
the considerable range of averaging, weighting, and indexing
procedures now in use or described in the extensive technical

Nevertheless, a quick review of some of the existing

- 102 -

compensation indexes is instructive.

a. BLS compensation indexes emphasizing measurement of change
There are a number of official BLS measures of compensation which suggest possible procedures or variations for
use in a TIP program.

The BLS compensation series include

some 12 measures (or groups of measures) concerned with pay
levels or pay changes.

Of these 12, 5 place emphasis on

levels of compensation; 3 are concerned with both levels and
change; and 4 place emphasis on measuring change in compensation rates.

The four which emphasize measurement of change are:

1) Hourly compensation measures of the Office of Productivity and Technology,
2) Developments in major collective bargaining units,
3) Wage developments in manufacturing, and
4) Employment Cost Index (SCI), now published and in
process of expansion.
None of these measures is tailor-made to provide
exactly the data gathering format apparently needed on an
employer basis for a TIP initiative.

However, ECI is de-

scribed by BLS as nee ting a need "for a comprehensive measure
of change in the price of labor (defined as the rate of compensation) comparable to the treasure of chance in the price
of comnoditic-s provided by the Consumer Price



BLS further indicates that "The to understand and cope
with inflation in the late l9G0 f s provided the immediate stimulus to fill this gap in our national statistics."-'

-^Suo n:.S "c-.-iSuros oT Co.:^n:^tion, U. S. Department of Labor,
bureau of LaLor Statistics, 1:>77, bulletin 19*1, e&rpecially
Table 1, pp. 4-6.
-'Ibid., Chapter 12, p. 73.

- 103 -

The BLS indicates that the ECI "will provide, for
the first time, a comprehensive and timely measure of changes
in the rate of employment compensation, free of much of the
influence of employment shifts."

In addition to uses in econ-

omic trend analysis and forecasting, the BLS feels the ECI
"may be of use in the formation of wage decisions by parties
to collective bargaining and in contract cost escalation, as
well as for those presently unforeseen uses which inevitably
arise from the ingenuity of users."-^
The compliance tasks which the collection of the
ECI compensation data on a quarterly basis imposes on a
sampling group consisting (at time of description) of some
2,000 establishments seem to be greater than those involved
in compliance v;ith TIP, chiefly because of its quarterly
reporting requirement and the detailed occupational coding it
calls for:

some 417 occupational categories.

b. Employee classification issue
It appears that the F.CI is designed as a Laspeyres,
fixed-weighL index at the occupational level in order to
eliminate the effects of employment shifts a:nong occupations.
The index weights remain fixed fro.n period to period pending
a major index revision, next scheduled to occur when the 1980

-'Both quotations in this parccraph arc from BLS Measures of
Cor.pens.11ion» previously cited, Chapter 1 2 , p. 75.
- / S O G T31.Sft-yridhr'.-i::o f "pL'^r
^, I.'. -. D--»ot. of Labor, "ureau of
Labor :jt;..tiii:ics, l//6, ;ir!oLiri l.r-l0, 7:iaoLer 2 5 , especially
pp. 3JJ5-167.

- 104 -

Census results become available.
This prompts the question whether and to what extent
the use of "moving" current year (or preceding year) weights
based on compensation or numbers of employees under the TIP
plan, with or without fairly numerous occupational categories,
would give rise to significant distortion due to shifts in
occupation or classification by employers.
Table 3 below reports the results of an exploration
of the effects of different employee classifications —


valent to an occupational shift of employees from one period
to another —

on average percentage increases in compensation

as computed under different averaging procedures.

This simpli-

fied illustration shows that the same overall payroll, the same
number of employees, and the same percentage increase in total
payroll and average compensation por employee from year 1 to
year 2 will be reflected in different measured average increases
in the rate of compensation merely as a result of using a different method of classification of employees.

The exception shown

is the weighted average of relatives method using year 1 (base
year) compensation-^ weights.

Where the quantity (employee years)

are constant, as assumed in the Table 3 illustration, this method
merely reflects the percentage increase in total payroll.

^ T h e reason for the classification neutrality of the year (base
year) compensation weighted average of relatives is evident: the
numerator of the averaging fraction calculated and the sum of the
class compensation figures each multiplied by the percentage pay
increase in the particular class is always equal to the total pay
increase no matter what the classification method. The denominator
is also the same, the base year payroll.

- 104a -

The differences in the measured average percentage
increase in compensation rules are not absolutely larce in
this example by ordinary standards.

But they would have a

significant impact on TIT liabilities.

The difference boiiv/een

Classifications A and ?, '.rouid result in a .023 pcrcontcicjo
point difference using year 2 compensation v.-eiyriLs -- equivalent to a 1.6 percent impact on the TIP- tax base.
is larc:^ using

The difference.

nu;.ij?ors of e m p l o y e e s as vei-.jM.s i.i chip, excsir.plo.


Table 3 Illustration or effects of employee classification
on average pcrcop.tor'O pay increase
Year 1
Year 2
Classification A
Class of employees
employee ,'.vcrnc."C Average Total percentage
pay increase in pay
(Lhou) yr 2 over yr 1
Hourly paid


Hourly paid

$9,68 0
$0, 830
37 3
100 . 51,500 . 103
11,957 1,100
12,750 1,173

Classification 3
3 GO
200 ' 20,300
100" 51,500
11, *>57" 1,130
12,750 1,173

Summary of results:
1. Average pay per employee
2. Payroll (total pay)
3. Unveicjhted average pay increase
Classification A
Classification 3
Excess P over A
4. Weighted average of relatives
(a) Compensation year 1 •..'•eights
Classification A
Classification B
Exccss 3 over \
(b) Compensation /car 2 voi'ihts
Clot.slJirai.ici A
Clo£:«iric.;Lion Ii
'•.:<cr.<;:3 3 o v ' o r A

5. .."Gif:ht<?t" a\er-..;o oZ r e l a t i v e s
E-.ipioyoe-yoar •.••ei;..i-.t«
Classification A
Cli-:-:.-5irirj:t;io:i ">
E;:cc>iS ?"J over A

(total pay)
(total pay)

Percentage increases

- 106 -

Thus the increase in compensation rates from year 1 to year 2
under the average weighted by numbers of employees is 7.728
percent using the 5-class system of employee classification
as against 7.565 percent using a 4-class system.

The dif-

ference of .163 percentage point is equivalent to some 6 to
6.4 percent of the potential TIP tax base as determined by
the differential between a 7.728 or 7.565 percent increase
and a 5 percent guideline.-^

c. Lessons drawn
This example shows the possibility of an employer's
utilizing the- classification of employees for TIP purposes to
reduce his TIP tax liability.

Under either the current year

compensation 'weighting or numbers of employees v;eighting systems (but not the prior year compensation weighting system)
as shown here, the employer could reduce his Til tax
liability by reclassifying custodial-maintenance into the
hourly paid category of employees, i.e., by switching do facto
from Classification 13 to Classification A.
In more general terms these results with respect to
classificution effect^ (not to be confused with upgrading or
d o wig r a d i ng ) i n d i c a to:
-- possi'jlo e r r a t i c rc-su] L S dope: r.d i..:j upon 'jmloyoc?
— inr:;uil.ip:. •::-.1x?!.;-.ron fir:.?;;. u,;on Lhc clr.ssif icvt i 'JIL : y.Lem •-•.sod t.:o configuration a/ •s' in
e-r»ployi T CJ. p._\s i;. i on
-- potenLi : 1 re v:\irds to :.iar.ipu:u-.Li cy.\ of c-'-oir.yc-e- cl.ass-

-' . l»31*'. 7.7:',"-;^ --. C O ^--rc.-r.i. .:.rl . l->'if 17. 303--3) - u.-l p o j e c n t .

- 107 t^c
ncecl Tor careful study of the classification issue
in formulating indexation methods for a TIP initiative

the need for careful monitoring of firms 1 classification rules and practices in the administration of TIP.
— use of the weighted average of relatives system with prior
year compensation weights (or equivalent aggregative) would
avoid this source of distortion, but might not be otherwise

D. Methods of pay increase measurement followed in past episodes
of wage stabilization
Anything resembling a full review of the various
historical episodes of v:ace stabilization and the methodology
involved is necessarily beyond the scope of this report.
A study of the experience under the guidepost efforts
of the l960»s has been published by The Brookings Institution.^
This study, vhich includes a selected bibliography, reviews
and appraises the guidepost concept, its evolution, and its
implementation from a broad policy standpoint.
A particular practical aspect of the experience
under wage-price guideposts of the lOGO's in the KennedyJohnson Administrations and the subsequent guidelines and
controls of the Nixon Administration of special pertinence
for purposes of this report is embraced by the questions:
How were vrages (or total employee compensation) measured and
rates of increase determined in applying the guideline benchmark to a particular firm or industry?
used in getting the required data?

i.hat mechanisms were

what were the data sources,

Have nev data since boon developed vhich vould better serve
a TIP initative?

--/..":ohii 3h(.Mnnn, T':r; '.iyi>!:rin' r.'ui.::r>i'.:-:L-,, T}\? "roomings
lnst.icuLi.on, .*as-h i.u;j ton: ivo7.

- 103 -

In answering these questions, we leave aside the
productivity measurement aspects which do not directly imp inc. e
on the tasks laid out for this report.

r>Jcr is this report

directly concerned with such ancillary matters as the measurement of increases in real versus value productivity of labor
in an inflationary economy or the merits and implementation
of a cost of living (COLS) adjustment.
From the best sources immediately available it
appears that no single DLS data scries was used.

Wage settle-

ments were approached on a case-by-case basis and with a certain amount of flexibility, possibly in implicit recognition
of differences in labor productivity between firms and industries which might theoretically call for individually tailored
guidelines. These differences may have been allowed for by
flexing the determination of the additional labor cost (compensation rate increase) which was to be compared with an
inflexible ccono.\iy-v:ide coiling of some 3 or 3.2 percent.

1. "Costing out" collective bargaining settlcr-.c-ntr.
The task involved in evaluating wage negotiations
or proposed settlements W«JS that of a "costing-out" approach, is provided
sation increases involved.

iaforr.iation oZ this type*

or v:hich

cnploys the equivalent o." "cootiiu/j-out" approach, is provided
in the "•Dcvr'loc'-.cnis in -na jor collective barc/ai.ii.-r;.1 units"
series on employee c-ompencdtion.

1'his is saia to have been the major

onrce relied on in the implementation of the guideposts and

- 109 -

These data, reflecting pay rate changes in cents per hour
and percent, are published quarterly by BLS in Current Wage

They related to wage rates and private supple-

mentary benefits for production and nonsupervisory workers:
wages for workers in bargaining units of 1,000 workers or
more and wages and benefits combined for units of 5,000 or
more workers.

The industrial coverage is the private non-

farm economy.

The 3LS data are apparently developed largely

from secondary sources.

The BLS has described its general

procedures but has never published data or forr.ulas used in
particular cases.—'
Although not limited to manufacturing and not
specifically cited by BLS staff familiar with guideline procedures in the past, the current wage developments series,
often used to determine trends in wage and benefit changes,
is pertinent.^

2. Compensation per nanhour
Other BLS compensation series, which give an overall
view on compensation trends and the performance of wage settlement
procedures are the hourly employee compensation measures- of the
Office of Productivity and Technology and the average hourly and
weekly earnings data for nonagricultural establishments.-'

d e s c r i p t i o n i s b a s e d on c o n v e r s a t i o n s w i t h BLS --staff a n d
t h e f o l ] ov.inq p u b l i c a t i o n . - :
->I S >•<-'. irur'.:?s o:7 Cv. ?:o..s:i-io;i, LJ. S .
D c p t . of L a b o r , B u r e a u of La "cor S t a t i s t i c s , 1 9 7 7 , :.Jullt»:,ir. 1 9 4 1 ,
T n h l e s 1, p . 5, rrnv. U h . ; o t e r !•:, p p . C i - 0 7 ; t l nd JLS ii.-t^.d'-ook c f
Molihoas, 1 J 7 U , - l u J l c c i n l r ' l 0 , C h a p t e r - 1 , p p . TTTT^TuT.""
•^Sire \JIJ_ 1li?^7-i_r^Vi_C':"_ : ^L_I^^j_ t i f £ , p r v i c j . J i l v c i t o d , Tr.ble 1 ,
p . 5 ana : ; ^ r'.t.:;J"--.\jo'": ~l~: ...•-. ":.".. t ChapwOt: 2 C , " p p . 1 5 4 - 1 6 6 .
^ B L S Measures o f C o m p e n s a t i o n . Chapter 9 , p p . 60 fir. and Chapter 5 ,
p p . 29 f f .

- no 3. Employment Cost Index (ECI)^'
BLS staff point to the relatively new ECI series,
now in process of further development and expansion, as
being the best single current measure of the price of labor

It was not available during the period the guide-

posts and guidelines were in operation, but apparently would
have done better in export opinion than the other data available at that time.^/
It should be noted that the LCI method for national
indexation purposes involves pricing a fixed "market basket"
or "package" of labor over the years and relating that package
cost to a fixed base period cost, the package to be updated
only at Census-taking intervals.

This lengthy retention of

a fixed quantity weighting would not seem to be suitable for

Where individual firms' indexes are subject to relative}v

quick and easily ascertainable changes in the weights with
the firm, each preceding year may be a new base year.

E. Definition of the taxpayer unit
The chief technical problem in the definition of
the TIT taxpayer is ho\: to treat multi-corporate enterprises
in Lheir various r.ani res tat ions , ir.c.U;::i;::: ( j.} ordinarv

- ^ L S Measures :)f Cr..rf:.::ti.on, previously cited, Table 1,
p. 5 a nd r e 1 a t. " cl r •.:.«". y c n c o s .
^ T h o D C I is doscrilr:?d ?.nrl d i s c u s rod briefly e a r l i e r in this

29-775 O - 78 - 14

- in controlled corporate groups consisting of parent and affiliates largely operating in a particular industry; (2) conglomerates —

controlled groups embracing affiliates in

various essentially different and unrelated industrial activities; (3) changes in corporate ownership of affiliates, including reorganizations, potentially affecting the practical
definition of the TIP taxpaying unit; and (4) the exclusion
of foreign subsidiaries.

1. Controlled corporate groups

a. Importance in the economy
The bulk of A-nerican corporate business activity is
conducted by controlled corporate croups.
under common control

Affiliated groups

of 80 percent or more have the privilege of filing

consolidated returns under sections 1501 and 1504(b) of the
Internal Revenue Codo, with the exception of special categories
of corporations such as certain insurance companies,-' regulated
investment companies and real estate investment trusts, a
DISC or former DISC <I!*<: isec. 992(a)), certain sec. y3b
possessions tax credit corporations, and foreign corporations.
However, many affiliated groups do not file consolidated
returns although t:.ey aro nov: denied multiple surLnx exemptions
wheel if* r they "ile separately or on a consolidated basis.
In 1973, U:o latest year for which complete data
are published, r=o:..e 3.1,-P0 consolidated returns were Jilcd
ttith a total of lfjj,573 subsidiaries, en average of about 5
sulr.^i^i.irio-, per :oiur::.

C ." Lho 3.1,-190 co:::-r>lldaLfv3 returns

-'New rules apply permitting inclusion of insurance companies
in a consolidated return beginning in 1981.

- 112 -

some 21,558 or G8.5 percent had net inT...e, while the remaining
9,93? or 31.5 percent reported deficits.
The total net income of those reporting net income
amounted to $73.5 billion.

After deducting the deficit total-

ling $0.1 billion for the deficit group, the net income of
consolidated groups overall amounted to $67.4 billion of
which some $66.4 billion was subject to normal tax, surtax,
and alternative tax.
Consolidated returns accounted for total receipts
of $1,227 billion, about 48 percent of the $2,558 billion
total for all active corporations in 1973.


return assets of $2,080 billion accounted for 57 percent of
the total $3,649 billion assets of all corporations in 1973.

b. F o tent i a 1 a p.or".a lies c\nd inequalities;

TIP tax she? leers

Since a corporate group under common control of 80
percent or more is in effect a single, albeit complex and
possibly diverse enterprise, the prescription should apparently be, particularly if it is consoi ida ted for corporate i;ico:.-o tax purposes, that it should bo r.roatod as a siiujlo taxpayer for TIr
ar; ve-ll.

i:o'..'over, there :.iight bo difficulties and drawbacks

in treating the consolidated return cntr.e-prisp di :" "ore. ntly
frorr. a non-consolidated croup in c-ssc-ntiall y the :•;,-...'.<-? posture
with re:.jard to Tli .

In a largo corporate •.. roup, c;;co33 V J C C S

for Lho vhole enterprise r.-.i-.-'ht. \:J tho ro;;k;lt of a Ic.rcjc excels
— Data in this section compiled and computed from information
presented in Statistics of Income 1973 Corporation Income Tax
Returns, Department of the Treasury, Internal Revenue Service,
(Publication 16 (11-77) Table 2, p. 14 and Table 17, p. 145.

- 113 in some parts of the multi-corporate organization only partially offset by small increases (or TIP "negatives") in
other parts.

On the other hand, situations would exist where

large excesses in some of the corporate segments might excape
TIP restraint or liability because other segments had small
compensation increases.
Affiliated groups may have net income while some corporate members of the group have deficits; on the other hand some
members may have net income which would be submerged for tax purposes if offset against deficits of other affiliates.
c. Labor-management strategy
Glaring disparities and anomalies of this character
might seem more striking and unjustifiable if the controlled
group was conglomerate in character.

Upward pressure on

wages in a particular industry would not be fully contained
by TIP if large units of the industry were part of larger
industrial conglomerates which in effect gave them a substantial cushion if not complete shelter.

The inequity would

appear striking to independent competitors forced to pay TIP
as a result of wage settlements forced upon them in part
because the conglomerate-hold segment of the industry was
TIP tax-sheltered and did not have the TIP incentive to resist
••excess" wage settlements.
Other possible effects merit attention.

i.'ould labor

unions follov a stratccy of first applying pressure on an
industrial- unit surrounded and protected by its conglomerate
affiliates in other industries, a settlement in this soft
spot thus weakening the position of others actually subject
to T1F?

What other impacts on, and distortions of, labor-

- 114 -

management economic incentives and strategy vould occur under

d. Interplay with form of tax
Excess wages appearing only in a particular segment
or subsidiary of a consolidated group (generally in conformity with
the guideline) treated as a single enterprise might result in a
penalty tax on the net income of a much larger whole if the TIP
tax penalty took the form cf an adjustment of the corporate income
tax rate.

This effect is one aspect of the general problem of

potential disparity between excess compensation and the TIP tax

It would be avoided under TIP plans relying upon disallowance

of deductions and similar tax penalties which singled out the
excess compensation as the TIP tax base.

3. Discrimination depending upon consolidation versus non-consolidation
If the TIP penalty tax took a form which resulted
in a larger penalty on a given excess wage in the hands of a
consolidated group than in the hands of a separately filing
corporation, there would be a tax incentive to file separate
returns, possibly great enough to override existing tax advantages of consolidation.

Dcconsolidation might result.

Cr in

some situations corporations might arrange to reduce control
over certain affected subsidiaries-below the critical SO percent figure in order to segregate their TIP tax problems fro;n
the rest oz the enterprise.—'

a i"f i: L.VOC"


- 115 -

The reverse type of tax differential might occur
where a separate corporate business incurred TIP penalty which
would be avoided by achieving "shelter" within a corporate family.
This would tend to encourage affiliation and/or consolidation.

f. Possible "i,~ tidiLory re;-! ^ol ic\i tio-i
To conhat deccnsolidjition, rclir*cuishivient o" troublesome subsidiaries, and discrimination botv.'C-o.i separate? and
consolid.VuCvJl filir.c;, it ir-icht :.e p-.jr.sizlc to :.<-:;:o c;.>r:.-;ol iaaLcd
returns mandatory for TIP purposes.

This would jc«n a rather

heavy and cumbersome step, however.

g. Separate filing for Til' purposes
Another alternative to deal with tho unintended
side effects would be to apply Til- on the basis of each separate corporation, whether filing on a consolidated basis or
separately for corporate income tax purposes.

This would be

easiest if the TIF tax applied to the wage deduction or excess
wages as such rather than as an adjustment of the rate on the
net income, since separate determination of net income of
consolidated subsidiaries is difficult and subject to distortion.
Making the TIP taxpayer unit the corporation would
do several things

helpful to TIP administration:

— eliminate discrimination between multi-corporate and
unicorporate organizations

- 115a -

— remove possible? TIP tax incentives to consolidate,
dcconsolida'c:-, disengage subsidiaries, add subsidiaries,
and the like
— avoid the distortions and side effects previously
mentioned ovin^j to the rnin^lirv; of different businesses
in different excess wcico postures
— neutralize the wh;>lo issue of the comparative treatment
of cony loine rate and non-cone,"lcrriCrate v^ulti-corporate
There would remain a possible problem of TIP tax incentives and distortions due to the possibility of marshalling labor
assignments among members of the multi-corporate family.

A related

problem would be the appearance of ineguity or hardship if a particular corporation incurred TIP penalty although the corporate
group to which it belonged would not.

The claim would be made

that the TIP penalty was an accident of disaggregation.

The pres-

sures encouraging consolidation or deconsolidation under the consolidated approach might reappear here in the guise of tax choice
problems affecting separate incorporation

versus disincorporation.

- 116 -

2. Conglomerate problem
Should an exception from the generally applicable
rules for defining the TIP taxpayer unit be made for conglomerates?

How should a conglomerate be defined for purposes of

such an exception?
It seems superficially attractive to separate out
the various non-homoceneous industrial components of multicorporate conglomerates to prevent "hiding" or "sheltering"
excess wages in one industrial category under the more moderate wage increases arrived at in other industry components.
There are certain obvious answers to this approach:
1) There are unicorporate conglomerates or near conglomerates. They would get the same TIP shelter for some
components as the multicorporates but would bo hard to
divide into separate TIP taxpayers.
2) Multicorporate corporate conglomerates could escape
heavy TIP liabilities by reorganizing on the division
3) Multicorporate giants may operate a considerable range
of businesses, ir.vnivinn H-1 ?^rpnh w^rrp neaotiations,
although not quite as heterogeneous, variegated, and unrelated as the
more recent conglomerate ventures. Traditional parts of
the economic landscape, they r.iqht avoid or resist a
definition as conglomerates for TIP purposes.
The whole problem of sheltering certain wage guideline
excesses under the good behavior of other corporate members of
a multicorporate conglomerate consolidated for TIP purposes
(or of other industry components of a unicorporate heir to a
previous multicorporate conglomerate complex) actually stems
from the implicit assumption that the TIP tax penalty is determined on a business-wide basis.

- 117 -

If the conglomerate or near conglomerate problem is
deemed serious, the assessment of excess wages could
be determined on a sectoral basis, with or without averaging
of compensation rate increases for the skill mix of a particular sector.

The penalty could be applied directly to, or

based on, the excess for that sector.

There would be no

"spillover" of penalty on the entire earnings of the whole

The application of this rule as an exception to

the general averaging system of calculating compensation
increases could be narrowed down further, if desired, by
limiting the separate-sector approach to conditions in which
there was both:
— substantial industry code disparity between the
industry components involved
— a marked difference between the rate of compensation
increase in one industry component as compared with the
rates of incre^c in the rest of the business.
The remedial approach suggested would not necessarily
be limited to multicorporato conglomerates.

It could be applied

on an establishment or division basis for the unicorporates.
Problems of achieving consistency between current
year and preceding year i'o,\se year) experience could be? resolved
if necessary by using current year labor quantity or Lotvl conpensation weights in arriving at chc» average increase in compensation rates over the prior year.

- 118 -

3. Changes of corporate ownership of affiliates
Changes in the composition of the affiliated corporate group due to acquisition or divestment of control of
of subsidiaries presents several possible problems:
— acquisition of affiliates with "good" wage settlement
experience to average against, and wipe out, excess
compensation in others,
— acquisition of affiliates confronted by a substantial
TIP liability by a corporate group with a margin of wage
increases below guideline level in order to offset the
new affiliate's excess
— disposition of shares below a controlling interest
level, of affiliates which might subject the enterprise
to a TIP tax penalty that might be avoided or reduced if
the affiliates were segregated for TIP definitional
purposes, and
-- possible difficulties in establishing consistency in
the definition of,an enterprise as between current and
preceding years."
Most of these "problems" may be dismissed as part
of the inevitable process of economic adjustment to a changing
tax environment and not seriously damaging to the essential
integrity of TIP.
Some may be dismissed as non-existent or dependent
upon a particular formulation of the TIP tax.

For example,

disposition of "control" of an affiliate with an impending
excess wage situation would not necessarily reduce the eccnomywide TIP tax liability except under specific structural assumptions, e.g., that the ril tax is imposed as an adjustment of
tax rate on not income and the affiliate has little or no net

If the TIP tax wore imposed on each corporation rather

than on the multicorporatc controlled group arid on the excess

': ">l'. :

frir 1 :-'^-•;
r p . o:-






.-.- . i v : 1


t.- ;

^ ^ - l i ; ' - ' -


•-. 7

1. : -\ • • i 1 : r


.;;-.:-; i ;

' '.-. •

-• i -.-.:.-•,. i j..



.. .7

t; >j].: j <-;. \

-v;.:i r ••.-•.:• '•'...


c-;;.-,'-. i :•.:•:!.



- 119 -

as such, the "problems" of acquisition and disaffiliation would
Assuming the TIP tax formulation to be related to
the multicorporate controlled group as the taxpayer unit and
the tax to be applied as a rate adjustment on net income (i.e.,
assumptions making the system most vulnerable to this kind of
manipulation), measures could still be developed dealing with
all of these taxpayer maneuvers if this were considered important.

For example, a multicorporate entity in year 1 might

be considered to remain intact for TIP tax purposes in year 2,
disregarding acquisitions and divestments for the next year
or two.
If the legalities prevented this remedial approach,
special tax sanctions :r.ic;ht be imposed on corporate acquisitions
or divestments to avoid tax.

For example, a TIP tax supplement

might be imposed equal to the TIP tax avoided ty the corporate

Such a rule might be extended to cover property

transfers between corporations which
shifts in employment.

^tailed corresponding

A precedent for the latter approach is

the present section 269 of the Internal Revenue Code which
disallows deductions, credits, or other allowances obtained
as a result of acquisitions of corporaLs control or property
of another corporation mado, directly or indirectly, to evade
oi avoid income tax.
Still another approach would be to raise the percentage
ownership and control tost fro:.', say, 30 uo 100 percent in the

- 120 -

case of acquisition and lover it from 80 to, say, 60
or even 50 in the case of divestments which substantially affect TIP liability.

Such adjustments of the

control test for TIP purposes would be temporary - effective for two or three years following the initial change
of ownership.

This would not remove the possibility

of acquisition and disposition of corporate subsidiaries
to manipulate the TIF tax base, but it would make it more
difficult or impracticable by ruling out transactions in^volving a small margin of control around a preexisting
percentage 3uch as the present 80 percent test for consolidated returns.


Foreign subsidiaries and branches


The treatment of foreign subsidiaries for pur-

poses of TIP should not be difficult.

They would be excluded

since they represent a segment of the corporate groups
business which is outside the U.S. domestic economy,
the ..stability of which is the concern of TIP and with
reference to v.-hich the TIP guideline would be developed.
No technical cr adir.instrativc problems seem to be involved
in this specification, except for minor ones such as
(1) the policing of possible payroll switches at the
executive level hotween foreign and domestic subsidiaries,

- 121 -

and the (2) semi-technical question whether dividends

repatriated earnings of foreign subsidi-

aries should form part of the TIP tax base, if the base
were corporate net income.

Exclusion of foreign subsidearies from the
corporate group for purposes of TIP presents the issue
of comparable treatment of foreign branches of U.S. enterprises.

The familar general rule of U.S. income tax

law is that a domestic corporation is taxed on its worldwide income. In this treatment, no distinction is made
between income from sources inside and income from sources
outside the United States. .U.S. tax on foreign income
may be reduced by the foreign tax credit (for foreign
income tax paid on foreign branch earnings).
Within the spirit and concept of the exclusion
of the secf.nont of foreign economic activity represented
by foreign subsidiaries, there should

be a similar

exclusion of tho branch activites, payroll, and income
fom the do to rrr.i nation of T1F.

Since a foreign branch is

more of an integral part of the domestic corporation
for account in-3 and tax purposes, Lhere night be some
difficulty in such a disappreciation.

I-Iovover, the prob-

lem dors net appear to be substantial, particularly since
the major focus of the? disacjorogatior. would be- jobs and

- 122 -



Western Hemisphere trade corporations
ht least part exemption would also seem to be

appropriate for V.'estern Henisptere trado corporations,
which - although domestic corporations - do all of their
business, other then incidental purchases, in i\orth,
Central, or South America, or in the V,:est Indies and,
among other tests, derive 95 percent of their gross income over a given 3-year period preceding the taxable
year from sources outside the United States.
To the extent these corporations have payrolls
for employees located outside the United States, they
should be exempt for TIP.

Whatever employment base

they have in the United States should apparently be subject to the usual TIP restraints on economic compensation



taxable incor.e from related foreign

"Constructive taxable income from related foreign corporations", a portion of the net incone base of
domestic corporations presumably should not be a part
of an income to which a TIP tax adjustment should

Such income amounted to $3.1 biilion in 1 9 7 3 . ^


• ^ T h o p u b l i s h e r 5 ^ i q - r e c o n s i s t r o f t h o sum o f ( 1 )
inclinab l e incor.;o f r c n C o i i L r o l l r - d / o r o i ' - n C o r c o r p t-' o n s a n d
f o r e i c j n d i v i d : .\C i:ico..'.c r c r » a l L i : ; - fro.-.i* ^ o r o i r - ; : t,.:::os
Jc-c *••(.- ' . : Li-.r.
•." Mu. . -^ 1 "'7>
' J j . v p o r r . L i o n In—
co.ViC 'TV>:: " ^ c t i i r . - . s , . > . ' ; : ' c . zi
^r.c : .•••?. i r u r v , i r . u c - r r . a l R e v e n u e S o r v i c c , i u ;1 i c ' j u i o n IC ( 1 1 - 7 7 ) pp". 1-1, 1 5 7 ,
1G21 0 3 , and ^ e l a t e d r c T s .

- 123 -


Timing problems
The formulation and implementation of a TIP

plan entails a variety of technical design and administrative issues that come under the general rubric of

These include provisions for (1) start-up

and transition questions, (2) nonconterminous tax and
wage contract years, (3) preexisting and multi-year contracts, (4) new firms and defunct firms, (5) catch-up
wato settlements, and (6) coordination of guideline determination, measurement of compensation increases, and
the timing of tax payment.


Start-up and transition problems
This dis^Uosion first outlines the problems

and unvarnished criticisms, then offers constructive
solution approaches.


Effective date of plan
A TIP plan, like certain other tax proposals

v/hich are likely to elicit advance adaptive behanvior
by affected taxpayers once they are put on notice, involves
the problem of the "effective date."

Unless the effective

dato is actually S O L as of t/.o cir.c Lh? proposal is
submitted Lo, or at least whon ip.Lroduccd in, .the ConcjresF* busincsj and laior rcpro;;ent.ativos .nay t:,kc advantage of the delay to work out anticipatory wage settlements.
If all wage payments or increases are treated alike for TIP
purposes, regardless or the date of the wage settlement or contract, the problem of preadaptive behavior would not be serious

- 124 -

unless there were protracted Congressional consideration which
permitted wage increases to be put into the ititial base year.
Thus, the main design issue here —
immediate effectiveness of TIP —

one of importance to the

is whether compensation

increases pursuant to one-year, two-year, or even three-year
wage contracts (sometimes with scheduled year-to-year pay
rises) entered into prior to the actual effective date should
be given blanket exemption in the determination of excess compensation for purposes of TIP.


Preexisting contracts and "catch-up" settlements
Apart from the problem of anticipating wage settle-

ments designed to "jump the gun," whenever a TIP plan is introduced it will of necessity make its debut in the midst of preexisting labor contracts.

Taxpayer firms will have no control

over scheduled pay increases under contracts entered
into prior to the effective date of TIP.
Would it be fair and legally acceptable to
treat wage increases pursuant to prior contracts in the
same way as others?

Would it be feasible to distinguish

on the basis of date or the facts cind circumstances
between (a) contracts entered into technically before the
effective date of TIP but actually consummated in contemplation of the legislation and (b) those entered into
before Til- was publicly presented and discussed?
Where preexisting contracts cover a number of
yo?.rs, Llioir renewal vould often tend to involve some

- 125 -

belated recognition of prior years' inflationary impact.
The? renewals vould thus enilrody "caLch-up" increases both
to put the ncv v:a<jo schcc.ulo on tc.ic!; *.nd possibly co
recoup some of the accumulated deficiency of the runout period under the old contract.
As a matter of prudent strategy it would appear
appropriate to minimize exclusions on the basis of equity
for corrective catch-ups or lack of notice to prior commitments and to resist provisions for special administrative
or discretionary relief.

The number of hardship cases would

not justify opening the door to claims for relief based based
on unwritten agreements, implicit understandings, and the like,

Start-up data requirements
Even if a prompt effective date is secured so

that taxpayers connot claim they were not put on notice,
some analysts have suggested there may be the problem
of having insufficient information from tax returns or
internal business payroll accounts to put the plan into
immediate operation,

iiome argue that ordinary accounting data

on total compensation and corresponding numbers of hours or
equivalent employee years may not be enough to permit systematic,
consistent calculation of rates of compensation and the
resulting vei'-ated average or index figure.-'
Some lapse of time would occur, they contend, before
the data collection system required could be mounted and
put into reliable operation.

29-775 O - 78 - 15

Data for the year prior

- 126 -

to the first taxable year would be needed on a reliable
basis to measure the first increase.

Unless the first

••prior" year data were obtained for a period with respect
to which the taxpayer and labor did not have an opportunity
to "jump the gun", the plan could start handicapped and
bearing the onus of actually scelerating wage increases
that otherwise would not have materialized so early
and under such artificial tax stimulus both to get increases in early without penalty and to establish a high
initial base.
. Such critics contend that unless a preemptively
early effective date and relatively simple data requirements are made part of the plan a wave of large wage
settlements may be made during the anticipatory startup period.


New companies
Critical analysts point out that start-up

problems of the type described for the initiation of
the;, system will be renewed in part (and with variations)
on a s.nall scale every time a new firm is born.


r.ow Cirrr. -..-ould not have a payroll or pr.y scale record.
It vould almost automatically seem to enjoy a first
year of exemption fror.i TIP tc.::.

The advantages of "nev-

noss" under Tl? .:iicjht f.iur> encourace the for. in Lion o."
psei;c!c»-nr>\' firms that would cueroe as the result oi mcrf rr, '-"iv.•.":;-:iri L".:-tiorir , Lr.^r.-i'ors end. ici O L

- 127 -

chunks of operating properties of old finns, and similar
types of occurrences.

Effective administration of a

TIP tax penalty plan would call for a method of identifying the false or old-new firms and applying suitable
TIP tax restraints in these situations.


Defunct companies
In the case of companies going out of business,

the technical problems do not appear significant.


payroll,payscale, and earnings records, would be available for use in applying TIP in the same way as for onaping enterprises.

There may be deterioration of the

continuity and general discipline of operations, including accounting, however.

There may be low or negative

If, however, the wage increase experience of
the outgoing firm is taxable under TIP - indeed the excess wage adjustments ;n?y be a factor in its demise the major technical problem would seem to be how to assure? collection of the overhanging Til tax liability.
The collection task would probably be more difficult if
there were no concomitant income tax liability, but the
collection problem would not sorm essentially different
from that encountered in collecting manufacturer:-; excise tax or payroll tax fron defunct enterprises, except
for the fact that final TTI" t».v dot'fnination may laq
(like income tax calcula t i ;jn) until after the taxable


year is closed.


Coordination of guideline determinetion, excess com-

pensation calculations, and timing of tax payment.
Some attention should be paid to the relatively
•traightforward and readily soluble questions involving
the sequential timing of guideline formulation,""excess
wage calculation, TIP liability determination, and TIP
tax payment.


Prompt availability of guideline standard
The initial task of timely do termination and

promulgation of a guideline for a particular year or
time period should not impose much of a burden on the
government. Guidelines based on productivity would tend
to change only slowly and slightly in any year.

If a

CCIA adjustment were to be embodied in the guideline,
somewhat greater suspense might be involved in the periodic declaration of a guideline "ic;ure for use in the
ensuing year.


Frcr~*tion of ciuiJol ir.on for "straddle" corior's
There should be no problem in the fact that

tax years of various :ior:-cr.londar year basis taxpayer
would straddle any proriul^dtion date designed :Tor the
calendar year return.

Guidelines for a particular 12-

::ont:i pp.-rioc1 durincj whicl: d i f f e r e n t auidPli:-.»??; were


- 129 -

effect would bo readily constructed by proration.


example, if a 4 percent guideline applied for one calenar year and a 5 percent guideline the next calendar year,
a fiscal year taxpayer whose year ended June 30 would
calculate his guideline at 4'j percent (6/12 x A

+ 6/12




Non-conterminousness of tax years and wage contract
years should not constitute a compliance or administrative

TIP would apply to compensation payments within a

t.*x year, regardless of the contract period, as noted later.


Current Tip tax payment


Avoiding lacccd and perverse timing
The TIP tax penalty would probably be nost

effective if paid concurrently with the excess compensation payments themselves.

The penalLy for above-guide-

line wage contracts would see™ to be brought ho:ne with
greater force and reality if not delayed or obscured by
a mere ace... p.t ing accrual procedure.

Periodic payment rather

than a luir.p-sur.i payment system v.;ould seen more orderly
and less disturbing to ths firm's cash-flow planning and
the financial economy at large.

The desired incentive


e.^fucts v/ouiT co weakened and an apparently perverse
timing c: tko TIP penalty Lax would occur if a year of
inflationary v:ac-e •:ohavior \:c.\'c .yy unta:-:cd only to be
follo:.T?d zy c. year of noninflatj onary compensation during
which a lagged TIP tax bill came due.

- 130 b


Intorrrating TIT \:ith tax current payment ?ystOin
. *'

To achieve concurrent pai'n-.pnt and avoid per-

verse and disorderly lagging, the firm might be called
upon to estimate TIF tax liability, if any, early in the
tax year.

Declaration and payment of estimated TIP tax

might !x= integrated with the current payment system for
corporate income tax.

This would in general require

that at least 80 percent of the tax be paid on four quarterly payment dates, followed by a clean-up payment at
time of filing the corporate income tax return.


usual penalties for underestimate, which are moderate
but sufficient to exercise a salutory incentive for accurate estimate and timely payment, might cover TIP tax
as well as- income tax.


Evaluation and constructive solutions
The litany of problems and issues in the area

of timing, particularly those relating to data availability, new firms, and non-conterminousness of wage contract
and tax years, may support the impression that TIP vould
be an "adminstrative nightmare", that it would put an
"already overworked" Internal Revenue Service in the
position of havinci to adiiinintor a complex and difficult form of vagc control.
Such an impression would be incorrect.

Some of

the problems listed prove on examination to be minor.


TH" tax structure, including its start-up and tiding
phases, IF quite? workable.

Altnoucjh it lias its incre-

mental cind :o:isc period features, tradition.?.! iy anathema

- 131 -

to old-lino tax administrators and theorist, TIP would
be considerably easier to formulate, comply with, and
administer than other special f orms of taxation such as the corporation excess profits tr-x.

Yet TIP would perform a

substantive anti-inflationary incentive function with
little or ro damage to the economy while the essentially
symbolic excess profits tax tends to create incentives
to waste which palpably aggravate inflation.


Simplified, operation in start-up year
If the start-up year presents problems because

available prior base year data are not exactly in line
with the employee classifications and comprehensive definitions of compensation required in full operation,
provision may be ruade for measurement of average rates
of increase in compensation on a simplified basis,


sistent as betveen b:iso and current years, until collection
and retrieval of data 0:1 the standard basis be cones feasible.


.'spy co'.vr T . i ?"\:~_

Specific." r e l i e f

f o r new cc.r>pa."iicr. C C J I U be c-x-

t n d o d by r'.otiioc^ roL..";hly a n a l o r ; out; t o tlicr-e

u n d e r t h e .'• ::c:e,jr; i:>ro"iL: t a x of
(r.xcoss r r o ' i l : . -

:\::; A c t cf

trv~- K o r e a n war pcL-iod


inci t h i : ; r-"\l ie. .7 V J : . LO c o ' . p c . i . - a l o
l a c - ; o r ;.:; t ..r\:.\:r,


:^\r 2 ':// ^ i / i : i

Y'..c; t u / . c - o r l y f o r lie.'.; cc~ipa:iic:; •
L~.°? -\ s. 1 i:.c ».\:.l i : o d

- 132 -

alternative invested capital return base.
In brief compass, the relief in question included :
-- a special liberalized allowance for new capital
generally (for old and new corporations) at a rate of
12 percent in computing the invested capital base (limited in its practical scope to corporations with invested
capital above .",< 5 inillion since 12 percent was allowed
anyway on the first $ 5 million of invested capital),
and more specifically,
— a n industry average rate of return for use in developing an alternative base period net income available
to new corporations only, including corporations which
began business durinc the base period and to corporations
which began at a later dace.
The excess

profits tax legislation took care

to exclude from the average rate of return alternative:
—corporations which merely acquired the assets of
an old corporation in reorganization transactions
and which t'.i-rrcfore had a base-period earnings record
made up of the combined experience of the predecessor and
^••lccessor corporation
--certain "ineligible corporations" whose assets were
presumed Lo have boon transferred from an old to a new
new corporation in order to obtain the benefits of a.,
comparatively largo industry average rate of return.-'
The analogous approach to provide new companies
with a base by which to ^ear.uro excess compensation
even in the first year of operation under TIP would be
to allow them tin industry average pay scale with which
to conr::.ruct their base period average? rate of pay (using
weights re 1<;tod to Lhcir current year employment or
^ S e e Dan Throop Smith, "Kole of Invested Capital Base
in Excess Profits Taxation," in "Symposium on the Excess
Profits Tax," National Tax Journal. Vol. IV, No. 3 (Sept.
1951) pp. 210-211; and Eugene E. OaKes, "General Relief
under the Excess Profits Tax," ibid., pp. 230-231.

- 133 -


the s i t u a t i o n u n d e r

t a x relief d e s c r i b e d ,

pay a p p r o a c h under TIP

p r o v i s i o n of a fair a l t e r n a t i v e
from TIP

the excess


the a p p l i c a t i o n of thds.. industry-

in the first y e a r .

m i g h t open the f l o o d g a t e s

is n o t relief but
to e f f e c t i v e



A b s e n c e of such a


to f o r m a t i o n of o l d - n e w b u s i n e s s e s .

E v e n v:ith the a p p l i c a t i o n of an average

for new c o m p a n i e s under T I P , it m i g h t be

to exclude

(1) c o m p a n i e s



from r e o r g a n i z a t i o n

actually had a p r e v i o u s payroll e x p e r i e n c e and
" i n e l i g i b l e " b u s i n e s s e s whose a s s e t s were
from an old

to a n e w c o r p o r a t i o n

the b e n e f i t s of a c o m p a r a t i v e l y
rate of p a y .





in order to obtair.
h i g h industry


The p r e s s u r e on n e w company rules of


type would probably be less than that on the e x c e s s p r o f its tax s a f e g u a r d s of the e a r l y


Cn the


h a n d , absence of t h i s whole s u b - s t r u c t u r e of rules d e signed to serve

in lieu of a de facto exemption of new

c o m p a n i e s w o u l d c o n s t i t u t e a s e v e r e w e a k n e s s in the



M;>kinf• _no:i-coilt^JL^LijlO;UL_1^; VHP. co.'.ur.-ct__oi!d_ :.?.:•: vo?.rs

co ..oatibio
The fnct t'.iat v,";^ c o n t r a c t n::d tax s o a r s
are not c o n t e r m i n o u s d o r s ::o',bliriq block.

nnc-i to ~«.> a srriour. :?tui.i'o-

Tip would not apply to wage contracts as such

Rather it would rest upon a comparison of actual



rates of compensation increase with a specified productivity-based guideline percentage.

If a wage contract

affects wage levels or increases for only part of a year,
its results will nevertheless be recorded in the wage
experience for the year in the saine way as vould the
results of any other factor influencing wage levels during only a fraction of the year.

The average rate of pay

increase under TIP would be calculated from the facts,
as shown by the company's records, not by the percentage
increase figured in announcing the terms of a v/age settlement.


Relief for predetermined pay increases and catch-up

wage settlements
Relief for predetermined pay increases is a
policy issue.

It nay well bo argued that predetermined

pay increases like any other should be part of the TIP
tax framework.

Particularly if a climulative approach

was followed in applying TIP on the basis not only of the
current year but also of the prior record over a considerable period of years, it would seem inappropriate to ease
the pressure in favor of a long-rarvre no:iir.flz\tionary
compensation policy by creating a predetermined pay increase as though it had ncL ".aproned.
natch-up wr.rc souulor.'/^-its arc in a different
category, since they would represent the consequence of
a curron'.. socLlc-.icrvL r e a c h e d i n f u l l :tno;:lc»c!co o f
the r.::i^\:.r:\iv-'i ~~ ?::Y .

'".;;• coi.cli:•-.:• r:\ =;-?\".s \ir.tivoidable-

- 135 -

th<it such settlements rjhould constitute a recognized pay
i-vroa^o for TIP purport,.

;,ven spreading them over a


!.?rv-i.rJ poi.-j.o-i equal, say. to the previous contract period

for which I W M ,\ r<"- supposed to represent a kind of retroactive ad , has relatively little appeal and merely
adds a conceptually simple but moderately burdensome c*..r;>l icat it.

IV. Specific problems of administration and economic iirpact
The discussion in this section touches very briefly
on a list of potential problem areas, including avoidance/evasion, hardship, and adverse economic impact.

The analysis

seeks to avoid excessive operlap vith the previous treatment
of those topical areas in section III and to o.-^l.asize
structive solutions.


The discussion will ^cn.o times xerely

demonstrate that certain so-called proble.n areas are in fact
minuscule or are automatically handled by preferred desic;:i

A. Tax avoidanco and evasion

1 . COMcea 1::K: ;IL o:7 1 r i ::vn '•:.••?ne ' i. t s




:o;io ."its



to escape






ir. forms


c r o a t . i o . ; or

i.o unclervMIvutio::

- - inv;-:lv- t...:-: c:-:d-.:t-: !;v.'. j L :i • L i\rc
" U iL;
e : i ;

ia on.-; i' ly


- 136 -- arc b.Tscd on private coj-aracts with employers that
involve no current tax deduction for cash payment or
accrual of employer liability but are valuable compensation, e.q., deferred compensation or deferred compensation
This for.-n of esc.ipn rujy from crude u n d e r reporting of pay or disguising

it t.s something else to more

sophisticated .r.othodn of providing

invisible or

fringe benefits, e.g., travel and entertainment

that is more

for the benefit of employees t'r.c.n for cu.suerrors or forking conditions, health care, recreational
the terws of r e t i r e m e n t ' work,nq

facilities, improvements in

r-.;;-.:-:, m r .

Those that affect executives or owner-offic^rn may
call for sophisticated scrutiny of the firm's operations and

Those that affoct large numbers of e m p l o y e e s , such

as health insurance or retirement benefit sweeteners or shortening of hours for the same pay, would seem lcs:-: concealment.

2. Cpr;radinq of enplovcos
Cne of the most conmonly employed methods of avoiding pny freezes and similar controls in to u p e n e ? oir.ploycos.
Pay scales remain ccnr.t.inL, l?-t employees move from

lover into

hic;hor p.jicl clr.s.'* If icucions wiLhoi..;!: corro.spc;idi:v c;i<:n--os in
their duties or •./orJ-:


f Lr.c;,e clia:\::os arc chal-

lenge d, pcrsu:)::;.-]. official." .':.iy orgu:: ;:h.jt LV.o previous


ific.Ttion '..•:.r; ir. error o:id tho r/jv; cl^s?. i "i':'.il. ior. n-"'re) _/ gives

employees aTf^cCcd tho hiqber p-«v !--.ov wor»" or.\ i».lod lo

in the first. p].«t>».

- 137 -

It is possible that upgrading in ter.r.s of real pay
may occur in cases of nominal downgrading of employee classification, so that overtime computation, for cxar.'.ple, and other
factors may actually cjive tko e.nployoe a higher paycheck without increasing the calculated average ratr- of pay for TIP purposes.
There is no easy ansv/er to upgrading as nn evasion

Detection of it" occurrence on a significant scale

may bo assisted by symptoms such as increase in average pay
per o.nployoe or unexplained changes in the relative numbers
of employees in the various classifications without corresponding chances in operations.
Conceivably there m y

be situations in which er.-.ployees

are dovricjrv.ded, for example, to correct or reverse previous
upgrading or to achieve adJu:;Lir.ent to econo.-ic pressures
calling for retrench.nont.

.Vith a weighted avcra-.'irK; systc.i,

thr? substantial pay decreases v.-ould not tc reflected in
puted average.-, or index firare.s.
whether relief uliould \:c provided.


The- policy quo:;Lion i.~. posed
Factual eviclcMco t_ho

rpvorf.c or that u?:ed to detect upgrading L-:ic.::~.t bo used to

for relief.

3 • Fvrti Liou:--. o v ri-j-.o jL^-[_^.d>A^-J±-^^lJ:^..±]A^J~^y:L±}~±^l
shift :• iv
o v o r t i ..'.? t h a t

p o s - i ; l o >y.c.r:'

tcc'."..ii-. /.i-.1 •..'.>•.!]:' :">% i. o ^.'.y

i.*:s i K ) L p r "-;"• v.- -(Hi.

v;.i.s I'.ir .-••?.i.'-.i'.n"' o f p . ; y


.' :" .we :,i o p . y


!.•:• ...•>.:•.'

L ' : O . \-f>-\.. .•• p. 1 ./ m i g h t



^ i n the case of overtime pay, the result for Til- purposes would
depend upon the adjustment or lack of adjustment of hours worked
for the overtime factor in calculating the average hourly compensation, as discussed earlier in this report.

- 133 -

affected by the real increase in compensation.


"' t.hi.° device

would be reflected in increases in average pay per employee,
especially in the employee classification involved.


'techniques could be systematized to identify this kind of
avoidance by watching increases in pay per employee and
increases in pay in relation to physical output.
Manipulation of differential shift pay (nicjht pay,
late shift, etc.) might offer similar opportunities for
camouflaging pay increases that would call for similar audit
and detection techniques.

4. Corporate reorganization:-; and transfers into "new" businesses
If no reasonable basis v:as provided for calculating
a constructive average percentage increase in compensation
for new companies, they would in effect be exempt from TIP
until their second year of operation.

The constructive base

period wage for implementing TIP in the first year of operation
of bona fide new companies would almost necessarily be calculated with reference to an industry average pay scale developed
by regulations pursuant to statutory directive? and authorization.
-\llovi:i.:.j one year of effective e::or'ption *"roni TIP
would r)f courv: ericour ••..'o a s ;.-.<! uo of "r.ow" c.'.::. ;p;ir.y format ion
thro-jrh reorc:ani./:itio:i of old cm-ipanierj or Incorporation of
property t ran:-: Tor red out of old cov.p^.r.ics.

Even a constuctive

base period cc.-.-poi'.s^Lion (::•Iculotion such <?.:3 descri'ced
abovo micht lead to forr/.aLior. o." "now" co..ip«-.niea \:\\OLC actual

- 130 -

pay levels had been lover than the constructive base, who were
faced with TIP liability, and who could reduce or eliminate
TIP liability by substitution of a constructive first-year
pay scale.
Suggested solutions:
1) Exclude or restrict companies forced by reorganization
of old from full use o~ the constructive base period pay
scale for new companies
2) Require such companies to employ their actual base as
carried over frotn Lheir prior history.
3) Apply similar restrictions to new companies formed
substantially on the basis of transfer of productive
properties fro.n old companies.

5. Sale or transfer of a subsidiary between multicorporate groups
(or acc:u.i sition of indcvjcndont corporations)
TIP tax considerations may motivate sale of subsidiaries froiu one corporate complex to another (or acquisition
of independent corporations) './here tho ever-all excess compensation computation by the acquiring corporation would oer.nit
absorbing tho subsidiary's compensation excess otherwise taxable under its forr/.or ov.norship.

This statc.-.iont of the pro:;.le:r.

implicitly assu.os Lh-a t the aff iliuLud croup is the TIP tax computation
unit, since- the of f3'"»t tin-.: of ;i subsidiary's excess aqair.r.L c\
group's margin of safety undor Tli v.rould not occur if the particular corporate entity vt.-r.^ Lhc Vii calculation unit.


particular problOT: is oZ course ruiLo scparr.te «..r.d disti.'.c^.
fr:):i tliat of tlie old-.iov: cc/.par.y, si:ico it dcior. i\oL involve
tii':ir..i advari'.:opr.' o f :;r".-; c::.'.pc.'-.y trc.vicno.-it b u t r^* o x p l o i t r ,

- 140 the advantages of averaging wi'chin the framework of a corporate
group with over-all favorable compensation guideline performance.
It would soon t-he he: t tor part of valor to tolerate
this relatively harmless form of TIP tax avoidance.

If pre-

ventive action were deemed desirable, a possible approach would
be to place individual corporations transferred into an affiliated group on a separate TIP taxpayer basis for the first year.
Thereafter, the new affiliate

.night be merged, along with its

post-acquisition compensation experience, with the- group for
TIF purposes.

6. Switches of err.plovmop.t to "deficit" subsidiaries
The problem miqht arise of switches of jobs to
"deficit" subsidiaries.
upon two conditions:

The TIP tax advantage would depend

(1) the application of tho TIP tax penalty

in the form of oither an adjustment of the corporate rate or a
disallowance of." excess compensation deductions, and (2) the
application of TIP on the basis of the particular corporation
as the TIP computation unit.

if TIP were applied either as a

direct tax on excess compensation as such or or. the affiliated
group as the TIP computation and taxpayer unit, the problem
would not arise.
If the transfer; too1.: t--.r? for- of actual physical
and lc.jCLl transfer oT lu'ror and prcducuica operations to the
location nno pr-.yroll of Lho deficit rii.::;; j.di.iry, it :-:i.c;hL be
appropriate to acquiesce in vhatever TIP tax saving consequences
occurred within the prevailing rules for defining the TIP computation unit.

Mandatory consolidation would remove the prob-

If the transfer took place on paper only, by switching

productive facilities from one subsidiary to another


it m i g h t

bo set aside


for TIP p u r p o s e s as a t r a n s p a r e n t



7. • "Contracting out,"
It is c o n c e i v a b l e

that, confronted with a

TIP t a x liability s i t u a t i o n —
of m o r e

than one or


two y e a r s —

m i g h t both l:e m o t i v a t e d

for a p r o s p e c t i v e

to "contract o u t " their labor
the d e l i v e r y

n e w e n t e r p r i s e , recoivinc; d i s t r i b u t i o n s
in lieu of their forr.-or e m p l o y e e



The for.ner e m p l o y e e s ::ii;;hc serve-as; p a r t n e r s

This may


the c o m p a n y and its labor

The former e m p l o y e r w o u l d pay a fee for


froi:i their o w n

in the



hut should not !:<? o v e r l o o k e d .

3i..i::l'."r "contractin:- o u t " c o a l s would be p o s s i b l e ,
in which c.iplcyc^s w i t h special
inc; p o s i t i o n T.ight c o n v e r t


skills mid

in a strong

their r e l a t i o n s h i p vith

The chief s a f e g u a r d


they threatc-:riccl .ii:,uifleant Scr:otar;0 of

The lc-v-jai

to be


«?uch arranc Oirenti
tae T'i

to pcr.;1.ii-

r^ia ^.ic";.is!iip ,.i.:d

tr.oir roi'.iTiicL'Jul fee:; as c:vp.loyc.^ co.•.•;-Dr.satio:i.

r. .11


i ri<r.\-iLi 'y ;,'v;"1 :-;;.;':sLanco j' ys.c'n L^an^CL.ions

as di-"-fjoi sir.': ..;•; c."-;.';c • Lial e:..pi oy^-s—.}'::?1 oyoo

29-775 O - 78 - 16


plan voald

to provide sta t-.j tori : y -."or ,a "l;io';Li-.rcu;;a" povor
ad!V.inistr:.t.o:."; to


the e m p l o y -

to ar. i n d e p e n d e n t c o a t r a c L o r . arrar.-.OMent.

a s p e c t s of this Ly^o of clcvo L voald need


- 142 -

recognition of certain hardship situations which would not be
automatically ironed out by the basic TIP tax specifications.
In some instances, as will be noted, whether the particular
situation constitutes qcnuir.e hardship of the type that should
be granted exception or alleviated within the spirit of the
TIP tax penalty may be open to question.

1. Renewal of rrulti-yoar contracts including a "first year
catch-up" incrcasg
In some instances renewal of
contracts entered into before the effective date of Tir, particularly contracts of more than one year's duration, r.iay
include not only a portion of the new settlement in recognition
of prior years* inflationary erosion of the buying power of the
money wages but also a special "first year catch-up increase."
After the first year "catch-up," the wage rates may resume a
level r.oro consonant with the guideline productivity standard.
Such a one-year catch-up may bo penalized u.ider TIP,
even though tho over-all average annual wage settlG;.r»nt nay be
below the guideline*.

Tho :\irdship he?re is not that: the- contract

vas entered ir.Lo viiihout :-JIO: leo^o of TIP; the <.iS3u..iptio.:> is
that tro ;:p'piicaL!o;-k o" 77? v:'S l;nov:i.

father, the hardship


(or dis Lor Li or:) :>.c\'_: ".-e ^.r:.uc*cl on z'.:c <• rounds that:
-- tlv"» prior ~x\\ Liycar L'.iac ::rocipif.iLcd tr.o need
Zov i.; caLc:-.-u;> ."; ^ rcr.n\:;: 1 ti:r.r> T.MH ontci-cd into ir. -J.-.r*

- 143 -

— if the one-year catch-up is not crr.ployod and the
settlement is forced into a srretch-out type of arrangement which would avoid TIP, there may be less equity for
the workers affected, since delay in the face of a changing
work force may in effect deny recompense for a considerable
If a relief feature is deer.ied desirable, it could
be provided, subject to fairly restrictive qualifying conditions, that the one-year catch-up element might be averaged
over the period of the contract.

This would entail minor

complication and require rather exact formulations.

It would

also unfortunately represent tolerance of an inflationary
one-year bulge in pay that should normally be discouraged by

The policy decision on this point would rest upon a

balancing of the so.aewhat tenuous equity considerations against
the cost in tcrr.s of inflationary slippage and statutory/administrative complexity.

2. New labor classifications
Tnn ?.npenrancc of new types of labor altering the
skill mix and calling for a new classification for purposes
of calculating; the average pay increase presents akin
to, but dirfc.'rent fror.;, those oC the treat, tent of the new

~>.oth potential hardship and tax avoidance possibi-

lities «.-. FC: JOL-c;;ent .
The appearance o.~ a ncv: -.ore lii^'.ily paid labor
element v.-ithi.i ct standard la'cor cl -.ssi-! ic:: Lion would ':e
re if lee toe1. i;i Lh<? pz.y JVP;\;;O a.^ an increr.sf.'1 in the average
pay r:ito.

i: J.\c: .\n\r I.-."- ^r ol^:vo4it i-, rc^ui^o, it:i .v.ent

- 144 -

in a new labor classification for TIP purposes would avoid
the appearance of a computed increase in the average rate of
pay, except for possible minor deviations due Lo the mathematics of indexation.
Two specific problems ariso here:
1) How is the base year pay rate to be provided in calculating the pay increase for the new category in the first
year? Or should i.ho nev classification in effect be
exempted or excluded fro:1?, averdcjo pay increase calculations the first year?
2) what safeguards are necessary and feasible in identifying and ruling cut resort to now labor classifications
in order to disguise substantive pay increases?
The answer to the first question seems to be that an industry
average r.ight bo granted as a presumptive pay rate fo_- the
new labor classification in the constructive base period.


data are not available the reality of the new classification
might be questioned, unless the firn could prove (l) that it
pioneered in the creation and use of this particular skill
and pay category and (?.) that use of the new classification
was not a veiled special pay increase for the component of
the: regular labor classification.

Tf data are not available

but the classification is accepted as real, ti-.r? now labor
category r..icht bo assigned a pay rate in the base (prior)
year ocual to its current yoar r^t-.e discounted by the overall cuick: 1 i no productivity p(To;nL^c:o,

"ho iriicrtioa of

this &J::. ny figure in the no\; avcrarj;.1 increase in t:ay would
seer: ics^ di.-. Lori i:i:i 1 a/id loss unduly liberal) than rr.erely
er-'.cludir.g thir labor category.

- 145 -

3. "Upward drift" in the skill mix
•A potential hardship problem similar in character
to that of the appearance of a new skill/pay classification
might arise whore a firm could plausibly argue a substantial
upward drift in its skill mix.

Such a drift, arising due to

the more or less gradual appearance of more and more elite,
highly paid employees in one or more of its employee classifications, might be reflected in the average pay increase,
with possible TIF liability as a consequence.

Yet the finn

might contend that its pay increases were not. in fact inflationary, above-guideline payments but merely the reflection
of a significant genuine change in the composition of its
work force.
It might be? desirable to allow reclassification of
certain types of workers ir. this situation or a revision of
the whole classification system of the firm, provided there
V.MS a clear shovine; that genuine upgrading of its skill r.iix
had occurred, suc\: that the previous classification resulted
in overstatement of the uvorage pay increase for Tip purpose:•.;.
This relief approach v:>iild require setting up traLivo
machinery pursuant to n .specific statutory directive.


Le i-^ijjocL


to so;-;o .--tu^c jr:u.i. p r o l ii'orat: r.n

clr. ir-.o f o r ad or.t.

A . "'L'andc.'.-, r o ] •'» t \ ow:'.\i p:- " / c . c c h - u p

ci~::• '•;!'..v'.

P r e v i o u s diijca.-v.uon <i».ovc c..\ 1L w i t : , p o s s i b l e ?


- 146 -

for catch-up wage settlements representing ono-ye;?.r increases
to compensate for lag in recognition of inflationary erosion
over a prior nulti-year contract.

A similar type of relief

problem arises in connection with so-called tandem wage relationships, for which relief is reported to have been provided at
times under the wage contracts of the Korean periods.
Thus in some cases, a wage rate in one industry might be historically related to the wage rate in another industry.


of the base date, one of these rates may have already changed
and the catch-up necessary to reestablish the historic tandem
relationship or parity might be too large to be covered by
the applicable ceiling or guideline.

The Korean War wage

control system apparently provided a set of regulations defining
situations where this extra catch-up to maintain tandem parity
would be permitted.
The primary issue here is a policy question whether
TIP should endeavor to recognize and allow adjustments to
exempt above guideline wage increases because they arise from
such tanden parity relationships.

If the policy decision is

affirraativo, the statute might include such situations in a
statutory relief feature which would spell out tandem wage
chancres and provide for tl.cir C'MClCGiori in specified quantitative amount.s in the computation of t"ne average- percentage
increar.G in pay rates.

The a&n.inistrative task of identifi-

cation and measurement for this typo oJ relief should to
delegated to a special "coard i;~i IP3 or elsov'.icrc, rather than

- 147 -

left to the administrative discretion of a particular IRS .

5. CCLA adjustments
This report does not examine technical or policy
questions involved in possible cost-of-living (COi^O adjustments in the implementation and administration of Til".


would appear that if accepted, CLLA adjustments would be uniform on a nationwide basis li*e the productivity measure
embodied in the guideline and thus be added to the productivity percentage embodied iu the guideline.
technical or administrative

Mo special

problems would appear to be

involved in applying TIP under a guideline embodying CCLA as
well as productivity factors.

The 5 percent guideline figure

used illustratively at several points in this report implicitly
assumes a partial COLA adjustment supplementing productivity
increase of 3 percent or possibly less.

6. Intor-f irir.. inter-industry, and inter-rcgional competitive
pay adjustments
The question is raised whether administrative ir.ochincry and related statutory directives should be
included in TIP "".lic/i vou.l;; provide exemption or reliei for
abnormally hich wage increases made to keep abreast of
individual firm, industry, or regional competition for scarce
labor to meet expanding demand.
TliG i don Li ricri L ion quantification problems
involved in such an ad voi-lci >e i.iorc complex chan i:i
ul:o oi^-ti-'.o C;uc:.-ap ;;i L J.I ; i^n1- previously :.\ent ioned .

It is

- 148 -

true that a TIP tax penalty in these situations might seem to
operate as an obstacle to normal and salutary wage and labor
supply-demand adjustments which arc part of the market mechanism and help allocate resources in optimum fashion.

It is

apparently also true that the Korean War wage control system
made an effort to permit at least some types of wage increase
in this general category.
This approach for TIP, however, would seem to be a
seriously compromising step since it would tend to introduce
all the bureaucratic paraphernalia of regulatory controls.
The merit of TIP is that it would be largely automatic, selfoperating, and administratively econo;;;ical.

TIP can ignore

some rough odges because it does not involve obsolete prohibitions, but only a tax penalty which will discourage or
moderate inflationary wage rises, whatever their immediate
economic excuse or motivation.

C. Undesirablo economic impacts:

export cf job-.

The economic impact of Til might well take certain
forms that vould have negative effects on the U. S. economy
and employeent opportunities ar.d vould be obvious targets of
public crilicir-i.
T'.ie f-xclur. ion cf 'orpi;:n su;;sidir. r ic ?• and foreign
branch operations would ofxv. f.:o :.vy Lo expansion of foreign
oporations in 1 ic_su of p^yvronc of highor rJ. 5. -..'ages subjoct
to Tir ta:: jr^.'.-.ltiiT . ':o:icoiv.r."ly, ..-.i;;:it tr.'.ie the form

- 149 -

of expansion in contiguous countries, with movement of U. S'.
workers across the border on a daily or periodic basis to
perform worl: that might be excluded on the basis of situs
from the? scope of TIT.
This kind of development poses two specific problems:
1) How should foroicn operations or employment be defined
for purpozos of tho TIP exemption? Should the definition
be modified to exclude the exemption of above-guideline
wage payments to L". 5. residents who merely cross the
border to work?
2) Flow should the design of TIP be shaped to minimize
the "export of jobs" aspects that result from cor-.fining
TIF to the soor.ients of U. S. business operating within
U. S. borders?

D. Accounting problems of r-r.Mll business
Some critics have expressed concern that millions
of small firms (retail stores, physicians 1 offices, and farm
enterprises) mostly unincorporated arid having extremely rudimentary accounting :;ii:;ht have difficulty in complying with

Thus, they .y.ig'.-.L be denied an opportunity to qualify

for tax benefits uiidor those vcrsio:::.: of the Til- approach
vhicli reward giiidclino-conronrrinr' ."ir..":S or be unable to abs::lvo t';c:!«ivT!:3 fro:. c-ir'%ct p d a l t i c s under thr more standard
T.TI" propos.: 1 •; for ir:pos i.rv; •:•. sr.nci " i;: \::\:i incroriorit on f;;:cc.;n
cor;ip(?n:ja tioi:, coarcrl proport ioiia Lely La t:.o oxcoss.
I'ho problGV. of L:i.-? very " : M ! 1 fir.:; under the Lyp;:


TTI- pro;Tc"." c> L:-\Ci*r,-M.'C :n t::o rop.Ti-t \:.">uld >(? -iiinor.

and even .r.oderatPlv l^.rr.c fir...s may -.•:r»ll co excluded fro^p.

S..-.r. 11

- 149A -

TIP under an exception based on size, noncorporate forra of
organization, or both.

Even if not excluded by such an

exemption, it i.~ difficult to conceive of a firm vith
employees vrhose '.•races arc subject to vithholdirnj1 and the
Form \!-2 vagc reporting procedures, which could not calculate
its average percentage increase in the rate of compensation
from one year to another.

The basic information needed is

the a:\ount of compensation paid by class of employee and the
number of employee hours or employee years for which the compensation was paid.
If a fine's books of account, tax accounts, and tax
reporLinr procedures under modern conditions are so rudimentary that it cannot determine the average percentage
increase in i'c~ pay rates over the preceding year, follovinc;
prescribed procedures set forth in an official ta:: reporting
for;?., thoro vould appear to be so,.-.e question as to its cor:fornity vith present tax accounting rules.

Some further

dcveiop./icnt or i^s accounting procedures might be salutary
both for tax uccountinc, and jusin^ss and financial management purposes.

'.Z . '.'i':-)1-,} •',• -- p 7 .z%-jsl-•:~* "•'"••"' *'•n'^:- :- •-"'^


^ c " a 1'-"' ti•"n

o f .- Lc:r.dr.rds

iiiv: ; ! . - T O a ; r " : :

L i i t i U . L i v : :S i : ;




'.1 .Til i..l)




l':. - c::~?cL



i r ^ c n i Li cr: of.


^warcl of



pcii-\i t y



- I49 r >

avoidance) requires that

standards and procedures must be

precisely definable in the tax law, and able to withstand
court review of their fairness.

This criticism is based

in part on the experiences in designing and administering
price controls during .iorld .Jar II, and the development of
restraints on va : o ;orice increases during the Korean war.
This report indicates the basic specification:, and procedures
which night be embodied in the TIL- statute.

This statutory-

base in turn would be amplified and detailed in regulations,
as all modern tax laws must be.
These criticisms imply that the detailed
of TIP might fill
with fine print,


endless volumes of the Federal Register
subject Lo constant revisions, exceptions,

and adjust-ientF necessary to cover special situations that
**ould never have been dreamed of in advance by the most imaginative economists, accountants, and lawyers.
livery tax law requires regulations and rulings to
put it into effect.

Those- are subject to the usual Federal

procedural requirement for permitting pu':lic hearing and co.n•.-ent.

regulations on particular features of the ir.cor.c- ta:c

lav: so .101Lues L^':o years to forr.iul.r to and put into final form,
"ever the IP ss, t'.io tr.:: ]«?.w ir c.d..\ Li is cored .i .1 a cc:op triple
althoj^'h rrf:r,'.;^.:Lly in ?JJ- •ittoc!].;' i ' p r ' o c : fashion.
J\:or^ ir, nc in:1.'.c^Li-iM L!:at t.\z .-tatute,,
^r rvilJ.-.:..! under a i'ii inll.ic.Liv? ::O.J 1:; ":r .•ore onerous


- 149C -

susceptible to continuing controversial revision than those
embodying the provisions of the income tax lav with respect
to depreciation, depletion, corporate reorganization, the
treatment of travel and entertainment expenditures, taxation of foreign income, and the like.

- 150 -

A p p e n d i x Ai A F r i n e r of Index N'urnbor C o n s t r u c t i o n for TIP
Index n u m b e r s are d e v i c e s for measuring


in the magnitude of a g r o u p of related v a r i a b l e s over a period
of tine (or as bot\/een p l a c e s ) . - ' The xost co:rjnon typo of ind e x is one w h i c h , like the measure required for applying T I P ,
reflects a change in average p r i c e s over time -- in the case
of T I P , a change in the price of labor employed by a firm or
TIF taxpayer u n i t . the five p r o b l e m s / t a s k s which a s t a t i s t i c i a n
typically e n c o u n t e r s in the construction of an index


of series for inclusion in the i n d e x , selection of source of
d a t a , selection of b a s e , method of combining d a t a , and system
of w e i g h t i n g ) , the first two and to a lesser e x t e n t , the
t h i r d , are automatically resolved by the specifications of
the TIP tax initiative.

The remaining two (method of c o m b i n -

ing data and systen or weighting) are there Tore the e s s e n c e
of indexation for TIP p u r p o s e s .

A . 5a.qr» rerioJ considers t. ior:s
The base? lor TIT is in a sen.^e the first available
war;e experience ye^r.

H o w e v e r , since the essence o:T the TIP

tar' procedure is the m e a s u r e m e n t of thr> averarc "..we increase
for a particular firr.1. or VII- unit ever cr-.o prior u\-sr, the
focus cf indexation procedure may 'y?: on C--o uverariiri^ c: c u r rent over prior year price r e l a t i v e s .





Thus L'ne base \.\c-.y be

. , , - , , .

1 • i ?•, 'c..';!;^cr .:.!, ^.:.. .:c.i •. f L: •-: . 17V.-J.-7.

- 151 -

said to move from year to year.

The initial or starting

base year may be retained in the sense of "chaining" average
wage relatives back to it or by continuing to use the same
base year weights.
In standard index number construction, a particular
base may be satisfactory for a number of years but "becomes
less meaningful as time passes, and it eventually becomes
desirable to shift to a more recent period."-^
moding of a particular fixed base?

Why the out-

The factors are:

— dispersion of individual wage relatives to such an
extent that no average is reliable
— chance in the pattern equivalent to
or "job package" of employment to such
aggregate of labor classifications can
includes the major payroll components

"market basket 11
an extent that no
be found which
common to both

— progressive chancre in the quality of labor classifications, nominally the same, due to their rise or decline
in the labor hierarchy due to skill and market changes
Since overall historical analysis and comparisons
are probably loss important in TIP implementstion than in
national or industry-wide inde:: number constructions, these
considerations are only of secondary importance for TIP.

B. Alternate

'.ot'iocls of constructincf vac^e index numir-c-rs

There arc t::o basic alternative methods of constructing indox m minors for vacjcs (or other p r i c e s ) :
-- by computing aggregative values and calculating; the
ratio of the a b r o g a t e in the current year to a base
f ir u re (tho acj g re 3 a t ivc i ndc :<. x.e thod)

- 152 -

-- by conputinu averages cf '.•.•t;<jo (price) relatives (ratios
of current year to base year
These tv;o m e t h o d s are briefly discussed in the f o l lowing sections of this appendix.

8. Aggregative v:ac;o index numbors
Aggregative index numbers of wages measure the
changing value of a fixed aggregate ("ir.arket basket" or "packa g e " ) of labor.

If the total value changes

';ut the labor

components do n o t , chances in value riust be due to changes in
rates of compensation.

1. Simole or "unveighLcd" an^rer-Ttos
The simplest, crudest form of aggregative index of
wages is one arrived at by adding up the vac,o rates (per hour
or other unit of labor) for the different classes of employees;
in the current year and 'ir.viding that sura by the corresponding
aggregate for the base year.

For example if there are three

categories of labor, 1 , lo,

1^, paid v:aces of .80, 1.20, and

1.50, respectively ir. the base year and .90, 1.10, and 1.70


the current yoar, Lhe calculation of the simple or "un^eicjhLed"
af'". rcrative index Ls> as follov/s

= 100

. 1>M









Tnc'e:: ( /e:.- )



1.1 >-2'} cc

- 153 -

The standard formula for this kind of index, treating p as the price wage for a given class of labor is:-*'

where P = wage or price index


= wage (price) of a particular class of labor
in the given year
- wage (price) of a particular class of labor
in the case year

In the simpler or "unweighted" aggregate each class
of labor is in actuality not unv:eighted but is arbitrarily
given equal weight, without regard to its relative importance
to labor operations.

2. Weighted aggroc-atcs
In order to have each class of labor have an influence on the index corresponding to its relative importance,
a quantity (or weight) nay be assigned to each and calculations rr.ace of the result ing acoregate value in the given and
baso year.

If the quantities (or weights) assigned 1 , 1_

end 1.,. in the previous oxn-iplo are 200, 300, and 500, the
calculation or the voi^hLcc Ji re [rotative index is as follows:
Z\ u a n t i I y


Ye a r













Yc a r ^

tirT. " "" ' ' """



-'i.'. L*\ L~ .:.:.'i -.;.:. f> a: •••:.t i.."".'•:: c.i".::-!.-?•: fc;r:»:L!l«.F y - ' ^ ^ t ' ^ t o d h e r e ,
l.i".o ry:i ;:.'.. J i-.: •:-.;':j-.i t .it • -i> ."or _:.<•> u . ; u a l :-. ir.n.' •..L...;;T\.3 t i o ; : o!c;.n.

- 154 -

In this case, the change of weighting resulted in
only a minor difference between the quantity weighted and
"unweighted" aggregative index.

Suppose, however, the weights

are more disparate than the 2, 3, 5 relationship assumed in
the preceding example, as shown below:

Year 0

Index (year ) = 1,310 = 1.1565 or multiplied by 100 = 115.-65

The higher indo;: figure which results reflected trie
heavier weight attached to labor classification 1 9 for which
the pay increase was 16.67 percent (1.40 - 1) as against
1. ?0
12.5 percent for 1 1 (^90 - 1) 13.33 for 1 3 (l_._"J2 " 1 ) .
The standard formula for this kind of aggregative
index is:
P =


the base ycr.r q u a n t i t i e s

..irr user' tl:o r-enoral

fori.iula bcco'.o:-.;:

'.•: c^voa year -.u.ii-.titics ; ; r j used,

29-775 O - 78 - 17

Lr.o formula

- 155 -

Various quantity weighting
b e e n used or s u g g e s t e d .
lating w o i g h t e d

A few p r o m i n e n t m e t h o d s of

aggregative price

with brief comment

s y s t e m s n a y be and



(wage) i n d e x e s are



a. Base period q u a n t i t i c s a? wei:?h-..
The L a s p e y r e s m e t h o d

P = Sp a



T h i s type of i n d e x is g e n e r a l l y

u p w a r d b i a s , b e c a u s e of the interplay of p r i c e
and accorv.paiiyir.r; opposite q u a n t i t y c h a n c e s .
consumer price
a v e r a g e price


is c r i t i c i s e d



to have an


Its use

in the

it m i o h t record


(•.•/ace) increase e v e n t h o u g h tlie i n c r e a s i n g

r e l a t i v e a m o u n t s of c o n s u m p t i o n of c o m m o d i t i e s t h a t
in price m i g h t p e r m i t an i n d i v i d u a l
of s a t i s f a c t i o n at a lover
less applicable


to buy the sair.e a m o u n t


This criticism

to the use of the ~ a s p o y r e s m e t h o d

u r i n g av-'irave varje i n c r e a s e ? .


LiuL still

it m a y be said

this iv.o tried Marl:.: an up^c-r Lo the price


for m e a s that

(\/d'jc) c h a n g e .

b . '"-iv^n (cuiT'.;r.L yoar) c:uj.;:li I:' e s u::r>d as '..•oi-i-ht<::
] he .aa-chP r.-otVoc..

1 .\

t:'/.- coii.^ui./jr

sic-.? c i r i t i c i . ; . - . !

r - ^Pj,^




!_j;i.. :\:;u.\v)ci

lcvL 1 . •:' a -...i.-.-L


ceo.-, t o

'_:.c.- i.^:..^c/n..-<



:..•;• Lhoc..

- 15G -

It is said to have a downward bias and to marlc the lower limit
of price (wage) change.

c. Avorncrc or totial riuanti tics of b: :u and given (current)
years used as -..•ci'-lits
The .Marshall-^drevcrth formula:
between laspcyrcs and Faaschc.
in a particular direction.

This is a compromise

It has no known general bias

However, ] ike Faasche's method

it has shifting weights and what is sometines termed "lack
of comparability" ar.iong the different year;;,

"..'here the focus

of interest is the change between two adjacent years as under
Til", this lack of comparability seems to carry less v.c-ight
except possibly where, for some reason, a full series of
index numbers is developed covering a lengthy period of a
f irm' s wage e::per ienee .

d. Average Lo"Q':l:or t.V-c guc'.ntitios for all (or selected typical)
years covered b'r the indo::
This typo of method \:culd offer a ccn:pro::-.isr: solution for an historical stucl/ buc is cu-•:jerscr".e and i'.v. practicable Tor puroosf.'S of a:i up-to-diLc .index liko Til it
requires conbinui>v.: (cr fvcrruont periodic) rcvif:ic;"; of \'(j\r--'.-its
and roco.'pu to r,io:i of prior \o\r ir.c:rv\ nu^Nirs.

o . '.'.i;•n'(?rl. c-- •'•.-Z-_-1 _~'ic\:r-*- •..r-'f-r. ,.s ' X M I _ . ' _ L


157 -

weights the quantities of a particular labor category common
to each year, either to the base and given year or to all the
years under comparison.

This approach tends to use as weights

the smallest quantity for any category in any of the years
under analysis.

Suggested by John Maynard Keynes in his

Treatise on Money (1930), it is designed uo remove the type
of systematic upward or downward bias of the base quantity
weighting (Laspoyres) and given year quantity weighting
(Faasche) methods outlined previously.

However, wide varia-

tions in quantities for particular categories could result in
the development of abnormally low weights for thc:nf with as
much distortion as the other techniques, and possibly a worse
type of distortion because it would be more erratic and less

f. Averac;G of two differently weighted index numbers (usually
employing geometric? rr.can)
Irving Fisher's "ideal" index number (geometric
mean of base and given year weighting):
Formula for the Fisher's "ideal" version of this
type of index number is:
r = square r o o t of

(vp .-j^ /_ op_q#



As w i l l be sor?n, F i s h e r ' s " i d e a l " indorc i s trio goorr.cLric r.'.oan ( s q u a r e r o o t of Lhe c r o s s p r o d u c t )

of the Lj::e

q u a n t i t y vcic;hLOc- vLaspoyros) and given year

v:c Ic;h t•"• c\ ( : <- .-.• sc:\;z-; r.;.; - m.; L\ t i vc i :idc:-:'? n .


- 158 -

g . '.-• eight ing biuz; criticises
While the Fisher's "ideal" avoids the biases of its
components and meets behavioral tests he regarded as important, it involves a different set of weights for each year's
index computation, so that logically the indexes for any two
years (other than the base and given year) are not comparable.
This somewhat technical and purist criticism of the Fisher
"ideal" may also be raised against the following systems:

given (current) year weighting


average of base and given year weights

— highest co:;mon factor method when quantities selected
are common only to the two years under comparison.
The following methods involving what amount to
"fixed" v:eiohts for the entire period under analysis are free
fro.n this particular technical-statistical criticism:
-- base year weight.s
-- average-of-all-years weights

fixed "typical" year weights

-- highest co.nmon factor r.iothod \:ho.n quantities coinmon
to all years under analysis are used.
The practices! importance- of different: weighting systems is frequently not c;rcat even in che field oT commodity
price indexation \;'.\oi:c considerable instubiliLy of particular
prices cften without r.ysLe.r.atic patterns of chaise is presc-nt.
It v.-ould be of oven lc.';s in the noa3Ui.-ement of
a;?r[:';:e increase in \.\ :^o. r^'-s, wliich urt: los- than
co::'^odity prices in ul.c- prc^oiiL ccor.i.;:;; L.:\C SOL.-::: to follov."



a similar co;nnon upward trend.

Accuracy of measuring wage

rates may be more important than the system of averaging
employed in the indexation procedure.

However, if impor-

tant changes in the relative importance of particular categories of labor with appreciably varying wage change occur,
the matter of weighting becomes quite important.

Some up-

dating of a "fixed" v.-ei-htir.g syste:?, may become necessary.
Automatic continuous updating of the base v/eighting
system, may be achieved by the "link relative" index number
system in vhich each annual index number is expressed not as
a percentage of the original base, but as a percentage of
the preceding period.

Such link relative index numbers rr.ay

be "chained" back to the original base by a process of successive multiplication (briefly illustrated in the course of
the text discussion).

D. Averages of v.~aie (price) relatives
The basic alternatives to aggregative indexation
is the construction of index numbers by averaging wage (price)
Under this approach, the wages (prices) of the
given year «-_ro each reduced to n percentage of its base
period counterpart.

The various vr.n (price) relatives are

then averaged for each year separately to obtain a series of
index numbers.

The cvorarjin-;; May. bo by taeans of the arith-

r.iotic, hctnr.oi.ic or geo.r.ctric :;::?an or by determination of the

- 160 -

modian (or even the node).

Various vrci rating systems arc

V.'ei;htinc; under the average of wage (price) rela-

tives method per::.its, and usually relics upon, use of value
weights, :;hcrcas the aggregative .r.cthod —

almost a., a matter of

loqical necessity -- relies upon quantity ..*eiqhting.
A simplified illustration comparing- aggregativeand averar/e of -..par;e relatives approach'^:- to indexation is
sho\.-n bc-lov.

Required Assumptions
'.. r.ce rates
Yr. Q


] .?.O

1.. i:50



Aggre; a Live




Average of -./age rate

.AlO 0










1. 70


3 70





112 . 5 x

130 =

116 .G7 x

960 x H4.336.6

] 13



Wt. pay- Weighted
by payroll

1, 3?0

]70 =



Index yr.


1/(1,330 • 1,150) ]00
153,352.7 * 1,330
The i l l u s t r a t i o n ~ : I T ; ?

o b t a i n e d vio.i :v; r.:^. ^ - r ^

t e close

si:;\ i i Ly of

a L i ' T v.vTthnri vith. c;ivo:i year

c;uar":tiLy v.T?i-!;tM and an iv/rrac'C? of v...i'^ rol;:Lives ""..^ciiod v:ith
rive A -:cp.r p a y r o l l s ;:oi .;IiLs. . .

a thc.-.a ^i.c.i''.ly

icier.ti ~al


ros 1 .: 1 LS •..••^;:!CI "...WO


- 161 -

the aggregative method and base year payroll weights lor the
average of relatives method.

The reason for the identical

relationship is demonstrated as follows:
Individual labor category




ft 'ft

All labor categories
used for index

A, further illustration of the identity of results
under aggregative and average of wage relatives method, using
the base year quantity and payroll weights, respectively, is
presented belov within a framework of assumptions consistent
with those e.-iployed in the preceding illustration of aggregative
vs. average of './age relations method:
Required assumption
'..'age r a t e s

y r -o


Aggre gative



' -o



















1.12.5Q .
1,080.50 ;i,080.50 1 ,250.50



A1,250.50 • 1,030.50) x 100
/(1,230.50 • 1,1)80.50) :: 100

Average of uac;e rate
VJt. pay- Weighted



1 .125 x 152
. 1.167 x 316

: i .133 x 112.50 =

roll 3 "'


The usual assessment
of relatives method

is that the weighted


is just a roundabout \:ay of doing vhat may

be accomplished more easily by the direct means of the aggregative approach.-^

So..;e also contend

is more understandable

of '..v.r'e (price) relatives.

that the aggregative

to most persons than an average
Comparative understr.ndability is,

however, a matter of opinion and rather subjective


For Many, the concept of a group of vage (price) relatives
averaged by a reasonable \rei<jhting system is essentially
clearer and furnishes a better insight into the components
and nature of the statistical processing
It is recognised

that the wage

(price) relatives

themselves provide information of interest from


interrelated standpoints all of vhich are relevant to TIF
— the behavior of particular v/aco (price) relatives
and their contribution Lo index changes of a fir.r., in
comparison '.:ii:h similarly situated firn.s
— the wirii.bility, diffusion, and pattern of tr.c various
•.•:c-r>Q (jr.-.Lc") rclaLi-.''" : of one fir.v. as compared :;ith
others a:; a COTIL of reasonableness and credibility
— !MT.; :;'.aLor it11 for dir.Lr to ob'.ain
in.-icl;L inLo av~raro ::<:huvior
-- t'.in i:\?-;t i f icaLicn ."uio -j;Uc-.nt if icicicn of c^n.r?'. tivc
factor:: ( ,i.o., :--ai-tic-'.l'.r \.\.:ro roi<. Livcf, cn\c*. t'.ioii.- "..•r«iglits
in unu~ii.;l over-all ;:.ia:-.-;o:? i:->. a finr.'.-, jr.clo:;.
.3 i"r\'iou:;l_" "L;- ^c.-.-L.rjcl, i.-. a !>:•'•".(?: o" ca.^os,

- 1C3 -

aggregative and average wage relative methods arc equivalent.
Excluding the more esoteric field of harmonic averages, there
are two basic equivalences:
-- an aritb_r.otic :-.ecn of '..'a^c^olativos weighted by base
year values (payroll aiucunL;-)^ is tae equivalent of an
aggregative; iridox weighted v:ith base year quantities
— an arithmetic roan of wage relatives weighted by trie
product of base year wares and c^yen year quantities
(employees or other l-~ bor units )^ is the equivalent of
an ar.^rcjativo index weighted ..'it'.i given year quantities
(employees or other labor units).
The average of relatives method has a special advantage for use in connection with Til .

It permits averaging of

varying types of rates of pay based on different labor units,
e.g., those for hourly workers, workers paid weekly vages,
and salaries workers without converting thc;r. to a cor.-non
denominator labor uni^.

The wage relatives for the various:

categories nay then be weighted with a dollar value figure ,
nost plausibly

by the amount of payroll payr.ents, thus deal-

ing with the nacd for a co.r^.ion denominator in the weighting

=s '.'eigiitinc fac

- 164 -

Definition of TIP taxpayer unit in the? case of -multicorporate

effects of .•jpparntn ard consolidate- reporting due

to interplay of labor skill mix and index lethod
Fossiblr Tit tax advantages and disadvantages of
TIF tax reporting on separate or combined bases by nulticorporate entities have heen r-.ontionod in the text.


advantages and disadvantages of including or excluding certain
corporate affiliates have been recognized chiefly (1) in the
case of affiliates which have an "unused" .nargin of guideline
ceiling above the firn average rate of pay increase or a substantive excess of compensation over the guideline and (2) in
situations vhero profits wore the base of a TIP tax rate
adjustment, -rinking it advantageous to "separate" high profits
or "include" low profit affiliates.

This appendix briefly

illustrates another technical sourcs of TIP tax cf'ccts
depending upon the inclusion or exclusion of affiliates:


interplay of skill :.iix and the averaging or ince:; procedure,
sov.otir.T-s cc --.plica ted by the forn of the TIF tax penalty.
This may be said to involve the definition of the business
unit used in the computation of the average rate of pay increase
and its comparison with the guideline to determine excess
For purposes of tho present brief analysis, the
following illustrative facto and circumstances are assumed:



Affiliate A

Affiliate 3






























yr 1
over yrO
S 333


(ave pay psr
employee yr]
























A ano "5






























(ave pay per
employee y r ;
0.2 7




enployec yv

in i:::2 avcra'.-? :•:.rce.itr.'ro ir.crca?e?
ir. p?

•tos A ;;ncl :», u.sing
-,-.frt.r'o-;..i3 of co :puti:•'.-;

•oTArc .ratw- o" pay



r :.::•




• •:::'••-:.*

r ; * . ; - ' : ; . ; a L.5.




.".vcrncje percentage iiicrer..->c in pay rates calculated under

separate and co.r.bir.ed reporting for


purposes, \;ith a l t e r -

native averaging or index methods.

Averaging or index method




A and 3
co .ibined


Avo. of r e l a t i v e - -.:&i_-hted
by year^ p a y r o l l




Ave. of r e l a t i v e 5 vrci-hted
by year r ) employee y e a r s




Lasp^yres anrrecjative
( v r n o:.plo-'ee-vr n u a n t i t v






2. Excess compensation calculated under separate and combined
reporting for Til" purposes, vrith alternative averaging or
index rv.e thocis .


"cr;> i r v c r iiic'cr. ~!f?Lhod



~>.vn. of r e l a t i v e s
by year


A and B

1 ercoiiLa/o
c : ; c o •:.•."'







'.v:. . o" rr-v-tivoo vci-.-htrrc


' c - t i n : vit>. oLV^r i 1J :^ -:l:r~ Live CT^.:.'; ••;•••.*-- ~'i^."n

t?».- nivr.-Tt

in contrast

;.• ir>.y til.--; be on the s i d e of combined reporting

- 167 -

with the unfavorable result shown above.

Other testing also

indicates that, as in the example above, while the Laspeyres
aggregative index shows less disparity bf*tv*ccn separate and
combined than the average of relatives ructhod, it tends to
move in the saiie direction.

D. Efforts on TIP tax liabilities
The implications of separate and combined reporting
for VI: purposes for TIE- tax liabilities would depend upon
the form of TIF tax penalty.

If the tax ire re based on the

excess compensation as such or vere implemented by the disallowance of the deduction of the excess, the resulting translation of excess into TIF tax is r.'.ore or loss self-evident.
Kovever, if the TIP tax took the for.n of r.n adjustment of the
applicable tax rate, proportioned (possibly with further scaling factors) to the degree of the excess, vide
and not easily predictable differences in the i'lF tax liability
may arise under combined versus separate re-porting for TIP

Th«se differences would of course depend upon the"

configuration of profits among the affected affiliates in
relation to the combined calculation of excess compensation.

•-• T T r r?la:-. <??r.:—."[ rrt:' Ezr\::--?.-ror c h o i c e


The c*j.-.iplc::i liz.z c-utli.;ed here suepj^t problems of
TI7 La:: dc-sicr. to '..;.inir.\izc? e r r a t i c i.a:-: vnriatiorio ^.croncUng

the- of La::payGr u::it rm-d budinc?ss ta:: decisions


in response the rote, and tc roauce i; roble.r.E of taxpayer choicG
as to ho\.r to crcj-:ni./:-, cons olid.? Le, rU.jagg re. ('ate, or conduct
business operations.
So"C- choice pro^lG;.-..-; for the taxpayer (ani1 opportunities for manipulation) coui^ ho reduced hy mandating consolidated reportincj or whatever forr. of rcportiuc is used
Eithc-r approach T.;o'Jld not >:c entirely

for inco-.e tax purpose:;.

offoc'-ivo, hoT.rover, since su^sioinriej jr.ay !:e disposed of,
required, or c-econtrollec ; :?usir.oz:-3 operations nay be switched
around or repriced v:ith respect to intercorporate transactions
vithin a controlled croup.

This kind of preventive


or adaptive behavior would of course not meet but rather


possible criticisms that TIP resulted





in tax differences

similarly situated economic aggregations*

T e n t a t i v e conclusi:\i-Fu.rthor study should "20 r i v e n to t'lis c;c.:eral

of Til


1"-.i;i i.ivolvo:-: the interplay oJ


the .:vi thec. of

cc-:;;uL::;. 2\mcsx..p ;.crc~L\-~[^^ :,riy ir.crc-r.oe^; or i .\<c::.o.:: and
ctV.r>r vr."in"?1.or: I-.i t'.-.c ::itur. tioii, incluc'ir^ n o t only
dr.-'i-.i tion o.T l'.\? VIZ


for"! -J. f. .0 r."I


La:: unit -;uL al;;o G.:.3ential d e t a i l s




i" reli.-.i-.i.-iry r:v--.:lt:- ?i <-_-?s\. t h a t

tho r'.r c'irpr.r": !: ^.^ .: '"r-L'.T'c: ;• x ; o r * : : ^ r;n-;l co.:'~:incrl r e p c r L i n r




Congressional Research Service


(A Review of Current Perspectives on the Inflation Issue)

Edward Knight
Specialist in Industrial Organization
and Corporate Finance
Economics Division
June 18, 1978

29-775 O - 78 - 18

(A Review of Current Perspectives on the Inflation Issue)

Table of Contents








The Administration's Program of "Deceleration"
An Update: The Administration's Most Recent
Anti-Inflation Strategy
Granting of Additional Powers to the Council on Wage
and Price Stability
Other Possible Congressional Initiatives
Combatting Inflation Over the Long Run
Current Role of Monetary Policy
A Word About Taxed Based Incomes Policy (TIP)


(A Review of Current Perspectives on the Inflation Issue)


Inflation, defined as a persistent upward movement in the general price level, has been a major economic problem to the Nation
for well over a decade.

Though there have been brief periods of im-

provement on the price front, the annual rate of inflation in six
of the past ten years has been in excess of 5.5 percent.
In periods of high inflation one would expect the economy to
operate with relatively low levels of unemployment.

However, this

has not been the experience of the economy since the early 1970's.
With the exception of two years—1970 and 1973—unemployment as a
percent of the total civilian labor force has been well in excess of
5.0 percent.

As of May, 1978, unemployment was at a level of 6.1 per-

Though this is considerably below the 8.9 percent peak reached in

May 1975 during the 1974-75 recession, it is still considered exceptionally
high by historical standards. During the latter months of 1977 inflation
(as measured by the consumer price index) averaged between 4.5 and
5.0 annually, and most forecasts were projecting a slightly higher
rate of 6.0 percent for 1978.

However, for the three-month period

ending in April of this year, prices rose by an annual rate (compounded) of 10.0 percent.

CRS - 3

This report surveys the short-term outlook for inflation. This
is followed by a review of the anti-inflation actions taken by the
Government to date and the various anti-inflation proposals that are
receiving the most active consideration in public policy circles
at the present time.
During the latter months of 1977, the annual rate of inflation
(as measured by the Consumer Price Index) averaged between 4.5 and 5.0
percent, seasonally adjusted.

Though most economic forecasts at the

end of 1977 projected a speedup in the inflation rate to about 6 percent for 1978, very few were forecasting a major spurt in inflation.
However, given the experience of the first four months of this year,
the outlook for inflation has deteriorated.

In January, February and

March consumer prices (measured over a three months span) rose at
seasonally adjusted annual rates of 6.7, 7.5 percent and 9.6 percent,
respectively. In April, the annual rate rose to 9.6. The wholesale
price index, which can foreshadow the future pattern of consumer prices,
rose by a 12.6 percent annual rate for the three month period ending
in April.
As shown in the table below, this marked acceleration in the
inflation rate has been due in large part to skyrocketing food prices
and sharp increases in the prices of services.

Other factors having

a bearing on the performance of prices since January have been:


CRS - 4

effects of mandated increases in social security taxes, the minimum
wage, and unemployment insurance which add to labor costs; various
import controls and regulatory policies which add to the cost of producing goods;

and sharp increases in worker compensation combined

with a marked decline in productivity during the first quarter of
the year—resulting in a sharp increase in unit labor costs.

Percent change from preceding
period; seasonally adjusted *

1977: Apr...

6. 1
7. 0

7. 2
2. 2
4. 3
20. 1

4. 5
5. 1

1978: J a n . . .


1. 3






Percent change from 3 months earlier; Percent change from 6 months earlier;
seasonally adjusted annual rates
seasonally adjusted annual rates






5. 0
4. 5
4. 5

18. 6
11. 6
3. 1
3. 5
4. 2

6. 1
4. 2
2. 7

9. 0
9. 9
9. 4

8. 0
8. 7
8. 9
6. 1
5. 1
4. 8

13. 4
11. 2
7. 5
6. 6

4. 6

9. 1



19. 1

5. 6
6. 1

9. 1
10. 5

6. 1
7. 1

10. 1

5. 1
5. 7


Source: Department of Labor, Bureau of Labor Statistics.

In recent testimony before the Senate Banking Committee on May 23,
1978, Barry Bosworth, Director of the Council on Wage and Price
Stability, estimated that the effects of these various Government
actions and policies will add about 1.5 percentage points to the
overall inflation rate this year.


4. 1
11. 3
8. 1
7. 3

'Annual changes are from December to December (unadjusted).
Note.—Beginning January 1978 data relate to all urban consumers. Earlier data
relate to urban wage earners and clerical workers.



CRS - 5

Despite the recent trend in prices, it is still too early to
come up with a concensus forecast for inflation Jor the balance of
the year. Updated forecasts are projecting inflation rates in consumer
prices that range between 6.5 and 9 percent annually. (The last time
the Nation experienced double-digit inflation was in 1974, when the
rate reached a level of 12.2 percent annually—the highest level
recorded during the post war period.)

Though most forecasters feel

that inflation for the remainder of the year will be worse than what
they had expected at the outset of the year, the outlook will depend
upon several factors: the condition of the dollar in world markets,
developments in the energy sector of the economy (including the type
of energy package finally approved by Congress), the pace of the
economy, the performance of food prices, the control of money supply
and credit conditions by the Federal Reserve Board, and the extent
to which Administration economic policies can succeed in dampening
inflationary expectations in the economy, which are high at the

A number of policy actions to combat inflation have been
recommended by students of public policy, in and out of Government.

CRS - 6

Of these, however, there are very few actions that the President can
take immediately that don't require legislative action. Currently,
the President does not have authority to institute mandatory controls on wages and prices. The most recent authority, the Economic
Stabilization Act of 1970, expired in April 1974. In August 1974,
Congress, however, did create the Council of Wage and Price Stability
which was called upon to monitor inflationary developments in the
public and private sectors of the economy.

The Council (which

operates within the Executive Office of the President) has some very
limited powers, but it must rely almost exclusively upon the power
of persuasion and publicity to encourage wage and price restraint
in the private sector.

It has no power to require prenotifi1/

cation of wage and price increases in key industries.


over, it lacks the authority to prohibit, change or even delay
price and wage actions it considers unduly inflationary. Though
the provisions of the Act by implication sanction the use of "jawboning" as a means of encouraging wage and price restraint, the
Act offers no specific guidelines as to how far the Executive Branch
may go in seeking industry and labor compliance with its anti-inflation


The Council operates with an authorized staff ceiling

Council on Wage and Price Stability Act, P.L. 93-387, as amended.

CRS - 7

of 39 persons.

Its authorized annual appropriation for both fiscal

years 1978 and 1979 is $2.2 million.

The Administration's Program of "Deceleration"
Some have recommended that the President set specific guidelines
for wage and price increases as one means of reducing the magnitude
of the wage-price spiral in the economy.

Industry's reaction to such

voluntary standards (which would vary from industry to industry, depending upon the level of productivity performance, availability of labor
skills, and demand and supply conditions in each industry) has been

Organized labor has voiced strong opposition, mainly be-

cause it maintains that such standards would constitute unwarranted
government intervention in the collective bargaining process, would
be difficult to apply with equity to all segments of the economy
(including labor and industry), and would serve to dampen wage increases more severely than price increases.
So far President Carter has refrained from taking such action,
but in January of 1978 he asked the business community and American workers to "participate in a voluntary program to decelerate
the rate of price and wage increase." More specifically,


U.S. President, 1977 (Carter). Economic Report of the President;
transmitted to congress January 1978 together with the annualreport of the council of Economic Advisers, pp. 19-20.

CRS - 8

...this program is based on the initial presumption that
prices and wages in each industry should rise significantly
less in 1978 than they did on average during the past
two years.
I recognize that not all wages and prices can be expected
to decelerate at the same pace. For example, where profit
margins have been particularly squeezed, or where wages are
lagging seriously, deceleration in 1978 would be less than
for other firms or groups of workers. In exceptional cases
deceleration may not be possible at all. Conversely, firms
or groups that have done exceptionally well in the recent
past may be expected to do more.
To enhance the prospects for success of this deceleration program, I have asked that major firms and unions
respond to requests from members of my Administration to
discuss with them on an informal basis steps that can be
taken during the coming year to achieve deceleration in their
industries. In reviewing the economic situation prior to
making my recommendations to the congress on the size of the
pay raise for Federal workers, due to take effect next October,
I will keep this objective of deceleration in mind.
This program does not establish a uniform set of
numerical standards against which each price or wage action
is to be measured. [Underlining added] The past inflation
has introduced too many distortions into the economy to
make that possible or desirable. But it does establish
a standard of behavior for each industry for the coming
year: every effort should be made to reduce the rate
of wage and price increase in 1978 to below the average
rate of the past two years.
I have chosen this approach after reviewing extensively
all of the available options. There is no guarantee that
establishing a voluntary deceleration standard will unwind
the current inflation. I believe, however, that with the
cooperation of business and labor, this proposal will work.

For some time the economy has been operating with an underlying
inflation rate of about 6 percent annually.

And in the view of Ad-

ministration policy makers there is little evidence that it is de-

CRS - 9


In recent years the average annual rate of increase in

hourly compensation (including private benefit programs and employer
taxes) for American workers has remained stuck between 8 and 9 percent.
In the same period productivity growth (the trend rate) has averaged
about 2 percent annually, with little evidence for any marked improvement in the foreseeable future.

Thus, when the increase in productiv-

ity is subtracted from the increases in compensation, one finds that
unit labor costs have increased on the average of between 6 and 7
percent annually.

Thus, as the Administration perceives it, this

is a basic reason why the economy has operated with an underlying
inflation rate of about 6 percent during the past two years.
To a large extent, the current wage-price spiral is a reflection of inflationary expectations which are widepread in the economy
at the present time.

For some time labor and management have based

their wage and price decisions on the assumption that inflation will
continue at a level of at least 6 percent annually, with no prospects
for any major reduction in this basic inflation rate in the foreseeable

Accordingly, workers seek wage increases which will compen-

sate for any decrease in real earnings that has resulted from past


In this connection, it should be noted that the Administration
recently raised its estimate of the inflation rate for 1978 to
6 3/4 to 7 percent from the 6 percent to 6 1/4 range forecast
earlier in the year.

CRS - 10


When union contracts come due for renegotiation, labor

seeks not only to adjust wages for past inflation but to protect
wages as much as possible from future inflation.

This is why so many

labor agreements currently have cost of living adjustment clauses in
their contracts.
Such efforts in turn set the pattern for wages,
or at least have a bearing on earnings expectations of unorganized
workers in our economy.
These expectations in turn tend to encourage business to pass
on to the consumer, in the form of higher prices, cost increases (past

and expected) that cannot be offset by increased productivity.


increases then become the basis for further rounds of wage increases.
The end result is no major let-up in inflationary pressures because
both business and labor are caught on a treadmill which neither group
can stop alone.
Aside from Government anti-inflation programs intended to achieve,
over the long run, increased productivity and basic structural changes
in the economy, policy options having an immediate impact in reducing
inflation are few.

1/ These adjustments are almost always add-ons to the annual earnings
increases negotiated in long-term basic union contracts.
2/ There are some exceptions to this rule, however. Some businesses,
because of highly competitive market conditions, may not be able
to pass all of the increase on to the consumer, thereby forcing
them to absorb such increases in the form of reduced profit margins. On the other hand, some businesses may choose to increase
prices to cover both higher costs and to increase profit margins,
particularly where they can readily pass on such increases to theconsumer without affecting sales volume.-

CRS - 11

In recent years, restrictive monetary and fiscal policies
alone have not been successful in achieving an appreciable and lasting
reduction in the Nation's underlying inflation rate.

Conceivably, the

Government could reduce inflation by shifting to "a policy of greatermonetary and/or fiscal restraint.

However, carried out to an extreme,

such action could lead to deep recession (or depression), thereby
resulting in high unemployment and lost production.

At the present

time this is not looked upon as a practical option by the Carter
Administration, since Government policy is still directed toward the
twin goals of achieving relative price stability and full employment.
Consequently, as the Administration perceives it, the only two options
lef*- £f> the government at this time (in conjunction with appropriate
monetary and fiscal restraint) that can have the most immediate short
term impact on the inflation problem are: (1) the application of mandatory wage and price controls and (2) a voluntary stabilization program
designed to inspire greater cooperation from labor and business in
trying to bring about a marked reduction in the current wage-price
spiral (or inflationary expectations).
As noted earlier, the President
has rejected the mandatory controls approach, saying that it would be
unworkable and counter-productive. However, as already noted, he has
committed himself to a voluntary wage-price stabilization program.

1/ Some would argue, however, that the basic cause of inflation is
excessive Government spending and expansion of the Nation's money
supply. Consequently, they claim that the only way to reduce inflation is for the Government to exercise much greater fiscal
monetary restraint than it plans at the present time.

CRS - 12

This program of exhortation and active monitoring of wage and price
developments in the economy is based on the assumption that the current
pace of price inflation can be decelerated if (1) workers on the average
were willing to seek wage gains in 1978 that are significantly less
than the 8 to 9 percent average annual increases in compensation recorded
in the past two years and (2) the business community were to increase
prices on the average by amounts considerably less than those in the
past two years.

Thus, for example, if workers were willing to accept

compensation increases averaging 6 percent and the business community
on the average were to increase prices by an amount equal to the difference between the 6.0 percent increase in compensation less the
average annual rate of increase in productivity for the economy—about
2.0 percent, then the underlying inflation rate in the economy could
be reduced from about 6 to about 4 percent for the year.

An Update:

The Administration's Most Recent Anti-Inflation Strategy

In a major address to the American Society of Newspaper Editors
on April 11, the President outlined the Administration's latest antiinflation strategy. He again rejected wage-price controls as a policy
He also made it clear that he would not support fiscal

1/ In responding to questions by editors following his speech, the
President, however, did say t h a t —
The only instance in which I can think wage and price controls
might be applied would be a case of national emergency, like an
all-out war, or some tragedy of that kind, where normal economic
processes would not be at work. (New York Times, April 12, 1978,
p. 35.)

CRS - 13

policies which would slow inflation by increasing unemployment. The
President's anti-inflation program consists of two types of initiatives:
those which can be carried out by administrative -action and those
which would require action by Congress.
The major administrative actions announced by the President include:
— T h e imposition of tariffs on imported oil to slow imports, if Congress fails to enact his energy proposals;
— T h e formation of a Cabinet level task force, chaired
by the Secretary of Commerce, to report within 60 days
on additional measures to increase exports;
— A promise to veto all congressional actions that would
increase the budget deficit beyond the level projected
in his budget—$60.6 billion.

(The President said that

he was "especially concerned" about spending increases
for tuition tax credits, highway and urban transit
programs, postal service financing, farm legislation,
and defense spending.);

pledge to veto any farm legislation, beyond what he

has already recommended, that would lead to higher food
prices or budget expenditures;
— N e w Government procedures that will require executive
regulatory agencies to minimize the adverse economic
consequences of their actions, to eliminate unnecessary
regulations, and to ensure that future regulations do

CRS - 14

not impose unnecessary costs on the American economy
(for more detail see Executive Order 12044, Improving Government Regulations, March 23, 1978);
— A directive to Federal agencies to avoid or reduce the
purchase of goods and services whose prices are rising
rapidly, unless by doing so we would seriously jeopardize our national security or create serious unemployment;
—Instructions to the Departments of Agriculture and
Interior, the Council on Environmental Quality, and
his economic advisers, to report to him within 30 days
concerning the best ways to increase the supply of
lumber (which has experienced sharp price gains in recent months) from Federal, State and private timber

request that independent regulatory agencies try to

reduce inflation when they review rate changes, and to
explore regulatory changes that can make the regulated
industries more efficient.

Other anti-inflationary actions recommended by the President
would require legislative action.

These include:

CRS - 15

— T h e freezing of federal executive pay and imposing
a 5.5 percent ceiling on pay increases for Federal
workers, to set an example for labor and industry to
moderate price and wage increases;
—Prompt passage of the airline regulatory reform legislation, which would allow for greater competition in the
setting of airline passenger fares;
— A requirement that the Budget Committees of Congress
report regularly to Congress on the inflationary effect
of pending legislation;
—Early enactment of the Hospital Cost Containment Bill
to halt the present spiral in hospital costs.
Though the President believes that these actions can play an
important role in combating inflation, he stated that " is a
myth that the government itself can stop inflation.

Success or failure

in the overall effort will largely be determined by the action of the
private sector of the economy."

In reemphasizing the importance of

his program for wage-price deceleration established earlier this year,
the President stated that "I expect industry and labor to keep price,
wage and salary increases significantly below the average rate for
the last two years."

To accomplish these deceleration goals in the

private sector, he said that the Council on Wage and Price Stability
has already begun a series of meetings with representatives of business

CRS - 16

and labor in a number of major industries, to determine what steps
these pace-setting industries can do to reduce inflation.


the President announced that he has asked his special Trade Representative, Robert Strauss, to take on additional duties as Special
Counsel on Inflation, and to "speak for me in the public interest."
Strauss is expected to play a key role in encouraging private sector
cooperation with the Administration's anti-inflation objectives.
In an interview with reporters on April 12, Federal Reserve
Board Chairman, G. William Miller, stated that the Administration's
anti-inflation efforts "are good first steps," but "I hope they
aren't the last steps."

Miller went on to say that fiscal policy

should be less stimulative, given the recent surge in inflationary

Accordingly, he recommended that the President consider

trimming or deferring his proposed $24.5 billion net tax cut as a way
of reducing the deficit and inflationary forces.

He said that next

year's budget deficit of about $60 billion could be cut by $9 billion
if the tax cut program were deferred by October 1 to January 1, 1979.
Initially, the Carter Administration opposed any such deferral or modifications in its tax package, taking the position that the requested tax
reductions are needed to support adequate economic growth.

However, on

May 12, 1978, the President, responding to concerns expressed by the
Federal Reserve Board and many in Congress, agreed to trim the size
of his tax package to $19.4 billion and postpone its effective date

29-775 O - 78 - 19

CRS - 17

three months to January 1, 1979.

For the forthcoming fiscal year

(FY 1979), which will begin on Oct.l, 1978, this alteration would
have the effect of reducing taxes overall by $15 billion —
below the original $24.5 billion proposal.
posed tax cut would be felt in Fiscal 1980.

$9.5 billion

The balance of the proThe Administration's

budget request to Congress earlier this year assumed a budget deficit
of $60 billion for Fiscal 1979 which it believed would promote continued expansion in the economy without generating additional inflation.
However, with the modification of its tax cut proposal, assuming no
change in spending levels, the estimated budget deficit would be reduced to about $50.5 billion.
On May 17, Congress approved the first Concurrent Budget Resolution

(Con. Res. 80) which set non-binding spending and revenue goals

(including both tax revenues and deficit financing) that would result
in a budget deficit of $50.9 billion for fiscal year 1979—almost
$10 billion below the budget estimate announced by the President at
the outset of 1978.

Binding revenue and expenditure targets for the

Budget will be set by Congress in September of this year.
Finally, on June 8 the President announced that he was ordering
an easing of beef import quotas to allow an additional 200 million
pounds of beef (most meat to be used in lunch meats or hamburgers)
to be imported into this country this year, above the 1.3 billion pounds

CRS - 18

allowed under the present import quota program.

Though the Admin-

istration makes no claim that this action will have a dramatic impact
on consumer prices, it believes that this gesture will reduce the
price of hamburger by 5 cents a pound by year's end and save consumers
$500 million.

In its view this "modest" increase in beef imports

"will not change the price of fat cattle at all."

However, the Cattle-

men's Association deplored this action, saying that "the projected
import increase will do little or nothing to lower retail beef prices
in the short term. ... Over the long term, the action is expected
to lead to smaller beef supplies and even higher prices."

Granting of Additional Powers to the Council on Wage and Price Stability
In the Joint Economic Committee's Annual Report on the Economic
Report of the President for 1978, the majority members of the Committee recommended that legislation be enacted giving the Council
on Wage and Price Stability authority to "require prenotification
of planned price increases from selected industries and to delay for
modest periods wage or price indreases which could have serious in2/
flationary effects on the economy."
These Committee members went


Washington Post.
1978, p. Al.

June 9, 1978, p. A2.

New York Times, June 9,

2J U.S. Congress. Joint Economic Committee. The 1978 Joint Economic
Report; report . . .on the January 1978 Economic Report of the
President together with minority and additional views. March 15,
1978. pp. 115-116.

CRS - 19

on to say that such action would be

...a reasonable start toward an income policy,
short of voluntary or mandatory controls which
would allow the council to review and comment on
the justification for wage and price increases.
In addition, prenotification and delay of wage
and price increases would help give the Administration and the Congress time to consider and
develop long-run measures to reduce inflation.

Two members of the Majority, however, expressed reservations

about this proposal.

Rep. Reuss stated that:

Prenotification is a useful idea under certain circumstances. However, the present nervous business climate
is such that prenotification requirements may do more
harm than good. Such requirements may impair the willingness of business to undertake new ventures and to
expand their capacity, and as a consequence impede the
attainment of full recovery and full employment.

Senator Bentsen, vice chairman of the Committee, voiced stronger

opposition to this recommendation saying t h a t —
I disassociate myself completely from this proposal which I regard as a very serious mistake. Despite
its reluctance to admit it, this Committee is recommending mandatory price and wage controls. . . The
authority to delay wage or price increases is logically the authority to fix and control wages and


Ibid. p. 116.


Ibid. p. 143

CRS - 20

Nonetheless, if the current wage-price spiral cannot be broken
by conventional monetary and fiscal actions supplemented by the voluntary stabilization program outlined by the President, Congress might
come under increasing pressures to give the President some authority
to require prenotification and delay of price increases in selected
industries, or broader authority to control wages and prices generally.
There appears to be little support in Congress for such action at this

This is due largely to recent memories of the mixed performance

of economic controls during the 1971-74 period, especially the widespread difficulties encountered by the Economic Stabilization Program
during Phases III and IV.

Other Possible Congressional Initiatives
In addition to the legislative actions, cited in the President's
anti-inflation program, Congress could take a number of other actions,
if it deemed them appropriate measures to combat inflation:
For example:
— I t could cut spending levels below those presently
requested by the President.
— I t could reduce the size of the President's tax cut
proposal, or postpone indefinitely any further reductions in Federal taxes.

CRS - 21

— I t could take actions designed to roll back or postpone
social security tax increases enacted last year, which
would reduce the labor costs of employers and increase
the take-home pay of workers, thereby moderating the
pressures for wage and price increases.
— I t could enact legislation to relax environmental,
health and safety standards, which could reduce production costs in industry.
— I t could enact tax legislation to provide additional
incentives to increase productivity and reduce production costs.

Combating Inflation over the Long Run
The Nation's success in reducing the rate of inflation over the
long run will depend to a large extent upon how the Government manages
its monetary and fiscal policies.

However, it is generally agreed

that our success will depend also upon how well Government policy and
private sector interests address a number of longer term structural
problems within the economy which impede the necessary expansion of
supply and can generate inflationary pressures in various sectors
of the economy.

Examples of such problems, which are not necessarily

affected by changes in aggregate demand, include:

CRS - 22

-the need to make agricultural production more responsive to changing demand and supply conditions, including the maintenance of buffer stocks to offset the
effect of surpluses and shortages caused by global
weather conditions;
-the need to achieve greater self-sufficiency in meeting
our nation's energy requirements;
-the need to overcome inadequacies in the structure of
health care and delivery and supply, which have contributed to skyrocketing increases in medical costs;
-the need to eliminate and/or modify outdated Government
laws and regulations which adversely affect the efficiency and competitive structure of the market place;
-the need to counter the abuses of excessive market
power that may be exercised by certain business and
labor interests in the economy;
-the need to improve the functioning of labor markets
to assure a much more efficient matching of labor demand
and supply; and
-the need to increase productivity in both the private
and public sectors of the economy.

CRS - 23

Current Role of Monetary Policy
This analysis has reviewed mainly the roles of the Executive
and Legislative branches in fighting inflation.

Yet, as already

noted monetary policy also plays a key role in the Government's
anti-inflation efforts. The Federal Reserve Board is empowered by
Congress to manage the Nation's money supply in ways that it deems
suitable to fulfill certain national economic objectives. Though the
Federal Reserve is subject to legislative oversight, it is given broad
discretionary monetary policy authority. In addition to making an
annual report to Congress, the Federal Reserve, as provided in P.L.
95-188 is expected by Congress t o —
...maintain long run growth of the monetary and credit
aggregates commensurate with the economy's long run
potential to increase production, so as to promote
effectively the goals of maximum employment, stable
prices, and moderate long term interest rates.
This law also provides that the Federal Reserve shall consult quarterly with the Banking Committees of the Congress about monetary policy and targets for monetary and credit aggregates for the forthcoming
year, taking into account past and prospective developments in production, employment and prices.
In making the Federal Reserve's regular quarterly report to Congress on April 25, Fed Chairman G. William Miller, stated that the
monetary policy has tightened slightly, but he indicated that any furfurther deceleration in monetary growth rates "has to be undertaken

CRS - 24

with caution."

He went on to say that the growth in money supply must

be reduced gradually over the year ahead, but "the pace of deceleration
cannot proceed much more rapidly than the pace atwhich built-in inflationary pressures are wrung out of the economy if satisfactory economic
growth is to be maintained."

Thus, the Chairman made it clear that

Fed, at the present time, plans to follow a course of "moderate restraint"
as its contribution in the fight against inflation.

A Word About Tax-Based Incomes Policy (TIP)
Another method of wage-price stabilization currently receiving
increased attention in policy circles is the tax-based incomes policy,
known as TIP.

In contrast to either exhortation or direct controls—

the two more traditional methods of incomes policies, TIP would utilize various tax incentives to promote greater wage and price restraint
within the private sector.

The proponents of TIP assert that this ap-

proach to economic stabilization, for the most part, would avoid governmental interference with the normal workings of the market system,
a characteristic of most other incomes policies.
There are numerous TIP proposals, but the three receiving the
most prominent attention at present are (1) the employer-incentive

In testimony before the United States Senate Banking, Housing
and Urban Affairs Committee, April 25, 1978.

CRS - 25

program proposed by Henry Wallich, a member of the Federal Reserve
System, and Professor Sidney Weintraub of the University of Pennsylvania; (2) the employer-employee incentive pack-age recently proposed

by Arthur Okun of the Brookings Institution;

and (3) a proposal by

Professor Laurence Seidman of the University of Pennsylvania which
combines elements of the two previously mentioned proposals.
The Wallich-Weintraub plan would place a tax penalty (or surcharge)
on employers who grant wage increases that exceed an "acceptable" wage
increase standard established by the Federal Government.

The designers

of this stabilization mechanism believe it would provide an incentive
to employers to resist "excessive" wage increases, since they would
have to pay a tax penalty based on a formula applied to that portion
of the wage increase granted by the employer that exceeds the economywide standard for wage increases established by the Government.


the employer were to grant a wage increase in line with the standard,
no tax penalty would be assessed.

Furthermore, the plan assumes that

the penalty could not be automatically passed on by the firm to consumer in higher prices because some of its competitors in the market
place may not have incurred as large a tax penalty (or any at all)


Sidney Weintraub and Henry Wallich. A Tax-Based Incomes Policy.
Journal of Economic Issues, June 1971: pp. 1-19. Arthur M. Okun.
Out of the Stagflation Swamp. Across the Board. January 1978:
pp. 68-75.

CRS - 26

because of their success in granting lower wage increases. Thus, this
element of competition, it is assumed, would make employers generally
more resistant to "excessive wage demands."
Instead of the stick approach, the Okun plan would extend the
carrot to both employers and employees, to encourage less inflationary wage and price increases.

This plan would establish voluntary

Government standards (or guideposts) for wage and prices.

If em-

ployees of a firm were to agree to wage increases that amounted to
less than the Government economy-wide standard for wage increases,
they would receive a tax rebate in the form of reduced payroll taxes
in proportion to the degree of wage restraint exercised.

At the same

time the employer would receive a tax rebate on its income tax liabilities on domestic operating profits, if the firm held its average
rate of price increase (apart from a dollar-and-cents pass through
of any increases in costs of materials and supplies) below the Government economy-wide standard for price increases during the course of
the year.
The Seidman plan would combine elements of both the Okun and
Weintraub-Wallich proposals, providing both a "stick11 and "carrot"
depending upon how labor and management abide by voluntary Government
standards for less inflationary wage and price increases.

If labor

and management agree to a wage increase by the amount equal to the
increase allowed under the Government wage-price standard, neither

CRS - 27

party would receive a tax penalty.

If the employer were to grant

a wage increase that exceeded the Government standard, both labor
and management would be assessed a predetermined -tax penalty on their
incomes (wages and profits) for that year in proportion to the size
of the excess.

On the other hand, if the employer were successful

in negotiating a wage increase that would be less than the Government standard, both labor and management would receive a proportionate

tax cut on their incomes.
Despite their differences, these three TIP proposals are based
on the assumption that monetary and fiscal policies have not been
effective in preventing labor from obtaining wage increases in excess
of productivity gains, even in period of economic slack and high unemployment.

They consider TIP not a substitute for, but an essential

complement to proper monetary and fiscal policy in promoting less
inflationary wage and price behavior in the economy.


as Henry Wallich noted in recent testimony before the Senate
Banking Committee, the various TIP proposals—


Laurence S. Seidman. A Tax-Based Incomes Policy: Statement
before the United States Senate Committee on Banking, Housing
and Urban Affairs, May 23, 1978. 22 p.


Henry C. Wallich, Member, Board of Governors of the Federal
Reserve System. Statement before the United States Senate
Committee of Banking, Housing and Urban Affairs Committee,
May 22, 1978.

. 297
CRS - 28

... rest on the well documented fact that prices follow wages
[underlining added]. Numerous researchers have arrived at
that conclusion. At the same time, of course, prices influence
wages, although tne relationship is less close. There are
other cost factors that often are claimed to be responsible
for inflation—high profits, high interest rates, monopolistic
practices, high prices of food, of oil, and the depreciation
of the dollar. While at times each of these does exert an
effect, the main factor governing prices nevertheless is wages.
With about 75 percent of national income representing compensation of labor, it could not be otherwise. All other elements,
although at times possibly significant, are bound to be small
by comparison. Therefore, restraint of wages means restraint
of prices. Labor does not lose from wage restraint. Whatever
it gives up in the form of higher wage increases, it can expect
to get back in the form of lower price increases.

The proponents oi: TIP view it as the most effective and least
disruptive way of attacking the current wage price spiral, and
reducing the inflationary expectations of both labor and management.
Because TIP relies on market incentives, they believe that direct
governmental intervention can be avoided.

None of the various plans

compel the employer or employee to participate in the stabilization

Nonetheless, the plans' incentive features are designed to

encourage widespread participation by the private sector.
These proposals have generated considerable interest in policy
making circles and amon,^ students of public policy, representing a
wide spectrum of political philosophies.

However, recent study of

these proposals has raised numerous questions concerning their

CRS - 29

workability as anti-inflation measures.
asked questions include:

Some of the more frequently

Are they simply another form of wage and price control?


Would they unduly complicate our tax system?


Would they open up new tax loopholes?


Could they lead to economic distortions by tipping
the balance between capital-intensive and laborintensive firms?

— A r e labor costs, as the proponents assume, the principal cause of inflation?
— W h a t type of administrative problems might occur?
— H o w are catch-up wage increases and long-term contract
agreements to be handled under such a standardized
—What effect will they have on existing industry-wide
bargaining arrangements?
— H o w would they affect the firm bargaining with many
different unions?


For two recent critiques of TIP, see: Gardner Ackley, Stagflation Swamp Revisited, Across the Board. April 1978: pp. 84-86.
Nancy Ammon Jianakoplos. A Tax-based Incomes Policy (TIP): What's
it all about? Federal Reserve Bank of St. Louis Review, February
1978: pp. 8-12.

CRS - 30

— H o w is the wage rate to be defined?
— H o w would cost of living escalators in contracts be
— H o w are firm's costs to be computed to come up with
an acceptable figure for profit margins?
— H o w are multi-product firms to be treated under such
In the face of these concerns, the various TIP proposals will
have to be subjected to many tests to determine their feasibility as
anti-inflation measures.

Because of their novelty and because they

offer interesting alternatives to other well known anti-inflation
measures, such as jawboning, voluntary guidelines, and direct controls,
TIP will likely continue to receive considerable attention in the
current debate over incomes policy.

Because of the sharp rise in the general level of prices during
the first four months of this year, most Government policy makers
now consider inflation to be the Nation's most pressing economic problem.
Though there is no cost-free solution to the inflation problem, one
should not as well overlook the high economic and social costs that
stem from high inflation.

Among many of its costs, inflation can disrupt

CRS - 31

the normal allocative processes of the economy, reduce the purchasing
power of the individual, redistribute real purchasing power from
creditors to debtors and from those whose incomes rise more slowly
to those whose incomes rise more rapidly, and prompt the Government
to resort to restrictive economic policies which may or (or may not)
reduce inflation, but at the cost of higher unemployment and lost
Given recent developments on the inflation front, some believe
that the Government should resort to much greater fiscal restraint
than is currently planned by the Administration.

However, the

Administration believes that any greater restraint would cause a
premature slowdown in economic activity, resulting in higher unemployment. In administering monetary policy the Federal Reserve Board
is following a policy of "moderate restraint" which is aimed at reducing
the growth rate of money supply over the year ahead without causing
a major slowdown in economic activity. Aside from these conventional
policies, the Administration is placing increased pressures on labor
and management to exercise greater wage and price restraint. Administration policy is based on the assumption that inflation is largely
"cost-push" in nature, because wages in general are increasing at
a much faster rate than productivity, despite slack in the economy
and continuing high unemployment. However, in its view the blame for

CRS - 32

such inflationary pressures cannot be placed solely on labor or any
other segment of the economy. Inflation is an economy-wide problem,
reinforced to a large extent by widespread expectations of continuing
spiraling of prices and wages. To reduce cost-push pressures and thereby
lower inflationary expectations, the Administration is banking heavily
on a strategy of exhortation designed to encourage voluntary action
by labor and management to exercise greater wage and price restraint.
Over the longer run our success in restoring the economy to relative price stability will depend not only upon how the Government
manages its monetary and fiscal policies, but also upon how it and
private sector interests address a number of structural barriers to
price stability which cire not readily affected by changes in aggregate

These problems are particularly evident in such areas as

agriculture, energy, health care, Government regulation, concentrated
industries, labor markets and in low productivity industries.
The various Tax-Based Incomes Policies (TIP) proposals which
have been given increased attention in policy circles suggest some
interesting policy alternatives.

However, they will require further

study before any conclusions can be reached concerning their suitability as an anti-inflation measure.
Government policy is committed to achieving both full employment and relative price stability.

2;)-775 O - 78 - 20

Therefore the Carter Administra-

CRS - 33

tion is attempting to steer a middle course in its anti-inflation

All anti-inflation policies involve some costs to society,

but the Administration believes that its program of "deceleration"
can minimize the costs of inflation without calling for any major
economic sacrifices from citizens or any one segment of the economy.
However, if this policy should fall short of its objectives, the
Government may well come under increasing pressures to resort to higher
cost actions.

It could tighten the fiscal reins on the economy by

reducing Government spending and/or increasing taxes.

Likewise the

Federal Reserve might choose to shift to a policy of greater monetary restraint causing a reduction in available credit and higher
interest rates.

In the current economic context, both actions individ-

ually or taken together have the potential danger of slowing economic
growth and increasing unemployment.

Voluntary guidelines could be

instituted, meaning greater direct governmental intervention in the
decision making process of private markets.

Or, if the Congress were

to enact a new authority for economic controls, the Government could
require prenotification and/or possible delay of price and wage increases
in key industry sectors of the economy, or go a step further and institute
a broader or more comprehensive system of mandatory controls on wages
and prices.

Such action would greatly reduce the economic freedom

of labor and management in the setting of wages and prices.

CRS - 34

In the final analysis, the Nation's success in reducing inflation
will depend upon the American people's perception of the seriousness
of the inflation problem and the extent to which they are willing to
bear the costs of effective government and private sector anti-inflation


Senator SCHMITT. It has a number of questions similar to those
and, in addition to those that Governor Lilly mentioned about TIP.
It also I think agrees with Governor Wallicli that—and I quote—
"they do not believe that T I P could offset the consequences of excessively expansive monetary and fiscal policies."
Governor Wallich, you seem to be a little bit—or maybe I misinterpreted—at odds with Dr. Okun about the effect of Federal monetary and fiscal policies. Is that correct, or where do you stand on this
issue ?
Mr. WALLICH. Dr. Okun and I use fundamentally similar economic
analysis but we come out somewhat differently. I would say, for instance, that in the present situation a large deficit is inflationary—
not primarily because it generates excess demand, although we are
very close to that situation—but because it generates the expectation
of another large deficit next year and the year thereafter, by which
time we will have excess demand if the economy is still expanding.
Expectations, therefore, are set on an inflationary path. That is one
link between Government deficit and inflation.
I do not think one should simply say that without excess demand
there cannot be inflation as a result of the deficit. The same applies to
increases in the money supply.
I would add to Dr. Okun's analysis that it certainly is true in the
short run that the studies show a reduction in demand leading mostly to a reduction in volume and only secondarily to a reduction in
prices. But over time the roles are reversed and a reduction, for instance, in the rate of growth of the money supply goes very largely
into price adjustments.
Senator SCHMITT. Well, do you think we always have to be wedded
to the short-term stimulative effect of the deficit ? I think you're right.
There have been some very persuasive studies in recent years that
showed exactly what you have described. In the first year you generally get some stimulation of demand with a deficit, but after about
2 years you get a very marked increase in the inflation rate. The converse would also be true. Should we make any attempt to balance those
Mr. WALLICH. It seems clear to me that where we have the choice
between bad effects now and worse effects tomorrow, we have to go
for the bad now in order to stave off worse tomorrow. I would always
look, therefore, at the long run and "bite the bullet" in the short run.
Senator SciiMrrr. Well, let's agree then on just what the effect of the
Federal deficit through the money supply and through it inflation
may be, and look at some other causes of inflation and some other factors in our economy.
One school of thought, primarily in business, is that Federal tax
policy is so designed that capital investment is being retarded and
that we may well be reaching the peak of our recovery, another peak
is lower than peaks in the past. There are those that would attribute
that to tax policy, and say that capital investment is low, that we
can't expand to meet all the potential demand, and that we can't
modernize plant and therefore we can't cut costs.
Do any of you gentlemen have comments on that particular aspect?
Mr. SUXLEY. Federal tax policy over the last 15 or 16 years has


been aimed continually at reducing the level of taxation on the income from capital, going back to 1962 when President Kennedy proposed and Congress enacted the Investment Tax Credit and shortened
depreciation lives. There was further shortening of depreciation lives
in 1971. The investment tax credit, though it's been turned on and off
several times, has been increased from the original 7 to 10 percent
now. The President in his tax program has proposed further significant tax reductions for business so that the overall program that the
President proposed would reduce the level of taxation on the income
from capital by $7 billion, whereas the individual tax cuts, as I said
earlier, just offset sort of the increases due to inflation and the impact
of the social security taxes that were enacted by Congress last year.
So I think that the Federal tax program has really been very responsive to the desire to stimulate and increase the level of investment.
I think if you would look over the last '-20 years at just the ratio of
the different taxes as a percent of total Federal revenue you will find
that social security taxes were 15 percent of the total, individual income taxes about 45 percent, and corporate income taxes about 30
Individual income taxes are still about 45 percent, but social security taxes have gone from 15 percent up to 30 percent.
That is a tax on labor income. And the corporate income tax, a tax
on capital income, has gone from about 30 percent of the total down
to about 15 percent, which I think reflects the kinds of shifts that
have been made over these years in Federal tax law.
So I think we have done about as much as we can through the
Federal tax system to keep twisting the output towards investment.
It may well be that the policy which we ought to pursue, as suggested by Governor Wallich, is one which would involve tighter
fiscal policy; that is to say, run a smaller deficit so we can get the»
interest rate down.
The mix between fiscal policy, on the one hand, and monetary policy on the other is one of the areas which people will be looking very
closely at.
Senator SCIIMITT. What about the relative bite the Federal Government puts on the gross national product? Do you think that
should be restricted and do you think we ought to try to let the Federal budget increase by only 2 percent per year to reduce the amount
of total tax we're taking?
Mr. SUXLEY. No, Senator. President Carter is committed to reducing the size of the Federal expenditures relative to GXP.
Senator SCIIMITT. What is that?
Mr. SrvLF.v. He's committed to bring that down to 21% percent:
from the 22% he inherited.
The. 1979 budget, as proposed by the President, included no really
new expenditure initiatives. In real terms, that budget has the smallest increase in Government expenditures in the last 5 years.
So the President is committed to holding down the rate of Government expenditures and reducing Federal Government expenditures
as a share of GNP and, at the same time, relying on tax reductions to
insure that additional jobs are in fact created in the private sector.


Senator SCHMITT. Well, that commitment may be there. It's not
entirely obvious that it is being carried out or can be by this administration with all the other desires that they have.
We had a commitment not too long ago to try to balance the budget
also within a fairly significant period of time.
Mr. SUNLEY. The President still believes that that is an important
Senator SCHMITT. Well, I understand. Everybody believes it, but
we don't seem to see much progress getting there.
What was the percent increase in Federal spending of the President's budget? Wasn't it about 10 or 15 percent over last year?
Mr. SUNLEY. I believe it was about 10 percent in nominal dollars
and 2 percent in real dollars.
Senator SCHMITT. Thank you, Mr. Chairman.
The CHAIRMAN. I would like to ask both Dr. Wallich and Governor
Lilly to comment on this.
Given the Federal Reserve's very strong interest in inflation, would
it be possible for the Federal Reserve to use its regional network to
determine business and labor's attitude toward TIP ?
I realize that you, Governor Wallich, are personally involved in
TIP, but still, it would seem to me that this would be an apparatus
that could be very useful in ascertaining what the difficulties and
objections might be and whether or not there is much prospect of
Mr. WALLICH. I would certainly welcome any comments.
The CHAIRMAN. Can you go out and seek people ? Can you aggressively go out and ask for them ?
Mr. WALLICH. That could be- possible. Of course, by no means are
all of the directors of Reserve Banks, businessmen or bankers. There
are academics and others.
The CHAIRMAN. I'm not asking the directors necessarily give their
views, although they would be welcome.
I'm asking if you use the apparatus of the Federal Reserve to
solicit a comprehensive response from businessmen from their region.
Mr. WALLICH. That kind of inquiry might be possible. I hope that
by now T I P is sufficiently well known that it would be relatively easy
to get responses from people. To the extent that this is not the case,
the difficult aspect of such a survey is how to get the facts before the
audience, as it were, so that meaningful responses could be generated.
The CHAIRMAN. Governor Lilly ?
Mr. LILLY. Well, I think that Governor Wallich is a little reluctant
to volunteer the services of his colleagues. But I don't feel under that
constraint since I'm no longer on the Board.
I think that it would be an undertaking that could be very well
done by the 12 Federal Reserve banks and the Board.
I think you could get a great wealth of information rather quickly.
Senator SCHMITT. Mr. Chairman, if you would yield. I think it's an
excellent suggestion. I also, though, would think that it might be useful to balance the record by asking the question: "What other components of inflation does the Federal Reserve System as a whole see?"
The CHAIRMAN. Yes. In other words, any other options.
Senator SCTTMITT. I'm asking for options or just their analysis of
the present inflation rate. Also what are the contributing pressures?


The CHAIRMAN. Well, we may write a letter to the Chairman of
the Federal Reserve Board and ask him to make this kind of a study.
Dr. Wallich, you said that labor does not lose from wage restraint.
Whatever it gives up in the form of higher wage increases, it can
expect to get back in the form of lower price increases.
Now that would be true if the wage and price restraint were of the
same magnitude. But how do you convince labor that you can deliver,
if they take the more modest wage increase, that prices won't go up
Mr. WALLICH. The evidence shows that prices tend to follow wages.
As wage movements have gone up and down, prices have been strongly influenced and ultimately determined by wages. The reason for
that, as I said, is that wages are by far the largest cost in production.
There is very little else, such as profits, raw material costs, oil, food
shortages, and that kind of thing, that might cause significant fluctuations in production costs. But by and large, the evidence that prices
are determined by wages is very strong.
Now if labor is concerned that wage restraint would not be followed by price restraint, I have made the additional suggestion that
we try to stabilize the share of corporate profits in national income
or GNP on some historic basis. Then if profit margins should widen
because prices do not decelerate fully as wages decelerate, the profits
tax—that is, 48 percent corporate income tax—would be raised
The CHAIRMAN. I understand that.
So you wouldn't have the kind of resentment angle working but
you would have the cold, hard fact, prices didn't come down.
Unless you feel the profits tax might result in a price reduction
Mr. WALLICH. I think the basic fact, Mr. Chairman, is that prices
will respond, and my concern is mostly to reassure labor about a concern I know that labor feels, even though I do not think it is a necessary concern.
The CHAIRMAN. Dr. Okun proposed a program for tax incentives
for those workers and firms that comply with wage guidelines would
lower tax rates, as I understand it, and therefore, increase the size of
the Federal budget deficit.
How much do you estimate the cost of your proposal would be and
would that amount be added to the deficit or would there be other
revenue increases that would compensate for it
Dr. OKUN. I would hope that the provision for a reward approach
on a tax-based incomes policy would be made without enlarging the
deficit, either by an explicit decision to defer any tax steps that would
otherwise be made during that period, or to put a strong curb on
Government spending during that period.
The program that I have outlined, with my guess that you would
have two-thirds participation, would involve revenue losses of perhaps $12 to $14 billion a year.
I think ideally one would like to exact TIP at a time when we
would otherwise be likely to make a tax cut. And we are in such a
position now. Because of the inflation upcreep on income tax brackets, on the value of the exemption and so forth, we will have to
make recurrent

The CHAIRMAN. What you are really proposing is a form of a tax
cut that would be as deflationary as possible.
Dr. OKUN. That's right.
The CHAIRMAN. Dr. Wallich, your version, as I understand it,
would apply a penalty for a wage increase above a certain norm. Dr.
Okun's version would give a tax cut for any wage increase less than
a certain norm.
Is there a possibility of merging these two? Can they work together in tandem, or do you have to choose one or the other?
Mr. WALLICH. It might be possible. For instance, one could have
a penalty for wage increases above a certain norm and a bonus for
increases below a certain norm.
It raises the problem, however, that everybody must have access
to such a scheme, and I believe it is only on the principle of universal
coverage, that one could easily apply something of this kind. Also,
there would be familiar administrative problems with evaluating low
wage increases of a firm that had created a special situation for
So I have not pushed farther in that direction because of these
difficulties, it is not impossible.
The CHAIRMAN. NOW, one of the results of TIP, as I understand it,
is not only to moderate inflation, but also, to give us a lower rate of
unemployment for any given rate of inflation.
Is that correct?
Mr. WALLICII. That is.
The CHAIRMAN. HOW significant would that be? Do you lower it
one-half of 1 percent, for example, or 1 percent?
Mr. WALLICII. I think 1 percent would not be an unreasonable
guess. It depends on how forcefully the system is applied.
The CHAIRMAN. HOW would that work? How do you estimate it
would work to reduce unemployment ?
Mr. WALLICII. TO be somewhat technical, there is a doctrine of the
noninflation rate of unemployment; that is, at some rate of unemployment inflation neither rises nor falls. Now if there is such a point,
assume we are at that point. If T I P is introduced, we would expect
inflation to fall while the level of unemployment remained constant.
This tendency for inflation to decelerate could be used to reduce unemployment to the point where inflation remained constant. That
would be the point at which there is an equilibrium between the
downward thrust of T I P and the upward thrust of a low rate of
The CHAIRMAN. Dr. Okun, as the author of Okun's law and one of
the outstanding experts in the world in inflation and unemployment,
and their relationship to each other, do you feel realistically that T I P
could play a part in moderating the rate of employment you would
have with a given rate of inflation ? And if so. how ?
Dr. OKUN. Yes, and along the lines that Dr. Wallich indicated. The
balance point in labor markets depends upon how firms and workers
respond in setting wage increases with a given degree of tightness or
If you can change the incentives, you can lower the unemployment
rate, and presumably, get the output that is associated with that.


Now, I think that gets into the question of whether one visualizes
T I P for a fairly limited time period primarily as a way of getting
out of the momentum inflation we have gotten into, or whether one
envisions this as a long-term continuing program.
My view is, let's strive for 3 years with the main emphasis being to
get out of this stagflation swamp. Then, if it turns out to be reasonably manageable, feasible, and not administratively cumbersome, we
can take another look and see whether it could do us some good in
the long run as a way of having a lower unemployment rate along
with a noninflationary economy.
All of this, of course, is a way of making it possible to accomplish
a given output and unemployment objective with lower money
growth because you won't have to finance as much inflation along
with it.
And I would think that with an improvement in investment attitudes and the like, it should be possible to operate the Federal budget
much closer to balance.
It seems to me that curing the inflation problem is a precondition
for getting the kind of monetary and fiscal policy that would be consistent with noninflationary performance over the long run.
The CHAIRMAN. Senator Schmitt.
Senator SCHMITT. Gentlemen, do you see T I P going to all components of the unemployment rate, or assisting in that? For example, would it have anything to do with so-called structural unemployment? Affecting those people without marketable skills? Dr. Wallich.
Mr. WALLICH. I do not see TIP as a means of dealing directly
with structural unemployment if I understand the question correctly. I do think that the unemployment rate can be lowered in the
long run given that T I P is continuously applied.
Senator SCIIMITT. Governor, my impression is that it would primarily assist in those areas employing relatively skilled individuals,
semiskilled or skilled individuals. The unemployment figures, however,
contain a great deal of structural unemployment.
They also contain figures for those people that are coming in and
out of the job market without a long-term commitment, if you will,
to full employment. Will it affect that group, that in-and-out employment group ?
Mr. WALLTCII. TO the extent that the whole unemployment rate is
lower over a period of time, I think that that group would tend to
benefit more than proportionately, because the unemployment in
that group is so high. When unemployment as a whole comes down,
that group generally has a higher reduction in unemployment. But
T I P is primarily directed against inflation. I believe it is in curing
inflation that it would have its main benefit of improving the whole
tone of the economy and the investment that you were concerned
with, Senator. In that way, I believe TIP would contribute to reducing unemployment at all levels.
Senator SCIIMITT. Well, I guess my concern, gentlemen, is that the
T I P proposal, taken by itself, tends to imply that the blame for inflation is in the private sector, both labor and business. Maybe I am
misunderstanding, but that seems to be where you are directing the
cure for something that has many components, one which we can't

completely agree upon, but others, such as energy crisis, regulation,
wage increases beyond productivity, and the inflation rate; and then
again, tax policy.
Do you think it can be successful without fairly significant action
in these other areas, including Federal spending?
Mr. WALLICII. I agree with you. Senator, as my testimony tries to
Senator SCIIMITT. Yes.
Mr. WALLICH. Unless we have fiscal and monetary restraint, although possibly less forceful than would otherwise be necessary, I
don't think T I P is going to do the job.
It is not a substitute; it is a complement for the right measures
which are in the Government area.
Senator SCIIMITT. Dr. Okun.
Dr. OKUX. I think the issue that you have raised, Senator, of the
appearance of blame, is an important one. As I see the way our private sector s}Tstem operates, we have wages that are determined, in
large measure, on the basis of certain standards of equity.
There are lots of employers that have long queues of workers
looking for jobs, but they don't turn to the present workers and say,
"We are going to freeze wages, and if you don't like it, there are
lots of fellows out there who would like your jobs."
That was the Marxist model of a labor market, and it turned out
to be wrong. We do have a career attachment between employers
and employees, and whether you are talking about a union or nonunion context, everybody has to do for his workers what others are
doing for theirs.
Similarly, on the price side, we have a situation in which, basically,
the only way a firm can manage its pricing is to do pricing that has
a very strong relationship to costs—cost-oriented pricing; you put
a markup onto your cost. In that kind of a world, inflation isn't all
that sensitive to the strength or weakness of demand.
The kind of recession that we have had in 1974 and 1975 by the
old textbooks should have produced declining prices and wages. And
it didn't. In auction-type markets where supply and demand are
nearly balanced—copper, lumber, and so forth—we did have major
price reductions resulting in an actual turnaround of inflation in
But that didn't happen in collective-bargaining areas; it didn't
happen in the administrative pricing system. I don't think it is bad
that our system operates in a long-term context of wagemaking between employers and employees; but in the present situation, it does
prevent us from getting out of the box.
It does give an enormous amount of momentum to an inflation
that was unquestionably caused by some very serious mistakes that
were made by the Government. I regret to say, that they began at
a time when I was a public official in the late sixties, they were compounded by some new mistakes made in 1971 and 1972 of seeking to
use controls as a way out of the box, and compounded by what I
think was, basically, misfortune and bad luck on the energy price
So we are here. To me it is no more a matter of blaming business
and labor than when we take the position that the only way people

toting guns in a frontier town can put them down is when there is
some sore of decision to engage in, multilateral disarmament.
We are looking for multilateral disarmament between business
and labor here, but not because they are sinful, or because anybody's
a villain of the piece, or because the Government is blameless and
faultless. Quite the contrary. We are in a momentum situation; we
are entrenched in it, and we have to make a collective decision to get
out of it.
Senator S( IIMITT. Doctor, you and I agree in all but one aspect of
your analysis of the history of the sixties and seventies that you
mention. I would disagree that the energy was bad luck. We brought
that on ourselves, also, by 25 years of bad policy.
Governor Lilly, would you care to comment?
Mr. LILLY. Well, I would comment on Governor Wallich's remark
about the question of whether this is to improve, will improve structural unemployment. I don't think it will. I think structural unemployment is something that we have to develop other programs for.
I think the main unemployment problem today is with minority
teenagers. I would hate to see that problem finally come to a solution
after all these other events of the period. I think Governor Wallich
said that he wasn't really addressing that problem with TIP. He
was addressing inflation. I think we need all sorts of programs to do
something about the minority teenagers.
Senator SCHMITT. I agree with you also. I am not sure Governor
Wallich was trying to advocate TIP as a way into that problem.
Mr. LILLY. I don't think he was.
Senator Sciranr. But we had been coupling or linking TIP with
the unemployment picture, and I felt we needed to understand that
it really goes to just one component of, if at all, the unemployment.
And that is those workers who are career workers. This includes primarily adults, most of whom arc adult males. I believe, at the present
time. That unemployment rate is somewhere around 3 percent. I believe, right now. That: is what we would be working on primarily.
Mr. Sunley.
Mr. SUXLEY. I might add, if I may. one comment on the structural
unemployment. President Carter, as part of his urban program has
proposed a restructuring of the new jobs credit by Congress enacted
in 1977. The 1977 version of the credit is really an award for firms
which are rapidly growing. What the President has proposed is to
restructure that credit as a reward for firms that are employing disadvantaged youth, defined as these between the ages of 18 and 24
who come from families with incomes of less than 70 percent of the
lower family budget published by the Department for different cities
in the country.
This is an example of a Government program aimed at structural
unemployment and not just relying on aggregate fiscal policy to
bring down the unemployment rate.
I think that T I P is another example of a policy which would permit us to moderate wages and prices without at the same time adding
substantially to the level of unemployment.
That, of course, has been the basic and difficult problem that we
have faced over the last 4 or 5 years—how can you moderate the

level of inflation in the economy without getting unemployment up
to 9 and 10 percent.
I think the President's proposal for the new employment credit is
moving us in the right direction.
Senator SCIIMITT. Mr. Chairman, I think it's been a very interesting panel. 1 have some very deep concerns. I think we have been
unwilling, for example, to see what an expansionary, in the terms of
decreasing inflation, tax policy and fiscal policy would do with respect
to long-term decrease in unemployment. We have been unwilling to
take those longer term steps. We have been trying to work in the short
term and have been afraid to do some things that I think would, in
fact, work, and not impact the employment picture at all.
I am also concerned that T I P is being advocated in part, certainly
not by Governor Wallich, in a vacuum of saying let's go work on the
private sector without really taking care of our own house here in the
Congress. And the chairman certainly has been trying to do that as
have a number of other people. I don't think we can do one without
the other.
The CHAIRMAN. Well, I appreciate that. I do think, as I understand both Dr. Okun and Dr. Wallich that they both recognize this
is one approach that they think is desirable, but they would like to
see a lot of other things done, too. I want to get to that.
Senator SCIIMITT. Of course, my other concern is that just administration of a program of this kind is conceivably extremely difficult,
particularly if you go the stick approach. We might actually cause
more damage to our economy by the administrative structure wThich
operates TIP, than any good that might come from it. That would be
something we would have to be very, very careful about.
Thank you, Mr. Chairman.
The CHAIRMAN. Dr. Okun, in your opening remarks you indicated
that current economic policies are on a collision course. I take it you
think monetary policy is likely to be too restrictive, while fiscal
policy may be too expensive. How severe is the collision likely to be?
For example, in your opinion, will monetary policies during the
next year be so restrictive as to lead to a credit crunch and a housing
recession ?
Dr. OKUN. I think that is a very serious risk, Senator. As I see it,
our monetary targets today are inconsistent with the projected growth
rate of the economy. What we have seen in the last year is roughly
a 200-basis point increase in interest rates. We are looking at, if anything, an attempt to lower the growth rate of the money supply
over the next year, at a time when there is very little evidence that
either private demand or fiscal policy is lowering the growth rate of
the economy.
If that is indeed the stance of monetary policy, and I am not sure
how wedded monetary policy is to a particular target, I think a
realistic estimate is that the rate of increase of interest rates will
somewhat exceed the 200-basis points of the past year. And I would
find it very difficult to believe that that kind of rise in interest rates
could take place without causing catastrophe in home building and
mortgage financing. That may well be the only alternative, from the
Federal Reserve's point of view, to basically validating 7 percent inflation.

I think that is a horrible choice, between taking a large risk of inflation and taking a risk of saying that 7 percent inflation is acceptable, because it isn't. And 6 percent wasn't acceptable, either. We
don't have a fiscal and monetary stance likely to result in a consistent
balanced pattern of economic activity.
The CHAIRMAN. We have done that again, and again, and again,
haven't we 2 We have followed a policy of high interest rates in response to an inflation threat with the result we have a housing
crunch, with the result that—we have a recession in housing, people
laid off there, and maybe some effect, maybe not in lowering prices,
but certainly a devastatingly adverse effect on employment and on
the economy as a whole.
I realize that the Federal Reserve is put in a touchy position when
they feel they—the only show in town—that they are the only show
in town fighting inflation and, of course, what you would do here is
provide another show to Tgo along with it. You wouldn't take them
out of the act, but you w ould provide something else to try to supplement it.
Governor Lilly, you have said that Government actions and regulations add. to inflation, and I agree. The Council on Wage and
Price Stability is responsible for examining the impact of agency
regulations on Government and inflation, but the Congress, in most
situations, doesn't consider the inflation aspect of laws as considering fully enough. As you know, the Congressional Budget Office prepares a budget impact statement so we know what effect legislation
will have on the budget. Nobody prepares an inflation impact statement.
What would you think of requiring that all major pieces of legislation carry some indication of what inflation effect they might have?
Do you think it would be worthwhile ?
Mr. LILLY. I think it would be one of the most significant things
that could happen in the Congress, if there were an inflationary impact statement with every major piece of legislation introduced.
The CHAIRMAN. Dr. Okun ?
Dr. OKUN. Yes. I have been advancing a proposal that has a
slightly different form, but the same intent, that is a quarterly report and scorekeeping system in which all of the pending and recently enacted legislation and executive discretionary decisions would
be priced out into their inflationary impact, favorable or unfavorable.
The CHAIRMAN. That would be a supplement, it would seem to me,
to have both of them. But it would be great to have it in advance
so when we have a vote on the floor, we could make arguments that
the given legislation would have inflationary impact.
Dr. OKUN. Exactly. I think these could be complements to each
other, having an inflationary impact statement program by program
and periodically summing up the totals so we could see exactly what
kind of net effect there is. Last year, what I have called the selfinflicted wounds of higher payroll taxes, a major increase in minimum wage, a return to a farm program that puts a heavy emphasis
on acreage set-asides, and a number of international trade actions
have probably been the decisive factor in making the inflation outlook more like 7 percent than like 6. That really needs to be brought
under control.

These cost-raising measures by the Government have become habitiial. They have become an easy way out to problems of how to
avoid either saying no to interest groups or financing it in ways that
enlarge the deficit. Notice these are things that didn't add "to the
deficit. I think we could have had a much more anti-inflationary
program by having a subsidy for low-income wage earners than a
major increase in the minimum wage. It would have showed up as
a Federal deficit, but would have had less effect on the cost structurpWhat we are doing now is passing costs on into the business and
household sectors. They don't show up in the federal budget. That
strategy, it seems to me, is the most dangerous new proinflationary
game in this town.
The CHAIRMAN. When that realization comes, it can be very effective. I can recall what happened to the farm bill, it was defeated in
the House. People thought it might be able to muster enough votes
to pass it over a veto, but there was finally a realization of how
enormously inflationary that proposal was, and it went down.
Unfortunately, that realization doesn't occur on most legislation
which can be inflationary.
I would like to have both you, Dr. Wallich, and Dr. Okun comment on the argument by Governor Lilly that TIP is a mild form of
wage and price controls. Would you accept that, or would you disagree ?
Mr. WALLICH. I have to differ with my colleague. It is intended
to be, and I think would be precisely the opposite. The mechanism
would be left in place, any employer can pay more than the guideline.
A union can demand and obtain more than the guideline. All that
happens is the economic pros and cons of doing that alter. Now, at
the present time, obviously, there are economic penalties to the firm
for any wage increase that it offers.
Here, the economic penalties under T I P would be further increases. It is simply a change in the balance of bargaining power, but
no interference that I can see with the free market.
The CHAIRMAN. Dr. Okun?
Dr. OKUX. I would certainly agree with Dr. Wallich's position on
that. I think we have avoided all of what I consider to be the hallmarks and defining characteristics of controls—that they interfere
with the market, that they require Government monitoring and advanced approval, and that they prohibit some form of private behavior and make it illegal.
None of those characteristics apply to either a penalty or a reward
I think T I P puts us in the position of saying there is a public
interest in private decisions made on wages and prices. And there is.
We are trying to influence behavior just as we do when we apply
an investment tax credit as an incentive to get people to invest more
and just as we do when we apply a large alcohol excise tax in an
attempt to get people to drink less. v
These are ways in which the tax system has traditionally been
used, to say that certain forms of behavior have either a favorable
or unfavorable influence on society as a whole that goes bevond the
decisionmaker. and that we want to give a reward or penalty to reflect that broader social concern.

The CHAIRMAN. Mr. Sunley, I would just like to ask you to follow
up on that. The investment tax credit is an approach to try to achieve
greater investment by using the tax system. The TIP approach is
an attempt to moderate price increases by using the tax system.
Would you say that the investment tax credit could be used, in a
sense to a limited extent, perhaps, as a kind of model for TIP?
Mr. SUNLEY. One of the points that I wanted to make in my first
statement was that there are considerably more administrative problems with the reward TIP than the penalty TIP
The CHAIRMAN. Let me ask you about the administrative problem. I think you have made that point emphatically, but the only
way you can measure that is by looking at the costs. There are other
elements too, of course, because the cost is not only cost to the Government but cost of compliance by the parties involved. Can you give
us any estimate at all of what the cost of, say, a TIP confined to large
corporations and labor unions, that is, this is the area where price
leadership and price determination is the clearest.
Mr. SUNLEY. NO, I do not have a means of quantifying
The CHAIRMAN. Would you work on that ?
Mr. SUNLEY. I think if the TIP proposal got far enough along
that it was fairly well developed, so that the Internal Revenue
Service could take a look at it, I think they could at least estimate
what the additional costs to the Government are to administer it.
I think it is fairly easy to determine between various ways of doing
things which are the more costly ways of doing it, but to actually
put a number on it is a major undertaking.
The CHAIRMAN. Without asking for a precise number, just some
order of magnitude, how many more people would have to do it,
that kind of thing, so we have some notion of what the administrative costs
would be.
I don?t see why it would be so difficult to say that this is a program
that would cost $5, $20 million, whatever general order it would be.
I take it would be something like that: is that right?
Mr. SUNLEY. I will take a look and see what is possible there.
The CHAIRMAN. Dr. Okun.
Dr. OKUN. I think this comment that Secretary Sunley made is
the most frequent major criticism of the reward approach. It does
have to be universal, whereas the penalty approach could be selective.
And that does create a significant administrative advantage in
favor of the penalty approach.
I just want to make a couple of comments on whether that issue is
overwhelming and decisive.
To begin with, the legislation will look the same and have to be
drafted with the same painstaking care whether it applies to as few
as 1,000 firms or as many as 1 million firms.
The forms will look the same, even though the amount of mailing
is tremendously different under the two schemes. The steup for inquiries at the Internal Revenue Service obviously has to be vastly
different, as there will be more people calling for information on
how to do it. if it is universal rather than selective.
I really question whether these are decisive costs. It does seem to
me that in a world in which we have operated with an investment tax
credit, employment tax credit, capital gains advantages, deductible

travel and entertainment expenses that are applicable to every employer and, indeed, every self-employed individual in this country,
we have a fair amount of experience with fairly complex provisions
of the income tax. They apply universally, and are enforced solely
by audit; and with low probability of audit, we still get pretty good
In an attempt to put these costs into perspective, let me highlight
a few advantages of the reward route. It seems to me that it provides a built-in incentive for enforcement if you are telling firms
that, when they claim the credit, they are getting a tax reduction
for their employees, rather than that when they claim a lower wage
increase, they are getting a lower penalty on themselves. I don't
think they are nearly as likely to take the risk of punishment by IRS
to get tax cuts for their workers, as they are to cut their own taxes.
It also seems easier to handle when you start enacting a program
and look at the special situations that may in some sense be inequitable at start-up time—like people who got very low wage increases last year being perhaps entitled to a catch-up. The Congress
following its traditional approach is likely to say, if we are offering
a reward, a credit, a benefit, a loosening of the bite of taxes, that is
the way the ball bounces, and some people may not get full equality
in the first year.
If you are%going to take money away from people, however. Congress is likely to try to be much more precise in making up for all
these special cases.
And I think once you try to do that, you create a very difficult
program. You really have to accept some imperfections, in order to
get an administratively feasible and economically effective program.
The CIIAIRMAX. Gentlemen, I want to thank all of you for your
testimony. It's been most helpful. This is a kind of a tough technical
area, but it is innovation and imagination and can be extremely
helpful to us.
The committee will stand in recess until 3 :00 o'clock this afternoon,
when Ambassador Strauss will be our witness.
[Whereupon, at 12:20 p.m., the hearing was recessed, to be re«*.onvened at 3:00 p.m., this same day.]

The committee met at 3:00 p.m. in room 5302 Dirksen Senate
Office Building, Senator William Proxmire (chairman of the committee) presiding.
Present: Senators Proxmire, Mclntyre, Schmitt, Tower, Riegle,
Brooke, and Sarbanes.

The CHAIRMAN. The committee will come to order.
Mr. Ambassador, we are delighted to see you, if a little tardy. I
understand you took the subway to fight inflation in your own way.
This afternoon we are continuing our oversight hearings on inflation and new ways to reduce inflation. We are honored to have with
us this afternoon Ambassador Robert Strauss who has been named by
President Carter as his number one spokesman and salesman of the
administration's anti-inflation program.
We are all well aware that the number one economic concern of
most people in our country is inflation. This morning we were told
that some new programs to reduce inflation by providing tax incentives would be a desirable complement to the President's program and
more traditional fiscal and monetary policies.
Those policies—fiscal restraint and a conservative monetary policy
—are not to be abandoned; they would be used along with the socalled tax-based incomes policies.
Also, the President's program to reduce inflation through voluntary programs and by reducing the inflationary impact of the Government itself would certainly be continued.
I am very interested in knowing how well the President's antiinflation program is doing. It has not gotten 100 percent acceptance
from either business or labor. Some press reports indicate that although everyone Tis concerned with inflation, support for the voluntary programs w ill be difficult to obtain.
It is obvious that you have undertaken a very difficult job, Mr.
Strauss. We would like to hear more about the types of activities and
programs that are under way and those that are being considered.
We would also like to find out how successful you have been in getting the business and labor people to agree to at least consider moderating wages and prices.

Senator BROOKE. Mr. Chairman, I would like to take just a moment
to commend you for calling these hearings on anti-inflationary proposals. This committee, with its jurisdiction over all matters relating
to the economy is in a unique position to assess the effectiveness of

2<)-77;> O - 78 - 21

anti-inflationary proposals made by the administration and by economic experts in the private sector. The polls I have seen indicate a
growing public awareness of the effects of inflation on the lives of
everyone of us. Xot only does inflation erode the value of savings and
push up interest rates, but it in effect imposes an across-the-board
sales tax on everything we buy. This "inflation sales tax" falls
equally on the rich and the poor; it destroys the value of the welfare
check, the social security check, and the stock dividend check as well.
This "inflation tax" is a most regressive tax, a tax made all the more
insidious by the fact that no one is required to vote for it.
But there is no question that repealing this "inflation tax" will not
be easy. It has insinuated itself into all of our economic calculations,
from the payment of the grocery bill to the purchase of a house. But
we must do all we can to root out this inflationary psychology.
And in this effort, if the President provides strong leadership, I
have no doubt he will receive support in the Congress.
I welcome Bob Strauss, to these hearings, and I look forward to
his testimony this afternoon.

Ambassador STRAUSS. Thank you, Senator.
First, may I apologize for being a few minutes late. One of the
things I was doing was working on inflation at the time, I might add.
I was specifically talking with John deButts. chairman of the board
of American Telephone & Telegraph; had a constructive and encouraging conversation with him, one that I think will lead to very positive steps.
May I, with your permission, read about a 12-minute statement,
and then take such questions as you might have, or would you prefer
I eliminate the statement ?
The CHAIRMAN. NO. That is fine. Why don't you go ahead with
the statement.
Ambassador STRAUSS. Thank you.
As every member of this committee knows, inflation has been a
major problem for a number of years, through several administrations.
We are not going to cure our inflationary spiral overnight. But I
am increasingly confident that we can begin to chip away at the
spiral, cause it to peak and then turn downward a bit..
We will begin to see some results within 12 months, but our program is directed at significant progress over more like a 30-month
For nearly a decade we have now been struggling with the twin
evils of high inflation and high rates of unemployment. Traditional
macroeconomic remedies have not succeeded in relieving the inflationary pressure in our economy—and they have imposed a severe
burden on our workers and businesses.
In dealing with inflation, this Administration will not fall back on
remedies that seek to solve the inflation puzzle through increased joblessness. There is no magical solution or "quick fix" for a problem
that is complex and stubborn, and that wTe recognize.

To understand our approach, it is important to comprehend the
magnitude of the, problems we are facing.
The first 3 months of this year wage and price increases accelerated.
This acceleration, through not likely to continue through the remainder of the year, provides clear evidence that we need to move
aggressively and without delay.
Reading the 1978 figures, in the context of this winter's developments, they tell me that while there is no cause for panic, there is
certainly cause for concern and immediate attention by the public
and private sectors.
On the wage front, several measures of employment costs displayed
sharp increases.
Prices also accelerated in the first quarter of this year. The consumer price index increased at an annual rate of 9.3 percent, compared to the 5.8 percent average annual increases in the 1976-77
The acceleration of wages and labor costs in the first quarter is
largely attributable to a series of factors which are not likely to
recur or persist in the remainder of the year.
Similarly, a 16.4 percent annualized increase in food prices was
the primary force behind the first quarters price acceleration. If
food prices return to more normal levels, the overall rate of price
inflation will slacken to some extent.
But we must candidly admit that the food price inflation this winter was worse than expected and, in areas such as meat price increases, we cannot be certain that the worst is behind us. Just look
at the futures markets.
There is no cause for all-out alarm, but an all-out alert is
Inflation may accelerate a bit this year, but it is unlikely that the
levels indicated by first quarter statistics would be characteristic of
the year as a whole. More likely is a lesser acceleration.
This expectation, however, provides no reason to breathe any sigh
of relief. In the absence of specific corrective action, the risks of acceleration are very real and very probable.
If we are unable to slow inflation during a period in which economic slack remains, then we are almost certain to face much higher
inflation rates by 1980 or 1981 as the economy approaches higher
levels of employment and capacity utilization.
Because of both public attitudes and economic reality, an accelerating inflation would almost surely bring economic expansion to a halt,
reverse progress towards lower unemployment rates, and depress investment spending. This is a scenario that we must avoid.
This administration has examined carefully the successes and
failures of past efforts to cure inflation. We have studied the advice
of the best economic experts.
Our approach will be one of voluntary cooperation between business, labor, and Government. We are setting specific performance
standards for each group, and we expect them to be met. We will not
be bashful in pointing out who is cooperating with us and who is not.
Too often in the past. Government has called on the private sector
to sacrifice without making any contribution itself.


President Carter recognizes that Government must take the lead in
this effort, and set the pace through responsible fiscal policy,
regulatory efforts, and a wage policy that practices what wTe preach.
There is little question that price levels in our society are affected
directed both by Government spending and by regulatory policy.
This is not a criticism of Congressional or executive branch programs, but a statement that the inflationary impact of proposed programs should be recognized and weighed before decisions are made.
Too much fiscal stimulus is clearly inflationary; too little stimulus
threatens the continuation of the expansion. We are not going to
slash the budget and throw people out of work in the hope that this
will moderate wage demands. The appropriate course is gradually to
reduce the federal deficit by controlling federal expenditures and
sustaining the economic expansion.
The President has already taken, and will continue to take, a great
number of specific steps to help reduce the Federal Government's
contributions to inflation. Let me mention just a few:
Limited federal employee pay raises to 5.5 percent and frozen
Federal Executive pay.
The President will appoint a small, high-level governmental task
force to coordinate efforts to improve Government efficiency and productivity. This task force will work to simplify procedures and see
that cost-effectiveness is considered in all Federal actions.
It is my expectation to work very carefully, very closely, and take
almost a daily interest in the actions of that group, which I tend to
think of almost as a governmental strike force against our own Government inefficiency where we find it.
The President last Thursday announced that he will establish a
Federal Purchasing Council to direct the purchase of goods and
services by the Federal Government in such a way that they do not
contribute to price inflation.
The President directed that price escalation clauses of all new or
renegotiated Federal contracts reflect the principle of deceleration.
Those of you in Congress have been asked to approve a hospital
cost-containment program to restrain the extremely rapid rise in
medical care prices.
In the short run, however, we will focus our efforts on measures
that promise some short-term relief from the inflation problem.
Senator MCIXTYRE. Mr. Chairman, may I ask a quick question
Mr. Ambassador, Senator Mclntyre would like to interrupt and
ask a question.
Ambassador STRAUSS. Yes?
Senator MCIXTYRE. I note that what has always been a high priority of the administration, to balance the budget, does not appear
among these thrusts that you are indicating here today. Does that
mean that it has been abandoned ?
Ambassador STRAUSS. NO, it does not, Senator Mclntyre. As a
matter of fact, I think the—there is going to be a strong and vigorous budgetary process take place within the next few months to try to
see what this administration can do with the budget.

I think you will sec a strong and vigorous policy as you have ever
seen by any administration.
Now, I didn't bring that up in here because it hasn't been cast for
me in the light of this inflationary program which I am responsible
for, but I am fully participating in that budgetary process and I
think it is going to be productive.
Senator MCINTYRE. Thank you. I hope so.
Thank you, Mr. Chairman.
Ambassador STRAUSS. But while the Government can take the lead
in the fight against inflation, it cannot solve the problem alone. The
cooperation of business and labor is essential to a successful effort.
We are asking the business community to publicly and vocally commit themselves to our deceleration standards. We believe that the
avoidance of a single number or yardstick and the insistence on
steady, gradual deceleration will make it possible for every major
American corporation to support our efforts. We expect no less.
We are asking individual firms to calculate the average rate of
price increase over the last 2 years, and to make a commitment that
any further price increases necessary this calendar year will be significantly less than the average of the last 2 years.
We have an overall industry goal of annual deceleration in the
range of one-half to 1 percent, but we intend to view each industry
On the wage side, we must bring down the pattern of 9 to 10 percent per year increases in total hourly compensation that characterized the 1976-77 wage round among major unions.
There are already signs of both an acceleration of nonunion wages
and attempts by smaller unions to match the inflationary gains Avon
by larger unions in their last round of bargaining. We cannot afford
to let this pattern become even more pervasive as labor markets continue to tighten.
We recognize that it is difficult for any one group of workers to
make the first step toward deceleration, but the time to begin is nowT.
We need to see results on both the wage and price side this year,
but one can't expect unions to enter into long-term wage agreements
until they see comparable restraint in pricing and Government
There are approximately 1 million rail and postal workers currently negotiating new agreements, and nearly another 1 million
workers bargaining this year in industries such as paper, cement, retail food, airlines, and construction.
To let these settlements slip by would set a bad precedent for next
year's negotiations. Even though the groups that are negotiating now
do not receive the amount of national attention devoted to truckers
or auto workers, their negotiations are important to the inflation
battle. Large settlements in smaller bargaining situations can have
very negative effects.
Finally, to make this program meaningful, we need to expand its
focus from Washington out to our States and cities. I will shortly be
announcing a stepped-up program of regional efforts to educate citizens to the nature of inflation, and what they can do to help us turn
the inflationary tide.


I want to assure you that the President lias put his full weight
behind this program. He has given me and my colleagues in this
effort all the authority and support that we could ask for.
I am pleased to report to you that the concerned agencies of the
Federal Government are working well together in the way Government officials and agencies should cooperate.
I intend to act forcefully and to speak out frequently, using the
full force of available pubiic and private resources to rally support
for this fight.
The years that I have spent in association with Members of Congress on both sides of the aisle is one unique strength that I bring to
this task.
I will need the cooperation and advice of the members of this
committee and your colleagues in the Senate if we are to succeed in
this effort. And I know that I can count on that support from Democrats and Republicans alike.
This is a battle we are all in together.
Thank you very much.
The CHAIRMAN. Thank you, Mr. Ambassador.
Mr. Ambassador, some time ago, oh, a couple of weeks ago, you
were asked how the inflation battle was going and you said the score
right now is inflation 100, Strauss zero.
I wonder if you have had a chance—in view of recent developments
and your activity—to give us a picture of what that score is now and
how you are doing now.
Ambassador STRAUSS. Well, Senator, that statement I made was
intended to gat the public to focus in on just how far we were from
making any progress in this inflation matter. It is one of those that
maybe might have been just as well left unsaid.
We have made some progress. Senator Proxmire, and I really am
rather pleased at the progress we have made.
I am disturbed a great deal by people who think that no voluntary
effort is going to work. It is amazing to me that the very people who
should be most keenly aware—some of our leading business executives
—some of those who continually say: "Get Government out of my
life; we need less Government," are the ones who say: "Well, the program is voluntary; it won't work."
Well, that is an outrageous posture for anybody in America to be
in, and I think this voluntary program will work.
We have seen automobile companies step forward. They haven't
made any great national sacrifice, but they have made steps in the
right direction. They have said—and they are doing the right things.
I just said to you that I just finished talking to Mr. deButts, chairman of A.T. & T. They are going to adopt a meaningful policy that
will be helpful. This afternoon—I think just about this very hour—I
think the announcement went off, so I might as well go ahead and reannounce it right now.
Some of you know Bill Battle. His father was the former distinguished Governor of Virginia. He is now in the textile business.
He is announcing that his company—this is a much smaller company,
about a $30 million line of textiles, tools, that they sell—they are
withdrawing a 7-percent price increase that they had set to go into
effect the next couple of months. It was set 2 or 3 months ago.


So we are finding examples of this going on and on.
I leave tonight to meet with a group of business people on the west
coast tomorrow, spending time on this. Most of them are cooperating.
Republicans, Democrats, conservatives, liberals, big business, little
The CHAIRMAN. The cooperation you have seen so far, however, has
been quite limited. Of course, you wouldn't expect it to be massive at
this point. But this example you gave of Mr. Battle is one example.
Are there others?
Ambassador STRAUSS. Well. I just happened to meet today
The CHAIRMAN. HOW about labor unions?
Ambassador STRAUSS. Well, the labor approach, I think, Mr. Chairman, was put a bit out of context this past week, 10 days ago when
the headline said Meany rejects Carter. I don't think that was true.
I really think George Meany to some extent rejected something
President Carter had not really asked for.
Now, what George Meany did was the same thing that I find Government and business do.
You know, Mr. Chairman, you never get an answer to inflation, full
answer, when you talk to any group.
I have found I get two-thirds of the answer with every group I
meet. One-third of the answer is missing.
If you talk to business, they tell you what labor and Government
ought to do. And Government tells you what business and labor
ought to do. And labor tells you what business and Government ought
to do.
I think that to expect labor unions to ink JJ-year contracts or to
commit, in 1978, to inking 3-year contracts in 1979, when they haven't
seen what is going to happen with Government or what is going to
happen with business, is calling on the average working man and
woman in this country, union or nonunion, to exercise some restraint
a bit ahead of time.
What the President really asked that they do is, subject to so and
so and so and so taking place, we would hope the following would
I think labor is prepared to do that. I think George Meany's position is that if we can bring about some deceleration in pricing and
some of these other things, that wages will follow suit.
The CIIAIRMAX. Let me ask you about another specific part of
your program. You were quoted in the Star as indicating that you
felt that wide use of the cost-of-living approach written into the
contract would be helpful because it would moderate the set increases.
Now, if you do that, don't you run the risk that you are going to
have an automatic relationship between inflation, a momentum relationship between inflation and wage increases that is going to be
perhaps worse than you would have otherwise?
For example, in the first 4 months of this year we had inflation at
a 12-percent annual rate. Then, if you add on that any kind of an
addition, it means that you are going to have higher wage increases
than you would if you had a set agreement.
Ambassador STRAUSS. Senator, you can argue which—it depends on
which way you want to argue. Now, I have used the same argument.


I agree with what you said. But I also think it is appropriate to say
to labor:
You can go ahead and step forward without guarantees because if in fact our
efforts fail, if in fact we were unable to restrain to the extent that we think we
should, a substantial or—it is not all—a substantial part of the detrimental
aspect of it will be covered by your cost-of-living increase.

So I will use that argument to say, "Go ahead and sign your name,
you are protected to the extent of 60 or 70 or 75 percent."
So I make it a positive argument on one side, you make it a negative on the other. Both are sound.
The CHAIRMAN. YOU protect them to 65 or 70 percent, you wouldn't
have a cost of increase
Ambassador STRAUSS. The average worker wouldn't be affected
The CHAIRMAN. YOU find some labor unions are willing to agree to
that kind of
Ambassador STRAUSS. NO one has pierced their finger yet and
signed in blood. But that is a partial answer when you are in a rather
strong argument, that there is some insurance for you.
The CHAIRMAN. NOW, you have an assertion that the President will
appoint a small, high-level governmental task force to coordinate
efforts to improve government efficiency and productivity on page 6
of your statement.
Ambassador STRAUSS. Yes, sir.
The CHAIRMAN. Why a small effort here? It seems to me on the
basis of all the testimony we have had for years now, the heart of our
inflation problem is productivity. We have had a diminution in productivity lately. It has dropped. And it is very serious because, as you
know, as productivity drops, it means almost the full wage increase is
reflected in a wage-cost increase.
Why can't we have a more ambitious program of this kind ?
Arthur Burns has called for it for years. Others seem to think it
is useful.
I have never heard any argument against it.
Ambassador STRAUSS. Senator Proxmire, I didn't say a small effort. I said a small group. My problem is that you start getting every
living soul in this Government, you put together a task force that is
going to have some power and some muscle, everybody in the Government wants to get in there and you get so damn many people you
don't have room in the hall and you never got anything done.
So that is my experience, limited as it is, in Government. I have
about had the most frustrating experience I have ever been up
This task force is my idea. I don't want it to be a small effort. I
want it to be a very, very stern, hard, tough effort. But I want it to
be done with a small enough group that it is wieldy and you get
something done.
The CHAIRMAN. Perhaps I didn't make myself clear.
You say the task force will work with simplified procedures and
see that cost-effectiveness is considered in all Federal actions.
The kind of thing we have been hearing for a really effective productivity operation would be having those task forces in many sectors
of the country operating in many industries. You would have a task


force for the automobile industry, a task force for the steel industry,
and so forth, working to make people much more conscious then
they are of productivity.
Ambassador STRAUSS. Senator
The CHAIRMAN. As you know, your fellow Texan, Dr. Grayson,
has been a great champion of this, he's worked hard on it and. as
you know, he had pretty solid experience in the inflation front when
he headed the price effort under President Nixon.
Ambassador STRAUSS. Senator Proxmire, I have talked with Jack
Grayson. I will meet with flack Grayson next week. The meeting is
set. In fact, I called and confirmed the date on [Monday. I think
Jack Grayson is one of the two or three authorities on the subject
of productivity in this country today. And T will ask him to make
a major contribution toward helping us get into this whole area of
But the two things we are talking about are not necessarily mutually exclusive. When you talk about Government trying to look
at Government waste. Government efficiency, trying to see how Government programs should be carried on a bit better, see what each
and every agency without cutting back on its program, necessarily,
without turning back on its goals, without abdicating its social responsibility, can still do those things with better efficiency and administration, and also see what kind of cost-benefit ratio there is in
there, that is what I would expect the task force to do, ask some
What are you, Mr. Chairman, of such and such agency; what are
you. Secretary So-and-So, doing to be able to put in this pot to help
bring some support behind this inflationary effort? That doesn't
have anything to do with the overall productivity approach.
Let me dwell on that for a minute. What Fm talking about is a
short term result that. I think we can begin to see some results out
of in 60 days or sooner. The productivity thing is a long-range plan
that needs—you are not going to do that overnight.
T met this morning with the economist, Rudy Oswald, AFL-CTO.
Talking to him about productivity. What suggestions they would
make to improve this thing.
But you know you have been in a job about B or BH weeks and
enough damn fools around Washington want to walk up and tell you
everything they are going to do and they have all the answers tomorrow.
T am very short on answers. T am not short on questions: T am
very short on answers. Senator; and I am not going to give you any
answers until T know where T am going.
We are working" very steadily, we are working hard, T think we
are working sensibly to develop the kind of program we can make
some progress in, and T know that is what you want.
The CITATRMAX. My time's up. T will be back.
Senator Brooke?
Senator BROOKE. Thank you, Mr. Chairman.
Mr. Chairman, T ask unanimous consent that my opening statement appear in the record immediately following yours.
Senator PROXMIRE. Without objection, so ordered (see p. 317).


Senator BROOKE. 1 would like to welcome my dear friend and
esteemed Ambassador, Bob Strauss.
Bob, 1 hoped you would have some answers. I am discouraged to
hear you don't have any answers. 1 hope you do. 1 hope you are just
overstating the case, but 1 am sure you have some answers.
Ambassador STKAUSS. 1 think 1 have given some answers, Senator; but 1 am not up here claiming to be the world's champion expert on inflation.
Hell, 1 couldn't spell inflation 2 months ago.
And you're trying to get me to answer all the questions on it, and
I am not going to do that. That is the trouble with what is wrong
with this Government. People inarch up here and testify that have
all the answers in the world to all the questions asked, and i don't
have those answers and nobody else does.
Anybody else comes up here and tells you they do you ought to
lock them up, get them out of here. That is what is wrong, the
President doesn't expect that out of me and 1 don't think the Senate
Senator BROOKE. The administration's definitely made the decision
that you are not going to ask for wage and price controls, is that
correct ?
Ambassador STRAUSS. Yes, sir.
Senator BROOKE. Under any circumstances, as you can see now.
Ambassador STRAUSS. I can see no circumstances now that would
encourage me to recommend it. I know of no whisper anywhere of
any discussion of it going on. 1 can't conceive of a set of circumstances in which I would be in favor of it. All you have to do, Senator Brooke, is look to Canada, look to Great Britain, we have got
two examples we are very close to. Their rate of inflation's gone up
since they went into these mandatory wage and price controls. They
have had a worse success than we had.
Senator BROOKE. SO you think jawboning is the bottom line?
Ambassador STRAUSS. NO, sir. I don't think jawboning is. Jawboning, Senator Brooke, as I define it, is trying to talk something
back out of, talking somebody back out of an action they have already taken.
What we are trying to do is get our hands on these problems before
they take place. What we are trying to do is start talking to labor
now. They have got major contracts coining up in 1979. What we
are trying to do is see things don't get away from us in 1978 that
make it impossible to functi m in 1979.
What wo are trying to do is go into business today and say,
watch out, stop now, restrain now. Those are the things we are
trying to do.
Now, where we miss, we are going to jawbone.
Senator BROOKE. Your candiate said in the election that by fiscal
year 1981 he would balance the budget.
Now, he's your President. And my President, our President. Has
he changed his estimate of when he will submit a balanced budget?
Ambassador STRAUSS. I would ask him about that. Senator Brooke.
I am no spokesman for him on when he's going to balance the budget.
I will say this, based on what I have seen right now, I have no rea-


son to believe that the President is not going to be able to balance
the budget in 1(J8O.
Let me go further and say, from what i see, have seen and what
I know, this President is going to make an allout assault on that
budget between now and 11)81. That 1 believe and that: 1 am participating in and that I think he will be successful in.
Senator BROOKE. DO you think he will be able to close the gap
between now and iiscal year 1(J81 i
Ambassador STRAUSS. 1 certainly do.
Senator BROOKE. AS President Carter noted in his economic message to the Congress on January 20, over the past 10 years the Nation's rate of productivity growth has slowed markedly. You have
touched upon this. It has slowed to about 2 percent or less per year
compared with an average increase of A percent during the first two
decades of the post-war period. That is a one-third drop.
During that same period, the rate of productivity growth of Western Germany, Japan and other industrial nations increased at rates
of from G to 14 percent a year.
Now, as the Presidentrs special counsel on inflation and the chief
trade representative, I expect that you would agree that productivity,
as you have said, has an impact on our ability to ensure reasonable
price stability, as well as to strengthen our competitive trade position and thus to contribute to the availability of jobs in the Nation.
Now, what specifically, are the administration's plans beyond the
initiative relating to capital described by the President in that economic message to increase productivity in the public and private
sector of the economy?
Ambassador STRAUSS. Senator Brooke, productivity in its overall
scope, is not my responsibility. I got about, my plate's reasonably
well full right now. The Labor Department, Commerce Department
and others, primarily are concerned with that. I have a productivity
concern in terms of my inflation, my efforts hero.
But let me remind you, sir, that the President didn't say, "I am
appointing Bob Strauss to form—to be responsible for programs in
the Labor Department." To sot financial policy that belongs with the
Treasury Department and Council of Economic Advisors.
He said, "lie's my special advisor on inflation to speak for me and
in my stead.'' So, 1 don't really, that isn't a responsibility of mine.
I have some notions about it, but I would like to confine myself to
what I am responsible for.
Senator BROOKE. Bob, you started out as a trade representative.
Ambassador STRAUSS. Yes, sir.
Senator BROOKE. Then, the President, seeing your usual abilities,
has expanded your responsibilities.
Ambassador STRAUSS. Yes, sir.
Senator BROOKE. TO inflation, which everyone will agree is the
No. 1 problem facing this Nation today. So obviously, you can't
say that productivity is not your responsibility because productivity
is so intricately woven into the whole question of inflation.
Ambassador"STRAUSS. Of course, but. Senator, lot me say to you,
I will testify what wo hope to do vis-a-vis the Federal Government.
I further stated, I meet next week with a gentleman that I think

probably is the, has do voted more time and effort and is the leading,
one of the leading voices on productivity in our country today.
Senator Proxmire commented on that and I am sure Senator
Tower also can tell you about Jack Grayson. We will be developing
programs on that. But we have both short run and long run. We
have to make two approaches to this thing. As I said to you, I have
been on the job less than a month. I am really trying to get a program in place now and to say that I spent a lot of time on that
really would be a misstatement.
Senator BROOKE. But it is certainly a matter that has your immediate concern.
Ambassador STRAUSS. NO question about that, sir.
Senator BROOKE. YOU expect between these two Texans that we
are going to come up with some answers to the problem?
Ambassador STRAUSS. Maybe a fellow out at George Washington
University, Dr.—I forget his name—who also—and a few others.
We may not have the answers, but we will chip away at it.
Senator BROOKE. AS you are well aware, there are some who feel
that the National Center for Productivity and Quality of Working
Life should be maintained as a vehicle for joint efforts between
management, labor and Government. They believe that if functions
are placed in one department or another, they will not enlist that
tripartite approach which is needed to ensure improvements in the
Nation as a whole.
What are your views on that ?
Ambassador STRAUSS. Senator, I am not sure I understood the
Senator BROOKE. YOU are aware of the National Center for Productivity and Quality?
Ambassador STRAUSS. Yes.
Senator BROOKE. Nelson Rockefeller was chairman until the change
in administrations.
Ambassador STRAUSS. Aware of it is about all. Senator. You have
just about finished the statement there with me.
Senator BROOKE. YOU are just aware of it ?
Ambassador STRAUSS. Yes, sir, that is about all the background I
have on it.
Senator BROOKE. Well, the administrntion requested $2.9 million
for fiscal venr 1979 under the National Productivity and Qualitv of
Working Life Act of 1975. And since that submission, and they have
not rescinded that submission, the President decided in Mnreh or
April of this year to propose that the functions of the center be
transferred to other agencies. The OMB director communicated that
decision to the Congress, and that apparently is what is in progress.
Are you familiar enough with this center to know whether it
should have been maintained or whether it should be dispersed in
these various departments of Government ?
Ambassador STRAUSS. Senator. T am not and T think anybody who
comes up here with responsibility on trade and then starts telling
you he is an expert on Government reorganization, you ou<rht to get
rid of the fellow. Obviously I have nothing, little or nothing, to do
with the reorganization program. I am not familiar with that.

I do understand productivity being a most serious matter. I don't
think you overestimate it; if anything, you underestimate it. You
are on target. It is something we are concerned about, something we
are working on. It is not my direct overall responsibility.
Senator BROOKE. Well, Mr. Ambassador, obviously it is not my
intent to embarrass you.
Ambassador STRAUSS. It doesn't embarrass me at all.
Senator BROOKE. YOU have been in the job 1 month and I don't
expect you to be an expert on reorganization of the Government. But
the Center performs an important function in the area of productivity, that I would have thought that the administration would have
discussed this with you as to whether they intended to continue it
in its present form, or whether they intended to disperse it and to
disperse its responsibilities to the various other departments of the
I think it is an important subject, and I hope you will look into it.
Ambassador STRAUSS. Senator, I will be delighted to look into it.
I must say to you that I have no more information on the subject
than I gave you. If I have been derelict, so be it.
Senator BROOKE. Well, if you say it, I believe you. And I know
whatever you say
Ambassador STRAUSS. YOU mean to say I have been derelict or
Senator BROOKE. I can count on what you say. I hope you will inquire about this because I would like to see you have some input on it.
As I said, there are many who believe that that Center could perform a very useful service.
My time is up.
Ambassador STRAUSS. Thank you.
The CIIATRMAX. Senator Riegle .
Senator RIEGLE. Thank you, Mr. Chairman.
Let me just say that I missed some of your early comments.
As you may know, we have a labor reform bill on the Senate
floor, which some of us are involved in. There are two or three things
I want to discuss with you.
First of all, I think there are a number of people who wonder
whether we are really going to be serious and competent about coming to grips with the inflation problem. That is not a reflection on
you, but T think it is a broader question and feeling about how tough
the inflation problem is, the fact that we seem to have some new
economic factors thnt we don't yet fully understand.
It is tough to make the Federal Government even do the things
that it wants to do once it figures out what those might be. As a
result, it seems to me one of the tough parts of your job is to just
convince people that the administration is doing something more
than making kind of a token effort in the area of fighting inflation.
Let me just speak to two specific problems that I think give rise
to some of the skepticism thnt obviously you have to be able to overcome nnd which those of us here who worry about the problem, too.
would like to help you overcome.
One is the energy package. A lot of people look at the energy
packnp-o PTKI whether thev are for it or against it or like part of it
or don't like part of it, I think there is a general consensus on the


part of many people who look at it—and T include myself in that
group—that says that if that package the administration is proposing, is adopted, it is going to raise prices and it is going to have a
serious inflationary impact. And yet that gets pushed off to the side
because it is argued that we need the energy package for other reasons which we know, and so forth.
I would feel more confident and I think we could do a better job
of putting forward the argument that the administration is serious
in this fight if we could demonstrate that the energy package either
was not inflationary or that we could have some reasonable answer
to give to people who raise that question.
The second has to do with the social security tax increase. A lot
of people, and I include myself among them, think that the way we
have written that tax it is going to be very inflationary as well when
it takes effect next year, and that both of those things by themselves
may more than offset anything you can do or that we can do in cooperation with you to try to persuade people voluntarily to make
restraining decisions and what-have-you.
I am just wondering how we reconcile this. Tn other words, if the
left hand is doing something that offsets what the right hand has got
to do, how do we convince anybody that they ought to make some
sacrifices for the common good ?
Ambassador STRAUSS. Senator, I think the answer to that is reasonably clear and I don't think it is an avoidance of the question or
failure to answer.
First, with respect to energy, I don't think there is any question
that to the extent that energy, the energy program that is eventually enacted, if one be out of this Congress, to the extent it raises
prices, it has an inflationary impact. As with everything else, there
is a tradeoff on everything you do. These aren't black and white
questions, yes and no questions, they are tradeoffs.
So, first you trade that off with a sound energy program. One you
hope will assist this country in, first, producing more energy and.
two, using less energy.
Second, the right kind of energy bill, and I hope we will pass
one, and T have no reason to believe it won't be a good one when we
pass it. will have a—should have an impact on our trade deficit. If
you have an impact on our trade deficit, you automatically have, and
our balance of payments, you automatically have a positive reaction
in a number of areas, including, T would add, the strengthening of
the dollar which in itself is—helps us in our deceleration program.
Nothing would help more than the dollar, it affects trade and you
fret an impact there. These are tradeoff issues and a balancing act
that one has to go into in the choices made and using values as you
find them.
T think the benefits we will get out of it will far outweigh the
loss in the energy thing.
With respect to social security, again, no one can argue that, as T
testified, the increase in social security that went into effect had an
offoct on our inflationary process. Xow should we have—should we
bring more effective fiscal stability in that social security program?
Should we have done the things we did ?

Well, Congress in its wisdom elected to do that, so again it is a
tradeoff. Every one of these things asks so much and costs so much.
Senator KIEGLE. Part of this attaches to the question of how much
credibility you can hope to have apart from how smart a guy you are
or how effective you are because initially the administration said we
ought to finance a part of the social security cost from general revenues and I happen to support that position.
The administration lost; the Congress had its way. We made a
mistake, I think. We took an approach that, as you admit, will be
inflationary. Xow the Congress sees the error of its ways and would
like to back up.
The administration however, has gotten stubborn and said, no, we
like the way it is, and we are going to stick with it and not go back
to the original proposal.
All I am saying is that it doesn't take very many of those kinds
of contradictions before the inflation program gets dismissed because it doesn't all hang together.
Let me just say with respect to the energy situation, T appreciate
the fact that you were honest enough to say that some gains might
come out of the package, that it is in effect inflationary, nobody
ought to kid themselves about that.
It seems we are going to have to make some technological breakthroughs in the energy area. I think we are going to have to find a
way to bring some new energy on line at a cheaper price or we are
never going to break this spiral.
Let me move to the labor problem. The Teamsters, as you know
will be renegotiating their contract some time in the first half of
next year. Tf T am not mistaken. President Fitzsimmons has made
it clear he is not going to settle for less than what the coal miners
got percentagewise.
One can argue that the two situations are quite different, but I
would like to know how you now in this now position aro able or
equipped or armed to deal with that kind of an issue. Tn other words,
taking that as a specific, what can we do there ?
Ambassador STRAUSS. T would hope, and T fully believe, that we
can convince trade union leadership—and T don't even believe that
they believe, no one seriously believes that the coal settlement should
be taken as some sort of guideline or magic number for any of these
other unions to follow. Coal is a unique situation. Industry and labor
relationship are a unique situation. T hope the record here will clearly
reflect that as the President's counselor on inflation, I will be speaking out very loudly and very clearly and bringing whatever moral
force of persuasion and other force of persuasion this Government
may have that I personally will have, and that the President personally will have, to see that that kind of process doesn't take place.
Senator RIEGLE. The reason I make the point is not just to give you
a tough one to deal with, because everybody else is paying attention
to this.
Fitzsiinmons' comment, as you know, was widely quoted to the
effect that they weren't going to settle—I think his words were to the
effect they weren't ffoing to settle for anything less than the coal
miners got. You read that, and everybody else read that.


I want to give you an opportunity to put to rest the feelings that
people have that say that that particular economic interest is so strong
and so powerful that all of the persuasive power of Bob Strauss notwithstanding, they have already announced what their approach is
going to be. And if that is left to stand, other people are going to
base their behavior and their decisions as to how they negotiate and
set prices they are prepared to make off those kinds of benchmarks,
the question is: Are we going to get very far?
Ambassador STRAUSS. Let me answer that very specifically. It is my
opinion, Senator Riegle, that the standards we begin to set and the
pattern that begins to flow from the postal settlement, from the rail
settlement—two matters now in negotiation—from the settlement
entered into by an independent group of paper unions on the west
coast right now—I think they are non-AFLr-CIO affiliated—came
out of an AFL-CIO union—out on the west coast involving most of
the paper people, if not all—we have met with the leadership of the
industry there. And I think Barry Bosworth's group has met with or
is going to meet with—they are trying the labor side of that.
All of that is important, leading up to the early negotiations next
year, Teamsters being one.
We cannot let—we cannot let coal by any sort of an example. I
don't mean any example, any sort of an example.
We have got to have an altogether different thrust. We have got—
those 10 percent, 9, 10 percent settlements of the past, we have got to
be careful about them.
We have to speak up forcefully. And. furthermore, we in Government have to do something first to set an example. And business has
to do something first. So by the time we come there we have something to say, "You now must show comparable restraint."
I have to say to you that T think both union and nonunion working
men in this country show the same kind of individual citizenship that
every other segment of the country shows. If we show an example,
they will be there.
I am not worried about it.
Senator RIEGLE. DO you see it as your job at some point to talk to
Fitzsimmons about this ?
Ambassador STRAUSS. I surely do.
Senator RIEGLE. But you haven't as yet?
Ambassador STRAUSS. I would rather not answer that question,
Senator, if I could avoid it.
I wouldn't say we had a long, drawn-out conversation. We haven't
negotiated for a long time as yet.
Senator RIEGLE. But you are being clear in responding that you
see that as falling within your range of responsibilities?
Ambassador STRAUSS. I certainly do. In fact, I would be derelict in
my responsibilities and ought to be fired if I did not. if I don't pursue this in all its aspects.
Senator RIEGLE. That is all, Mr. Chairman.
The CIIATRMAX. Senator Tower?
Senator TOWER. Thank you, Mr. Chairman.
Mr. Ambassador, I want to thank you for your very lucid and very
candid statement.


Taking note of the comment in your testimony: i;Wc must candidly admit that the food price inflation tins winter was worse than
expected. In areas such as meat price increases we cannot be certain
the worst is behind us."
One concern of mine is getting at the real cause of the increase in
food prices. We have talked about productivity here today and it
seems to me that the American farmer may be a victim of the fact
that he is very highly productive indeed. Whereas per man productivity has gone down and labor costs have gone up in other areas
which contribute to his costs, his ability to supply in abundance, indeed, in surplus, has hurt him.
I point out the fact that 4 years ago the cost of wheat was $5 a
bushel. Today it is $2 a bushel. Yet the price of bread has gone up
25 to 30 percent.
I can understand the rationale of the President in threatening a
veto on the flexible price support program on the grounds it was inflationary, but is some effort going to be made to get at the high
production cost that the farmer incurs? At the same time, the enormously high cost that occurs from the time the farm products leave
the farm to the time they arrive at the consumer?
I note now that the cost of labor and processing and distributing
foodstuffs is higher than our total production.
Ambassador STRAUSS. Senator Tower, I met with a couple bakery
executives recently, within the last few days, on that very subject you
are talking about. T couldn't agree more with the comment you made
and the thrust of your question.
Barry Boswortlvs group is going to be meeting, T think, with, oh,
cereal manufacturers, bakeries, and a lot of others. Isn't that correct ?
And they have those meetings scheduled right now.
What we are trying to do is get these people in and talk to them
just about that sort of thing.
I just fully agree with the thrust of your question; no question.
Senator TOWER. I am concerned the farmer be not made the scapegoat for high food prices. Indeed, he has a cash flow problem and if
a lot of farmers go bankrupt you will have the increased cost of
Ambassador STRAUSS. Your question is just as right as it can be,
and goes to the very heart of this food problem.
Senator TOWER. In your testimony you note that there is no question price levels are affected directly by both Government spending
and by regulatory policy.
It occurs to me that regulatory policy, where—though it doesn't
cost the Government too much perhaps to enforce these regulations,
costs private, the private sector a great deal, and these costs are
passed on to the consumer.
Now, I know that standing alone we need environmental protection,
we need some occupational safety and health, we need these things.
But we do impose an enormous regulatory burden on the business
and labor community. And I don't think that we are really aware of
what that regulatory burden is costing us in terms of how it is passed
on to the consumer.

2'i-77,j (.) - 78 - 22


Is there any thought given to maybe trying to relax this regulatory burden to some extent or reduce the cost that business itself pays
or, indeed, finally the consumer pays for this regulatory burden?
Ambassador STRAUSS. Senator Tower, when I first was appointed
to this job I commented on a number of areas that I thought we
ought to look at. And in the regulatory area I either wisely or unwisely mentioned, for example, the fellow talking to me said: "Well,
what do you mean?" I said: "Well, for example, EPA."
I didn't mean to single out the Environmental Protection Agency
in any way, and I am strongly committed to their goals. What I
meant was that I think we have an Administrator at the EPA now,
Douglas Costle, who understands what cost-benefit ratios are; and I
think we can, without turning back on any of their goals, to which
everyone is committed, I think we can look and see what administrative procedures we can improve upon and what of their regulatory
procedures we can improve upon without lowering science any. And
I don't think there is any disagreement between Douglas Costle and
myself there.
The Administrator and I have talked a half a dozen times and we
are going to be meeting more and more on this.
I share your concern. It is a concern shared by many people around
this country. Most people around this country. Not just environmental agency, but all of our regulatory agencies.
People don't want to turn back. They don't want to turn their
backs on the buying public here and forget about the consumer. They
don't want to turn their back on the environment. They don't want
to do that. They don't want to turn their back on regulatory authorities, whether it be the SEC or any other.
But what they do want is a sensible, efficient administration. And
most of those things, as you know, are bound by legislation already.
But you can function—your regulations under that legislation can be
Senator TOWER. I might note that sometimes the regulators go a
little further than Congress intended them to go; they do things we
didn't anticipate they would do.
I am delighted to note that you said that your tax proposals would
expand incentives for capital formation as a means of promoting the
growth of industrial capacity and productivity.
I think this is enormously important and I think that one of the
crises we may be facing up to over the next few years is the shortfall
of capital formation. That itself can have an inflationary impact
from the standpoint of both demand-pull and cost-push inflation.
I would like your reassurance that you are really dedicated to this
proposition of expanding our potential for capital recovery and capital formation.
Ambassador STKAUSS. Senator Tower, I am, as you know, particularly sensitive to that.
Senator TOWER. Knowing you personally. Bob, I know that you
appreciate capital.
Ambassador STRAUSS. T am fully committed to that and I know
that and I know that the President is. I think you are—I think you
will be satisfied with our efforts in that direction. We are not going


to get everything done that I would like to get done or that you
would like to get done or that President Carter would like to get
done or members of the business roundtable or others in terms of
capital formation but I would hope we would make some progress.
Senator TOWER. I hope we don't come up with the notion that profit
is a dirty word because, after all. that is where capital is going to
come from.
Ambassador STRAUSS. I have seen no indication in this administration that profit is a dirty word. That I surely haven't seen.
Senator TOWER. YOU also noted the hospital cost containment program. It occurs to me that there are a lot of things that have contributed to the cost of medical care over which the medical community has no control.
Ambassador STRAUSS. Yes.
Senator TOWER. They are affected by Government regulations.
Ambassador STRAUSS. That's correct.
Senator TOWER. And Government requirements.
I think in terms, for example, of a hospital in a small town that is
required to put in a sprinkler system, whereas it might be better and
more efficiently served by smoke detector devices and that sort of
Some rigid application of certain Federal standards, I think, have
contributed somewhat substantially to the increase in hospital costs.
Are you going to get at that, rather than just try to put a cap on
what they are charging for medical service; are you going to look at
this business of what is costs them to provide that service?
Ambassador STRAUSS. I think that, the President's hospital cost
containment bill is a far-reaching and significant piece of legislation,
and I think it will go further than anything I know to bring medical
care under some sort of control.
Hospital rooms in this country, as I recall the figure, was about,
last year, averaged around $18-3 per night per room, I think that is
the figure. Well, that is just a little outrageous.
I don't blame all that on any one group, but that is an area where
—really has a dramatic impact on the public generally and on our
senior citizens particularly.
Senator TOWER. Finally, my last, question. You talk about labor
and labor's contribution to this business and you say one can't expect unions to enter into long-term wage agreements until they see
some comparable restraint in pricing. Can we really expect any restraint in pricing unless there is some restraint in union wage
demands ?
Ambassador STRAUSS. Yes, 1 think wo can. Senator Tower. I think
that it can't go on, if we don't get that it's going to fall by the wayside. Tf wages keep going up.
But T think business generally knows that they are going to have to
step forward first and show their willingness to participate in a voluntary deceleration program. They have indicated that. They have
indicated their willingness to do so. Tf we take the right steps the
next (> to 12 months, it will have, in my judgment, a very, very salutary effect on our labor negotiations of next year when the big rounds
come up.


Senator TOWER. It seems to me you get into a little bit of a problem, if you are going to insist that wage increases come out of profits
in terms of your capital formation problem down the road.
Ambassador STRAUSS. Well, you get a chicken-and-the-egg problem,
too, in that.
Wait a minute, maybe I didn't understand your question. I really
thought you were asking which of these came first.
Senator TOWER. That is not exactly what I said but that is pretty
much along the same lines. We are asking business to keep their
prices down, perhaps absorb wage increases in terms of diminished
profits; then we are trying to ad&ress ourselves to long-term capital
requirements on the others.
Ambassador STRAUSS. XO question, part of our long-term capital
requirements come out of profits. They also come out of other things,
kind of incentives to enable capital investments to be made.
Let me say this. I do think this, Senator Tower. That when the
average working man and woman whether they be a member of a
major union or just working in a filling station or a restaurant in
some small town in west Texas, I think they have—the average working man and woman really has a right to expect that, if they are
going to accept any—as they accept restraints in their wages or in
their bargaining for wages, that they have a right to expect that—
to see that restraint, to see that restraint whether it's on the carlot or
in the department store or the grocery store, see the similar or greater
restraints felt there because when that salary check comes in at the
end of the week, there is no time left. It has to be there that week. Or
things just aren't going to meet.
Senator TOWER. I understand that. And I don't dispute that at all.
I wonder if some effort could be made to get at some archaic work
rules that result in a diminution in productivity, in some instances the
unions fine workers for laying more bricks per hour or producing
more per hour than union rules permit them to do.
I am not really so concerned about wage increases as I am sometimes about these archaic work rules that tend to retard productivity
or diminish it in some way.
Ambassador STRAUSS. In the rail negotiations right now and also
in the construction agreements where we have had considerable success, those things have been taken into account and I think considerable progress has been made on that.
And we have had, we really, while there is no reason for jawing,
I think there is reason, in this whole overall thrust, for a little cautious optimism that at the end of this year we will be making some
progress, Senator Tower.
Senator TOWER. Thank you very much. Mr. Ambassador. I appreciate your candid answers.
Ambassador STRAUSS. Thank you, sir.
Senator PROXMTRE. Senator Sarbanes.
Senator SARBAXES. Thank you. Mr. Chairman.
Mr. Strauss, the first thing T want to say is that I welcome the
statement that the administration will not seek to solve tho problem
of inflation by falling back on remedies that increase joblessness.


I would like to take it a step further and surest that joblessness
and unused capacity, in fact, contribute to inflation. If you can get
high employment, and a reasonably high use of our capacity, not
necessarily approaching the high 90's or the 100 percent figure, where
you are using antiquated plant, but a good capacity utilization figure, you may, in fact, contribute to productivity and, therefore, help
fight inflation. T think that is very important. I hope that you and
the administration won't depart from that approach.
I want to ask you this question. You are a very gifted person.
But I have to confess to you, T don't really understand exactly
the role or the charge you have been given. I take it you are here
now wearing the hat of the Special Counselor on Inflation.
Now, what does that mean ?
If I want to reach you as a Special Counselor on Inflation, where
do I reach you, in the Office of the Special Representative for Trade
Ambassador STRAUSS. That's correct.
If you ask what it means, I really think that the President felt
that we needed an additional drive and thrust in this program, someone to, as he says: "Speak for me and in my stead in all these
I think he's given me a pretty broad mandate. Senator Sarbanes.
The President and I have developed a pretty good working relationship during the time he's been in the White House and T have
been in his Cabinet. We speak shorthand. And T think he believes I
am not going out and do some damn foolish thing, and I don't have
such, any specific restraints on me, or I don't have the specific guidelines on me that one would think T might have.
lie asked me to take over the coordination of this fight on inflation.
That is what I am doing.
Then—let me continue 1 minute, if I could please, sir.
Not, as I said earlier before you came in, not to do the planning for
—financial planning for this Government, not to do the agricultural
planning for this Government.
That belongs in Secretary Bergland's backyard. Not in the housing field, that is Secretary Harris.
But to coordinate all of our efforts to see that we reach into every
one of these Departments and we reach around the country.
And that is what I'm trying to do.
Senator SARHAXES. Well, now, are you in charge of economic
policymaking with respect to the question of inflation?
Ambassador STRAUSS. NO, T am not.
Senator SARBAXES. What is the nature of your relationship with
the Secretary of the Treasury, the Council on Economic Advisors,
the Council on Wage and Price Stability, the Office of Management
and Budget, and then somewhat apart from that, the Federal Reserve
Board? What authorities, if any, do you have in dealing with these
economic policymaking organs of the Federal Government?
Ambassador STRAUSS. T have the authority that, being the spokesman, the President of the United States gives me. Senator Sarbanes,
and that is considerable. That doesn't mean that the President expects me to write the tax bill for the Treasury Department. It does

mean that the President doesn't expect me to write the agricultural
bill that the Congress takes up: or the farm bill.
What it does mean is that working with the Council on Wage and
Price Stability, Barry Bosworth, and it does mean working with
the Council of Economic Advisers, that we exercise some monitoring
over that.
It means we ask some hard questions and it means we call some
people in. It means that we have a coordinating role. It means we
bring, as I said, the force of the Presidency.
Senator SARBAXES. Are you the spokesman from the President to
these Government policymakers?
Ambassador STRAUSS. Yes, I would—yes, I think the President
would describe me as having that responsibility, yes.
Senator SARBAXES. Are you the spokesman from the President to
the private sector, management and labor?
Ambassador STRAUSS. Well, with respect to the problem of inflation, there is a role for everyone to play, but I think I am the point
man. I am the point man on it, yes.
Senator SARBAX~ES. I am really trying to find out—I think it is
important, since this is the first time we have had you here—to get
a sense for what your role is and what authority you have been
given and where responsibility falls.
Do you have a staff as the Special Council on Inflation?
Ambassador STRAUSS. Well, I have been using. Senator Sarbanes,
let me see if I can describe it a bit better in my words, rather than
try to answer a narrow question,? do I have a staff.
Senator SARBAXES. Why don t you answer that, then describe it in
your own words.
Ambassador STRAUSS. DO I have a staff?
Senator SARBAXES. For this function.
Ambassador STRAUSS. I do not have a specific staff for this function, although Lee Clink, who T think you know, a very distinguished
businessman from St. Louis with whom I have worked over the
years, has just left his business, taken a leave to come and join me on
a full-time basis. So, yes, now we are a two-man staff.
What I would really like to do is have just enough people to kind
of be able to coordinate this thing and not build another damn
bureaucracy. Senator Sarbanes. I can get all the staff I want, I guess.
In Washington there doesn't seem to be any problem getting staff.
Getting something done, it seems to me to be the problem, and knowing what—and getting communication between what people term
Now there are a lot of good staff people. But I am—I would like
to use some of the people that are there. The young man who is on
my left, his name is Jack Myer, he? is the Xo. 2 man, I guess, over
there at Barry Bosworth. Well, he s sitting here with me and the
Council of Wage and Price Stability is a primary resource. Council
on Wage and Price Stability called me, I talk to them three or four
times a day. They have a feel for what is going on out there, they
are in touch with the various industries, and labor negotiations, and
pricing problems that are going on. And they involve me either at
point of problem, point of decision, point of meeting. Charlie


Sehultze, Chairman of tlie Council of Economic Advisers, is another
one who has the economic data before him who is far better able to
analyze that data than am I, and who—he doesn't report to me, and
I don't report to him, but I am the President's point man on doing
something with that data.
Why? I don't know, you will have to ask the President on that.
But with respect to our initial discussions with a board segment of
the labor movement, yes, I spoke with the President. T spoke and he
spoke. "With respect to contact with business, whether it be the Small
Busmc-ss Administration or whether it be the Business Council,
business roundtable, is that inv responsibility? Yes.
Senator SARBAXES. ITOW do these Government economic policy decisions, how do you coordinate ?
Ambassador STRAUSS. First, I would have to ask you what kind of
Let me sav this: The Economic Policy Council is chaired by Mike
Blumenthal. It deals with all economic decisions of this administration.
Senator SARBAXES. Are you now a member of that Council ?
Ambassador STRAUSS. I am a member of that since I took this
task. That really is a clearinghouse. As those problems relate to a
tax bill, it wouldn't be my problem. Senator Sarbanes. As those
problems relate to the problems of inflation, it would be my responsibility. If it relates to a sugar bill that comes up there, it will go
over to Secretary Bergland.
I might have an input over there and say: Mr. Secretary, this is
inflationary as can be. or this is deflationary. But it would be his
responsibility to formulate the program.
Senator SARBAXES. Let me ask you this question. As Special Trade
Representative, you deal with many questions involving importexport policy and they interrelate with questions involving employment and inflation.
Ambassador STRAUSS. Yes, sir.
Senator SARBAXES. XOW if you have that hat and you have now
been given another hat. Special Counselor on Inflation, you still
don't have a hat; as Special Counselor on Unemployment. I really
put the question to you of the nature of the interrelationship between
your role as Special Trade Representative and the judgments that
have to be made there, and your role as counselor on inflation only.
Ambassador STRAUSS. Well, what is the question. Senator Sarbanes ?
Senator SARBAXES. Well, T guess the question is whether there
should be a concern that your policies in the area of Special Trade
Representative will now be overly influenced by your new role in
terms of striking the balance
Ambassador STRAUSS. The answer to that is that no, there should
be no concern.
As a matter of fact, while there are some narrow areas of conflict
that could arise, 95 percent of it is an area of intertwine and it
makes it even more efficient, more effective, and enables one to do
each job better than he would without the other.


Senator SARBAXES. Arc you the President's representative now on
inflation questions, to discuss economic policy with Chairman Miller
and the Federal Reserve Board?
Ambassador STRAUSS. Well, economic policy, I need not tell you,
you know better than T, that the Federal Reserve is an exceedingly
independent atrenev. If you ask. if the question is have T discussed
Chairman—with Chairman Miller the problems of inflation, the
answer is yes, we have had two very long and constructive conversations, but on the basis of overall planning of economic policy, I
suspect Mike Blumenthal would meet with him 10 hours for every
1 hour I would if in fact they do have that relationship.
But I do not determine the economic planning of this administration or this Government. We structured this job just in that way
where it would not have that. Nobody can do that and do it well.
Senator SARBAXES. I see I have a red light and they are coming to
tell me my time's up.
Let me just ask this one final question.
Ambassador STRAUSS. Yes, sir.
Senator SARBAXES. HOW do you see the division of your time as
the President's spokesman on inflation between talking to and coordinating other policymakers in Government in the economic field,
and talking with the private sector, management and labor, with respect to their economic policies? How do you expect that time to
break down; how has it broken down so far ?
Ambassador STRAUSS. Senator Sarbanes, I think that would be a
question if I tried to answer it, it would—I would look kind of silly.
I don't know, it depends on the problem.
I know one thing. They are two very serious problems, and I devote
a tremendous amount of time and energy to both. I think I am able
to do that. I understand the business community. I know them. I
understand them. I know what makes them tick. I have been a part
of it.
I have been a lawyer representative. They are friends of mine. I
have great personal relationships there and I think I can be effective. That takes care of No. 1.
No. 2, with respect to the Government and its agencies, I know a
little something about Government. I have been around this town, I
have been around the Hill for a while, and I have been around Government for a while and I think I know something about what makes
things tick in this town. I think I can be effective there.
If you ask me how I am I going to divide my time, hell, I don't
know. Let me think today. There is no way in the world of doing
that. They are both so very important, Senator Sarbanes. I hope to
give them sufficient time, let me say that.
Senator SARBAXES. One other question I am going to put to you
when I get back to you is, how much time you are going to give to
the role of Special Counselor on Inflation and how much to Special
Ambassador STRAUSS. I have been given—I have been giving about
a full day's work to each one. I have been working 7 days a week
about 12 to 14 hours a dav.

Now, we have got a hard negotiation coming up between now and
July 15 in the trade field. I think we are going to be successful there.
Happily I picked two good deputies. Ambassador Wolf and Ambassador Macdonald. They do a major, major part of my work for
me there, always have.
I have done other things, as well as my job. And I don't anticipate
any breakdown in our negotiating process because of this job, and
I don't think you will find that there is any breakdown on it. Obviously, it's hard work. I am tired. I leave, when I got through here
today, I started pretty early this morning and I leave to go to the
west coast. T have got a breakfast out there at 7 o'clock in the morning. I will be there with a group of businessmen.
While I am on the west coast, the Japanese come in, I will be
negotiating with Prime Minister—Mitsubishi on the west coast,
negotiating a number of areas having to do with the trade thing. So
it fits.
Senator PROXMIRE. Senator Schmitt.
Senator SCIIMITT. Thank you, Mr. Chairman, and thank you Mr.
Ambassador for your testimony and answers to questions.
I am going to assume you are talking for the President, I think
that is what you have been trying to tell us.
But I am also afraid I have to say I am very disappointed, but not in
your abilities; you are smooth, quick, intelligent, experienced, as you
have said. You know what makes things tick, I think you are very
political and I think that is a good reason for the President to have
you in the job from his point of view.
But what I have heard you saying you are going to do reminds
me a little bit of trying to mobilize the flies to clean up the barnyard.
I am very concerned, for example, that the thrust of your testimony,
which is apparently what you really wanted to say today, concentrates largely on the private sector, both labor and management, who
are the victims
Ambassador STRAUSS. Let me clear that up very quickly, if I left
that impression, I am not as articulate as I should have been.
I do not think that's the case. I started out by saying, I think the
No. 1 problem lies with our own Government, we better get our own
house in order, if we expect to have any credibility with the private
sector, whether it be business or labor, period, paragraph.
Senator SCIIMITT. Why don't you have a list in your testimony
to indicate the things that the Government is doing that are inflationary? The programs that the Carter administration has sponsored, you have already talked to Senator Riegle about social security tax increases, and energy tax, and regulation increases in the
President's energy policy.
The President has been against a permanent income tax cut. He
pushed the coal wage package. PTe pushed the coal-mining regulations, timber withdrawals and new regulatory agencies such as the
Consumer Protection Agency, minimum wage increase, labor law
changes—all these things have an inflationary impact.
I would hope that you would begin to compile a list, for this committee, for the Congress and, more importantly, for the administra-


tion, of these kinds of things, as well as those concerning what the labor
unions and management may do.
Ambassador STRAUSS. Senator Schmitt, let me say this. Compiling
lists sometimes, it depends on who's compiling the list, what the list
looks like. Your list and my list would probably be, might be a bit
I am not here to say that the administration's done nothing that
isn't inflationary or that this Government hasn't or that this Senate
hasn't, I might add.
But it is not going to do any good for us to start compiling lists
of what the Congress has done wrong.
Senator SCHMITT. Well, it might do a lot of good, Mr. Ambassador.
It might do a heck of a lot of good. It might at least make those
voters out there who think you are coming out to jawbone them to
keep their wage increases down and keep the prices from increasing,
it might at least encourage them to think that the administration
thinks that some things might not be done right here in Washington.
I think Senator Riegle is exactly correct. What we have done this
year in this session of Congress to enhance inflation is going to swamp
anything you can do out there.
I am not saying, don't go try to do it, but it's going to swamp you.
Your abilities are being wasted, if you are not talking to the administration.
Ambassador STRAUSS. Senator Schmitt, let me say to you that, in
the first place, I am well aware of the fact, and in every speech, every
public utterance that I have made and in my testimony here, I want
to repeat, I have made it plain, I said we—that the Government is
its own worst enemy in this and we have to do something about it.
But, rather than just talking about the President, let's talk about
the Government, let's include the Congress in this.
Senator SCHMITT. I am happy to do that.
Ambassador STRAUSS. And the Congress, Government, all of us in
It depends on whose ox is getting gored and it depends on whose
program it is.
I started out with the minimum wage. The minimum wage was
passed higher than the President requested, as I recall. Let's take
that into account.
Number two, social security, the President asked for something
different than was passed, let's remember that.
Senator SCHMITT. Mr. Ambassador, let's face it. He was still asking for a major increase in social security taxes at a very opportune
time without any indication as to how we are going to get out of
a system that basically is not going to work for any length
of time. We may be able to shore it up and tie it together a little
bit for a few more years, but you know, as well as I do, that7 it is
not an actuarially sound program and that it is taking awa} from
our gross national product, not adding to it.
Ambassador STRAUSS. I would say to you that the social security
program is a program I certainly agree presents a great many problems.


But I must point out to you for this record, Senator Schmitt, that
President Carter neither built nor created nor funded the social
security program, since its inception in the early 1930s.
He inherited a problem, he inherited a problem which the American public was terribly concerned about, and that is improper funding and irresponsible funding, if you want to, and made a suggestion
then took some political scars on it. set a program up, suggested that
the Congress adopt it.
They elected to adopt a different one and again it's a balancing
Senator SCTIMHT. Mr. Ambassador, the difference is whether it
is payroll taxes, social security taxes, or whether it is general revenues
which are still taxes. At this point in time, that is going to have
more impact on the inflation in this country than any one other thing
wo can do. Except if the Congress is stupid enough to pass that socalled energy policy and if the new taxes which are going to amount
to $300 billion, that are in that bill, at least, by 1985, are included in it.
Ambassador STRAUSS. Senator, one of the things I hoped to get
out of here was some suggestions, and is it your suggestion that we
shouldn't attempt to appropriately fund in any way the Social
Security program ?
Senator SCIIMTTT. XO, it is my suggestion, sir, that you and the
very, very wise people that should be in the Administration start to
look for a program that is actually sound to which we can transition
over the next 20 or 30 years. That will mean that money is being
invested in the private sector so it is earning something and still
guarantees at least as good, if not a better, retirement program for
people in the future.
Ambassador STRAUSS. Senator, there are a great many long-term—
people in the administration are looking at some terrible problems
that we face, of the kind you have enumerated, looking for some
long-run solutions.
Senator Scmrrrr. They are awfully quiet about it. I would like to,
though, further ask you to comment on the energy program, Mr.
Ambassador. I know that you are an advocate of it. We have talked
about this on other occasions, and found we did not agree.
But the basic problem facing us is that we are not going to produce the things, domestically, that we can produce, whether it is oil
and gas, or new technologies that will eventually break the back of
the OPEC cartel.
There is nothing in the President's energy policy that is going to
eventually break the back of that cartel. There is no real incentive
for domestic production. It is only through domestic production that
we are going to do that. We need a half-trillion dollars by 1985 in
order to do it. But it is there.
Xow, is depending on foreign supplies of oil, at a price higher
than what we could produce it domestically, anti-inflationary?
Ambassador STRAUSS. Senator, I was really listening to your statement, and T got lost in it before you got to the question.
Senator SCHMITT. I thought you paid attention better than that,
Mr. Ambassador.


Ambassador STRAUSS. I'm not trying to be rude; I'm really trying
to answer sensibly.
Senator SCIIMITT. Let me try again.
Ambassador STRAUSS. Yes, sir.
Senator SCHMITT. If we do not increase domestic production, and
provide the incentives to do so, how in the world are we going to get
out of the habit of using higher priced, foreign oil ?
Ambassador STRAUSS. Senator, let me, in a positive way, I think
it is essential that we increase domestic production. And we also
search for new and other sources, or, obviously, be dependent upon
foreign imports.
Senator SCIIMITT. DO you think the energy policy, energy bill that
President has advocated, is going to do that?
Ambassador STRAUSS. Yes, Senator. I think so. I have talked to, at
least, oh, any number of people in the oil industry, energy business,
in the last few weeks, major representatives of major oil companies
on down, who think so.
Senator SCIIMITT. "Well, I have talked to them, too, Mr. Ambassador, and they are telling us different stories, or we are talking to
different people.
Ambassador STRAUSS. They don't think it's A-plus; I don't want
to say that, but they think it is a bill that would be good for the
country, and ought to be passed, and I certainly urge that we get it
Senator SCIIMITT. Well, I know you do, and I am sypathetic, particularly with all the reasons, I think, that require you or encourage
you to say that. But, Mr. Ambassador, there is nothing in that bill
that is going to tap these vast resources, that I think everybody
knows are there, in this country, whether it is oil, or natural gas,
or uranium, or geothermal, thorium. It just isn't going to happen.
There is not a coherent short, medium, and long-term policy available to this country, right now, and the people realize it. Frankly,
Mr. Ambassador, the people learned how to spell inflation years ago.
And it is just now starting, everybody in this country is starting to
realize what the inflationary problem is.
And they won't tell you that it's wages and prices. They will tell
you it's the Government. Xow, you may not believe that that's true,
and those of us who have been in this room saying it is true maybe
ought to be locked up, but there is no question in my mind, and I
think, in the mind of anybody that looks at the history of our economy over the last—since World War II, and look at the way the
Federal deficit, the money supplies, the recessions, the recoveries
from recessions, how they have gone, and how they interrelate, who
can't say that Government isn't largely responsible.
Ambassador STRAUSS. Senator Schmitt, I think I started off my
testimony, and all through it I have tried to resay and restate, and
I want to say again, for the record, and so you will know, I agree
with you that the first steps must be taken by this Government.
Unless the Government shows that it is going to do some things
to clean up its own house and improve it, there can be no credibility
to the program. I repeat again, I don't know what else to do, but I
believe that. I have said it. I say it publicly, and I say it privately.


Senator SCHMITT. "Well, I am glad you are saying it. I will look forward to hearing you continue to say it. I just hope that the next time
you testify with us you will have the list of things you are recommending to the Administration that it do to fight the inflation problem, and
along with the things that you say you are going to do with industry
and labor.
Ambassador STRAUSS. Senator. I have in my testimony a list of
those, and we read them off. I think you will find them in there,
things we have already done, and recommended, and have announced.
You came in late. Possibly, you missed it.
Senator SCIIMTTT. I was here the full time, Mr. Ambassador.
Ambassador STRAUSS. I'm sorry. I must not have made it clear.
Senator SCIIMITT. I am afraid the impression I get is that there is
no coherent recommendation, for example, for a specific annual cut
in the Federal deficit, or specific annual cut in personal income
taxes, or a specific annual cut in the rate at which our money supply
grows, or in the rate of increase in the absolute amount of the Federal deficit.
A specific set of recommendations on how to decrease regulatory
impact rather than not having any further increase; it is too late.
It has already been done. The damage is there.
Thank you, Mr. Chairman.
The CHAIRMAN. Mr. Ambassador, you have just—you have piqued
our curiosity by indicating that you have just returned from a conference with the head of the biggest corporation in the country, and
a man whose corporation, of course, has a lot do do with prices
people pay, certainly, in the communications area.
Can you tell us what, if any, progress you were able to make in
that conference ?
Ambassador STRAUSS. Senator Proxmire, I would not like to be
specific because we didn't sign off on anything specific. I am sure he
will want to make his own announcement, but I would say substantial progress was made, Senator Proxmire. And he could not have
been more positive, and more supportive, and more encouraging; Mr.
deButts could not have been.
I possibly did him a disservice by mentioning that. But I had a
most possitive, constructive conference about the total thing, the total
contribution that A. T. & T. might make to this effort.
The CIIATRMAX. It is very encouraging to hear. Incidentally, that
is one industry which, over the years, has remarkably stable prices.
Ambassador STRAUSS. Amazing productivity, and I was very
pleased with that. John deButts also expressed his personal confidence this program will work, which meant a great deal to me.
The CHAIRMAN. Without any criticism of you, and with, not meaning to criticize the President, who also has been in office, relatively,
a short time in relationship to the enormous momentum behind the
inflation situation, I just wonder if this program is really up to the
size of the problem.
This is a—this is such a big problem right now. Let me just point
out, we have a $50 billion deficit, at best. We have a $500 billion
budget which is, of course, far bigger than it was in years past. We
have a one-third drop in productivity in recent months. We have a


galloping inflation in the last 4 months, as we pointed out. We have
big increases in steel, in food, in social security, in energy, energy
prospective. First-class stamps are likely to go up; medical costs.
If you look at the wholesale price index, the discouraging element
there, the crude costs which are on a lag, as the year goes on the
crude costs are up sharply, so I just wonder if it is not necessary to
have a really dramatically tough program to knock out the inflationary expectations. I'm talking about a "No more Mr. Nice Guy"
from the President; a program of really vetoing legislation that
comes down the pike that reaches the budget.
The President said, "* * * by every means at my disposal, I will
resist those pressures, and protect the integrity of the budget."
Now, this committee, with bipartisan support, both sides of the
aisle, including some people who speak, mostly likely, against expenditures, voted to bust that budget on mass transit, voted to bust
that budget on housing. I hope the President will use that veto, and
wield it very strongly if it goes through the House and Senate that
way. Can we have that kind of assurance ?
Ambassador STRAUSS. Let me say this, Senator. I share your hope
the President will use that veto, and use it freely on any budget-busting that comes up there, and I think he will do that.
The CHAIRMAN. Well, that is reassuring.
Ambassador STRAUSS. I wouldn't say it just without some reason
to believe he would do that. President Carter is determined to maintain the integrity of this budget process.
The CHATRMAX. I would like to look at it in a little broader sense.
There is a tendency on our part, particularly in the Authorizing
Committee, to improve programs that have their real impact in their
effect on uncontrollable spending so-called, 2, and 3, and 4, and 5
years out.
The outlay may not be so big but the obligational authority may be
very big indeed. I wonder if the President would feel obligated,
under those circumstances, to veto, even though the effect on the—
immediate effect on the budget in the coming year might not be so
Ambassador STRAUSS. I do.
The CHAIRMAN. HOW about a program in which you show the real
concern of the Government by going as far as to ask for an even
stiffer cut in Federal salaries, cut in the increase in Federal salaries,
I should say.
Say, for example, that the general guideline of the industry might
be 6 percent, reducing the Federal salary increase to 3 percent. Calling on—having the President reduce his own salary, and members of
Congress to reduce their salaries. Calling on top business executives
to freeze their salaries this year, not just to increase it slowly, but
to freeze it. How about that kind of program.
Ambassador STRAUSS. I am not prepared to answer that question
with any authority or responsibility, so I prefer not to. If you care
for me to attempt to do so, I will attempt to provide one.
The CHAIRMAN. What I am trying to understand is whether or not
a more dramatic, more far-reaching program wouldn't be more likely
to have a real effect on inflationary expectations, persuaded both


business and labor unions to realize that the Government does mean
business, that it is making sacrifices, and, therefore, when the Government asks them to hold, for instance, wage increases down below
the expected increase in prices, that there is a basis for people asking
for it without being hypocritical.
Ambassador STRAUSS. I think anything we can do to put toughness
and hardness in this. Senator Proxmire, we should do. I do believe
that with the tools we have, and with the authority we have, and the
direction we have, I think we can develop a tough program that will
make some progress.
We are also, I might add, we continue to look at, will be looking
at in more detail, all of these other things that are floating around,
various policies, whether—one columnist suggests as well as another,
and we are trying to see what we can do to put together a really hardhitting program.
I feel we can do that. I also feel, and share Senator Schmitt's concern, and others expressed here, Senator Riegle's and Sarbanes', we
have to start with the Federal Government. You know that better
than most of us around here. We have got to start with our own
house; I hope we will do that.
May I just say one thing? I have a plane to catch in about 45
minute at Dulles. I wonder if I could—will we be completed in time?
The CIIAIRMAX. T have other questions I will ask for the record,
and I will desist right now.
Senator SCIIMITT. Mr. Chairman, I have no other questions. I want
to thank the Ambassador.
Ambassador STRAUSS. Thank you. Senator Schmitt.
Senator SCIIMITT. Like he does, I get excited about this problem,
and I apologize if I got too excited.
Ambassador STRAUSS. YOU don't need to apologize to me at all,
Senator Schmitt.
The CHAIRMAN. Tf you have to be in Dulles in 45 minutes, maybe
one more question, and we will send you on your way.
Senator SARBAXES. XO. I don't have a question; I want the Ambassador to catch his plane. I want to leave with him two thoughts.
One, people come at you pretty hard from a lot of directions. I think
that your statement, in terms of what you are going to do, you say,
first of all, there is no magical solution or quick fix.
Second, where you talk about a steady, gradual deceleration that
is a sensible approach to this problem.
Ambassador STRAUSS. Thank you.
Senator SARBAXKS. A few years ago, both unemployment and inflation were significantly worse than they are today, and that fact ought
not to be lost sight of. I think a policy that lurches from one side
to the other may well be the worst kind of policy.
I don't want unemployment back at 9 percent because you are
going to panic and do a lot of unwise things because the inflation
problem is serious. Inflation and unemployment are both serious
problems, and we ought to address them both in a balanced way, and
T think your statement reflects that, and I don't think you ought to
let people press in on you and get you off course.

Ambassador STRAUSS. Xot one bit, Senator.
Senator SARBAXES. Stay on a steady course.
Ambassador STRAUSS. Senator Sarbanes, I served 4 years as chairman of the Democratic Party. I have got a course charted, and I
am going to stay there come hell or high water.
Let me tell you one more thing I am not going to do, Senator
Sarbanes. It is awfully easy to be pressed before a distinguished
committee like this, and other places, and get where you overpromise and underperform. I don't intend to do that. I got to this
table under-promising and overperforming. I expect to do the same
damn thing in this job. Thank you very much.
The CHAIRMAN. Thank you very much, and thanks for your overperformance today.
The committee will stand adjourned.
[Whereupon at 4:45 p.m., the hearing was adjourned.]

TUESDAY, MAY 23, 1978

Washington, D.C.
The committee met at 10:00 a.m. in room 5302, Dirksen Senate Office Building, Senator William Proxmire (chairman of the committee), presiding.
Present: Senators Proxmire, Stevenson and Schmitt.
The CHAIRMAN. The committee will come to order.
This is the second day of hearings on the anti-inflation program of
the administration. We had an excellent record made, in my judgment, yesterday on using the tax system to try to retard inflation and
also a vigorous statement by Ambassador Strauss on the administration's program.
One of the most outstanding figures in the country in fighting inflation over the past few years has been the former chairman of the
Federal Reserve Board, Arthur Burns. We asked Dr. Burns to testify and Dr. Burns thought he couldn't testify at this time but he did
send us a statement on his position on what course we should follow
in combatting inflation under present circumstances. That statement
is available to the press. I'm going to read briefly from that statement
this morning before we call on our witnesses for their statements because I think we all recognize Dr. Burns' great integrity, tremendous
ability, great years of experience, and while many of us disagree
with some of his recommendations and some of the actions that he
took as chairman of the Federal Reserve Board, we all recognize his
great ability and I think we should share his judgment at this time
on what is the most troublesome and difficult economic question that
confronts us.
So I'm going to take just a couple minutes to read only a part of
the Burns statement and the entire statement will be printed in the
Former Chairman Burns writes:
On April 11, President Carter addressed the issue of inflation in a forthright
fashion. A little later the Administration announced that it will seek a smaller
tax reduction than it had previously recommended to the Congress. Clearly,
President Carter's concern about inflation deserves our commendation and support. I believe, however, that the policies thus far announced by the Administration fall short of being a strong and credible anti-inflation program that our
country needs.
Let me comment therefore on some of the ingredients of an anti-inflation
policy that in my judgment"

20-77") O - 78 - 23


this is Chairman Burns speaking—
would make practical sense at the present time.
First of all, the Federal Reserve needs to continue its monetary policy without any interference from the executive or the Congress. Second, the federal
budget for fiscal '79 needs to be substantially revised so that the deficit would
definitely shrink instead of remaining at its current level or continuing to
expand. Third, both this year and next increases in salaries of federal employees
should be scaled down to one-half of the figure indicated by wage comparability
studies. Thus, if those studies suggest an increase of, let us say, 6 percent,
salaries should go up only 3 percent. By adopting such a measure our government wTould set an example for the country at large and thus take the lead in
the process of unwinding the inflation. Fourth, and again to emphasize federal
leadership in unwinding the inflation, I would suggest that the President cut his
own salary by say 10 percent and call on all presidential appointees and members of Congress to do likewise. Fifth, the President should call on top corporate
executives to refrain entirely from any increase in their compensation over the
next two years. Sixth, the federal government should establish rather promptly a
national productivity center to assist business and labor leaders in each of our
sizable cities to form productivity councils within individual factories, offices,
and so forth, with
the objective of raising output per man hour. This country has
to go back to wTork. Seventh, it would be well if our government finally made a
start on reducing the cost-raising practices that it has encouraged or tolerated
over the years. I have in mind dropping or relaxing restrictions on agricultural
production, relaxing legal requirements on minimum wages, suspending if not
abolishing the Davis-Bacon Act which simply escalates costs. Finally, eighth, our
government needs to deal more firmly with the dollar problem in foreign exchange markets. If the dollar should continue to depreciate further there would
be a risk of recession in the entire international economy.

I think those are rather far-reaching recommendations and I
wouldn't hold my breath until all of them are put into effect, particularly Congress reducing their salary by 10 percent, but I think we
should have the counsel of Dr. Burns who has the respect of all of us.
[Complete statement of Dr. Burns follows:]

Arthur F. Burns
American Enterprise Institute
Washington, D. C.
May 22, 1978


The quickening of the rate of inflation in our country
during the past year is a disturbing development.

It has many causes.

For one thing, our economy has been expanding rather rapidly.
As generally happens in such a case, some upward pressure on prices
in individual markets has developed--for example, the market for lumber
and the market for insulating materials.

There is still considerable

underutilization of capacity in our country, but this has not prevented
supply problems from emerging here end there.

That is one factor in

the quickening of the inflation rate.
Another is that our government has delayed attending to the
depreciation of the dollar against foreign currencies.

This has naturally

served to raise our domestic inflation rate.
Third, governmental policy has contributed more directly to
the faster rate of inflation.

As the expansion of our economy stretched

out, the deficit of the Federal Government--instead of narrowing
rapidly as is normally the case at such a time--has tended to become
larger and now appears to be in process of becoming larger still.
When the Federal Government runs a deficit, it pumps more money into
the pocketbooks of people than it takes out.

That has always been a

major cause of inflation, and this process has lately been speeded up.

Moreover, our Government has sanctioned increases in the
minimum wage; that serves to raise costs and also prices.

Our Govern-

ment has sanctioned increase in Social Security taxes, and that also
affects prices.

Our Government has sanctioned subsidies to farmers

for producing less; that, obviously, will tend to raise prices.


Government has sanctioned restrictions on imports of steel, shoes,
television sets, and all that tends to raise prices.

Our Government

has sanctioned a spate of consumer protection and environmental bills
that run up costs for industry and thereby serve to raise prices.
And more recently, our Government has done little to prevent a highly
inflationary increase of wages for coal miners—an increase that will
tend to raise costs and prices broadly.
These policies are already reflected in a faster rate of

As a consequence, fears have mounted that in the absence

of modified governmental policies the rate of inflation in our country
may keep moving higher and higher.
On April 11, President Carter addressed the issue of inflation
in forthright fashion.

A little later, the Administration announced

that it will seek a smaller tax reduction than it had previously
recommended to the Congress.

Clearly, President Carter's concern aboutV

inflation deserves our commendation and support.
I believe, however, that the policies thus far announced by
the Administration fall short of being the strong and credible antiinflation program that our country needs.

Let me comment, therefore,

on some of the ingredients of an anti-inflation policy that, in my
judgment, would make practical sense at the present time.
First of all, the Federal Reserve System needs to continue
its monetary policy without any interference from the Executive or the
Second, the Federal budget for fiscal 1979 needs to be
substantially revised, so that the deficit would definitely shrink
instead of remaining at its current level or continuing to expand.
Third, both this year and next, increases in salaries of
Federal employees should be scaled down to one-half of the figure
indicated by wage comparability studies.

Thus, if those studies suggest

an increase of, let us say, six per cent, salaries should go up only
three per cent.

By adopting such a measure, our Government would set

an example for the country at large, and thus take the lead in the
process of unwinding the inflation.
Fourth, and again to emphasize Federal leadership in unwinding
the inflation, I would suggest that the President cut his own salary
by, say, ten per cent, and call on all presidential appointees and
members of Congress to do likewise.
Fifth, the President should call on top corporate executives
to refrain entirely from any increase in their compensation over the
next two years.
Sixth, the Federal Government should establish rather promptly
a National Productivity Center to assist business and labor leaders

In each of our sizeable cities to form productivity councils within
individual factories, offices, etc., with the objective of raising
output per manhour.

This country has to go back to work!

Seventh, it would be well if our Government finally made a
start on reducing the cost-raising practices that it has encouraged or
tolerated over the years.

I have in mind dropping or relaxing restric-

tions on agricultural production; relaxing legal requirements on minimum wages; suspending, if not abolishing, the Davis-Bacon Act, which
simply escalates construction eosts.

I also have in mind relaxing the

detailed regulations that run up costs all around for industry-in particular, postponing the target dates set for compliance with
environmental regulations.
Finally, eighth, our Government needs to deal more firmly
with the dollar problem in foreign exchange markets.

If the dollar

should continue to depreciate further, there would be risk of recession
in the entire international economy.
A fundamental cure to the international dimension of the
dollar problem is to be sought simultaneously along four routes.
First, we need an anti-inflation policy that is both firm
and credible.

Obviously, it may or may not contain all the specific

features that I've enumerated.
A second path to curing the dollar problem in international
markets is to work out an energy policy that will help this country to
conserve oil and, far more important than that, that will serve to
develop new substantial sources of energy supplies.

The third cure to the dollar problem in international markets
is a tax policy that will encourage business capital investment, including foreign investment, in our business enterprises, in our market
securities, and in real estate.
And, of course, there is a fourth route, but it is not under
our control; that route is faster economic expansion in the outside
There are also some financial bridging actions--such as the
sale of gold or the sale of Treasury securities denominated in foreign
currencies--that may become necessary, since the permanent cures cannot
become effective very quickly.
Let me close by saying that a strong and credible antiinflation program is long overdue in our country.

If we embark on

such a course we could have a true renaissance of our free enterprise

On the other hand, if we continue to rely heavily on rhetoric

in dealing with the inflation problem, our economy may be headed for
serious trouble.


The CHAIRMAN. We have as witnesses this morning Dr. Barry Bosworth, Director of the Council on Wage and Price Stability; Prof.
Albert Rees, Princeton University, economics department; Prof. Sidney Weintraub, University of Pennsylvania, economics department:
and Prof. Laurence Seidman, University of Pennsylvania, economics
Dr. Bosworth, go right ahead, sir. I might say that these statements are all brief and we appreciate that very much. We would
appreciate it if you could limit your remarks to about ten minutes. If
you go a little over that it's certainly OK, but for your guidance we
are going to run the clock here. The green light will be on 9 minutes,
the yellow light will be on 1 minute, and then the red light goes on
after 10 minutes.

Mr. BOSWORTH. I do have a statement, Mr. Chairman, which has
been submitted for the record.
One place I might try to start this morning is simply to try very
briefly to summarize where I think we stand and to outline the administration's goals that it has tried to put in place thus far and the
progress that's been made in those areas. I'll also speak of the difficulties that we envision coming up.
First, it's very clear that we are not at the present time making any
significant progress in reducing the rate of inflation. Over the last 3
months there's been a rather dramatic acceleration of the rate of
price inflation, now running at nearly 9 percent. We can anticipate
both in April and in May that inflation will continue to remain at
levels near 9 percent.
Because so much of the inflation of the recent months has been due
to food price increases, I think we can also look forward in the latter
half of the year to a substantial moderation of the rate of inflation,
very like what occurred last year. Unfortunately, all of that moderation, just like the acceleration, is due almost exclusively to food
prices and a few erratic elements of the Consumer Price Index.
After adjusting for some of these erratic movements, it's perfectly
clear that the underlying rate of inflation in the industrial sector is
one of longer-term significance. While it's not worsening the way it
was indicated in the first quarter, it's definitely not getting better.
There seem to be signs now that the basic rate of inflation in this
country is starting gradually to accelerate.
In hourly earnings, for example, we find that wage increases have
now run up and are averaging year-over-year increases of close to 8
percent compared to something around 7 percent last year. Less than
half of this can be attributed to the minimum wage and a very real
problem seems to be developing in an acceleration of the average rate
of wage increase.
Because of the sluggishness in wage movements, it's clear that this
sort of inflation lias longer term significance and cannot be turned
around in a few months.


With that outlook of not making progress, what are the alternatives that we have available to us?
One way to start is to state two extremes which we hope to prevent.
One is that this country could repeat another episode of aggregate
demand. We could have an increase in unemployment, and try to
throw so many people out of work that they would quit asking for
wage and price increases. The answer to that is that it is excessively
costly and has been totally ineffectual in the past.
The CoimciFs own estimate, just looking back over the last couple
of business cycles, is that it would require- about 1 million unemployed people for about 2 years simply to take 1 percentage point off
the rate of inflation. I don't think that the nature of the current inflation problem we have is due to excess aggregate demand and a
policy of trying to increase unemployment is not a reasonable response to that inflation problem.
At the same time, I think the other extreme of wage and price controls is an unworkable policy. It does not address the more fundamental, long-run structural changes that have occurred in the economy. At best controls would be a panacea for a short period of time
but would ultimately cause even further distortions and other problems that would increase the inflationary pressures.
Thus, this leads us of necessity to focus on some form of a voluntary program that tries to induce people to exercise some restraint.
That's the policy the administration has finally adopted and has been
trying to promote vigorously in recent months. That policy has four
parts to it.
The first has to be a clear recognition that Government itself has
become a major source of inflation, but not because Government is
trying to create jobs and not because Government is running substantial budget deficits in order to stimulate the economy. Rather, it
is because in so many of its other actions and its attempts to aid
special interest groups and provide them with price protection, protection against imports, and in the regulatory area. Government in a
very direct fashion is adding significantly to the rate of price inflation at this time.
In the regulatory area alone we could provide estimates indicating
that regulations are contributing about three-quarters of 1 percentage
point in terms of the rate of inflation. If we just take three specific
tax actions—the minimum wage, the increase in social security taxes,
and unemployment taxes in 1978, then the sum of those three items
would add another three-quarters of 1 percentage point. Therefore,
the Government is contributing at least li/ 2 percent to the rate of
Therefore, one of the first actions we have to take is to adopt more
vigorous policies by the Government to resist the efforts of special
interest groups and others to get a little bit of price protection. I
don't know how many times over recent months we have heard that
each one of these proposals for administration action or regulatory
action would add two-, three-, or maybe four-tenths of 1 percent to
the price levels. It's always true that they are all very small. But
what people forget is that we take hundreds of these actions in a

given year and the cumulative impact of this sort of regulatory actions and administrative and legislative decisions has now reached
the point where its impact on inflation is considerable.
The administration has adopted a much more vigorous policy in
resisting these sort of pressures than they did last year. I think it
began with the President's speech indicating that he would veto the
farm bill that was then being proposed by the Congress. It also
shows up in many regulatory reforms that the administration has
taken to try to improve the cost effectiveness of our environmental,
health and safety, and other regulations without backing off from the
ultimate goals of those regulations.
I disagree, for example, with Mr. Burns that we have to postpone
those goals. I think that there is so much progress to be made in
learning to do the regulations better, at lower cost, and more efficiently that it is not necessary to back off from the nation's environmental
goals or health problems. However, we do have to recognize that
these regulations are not free.They do cost the country in terms of
resources and they do contribute to inflation, but we can do them in
a far less inflationary fashion than we have been.
The second aspect of the problem is on the price side. While there
must be a recognition that Government is contributing to inflation,
there must be an equal recognition in the private sector that they
also are contributing to the inflation problem and it can't be solved
by Government actions alone.
I think that there is a standard of pricing behavior for business
that makes sense. They can calculate the average rate of price increases that they have had over the last few years, price increases
which will reflect a lot of the underlying trends in productivity, material costs, energy costs, and labor cost that they have incurred. "We
could then work to take the- edge off that rate of price increase and
cost increase.
So we are asking business basically to make an effort to limit price
increases during calendar year 1978 to less than the average for their
industry in the prior 2 years. In the recent months we have been fairly successful in getting a fairly good understanding on the part of
business of what this objective means and how it can be implemented.
And we have received a considerable level of support for it, at least
verbally. Whether or not that will be translated into actual pricing
action will be determined a little later in the year.
The third part of the program is on the wage side. You cannot get
down the rate of price inflation in this country without having a
comparable amount of restraint in wage negotiations. Labor costs,
after all, are about 70 percent of total GXP. You will never solve the
inflation problem by exempting 70 percent of income from the effort.
But on the labor side we do have a special problem because, unlike
prices, we can't ask everybody to undertake an equal constant amount
of deceleration from average wage increases of the past 2 or 3 years.
The reason for that is that there's been such a wide dispersion of
wage increases. Some people, particularly in the large industrial
sectors of the country, have received wage increases averaging about
30 percent over a 3-year contract period. At the same time, if we look
at workers in the apparel industry and others, where competition and

fears of unemployment have had a greater restraining influence on
wage behavior, they have received very small wage increases. It is
not equitable to ask people who have had very little to show an equal
amount of restraint with people who have had a 30-percent wage
So we have to ask labor that there be greater restraint shown by
those who have had the very large increases in the past. It has been
difficult thus far to get active support from those in the labor unions
for such an effort toward wage restraint.
The fourth part of the program is dealing with some aspects of the
economy, such as health care, housing and food prices, where the
source of the inflation is not easily addressed by talking about labor
costs or looking at prices alone, but reflects many fundamental structural problems.
In those areas we have developed individual task forces within the
administration to focus on those specific problems, including compiling a list of policy actions that could be developed by the administration to slow the rate of health costs and specific actions that could be
taken to slow the rate of inflation in housing prices.
Those four parts describe fairly completely what the administration's current efforts are in the inflation area.
The topics specifically that you wanted to talk about this morning,
like TIP programs, are various incentive programs which come to
mind for me specifically because of our difficulties in dealing with
getting wage restraint. I understand the problem on the wage side,
particularly in a 3-year contract, to undertake wage restraint on the
basis of some promise that there might be a comparable amount of
price restraint. It is a lot more risky for wage earners than it is for
a business firm who 6 months later, if things don?t work out. can jack
its prices back up again.
One looks to tax incentives, from my point of view, as a way of
reducing those risks, to provide some form of a guarantee to labor
that if they cooperate in a program of wage restraint they will be
protected to some degree against unanticipated price increases.
Thank you.
The CHAIRMAN. Thank you very much. Dr. Bosworth.
[Complete statement follows:]


Mr. Chairman, my name is Barry Bosworth.

I am director

of the Council on Wage and Price Stability in the Executive
Office of the President.

It is a pleasure to appear before

your committee today.
I wish I could appear before your bearing good news.


would like nothing more than to be able to tell you that we
have made progress against inflation.
Unfortunately, this is not the case.

As you are well

aware, the rate of inflation has worsened some in the past
few months.

There has been some wage and price acceleration.

The most recent figures have been, needless to say, disappointing.

But they do not suggest that the country is

headed for unbridled inflation with double-digit rates on
the horizon.

There is no doubt that the direction is up when

we would like it to be the other way.

This is disturbing,

but it is certainly not cause for hysteria.
It is true that if we look at the latest CPI, inflation
is running at an annual rate of more than nine percent.


we thought for a moment it would remain there we certainly
would be frightened.

But we are convinced it will not.


expect the year-to-year inflation rate to approach seven percent.

Most of the increased inflation is coming from food.

And as the summer wears on and we get the bad effects of last
winter behind us we expect significant improvement.
If we look at the underlying industrial rate of inflation, which excludes volatile items like food, mortgage interest rates, energy and used car prices, the rate of inflation
is inching up only a little.
Essentially we are bogged down in an inflation rut.
are not really sinking much deeper.


But neither are we making

any progress in extricating ourselves.

And to me this is

one of the most worrisome aspects of the current dilemma.


we cannot improve our position with six percent unemployment,
how will we be able to as the economy moves closer to full
For the moment I do not see very convincing evidence
that demand pressures threaten to exert a new inflationary

There is still too much unused capacity in our

industrial economy.

We could be heading in that direction,

This is why it is so very important that we do some-

thing about the kind of inflation we have before it is compounded by aggregate demand intrusion.
For the past few months the Administration has been working to slow the rate of inflation through its voluntary
deceleration program.
dramatic results.

So far this effort has not produced any

We did not expect any in this short time.

It took a long time for us to arrive at this inflation plateau.
We won't get off quickly.
The first part of the deceleration program is a recognition that the Federal government itself is a major contributor
to the inflation process.
branch and Congress.

This applies to both the executive

Increases in Social Security, the minimum

wage and unemployment insurance added three quarters of a percent to the inflation rate.

Regulatory actions added an equal

I am not for a moment arguing that there are not some
things that must be done despite inflationary implications,
especially where the public good is involved.

But I am saying

that if we are going to get a handle on inflation the Federal
government must be more aware of the interaction between what
it does and inflation.

We are going to have to learn to say

"no" to special interest groups, even when we recognize there
is both merit and equity in their requests.

The President

led the way in April when he announced his intention to limit
pay increases for Federal employees to 5.5 percent.
not a popular move.

It was not easy.

This was

It will not be easy

for Congress to demonstrate restraint in the face of rising

It is painful to deny new programs where there is

demand; or extend old ones where there is a need.
of course, not try.

We could,

But I think this could lead us down the

path of recession and to a point where the Federal government
would be forced to do even less.
The second part of the deceleration program is to convince business to hold price increases below the 1976-77 average.

For the last two months the Council on Wage and Price

Stability has been meeting with representatives from key industries.

We have stepped up the pace of those meetings and in

coming weeks there will be more.

When the program was first

announced last January business leaders viewed it with considerable skepticism.

This was not surprising, given past performance.

Recently, however, we have detected a very noticeable change.
A good and industrial people now feel the approach
is a reasonable one.
best interest.

And they are persuaded that it is in their

Our success has been limited, but I think

The automobile companies have pledged to meet the

deceleration target by the end of the year.

We have every

reason to believe the aluminum industry will be able to do the

We are confident there will be additional commitments

as the result of future meetings.
The deceleration program has been criticized because of
its voluntary nature.

This is understandable.

But the problem

is that between the extremes of wage and price controls and
aggregate demand restraint, there just is not very much left.
We don't want controls because they don't work and cause distortions.

We don't want demand restraint because this just a

polite way of calling for more unemployment.



Given the lack of options between the two extremes, we
decided to try the voluntary route.

We think it does have a

Great Britain, which went right to the brink and

didn't like what it saw over the edge, found voluntarism will
work if the national will is strong enough.

I hope that we

don't have to go as far as Great Britain to gain the will to
voluntarily restrain ourselves.
We have been searching for other ways to strengthen
incentives if a desire to avoid another recession is not enough.
We have looked especially at a number of ideas that are
loosely lumped together as tax incentive programs (TIPS).
There are some interesting aspects to them.

For one thing,

they seem to address the problem caused by the fact that demand
restraint is not an effective tool in dealing with the kind
of inflation we have today.

The cost of jobs and lost output

simply would be unacceptably high.

There is a possibility that

the incentive notion could serve as an inducement to price
and wage restraint stronger than jawboning without ignoring
market forces.
The incentive approach is indeed a novel one as a possible
tool to combat inflation.

It is too early to talk seriously

about attempting to implement such an idea.

But I think it is_

time to explore the possibility carefully and develop a public

dialogue to determine whether there'is enough merit to seriously
look in this direction.
Two variants of the so-called tax-based incomes policies
recently have received considerable public attention.


proposed by economists Wallich and Weintraub, uses a "stick"

It would levy a surcharge on corporate income taxes

for firms that grant wage increases in excess of a predetermined

The surcharge would be proportional to the excess wage

Arthur Okun has proposed a variant of his own using only
the "carrot" approach.

It proposes that firms and workers

become eligible for tax relief if they voluntarily enlist in
an anti-inflation program.

Firms would pledge to keep their

average rate of wage and price increase below certain target

In return, workers would receive a tax rebate equal

to some fraction of their wages or salaries up to a ceiling
($225 per person).

Firms would receive a rebate (5 percent)

on their income tax liability on domestic operating profits.
The idea is to provide incentives to both workers and companies
to hold down wage and price increases.
The Council on Wage and Price Stability has studied
both ideas.

And in our view, for different reasons, both

encounter some serious difficulties.
The stick approach has the advantage that it could be

29-77') O - 7H - 24

limited in its application by excluding very small or competitive firms.

This would go a long way toward lowering the

administrative costs.

In addition, it almost certainly would

generate some revenue since it is hard to imagine that some
firms would not increase wages beyond the target.
to us'that the problems far outweigh the benefits.

But it seems
There is a

very real possibility that firms with market power would grant
big increases and simply pass the cost of the higher tax, as
well as the wage increase, on to consumers in the form of
higher prices.

This could be true especially in those indus-

tries where all firms negotiate with the same union.
The straight carrot appraoch probably would be more
politically acceptable since it rewards good behavior rather
than penalizing offenders.

It would also be more difficult

for workers to oppose since it provides a reward for them.
But since it does provide rewards, it would be difficult to
exclude segments of the economy such as small firms or nonprofit institutions.

This would add to administrative costs.

It would also require Federal budget expenditures, thus putting
it in conflict with efforts to reduce the budget deficit.
Probably the largest objection of all is that it would require
enormous administrative machinery —
extended to prices.
in our economy.

particularly if it is

There are hundreds of thousands of prices

To keep tabs on each and every one would

require a bureaucratic effort at least equal to the one we
had during controls.

I don't think anybody wants this.

The notion of incentive payments to reduce inflation
may be useful in a slightly different context.

In our

efforts to develop support for a voluntary restraint program we have frequently been told that it imposes an unfair
burden on workers.

Unlike prices, wages are often locked

into two and three labor contracts.

Thus wage earners are

reluctant to commit themselves to a deceleration effort lest
it fail and they are left holding the bag while prices are
free to rise.
It may be possible to respond to this perceived problem
by offering workers an insurance plan that guarantees that
those who cooperate in a deceleration effort would not suffer
a loss of real income.

This might be preferable to the

uncertain promises of government.

Workers would have to

pledge that they would limit increases in their wage and
fringe benefits to less than some fixed figure approximating
the inflation rate.

In return they would receive a one-time

Federal payment equal to the increase in the cost of living
above the target figure.
For example, if a worker belonged to an employee group
that agreed to limit its average wage increase to seven percent, the government would commit itself to a payment equal

to the excess of the rise in the CPI above seven "percent.
The employer would certify the wage increase by placing an
asterisk on the employee's W-2 form.
The focus on average wages for an employee group and
the need to check compliance only for those wage increases
near seven percent would sharply reduce the administrative

In addition, the insurance feature would be triggered

only in about one year out of 10.
major administrative cost savings.

This would result in

The CHAIRMAN. Professor Rees.

Mr. Chairman and members of the committee, I am very pleased
to have this opportunity to present my views on the tax-based incomes policy, or TIP'S. Professor Weintraub was one of the first to
propose them. They have recently been receiving renewed attention
because of our lack of progress in reducing the rate of inflation.
TIP's may have some advantages over alternative ways to fight inflation, but in my opinion they also have substantial disadvantages
that have not received sufficient attention. These should be carefully
considered by the Congress.
[Complete statement follows:]

Statement of Albert Rees "before
the Committee on Banking, Housing, and
Urban Affairs, United States Senate
May 28, 1978

Mr. Chairman and members of the Committee, I am pleased to have
this opportunity to present my views on tax-based incomes policies, or

Such policies were first proposed a number of years ago, but

they have recently been receiving renewed attention because of our
lack of progress in reducing the rate of inflation.

TIPs may have

some advantages over alternative ways to fight inflation, but in my
opinion they also have substantial disadvantages that have not received
sufficient attention.

These should be carefully considered by the Congress.

Several variants of TIP have been proposed.
wages and others both to wages and to prices.

Some apply only to

Some would levy tax

penalties on firms that exceed wage and price guideposts; others offer
tax rewards to firms or workers whose wage or price behavior is more
moderate than the guideposts.
In my opinion, only one of these four basic varieties of TIP
is administratively feasible, and that one is the original Wallich-Weintraub
proposal for a tax penalty based on wages only.
bilities are administrative nightmares.

The other three possi-

The basic source of the admin-

istrative problems of reward TIPs is that everyone will want to be
included in the program so as to receive the possible reward, down to
the very smallest firms and employers.

Reward TIPs will be almost

impossible to end if they prove to be unsuccessful in reaching their
objectives, and they could be extremely costly in terms of reduced tax

The difficulty with penalty TIPs levied on prices is the

impossibility of setting reasonable price guidelines for all products,
given the incredible diversity of products in our complex economy and
the great disparity across industries and firms in changes in materials
costs and in labur productivity.

A uniform price guidepost would be

manifestly unfair to firms with large increases in materials costs or
small or negative changes in productivity.

Separate price standards

for each product would make a price TIP as hard to administer as price
Since I have argued that only a wage-based TIP is administratively
feasible, I shall devote the rest of my remarks to that proposal.


theory underlying a wage-based TIP is that inflation in the American economy
has been essentially wage-push inflation.

This theory is at best a great

It does not allow for the role in recent inflation

played by higher food prices at the farm, by the sharply increased price
of energy, and by the costs of environmental and safety regulation.
More fundamentally, it does not allow for the contribution to inflation
of continuing Federal budgetary deficits and of increases in the money
supply, and for the effects of these forces on expectations of future
Proponents of TIP argue that their proposal is superior to wage
and price controls because it will not cause distortion in relative
prices and consequent misallocation of resources.

Distortion is avoided

because firms facing shortages or excess demand are free to raise
wages and prices and to pay the appropriate tax penalties.

This is a

true advantage of a price TIP over price controls, since it is well
established that the price controls of 1911-lh did cause substantial
distortions of relative prices in some product markets and severe shortages of. some commodities.

However, there is no corresponding advantage

of a wage TIP over wage controls.

I do not know of a single instance

in which wage controls created or contributed to labor shortages during
the period 1971-7^.

This is because wage controls were applied largely

to wages that were already above the levels that would clear the market


to relatively high wages in jobs for which there was an ample supply of

Wage controls can create inequities in wage structures, and

in this respect TIP would probably be superior.
A wage TIP would work, according to its proponents, by "stiffening
the backbone" of management.

When faced by possible tax penalties for

excessive wage increases, management will take a tougher negotiating
position and make fewer concessions at the bargaining table.

A predict-

able consequence of a policy that stiffens management resistance to union
demands is that we will have more and longer strikes.

These strikes

could themselves contribute to inflation by creating shortages.


Federal government would no doubt have to intervene in an effort to
settle some of these strikes, as it did in the recent coal strike.
When it does, it will be working at cross purposes with its own taxbased incomes policy, or may have to set it aside.

Wage controls, in

contrast to TIP, actually reduce the number of strikes, since unions
will not strike for gains management cannot legally concede.

One of the principal difficulties of a wage TIP is that of
setting a wage guidepost that is fair and equitable.

In 1977 the

adjusted hourly earnings index for private nonagricultural workers
rose 7.3 percent.

To have an appreciable effect in restraining

inflation, the TIP guidepost would have to be set lower than this


let us say at 6 percent, which is a number that some advocates of TIP
have suggested.

But 6 percent is less than the increase in the Con-

sumer Price Index during 1977.

In other words, to have a substantial

effect a TIP guidepost would have to try to induce a decline in real
hourly earnings.

This would be totally unacceptable to the trade union

movement for obvious reasons.

In some areas, such as the construction

industry, there is also a danger that a wage guidepost would become a
minimum demand for unions that might otherwise have settled for less.
Where employers have both union and nonunion employees, as almost
all employers do, strong unions might insist on wage increases above
the TIP guideposts, and might argue that management could nevertheless
avoid tax penalties by giving nonunion employees increases smaller than
the guideposts.

Management would then be left with the unpalatable

choice between allowing union-nonunion wage differentials to widen or
paying tax penalties —

and in most cases they would probably choose the

But, of course, unions would not have to give any particular

reason for demanding more than the guidepost.

Where unions have enough

muscle, stiffening management's backbone is not likely to do much good.

I have mentioned that I "believe that the Wallich-Weintraub
TIP proposal is administratively feasible, a judgment that rests on
its being confined to large private corporations.
is achieved at a price.

This feasibility

By omitting state and local government and

nonprofit institutions, the proposal omits sectors in which union
wage pressures have been strong in recent years.

By omitting small

firms, it fails to cover many employers in construction and trucking,
industries with high wages and strong unions.
The Wallich-Weintraub proposal also does not offer any deterrent
to wage increases for unprofitable corporations with no corporate tax

It therefore creates a danger that in collective bargaining

some unions would concentrate on unprofitable corporations to set wage
patterns, which profitable corporations would have difficulty in breaking.
To say that a proposal is administratively feasible does not
mean that it is without administrative costs.

These costs would be

substantial, both to the government and to the private sector.


regulations would be needed explaining how to compute wage changes,
fringe benefits, bonus payments, and other elements of compensation.
Special rules would be needed to deal with incentive pay plans, with
cost-of-living escalator clauses, and with collective bargaining agreements that were already in effect when TIP began.

Although TIP might

not require a completely new administrative agency, it would require the
Internal Revenue Service to add to its- staff many experts in the area of
wages, collective bargaining, and compensation.

One reason why the administration of wage controls in the early
1970's was relatively inexpensive to the government is that few employer
returns to the Wage Board or the Cost of Living Council were ever audited.
A tax-based incomes policy would be subject to tax audits and controversies
arising from the policy would form the basis for tax litigation.

All of

this will take much of the valuable time of corporate executives and union
leaders —

time that could better be devoted to improving collective

bargaining and raising productivity.

The only sure beneficiaries of this

process will be accountants and tax attorneys.
Before the Congress imposes tax penalties on the private sector
for contributing to inflation, I think it should first examine its own

As the economy approaches full employment, the Federal

budget deficit should be substantially reduced.

New regulatory legis-

lation should be designed and existing regulatory legislation redesigned
so as to minimize its adverse impact on costs and prices.

Cuts in excise

and payroll taxes should be given high priority when the budgetary situation permits tax reductions.

If the Federal government leads the vay,

I believe that slow deceleration of inflation is possible without resort
to the elaborate new machinery of TIPs.

But there is no quick and easy

solution to an inflation as well established as the present one. We
shall have to be content with modest progress over a long period.
Mr. Chairman, this completes my prepared statement.
happy to reply to questions.

I should be


The CHAIRMAN. Thank you very much, Professor Rees.
Mr. Weintraub.

Mr. WEINTRAUB. Thank you, Mr. Chairman.
My seat here occupied by Governor Wallich yesterday is merely
I'm going to just comment on why an incomes policy is necessary
to free our economy of the stagflation blight. You have had copious
discussion through the years of monetary and fiscal policy. They
haven't worked. The question is why; and what do we do now ?
I share the views of others that inflation is the No. 1 problem. It is
"the one in many." It affects the foreign exchange value of the dollar,
leading to the decline of the dollar in the world markets. It affects oil
prices; it gives OPEC a reason for its higher prices. Our continued
inflation leads to higher interest rates, tightens the mortgage market,
and thus the housing market. It gives rise to stock market jitters.
If we can solve the inflation problem we can then devote our energies to the other problems that face us. I'd say that inflation has
been our No. 1 intellectual distraction. I have been in this profession
for 40 years, a-nd through my entire lifetime we have been discussing
inflation and unemployment, and unemployment and inflation. It
used to be one or the other. Now it is both simultaneously. We have
succeeded only in creating the impossible. The kinds of things that
we used to think only happened in "banana republics" or comic
operas has been happening to us—the mature, the affluent, the advanced, the politically stable democracy with all the modern stabilization tools. And I say it does raise some questions in this asre when
economics has become mathematized and aspires to a scientific status.
With econometrics, the computer, and piles of data, we have just succeeded in doing what no previous generation of economists has been
able to accomplish; have simultaneous inflation and unemployment.
I think the problem is at a different level, at the level of basic ideas.
In essence, this is the stagflation ordeal. What to do about it?
Now monetary policy has been ineffective and I predict it will continue to be ineffective. We have had champion inflation fighters—Mr.
Martin, Dr. Burns. There was no lack of dedication on their part.
They had the keenest desire to accomplish the job. They just couldn't
do it with the tools available. Mr. Martin fought inflation consistently. After 19 years in office, after this valiant fighting, the price level
was about 65 percent higher than when he came in. Dr. Burns, an
equally valiant inflation fighter, left office after 8 years with the price
level 50 percent higher.
I think the question is not a matter of will. It's not a matter of
zeal. It's a question of the lack of instruments. In the military, if you
had a general who promised light at the end of the tunnel, I think
that after 64 years when this promise was repeated, asking for eternal
vigilance and dedication, you would question whether it could be
done. You would question the weaponry. You would question the
strategy. The time has come to question the traditional cures.


Now then, you have all been confronted with the Phillips curve
doctrine, the fact that we need unemployment to fight inflation, to
fight unemployment we'll have to have some inflation. This reminds
me of the doctor whom you go to and you tell him you have a coronary and he'll say: "Yes, I can take care of it, but you will have
kidney disease for the rest of your life"; or you go to another one and
say you have trouble with your kidney and he says: "I can take care
of it but you will have coronary problems." We've got to get rid of
both. We've got to get full employment. We've got to get a stable
price level, and we must not be misguided or beguiled by views that
we've got to live with both ailments.
Now, Mr. Chairman and members of the committee, we are embarking again on what I call a destroy-to-revive fantasy. Whenever we
get close to the promised land of full employment we are always told
we'd better draw back; we'd better start fighting inflation. In other
words, whenever we get close to a robust and healthy economy we are
told we'd better make this economy a little sick, a little sicker, because if it gets healthy it will really be sick. Frankly, I don't understand that at all.
Again, I say I have been watching this for 40 years and the last
10 years have been rather disastrous, creating so much havoc in our
I have long argued that what we have been trying to do is assault the laws of arithmetic. Production goes up by 2 or 3 percent
per annum. We have been trying to raise our incomes by 8 and 10 and
12 percent per annum. In the U.K. they try by 25 percent; in Australia by 25 percent; in Canada by 10 and 12 percent; and then they
are astonished that the price level rises by 25 percent or 10 percent,
or we are astonished; yet we should not be.
If there was a way to raise money incomes without inflation by 10
and 15 percent per annum, while productivity goes up by 2 percent,
then there's no reason why we should not say to labor when it asks
for 10 or 12 percent per annum, "Why are you so modest? Why don't
you ask for 120 percent or 1.200 percent? Let the Fed fight inflation.
Let the Federal Government fight inflation." It cannot be done. We
cannot create instant-money billionaires without inflation.
Now I have spoken of the futility of monetary policy under outsized pay increases. This is an implication of my remarks. I must not
be misinterpreted to suggest that monetary policy is impotent. It's
not. It's very potent, but its potency is not on the price level but on
jobs. To say it's impersonal is erroneous. It's very personal. It always
clouts the housing industry. We know who gets socked by tight
money, and with multiplier ramifications spread through the
Now then, let me talk of what I call some errant theories of inflation and I suspect there will be discussion of my remarks here.
First: I want to say inflation occurs in the private sector of the
economy. It's for food prices. It is clothing prices, appliance prices—
these are goods produced by the private sector. We are talking about
the price level in the private sector.
There are those who argue that it's due to Government expenditures. Our fiscal 1979 budget projected outlays up to $500 billion. At
1963 prices that would be about $240 billion. It is inevitable that


Government expenditures will go up when money wages and salaries
rise. If money wages and salaries go up next year by 10 percent, I
will predict the price level and Government expenditures will go up
by that amount. If you find that costs go up in the defense industry,
why is it surprising that Government outlays on defense go up? The
deficit is not remotely the cause of inflation. The deficit currently is
about 2.5 percent of the GNP, much smaller than in the 1930's when
prices were falling. I will say more on this later.
Likewise, with respect to the Government debt, Federal Government debt has not been rising remotely as fast as private debt.
Now I oppose wage and price controls. The Wallich-Weintraub
T I P is reasonably well known but I had always hoped people would
read the original rather than just skim it off the top. Many of the
questions raised I think were answered there. To get around the
weighting problem that Dr. Wallich suggested, I suggested T I P CAP—CAP for corrected average product—to get away from the
weighting trouble, and it seems to me there's been absolutely no discussion of this point.
On the Okun variant, Dr. Okun has spoken. I won't comment further on it.
Now I have developed another idea on policy that can be implemented rather quickly, and which would not require the 2 years to
go, perhaps through congressional committees; it is called CAIP—a
contract authorization incomes policy—under the Davis-Bacon Act.
Currently, there are labor lobbies for new construction awards. Business firms want them—3 months, 4 months, 2 months, whatever the
day is—and then there is a strike for higher wages. For the life of
the contract I would suggest clauses in the Davis-Bacon Act to the
effect that average pay increases do not rise by more, perhaps, than
an average of 5 percent per annum. Raids on the Treasury could then
be averted.
Lincoln, during the Civil War, spoke of the "slows" of his generals. He had lavished equipment on them. He gave them large numbers of men, and all they wanted to do was stay in the drill camp.
They never wanted to go into battle. And this, I think, characterizes
our national life over the last 10 years in dealing with inflation. We
have a case of the slows. I do not regard the present approach as
likely to be successful. I wish it would be successful. The only consequence then would be for people to say: "Well, he was wrong."
Fine. No great loss. But it's not going to work. You're going to have
to face this issue—this committee or a future committee. We are losing valuable time.
One or two final remarks. Thomas Jefferson, if he were writing the
Declaration of Independence today and if I knew him, I'd try to prevail upon him to put a clause in on labor's "unalienable right to a
job." Employment opportunities must be abundant. People should
have the opportunity to work, to have income, and to walk in dignity; but labor—and whenever I say labor I'm talking about wages
and salaries—labor does not have an inalienable right to inflate, and
to inflict damage on others. We must have the vision to proceed, noting the prospective costs relative to the overwhelming gains. We must
have the courage to venture, to restore, to revive, to improve, and to
salvage the market system from both its foes and its complacent

friends. Both are too willing to preside over its substandard performance, thereby to provoke the biggest threat of all to its survival.
One final remark. I call your attention to the artwork at the close.
It is good artwork because I didn?t do it myself. You can see the
steep rise in the average money wage. You see the much slower rise in
profit markups. From the standpoint of business markups you would
find that the price level would be lower today, on the score of profit
margins, than perhaps in 1950. That's not the problem.
The problem is in that big line, "w?\ that high line, of average
wages and salaries, money incomes, rising so much faster than
I thank you, Mr. Chairman.
The CHAIRMAN. Thank you very much, Mr. Weintraub.
[Complete statement follows:]

Statement of Sidney Weintraub, Professor of Economics, University of Pennsylvania
Committee on Banking, Housing, and Urban Affairs, United States Senate, May 23
1978, Senator William Proxmire, Chairman

Comments on why Incomes Policy i s necessary to free our economy of the
stagflation blight will be briefj over the years the Committee has heard
copious discussion of the monetary and fiscal policy alternatives which have
not worked, and which cannot be effective even under the best rules of implementation. Remarks on Incomes Policy design will concentrate on key features
of TIP, the tax-based incomes policy -that has been associated with the names
of Governor Henry Yfellich of the Federal Reserve and myself. Some supplementary
features to strengthen and simplify the implementation of TIP, and a slightly
different approach to Inoome Gearing (through CAIP), will also be sketched.
Inflation; The Number One Problem* Inflation remains our number one economic
problem. I t is "the one in many" that mars our econonic achievements, holding
our actual accomplishments far short of our potential performance. I t impedes
full employment, i t creates social unrest and some politioal turbulence, i t
contributes powerfully to the international decline of the dollar, i t occasions
stock market j i t t e r s and record high interest r a t e s ; i t upsets government and
private budgets; i t has repercussions on housing and construction, with 'mult i p l i e r ' ramifications through our
The Great Intellectual Distraction* Not least, inflation, and the alarms over
i t s acceleration, constitutes the great intellectual distraction. We constantly
discuss i t , and fear i t , so that new issues are pushed out of mind and new
initiatives are denied the attention they deserve. In the competition for the
limited attention span devoted to public issues,^ Gresham's law is at work:
concern with the familiar diverts attention from the more novel problems of our
age. An undue amount of professional s k i l l s , likewise, becomes preoccupied
with the old and now chronic economic i l l . To be sure, despite this concentration of skilled resources, the number of good and original ideas to arrest the
inflation mess are conspicuously few.
The Stagflation Ordeal: The Impossible Has Happened. The last decade has
witnessed the simultaneous distress of too much inflation and too much unemployment, marking the stagflation ordeal. The debacle in the United Kingdom has
been even more severe as output fell amid a more ruinous price level surge,
giving currency to the slumpflation term.
In the older boom-bust cycles, prioes and output rose, and unemployment
rates f e l l , during the upswing; the paths were reversed during the downswing.
Thus there was either inflation oar^ higher unemployment r a t e s . Now, rather than
the tandem movements we encounter simultaneous bad tidings. Instead of a single
disorder a t one time, we have come to suffer a twin trauma. V/hat used to happen
only in 'banana-republics,' or in bizarre comio opera where everything went
wrong, has happened to us, and to other affluent, politically mature, and sophisticated economies presumably endowed with a l l the advanced stabilization

The 'i-npossi >le' - or inconceivable 1 - has thus happened. Manifestly,
i t a t t e s t s to some failure of ideas. I t is disconcerting to contemplate th;. t
in an age \jhere economics has become mathematized, with econometrics, the
computer, i-.nd piles of data, we have only succeeded in generating what previcu,
generations avoided, namely, the simultaneous inflation and unemployment i l l s .
Buried -inder tho technical intellectual avalanche,progress in ideas on the
operations of the economy, and the consequences of familiar stabilization mechanics, has been impaired•
The Ineffectiveness of Monetary Policy* The Keynesian-Monetarist Dialogue.
Passing reference might be made of the dominant Keynesian and Monetarist dialogue.
Monetarists generally allege that monetary policy has been too lax, culminating
in inflation. They usually advooate annual money increases in the 3 to 5 percent
range, and direct much misplaced profundity to "the" } roper definition of moiv.y
supply- Keynesians have Generally targetted on unemployment, advising rates of
monet. expansion in the 7 to 10 percent zone, Liach hae thus focussed on half-a loaf of economic policy though, to be sure, each grouj has insisted that i t s
policies will restore full s t a b i l i t y .
Much of this discussion is misspent. Monetary policy will not, of itself,
stabilize the econo.-ny. Monetary policy is potent, but i t s direct hammer blows on jobs and production, particularly destructive to the housing industry
when i t is severely r e s t r i c t i v e . To be s i r e , by creating enough unemployment as under -o0d Phillips curve dootrine - i t can indirectly slow up the money
income advance (particularly in wages and salaries); by inflicting the unemployment disaster i t can abort the inflation disorder: i t inflicts the unwanted
for tho undesirable. Past Keynesians, bereft of an inflation policy, have
concentrated on rescuing us from the unemployment seas by casting us out with
the inflation t i d e s . Each has a recipe for returning us to the world of one
disaster, without ameliorating the double anguish.
Mont?friry policy has failed, as documented in the s t a t i s t i c a l annals, to
protect us from the inflation agonies. I t i s also my conviction that i t is
destinea to f a i l . The dismal record of inflation is e» result not of the loss of
will on t;he part of the Federal Reserve but of a lack of tools to do the proper
job, without dumping us in the unemployment ditch.
The Fed has been fighting inflation over most of i t s 64 year history. The
last two chairmen of the Fed were dedicated inflation fighters; both left office
with prices over 50 percent higher than at their incunbency. tven as they r e minded us of their zeal and vigilance, they lugubriously announced the t o l l of
mounting price s t a t i s t i c s . In the military analogy there was always 'light at
the end of the tunnel.' After 64 years of retreat and culminating distress we
would long ago have changed our military strategy, ant' probed whether the
weaponry was adequate to the task. .\iy conclusion has been, for a long time now,
that unaided monetary policy cannot usher in a sidewice price trend.
;>Iischievous Phillips
tight money medicine
that the policy will
curve doctrine - but
our market economy.

29-775 O - 78 - 25

Curve Doctrine. Monetarists nonetheless insist that their
will stop inflation. The more ctndid among them admit
engineer substantial unemployment. This is good Phillips
b^d theory or policy, even dangerous to the viability of

There is no need to dwell on the intricacies of Phillips curves, or their
wayward patterns of revent years, or the transformation of what was originally
a predictive law into a post-mortem on why events went awry.
What i s most dejecting i s the advocacy of a policy that aims to replace
one dismemberment with another disfiguration, or to supplant the inflation woes
with the unemployment wickedness. To me i t i s sheerly immoral, l e t alone uneconomic to recommend unemployment for other people, to menace the least
adaptable members of our economy with the loss of jobs and income. I have said
on occasion that advocates of these policies should resign, join the ranks of .
the unemployed, and become the great inflation fighters. If unemployment i s
good policy they should e n l i s t in the b a t t l e .
The policy i s spurious, too. I t i s as i f a doctor advises a patient that
he can cure him of a coronary ailment by inducing a kidney f a i l u r e . Most of us
would seek a new physician. Medicine i t s e l f generally t r i e s to eradicate a l l
ailments, and not to substitute a new pernicious disease for an old one. In
economics, however, we seem less concerned with restoring t o t a l health. We
prefer some impenetrable, often mystic, talk of "trade-offs."
The Destroy-to-Revive Fantasy. Monetary policy, as practiced, also entails a
ourious "destroy-to-revive" fantasy that would s t i r disbelief in wanderers not
steeped in the conventional mythology*
Every time the economy advances, in lowering the unemployment rate and
entering the Promised Land of jobs for a l l , we are warned of inflation ahead,
of the economy 'overheating. 1 The sequel i s a tightening of the money screws,
the deliberate retardation of the GNP growth rate and of job access.
This i s bewildering. Every time we show signs of good economic health, we
are consciously reined by inflation fears. Thence the economy is dropped into
some recession t a i l s p i n . Yftien this depressive proces6 runs on for a time, we
quickly denounce the government for unemployment; money policy is thereafter
eased, to restore the patient to better health, not too robust to be sure, but
to mitigate the worst symptoms.
Thus we are capped below our best performance, deliberately. We are compelled to adopt a posture of deep underachievement at worst, and significant
frustration at best. Self-immolation, or masochism, assumes the fancy name of
"fighting inflation."
Of course we have not succeeded in preventing the skyward price ascent,
but we have succeeded too well in making the market economy sputter rather than
to ride smoothly at top efficiency. Monetary policy, despite p;ood intentions,
has mired us in an abject performance compared to our attainable goal.
The Assault on the Laws of Arithmetic. We have, over the last decade especially,
been engaged in a mad assault on the laws of arithmetic* Average productivity
has been inching ahead by 2 and 3 percent per annum, end money incomes - with
money wages and salaries comprising the bulk 75 per cert of the t o t a l - leaping
ahead by 8, 10, 12 • • • percent or more per annum. In the United Kingdom and
Australia, to name but two countries, the pay increases have sometimes approaches
25 percent per annum.

The inperetive has been a price level surge, inevitable whenever there is
a sharp money income and productivity disproportion. The only source of amazement has been our inability to apprehend that this would happen. The results
must follow from the truism of P = Y/Q, where P = price level, Y = money inccnx
(or Gross Business Product) and Q • physical output.
Regardless of what the Federal Reserve does, so long as the rate of money
income ascent surpasses the rate of production flow, price level stability is
Futility of Monetary Policy Under Qutsized Pay Increases. Another formula r.ic/xs
money wages and salaries stand out more indelibly in the inflation surge, writing Y = lew!!, and therefore P = kw/A, where W = the, average wage and salary, and
A = average productivity of labor, with k • the average mark-up of prices over
unit labor costs (which equal w/A), the inevitability of the inflation outcome
when averape money wages jump faster than 3abor productivity, is disclosed. It
happens that year-to-year, and over the long haul, k is fairly constant with a
slight downward d r i f t .
There are those who characterize this as a "wage-push" theory of inflation.
This is a cultivated error: money wages are simultaneously the chief costingredient on the supply side of the price equstion, end the mainspring of
consumer demand. "Cost-push" and "demand-pull" are thus inherently simultaneous
strings emanating from the same phenomenon, rather than being diverse strands of
a price ljvel theory. As an i l l u s t r a t i o n , salaries paid to university faculty
are costs to the university and, at the same time, the source of purchasing
power and demand to faculty recipients.
The attached chart shows on ratio scale since 1929 the course of average
money wages (and salaries) of average productivity, and average mark-ups over
the period. From the side of markups (k), the price level should be lower
today than in 1950. Likewise, growing productivity has acted as a price level
brake. Money wa(^es and salaries, however, have climbed a t a heady pace* Inflation has been an irresistable outcome in the circumstances: if P were plotted
on the chart field i t would run about half-way between w and A.
Instant Billionaires? The general theory must be correct* Otherwise we could
raise money wages and salaries not by 8 or 10 or 12 percent per annum, but by
1,000 or 1 million percent or more. We could ask labor at the beginning of
each year how much of a pay increase i t wants, and then deplore the modest size
of the wage demands, multiplying them a thousand or mi 11 ion-fold. V/hy not make
everyone an instant billionaire? After a l l , the monetarists assure us, the Fed
can protect us from inflation! Why leave people unhappy with their momey
income lot?
Once we say there is a "right" or optimal rate of money v.age increase we
are recognizing the ubiquity of Incomes Policy.
Some arrant Theories of Inflation. A word on other, and errant, theories of
inflation. Many would fault big business for excessive price markups. Our
chart invalidates this view as a general factor. Others allege that government
deficit finance is at the bottom of the price virulence. Yet, over the last 50
years we have only had nine years of surplus, often of piddling amounts; until
the last decade the price level, by recent standards, behaved well; in 1935
the deficit was about 55 percent of expenditures - far above the projected 12
percent for 1979 - yet the 1933 price level f e l l . Deficits are hardly the

inflation-maker that passionate controversy i n d i c t s . Analytically, the d e f i c i t
theory is usually a step-sister of monetarist versions of increases in the
money supply as the price culprit.
Jurecs also goes to the government debt. The facts are that since 1945
private dejt has increased far faster; likewise, the big lurches in the relative
debt size occurred between 1930 and 1945 when the price level was "orderly11 by
recent standards. Too, in that period we were concerned with "reflation," or
l i f t i n g the price l e v e l .
Others blame government expenditure. The projected $500 b i l l i o n of outleys
for 1979 would, at 1963 prices, amount to about $240 b i l l i o n . It would be more
accurate to argue that government expenditures jump more as a consequence of
higher prices than as cause. Vlfhen money wages go up c i v i l service pay can hardly
lag too far behind. When military hardware costs more i t i s inevitable that the
defense b i l l mounts. The federal government has hardly increased i t s portion of
GNP purchases; in f a c t , while eyes have been riveted on V/ashington the State and
Local outlays have spurted, and are now about 50 percent higher than Federal GKP
Income Gearing: Some Proposals
All economic ay stems that pay out money incomes, whether a capitalist or
c o l l e c t i v i s t model, must have some method of gearing money incomes to output
flows. Those of us who want to preserve the market system must seek out poli c i e s that are compatible with the market system and i t s institutions of privcte
decision-making and largely unfettered choices.
Those of us who have suggested some institutional changes are concerned to
protect, to improve, to salvage the market system, to see i t operate up to i t s
best potential. Foes of the raarket system are content to witness i t s f a i l u r e s .
Paradoxically, avowed friends of the market system whe refuse to even consider
new policies lock hands with i t s foes; persevering in old p o l i c i e s , and thereby
tolerating inflation and unemployment, they are in some t a c i t and unintended
alliance with those who would dethrone the system without any concern with the
chaos that would ensue and the threats to freedom i t s e l f .
Opposition to Price and Yfage Controls. 3efore discussing some inherently noninterventionist p o l i c i e s , and to avoid any confusion on the matter, wage and
price controls are not advocated. They are noxious for they are bureaucratic,
dilatory, harassing, costly to administer, apt to be politicized, requiring a
legion of snoopers and enforcers, and too anxious to make criminal offenses out
of consensual agreements involving transactions as simple as purchases of a
quart of milk or loaf of bread. Controls would clog court calendars, providing
mainly a forum for histrionic performances by lawyers, and f u l l employment for
them, and a retinue of oourt attendants and j a i l e r s .
The image of Captain Queeg tyrannizing over the theft of a plate of strawberries must not be rendered the prototype of our economic system. So, nothing
in my remarks are to be construed as advocacy of price controls. I oppose them
except for the shortest possible period while other policies are being prepared.
The Nixon Phase One, some will say, succeeded in stopping the 1971 price upheava l . In my view they only proved that our economy oan stand almost anything for
90 days .

The Yfollich-Weintraub TIP. The Y/allich-Weintraub tax-based incomes policy (Ttlj
is reasonably we 1]-known* Briefly, i t is intendec to subject firms that violate
an average money wage and salary norm of, say, 5 jercent per annum to an extra
corporate income t a x . The object, however, is not to collect taxes but to deter
inflationary conduct. Corporate tax levies can, en balance, be reduced, especi a l l y as the economy works toward full employment. Insofar as TIP yields some
revenue, the ordinary corporate tax can be lowerec so that no erosion of corporate financing-capital occurs. TIP cannot be tarred with aiming to increase
the corporate tax burden; this would misconstrue or misrepresent i t .
An analogy with a speed limit can convey the essential idea. Speed limits
are imposed to prevent suicidal road conduct, menacing mainly life and limb of
others. Revenue is not - or should not be - the objective; if revenue were
sought we should put the limit down to about 3 miles per hour, to collect revenue
a l l day long!
Speed limits, however, do permit individuals to violate them in cases of
emergency with cognizance of a penalty* TIP, likewise, permits the pay guides
to be punctured, with penalty. Thus TIP, like all good legislation, contains a
safety-valve for firms who see the need to surpass the pay norms*
I would confine TIP to the largest 1,000 or 2,000 firms, or firms employing
above a given number of people. If TIP were confined to firms of 500 employees
or more we would encompass firms with sales of perhaps $15 millions or more for
inclusion. Administrative convenience should largely govern the lower cut-off
point. There is no need to subject small business to TIP; on pay policy they
typically follow the practices of the larger business cohorts.
To strengthen TIP and compel settlements of unions with firms that offer en
average increase of, say, 5 percent (or perhaps slightly more), a variety of
supplements can be conceived. Some firms may face bankruptcy, in the event of
a long s t r i k e , because of onerous fixed charges. Some circumscribed guaranteed
loan features may thus be attached. Some NLRB penalties may, as a strike continues, be placed on unions, for a period of years. No particular recommendations are made here but labor market specialists may have ideas that could
hasten wage settlements in the 5 percent range*
TIP-GAP. In my own e a r l i e s t statement of TIP, a simple average pay level was
calculated for the f i r s t year, say 1977, and then another similar average was
computed Tor 1978. If the average rate of pay increase exceeded the norm, say
5 percent, a penalty corporate income tax would be imposed. In the collaboration with Governor "Wallich, a weigjhted pay average was injected to mitigate some
possible fudging by firms that granted top executives extravagant increases and
then hirea superfluous low skilled employees to drive the average pay award
be low the. taxable increment.
'weighting the average introduces extra complexity, and invites interminable
controversy on a correct set of weights. To avoid t h i s , and to immunize some
pay grants in excess of the average guidepost, firms can be permitted to compute
a simple average of labor productivity, and correct this for price level changes
(following their selection of a price index), and to enable labor to share i>>
superior productivity improvements. This is the CAP aspect, where CAP signifies
"corrected average productivity." Labor would thus be the direct partia] beneficiary of extraordinary productivity improvements steminingj^echnological improvements in equipment. Only eler.ientary aritljnetic calculations are entailed,
well within minimal accounting s k i l l s .

The Okun TIP Variant. The dkun TIP variant is discussed very briefly for Dr.
Okun, who has contributed so much to recent discussion and awareifiss of TIP,
nay have some modification of his ideas. For one thing I remain skeptical oP
the original voluntary participation in his plan; this would be tantamount to
a skin;; speeders to behave voluntarily. Too, the main principle seems to be to
"bribe" drivers to travel below the speed limit rather than to penalize them
for surpassing the posted norms. I t i s questionable whether the payment can
be large enough to sponsor proper wage conduct.
Too, the use of tho personal income tax to pay rebates for non-inflationary
conduct would appear to be complicated, with the disadvantage of being discriminatory against non-union employees. Finally, the original Okun variant fares
better as a method of reducing the rate of inflation, whereas the V/allichj'eintraub plan could be a mode of stopping i t . Inflation woulo. be stopped if
the average pay increase was set wi-tfiin a 3 percent threshold, and a steep
graduated penalty was imposed for violations.
CAIP. TIP, because of i t s tax aspects, would have to clear the tax cor.mittues
of Congress where i t could be misperceived as a tax measure, and subject to
long debate. Faster progress in Incomes Policy, or Income Gearing, might follow
another approach.
Under V/alsh-Healey and Davis-Bacon the government already operates an
incomes policy. Davis-Bacon # for example, mandates that on government or
government assisted construction contracts, prevailing wage r a t e s , apparently
interpreted as the highest in the general vicinity, be paid employees. Effectively, this nails a high floor under pay scales.
Often, labor lobbies for government construction contracts and then, when
the sums are voted, there are strikes for higher wages. It should be possible
to limit pay grants, over the life of the contract, to an annual increase of no
more than 5 percent (or whatever pay norm is adopted). The limit would also
cover executive pay scales, thus taking some of the fat of salary aggrandizement
out of the government outlays. Penalties could take the form of disallowing
magnanimous pay increases from entering as costs for computing corporate income
tax, or denying cost overruns occasioned by the pay upkick in contract negotiation.
Raids on the Treasury could be thwarted under this proposal to make DavisBaoon. conform to a limited annual l i f t in the pay ceiling. The idea could be
extended to military procurement. Inasmuch as construction and government
procurement outlays extend to a veritable Who's Vftio of American enterprise,
this approach could blanket about 10 to 25 percent of the business sector and
could suppress a money income explosion. Government employees could be allotted
limited annual average pay increases, subject to corroction every three years,
conformable to pay experience in the private sector.
CAIP (= Contract Award Incomes Policy) could thus establish a fairly quick
transition to a more universal TIP-CAP policy. CAIP could remain to cover tho
past runaway wage costs in the construction sector.

Lincoln and the Slows
During the Civil -.'ar Abraham Lincoln moaned over his Generals, until he
found Grant, as having a case of the 'slows. 1 He f e l t he gave them superior
equipment and advantageous manpower, and yet they rirely wanted to move out of
their training canps, preferring d r i l l field maneuvers to b a t t l e . The 'slows'
have also afflicted inflation policy over the last decade. We talk oi' inflation but we have - until very recently - shut our eyes to any innovative
policies to staunch the debilitating phenomena. The llixon-Ford years yieldod
the rhetoric of "game plans," and the spectacle of "gradualism;" apparently
the intention was sneak up on the stagflation phenomenon and dispel i t .
A decade has elapsed. Policy-wise l i t t l e has changed. The 16 Certer
months have been devoid of a policy to cope with the double-trouble of inflation and unemployment. Recently the President has uttered more encouraging
sounds and has concentrated anti-inflation policy in the hands of Ambassador
A Fly-Swatter Approach? Recently we have witnessed the end of the coal strike,
a cut-back in what appeared to be an extraordinary steel price r i s e , some
efforts at boosting farm prices, and a promised restraint on government pay
increases. The progress seems to be by nature an ad hoc patching of what is
inherently an income 3-productivity problem. Only an integrated income gen ring
policy, resembling TIP, is likely to stop inflation and permit full employment.
Otherwise we are likely to resemble the man in an unscreened house neer the
lake, running about with a fly-swatter to stomp out one by one the countless
pests entering through windows on a l l sides.
An Addendum to the Declaration of Independence?
Resisting entreaties on his behalf for the onerous and v i t a l chore of
drafting the Declaration of Independence, John Adams advised that the assignment
go to Thomas Jefferson for, as Adams said, Jefferson possessed the gift of "o
peculiar felicity of expression."
Capturing the mood of the times and ideas in the a i r , Jefferson wrote of
man's "unalienable" r i g h t s . If the document were written today, perhaps we
might petition Jefferson to include a passage on Labor's "unalienable right to a
job." But with rights go obligations: there is no unalienable ri^ht to infl&te,
and thereby injure others in the economy, ozjto invite anti-inflation responses
that jeopardize jobs.
TIP Is Not Anti-Labor but Anti-Inflation and Pro-Full iinployraent
TIP is not anti-labor. I t is not anti-business. I t is anti-inf lot ion end
pro-full employment. 3y tethering money incomes to productivity advances the
price level can be stabilized, rational behavioral decisions on saving, business
investment, and government budgeting, can be made; jobs can be assured for a l l
willing to work at prevailing wage scales; monetary and fiscal policy can be
devoted to full employment ends so long as the inflation fears are eliminated.

Events between early 1961 and late 1968 demonstrated that we can achieve
continuous expansion and abundant job opportunities. I t i s a Marxist tenet,
too often pronounced by conservative friends of the market system, to assert
that the expansion of the 1960s was attributable to the Vietnam war. It i s
not war that makes a market economy tick, but expenditures by the private and
public sector. There i s much work to be done as we enter the 1980s. Our
traumatic fear of inflation, and our f u t i l e and inept methods of combatting
i t , have created the stagflation f o l l y , with an output and income loss ranging
from $75 to $100 billions per annum.
This i s wasteful in the extreme. A big $100 b i l l i o n annual prize dangles
before us, waiting to be grasped. TIP i s a promising lever, free of the
oppressive features of wage and prioe controls. Administratively i t i s f e a s i b l e ; oost-wise i t i s modest, requiring $1 to $5 millions for implomontation.
'•Ye must have the vision to proceed, noting the prospective* oout ro]< i.ivu
to the overwhelming gains. We must have the courage to vonturo, to roctoro,
revive, improve, and salvage the market system from i t s fores and i t s complucont
friends. Both are too willing to preside over i t s sub-standard performance,
thereby to provoke the biggest threat of a l l to i t s survival*

The WCM Theory: The Double-Edged Demand and Cost Blades

Index numbers of k, w, A, 3929-1975

The CHAIRMAN. Professor Seidman.

Mr. SEIDMAX. Mr. Chairman, Senator Schmitt, because of the time
constraint I will be skipping sections of my prepared statement and
I will indicate the page I'm skipping to so you and others can follow
my testimony.
The CHAIRMAN. Let me say the entire statement will be printed in
full in the record as will the other statements.
[Complete statement follows:]

Laurence S. Seidman
May 23, 1978
My name is Larry Seidman.

I am an Assistant Professor of

Economics at the University of Pennsylvania.

During the last four

years, I have been engaged in research concerning the theory and
design of a tax-based incomes policy (TIP).

I recently presented

a paper on tax-based incomes policies at the Brookings Conference
devoted to that subject.
This morning, I want to explain why I believe a tax-based
incomes policy should be adopted, and offer specific suggestions
for its design.

A permanent tax-based incomes policy-or TIP- com-

plemented by proper monetary and fiscal policy, offers the prospect
of permanently reducing both inflation and unemployment.


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 taxbased incomes policy.
TIP is fully compatible with our market economy, its institutions, and traditions.

In contrast to either persuasion or controls-

the two traditional methods of incomes policy- TIP would harness
the instrument that has proved its effectiveness in our market
economy: financial incentives.

Business and labor would remain

free to bargain collectively, and weigh the particular features of
their own situation against the TIP incentive, arriving at the
wage and price decisions they regard as best, without government
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 salaries to catch-up with inflation, to stay
ahead of it, or to improve their standard of living, are simply

reacting to protect their own self-interest, exactly as managements do when they seek profits.

Since labor is responding to the

same incentives that drive all economic agents in our economy,
fault-finding is unjustified.

Similarly, when business 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 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.
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.


behavior imposes a cost on society in either of tvc forms.


monetary and fiscal policy 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 have 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 externality."

The employer and employees at eaoh

firm should bear a private cost whenever they impose a social cost,
in the form of higher inflation or unemployment, on the rest of

They should either incur a financial penalty, or forego

a financial reward, when they engage in such behavior.
TIP is to provide such a financial incentive.

The aim of

Even advocates of TIP have not yet agreed on the best design.
Today, I want to set out tenatively a TIP package that promises
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 employer-employee
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 tenatively, 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.


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 smaller price increase.

Today, the average

annual wage increase is 87»; but because the trend growth rate
of productivity-output per manhour- is only 27O (and varies little
from this figure) , the average unit cost increase is 67O.
basic inflation rate, therefore, is 67O.


The best way to predict

the inflation rate is to observe the average wage settlement and
subtract 27O- 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 difference


Price-Unit Labor Cost Relationship
(Percent Change from the Previous Period)


per hour

per hour

labor costs


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.

between the average wage increase and the average productivity

For example, in the early 1960's, the average wage

increase was 47», the average productivity increase was 3%, and the
inflation rate was 17o.

This rule of thumb is one of the most

stable empirical relationships in economics.
about this.

There is no mystery

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 empiri-

cal evidence strongly reject the view that sustained price increases
can occur without accompanying increases in unit labor costs.
Today, unit labor costs are rising 6% per year, and therefore, so
are prices.

The only way to bring the inflation rate down to 0%

is to stop the advance of unit labor costs, by gradually reducing
the growth rate of wages from its current 8% down to 2%, the
growth rate of productivity.
Suppose TIP sets as its initial target a wage inflation rate
of 6% (instead of the current 8 % ) , and a price inflation rate of 47»
(instead of the current 67»). Then TIP might consist of the following two incentives:
(A) Employer Incentive
A firm that grants a wage increase in excess of 6%
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%, it

would enjoy a proportionate tax cut; it it grants 6%, its tax rate
would remain at the base (currently 487o for many corporations).
For example, if a firm grants 7%, and the TIP multiplier is 6,
its tax rate would rise to 54%; it if grants 87O, its tax rate

would rise to 60%.
(B) Employee Incentive
Employees at a firm that grants an average wage
increase in excess of 67O would receive a tax increase for that
year in proportion to the size of the excess.

If the firm grants

less than 6%, they would enjoy a proportionate tax cut; if it
grants 6%, 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%, 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 67<>, 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% 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%, 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.
and B, 7%, for an average of 8%.
B, 57o, for an average of 6%.

Without TIP, A might grant 9%,
With TIP, A might grant 7%, and

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.


controls, all firms would be prohibited from exceeding the wage
target of 6%, 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 77o wage increase, and accept the tax penalty.


controls, the employer and employees at A would not be free to
arrive at their own decision.
case to a regulatory board.

They would have to submit their
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.

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.

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 investi-

gate a sample of firms according to its usual procedure.
TIP would complicate the tax code.
tax credit and accelerated depreciation.

But so do the investment
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

over-emphasized 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

29-775 O - 78 - 26

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 accepted?
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.


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% 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 97O; 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

These objections will be reviewed later.

A TIP that

provides incentives for wages-only avoids these problems.


I will show how prices and profits can be restrained effectively
without direct tax incentives.
In summary, TIP differs fundamentally from controls.


in my view 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 my view, the most crucial ingredient in the
package is the income tax penalty on the employer- the original

Weintraub-Wallich incentive.

In a technical 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 sum-

marize 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

In the above TIP package, the employer incurs a tax penalty

if he grants a wage increase above the 67o 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%- but his tax rate
would remain 48% if he grants 8% or higher.

It is possible that

the opportunity for a tax cut will induce him to reduce his wage
increase below 87o.
than he is today.

But if he does not, he will be no worse off
It is therefore uncertain whether he will

Suppose under the penalty proposed in the above package,

his tax rate would rise to 60% if he grants 87o (6 percentage points
for each 1% excess).

If he insists on granting 87Of 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-topay.

The income tax penalty would threaten a squeeze in after-

tax profit if the firm grants the same wage increase.

The evidence

suggests that this threat would cause managements 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 potential
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
In response to this argument, the following question can be
raised: Is it possible that firms will ignore penalty-TIP, grant 8
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 this possibility will not

undermine penalty-TIP.
Since the tax penalty is on the income tax of the firm, in
effect "IRS goes last."

First, the firm raises its price, hoping

to increase its before-tax profit enough to offset the TIP tax

Then, IRS taxes a fraction of this gross profit.


the TIP penalty multiplier is made stiff enough, the firm will
be unable to avoid an after-tax profit decline if it grants 8%,
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%
to 60%, the firm would have to be able to raise its before-tax
profit by 307» to avoid a decline in after-tax profit (without
TIP, the firm would keep 52%, which is 30% greater than the 4 0 %
it would keep under TIP if it grants 87o) .

If the multiplier were

13, so that the firm's tax rate increases from 48% to 74%, 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% without TIP, but 26% with TIP if it grants 8%). Finally, if
the TIP multiplier were 26, so that the firm's tax rate increases
from 48% to 100%, it 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%.

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 its 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 raising price, and won't this worsen inflation?
The answer is as follows.

As long as the average firm reduces its

wage increase to the target, the average tax rate will remain at
the base (today, 48% for most corporations), and there will be no
tax increase to pass on. Suppose, pessimistically, that the average
firm exceeds the target, and incurs a tax increase.

The result will

at worst be a one-time increase in the average firm's mark-up, and

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 increase once.


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.


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 introduced, 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

If the penalty were on the payroll tax of the firm, in

effect IRS would "go first," and the shifting problem would be more

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 guarantee that the firm

would suffer an after-tax profit squeeze if it granted 8%.


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.
firm "digs in" at 8%.

Today, the average

If the TIP target is 6%, the average firm

will "dig in" with the same intensity at 6%.
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


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 administra-

tion, 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

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

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 someone

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%, and price
inflation to 4%, then the dividing line between penalty and reward
under TIP should be lowered to 4%, and ultimately (after several
years) to 2%, the average growth rate of labor productivity, and
therefore, the rate required to keep inflation near zero.
As disinflation steadily occurs, the unemployment rate can
gradually be brought down perhaps to near 47O.

Econometric evi-

dence suggests that without TIP, a 4% unemployment rate would
cause wage and price inflation to gradually accelerate, so that
4% could not be maintained.

With a permanent TIP, exerting per-

manent downward pressure on wage increases, it should be possible
to keep wage increases equal to productivity growth at a 4%
unemployment rate.
My own analysis suggests that a permanent TIP would cause
a significant structural change in the economy.

TIP would per-

manently reduce the non-accelerating-inflation rate of unemployment (NAIRU) of the economy- from perhaps 6% to 4%.

It would

then become possible to run the economy at 4%, instead of 6%,
without generating a rise in the inflation rate.

This reduction

in the NAIRU would yield large social benefits each year.


ing to Okun's Law (a 1% reduction in unemployment yields a 37O
increase in real GNP), if the economy can be run at a 4% unemployment rate, real (inflation-adjusted) GNP, labor income, private
investment, and profits, will all be 6% higher each year than if

the unemployment rate were 6%.
The monetary growth rate prescribed by monetarist economists
would then be essential, on average, to maintain 47O unemployment
(the new NAIRU under TIP), and near 0% inflation.

It will be

easier for the Federal Reserve to gradually reduce the monetary
growth rate to its target if the full employment 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.


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

significantly reduce the frequency, and degree, of stagflation in
our economy.
Why can't we use monetary and fiscal discipline alon£?
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, unit 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.


inflation was reduced from just above 107» to 87O; therefore, price
inflation declined no further than 6%.

Despite the loss to our

society of billions of dollars worth of output, the inflation rate
declinedonly a few percentage points to 67o.

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.


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 incen-

tive 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 restraiit; vs. monetary and fiscal restraint

The choice is therefore between reducing inflation and

unemployment 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

67o 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
67o in order to maintain low inflation.

In contrast, TIP offers

the prospect of reducing the NAIRU perhaps to 4%.

Thus, in the

longer run, the choice is between running the economy at a 47O
unemployment rate without inflation, vs. running the economy at a
6% unemployment rate without inflation.

TIP therefore deserves to

be regarded as an anti-unemployment, as well as anti-inflation

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
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, suppose

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?

Similarly, 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 pro-

ductivity 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% in 1977, some prices were
cut sharply, while others increased sharply.
serve a vital function.

These disparities

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.


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% to 67o in the initial year under TIP, but price inflation
declines from 67o to only 5% (although theory and evidence expect
a decline to 4 % ) . Then Congress would authorize in advance compensatory tax cuts for employees to make up the difference.


tax cuts could be integrated with employee-TIP, and implemented
through withholding at each firm.

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.
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

are unnecessary.

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% when unit labor cost inflation
declines 27O, then unit profit inflation must decline 27O.
less, labor deserves insurance.


I would therefore suggest that

the following proposal, offered by Drs. 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 adjust-

ment 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 economy) would be of concern.
Their proposal would therefore avoid the difficulties of past
excess profit taxes.

1) A tax-based incomes policy (TIP) should be adopted.


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

the instrument 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
3) The employer and employees at a firm that grants a wage
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 stiff, 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 outcome is
best for labor, business, 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%). Thus,
if TIP reduces the wage inflation rate gradually to 2%, it
will automatically reduce the inflation rate to zero.


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 economy; and possibly by an automatic upward
adjustment of the corporate income tax rate for all firms should
profit inflation fail to decline with wage inflation.
8) A permanent TIP may be able to reduce the non-acceleratinginflation rate of unemployment (NAIRU) of the economy.

If so,

it would be possible to run the economy at perhaps a 4%
unemployment rate without causing a rise in the inflation rate.
TIP should therefore be regarded as an anti-unemployment, as
well as an anti-inflation policy.

The CIIATRMAX. Thank you. Professor Seidman. Thank you for a
very lucid clear explanation of TIP and Professor Weintraub also
did an excellent dramatic and very amusing job of explaining our
problems; and we are delighted to have Dr. Bees, who gave us the
other side of it so well, and. Dr. Bosworth, I must say your appearances are very impressive. T think you hit exactly the right tone
in pointing out we are not making progress on inflation and we
should recognize and you recognize it right off the bat, and we do
need vigorous action by the Government to achieve it.
You say that the first part of the deceleration program is a recognition that the Federal Government itself is a major contributor
to the inflation process and you say this applies both to the executive branch and the Congress. Then you go on to say we are going to
have to learn to say "no" to special interests.
One of the elements that's necessary if we're going to say "no," is
an awareness of Members of Congress when they vote on this legislation that it has an inflationary effect. When they vote on it, not
after, as a matter of history. We don't have that now. "We have been
hoping the Congressional Budget Office would provide us on major
legislation at least some notion of the inflationary impact.
Do you feel this is practical and do you know whether or not this
should be forthcoming in the near future?
Mr. BOSWORTH. I think it's practical and I think it's an absolute
necessity because Fin convinced that even though many of the actions
in the regulatory area are well-conceived, it's pretty clear that the
Congress does not look at the cost of those programs as intensely as
it looks, say. at defense expenditures.
The CHAIRMAN. We look at the budgetary cost.
Mr. BOSWORTII. Yes, budgetary.
The CIIATRMAX. But we don't look at the cost in relationship to
Mr. BOSWORTH. But that's the biggest change that's occurred. If
somebody asked 20 years ago, "What's the impact of Government on
the economy?" you'd answer, "The Federal budget," and it would be
a pretty good summary of what Government was doing to the economy. Today, I'd almost argue that the budget is irrelevant to what
the Government is doing to the economy because we got tired of
getting used to the Government increases. More and more now we
have national goals like cleaning up the environment. We don't want
to spend budget funds on this. We've got a gimmick. We order people to do it—"You clean up the environment." Who at that point
makes the calculation of what it costs society? We don't pay for it
in taxes.
The CHAIRMAN. You say you're in favor of cleaning up the environment, you think it's a good end and you don't think, as Dr.
Burns suggests, we should suspend that: but you think we should be
aware of the costs of doing so and of the various options. In other
words, we clean it up to a certain point the cost may be moderate, if
we clean it up beyond that point the cost may be excessive. Is that
Mr. BOSWORTTF. One good way of putting it is I don't give a damn
what von do if I am convinced vou understand the cost of what it

29-775 O - 78 - 27

is you're doing. In many cases, I don't think the Congress does understand. We can now in most areas provide you with as good an
estimate of the costs of these actions as you can get on budget actions.
What we seek to do is get an estimate of the cost that's in order of
magnitude correct, a basis for judgment. I think that the estimates
today of the cost impact of specific regulations or special interest
legislation is of an order of magnitude to be very useful to you in
making decisions. We have had some discussions with the Congressional Budget Office on our procedures used to measure those costs.
We have measured the cost impact of a lot of such actions ourselves.
Frankly, we are always too late. We never find out what's going
on in Government until after the fact.
The CHAIRMAN. That's it. If we could at the committee level—this
is where it would be most useful to us. Certainly we'd like to have it
before we act on the floor.
Mr. BOSWORTH. Since these agencies know what the Council is going to have to say about it they try to keep it a secret; we never
hear about anything until it's announced by the Congress or announced by the administration. We have no idea what's going on inside major Government agencies because they know if they tell us
we're likely to have a negative-type comment about it because it's
bound to be costly. So it is better for them to keep it quiet. So many
times anything we have to say is too late. We're after the fact. We're
The CHAIRMAN. NOW the second part of the deceleration program
you say is to convince business to hold price increases below the
1976-77 average. You argue that they were making some good
progress in that respect and you refer to the automobile industry and
aluminum industry and that is encouraging. I just wonder, though,
on the basis of past experience, number one, if we are likely to get
delivery like that from the automobile industry and, number two,
whether or not this can be sufficiently comprehensive to really assure
us that we are likely to have a slowdown and, three, whether when
you leave food out, which is the area where we are most sensitive to
inflation where I don't see what you can do this way. I just wonder
what kind of substantial progress we can make.
Mr. BOSWORTH. I think it's going to be very limited. I would say
with respect to automobiles, it seems to me we'll get deceleration in
automobile prices one way or another. If there is enough leverage
that the American public and Government can bring to bear on the
automobile industry we can deliver on that one.
Unfortunately, you're absolutely right about food prices. We can't
jawbone food prices down and our policy is just so inappropriate to
this major portion of the U.S. economy, where there's nobody to talk
to about these price increases, so that sort of thing is always going
to be quite limited.
The CHAIRMAN. NOW you get into the T I P situation and you indicated a kind of a modified T I P proposal yourself, did you not?
That is, that you would favor for those industries that hold wage
increases down, as I understand it—correct me if I'm wrong—a tax
credit to the employees who have less than an average increase in
their wages.

Mr. BOSWORTH. Xo. One of the problems I see with the tax credit
approach is that you can't go around every year cutting tax rates.
You run out of money after a while. But I do understand labor's
problem with the current program. They say, "We can't give you a
commitment for 3 years to hold down our wages when you give us
some promise that prices will come down. We've heard those promises before." Well, it does seem to me one way to handle this is to
give them an insurance contract—to give them a conditional tax cut.
In other words, we could pledge that; if prices do not come down,
then we'll cut your taxes if you held your wages down.
The CHAIRMAN. If prices do not come down, then they would get
a tax credit that would compensate them for the increase in the cost
of living ?
Mr. BOSWORTH. Eight. If, for example, a worker belonged to an employee group that held its average rate of wage increase to say 6
percent, I think it would be reasonable to guarantee him that if
prices rose more than G percent he would get a tax cut equal to that.
Xow as Professor Seidman pointed out, 99 times out of 100 that
would never happen, but the worker is not sure of that. He remembers 1973 and 1974 and it happened then and he says, "Well, I want
a guarantee on that." So you give him some insurance. Wouldn't he
be better off with a guarantee than with a vague promise from Government that somehow we will do it when we have broken all our
promises before ?
The CHAIRMAN. But here you begin to move into what is a misallocation of resources. You spoke yourself about some industries that
are so depressed for one reason or another—the apparel industry, for
example, where they had no wage increase at all. Under those circumstances they have to do it because of the competitive situation
and the demand situation. Xow aren't you going to have tens of
millions of people in the country who are going to have a tax increase and aren't you going to have then a tax cut and then aren't
you then going to have a kind of a removal from the market economy that could be pretty severe?
Mr. BOSWORTH. One is that there would be a lot of free riders, a?
you put it. Everybody who got a wage increase
The CHAIRMAN. Tens of millions of them.
Mr. BOSWORTH. Yes, but normally if there were a lot of people
with wage increases below G percent, prices would not rise more than
G percent. You don't pay them anything. Only if the rate of inflation
went above G percent would you pay anything. And is it such a bad
idea for workers in depressed industries who have been getting 3
percent wage increases—does it bother you to get 1 year out of 10
when they may get a small tax cut ? There is a free rider problem
associated with any of these proposals, which is that some people
are going to get it when they have really not changed their behavior.
The CHATRMAX. Dr. Seidman, why is the limited Bosworth proposal inadequate? Why wouldn't that be at least an approach in the
direction of your proposal?
Mr. SETDMAX. His real wage insurance policy here is essential and
exactly the kind of thing I was suggesting that Arthur Okun had
proposed back in 1974. Let me just review this last point that be

made about why these tax credits will in all likelihood not be
Today, or last year at any rate, we had roughly wage increases of
8 percent. We have productivity increases of only 2 percent. So unit
labor costs went up by the difference, 6 percent, and that was our
basic inflation rate last year, 6 percent.
If we bring the average wage increase down from 8 percent to 6
and productivity stays at 2 percent, then the difference between them,
4 percent, will be the unit labor cost increase, and we expect, based
on all empirical evidence, that price increases which are tied to unit
costs will go up only 4 percent rather than 6 percent.
Xow if we get that result, which past empirical behavior supports,
then this guarantee—this tax credit, will not have to be paid.
The way it ought to work is to say to labor, if your wage increase
comes down on average from 8 to 6 in the economy but price increases don't come down from six to four, then we will give you a
tax credit. If it comes down from six to four, you're just as well off
getting a 6 percent wage increase and a 4 percent price increase, a
gain of two, as you would have been with an 8 percent wage increase.
This is an insurance proposal which we don't expect will in fact
have to be paid, but I think Dr. Bosworth's point was exactly right.
You can't expect the average wage earner to have as much reliance
on econometric relationships as maybe economists will. They deserve
and will need insurance. But given that insurance, it's very likely
that we will not in fact have to pay that compensatory tax credit.
The CJIATRMAX. My time is UD. This would seem to me to exaggerate the cycle somewhat and it would do so because as you don't
meet your inflation target and prices rise then you have to feed the
inflation by providing for a reduction in tax revenues and taxes.
Therefore, your deficit gets bigger, not smaller.
Mr. SETDMAX. That's right.
The CIIAIRMAX. On the other hand, when you're going the other
way and you've moving into a recession period, you don't provide
the tax benefits that might stimulate the economy which might be
desirable under those circumstances and you therefore aggravate the
cycle, don't you?
Mr. SEIDMAX. It's possible, but, for example, if you look at 1974,
the reason that prices advanced as much as wasres—what drove a
wedge into the traditional relationship was the OPEC price increase
and that was a period of time where had we had some more stimulus
we may have greatly reduced the severity of the recession.
So you're right. It's possible that at certain times vou wouldn't
want that stimulus. In that case monetary policy might have to be
called upon to provide the restraint at a time when equity requires
you to pay the insurance in the form of a tax credit, but there are
other cases where a tax credit would be what you wanted. So again,
I think looked at on the whole, if the only equitable way to get
labor to agree to a TIP focused on wages is to provide this insurance, I think that the benefit of doing that greatly outweighs this
possible minor problem with it.
The CITATRMAX. My time is up. Senator Schmitt.

Senator Sen MITT. Mr. Chairman, I don't know whether I have discussed this with you or not before, but I think I have discovered a
new natural law in the Washington environment. I had first made it
relative to agencies. That is, once created they tend to take on the
characteristics of their achronym and if you think about some of the
achronyms that we deal with in this committee such as DUD and
DOT and a few others and just use your imagination I think you
know what I'm talking about.
I have discovered today that programs tend to take on the characteristics of their achronym and we have heard about CAP and
CATP which suggest really a coverup of the basic inflationary problems in my opinion. T I P is sort of a negative achronym in the sense
it's probably almost certainly not a gratuity of any kind, or it's
been suggested it might be the tip of an iceberg.
I'm afraid, Mr. Chairman, as I said yesterday, the hearings have
tended to focus on the symptoms of inflation rather than on the
real causes, particularly workers and business. It would be interesting if the economists of the world had to go out and get elected to
their positions and talk to the voters because voters believe that it's
Government that's causing inflation, whether the economists agree
with that or not. When they mention to me—and I'm sure they have
mentioned to you—the size of the Federal deficit, they don't understand how it can continue and still permit a viable economy. The cost of
regulation which has been discussed today I'm glad to see, payroll
taxes, institutionalized wage increases, decreased productivity due to
tax depleted supply of risk capital, and a dependency on high cost
foreign energy. And I think most of the people in this country fully understand where the source of inflation is and when we come to them
and say, well, we want wage and price restraint, it's hard for them
to grasp why in the world they should be the ones that are showing
restraint when the Government is not.
Xow Dr. Burns in his statement to the committee said, "When the
Federal Government runs a deficit, it pumps more money into the
pocketbooks of people than it takes out. That has always been a major cause of inflation and this process has lately been speeded up."
Now I detected maybe a little bit of difference in opinion here. Professor Weintraub said deficits don't cause inflation. At least I presume he's saying that a deficit of about $50 or $60 billion a year
does not cause inflation.
Professor, is there a deficit that would cause inflation in your
mind ? Would a deficit of $100 billion. $150 billion cause inflation ?
Mr. WEIXTRAUB. Let me put it this way. Senator. If our economic
system was different, different things could happen. I'm talking
about the here and now. We have had since 1929 50 budget years,
through fiscal 1979. Of those 50 years, we have had surpluses in
only 9 years. Many of them were piddling amounts of $20 million,
that sort of thing. Over most of the 50 years, until the last 10 years
really, the price level behaved rather well. In other words, with
deficits, the price level behaved rather well.
Xow in the worst deficit, the biggest—and I think you will agree
we don't know how big an elephant is unless we compare it to some-

thing—compared to a fly it's very big; compared to a mountain it's
not so big. Now then, let's make a comparison with GNP.
In 1933 the expenditure total was $4 billion, revenue intake was
$2 billion, a deficit of 55 percent, and prices actually fell by about
12 percent. Through the 1950's we had deficits, and by the standards
of the last 10 years the price level behaved rather well. In other
words, the deficit of $50 billion is a lot of money, as Senator Dirksen
might have said to you and me, and to the country, but $50 billion
as against $2.2 trillion GNP—that's less than 2.5 percent.
Senator SCHMITT. But, Professor, we changed the base conditions.
For example, the tax bite in terms of the percent of the GNP is
vastly larger than any of those other examples that you gave.
Mr. WEINTRAUB. Right, Senator. So you can reduce the deficit by
cutting expenditures or raise taxes. Would anybody argue for a rise
in taxes currently ?
Senator SCHMITT. NO.
Mr. WEINTRAUB. They would not.
Senator SCHMITT. But what I'm saying is the effect of a large tax
bite on the vitality of the economy is a very real fact that was not
present in those particular examples which you mentioned.
Mr. WEINTRAUB. Well, there are the same sort of complaints as we
go back, but I agree that taxes are too high and through T I P I want
to cut taxes.
Senator SCIIMITT. Well, Professor, what I'm interested in is "where
do we get a deficit that would be inflationary?" The scenario is, of
course, that a deficit does require, in order to keep interest rates
down, an increase in the rate of growth of the money supply. If you get
too much money going into the economy without an increase in goods
and services you're going to have an inflationary pressure. You're saying that isn't here now. When does it arrive ?
Mr. WEINTRAUB. All right, Senator. You're going to have larger
deficits unless you keep the price level under control. The Federal
Government outlays are going to go up if average wages—civil servants too—and I'm just taking numbers—if they go up by 10 percent per annum then in about 6 or 7 years it's about a 100-percent
increase, and your expenditures for Government employees will
double. Your expenditures for defense, military procurement, will
likewise double and the $50 billion total will be'a $100 billion total.
You can keep that deficit in hand only if you keep the price level
in hand and the price level occurs in the private sector of the
Senator SCHMITT. Professor, I'm afraid that an awful lot of that
price level is due directly to Government intervention in the economy.
The cost of regulation's estimated at varying figures. I just saw
one today in the newspaper in the New York Times, a quote that
Dr. Miller made, that the estimate now is that the total cost of EPA
regulations is going to be about $670 billion. I don't know whether
you agree with that or not. There are a number of other cost figures
that are given for regulation and I think everybody agrees they are
tremendous. Also, the increase in payroll taxes, tho direct input on
the price structure because of institutionalized wasro increases, some
of which are a reaction to inflation, have been institutionalized; the
fact that we have done nothing to decrease our dependency on foreign

oil which is artificially high priced, although there are still some
limits on how high it can get—it is a future price structure rather than
a present.
So I'm afraid that until we see the relative proportions of these
price increases it's hard for me to accept that Government doesn't
have a major role in creating its own problems.
Mr. WEIXTRAUB. Senator, let me reply to that in this fashion, and
it permits me to make a comment to Dr. Bosworth's remarks.
Suppose you remove all of the pollution controls. This is what
economists would call largely a one-shot affair. If you did this—
you also have to clean up the environment—in my terms, this lowers
average productivity of labor. This would mean you would have to
run a tighter incomes policy, rather than a looser one.
Suppose I followed this sort of view in general. Suppose we agreed
we abolish all of these controls.
Senator SCIIMITT. Professor, I must interrupt because I have not
said we have to abolish them. I'm with Dr. Bosworth. I think we
have to understand what we have done and see if we can't mitigate
the effect, but you can't abolish things like that.
Mr. WEIXTRAUB. I take the extreme case just as an illustration.
This afternoon, suppose we eliminated all of the controls, all of the
safety regulations. I then ask, tomorrow, what do we do for an
encore? We will still be faced with the question of bringing money
wages and salaries in line with productivity. These are particular
cost-raising measures.
I have argued that it is necessary to demonstrate, for the price
level, that phenomena affects either "w", the average money wage,
or "a", average productivity, or "k", the average markup. The average markup has been trending down. The big jump, as the chart reveals, has been in average wages and salaries relative to productivity.
That's the problem.
Again I say, if I'm mistaken, why should we ever have a strike?
Why should we ever say no to labor? Whatever they ask for, double,
treble, or quadruple it. This is the issue. Average rates of pay have
teen moving too high and too fast; T want to insist T I P is not antilabor. It's not anti-business. It's anti-inflation. Tt is pro-employment.
I will make the same talk to a labor group that I will make to a
business group.
Senator SCIIMITT. Professor, I agree with your analysis of the
wage structure, that it has moved much beyond increases in productivity, but you have to admit there's been an inflation push concerning those wage demands, that one reason wage increases have become more periodic is because of an inflationary push.
Xow you're saying that's because of wage increases, and all I'm
saying is that there's a component in there that's due to excessive
wage increases but there's a major component that's due to what
we're doing here in Washington.
Mr. WETXTRAUR. Senator, T have had some ailments. If I were to
argue with my doctor as to the ultimate causes, I'd long ago have
been dead. He knows something about symptoms and tr/atment.
Whatever the reasons for a wage push, we've got to somel *w keep
those movements in line.

Senator SCHMTTT. YOU just used exactly the wrong word. You said
symptoms and what we have to get at is the disease. We can treat
symptoms and have been for decades but we haven't gotten to the root
causes of the disease, and I think that's what we have missed in this
particular set of hearings.
Mr. WEIXTRAUB. I'm content with my treatment. Senator.
Senator SCIOIITT. "Well, unfortunately, the diseases is going to
continue unless we realize that it's far more than just the wage and
price push. That is there. There's no question about that. But the
list of things that I read I'm afraid swamp whatever benefit we can
get from TIP. I'm not saying that we shouldn't consider T I P and
try to see if we can figure out some way to manage it—I'm not sure
we can—but I'm afraid it's going to be swamped unless this Congress and this administration are willing to make some other gradual
but major longterm commitments toward the reduction of the deficit,
reduction of taxes, particularly payroll and risk capital related
taxes, and do something about this energy business and a number
of other things that make T I P almost ineffectual if we don't do
Mr. WETXTRAUB. I'd say those other things are relative prices
which are individual and smaller icebergs, to use your analogy,
within this big gigantic ice mass and the ice mass consists of money
incomes moving faster than productivity and it so happens that the
big 75 percent component of national income does consist of wages
and salaries, and that's where our problem is.
Senator SCIIMITT. Maybe we created too much money. Professor.
Is that what you're saying ?
Mr. WEIXTRAUB. If you must, Mr. Chairman, you will lead me
into monetary theory. We must have the money. Ts it surprising
that in the 1930s, for those of us who are old enough, rarely had a
$20 bill. When our average income was $30 a week we had a $1 and
a $5 and this sort of thing, and we were well off with this assortment. When our income is $200, $400 or $500 a week, why is it surprising we hold more money? The money must be there if money
incomes are larger.
Senator SCITMTTT. Professor, you have become an artist and a
chartsman, as all of us have, and one of the charts that I think is
interesting—and I will get to as I get to my next round of questioning—is the relationship between the rate of growth of money
supply and the inflation rate and there are some very illuminating
charts if you're willing to put in about a 2 years' lag time of when
inflation takes off relative to the rate of growth of the money supply.
Mr. WEIXTRAUB. I'd like to answer that, Mr. Chairman.
Senator SCTTMTTT. My time has been up for almost as long as the
time of the chairman was up.
Mr. WETXTRAUB. Mr. Chairman, perhaps we can get a chart in on
the total relation between my aging process and the aging process
of the Federal Reserve. You will find a 100-percent correlation.
The CIIATRMAX. Senator Stevenson ?
Senator STEVEXSOX. Mr. Chairman, T apologize for being1 late and
trust if I go over any ground that's already been plowed that you
will stop me.

The council on wage and price stability has its origins in this
committee. We gave it a very broad charter and we have gradually
increased its authority over the years. This administration began its
treatment of the council on wage and price stability by subordinating
it to the council of economic advisors.
We have in the past tried to make it somewhat independent, at
least within the executive office of the President, and an important
council. And as far as the budget goes, I believe the administration
insisted on allowing no real growth for the council. Am I right?
Mr. Bos WORTH. It was left the same size it was.
Senator STEVEXSOX. Was there any increase for inflation?
Mr. Boswoimr. Just the same percentage increase for inflation as
that which is allowed for the other agencies. I think there was a
supplemental for all of the agencies.
Senator STEVEXSOX. DO you remember how much that was ?
Mr. BOSWORTII. Xo. I don't know my budget very well.
Senator STEVEXSOX. Well, I have a feeling that the council on wage
and price stability hasn't been monitoring its own budget to account
for the full effect of inflation on its own activities.
Mr. BOSWORTU. I would thing right now our biggest problem is
a shortage of ideas rather than shortage of money.
Senator STEVEXSOX. You're getting ahead of me. T haven't got
there yet. How many professionals do you have. Dr. Bosworth, to
monitor the entire U.S. economy and all of the actions, programs,
policies, and activities of all of the departments and agencies of
the U.S. Government ?
Mr. BOSWORTTI. Right now we have about 18 people on the staff.
Senator STEVEXSOX. TS that enough ?
Mr. BOSWORTIT. If we had more people we could do more. Obviously, there are many things that we miss.
Senator STEVEXSOX. That's all I was trying to get at.
Mr. Chairman, that's appalling and it says something about the
seriousness which this administration, like its predecessors, has
viewed inflation.
Xow beyond the staff resources with which to monitor both the
public and the private sectors which are grossly inadequate, how
about the Council's authorities? We gave you with very little enthusiasm as I recall subpena powers. Have you used those?
Mr. BOSWORTTT. We used them in two cases, but in both cases at the
request of the company.
Senator STEVEXSOX^. For protective purposes?
Mr. Boswoimr. For protective purposes.
Senator STEVEXSOX. What about pro-notification ? Do you have that
authority now? Would you like authority to require pre-notification
of wage and price increases in large, heavily organized industries?
Mr. BoswoRTir. In the current situation we have gotten around
that problem a little bit because we stopped doing this cost passthrough, saying if you've got cost increases you're going to have
price increases. Instead, we've set for each industry an annual target
for price increases that we expected them to hold to. So we have
been more interested not in pre-notification of each individual price
action but in prior discussions about whether or not they are going


to be able to reach the target rate of price increases for the year as
a whole.
The trouble with pre-notification—and we have it with some on a
voluntary basis that have been coming in and prenotifying us—is
that they are nickeling and diming us to death. They come in and
pre-notify us of a 1 percent price increase on 10 percent of their
product line and a lot of staff resources then go into what is not really
a big issue.
Senator STEVENSON. Instead of letting them nickel and dime you
to death, why don't you target pre-notification on a large increase in
wages or prices where it isn't nickels and dimes, and you have particular information that you want to acquire?
Mr. BOSWORTH. In most of the basic industries—on a voluntary
basis—we have worked out exactly that sort of arrangement. On several industries where we believe the impact of a significant price
change would be of major importance to us we have asked them to
let us know ahead of time and come in and discuss it.
Senator STEVENSON. And you haven't had any problems?
Mr. BOSWORTH. NO. AS far as asking for the pre-notification, in
fact they do it.
Senator STEVENSON. Would you have the pre-notification authority
that I have mentioned if you needed it ?
Mr. BOSWORTH. NO. If they told us they did not want to pre-notify,
they would not have to pre-notify.
Senator STEVENSON. "They?" What's your position? Would they?
Mr. BOSWORTH. It depends upon the individual circumstances. So
far, whenever it's come up, I have found that prenotification on this
voluntary basis has been adequate.
Senator STEVENSON. YOU don't want the broom in the closet?
Mr. BOSWORTH. I have no objections to having a broom in the
closet. Let's put it that way.
Senator STEVENSON. An enthusiastic statement of support.
Now let's come to Dr. Burns' on and off again proposal. I don't
like putting words in Dr. Burns' mouth, but I understood him to say
that he supported deferral authority, but he didn't always support it
publicly, and was on and off depending on the timing. It wasn't always timely to suggest deferral authority. There have been such
recommendations. They originated with Dr. Burns. The recommendations are to give the Council on Wage and Price Stability authority
to defer for short periods of time—15 days, perhaps two consecutive
45 days' deferral—of large wage and price increases in the large,
heavily concentrated, heavily organized sectors of the economy in
order to give such increases the spotlight of public opinion and some
time for cleansing and also to give Government some time, if necessary, to look into the matter to determine what, if anything, should
be done before it is too late.
I'd like to address this question to all the witnesses. How do you
feel about Dr. Burns' suggestion?
Mr. WEINTRATJB. Senator Stevenson, I would tend to think this is
just a one-step toward controls—45-day notification and then approvals, and perhaps court hassles and field days for attorneys. So I
would oppose it.


Further, this sounds like our present problem is just a temporary
one—it supposes that if we get over the next 3 or 6 months and then
everything will be all right. No. I think our problem is to create a
policy for the decade rather than for the day, not to just look at
whether this month's inflation number is going to turn out better. We
have a more durable problem.
We have waited 10 years and I don't think this particular recommendation of Dr. Burns would assist us much in what I regard as
the deeper problem.
Mr. BEES. Senator Stevenson, I think the Council on Wage and
Price Stability can get deferral of price increases by major corporations without it having legislative authority for it if it requests it.
There is a case on record in the summer of 1975 when I was sitting
where Mr. Bosworth sits now. We requested the aluminum industry
to delay a price increase for 30 days while we held hearings and they
did delay it for 30 days and we did hold hearings. I think they would
have been willing to delay it longer if we had requested an extension.
I think the difficulty, the place where you cannot get delays voluntarily, is on the wage side, not on the price side.
Mr. SEIDMAX. Senator Stevenson, concerning the pre-notification
problem and also your earlier questions about whether the Council
on Wage and Price Stability has adequate staff, I think this gets into
one of the fundamental differences between a tax incentive or a taxbased incomes policy and a controls program.
Under a controls program or moving towards a controls program
you would have to add enough staff in the Government overviewing
regulatory body, whether you call it the Council on Wage and Price
Stability or a pay board or price commission, to match
Senator STEVEXSOX. Let me interrupt. Nobody is suggesting a controls program.
Mr. SEIDMAX. NO, but let me see if T could point out the advantage
of the tax incentive approach. Without any central staff in Washington every company and every group of employees would know that
there will be tax penalty if they come in above the national target—
suppose it were 6 percent—and a tax reward—a tax cut if they come
in below. There would be no need for a staff in Washington to try
and match the knowledge of each firm and industry, case-by-case, to
try and stay ahead of them, to try and stay ahead of the schedule.
Without any of that, each of them would know that there will be tax
consequences of their own action at the end of the year.
So without that kind of central bureaucracy, I think you will have
been more effective, much more flexible, if we go the tax-based incomes policy route than to try and beef up—as much as I admire Dr.
Bosworth—the Council on Wage and Price Stability and its staff under the current approach.
Senator STEVEXSOX. Dr. Bosworth, how do you feel about it?
Mr. BOSWORTH. I, in part, agree with Professor Weintraub, that il
you think there's going to be some major solution to the problem, the
answer is no.
On the other hand, as Professor Rees points out, in some cases with
some firms we can get them to agree voluntarily to delay. In other
cases where we have asked about delay, it has not been possible.


Where we would like to use delay onc£ in a while—and they do
come up occasionally—is on the labor side. I believe that certain
wage negotiations do set patterns for others, and influence other people. Sometimes you get a breakthrough because out of your own ignorance you did not realize something was going on in a specific
negotiation and all the sudden they settled before you knew what
happened. We'd like a chance before that settlement went into effect
to hold it up and examine before the public the economic reasons
that that particular benefit was given. Certainly the public's interest
in the negotiation is at its height when it's being negotiated. They're
not interested in getting the facts afterward.
Senator STEVENSON. Would you be unopposed to deferral authority ? Do you support that with equal enthusiasm ?
Mr. BOSWORTH. With about equal enthusiasm. I don't feel very
strongly about it.
Senator STEVENSON. Thank you, Mr. Chairman.
The CHAIRMAN. Gentlemen, I'd like to ask you, starting with Dr.
Bosworth, each to comment on two of the proposals by Dr. Burns
that he gave us just this morning. They are difficult for Members of
Congress to judge themselves because it affects us directly.
I'm talking first about the proposal—he says: "To emphasize Federal leadership in unwinding inflation, I would suggest the President
cut his own salary by, say, 10 percent and call on all Presidential appointees and Members of Congress to do likewise."
My colleagues are leaving at this point. He also says: "The President should call on top corporate executives to refrain entirely from
any increase in their compensation over the next 2 years."
I'm pretty serious about this. I can imagine introducing this kind
of amendment and a lot of Senators voting for it for obvious political
reasons and maybe for conviction. I'd like to have you give us your
opinion as to whether this kind of dramatic action by Congress would
represent a signal to the public, an effective signal, that the Government really means business and is making the kind of sacrifices to
prove it.
Mr. BOSWORTH. I'll give you two comments. One, I resent the point
Chairman Burns suggests because it's symbolic.
The CHAIRMAN. It's entirely symbolic.
Mr. BOSWORTII. The notion that it's going to combat inflation is
false. On the other hand, I do believe in the area of wage restraint
that such a demonstration affects the public's willingness to take the
risk, and the chance that others will go along is very important.
It's very difficult to ask labor for restraints when they can point to
some chairman of the board of some major corporation and say: "He
got a 15-percent wage increase. Why can't I ? " And you must admit,
the public was upset about the increase in Government salaries. While
Dr. Burns' suggestion goes in the right direction to build some public
support, I don't think it's terribly dramatic or that it's a turning
point. It's a small effort. I don't think he's willing to face up to the
fundamental underlying pressures, and that some of these ideas are
rather cheap gestures.
The CHAIRMAN. Dr. Eees.

Mr. REES. Senator Proxmire, I hate to disagree with Dr. Burns. He
was my boss for 1 year when I was on the staff of the Council of
Economic Advisors in the 1950's and I have never had a better or
more demanding boss, but I do disagree with this suggestion, I think
partly because it is symbolic and partly because it just overlooks the
realities of the Federal pay schedule.
The one place in which Federal pay is below the pay in the private
sector is for the top executives in the Federal Government. Where
the Federal Government pays much more than the private sector is
for the low-paying employees of the Federal Government, that is,
the least skilled employees of the Federal Government up through
most of the middle ranges.
So I think a proposal to hold down the general level of Federal
pay increases of the kind that the President has made is vastly to be
preferred to this dramatic gesture of cuts at the top which will make
it harder to recruit able Federal executives which we very much need.
I can say that in good conscience because I'm no longer a Federal
executive and have no plans to come back.
The CHAIRMAN. Professor Seidman.
Mr. SEIDMAN. Well, I agree. If this is to be a substitute for a taxbased incomes policy and fiscal and monetary restraint, then I think
it's just diversionary.
Now if he meant that together with taking on what's politically
more difficult, enacting a penalty-reward innovative tax proposal,
coupling it with gradual reduction in monetary growth, gradual reduction in the Federal budget deficit, if he then wanted to add this
as a dramatic gesture, I don't know. I think the key element that's
missing from his proposal so far is any reference to a new tax-based
incomes policy. I think his proposal would be seen for what it is—
escaping the difficult political issues that have substance and putting
symbolism first.
Mr. WEINTRAUB. Senator, far from being partisan, but I think
Democrats might ask Governor Burns why he didn't propose this in
previous administrations.
I would say, with my colleagues, the entire group, that this would
be substantially a gesture. We're talking o f a wage salary bill of $1.4
trillion and I think what is involved here might come to $5 million
or $10 million and is minor, if you work out the percentages.
The CHAIRMAN. There's no question the amount is very, very small.
It would be symbolic. It would simply be an indication.
It might have one other effect, and that is, obviously, if Members
of Congress would do this—and I would doubt very much if they
would—but if they would do this, it would reinforce their determination to fight inflation perhaps on other fronts and they would probably be more inclined to make it tough everywhere.
Mr. WEINTRAUB. Suppose we carried the logic of this through.
Suppose we did not raise any incomes but actually cut them by 10
percent. Dr. Burns is really asking for roughly a 7-percent fall in
the price level and none of us want to go quite that far.


Second, after you have done it for the first year, as I said before,
what you do for an encore—it's not a permanent policy and I think
that that's what should concern members of this committee.
The CIIAIRMAX. I'm not suggesting this is the only policy that occurs. It's just part of other things.
There's one other proposal that he makes that I think is well
worth your comment because there's been less emphasis on productivity and what we do about productivity than there probably ought
to be.
You all recognize the fact that it's wage costs that we're concerned
about. Substantial wage rate increases can be accepted and would
not be as inflationary if productivity increases. This is what Dr.
Burns says here. He says that the Federal Government should establish promptly a national productivity center to assist business and
labor leaders in each of our sizable cities to form productivity councils within individual factories, offices, with the objective of raising
output per man hour. He's been pleading for this for many years
and some members of Congress support it, but we don't seem to do
more than just token efforts in the direction of productivity. We
bow to it, but then we don't really take action. Dr. Grayson has
pointed out that his experience in pushing productivity is that a
very large number of people in the business sector, very fine and able
businessmen, didn't understand it, didn't know what it was.
Mr. WEINTRAUB. Senator, this sounds like the program for many,
many years in Russia to increase productivity. It would be nice if
it could be done. If it could be done we would have no poor countries in this world. An increase in productivity from 2 to 3 percent
per annum is not just 1 percent; it's 50 percent, as a bank clerk
with the compound interest table knows. From 3 to 4, it's 33% percent. Why don't we cut the running time of 100 and 200 meters, cut
it in half? It would be a great nice record, but it's not easy to get
individuals or have them do more than they can. I wish it could be
so. I'm not opposed to it. It's just that I tend to think it's likely to
be more of a gesture and a hope and a wish rather than a fact. I'd
be all for it if it could be done. We could life all standards of living
The CIIAIRMAX. Dr. Seidman.
Mr. SEIDMAX. Once again, I think that this proposal is just symbolic. The real determinant of the growth rate of our productivity
is whether we are able to run this economy with sufficient aggregate
demand so that it is profitable for business to undertake a sufficient
rate of investment in capital formation which is where we get our
productivity growth from, and the reason that we have had to ride
the brake in our fiscal and monetary policy is because of the fear of
The whole point of the tax-based incomes policy is to enable us to
exert downward pressure on wage increases to counter upward pressure coming from the labor market so that we can run the economy
at a permanently lower rate of unemployment, higher rate of aggregate demand, higher rate of real output, real investment, real capital
formation, and growth of real productivity.


So I think the proposal here of Dr. Burns gets it backwards. We
have to find a way to get the incentives on business and labor such
that we can run the economy with a higher level of demand and have
that greater rate of increase in investment which would bring us our
Now, as Professor Weintraub pointed out. we should not expect
miracles from this. It's a major accomplishment for society to raise
productivity growth from 2 percent to ?> percent per year and we'd
be kidding ourselves if the solution to our inflation problem is not
to get money wages down from 8 percent, which is where they are
now, to 2 or ?> percent but, rather, we are going to somehow get productivity up to the 8 percent. We've got to find a way to say: Whatever our productivity growth is, we have to get incentives on business
and labor to keep wage increases in line with it and, again, we are
ducking the issue. Everybody would be for raising productivity.
That's not politically difficult to propose. What's difficult to propose
is a tax penalty-reward combination which will affect business and
labor. I bet everybody will nominally bo for raising productivity
through a commission, if that's the issue.
The CnAimrAX. Dr. Eees. before you respond, T hope you will
recognize that I'm not doing anything else. You like TIP. You might
do many, many other things, but this is just one measure to put
more emphasis on it and see that productivity isn't a matter of a
statement in Washington or a commission that looks at it and makes
a report to Congress but, as Dr. Burns has said, in every factory, in
every substantial office, and so forth—so that productivity focus is
understood and that some progress is made.
Mr. REI:S. I agree with what Professor Seidman has said about
the basic source of productivity. I think the place where you get
productivity growth comes largely through new investment and more
productive kinds of capital facilities and I think the most important
way to go that probably, in addition to keeping the economy at reasonably full employment, is to remove some of the disincentives to
investment. One particular one that bothers me is we're not making
any allowance for inflation in computing capital gains. I think I
would be willing to have a sharply increased rate of tax on capital
gains provided that in calculating the capital gains you don't count
the fictitious part which is just due to the rise in the price level.
There is. of course, the Federal agency called the National Center
for Productivity and Quality of Working Life. I suppose it could
be expanded.
The CHAIRMAN. Tt.\s very small.
Mr. EKES. It is very small. I'm not convinced that simply by expanding that agency you would have a noticeable impact on the
rate of growth of productivity.
The CnAimiAx. You see, my problem is: Tsn't this exactly what a
productivity council would do? Tt would point out the great advantage of investment and point out in specific terms and specific
areas. We found, for example, that in some Government operations
where they didn't have the incentive you have in the private sector
that by mandating that—GAO discovered this—by mandating they

spend a million in capital equipment in a period that they were
able to get that back in less than 60 days because of the enormous
savings that they developed there.
Now many small businesses and many rather large businesses operate with some of the same naivete, lack of information, misunderstanding about productivity, and what Dr. Burns is trying to do is to
do all we can to bring to business everywhere we can in the country
and bring to labor an understanding of how they can be productive,
pointing out the kind of investments they can make, pointing out
the way that they can save labor and save costs and cut down their
cost of their operations.
Mr. BOSWORTII. I have mixed emotions about it. I would agree,
first of all, that it's not easy to find a way to raise productivity. On
the other hand, our own examinations of the problem have made us
more and more concerned. It's now definitely determined that the
rate of productivity in this country in the last decade has slowed
dramatically from previous decades. You say it's 1 percentage point.
That doesn't sound like much, but remember when we only get 3
percent per year you're talking about a 30-percent reduction in real
income gains.
One of the problems we face in trying to do something about inflation in this country is that people naturally expect that living
standards will grow. When there's no productivity growth there's
no room for any real improvements, and then you get into these
fights over I want more and that means somebody else has to take
The difficulty I have with the Burns proposal is that he doesn't
recognize the productivity slowdown. Earlier this year we published
a report where we looked at why it has slowed down, but we can't
tell you why. We're at a loss to explain the reasons for it, outside
of economic regulation because that's where a lot of the regulatory
costs show up. They don't raise profit margins. They don't raise
wages. They show up in productivity. We're going to be doing some
work over the next few months of a slightly different type that may
get at the same thing that Burns is after. We're trying to focus on
a couple of specific industries with respect to work rules and other
factors that hold down productivity growth.
I'm a little worried about a national program of having a bunch
of worker committees, and I'm not very impressed with the performance of the Xational Productivity Center. They have tended to
be a group of academics that talk about capital stocks and we never
really get anything else, but there is a problem with work rules
that you run into when you talk to individual industries, both on
the labor and business side. In industries like railroads and steel
work rules are becoming a major problem. On the labor side, naturally they are afraid of losing their jobs. In the type of economy
we have had in the last decade, with its very high levels of unemployment, they are not about to give up that job protection in those
work rules.
It's a difficult problem that T don't think is going to be handled
by setting up a lot of committees in individual plants, because another term for productivity with a slightly different connotation is


automation, and if you don't have a growing economy it means a
loss of jobs. People don't think automation is a good idea. They oppose automation. They like improvement in their living standards.
It all depends on which side you're on.
I think right now many industries are like this, and steel is a
good example. They fear the loss of a good job. A little committee
isn't going to solve that problem. Rather, the solution lies with collective-bargaining negotiations between union and management and
the working out of some job guarantees, et cetera.
The CHAIRMAN. Senator Stevenson.
Senator STEVEXSOX. Mr. Chairman. I'd like to take this closing
opportunity to try to provoke our witnesses with some observations.
First: The causes of inflation are basically twofold, both represented here. One, politicians; two, economists.
Let me start with politicians and with an observation that Mr.
Bosworth made earlier about all of us finding out too late. This is
only partially true. Where was the Council on Wage and Price
Stability when we were all going along with the coal settlement?
Talk about a case of declining productivity and increasing wages.
Where were you when we were debating the minimum wage and
exemptions for teenage labor, or mandatory retirement, the substitution of low-cost jobs for the jobs of more senior workers which,
without that legislation, might have taken place? Where were you
when we were considering the social security tax increase last year
when a couple of us were trying to stem that tide? Where were you
just a couple weeks ago, right here in this committee, when the
room was full, wall-to-wall with poor people, sick people, crippled
people, the handicapped, who were there to oppose my suggestion
that it was unwise for their sake and for the economy to insist that
this administration's proposal that every mass transit facility in the
United States be retrofitted to provide full accessibility—that is to
say, every train station, every train car, every bus be replaced, retrofitted, made fully accessible to the handicapped at the expense of
the handicapped, at the expense of efficient transportation for everybody, at a cost of over $$.?> billion?
If politicians are to act responsibly, they have to know in advance
and there are opportunities. There is an opportunity, for example,
right now to focus on the regulatory process within the Transportation Department which is working on this.
Mr. BOSWORTTT. So are we.
Senator STEVEXSOX. Good,

and with 10 employees you could do
even more. Xow that's rhetorical. T want to be fair and give you an
opportunity to respond if you like. My main observation is going
to be on the economists, but you will have a chance to rebut at this
Mr. BOSWORTH. On the whole, T think you're right. If you take
coal, we followed it. We talked to people ahead of time and they
said the best idea was to keep out. T think in retrospect it's clear that
it wasn't. Those negotiations got to the point where management
offered such extremely large wnjsre increases in return for the work
rule issue that it was a disaster. We at the council suspected that the
economic effects of the coal strike would not be nearly as severe as

29-775 O - 7H - 28


many people thought ahead of time, but we did not have the courage
of our own convictions. So we are very silent on the coal situation.
I don't feel that way about the minimum wage. I was not at the
Council at the time, but when I was in the administration in the
Council of Economic Advisors I did prepare a study that illustrated
specifically what the cost of the minimum wage proposal was.
Senator STEVEXSOX. Was it made public?
Mr. BOSWORTII. Several copies of it leaked. I don't think there was
a public release, but I think it was very influential. The inflationary
issue was a major issue for the President with regard to the minimum wage. You could have had a better outcome, in my view, on
minimum wage than we did. We compromised, it was not a great
compromise, but it was not so terrible in many respects.
On mandatory retirement. I don't know. I just didn't see that as
a major inflationary issue.
Senator STEVEXSOX. It's not major but they all add up.
Mr. BOSWORTII. On social security taxes, within the administration
there was an effort to ^Qt to propose a social security tax proposal
that would reduce the reliance on employment taxes. It got nowhere
before the House Ways and Means Committee and at that point it
was dropped.
I was involved in that, again before I came to the Council on
Price and Wage Stability, and we have had several publications since
then illustrating that employment taxes are a major source of inflation. I mentioned one this morning.
On mass transit, I have heard the same story that you just mentioned. We have just recently gotten involved in that issue. I was
not aware the hearings you mentioned but somebody just said a
couple days ago to us that that regulation had been proposed. That
certainly has to be looked into.
I guess you're right. In many situations, we miss them. In retrospect it's always easier to see them, but we did get into several of
them. We were involved in the farm bill.
Senator STEVEXSOX. I forgot to mention the farm bill. There are
a lot of things I forgot to mention. My point is, the Government is,
to a large extent, the cause of inflation. We all know it but our habits
are uncontrollable and the Congress and also the President need
help. They need an opportunity to know and they also need to have
it made easier to do what is right. If the inflationary consequences
of these well-intentioned acts, such as replacing all the buses, could
be made public and known to the public, it might even be expedient
to do the deflationary thing.
Now I, myself, feel, therefore, Mr. Chairman, that in addition to
increasing the authority and the resources of the Council on Wages
and Price Stability, we should seriously consider getting it out from
under the Executive and giving it visability, prominence, and above
all, independence, so that it can make its decisions with respect
to priorities and also make them public without any political pressures or political temptations, and in such a completely independent
setting that the integrity of its work would entitle it to greater public confidence and attention.

Xow to the economists. Economists, in case you haven't noticed,
Mr. Chairman, break down into roughly four groups. There are the
monetarists who subdivide into the string pushers and the string
pullers, and the Keyncsian demand management—aggregate demand
management economists, who subdivide into two groups, one wanting to increase demand in order to decrease unemployment, the other
wanting to decrease demand in order to control inflation. That's
about it. All of them pretty much work with a model that was created by Adam Smith. It hasn't changed much since Adam Smith.
Everything has changed except the assumptions of the economists
about the marketplace and that "invisible hand."
The problems are, as we just indicated. Government—Government
interference in that marketplace and structure. They are very much
on the supply side, as opposed to the demand side, and require an
entirely new emphasis on microeconomics selective supply management. The oil price changes in 1973 were symptomatic. They should
have been seen then for their larger significance. In Government are
all the captives of the economists and the captives of economic
orthodoxy, and so we react as a Congress with monetary stringpulling and pushing, or at least we try to push Bill Miller or pull
him, or we increase taxes or decrease taxes to fool around with demand management.
We might recognize that some increases in expenditures can be
deflationary, such as increasing expenditures for R. & D. Mr. Chairman, since I've been here I haven't heard a word about the trade
deficit which is causing inflation. The only response that I have
seen in the Government has been to decrease oil consumption, and
we are not going to do that. We are going to increase the consumption of foreign oil. We might be increasing exports as other countries have done and recognize that that in turn requires some new
solutions. One of those I think has to do with R. & D. and an increase through Government expenditures for R. & D. Take a look at
our industries. The most export-oriented are the high-technology industries. They are Government-supported industries. Government
expenditures for aerospace made it the most export-oriented of all
the industries. So why don't we put Adam Smith behind us and
recognize, as Dr. Keyncs probably would have, that the world has
changed and that the time has come for some new ideas, not just
fooling around with taxes. Many of those high costs originate in
foreign countries, not just oil either. Why don't we start developing
a new demand-supply management theory on a selective, micro basis
instead of causing everybody to subsidize everybody else with still
more burdens to the entire economic system to absorb. Any reactions
to that from our panel.
Mr. SETDMAX. Senator, I agree with you completely that we have
got to get out of the limitations of traditional macromanagement
policies, whether fiscal or monetary, but from your comments my
hope would be that you would be extremely interested in the taxbased incomes policy proposal. The whole idea of it is to use the
taxes in a very different way from traditional use of the taxes as
part of macromanagement.


The aim is to provide a micro incentive on each individual firm
and employees at that firm—to give them an incentive which they
do not now have to weigh the cost they are imposing on the larger
society every time they grant wage increases that are in excess of
productivity. So as a matter of fact, one of the reasons that it's
only been recently that we have begun to receive support within the
economics profession is that this approach is very different from the
traditional policies and a very different use of the tax system, and
it's taken time for economists to begin to open towards it and give
I think the same is becoming true among the larger public. I agree
completely with you, we need new microsupply oriented approaches
and that's exactly what T I P is. So I hope that will be one of the
approaches you will look carefully at.
Senator STEVENSON. YOU give me more hope for the economists.
Mr. WEINTRAUB. Senator, I suspect you didn't expect me to agree
entirely with your remarks. I think this might be the first time I
have ever been lumped with monetarists or even Keynesians.
Senator STEVENSON. I wasn't being personal about this.
Mr. WEINTRAUB. I am aware, however, this is very personal to me.
20 years ago when I suggested that it was unit labor costs that were
important there was much abuse. The position has become somewhat respectable and I feel somewhat at a loss; I feel maybe I
should reconsider it now that others have taken it up.
I've also, with an 8-year time lag, seen this discussion of T I P and
I regret we haven't gotten deeper into the details of TIP.
With respect to Dr. Adam Smith, I think the world has changed
and if he were alive I suspect he would have changed. As you know,
Lord Keynes never did take a doctorate. He was above that.
Senator STEVENSON. They are disciples.
Mr. WEINTRAUB. I regard myself as a different sort of disciple. I
think there has been some ground swell because the old policies
haven't worked.
Now you refer to our trade deficit. It's of enormous size, but this
too is a result substantially of inflation. Earlier I said inflation is "the
one in many." It determines in large part the value of a dollar on the
world markets. It does affect our ability to export and, given the cost
of our imports, if we can solve the inflation problem much of the
trade deficit will take care of itself.
With respect to research and development, I hope that there isn't
just the view of only throwing more money at these things and that
it will mean enormous advances in productivity. Dr. Bosworth has
spoken of the difficulty, and I think if we create a lot of these councils or create research and development staffs you will find just another way to expend money. Much of the research and development
that you refer to of the largest corporations have just been used to
take our technology and put those firms, as multinationals, overseas,
in other countries and with less than full benefit to our own economy.
With respect to politicians as causing inflation, I do not subscribe
to that view. Perhaps expenditures are higher than they should be,
but expenditures and what you do does reflect the wishes of the constituency, imperfectly no doubt, but you do largely what your constituents expect.


As to economists, I have been unhappy with them for so long, I
can say over this period you have in mind, sir, I have protested. I
think now we've got to get on to new policies for this new day, and
the only one—and I hope it would stimulate other thinking—the only
new one is T I P with the several variants—the only one that's come
forward other than the old-fashioned controls which can't work, and
I do not necessarily intend to stay until death with the acronym TIP.
I'm interested in the new ideas; I think if you cannot lick the inflation issue I don't think you're going to be able to solve any of the
other problems. Inflation does complicate everything. You say, "Simply do this." "Oh, no, it means inflation." "How about that?" "Oh,
inflation" and so it goes.
For 10 years we have been in this position through both Democratic and Republican administrations. It doesn't happen to be a
partisan inflation. It's a very nonpartisan affair and I think that your
observations have reflected economists, and my profession, who have
in effect said: "Don't worry about wages. Let collective bargaining
proceed. Let's not do anything there. Let the Fed worry about it." It
has worried me for it has continued to create the inflation and I'm
afraid events are moving in that direction again.
There is then some new thinking on the economic front about the
question, and of its impact on the political level.
Mr. REES. Senator, I'm afraid I'm going to have to disagree a bit
with Professor Weintraub. I have been smarting a little bit under
some of the things he's been saying this morning. I think, as I said
in my prepared testimony, that this notion that inflation is a simple
problem with a single cause and that cause is the relationship between wages and productivity is just grossly oversimplified. This is a
complicated problem. There are lots of contributors to it. It has both
a supply side and a demand side. Sometimes the demand side is predominant and sometimes the supply side is predominant. We have
been through a period in recent years where clearly the problem was
not excessive demand and one wanted to concentrate on the supply
side. That I think is what the Council on Wage and Price Stability
has been doing to the limit of its resources, which as you pointed out
are not terribly great.
But all this got started with excessive demand in the late 1960's
and if we hadn't had excessive demand in the late 1960?s maybe this
whole ball would never have gotten rolling. It got another push again
from the demand side in 1971 and 1972 because I think the people
who were responsible for demand management relied overly on the
existence of wage and price controls to contain inflation and they
didn't, and then excessive demand broke through the wage and price
controls and they became unstable at that point.
So there are times when one has to worry about the demand side
and when both the Keynesians and the monetarists have something
proper to say in terms of what the monetary and fiscal policies should
be like.
Now Professor Weintraub said earlier on that budget deficits
weren't inflationary because we had a huge budget deficit in 1933
and we had prices going down, but we also had 25 percent unemployment in 1933. I'm perfectly willing to concede that budget deficits


are not inflationary when unemployment is 25 percent. I'm not willing to concede that they are not inflationary when unemployment is
4 percent and T'm not sure about 5 or 5i/2.
So I think if you're looking for an economist to come up with a
single explanation and a single cure, you can look for centuries and I
don't think you will ever find it. Tt may be that this T I P policy has
some advantages, but to present it is the be-all and cure-all of the
inflation problem I think is misleading this committee.
The CHAIRMAN. Gentlemen, the hour is late. We could continue for
a long time. I would like to spend a few minutes getting into the ingredients of TIP. We have neglected that and I want to get into that.
Dr. Rees, you indicated that various versions of T I P have surfaced and only the Wallich-Weintraub version is administratively
My major concerns about that are this: No. 1, would it work to
short-cut the inflation spiral? Xo. 2, is it needed to complement our
other inflation policies? You said it's not a be-all and end-all, but
would it work to complement our other inflation policies? Third,
could it be implemented at reasonable costs?
First, would it work to shortcut the inflation spiral in your view?
Mr. REES. I think it might make some contribution to reducing the
rate of inflation, but at a cost that might be very high. I'm not sure
that, on balance, it would be a desirable policy.
The CHAIRMAN. Well, Dr. Okun presented it yesterday as the tax
cut in effect; instead of having some of the other tax cuts that have
been proposed, use this as the tax reduction—his carrot version. So
the cost in that sense would be a cost that we're going to have anyway
in the sense we're going to have a tax reduction.
Mr. REES. There's a much simpler way to use the tax reduction to
reduce the rate of inflation, and that is simply to take some of the
programs now financed by payroll taxes out of the payroll tax financing and substitute a cut in payroll taxes for a cut in the income taxes.
The CHAIRMAN. Would it be as effective? There's a reward if you
comply, if you hold down your wages. There's not necessarily a reward if you simply reduce payroll taxes.
Mr. REES. I think that the reduction in payroll taxes would have
an impact on unit labor costs and, therefore, on prices.
The CHAIRMAN. Well, it would have, yes, but my point is, you don't
have the discipline. You don't have the force. You don't have the
direct relationship. You still have these power elements of labor getting all it can get and management trying to make the highest profits
it can in its pricing system. You don't have the incentive explicitly
spelled out as you do when you put T I P in effect.
Mr. REES. Well, the other side of that coin. Senator, is I think it
would be much simpler and quicker to implement than TIP. It would
require, even for the feasible Wallich-Weintraub proposal, a while
to get that in place. The other could be done very quickly.
The CHAIRMAN. Well, maybe we can do both. There's no reason
why you couldn't act as far as payroll taxes are concerned now this
year and move toward T I P maybe in 1980 or something of that kind.
Mr. REES. Well, I certainly have no objection to its being studied
further, but I think a lot of the practical aspects of it are just beginning to be looked into and much more work is needed before anybody


is ready to adopt it. I'd like to see draft legislation, for example. I'd
like to see what the Internal Revenue Code would look like if we
were to enact TIP. Obviously, the Congress wouldn't enact it just the
way the draft legislation is proposed, but just that discipline would
be good for the proponents.
The CIIAIKMAX. Professor Seidman, you said in your statement
the most crucial ingredient in the T I P is the penalty on the employer that grants higher wages. What's the evidence that indicates
when profit rates decline below normal business firms grant below
normal wage increases ?
Mr. SEIDMAX. Well, I have an article coming out where I do an
econometric wage equation study trying to relate changes in wages
for U.S. manufacturing over a 20-year period to see what causes
movements in the rate of wage increases. Traditionally the unemployment rate has been an important variable in that wage rate and
it seems to have been an important cause, I find that result; but
what I also find is that the profit rate also seems to have a statistically significant effect on the rate of wage increase.
In other words, in the data it appears—now again, I should certainly want to repeat the caution that this is an econometric study
subject to uncertainty, like all other empirical studies in economics,
but it appears that if the profit rate is below normal for a period
of several months that that in itself has an independent effect on
reducing the rate of wage increase relative to what it had been in the
last 2 or 3 years.
The CITAIRMAX. Will you make that study available to us?
Mr. SETDMAX. Sure. [See reprint of study at p. 440. ]
The CHAIRMAX. AVe'd like to study it.
Mr. SEIDMAX. XOW one thing, though, I should repeat here, the
penalty version of TTP would not cause an actual reduction in the
profit rate of firms. It would threaten to squeeze the level of profit
if the firm ignored it and gave the same eight percent wage increase.
But if it comes down to the target there would be no actual reduction in profit rate. So it's only the threat of it.
The CJTATRMAX. So there's a direct relationship there, to the extent they comply, to the extent they hold down wages. Tf they don't,
there's a penalty.
Mr. SEIDMAX! That's right.
The CITAIRMAX. NOW in your statement you say under T I P the
monetary growth rate prescribed by monetarists economists would
be easier for the Federal Reserve to achieve.
Mr. SETDMAX. That's right.
The CTIATRMAX. How would that be possible?
Mr. SEIDMAX. AA'ell, T take the view that TTP is a complement,
not a substitute, for reducing the rate of growth of the money supply and moving the Federal budget towards a full employment
The CTTATRMAX. Simply because it would ease inflation and in the
process would have that effect ?
Mr. SETDMAX. Right. In pages 15 through 17 of my testimony,
which I would hope you would look at later, I try to explain the
difference between what happens if you slow monetary growth with
out T I P versus if you slow monetary growth together with TIP.


The basic idea is simple. As most monetarists who themselves don't
support T I P would admit, such as Professor Friedman, if you
merely slow the rate of monetary growth, and Professor Friedman
concedes this—wages and prices will continue to increase at almost
the same rate for 1 year or 2. Therefore, with the rate of inflation
continuing, the slowdown in monetary growth for the first few
years—he's said a few years—takes the form of reduced ability to
buy real output and the reduction in real output and production
causes a rise in unemployment. Now he then says after several years
unemployment will apparently get so high and profit rates so low
that wage increases will moderate.
What I'm suggesting is let's add T I P to the slowdown of monetary
growth. What will then happen is you will get a slowdown of wage
increases and price increases immediately from T I P and the slowdown in monetary growth will still enable people to buy as much
real output, so there will not be the slowdown in production and
employment. So the two need to work together in tandem.
The real issue is not which would you prefer but
The CHAIRMAN. Did you talk to Dr. Friedman about that ? Did he
accept that?
Mr. SEIDMAN. I haven't talked to him personally, but monetarist
The CHAIRMAN. Do you find support for your T I P from the
monetarists on this basis? I would think they would be enthusiastic.
Mr. SEIDMAN. I would think they should be, but T think that they
seem to be more cavalier about the several year transition than I
think many
The CHAIRMAN. That's the reason they can't achieve it. They're
very bright people. They understand that. If they really want to
achieve their end and they think your system would work they would
embrace it with open arms, with enthusiasm.
Mr. SETDMAX. I would hope they would. We'll see. This is a now
proposal. Maybe they will decide that it complements them. I think
it complements their approach.
The CHAIRMAN. Dr. Wointraub, a fundamental question is how far
we want to go in using tho tax system for social ends. T think that's
one of the objections here. We are using it for every thing. We use
it to promote employment, stimulate investment, provide home
ownership. It's being proposed now for many other things, to reward college attendance, provide retirement to a greater extent than
now and so forth. And we Q:ot frustrated frankly here in the. Senate
because it seems Russell Long runs the whole operation. Ho determines most of our social programs as well as our tax programs because so much is funneled through the tax system.
Aren't we going to end up, if we use TIP, with the tax system
abused, overused even more than it is now, more complicated, and in
greater disrepute?
Mr. WETNTRAFR. Senator Proxmire, I run the risk of troubling my
dear friend, Al Roes. I have enjoyed his company through the years
and I upset him a little bit.
We have two levers to affect the economy, apart from the law listing penalties and prohibitions, and so on. We can affect the economy
through the tax side or we can affect the economy through the ex-


penditure side. There is some view of "let's simplify the tax system."
Well, let's simplify everything. Some things can't be simplified.
We have the tax system. It should be used as a lever to affect the
market economy in ways that are regarded as desirable. Why throw
it away? I don't object to tax deductions. If you do want to influence
home ownership we have every reason to use the tax mechanism. Of
course we might disagree on the particular deductions.
The CHAIRMAN. Could you do it this way: Could you confine the
use of T I P to the larger firms so you don't have every small businessman in the country in a quandary as to what he does to figure out his
product price and so forth and all the fringe benefits involved in
wages and so on ?
Mr. WETXTRAUB. Senator, I appreciate your raising that question. I
have only argued for T I P for 1,000 or 2,000 firms. With 1,000 firms
you would cover or recapture about 55 percent of the gross business
product. With 2,000 firms the estimates I have seen suggest that you
would affect 85 percent of gross business product. There has been the
earlier remark—and I think it was my friend Al Eees here, who said
Government was excluded. With respect to Government employees,
you could say for 1 year or 2 years—I take 2 years—2 years, limit
average wage increases, salary increases, to the number that—5 percent seems to be the magic number—and perhaps if at that time Government salaries have lagged behind you could make the corrections.
So quickly you could bring in the pacesetters in the economy, ultimately through T I P ; this hasn't come out adequately in these discussions. You could not include the construction industry because that
consists largely of small firms. You could not include the trucking
industry for much the same reason. And it is for this reason that I
referred to CAIP. Now these are identifying initials for the contract
authorization incomes policy.
I think this could do something in construction by controlling costs
in Government construction. Government assisted construction; it is
a subject that has interested you through the years, and on which
you have done so valiantly on cost overruns in procurement, where
the salaries get entirely out of hand for doing jobs in the private
sector that perhaps an admiral or a colonel does at the same level in
the Government sector.
The CHAIRMAN. AS you know, we have a very complicated procurement policy now. Wouldn't this complicate it further if we applied
T I P to establish a form for defense contracts?
Mr. WEIXTRAUB. I don't see it—we have Davis-Bacon largely on
the construction side: I don't know what you do on the procurement
side, but I don't see that it would be complex. It's a complex society
and inflation is a complex problem. T I P has been criticized as being
an oversimplification. Well, at least it's a simplification. It's not a
complex approach, using taxes.
We can stay up waiting for the latest article on monetary theory,
and at the end of it what do we have ? Somebody argues you should
increase the money supply or decrease it or keep it constant. Well,
now, on taxes, this is the same sort of phenomenon.
No, I don't see it as complex or beyond the abilities of accountants
for 2,000 of our largest firms. They can handle it easily.

The CHAIRMAN. Dr. Seidman, yesterday Governor Lilly said in his
testimony that the TIP's are a mild form of wage and price control.
Your statement emphasizes that TIP is not a form of wage and price
control. How would you dispute Governor Lilly? It seems to be the
perception, too, of many people in business.
Mr. SEIDMAN. What TIP would do is let each firm and each group
of employees make their own decision as to what wage or price increase is to take place at that firm. They would not have to clear it
with any regulation or any regulatory body.
Under controls, that isn't the case. Any collective bargaining agreement has to be in line with particular regulatory guidelines.
The CHAIRMAN. Let me just interrupt to say you're saying for
many of the firms in this country the Congress' decision as to what
level of wage increase would be permissible—6, 7, 5 percent. That
would be an enormously important collective bargaining decision
made by members of Congress or made by the Congress and the
President, not made on the basis of the marketplace, not made on the
basis of negotiations, taking labor unions and management with their
know-how and experience just out of the act.
Mr. SEIDMAN. That's right. If the penalty under T I P were severe
and prohibitive, then it would be the same as controls. In other
words, if you were saying to firms: our guidelines
The CHAIRMAN. It's pretty severe if you go up to 60 percent corporate income tax.
Mr. SEIDMAN. NO. I just gave those numbers as a particular example. There's no good study yet as to what would be the appropriate number. That was only for illustration.
What you need to try and estimate is what level of penalty would
be significant to a firm.
The CHAIRMAN. I think Dr. Rees pointed out he would like to see
draft legislation so he would have something specific to zero in on
and criticize and understand. Here's a point that it seems to be most
useful. You said you haven't made a study as to what level you would
go to, whether it would be 54 or 64 percent. Those were just tossed
out as illustrations.
Mr. SEIDMAN. That's right,
The CHAIRMAN. If you're really serious—and you're one of the
prime authors, and Dr. Weintraub and Dr. Okun and Dr. Wallich—
you're the four men that probably know more about this than anybody in the country—it would seem to me you should come forward
with specific legislation drafted available for us to look at, and see,
and criticize, and understand. Can you do that?
Mr. SEIDMAN. I think we should try and
The CHAIRMAN. When do you think you could do that? Do you
think you could do that? Would you like to comment, Dr. Weintraub ?
Mr. WEINTRAUB. Yes, Senator. It is most difficult to get any assistance. I can say I have been working alone on this for a long, long
while and if you look at the typing job on my statement you can see
I'm not the world's best typist either. To suggest immediatelv a legislative kind of proposal, I think that those are available. Those are
available in any number of the statements of my own, the one of Dr.
Wallich's, the three chapters in my book on inflation and employ-


ment and prices. It's a new book and from the present references at
these hearings it should be one of the rare books in economics—unheard of.
The CHAIRMAN. Well, with all this discussion—and I would agree
this is one of the very few options we have to combat inflation. It's
the only one that seems to have substantial stature with support by
very able economists and seems to move us in this direction, but as I
say, to discuss it is fine and I think these hearings have been most
useful in that respect, but we would like to get draft legislation so we
can know whether we have something or whether we'd better get to
work on something else.
Mr. WEINTRAUB. I'm eager to help. Until this morning there has
been no serious discussion of this in Washington and I commend the
committee for being a lert to the existence of this. As I say, this has
taken 7 or 8 years and it's been newspaper discussions that has led
this on. Yet there has not been any support for any kind of study
The CHAIRMAN. What would be a reasonable deadline? Do you
think we could have draft legislation available by September 1 ?
Mr. WEINTRAUB. By the middle of July.
The CHAIRMAN. I'm serious. The middle of July?
Mr. WEINTRAUB. I'm serious. Yes.
The CHAIRMAN. All right. Try and do that then by July 15.
Gentlemen, I want to thank you very, very much. You have been
most helpful and you have made a fine record and we appreciate it.
The committee will stand adjourned.
[Whereupon, at 12:35 p.m., the hearing was adjourned.]
[Additional material received for the record follows in the




Laurence S. Seidman
Discussion Paper #363
August 1977

After showing statistical significance in most wage

studies in the early 1960's, the profit rate

disappeared from most wage equations, as researchers focused
their attention on the adjusted unemployment rate.

This paper

reopens the issue of the influence of the profit rate on wage

It tests the performance of the profit rate and

the adjusted unemployment rate in the wage equation against
time series data for U.S. manufacturing.

It concludes that

the result is a drawi the profit rate does as well as the
adjusted unemployment rate.

The data are consistent with the

hypothesis that the profit rate influences wage inflation.
Economic "theory or policy that postulates an impact of the
after-tax profit rate on wage.inflation is not contradicted
"by empirical evidence for U.S. manufacturing.


I am grateful to Michael Wachter, for use of his time
series data and his UGAP variable; to George Perry, for his
weighted unemployment rate series; to Dennis Ahlburg, for
his assistance with the Wachter data; and to Michael Golden,
for his excellent research assistance

In the early 1960's, several econometric wage equation
studies concluded that the profit rate significantly influences
the growth rate of money wages.

Among these were studies by

Eckstein and '.Vilson (5), Bhatia (1), Schultze and Tryon (15),
and Perry (11).

While there were also wage equation studies

that either omitted, or specifically rejected, the profit variable,
it was clearly regarded as an important contender for inclusion
in the wage equation by many economists.
In the late 19-60's, however, the profit variable began to
disappear from most wage equations.

Occasionally, it was speci-

fically rejected, with the assertion that it was no longer statistically significant (23).
without explanation.

More often, it mysteriously disappeared,

For example, Perry's 1970 wage equation

study simply omits the profit variable, although it had been
significant in his earlier studies (13)•

Most wage equation

studies since 1970 have ignored the profit variable.
Why did the profit variable vanish from the wage equation?
One possibility is that, while researchers still believed that
its inclusion was theoretically plausible, the data rejected it.
Another possibility is that most researchers did not believe,
a priori, that the profit variable belonged in the wage equation.
Studies in the late 1960's and 1970 f s reflected a growing conviction that proper measures of excess demand in the labor
market, and price expectations, could satisfactorily explain
wage changes.

Creativity and ingenuity were exhibited in

adjusting the unemployment rate, and constructing proxies for
price expectations (13, 7* 2 5 ) .
This paper reopens the issue of the role of the profit

variable in the vage equation.

Do the data reject, or support,

the inclusion of the profit variable?

Given the improved measures

of excess demand in the labor market, do these adjusted unemployment variables work better, or worse, than the profit variable?
According to the data, which should the wage equation include:
(1) the adjusted unemployment rate (2) the profit rate (3) both
(k) neither?
I A Comparison of Wa^e Equations
Six wage equations are presented in Table 1.

The first

three are of the formi
(1) w t = a 0 + a 1 n t _ i + a 2 (l/u t _ i ) + a^w.^
w-j. = percentage rate of change of the wage variable
n t - i = distributed lag of the profit variable
l/u t- ^ = distributed lag of the reciprocal of the
adjusted unemployment rate


distributed lag of the percentage rate of change
of the wage variable

The three equations differ solely according to the adjusted
unemployment variable that is used.
The second three equations are of the formi
(2) w t = a 0
frfcill = distributed lag of the percentage rate of change
of the price variable
Again, these three equations differ solely according to
the adjusted unemployment variable that is used.





= -5.58 + 5-5^t^i +
(-4.08) (4.19)





R =.?3






R =.74



R =,72







wt = -2.61 + 3.25n t _ i + 6 . 2 1 ( l / u t - i ) + 0.98p t
(-1.49) (I.65)

R =.72


wt = -1.99 + 3.13n t _i + 3-38(l/u t _ i ) + 0.96$
(-1.22) (1.82)



= -6.60 + 6.12nt_i + 6.07UGAPt_i + 0.88wt(-4.71) (4.43)




= -6.26 + 6.10nt_j, + 3.24(l/ut_i) + 0.94wt









= -3.01 + 3-3?nt.i +
(-1.76) (1.81)



3 =.73 S.E.=1.20 D,W.=1.94
All equations were estimated using ordinary least squares.*
The numbers in parentheses are t-statistics. RZ is the R^
corrected for degrees of freedom. S.E. is the standard error
of the estimate. D-W. is the Durbin-Watson statistic. Each
variable is described in section I-A of the text. Equations
(1-M) and (2-M) use the prime age male unemployment rate; (1-P)
and (2-P) use Perry's weighted unemployment rate; (1-W) and (2-W)
use Wachter's UGAP. Decimal points are positioned as followst
(a) a wage or price inflation rate of 7% is entered as 7.0
(b) an unemployment rate of 6% is entered as 6.0. Each variable
is a apolynomial
distributed lag (of second degree). n+-i a n d
t-i a nr de laSSecalr efour
quarters (constrained to zero in the fifth);
Sged twelve quarters (constrained to zero in
the thirteenth). The coefficient shown above for each variable
is the sum of the individual distributed lag coefficients; the
t-statistic applies to the coefficient sum.

29-775 O - 78 - 29

Profit Ratio ( n h _ i )













Prime Age I.ftle Unemployment Rate (l/u+_£












Wage Inflation Rate (w t-0



































These are the distributed lag coefficients and
t-statistics for the variables in equation (1-M) of

(A) Data
The equations were run on quarterly data for the U.S.
manufacturing sector from 1955«02 to 1975t02.

The wage variable

is the "hourly earnings index" which the Bureau of Labor Statistics
regards as the best available measure of wage-rate movements (2).
The price variable is the non-farm price deflator: it is used in
several studies that feature the adjusted unemployment rate (2^,25).
Three different adjusted unemployment variables are used.


tries to correct for the changing composition of the labor force
that occurred over the sample period.
male unemployment rate.

The first is the prime age

The second is George Perry's weighted

unemployment rate, described in detail in his 1970 article (13).
Both the prime-age male rate, and Perry's rate, are entered as (l/u-^)
The third is Michael Wachter's UGAP, which increases as the labor
market tightens, as described in his 197& article (25).

In general,

the results proved to be substantially the same for all three.
The profit variable is the ratio of the actual after-tax
profit rate on equity to the "normal" profit rate for that quarter.
The "normal" rate is given by a simple linear trend.

It seems

plausible to conjecture that what matters for w^ is whether the
profit rate has been above or below normal.

As it turned out,

the equations in Table 1 would have been largely unchanged if
the profit rate itself, rather than the ratio, were the profit

The actual profit rate on equity is given in the

Federal Trade Commission's Quarterly Financial Reports for U.S.
It may be objected that the accounting profit on the book
value of equity differs from the "real" profit rate in an
inflationary period.

Nevertheless, the reported profit rate may

be the appropriate variable for wage determination.

The relation-

ship between the reported and "real*1 profit rate is complex (22).
Management, stockholders, and union may not know the real profit
rate, or even whether it is greater or less than the reported rate.
If stockholders, and union, are likely to judge according to the
reported rate, it becomes rational for management to do the same.
In a study of U.S. profit behavior, Nordhaus concludes that firms
seem to set prices with reported, not real profit, in mind.


concludes, "When in Rome,..." (10).
(B) Lag Structure, Simultaneity, and Autocorrelation
All variables are entered as polynomial (of second
degree) distributed lags.

The profit and unemployment variables

are lagged four quarters (constrained to zero in the fifth) i the
wage and price wariables are lagged twelve quarters
to zero in the thirteenth).


Any influence of more distant profit

or unemployment rates is assumed to be reflected in the lagged
wage or price variable? if a past profit or unemployment rate
affects past wage inflation, it also affects past price inflation
through the price equation relationship.

The wage variable is

lagged twelve quarters to allow for the impact of three-year

The price variable is lagged twelve quarters to allow

for a gradual impact of past inflation rates on current expectations.

Higher degree polynomials, and longer lags, were tried

but appeared to make little difference (although obviously not
every permutation was attempted).
In both the lagged profit and unemployment variables, the
first quarter is (t-1), not t.

This is done for two reasons.

First, wage increases that occur this quarter have almost always
been decided upon at least one quarter ago.

Thus, \ or u^ is not

known when the decision for w^. occurs.

Second, including

i^ or u^

would introduce the problem of simultaneous equation bias.

If a

stochastic disturbance raises w t , this will affect n^ and u^ in a
complete macronodel.

Unfortunately, in many wage equation studies,

nt O P u t is included, unlagged, in the wage equation, but no mention is made of the simultaneity problem, or its implications for
tests of statistical significance, or parameter estimates.


for both theoretical and econometric reasons, n-t-i and u^._^ are
entered beginning with t-1.
Another potential econometric problem is created by the
lagged dependent variable, w^..^.





s there is no serial

correlation, the OLS estimators are still maximum likelihood
estimators, and are consistent and asymptotically efficient,
although they are biased in small samples (9)«

Since ours is a

large sample, with 81 observations, the desirable large sample
properties are most relevant.

If there is autocorrelation,

however, then the disturbance, e^, will be contemporaneously
correlated with the right hand variable, w^.^, and the OLS
estimators will not be consistent.
In contrast to some models that result in a lagged dependent
variable— such as a Koyck scheme, or adaptive expectations- an
inertia hypothesis does not require a serially correlated disturbance.

Nevertheless, serial correlation may be present, as it

often is, in time series.

With a lagged dependent variable, the

standard Durbin-Watson statistic will be biased towards the conclusion that there is no autocorrelation.

It will underestimate

the probability that autocorrelation is present (9).
Fortunately, Durbin has proposed a large sample test for
serial correlation when lagged dependent variables are present (3).

According to t h i s t e s t , i t is s t i l l true that if the standard
Durbin-V/atson s t a t i s t i c is close to 2.0, the probability of s e r i a l
c o r r e l a t i o n is low.

V/ith our D.V.'. equal to 2.03 in equation (l-il)

in Table 1, i t i s s t i l l correct to infer t h a t autocorrelation is

More precisely, Durbin a s s e r t s t h a t h has a standard

normal d i s t r i b u t i o n !



r / n
1 l-nV(c 1 )


r =* 1 - id

= standard D.V/. statistic


= number of observations in the sample

V(c^) =

the estimate of the sampling variance of c^, the
coefficient of w ^ i in the least squares regression

If the null hypothesis is no serial correlation, it can be
rejected with 95$ confidence if h exceeds I.65 in absolute value.
If the standard D.W. equals 2.00, then r will be zero, and therefore
h will be zero, so the hypothesis of no serial correlation will be

In equation (1-M) in Table 1, h is (-0.16), much closer

to zero than to (-I.65),

Thus, autocorrelation is unlikely.


means that OLS estimates should be consistent, and the t-tests
substantially correct.
(C) Regression Results
The results are presented in Table 1. All equations are
estimated using ordinary least squares.

In all six equations, the

sum of the coefficients on the lagged wage or price variable is
close to 1, and highly significant.

This supports "accelerationist"

A permanent increment in n^ or (l/u^) will continue to

raise the wage inflation rate indefinitely, through
subsequent feedback that will occur through the lagged

wage or price ten.i (feedback through the price term occurs
because of the price equation relationship, in which price inflation is a function of wage inflation).

If the coefficient sum is

approximately 1, the wage inflation rate will be constant only if

and u^ are at their "natural rates."

If n-t is permanently

raised above its natural rate, and u^, below its natural rate,
the wage inflation rate will rise gradually without limit.


versely, the wage inflation rate will decline gradually if n t is
held permanently below its natural rate, and u^, above its natural
In all six equations, either nt or u^ is highly statistically

Since a change in aggregate demand will influence

these two variables, the influence of aggregate demand on wage
inflation receives strong support.
though reliable, is gradual.

The response of wage inflation,

In equation (1-M), if w t - ^ has been

constant at Q%, then a prime age male unemployment rate of about
k% (corresponding to an official unemployment rate of


and an after-tax profit rate on equity of about 1 2 ^ (which would
make the profit ratio about 1, since the "normal" profit rate was
about 12<£ in 1975)» would keep the wage inflation rate approximately
constant at 8%,

If the profit rate were raised to 1J%, and the

male unemployment rate lowered to 3#, then by the end of the
first year, w^ would be roughly 9% (the distributed lag weights
for the variables are given in Table 2 ) . Subsequent feedback
through the lagged wage terra, however, would continue to raise
w^ almost indefinitely ("almost," because the coefficient sum is
0.9^ instead of 1 ) .
It is also true that aggregate demand is not the only
important influence on w t .

w t is affected by stochastic dis-

turbances, which are then incorporated in the lagged wage or
price term.

It is therefore incorrect to conclude that, since

these wage equations have an R 2 near 75%, aggregate demand
explains 75$ of the variation in wage inflation.

The long-run

effects of aggregate demand do operate through the lagged wage
or price term.

But so do the lagged effects of other influences.

Thus, this study supports a "moderate" view concerning the
influence of aggregate demand on wage inflation.
We now turn to the comparison of the profit rate, and the
adjusted unemployment rate.

Based on t-statistics, the profit

rate outperforms the adjusted unemployment rate in the first
three equations, with the lagged wage termj but the adjusted
unemployment rate outperforms the profit rate in the second
three equations, with the lagged price term.

A wage inertia

hypothesis would support the specification with the lagged wage

A price expectations hypothesis would support the speci-

fication with the lagged price term.

To a researcher without

strong a priori convictions concerning which specification is
more appropriate, the verdict of the data is surely a draw.
The data, therefore, do not reject the hypothesis that the
profit rate influences wage inflation.

The profit hypothesis

is as consistent with the data as the unemployment hypothesis.
The disappearance of the profit rate from wage equation studies
over the last decade was not mandated by the data.


theory or policy that postulates an impact of the after-tax
profit rate on wage inflation is not contradicted by the
available empirical evidence for U.S. manufacturing (16,26).

(1) Bhatia, R. "Profits and the Rate of Change of Money Earnings
in the U.S., 1935-59," Economica, Aug. 1962
(2) Bureau of Labor Statistics, "The Hourly Earnings Index,"
Bulletin 1897 (1976)
(3) Durbin, J. "Testing for Serial Correlation in Least-Squares
Regression When Some of the Regressors Are Lagged Dependent
Variables," Econometrica, ray 1970
(4) Eckstein, 0. (ed. ) The Econometrics of Price Determination,
Board of Governors, Federal Reserve System (1970)
(5) Eckstein, 0., and Wilson, T. "The Determination of Money Wages
in American Industry," Quarterly Journal of Economics, Aug. 1962
(6) Federal Trade Commission, Quarterly Financial Reports for
U.S. I/ianufacturing
(7) Gordon, R.J. "Inflation in Recession and Recovery," Brookings
Papers on Economic Activity, 1971tl
(8) Kaldor, N. "Economic Growth and the Problem of Inflation,"
Economica, Nov. 1959
(9) Johnston, J. Econometric Methods (2nd edit.) (1972)
(10) Nordhaus, W. "The Falling Share of Profits," Brookings Papers
on Economic Activity 197^:1
(11) Perry, G. Unemployment, Etoney Wage Rates, and Inflation (1966)

, "Wages and the Guideposts," American Economic
Review, Sept. 1967


, "Changing Labor Markets and Inflation," Brookings
Papers on Economic Activity 1970*3
^ ,"Determinants of Wage Inflation around the World,"
ings Papers on Economic Activity 1975»2

(15) Schultze, C. and Tryon, J. "Prices and Wages," in Duesenberry, J.
et. al. (eds.) The Brookings Quarterly Econometric Model (19&5)
(16) Seidman, Laurence S. "A New Approach to the Control of
Inflation," Challenge July/Aug. 1976

, "A Payroll Tax Credit to Restrain Inflation,"
The National Tax Journal, Dec. 1976


, "Would Tax-Shifting Undermine the Tax-Based Incomes
Policy?" Univ. of Pennsylvania Economics Discussion Paper
(UPEDP) July 1977


, "Tax Incentives to Lower the Natural Rate of
Unemployment,M UPEDP May 1977


, "A Microeconomic Foundation for InflationUnenployment Dynamics," UPEDP June 1977

(21) Shoven, J. and Bulow, J. "Inflation Accounting and "onfinancial Corporate Profits t Physical Assetc-," Brook inp;s
Papers on Economic Activity 197o'-l

, "Inflation Accounting and ?ionfinaneial
Corporate Profits: Financial Assewts and Liabilities,"
Brookings Papers on Economic Activity 1976tl

(23) Wachter, IT. "V/ages and the Guidepostsi Comment," American
Economic Review June I969

, "The Wage Process 1 An Analysis of the Early 1970 f s,'
Brookings Papers on Economic Activity 19?^:2


, "The Changing Cyclical Responsiveness of Wage
Inflation," Brooklngs Papers on Economic Activity 197oil

(26) Weintrauh,"S. and Wallich, H. "A Tax-Based Incomes Policy,"
Journal of Economic Issues June 19711 also in Weintraub, S.
Keynes and the Monetarists (1973)


The Financial Analysts Federation
Tower Suite. 219 East 42nd Street New York N Y 10017 (212^557-0055
Theodore R. Liiley, C.F.A.

O.-L. : :, -.-.



iz~ Z

May 26, 1978
The Financial Analysts Federation is the professional
association for security analysts, investment managers and
others involved in the investment decision-making process.
It consists of 48 societies with over 14,000 members in the
United States and Canada.

As investment professionals, we are perhaps more concerned over inflation than other segments of our society.
Inflation increases uncertainty and risk in the economy,
limits growth and makes it more difficult to achieve full
utilization of our resources.

We know from experience that

developments in the general economy are transmitted directly but with a leverage effect - to financial markets.


has also shown that what is good for the economy is very good
for the investor; what is bad for the economy is very bad
for the investor.

There are many sources of inflationary pressures and a
number of approaches might usefully be employed to reduce

these pressures.

Indeed, these hearings are examining in

detail one particular concept, the tax-based incomes policy.
We will concentrate our comments on the critical importance
of a sustained high level of capital investment as a means
to ameliorate the price and wage increase pressures of inflation.

Investment is the focus of our knowledge and experi-

ence and the area in which we are most likely to make a contribution to these proceedings.

Critical Role of Investment
Capital investment influences the rate of inflation
in two principal ways.

First, the level of investment is

the critical determinant of whether we will have ample
supplies of goods and services and competitive restraints
on business pricing or whether we will have shortages,
sellers1 markets and rapid price markups.
Second, investment is the key element influencing
the rate of gain in labor productivity, which provides
a direct offset to increases in wage costs.

The relation-

ship of growth in capital spending (after adjustment for
inflation and for outlays for controlling the environment)
to growth in the labor force has deteriorated in the 1970's,
and annual gains in output per worker have fallen almost a
full percentage point from the average experience in the
1950's and 1960's.

Over the next several years, investment needs will
be enlarged by a series of special factors which are
largely unrelated to expansion of capacity or improvement
in the efficiency of the capital stock.

These include

increased spending to provide for the development of new
energy sources and for facilities to meet environmental
and safety standards.

As a consequence, there is a broad

consensus among economists that total capital spending
will have to increase faster than general economic
activity if shortages are to be avoided and the historic
pattern of productivity improvement restored.
Limits on Debt Financing
The increase in investment requirements, unfortunately,
coincides with a reduced ability of business to raise
capital through debt financing.

From 1965 through 1977,

net additions to debt supplied 88% of total outside funds
raised by non-financial corporations, with equity financing providing only 12%.
Because of this buildup in the debt burden and an
accompanying steep rise in interest rates, the coverage
of interest charges by earnings (which is the essential
test of the safety of a debt security) has worsened significantly.

Interest coverage for non-financial corporations

has narrowed from an average of lOx in 1965-1967 to 4.5x
in 1975-1977.

Earn. Avail.
For Interest*



($ bil.)




*Pre-tax earnings (after inventory valuation
adjustment) plus foreign branch profits and
interest charges.

Federal Reserve Board, Flow of Funds

Graham, Dodd and Cottle in the standard text
"Security Analysis" recommend a minimum coverage of
interest charges for high quality bonds of 7x for industrial companies and 4x for utilities.

Weighted for rel-

ative size, this would represent an overall figure for
non-financial corporations of about 6.5x.
The inadequacy of present coverage ratios is even
worse than the above figures would suggest.

The earnings

figure recommended by Graham, Dodd and Cottle for use in
calculating coverage is the average for the prior 7 years
rather than the latest year alone.

Using this approach,

coverage in 1975-1977 would fall to just over 3x.


addition, because of a lack of data no allowance has
been made for the interest component of lease rental
charges, which realistically is part of the interest

Finally, the use of aggregate figures obscures

the very high coverage ratios for many leading companies,
e.g., 88x for IBM in 1977 and 36x for Johnson & Johnson.
These are necessarily offset by ratios for many other firmsparticularly smaller firms-that are below the aggregate level.
Importance of Equity Capital
A reduced emphasis on debt as a source of capital
seems clearly indicated; this will just as clearly require
a corresponding increase in equity financing If overall
investment needs are to be met.

Calculations we have made

based on the assumption that earnings coverage of interest
charges will stabilize at present level.s indicate that the
required level of equity financing in the 1976-1985 period
will be almost four times as great as in the prior ten years
(ar. average of $23 billion a year versus $6 billion in 19661975 and $8 billion in 1977).
Prospects for raising a much larger supply of equity
funds, however, are not promising, given the poor experience
of equity investors since the mid 1960's.

The current level

of 858 (as of May 17, 1978) for the Dow Jones Industrial
Stock Average compares with a mean annual price of 911 as
far back as 1965.

Equity investors have made no progress

in nominal terms for approximately thirteen years.


terms of real purchasing power, overall equity values
have shrunk by 50%.

Real GNP, on the other hand, increased

by 44% from 1965 to 1977.





Dow Jones Avg.
S&P 500
Value Line

Reported Inflation
( 6)%


* as of 5/17/78
The consequences of this weak performance have been
about what could have been expected.

The number of indi-

vidual shareholders declined 18% from 1970 to 1975, equityoriented mutual funds have been in a net redemption phase
in 5 of the past 6 years and the flow of pension fund
money has shifted from stocks to bonds.
Case for Tax Reduction
The lag in stock prices has been caused in large
part by a faster pace of inflation, which has pushed up
interest rates and thereby depressed the value of all
income-producing assets.

At the same time, business

profitability has not increased so as to provide an offset

to higher inflation and interest rates.

For the Dow Jones

Average, return on equity investment or net worth has
remained relatively constant at around 12% throughout the
postwar period, while interest rates on high-grade bonds
have risen from around 5% in the mid 1960's to 8.6% at

As a consequence, the difference between the

rate of return realized on equity investment and the
return available on relatively risk-free, high quality
bonds has-been cut in half over the past 10 - 12 years.

Return on






* Dow Jones Average
**Moody's AAA Corporates
Since inflation itself is the problem being addressed,
a reduction in inflation cannot be offered as part of the

The attractiveness of common stocks and the

availability of equity funds for investment can be enhanced,

29-775 O - 78 - 30

on the other hand, by Government actions (especially in
regard to taxes) that are designed to raise returns on

Treasury Secretary Blumenthal stated on May 8

at the Annual Conference of the Financial Analysts
Federation, "The chief drag on investment, however, is
low profitability, an inadequate real rate of return on

For this problem one of the important remedies

has to be tax policy."
A wide range of proposals have been made to reduce
the tax burden on business and investors and the adoption
of any or all of these proposals would be expected to have
a positive influence on investment.

We would, however,

like to single out for particular emphasis the benefits
that could be derived from a reduction or elimination
of taxes on capital gains.
The Securities Industry Association has studied the
effects of various tax proposals on the capital formation
process based on econometric models prepared by Dr. Otto
Eckstein's firm, Data Resources, Inc.

These models indicate

that over a five-year period elimination of the capital
gains tax would have the most positive influence on
investment, real GNP, employment and Government revenues
of any of the proposals examined.

Relative to what would

otherwise be expected, the projected impact on these economic

variables as a result of elimination of the capital gains
tax is as follows:

Aggregate Increases
Capital Formation (1978 $)
GNP (1978 $)
Employment (man years)
Federal Tax Revenues (current $)

$ 81 bil.
$199 bil.
$ 38 bil.

Arguments against a lowering of the capital gains tax
typically emphasize the first-year loss of Government
revenues, but this objection seems unrealistic. The problems
of lagging investment and high inflation developed over a
long period and are not likely to be resolved other than
by an approach extending over several years. Similarly,
criticism that only a few would benefit directly from this
method of tax reduction miss the main point - that benefits
from an increase in investment, production and job opportunities would spread over all segments of society.

To summarize, a sustained high level of capital
formation is an essential element in any program to limit
inflation due to the influence of investment on the supply
of goods and on the productivity of labor.

Because of a

reduced ability of corporations to finance with debt, a
substantially higher level of equity investment is needed.
The availability of equity capital, meanwhile, has been
impaired by the prolonged period of poor market performance by common stocks.

One of the most promising ways

to stimulate equity investment would be to increase rates
of return through a reduction in taxes on business and

prepared for the Federation by WalteT McConnell, Senior Vice President and
Director of Wertheim 5 Company

The following letter was mailed April 26., 1978 to
numerous experts on inflation and taxation to get their
views on tax based incomes policies.
The list of individuals the letter was sent to and the responses received follow:

The Committee on Banking, Housing and Urban Affairs has
scheduled two days of hearings, May 2 2 and 23, 1978, to consider the merits of new anti-inf1 ation programs such as "TIP" -Tax Based Incomes Policies.
The tentative witness list for those hearings has been
set, and I am enclosing a copy of it with this letter. Clearly
two days of hearings on this subject will only be a beginning
of considerations of the pros and cons of "TIP" or any other
new anti- inflation program that may surface.
In order to assure the Committee of a wide range of views,
T am writing to experts on inflation and taxation to get their
views in "TIP". Given your background it would be beneficial
to the Committee if you could provide your views on "TIP" in
writing so that they may be included in the hearing record. I
believe that the following questions about "TIP" should be
raised, although you need not feel constrained to answering

Are special types of programs such as "TIP" needed
to combat inflation in general, and the type of inflation currently afflicting our economy in particular?


What benefits would be gained through "TIP" that
cannot be derived through other types of anti-inflation programs? What are the costs to the economy
that would accrue through "TIP"?


What type
a penalty
wages and
tuted for


Can an effective set of tax based incomes policies
be devised that would treat everyone fairly?


What problems should the Congress be mindful of as
it considers proposals for "TIP"? What safeguards
would, therefore, need to be built into a workable
version of "TIP"?

of "TIP" program would be best, such as
or rewards approach, applied to both
prices or only one or the other, instia limited period or permanently?

"TIP" Letter (cont.)

Would "TIP" best be implemented by applying it to
large firms only, to all corporations, or still more


Can and should the tax system be used to implement
anti-inflation guideposts? What special problems
would this cause for the tax system, and are solutions possible and at what cost?


What would be the cost to the Treasury of implementation of "TIP"?


Do you view "TIP" as being related to mandatory wage
and price controls, or to a social contract among
government, labor, and business?

I hope that you will find time to take a careful look at
"TIP" proposals so that you will be able to share your views
with the Committee. Should you have any questions about the
Committee's hearings or about the submission of material for
the hearing record, you may contact Steven M. Roberts of the
Committee staff at (202) 224-0893.
With all best wishes.


William Proxmire



Mr. Murray
Center for
St. Louis,


Mr. Paul Volckcr
Federal Reserve Bank of New York
33 Liberty Street
New York, New York 10045


Mr. Allan H. Meltzer
Carnegie-Mellon University
Graduate School of Industrial Administration
Schenley Park
Pittsburgh, Pennsylvania 15213


Dr. Jack Carlson, Vice President
Chief Economist
Chamber of Commerce of the United States
1615 H Street, N.W.
Washington, D.C. 20062


Professor Saul Hymans
Department of Economics - 17
University of Michigan
Ann Arbor, Michigan 48104


Professor Frederic Mishkin
Department of Economics
University of Chicago
1126 E. 59th Street
Chicago, Illinois 60637


Professor Gardner Ackley
Department of Economics
University of Michigan
Ann Arbor, Michigan 48104


Professor William C. Brainard
Department of Economics
Yale University
Box 2125, Yale Station
New Haven, Connecticut 06520


Professor William Branson
Department of Economics
Princeton University
Princeton, New Jersey 08540

the Study of American Business
Missouri 63130

Addresses (cont.)

Professor James Duesenberry
Department of Economics
Littauer Center
Harvard University
Cambridge, Massachusetts 02138


Professor David I. Fand
Department of Economics
Wayne State University
Detroit, Michigan 43202


Professor Martin Feldstein
Department of Economics
Harvard University
Cambridge, Massachusetts 02138


Mr. William J. Fellner
American Enterprise Institute
1150 17th Street, N.W.
Washington, D.C. 20036


Professor Robert J. Gordon
Department of Economics
Northwestern University
Evanston, Illinois 60201


Professor Edward M. Gramlich
Department of Economics
University of Michigan
Ann Arbor, Michigan


Mr. Alan Greenspan, President
Townsend-Greenspan Company
One New York Plaza
New York, New York 10004


Professor Walter W. Heller
Department of Economics
University of Minnesota
1035 Business Administration Building
Minneapolis, Minnesota 55455


Professor Hendrik S. Houthakker
Department of Economics
209 Littauer Center
Harvard University
Cambridge, Massachusetts 02138


Mr. F. Thomas Juster, Program Director
Survey Research Center
Institute for Social Research
University of Michigan
Ann Arbor, Michigan 48104




Professor John H. Kareken
Federal Reserve Bank of Minneapolis
Minneapolis, Minnesota 55450


Professor Franco Modigliano
Department of Economics
Massachusetts Institute of Technology
Cambridge, Massachusetts 02139


Professor Edmund S. Phelps
Department of Economics
International Affairs Building
Columbia University
New York, New York 10027


Professor William Poole
Department of Economics
Brown University
Providence, Rhode Island 02012


Professor Paul Samuel son
Department of Economics
Massachusetts Tnstitue of Technology
Cambridge, Massachusetts 02139


Professor John B. Shoven
Department of Economics
Stanford University
Stanford, California 94305


Professor Robert M. Solow
Department of Economics
Massachusetts Institute of Technology
Cambridge, Massachusetts 02139


Professor James Tobin
Department of Economics
Yale University
Box 2125, Yale Station
New Haven, Connecticut 06520


Mr. Abba Lerner
Department of Economics
Florida State University
Tallahassee, Florida 32306


Professor Michael L. Wachter
Department of Economics - CR
University of Pennsylvania
Philadelphia, Pennsylvania




Professor Maria v.N. Whitman
Department of Economics
University of Pittsburgh
Pittsburgh, Pennsylvania 15213


Mr. Richard Slitor
9000 Burning Tree Road
Bethesda, Maryland 20034


Mr. Milton Friedman
Hoover Institute
Palo Alto, California 94302



May 1 2 ,


Senator William Proxmire
Committee on Banking, Housing, and
Urban Affairs
United States Senate
Washington, D.C. 20510
Dear Senator Proxmire:
In response to your letter of May 1, I am pleased to offer the following comments
on the proposals for Tax Based Incomes Policies (TIP):
No Need for TIP
In my view, Incomes policies—Including those that would use the tax system to
influence private wage and price decisions—are not a useful way to deal with the
problem of i n f l a t i o n . The basic shortcoming of the Incomes policy approach 1s
that i t deals with the symptoms of I n f l a t i o n rather than the underlying causes.
The basic causes of the I n f l a t i o n facing the American economy are 1n the public
sector Itself—excessively large budget d e f i c i t s , tax policies that dampen the
Incentive for saving and Investment, too rapid a growth 1n the money supply, and
various governmentally-imposed Institutional r i g i d i t i e s and limitations (especially
1n the regulatory area) which give an Inflationary bias to the economy.

Benefits and Costs
It 1s hard for me to see the benefits that would arise from Incomes policies, but
the potential costs are substantial. "TIP" would place business between labor and
government. "Lucky" companies, facing cooperating or weak labor unions who settled
for compensation increases within the government's guidelines, would tend to receive
windfall tax benefits or avoid penalty tax payments, depending on whether the carrot
or stick type of TIP would be utilized. Similarly, "unlucky" companies, facing
uncooperative or strong labor unions, would tend to be hurt by having penalty tax
payments imposed upon them or foregoing tax subsidies because they granted wage
Increases above what the federal government determined were appropriate.
Thus, the results of TIP would be determined by the relative power of a company and
the unions with which it deals, with the tax payment or rebate being Incidental.
The administrative costs, moreover, could be very substantial, Including the deflection of the Internal Revenue Service from fulfilling its traditional functions.

BOX 1208
314 889-5630

The Size of Companies
The great variety in the size and nature of business firms would present a host
of operational difficulties. The suggestion to limit the program to the larger
economic units would present many Issues of equity for the employees, owners,
and customers of the affected firms. The administrators of TIP would be faced
with a "no win" situation. If they exempted the smaller organizations, they
would be omitting many of the sectors of the economy which have been experiencing
the most rapid price increases. If, alternatively, they included all companies,
the enforcement burdens would be most severe.
Prior Experience With Incomes Policies
The Congress would be well advised to examine prior experiences with Incomes
policies, both in the United States and in other industrialized nations. It will
be apparent, I believe, that these policies do not represent a durable solution
to the problem of inflation. At best, they postpone and usually 1n the process
exacerbate the underlying Inflationary pressures.
The Need to Consider Alternatives
The Interest in Incomes policies arises because of the dissatisfaction with the
operation of conventional macroeconomic policies. In my view, monetary and fiscal
Instruments are necessary but not necessarily sufficient mechanisms for dealing
with the severe Inflationary pressures facing this nation. The answer, however,
is not to Increase further the government's intervention 1n economic matters but,
rather, to reverse the trend of recent policy.
We need to recognize the basic reason that incomes policies—both voluntary and
compulsory, both here and abroad—have been resorted to. It 1s hardly because we
as a nation H k e to interfere with private decision making. Rather it is that
citizens and policy makers have not been satisfied with the results of indirect
measures such as monetary and fiscal policy. Attempts to reduce unemployment by
expanding demand often lead mainly to greater cost and price pressures, with
unemployment staying uncomfortably high. Moreover, when we attempt to check these
rapid cost and price Increases, those efforts often lead to still higher levels
of unemployment.
The fundamental cause of this state of affairs lies in the numerous departures
from the free market model, the numerous concentrations of private economic power
1n the United States. The result 1s that various factor and product markets 1n
good measure have become Insulated from the Influences of monetary and fiscal policy.
Cost-push inflationary pressures are the most obvious manifestation of this
structural condition.

The alternative to incomes policy can be called the "free market" approach-a greater reliance on the competitive forces of the business system to keep
down inflationary pressures while providing higher levels of production, income,
and employment. This in turn makes the access to many products and markets by
the rest of the economy less difficult and less expensive. Specifically, we need
to reduce that massive array of government laws, rules, and regulations which
give an Inflationary bias to the economy and often also reduce job opportunities
in the process.
What is the answer? We need a fundamental change in the prevailing attitudes
towards government involvement in business decision making. The Congress should
take a new and hard look at that massive array of government regulation that has
accumulated over the past century. It should eliminate those, such as in the
transportation field, that Interfere with the effective functioning of competitive
market forces. The others, such as 1n the health and safety areas, should be
required to meet the rigorous standards of a benefit-cost test. This approach
is not a guarantee for less government intervention in the economy, but it will
help to ensure less costly and less disruptive regulation where government action
is necessary. Thus, progress will be made to reduce Inflation and unemployment
without expanding further the role of government.
The obstacles to change should not be underestimated. The politically relevant
criterion hardly 1s that the cost to the nation of each of these special provisions
may exceed the benefits to the nation. Of much greater political relevance is
the fact that the benefits to some particular group are likely to far outweigh
the costs to them. Thus we find that a powerful clientele exists to oppose the
reduction of each special benefit.
An effort to reduce or eliminate these impediments to a free market is more likely
to be taken seriously if it is evenhanded. It may be relatively easy, of course,
to obtain business support for eliminating legislation favorable to labor unions
or to obtain labor's backing for an effort to curtail subsidies to business. Both
business and labor might readily unite behind a proposal to reduce price support
payments to farmers. Yet such attempts are so obviously self-serving as to be
ineffective. Hence effort to identify and remove these special protective devices
must be broad and comprehensive. It must cover union powers, business and farm
subsidies, and restrictive practices in the services sector, including medical
and other professions.
One unifying approach which might be used is the desire to remove the influence
of "the dead hand of the past." Many of the specific protections were instituted
to deal with depression conditions of the 1930s or the wartime period of the 1940s—
situations which hardly correspond to the current reality. Certainly, a rereading
of the original arguments for many of these special benefits brings to light
anachronisms lingering on from a different age.

Unless the underlying Institutional problems are dealt with, we may experience
bursts of Inflationary pressures and subsequently additional experiments in wage
and price controls or other varieties of Incomes policy. Although generalizations are frequently treacherous, the choice facing the United States 1s likely
to be either creating more competition 1n private markets or relying more heavily
on government controls over private decision making. This may well be the most
enduring lesson emerging from our recent experience.
I appreciate the opportunity to present these views and I hope that they will be
of help to you and the other members of the committee.
Best wishes.





P A U L A. V O L C K E R



"'; • -V 2 , - /'!



The Honorable William Proxmire
Chairman, Committee on Banking,
Housing and Urban Affairs
United States Senate
Washington, D.C. 20510
Dear Mr. Chairman:
Thank you for soliciting my views on Tax Based
Incomes Policies and other new anti-inflationary proposals
that are to be the subject of the Banking, Housing and Urban
Affairs Committee hearings on May 22 and 23.
While I am not prepared to endorse the so-called
"TIPs" approach at this point, I do think it is highly constructive for your Committee to examine these ideas more
closely. The need for new ideas in the inflation field is
clear. Our inflation problem has obviously not improved.
Indeed it is threatening to get worse as a result of deteriorated supply conditions in agriculture, the decline in the
dollar, a range of Government actions affecting costs and
prices, the re-emergence of some scattered signs of tightening in the labor market and rising business confidence that
market demand will support efforts to strengthen profit
margins through higher prices.
The recent signs of stronger inflationary pressures
and, indeed, our whole experience with inflation in this recovery have pointed up limitations of the traditional aggregate demand policies, including monetary policy, to cope with
inflation by_ themselves without difficult side effects. The
problem arises from the fact that for a variety of reasons,
the wage and price setting mechanisms in this country (and in
other modern industrial economies) seem to be (or to have
become) rather rigid and subject to a substantial amount of
inertia. As a result, once inflation becomes established,
prices and wages seem to respond more to ongoing inflationary


expectations than they do to current demand conditions.
This fact produces a self-sustaining and hard-to-break core
rate of inflation.
Thus changes in nominal aggregate demand in our
economy tend to have relatively little effect on prices in
the short run. This means that policies operating primarily
on aggregate demand such as monetary policy, while absolutely
essential to restore a climate of price stability, cannot .
move very rapidly to contain inflation without excessively
restraining needed real economic expansion. Putting it another
way, it means that aggregate demand policies by themselves can
realistically be expected to reduce inflation only over a long
time horizon without substantial risk of impairing economic
growth. These features of our economy explain why the Federal
Reserve has had to move so gradually over the past three years
in reducing its long-term monetary targets and, to some degree,
why, despite this approach, the actual path of monetary growth
has not in fact been one of steady deceleration. I remain convinced that the Federal Reserve's long-run strategy of gradually reducing monetary growth will be an essential element in
beating the inflation problem, but our experience of the last
three years does clearly raise the question of whether it will
be enough by itself.
It is this very painful situation in which we find
ourselves with regard to inflation and the apparent limitations of traditional tools, coupled with the widespread (and
amply justified) aversion to mandatory wage and price controls
that make it desirable to debate new and as yet untried ideas
such as the TIPs proposal as possible supplements to monetary
and fiscal policy.
At this point, I confess to considerable skepticism
about that approach, and my ideas on exactly what form a possible TIPs approach might best take are by no means fixed. It
is, however, fairly easy to draw up a list of desiderata for
the ideal TIPs plan. Obviously, a TIPs plan should be significant in its quantitative impact, should involve minimal
distortion of the price and wage mechanism's allocative function, should be able to attract widespread support as equitable,
and should involve only moderate administrative problems. My
skepticism reflects the difficulty in devising a program that
successfully embodies all these objectives. On grounds of
administrative simplicity, for example, a TIPs plan aimed at
wages would appear preferable to one aimed at prices or at both
wages and prices. Moreover, such an emphasis on wages would be
justified on the grounds that profit margins are not currently


high and have not themselves been a significant source of
our inflationary problem. On the other hand, it is quite
likely that a plan aimed solely at wages would have difficulty in attracting the support of organized labor (even
though the actual tax were levied on profits) without some
means of assuring that moderation in wages would be matched
by moderation in prices rather than simply by widened profit
margins. But if the result would be an artificial squeeze
on profit margins, prospects for growth and investment would
be stifled. This seems to me indicative of the kind of
political/economic problems that the approach raises.
Similarly, it could be argued that ease of administration would argue for confining TIPs to penalties for
above-target wage (or price) increases since it might be
easier to limit a pure penalty system to a relatively small
number of large firms whereas any "reward" for lower-thantarget increases would probably have to be made available
to all firms meeting the standards. But the inclusion of
both penalties and rewards in a TIPs program would have a
desirable broadening effect on its impact since a penaltyonly program would involve incentives to moderate wage increases only for firms whose increases would have been above
the norm in the absence of TIPs.
I am not suggesting that it will prove impossible
to reconcile these various competing objectives, but they are
obviously problems requiring some satisfactory resolution
before a specific TIPs program could be accepted as workable
and effective. The theoretical value of a satisfactory TIPs
program is that it could facilitate the adjustment of the
economy to a gradually lower rate of inflation though the
use of the traditional monetary and fiscal policy tools while
maintaining acceptable patterns of real growth and employment
in the economy and without major distortions in the allocative
functions of the price mechanisms. I regard the TIPs proposal
as essentially an effort to use tax incentives in conjunction
with the market mechanism to achieve certain effects; it is
neither related to mandatory controls nor to voluntary "social
contract" ideas and is in principle, at least, within the
mainstream of our traditional approaches to economic issues.
Broadly, the problems with TIPs seem to relate to
gaining widespread acceptability for it without introducing
excessive administrative complexity and rigidity. I do not
know whether these problems can be ironed out well enough to
produce a satisfactory program. But I am convinced that the

29-775 O - 78 - 31


bind we find ourselves in with respect to inflation is
serious enough to warrant careful study of the TIPs proposal and I welcome the efforts of your Committee in this
respect. I only hope that the approach in any event, not
be viewed as a panacea that distracts attention from
budgetary problems and the need for prudent monetary policies.

Sincerely yours,

Paul A. Volcker

OO University

Graduate School of Industrial Administration
William Larimer Mellon. Founder

Schenley Park
Pittsburgh, Pennsylvania 15213
578 2283
Allan H. Meltzer
Maurice Falk Professor of
Economics and Social Science

May 17, 1978

Senator William Proxmire
.United States Senate
Committee on Banking, Housing
and Urban Affairs
Washington, D. C. 20510
Dear Senator Proxmire:
I am in receipt of your letter of May 1 inquiring about the
merits of Tax Based Incomes Policies. I am of the opinion that
such policies should not be adopted. Policies of this kind are
based upon the mistaken notion that inflation rises because some
groups raise their prices or wages faster than others. Inflation
is principally an aggregative phenomenon and can be solved only
by aggregative policies.
Let me turn to your questions.

Discussions of special types of inflation are generally
based on the confusion between one-time changes in the
price level and changes in the maintained rate of price
change. Inflation is a maintained rate of increases in
the price level.


No benefit can be obtained through TIP but substantial
distortion of individual wages, prices and taxes can
occur. These will have important allocative effects on
the economy without having very much affect on the
measured rate of price change.




Of course not. Canons of equity require that individuals
receiving the same real income should repay the same taxes.
Tax based incomes policies distort the tax structure.


The Congress should not enact any type of TIP. There
are no safeguards that can prevent the distortion
between workers who receive current versus future
wages, workers who elect to take vacations rather than
money income, workers who receive substantial increases
in their pension or health insurances instead of money
income, etc.

Questions 6, 7, and 9 imply that TIP is to be adopted. I
believe that any policy of this kind is inefficient and inferior
to a general policy of gradual reduction in the budget deficit
and in the rate of monetary growth.

Allan H. Meltzer

Comments on Tax Based Incomes Policies
Frederic S. Mishkin*
Department of Economics
University of Chicago
May 1978

There are several issues that should be raised in a discussion of
Tax Based Incomes Policies (TIP):

Important political issues arise with a TIP program or any other type of
wage-price controls.

Such programs will, for a time, make the inflation

situation appear to be better than it is, because the inflation rate may
be artificially low when the program is in effect, but will jump back up
again as soon as the program is eliminated.

As a result of an illusory

improvement on the inflation front, politicians may be prone to pursue
more expansionary monetary and fiscal policy.

This would lead to a build-up

of inflationary pressures, resulting in a rise in the inflation rate in the

Thus, these programs might even end up worsening the inflation

rather than containing it.

Such a scenario is not unreasonable considering

our experience with the last round of wage and price controls.

A point which cannot be understressed is that inflation can only be killed
by appropriate monetary and fiscal policy.
expansive policy must be doomed to failure.

A TIP program with overly
If an inappropriate full

employment target for unemployment is chosen—and there is substantial
evidence that a four percent unemployment target is far too low—then
our inflation problem will not be solved.

There is absolutely no serious evidence supporting the view that a TIP
program will lower the minimum unemployment rate that is consistent with
price stability.

A TIP program by itself cannot lead to a situation where

full employment is reached at a lower unemployment rate.

Thus, there is

little, if any, support for a TIP program that is permanent.
*The views expressed here are solely those of the author and do not reflect the
opinion of the Department of Economics or the University of Chicago.


Use of a TIP program to combat inflation will not be without c °st to the

First, there might be heavy costs and distortions as a result of

the administrative difficulties of implementing such a program.


Sunley, and Rees have discussed some of these issues in the forthcoming
volume of the Brookings Papers on Economic Activity and are far more
qualified to discuss these administrative difficulties than I.


a TIP program which is administered fairly should not allow firms to
escape TIP penalties (or alternatively get TIP subsidies) by increasing
the proportion of their labor force who are low quality, low wage workers
in order to lower the firm's overall wage bill per worker.

Hence, one

result of a fairly administered TIP program would be the imposition of an
additional distortion on the economy, which is explained below.


industries would want to attract more workers of a given quality by offering
them a higher wage.

These industries would thus be more likely to incur

TIP penalties (or lose TIP subsidies) as a result.

On the other hand,

industries which are experiencing a decline in demand will not want to
attract more workers and would have lower wage increases.

Declining industries

will thus not be as subject to TIP penalties and may even be entitled more
frequently to TIP subsidies.

In a sense, a fairly administered TIP program

will be imposing a heavier tax on expanding industries than on declining
industries, resulting in a shift of resources from expanding to declining

This of course imposes a distortion on the economy which, along

with other distortions created by a TIP program, should be weighed against
the possible benefits of such a program.


American Enterprise Institute for Public Policy Research
1150 Seventeenth Street, N.W., Washington, D.C 20036

May 4, 1978

(202) 862-5800

®& Htf -8 fty Q: QJ

The Honorable
William Proxmire
United States Senator
Chairman of the Committee on Banking,
Housing and Urban Affairs
United States Senate
Washington D.C. 20510
Dear Senator Proxmire:
Thank you for your letter of May 1 in which you ask me for my opinion
concerning policy proposals that have come to be known as TIP, that is,
Tax Based Incomes Policy. In what follows I will briefly express my
(1) The advocates of TIP are motivated by the desire to achieve
by means of taxation and/or subsidization the objectives which others
would want to accomplish by the harmful method of subjecting the wage
and price-setting processes to administrative controls. The objective
to which these proposals are directed is that of preventing cost and
price developments that might lead to continued inflation coupled with
an increasing degree of underutilization--so-called stagflation--when
monetary and fiscal restraint is introduced with the intention of curbing inflation. Attractive though the general idea is as compared to
direct controls, I do not believe TIP programs to be workable.
(2) Before turning to TIP, let me say this: I see no reason
for assuming that, in the absence of incomes policies of any sort, consistent and credible monetary and fiscal restraint, expressing itself
in a gradual reduction of the rate of increase in money GNP, would have
the consequences the advocates of incomes policies fear (stagflation).
A consistent and credible policy of gradual disinflation by monetary
and fiscal means would have a significant effect on price expectations
and thus on money-cost trends. Such a policy could, of course, not make
the economy recessionproof (no policy could), but it would have a very
good chance of avoiding major bumpiness on the road to price stability.
In contrast to this, continued adherence to the policy of accommodating
the underlying inflation rate would be figured out by the markets with
great ease, and it would lead to continued upward flexibility of inflationary expectations. Therefore such a policy would lead to having to
accommodate increasingly high : "underlying" inflation rates in the successive rounds and, after a short while, this would lead to a truly severe recession.
The chances of a consistent and credible policy of monetary-fiscal
disinflation cannot be appraised by examining the experience of the post"
1965 period. In these years the decision makers in the private sector
have had excellent reason to expect that the occasional brief periods of

anti-inflationary restraint will soon be followed by the resumption
of inflationary policies. Under erratic and inflation-biased policies of that sort demand restraint will obviously result in the
contraction of output rather than in the reduction of the steepness
of price expectations and of the cost and the price trend. But this
proves nothing whatever concerning the outlook under a consistent and
credible policy. It does not support the kind of skepticism which
the proponents of incomes policy have concerning reliance on consistent monetary-fiscal policies without the additional measures they favor.
(3) In my appraisal TIP would prove unworkable for at least two
reasons. In terms of basic principles the main reason is that the policy inevitably implies some arbitrary conception of the wage structure,
the price structure, or of both. Setting the same standards for all sectors would come near to a policy of trying to freeze these structures as
of the time when the measure goes into effect, and this is one of many
arbitrary decisions that could reached. If it were reached at that time,
the decision would soon have to be modified. Subsequently the modified
decision would have to be modified again without becoming less arbitrary,
and so on. All these arbitrary structures would get a very low mark for
efficiency as well as for equity.
The other major reason for unworkability is that for a very large
number of important firms it is impossible to ascertain, with the accuracy on which the IRS would have to insist, the rate of wage increase (or
increase in compensation) for the identical kind of labor; and the difficulties are surely no smaller for the prices charged by multiproduct firms.
One surely would not want to penalize firms for changes in their input mix
or in their output mix nor for being unable to carry out mix changes which
differently located firms, or firms in rival industries, are able to carry
out. At the same time one does not wish to induce practices that give merely
the artificial appearance of mix changes. I do not see how any version of
TIP could guard against these unwanted consequences of major importance.
(4) Except for the involvement of the IRS, all these grave disadvantages are shared by mandatory wage and price controls and by euphemistically described equivalents of these. Indeed, such controls have significant
additional disadvantages, and suspicions that we shall once more start experimenting with them is at present one of the major causes of the uncertainty
surrounding business decisions. The advocates of TIP are aware of this, and
they are trying to find an alternative, but in my appraisal their alternative
is not a workable one. I feel convinced that disinflation, as I described
it in (2) above, is the policy we shall have to adopt. While at present
that policy still could be made one of gradualism, it would be much more
difficult to do so after further flare-ups of inflation.
I remain, Senator Proxmire,
Very sincerely yours,

William Fellner
American Enterprise Institute
Sterling Professor of Economics Emeritus,
Yale University

Comments of Alan Greenspan;
Brook ings Panel on Economic Activity

April 21, 1973

£18 IV.Y 12 PM f: |7

I have never been torr ; t ; y persuaded that income policies, if one can generalize
that term, cor. work for ;>ny protracted period of timo, or leave any permanent effect
on the wage J.nd price structure-

Nonetheless, it is clear that the TIP proposals try

to confront sons of the becic problems most 'names po-iiciss have.

Since there is a great deai of incentive, carrot or stick, involved, one would
assume the TIP proposals simulate, in many respects, market processes. Thus, if TIP
were not employed as a substitute for conventional, fiscal and monetary policies,
some anti-inflation impact might bo achieved.

Certainly in the abstract, as a model

of the type developed by Seidman iI'ustrates, it is not difficult to construct fairly
general conditions in which TIP would appear to have some marginal advantage.

The difficulty I have had, and still have, especially after these meetings, is
that, while we can construct a simplified model in which a tax based incomes policy
could work, the abstraction can never fu'ly capture the complexity of a TIP in application.

On this point ! find myself in agreement with Pechman.

we are dealing with a problem in which administration is difficult.

No one questions
But is that

difficulty merely something that could bo overcome with operational experience, or
are we confronted with an issue where the very compiexity of administration itself is
its fatal flaw?

I suspect there is no solution to the administrative problem.

Dlldlne and

Sunley did an excellent job on their paper. However, it strikes me that they barely
scratched the surface of the problems we would confront with a TIP in full scale

They would not be significantly different from the administrative nightmare of
our wage-price control experience following August, 1971. What struck me about that
period was the inconceivable complexity of what the controllers were attempting to
do, firm by firm, product by product, wage by wage, and how the whole thing held
together, largely because the controllers really never attempted to confront market
forces head-on.

There was an accusation at the time that the people who ran the control program
did not have their heart in it and, therefore, the program did not work.
every time they attempted to make the control system work —

In fact,

in the sense of trying

to prevent companies and unions from doing what they would ordinarily do —


program ran into extraordinary problems and, the controllers backed away.

One very Important aspect of Phases Two and Three of the control program to
remember is, that although price and cost data were submitted in tremendous detail,
they were never really audited.

There was no effort to actively administer the

It was de facto a voluntary program characterized by a huge paper flow,

frenetic committee meetings and vague pronouncements.

It was fundamentally wheel-


But, if we were to go to a legal TIP, In any of the versions, legislation would
require auditing and verification of the elements of the system, at least to the same
degree our tax system is audited. This would create an Insurmountable administrative


Litigation would quickly swamp the courts and make TIP politically infea-

sible almost immediately.

That does not mean it may not be tried.

There is a grow-

ing sense of desperation which could easily trigger risk laden policy initiatives.
If the cost of failure of this type of program were zero, or there were only inconveniences associated with it, there would be no reason not to try.

If worse came to

worst, we would end up with an administration mess but with no permanent damage.
However, there are significant costs to every policy failure; and in constructing
policy initiatives, it is essential TO be aware of what happens if the policy initiative goes wrong.

That is certainly true of fiscal and monetary policy.
failed, we would still have in place a control-oriented
political pressures that would emerge to emplcy it.

In the case of TIP, if it

bureaucracy and I fear the

When government in effect says

that certain price or wage relationships are appropriate, and a quasi-voluntary
program fails to induce them, there is very strong political pressure to mandate

If a TIP were put into place, judging from what has happened in the past during
control programs, the participants would very rapidly learn how to beat the system.
Because it would be almost phvsicallv impossible to maintain an appropriate audit of
wages and prices, the extent of avoidance, if not evasion, would become far greater
than anything even remotely contemplated in the income tax system itself.

This could

be quite disruptive to economic policy.

Obviously, to the extent that a TIP program is narrowed and limited, the problems I outlined above are, themselves, narrowed.

Thus, a limited form of "stick"

TIP restricted to wages and to large companies only would, of course, sharply reduce
administrative and auditing requirements.

The requirements would still be voluminous

and wrought with problems, many of them unforeseeable, but it is unlikely that the
system would be swamped by them.

However, to the extent that TIP is narrowed, whatever positive benefits one
would expect to get in theory, would be lost.

A priori it Is very difficult to

effectively judge the tradeoff between administrative simplicity and anti-inflation

My suspicion is, however, that the irrpact on wages from a limited program is
likely to be much too small to be worth implementing such a major initiative in
economic policy.

For even a limited TIP is a big program with large administrative

Unless we have a reasonable expectation of a significant anti-inflation

pay-off, it is difficult to make a case for going ahead with even a limited TIP.

That is not to say I see a simple solution to the current type of chronic inflation.

I am not persuaded we are stuck at a 6% or 1% inflation rate and that the

unwinding which started in 1975 and lasted through late 1976, is necessarily over.

If ?t is, I would be gravely concerned that we might now be running up against
some form of unsuspected capacity restraint.

At this stage it would seem that we

still have the room to continue unwinding the inflationary pressures, provided we
maintain reasonable macro-policies.

I think it is much too soon to throw in the

sponge on macro-policy, especially if we are looking at TIP as the alternative.

This conference has made a great contribution in airing a number of the problems
confronting TIP.

But it may be even more complex than those of us who have been

involved in similar undertakings suspect and, hence, more analysis is needed.
most concerned that we will too easily dismiss the administrative problems.
do, we are in for some very serious policy difficulties.

I am
If we


;-;; (•;.• ! 2 FM 2- 25

May 15, 1978

The Honorable William Proxmire
Chairman, Committee on Banking,
Housing and Urban Affairs
United States Senate
Washington, DC 20510
Dear Senator Proxmire:
Thank you for the invitation to register my views on the efficacy and desirability of "TIP"—Tax Based Incomes Policies. In
general this note follows the format of the questions raised in
your letter of May 1, although on some I have no expertise and
therefore no opinion to offer.
Let me begin by stating that I view "TIP" as only one of a
number of devices whose purpose is to make it possible to achieve
a deceleration in the rate of price inflation by impacting directly
on costs and the supply side of output rather than on the demand
for output, profit margins, and eventually costs. And "TIP" may
not be the most effective such program, although it may well play
an appropriate role in a set of programs designed to reduce costs
and thus prices. As you doubtless know, empirical studies of the
impact of costs on prices suggest that cost changes are dominantly
passed on through into price changes, with the price impact having
some interaction with the strength of product demand.
The following points refer to your specific questions:

Special types of programs such as "TIP" are essential to an effective inflation control policy,
unless one is prepared to pay a very heavy price
in terms of the amount of fiscal and monetary restraint needed to reduce inflationary pressure by
operating solely on the demand side. Lags in adjustment to past increases in prices, lags in contracts,
considerations of equity, and expectations relating
to future costs and prices all mean that the principal
short-run impact of aggregate demand restraint is
on output and employment and not on prices and
costs. It is of course possible that a really severe
set of fiscal and monetary constraints might be able
to ring out inflation much more quickly than is
typically supposed, but we have no direct empirical
evidence (of recent relevance) on that issue.


It is necessary to distinguish benefits gained
through "TIP", and other policies that work on
costs, from benefits gained through conventional
(aggregate demand restraint) types of anti-inflation
programs. The benefit of the cost-focused programs is that they hit directly at cost-push
inflation pressures, which are the ones that tend
to make inflation reduction so difficult. Thus
the benefits from "TIP" and similar programs is
that they have the potential for reducing inflationary pressure without the excessive costs that
seem to be associated with reducing inflation with
conventional policies—those costs being very slow
response, very high cost in terms of real output
forgone, etc. Thus the principal benefit from "TIP"
and related programs is that they have some prospect for producing a deceleration of inflation at
reasonable social costs, while conventional policies
seem to have little effect except at very high
social costs.
The costs of "TIP" and related programs focused on
cost-push are that they are likely to create inequities because of administrative difficulty in
application, and are likely to result in hidden
costs in the form of unforseen side effects which
cannot really be fully ascertained until the program
is actually tried. "TIP" would also be ineffective
in significant areas of the economy (the public
sector, the nonprofit sector) where tax incentives
cannot be applied because taxes are not paid.


I do not have an opinion on the merits of penalty
or rewards approaches, although errors caused
through administrative shortcomings are likely to
be more serious under a penalty system than a reward system—or at least they are likely to be
perceived as more inequitable.
I would not generally try to apply "TIP" or
related systems to prices, but would limit it to
wages. This is largely because the difficulty in
administering a "TIP" system applicable to prices
is much more serious than even the formidable
difficulties involved in applying the system to
wages. Moreover, I am persuaded that the provision
of price-based incentives would be largely redundant to the beneficial effects from applying "TIP"
or similar programs to wages. It is a reasonable
expectation that an effective cost deceleration

program focused on wages will be carried through
into prices without excessive lags.
Since a "TIP" or other cost-control system does
have social costs in the form of administrative
difficulties, inequities, etc., one would not like
to see it installed as a permanent feature of the
American economic system. On the other hand there
is no obvious reason why it could not be seen as
a stand-by device, to be used when the inflation
rate needs to be decelerated and dropped when the
inflation rate has been brought under better control. That would suggest that it be neither temporarily nor permanently installed, but installed
for periods of time when the social benefits of
bringing down inflation rates are high enough to
outweigh the costs.

I doubt that an effective set of Tax Based Incomes
Policies could be devised that would treat everyone
fairly. I would argue that some inequity is inevitable, that the more comprehensive and detailed
the system the less the inequity but the greater
the cost, and quite possibly, the less effective
the policy. Hence I think that one should view
these systems as ones which buy one social good
(deceleration of inflation) by trading it off against
another social good—equity in relative income position.


The principal problems that should be kept in mind
in considering "TIP" proposals seem to me to be
A. As indicated above, "TIP" is only one of a number
of cost-decelerating programs that the Congress might
well wish to consider. "TIP" is usually interpreted
as a system which gives business firms incentives
to hold down rates of wage increase in return for
tax benefits. But the Congress itself has legislated
significant cost-increasing programs, and these could
be modified and/or reversed. For example, recent
payroll tax, agricultural, and trade legislation or
administrative decisions have clear tendencies to push
up the basic inflation rate, rather than cause it to
decelerate. Other people have pointed to a long list
of governmental actions and programs which have the
effect of pushing up costs for the private sector,
and I see no reason why these should not be considered
as candidates for policy change in conjunction with "TIP."

JB. The second principal problem is that a workable
version of "TIP" is almost certainly going to be
less than universally applicable, and therefore
will create inequities. Attempts to expand the
coverage of "TIP" are likely to improve equity, but
to greatly increase its administrative burden and
probably to reduce its overall impact. As indicated
before, I think you have to trade off inflation
deceleration gains resulting from "TIP" and related
programs against some disruptions and inequities.

The comments above suggest that "TIP" is likely to
be more effective if applied in limited areas where
it can be fairly easily administered and where its
effects would be visible. Both those criteria suggest limitations to large firms.


I see no reason not to consider use of the tax system for the implementation of anti-inflation policy.
The tax system is now used for a variety of social
purposes—distributing the cost of public services
among the population, promoting full employment, etc.
If inflation control is an important objective, as
it clearly seems to be, and the tax system can be
used to aid on that front, I see no reason not to
use tax incentives.
The particular problem that this causes is probably
best reflected by the use of the tax system to create
equity in the financing of public goods. Use of the
tax system for anti-inflation purposes will probably
result in some deterioration of equity. As indicated
above, whether that deterioration is worth the antiinflation benefits is a judgment that the Congress
will have to make.


I really have no idea how costly implementation of
"TIP" would be. A program that is content not to be
comprehensive would clearly cost less than an alternative system, one limited to rewards and not penalties would mean less implementation cost (because
you are likely to get less requests for review of
what is seen as an inequitable impact), etc.


I see "TIP" as more attuned to the social contract
notion than to wage and price control ideas. The
attractiveness of the social contract notion is that
a simultaneous decision to lower the rate of increase
in wages and pirces will lead to a lower rate of price
inflation with no one losing out in the process.

But simultaneous agreements like that are difficult to obtain, since everyone is always looking
backwards to the most recent inequity and looking
for an adjustment which brings them back up to
where they ought to be in the wage/price spiral.
That process, coupled with strong expectations of
continuation, constitutes the vicious circle that
either a social contract or a "TIP" policy might
be able to break. Social contract does it by informal agreement without specific financial penalties, while "TIP" achieves something of the same
result by instituting penalties or rewards.
An important dimension of any such program is the
impact that it has on expectations about wage and
price decisions. Evidence of what determines wage
rates indicates that emulation of the wage increases
of others is the most important single factor.
Similarly, price decisions that meet the decisions
of others are not perceived as creating competitive
disadvantages. Thus a policy of decelerating inflation that is widely perceived to be effective will
have far-reaching influences on the wage and price
decisions of people who are not directly affected.
For example, even a "TIP" restricted to large corporations would have an impact on the wage decisions
of everyone else, since it will affect the comparison
base for wage decisions.
I appreciate the opportunity to share these views with the

F. Thomas JiUter
Director, ISR

29-775 O - 7H - 32

Abba P. L e m e r for the Brookings seminar on measures to slow inflation.

I want to discuss not the sons of TIP but what is perhaps a grandson
toward which the TIP family was developing.

It is a Wage Increase Permit

Plan (WIPP) of which I have written briefly in Challenge and Social Research,
Although I considered WIPP more logical, more manageable and more effective
than any of the TIP f s, I said there that I would support some form of TIP
which seemed more likely to be acceptable and implemented.

But the dis-

cussion here has convinced me that the objections to the various TIP's are
much more serious than I had supposed, that most of them would not apply to
WIPP, and that it is not at all so clear that a TIP would indeed be more
likely of acceptance.

I have also been thinking more about WIPP, developing

it further and becoming more fond of it, so I want to restate it.
WIPP is based on a view of the economy on the lines suggested by Perry.
I see our inflation as not due to excess demand (there is more than 5 percent
unemployment), but as the result of self-fulfilling expectations, with prices
rising at about 6% to keep up with cost of production, wages rising at about
9% to keep up with the cost of living and increasing productivity, while the
government keeps increasing total spending in the economy to prevent catastrophic unemployment.

We are caught in a vicious cycle of rising prices,

rising wages, and rising total spending in which none of these can stop because the others are going on.

And yet we are in a new kind of fairly stable

process equilibrium—a 6 percent expectational inflation.


"Stagflation - Its Cause and Cure," Challenge^August 1977 and "From.PreKeynes to Post-Keynea", Social Research Fall, 1977.

This condition of our economy is the result of a flaw in the market

We can learn some very important lessons from the natural history

of another flaw.

During World War II there arose a "shortage" of some

essential items /which led to intolerable price increases.

Poor people were

deprived of vital necessities which rich people were using wastefuily.
The natural history begins with price control.

That leads to black markets

and to arbitrary and discriminatory informal • rationing by shopkeepers.
informal rationing is then replaced by official formal rationing.


This is

still found bothersome and wasteful and is greatly improved by point rationing
under which the same ration points can be used for several substitutes.


come ration points valid for wider ranges of goods which diminishes illegal
trading of rations and ration-tickets.
Michel Kalecki's general rationing.

The final stage takes the form of

This uses just one set of points expressed

in money» which essentially serve only as permits to limit the amount of
money any individual can spend on the "scarce" essential commodities.
As the scarcity abated after the war, the prices of the scarce items fell
so low that the allotted permits (which had had valuable black market prices)
almost permitted the purchase of more than people wanted to buy.

They would

have become redundant and quite worthless, and simply have faded away, but
the whole system was scrapped before this happened so as to provide a more
dramatic (if somewhat synthetic) occasion for celebrating Decontrol.
TIP is a similar development, not quite completed, of procedures for
correcting a flaw in the market mechanism, and most of the objections to
TIP raised at this meeting owe their validity only to the incompleteness of
the correction of the flaw.

The flaw in the present instance is a mutation

of the flaw responsible for the great depression of the 1930's.

That flaw was diagnosed by Keynes, and its cure prescribed, in the
more elementary chapters of his General Theory of Employment Interest and
Money in 1936.

It was the failure of wages to fall far enough and fast

enough, in response to a deficiency in demand for labor, to maintain a
satisfactory level of output and employment, given the level of total

The cure was made easy by the availability of a free variable—

increases on the level of spending.

This could be adjusted to take the

place of the lacking decrease in wages and prices.

It was costless because

of the great scope for continuing government deficits and growth of intranational debt, and the unlimited scope for costless increases in the quantity of money.
The mutation is that wages not merely refuse to fall but keep rising,
caught in a self-fulfilling expectational inflation (however it was initiated).

Governments, and business, seeming to have an incurable pro-

pensity to treat our inflation as if it were due to too much total spending,
hold down total spending as long as prices are rising, but desist from
this when the resulting unemployment threatens to reach double digits.
This is what creates the Stagflation but avoids catastrophic depression.
To deal with this mutation "the simple Keynesian remedy is no longer

The task is now a two-fold one.

It is necessary (1) to

stabilize the average price (the price level), with average wages rising
at the national average productivity increase, and (2) to adjust relative
wages and relative prices to the continuing changes in tastes and techniques.
To do this the vicious cycle must be broken of wages, prices and total
spending all rising,

each having to keep rising because the others are

Stopping any one of them could break the spell.

But stopping

the spending (which the- government could do) only works through catastrophic depression and severe unemployment.

Prices or wages could be regu-

Prices are much more complicated than wages and price regulation is

more easily evaded by quality changes.

The best bet seemed the regulation

of wages, which are already largely administered by collective bargaining
and other large-scale decisions.
In the 19i+0's I developed some rules for wage regulation to achieve
the two objectives, and published them in my Economics of Employment in

Later this was attempted in practice by Wage-Price Guidelines and

Guideposts, which included price regulation for cosmetic political purposes.

Objective (1) was achieved with some success by a freeze of prices

and wages, but it was soon eroded by the regulations for adjusting relative
wages and prices.
This turned out to be an "administrative nightmare", parallel to the
use of price control against the intolerable price increases caused by
World War II "scarcities".

The administrators were unable to handle the

complexities or to deal with the resistances.
trative decision mechanism broke down.

The bureaucratic, adminis-

The task required local decisions

by local people who knew the local conditions, so that something more like
a decentralized market mechanism was called for.
A great step forward was made by Weintraub and Wallich in proposing
such a device in Tax Incentive Plan, TIP.

Weintraub used the analogy to

laws against speeding, laws which people can break if they are prepared to
pay the fine.

The analogy is faulty because a speeding law which succeeded

in keeping everyone below the speed limit would be regarded as successful.

What we need in this case is a rule—if you could call it that—which
would normally and properly be broken half the time.
To fulfill our two-fold task of keeping the average price constant
while leaving individual prices free, we have to keep average wages
rising at a norm equal to the national average rate of productivity increase while leaving individual wage rates free.

For this we need a

discouragement to the granting of wage increases (or an incentive to resist wage increases) that will still permit some wage increases to exceed
the norm by as much as other wage increases fail to reach the norm,
If TIP is adjusted (1) to eliminate all subsidies,

and (2) to pro-

vide equal tax incentives at all levels for equal reductions on the amounts
of wage increase, with no lower or upper limit (no minimum threshold and no
maximum of any kind), it would solve the incentive problem efficiently.
(These are indeed the adjustments I suggested in proposing to yield WIPP
in favor of TIP in my Challenge article, condition (2) is similar to
adjustments suggested by Seidman).

But TIP would still be left with much

of the "litigation nightmare" of unlimited disputes about the appropriateness or the equity of the charges and the subsidies on different situations,
because it is left with the problem of deciding how strong to make the tax-


Subsidies are proposed only because of a confusion of the necessity of
offsetting the effects of taxes on total spending with the desirability
of ameliorating hardships. Hardships apply only to people, not businesses,
and their amelioration calls for income benefits, not changes on prices
or wages. Similarly the word penalty is very unfortunate because it
suggests a punishment imposed for doing something wrong. It is really
more like the proper use of a price, which, as always, discourages people
from buying something because they would rather keep the money for something else, but is not a punishment for any improprieties.
This does not rule out the grants or tax reductions required to increase
total demand so as to offset the effect of the charges in reducing total


It would have corrected only a part of the flaw.

It would have mobilized the essential functions of price in the market
mechanism namely, to discourage whatever activity calls for a price to be
paid and (its mirror image), to encourage whatever enables a price to be

Still missing would be the other half of the market mechanism,

the guide to the free decisions in the social interest by setting the price
at the level which equates supply to demand.

WIPP, unlike TIP, uses the

market mechanism to provide this guide and to adjust the incentive to the
Btrngth required.
The Wage Increase Permit Plan (WIPP), works as follows:
(1) The government grants "Wage Increase Permits" to every employer
who qualifies by employing more than (say) 100 workers—or any workers
whose wages are fixed by an agreement that covers more than (say) 100
workers—one permit for each (say) $1000 of his total costs of employment
(called his Wage-Bill but including all fringe benefits, etc. 3 ).


is kept of his Wage-Bill from a base date, including each employee's Wage
(his pay plus his share of the other costs of employment ) •


"It is now uniformly recognized that payments to common benefits trust
funds providing, pension welfare, vocation and vocation training and
other benefits represent a substantial economic portion of employee
wages" (Statements and REports Adopted by the AFL-CIO Executive Council,
3al Harbour, Florida, February 20-27, 1978, pp. 57-58).


These data are required by the IRS or by the Social Security Administration, with whom the Permit Authority would cooperate. The firm can
allocate its total fringe benefits among the employees any way it likes
as long as the total cost of all the fringe benefits is included in his
Wage Bill.

(2) Newly hired employees (including all employees of new firms) entitle their (qualified) employers to additional permits—also one for each
$1000 of the Wage.

Conversely, on the separation of an employee from a

firm (which includes all the employees of a firm that closes down) the
corresponding number of permits must be returned to the Permit Authority.
This adjusts the total number of permits to changes in the Wage Bill that
are due to changes in employment, not to changes in the wage level.
(3) Each permit gives the employer in possession of it the right (by
raising wage rates) to raise his (adjusted) Wage-Bill by (say) $30 per
annum per permit (3% of the face value of his Permits, 3% being the estimated national average rate of increase in output per employee—"productivity").
(4) The permits are freely tradable on a perfectly competitive marketlike a share of IBM on the stock exchange.

Any employer who wishes to in-

crease his (adjusted) Wage Bill by more than 3% by raising wage rates must
acquire correspondingly more permits. He can obtain them only by buying
them or renting them from others,who have to reduce the increase in their
Wage Bill by the same amount below the 3%.

Any employer who reduces his

wage bill would qualify for a grant of additional permits for the corresponding amount (1

Permit per $30 of Wage Bill cut) which he can sell

or rent out. The national total Wage Bill is thereby always raised by
just 3% per annum by the different firm Wage Bill increases.


Since the

Care would have to be taken to prevent evasion by firing and rehiring
at higher pay so as to get free permits for an "employment increase"
instead of buying permits for what is really a wage increase; and related collusions between firms and unions or among firms to switch
employees for this purpose.

Wage Bill (firm and national), with the corresponding number of permits, is
adjusted for changes in employment, this keeps the national average Wage
rising at 3% per annum.

The price of the permit is set by the market at

the level where supply equals demand, which is where it just offsets the
pressure, powered by the inflationary expectations, for raising wages by
more than

A year later each permit would correspond not to $1000 but to

$1030 of Wage Bill, and there would be a continuing and exponential rise
in the adjusted face values of each permit.

A simplification would be to

103 new, dated, $1000 permits once a year for each 100 old ones

turned in.

The national total number of permits would then keep up with

both components of the National Total Wage Bill;

the volume of employment

and the national average Wage.
WIPP would thus indeed "Whip Inflation Now" by achieving the two
tasks attempted by wage-price regulation.

It would (1) keep the average

wage rising at the same rate as output per man, thus eliminating price
level inflation, and (2) it would leave each particular wage free for
determination by individual or collective bargaining.

All other prices

would be left for such free market determination as ruled before WIP? was

The money paid or recieved for permits would now be just one

more of the many considerations that influence the agreements.
Wage bargaining, individual and collective, could proceed just as before, and the same is true for the setting of prices by the market.


and WIP? do nothing about other market imperfections, restrictive practices,
monopoly, monopsony, cartels, oligopolies, etc.

They do nothing to prevent

monopsonistic exploitation of workers in company towns or to prevent

strong unions from forcing their employees to grant exorbitant wage increases or even from getting the government to pressure the employers to
cave in where a strike threatens to endanger the economy or the health or
safety of the public.

As far as WIPP is concerned no individual wage or

average firm wage or wage increase is "excessive" or "too little."


concerned only with the national average rate of wage increase.
One very important thing that WIPP does do — a n d none of the TIP's
does--is to make the pressure on the employers take the form of forcing
them to buy the required permits from other employers.

The gains from

the pressure is they clearly seem to have to be at the expense of other
workers t (whose employers sell these same permits).
This is the elementary economic lesson that the economic profession
has failed to teach effectively.

Made clear by WIPP's

permits, the

pressure groups will not be able to recruit the support of the victims
of their extortion.

The other workers whose wage increase permits are

being taken away, will be more reluctant to support the.extortion
under the fraudulent slogens of working class soldarity or to honor the
picket lines ,tha,t,are picking their own pockets.
But not this is the basic insufficiency of TIP.

TIP (as modified)

simulates price in using the tax as a uniform incentive for resisting the
pressure for wage increases but it provides no guide to indicate how
strong the tax must be to offset this pressure or to monitor the changes
in the pressure.
If the pressure were fairly stable, one could rely on trial and error.
But the pressure is nothing but the impact of the inflationary expectations.
At present these seem to be about 9% for. average wages and 6% for average


If either TIP or WIP? is applied, these expectations and the

consequent pressures would decrease, and the incentives would have to be

Legislative and administrative adjustment of the taxes are

much too slow.

They would work like legislative or administrative de-

cisions required to change the price of IBM on the stock exchange.
In speaking of WIPP as "Internalization the Inflation externality,"
I was shortchanging it.

The adjusted TIP also iternalizes it, but the

"legislative nightmare"—-though diminished by making the TIP tax uniform,
can be exorcised only by WIPP'a completion of the correction of the flaw
in the market mechanism.
"Internalization" is borrowed from Pollution Theory, where Pollution
Permits are an improvement on earlier anti-pollution cries like "prohibit
it" or "limit it".

But modern economists, prodded by Coase, understand

that government fixing a price for a permit to pollute is justified only
if a proper market cannot be established.
If it can, which requires the defining of a previously undefined, or
inadequately defined, property right and the settlement of clear ownership, there is no longer a "pollution problem."
scarce commodity on the market.

There is just one more

The externality has not merely been in-

ternalized by a charge, tax or permit and turned into a cost at a level
decided by an administrative or, as here, by a legislative authority.
Something more has been done.

It has been made to reflect the value of

the damage as indicated on the market by the damaged party.

The full-blown

market mechanism now serves as a guide to the proper intensity of the

No litigation is called for.

The market determines the correct

Clarification of property rights is the euthanasia of litigation.

This completion of the corrections of the flaw corresponds to
Kaleckis general rationing, which prevents the rich from wasting the necessities of the poor, plus its missing crowing perfection - making the
general ration points legally tradeable.
WIPP thus automatically adjusts the wage increase permit price to the
level of the current self-fulfilling inflationary expectations.

As it

offsets the expectation of inflation, it diminishes the inflationary wage
increase, the cost increase and the price increase.

This decrease in

actual inflation reduces expectation of further inflation and this decreases
further actual wage-, cost- and price-inflation.
ally deflated.

The inflation is automatic-

The self-fulfilling expectational inflation becomes self-

Since the power of WIPP lies in the price of the permit, and the permit
price is equated in the market to the pressure of the inflationary expectations, and the inflationary expectations rests on the experience of actual
inflation, the price of the permit and the power of WIPP run down parallel
with the inflation.

In making the inflation self-liquidating WIPP also makes

itself automatically self-liquidating.
The falling of the WIPP permit price to zero, when the inflationary
pressure, the inflation and WIPP itself are all liquidated, corresponds of
course to the eroding of the "scarcity" and the consequent fading away of
the general rationing permits.
My yielding WIPP to TIP was partly due to the belief that WIPP would
seem to too many people a wild-eyed revolutionary dream too good to be

But it is indeed a most conservative device that is operating under

our eyes a million times a day.

It leaves each one of the large number of

quantities of some item unregulated—for free determination by a large
number of people concerned with it—while the average of all these
quantities stays fixed.

What makes WIPP seem strange is only that the

item is a new one and has not been treated in this overwhelmingly familiar
way in the past.
One example of the familiar miracle will suffice.

The number of

oranges per consumer is freely chosen by him when he takes the equilibrium
price into consideration.

This price, reached by the market, automatically

makes the average number of oranges demanded per consumer just equal to
the average number available per consumer because the total numer demanded
is equal to the total number supplied.
For this miracle to work, society, at one time, had to decide to make
the ownership of oranges a legal property right of individuals.


undoubtedly was an impious, revolutionary and "antisocial" idea when first
suggested to the head of an unindividualized tribe.
The new property right that needs to be created unfortunately is very
different from an orange.

It is the right of an employer to raise his

Wage Bill and thus his average Wage.

The property right comes in units

of $30, its ownership registered by the possession of one $1000 permit.
Its (uniform) price and its annual rental is determined by supply and demand
in the market on which the permits (rights ) are freely bought and sold
borrowed and loaned.

This corrects the flaw in the market mechanism to

which our inflation is due.


Let me conclude by touching briefly on a few questions about WIPP and TIP
that have been raised here and elsewhere.
(1) The relatively stable 6% per annum price inflation that we have experienced in the last few years has as much right to be called an equilibrium
state as the Keynesian unemployment equilibrium with stable wages.

This may

seem strange to those who have learned from the textbook that price rises only
when there is excess demand - not in equilibrium, when demand is equal to

But that rule relies on a hidden (perhaps unnoticed) assumption that

stable prices had been expected.

It is only a special case of a more general

The more general rule says that if there is excess demand, the previous

expectation is raised and price will rise faster than had been expected.


the special case where the expectation of price rise was zero, excess demand
would cause price to rise faster than zero, and the words "faster than zero"
were omitted as understood.

After all, rising seems to mean rising faster than

If, however, the expectation was not a zero price rise but a 6% price rise,
then an excess demand, which always makes price rise more than expected, would
now make price rise at more than 6%.

Demand equal to supply, with no disappointed

buyers or sellers, would mean no change but again it means no change in the expectation, i.e. a confirmation of the previous expectations and a continuing of
the equilibrium 6% rate of price inflation.

This equilibrium is the vicious cycle

that TIP and WIPP have to break.
(2) The strategy of TIP and WIPP is to put a price on the granting of wage
increases (over and above the actual wage increases) that would make inflationary
wage increases too expensive.

The use of expressions like "penalty" instead of

price, or charge, is responsible for proposals of progressive punishment for more
heinous "crimes" in the form of more than proportional charges for larger wage


But price does its work properly only if the total paid is propor-

tional to the amount bought, and this also applies to the price paid for granting a wage increase.

More recent estimates have reduced the rate of increase of output per

man from 3% to 2%.

I think this is partly a reflection of the state of depre-

sion in our stagflation in which output declines in a larger proportion than
employment, so that the figure would return to the previous 3% or so if TIP or
WIPP succeeds in conquering the stagflation.

The reduction may also be due in

part to more of our resources going to produce benefits which do not appear in
the measure of output—such as improvement of the environment for which only
the costs are shown in the figures for output per man.
However, it will not make very much difference whether the figure adopted
is 3% or 2% or 4%.

Any one of these will give a stable rate of inflation be-

tween +1% and - 1 % and none of the serious inflation or stagflation problems.
There have also been suggestions that instead of setting the wage increase
norm at the final goal of 3% (or 2%, or 4%) one should only gradually lower it
from the current 9% to reach the final figure only after a number of years.. One
reason given for this is that a sudden end to the inflation would give an unfair advantage to those whose wages have recently been raised at the inflationary rate of around 9% as compared to those who have been waiting a year or two
for their raise when the imposition of TIP or WIPP will reduce theirs to around

But to continue Stagflation for years in order to soften this effect seems

much to expensive a way.

It is easier and far less expensive to give even the

most generous compensation to those who feel they may have been harmed by the
sudden and unexpected end to the inflation.
More importantly, a gradual reduction in the rate of inflation is bound to be

obscured from time to time by incidental increases and decreases in cost due
to changes in circumstance.

These would hide the effect of the TIP or WIPP

only temporarily, but could easily lead to feelings that the inflation is not
being reduced by the Plan and it would be dismantled before it had finished
the job.

There can be no real distinction between incentives to employers to

increase their resistence to wage increases and incentives to workers to
reduce their pressure for wage increases.
same tax on the same transaction.

In either case the incentive is the

The remaining issue in all the TIP's is who

should pay the tax and who should get it (as "grant").

This is the source of

the "litigational nightmare".

WIPP solves this problem in its allocation


the property rights involved.

The "tax" is paid by those who buy or rent the

permits and the "revenue" is received by the sellers or lenders of the permits.
A clear title to the property rights eliminates this litigation.

Cutting excise taxes, or any other taxes that enter into cost, would

reduce costs and the price level.

So also will any reductions of monopolistic

restrictions or of restrictions on imports.

There are excellent reasons for

such measures to increase economic efficiency,but they do not touch the core of
our inflationary process.

They lower the level of prices, but only once.


do nothing to prevent the continuing and exponential inflationary trend from
continuing to rise and soon more than make up for the one-time drop.


windfalls could affect the inflationary trend only if there were a serendipitous succession of them which flatten out the actual average price movement for
a period long enough to establish expectations of further stability.


such expectations would have to be based on unwarranted anticipations of continuing windfalls, they could establish a self-fulfilling expectation of stability -

a zero rate of self-fulfilling expectational inflation - but such a happy concatenation of windfalls is not to be relied upon.

If we have an efficient TIP, i.e. one with the same incentives (tax

or grant deduction) to hold down wage increases at all levels, the basic grant
(before the deductions) would have to be equal to the sume of the taxes and the
deductions, so that the remaining part of the grant would just counterbalance
the deflationary effect of the taxes.

If the grant is given only to the workers

who get wage increases less than the norm (as seems to be implied in Seidman's
"carrot (and stick)" to induce workers to moderate their wage increase demands
so as to reduce the "stick" - the deductions from the grants, we have a problem.
The grants would amount to twice the total deductions.

Some way would have to

be found to prevent workers from doing anything at all to qualify for some of
the grant or to prevent themselves from being disqualified.

Otherwise, the

grant would no longer be "lump sum" - i.e. independent of the wage increase.

It would not be possible for departments of government to compete with

private industry for permits to raise the wages of their employees.

This is

because the decision between public and private economic activity is a political
one and cannot be left to the free market.
valid within the government sector.

However, the same principles are

There would therefore have to be a separate

set of government wage increase permits which operate within the government

This would check the inflation of government wages while permiting the

different departments to compete with each other for employees.

It would also

yield the same demonstration that wage increases by any department would have to
come at the expense of wages in the other departments from which the government

29-775 O - 78 - 33

wage increase permits must come.
To have the same permits for government and for private industry would impose
too great a pressure on the government to expand the budget in response to an
increased price of permits and would result in an unconsidered shift from private industry with its limited budgets to the government with its elastic budget.
(8) WIPP does not induce any shift from employing higher paid labor to lower
paid labor.

I would not consider it an objection if it did.

As long as there

is greater unemployment among low wage workers such a shift would be socially
most desirable (though full employment is of course much better).
employment the effect would be to reduce income
socially desirable.

With full

inequalities and this too is

It is not even certain that efficiency would be sacrificed

to equity in this case. Higher earnings are largely not rewards for investment in training but the result of privileged opportunities from ones parents
in education, money, connections, and good advice or just good luck in chance
Anyway, the complaint is not valid, and any of the benefits just mentioned
should be pursued directly.

WIPP does not cause such a shift because the per-

mits are proportional to the wages and the charges for wage increases are proportional to the wage increases.

Relative costs are unaffected.

The complaint does hold for TIPs with upper or lower limits to the range
requiring wage increase subject to

the incentives, or with different rates

of charge at different levels of the firm's average wage.
(9) WIPP will not add to average cost to be passed on in additional price
increases because the increase in cost to those who buy permits . is exactly
balanced by the decrease in cost to whose who sell the permits; and in any
balanced TIP the taxes which add to cost must be balanced by the offsetting

grants which do the reverse.

There remain only what effects there are in the

reduction of the cost due to the reduction in the wages paid.

A frequent objection is that the price of the permits would be too

high for practical purposes.

It cannot be "too high".

The price cannot be

higher than what the buyers are willing to pay!
Frightening figures are obtained by counting the capital value of a permit
(which would allow wage increases to be paid forever), and assuming that the inflationary pressure would last forever.
current cost of the renting of a

The appropriate measure is the

permit for a year, and that depends on the

current inflationary pressure which WIPP will reduce and eliminate.
The permits could also be used to work in the reverse direction if there
should ever arise again a self-fulfilling expectation of falling average prices
and wages, such as we had in the 1930's.

We would then need an incentive against

decreases in wages, and a requirement of permits for raising the Wage Bill less
than the 3 percent required for price stability (and of course of still more
such permits for actually lowering the Wage Bill).

This would have served to

cure the self-fulfilling deflation of the 1930's it could be what was being
groped for in the pre-New Deal NIRA attempts to_raise prices—e.g. by."Blue Eagle"
appeals to patriotism and ideology or by raising the price of gold.

I have come across concern that there would be speculation and

hoarding of permits.

I can see no harm in speculation, but if it should be

felt desirable to prevent fluctuations in the price of the permits

in order

to make it easier for firms to plan, it would be possible for the government
to engage in "counterspeculation"—buying and selling permits in pegging
their price at what it would guess to be a longer period equilibrium price.
The problems here are identical with those of fixing the rate of foreign


(The concept of "counterspeculation" is developed in my books

Economics of Control (1944) and Flation (1971).

Here as in the case of

exchangesfI think the argument for a free market price is the most

convincing one.
There is no "hoarding" problem. Any permits purchased for speculative
permits would be loaned out and still perform their function.

The owner of a

permit can gain nothing by holding it unused.
(12) WIPP does require monitoring, to see that there is no cheating. This has been
considered equivalent to the problem of monitoring compliance with the wage
and price regulations of the guidelines and guideposts.

However, in that case

what had to be checked for compliance were the innumerable prices of different
products as well as the different wages, to see if they are following the
guidelines, with all the problems of checking quality of products and grades
of labor.

None of these apply to WIPP.

There is only the problem seeing

that people do not claim to have permits which they do not have or give false
wage statements.

These involve only the detection of fraud.

They do not seem

to be different in kind or volume than those which are currently being handled
by the IRS in connection with auditing the income tax.

WIPP does not require any calculations by anyone of any average wage,

classified or unclassified (although the information required for monitoring TIP,
and for the IRS and for Social Security, do provide data for compiling statistics of any kind of average wage in which anybody might be interested).

It is certain that WIPP and most forms of TIP would be denounced as

anti-labor because they regulate wages and not prices.

Workers might fear that

holding down wages would not result in a corresponding holding down of prices
so that real wages could fall.

The government could alleviate such fears by a

guarantee to compensate all employees for the average real wage falling, or
even failing to increase by a considerable amount.
little risk in this for the government.

There would be

If in fact there should be an increase

in the mark-up, so that real wages would increase by less than the increase in
productivity, enormous profits would have been made on which the government
could collect very high taxes.
The proposal to win the workers' support by the government granting them an
initial tax rebate equal


the wage increase which is prevented by TIP or

WIPP (giving them such a guarantee in advance, as it were) is most inadvisable.
It would give the workers a large increase in real income.

The pay raise, based

on anticipated inflation, would be used to buy goods at the disinflated prices.
It would pre-empt a major part of the benefits from the possible increase in
output coming from the success in combatting the depression.

Although it would

be worth paying this for the sake of getting the future benefits, there is the
danger that it would establish a precedent for the workers to expect to continue
to get more than the economy provides for them in wages, and it could turn into
a permanent and economically devastating subsidy to wages entailing heavy
taxation and drastic reductions as government services to prevent demand inflation.

It is frequently implied, and occasionally even actually stated ex-

plicitly, that the workers must ideally want the inflation or else they would
not insist on the pay increases which are responsible for it.

But even if it

were conceded that all the owrkers are very good economists and understand
this, it does not follow that they want the result.
to raise wages in general.

wage of their particular group.

No workers are deciding

They only decide to push for the increase in the
The purpose of TIP and the primary purpose of

WIPP is to internalize the externality by putting into the particular pay enverlope the effects of the wage increase decision on the economy as a whole.


say that the workers make the particular demands because they desire the
collective result is similar to saying that the people who individually rush
toward an exit in the case of a fire in a theatre, knowing that if they all
do this the exits would be blocked and would all collectively perish in the
fire;must be desirous of this result or else they would not rush towards
the exits.



May 16, 1978

The Honorable William Proxmire
Committee on Banking, Housing, and Urban Affairs
United States Senate
Washington, D.C. 20510
Dear Mr. Chairman:
Thank you for your letter of May 1, 1978,
with enclosed tentative witness list for hearings
scheduled by your Committee for May 22 and 23,
requesting a submission of views on the subject of
the hearings - new anti-inflation programs such
as TIP (Tax-Based Incomes Policies),
The enclosed memorandum has been prepared
in response to your request. The discussion in the
memorandum is organized under headings which
correspond to the nine questions posed in your
letter for purposes of eliciting a comprehensive
range of views for the hearing record on this
important area of public policy.
I appreciate the opportunity to submit
this material for the use of the Committee and
others assisting them in the examination and
analysis of constructive new policy approaches
to the role of taxation in anti-inflation programs.
With best wishes,


Memorandum for the Hon. William Proxmire
Chairman, Committee on Banking, Housing, and Urban Affairs
United States Senate
Subject: Questions and issues raised by "TIP" (Tax-Based Incomes
From* Richard E. SIitor
9000 Burning Tree Road
Bethesda, Maryland 20034
This memorandum is submitted in response to your request
for views for inclusion in the hearing record on TIP. The
discussion of TIP and its merits as an anti-inflation program
is presented here under a number of headings reflecting specific
economic, technical, and policy areas in which the Committee
is understood to want a variety of views from those who have
given particular study to inflation and taxation.
1. Type of inflation to which TIP is addressed
Various types of inflation and combinations thereof have
figured in the inflationary developments and public discussions
of the problem in recent years. These include the familiar
classic quantity theory focussing on money supply, the
Keynesian aggregate demand pull concept, the cost push process,
and various sometimes related structural, bottleneck, and
wage-price ratchet-effect concepts. Let me state briefly the
interpretation of the current inflation problem to which
I believe TIP is appropriately directed.
TIP is not designed to cope with an inflation problem
stemming from a gross overexpansion of the money supply
in relation to supplies of goods and services or in relation
to credit needs or the amount of money work to be done.
TIP is not, in other words, a form of disguised direct
control of the type almost conventionally relied upon in war or
similar severe emergencies to suppress the powerful impact on
the wage-price structure of huge deficit spending, monetary
expansion, and the diversion of supplies of goods, services,
and productive factors to national uses.
TIP is effectively designed for conditions like those
which have materialized in the American economy in which
expansionary and supportive fiscal and monetary policies
intended to maintain and bolster the level of economic activity
and increase employment have been absorbed and consequently
frustrated in part because money wages and other labor
compensation and therefore costs have outpaced productivity.
These conditions have led into what is simplistically
described as cost-push inflation. Whatever its origins, some
of which will be discussed in a moment, this process is centered
in the large corporate sector of the economy, where a few
giant or near-giant firms with entrenched oligopoly positions
and reserve market power have engaged in periodic inflationary
wage settlements with powerful unions. The participants in

these confrontations hold differing views as to which a given
compensation increase would merely reflect productivity or
past price and profit increases or would have to be translated
into new rounds of price increase by employers. In actuality,
however, whatever the relative timing of the wage-cost and
price increase cycles, the stakes in these confrontations have
been not so much the sharing of rewards between capital and labor
as the wresting of income shares away from labor and consumers
in general by the strategically stronger organizations of both labor and business - in position to exploit their
economic power.
From the centrum of big business and big labor, the
wage-cost-price inflation process is propagated into other
other areas, including government.
One can sympathize fully with the goal of labor to get and
protect its fair share and the response of business to maintain
profits by passing on substantial cost increases to customers.
But more than the direct distributional effects of the interplay
of wages and prices is involved. The efficacy of macroeconomic
policies to cope with unemployment and lagging economic
progress is weakened. Additional spending by government and
by beneficiaries of liberalized credit and fiscal policies
is partially at least squandered on the support of inflationary
price increases. More and more is spent on higher prices for
the same flow of goods and services and higher wages for the
same volume of production by already employed people. A pervasive
side effect is the not-so-creeping expropriation of fixed
dollar savings and incomes that are not adjusted to the
continuing process of inflation. At some early stage,
monetary and fiscal policies dedicated to aiding employment and
production hesitate in the face of the employment-inflation
dilemma and in the light of traditional counsels to go slow in
the shadow of accelerating trends. Complacency over a chronic
low annual rate of price rise gives way to reasonable concern
that the process will get out of hand. After all, there is even
the possibility that fueled and accommodated by fiscal and
monetary concessions the process of inflation may destroy
real purchasing power as fast as it is created.
There are other aspects of the present inflation problem
that need to be mentioned. One of the basic realities that
monetary and fiscal policy must take into account is the
hierarchy of ernployability. The existence of what has been
termed hard core unemployment is only one aspect of the
range of labor differences reflecting variations in energy, character,
skill, intelligence, connections, and plain likeability. Monetary
and fiscal expansion to absorb the unemployed and upgrade the
conditions of the Jowly almost inevitably spill over into
greater demand for the services of those better placed in
the hierarchy of employability. Their compensation is bid up
or pushed up contributing to the spiral centered in the big wage

settlements. This side process absorbs purchasing power
intended to expand employment. The unemployed and the less
strategically placed in the employability hierarchy may be
left out or benefit little. The unemployment, welfare, and
other benefits paid them to assuage the social conscience
may have some adverse effect on the process of getting them
back on board and on the effort to absorb the new supplies of
skill and talent that flow into the economy each year.
Another aspect of the present inflation process is the
inertial force, the perseverative or repetitive features of
the spiral - reinforced by self-fulfilling expectations.
Wages chase prices, and price increases are triggered and
justified by wage rises. Fiscal and monetary policies become
chained to the chariot of the perseverative process.
TIP can make a contribution in dealing with all these aspects.
TIP is designed to help decelerate the process of wage determination
in excess of any reasonable productivity increase standard.
It also increases the attractiveness of labor receiving no more
than productivity-based wage increases relative to those
elements in the labor force that are already in good demand
or strongly placed in the system to obtain greater compensation
TIP would also serve to deal with the inertial process.
It would apply tangible braking incentives and symbolize the
national recognition that the present spiral is an evil, that
it requires remedial attention, and that the imposition of a
tax reflecting the social costs which the economy as a whole must
bear as a result of excessive wage-cost settlements is a
restraining instrument that will help forestall an elaborate
system of controls toward which the economy may be headed if the
present deteriorative process is not treated and slowed.
2. Benefits and costs of TIP
The benefits gained from TIP as against other types of
anti-inflation programs are tangible and substantial. It avoids
the increase in unemployment and decline in output which would
result from resort to traditional restrictive fiscal and
monetary approaches which buy price stability or a measure
thereof at the cost of jobs, waste of economic potential,
social disarrangements, and discredit to the free enterprise
system. Under the conditions which have developed in the
American economy, it. can be argued very plausibly that moderate
restrictionism previously practiced when inflationary trends
threatened would now fail to curb and might even exacerbate
rising prices even though employment suffered.
It is more difficult to compare TIP with voluntary approaches,
including jawboning and broad social contract types of
voluntarism. The evaluation of the prospects of the latter
approaches under present circumstances is bound to be subjective.

When the forces of inflation are as strong and persistent
as experience of recent years has demonstrated, it is difficult
to place great faith in the various versions of jawboning,
which have a history of ineffectiveness. Only a more substantial
coming together of labor, business, and government in a serious,
good-faith compact to adhere to real restraints, under the pressure
of alert, aroused public opinion, could escape the label of
As compared with a wage-price freeze or more elaborate
direct control systems, TIP enjoys the advantage of being
more flexible. The application of a substantial economic incentive
to restrain wage and cost increases moves firmly toward the
objective of deceleration of the wage-price spiral, but it avoids
absolute prohibitions which tend to be effective only for
an emergency period and which soon tend to call for numerous
modifications, exceptions, relief features, and similar
adaptations - some of doubtful equity and all dependent upon
the operation of a complex bureaucratic machinery. In contrast
with the direct control approach, TIP permits the parties to
wage settlements to decide in the light of the TIP tax incentive
structure whether it is worthwhile exceeding the anti-inflation
guideline. In short, it provides incentives rather than an
all-or-none, rigid, regulatory standard, which draws hard and fast
limits. The elasticity of the TIP approach within the framework
of the free market system is the key to its superiority over
control alternatives. Such an elastic approach should be as
effective as controls in bringing a halt to the destructive
process of repeated rounds of "wage-price inflation and would
accomplish the result without the abrupt confrontation of
rival economic interests over the question of who stands to
gain more from the constellation of wages-costs-prices at
the moment the anti-inf3ation system goes into effect.
Both the administrative-compliance and the econc.uic-impact
costs of TIP would be relatively low. The administrative
costs of an effective program can be kept very low, as discussed
under a later heading of this memorandum. The departure from
the free market system would be insignificant, an appreciable advantage
over the direct control alternative.
In certain situations TIP may have the effect of moderating
wage increases of the type called for by particular labor shortages
due to redirections of economic demand and activity. This might
slow the process of resource reallocation to meet the new
conditions. Even in such situations, where there may seem to be
an allocative inefficiency, TIP would tend to have the salutary
effect of putting some pressure on hirers of labor in the
expanding area of the economy to utilize labor resources which
are more abundant, possibly unemployed and needing some training
and exporienco which would cost less than the payment of aboveguidelino compensation to bid the scarce labor away from existing
Whatever costs are entailed in the slower adjustment and
substitution processes just described are counterbalanced by

by the gain in terms of overall stability of the economy
as well as the better employment opportunities for the
substitute labor. The stabilization contribution of TIP in this
kind of adjustment can be real in an economy in which vages
and costs in economic sectors in which demand may recede do not
decrease owing to the floor or ratchet restraints that characterize
the system. Thus, pressure of greater demand in one area creates
bottleneck efects without wage and price offsets elsewhere, so that
the "local" pressure becomes tantamount to some measure of
overall wage-price inflation.
3. Penalty versus rewards approach to TIP and other options
The design options reviewed under this heading have been
explored elsewhere recently, notably in the Brookings
Institution panel meetings on the subject of TIP, April 20-21, 1978.
Consequently, my comments on these matters are brief.
Rewards approach calls for universality of application of TIP
A major drawback of the rewards approach is that its
desired contribution to the palatability and "saleability" of
a TIP program is more than offset by the fact that it almost
necessarily requires that the availability of the TIP reward for
non-inflationary behavior be made universal. Thus the coverage
of the program would include all corporations large and small,
sole proprietorships, and partnerships. Possibly other
employer organizations which pay some form of tax on income
would press for entrance. No one would very willingly consent
to be left out of a special tax reduction program for which
a large number, probably the vast majority, would almost
automatically qualify. Nevertheless, all would have to be
made subject to compliance requirements, with corresponding
processing of returns by the government.
By contrast, the penalty approach may be applied to limited
economic sectors that play a key role in the wage level
determination process, with simplifying exemptions for
small companies and unincorporated business.
Apart from the obvious revenue consequences of the rewards
as against the penalty approach, there are other design problems
and dilemmas in the rewards method, such as the commitment to
two tax levels for all business sectors, with a differential
between conformers and non-conformers which would be somewhat
difficult to make consistent as between corporate and non-corporate
business and which would have to be built into the tax structure
from one revision episode to another.
Waqes-TIP versus prices-TIP
The consensus among economists seems to be that a wages-TIP
is administratively practicable, especially if confined to the
large corporation group, but a prices-TIP would probably have
to take the form of a tax related to some form of profit margin
behavior or limitation, the definition of which would involve
some sub-options. I am inclined to agree with that consensus.
The prospects of administering a prices-TIP involving the
application of individual business price index calculations
would be too formidable.

If a tandem wages-TIP and prices-TIP system were to be
implemented in order to provide a balanced package acceptable
to both business and labor, it would seem likely that the
profit margin approach would need to be followed with relaxed
profit margin concepts in the interest of economic and
administrative workability.
Limited period versus "permanent" TIP program
If it is to be effective, TIP should not be viewed as
a temporary or one-shot initiative. If introduced as a
temporary restraining measure, it would invite a very
temporary suspension of the wage-price spiral, during which
preparations and negotiations could be carried on looking
toward the post-TIP relaxation and resumption of the
faniliar rounds of inflation.
The pressures of macroeconomic stimulation of growth and
employment, the security which a high employment commitment
by the Federal government offers to organized labor, and the
persisting condition of upwards flexibility, downside floor or
ratchet support for industrial wages and prices - all these
factors - suggest the need for adding a TIP instrument to the
armory of economic policy for growth and progress with reasonable
The potentiality for spiralling inflation, chiefly of the
cost-push variety, is present where economic stimulation for
progress and high employment is a must, and the tone of the
wage-price structure is set by a continuing confrontation between
big business and big labor, with government, consumers,
unescalated passive income recipients, small and moderate-size
business, and farmers all called upon in some degree to
pick up the tab.
4. Is universal fairness under TIP a realistic goal?
The fairness of the treatment of individuals, businesses, and
economic interest groups under TIP may be judged by varying sets
of standards. Cne set of standards applies tax equity criteria.
Another, broader set relates to TIP in terms of its broad social
and economic policy effects and implications.
Particularly as judged by tax equity standards, TIP presents
three specific issues:
- the fairness of the base or starting-point wage from
which increases are measured
- the fairness of interfering with the worker's
ability to extract and the employer*s willingness to
pay above-guideline compensation, either by
collective bargaining or individual wage negotiation
- the ultimate incidence or burden of the TIP tax: does
it get paid ultimately by the worker, the employer,
or the consumer?
Even within the relatively narrow view of tax equity standards
TIP would compare favorably with tax measures such as the excess

profits tax, which has been found necessary for economic
stabilization and public morale purposes in several past periods
of war and related public finance and inflation emergencies.
Another analogy is the interest equalization tax of 1963-74,
the equity and rationale of which was supported in terms of
the defense of the international balance of payments. In concept
and spirit, TIP is also analogous to taxes on pollution which
internalize the social costs or adverse "externalities" of
pollution-causing activities which are not reflected in the
marketplace - measures which have been actively discussed and
in some cases employed here and abroad. Inflationary behavior
at the expense of the stability of the whole economy and the welfare
of millions of people outside the direct ambit of the particular
wage settlement is an especially dangerous form of economicenvironmental pollution. It hurts nearly everybody. Its
clean-up costs for the various levels of government are great,
and the costs to society which are not cleaned up because they
are beyond the corrective power of government possible greater.
This country has a lengthy history and tradition of sumptuary,
regulatory, and user charge taxation - typically in the form
of excise taxation designed to discourage, restrain, or assist
in the regulation of manufacture, use, or consumption of items
which are unwholesome, dangerous, or deemed socially undesirable.
The basic rationale and equity of this tax approach are generally
accepted. They may be rejected by an extremist few whose philosophy
is: Anything goes!
There are indeed those who do not wish to resist inflation
by TIP or any other means. They even express the viewpoint that
inflation may be regarded as fair - a legitimate instrument of
national policy. They invert the traditional view that inflation
is the cruelest, most disorderly form of taxation so that it
becomes: Inflation on a systematic basis is a logical extension
of ordinary tax financing that serves to commandeer resources
and carry out purposes that are important for government but not
important enough to the electorate to win support for straightforward
tax financing. Without attempting to examine the motives for this
extremist view, it is necessary to point out that much if not most
of the current inflation - being of the cost-push, inertial process
variety - does not serve as an extension of public finance by taxation.
It represents essentially a redistributive process that helps
the strong and alert to the detriment of the less favorcid; it weakens
government and complicates its tasks, in spite of some illusory,
short-lived gains.
Like any tax which measures an excess over a prior or base
period figure, TIP may involve adjustments for potential inequities
such as initially low compensation or initial catch-up wage
settlements. Since TIP would apply each year to excessive
compensation increases over the prior year, and the tax applicable
to any one year's excess would presumably not be of indefinite
duration, impacts on on a particular year's abnormality and
resulting inequity would be limited. In this regard, TIP would

compare favorably with arbitrary wage freeze and control approaches,
particularly since TIP does not seek rigid control or determination
of compensation levels or adjustments but merely applies a tax
incentive designed to moderate abrupt, inflationary increases
and make them pay for the social costs they entail if they occur
in spite of the tax deterrent.
If the application of TIP to substandard or other low wage
areas is deemed unfair or inappropriate, an exemption might
be provided for excessive average wage increases for a firm
to the extent attributable to very low wage adjustments.
5. Problems and safeguards
Since I have written extensively elsewhere on the design
problems of a TIP program, particularly of the Wallich-Weintraub
type, and these materials are available to the Committee, my
comments on these aspects here will be brief. Apart from the
question of coverage, these aspects include definition of the TIP
taxpayer or TIP accounting unit, comprehensive definition of
compensation for TIP purposes, the mode of applying the tax,
the calculation of average rates of compensation increase or
equivalent index procedures, and assorted problems of avoidance
and hardship relief.
Two specific suggestions are offered here:
a. The design should avoid excessive cost-of-living (COLA)
supplements to the basic productivity component of the
TIP guideline standard. The purpose of TIP is not to
"exonerate" all COLA adjustments. It is to decelerate
the wage-price spiral until COLA adjustments are no
longer necessary. Some COLA may be necessary initially
to supplement the true productivity factor (probably
in the vicinity of 3 percent), but it should be moderate
at the start and should be phased out on a relatively
short time schedule. Too great or prolonged a COLA
factor would erode the effectiveness of TIP.
b. The design should avoid morale-weakening special
concessions to highly compensated elements in the
labor market, including executives, highly skilled,
and highly organized or strategically placed labor
elements. TIP should apply equally and with significant
incentive force to all elements, particularly those
affecting largo and critical segments of the price structure.
6. Coverage
The most critical area for the application of TIP
deceleration incentive is the large corporate industrial sector.
Here compensation determinations tend to be pushed upward
by reliance upon oligopoly-typo pricing power of the employer and
a similar type of market power of the employee organization.
Here also inflationary compensation arrangements ramify throughout
the cost-price structure.

Coverage-design decisions cannot rest at this point, however,
with the assumption that the job is done in this manner at
relatively low administrative and compliance cost. Some attention
must be given to those industries characterized by relatively
small business units but strong labor organization and important
implications for the wage-price structure. These include
trucking, construction, and possibly others in the service area,
as well as mining, where the giant firm is not wholly dominant.
The development of means of reaching businesses without
taxable income should also be given special consideration.
In recent years some 35 to 40 percent of all active corporation
income tax returns have reported no net income. In 1975, the deficit
corporate group accounted for about 15 percent of total corporate
receipts. As of 1973, about 13.5 percent of all corporations
with assets of $250 million or more had deficits.
7. Use of the tax system to implement anti-inflation quideposts
Use of the tax system to discourage compensation increases
in excess of a reasonable noninflationary guideline or guidepost,
and thus to decelerate the present spiral process through
moderation of the wage-cost inflation factor is feasible and
constructive. The extension of the same approach to some
form of price guidepost enforcement - sometimes termed wages-TIP would be more difficult in terms of administration and compliance.
On the other hand, some assurance should be given labor that
guidepost enforcement is not a one-way proposition, limited to
wages, which would permit widespread price increases at the expense
of a compliant and cooperative labor force.
The chief problems in a full-fledged prices-TIP geared to
price increases as such seem to be the greater volatility of
prices in response to specific commodity supply-demand relationships,
the factor of product variation, and the difficulties in
determining average price change or price indexing on an
individual company basis.
Granted that problems exist, the price aspect of dealing with
the inflation spiral under conditions of substantial unemployment
calls for attention not merely as a counterbalance to wages-TIP
but also because of the potentialities of persisting price
movements in an upward direction due to structural factors,
price maneuvering to maintain a perceived market-profits position,
and the proliferation of one-way price changes without
offsetting decreases due to the prevailing ratchet effect.
The price aspects of the inflation problem may call for
measures other than TIP to help maintain stability without
basic interference with market mechanisms. If a prices-TIP
were to be adopted as a companion to wages-TIP, the most feasible
approach would seem to be a special tax based on appropriately
defined increases in profit margins.

8. Cost to the Treasury of implementing TIP
The most economical or cost-effective approach to implementing
TIP would be to apply it on the basis of a size exemption which
include only some 2000 to 3000 of the largest corporations. This
might be amplified by extension of coverage below the standard
exemution in a few critical industries, mentioned earlier,
characterized by relatively small corporate units. Such a
coverage would include a portion of the economy accounting for
about half the total receipts of American corporate enterprise,
some two-thirds of the assets and net income, but a considerably
smaller fraction of employment. Nevertheless, this coverage
would deal with the crucial sectors involving key wage settlements
from the standpoint of decelerating the inflation spiral.
The dollar costs of implementation would, of course, vary
with the scale and intensity of audit and monitoring operations
and the consequent quality and thoroughness of administration.
They would also vary with the inflationary pressures in the
corporate economy and would be expected to ease off as the
inertial movement of the prevailing spiral was brought under
control. Economies of administration could be achieved since
some of the TIP audit would seem to be combinable with regular
income tax audit of the large companies.
We are aware of estimates that implementation on the basis
of kind of large corporation coverage described above would
cost only several millions of dollars. This may be too optimistic
although not impossibly low. Before passing judgment, it would
seem helpful to go through a simple exercise of calculating
what might be regarded as a reasonable maximum cost figure.
If we assume that the administration of TIP is integrated
with that of the corporate income tax, that some 1000 of the
large corporations covered by TIP are selected for TIP audit on
a fairly intensive basis in a particular year year, and that
the additional audit-enforcement effort involves personnel and
back-up services and support averaging $20,000 per selected
corporation, the total cost per year would be some $20 million.
A relatively small amount might be added for routine processing
and statistical tabulation of TIP schedules and for the usual
development of regulations, rulings, and review procedures.
This kind of estimate would seem to give a very outside figure,
based as it is on an assumed quality audit of a very large
portion of the affected companies each year by skilled personnel.
A more reasonable estimate, which assumes a quality level of
audit focussed on selected areas of the large corporate coverage
in which wage settlement pressures were greatest for the particular
year, would be half the outside figure developed above. Thus,
a rough but conservative estimate would place the cost to
the Treasury at about $10 million in an initial year. As inflation
pressures eased eased in response to the decelerating impact of TIP,

2f?-775 O - 7fi - 34

the initial costs could appropriately be reduced. Even if the
TIP program were only moderately successful in bringing the
inflationary spiral under control, the ratio of benefits to cost
would be remarkably high, the benefits here being counted in
terms of inflation-free growth of output and employment with
associated restoration of confidence in the strength and
durability of the free market economy. With substantially full
success, the payoff by TIP in terms of restructuring and reinforcing
the present fiscal and monetary tools for achieving a high-level
economic effort would be enormous.
Extending the coverage of TIP to smaller corporations and
possibly to sizeable unincorporated units, particularly
businesses occupying a field of strategic wage determinations,
would involve some addition to administrative costs for a
given level of administrative effort. In general, however, the
costs of expanded coverage would be far less than proportionate
to the economic magnitudes affected. The reason for this effect
would be the smaller frequency of smaller enterprises in which
wage or salary increases averaging near or above the guideline,
particularly in an environment in which wage-price spirals in the
large corporate sector were decelerated and the more passive
compensation adjustments of the smaller enterprises - less
frequently excessive to begin with - consequently moderated.
Another point should be mentioned. If upward pressures on
the wage structure should be heavy, so that numerous instances
in which TIP liability is incurred appear, there would be
appreciable revenue from TIP. This could exceed by many times
the estimated cost figures cited here. The scrutiny of costs
and operations involved in TIP might also produce a revenue
payoff in terms of improved enforcement-compliance of the
income tax as applied to the affected business sector.
9. View of TIP as being related to mandatory wage and price
controls versus a social contract among government, labor,
and business
TIP should be regarded as a preferred alternative to
mandatory anti-inflation controls, in a situation in which
we are fast running out of options. TIP does not attempt
absolutely to prohibit inflationary conduct on the part
of labor and employers. It merely imposes a tax penalty
(or loss of reward) for economic decisions which impose
widespread social and economic damage and costs on other
groups and society in general.
TIP may also be regarded as a supplement to a social
contract arrangement in which government, labor, and business
come together in a broad agreement to decelerate and minimize
inflation-laden settlements and related actions. Where the
general terms of the social contract dnsigned to slow or halt
the inflation spiral are breached or threaten to be breached due to
intransigence or disagreement on the facts in cases where*
hardship or special need may justify departure from the

general rule, the TIP penalty serves to deter still greater
infringement and to symbolize in tangible fashion the general
consensus that such actions are inimical to the general interest
in high employment with stability.
To pursue the question of interrelationships among the
basic options a little further, while TIP and social contract
voluntarism may be conceived to operate side by side but
mandatory controls are antithetical to voluntary arrangements
of the social contract type, it is possible to conceive of
some forms of compatibility between a mandatory system of
anti-inflation controls and some elements of the TIP approach.
Entertaining these "far-out" models has some heuristic value
in a field that is in dire need of explorative thought and ideas.
One combination approach which would rely upon both a "control"
system and TIP would embody a wage guideline system that was
operated by a stabilization authority outside the tax administrative
structure. If the control standard was infringed, the penalty
would be determined and collected under a TIP structure, which
might well impose progressively greater penalties the greater the
degree of infringement, ranging up to prohibitive levels for
extreme infringement.
The combination system just described would transfer the
specialities of inflationary wage definition and interpretation
to a specialized stabilization group, Keeping them out of the
revenue structure. It would retain the advantage of flexibility
and elasticity with respect to the enforcement of conformity
by permitting infringement subject to specifically determined
tax penalties.


The Wrong Way to Fight Inflation
Preston Miller

Associate Director ot Research
Research Department
Federal Reserve Bank of Minneapolis

According to a recent survey, most Americans believe that
inflation is our number one problem and President Carter "isn't doing
enough" to combat it.—

The only proven way to solve our inflation

problem—fiscal and monetary restraint—takes time to work.

But with

inflation accelerating, pressure is mounting on the Administration to
come up with a quick fix.

And that likely means some form of incomes

a government policy which directly limits wage and price

The government has moved in that direction this year.

In his

first State of the Union Address, President Carter proposed a system of
"voluntary contraints" on wage and price hikes in 1978.

As Herbert

Stein, past chair of the President's Council of Economic Advisers, aptly
noted, "voluntary constraints" is a contradiction in terms, since con2/
straint implies compulsion or coercion.—

Few people expected an appeal

to patriotism to have much effect on inflation, so it seemed likely from
tne outset that emphasis would eventually switch from the "voluntarv" to
the "constraints" side of this program.

That is how AFL-CIO President

George Meany saw it when he termed President Carter's proposal "wishboning" and then voiced the concern held by many others that "it would
be 'a step down the road' to outright wage and price controls."—
That concern was not unwarranted.

President Carter recently

appointed Robert Strauss as his special, counselor on inflation and
assigned him the: uask of jawboning down wage and price increases.


will launch public attacks on companies or unions which violate the
spirit of the government's "voluntary" anti-inflation program.

He has

stated, "We will certainly be speaking out where we think there has been
poor citizenship."

And Barry Bosworth, director of the Council on Wage

and Price Stability, issued a public reminder that his agency has the
power to subpoena cost information from business.—

This is voluntary?

If the government takes the next step of actually implementing
an explicit wage and price constraint policy, there is a strong chance
it will be a Tax-based Incomes Policy (TIP).

In its basic form, this

policy levies a tax on wage increases and counts on lower wage increases
turning into lower price increases.

Arthur Okun of the Brookings

Institution and Henry Wallich of the Board of Governors of the Federal
Reserve System have urged adoption of their own versions of TIP in
speeches and articles carried prominently in the media,—

the Council of

Economic Advisers discussed TIP plans in their 1978 Annual Report,—


Ford Foundation gave the Brookings Institution S75,OOO for a one-day
seminar on TIP in April,—

and the Senate's 3anking, Housing, and Urban

Affairs Committee held two days of hearings on TIP in May.—
In this article we examine the case for TIP and explain why
this policy is the wrong way to fight inflation.

Looking closely at how

TIP would affect the economy, we find that it would be counterproductive.
A major flaw in TIP is its reliance on the stability of the
relationship between wages and prices.

TIP proponents argue that the

relationship is so ciose that lower wage inflation turns directly into
lower price inflation.

Economic theory and empirical evidence show,

however, that while wages and prices may be closely related in normal
times, the relationship changes when government policies disrupt the

wage process.

With TIP, the relationship would change enough to actually

result in higher prices with lower wages.
Another big flaw in TIP is the side effects it would have.
Contrary to what its proponents believe, TIP would cause all the distortionary and administrative problems of other incomes policies; the
difference between TIP and explicit wage controls is just a matter of

The Mechanics of TIP
Although TIP has many variants, they all reduce to being a tax
on wage increases.

They would work something like this:

Each year the

government would announce a wage increase guidepost for the next calendar

It would also announce a TIP tax schedule.

At the end of the

year firms would pay a tax according to the schedule if the wage increases
they granted exceeded the government's guidepost; they would receive a
subsidy (a negative tax) according to the schedule if the wage increases
were below the guidepost.
As an example, suppose the government announced a wage increase
guidepost of 6 percent and a tax rate of 3 percent.

That would mean

that for each percentage point of wage increase a firm granted over (or
under) 6 percent, 3 percentage points would be added to (or subtracted
from) its corporate profits tax rate.

If a firm granted a 10 percent

wage increase—4 percentage points more than the guidepost—the firm
would have 12 percentage points (the 4 excess points times the 3 percent
tax rate) added to its profit tax rate (see illustration).

If a firm

actually granted a 6 percent wage increase, it would pay no tax and
receive no subsidy.

But if a firm granted a wage increase of, say, 4

percent, that would come under the 6 percent guidepost by 2 percentage

Example of Effects of TIP on a Corporation's Profits

Profits before
taxes and salary
Less: Salary

10 Percent Wage
Increase without TIP

10 Percent Wage
Increase with TIP



















Equals: Profits
before tax

Profit tax rate
Plus: TIP
Equals: Effective
profit tax rate (t)

Profit tax (T»TT BT . t)




Profits after tax







Employment costs:
Salary expense and
TIP Surcharge

^Calculation of TIP Surcharge:
6 percent guidepost
3 percentage point surcharge for each percentage point of exces
wage increases
Excess wage increase = 10 percent - 6 percent = 4 percent.
TIP Surcharge = 3 x 4 percent = 12 percent or .12

points, so the firm would have 6 points (the 2 points short rimes the 3
percent tax rate) subtracted from its profit tax rate (a subsidy).
TIP, as presently described, could affect output and prices
through two channels:

It would change firms' employment costs since each dollar of
wage increase would cost firms more than a dollar when the tax
was included.


It could change federal revenues and thus alter the federal

TIP proponents have proposed that the tax rate and guidepost be set so
that the taxes and subsidies balance out.—

TIP is intended, then, to

have no direct effect on the federal deficit.—
The goal of TIP is to reduce inflation at given levels of

According to Wallich and Sidney Weintraub:
The twin goals of price level stability and full

employment have so far eluded conventional monetary
and fiscal techniques . . . .

[TIP] is conceived as a

supplement to the familiar monetary-fiscal policies
so that the economy might operate closer to full
employment without the inflationary danger of excess
demand and "overheating."—
Two features of TIP distinguish it from previously implemented
incomes policies.
First, although the goal of TIP, like that of all incomes
policies, is to slow the rate of price inflation, TIP would act directly
only on wage inflation.

Previous incomes policies have coupled wage

constraints with price constraints.

Thus, TIP's effectiveness relies on

the closeness and stability of the actual relationship between wage
increases and price increases.
The other and perhaps most novel feature of TIP is that it
would allow wage increases in excess of the government's guidepost; it
would, however, penalize excessive wage settlements with a tax.


ness and labor would still be free to reach their own bargains, though
the costs of settling could be different for firms under TIP.


constraints applied in the past have treated guideposts as ceilings and
prohibited wage settlements above them.

In this respect TIP is intended

to be less repressive and more reliant on market forces than previous
wage constraint policies.

The Case for TIP
Arguments in favor of incomes policies generally reduce to the
claim that they improve the Phillips curve relationship between inflation
and unemployment—at least in the short run.

That is, they allow at

least temporarily a lower inflation rate at any given rate of unemployment.

Indeed, Wallich and Weintraub state:
An incomes policy projects a direct attack
[on wage and price increases] and can thus improve
such a tradeoff between inflation and unemployment
as may exist in the short r u n . —
The claim that TIP will improve the tradeoff between unemployment

and inflation is built on three arguments:

TIP will lower the rate of wage inflation.
According to its proponents, TIP will do this by stiffening

employers' resistance to labor's wage demands.

Since TIP makes larger

wage settlements even more expensive to employers, they will be more
willing to hold out for smaller settlements.

Lower wage inflation resulting from TIP will be translated
directly into lower price inflation.
This argument is based on one observation and one claim.


observation is that for the economy as a whole, prices tend to be a
constant markup of unit labor costs (the total wage bill divided by
total output).

A constant markup implies that the rate of growth in

prices is equal to the rate of growth in wages less the rate of growth
in output per hours worked (productivity). The claim is that while
productivity growth may vary due to cyclical factors such as employment
and structural factors such as technological innovation, it will not be
affected by the introduction of an incomes policy such as TIP.


TIP will not affect productivity growth, it will, according to the
growth rate relationship, lower the rate of price inflation by the same
amount that it lowers the rate of wage inflation.
While TIP proponents' first two arguments build a case why TIP
will reduce the rate of inflation, they do not imply by themselves that
TIP will improve the existing tradeoff between unemployment and inflation.

It is logically possible that TIP will lower inflation by creat-

ing more unemployment and so result in a different outcome along the
Phillips curve rather than in shifting the curve.

That is why TIP

proponents must add a third argument to their case.

TIP will have only minor effects on output and employment.
Proponents include these points in their case:

First, "Since

wages and prices will be free to adjust to market forces under TIP, the
program will introduce very few economic distortions and inefficiencies.

Second, most versions of TIP couple it to the corporate profits tax
which is considered to be a nondistortionary tax.

That is, the cor-

porate profits tax is not supposed to alter the profit-maximizing level
of a firm's output, and proponents argue TIP won't either.


since TIP will be a surcharge on corporate profit taxes, it will be easy
to enforce.

The IRS can police TIP with little increase in staff, so

unlike previously implemented incomes policies, a huge bureaucracy
draining resources from the private economy need not arise.

Our Case Against TIP
We believe TIP proponents are right that TIP would slow wage
inflation but wrong in their other contentions:

lower wages under TIP

would translate into higher, not lower prices, and TIP could have large
effects on output and employment.

To reach those conclusions, we first

consider how TIP changes the employment, pricing, and output decisions
of a typical firm.

We find that TIP acts as a tax on labor.

We then

expand this analysis to the overall economy.
Our representative firm is assumed to have some power to
determine wages and set prices; that seems consistent with what TIP
proponents have in mind when they say firms are able to bargain for
lower wages and mark up prices based on costs.

The firm can produce one

good with various combinations of capital and labor.

It can employ all

the capital it wants at a fixed per unit rental rate, but it can add
more workers only by paying a higher wage rate.—

It can sell more of

its product only by lowering the price.
Without TIP the firm maximizes its profits by producing up to
the. point where the extra revenue from one more unit of output exactly
equals the extra cost of producing that unit.

Similarly, the firm

employs each input up to the point where the extra revenue from the
resulting increased production exactly equals the cost of that additional input unit.

The extra revenue generated by one more unit of

either input is essentially the increase in revenue from selling more
output at the original price less the decline in revenue from selling
the original output at a lower price.

The cost of an extra unit of

capital is the per unit rental rate; the cost of an additional unit of
labor is essentially the wage paid for the extra unit plus the increase
in the wage bill resulting from the higher wage required to attract the
extra labor.

When the firm maximizes its profits, the change in revenue

generated by a minute increase or decrease in labor or capital is exactly
offset by a change in costs, leaving its profits unchanged.
Now let us suppose TIP is introduced as a surcharge on the
corporate profits tax, as in the earlier illustration.

Without loss in

generality, we assume that the TIP guidepost is set equal to the wage
increase the firm would have paid without TIP.

The question is whether

TIP changes any of the firm's hiring, pricing, or output decisions.
TIP doesn't change some things.

It doesn't change the extra

revenues generated by additional units of capital or labor.


relationships depend on how much output is produced with an extra unit
of either input, on how much revenue is increased by selling the extra
output at the original price, and on how much revenue is reduced due to
lowering the price to sell the extra output.

And the cost of an extra

unit of capital is still its per unit rental rate.
TIP does, however, change some things.
more unit of labor is now higher.

The cost of adding one

Besides the original cos., the firm

will have to pay the TIP tax, because to hire another worker the firm

will have to pay a wage above the guidepost.

Thus, at the original

profit-maximizing position adding another worker under TIP raises costs
more than revenues and therefore decreases profits.

But if at that same

position the firm hires one less unit of labor instead, its costs
decline more than before.

That is because the firm can pay a lower wage

to attract less labor, allowing its wage to come in under the guidepost
and entitling it to a subsidy.

Thus, at the original profit-maximizing

position the decline in costs from hiring one less unit of labor is more
than the decline in revenues and therefore increases profits.
So TIP will cause the firm to change its hiring, pricing, and
output policies:

The firm will hire less labor and offer a lower wage,

and it will increase its ratio of capital to labor.

It will offer fewer

goods on the market due to the reduction in labor and thus will charge a
higher price for its product.

With the guidepost set at its original

wage offer, the firm's profits will increase as a result of the TIP
Not only will TIP change the firm's decisions in a given^
economic environment, it also will change the firm's responses to a
changing environment.

Normally, the firm will increase its labor force

and its output when demand for its product increases or when its production process improves to make labor more productive.

But with TIP

the cost of adding labor rises more steeply than before, so that the
firm will respond less to such changing conditions:

it will hire fewer

extra workers and increase production more modestly than without TIP.
So even though TIP is a tax on profits, it still affects a
firm's employment, output, and pricing decisions.
are precisely those of an excise tax on labor.

In fact, its effects

The economy-wide effects

of TIP, therefore, will be similar to those of any excise tax—and quite
different from what TIP proponents claim.

TIP will lower wages, as proponents say.
An excise tax lowers the demand for the good being taxed—in

this case, labor—and results in a lower price net of the tax—in this
case, the wage.

But TIP will raise prices, not lower them, as intended.
The average price level in the economy is determined by aggregate

demand and aggregate supply, the schedules of all goods demanded and
offered at given prices.

As a first approximation, an excise tax affects

aggregate demand only to the extent that it changes government tax

Since we are assuming, as TIP proponents have proposed, that

the taxes and subsidies balance under TIP, we conclude that TIP will
not change aggregate demand.
TIP will, however, reduce aggregate supply.

Just as with

other excise taxes, TIP will result in a lower demand for and a lower
supply of the good being taxed.

Here, the good is labor, and as we have

seen, TIP raises the cost of hiring more workers and reduces firms'
demand for them.

Faced with lower wages, more workers will substitute

leisure for labor, thus lowering the amount of labor supplied.


less total employment and a given stock of capital, then, firms altogether will produce less; that is, the aggregate supply of goods will
Since TIP will not change aggregate demand but will reduce
aggregate supply, it will increase the average price level.

This means

that TIP will change the normally stable relationship between average
wages and average prices, the relationship TIP proponents count on to

make TIP an effective inflation fighter.

Because of the TIP tax "wedge"

between what employers have to pay for labor and what workers receive,
prices will no longer be the same constant markup of wages.
Standard economic theory suggests that any government policy
which alters the wage process will also affect the relationship of
prices to wages for a price-setting firm.

In his careful study of firm

decision making, John Geweke found that:
. . . it cannot be inferred that since prices
of manufactured goods are a markup on wage and raw
materials prices, only the latter need be the target of any wage and price control program


It is . . . likely that the form and very existence
of the price equation are sensitive to any major
change in policy.—
Historical evidence supports this contention—and not the case
for TIP.

Geweke's study sharply rejected the hypothesis that the rela-

tionship between wages and prices was the same during either of the last
two price control regimes as in other times.—
early 1970s controls yields similar results:

And our study of the

Before and after the last

controls, prices were closely related to unit labor costs.


this relationship does not imply a one-for-one pass-through from wages
to prices.

And more importantly, the relationship shifted significantly

when wage and price controls were introduced.—

Controls seem to have

initially lowered inflation by lowering the price markup and, hence,
profit margins.

Both the markup and margins quickly recovered after the

policies were removed.

TIP's effects on output and employment can be significant.

TIP proponents argue that wages can adjust better to market
forces under TIP than under explicit wage controls, so TIP will produce
relatively few market distortions and inefficiencies.

But the easier it

is for wages to adjust under TIP (the lower the TIP tax rate), the less
effective TIP will be in controlling wage inflation.

The more effective

TIP is in controlling wage inflation, therefore, the less wages will be
able to adjust to changing economic conditions, and the effects on
output and employment can be very great.
Also contrary to what its proponents believe, TIP will divert
resources from productive use to the maintenance of a costly bureaucracy.

All the administrative problems normally attributed to controls

also occur to some degree with excise taxes.

That is because an excise

tax and a control are not substantively diff-erent; they are different
only in degree:

the size of the tax rate.

With a high enough TIP tax

rate on wages, for instance, no firm can afford to pay a wage above the
guidepost, so that the guidepost becomes a wage ceiling.

And the higher

the TIP tax rate, the more severe the administrative problems will be.
As the tax rate climbs, people will have more incentive to evade TIP, so
maintaining voluntary compliance will be harder.

And as with all taxes,

defining the tax base will not be easy.
Our last bout with wage controls required 82 pages of definitions,
regulations, and rulings.—

Just some of the questions likely to arise

with TIP:

Since TIP is attached to the corporate income tax, how will it
be applied to unincorporated businesses and nonprofit institutions?


How will TIP be applied to new firms with no past records of
salary expenses?


How will "the wage" be defined?

Wallich and Weintraub suggest

that a wage be computed for each firm by totaling wage and
salary payments in each job classification and grade, dividing
by the number of hours worked in the respective categories,
I Q /

and then combining into a weighted index.—

This definition

does not resolve many problems:
• How will firms be kept from evading TIP by granting

If firms promote people receiving above-

guidepost wage increases, their wage indices could grow
less than the guidepost although all individual increases
are above it.
• How will dollar values be attached to increased payments
in kind, like more liberal use of company cars or longer
work breaks and vacations?
• How will TIP be applied to payments for work contracted
out to self-employed people?
Special Cases

Will TIP be applied retroactively to previously negotiated
wage increases?


Will TIP allow wage catchups to preserve wage structure?


miners, for instance, settled fofUKfgported 37 percent wage
and benefit increase over three years; should not other
miners be allowed to receive similar increases?

Will TIP allow wage increases in excess of the guidepost if
they are needed to satisfy government regulations?

29-775 O - 78 - 35

It is

conceivable that to comply with an OSHA regulation, for
example, a firm will have to hire some high-priced labor which
will cause the increase in its wage bill to exceed the guidepost.

Should the firm also have to pay the TIP tax as a


What if TIP taxed price increases too?
TIP is obviously the wrong way to fight inflation.

While it

could hold down wages, it would boost prices and cause a lot of economic
distortions and administrative problems.
Possibly in response to criticisms like these, Wallich has
suggested that TIP be expanded to also tax price increases.—

But this

would make TIP not essentially different from past wage and price
control policies.

The difference once again would be just a matter of

degree, the size of the TIP tax rate.

And many economists have pointed

out that although wage and price control policies have beer, used against
inflation in many countries at many times in history, they have never
worked for long.

Though they may temporarily hold down price increases,

once they are removed the distortions they have caused push prices
higher than they would have been otherwise.—
Why, then, do governments continue to resort to incomes policies?
The answers usually given to this question are either that
governments do not learn from history or that people can be. fooled into
believing that their governments are attempting to do something about

Maybe these answers are right, but they do not attribute

much intelligence to governments or their citizens.
Our answer is that governments use incomes policies as a form
of taxation.

Just as income taxes and inflation transfer resources from

the private sector to the public sector, so too do wage and price

With controls, the government takes the resources it wants

and then does not let people buy all the goods and services they want at
market prices.

By not allowing people to spend all they want at given

prices, controls can be considered a kind of tax on money holdings.
Some form of taxation is necessary to pay for most government
expenditures, of course, and governments use a variety of them—income
taxes, sales and excise taxes, property taxes, inflation.

This is

because any single tax creates economic distortions which grow increasingly
severe as the tax grows in size.
This is true for incomes policies, too.

When government

expenditures outstrip revenues which can be comfortably raised through
existing taxes and inflation, wage and price controls may be no worse a
way to transfer resources to the government than greater reliance on
normal channels—but not for long.

Experience has shown that very

quickly controls disrupt our market economy so much that they have to be
Incomes policies, therefore, are very expensive as both a tax
and an inflation fighter, and we should be wary of using them.


in very unusual situations, the government should rely on normal ways to
get resources.

And it should use the only proven way to control infla-

sound monetary and fiscal policies.

Richard J. Levine, "Carter Inflation Battle Still Faces Problems
Despite Tax-Cut Delay," Wall Street Journal, May 15, 1978, p. 1.
Herbert Stein, "Is Government Our Partner?" Wall Street Journal,
January 30, 1978, p. 12.
Michael Ruby, Rich Thomas, and Pamela Ellis Simons, "Carter and Your
Money," Newsweek, January 30, 1978, p. 23.
Levine, p. 18.

Henry C. Wallich, "Stabilization Goals:

Balancing Inflation and

Unemployment," American Economic Review, May 1978 (Papers and Proceedings of the Ninetieth Annual Meeting of the American Economic Association, New York, December 28-30, 1977), pp. 159-164; Arthur M. Okun, "The
Great Stagflation Swamp," Challenge, November-December 1977, pp. 6-13;
Lindley H. Clark, Jr., "The Outlook:

Review of Current Trends in Busi-

ness and Finance," Wall Street Journal, February 6, 1978, p. 1; Gardner
Ackley, "Okun's New Tax-Based Incomes-Policy Proposal," Economic Outlook
USA (Survey Research Center, Institute for Social Research, University
of Michigan), Winter 1978, pp. 8-9; "Another Weapon Against: Inflation:
Tax Policy," Business Week, October 3, 1978, pp. 94, 96.
U.S., President, Economic Report of the President together with The
Annual Report of the Council of Economic Advisers (Washington, D.C.:
Government Printing Office, 1978), pp. 151-2.
Thomas E. Mullaney, "$75,000, One-Day Seminar on Okun Plan for
Inflation," New York Times, February 15, 1978, p. 53.
David Pauly and Rich Thomas, "TIP: A New Approach," Newsweek,
May 29, 1978, p. 76.
Business Week, p. 94.

One version of TIP would tax wage increases above the guidepost but
would not subsidize increases below it (the "stick" approach), while
another version would subsidize but would not tax (the "carrot" approach).
Each version is a special case of the policy examined in the text.


one would increase the cost of hiring an extra unit of labor—the stick
version due to the increase in tax; the carrot version due to the decrease
in subsidy.

The actions needed to neutralize the effect of TIP on the

federal budget, however, would be different for the two versions.
Henry C. Wallich and Sidney Weintraub, "A Tax-based Incomes Policy,"
Journal of Economic Issues, June 1971, p. 1.
"Wallich and Weintraub, p. 2.
If we had assumed that the firm could hire all the workers it wanted
at a given wage rate, TIP would be irrelevant.

The extent to which the

market wage rate exceeded or fell short of the guidepost would raise or
lower the firm's corporate profit tax rate, but it would not affect the
cost of hiring an additional worker.
John Geweke, "Wage and Price Dynamics in U.S. Manufacturing," New
Methods in Business Cycle Research:

Proceedings from a Conference

(Federal Reserve Bank of Minneapolis, Minnesota, 1977), p. 133.

Geweke, pp. 128-9.
We estimated a quarterly regression of consumer prices except food

against ten past and four future lags of unit labor costs in the private
nonfarm sector.

In the period 1953:1 through 1971:2 the relationship

appears close with an adjusted R*~ of .37. However, the coefficients on
future lags are significant and indicate there is feedback running from
prices to unit labor costs.

Hence, ordinary leiist squares regressions

of prices on current and past values of unit labor costs will have

biased coefficients and will not give reliable estimates of how prices
change to a change in wages.

Moreover, our study, like Geweke's, very

strongly rejects the hypothesis that the relationship of prices to unit
labor costs remained stable after the imposition of controls in 1971.
U.S., General Services Administration, Office of the Federal Register,
Code of Federal Regulations:

Economic Stabilization, revised as of

October 1, 1972 (Washington, D.C.:

Government Printing Office, 1972).

Wallich and Weintraub, p. 14.

Wallich, p. 164.
See the preceding article in this Quarterly Review.




by Walter S. McConnell and Stephen D. Leit

Inflation, Stock Prices
and Job Creation
• HE poor price performance of common
stocks over the past decade and the resulting substantial loss of real wealth by stock investors is widely recognized. As measured by
the Dow Jones industrials, the average level of
stock prices in 1976 was up only 14 per cent
from the average level 10 years earlier, in contrast to an increase in Gross National Product
over the same period of 125 per cent. After adjustment for inflation, stock prices declined 36
per cent while GNP rose 29 per cent.
The principal cause of this poor performance
has been the steep rise in the rate of inflation,
which has led to higher interest rates and a fall
in price/earnings ratios for common stocks. Although earnings for the Dow Jones companies
increased approximately 70 per cent in the 10
years ended 1976, the positive effect on stock
prices was largely offset by a reduction in
price/earnings ratios from an average of 15 in
1966 to 10 last year.
Apart from the direct impact on the owners
of these securities, the weak trend of stock
prices has important implications for capital investment and job creation. Jobs depend on investment and investment depends on the availability of adequate supplies of capital. Outside financing has accounted for approximately 40
Walter McConnell is Senior Vice President of
Wertheim & Co., Inc., New York, and Chairman of the
Financial Analysts Federation. Stephen Leit is Vice
President -Research of Wertheim dfc Co.

per cent of total fund requirements for non-financial corporations over the past 10 years, and
the dependence on external sources of funds is
likely to be at least as great in the 10 years
ahead. Corporate financial positions have
deteriorated, meanwhile, because of past emphasis on debt financing. As a consequence, a
larger volume of equity financing seems necessary if overall capital needs are to be met. An
adequate supply of equity capital would appear
to require a stronger trend of stock prices, and
this in turn will depend importantly on the pattern of inflation.
The interrelationship of these factors—inflation, interest rates, stock prices, capital investment and job creation—suggests that inflation
and unemployment are not separate issues, but
rather that inflation must be controlled if a
large, permanent reduction in unemployment is
to be achieved.
Poor Investor Performance
Stock prices have lagged well behind the growth of
the economy during the last 10 years and have actually declined after adjustment for the effe^ of inflation. As shown in Table I, the average price of 982
for the Dow Jones industrials in 1976 was only 14
per cent greater than the average price in 1966. After
allowance for the loss of purchasing power of the
dollar, stock values declined by 36 per cent.1 Over
the same period. Gross National Product more than
1. Footnotes ;»p|v;ir at end of article.





$ 753


Gross National Product ($ bil.)

As Reported
Adjusted for Inflation*


Dow Jones Industrials

As Reported
Adjusted for Inflation*
Price/Earnings Ratio


98 (Est)
10x (Est)



(5) pts.

* 1972 dollars.

doubled in current dollars and increased 29 per cent
on a constant dollar basis.
The immediate cause of the lag in market performance has been the lower valuation placed on earnings by investors. While earnings did not expand in
line with the economy in this period, they did increase by an estimated 70 per cent. The average level
of price/earnings multiples, on the other hand,
declined from approximately 15 in 1966 to 10 in
Causal Role of Inflation
Although a wide range of factors influence the
market's valuation of earnings, particularly on a
short-term basis, both investment theory and an
analysis of events in the 1966-76 period support the
view that the major depressant on price/earnings
ratios has been the sharp advance in interest rates.
The classical approach to valuation of common
stocks is to (1) project the probable flow of earnings
and (2) apply a capitalization rate based on the
return available from essentially risk-free investment
(generally the interest rate on high-quality bonds),
with an appropriate adjustment for risk. From the
standpoint of investment theory, therefore, common
stock prices can be expected to vary inversely with
changes in interest rates as well as directly with
changes in earnings and earnings prospects.2
The relationship between interest rates and inflation also is well established. Interest rates consist essentially of two components—a real rate of interest,
which represents the return to investors for the use of
funds, and an inflation premium to compensate for

the loss of purchasing power caused by a rise in the
general price level. Because the inflation premium is
based on expectations of inflation, rather than current experience, the indicated real rate of return can
vary significantly from year to year.3 Over a period
of time, however, changes in interest rates can be expected to conform closely to changes in the pattern
of inflation.
In practice, the influence of inflation on interest
rates and stock earnings yields (the reciprocal of
price/earnings ratios) has been closely in line with
theoretical expectations. As shown in Table II, the
rate of inflation increased by 2.9 percentage points
from 1966 to 1976 and this was translated into similar increases in interest rates and stock earnings
yields. As a consequence, price/earnings ratios
declined by one-third, substantially offsetting the
favorable influence of larger earnings on market
Increased Investment Requirements
A continuation of the sluggish pattern of stock prices
that prevailed in the 1966-76 period could seriously
restrict the economy's ability to function effectively
in terms of growth of output and creation of new job
opportunities. Both business investment and external financing needs are estimated to increase substantially over the next decade. Because of the
weakening of corporate balance sheets, the need for
new equity capital is expected to rise more than proportionately, and this capital may not be forthcoming unless the experience of equity investors improves.

Interest Rates**
Stock Earnings Yields***
'Consumer Price Index.
**Moody's AAA Bonds.
***Dow Jones Industrial Average.






2.9 pts.
3.3 pts.
3.3 pts.

For the 10 years ended 1975, total fund requirements of non-financial corporations (for plant and
equipment expenditures, other physical investment
and acquisition of financial assets) averaged $108
billion a year. Capital generated internally provided
60 per cent of the total sources of funds, while outside financing provided 40 per cent. Owing to the
predominance of debt financing, net additions to
debt averaged $41 billion a year, or more than twice
the $19 billion average increase in equity capital
(derived from retained earnings of $13 billion and
new equity financing of six billion dollars).
A significantly higher level of investment is expected to be needed in the 10 years 1976-85 if economic and social goals are to be met. For purposes
of this analysis, real growth in the economy is
assumed to average four per cent a year and the inflation rate five per cent a year. Using these assumptions. Gross National Product in 1976-85 would
average 135 per cent higher than in the previous 10
Expenditures for plant and equipment are expected to increase faster than GNP, because of higher outlays associated with (1) the development of
new energy sources, (2) a shift by industry to more
energy-efficient technology and (3) the installation
of facilities to meet mandated environmental and
safety standards.4 With other physical investment
and the acquisition of financial assets expected to increase in line with general economic growth, total
investment in 1976-85 is projected to average $274
billion a year, up 154 per cent from the average in
the previous 10-year period.
The balance between internal and external
sources of funds seems likely to be maintained at
about the same level as in the past decade. The relationship of capital consumption allowances to GNP
has been comparatively stable and no significant
change is anticipated. The long slide in business
profitability, meanwhile, appears to have ended.
Pre-tax profits of non-financial corporations (after
inventory adjustment) declined from 8.9 per cent of
GNP in 1965 to 5.5 per cent in 1975, but recovered
to 6.6 per cent in the 12 months ended September
30, 1976. The profit rate for the 1976-85 period is
estimated at 6.1 per cent, in line with the average for
the prior 10 years. After allowance for a moderate
decline in the dividend payout ratio, retained earnings are expected to be three times the average in
Need for Equity Capital
Because of the big buildup in the debt burden
over the past 10 years, the heavy reliance on debt financing to meet outside capital requirements is not
expected to continue. Complete data on assets and

Earnings Available
for Interest*







* Pre-tax earnings (after inventory valuation adjustment)
plus foreign branch profits and interest charges.
**12 months ended September 30, 1976.

liabilities of non-financial corporations are not
available, but for manufacturing companies alone
liabilities rose from 64 per cent of net worth at the
end of 1965 to 86 per cent at the end of 1975. (For
manufacturing companies with assets of less than
$50 million, liabilities increased from 76 to 100 per
cent of net worth over the same period.)
With interest rates also higher, the coverage of interest charges by earnings has worsened to an even
greater extent, as Table III shows. Interest coverage
for non-financial corporations narrowed from 11
times in 1965 to less than four times in 1974 and
1975. Although coverage increased to just over four
times in the 12 months ended September 30, 1976,
the ratio was below the minimum standard recommended by investment authorities.5 It should be
noted, moreover, that the coverage figure relates to
non financial corporations as a whole, with the ratio
considerably worse for many secondary companies.
The weakening of corporate balance sheets
already appears to be having an adverse effect on
debt financing. The sharp rise in the incidence of
bankruptcies and near-bankruptcies in 1974 and
1975 frightened lenders and borrowers alike. Many
weaker credits are still unable to find a market for
new debt securities despite the recovery in corporate
profits since the bottom of the recession. In other
cases, managements are emphasizing debt reduction,
and this may be a factor in the current slow recovery
in business spending for plant and equipment.
A reduced emphasis on debt as a source of capital
will require a corresponding increase in equity financing if overall investment needs are to be met.
The calculations used in Table IV assume that the
ratio of debt capital additions to equity capital additions will decline to 1.5:1 in the 1976-85 period (an
average of $99 billion a year for debt versus $66 billion for equity) from 2.1:1 in the prior 10 years.

TABLE IV: Sources and Uses of Funds
(Non-Financial Corporations)
($ bil.)

Uses of Funds
Plant & Equipment
Other Physical Investments
Net Acquisition of Financial Assets
Total Uses
Sources of Funds
Capital Consumption Allowance
Retained Earnings**
Net Addition to Debt
Net New Stock Issues
Total Sources




$ 82






$ 59









'Source. Federal Reserve Board, Flow of Funds.
** Earnings, including foreign branch profits, less dividends and inventory valuation adjustment.

With this rate of debt additions, by 1985 total liabilities of non-financial corporations would be more
than twice the 1975 base. After allowance for a moderate increase in the effective interest rate, as lowercoupon bonds mature and are refinanced at higher
rates, interest charges would rise about in line with
the increase in pre-tax corporate profits and earnings coverage would stabilize at around the current
level of four times.
Of the indicated requirement for additional equity
capital of $66 billion a year, retained earnings are
estimated to supply $43 billion, with the remaining
$23 billion to be provided by new equity financing.
This level of equity financing would be almost four
times the average in 1966-75 and twice the postwar
peak of $11 billion in 1971.
Barriers to Equity Financing
There is a serious question, however, whether adequate supplies of equity capital will be made available in the absence of a sustained upward movement
in stock prices. The willingness of individual investors to absorb substantial quantities of new stock
issues appears particularly subject to doubt. The
Value Line Composite Stock Average, consisting of
1,635 equally weighted stocks, probably comes
closest to documenting the experience of individual
investors, and this has been the worst performing of
the general market indexes over the past 10 years.
The softness in underlying demand for stocks by
individual investors is reflected in two separate measures. First, a census taken by the New York Stock
Exchange showed that the number of individual
shareowners fell from 31 million in 1970 to 25 mil28 O FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1977

lion in 1975. Second, redemptions of mutual fund
shares have exceeded new sales in each of the past
five years, as shown in Table V. The cumulative total
of net redemptions in this five-year period has
amounted to over six billion dollars.
The attractiveness of common stocks to pension
fund investors also has diminished as a consequence
of the low rate of return realized on stocks over the
past decade and the extreme price fluctuations from
year to year. In addition, the new pension reform
legislation has focused attention on the personal responsibility of pension fund trustees and fiduciaries
and made them less willing to assume the risks associated with stock investment. As shown in Table VI,
the portion of new pension fund investment allocated to common stocks dropped steeply in
1973-74 as market prices declined. The percentage
TABLE V: Mutual Funds*
($ bil.)





•Excludes money market funds.
**11 months.
Source: Investment Company Institute.

Net Sales


TABLE VI: Private Non-Insured Pension Funds

($ bil.)
Year-to-Year Change in Book Value




$ 4.1

$ 6.3

Change in Stocks
as percentage of
Change in Assets


*Six months.
Source: SEC Statistical Bulletin

of funds applied to stock investment has since increased with the recovery in the market, but has remained below the levels typical of earlier years.
These indications of reduced investor interest in
common stocks suggest that the market will not accommodate the much larger volume of equity financing that appears to be needed in the 1976-85 period. To the extent that a shortfall of equity capital
develops, the economy is likely to be faced with a
persistent problem of underinvestment and a chronic
tendency toward unacceptably high levels of unemployment.
With the surplus of labor at present apparently
greater than the surplus of plant and equipment, the
effect on unemployment of an inadequate level of investment may show up over the relatively near term.
As indicated in Table VII, the 7.7 per cent average
rate of unemployment during 1976 was significantly
higher than in earlier periods when the utilization
rate for manufacturing capacity also was on the
order of 80 per cent. The current utilization rate,
meanwhile, is less than 10 per cent below the 1973
figure of 88 per cent, when the economy was characterized by shortages of a variety of products. Accordingly, an accelerated pace of new investment apTABLE VII: Unemployment and Manufacturing
Capacity Utilization








'Source: Federal Reserve Board.

pears necessary if a relatively full rate of employment is to be achieved during the current recovery
In addition to the direct impact on employment, a
lag in common stock financing and in overall capital
formation would have secondary effects that also
would be contrary to public policy. In an environment of relative scarcity of capital, funds would be
expected to flow to the largest and financially
str< nest companies, with an accompanying increase
in concentration of economic power. Because of the
greater incidence of risk, capital inadequacies would
be reflected primarily in a reduced supply of funds
for secondary companies, small businesses and venture capital projects.
Policy Alternatives
Either of two courses of action could eliminate or
modify significantly the prospective shortfall in the
supply of equity capital. The first would provide tax
incentives to increase business earnings and cash
flow. Tax incentives might consist of a reduction in
the corporate tax rate, an increase in the investment
credit, the elimination of double taxation on dividends and a faster write-off of business investment.
An increase in earnings as a result of tax relief for
business would enhance the supply of equity capital
directly and also indirectly through a rise in stock
prices and an accompanying increase in the ability of
the market to absorb new equity issues.
A major change in the tax laws to aid business
profits, however, would probably not be practical
from a political standpoint. Moreover, the effect of
higher earnings on market prices and access to
equity financing would depend importantly on the
trend of inflation.
Another, and more promising, approach would be
to focus fiscal and monetary policy on lowering the
rate of inflation. A reduction of two percentage
points in the perceived rate of inflation, for example,
with a corresponding decline in interest rates and
stock earnings yields, would increase price/eamings
multiples from 10.0 times to 12.5 times. After allowance for earnings growth over, say, a three-year period, the combination of larger earnings and higher
multiples might raise the overall level of stock prices
by 50 per cent. Such an increase would be expected
to have a meaningful effect on the market's ability to
absorb new equity financing. At the same time, a
lower inflation rate would reduce the current dollar
cost of new investment, while a decline in interest
rates would improve earnings coverage of interest
charges and permit business to carry a larger volume
of debt.
A policy emphasizing control of inflation would
concluded on page 62

Inflation, Stock Prices
and Job Creation
concluded from page 29
also face political obstacles, although increased recognition by the general public of the adverse effects
of inflation on real incomes and purchasing power
suggests that opposition would be less than in the
past. In view of the positive impact of a lower inflation rate on economic growth and job creation (as
well as the ancillary advantages of increased social
and stability), the cost-benefit relationship
of a policy of inflation restraint would appear to be
clearly favorable.
I. Figures tor other stock market averages are as follows:
1966-1976 Change
Adjusted for
S&P Industrials
Value Line Composite




2. Arthur Stone Dewing, Financial Policy of Corporations: "Irrespective of the influences which play upon
the relative security of a particular investment and irrespective of other economic forces, a rise in pure interest rates tends to depress all investment values, and
conversely a fall in pure interest rates tends to enhance
all investment values."
3. In 1974 and 1975. real returns were negative, apparently because bond investors assumed that the high
current rates of inflation would not continue, an assumption that so far has proved correct.
4. Capital Formation: The Problem Remains (General
Electric Company, 1976). Barry Bosworth, James
Duesenberry and Andrew Carron, Capital Needs in
the Seventies (Brookings Institute, 1975). Benjamin
Friedman, Physical Capital Formation and Financial Capital Scarcity (Harvard University, 1976).
The Annual Report of the Council of i.eonotnic
Advisers, 1976.
5. Graham, Docld and Cottle, in Security Analysis, recommend a minimum coverage of fixed charges of seven
times for industrial companies and four times for utilities. The earnings figure recommended for use in calculating coverage is the average for the prior seven
years, a more stringent standard than current-year

Remarks bv

Mark H. Willes
Federal Reserve Bank of Minneapolis

at the
St. Scholastica College

June 1, 1978
Duluth, Minnesota

Isaac Newton was once asked why he was able to make so many
great scientific discoveries.

He responded; "if I have seen further

than other men, it is because I have stood on the shoulders of giants."
Unfortunately, when we talk about economics, we mostly stand on each
others feet.

For example, according to a recent national opinion poll,

inflation is now regarded as the number one economic problem in the
United States.

And according to the same poll, 50 percent of the people

feel that because of our worsening inflation problem, wage and price
controls should be imposed on American businessmen and workers.


faith in the ability of wage and price controls to improve the inflation
outlook is unfortunate, because the available evidence suggests that
controls are ineffective in solving the inflation problem.
In fact, if we get off each others feet and try to stand back
where we can get a clear view of wage and price controls, we see that
they merely attack the symptoms rather than the causes of inflation.
The principal causes are excessive monetary growth, large deficits in
the federal budget, and government policies that inhibit the workings of
our market economy.

Consequently, only by cutting the government deficit,

reducing the rate of growth of money, and improving the structure of our
economy can we expect to make lasting progress against inflation.


and price control programs (including so-called TIP programs) won't

In fact, they tend to make our inflation problem worse.


Why Wage and Price Controls Cause Higher Inflation
It has always been recognized that price controls can cause

disruptions in economic activity.

Because an economy under price con-

trols is constrained in its ability to adjust to changing tastes and

resource availability, lower production will generally accompany any
controls program.

If the underlying factors that cause inflation are

unaffected by price controls, the economy will end up with higher, not
lower, prices.

That is, with the same amount of money and government

debt outstanding and with a smaller volume of goods produced, the
average price of those goods will be higher.
A brief look at what happened in our ill fated use cf controls
in 1971-74 will hopefully remind us that such wage and price policies
have very unfortunate and undesired effects.

Rigid Prices Produce Bottlenecks and Shortages
In setting prices in a market economy, individual decision
makers process a lot of information.

Each day, some businessmen adjust

the prices of their goods and services in response to new information—
they increase some prices, decrease others, and leave the rest unchanged.
These relative adjustments in prices ensure that markets "clear" and
that resources are directed toward uses most highly valued by spenders.
But the imposition of wage and price controls short-circuits this automatic adjustment process.

Prices of goods are locked into fixed rela-

tionships to each other, with the result that changing market conditions
produce shortages in some sectors of the economy.
For example, in the summer and fall of 1973—two years after
comprehensive controls were first imposed—we had extensive shortages of
a wide variety of goods.

But at the same time we had substantial slack,

or excess capacity, in many sectors of the economy.
Production cutbacks in the aluminum industry, for exair.ple,
caused serious shortages in other key industries.

In the fall of 1973,

a large aluminum company announced that it was cutting production of
several major items due to "poor cost-price relationships present under
price restrictions."
low-profit items.

Other companies also reportedly cut production of

At the same time, shortages of critical aluminum

inputs threatened a significant reduction in production for air conditioning and refrigeration manufacturers.

And according to a major

architectural trade association, operations of its members were cut back
30 percent in the fall of 1973 due to shortages of aluminum.

In each of

these cases, many jobs were lost as production was shut down.
Similar problems developed in the steel industry.


faced with substantial excess capacity and strong market demand in many
product lines, steel manufacturers nevertheless cut production because
the controls had frozen prices too low for them to make a reasonable

Production in bot