Full text of Business Review (Federal Reserve Bank of Philadelphia) : May/June 1984

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ISSN 0007-7011

Federal Reserve Bank o f Philadelphia
Ten Independence Mall
Philadelphia, Pennsylvania 19106
MAY/JUNE 1984

TARGETING HIGH TECH IN THE DELAWARE VALLEY........................................3
John M. L. Gruenstein
Many regions’ programs for econom ic development include efforts to foster the presence o f
high tech industries. The aim is often to induce established high tech firms to set up branches in
the area. But this strategy can prove to be costly, or even futile. Depending on a region’s
characteristics, it may make more sense to try to encourage local entrepreneurs to start up their
own high tech ventures. Comparing the Delaware Valley with other areas in the nation reveals that
start-ups seem to be a better target than branch plants.

SIZING UP THE DEFICIT: A N EFFICIENT TAX PERSPECTIVE............................15
Brian Horrigan
The sheer size o f the federal deficit seems staggering. But some economists claim that deficits as
high as $ 100 billion, or even higher, may promote efficiency under certain economic conditions.
Their arguments depend on a particular view o f deficit behavior— an approach which emphasizes
the efficiency losses due to taxation. Such a framework can be used to analyze the econom y to give
a rough measure o f the size o f an “efficient” deficit. By this measure, although projected deficits
are too large, even fairly modest policy changes may reduce the size o f the deficit too much by
efficiency standards.

The BUSINESS REVIEW is published by the
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Targeting High Tech
In The Delaware Valley
John M. L. Gruenstein*
Around the country and around the world,
econom ic development officials are trying to jump
on a speeding bandwagon called high tech. Places
with high tech concentrations like California’s
Silicon Valley, the Boston area’s Route 128, and
North Carolina’s Research Triangle have become
the new models for job creation efforts. Targeting
technological frontrunners— like computers, ro­
botics, and genetic engineering— has become a
new gospel o f development strategy for planners
from Peoria to Paris.
‘ John Gruenstein is a Vice President and Economist in the
Research Department at the Federal Reserve Bank o f Phila­
delphia.




In the Delaware Valley, as elsewhere, however,
there is a broad range o f opinion about develop­
ment efforts that focus on industries at the leading
edge o f rapid technological change. Some view the
game as not worth the candle, because o f the
relatively few jobs that high tech industries are
expected to produce and the intense competition
involved. Others say it’s how you play the game
that matters for success— for instance, whether
you try to lure branch plants o f giant firms like
IBM, or whether you nurture local entrepreneurs
who might be able to create the IBMs o f the future
in your own backyard. To analyze the local pro­
spects for success, it is useful to look at examples
o f how high technology industries have developed
3

BUSINESS REVIEW

in the places where they have grown fast, and then
to make a more systematic comparison o f the
factors which promote high tech growth with the
strengths and weaknesses o f the region.

MAY/JUNE 1984

DEFINING HIGH TECH
A num ber o f researchers have drawn up lists of
high tech industries, which are usually based on
the percentage o f revenues allocated to research

CHARACTERIZING HIGH TECH

and developm ent (R&D), the proportion o f tech­

Before anyone can figure out whether to take
aim at high tech, the first thing that has to be
settled is, what is “ high tech.” In general, high
technology industries are usually taken to mean
those at the leading edge o f rapid technological
change. Such a definition by its very nature pro­
duces a list o f industries that changes over time—
Philadelphia’s Baldwin Locom otive Works was a
high tech firm in the nineteenth century, and
robotics could become a “ smokestack” industry of
the twenty-first. Using research and development
(R & D) spending and the proportion o f technical
workers as criteria, the U.S. Bureau o f Labor Sta­
tistics (BLS) has proposed three different defini­
tions o f high tech industries (see DEFINING HIGH
TECH). The six industries in the most narrowly
defined group— office equipment and computers,
communications equipment, electronic com po­
nents, aircraft, guided missiles, and drugs— are
included in virtually all lists o f high tech industries.
Therefore they provide a good starting place for
discussing the characteristics that make these in­
dustries attractive to econom ic development plan­
ners.
One attractive feature is fast-growing sales.
Recent studies predict larger average annual growth
rates for sales and shipments in most high tech
industries over the next five years than for in­
dustry in general (see TABLE 1). Projections are
particularly strong for computers and electronics.
Fast-growing sales means fast-growing employ­
ment, although not usually on a one-to-one ratio.
The narrowly defined group o f six high technology
industries showed job growth o f 39.8 percent
between 1972 and 1982, compared to 20.1 percent
for all wage and salary workers. For 1982-95, the
BLS projects that employment in these industries
will register growth between 34 and 38 percent,
while employment in all industries grows between
25 and 31 percent.
A particular advantage o f high tech industries is
that a high proportion o f the goods and services
they produce are sold in national and global
markets— that is, outside the region where they

nical or scientific workers in the industry’s em­

4




ployment, or a com bination o f these factors. A
recent study by the U.S. Bureau o f Labor Statistics
laid out three alternate definitions o f high tech
industries.3 The broadest definition includes
those industries with at least 1.5 times the aver­
age proportion o f technology-oriented workers
(engineers, life and physical scientists, mathe­
matical specialists, engineering and science tech­
nicians, and computer specialists) compared to
the average for all industries.13This wide-ranging
group contains 48 industries, not all o f which
would be commonly thought o f as high tech. The
next broadest group is defined to include
manufacturing industries with a proportion of
technology-oriented workers equal to or greater
than the average for all manufacturing industries,
and a ratio o f R&D expenditures to sales close to
or above the average for all industries. Two non­
manufacturing industries which provide tech­
nical support to high tech manufacturing in­
dustries are also included.
This definition brings the list o f included indus­
tries dow n to 28, eliminating such mature in­
dustries as heavy construction, tire production,
motor vehicles, and household appliances. The
criterion for inclusion in the third group, the most
narrowly defined, is a ratio o f R&D expenditures
to sales at least twice as large as the average
across industries. Only six industries meet this
criterion— drugs, office equipm ent and com ­
puters, communications equipment, electronic
components, aircraft, and guided missiles.

aRichard W. Riche, David E. Hecker, and John U.
Burgan, "High Technology Today and Tomorrow: A
Small Slice o f the Employment Pie,” Monthly Labor
Review. (November 1983), pp. 50-58.
^Industries as defined by three-digit Standard In­
dustrial Classification (SIC) codes.

are produced. This is important to state and local
economic development planners because it means
that money spent to stimulate local growth o f high
tech firms has the potential to generate a net gain
o f jobs for the region. A plant manufacturing
FEDERAL RESERVE BANK OF PHILADELPHIA

John M. L. Gruenstein

Targeting High Tech

TABLE 1

GROWTH PROJECTIONS FOR
HIGH TECH INDUSTRIES
Industry Shipments, 1983 - 1988
(Adjusted for Inflation)
Annual Average
Compound Rate
Industry

o f Growth3

Computers

17

%

Electronics

14.5%

Telecom m unications
Equipment
Radio and Television

8

%

Telephone and Telegraph

5

%

Drugs

4

%

Aerospace

3

%

All M anufacturing

4.8%

b

aU.S. Bureau o f Industrial Economics, 1984 U.S. In­
dustrial Outlook (Washington, D.C.: U.S. Department o f
Commerce, 1984).
^Estimated average annual growth rate o f output,
adjusted for inflation, 1983-88. Source: Interview with
Gorti Narasimham, U.S. Bureau of Industrial Economics,
March, 1984.

computers, for instance, will likely sell well over
90 percent o f its products outside the area where it
is located. If such a plant is stimulated to operate
in a region, the revenues it generates to pay its
employees will generally be a net gain to the region.
Even if the new sales cut into competitors’ revenues,
those competitors are likely to be hundreds or
thousands o f miles away. In contrast, if economic
development funds are expended to help firms in
industries which provide goods and services only
to local consumers— for instance, grocery stores,
dry cleaners, or beauty parlors— the net effect on
local j obs is most likely to be near zero, because by
and large the firms which are helped can expand
employment only by taking sales away from other
local firms in the same industry, who will therefore



have to cut employment.1
On the other side, however, even though high
tech industries are fast-growing, the absolute
number o f jobs they will provide over the next ten
years will probably be relatively small for most
regions, because the number o f current high tech
jobs is small. High tech industries will likely con­
tribute far fewer jobs than the much larger service
industries, for instance. Overall, the BLS projects
that only about one million o f the new jobs created
between 1982 and 1995 will be in the six narrowly
defined high technology industries, representing
about 3 percent o f all new jobs created over that
period. Of course, it is true that high tech industries
also indirectly stimulate job growth in other sectors
through local purchases o f goods and services by
high tech firms and their employees. Some o f the
growth in business service industries, for instance, is
attributable to the growing demand from the high
tech sector. But even taking direct and indirect
effects together, high tech industries alone will
not be a panacea for regions that have been hard
hit by losses in traditional manufacturing sectors.
Balancing the pros and cons, state and local
economic development officials around the country
have opted in many cases to make high tech tar­
geting a substantial part o f their overall strategy.
One strong motivating factor in their decisions has
been that, despite the statistics suggesting rela­
tively small overall job growth, some particular
places have benefited greatly from high technology
growth. Planners point to these examples o f success
as possible models for the development o f their
own regions.

HIGH TECH SUCCESS STORIES
State and local planners who look with enthu­
siasm toward high technology industries are en­
couraged to do so by several well-known places
where fast employment growth has been fueled by
high technology development. Three areas in
particular stand out— Silicon Valley (Santa Clara
County, California), Route 128 (the highway ringing
the Boston-Cambridge metropolitan area), and

1It is true that some services do constitute part o f the export
base o f many regions. See John Gruenstein and Sally Guerra,
“Can Services Sustain a Regional Economy?” this Business
Review (July/August 1981) pp. 15-24.

5

BUSINESS REVEIW

Research Triangle, North Carolina. These areas
have similarities and differences which provide
useful information about the possibilities and
prospects for regional high tech targeting.2
Historical studies o f the development o f Route
128 and Silicon Valley indicate that much o f their
growth came from new high technology ventures
started up by engineers and scientists who were
already working for other technology-oriented
companies or for universities in the same geo­
graphic area. A good deal o f the impetus for these
new ventures came from defense spending by the
U.S. government for research and new product
development. The excellence o f the engineering
and science faculties at M.I.T. and Harvard (in
Cambridge) and Stanford and Berkeley (in the San
Francisco area) drew a large proportion o f tech­
nologically-oriented defense spending to these
universities, and created opportunities for faculty
members to start new firms based on research they
were pursuing under federal grants. State and local
government incentives for high tech development
in these two areas, however, were largely non­
existent during their first few decades o f growth,
although in recent years, both Massachusetts and
California have initiated programs to promote the
development o f high tech industries. Rather than
reflecting the success o f local targeting efforts, the
development o f Route 128 and Silicon Valley
reflected the entrepreneurial response o f scien­
tists, engineers, venture capitalists, and real estate
developers to the stimulus o f demand for high
technology products by the federal government
and subsequently by firms in other industries.
This entrepreneurial response took place in geo­
graphically concentrated areas around the uni­
versities which provided the initial impetus. It
became self-sustaining as other resources needed
for its further growth— like capital, skilled man­
power, and o ffice and production space— were
made available in the same area.
By contrast, the Research Triangle Park in North
Carolina was the result o f a deliberate effort by

MAY/JUNE 1984

academic, private sector, and government leaders
to target the attraction o f scientific research faci­
lities as a way o f stimulating local economic
development. In 1958, a committee organized by
the state governor, Luther H. Hodges, and including
prominent businessmen, bankers, and university
presidents, raised about $2 million in private
contributions to buy the 5500 acres o f pineland in
the triangle formed by Duke University, the Uni­
versity o f North Carolina, and North Carolina State
University that was to become the park. The com­
mittee then formed the non-profit Research Triangle
Foundation, the owner and manager o f the de­
velopment. The Foundation’s sole asset is the land
inside the park, and its only source o f revenue is
from leasing and selling the land.3
While the park is not run by the state, there has
been strong indirect state government support for
the development. In 1963, North Carolina set up
the first state agency in the U.S. directed at en­
couraging scientific research and technological
applications. State funds have been forthcoming
for educational programs that tie into the activities
o f prospective park tenants. In 1980, for instance,
the state allocated $24 million to fund microelec­
tronics research at the three universities surround­
ing the park, which helped to attract a $ 100 million
General Electric Microelectronics Research Center.4
Another way government has helped the park grow
is through salesmanship— for instance, James
Hunt, the current governor, has visited Silicon
Valley to try to induce firms there to relocate or
open branches in North Carolina.
Unlike Route 128 and Silicon Valley, Research
Triangle Park has grown principally through the
attraction o f outside establishments instead o f
through the start-up o f indigenous firms. The
majority o f the 20,000 jobs currently located in the
park are in research or manufacturing facilities of
corporations headquartered elsewhere, such as
IBM and Monsanto, and o f federal agencies, such
as the Environmental Protection Agency. The
presence o f the park has also lured some heavy
manufacturing branch plants o f companies like

o

A good overview o f the development o f Route 128, Silicon
Valley, and Research Triangle is in Robert Premus, “Location o f
High Technology Firms and Regional Economic Development,"
Joint Economic Committee o f Congress, (Washington, D.C.:
Government Printing Office, 1982), Appendix A.

Digitized 6for FRASER


•7

See Paul Horvitz, “A Park That's Always in Season,” Raleigh,
N.C. News and Observer, (February 27, 1977), p. 1.
4See Roger Lopata, “ Research Triangle: A Far Out Concept
That Worked,” Iron Age. November 23, 1981.

FEDERAL RESERVE BANK OF PHILADELPHIA

Targeting High Tech

General Electric and SCM Glidden Metals to loca­
tions just outside the park’s boundaries. By and
large, however, relatively little employment has
been generated in the area through start-ups of
small high tech companies.
These three examples show two alternative
ways in which high tech concentrations have grown:
through civic efforts to attract branch facilities o f
large multi-establishment organizations, as in
North Carolina, or through largely private initia­
tives leading to the growth o f new high tech ven­
tures, the type o f development that has charac­
terized the Boston-Cambridge nexus and Silicon
Valley. Both components o f employment growth
probably generate a sizable proportion o f new
high tech jobs.5 Both branch plants and new firms
can expand over time, adding to the third impor­
tant source o f job growth, expansions o f existing
firms. Both can themselves spin o ff still more new
firms, as employees with a desire to run their own
business and the technological know-how to create
a new product decide to become entrepreneurs.
Since traditional economic development activities
have emphasized attracting facilities from outside,
success stories like Research Triangle’s have
prompted many states and localities to adapt their
programs to attracting branch facilities o f high
tech firms.

GOING AFTER BRANCHES
As high tech markets expand, and high tech

5A substantial percentage of total employment growth in all
industries— not just high tech— comes from start-ups and
branches. Researchers at M.I.T. have estimated that between
1979 and 1980,4,275,000 million net new jobs o f all types were
added in the U.S. by start-ups, and 1,903,000 net new jobs of all
types were added through new branch plants. See David Birch
and Susan MacCracken, "The Small Business Share o f Job
Creation: Lessons Learned from the Use o f a Longitudinal File,”
M.I.T. Program on Neighborhood and Regional Change, March
1983 (mimeo), Table 8. Researchers from the Brookings In­
stitution using the same data base had previously come up with
smaller totals for the number o f jobs generated by new ventures
and a larger proportion for the number generated by branches
for 1976-1980, but the percentages are still large for both
components. See Catherine Armington, “ Further Examination
o f Sources of Recent Employment Growth: Analysis o f USEEM
Data for 1976 to 1980,” Business Microdata Project, The Brook­
ings Institution, March 1983 (mimeo). It is likely that job growth
in high tech industries follows roughly the same pattern as total
employment growth.




John M. L. Gruenstein

firms expand to meet the demand, they often set
up new branch establishments. This growing pool
o f new high tech branches is a tempting prize for
regions to compete for. States and localities have a
variety o f instruments at their disposal to try to
attract high tech branches, including low interest
loans, tax abatements, providing land at below
market value, and other potentially costly programs.
For any region, the amount they want to spend
depends on the probability o f success, which, in
turn, depends on the number o f competitors and
the comparative advantage o f the region.

Stiff Competition. W hile high technology
markets are growing fast, so is the number o f state
and local initiatives aimed at high technology
development. Before 1981, the U.S. Office of
Technology Assessment (OTA) reported nine state
programs. Ten more were started in 1981, fifteen in
1982, and by May 1983, there were 38 state pro­
grams in 22 states exclusively dedicated to high
technology development— including Pennsylvania’s
Ben Franklin Partnership Fund.6
Two aspects o f the pursuit o f high tech branches
deserve to be noted. First, regions are unlikely to
be able to induce firms to make a decision to
branch: they can only try to induce firms to locate
establishments in their area once the firms them­
selves have decided to branch. So the number of
branches that regions are competing for is largely
a result o f macroeconomic and industry condi­
tions, and therefore out o f the control o f regional
policymakers. Second, the competition for those
branches is stiff, and such strong competition
among regions means that high tech firms looking
to construct a new branch plant can do a lot o f
shopping around to get the best deal from local
economic development agencies. Officials in one
region are under great pressure to match the in­
terest rate subsidy, tax break, site price, or special
training programs that other localities are offering.
Thus, competition pushes up the costs o f putting

®U.S. Office o f Technology Assessment, Technology. Innovation,
and Regional Economic Development. Background Paper # 1 (May
1983) and Background Paper # 2 (February 1984). The state
programs described in these publications include ones directed at
stimulating high tech entrepreneurship and technology transfer
to firms in older industries, as well as high tech branch plant
attraction.

7

BUSINESS REVEIW

together a winning hand in the game o f attracting
branches.
To a large extent, the costs o f attracting branches
depend on a region’s initial comparative advan­
tage— the underlying structure o f cost and market
factors that an incoming firm faces. A poker player
may improve his hand by drawing new cards, but
the probability o f winding up with a winning hand
depends a lot on how good his hand was to begin
with. So, in assessing the prospects for improving
the Delaware Valley’s chances for attracting high
tech branch plants, it is important to know what
factors are the most significant to high tech location
decisions and how the region stacks up on these
factors.

High Tech Location Factors. Three recent
studies, one by the Joint Economic Committee
(JEC) o f Congress, one by the Fantus Company, a
consulting firm, and one by a research group at
Berkeley, have attempted to find out what factors
are important to location decisions o f high tech
firms. In June 1982 the JEC released a study o f
high technology manufacturing industries based
on a survey sample o f almost 700 high tech firms.7
The respondents were asked what were the most
significant factors influencing a firm’s choice o f
region. Highest rated was the availability o f skilled
labor: about 90 percent o f the respondents stated
this was a “ significant’ or “very significant’ factor.
The next most important factors were labor costs
and taxes, follow ed by the presence and quality o f
academic institutions, cost o f living, transportation,
and access to markets. Some factors associated
with more traditional manufacturing concerns,
such as energy costs and access to raw materials,
were ranked fairly low. Somewhat surprisingly,
climate and cultural amenities, which are some­
times described in the popular press as quite
important to high tech firms, were also rated low.
The second report, undertaken by the Fantus
Company (a consulting firm which specializes in
helping firms find sites for new facilities), reviews
86 location studies for high technology facilities,
and it supports and refines the JEC results.8 The

7

'Robert Premus, “ Location o f High Technology Firms and
Regional Economic Development,” Joint Economic Committee
o f Congress. June 1, 1982.
8Robert M. Ady, “ High-Technology Plants: Different Criteria

8



MAY/JUNE 1984

Fantus study divides high technology facilities
into three categories based on the stage o f product
development, with the two later stages most rele­
vant to branch plant location decisions.9 In the
second stage o f development, the facility is de­
scribed as product-driven. In this stage, the product
is commercially viable, but without strong com­
petition. Close monitoring o f production to assure
quality control is important, and there may be a
need to modify individual units to meet customer
specifications. Here, the main location factors are
availability o f technicians and skilled workers,
accessibility to the R&D facility o f the parent firm,
attractive living conditions, and a favorable busi­
ness climate. At the third stage o f the high tech
product life-cycle, the market-driven phase, price
competition from other firms pushes the location
choice toward the lowest cost location. At this
stage, the most important locational criteria are
the availability o f low cost labor, low cost utilities,
and government incentives.
A third study, conducted by researchers at the
University o f California at Berkeley in 1983, found
a very different pattern.10 Instead o f relying on
survey data, the Berkeley study analyzed actual
concentration and growth patterns o f high tech­
nology employment and plants across regions
during the period 1972-1977. In contrast to the
JEC study, the Berkeley group found virtually no
relationship between labor costs (as measured by
average manufacturing wages in 1977) and high
technology activity. In fact, after examining a wide
range o f variables, the Berkeley group found very
little explanatory power from most o f the common
hypotheses concerning high tech location factors,
and found conflicting results from different sorts
o f tests. In general, high defense spending and

for the Best Location,” Economic Development Commentary.
(Winter 1983), pp. 8-10.
fa c ilit ie s in the first stage o f development, described as
theory-driven are primarily embryonic firms doing advanced
theoretical research. As the discussion o f new high tech ven­
tures in the next section points out, most firms at this stage o f
development do not make an explicit location decision, but
rather start up wherever the founders happen to be.
^ A m y K. Glasmeier, Peter Hall, and Ann R. Markusen,
“Recent Evidence on High Technology Industries’ Spatial
Tendencies: A Preliminary Investigation,” Institute o f Urban
and Regional Development, University o f California, Berkeley,
Working Paper No. 417, (October 1983).

FEDERAL RESERVE BANK OF PHILADELPHIA

John M. L. Gruenstein

Targeting High Tech

good access to major airports were most consis­
tently related positively to growth o f high tech­
nology industries. Less consistently, the presence
o f major universities with good engineering or
business schools was also found to be associated
with high tech activity.
From the point o f view o f an economic develop­
ment planner trying to assess the attractiveness o f
his region for high tech branch plants, the Fantus
and JEC studies are probably better guides than
the Berkeley study. It is true that the latter has the
advantage o f looking at the results of actual location
decisions, rather than merely asking respondents
before the fact what they would do, as the JEC
study does. But this advantage is counterbalanced
by the fact that the Berkeley study analyzes aggre­
gate employment changes, which include employ­
ment increases due to new start-ups and expan­
sions o f existing firms, as well as those due to
branch plant openings, along with employment
decreases due to facility lay-offs and closings.11
Thus, the lack o f significance for most location
factors found by the Berkeley study, and its lack of
consistency with the more narrowly focused surveys,
may very well be a good indication that different
factors influence these different components o f
change— a point that relates closely to the Fantus
study’s finding that facilities at different stages of
production respond to different location factors.

Delaware Valley’s Climate for Branch
Plants. Because the relatively consistent results
o f the Fantus and JEC studies likely provide a good
indication o f factors important to high tech branch
plant location decisions, they are useful for ana­
lyzing the strengths and weaknesses o f a parti­
cular region for branch plant attraction. In general,
the Delaware Valley seems to rank about average
on factors that the two studies found most sig­
nificant, such as labor skills and costs and taxes
(see TABLE 2 page 10). Some o f the area’s stronger
attributes, such as the presence o f high quality

11 Employment changes due to all these other components
combined have been shown by other researchers to be far
larger than the changes due to branch location. Birch and
MacCracken, in "The Small Business Share o f Job Creation
found employment changes for all industries (not just high
tech) due to new branch plants were only 12 percent o f gross
employment change from all components and only about 39
percent o f net change, for 1979-80.




academic institutions and a major airport, lie in
the middle range o f high tech facility location
attributes as described by the JEC study. In some
cases, what are perceived to be Delaware Valley
strengths, like the presence o f strong arts and
cultural institutions, seem to be relatively unimpor­
tant to high tech firms. (Separating branches into
the two categories o f the Fantus study indicates
that the area does somewhat better on factors
affecting product-driven facilities than on factors
for market-driven facilities, but even so, the pluses
and minuses are relatively equal.)
The overall impression is that in terms o f
com peting fo r high tech branches, the Delaware
V alley’s advantages compared to other areas are
balanced by factors on which the region rates no
better than average. Given the stiff com petitive
environment, these results suggest that while
some benefits can be gained by targeting
branches, it is likely to be a costly, uphill battle.
But this need not mean that an emphasis on high
technology has little place in local econom ic
developm ent efforts. An alternative to targeting
high-tech branch plants for econom ic d evelop­
ment is to focus instead on stimulating start-ups
o f new high tech nology firms by local entre­
preneurs.

TARGETING HIGH TECH START-UPS
An advantage o f targeting start-ups is that an
entrepreneur’s decision to set up a business very
rarely involves a location decision. Most people
who decide to produce and market a new product
or service usually start up wherever they happen to
be at the time— the decision is whether to set up the
firm, not where. Because o f this, one region’s gain
in an additional new venture isn’t necessarily
another region’s loss, as it is in the case o f high
tech branches. So local efforts to increase the rate
o f start-ups may actually be able to expand the
total number o f new ventures nationally, creating
a larger overall pot for regions to go after, as well as
increasing the probability o f getting a share. Thus,
economic development activities directed at start­
ups run into less direct competition with other
areas than those directed at branches.1
121
19

"‘ Regions attempting to stimulate start-ups would be com­
peting indirectly, however, in the sense that an entrepreneur in
one region could be competing with a firm in another.

9

BUSINESS REVEIW

MAY/JUNE 1984

TABLE 2

DELAWARE VALLEY RANKING ON HIGH TECH LOCATION FACTORS
Effect on Firms

Factor

Attractiveness o f
Delaw are Valley

JEC

Fantus

Good Labor Skills

High

Strong

Low Labor Costs

High

Strong

M edium

Good tax climate
Academ ic Institutions

High
M edium

Strong
Strong

Low Cost o f Living/
Low H ousing Prices

M edium

Strong

Low to M edium
High
M edium

Good Access to Markets
Good Regional Regulatory

M edium
M edium

Not Strong
Strong

High
N o good measure

Practices
Low Energy Costs/

M edium

Strong

Low

Low
Low

Strong

Climate

Strong

High
M edium

Access to Raw Materials

Low

Not Strong

M edium

M edium

Availability
Cultural Amenities

NOTE: This table summarizes the JEC and Fantus studies results. In the JEC study, respondents were asked to rate each
factor as "very significant, significant, somewhat significant, or no significance,” with respect to location choices. The
percent o f “very significant” and "significant” responses were added together to obtain a ranking o f overall importance.
"High” represents 70-90 percent response, “ Medium” represents 40-60 percent response, and “Low” represents under 40
percent response. The Fantus study rankings are relevant for product-driven or market-driven stages o f firm development
The Delaware Valley rankings were constructed by using variables corresponding to the JEC and Fantus categories that
were available either for SMSAs, states, or cities (Delaware Valley is defined here as the Philadelphia SMSA, including
Philadelphia, Bucks, Chester, Delaware, and Montgomery counties in Pennsylvania, and Burlington, Camden, and
Gloucester counties in New Jersey). In some cases the ranking among the largest states or the largest cities was used. “High”
indicates best third, “ Medium,” middle third (or, in some cases, within 10 percent o f the U.S. average), and “ Low," bottom
third, where order reflects attractiveness to high tech branches.
The labor skills variable was measured as percent o f high school graduates and percent o f college graduates in
population aged 20-64.a The labor costs variable was measured as average hourly earnings o f production workers in
manufacturing.^1 The tax climate variable was based on a study comparing state and local taxes paid by a model
manufacturing corporation in various cities.c Academic institutions, cultural amenities, and climate variables were
measured among SMSAs d Cost o f living/housing was also measured among SMSAs, and was chiefly determined by the
median value o f owner-occupied homes.e Energy costs were measured as the average prices o f residential utility, gas,
electricity, and fuel oil # 2 .f Objective measures for the remaining variables were not available, and those rankings reflect the
author’s judgment.

aU.S. Bureau o f the Census, U.S. Summary o f Census o f Population, 1980. (Washington, D.C.: Government Printing Office,
1982).
^U.S. Bureau o f Labor Statistics, Employment and Earnings (Washington, D.C.: Government Printing Office, March,
1984).
cPennsylvania Economy League, Taxes in Philadelphia Compared to Other Large Cities. Report No. 415 (Philadelphia, 1980).
d Richard Boyer and David Savageau, Places Rated Almanac: Your Guide to Finding the Best Place to Live in America (N. Y.: Rand
McNalley & Co., 1981).
eIbid., and U.S. Department o f Commerce, State and Metropolitan Area Data Book (Washington, D.C.: Government Printing
Office, 1982).
fy.S. Bureau o f the Census, Statistical Abstract o f the U.S.. 1982 ■ 1983 (Washington, D.C.: Government Printing Office,
1984).

10




FEDERAL RESERVE BANK OF PHILADELPHIA

Targeting High Tech

Targeting start-ups involves risks for a com­
munity as well. Many new firms fail in the first few
years o f business. To expand employment signifi­
cantly, regions need to create conditions which
increase both the probability that people will
choose to start new high tech firms and the pro­
bability that their ventures will succeed. A number
o f studies have investigated the factors important
to new ventures. In general, these studies have
found that the needs o f start-up firms are very
different from those o f new branch plants.13
Factors Important to Start-Ups. One
factor important to a region’s probability o f gen­
erating start-ups is the pool of potential entrepreneurs.
Entrepreneurs are often people in existing tech­
nology-oriented firms who have an idea which the
company is unwilling or unable to develop. Such
people may be tempted to start up a new firm if
entry into the particular field is not too difficult for
a small firm. (Some fields, like pharmaceuticals,
are harder for small firms to compete in because o f
high development, testing, and market costs,
while others, such as electronics, are easier to
enter.) Faculty and students in universities in the
area also are potential business founders. How
large the pool is depends partly on numbers o f
businesses and local academic institutions, but
size isn’t everything. Different places seem to have
different entrepreneurial climates— that is, cultures
encouraging or discouraging entrepreneurship. A
positive climate, which feeds on demonstrations
o f previous successes, can encourage people to
take the risks and endure the hardships associated
with start-ups.
A very important factor for new ventures is the
availability o f capital. New firms need different
types o f financing at different stages o f develop­
ment. In the earliest phase, prototypes o f the
product or service are typically being developed, a
management team is being assembled, and busi-1

1^

Studies describing the factors important to high tech­
nology start-ups include Edward B. Roberts, “How to Succeed
in a New Technology Enterprise,” Technology Review (December,
1970); Karl H. Vesper, New Venture Strategies (Englewood Cliffs,
NJ: Prentice-Hall, 1980), Arnold C. Cooper and John L. Komines,
eds., Technical Entrepreneurship: A Symposium (Milwaukee,
Wisconsin: The Center for Venture Management, 1972), and
Elizabeth P. Deutermann, "Seeding Science-Based Industry,”
this Business Review. (May, 1966).




John M. L Gruenstein

ness plans are being formulated. Financing for this
stage, commonly called seed money, is often
provided by informal sources, family and friends,
or through personal resources. At the next stage, in
which a high tech firm gears up for commercial
production levels, financing is often provided
through venture capital— fairly risky equity fi­
nancing that is unsecured by assets. Decades ago,
venture capital, if available at all, was usually
provided by wealthy individuals through private
placements. Since W orld War II, formal organi­
zations devoted to providing venture capital,
mainly limited partnerships and small business
investment corporations (SBICs), have provided
increasing amounts o f such financing. At a later
stage o f development, when assets have been
acquired and the firm is operating close to or at
profitability, capital may be available from a wider
variety o f sources, ranging from ordinary com­
mercial loans from a bank to a public stock of­
fering.
The existence o f suitable sites for operations is
another factor in the start-up process. The site
requirements o f a new venture are typically very
different from those o f a branch plant o f a large
firm. Low-rent space is usually vital to hold down
costs in the beginning. Sometimes it is important
for such a site to be close to a university or re­
search facility— for instance, if specialized labor­
atory equipment or professional libraries available
on campus can be used, if the founders are still
faculty members or students, or if consulting help
is needed. Access to shared business services, like
photocopying or a receptionist, can be another
useful feature o f an incubator site. Only at a later
stage o f growth will a new company often be able
to afford the large new facility in a suburban light
industrial park setting that a branch plant may
prefer.
Most o f the factors influencing the develop­
ment o f new firms are quite different from those
affecting branch plant location decisions (see
FIGURE 1 page 12). Capital— particularly venture
capital— the entrepreneurial climate, and low-rent
sites foster start-ups, but are relatively unimpor­
tant for branch plant location decisions. Labor
quality, labor cost, and taxes probably play a role
for branches, but have little likely effect on entre­
preneurial vigor— at least at an early stage. Uni­
versities affect both kinds o f decisions, because
11

BUSINESS REVEIW

MAY/JUNE 1984

FIGURE 1

DIFFERENT FACTORS
INFLUENCE HIGH TECH BRANCH LOCATION DECISIONS
AND THE SUCCESS OF NEW VENTURES
BRANCH PLANT

START UP

they provide a pool o f technical people who can
become either employees o f high tech branches or
entrepreneurs them selves.14 Because o f these

differences, a region’s comparative advantage in
fostering new high tech ventures could be quite
different from its comparative advantage for at-

1U n iversities probably attract branches and stimulate start­
ups in some other ways as well, for example, by providing

possibilities for further study or teaching for branch employees
or by sharing equipment and libraries for start-ups.

12 FRASER
Digitized for


FEDERAL RESERVE BANK OF PHILADELPHIA

Targeting High Tech

tracting high tech branches.

Delaware Valley’s Climate for StartUps. The Philadelphia metropolitan area has a
large pool o f potential entrepreneurs. The region
has many existing technology-based firms, several
high quality universities, six medical schools, and
many other research facilities, which serve as a
breeding ground for new high tech ventures.
Researchers from the University o f Pennsylvania,
for example, have founded several biotechnology
companies in recent years, including Centocor,
Biological Energy, and Phospho-Energetics. SMS
Corporation o f Malvern, Pennsylvania, a software
company with revenues over $200 million, was
started in 1969 by three locally-based salespeople
for IBM. SMS has itself been the source o f more
local spin-offs, including fast-growing Rabbit
Software, founded in 1982.
Despite this large pool o f potential company
founders, the entrepreneurial climate o f the Dela­
ware Valley has been described as being some­
what weaker than that o f other parts o f the country
that have experienced fast high tech growth.15
Assessing anything so hard to quantify as a cul­
tural factor o f this sort is a risky business, o f
course, and systematic studies are hard to come
by, but a general feeling that this is true has
persisted. Over the past few years, a group o f new
regional organizations— including the Technology
Council o f the Greater Philadelphia Chamber o f
Commerce, the Delaware Valley Venture Group,
and the Advanced Technology Center o f South­
eastern Pennsylvania— have worked to improve
the climate for high tech entrepreneurship through
the provision o f free legal and accounting services,
technology transfer conferences, the publication
o f a technology newsletter, and other means.16
Capital availability— particularly venture capital—
has been a problem in the past, but conditions
have changed greatly in the last year. As recently
as 1982, a report on venture capital in the area
stated that

John M. L Gruenstein

the net impression is that there is little money
currently available in the Philadelphia area which
is oriented toward start-up and first-stage venture
financing and virtually no “organized” money
available in the seed financing category. 17

The same report pointed out that Pennsylvania,
New Jersey, and Delaware ranked low on the
number o f venture capital limited partnerships,
compared to states like California, Massachusetts,
and New York. But in the last year, conditions have
changed. One local venture capital partnership,
capitalized at $20 million, has started up, and a
half dozen other funds are in various stages o f
development lo ca lly.1
18 Although probably not all
7
o f these partnerships will get o ff the ground, the
supply o f venture capital in the area coming from
organized sources is definitely increasing.
Site availability for high tech start-ups in the
area is good. In addition to having a stock o f older
buildings, which provide low-rent space, the region
has at least three facilities explicitly designated as
incubators— the University City Science Center
and the Business Technology Center in West
Philadelphia, and the Technology Center in Mont­
gomery County. The Route 202 Corridor near King
o f Prussia and Malvern has provided another
fertile area for start-ups, like Rabbit Software, and
for relocating firms, like Centocor, which began
elsewhere in the area and needed more space.
Because the requirements o f new high tech
ventures are harder to quantify (aside from capital)
than those o f high tech branches, assessing how
the Delaware Valley ranks in this area is more o f a
judgment call. As with high tech branch location
factors, the metropolitan area probably falls some­
where in the middle range compared to other
regions. But in some ways the possibilities for
improving the conditions for high tech entrepre­

17RobertMittelstaedtand Thomas A. Penn, "Venture Capital
(or Lack Thereof) in the Philadelphia Area,” A Report o f the
Venture Capital Ensemble Group: Philadelphia, Past, Present
and Future Project (Philadelphia: Wharton Innovation Center,
University o f Pennsylvania, August 1982).
18

1^Digby Baltzell, in Puritan Boston and Quaker Philadelphia
(New York: Free Press, 1980), puts forth a form o f this thesis.
16These organizations are also working actively to promote
the transfer o f new technologies to mature industries in the
region as another way o f spurring economic development.




Although capital in general is a very mobile resource, ven­
ture capitalists often like to finance nearby deals or have a local
partner in a syndication, because the early stage o f the venture
requires a large information flow and much face-to-face inter­
action. So having locally based venture capital firms increases
the probability that local entrepreneurs will secure financing
and reduces their costs (time and money) o f getting it.

13

BUSINESS REVEIW

MAY/JUNE 1984

neurs are better than for improving the conditions
for branch location. Improving labor skills, lower­
ing labor costs, and creating a better tax climate—
the factors conducive to branch location— involve
very broad institutional changes, whereas setting
up a venture capital partnership, while difficult,
requires the cooperation o f far fewer people.

IN SUM
Motivated by success stories in other regions,
Delaware Valley policymakers are turning to high
tech industries as a component o f an overall
regional growth strategy. Competition is s t i f f other regions are wooing electronics, biotechnology,
and computer firms with great vigor— and stiff
competition means that the potentially large payoff
from attracting a high tech branch plant can be
offset by the increasingly high cost o f trying. The
Delaware Valley ranks about average on the factors
which influence high tech location decisions, so
the probability o f attracting high tech branches,

particularly those for which cost competition is
extremely important, is somewhere in the middle
range.
An alternative to trying to attract high tech
branches is trying to stimulate high tech entre­
preneurship. The Delaware Valley has the advan­
tage o f a large pool o f potential entrepreneurs.
While many regions also are striving to promote
high tech entrepreneurship, competition in this
sphere has less o f an effect on the probability o f
success and the net payoff. As with branches, the
Delaware Valley’s underlying conditions for fos­
tering entrepreneurship are about average, but it
may be easier to change features o f the area, such
as a lack o f venture capital, which hold down new
venture formation, than to change those factors
which make it less attractive for high tech branches.
So if Delaware Valley planners decide to play a
“high tech” game, they have a better chance to
score with start-ups than with branches.

FURTHER REFERENCES
In addition to the references cited in the footnotes, the follow ing Federal Reserve System publications
provide valuable analyses and inform ation about high tech.
Lynn E. Browne, “H igh Tech in the Great Lake States,” New England Economic Review, (Novem ber/Decem ber
1983).
Lynn E. Browne, “High Technology and Business Services,” New England Economic Review. (July/August
1983).
LynnE. Browne and J o h n s. Hekman, “N e w England’s Economy in the 1980s,” New England Economic Review,
(January/February 1981).
John S. Hekman, “Can N ew England Hold On To Its High Tech Industry?” New England Economic Review.
(March/ April 1980).
John S. Hekman, “The Future o f H igh Technology Industry in N ew England: A Case Study o f Computers,” New

England Economic Review. (January/February 1980).
John S. Hekm an and M ike E. Mills, “Venture Capital and Economic Growth in the Southeast,” Federal Reserve
Bank o f Atlanta, Economic Review. (July 1983).
Donald L. Koch, W illiam N. Cox, Delores W . Steinhauser, and Pamela V. W higham , “High Technology: The
South Reaches Out for Growth Industry,” Federal Reserve Bank o f Atlanta, Economic Review, (September
1983).
W. Gene W ilso n and Gene D. Sullivan,” The Advent o f Biotechnology: Implications for Southern Agriculture,”
Federal Reserve Bank o f Atlanta, Economic Review, (M arch 1984).

14 FRASER
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FEDERAL RESERVE BANK OF PHILADELPHIA

In the ongoing debate about the size o f federal deficits, views vary widely among economists. In
the follow ing article, the author uses a particular framework to assess the size o f the federal deficit
in light o f concerns about economic efficiency. Other views about the deficit based on alternative
frameworks may appear in the Business Review from time to time.
— Editor

Sizing Up The Deficit:
An Efficient Tax Perspective
Brian Horrigan*
It seems that everyone is talking about the size
o f recent and projected federal government budget
deficits these days, and many believe that deficits
should be very low or zero. A number o f politicians,
journalists, and pundits seem to worship at the
shrine o f the balanced budget. The popular view is
epitomized by Shakespeare’s dictum: “ Neither a
borrower nor a lender be.” Contrary to popular
belief, there are good reasons why a fiscally re­
sponsible government should sometimes run bud­
get deficits, even large budget deficits for several
years in a row. Deficits and surpluses perform an
important econom ic function, namely, to promote

"Brian Horrigan is a Senior Economist in the Research De­
partment at the Federal Reserve Bank o f Philadelphia.




economic efficiency. Indeed, if efficiency is the
main criterion in deciding how to finance govern­
ment expenditures, then the budget will typically
be in a deficit or surplus position. From this point
o f view, the question in the deficit debate should
focus not on whether there should be deficits, but
instead on whether deficits are “too large” or even
“too small” to further efficiency.

W H Y DEFICITS? SOME BUDGET BASICS
In many ways, the government is no different
from any o f us. People do not typically run a
balanced budget year in and year out; neither does
the government. Because their receipt o f cash is
rarely synchronized with their spending desires,
people sometimes spend more than they receive in
income (by using their savings or by borrowing),
15

MAY/JUNE 1984

BUSINESS REVEIW

and other times they spend less than they receive
(saving the difference). As with individuals, the
government sometimes borrows and sometimes
saves because it is inefficient — it wastes resources—
to synchronize perfectly its income (tax revenues)
with its spending plans.
In other ways, the government is radically dif­
ferent from the individual. In particular, the gov­
ernment is “immortal.” An individual, for example,
can borrow only up to his expected ability to repay
the principal and interest on his loans within his
own lifetime. Since the government’s “ lifetim e” is
indefinite, it can refinance its debt year after year,
so long as its capacity to raise tax revenues to pay
the interest on the debt is assured.1
Some economists hold the view that government
deficits play no major role in econom ic activity
unless they are so big that, if they continue, it
would be doubtful that the government could raise
taxes to service its debt. (Indeed, the weight of
economic research has not indicated a strong re­
lationship between government deficits, or debt,
and economic activity.) If we adopt this view of
government deficits, which is an unsettled issue in
macroeconomics, and if we emphasize eliminating
waste in financing government spending, then
some judgments can be made about whether pro­
jected deficits are too large. (See Debt Neutrality in
A THEORY OF DEFICITS.) The logic involves a
notion o f “efficient taxation,” which suggests a
rule for financing government expenditures while
minimizing tax-related inefficiencies in the econ­
omy.

H OW TO SET TAXES TO MANAGE THE
DEFICIT
Judgments about how to finance government
spending, and, therefore, to manage deficits, are
very different from judgments about the proper

'The government, like each individual, faces an intertem­
poral budget constraint: the present value o f all tax revenues
equals the present value o f all government non-interest spend­
ing plus the value o f the national debt. The constraint can only
be violated by declaring bankruptcy.
Throughout this paper, I ignore the possibility that some
government revenues come from the creation o f money—
"seignorage,” in economic jargon. If the present value o f
spending plus the national debt exceeds the present value of
tax revenues, the government presumably must print money
(with inflationary consequences) to close the gap.

16 FRASER
Digitized for


size o f government or the level o f expenditure on
particular items. Unfortunately, these two issues
have been confounded in much o f the discussion
about the size o f the deficit. Economists who
apply the principles o f efficient taxation to the
problem o f financing government spending take
the level o f government spending as given, and
ask: what is the best way to finance current and
future government spending?
The government could keep the budget balanced
(or nearly so), if it so desired, by raising tax rates
whenever tax revenues fell below expenditures,
and by reducing tax rates whenever tax revenues
were larger than expenditures. Many economists
do not think such a policy is sensible because it is
inefficient. They argue that a policy which fre­
quently raises and lowers tax rates imposes un­
necessary costs on the economy. Instead, they
claim, it is preferable to stabilize tax rates, and to
let deficits and surpluses occur.
The theory underlying this notion rests on two
propositions: first, taxes cause inefficiencies—
waste— in the economy. For example, income
taxes discourage work and investment, change the
allocation o f resources among industries, generate
administrative and collection costs, and encourage
tax avoidance and tax evasion. Economists call the
economic inefficiencies caused by these distor­
tions the “deadweight loss due to taxation.” Second,
as tax rates rise, these deadweight losses rise more
than proportionately. If tax rates increase twofold,
for example, then the deadweight loss more than
doubles.2 Resources are wasted adjusting to the
changes in tax rates.
Taken together, these two propositions imply a
tax “rule” that sets the tax rate as low as possible
(given projected government spending and tax
base changes) and that stabilizes the tax rate, that
is, that minimizes fluctuations in the tax rate.
Following a rule based on the importance o f e ffi­

2

For a discussion o f the theory and evidence concerning the
inefficiencies caused by the tax system, see A. Protopapadakis,
“ Supply Side Economics: What Chance for Success?” this
Business Review. (May/June) 1981. There is a large literature on
the economic theory of efficient taxation. Standard references
are: A. Harberger, Taxation and Welfare. (Boston: Little, Brown
and Co., 1974), Chapter 2, and A. Atkinson and J. Stiglitz,
Lectures on Public Economics, (New York: McGraw-Hill Book Co.
1980), Chapters 11 to 14.

FEDERAL RESERVE BANK OF PHILADELPHIA

Brian Horrigan

Sizing Up the D eficit

cient taxation suggests that there will be deficits
(indeed, that there ought to be deficits— see
Principles o f Efficient Taxation in A THEORY OF
DEFICITS) whenever there are changes in economic
conditions. And econom ic change, o f course, is
typical o f our world: GNP and the tax base grow
over time, there is inflation, GNP fluctuates with
the boom and bust o f the business cycle, and
government expenditures fluctuate during the
business cycle and between wartime and peace­
time.

W H Y THERE SHOULD BE DEFICITS
...With Economic Growth... a somewhat
surprising implication o f the efficient-tax rule is
that if real (inflation-adjusted) GNP grows steadily,
then the debt should grow with it, which means, of

course, that there will be continuing deficits.
(Recall that the efficient tax principle presumes
that deficits have no macroeconomic impact save
these financing considerations.) For example, take
an economy in which real GNP, the tax base, and
government expenditures (excluding debt service—
interest payments on the debt) are expected to
grow at the same fixed rate indefinitely. If the tax
rate were set so that the budget was balanced now,
then in the future the government would show
increasing surpluses as the economy continues to
grow. The surpluses come about because tax re­
ceipts grow as the tax base grows. However, the
debt service component o f the budget remains
constant, because the debt is not growing. Thus,
total government expenditures (non-interest ex­
penditures plus debt service) will grow more slowly

A THEORY OF DEFICITS
Some econom ists have worked out a theory which attempts to find the optimal com bination o f deficits and
taxation necessary to finance a given pattern o f government spending plans. The theory o f optimal deficits
rests on two pillars: first, the proposition that government debt is neutral, and second, the theory o f efficient
taxation.

Debt Neutrality
The proposition that debt is neutral recognizes that government spending must be paid for and suggests
that governm ent debt is nothing more than a means o f substituting future taxation for current taxation. If
people are rational, they realize that real deficits today imply higher taxes in the future. Knowing that higher
future taxes will reduce their future after-tax income, people will save more when there is a deficit to maintain
a constant level o f consumption. In other words, people base their consum ption plans on the present value o f
their after-tax income. Suppose the governm ent were to reduce taxes by $ 1 billion today, issue a bond (that is,
run a deficit) worth $ 1 billion bearing an interest rate of, say, 6 percent, and announce that it will raise taxes by
$ 1.06 billion nextyear to pay the debt plus interest. Then rational taxpayers w ould save the $ 1 billion from the
deficit caused by the tax cut, invest it in a bond earning 6 percent, and use the principal and interest from the
bond to pay o ff the tax increase in the follow ing year. By acting in this way, they are better o ff than not saving
the $1 billion today and having to consum e $1.06 billion less the next year when taxes are raised. Deficits
(surpluses) raise (reduce) savings, dollar for dollar, according to the theory o f debt neutrality.
W h e n debt is neutral, deficits do not raise interest rates, crowd out borrowers, reduce investment,
appreciate the dollar on foreign exchange markets, or cause inflation, because deficits automatically
generate enough extra savings to fund the deficit.

Principles o f Efficient Taxation
Deficits redistribute the tax burden from year to year. But is there a unique pattern o f taxes better than any
other? If all taxes were lum p-sum (fixed amounts) in nature, then as long as debt is neutral it would not matter
how or w hen the governm ent ran deficits. But what if taxes are not lump-sum, but instead are proportional to
income? This is where the theory o f efficient taxation plays a role. As long as debt is neutral, the only
consideration necessary in setting the level o f deficits is the goal o f minimizing the deadweight loss due to
taxation. Efficient taxation requires that tax rates be set so that they are expected to remain constant, given
forecasts o f future G N P and government spending. If new information is obtained, the tax rate must be
revised to reflect the new information. The new tax rate must be set such that, once again, the expected tax
remains constant in the future. (M ore technically, the tax rate follow s a random walk.) If tax rates are set
efficiently, then the deficits that result are "efficient” deficits.




17

BUSINESS REVEIW

MAY/JUNE 1984

than tax receipts. In fact, as the government shows
surpluses, the debt will shrink, reducing the debt
service. If the government wished to maintain a
balanced budget over time, it would have to keep
reducing the tax rate. But, according to the efficient
tax rule, a strategy o f continuously falling tax rates
is inefficient, because resources would be wasted
adjusting to the changes in tax rates. Deadweight
losses would be lower if taxes were lower to begin
with and set so people expected them to remain
unchanged. The efficient tax rate is set to allow
deficits which, on average, grow in real terms at
the same rate as real GNP. Deficits will not show
steady growth, however, because they will fluctuate
with inflation and business cycles.

tion that actually occurs has been correctly antici­
pated, then the real value o f the debt does not
increase— that is, there is no real deficit— and
therefore, there is no need for additional future
real tax revenues to service it.
The difference inflation makes between real
deficits and nominal deficits can be dramatic. In
the last half o f the 1970s, nominal deficits were
high, but this was due largely to inflation; in 1979,
for example, the nominal deficit was $56 billion,
yet the real deficit was not a deficit at all, but rather
areal surplus o f $7.5 billion.3 Inflation can have a
substantial effect on the dollar value o f the deficit,
but it does not affect real deficits. Business cycles,
however, do affect the size o f real deficits.

...With Inflation... Inflation leads to higher
deficits when the government follow s the tax-rate
stabilization rule, yet such deficits have no impact
on the economy because they do not add to the
real value o f the debt. The link between inflation— a
general rise in prices— and interest rates is the key
to this argument. Workers understand that if
wages double while the price level also doubles,
then real wages haven’t increased at all. Similarly,
investors who buy bonds know that inflation
means that a dollar in the future buys less than a
dollar in the present. So, investors demand higher
interest rates to offset the expected decline in the
dollar’s purchasing power. This rise in interest
rates increases the dollar size o f the deficit.
Suppose, for example, that initially the govern­
ment budget is balanced, and that the inflation
rate is zero. If the interest rate is 2 percent and the
national debt is $1 trillion, then the interest ex­
penditures o f the government are $20 billion. If
the expected inflation rate were to rise from zero to
10 percent, then interest rates would rise from 2
percent to 12 percent (because investors demand
compensation for inflation). The annual interest
expenditures o f the government would rise to $ 120
billion, and the nominal deficit would automa­
tically rise from zero to $100 billion. The deficit
rises, even though tax rates, real governmental
purchases o f goods and services, and real GNP do
not change. The nominal value o f government
spending and taxes rises in step with inflation, as
does the total stock o f government debt. But, since
the price level also rises by 10 percent, only the
nominal value o f the debt changes, not the real
value o f the debt. So, if one assumes that all infla­

...And During Business Cycles. Much of
the variation in real deficits is accounted for by the
responses o f tax revenues and government spend­
ing to business cycles and wars. The business
cycle is the fluctuation o f real GNP around its trend
growth path, and is composed o f a recession (a
significant and prolonged fall in real GNP below its
trend), and a boom (a rise in real GNP above its
trend). When real GNP falls during a recession, tax
revenues necessarily fall also, while at the same
time, government expenditures rise (relative to
trend) due to increased spending on unemployment
compensation, public works, and welfare programs.
Unless the tax rate is changed, the real deficit
automatically rises in a recession and shrinks in a
boom. For example, if GNP falls $300 billion below
its trend value during a recession, and if the tax
rate on GNP is 20 percent, tax revenues will auto­
matically fall $60 billion dollars. At the same time,
government spending on unemployment com­
pensation and other programs may rise $20 billion
above its trend. Then the real deficit will be $80

18 FRASER
Digitized for


3Real deficits are calculated as changes in the real national
debt. The national debt is defined as interest-bearing debt
outstanding plus agency debt whether owned by the public,
foreigners, or the Federal Reserve System. This debt is divided
by the Implicit GNP Deflator (1929=1.0) to generate the real
debt. The annual change in the real debt is the annual real
deficit. Further analysis o f the relationship between the mea­
sured deficit and inflation can be found in: Economic Report o f
the President U.S. (Washington, D.C.: Government Printing
Office, 1982), Chapter 4, and B. Horrigan and A. Protopapadakis,
“ Federal Deficits: A Faulty Gauge o f Governments Impact on
Financial Markets,” this Business Review. (March/April 1982),
pp. 3-16.

FEDERAL RESERVE BANK OF PHILADELPHIA

Sizing Up the D eficit

billion higher than if there were no recession.
Temporary fluctuations in government spending
around its trend occur not only over the business
cycle, but also during wars, and other kinds of
national emergencies (because civilian spending
is never reduced enough to offset completely
increases in military or emergency spending). Just
as the government finances its expenditures with
debt when tax revenues are unusually low during
recessions, so the government should finance
unusually high expenditures with debt.4 In fact,
running real deficits during recessions and wars
and running smaller real deficits or real surpluses
during booms and peacetime has been the pattern
o f deficit behavior in the U.S.
Figure 1 plots the.ratio o f the real deficit to real
GNP for the U.S. from 1790 to 1983. Examining the
graph reveals that large deficits are associated with
wars and recessions, and peace and prosperity
bring smaller deficits or surpluses. The U.S. started
in 1790 with a national debt, the financial heritage
o f the deficits which financed the American Revo­
lutionary War. The new government almost always
ran surpluses (except for some large deficits during
the War o f 1812) until Andrew Jackson paid o ff the
national debt in 1834. The Civil War produced
deficits which drove the deficit-GNP ratio to as
high as 6.6 percent in 1865. After the war, the ratio
was virtually zero— except for a few brief rises
during the 1870s and 1890s— until World War I
raised the deficit-GNP ratio to 17 percent by 1918.
There were surpluses in the years following the
war until the Great Depression produced some real
deficits over 8 percent o f real GNP, and World War
II pushed real deficits over 27 percent o f real GNP
in 1944. Since then, the real deficit-GNP ratio has

4If government expenditures as a share o f national income
rose permanently to a new higher level, tax rates would have to
be raised immediately. If taxes were not raised and the per­
manently higher government spending were all financed by
deficits, the national debt would balloon out o f control, ulti­
mately forcing the government into bankruptcy (but only if the
after-tax interest rate on government debt exceeded the growth
rate o f GNP). If debt plus interest is paid o ff by issuing more
debt, which is paid o ff with more debt, and so on forever, the
national debt would grow more rapidly than national income.
That would amount to a government-run perpetual chain letter,
a Ponzi game— it cannot work. Once the interest bill on the
national debt exceeds the tax capacity o f the government, the
government reaches insolvency.




Brian Horrigan

been low — except during a few recessions in this
period. The ratio was less than 1 percent in 1980.
The recession o f 1981 -1982 produced a real deficitGNP ratio o f 5.7 percent, the highest value o f that
ratio in the post World War II period. Historically,
a high real deficit-GNP ratio is associated with the
real deficits caused by large wars and recessions;
in the intervening period, the real deficit-GNP
ratio is low .5
The behavior o f the government over business
cycles and during wars is exactly analogous to the
behavior o f families with fluctuating incomes.
During hard times, families borrow or dip into their
savings to maintain their standard o f living, and in
good times, families pay o ff loans and rebuild
savings. It would be unwise for the government to
slash spending on, say, national defense, education,
and health merely to keep a balanced budget in a
recession or during a war. And most economists
agree that it is destabilizing and inefficient to raise
taxes during a recession (which would reduce
private spending and discourage work precisely
when employment is low) to maintain a balanced
budget. Tax rates should be changed only when
government spending is changed permanently or
when the path o f real economic growth changes.

H O W LARGE IS TOO LARGE?
Assuming agreement about the size o f govern­
ment spending relative to the economy, the theory
o f efficient taxation and o f the resulting deficits
suggests that the higher real economic growth and
inflation are, the larger deficits should be. Further­
more, during recessions the year-to-year deficits
should rise above the level implied by economic
growth and fall below that level during booms.
By interpreting the U.S. historical experience in
terms o f the efficient taxation theory, and by using
this interpretation o f history, we can get a rough

5The experience o f Britain parallels the experience of the
United States. The financing requirements o f the Napoleonic
Wars drove the British real deficit-GNP ratio to very high levels.
The following century witnessed low real deficit-GNP ratios
(with only a few blips) until 1914. World War I, the Great
Depression and World War II all produced major increases in
the real deficit-GNP ratio, but the ratio fell following all o f
those unfortunate occurrences. Indeed, despite all o f the talk
about Britain’s deficits during the 1960s and 1970s, the ratio o f
real deficits to real GNP was low.

19

MAY/JUNE 1984

BUSINESS REVEIW

FIGURE 1

The graph displays annual values o f the ratio of real deficits to real GNP from 1790-1983. Footnote 3 describes how the
real deficit is calculated.

20




FEDERAL RESERVE BANK OF PHILADELPHIA

Sizing Up the D eficit

idea o f whether present and projected deficits are
out o f line with historical experience.6 This ap­
proach involves estimating the historic relationship
between real deficits and the economic variables
suggested by efficient taxation considerations.
Given forecasts o f real GNP, real government
spending, and inflation, it is possible to estimate
what deficits would be if the U.S. economy con­
tinues to perform as in the past. We call these
estimated deficits “efficient deficits” to distinguish
them from the deficits predicted by various econ­
omists and by government sources. The calculated
“ efficient deficits” are not predictions. Rather, they
should be regarded as benchmark figures that
incorporate both the efficient taxation considera­
tions and the historical performance o f the U.S.
economy. By comparing the actual deficits from
1975 to now, and the projected future deficits to
these “efficien t” deficits, we have a rough and
ready way to judge whether the deficits have been
or will be “too large.” In particular, if the projected
deficits are consistently larger than the efficient
deficits, then this suggests that tax rates are not set
at their “ efficient” levels and should be raised. The
formula for calculating efficient deficits and the
econom ic assumptions underlying the estimates
are explained in the Appendix.
Table 1 presents actual and efficient deficits for
1975 through 1983, and projections o f actual and
efficient deficits for 1984 through 1990. The pro­
jections assume no change in government fiscal
policy and are based on forecasts o f the economy
from Data Resources, Inc. (DRI). Projected actual
deficits exceed $200 billion in 1984 and beyond,
rising to over $300 billion by the end o f the decade.
Efficient deficits are also substantial for the entire
time period, and after 1980, they never drop below
$100 billion. One reason the efficient deficits are
so high is inflation. For example, the contribution

6Barro and others have used statistical methods to determine
how well American deficit behavior conforms to the predictions of
the theory o f efficient deficits. Barro (1979) found that the data
neither strongly accept nor strongly reject the predictions o f
the theory. Barro’s conclusions were verified using different
data by Horrigan (1982, 1984). Benjamin and Kochin (1980) and
Barro (1981) tested the implications o f efficient taxation theory
using American tax data and did not reject the theory. The
theory o f efficient taxation as applied to deficit behavior is
new, but the results o f early tests indicate that it does provide a
plausible description o f deficit behavior.




Brian Horrigan

TABLE 1

ACTUAL AND EFFICIENT
FEDERAL DEFICITS
NO FISCAL
POLICY CHANGE
Year

Federal Deficits

Difference
Between Actual
or Projected
Deficits and

Actual and
Projected

"Efficient”

Efficient Deficits

1975

$ 83.9

$ 71.3

$ 12.6

1976

76.9

45.1

31.8

1977

65.4

40.8

24.6

1978

70.3

40.8

29.5
1.9

1979

55.9

54.0

1980

85.1

105.3

- 20.2

1981

98.5

128.2

- 29.7

1982

168.4

163.2

5.2

1983

213.6

155.1

58.5

1984'

252.4

141.7

110.7

1985*

246.0

160.2

85.8

1986*
1987'

271.4
297.0

186.7
211.7

84.7
85.3

1988'
1989*

292.0
306.7

228.8
249.6

63.2
57.1

1990'

324.9

277.9

47.0

All numbers are in billions o f dollars.
'Projections based on forecasts prepared by Data
Resources, Inc.
aActual deficits, defined as the end-of-year to endof-year change in the gross public debt outstanding, are
from various issues o f the Federal Reserve Bulletin. The
deficit measured this way is nearly always higher than
the deficit measured by the National Income and Product
Accounts or by the Unified Budget, the result o f offbudget financial transactions.

o f inflation to the deficits in 1983, 1984, and 1985
is about $50, $62, and $73 billion, respectively.
The high unemployment currently troubling the
American econom y is another reason for high
efficient deficits. If real GNP equaled its trend
value in 1983, 1984 and 1985, the efficient deficits
in those years would be lower by $105, $78, and
$85 billion, respectively. (Projected deficits would
21

BUSINESS REVEIW

fall by a comparable amount.) Efficient deficits
remain high in the 1980s (exceeding $200 billion
after 1987) because real GNP returns to trend very
slowly and inflation rises to 6 percent in the DRI
forecasts used here.
A balanced budget, or even a small d eficit then,
is far from efficient in the 1980s. In 1980 and 1981,
the actual deficits were smaller than their efficient
levels, while the deficits for 1983 and 1984 are well
above efficient levels. Because the projected defi­
cits for 1984-1990 are consistently above the cal­
culated efficient deficits, these figures lend some
support to those who argue for tax or expenditure
actions to reduce future deficits. But this approach
also suggests that such a fiscal policy package
should not be aimed at producing a deficit sub­
stantially lower than the efficient deficit— in par­
ticular, not a zero deficit.
In fact, tax increases that would appear modest
to many analysts may result in future deficits that
are “too low” relative to efficient deficits. For
example, DRI also has a long-term forecast o f the
economy that is based on what it considers to be a
likely change in fiscal policy effective in 1985. It
involves a gradual rise in tax rates and modest
expenditure reductions. (See Appendix for details.)
The impact o f this fiscal policy on projected
deficits is shown in Table 2, which presents the
difference between the deficits projected on the
basis o f this policy and efficient deficits. As the
negative numbers after 1987 show, projected
deficits actually fall below efficient deficits, and,
over time, the gap between the two widens. This
result is caused primarily by the gradual increase
in tax rates that occurs under DRI’s assumption
about changes in fiscal policy.
From the efficient tax viewpoint, having pro­
jected deficits consistently lower than their e f­
ficient levels implies that tax rates move too high,
and deadweight losses are unnecessarily large. So,
a better strategy, by the standards o f tax efficiency,
would be a one-time, smaller tax increase imposed
immediately.
The estimates o f efficient deficits depend on the
estimates o f trend real GNP and trend federal
government expenditures as well as forecasts o f
real GNP and government expenditures. Econo­
mists who have different estimates o f these trends
or different forecasts o f these variables will ne­
cessarily have different estimates o f efficient
22



MAY/JUNE 1984

TABLE 2

DIFFERENCE BETWEEN
PROJECTED AND EFFICIENT
DEFICITS WITH
FISCAL POLICY CHANGE"
1984

$ 95.3

1985

83.1

1986
1987

51.5
24.9
- 4.3

1988
1989

- 25.7

1990
1991

- 53.0
- 77.4

1992
1993

- 94.3
- 111.9

1994
1995

- 132.4
- 160.8

aSee Table 1 for notes. For details o f the fiscal policy
change, see the Appendix.

deficits. There is room for disagreement in making
these estimates. Indeed, there is substantial dis­
agreement about the usefulness o f this approach
to analyzing deficits. In particular, some econo­
mists would contend that deficits affect the econ­
omy aside from financing considerations (see
ALTERNATIVE VIEWS OF THE DEFICIT). These
effects need to be addressed in assessing policy
actions concerning deficits, in their view.

CONCLUSIONS
According to the efficient taxation approach,
deficits may not present a problem unless they are
consistently different from their “ effic ie n t’ levels.
If the deficit is smaller than its efficient level, the
government is squeezing the economy with ex­
cessive taxation or depriving the econom y o f use­
ful government spending. If the deficit is con­
sistently larger than its efficient level, tax rates
must be raised eventually (or future spending
reduced) to finance the excessive debt.7
The estimates o f efficient deficits presented
here show that, without a policy change, current

Alternatively, if neither expenditures are reduced nor taxes
raised, the only way left to finance deficits will be for the
Federal Reserve to ’’monetize” the deficits, thereby creating
inflation.

FEDERAL RESERVE BANK OF PHILADELPHIA

Sizing Up the Deficit

Brian Horrigan

ALTERNATIVE VIEWS OF THE DEFICIT
There are schools o f econom ic thought that deny the econom ic reasoning or the political relevance o f the
theory o f debt neutrality. Keynesian economists believe that the econom y is inherently so unstable that it
needs strong doses o f monetary and fiscal stimulation to remain near fu ll employment. Keynesians
recom m end— am ong other policies— tax cuts to stimulate the econom y when itfalls below full employment,
and tax increases when the econom y “overheats." Keynesians assert that the improvement in w ell-being due
to having an econom y nearer full employment on average justifies the relatively minor— in their opinion—
deadweight loss caused by changing the tax rate. Under Keynesian fiscal policy, budget deficits during
recessions should be even larger than the efficient deficits calculated here, and the deficits during econom ic
boom s should be sm aller.3
Other econom ists are more interested in using fiscal policy to stabilize inflation than they are in using
fiscal policy to stabilize employment. They believe that deficits are always monetized to some extent; that is,
when the governm ent issues more debt, the Federal Reserve purchases more o f it, which creates bank
reserves, thus expanding the money supply and ultimately raising the price level. Monetization turns deficits
into an engine o f inflation. These economists recommend raising taxes or cutting expenditures to reduce
inflation when the inflation rate is too high. During inflationary periods, these economists recommend
deficits smaller than those advocated by efficient deficit theorists.13
The “neoclassical” school asserts that the higher real deficits are relative to real GNP, the higher are real
interest rates, w hich crow d-out private investment: too high real deficits result in too little investment and
eventually in a too small capital stock. These economists do not believe that debt is neutral and recommend
that the deficit-G NP ratio be kept low, on average, in order to increase the capital stock. These economists
agree with efficient deficit theorists that deficits should fluctuate over the business cycle and with war and
peace, but they recom m end that the average level o f the deficit should be smaller than that advocated by
efficient deficit theorists.0
Some balanced-budget advocates, on the other hand, are not concerned with the deficit perse but with the
size o f the governm ent relative to the entire economy. They believe the governm ent has a tendency to grow
larger than it should and that there is less political opposition to governmental growth when government
spending is financed by deficits instead of taxes. W h en the government is forced to pay for its spending with
taxes, the governm ent will be smaller, in their opinion. They believe that the benefits o f tax stabilization are
small relative to the benefits o f having less government.d
aFor an exposition o f Keynesian deficit theory, see: A. Blinder and R. Solow, “Analytical Foundations o f Fiscal Policy,” in
The Economics o f Public Finance. (Washington, D.C.: The Brookings Institution, 1974), pp. 3-118.
^This traditional point o f view is being defended with rigorous (though controversial) economic analysis by: P. Miller,
“Deficit Policies, Deficit Fallacies,” Federal Reserve Bank of Minneapolis Quarterly Review. 4 (Summer 1980), pp. 2-4; and T.
Sargent and N. Wallace, “ Some Unpleasant Monetarist Arithmetic,” Federal Reserve Bank o f Minneapolis Quarterly Review 5
(Fall 1981), pp. 1-18.
cThis “ neoclassical” point o f view has been discussed and defended in many publications. A good example is M.
Feldstein, “ Fiscal Policies, Inflation, and Capital Formation,” American Economic Review. 70 (September 1980), pp. 636650.
dThis point o f view is strongly argued in J. Buchanan and R. Wagner, Democracy in Deficit The Political Legacy o f Lord Keynes.
(New York: Academic Press, 1977). The authors recommend a constitutional amendment to prohibit deficit spending
except during declared national emergencies. Critical evaluations o f Buchanan and Wagner’s work can be found in a
symposium published by the Journal of Monetary Economics. 3 (August 1978).

and projected deficits are larger than efficient,
given the state o f the economy over the remainder
o f the 1980s, and should be reduced. Yet, the
analysis o f one projected change in fiscal policy—
which is similar to many other proposals— shows
that deficits can be reduced too much for e ffi­
ciency purposes, producing unnecessary dead­
weight losses for the economy.



Although newspapers and magazines are packed
full o f warnings about the dire consequences of
deficits, and opinion polls show that deficits are
about as popular as heroin addiction, there is an
alternative perspective on deficits. If economic
efficiency is the criterion driving fiscal policy,
then having some level o f deficits— the efficient
level— can actually be viewed as beneficial.
23

BUSINESS REVEIW

MAY/JUNE 1984

APPENDIX
The form ula used to calculate efficient deficits is derived from Barro’s equation for the determination o f
the optimal (or efficient) growth rate o f the public debt (Barro (1979)):

(B — B )/B
t
M
t-

( 1)

= 0.0006 + 1.00 77 a + 0.40
t

where

B — publicly held federal debt, measured at par value, at time t
Bt j = publicly held federal debt at time M
77^ = anticipated inflation rate (the percentage change in

)

pt = price level, measured by G N P deflator
G( = real value o f federal expenditures (NIPA definition)
= trend value o f G(

Y = real GN P
Yt = trend value o f Y(
The parameters in equation (1) were estimated using annual American data for the time period 1948 through
1981. The parameters are similar to the ones Barro estimated. In the estimation, the coefficient on anticipated
inflation was restricted to unity, the theoretical value o f the coefficient. (Unconstrained, the coefficient on
anticipated inflation was 1.47. The data did not reject the restriction to unity.)
Trend growth in real G N P and real federal expenditures for the time period 1948 to 1981 are 3.5 and 4.5
percent per year, respectively. The trend growth in real G N P is determined by the growth o f the labor force, o f
productivity, and o f natural resources. Based on the expected slow dow n in labor force growth, DRI forecasts
trend G N P to grow at about 2.8 percent for 1982 to 1990,2.6 percent for 1991 to 1995. The trend growth in real
government spending is determined by fiscal policy. Ultimately, government spending cannot grow faster
than GNP, but it is possible for spending to grow faster than G N P for long periods o f time, as it did for the postW orld W a r II era. I assum e that the ratio o f trend real federal expenditures to trend real G N P is 23 percent in
the time period 1982 to 1995, the value o f the ratio in 1980 and 1981. The definition o f debt used in Barro's
theory and in estimating equation (1) excludes all federal debt held internally by federal government agencies
and trust funds, and the Federal Reserve System. However, no forecasts are available for how much o f newly
issued debt will be held internally by the government, so projections o f efficient deficits are made using the
gross public debt. But note that as long as the percentage o f gross public debt held internally by the
government remains constant, these definitional issues cause no error in the analysis.
To use equation (1) to make estimates o f efficient deficits, I assume that the inflation rate is correctly
anticipated (both within and outside o f the sample period), and that the DRI forecasts o f real GNP, the G N P
deflator, real federal expenditures, and the gross debt are accurate.3 The estimates o f efficient deficits are
generated dynamically, meaning that in each year, the efficient v alue o f the previous year's debt is used as the
base for calculating that year’s efficient deficit.15
aI derived my projections o f inflation, real GNP, real federal expenditures, and the size o f the gross debt from the U.S.
long-term forecast o f Data Resources, Inc., as o f April 1984. The issue is not whether these forecasts are accurate but rather
how close projected deficits are to efficient deficits, where both projected and efficient deficits are calculated using the
same set o f economic assumptions. Different economic assumptions would change estimates o f both efficient and actual
deficits in a similar manner.
^Similar results were obtained from estimates o f efficient deficits generated statically— that is, by using the projected
value, not the efficient value, o f the previous year’s debt as the base for calculating that year’s efficient deficits.




FEDERAL RESERVE BANK OF PHILADELPHIA

Sizing Up the Deficit

Brian Horrigan

DRI assum es a small tax increase and a small expenditure cut take effect in fiscal year 1986, which reduces
the deficit by $49 billion (under static assumptions) in that year. A modification in tax indexation is included
in the tax package. In 1981, Congress revised the tax code, providing that as o f 1985, the code would be
indexed to the Consum er Price Index (CPI). That way, purely nom inal increases in income would not cause
“tax bracket creep.” In DRI’s simulation of a new fiscal policy, the tax code will be indexed only to the extent
that the CPI rises more than 2 percent per year.
DRI assum es that nominal G N P grows at approximately 9 percent per year for the remainder o f the
decad e— about 6 percent inflation and 3 percent real growth. Real G N P returns to trend slowly in the DRI
forecast; by 1990, real G N P is still 4 percent below trend.

ANNOTATED BIBLIOGRAPHY
The theory and evidence on optimal deficits have been largely developed in a series o f articles by Robert
Barro. These articles include:
Barro, R. J., “Are Government Bonds Net Wealth?,” Journal o f Political Economy 82 (Novem ber/Decem ber 1974),
pp. 1095-1117.
____________ , “Public Debt and Taxes,” in Federal Tax Reform: Myth and Realities, ed., M ichael Boskin, (San
Francisco, CA.: Institute for Contemporary Studies, 1974).
___________ , “On the Determination o f the Public Debt,” Journal o f Political Economy 87 (October 1979), pp. 940971.
____________, Macroeconomics. (N ew York: John W iley & Sons, 1984).
Daniel Benjamin and Levis Kochin have been conducting research on optimal deficits simultaneously with
Barro. Their key papers are:
Benjamin, D. and L. Kochin, , “A Theory o f State and Local Finance: The Comparative Statics o f Mobility,”
u npublished manuscript, University o f Washington.
_______________________________ “On the Observational Equivalence o f Rational and Irrational Governments and
Consum ers,” unpublished manuscript, University o f W ashington (October, 1980). Revised 1983 with M.
Meado.
Mathem atical contributions to the theory worth reviewing are made by:
Chamley, C. , “Optimal Intertemporal Taxation and the Public Debt.” Cowles Foundation Discussion Paper
No. 554, Yale University (1980).
Lucas, R. E., Jr. and

N. L. Stokey,(1983), “Optimal Fiscal and Monetary Policy in an Economy Without

Capital,” Journal o f Monetary Economics 12 (July 1983), pp. 55-94.
Additional empirical examinations o f the theory o f optimal deficits include:
Horrigan, B., “The Determinants o f the Public Debt in the United States, 1953-1978” W orking Paper, 82-6,
Department o f Research, Federal Reserve Bank o f Philadelphia, (1982).
____________ _ “The Long-R un Behavior o f the Public Debt in the United States,” paper presented at the Eastern
Econom ics Association Meeting, (March, 1984).




25

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