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Federal R e se rve Bank of Philadelphia
ISSN 0007-7011
N O V E M B E R DECEMBER I982
Forecasting with the Index
of Leading Indicators
NOVEMBER/DECEMBER 1982
SPENDING
THROUGH THE TAX STRUCTURE:
ARE WE TAXING
THE REVENUE SYSTEM?
R o b e r t H. D eF in a
. . . Tax expenditure programs offer few
advantages to offset their drawbacks.
FORECASTING WITH THE INDEX
OF LEADING INDICATORS
G a ry G o rto n
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#
*
*
*
*
The Federal Reserve Bank of Philadelphia
is part of the Federal Reserve System—a
. . . The leading indicators approach provides a useful complement to econometric
modeling.
System which includes twelve regional banks
located around the nation as well as the
Board of Governors in Washington. The
Federal Reserve System was established by
Congress in 1913 primarily to manage the
nation’s monetary affairs. Supporting func
tions include clearing checks, providing coin
and currency to the banking system, acting
as banker for the Federal government, super
vising commercial banks, and enforcing
consumer credit protection laws. In keeping
with the Federal Reserve Act, the System is
an agency of the Congress, independent
administratively of the Executive Branch,
and insulated from partisan political pres
sures. The Federal Reserve is self supporting
and regularly makes payments to the United
States Treasury from its operating surpluses.
FEDERAL RESERVE BANK OF PHILADELPHIA
Spending
Through the Tax Structure:
Are We Taxing
the Revenue System?
by Robert H. DeFina*
“T h e ta x in g p o w er o f G o v e r n m e n t m u st b e u s e d to p r o v id e revenu es fo r le g itim a t e G o v e r n m e n t
purposes. It m ust not be used to r e g u la te th e e c o n o m y o r b rin g about s o c ia l c h a n g e . ”
— P r e s id e n t Ronald R ea g a n , 1981.
Recent concern over the growth in Federal
spending has led both politicians and bureau
crats to pore over the budget in search of
ways to trim the fat. Thus far, their efforts
have yielded unprecedented cuts. But large
and growing numbers of government expendi
tures have managed to avoid the ax, if only
because they never show up in the budget.
These phantom outlays are known as tax
expenditures, and they represent spending
accomplished through tax relief and tax sub
sidies embodied in our income tax laws.
Like some direct Federal payments, such
as grants or loans, tax expenditures are used
to encourage certain activities and favor
specified groups through financial assistance.
In fact, tax expenditures can be viewed as
alternatives to direct subsidies. Most policy
goals that are pursued with direct assistance
could, in principle, be sought with tax
spending as well.
Using the tax system to meet national
objectives, however, may not be a good idea.
Tax spending presents substantial difficulties
that do not arise with direct spending and
which can seriously impair the efficiency of
* Robert H. DeFina is an economist at the Philadelphia
Fed. He received his Ph.D. from Washington University
and specializes in public finance. Mr. DeFina would like
to acknowledge the helpful comments and suggestions
of Professor Charles Davenport of Rutgers University
Law School, Professor Stanley Surrey of Harvard
University Law School, and Mr. James Verdier, Director
of the Tax Analysis Division of the Congressional
Budget Office.
3
BUSINESS REVIEW
NOVEMBER/DECEMBER 1982
the fiscal process. Moreover, tax spending
offers little advantage over direct spending to
make up for its drawbacks.
In the coming years, tax expenditures are
expected to increase dramatically relative to
direct outlays, continuing a trend begun in
the recent past. Given the difficulties as
sociated with the use of tax spending as
compared to direct spending, policymakers
might want to reconsider their growing re
liance on the tax system to help cure society’s
ills.
order to further certain social goals [see
HOW TAX EXPENDITURE PROGRAMS
WORK].
In conferring the title ‘tax expenditure’,
policymakers agree that these forgone
revenues are really expenditures of Federal
im p lic it in the definition of tax expenditures is the
notion of a benchmark tax structure from which the
special provisions depart. As detailed by fiscal spe
cialists involved with tax expenditures, these bench
mark provisions (commonly referred to as the “normal
tax structure”) include the overall rate schedules and
exemption levels, general rules as to who is subject to
tax and what accounting periods should be used, and the
definition of income. It may also be noted that the
legislative history of the Budget A ct makes clear that the
classification of an item as ‘special’ is to be made by
employing techniques that had been used by Treasury
and Congressional Staff technicians in developing tax
expenditure lists prior to the enactment of the Act. For a
comprehensive description of and discussion of issues
related to the normal structure, see Stanley Surrey,
Pathways to Tax R eform (Cambridge: Harvard Uni
versity Press, 1973).
SPENDING THROUGH THE TAX SYSTEM
The Budget Act of 1974, which established
our current budget process, defines tax
expenditures as “revenue losses attributable
to provisions of the Federal [income] tax laws
which allow a special exclusion, exemption,
or deduction from gross income, or which
provide a special credit, a preferential rate of
tax, or a deferral of tax liability.”1 Loosely
speaking, these are tax dollars that the
government purposely does not collect in
HOW TAX EXPENDITURE PROGRAMS WORK
There are six main types of tax expenditure programs and each can be used to provide individuals
with tax breaks to encourage participation in particular activities or to relieve financial hard
ship.
Three of these, namely exclusions, deductions, and exem ptions, allow taxpayers to reduce their
taxable income by a specified amount. The value to taxpayers of the reduction depends upon their
marginal income tax bracket: the higher the bracket, the more the reduction in taxable income is
worth. For instance, a one-dollar deduction is worth fifty cents to a person in the 50-percent bracket
(since that is how much tax would have been paid on that dollar), while it is worth seventeen cents to
a person in the 17-percent bracket. In many cases, personal deductions must be offset against the
zero bracket amount (formerly known as the standard deduction) prior to subtracting it from
income.
A tax credit permits taxpayers to deduct a certain amount directly from their tax liability. Unlike
exclusions, deductions, and exemptions, the value of a credit does not depend on the marginal tax
bracket because the reduction comes after the tax bill is initially calculated: however, eligibility for
the credit depends upon whether taxpayers have a sufficient initial tax liability to use the credit.
P referential tax rates let taxpayers compute their tax liability using tax rates that are lower than
those normally used. The value to taxpayers, in this case, is equal to the amount of taxable income
subject to the preferential rate multiplied by the difference between the preferential and regular
rates.
Finally, a d eferral o f tax liability permits taxpayers to put off paying their taxes for some period of
time. This benefits individuals because they can invest the tax otherwise owed and earn interest up
until the time the taxes are due.
4
FEDERAL RESERVE BANK OF PHILADELPHIA
who join the ranks of philanthropists; and
deductions of mortgage interest on owneroccupied homes ($23.0 billion) encourage
citizens to pursue the American dream of
owning a home. Tax expenditures are also
used to nudge corporations toward socially
desired activities: the investment tax credit
($15.0 billion) defrays the costs of new capital
purchases in order to stimulate investment,
while the special treatment of oil and gas
exploration and development costs ($2.7
billion) promotes energy development.
In many cases, the objectives sought
through tax expenditures are also pursued
with direct spending programs. Designated
groups in the labor force have been helped
both with the CETA grant program (direct
spending) and the jobs tax credit; individuals
receive assistance with their medical
expenses both through direct medicare pay
ments and through medical expense deduc
tions from taxable income; and business
financing costs are lowered both with direct
interest subsidies and through business use
of tax-exempt bonds. Such instances of
common purpose clearly show that tax ex
penditures and direct outlays are alternative
policy instruments.
In principle, most policy objectives that
require financial assistance can be addressed
with either spending mechanism. As a recent
study of tax expenditures by the Congres
sional Budget Office notes, almost any of the
structural details included in direct assistance
programs could conceivably be incorporated
into tax-based programs:
monies channeled through the tax system. 2
By reducing the tax associated with a favored
activity or otherwise owed by a targeted
group, the government is spending its scarce
budget dollars just as it does when it makes
direct payments, such as grants and loans.
Whether the government first collects a dollar
of tax from an individual and then sends him
a one dollar check, or whether it does not
collect the money in the first place, the bottom
line is the same. For both the beneficiary and
the government, a dollar less paid in taxes
has the same effect on budgets as a dollar
more directly paid out by the Treasury. The
only substantive difference is how this
financial assistance is delivered.
A Profile of Tax Expenditures. At present,
a substantial amount of Federal assistance is
delivered through the tax system in pursuit of
a variety of goals (see A SUBSTANTIAL
AMOUNT. . .overleaf). All told, the govern
ment is estimated to have incurred almost $254
billion in tax expenditures during fiscal year
1982—close to 35 percent of scheduled direct
Federal outlays—for the operation of over
100 tax-based programs.
The lion’s share of tax spending accrues to
individuals, providing them with aid and
incentives in their capacities as homeowners,
donors, savers, and so on. For example: the
tax exclusion of employer contributions to
employee pension plans ($25.8 billion) fosters
saving by workers for their retirement; de
ductions of charitable contributions from
taxable income ($9.7 billion) reward people
o
Providing tax [expenditures] in the form
of credits rather than deductions, and
including the credit in taxable income
can assure that the value of the tax sub
sidy is the same as that of an equivalent
direct grant. Making the credit refund
able . . . can extend the subsidy to non
taxpayers . . . . Providing the subsidy in
the form of a deferral of tax liability
makes it the equivalent of a loan pro-
Some people have interpreted the concept of tax
expenditures as implying that the Federal government is
entitled to one hundred percent of everyone’s income,
and that any portion that taxpayers are allowed to keep
is theirs only by special permission. This view is in
accurate. Tax expenditures are defined as special de
partures from a benchmark or normal tax structure.
Thus, for the interpretation in question to be correct, the
benchmark tax structure would have to tax one hundred
percent of all income. However, the normal provisions
of our income tax fall far short of such complete
taxation.
5
NOVEMBER/DECEMBER 1982
BUSINESS REVIEW
A SUBSTANTIAL AMOUNT OF FEDERAL ASSISTANCE
IS DELIVERED THROUGH THE TAX SYSTEM
IN PURSUIT OF A VARIETY OF GOALS
Selected Special Provisions
Tax Expenditures
(Fiscal year 1982, millions of dollars)
Individual
Corporate
Total
Exclusions
Employer contribution to pension plans
Employer contributions for medical insurance
premiums and medical care
Dividend and interest
Interest on general purpose state and local debt
OASI benefits for retired workers
Interest on state and local industrial
development bonds
$25,765
$25,765
15,330
2,185
1,925
9,980
15,330
2,185
5,830
9,980
315
$3,905
1,295
1,610
Deductions
Interest on consumer credit
Mortgage interest on owner-occupied homes
Property tax on owner-occupied homes
Charitable contributions*
Medical expenses
Nonbusiness state and local taxes other than on
owner-occupied homes
7,585
23,030
10,065
9,705
3,925
895
7,585
23,030
10,065
10,600
3,925
20,395
20,395
995
2,355
22,995
2,355
Exemptions
Parental personal exemption for student age 19 or over
Additional exemption for elderly
Tax Credits
Investment tax credit, other than Employee Stock Ownership Plans, rehabilitation, reforestation, and leasing
Credit for child care and dependent care expenses
Earned income credit
Energy conservation credit
3,475
1,350
555
415
14,970
315
18,445
1,350
555
730
18,315
1,495
19,810
1,350
2,720
4,070
1,560
65
1,560
65
Preferential Tax Rates
Capital gains (other than agriculture,
timber, iron ore, and coal)
Expensing of exploration and development cost
for oil and gas
Tax Deferrals
Deferral of income of domestic international sales
corporations
Deferral of tax on shipping companies
‘ Represents the sum of the estimates of deductions of charitable contributions for education, health, and pur
poses other than education and health.
SOURCE: Estimates of Federal Tax Expenditures for Fiscal Years 1982-87, prepared by the Staff of the Joint
Committee on Taxation (March 8, 1982).
6
FEDERAL RESERVE BANK OF PHILADELPHIA
gram. While no interest is normally
charged on tax deferrals, it could be if
Congress wished___Congress can make
tax subsidies look and work as much or
as little like direct spending . . . as it
chooses.3
more, tax spending offers little benefit over
direct spending to compensate for its adverse
effects.
TAX EXPENDITURES
OFFER LITTLE ADVANTAGE
OVER DIRECT ASSISTANCE
Those who applaud the use of tax spending
see in it a major advantage over direct
assistance—a greater compatibility with the
philosophy of private decisionmaking and
individual initiative. As Murray Weidenbaum,
former Chairman of the Council of Economic
Advisors, wrote:
Once it has been decided that a particular
subsidy is desirable, both spending options—
tax expenditures and direct outlays—are
usually open to policymakers as a potential
means of providing the assistance.
Reliance on Tax Spending Is Increasing.
Although direct outlays have traditionally
been the primary form of financial assistance
from the Federal government, tax expendi
tures are growing in relative importance. In
1976, for instance, the ratio of tax spending
to direct spending was about 1:4; by 1981 it
had risen to 1:3. And while tax spending
more than doubled since 1976, growing at a
rate of about 18.6 percent annually, direct
outlays grew by 12.5 percent a year. The
differential was most pronounced over the
past two fiscal years when tax spending
increased at a 24-percent yearly rate, com
pared to the 15.7-percent annual growth of
direct spending. The future promises a con
tinuation of this trend: over the next five
years, tax expenditures are expected to grow
by three-quarters, while direct outlays are
estimated to rise only by one-third. As a
result, by fiscal year 1987, the ratio of tax
spending to direct spending is expected to
jump to about 1:2.
Despite the apparent popularity of tax
expenditures, there are reasons why using
the tax system to deliver financial assistance
may not be the best idea. Tax spending has
certain practical difficulties not shared by
direct spending which can have adverse con
sequences for our fiscal process. Further-
The choice between tax incentives and
direct Federal expenditures turns out to
involve more than the selection among
technical financing mechanisms. The
choice involves altering the balance
between public and private power in our
society.4*
Promoters of tax spending argue that, all too
often, direct payment programs involve an
endless maze of rules, regulations, and
eligibility requirements that needlessly
restrict individual choice. This government
influence, they feel, hampers progress toward
reaching a program’s stated objective. In
contrast, tax expenditures are viewed as
placing most of the decisionmaking process
with the beneficiary: the incentive is created,
and the individual is left to respond. Tax
expenditures, they allege, help get govern
ment off our backs.
There is not much validity, however, to the
assertion that tax expenditures are neces
sarily more compatible with private choice
4 Murray L. Weidenbaum, "The Case for Tax Loop
holes,” Center for the Study of American Business,
Reprint Series, No. 21 (St. Louis: Washington Uni
versity, September 1978), p. 12. For similar views, see
the remarks of Senators Packwood, Roth, andDomenici
in Joel Havemann, “Tax Expenditures — Spending
Money Without Expenditures,” N ational Journal,
December 10, 1977, pp.1908-1911.
3Congressional Budget Office, Tax Expenditures:
Current Issu es and Five-Year B udget Projections for
F iscal Years 1982-1986 (September 1981), pp. 46-47.
7
BUSINESS REVIEW
NOVEMBER/DECEMBER 1982
Some observers of the fiscal policy process
take a more cynical view concerning the
benefits of using tax expenditures rather than
direct payments. They note that the main
attraction of tax spending may be that it does
not show up on the expenditure side of the
government’s budget; that is, it allows spend
ing without the appearance of spending.7
Whether or not this aspect of tax spending
has contributed to the relative growth of tax
expenditures in recent years is uncertain.
What is clear, however, is that, from society’s
perspective, this feature does not provide any
substantive benefits. A dollar spent through
the tax system represents the same use of
Federal monies as a dollar spent through a
direct outlay, regardless of how it is accounted
for. Some political gains well may result
from using tax expenditures if the electorate
does not recognize that funds are spent
through the tax system; however, such
benefits should not be an important consider
ation when choosing between tax and direct
spending mechanisms.
Although tax expenditures do not appear
to provide any meaningful advantages over
direct spending, the choice between the two
remains consequential. In particular, spend
ing through the tax system complicates the
workings of the fiscal process in ways that
are not encountered with the direct provision
of assistance.
than is direct spending. The extent of any
intrusion into the free market—that is, the
amount of administrative control, bureau
cracy, and red tape involved—is a matter of
program design. And a program’s design is
determined by the preferences of policy
makers, not by the particular policy instru
ment [in this case, tax spending or direct
spending] chosen to implement the program.
Indeed, the choice of direct spending or tax
spending as the means of providing financial
assistance comes after the determination of a
program’s eligibility requirements and regu
lations. If direct assistance programs are
more complex, as proponents of tax spend
ing lament, the reason lies not in the fact that
direct payment mechanisms are used to pro
vide the incentives; rather, it lies in the
policymakers’ decisions to structure the under
lying programs in particular ways. And both
tax spending and direct spending programs
can be designed with as much or as little red
tape as is desired.
The deduction for charitable contributions
provides a useful illustration of this point
about program design since it is frequently
touted as an unrestrictive Federal program
that enlists private support for the public
interest.5 According to the guidelines of this
deduction, individuals decide, free of govern
ment direction, both the recipient charity and
the size of the donation. But the same
objectives could be accomplished through a
direct spending program as well. Private
contributions could be matched, for instance,
by Federal grants, with individuals deter
mining both the beneficiary and the amount
of the contribution. As this example shows,
neither compatibility with private initiative
nor the simplicity of a program’s structure
hinges on the choice between tax and direct
spending. These are questions of program
design, and they are independent of the ex
penditure mechanism.6
TAX SPENDING HAS ADMINISTRATIVE
PROBLEMS NOT SHARED BY DIRECT
SPENDING. . .
Some of these complications occur at the
administrative level. Tax expenditure pro
6The same argument holds true against claims that
direct spending programs force uniformity on the re
cipients of the aid while tax expenditures do not and that
tax expenditures allow regional diversity while direct
programs do not.
7For a representative view, see Charles Davenport,
“Impact of the Congressional Budget Process on Tax
Legislation,” N ation alT axJou rn al, September 1979, pp.
262-269.
5This and other examples are discussed in Stanley
Surrey, P athw ays to Tax R eform .
8
FEDERAL RESERVE BANK OF PHILADELPHIA
these departments are much more adept than
IRS agents at gauging the effectiveness of
particular spending programs or program
features, and they are more skilled in making
judgements regarding eligibility. Furthermore,
the executive agencies are better positioned
and equipped than the IRS to deal with pro
gram problems that might arise. Yet when
spending programs are built into the tax
system (and, hence, are administered by the
IRS), the resources and detailed knowledge
of the different government agencies are
largely ignored. Such a division of respon
sibilities is counterproductive, and it need
lessly diminishes the potential success and
efficiency of these programs.
By the same token, this awkward arrange
ment also substantially compounds the pro
blems of tax administration, impeding the
smooth functioning of the tax system. Rather
than concentrating on their primary job of
efficiently collecting taxes, IRS agents must
devote considerable time and effort to writing
grams are administered by the Internal
Revenue Service rather than by the executive
agency normally involved with the policy
objective being addressed. As a result, the
knowledge, insight, and resources of that
executive agency are neglected. And the
IRS, despite its limited resources, is called
upon to administer programs that it may be
ill-equipped to handle and that are unrelated
to revenue raising.
Administrative Responsibilities Are
Inappropriately Assigned. Tax expendi
tures involve an inappropriate assignment
of administrative responsibilities for spend
ing programs. This issue was discussed by
Jerome Kurtz, a former Commissioner of the
IRS:
Each of the tax expenditure programs is,
in effect, a non-revenue related expendi
ture program written into the tax law.
Each entails its own special set of issues,
definitions, and limitations . . .. Because
of these provisions, I find myself, a
Commissioner of Internal Revenue, ad
ministering programs of many other
agencies. If these programs were parceled
out to those agencies, the concentration
of programs would be diffused and the
tax law and administration would be
vastly simpler.8*
regu lations, v erifyin g eligibility, and pur
suing litigation for over one hundred pro
grams that are unrelated to revenue raising.
The recent controversy over the legality of
the tax-exempt status of racially discrimina
tory schools clearly illustrates how tax ex
penditures can embroil the IRS in issues that
have nothing to do with revenue raising.
IRS administration of these spending pro
grams also neglects the crucial role of ob
jectives and incentives in program manage
ment. Direct spending programs involve their
administering agencies from the standpoint
of stated department goals: the particular
program aims are assigned to be compatible
with those agency objectives. In contrast, the
IRS has aims that are separate from those of
the spending programs it administers. The
IRS’s overriding concern is the efficient
collection of revenue, and not, for instance,
the stewardship of the country’s natural
resources or the caretaking of our nation’s
elderly. As such, IRS personnel have no
institutional incentive to accomplish the goals
Indeed, the staffs of the various executive
agencies and other Federal departments
have accumulated a large stock of expertise
and experience in particular areas: the
Department of Housing and Urban Devel
opment specializes in housing, the Depart
ment of the Interior in conservation and
wildlife, the Department of Labor in em
ployment and unemployment, and so forth.
As a consequence, the trained personnel of
®Cited in Stanley Surrey and Paul McDaniel, “The
Tax Expenditure Concept: Current Developments and
Emerging Issues,” B oston C olleg e Law Review , January
1979, pp. 278-279.
9
BUSINESS REVIEW
NOVEMBER/DECEMBER 1982
payments to the high-tax firm].
Although schemes of this sort might ulti
mately channel program subsidies to nontax
payers, they needlessly complicate the tax
code and use the resources of the IRS in
efficiently. To continue with the leasing
example, tax administration efforts must be
devoted to processing and verifying details
of the transactions such as the term of the
lease, the interval between the date property
is leased and the date it is acquired, and the
amount of investment the lessor risks through
out the term of the lease. All this has little to
do with revenue raising. Futhermore, the time
and money of the private sector are wasted in
locating leasing partners, arranging meetings,
negotiating the final agreements, and ex
plaining it all to the IRS. Compared to the
direct payment alternative, in which the
appropriate government agency deals directly
with the targeted beneficiaries, such make
shift tax spending arrangements seem infe
rior. 10
In sum, the administration of spending
programs will always entail costs, regardless
of whether these programs are formulated as
direct payments or tax expenditures. How
of the many tax-spending programs. They
instead treat these programs like any other
provision of the tax code: emphasis is placed
on assuring technical compliance with the
rules governing the special tax treatment,
with no effort expended to publicize the
program’s availability, to promote its use, to
monitor its effectiveness, and so on. Incom
patibility between the overall objective of the
IRS and the aim of individual tax expenditure
efforts makes it more difficult for such pro
grams to succeed.
Providing Aid and Incentives to Nontax
payers Is Harder. Providing nontaxpayers
with incentives and relief is harder to ac
complish through the tax system than through
direct payment schemes. Unlike direct out
lay programs, tax expenditures cannot be
extended directly to individuals and organiz
ations that do not pay tax. Instead, some
auxiliary arrangement used in conjunction
with a tax spending program is required if
nontaxpayers are to be reached.9
The complex leasing rules that have been
written into the tax code exemplify such
arrangements; they represent an effort to
extend tax incentives for investment to firms
without enough tax liability to take advantage
of the subsidies. (According to the new leasing
rules, a business with inadequate tax liability
is permitted to lease equipment from another
concern that has sufficient liability to be
eligible for the tax breaks. In this way, the
low-tax firm can receive some of the tax
incentive indirectly through lower lease
10There are other, more direct, tax approaches such
as making tax credits refundable even to nontaxpayers,
but these, too, are costly and burdensome and are very
likely to be ineffective. This point is discussed in the
Congressional Budget O ffice’s tax expenditure study:
"People whose incomes are so low they do not have to
pay taxes usually do not have to file tax returns, so the
IRS may have no record of their existence. It is thus hard
to inform them of their possible eligibility for a subsidy.
Once they learn about the subsidy, they may have
difficulty with the forms and paperwork necessary to
establish their eligibility, and the IRS has relatively few
resources to provide them with assistance. Many lowincome nontaxpayers also have considerable fear and
skepticism about dealing with the IRS, and may thus be
reluctant to apply for an IRS-administered subsidy. It
may also be a hardship for them to have to wait until tax
returns can be filed to obtain the subsidy. While attempts
have been made to have the earned income tax credit
reflected currently in withholding, there have been
administrative problems with this approach.” Con
gressional Budget Office, Tax Expenditures, p. 48.
9In the case of most tax spending programs, there is
little reason why nontaxpayers should be excluded. If
these schemes were recast as direct payment programs,
it is very doubtful that individuals and organizations
would be ineligible for incentives simply because of a
lack of taxable income. The fact that many tax ex
penditure programs do not include nontaxpayers does
not reflect a prudent policy decision; rather, it points to
an inadequacy of the tax spending technique. Exclusion
of nontaxpayers is automatic and largely arbitrary and,
hence, limits the potential success of tax spending
programs.
10
FEDERAL RESERVE BANK OF PHILADELPHIA
ever, the administrative dollars are bound to
be spent less efficiently when the tax ex
penditure route is traveled.
of the decision to operate those programs
through the tax structure. Indeed, the ex
pertise of the tax committees is not in dealing
with the nation’s housing problems or in
overseeing interstate commerce; rather, it is
in the handling of the technical revenueraising aspects of the tax structure.11 The
tax committees’ lack of familiarity with
specific expenditure areas can only work to
the detriment of the spending programs placed
under their control.12*
Tax Incentives Can Be Arbitrarily
Changed. Placing spending programs in the
tax structure also subjects the incentives
they provide to arbitrary change. These
changes will occur whenever the overall rate
schedules or exemption levels are revised,
regardless of intent. A modification of tax
rates, for whatever reason, automatically
alters the value of income deductions and
exclusions to taxpayers. As a result, the ac
. . . AS WELL AS SOME LEGISLATIVE
AND BUDGETARY DRAWBACKS
The shortcomings of the tax expenditure
route are not restricted to the administrative
level; rather, they arise at the legislative and
budgetary levels as well. In particular,
spending through the tax system results in an
inefficient division of legislative responsi
bility, hinders budget planning, and makes
control of the budget more difficult. Further
more, placing spending programs in the tax
structure can make for unintended shifts in
the nature of the incentives provided by
those programs.
An Inefficient Division of Legislative
Responsibility Arises. Congress is comprised
of many different committees, each of which
has legislative responsibility for specified
areas. For example, the House and Senate
Veterans Affairs Committees oversee legis
lation dealing with veterans of the armed
forces, while the banking committees of both
houses are primarily concerned with laws
affecting the country’s financial system.
Such division of labor permits the committees
and their staffs to develop expertise in parti
cular areas.
When tax spending is used, the purpose of
the Congressional committee system is de
feated and the benefits associated with that
system are forgone. Because spending pro
grams administered through the tax structure
are legally part of the tax code, their legisla
tive jurisdiction lies solely within the two
Congressional tax-writing committees—the
Senate Finance Committee and the House
Ways and Means Committee. Thus, the tax
committees have legislative responsibility
for more than one hundred spending pro
grams—not as a result of careful planning to
insure that the most informed Congressional
participants are involved in the programs’
development and oversight, but only because
^ Indeed , as Senator Edward Kennedy once re
marked, “It is humanly impossible for the members of
the Finance Committe and . . . Ways and Means
Committee to be Renaissance men and women in
employment, commerce, energy, health, education,
housing, banking, state and local finance, transporta
tion, investment, the cities, shipping, . . . . and all the
other areas in which tax spending programs are now
being used and in which expertise in the area is obviously
required.” 123 Congressional R ecord S11408, as cited in
Surrey and McDaniel, “The Tax Expenditure Concept,”
p. 290.
12The tax committees might try to overcome, to some
extent, their deficient knowledge and lack of insight
regarding the spending programs placed under their
jurisdiction, say, by consulting with appropriate leg
islative committees. But this sort of scheme is extremely
cumbersome; it unnecessarily entangles the tax com
mittees in deliberations with every other Congressional
committee over matters that are substantively outside
the tax committees’ area of responsibility. And such
onerous deliberations would be necessary on an on
going basis, to handle both the continuing oversight of
the more than one hundred existing programs, as well as
the flow of proposed tax spending programs. Fur
thermore, the basic question would still remain as to
why the inappropriate jurisdictional arrangement is
used in the first place, given tax spending’s lack of
advantage over direct spending.
11
BUSINESS REVIEW
NOVEMBER/DECEMBER 1982
tivities fostered by these tax spending pro
grams become either more or less attractive,
depending upon the nature of the rate
changes. Similarly, increases in the zerobracket amount or in the level of the personal
exemption can cause an unintended elimi
nation of incentives by decreasing a tax
payer’s liability below that necessary to
make use of the special provisions.
A case in point is the recent Economic
Recovery Tax Act of 1981 and its effect on
the incentives provided by the tax deduction
for charitable donations. Although the stated
intention of the tax cuts embodied in the Act
is to spur economic growth by enhancing
work and investment incentives, those rate
reductions have the inadvertent conse
quence of seriously diminishing the incen
tives offered by the charitable gift deduction.
Consequently, charitable giving is expected
to decline; the Urban Institute projects that
the new tax law, by lowering the incentive
provided by the deduction, will result in a
drop of at least $18 billion in donations
during the period 1981 to 1984. All this
happens despite the absence of an explicit
decision to alter the program.13
These sorts of spontaneous program ad
justments, which are associated with general
revisions of the basic tax code, impede the
success of the individual programs. Such
adjustments reflect neither an evaluation of a
program’s effectiveness nor a reassessment
of overall expenditure priorities; instead,
they are haphazard and occur for reasons
unrelated to the objectives of the tax spending.
Hence the incentives provided by the tax
expenditure programs will no longer be
appropriate for the goals being sought.14 No
such unintended and detrimental changes
would occur if the spending programs were
framed as direct assistance schemes.
Budget Control Becomes More Difficult. . .
Tax expenditures make budget control more
difficult because funds spent through the tax
system are harder to monitor than those
disbursed through direct assistance schemes.
Direct spending, whether accomplished
through programs with statutory ceilings or
through open-ended entitlements, is highly
visible. In each case, unplanned increases or
decreases in expenditures for particular
programs can be rapidly identified by the
specific agency responsible for the payments.
Desired program adjustments can then be
quickly implemented.
By contrast, changes in individual tax
expenditures are reflected only in fluctu
ations of total revenue collections. This
makes such changes extremely difficult to
identify. Forecasts of aggregate revenues
can be wrong for a variety of reasons. It may
take quite a while to associate, say, an
unexpected shortfall in overall revenues
with a greater-than-expected use of a particu
lar tax expenditure program. As a result,
legislators cannot respond effectively to
unanticipated and undesired tax spending
program developments.15
. . . And Coordination of Spending Plans
Is Hindered. The use of tax expenditures
14It might be possible, in principle, to restructure all
affected tax expenditure programs after each tax code
change; however, as a practical matter, such read
justments are not feasible.
13See “New Tax Law Is Said To Endanger Billions in
Gifts to Private Groups,” N ew York Times, August 27,
1981, p. A l. The remarks of Brian O’Connell, president
of the Independent Sector (a coalition of 320 leading
foundations, corporations, and nonprofit organizations)
are particularly pertinent to the discussion. Speaking
about the effect of the tax cuts on charitable giving, he
noted, “The irony in these developments is that the
Administration wants to strengthen the nonprofit sector
but the tax cut inadvertently undercuts the very or
ganizations the President is counting on.”
43The use of tax-exempt bonds to finance single
family housing provides an example of the problems
that can arise. Rapid and unforeseen increases went on
for months, threatening multibillion dollar annual
revenue losses, before Congress finally stepped in to
impose limits. See Congressional Budget Office, Tax
Expenditures and Tax Exempt B onds fo r Single-Fam ily
Housing (April 1979).
12
FEDERAL RESERVE BANK OF PHILADELPHIA
impedes Congressional budget-planning ef
forts as well. When spending programs are
placed in the tax structure, they are removed
from the normal budgeting process that
applies to all direct outlays.16 (For example,
tax expenditures are not covered by the
detailed spending targets that guide legis
lative consideration of direct spending op
tions.) In this way, funds spent through the
tax system are insulated, to a significant
degree, from explicit competition with other
spending priorities for scarce budget dollars.
But this competition lies at the heart of
effective budget design since it is the
mechanism by which the relative values of
alternative spending options are determined.
Thus, running expenditure programs through
the tax structure hinders Congress’s ability
accurately to assess the value of these pro
grams relative to other social needs. Needless
to say, this obstructs the formulation of a
coordinated and consistent budget plan.17
TO SPEND, OR NOT TO TAX —
THAT IS THE QUESTION
The practical shortcomings of tax spending
bring into question the wisdom of the growing
reliance on its use. At the administrative,
legislative, and budgetary levels, spending
through the tax system has drawbacks not
shared by direct outlay mechanisms. And
these drawbacks significantly encumber the
efficient working of the fiscal process. Al
though some of these difficulties might be
overcome, there seems to be little gain from
trying; tax expenditures generally provide
no substantive advantages over direct
spending. In light of these considerations,
policymakers would do well to shift em
phasis away from using the tax system as a
conduit for distributing Federal dollars.
1 ft
°According to the Budget Act of 1974, outlays and
revenues are subject to different budgeting procedures.
Because they are considered revenue items in a legal
sense, tax expenditures are treated as such for budgeting
purposes despite their more appropriate substantive
characterization as outlays. For a detailed description of
the Congressional budget process, see Allen Schick,
Congress and Money (Washington: The Urban Institute,
1980).
* 1*7 *T he discussions of the Tax Reduction Act of 1976 in
Allen Schick, Congress and M oneyand in Davenport,
“Impact of the Congressional Budget Process” indicate
the adverse consequences for the budget that the divided
consideration of expenditures can have.
13
The
Federal R eserve B ank
o f P hiladelphia
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SERVICES OF TOMORROW, TODAY
FEDERAL RESERVE BANK OF PHILADELPHIA
Forecasting
With the Index
of Leading Indicators
by Gary Gorton*
H en ry : Y es, th at's right.
Joh n :
C a n y o u fo r e t e ll t h e fu tu re?
easy to use, they are rather easy to construct.
Unlike econometric modeling, the leading
indicator approach to forecasting does not
require assumptions about what causes
people’s economic behavior. Instead, it relies
on statistically detecting patterns among
economic variables which can be used to
forecast turning points in economic activity.
Using the leading indicators is a simple
means of accomplishing the difficult task of
predicting the future. But does this approach
pay high dividends? In particular, does it
forecast turning points accurately? Is it reli
able? Does it have any problems? In the main,
is it worth using? The predictive abilities of
the Index of Leading Indicators can be
evaluated by examining its past performance
and its method of construction. On balance,
although it has certain weaknesses, the Index
of Leading Indicators also has particular
strengths that make it a useful tool for pre
diction.
Judging by how long they have been in use,
leading indicators of economic activity must
be considered a forecasting success. Even
with the widespread development of econo
metric models, the use of leading indicators
has continued and even flourished in popu
larity. Indeed, the announcements of such
indicators are widely reported in the popular
press. Such widespread acceptance and
attention probably are explained by the
appealingly simple logic of this forecasting
approach: if the indicator goes one way today,
economic activity will go the same way
tomorrow.
Not only are leading indicators apparently
*Gary Gorton, an economist in the Philadelphia Fed’s
Department of Research, specializes in monetary theory
and policy.
15
NOVEMBER/DECEMBER 1982
BUSINESS REVIEW
THE NATIONAL BUREAU
BUSINESS CYCLE CHRONOLOGY
Business cycles are recurring alternations
of prosperity and recession. The first business
cycle indicators were published in the 1920s
by the Harvard Economic Service. Popular
during the 1920s, these indicators were dis
continued when they failed to predict the
Great Depression.1 During the sharp reces
sion of 1937-38, Henry Morgenthau, Jr., the
Secretary of the Treasury, asked the National
Bureau of Economic Research to devise a
system of indicators that would signal when
the recession was nearing its end.2 The
National Bureau, under the leadership of
Wesley C. Mitchell and Arthur F. Burns, had
assembled and analyzed hundreds of eco
nomic time series since the 1920s. Based on
this analysis, Mitchell and Burns selected a
number of series which seemed to have been
good predictors of past business upturns.
The Treasury Department published the list
in May 1938.
There have been numerous refinements
and modifications of that original list. The
Bureau has, by now, analyzed over 1,000
economic series. Today a wide variety of
indicator data is published in a monthly
Business C onditions D igestby the Bureau of
Economic Analysis, a divison of the Depart
ment of Commerce. The basic approach,
however, is the one originally devised by the
National Bureau.
In studying the business cycle, statistical
techniques must be used to separate the
cyclical component from other movements
(such as seasonal and trend-related changes]
in a particular economic series. Once the
cyclical component of the series has been
identified, the peaks and troughs can be
picked out—sometimes easily, sometimes
with difficulty.3 The basic procedure for
identifying a business cycle is to plot the
cyclical component of each series against
calendar time and then to inspect the move
ments of the series for common turning points.
An historical plot shows that there are dates
around which many of the series move down
wards and other dates around which many of
the series move upwards. The dates of these
clusters of turning points are called reference
dates, and the collection of reference dates is
called the business cycle chronology. This
chronology shows the peaks and troughs,
when booms turn into recessions and reces
sions turn into upswings.
The cyclical components of different series
don’t all move in exactly the same way, but
inferences about the business cycle pattern
can be made by identifying clusters of turning
points. If the turning points of many different
series are bunched closely together, then the
procedure will not likely go astray.4*
Given the business cycle chronology,
various economic series can be classified
with respect to the reference dates. The
cyclical components of some series almost
always have peaks before the reference
troughs. Such series are called leading indi
cators. In many cases the relation between a
series and the cycle is easy to explain. Some
series, such as housing starts, contracts for
3See Arthur F. Burns and Wesley C. Mitchell,
Measuring Business Cycles(New York: National Bureau
of Economic Research, 1946), Chapter 4, Section 1.
4 Sometimes it is difficult to date a business cycle if the
turning points of the individual series are widely
scattered or if they are concentrated around two separate
dates. The method of visuallyexamining the plots of the
series in search of turning points is somewhat arbitrary.
Burns and Mitchell concede that there are problems with
the notion of a reference date, writing: “If this concept is
somewhat fuzzy, so must be our dating” (p. 95). They go
on to say: “Neater results could be attained by estimating
the cyclical turns of a quantity corresponding to some
precise concept of aggregate economic activity. B u t. . .
the existing records virtually rule out this course except
for the most recent business cycles” (p. 95).
1This early system of indicators, called the Harvard
ABC curves, is described by Oskar Lange, Introduction
to Econometrics, pp. 85-94.
2The National Bureau of Economic Research is a
private, not-for-profit research group.
16
FEDERAL RESERVE BANK OF PHILADELPHIA
The individual components are weighted to
reflect their relative importance as turningpoint indicators, then added together to form
a single Index of Leading Indicators. This
composite index should consistently turn
down (up) prior to business-cycle troughs
(peaks) if the National Bureau approach is to
be useful for prediction.
construction, and new orders for machinery
and equipment, represent decisions made
early in a lengthy investment process. For
example, changes in actual production lag
behind new orders because the orders must
first be filled, and how soon they are filled
depends on the volume of unfilled orders and
on the state of inventories. Thus unfilled
orders and order backlogs are leading indi
cators of production activity. Another ex
ample of a lead-lag relation is changes in the
workweek and employment. Many employers
find that it is cheaper to increase or decrease
hours of work for existing employees than to
hire or fire workers. Consequently, most
manufacturers increase or decrease the work
week before they increase or decrease the
level of employment. As a result, the work
week leads employment.
For most series, however, the relations are
not so clear cut. Rather than analyze very
complicated economic relations, the general
strategy of the National Bureau procedure is
to measure leads and lags against the com m on
standard of the business cycle chronology.
Using the chronology, individual series can
be classified without assuming a theory of
the business cycle. Consequently, the ap
proach may be thought of as “measurement
without theory,” since it does not try to ex
plain the behavior of each series but simply
notes its relation to the chronology.5 The
lack of explicit economic theory is considered
a virtue by some economists, a vice by others
(see ECONOMETRIC MODELS AND THE
INDEX OF LEADING INDICATORS
overleaf].
The National Bureau, recognizing that
fluctuations in business activity typically are
spread over a number of sectors in the econ
omy, employs a variety of leading indicators.
HOW WELL
DOES THE INDEX PERFORM?
One frequently used measure of economic
activity is the Federal Reserve Board Index
of Industrial Production. Its turning points
correspond closely to the business cycle
reference dates.6 Because of this close coin
cidence, the forecasting performance of the
Index of Leading Indicators can be tested by
examining its ability to predict the Index of
Industrial Production. There are two ways to
evaluate the performance of the Index of
Leading Indicators. One way is to look at its
ability to predict business cycle turning points
only. The other is to look at its ability to
predict movements of economic activity at
all points of the cycle.
The Turning Point Approach. The first
method of evaluation accepts the National
Bureau’s emphasis on turning points. The
Index of Leading Indicators is supposed to
predict business cycle turning points, but
how do we know when the Index is predicting
a turning point? One common approach is to
decide that an upturn (downturn) in economic
6The Index of Industrial Production put out by the
Federal Reserve Board goes back to 1923. An older
version goes back to 1919, and a still older version to
1913. Consequently, it could not be used by the National
Bureau to construct the business cycle chronology for
earlier periods. The forecasting performance of the
Index of Leading Indicators is evaluated in this article
for the post-World War II period, so the Index of Indus
trial Production is used instead of the reference dates.
Another possibility is to use the Gross National Product.
Construction of this measure, however, began in the
1920s. In addition, the GNP is only available on a
quarterly basis, while the Index of Leading Indicators
comes out monthly.
^See Thomas J. Sargent and Christopher A. Sims,
"Business Cycle Modeling Without Pretending To Have
Too Much A Priori Economic Theory,” in N ew Methods
in Business C y cle Research (October 1977), Federal
Reserve Bank of Minneapolis.
17
NOVEMBER/DECEMBER 1982
BUSINESS REVIEW
ECONOMETRIC MODELS
AND THE INDEX OF LEADING INDICATORS
Both macroeconometric models and the Index of Leading Indicators are designed to forecast
future economic activity. Econometric models are typically quarterly or annual models which can
accommodate long-run and short-run forecasting as well as some policy simulation. The Index of
Leading Indicators is very simple in comparison to large econometric models. The Index cannot be
used for simulation, nor can it make long-range forecasts.
The Index of Leading Indicators, however, is an example of an approach to forecasting which
represents a major alternative to econometric models. Construction of the Index does not rely on the
type of a priori theory embodied in econometric models, though it does require choosing individual
series and a method of combining them to construct an index. A main virtue of the Index of Leading
Indicators is that it may detect statistical regularities which are missed by large scale econometric
models precisely because the data are not subject to the type of restrictions imposed by such models. *
Some of these restrictions, which are hypotheses about how people behave, may be mistaken. The
Index of Leading Indicators also imposes restrictions on the data, in the form of the weights attached
to the individual series in the Index. But the weights on the individual series are not derived from
assumptions about people’s economic behavior. Though it is not known for sure, the Index may
contain different, and possibly more, information than econometric model forecasts.!
As with econometric models, however, it is not now known how the behavior of the Index is
affected when the government makes major changes in policy. People’s economic behavior changes
when new policies come into existence, making econometric models which are based on people’s
previous behavior patterns inadequate for forecasting behavior under the new policies.! A policy
change can also affect the way leading indicators are related to the underlying pattern of economic
activity. How a policy change affects this relation cannot be known in advance, so the problem with
the Index of Leading Indicators when policy changes is the same as with econometric models.
Economists do not agree on whether econometric models are inherently deficient or not, or on
whether forecasting methods in the spirit of the National Bureau’s approach represent a positive step
forward in forecasting. In the face of this disagreement, the practical forecaster should use all
available information; so a method which does not specify causal-economic relationships, like the
Index of Leading Indicators, is worth using.
*
For evidence that large scale econometric models fail to detect important statistical regularities see: J.P.
Cooper and C.R. Nelson, “The Ex Ante Prediction Performance of the St. Louis and FRB-M IT-PENN Econo
metric Models and Some Results on Composite Predictors,” Journal of Money, Credit, and B an king 7, 1
(February 1975), pp. 1-32; also, C.R. Nelson, “The Prediction Performance of the FRB-M IT-PENN Model of the
U .S. Economy,” American Economic Review 62, 5 (December 1972), pp. 902-917.
^ For a discussion of the comparative performance of econometric models and time series, see: C.W .J. Granger
and Paul Newbold, F orecastin g E con om ic Tim e Series [N ew York: Academic Press, 1977), pp. 289-302; andR.L.
Cooper, “The Predictive Performance of Quarterly Econometric Models of the United States,” in Econometric
M odels o f C y clical Behavior (New York: Columbia University Press, 1972), edited by B.G. Hickman. Also, see
Ray C. Fair, “An Analysis of the Accuracy of Four Macroeconometric Models, ” Journ al o f P olitical E con om y 87,
4 (August 1979), pp. 701-718.
* Economists disagree on how important this problem is. See Richard W. Lang, "Using Econometric Models To
Make Economic Policy: A Continuing Controversy,” forthcoming in this Review . Also, Robert E. Lucas,
"Econometric Policy Evaluation: A Critque,” T he Phillips Curve and L a bo r Markets, Carnegie-Rochester
Conference on Public Policy (Supplement to the Journal o f M onetary Economics, ed. by Karl Brunner and Allan
H. Meltzer, 1976).
18
FEDERAL RESERVE BANK OF PHILADELPHIA
it would not predict a downturn.
There is an inherent arbitrariness to the
number-of-months approach. It is not obvious
how many months the Index of Leading
Indicators must move in the same direction
before a turning point in economic activity is
predicted. Different rules for determining
turning points in the Index of Leading Indi
cators result in different predictions about
turning points in the Index of Industrial
Production.
Using the one-month rule, the Index of
Leading Indicators successfully predicts all
ten turning points in the Index of Industrial
Production during the period 1948-70 (Figure
l ) . 7 This seems to be persuasive evidence of
the predictive ability of the Index of Leading
activity will occur if the Index has been
above (below) its previous high (low) for a
specified number of months. The problem is
to decide how many months should be looked
at before deciding that the Index is predicting
an upturn or downturn.
Since movements in the Index of Leading
Indicators are partly random, many upward
or downward movements are reversed if we
wait long enough. Suppose, for example,
that the Index declines for two months in a
row. If we adopt a two-months rule, we would
conclude that the Index is predicting a down
turn in economic activity. It could well be the
case, though, that in the next month the
Index will rise to a level above that of three
months ago. Then under a three-months rule,
FIGURE 1
LEADING INDICATORS PREDICT
WITH DIFFERENT LEAD LENGTHS*
Performance of the Index of Leading Indicators, 1948-1970, Using the One-Month Rule
Date of Turn in Index
of Leading Indicators
Date of Turn in Index
of Industrial Production
Lead
Months
Peaks
June 1948
January 1953
November 1956
January 1960
September 1969
July 1948
July 1953
February 1957
January 1960
July 1969
Average Lead
1
6
3
0
-2
1.6
October 1949
April 1954
April 1958
February 1961
November 1970
Average Lead
5
5
5
2
6
4.0
Troughs
May 1949
November 1953
February 1958
December 1960
May 1970
‘ Figure 1 summarizes the results of a study by Stekler and Schepsman which applied the one-month rule to
leading indicators. The left hand column shows the turning points chosen in the Index of Leading Indicators. At
these dates the Index predicted turning points in Industrial Production. The middle column shows the subsequent
turning points in the Index of Industrial Production. The last column shows the lapse of time between the change
in the Index of Leading Indicators and the actual turning point in Industrial Production.
SOURCE: H.O. Stekler and Martin Schepsman, “Forecasting With an Index of Leading Series,” Journal of the
American Statistical A ssociation 68, 342 (June 1973), pp. 291-296.
19
BUSINESS REVIEW
NOVEMBER/DECEMBER 1982
Indicators. The Index produces a number of
false signals, however, over the same period.
That is, one-month changes appear in the
Index of Leading Indicators which do not
correspond to any subsequent turning point
in the Index of Industrial Production. Under
the one-month rule, over the period 1948-70,
the Index of Leading Indicators predicted
twenty-four peaks and nine troughs w hich
did not happen (Figure 2).
At the other extreme, if we adopt a fourmonth rule or a five-month rule, we make
fewer mistakes but the average lead declines.
In general, the accuracy of the prediction
from the Index of Leading Indicators in
creases as the number of months used for the
rule increases. But while the accuracy of the
prediction increases, the Index loses its ability
to give advance notice.78 Using a five-month
rule, business cycle peaks are, on average,
detectable two and one-half months afterthey
have happened. Troughs, using the fivemonth rule, are identified, on average, just as
they are happening. Thus there is a trade-off
between the accuracy of the prediction of the
Index of Leading Indicators and the length of
time of advance notice. Further, the trade-off
is not the same for peaks as for troughs. The
Index of Leading Indicators predicts troughs
more accurately than peaks under any month
rule. Also, the length of the advance notice
period quickly declines as the number of
months increases when predicting peaks.
8In a similar study by Hymans, the Index of Leading
Indicators not only signaled false turns, but, for the
period 1956-71, the Index did not signal half the peaks
and 42 percent of the troughs which actually occurred.
Hymans, roughly speaking, used a two-month rule. Saul
H. Hymans, "On the Use of Leading Indicators to Predict
Cyclical Turning Points,” Brookings Papers on Economic
Activity 1973, 2, pp. 339-384.
7H.O. Stekler and Martin Schepsman, “Forecasting
With an Index of Leading Series,” Journ al o f the
A m erican Statistical A sso cia tion 68, 342 (June 1973),
pp. 291-296.
FIGURE 2
LEADING INDICATORS
SOMETIMES SIGNAL FALSE TURNS*
True and False Turns, 1948*1970
Criterion
Number of
months
up or
down
1
2
3
4
5 or more
Peaks
Troughs
Average
Lead
Number
of True
Turns
Number
of False
Turns
Average
Lead
Number
of True
Turns
Number
of False
Turns
1.6
0.6
-0.4
-1.4
-2.4
5
5
5
5
5
24
15
9
5
3
4.0
3.0
2.0
1.0
0.0
5
5
5
5
5
9
3
2
1
0
*A negative number for "average lead” means that the Index is “predicting” turning points w h ich h a v e already
happened.
SOURCE: H. O. Stekler and Martin Schepsman, “Forecasting With an Index of Leading Series,” Journ al o f the
American Statistical A sso cia tion 68, 342 (June 1973), pp. 291-296.
20
FEDERAL RESERVE BANK OF PHILADELPHIA
from peak to peak, for a period of thirty-six
months. Studies of the relations between the
business cycle and the Index of Leading
Indicators should focus on cycles with per
iodicities close to those of the business
cycle.
The cyclical behavior of an individual
series can be represented by adding together
many cycles of different periodicities. That
is, any cyclical pattern can be approximated
by adding together many waves with dif
ferent periods (see REPRESENTING A
SERIES BY CYCLES . . . overleaf). There is a
statistical indicator that measures the cor
relation, or strength of association, between
cycles of the same periodicity from any two
series. This measure is called squared
coherence.11 The more closely related these
movements are, the closer the squared
coherence is to unity for each periodicity. If
the movements of the two series are not
related for a given periodicity, then the
squared coherence is zero for that periodicity.
Calculating the squared coherence for the
whole range of periodicities yields a profile
of the degree of association between two
series.
Time-series tests of the relationship between
the leading indicators and the business cycle
also typically use industrial production as
the basic measure of economic activity. At a
periodicity of twenty-four months, the squared
coherence between the Index of Leading
Indicators and the Index of Industrial Pro
duction is .83, close to unity (Figure 3
overleaf). Futhermore, for two-year cycles
the Index of Leading Indicators leads the
Index of Industrial Production by about two
months on average. Hence, for two-year
cycles the predictive content of the Index of
Leading Indicators is high; that is, the move-
Though the Index of Leading Indicators
occasionally signals turning points in eco
nomic activity which do not occur, much of
the time it is successful. Evaluated from the
standpoint of the number-of-months approach,
the Index does not always predict accurately,
but at least it does not miss turns in the
direction of economic activity. If the Index
of Leading Indicators could be used to pre
dict economic activity at all points in time,
however, then the difficulties of choosing a
months rule could be eliminated.
The Whole-Cycle Approach. A number
of economists have used so-called time series
methods to investigate the historic lead-lag
relations between the Index of Leading Indi
cators and economic activity over all points
in the cycle rather than just near turning
points.9 These methods can identify certain
movements in one series which are associated
with movements in another series.10
The length of time it takes for a complete
business cycle, up-down-up, is called its
period. The National Bureau has found that
business cycles average about three years
^Hymans, “Leading Indicators;” M. Hatanaka,
“Application of Cross-Spectral Analysis and Complex
Demodulation: Business Cycle Indicators,” in C.W.J.
Granger, Spectra 1 Analysis of Economic Time Series
(Princeton: Princeton University Press,1964); Alan J.
Auerbach, “The Index of Leading Indicators: ‘Measure
ment Without Theory,’ Twenty-five Years Later,”
National Bureau of Economic Research, Working Paper
No 761; Salih N. Neftci, “Lead-lag Relations, Exogeneity
and Prediction of Economic Time Series,” Econometrics
47, 1 (January 1979), pp. 101-113.
10 A time series is a sequence of values usually recorded
at equidistant time intervals. Examples are the monthly
unemployment rate, the weekly money supply, the
annual Gross National Product. Time series analysis is a
statistical method which aims to make inferences about
the basic features of the random process generating the
series from the information contained in the observed
series. This is done by constructing a model from the
data, but it is a purely statistical model, not a model
based on economic theory like econometric models. For
an introduction to the subject, see C.W .J. Granger and
Paul Newbold, F orecastin g E con om ic Tim e Series (New
York: Academic Press, 1977).
•j «j
Z
1 AThe squared coherence is analogous to an R statistic
in regression analysis. It shows the proportion of the
variance in one series at frequency u> that is accounted
for by variation in the other series.
21
BUSINESS REVIEW
NOVEMBER/DECEMBER 1982
ments in the two series at a periodicity of two
years are very close. For cycles of 20 to 60
months the Index of Leading Indicators is
also a good predictor. It has high squared
coherences at these periodicities, and it
leads. But the lead length is highly variable
depending on which periodicity dominates
the cycle. The lead varies in length from
seven and a half months (for cycles of 60
months) to less than two months (for cycles
REPRESENTING A SERIES BY CYCLES
OF DIFFERENT PERIODICITIES
A time series is a sequence of observations of some economic variable recorded at equidistant time
intervals. The weekly money supply and the monthly Index of Leading Indicators are examples of
time series. Even though the observations are at discrete intervals (weeks, days, months, years), they
can be regarded as coming from a continuous process. In the right-hand panel, the hypothetical time
series, S(t), is plotted as a continuous function, even though the observations are at intervals of years.
S(t) is measured in dollars in this hypothetical example.
Cycle 1
Dollars
Cycle 2
Cycle 3
Dollars
Dollars
Time Series S(t)
Dollars
The other three panels show three artifically generated component cycles of different periodicities.
The time series, S(t), is approximated by the strictly periodic cycles in the other panels. * Thus each of
the three cycles has been chosen in such a way that, when they are added together at each year, the
resulting series is very close to the series, S{t). Some of the values plotted in the panels are:
Year
Cycle 1
Cycle 2
Cycle 3
m
1
5
10
20
30
40
50
5.39734
6.68294
6.81859
3.48640
4.44117
6.97872
3.91196
7.00505
6.54500
6.68682
8.63025
9.40234
7.56815
6.53656
11.4135
10.7285
9.5775
6.7081
3.9407
2.2420
2.2054
23.8159
23.9565
23.0829
18.8248
17.7842
16.7889
12.6539
In this example, the three cycles have been chosen so that their values at each year exactly add up
to the time series, S(t). Actual time series can only be approximated.
See Gwilym M. Jenkin and Donald G. Watts, Spectral Analysis and its Applications(San Francisco: HoldenDay, 1969), for an introduction to these approximation methods.
22
FEDERAL RESERVE BANK OF PHILADELPHIA
of 20 months).
The shortest peak-to-trough or trough-topeak duration on record is six months, cor
responding to a one-year cycle. So cycles
with periods of less than one year are not of
much practical interest when studying busi
ness cycles. This is fortunate, since the data
indicate that leading indicators would per
form quite poorly for short cycles. The timeseries approach suggests that leading indi
cators work best for cycles with periods of
two years or more.
When the Index of Leading Indicators is
evaluated using the whole cycle approach,
many of the same conclusions reached in the
turning-point analysis hold up. The Index
still can give false signals, and the lead time
still varies. Thus, while there is some infor
mation about future economic activity in the
Index, its signals are highly variable and
therefore somewhat unreliable.
FIGURE 3
THE INDEX
OF LEADING INDICATORS
IS A GOOD PREDICTOR
FOR SOME CYCLES,
NOT FOR OTHERS
Lead-Lag Relations Over the Whole Cycle
(1948-Mid-1972)
Phase Lead (-4 or
LagH of ILI*
POSSIBLE PROBLEMS
WITH THE INDEX
OF LEADING INDICATORS
False signals and variable lead times appear
whether the Index is evaluated by the turning
point approach or by the whole cycle ap
proach. If these problems could be elimi
nated, or at least minimized, the Index of
Leading Indicators would be a more accurate
predictor of future economic activity.
It could be that false signals and variable
lead times are, at least partially, the result of
the method used to construct the Index of
Leading Indicators. Constructing the Index
involves choosing the component series, then
deciding how to weight each of them in
importance in adding them together. Both of
these steps are difficult, and they may be the
source of some of the Index’s undesirable
features.
The Bureau of Economic Analysis, which
produces the Index of Leading Indicators,
chose the twelve component series of the
Index and their weights after evaluating over
150 candidate leading series with respect to
Periodicity
(months)
Squared
Coherence
Relative to Index
of Industrial Pro
duction (months)
60
40
30
24
20
12
8
6
4.8
4
3.4
3
2.7
2.4
2.2
2
0.85
0.92
0.93
0.83
0.54
0.46
0.49
0.35
0.19
0.14
0.18
0.19
0.11
0.10
0.16
0.10
7.6
4.3
2.8
2.3
1.5
-0.1
0.2
0.2
0.4
0.3
0.0
-0.2
0.0
0.0
-0.1
-0.1
“Index of Leading Indicators.
SOURCE; Saul H. Hymans, “On the Use of Leading
Indicators to Predict Cyclical Turning Points,”
Brookings Papers on Econom ic Activity 1973, 2,
pp. 339-384.
six criteria.12 These criteria were: (1) eco
nomic significance; (2) statistical adequacy;
12The Index of Leading Indicators has recently been
changed by the removal of one of the twelve series. The
Index of Net Business Formation has been eliminated
because of data collection problems. No new series
replaced the Index of Net Business Formation. Instead,
23
BUSINESS REVIEW
NOVEMBER/DECEMBER 1982
(3) timing at turning points; (4] conformity to
historical business cycles; (5) smoothness; (6)
currency or availability of data. Candidate
series were scored; that is, points were given
to each series for each criterion, and then
they were totaled. The twelve chosen had
high scores but not necessarily the highest,
since diversified coverage of economic
activities was also desired. The weights are
the scores (Figure 4 ).13
Choosing Series. A good leading indicator
consistently leads business cycles by at least
a few months, as evidenced by its having
turning points just prior to the reference
dates. But choosing series on this basis sug
gests a particular notion of causality based
on the temporal ordering of the turning points.
This notion of causality is a statistical one
which is used in forecasting.14 An inference
can be drawn about future economic activity
when a turning point in the leading series is
observed. When the leading series rises, it
implies a rise in future economic activity.
For the leading series to “cause” subsequent
economic activity, forecasts using the leading
series must be more accurate than forecasts
which do not use the leading series. It is not
enough that turning points in the leading
series come before reference dates.
If the classification of economic series
using the National Bureau turning point
approach is valid, then forecasts of, say, the
Index of Industrial Production should be
more accurate when the leading indicators
are used than when they are not used. After
all, forecasts about future Industrial Pro
duction can be made from observing past and
current values of the Index of Industrial
Production alone. If forecasts of Industrial
Production based on the leading indicators
are more accurate than forecasts using only
Industrial Production’s own past history,
then the leading indicators have been chosen
in a useful way. The particular leading indi
cators which most improve forecasting ac
curacy would be the most useful ones.
The National Bureau’s only criterion for
leading indicators is that they consistently
lead. But an indicator which consistently
leads the Index of Industrial Production, for
example, does not necessarily help predict
the Index of Industrial Production any better
than can be done by using only current and
past values of the Index of Industrial Pro
duction. In other words, there may be no
additional information in a leading indicator;
the leading indicator may not “cause” the
Index of Industrial Production.15*
Using modern statistical techniques, the
various leading series can be tested to see if
they contain information which is really
useful for predicting. Testing eleven of the
twelve component series in this way reveals
that six of the component series are not
helpful in predicting the Index of Industrial
Production when the individual series are
adjusted to remove regular seasonal move
ments (Figure 5 overleaf). When the past
history of Industrial Production is used to
forecast its future value, taking account of
these six leading series does not improve the
forecast.
the weights on the remaining eleven series were adjusted.
Since the bankruptcy rate reached Depression levels
during the current recession, the removal of the Index of
Net Business Formation is not a trivial change and has,
consequently, led to a minor controversy. See, for
example, Business Week, July 26, 1982, p. 11.
13For a complete description of the criteria and the
“scoring” procedure, see Victor Zarnowitz and Charlotte
Boschan, “Cyclical Indicators: An Evaluation and New
Leading Indexes,” Handbook of C yclical Indicators
(May 1977), Bureau of Economic Analysis, U .S. Depart
ment of Commerce.
14See C. W. J. Granger, “Investigating Causal Relations
by Econometric Models and Cross-Spectral Methods,”
Econom etrics 37, 3 (1969); and Christopher A. Sims,
“Money, Income, and Causality,” A m erican Economic
Review 62, 4 (1972).
15Thomas Sargent gives some theoretical examples
of this in his book M acroeconom ic Theory (New York:
Academic Press, 1979), pp. 247-248.
24
FEDERAL RESERVE BANK OF PHILADELPHIA
FIGURE 4
THE INDEX OF LEADING INDICATORS
INCLUDES TWELVE DATA SERIES
Component Series of the Index of Leading Indicators
BEA
Series Number
1
3
8
12
19
20
29
32
36
92
104
105
Description of Series
Weight
Average workweek of production workers, manufacturing
Layoff rate, manufacturing (inverted)
New orders, consumer goods and materials, 1972 dollars
Index of net business formation
Index of stock prices (Standard and Poor)
Contracts and orders, plant and equipment, 1972 dollars
Building permits, private housing
Vendor performance
Change in inventories on hand and on order, 1972 dollars
Percent change in sensitive prices (smoothed)
Percent change in total liquid assets (smoothed)
Money supply (M l), 1972 dollars
.984
1.025
1.065
.984
1.079
.971
1.025
.930
.957
.971
1 .0 1 1
1.065
SOURCE; Handbook of C yclical Indicators(M ay 1977), U .S. Department of Commerce.
tical sense, these weights were not chosen in
the best way. That is, they were not estimated
from the data, but rather were computed
according to a more or less subjective scoring
procedure.
When the weights to be used in constructing
the Index are statistically estimated they do
not resemble those currently used in the Index.
Indeed, some of the statistically estimated
weights turn out to be negative. Moreover,
one researcher found that estimating the
weights over different sample periods indi
cated that the relations between the com
ponent series of the Index and the underlying
business cycle pattern were not stable, since
different weights for the Index were chosen
for each sam ple.17 This finding suggests that
When nonseasonally adjusted data is used,
only one component series is not helpful.
These results suggest that it would be better
not to seasonally adjust the data, contrary to
the Commerce Department’s current pro
cedure. Also, other series which are not
presently used as components of the Index of
Leading Indicators have yet to be tested to
see if they could improve the forecasting
power of the Index of Leading Indicators.
Choosing Weights. Perhaps the unrelia
bility of the Index of Leading Indicators
could be reduced if the weights used to
combine the twelve included series were
chosen differently. The twelve series chosen
represent a fairly diverse coverage of eco
nomic activity.16 The Index is for all prac
tical purposes unweighted since the weights
vary so little (from .930 to 1.079]. In a statis-
17Alan J. Auerbach, “The Index of Leading Indicators;
‘Measurement Without Theory,’ Twenty-five Years
Later,” National Bureau of Economic Research, Working
Paper No. 761.
*®The indices of lagging and coincident indicators are
also described in the Handbook of Cyclical Indicators.
25
NOVEMBER/DECEMBER 1982
BUSINESS REVIEW
—■
......
.......................
.
------ --------------------
- .................. —
...... ..........
................................ .
!
..................... .........
---............■,
"
FIGURE 5
NOT ALL SERIES ARE HELPFUL PREDICTORS
Component Series of the Index of
Leading Indicators
Seasonally Adjusted
Data
Nonseasonally Adjusted
Data
Average workweek of production
workers, manufacturing
Layoff rate, manufacturing
(inverted)
New orders, consumer goods
and materials, 1972 dollars
Index of net business formation
not helpful in prediction
Index of stock prices (Standard
and Poor)
not helpful in prediction
Contracts and orders, plant and
equipment, 1972 dollars
Building permits, private housing
not helpful in prediction
Vendor performance
Change in inventories on hand
and on order, 1972 dollars
not helpful in prediction
Percent change in sensitive prices
(smoothed)
not helpful in prediction
Percent change in total liquid
assets (smoothed)
(not tested)
Money supply (M l), 1972 dollars
not helpful in prediction
not helpful in prediction
(not tested)
SOURCE: Salih N. Neftci, "Lead-Lag Relations, Exogeneity and Prediction of Economic Time Series,”
Econometrica 47, 1 (January 1979), pp. 101-113.
the relations between the individual series
used to construct the Index and the under
lying pattern of economic activity change
over time.
When the weights are estimated over one
sample period and the Index so constructed
is employed to forecast over another sample
period, however, the results are poor com
pared to the Bureau of Economic Analysis
Index with equal weights. Even though the
weights chosen by the Bureau of Economic
Analysis don’t seem to be the best in a statis
tical sense, no obviously superior set of
weights has yet been found.
Consideration of how the component series
and the weights for the Index of Leading
26
FEDERAL RESERVE BANK OF PHILADELPHIA
is unreliable lead times. It would be easy to
conclude that the difficulties with the Index
are so serious that it should be discarded. But
that would be too hasty. Good forecasters use
a variety of techniques and information. The
Index of Leading Indicators does forecast
turning points, and it has a strong record
when evaluated by the whole cycle approach.
The Index is a useful summary of the outlook
for the aggregate economy since it combines
a great deal of information about diverse
activities. Moreover, it’s free.
While the Index of Leading Indicators has
some problems, the general approach has
proven useful. No new, improved, index is
yet available, but progress in the spirit of the
National Bureau’s “measurement without
theory” approach is being made toward
indices with improved predictive abilities.19
Indicators are chosen reveals some problems
and puzzles, but not necessarily solutions
and answers. Not all the component series
really improve the forecasts when compared
to forecasting with only the past history of
Industrial Production. But this is only a pro
blem when seasonally adjusted data is used.
The weights, seemingly not chosen in the
best way, haven’t been improved on. Only
more research can resolve these issues. On
balance, the most important problem with
the Index of Leading Indicators seems to be
that it uses seasonally adjusted data.18 But
no index has yet been constructed with nonseasonally adjusted data.
WHERE DOES ALL THIS LEAD?
The Index of Leading Indicators, like other
forecasting methods, has its drawbacks. The
most important of these is its tendency to
signal turning points falsely. Another problem
19An example of such current work is Robert B.
Litterman, “A Use of Index Models in Macroeconomic
Forecasting,” Federal Reserve Bank of Minneapolis,
Staff Report 78. Also Stephen Beveridge and Charles R.
Nelson, “A New Approach to Decomposition of Eco
nomic Time Series with Attention to Measurement of
the‘Business Cycle’,” Jou rn al o f M on etary E con om ics 7
(1981), pp. 151-174.
18The government’s method of deseasonalizing data
has been criticized before. See, for example, W .S.
Cleveland and G.C. Tiao, “Decomposition of Seasonal
Time Series: A Model for the Census X - l l Program,”
Jou rn al o f the American Statistical A sso cia tion 71
(1976), pp. 581-587.
27
FEDERAL RESERVE BANK OF PHILADELPHIA
BUSINESS REVIEW CONTENTS 1982
JANUARY/FEBRUARY
Thomas P. Hamer, “The Casino Industry in
Atlantic City: What Has It Done for the
Local Economy?”
Mark J. Flannery, “Deposit Insurance Creates
a Need for Bank Regulation”
JULY/AUGUST
Herbert Taylor, “Interest Rates: How Much
Does Expected Inflation Matter?”
Janice M. Moulton, “Implementing the Mon
etary Control Act in a Troubled Environment
for Thrifts”
MARCH/APRIL
Brian Horrigan and Aris Protopapadakis,
"Federal Deficits: A Faulty Gauge of Govern
ment’s Impact on Financial Markets”
LaurenceS. Seidman, “H ealthcare: Getting
the Right Amount at the Right Price”
SEPTEMBER/OCTOBER
Joanna H. Frodin, “Electronics: The Key to
Breaking the Interstate Banking Barrier”
John J. Mulhern, "Delaware Valley Defense
Industry Update: Is Better Information the
Way to Greater Growth?”
MAY/JUNE
Stephen A. Meyer, “Margaret Thatcher’s
Economic Experiment: Are There Lessons
for the Reagan Administration?”
Gerald Carlino, “From Centralization to
Deconcentration: Economic Activity Spreads
Out”
100 North Sixth Street
Philadelphia, PA 19106
NOVEMBER/DECEMBER
Robert H. DeFina, “Spending Through the
Tax Structure: Are We Taxing the Revenue
System?”
Gary Gorton, “Forecasting With the Index of
Leading Indicators”
Contents 1982
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