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No. 3, December 1945





Published December 1945



Inside Front Cover



Why Fiscal Policy?
Total Expenditures and Level of Employment
Role of Fiscal Policy
Alternative Budgets for Full Employment
Adjusting Revenue and Expenditure Structures
Deficit: Higher Expenditures vs. Lower Taxes
Balanced Budget: Higher Expenditures and Higher Tax Yield..
Short and Long-Run Budget Planning
Basis for Planning Public Expenditures
Long-Run Budget Planning
Short-Run Adjustments
Fiscal Policy in a Broader Program
Fiscal Policy and Other Approaches
Fiscal Policy and Private Enterprise






Economic Requirements for Tax Policy
Revenue Structure and Size of Deficit
Level of Yield
Minimizing Tax Deterrents to Consumption
Taxes from Personal Income
Taxes from Business Income
Minimizing Tax Deterrents to Investment
Supply of Savings
Investment Incentives and High Bracket Rates
Investment Effects of Personal vs. Corporation Taxes
Loss Offset
Averaging of Income over Time
Capital Gains
Small and New Enterprises
Tax Exempt Securities
Incentive Taxation
Taxation of Idle Balances
Taxation of Idle Income
A Flexible Tax Policy
Elasticity of Yield
Adjustability of Rates
Place of the Corporation Income Tax
Integration of Personal and Corporation Income Taxes
Corporation Tax and Alternatives
Is the Corporation Tax Shifted?
Corporation Taxes for Industrial Control




Outline of Revenue Program
Timing of Rate Reductions
Yield Composition
Further Considerations





Debt as an Instrument of Fiscal Policy
Effects of Debt Changes on Income
Debt and Fiscal Policy
Secular Expansion of the Debt
Importance of Relative Magnitudes
Relation between Debt and National Income
When Income Remains Constant
Growing Income
Numerical Magnitudes
Implications for Fiscal Policy
How Can a Rapidly Rising Income Be Achieved?
Productive Capacity and Realized Income
Need for Technological Progress
Cyclical Drop in Income
Declining Rate of Growth
Effects of a Growing Debt on Distribution of Wealth and Income.
The Argument
Comparison between Public and Private Investment
Average Rate of Return
Source of Property Income





Monetary Expansion during the War
Inflationary Potential of Present Debt Structure
Easy Access of Banks to Reserves
Insecure Ownership of Government Securities
Critical Matter Is Not Interest Rates Alone
Practical Considerations in Public Debt Planning
Proposed Changes in Public Debt Structure
Public Debt in the Banking System
Other Holders of Government Securities
Credit Policy with Proposed Debt Structure
But What about Deflation?









Debt Service and Income Stream
Slowing Down of Income Stream
Redistribution of Income
Tax Effects
The Government's Creditors
Commercial Banks
Insurance Companies




Functions of State and Local Governments
State and Local Tax Systems
Sources of Taxes
Aggregate Revenue
Grants-in-Aid and Shared Revenues
Credit Resources of State and Local Governments
Cyclical Characteristics of Government Finance
Local Expenditures
State Expenditures
Federal Expenditures
Public Construction
Financing Government Expenditures
Local Deficits and Surpluses
State Deficits and Surpluses
Federal Deficits and Surpluses
Geographic Disparities in Wealth, Income, and Need for
Government Services
Full Employment and State and Local Fiscal Policies
Obstacles to Counter-Cyclical Policy for State and Local
Federal Grants for Counter-Cyclical Expenditures
Rationalization of Federal, State, and Local Fiscal Relations..
Tax Reform
Multiple Taxation













R I C H A R D A.


Division of Research and Statistics, Board of Governors
Through a decade and a half of depression finance and wartime expansion, there has been a growing, if hesitant, recognition of public
finance as a powerful instrument for maintaining a high and stable level
of income. In this first essay the general role of fiscal policy in the postwar
economy will be appraised and some basic aspects of fiscal planning will
be considered.

Government expenditure, tax, and debt policies are of strategic importance to prosperity, because through them public policy affects the
level of total demand in the economy. As such, budget policy is a vital
factor, quite apart from the intrinsic merits of specific expenditure programs or the equity of specific revenue measures. Budget policy is bound
to be a matter of broad economic policy.
Total Expenditures and Level of Employment. Production, employment, and hence income in a private enterprise economy depend upon
the existence of the necessary markets. Unless prospective market demand appears sufficient to businessmen to pay for the costs of production
and to leave an adequate profit, production will not be forthcoming and
resources will be unemployed, as was the case to varying degrees during
the thirties. And similarly, unless market demand remains within the
limit of available supplies once a high level of employment has been
reached, prices will be driven up and inflation will threaten. The key to
economic prosperity and stability therefore is to secure and maintain a
sufficiently high but not excessive level of expenditures, public and
This general requirement is clear cut, but its fulfillment is by no means
simple. Policy considerations must begin with the basic fact that there is
no self-adjusting mechanism, in a private enterprise economy, which
assures that a full employment level of expenditures will be maintained
year in and year out, so that neither inflation nor deflation will develop.




The cyclical ups and downs of the past give ample evidence to the contrary. Beyond the issue of stability, moreover, it must be recognized
that there is no automatic mechanism, inherent in the private enterprise
economy, which assures that the level around which total income and
expenditures may fluctuate will be one of good business and reasonably
high employment; quite possibly it may be one of low profits and substantial unemployment.
This, of course, is no novel conclusion; rather it is surprising that at
times it has been denied. In an economic system where decisions to buy,
to produce, to sell, to save, or to spend, are made by millions of separate
households, workers, and business enterprises, there is no reason to expect
that the multitude of individual decisions necessarily should combine to
meet the conditions of full and stable employment for the economy as a
whole. Rather, each small planning unit can do no more than to adjust
its program to the general economic setting with which it is confronted.
Thus consumers must budget within the limits of their current and prospective incomes; workers must choose their jobs depending on what openings there are for them; and businessmen must plan their production
according to their prospective markets. Not even large corporations
acting alone, can expect that an addition to their disbursements will substantially affect the market for their products. As far as individual decisions are concerned, general economic conditions, like the weather,
must thus be accepted as uncontrollable. These conditions, moreover,
are not planned consistently by some central authority, but come about
indirectly as the result of a multitude of separate individual decisions.
Given a flexible and competitive business structure, we may, over time,
expect this process of decentralized planning, that is, the price system,
to provide for a reasonably efficient utilization of resources within the
limits of a given level of total output, but we cannot expect it to assure
a high and stable general level of income and employment. Yet, the
events of three decades have taught us that a much higher degree of
stability and average level of employment than characterized the interwar period must be achieved after this war.
The goals of stability and full employment as used in this context have
a well understood, commonsense meaning, but some comment may be
needed to avoid misinterpretation. Leaving aside matters of technical
definitions which are less important, the terms express the need for
setting our sights high and for preparing to meet contingencies. Stability
obviously does not imply that the general level of income and employ-



ment should never be permitted to vary. In a growing economy income
must increase if resources and labor are to be kept employed, and in the
process of growth some fluctuation in employment and resource utilization is desirable, provided it is assured that excessive instability will be
forestalled. Full employment similarly does not mean that the strained
wartime level of employment should be maintained, that all frictional
unemployment can be avoided, or that an unreasonable premium should
be placed on jobs as against education, home keeping, or voluntary
leisure. Nor does it mean that at times there should be no losses or shrinkages of employment in particular industries. It does mean, however, that
business as a whole should be profitable and that there should be no
group desiring to work who suffers sustained or permanent unemployment. If the reader should prefer, the terms "sustained income" and
"high employment" may be substituted without changing the basic
The potential national output at full employment for a later posttransition year, say 1950, has been estimated in the neighborhood of a
gross national product of 200 billion dollars, measured in 1944 prices.
Whatever the precise figure, 200 billion may be used to illustrate the
problem. If 200 billion dollars worth of goods and services are to be
produced, there must be buyers—including consumers, business, and
Government—standing ready to purchase that much. On the other hand,
if 200 billion dollars worth of goods and services are produced and sold,
the community will receive 200 billion worth of gross receipts, in the
form of wages, profits, taxes, depreciation reserves, and so forth. But,
and this is the crucial point, these two statements are not equivalent to
saying that 200 billion dollars worth of goods and services will be sold
and 200 billion worth of income will be received.
The thesis that production always creates its own market is erroneous
because income, once received, may or may not be returned to the expenditure stream. The mere fact that 200 billion dollars of income are
received gives no assurance that expenditures of 200 billion will be made.
This may be readily explained, and to simplify matters, public expenditures and taxes will be disregarded at this point. Income, when
received by individuals or families, is largely returned to the expenditure
stream through consumption outlays but some part is saved. Also a
part of corporation profits are normally not distributed to individuals
but are retained as business savings. Unless these current savings are
matched by an equivalent total of nonconsumption expenditures, such



as outlays on construction, equipment, and other investment items, it is
evident that total expenditures will fall short of income received. I t
matters little in this respect whether the investment outlays are made
directly by individuals or corporations who do the saving or indirectly
by others to whom savings are made available through security purchase
or other channels. Similarly, it matters little whether the investment
outlays are actually paid for out of dollars currently saved or are financed
out of existing cash reserves or new bank credit. What counts is whether,
on the whole, there is a balance between (1) income not spent on consumption but saved and (2) expenditures for nonconsumption goods.
If (2) is in excess of (1), total expenditures will exceed income received.
Markets will increase and a rise in prices and/or in employment will
result. If (1) is in excess of (2), total expenditures will fall short of income
received. Total demand will fall off and markets become insufficient to
sustain the income level. Production will decline until, at a lower level of
income and employment, total outlays on consumption and investment
will again be sufficient to return the entire income to the expenditure
stream. 1
The cause of such a decline may be temporary only, and sooner or
later private investment may increase, setting in motion a cumulative
upward movement, until conditions develop which in turn may result in
a renewed decline. There are many factors in the economy which may
induce such cyclical fluctuations. Apart from these short fluctuations,
however, general economic conditions may also be such that for substantial periods output and employment remain at or fluctuate around
low levels, where a substantial portion of labor and equipment is unused.
In the absence of stabilizing policies, major cyclical fluctuations will
no doubt continue in postwar years. Certain factors, such as the increased importance of consumer durables, the demand for which is apt
to accrue in spurts, may well add to cyclical instability. But besides
cyclical fluctuations, there may also be the problem of a more continuous
condition of unemployment. The dollar amount of savings at a full em1
Theoretically, of course, a lower level of expenditures can be sufficient to provide a high
level of employment if only the level of prices is sufficiently lower. Also, it is evident that there
is no merit in having a high level of prices as such. But under conditions of threatening or
actual unemployment, a sharp decline in che general level of prices (as distinct from adjustments in selected price and cost factors) is more likely to be harmful than corrective. I t may
involve structural changes which may improve the profitability of specific lines of production,
but more important, it implies a general and easily cumulative shrinkage in expenditures and
markets. To absorb (or prevent) substantial unemployment, increasing (or maintaining) the
general level of money demand is far more effective than a decline in the general level of prices.



ployment level of postwar income will undoubtedly be much above past
peacetime levels. That is to say, unprecedentedly high levels of saving
outlets will be required to provide full employment. There is little doubt
that some sources of demand for savings, such as railroad or public
utility construction, which have been of great importance in the past
will figure less heavily in the postwar period. The potential demand for
capital which may spring from new products, from technical innovations
which increase the rate of obsolescence, or from the development of backward countries and higher living standards can hardly be estimated in
advance. It may prove sufficient to absorb the potential supply of savings,
but certainly this cannot be assumed in making postwar policy. To assure
a high level of resource utilization and with it the benefits of rising living
standards, we must be prepared for the possibility that at high levels of
income private demand for savings will fall short of the supply. If so, the
level of total expenditures required for full employment cannot be
achieved unless public policy undertakes to restore the necessary balance.
Role of Fiscal Policy. The vital importance of fiscal policy for avoiding
deflation or inflation will now be apparent. Depending on what revenue
and expenditure measures are adopted, fiscal policy may be used to curtail or increase the total demand for goods and services, whichever is
needed. This may be done directly by changing the level of public expenditures, or indirectly by affecting the level of private spending. A
shift from taxation to borrowing, for instance, will tend to increase
private spending and vice versa. Postwar fiscal policies therefore will
have to differ vastly depending on whether economic pressures are inflationary or deflationary.
The prospects for postwar levels of national income are examined in
detail in another paper in this series and a brief statement of position
must suffice here. 2 The target for the economy's peacetime output has
been raised greatly as the result of the wartime experience. During the
more immediate post-transition period an output of 170 to 180 billion
dollars might be needed for full employment and 200 billion or so would
be a likely figure for 1950, both amounts being measured in 1944 prices
and based on a 40-hour work week. For the immediate transition and
early post-transition years there is a good chance that the target will be
reached, although the cutback in Government expenditures will be an
For a discussion of postwar income estimates, see Output and Demand after the War,
by Everett E. Hagen. in Jobs, Production, and Living Standards, the first pamphlet in this



unprecedented deflationary factor. Notwithstanding this, backlog demands for consumer durables, residential construction, and business
plant and equipment, together with large exports, may well keep the
economy going at a high level, while at the same time a balanced Federal
budget is approached. As long as general inflationary pressures continue,
high levels of taxation, retrenchment in public expenditures and, if possible, debt redemption will be required. But whatever the situation for
the more immediate transition years during which abnormality of conditions defies prediction, it is unlikely that general inflationary pressures
will be the rule thereafter.
A full employment product of about 200 billion dollars at 1944 prices
is over 50 per cent above the country's 1940 output, after adjusting for
differences in prices. Hence, to achieve the 200 billion dollar product,
consumers, businesses, and Government on the average must purchase
one and one-half times as much in goods and services as in 1940. If they
do not, that is, if the general level of expenditures is deficient, It will be
impossible to sustain a full employment income. Reduced production
and unemployment will follow. Assuming (1) private consumption expenditures at levels indicated by past relationships between consumption and disposable consumer income and (2) balanced Federal, State
and local budget totals of about 35 billion dollars, the volume of private
investment required to sustain a full employment income in 1950 may
be estimated at well above 30 billion. This is a large amount indeed,
particularly after backlog demands for construction and replacement
have run their course. Nor will it be sufficient that this level of investment should be maintained thereafter. While the economy's capacity to
produce increases, an ever expanding volume of private investment will
be required to assure full employment, unless increasing outlets for savings are provided by Government or the rate of savings is reduced. Any
initial deficiency in the required volume of investment, moreover, is
bound to result in a cumulative deficiency in the level of income several
times as large, since a drop in the earnings of the construction or machinetool worker will in turn mean less income for the merchant with whom
he deals, and so forth. Thus, if investment expenditures should fall short
of the required amount by, say 10 billion dollars, the level of income
might well fall short of capacity by 30 billion or more, and substantial
unemployment would result.
If this appraisal should prove correct, we may expect the application
of fiscal policy in the post-transition period to be concerned msiinly with



fighting deflation and unemployment rather than inflation. For this
reason and because the economics of depression finance are more controversial than those of inflation control, the remaining discussion will
deal mostly with the role oj fiscal policy in preventing deflation. If inflationary
pressures should continue after the transition, a parallel argument may
readily be developed for inflation control. Since the Federal budget in
the postwar economy promises to be substantially above State and local
budgets and since Federal finances may be adapted more readily to the
purposes of fiscal policy, this discussion is primarily in terms of Federal
We now turn to consider the policies by which public finances may
serve to raise the over-all level of expenditures and employment in the
economy. Let us assume a situation of substantial unemployment and
examine what budget adjustments may be undertaken which will raise
the level of total expenditures—public or private, for consumption or investment—until the level of demand is sufficient to provide for an adequate number of jobs. Specifically, three approaches will be considered:

Adjusting the public expenditure and tax structures, with no change in the
of total public expenditure and total tax yield.
Incurring a deficit, either by raising public expenditures or lowering tax yields.
Increasing the levels of public expenditure and tax yield by equal amounts.

While for purposes of policy the various approaches in no way exclude
each other but should be combined, their respective merits may best be
appraised by considering them as alternatives.
Adjusting Revenue and Expenditure Structures. If adjustments need
be made, it will be well to consider first whether an increased flow of
private expenditures may not be released through improving the prevailing tax and expenditure structures. Unfortunately there are fairly
narrow limits to such adjustments, particularly if the fiscal structure is
already reasonably sound.
The flow of private expenditures will be increased if tax pressures upon
consumption and deterring effects upon investment are reduced. The
pressure on consumption might be reduced substantially if the initial
situation is one where a large portion of the tax yield is drawn from consumption and pay-roll taxes. These are taxes which are borne mostly by
low-income families who consume a high portion of their incomes and

For a discussion of State and localfinances,see pp. 101-30 of this pamphlet.



whose tax payments therefore are largely reflected in reduced expenditures for consumption. To the extent that the tax burden can be shifted
to others, such as high-income families who spend a smaller share of their
income and save more, the pressure of taxes on consumption is lessened.
However, if at the outset a substantial part of the Federal tax yield comes
from progressive personal income taxes while excise and pay-roll taxes
already occupy a minor position, no great reliance can be placed upon
further shifts in the tax structure. Moreover, the very adjustments which
will release consumption by rendering the tax system more progressive
will also tend to deter investment expenditures by making investment
appear less attractive. If the tax bill is sizeable in relation to rational
income, it is hardly avoidable that a substantial part of the yield will
have the effect of depressing private spending.
The situation is similar on the expenditure side of the budget. No
great reliance can be placed on raising the level of spending through
changes in the composition of a given total of public expenditures unless
the budget is very large. Different expenditure items, to be sure, will
differ substantially in their effects upon private consumption and investment outlays. But within the framework of an established budget pattern,
there is relatively little leeway for reshuffling expenditure items from this
point of view. After contractual obligations and indispensable expenditures for basic governmental functions are excluded, only a relatively
narrow range remains in which adjustments can be made. Moreover, the
intrinsic merit of expenditure items is the first criterion of choice, not
their effect on employment.
This of course is not to conclude that improvements in the revenue
and expenditure structure are unimportant to our problem or that much
harm may not be done by a defective policy. However, once a reasonably well-adjusted system of Federal revenues and expenditures has
been worked out, further reliance upon raising the total expenditure flow
through mere re-allocation of public revenue and expenditure items cannot
be extensive.
Deficit: Higher Expenditures vs. Lower Taxes. If the budget adjustment is to provide for a substantial increase in total expenditures in the
economy, an increase in the public expenditure level and/or a reduction
in tax yield will be required. A deficit will have to be incurred in either
case, that is, part of the budget will have to be financed by borrowing
rather than taxation. But this may be accomplished in different ways.
Public expenditures may be increased; tax yields (and rates) may be



reduced, or both may be done at the same time. 4 The relative effectiveness of the two approaches may be examined by comparing the increase
in the demand for goods and services, and hence in employment, which
results if the same amount of deficit is incurred by raising public expenditures or by lowering tax yields. To simplify matters, we shall assume
that the loan funds by which the deficit is met are obtained from bank
credit or in some other way which will not reduce expenditures on the
part of bondholders.
The total increase in demand for goods and services brought about by
a budget adjustment may be divided into the initial increase in demand
and subsequent increases. If the Government undertakes additional construction expenditures, there is an initial increase in demand for construction. If higher pensions are paid or taxes are lowered, income available to pensioners or taxpayers is raised and some initial increase in their
consumption expenditures will result. In either case, this initial increase
in expenditures on goods and services will be followed by subsequent
respending. The construction worker who sold additional services to the
Government; the grocer who sold additional food to the pensioner; the
tailor who sold an extra suit to the taxpayer—all will respend part of
their additional income and so will those whose incomes are increased in
turn, etc. As far as consumption expenditures are concerned, total respending will be the greater, the lower the rate of savings of the income
recipients. Because of this chain of respending, the total increase in demand brought about by a budget adjustment will tend to be a multiple
of the initial increase; an initial addition to demand of 1 billion dollars,
for instance, may raise total expenditures on goods and services by 2 or
3 billion. In the absence of special considerations the multiplying effects
are likely to be about the same, whether the initial increase in demand
is for the services of the construction worker or for additional groceries.
Therefore, to facilitate the comparison between various budget adjustments, we may assume these subsequent effects to be the same for any
given initial increase in demand, wherever it occurs. The effectiveness of
If public expenditures are increased while taxes are kept the same, this may imply either
that tax yields or tax rates are held constant. When as the result of increased public expenditures the level of total expenditures and income in the economy is raised, given tax rates will
yield larger amounts. Hence, if tax yields are to remain constant while public expenditures
are raised, tax rates must actually be reduced. The discussion above compares variations in
either public expenditure or yield levels and thus implies such rate adjustments. This simplifies our analysis, even though it might be more realistic for the case of the expenditure increase to assume that rates remain constant and to allow for the offsetting factor of an automatic yield increase on the resulting addition to private spending.



various adjustments may then be rated in terms of the resulting initial
increase in demand. 5
As it is helpful to consider the problem by stages, we shall first assume
that private investment will be unaffected and allow for investment
effects later on.
As far as employment is concerned, it will make no difference whether
the additional demand and expenditure for goods and services takes the
form of public or private purchases if the magnitudes are the same. However, the amounts of the initial increase may differ in accordance with
the approach taken. To anticipate the conclusion, there is a presumption
that the initial increase in demand will be greater if public expenditures
are raised than if tax yields are cut by a similar amount.
This is fairly evident in those cases where the increase in total expenditures results from a Government deficit incurred to provide items
such as education or highway construction. The full amount of the public
expenditure or deficit then constitutes a direct addition to the demand
for goods and services. If, by comparison, the deficit results from cutting
tax yields by a similar amount, the initial increase in the demand for
goods and services which results may well fall short of the loss in yield
or deficit. If tax payments are reduced, private income available for
spending is increased, but private expenditures may rise by only a fraction of the tax reduction. The fraction of tax savings spent by private individuals will tend to be the greater, the lower the taxpayer's income
bracket since, on the whole, low-income families tend to consume a
larger portion of their income than do those in the upper income brackets.
At the most, the resulting increase in consumption may equal the tax
reduction and thus match the alternative increase which might have been
obtained by Government expenditures. More likely, however, consumption will increase by only a fraction of the tax reduction.
The matter is less evident where the increase in public expenditures
does not initially provide for an addition to public demand but, as in the
case of relief or pension payments, merely adds to the purchasing power
of private income recipients. There is no difference in principle between
In technical terms, our approach is to compare the multiplicants which result if public
expenditures are increased or tax yields are lowered while the multiplier is assumed the same
for both cases. The multiplicant (that is, the "initial" increase in demand) is defined to include the total increase in real public expenditures and such fraction of transfer expenditures
or reduction in tax yield as are reflected in increased private consumption outlays, For a more
detailed discussion of the problem, see the author's note on "Alternative Budgets for Full
Employment" in the American Economic Review for June 1945, p. 387.



incurring a deficit for raising public expenditures of this kind or for reducing tax yield. In either case, the outcome depends upon the extent to
which the resulting increase in available private income is reflected in
increased private spending. The results will depend for any specific case
upon who receives the public payments and who finds his tax reduced.
If the additional expenditures are for relief or social security and thus
go to low-income families, the initial increase in private consumption
will undoubtedly be greater than if the outlays are for redemption of
public debt held by banks or high-income families. Similarly, if the tax
reductions come in the excise, pay roll, or first bracket income tax field,
consumption will increase more than if estate tax or top income tax rates
are cut. As a general rule, however, additional public expenditures may
be directed to those who are most in need of funds and whose rate of
respending will be relatively high, while tax reductions necessarily accrue
to those who have sufficient income to pay taxes and whose average rate
of respending will therefore tend to be lower. I t again appears that the
initial increase in consumption outlays will tend to be greater if public
expenditures are increased than if taxes are reduced. This is especially
true if the tax reduction is spread over the entire range of taxpayers, as
may well be the case if the change is large.
To sum up: Comparing (1) a given cut in tax yield with a similar increase in the public demand for goods and services, it is evident that the
initial increase in private consumption demand out of tax savings may
at best measure up to the increase in public demand for goods and services.
More likely, however, it will fall substantially short of the full amount.
Comparing (2) a given cut in tax yield with a similar increase in public
expenditures which involve no addition to public demand, there is again
a presumption in favor of the expenditure increase, since the additional
amount paid out by Government will tend to accrue to people who are
apt to respend a larger fraction on consumption than are those who
benefit from tax reduction.
These conclusions may be modified, however, by resulting changes in
private investment, which have been disregarded so far. Increased public
expenditures, such as developmental programs, may have direct investment-inducing effects. They do not interfere with private markets, but
may expand and develop them. Tax reduction will have an advantage if
investors are hostile to an expansion of Government expenditures as such
or if public investment threatens to replace private ventures. Also, an
increase in investment yields due to reductions in tax rates may provide



for a higher volume of investment, particularly if the initial rate level is
high and the definition of taxable income unsatisfactory. However, it
must be noted that tax reductions cannot readily be designed to favor
an increase in both consumption and investment. Just as taxes which fall
most heavily on consumption will tend to depress investment yields least,
so tax relief which is most helpful to consumption is of least direct benefit
to investment.
Combining these considerations, it is unlikely, within the limits of
reasonably moderate budget adjustments, that the previously noted advantages of a public expenditure increase will be canceled or reversed by
the possibly superior investment effects of tax reduction. On balance we
may expect that a given increase in public expenditures will usually
cause a greater increase in demand than will a similar reduction in tax
yield. Hence, the dollar reduction of tax yield required to raise total expenditures in the economy by a given amount will tend to be greater
than the required dollar increase in public expenditures; similarly, the
resulting deficit will tend to be greater under the first approach. If the
budget is to provide for a given increase in total {public plus private) expenditures^ there is a choice between a somewhat smaller addition to the
public debt together with a higher level of public expenditures and a somewhat larger addition to the public debt together with a lower level of public
Balanced Budget: Higher Expenditures and Higher Tax Yield. As a
final approach one might consider raising both public expenditures and
taxes by equal amounts. While intriguing at first sight, this approach
has little promise. When public expenditures are increased and tax yields
are raised by the same amount, income available for private spending is
initially unchanged: What is added to disposable income on the expenditure side is taken away on the tax side. This does not exclude the possibility that, as a result of income redistribution, private consumption expenditures may be increased. But at best this increase will fall much
short of the gain in private consumption outlays which might have resulted had the same increase in public expenditures been introduced
without raising taxes. 6 Multiplying effects will thus be absent or much
smaller. Hence, to obtain the same increase in total expenditures, a much
In discussing the effects of a deficit, we assumed that public borrowing does not affect
the volume of spending on the bondholders' part. In a generally deflationary setting and
given appropriate borrowing policies, this is a fair assumption, even though at other times,
as during the war, debt policy may be used to reduce consumer spending.



larger addition to public outlays is required if tax yields are increased
as well.
Apart from consumption effects, the level of total demand will again
be raised by direct additions to public demand, provided for in the expenditure increase, and again changes in private investment may result 7
If the initial deficiency in total spending is large so that a sharp increase
in public expenditures and taxes is required, private investment in ay
well react unfavorably. Beyond a certain point of budget expansion, ii i>
likely to fall rather than rise, which will further reduce the total leverage
effect. I t is quite possible, in fact, that the required increase in public
expenditures and tax yield would have to match the full deficiency in the
level of total expenditures, or might even exceed it. Without increased
tax yield, on the other hand, an increase in public expenditures by a fraction of the deficiency only might suffice. Given a substantial deficiency,
the balanced expenditure and tax yield increase, if feasible at all, may
well require a budget so large as to be of little practical interest. 8
If private expenditures on both consumption and investment are unaffected while paMic
expenditures on goods and services increase, an increase in the quantity of money or income
velocity is indicated.
Numerical illustration of the preceding discussion is given in the following table:

Budget and product components

Expenditures on goods and
Expenditures on transfer








The Federal Budget (in billions of dollars)



After alternative budget adjustment?



The Gross National Product (in billions of dollars)

States and localities
Federal Government
Private investment
Private consumption
Total, gross national











The magnitudes in column (A) show the initial budget situation (Part I) and the initial gross national product
(Part I I ) . I t is assumed t h a t the initial gross national product of 160 billion dollars is to be raised to 185 billion
Columns (1) to (4) of P a r t I show adjusted budgets which will bring about this 25 billion dollar increase in the
total level of expenditures, the resulting gross national product patterns being shown in columns (1) to (4) of P a r t I I .
{Continued at bottom of p. 14.)



The question remains to what extent a relatively high level of expenditures and taxes resulting in a more moderate deficit should be preferred
to a lower level of expenditures and taxes resulting in a somewhat larger
deficit. The answer in part depends upon the implications of a rising
public debt. These are discussed in later papers and may be omitted here.
Next and more basically, the answer depends upon how much of its resources the community wishes to devote to public purposes and what
transfers of disposable income it wishes to undertake through expenditures of the social security or pension type.
Basis for Planning Public Expenditures. There is nothing in the nature
of fiscal policy and compensatory adjustments which requires public expenditures that are not warranted on their own merits. If budget adjustments are needed to raise the level of total expenditures, public expenditures may be increased if additional public services are desired; this may
take the form of public investment outlays such as public construction
or, depending on social needs, the additional expenditures may well be
for school luncheons or education. 9 If the existing level of public expenditures is considered adequate, taxes can be reduced, even though private
expenditures might not rise commensurately. Public expenditure planning
with regard to both the level and composition of expenditures should be
guided as much as possible by considerations of efficient resource allocation. Employment effects of various expenditure items are important but,
apart from questions of timing which are discussed later, they should not
be the basic criterion of choice. There are large areas of public services
such as resource development, public health, education, and housing
which have been badly neglected and rate a high priority in the nation's

Continued jrom p. 13:
The gross national product changes in Part II are derived from the budget changes in Part I on the basis of these
assumptions: (a) The initial increase in private consumption expenditures equals 90 per cent of an addition to public
transfer expenditures, 75 per cent of an addition to public expenditures on goods and services, and 70 per cent of
an addition to private investment expenditures, (b) the initial decrease (increase) in private consumption expenditures equals two-thirds of an addition (reduction) in tax yield; (c) the total increase in private consumption
expenditures equals three times the initial increase, the multiplier of 3 being based on income after tax but not
exclusively determined by the individuals' propensity to consume out of disposable income since allowance must also
be made for such leakages as corporate savings; and (d) private investment is assumed to increase moderately under
adjustment (2) and (3), somewhat more under adjustment (1), and is held constant under adjustment (4).
These assumptions involve judgment rather than precise information and the reader will wish to substitute his
own coefficients, which may yield different results. This will apply particularly with respect to the investment
assumption in column (4), which may well be over-optimistic.
Private offsets to saving (i. e., to income not spent on consumption) must by definition
be in the form of investment expenditures. Public offsets may be public expenditures of any
kind, whether for current consumption or for investment projects.



needs. They will stand on their own merits; other projects of a makework kind do not. The argument here is not for or against any particular expenditure level, but merely relates to the considerations upon
which expenditure planning should be based.
The implications for purposes of short and long-run budget planning
may be considered briefly. Ideally, budget adjustments should be made
continuously, to meet current changes in economic conditions. Yet, longrun budget planning is necessary because many phases of budget policy
are rigid and cannot be adjusted currently, some not within a year and
others not even over a period of several years.
Long-Run Budget Planning. As a matter of long-run budget planning,
the problem is one of devising a budget which for the period ahead (be
it a year or five years) will fit "most requirements most of the time,"
that is, which will meet the needs of the "average" situation. For efficient
budget planning this means that the first step should be to plan public
expenditures on the basis of need, and of economy and efficiency in the
public use of resources. After the expenditure side of the budget has been
thus planned for the period ahead, the question of the level of tax yield
must be examined. If short-run adjustments in tax yield were readily
feasible, there would be no problem of longer run tax planning, but this
is not the case. As shown in the following paper, a good tax structure will
differ considerably for different yield levels. Because of this and the difficulties of adjustment, it is important that the tax structure be fitted to
the yield requirements of the "average" situation. For any given level of
public expenditure, yield requirements should be relatively high if there
is reason to expect that the "average" situation will be on the inflationary side; they should be relatively low if there is reason to think that the
"average" situation will tend to be deflationary. More precisely, the basic
tax structure should be set so as to provide a yield at the full employment level of income which (in view of the given public expenditure
level) will leave such budget surplus or deficit as is required in the
"average" situation to maintain stability and full employment. If this
is accomplished, the need for short-run adjustments will be minimized and
unnecessary and wasteful distortions in the basic expenditure program
will be avoided.
Conceivably the desired level of public expenditures and the economic
conditions for the "average" situation may be such that tax rates should
be set to balance the budget at full employment. But this would be one
possibility only. If, as is quite possible, the "average" situation and the



desired level of expenditures are such that a deficit will be needed, the
basic tax structure at the outset should be set sufficiently low to provide
for a deficit at full employment. The formula that the budget should be
balanced at full employment would under such conditions provide neither
full employment nor a balanced budget, but an arbitrary and inadequate
level of deficit. The opposite of course will be the case if the outlook for
the " aver age'' situation is on the inflationary side.
In the preceding discussion of budget adjustments, no reference was
made to the "pump-priming" thesis which proposes that a temporary
budget adjustment will bring about a more permanent increase in the
level of private investment. This result might come about if conditions
already point toward an upswing in the business cycle, but it is unlikely
otherwise. A high level of over-all expenditures having been attained as
the result of fiscal measures, these measures need be continued if the recurrence of a slump in income is to be avoided unless, in the meantime,
a sustained and independent increase in private investment or private
expenditures for consumption has occurred. Without such change, a
decline in public expenditures would be followed promptly by a drop in
private consumption and investment outlays. Thus the long-run effectiveness of fiscal policy must not be measured in terms of successful
pump-priming, but in terms of the higher level of income which can be
sustained as long as a vigorous fiscal policy is continued. If conditions
are such that for some period the "average" situation continues to be
deflationary, a net deficit will be required for that period.
Short-Run Adjustments. Apart from adjusting the basic revenue and
expenditure programs to the need of the "average" situation, a maximum
of flexibilit}^ is needed to permit current adjustments to short-run fluctuations which are likely to deviate substantially from the "average." The
flexibility requirement applies to both sides of the budget.
Tax adjustments in recent years have required from six to twelve
months of preparation and enactment. For purposes of controlling shortrun fluctuations, this is an impossibly long delay. However, the usefulness
of tax adjustments as an instrument of flexible fiscal policy might be increased greatly by providing some mechanism for prompt adjustment in
rates, low bracket income tax rates in particular. Under the new system
of source collection, rate changes under the personal income tax could
operate very promptly in contracting or expanding disposable income,
whereas valuable time might be lost in mobilizing public expenditure
programs. Depending upon the changes in tax rates, variations in con-



sumer expenditures by perhaps several billion dollars (in annual rates)
might be effected.10
But even if some flexibility of tax rates was introduced, substantial
reliance on expenditure flexibility would still be necessary. Feasible magnitudes of tax adjustments from an "average" postwar level may well be
insufficient to cope with a sharp downswing. Specific expenditure measures, moreover, are more effective in dealing with specific conditions of
distress and unemployment than are tax cuts, which necessarily aim
at increasing the general level of income. A 100 million dollar work project
may very directly and promptly relieve a depression situation in a specific region or occupational group, whereas a similar tax cut accruing
to those who have income rather than to those who have not is bound
to operate more indirectly and more slowly. This is significant in particular in the political context where the permissible size of the deficit
may be subject to narrow limits, so that it is important to use such ammunition as is available in the most effective manner.
There should be no conflict between long-run expenditure planning
based upon the community's need for public services and the timing of
public expenditure projects so as to compensate for cyclical swings in
private spending; the list of desirable expenditure projects contains a
sufficient number of flexible items. But much depends upon advance
planning. To reduce the time lag involved in the introduction of expenditure adjustments and to maximize their usefulness in the framework
of long-run expenditure planning, everything should be done to build up
a reserve of carefully selected projects, both by regions and time requirements, including public works, construction as well as public services.
Also, provision must be made for the administrative machinery needed
to put these projects into operation promptly when conditions require. 11
The legislative framework within which a flexible expenditure and tax
policy may operate is now being considered by Congress in the Full
Employment bill. Implemented effectively, it will equip public policy
with an anti-cyclical weapon much more powerful than anything heretofore available.
We have endeavored to show how full employment requires a high and
stable level of expenditures and how fiscal measures may help to achieve

For further discussion see p. 42.
For a more detailed discussion of public expenditures, see Walter F. Stettner, "Public
Works and Services", Housing, Social Security, and Public Works, a later pamphlet in this



it. Emphasis has been upon the effectiveness of the fiscal approach, but
in conclusion some comments on its limitations are in order. Fiscal policy
like any other single line of approach, obviously provides no panacea.
Fiscal Policy and Other Approaches. Fiscal policy is primarily an aggregative approach, operating upon the general level of expenditures and
prices rather than the direction of expenditures or the structure of prices.
Yet these raise policy problems of great importance which must be dealt
with through more direct approaches. Public policies regarding such
matters as minimum wages, economic mobility or monopolistic practices,
for instance, remain vitally important whether or not fiscal policy provides for full employment.
Nor are budget adjustments the only vehicle through which total expenditures and the level of employment may be affected. Even though
the fiscal approach may be the most direct or powerful, this is no reason
for neglecting others which may be helpful in securing a high and stable
level of private expenditures. On the contrary, the more effective these
other measures, the more manageable will be the task of fiscal policy.
Counter-cyclical budget adjustments will thus be less difficult if other
policies succeed in reducing inventory fluctuations or spreading private
construction demands. Similarly, deficits are less likely to be necessary
if ways are found to raise private expenditures through the development
of new markets, high wage policies, or increased economic security which
may permit a lower level of private saving. But more likely than not the
remaining job for fiscal policy will be substantial.
Fiscal Policy and Private Enterprise. Fiscal policy must be evaluated
not only by its effectiveness in providing full employment, but also by
its ability to do so within the framework of a free market economy. There
are several sides to this picture.
Compensatory fiscal adjustments, it is frequently argued, will lead
directly to increasing encroachment of Government upon business and
the freedom of consumers' choice. Some illustrations will show that the
implementation of fiscal policy is sufficiently flexible to avoid these results.
First, with respect to public versus private employment: If the Government wishes to provide a highway bridge it may do so under its own
management and with its own labor force, or instead it may engage a
private contractor. This choice involves issues of public policy which
are quite distinct from and not dictated by the project's impact upon
the general level of income and employment.
Public expenditure areas which rank highest from the point of view of



social needs, such as resource development, low-cost housing, aid to education, or health improvements are largely areas which are not readily
accessible to private enterprise. Unless there is desire for public ownership,
the necessary area of conflict involved in even a substantially expanded
peacetime budget is small. The advantages which private enterprise might
derive from expenditure programs of various kinds are substantial.
Second, with respect to public versus private spending: If the total
demand for goods and services is to be raised, this may or may not be
done through increasing public demand. This choice depends on the
community's preference between alternative uses of resources; it is not
dictated by the impact upon general economic conditions. If no increase
in public expenditures on goods and services is desired, there are the
alternatives of reducing taxes or increasing such budget expenditures as
social security payments, which do not add to public demand. In either
case, there is no interference whatever with consumers' choice. Which
approach is to be preferred involves a new set of policy issues, including
matters of equity in income distribution, but again, considerations of
general income and employment effects are not controlling.
The way in which budget adjustments are implemented will obviously
have some effect upon their impact on the general level of income and
employment. The decisive point, however, is that the basic fiscal policy
objective, that is, the stabilizing of income and employment at high levels,
may be implemented in one way or the other. The particular approach
chosen therefore can be determined by, but does not determine, other
and broader policy considerations. 12
Fiscal policy, moreover, may directly contribute toward creating the
environment in which private enterprise can operate to the community's
best advantage. If total markets are stabilized at high levels, the risk of
investment is greatly reduced. While stability of total income does not
guarantee profits in individual ventures, it does eliminate the hazard of
loss caused by a general shrinking of markets which has come to be the
This is not to deny that the merits of fiscal policy with regard to maintaining employment cannot be isolated in the political context from their merits or demerits on other grounds.
Arguments for a larger budget based on the desire to provide additional public services, or
arguments for increased tax progression based on the desire to reduce inequality in income
distribution, may well be strengthened if the employment effects of such action are also
favorable. Such fusion of issues, of course, occurs throughout all phases of public policy; it
is not limited to the fiscal approach.
As far as the "politics" of fiscal policy are concerned, their potency may be expected to
decline to the extent that compensatory budget adjustments come to be accepted as a normal
and nonpartisan function of public policy.



major risk factor. With this factor removed, success or failure in business
will depend less upon fortunes in weathering cyclical changes and more
on abilities to meet the customers' approval. Once confidence in a successful public policy is established, moreover, consumers and investors
will learn to adjust their expenditure plans to the prospect of large and
stable markets. From this a higher and more stable flow of private expenditures will result which in turn will reduce the need for fiscal support.
Nevertheless, the question remains whether in some other respects the
fiscal approach is not likely to involve an increasing degree of Government control. A large budget may be thought directly to entail increased
power of Government. A high level of public debt or liquidity incident
to it may be expected indirectly to call for further intervention. These
considerations cannot be dismissed lightly even though they appear
less serious once we recognize that the magnitudes involved must be
considered not in absolute terms, but relative to total income. If by
1950 total money income is well above twice that of the late thirties, it is
evident, for instance, that the dollar amounts of budget expenditures,
interest payments, or money supply may also be substantially above
prewar levels without calling forth additional difficulties.
The implications of public debt and liquidity are considered later in
this pamphlet. 13 The magnitude of postwar problems along these lines
will have been determined, to a large extent, by war financing rather than
by postwar changes. As far as possible postwar additions to the debt or to
liquid assets are concerned, it is unlikely that the ratio of debt, interest
service, or money supply to total income will rise substantially even
though for a decade or two some deficits on the average should continue.
This assumes, however, that a fairly high level of employment will be
maintained, and with it, a rising level of income. Without these the
burden of the war debt may indeed become oppressive. On the whole
there is more reason to be concerned about the effects of debt accumulation upon the adequacy of control in a future boom period when wartime restrictions have been withdrawn, particularly if no mechanism for
prompt fiscal adjustment has been provided.
While these implications may cause concern, they cannot be appraised
without considering the alternatives which may well be less attractive.
Without vigorous public policies and a clear recognition of public responsibility, severe cyclical swings will undoubtedly reoccur in the post13

See the papers by Evsey D. Domar, Roland I. Robinson, and Henry C. Wallich, pp.



war years, and quite possibly there Will again be long periods of heavy
unemployment. If permitted to reoccur, the chances are that these would
lead to violent reactions and most extensive public controls. The true
issue, therefore, is not whether we should choose or reject some Government participation in economic life, but whether we should select and
implement those policies which qualify best to check instability and unemployment while maintaining a free market economy. Fiscal policy
rates high in such a program.

Division of Research and Statistics, Board of Governors
Revenue legislation during the next few years offers a unique opportunity for Federal tax reform. Yield requirements will drop sharply in
the shift from war to peace and sweeping changes in economic conditions
will call for a reorientation of policies. Public interest in tax legislation
will be lively and sympathetic, as the change at last will be for less, not
more, taxes. In this setting one may hope that haphazard rate cuts will
be avoided, and the basic structure of Federal taxation be reconsidered.
This discussion is focused on a few major aspects of Federal tax reform;
many details will be omitted. First, we shall consider the basic economic
issue, namely how to minimize the deflationary effects of taxation upon
private spending. This will be followed by a discussion of flexibility in
tax policy. Next, we shall examine the place of the corporation income
tax and its coordination with the personal income tax. In a final section
the outlines of a revenue program will be presented. Questions of equity
in taxation, while most important factors in tax policy, have been discussed widely elsewhere and are here dealt with by inference only.

In the preceding essay we have seen how public expenditure and
revenue policies combine in shaping the Federal budget's contribution
to income and employment. Now, the level of public expenditures is
taken as given and the tax aspects of budget policy are singled out for
closer consideration.
Revenue Structure and Size of Deficit. Federal expenditures for the
average postwar year are estimated to be in the neighborhood of 28
billion dollars; that is, total receipts of 28 billion will have to be ob-




tained. 1 Tax policy then raises two major issues: how much of the 28
billion shall be obtained through taxes and what tax sources shall be
relied upon? The questions are closely related.
Tax and loan finance differ because borrowing gives rise to public
debt, whereas taxation does not. They also differ in their current impact
upon the level of private demand. With the help of monetary policies,
loan finance may be arranged to have little or no deterring effects
upon the creditor's outlays, but taxes for the major part do result in
reduced private expenditures. The budget's contribution to total demand,
therefore, will be greater if public expenditures are financed from borrowing than from taxes. Depending upon economic needs, one or the
other combination of tax and loan finance will be called for. If the level
of private expenditures is high and conditions are on the inflationary side,
the entire 28 billion dollars may well be raised from taxes and in boom
periods an even higher level of tax yield with accompanying debt redemption may be called for. If private expenditures are low and the setting
deflationary, it may not be possible to meet all requirements from taxation. Some deficit may be needed to assure an adequate level of total
The choice, however, is not only between taxation and borrowing, but
also among different taxes. While most taxes tend to curtail private
spending, some do so more than others. This is why the revenue structure
and the size of the deficit (or surplus) are closely related. A simple illustration will bring out the point. Suppose that a full employment level of
demand cannot be maintained unless one-half of the 28 billion dollar
budget is financed from funds which do not curtail private spending. If
highly deflationary taxes are used which are matched dollar for dollar by
reduced private outlays, one-half of the funds or 14 billion dollars will
have to be obtained from borrowing. If less deflationary taxes are used,
reducing private demand by two-thirds only, 21 billion dollars can be
While effective fiscal policy requires that expenditure and revenue policies be determined
in conjunction, a concrete discussion of the problem must begin with one or the other item.
As explained on page 15 above, the expenditure side of the budget provides the logical starting point.
The 28 billion dollar budget here assumed does not reflect a proposed expenditure program
but is an appraisal of likely levels. It might include 5 billion dollars of interest on public debt;
1.5 billion for non-military operations of Government; 7 billion for military establishments;
3 billion for veterans and pension payments; 1 billion for publicly financed foreign investment;
2.5 billion for aid to agriculture; 1 billion for aid to education; 2 billion for public works and
developmental projects, and 5 billion for an expanded social security program. Note that
social security expenditures are included in ther budget total. Similarly, taxes raised to finance
the social security program are considered an integral part of the tax structure.



obtained through taxation, and borrowing be limited to 7 billion. In short,
the less deflationary the tax structure, the smaller will be the deficit vjhich is
required to provide an adequate level of total demand. In periods of high
prosperity, similarly, the permissible budget surplus and debt redemption will be the greater, the less deflationary the taxes used.
This relationship holds under conditions of prosperity or depression
but it is significant particularly in a deflationary setting, where the choice
is between better (less deflationary) taxes and a larger deficit. More likely
than not, this will be the situation when pent-up war demands have
tapered off. A tax structure with a minimum of deflationary effects will
then be needed because it will permit the maintenance of full employment with a minimum increase in the public debt. Even though the
dangers of an increasing public debt are usually exaggerated, its economic
implications are not a matter of indifference and public attitudes are such
that fiscal policies for full employment will be more acceptable if the required debt increase is minimized. 2 Our discussion thus rests on the assumption that it will be desirable on the whole to minimize the public
debt to the extent that this is possible within the frame-work of a full
employment policy. If alternatively it was assumed that the level of
public debt was a matter of no relevance, most of the problems here
considered would disappear. Tax policy then could be determined purely
on grounds of social policy, equity, and effects upon the allocation of
resources, e. g., the control of monopoly. As far as the total levels of expenditures and employment in the economy are concerned, tax policy
would enter the picture only with respect to determining the correct
level of total yield. However, so sweeping a disregard of the debt problem
is not justified.
The basic economic requirement for the postwar tax structure LS therefore evident: Taxes should be relied upon which depress private expenditures least. In the following pages we shall see how this principle applies
to consumption and investment outlays. A second principle, that the
revenue structure should be sufficiently flexible to meet changing conditions, will be considered later.
Level of Yield. Before proceeding with this discussion, a word need be
said about the yield objective which we have in mind. Issues which might
be simple if the revenue goal were set at 10 billion dollars, might become
most complex with a goal of 20 or 30 billion. Similarly, issues which
might be simple if 20 billion dollars were to be obtained with a gross

For a discussion of debt problems, see pp. 53-100 of this pamphlet.



national product of 180 billion, might be most complex if the same amount
had to be drawn from a product of 140 billion.
The higher the yield objective, relative to the level of national income,
the more difficult does it become to rely on good revenue sources only.
The deflationary pressure of the average tax dollar, as we shall see, is
likely to be the greater the higher the revenue goal. This leads us into a
dilemma. We wish to set a high revenue objective so that the deficit will
be small, yet, to have full employment, a high revenue goal will be permissible only if the deflationary pressure of the average tax dollar remains low. As this condition becomes increasingly difficult to attain the
more we collect, the possibilities of reducing the deficit by improving the
revenue structure are limited. The solution, in principle, is to devise the
best possible revenue structure for a range of yields and then to choose
that yield which will leave the economy with an adequate level of total
Setting the yield objective thus requires a general appraisal of the
economic outlook as well as an estimation of the kind of revenue structure
which will be possible. Because the difficulties of tax policy are more
apparent if a high revenue goal is chosen, it may be well for our purposes
to assume a yield objective of 25 billion dollars, to be obtained at a level
of output close to full employment as measured |by a gross national product of 185 billion dollars, or a national income of about 155 billion.3 With
an average expenditure budget of 28 billion dollars, a deficit of 3 billion
would thus result at such a level of output. Whether this will be sufficient
or excessive remains to be seen; quite possibly the combination will prove
on the optimistic side.

Taxes in the last resort may be paid out of funds which might otherwise have been used for consumption expenditures or out of individual
or business savings. To the extent that they are paid out of savings, no
direct reduction in consumption expenditures will result. What taxes are
most likely to meet this requirement?
Taxes from Personal Income. The most effective way of checking tax
pressures on consumption would be through a tax on income saved, that
is, not spent on consumption, with income spent on consumption being
left tax free. This approach will be considered later.

The levels here assumed approximately correspond to column (3) of the table shown in
ootnote 8 on p. 13 above.



As far as the more traditional tax devices are concerned, such as personal income, estate, pay-roll or excise taxes, the general rule applies
that tax pressures on consumption will be the less, the more largely the
taxes are paid by the higher income groups, that is, the more progressive
the burden distribution. Taxpayers with larger incomes tend to save proportionately more than do those in the lower income brackets. If taxes
are drawn from higher incomes, a larger fraction of the tax dollar will
thus tend to be reflected in reduced savings, and consumption will be
affected less. I t follows that estate or progressive income taxes which
are paid more largely by the higher income groups are superior in this
respect to a severe personal income tax rate on incomes in the bottom
bracket, a pay-roll tax on low wage incomes, or to excises on mass consumption goods.
The general tendency for progressive taxes to fall less heavily on consumption is clear cut; but the amount by which taxes may actually be
prevented from curtailing consumption is easily over-estimated. Suppose
that pay-roll taxes or excises on mass consumption goods, which bear
most heavily upon consumption, are repealed, and that the personal income tax is relied upon. Even then our problem is far from simple. The
bulk of individual incomes, normally 80 per cent or more, flows into consumption expenditures. If 140 billion dollars of money income is received
by individuals, for instance, consumer expenditures in the absence of
taxes might amount to 120 billion, leaving savings of 20 billion. These
20 billion dollars could furnish a substantial source of tax yield if tapped
directly, but conventional tax techniques do not permit this. If the required yield is small, say 5 billion dollars, it might be possible nevertheless to draw mostly on the savings sector, by taxing the high-income
groups. Since these groups save a large part of their incomes, taxes they
pay will come predominantly from savings. If the required yield is large,
however, say, 20 or 25 billion dollars, it will be necessary to extend taxation into the middle and middle to lower income groups, where consumption expenditures absorb a larger share of income.
This is necessary because the largest part of total income goes to
families in the lower and middle income groups, which include the bulk
of the total population, even though a very small fraction of income recipients who constitute the top group receive a disproportionately large
fraction of total income. Considering a possible postwar income distribution, we may find, for instance, that nine-tenths of all families fall into
the income group below $5,000 and that this group receives about two-



thirds of total income. Also, we may find that one half or more of all
families fall below the $3,000 level, with about three-tenths of total income going to this group. While these income shares may be small relative to the number of families they support, they are large relative to
total income. Given such an income distribution, we find that out of a
possible total of 50 billion dollars of net income subject to surtax, not
more than 10 billion dollars would fall in surtax brackets above $5,000.
The bulk of income taxable under the personal income tax falls into the
lower brackets.4 While the problem of progression is thought of mostly
with reference to the taxation of "high" as against "low" incomes, the
amounts of taxable income and of yield involved are more important
with respect to the distribution of tax burdens between, say, those below
$3,000 and those in the $3,000 to $5,000 range.
But even where there is a choice between the taxation of high and low
incomes, there is a second reason why progression is less effective in reducing the consumption impact of taxes than is frequently thought. The
difference in the average fraction of total income saved by high and low
income families is substantial indeed, but it is not the factor upon which
the differential consumption impact of more or less progressive taxes
depends. What counts, rather, is the difference in the marginal rates of
saving, applicable to the two groups. A person with an income of $100,000
may save $50,000 or 50 per cent of his total income. Yet, if he pays an
additional $100 in taxes, his savings may decline by $70, or 70 per cent
of the tax payment. Similarly, a person in the $3,000 group may save
10 per cent of his total income, but if an additional tax of $100 is paid,
his savings may fall off by $40, or by 40 per cent of the tax. What counts
in determining the impact of a tax upon savings or consumption are the
marginal rates of saving of 70 and 40 per cent, not the average rates of
50 and 10 per cent. From available information it appears that the differences between the marginal savings rates of high and low income
groups tend to be less than those between their average rates. Hence,
the difference in the savings impact of more or less progressive taxes is
less than may be surmised from a comparison of average savings rates.
* Reference is made to a level of income payments of about 150 billion dollars. If the income level were higher, the bracket limits would be raised accordingly, but the general distribution picture would not be greatly changed.
With income payments of 150 billion dollars and current surtax exemptions, the total tax
basis (i.e. surtax net income after exemptions and deductions) might equal about 50 billion;
of this, about 10 billion might be subject to surtax rates applicable to brackets in excess of



If the tax yield required is large relative to total income, it is more or
less inevitable, for these reasons, that a substantial fraction and, in fact,
the larger part of the tax burden will be reflected in reduced consumption
outlays. With a 25 billion dollar yield, it is difficult to see—even with
extensive reliance upon the personal income tax—how the fraction of
total yield falling upon consumption could be reduced much below twothirds. Data upon which such estimates can be based are rather inadequate, yet quantitative analysis suggests that no major reduction in tax
pressures on consumption can be achieved by pushing the degree of progression within feasible limits, once excise, pay roll, or other high consumption ta.xes have been eliminated and a reasonable degree of progression in income taxation has been obtained. This, of course, does not
render it unimportant to utilize progression for curtailing tax pressures
on consumption; nor does it weaken the proposition that progression is
desirable on equity grounds. I t appears, however, that increased progression cannot be expected materially to alleviate the deflationary
effects of taxation should a substantially increased level of consumer
expenditures be required.
Taxes from Business Income. The problems posed by the corporation
income tax differ, depending upon its incidence. To the extent that the
tax is shifted into higher prices or lower wages, it is equivalent to an excise or pay-roll tax. Its consumption impact, like that of excise or pay-roll
taxes, will be most severe. To the extent that the tax is reflected in lowered dividends, the problems are similar to those of the personal income
tax. Much will depend upon the way in which the dividend loss is distributed among different income groups, a matter which is discussed in
more detail on page 46 below. To the extent that the tax is paid from
corporation savings, the situation is quite different. No immediate or
direct pressure on consumption will result and our preceding conclusions
will have to be revised accordingly.
Again, it is important to obtain some idea of the magnitudes involved.
No satisfactory study of corporation tax shifting has as yet been made,
but let us assume as a working rule that one-third of the corporation
income tax will ordinarily fall on corporation savings, the ratio being
higher in boom periods and lower in times of depression. Assuming corporation profits before tax of, say, 18 billion dollars and a 30 per cent
tax rate, we would have a yield of 5.5 billion. Of the total, close to 3
billion might come out of savings, personal and corporate, whereas this
portion might have been less than 2 billion had the same yield been ob-



tained from personal income taxes. 5 If the corporation tax was imposed
upon retained earnings only, its advantage would be increased further,
unless as a result investment would be reduced. While the billion dollar
difference between personal and corporation income taxes shown in our
illustration is significant, it is not large relative to a revenue total of 20
or 25 billion dollars. The consumption impact of the revenue structure
as a whole will not be reduced greatly by general corporation taxes unless rates are very high. In this case, possible adverse effects upon investment must also be considered.

Next to minimizing tax pressures on consumption, tax deterrents to
investment must be avoided. Nothing is gained, in terms of total demand,
if tax pressures on consumption are lifted by $100, while investment expenditures are depressed by a similar amount. There are two main aspects
to this problem. Taxation may curtail investment by reducing savings
and hence the supply of available funds, or it may reduce the attractiveness of investment and hence the extent to which available funds are
channeled into investment outlets. In either case a serious dilemma
arises. Among the conventional forms of taxation, those which depress
consumption least are also those which are likely to deter investment
Supply of Savings. Barring drastic changes in the community's saving
habits or in methods of taxation, it is unlikely that for some time there
will be a general shortage of savings, relative to the demand for investment funds. Should a general shortage of savings arise, moreover, the
problem would be how to check inflation, not how to prevent deflation.
The answer might then lie in additional taxes on investment or consumption, depending upon the community's choice. The problem would be
relatively simple in either case, as the deflation dilemma of having to
minimize the tax burden on both consumption and investment would
not exist.
The illustration is based on these assumptions: Suppose that one-third of the corporation
tax is shifted to consumers or wage earners, one-third drawn from reduced dividends, and
one-third from reduced savings. The total tax impact upon savings might then equal 1.8
billion dollars (the fraction falling upon corporation savings) plus 0.6 billion (reduced individual savings due to reduced dividends) plus 0.3 billion (reduced individual savings due to
higher prices or lower wages), or a total of 2.7 billion. (These figures are based on the assumption that the cut in dividends, being borne more largely by the higher income groups, will also
be reflected more largely in reduced savings than the cut in wages.) Had the 5.4 billion dollars
been raised by a general increase in the personal income tax, the savings fraction might have
been nearer to one-third or 1.8 billion.



The situation is different, however, if effects upon specific kinds of
savings are considered. While the general situation may remain deflationary and total savings ample, taxes may curtail the availability of
funds to certain enterprises and hence depress investment. This result is
most likely to arise from heavy taxes on small or new firms which have
limited resources and no ready access to the capital market. While the
solution is mainly in providing these firms with the necessary market
facilities, special income tax provisions are required to protect their
interests. Also, there is a possibility that progressive taxation may leave
an adequate savings total, but curtail just those personal savings which
would have been most likely to flow into risk investment. There has been
much discussion of venture capital in this connection, but little is known
about its sources. If surtax schedules are to be planned intelligently,
more information is needed regarding the investment patterns pursued
by various income groups.
While no general case against progression is established by these considerations, progression must be applied in a way which will allow for
the qualitative aspects of capital supply.
Investment Incentives and High Bracket Rates. More important than
effects upon the supply of savings are tax deterrents to the investment of
available funds, which may be considerably in excess of current savings.
If expected investment yields are cut through severe tax rates, investment tends to be discouraged, particularly in risky ventures, while the
holding of cash balances tends to be encouraged. As a result, taxation of
investment income may depress expenditures for plant and equipment
by a multiple of the tax yield.
The level of tax rates on capital income is usually the first concern in
this connection. Actually, the definition of taxable net income may be
the more basic factor. Considering first the level of rates, we are confronted with a conflict between various objectives. Investment considerations make it desirable to avoid very high surtax rates in the upper income ranges while consumption considerations call for moderate rates
in the lower income brackets. Yet, if the necessary yield is to be raised,
some compromise must be reached. While it is not possible to say exactly
how high tax rates may be without investment effects becoming oppressive, some general comments can be made.
The case for steep progression at the very upper end of the income
range—for incomes in excess of $100,000, for instance—is not very impressive from the point of view of tax yield. The number of taxpayers



and the total income affected by steep rates in these brackets are relatively small. Total income subject to surtax rates in excess of the $100,000
bracket is less than 1 billion dollars. The yield gained from applying say,
an 80 per cent rate instead of a 65 per cent rate would thus fall short of
150 million dollars. 6 This slight yield advantage may not be worth the
price of the deterring investment effects which it may entail. But by the
same token, it may also be argued that investment effects are not likely
to be substantial, since the amount of income involved is small. Hence,
equity considerations in favor of steep progression may be decisive. On
balance, however, the case for a maximum rate not in excess of say 65
per cent appears fairly strong, particularly since heavy taxation of the
highest income brackets can be undertaken with less detriment to investment through additional reliance on estate taxation.
The question of progression is more serious within the $25,000 to
$100,000 brackets, as the level of rates over this range will have a substantial effect upon tax yield. Also, these are the income groups which
are likely to supply the bulk of individual investment and to control the
larger part of corporation capital. The issue here is not only what rate
should be reached for incomes close to $100,000 but also how fast progression should increase. The bulk of income, and hence of potential
yield, is again concentrated at the lower end of the range. With a yield
requirement for the personal income tax of approximately 15 billion
dollars, it will be necessary to have a rate schedule which rises fairly
rapidly over the middle income range reaching say a 40 per cent level
for surtax net income in excess of $20,000. If at the same time the top
rate is not to exceed 65 per cent, it follows that progression between the
$20,000 and $100,000 levels could be fairly moderate. What the exact
rate of progression should be must eventually be determined with reference to the investment patterns of taxpayers in the different income
brackets. Assuming that a proper definition of net income is applied, surtax rates ranging from about 40 per cent at an income of $20,000 up to
50 per cent around $50,000 and to 65 per cent for incomes in excess of
$100,000 may prove a reasonable compromise, if supplemented by a
tightening of the estate tax.
Investment Effects of Personal vs. Corporation Taxes. As far as the
Under the present rate schedule the 65 per cent rate applies to surtax net income' in excess
of $32,000. The revenue loss which would result if the present rate schedule were retained
except for limiting surtax rates to 65 per cent would amount to approximately 700 million
dollars out of a total surtax yield of about 15 billion.



total tax burden upon capital income is concerned, the combined tax
rates under the personal and corporation income taxes must be considered.
With a 60 per cent surtax rate and a 15 per cent corporation rate on dividends paid, for instance, the combined rate on dividend income would
be 66 per cent. 7 Whatever the combined rate, there is the question, however, at what combination of the two the pressures upon investment will
be least.
Personal taxes may well be less but will hardly be more detrimental to
investment than corporation taxes. Where investment decisions are made
by the corporation executive, guided by the corporation's interest and
with little or no immediate reference to the stockholder's personal tax
situation, the corporation tax will clearly depress investment more than
the personal tax. Where decisions are made by the individual investor,
the investment deterrent will tend to be the same whether the tax is
collected from the corporation prior to dividend payment or from the
stockholder later on, provided only that the same total burden is borne
by dividend income under the two approaches. As a matter of practical
policy this proviso, of course, need not hold. The individual investor may
well prefer taxation at the corporation level if he expects the corporation
tax to be shifted, undistributed profits to go untaxed, or a highly progressive increase in the personal income tax to threaten as the alternative
to a lower corporation tax. Similarly, the investor might well prefer the
personal income tax if its rates would prove to be less progressive, either
in terms of the surtax schedule or of the capital gains loophole. The answer
thus depends on the specific alternatives which are compared.
Loss Offset. Tax deterrents to investment depend not only on the level
of rates and the degree of progression but, in a more basic sense, on the
way in which taxable net income is defined. Most important in this respect is the provision for offsetting losses against other income earned in
preceding or later periods to determine net income for tax purposes.
Without such offset, risky investments are discriminated against because
they involve the greatest likelihood of losses. If gains are made, taxes
must be paid, but if losses are suffered, no tax advantage results. With
loss offset assured, there would be no such discrimination since tax liabilities on other income would be reduced when losses were incurred.
The Treasury, under these conditions, would share at the same rate in
Out of $100 of corporation profits otherwise available for distribution, $85 would be left
for dividends. After a 60 per cent personal tax, $34 would remain. The total rate would thus
be 66 per cent, not 75 per cent, as would be surmised if both rates were added together.



potential investment losses as well as in potential gains. The tax in effect
would reduce the investor's potential loss as much as gain, thereby leaving intact the return on risk-taking. 8 By assuring that losses can be offset,
we can substantially reduce the discriminating effects of taxation on risktaking and hence tax deterrents to investment.
Full offset of losses is, however, not always possible. With a carryforward period of, say, six years, and a carry-back of perhaps two years,
the possibility of loss offset is likely to be assured as far as established
corporations or wealthy individuals are concerned. The new enterprise
which does not succeed, however, cannot be taken care of by any such
averaging provision. As success or failure is always uncertain at the
outset, this is a serious deterrent to investment. I t could be remedied
only by adopting a policy under which the Treasury would undertake to
make refunds (at a fraction equal to the tax rate) for losses which cannot
be deducted from taxes because of the absence of other income on which
taxes are paid. While this approach is somewhat unorthodox and not
without difficulties, experimentation in this direction might be desirable.
Estate taxation, as any tax on capital, has the peculiar advantage in
this respect that a complete offset of losses is automatically assured. This
arises from the fact that an investment loss is also a capital loss and thus
directly reduces the future estate tax liability. The presence of taxable
income, against which the loss may be offset, is not required. This is an
important reason why estate tax rates are less likely to interfere with investment incentives than equivalent surtax rates under the personal
income tax.
This may be illustrated for the case of a proportional tax of, say, 25 per cent, assuming
a full loss offset to be possible. Consider an investor who, in the coming year, will obtain an
assured income, say, a director's salary of $10,000. Of this, $2,500 will be paid as tax, and
$7,500 will remain after tax. Suppose now that he considers an investment of $2,000, which
in the worst case may result in a loss of that amount. He knows that if a profit is made it will
be taxed at 25 per cent, but he also knows that if a loss is incurred, it may be deducted from
his other income. If a $2,000 loss is suffered, his taxable income will thus be reduced to $8,000
and his tax would be cut to $2,000. Total income remaining after tax (and loss) would then
be $6,000 as against $7,500 had the investment not been made and no loss suffered. The net
loss from the investment, after accounting for the drop in tax liability, would thus be $1,500,
even though the gross loss was $2,000. The remaining $500 or 25 per cent (that is, a fraction
equal to the tax rate) would have been absorbed by the Treasury via a reduced tax liability
on the investor's other income. In considering the advisability of investment, the investor
thus finds both the expected return and risk (or loss) of the investment equally reduced by
the rate of the tax, this result being the same whatever the tax rate which applies. The compensation for risk-taking (that is, the ratio of the expected return to the expected loss) thus
remains unchanged.
For a more detailed discussion, see Evsey D. Domar and Richard A. Musgrave, "Proportional Income Taxation and Risk-Taking," Quarterly Journal of Economics, May 1944,



Averaging of Income over Time. The application of progressive rates
under the personal income tax, and to a much lesser extent under the
corporation income tax, produces a further difficulty. If potential gains
fall into a higher rate bracket than potential losses, risk-taking is discriminated against even though losses can be offset. To avoid this, a redefinition of taxable income would be required which would substitute
an income average for the per annum income definition now in use. This
revision would meet a further important objective. The combination of
annual accounting periods with progressive rates discriminates against
those incomes which accrue unevenly over time. Thus, the total tax paid
on an income of $100,000 received over a period of five years will be
substantially higher—up to twice as much—if the income flow is distributed unevenly than if $20,000 is received each year. Since volatile
income is likely to be income from risky investments, this involves a
further deterrent to risk-taking.
Both on economic and equity grounds, there is a strong case for a
general averaging device. If a longer income period will result in a better
definition of taxable net income, there is no basic reason why the annual
accounting period should be retained in the tax law. While an averaging
procedure may be devised which would avoid the pitfalls of earlier experiments in Wisconsin and abroad, the administrative difficulties of a
general averaging scheme are nevertheless formidable. 9 In particular this
applies to taxpayers in the low-income brackets. A general averaging
scheme to be equitable should apply to all taxpayers. Since there is no
difference in principle between exemptions and progressive bracket rates,
both should be included in the averaging privilege. Taxpayers at the
lower end of the income scale, whose incomes may fall below the exemption limits in some years, should thus be permitted to carry these
unused exemptions against their taxable incomes of other years. While
this would be wholly equitable, it would vastly increase the number of
returns subject to averaging. Should substantial fluctuations in employment occur, extensive refund claims would result during depression
periods. The timing of such refunds would, on the whole, articulate com9
The most feasible averaging provision would permit the taxpayer to recompute his tax
liability on an average income basis at, say, five-year intervals, and to claim refunds for the
difference between aggregate taxes paid on annual incomes and revised liabilities on an
average income basis. This approach would protect the taxpayer against the danger of having
to pay high income taxes in a low income year (as might result if the tax base was defined
annually as an average of the last two or three years' income) and the Treasury against the
danger of having to pay large refunds at an inexpedient time. An averaging procedure along
these lines has been advocated for some time by Professor Henry Simons.



pensatory policies, but there is some doubt whether it would be desirable
to allocate in advance a large part of the depression budget for this purpose. The whole problem is in need of further study.
Capital Gains. Averaging proposals may be based upon equity considerations, in which case they should apply to all volatile incomes. As
far as investment incentives are concerned, however, the problem largely
reduces to the treatment of capital gains and losses, since the bulk of
volatile investment income accrues in the form of capital gains rather
than salaries or dividends. With respect to investment incentives the
problem of averaging is largely one of capital gains treatment.
Under current and prewar practice capital gains are taxed at a preferential rate, and only limited offset of capital losses is permitted. This
position is a compromise between inclusion of all capital gains and losses
with other income and their complete tax exemption. It has several disadvantages. The preferential rate for capital gains seriously interferes
with the progressiveness of the income tax, since capital gains compose
an increasing portion of income, the higher the surtax bracket. Moreover,
income of various kinds may be translated into capital gains to avoid
high surtax rates. Thus a major loophole results from the preferential
treatment of capital gains.
Whatever the tax rates, capital gains income has the advantage of
becoming taxable only when realized. Yet, where bona fide investment
gains are concerned, some further argument might be advanced for providing the incentive of a preferential rate. Profits from new ventures, in
many cases, are derived in the form of capital gains. These particular
gains, therefore, may have a more strategic position in regard to investment incentives than dividends or other forms of capital income. However, this is by no means true for all forms of capital gains. Where the
capital gains are of a purely speculative kind or act as a cloak for other
income, there is no case for preferential treatment. Redefinition of capital
gains to exclude profits from purely financial speculation or similar
sources might be a solution, but is technically most difficult. Neither can
the problem be solved by including all capital gains and losses with other
income, desirable as this may be in principle. Since the accrual of gains
and losses is highly irregular, their taxation on an annual basis and at
full rates would be discriminatory.
The problem might be solved by applying an averaging device to capital
gains income. As capital gains offer a special case, this would not necessitate the immediate application of averaging to all other income. It would



thus be more manageable. The principle of the plan would be to permit
the taxpayer to average his capital gains or losses over a period of years,
the period being equal to the number of years for which the asset was
held prior to realization. 10 Given such an averaging provision, the preferential rate for capital gains could be discontinued and the averaged
gains or losses be included with other income. Determination of the rates
at which capital gains, as other investment income, should be taxed would
become part of the general problem of progression in high-income brackets. To close further loopholes, capital gains should be considered realized
at the time of death and be made taxable under the personal income tax
prior to inclusion in the estate. 11
Small and New Enterprises. Investment effects of taxation need to be
considered in particular in their impact upon small and new firms. Enterprises of this type, which are not firmly established and have limited
capital resources, are most susceptible to tax deterrents. If subjected to
the same rate of tax, they are likely to suffer a greater hardship than
large and established firms. They are less able to offset their losses or to
obtain new capital. Yet they are the very firms which are most vital to a
vigorous enterprise system, to assure competition, develop new products,
and provide for a high level of investment. The tax structure must not
only avoid discrimination against such firms but should discriminate in
their favor.
T a x advantages for small corporations have been provided in the pas
through specific exemptions or progression in the lower rate brackets.
The mechanics of both procedures are fairly simple and might be extended
further, preferably through providing for increased exemptions up to
perhaps $25,000 under the corporation income tax. 12 This might exempt
80 or 90 per cent of all corporations from taxation, while reducing taxable net income by perhaps less than 10 per cent. Also, if a general corporation tax is retained, it may be desirable for tax purposes to treat
small corporations as partnerships.
Preferential tax treatment of new firms is desirable as a matter of
economic policy, but unfortunately it is difficult to design a workable
Gains or losses from assets held for over 5 years might be limited to a 5-year averaging
period; gains or losses from assets held for only one year would be excluded from averaging.
This proposal also has long been advocated by Professor Henry Simons.
One reason for limiting the exemption to some such level is that higher exemptions provide a loophole through which larger corporations could evade taxes by separating formally
for tax return purposes. Also, to the extent that profits are exempted from the corporation
tax, retained earnings will remain free of any tax until dividends are distributed or capital
gains are realized.



definition of a "new" firm. The general economic criteria which should
be followed are fairly clear: The venture should involve the development
of a new product or the entry of a new firm into an established field; the
new firm should have no close financial links to existing enterprises; and
preferably the venture should involve the purchase of new capital assets.
Whatever the general criteria that may be established, a good deal of
discretion is necessary in their application. Possibly the creation of a
special tax court might be considered which would have to rule on the
eligibility of new firms applying for favorable treatment under a newfirm provision, the burden of proof being upon the claimants.
Pending a solution to this problem, new firms will be helped by any
device aiming at a favorable treatment of expanding enterprises, whether
new or old. Within the framework of the regular corporation income tax,
one of the most important items in this connection is the treatment of
research expenditures. They should be defined liberally to include a comprehensive group of outlays undertaken for the development of new
processes or products. The taxpayer should be permitted to treat these
outlays as current expenses to be charged against current income. Also,
adequate provision for the treatment of losses is most important to the
new and expanding firm.
Tax Exempt Securities. Any program aimed at removing tax deterrents
to investment must include repeal of the tax exemption privilege now
granted to interest on State and local securities. This exemption privilege
is not only highly inequitable and costly to the Treasury but acts as a
major deterrent to risk-taking. A wealthy taxpayer who is subject to a
surtax rate of 65 per cent, for instance, will find investment in a taxexempt 4 per cent bond equivalent to investment in a taxable venture
paying 12 per cent before tax, quite apart from avoiding the risks of the
higher yield security. The tax advantage of gilt-edged investment, and
the relative disadvantage of risk investment, moreover, are greater the
higher the surtax bracket. Risk investment, therefore, is deterred most
at the very source from which venture capital should be expected to
flow. Speedy steps should be taken to remedy this situation.
The preceding discussion has been concerned with ways and means of
minimizing the "deflationary evil" of taxation. Reviewing our conclusions, it appears that if the required tax yield is high, the potentialities
of tax policy in this direction are not very promising. It is more important



to decide upon the correct level of total tax yield than to construct the
best possible tax system. The case for qualitative tax policy may become
stronger, however, if a more positive approach is taken and tax instruments are designed to achieve desirable ends, rather than merely to avoid
undesirable results. The possibilities of an active tax policy of this kind
are as yet unexplored; quite possibly they are very great. 13
Only some of the major aspects of incentive taxation can be noted
here. The entire approach is based on the taxpayer's natural desire to
avoid taxes. I t offers him the option or incentive to reduce his liability
by complying with certain requirements established by the law. The incentive may be aimed at increasing or reducing the level of private investment and consumption outlays. During the war, for instance, a proposal
was advanced to supplement the personal income tax with a further tax
imposed on income spent. Savings would have remained tax free under
this supplementary "spending tax,"' so that there wTould have been a
direct inducement for the taxpayer to save more and to spend less. The
resulting reduction in expenditures would obviously have been greater
than under the traditional income tax which reduces the taxpayer's
ability to spend but does not increase the relative attractiveness of saving as against spending.
For the postwar setting, we shall be more interested in incentive taxation aimed at rendering it advantageous for the taxpayer to consume
and to invest, rather than to retain idle income. There are two approaches
to this goal. One is through the taxation of idle balances; the other through
favorable tax treatment of current income spent on consumption or investment, as against income which is not returned to the expenditure
Taxation of Idle Balances. The first approach, a tax on accumulated
hoards, would render it costly to hold idle funds and thus increase the
relative attractiveness of expenditures for consumption or investment.
An annual tax on existing bank balances and holdings of cash at a rate
Incentive taxation is found objectionable at times because preferential tax treatment of
some taxpayers is considered the equivalent of a subsidy payment. This, however, is largely
a matter of terminology. Suppose, for instance, that income which is reinvested is taxed less
heavily than income which is retained idle. It would then seem a moot question whether the
tax advantage to those who invest should be considered a subsidy and the resulting drop in
tax payments a loss in tax yield, or whether the tax disadvantage to those who do not invest
should be considered a penalty and the resulting increase in tax payments a gain in yield.
The very same kind of problem is involved whenever a choice is made between drawing on
one or another tax source.
The political aspects of incentive taxation, which may form another basis of objection,
cannot be considered here.



as low as one or two per cent, for instance, might considerably reduce the
attractiveness of hoarding. As a result, expenditures on consumption and
investment might be greatly increased. As far as a choice between liquidity or investment is concerned, the result of such a tax would be much
the same as that of a rise in investment yields; in both cases the relative
attractiveness of investment would be increased. At the same time, however, the tax on idle balances would not raise the cost of capital to the
borrower; on the contrary, this cost would be reduced. 14
Such attention as has been given to this approach in the past has been
concerned largely with its administrative difficulties. Thus, it has been
pointed out that, short of a periodical calling in of outstanding currency,
it might not be possible to enforce the declaration of assets held, even
though this difficulty might be reduced by granting substantial exemptions. Similarly, it has been pointed out that attempts might be made to
evade the tax through transfer of funds into other liquid assets which
might remain untaxed and would come to serve as money substitutes.
This, however, would result in an increased tax liability to new holders
unless debts to banks are paid off and the balances disappear. To the
extent that the bidding for liquid assets would result in a general reduction of the interest rate and through it in a higher level of expenditures,
the purpose of the plan would be met. Allowing for technical and other
difficulties, such as questions of constitutionality, this approach deserves
a more careful consideration than it has been given to date. If feasible,
it might greatly change the techniques of compensatory fiscal policy.
Taxation of Idle Income. The second approach appears less difficult
and novel, particularly as it applies to incentives for investment expenditures. While investment might be given some encouragement through a
simple reduction in tax rates, it might be encouraged more powerfully
and more directly by giving preferential tax treatment to income which
is reinvested as against income which is hoarded. Application of this
principle to the corporation income tax will be considered briefly. The
more far reaching and difficult problems of a personal tax on additions to
liquid balances will be passed over.
Taxable income under the corporation tax (or a tax supplementary
thereto) could be redefined to include net income before depreciation
allowances, minus distributed profits and minus current expenditures on
The implications of this approach are far reaching. If a tax on liquid funds was imposed,
the yield on relatively riskless investment might be driven to zero or become negative. The
inability of the interest rate to fall to a sufficiently low level, which at times has been blamed
for our economic ills, could thus be overcome.



plant, equipment, or inventory. All such capital expenditures would be
deducted, whether undertaken for expansion or replacement. The tax
would thus be limited to that part of gross income which is neither distributed nor reinvested in real terms. The taxpayer would have the option
of avoiding the tax either by distributing his profits in the form of dividends or by reinvesting his retained earnings. To protect legitimate requirements for cash holdings, liberal carry-over provisions would be applied so that short-run accumulation of funds would not be penalized.
Provisions would have to be made to allow for increasing need of working
capital in a growing firm. While all plans of this kind involve technical
difficulties such as the treatment of changes in debt liability or transfers
of second-hand equipment, which cannot be discarded easily, it should
be possible to work out a practicable solution.15
An alternative and simpler approach to the problem might be: taken
through accelerated depreciation, that is, shortening of the time period
over which depreciation charges may be written off against taxable income. In the extreme case, the taxpayer would be permitted complete
freedom in the timing of his depreciation charges. Income currently invested in depreciable assets (whether for new or replacement purposes)
could then be fully charged to depreciation and would in effect be exempt
from taxation. Combined with a full or partial tax exemption of undistributed profits, the result would be rather similar to that of the previously indicated approach: Essentially the tax would be restricted to
income which is retained but not invested in depreciable assets. No tax
would be paid by the firm which distributes or reinvests its current income. Accelerated depreciation would thus give a considerable stimulus
to investment expenditures and a substantial tax advantage to the young
and expanding firm. Combined with a credit for dividends paid, it would
be a powerful deterrent to corporate hoarding.
Accelerated depreciation should be applicable to depreciation charges
on new investment only; no incentive purpose would be served by extending the privilege to depreciation on existing assets. Though limited
to new investment, accelerated depreciation might still result in a considerable reduction in corporation tax yield, but this is no argument
against it unless the effects of other yield reductions should prove prefer15
Proposals of this kind have been advanced by various authors. Cf., for instance, Gerhard
Colm, "Full Employment Through Tax Policy?," Social Research, November 1940; Ruth P.
Mack, "The Fullest Measure of Employment after Victory," Pabst Prize Essays, 1944; and
M. Kalecki, The Economics of Full Employment, Oxford, 1944 p. 46.



able. 16 If desired, moreover, the revenue loss may be made good through
a higher corporation rate. Whatever the precise rates of depreciation
allowed should be, a sharp acceleration of present schedules is highly
The discussion so far has proceeded on the principle that taxes should
be raised with the least depressing effect upon private spending. The
underlying assumption has been that general economic conditions will
tend to be deflationary. With respect to the basic revenue structure,
which cannot be altered frequently, this is the more prudent approach.
Yet, it is also evident that economic conditions will differ from time to
time. Hence, a second principle must be allowed for: The revenue structure
should be sufficiently flexible to meet changing conditions as they arise.
The requirements for a flexible tax policy are of two kinds. Preference
should be given to taxes whose yield is sensitive to changes in income, so
that yields rise sharply when national income rises and fall when income
falls. Thereby the tax burden tends to adjust itself to the community's
capacity to pay and the need for frequent changes in tax rates is reduced.
However, automatic changes in yield will hardly suffice, so that provision
must be made for prompt adjustability of rates at some strategic points
of the system. This is needed even though frequent changes in the basic
revenue structure are undesirable.
Elasticity of Yield. The yield of taxes under any given set of rates depends upon the general level of income and employment in the economy.
Changes in national income, therefore, result in more or less similar
changes in tax yield. Since some components of income have less stability
than others, the yield of certain taxes will be more sensitive to changes
in income than that of others. Wages, for example, are more stable than
corporation profits, and consumer expenditures more stable than consumer incomes. The yield from taxes on the lower income groups or on
consumption, therefore, tends to be less sensitive to changes in business
conditions than the yield from profit or high income taxes. On the whole,
If investment does not increase, the annual loss of yield from accelerated depreciation
will finally disappear after some time. If increased investment results, an annual loss of yield
will continue, but it might be more than offset by generally increased yields due to a higher
level of national income.
Accelerated depreciation proposals also have their difficulties. If tax rates change over the
years, the Treasury must protect itself against manipulations in the timing of depreciation
charges. The taxpayer may be permitted to choose his depreciation schedule, but he should
be required to retain this schedule thereafter. A further difficulty arises with regard to the
cyclical effects of accelerated depreciation which may not be altogether desirable.



the selection of elastic yields leads to the same preference between types
of taxes as does the minimizing of tax burdens upon consumption. Estimated differences in the yield elasticity of various taxes are given in the
table below.

(index numbers)
Tax yields
Levels of gross
national product


income tax


income tax






The elasticities shown are estimated from data of the prewar period (1930-41) with a gross national product of
85 billion dollars equal to 100 in the index. While postwar levels of gross national product will most likely be much
higher, the relative elasticities will hardly be changed very greatly. The results thus obtained on the prewar basis
will tend to be more reliable than those furnished by extrapolation to postwar income levels.
Straight-line regressions were used for the interpolation of postwar data. Since the data were drawn from a period
of rising income, there is some doubt whether they can also be applied to downward changes in gross national product.
Moreover, the fluctuations under consideration were moderate; the results may vary for more drastic changes in
income. On the whole, the table should be read for the relative magnitudes of fluctuation under the various taxes;
the absolute magnitudes should not be taken too literally.
The estimate for corporation tax yields was based on the years 1938-41 only, so as to exclude the sharper upturn
of profits from the depression period. Income tax rates similar to those now in effect were used. With higher exemptions, the elasticity would be increased; with a less progressive surtax schedule it would be reduced. The payroll tax estimates are based on data from 1937 to 1943, earlier data not being available. The excise elasticities reflect
a weighted average of elasticities (by yield), applicable to the three major sources of excise yield—liquor, beer, and
tobacco. While the elasticity for taxes on high luxury items, such as furs, would undoubtedly be greater, their
yield is of minor significance.

The table shows the fluctuations in the yield of different taxes which
would tend to accompany a moderate increase or decrease in the level of
national income or gross national product. It indicates that the corporation income tax will be most sensitive and excises will be least sensitive
to the change. Personal income tax yield, similarly, is rather sensitive,
while pay-roll tax yield is rather insensitive. The result clearly speaks in
favor of extensive reliance on income taxes.
Adjustability of Rates. The assurance of speedy action in rate adjustment is essential to the success of a full employment policy, both to forestall incipient inflationary booms and to check a downturn in business
activity before a deflationary spiral has been generated.
The mechanics of the problem are fairly simple. Approximately threefifths of the total income tax yield is now collected at the source. The
general application of source withholding under the personal income tax,



introduced during the war, is most important in this connection. I t represents the major accomplishment of wartime tax legislation. Through
source collection, it has become administratively feasible, in the course
of a few weeks, to change the level of withholding rates. The resulting
changes in the level of disposable income in turn will bring about substantial changes in the rate of consumer spending. A 10 percentage point
decrease in the first bracket rate, for instance, might raise the annual
rate of consumer expenditures by well above 3 billion dollars; an additional 10-point variation in the second bracket might bring the increase
to 4 or 5 billion dollars. While this might not be sufficient to hold off a
threatening deflation, if applied promptly it might go far in meeting the
situation until more extensive counter measures could be taken. Possible
increases in rates and reduction in consumption expenditures, called for
under conditions of incipient inflation, may be undertaken in much
wider limits. If applied courageously, they provide a most powerful tool
for checking inflation.
Variation of withholding schedules raises some administrative difficulties, and in some cases may require a semi-annual tax return. However,
the technicalities involved are not too serious and the prevention of instability may be worth the price of an occasional inefficiency in tax collections. Rather, the major difficulty is political. To expedite prompt
adjustments, the lengthy process of revenue legislation must be short
circuited: Power to adjust rates would have to be delegated to some
authority which would be in a position to act quickly. Again, the obstacle
may be overcome. Congress might define the limits within which rate
adjustments could be made and, possibly, the general conditions under
which adjustments could be undertaken. The authority responsible for
such adjustment should include representatives from both the legislative
and executive branches of the Government. Legislation along these lines
is urgent and would make one of the most promising contributions to
postwar stability.

The tax treatment of corporation profits will be a key factor in the
coming revenue legislation. While it is altogether unlikely that an excess
profits tax will be reenacted in the post-transition period, opinions differ
widely regarding the future of the regular corporation income tax.
In principle, there is no good reason why income should be taxed at
the business level, if it may be taxed more equitably when received by



the individuals who own the business. Why not repeal the general corporation tax in favor of increased reliance on the personal income tax?
Actually, the choice is not that simple. First, we cannot successfully tax
all corporation profits when received as personal income by the shareholder, since a substantial part of corporation income, temporarily or
permanently, remains with the corporation and is not paid out in dividends. An integration of income taxation under the corporation and
personal income taxes is needed. Secondly, it will hardly be feasible
politically to meet total revenue requirements from the personal income
tax alone; a corporation tax, for instance, may well be preferable if
increased reliance on excise taxation would be the alternative. Thirdly,
the corporation tax needs to be appraised as a means of controlling
monopoly or the size of business units. Each of these aspects requires
closer consideration.
Integration of Personal and Corporation Income Taxes. The main
function of the corporation tax is to facilitate the taxation of income retained by the corporation and not subject to the personal income tax,
unless and until it is distributed at some future date or realized by the
shareholder through capital gains. Even though no corporation tax were
imposed, the eventual taxation of retained earnings may be assured under
the personal income tax by providing that all capital gains should be
subject to personal income tax at the time of death, whether or not the
gains have been realized. But this is not a satisfactory solution, since it is
also desirable to subject retained earnings to some current taxation.
Ideally these earnings could be imputed to the shareholder and included
in his personal tax liability; but this is hardly feasible except for small
and closely held corporations which might be treated as partnerships.
Various techniques may be developed, however, to approximate this
result. An additional undistributed profits tax might be imposed as in
the thirties; or, as suggested in some current tax plans, a moderate corporation tax might be continued but the corporation might be permitted
to deduct dividends paid (fully or partly) from taxable income. If, as is
now likely, the courts would regard stock dividends as taxable income
under the personal income tax, stock as well as cash dividends might be
deductible. As an alternative to permitting the corporation to deduct
dividends paid, the corporation tax might be applied to totatl profits
and the dividend recipient be permitted to credit the tax paid for him by
the corporation against his personal income tax liability. Where necessary, refunds would be made to the dividend recipient. This is the ap-



proach taken by the British law and currently proposed by the Committee
for Economic Development. Many variants to both approaches might
be considered. While neither approach is completely satisfactory and the
result of both may seem similar, it appears preferable, for various reasons,
to permit the deduction of dividends by the corporation rather than to
give a credit to the shareholder. 17
If corporations are taxed on retained earnings, what will be the appropriate tax rate? To approximate the conditions of yield and burden
distribution which apply to the taxation of distributed profits, the rate
should equal the average rates at which dividend income is taxed under
the personal income tax. Considering a likely schedule of postwar surtax
rates, this might be at about 35 per cent. The final rate might be somewhat higher or lower, depending upon the extent to which dividend
distribution is to be encouraged.
Arrangements should be made uiider this plan to protect the needs of
small and growing corporations which have no access to the capital
market and must rely upon retained earnings for expansion. For this
purpose, a certain amount of retained earnings (defined in dollar terms
or, preferably, as a percentage of total profits but subject to an absolute
upper limit) should be considered distributed for tax purposes and
be exempt from the tax. Also, an extensive carry-over period should
be permitted, so that retention of earnings in one year may be offset
against distribution in excess of earnings in another year. If such safeguards are applied, the objections to the earlier undistributed profits
tax would be avoided. Some pressure for the distribution of retained
earnings would remain and, to the extent that this would activate otherwise idle funds, the results would be wholesome. If it was found feasible
to grant a further credit for retained but reinvested earnings, as discussed
on page 39 above, the taxation of retained earnings would be incom17
This preference exists even though in terms of arithmetic, the deduction of dividends
by the corporation may be shown to yield exactly the same result as a corresponding credit
to the shareholder, such as has been proposed by the C.E.D.
Three points in particular may be noted: (1) To the extent that the corporation tax is
shifted, shifting is more certain to be discontinued if tax payments made by the corporation
are actually reduced, as would be the case under the dividend paid credit; (2) unless the
corporation and first bracket surtax rates are at the same level, which would probably be undesirable, the personal credit approach is likely to involve a need for large refund payments
by the Treasury which may be avoided under the other approach; (3) some pressure for
dividend distribution resulting under the dividend paid credit is desirable, providing that
adequate provision is made for small and growing corporations.
Note that the definition of corporate net income will remain an important problem in
either case, whether or not taxation of corporation profits as such is continued.



plete, but the resulting incentive advantages might well be worth
this defect.18
Corporation Tax and Alternatives. If the taxation of undistributed
profits is taken care of, there remains little reason on equity grounds for
retaining a general corporation income tax, applicable to total corporate
profits. Disregarding, for the time being, considerations of industrial
control, the continuation of a general corporation tax then becomes a
question of expediency, that is, of alternatives. Should the alternative
be excises on mass consumption goods or higher pay-roll taxes, a general
corporation tax should be retained at a moderate rate. Its impact upon
consumption would be less severe and, given adequate provisions for loss
offset, its investment effects would hardly be serious. If the alternative
is higher personal income taxes, however, the case is not clear cut.
Compared to increased personal ^ncome taxes, the impact of a corporation tax upon dividend income is less progressive than might be
thought. Two opposing tendencies are involved. On the one hand., a tax
on dividend income tends to be progressive because dividends are a
sharply rising portion of income when moving up the income scale. On
the other hand, it tends to be regressive because the additional burden
which it imposes will be the smaller, per dollar of dividend income, the
higher the dividend recipient's income bracket. While the shareholder
will find his dividend income reduced when corporation taxes are raised,
he will also find his personal income tax liabilities on dividend income to
be less. This offsetting tax saving will be the greater, per dollar of dividend reduction, the higher his surtax bracket and his surtax rate. The
additional burden of a corporation tax upon dividend income, in fact,
will be the less progressive the more progressive is the personal income
tax schedule.
Because of these tendencies, emphasis upon the corporation as against
the personal income tax is not likely to increase progression for incomes
above, say, $4,000; it may, on the contrary, reduce it.19 The situation is
different, however, if the alternative addition to personal income tax
rates reaches down to the first and second surtax brackets, where the
In essence, a scheme of this kind would differ but little from the philosophy of the present
Section 102 of the Revenue Code, which places a penalty upon the accumulation of unnecessary surplus. However, imposition of a tax on corporate hoarding would put teeth into the
Calculations with alternative rate schedules suggest that the degree of progression wrill
remain about the same above this level, if in place of a corporation income tax, personal income tax rates are increased so as to add equal percentage points to each bracket rate.



corporation tax tends to be more progressive. 20 Thus, the answer depends upon the nature of the alternative rate increases.
To the extent that the general corporation tax falls on business savings,
not dividends paid, some aspects have already been considered on page
28. However, they will hardly be substantial if a tax on retained earnings
is already in effect. If a general corporation tax is applied as well, the
differential rate applicable to retained earnings would have to be lower
lest the combined rate would become excessive. Since corporate savings
are reached more effectively through the differential rate, the net gain
from the additional tax on total profits would be small in this respect.
Is the Corporation Tax Shifted? In the preceding discussion it has been
assumed implicitly that the corporation tax falls on business profits; that
it is not shifted to consumers through higher prices or to workers through
lower wages. To the extent that the corporation tax is shifted, it is in
effect an excise or pay-roll tax, and different considerations apply. The
shifting factor is thus crucial in analyzing the case for or against the
corporation tax. The double taxation argument or the fear that investment yields may be curtailed, for instance, makes sense only to the
extent that the tax is not shifted; the argument that its repeal will result
in lower prices or higher wages makes sense only to the extent that the
tax is shifted.21 Both positions cannot be argued at the same time, except
as they apply to different fractions of the tax.
Probably the corporation income tax is shifted in part, although little
is known about the exact extent of shifting. It is perhaps more extensive
during a war boom or a period of high excess profits taxation, and less
extensive under other conditions, as in depression periods when there is
no sellers' market and tax rates are lower. Such evidence as is available,
however, suggests that under ordinary conditions a substantial—probably the larger—part of the tax is not shifted. More concretely, the
assumption that two-thirds of the tax falls on corporate profits would
seem a reasonable working hypothesis.
Much of the dividend income received in the lowest surtax brackets, moreover, flows to
taxpayers who file separate returns and, in terms of family incomes, fall in substantially higher
This does not exclude the possibility that in the absence of immediate shifting, lower
profits may result in reduced investment which, in turn, may lead to lower wages. Excise
taxes similarly may result in reduced demand which, in turn, may lead to less investment
and a decline in profits. But before analyzing the long-run effects of either tax, we must know
its initial effects. Whether a tax on profits is thought to be more harmful than a tax on wages
or prices, or vice versa, the effects of the corporation tax cannot be analyzed without knowing
what its initial impact will be.



If the shifting factor is allowed for, our conclusions are not substantially
modified. The general corporation tax becomes less progressive and its
merits, relative to those of additional personal income taxes, are reduced.
Still, as long as the corporation tax is shifted only in part, it remains
superior to additional excise or pay-roll taxes. The shifting factor, finally,
strengthens the case for a tax on retained earnings, since shifting will be
more difficult if the tax is imposed on a segment of profits only.
Corporation Taxes for Industrial Control. An altogether different approach to the corporation tax problem can only be noted here. If taxes
are to be used to strengthen the competitive position of small enterprise,
as may well be desirable for social or economic reasons, exemptions from
a moderate tax on retained earnings might not be sufficient to do the job.
A penalty tax on bigness might be required, that is a corporation tax on
profits, involving high exemptions and possibly progressive rates. 22 While
the case for a general corporation tax with exemptions is strengthened by
these considerations, tax penalties on bigness should not be permitted,
at this time, to conflict with the maintenance of a high level of total
business investment by small and large enterprises combined.
I t should also be pointed out in this connection that bigness and
monopoly are not identical. A general corporation income tax with appropriate exemptions may serve to improve the relative position of small
(and possibly new) enterprise, but it does not offer a direct attack on
monopoly profits. To do so a different approach, perhaps in terms of an
adjusted excess profits tax, would be required. A host of difficult technical and administrative problems are involved which cannot be considered here. 23

I n conclusion, the outlines of a revenue program are presented. As the
program is based on the principles developed in earlier pages, a summary
statement will suffice.
Timing of Rate Reductions. The timing of further tax cuts, as other
details of tax policy during the transition period, cannot be considered
here. Wartime taxation should be tapered off gradually only, in pace
Theoretically, the matter might also be taken care of through preferential personal income tax treatment of dividends or capital gains derived from investments in small corporations, but the administrative difficulties involved would be much greater.
They do not rate, on the whole, a very high priority for postwar tax policy, particularly
if the monopoly problem and monopolistic barriers to investment are attacked vigorously
through other channels. Cf. Howard S. Ellis, "Monopoly and Unemployment," in Prices,
Wages, and Employment, another pamphlet in this series.



with the economy's transition to a peacetime basis. While general inflationary pressures continue and the Federal budget remains abnormally
large, wartime taxes should continue to apply. The 6 billion dollar reduction in 1946 liabilities already provided for under the Revenue Act of
1945 was not in accord with this principle. The excess profits tax, in
particular, should have been retained for another 12 months, though at
a reduced rate, to be terminated together with its carry-back provisions
at the end of 1946. Further tax reductions should not be undertaken
hastily but should be postponed until peacetime production has been resumed more fully and present inflation potentials have subsided. The
following program disregards these timing factors and presents the end
results toward which gradual adjustments should be aimed.
Yield Composition. The proposed plan provides for a yield of 25 billion
dollars, including pay-roll tax receipts, to be obtained at a gross national
product level of 185 billion. This is about 6.5 billion dollars below the
yield provided under the present (1945) law. It is roughly in line with
the yield of some other recent plans.24
From the preceding discussion, it appears that the greatest possible
reliance should be placed on the personal income tax, supplemented by a
tax on retained corporate earnings and a revised estate and gift tax. Also,
it appears that pay-roll taxes and excises should be repealed, with the
possible exception of excises on some luxury items. But certain exceptions to the rule may prove necessary.
While pay-roll taxes are highly undesirable in their economic effects,
there are compelling social reasons for retaining them in part.25 The
yield of 2.5 billion dollars derived from a 2 per cent tax on employers
and employees each, will be approximately sufficient to finance one-half
For a gross national product, prior to Federal excises, of 170 billion dollars, I have estimated the yield of the Committee for Economic Development, Ruml-Sonne and Twin City
plans at 19.5, 18.4 and 23.2 billion, respectively. Including 3 billion dollars for pay-roll taxes
(here provided for), the totals would be equal to 22.5, 21.4 and 26.2 billion. Adjusting upward for a gross national product, prior to excises, of 180 billion dollars, the plans might
provide for 25, 24 and 29 billion, respectively. These amounts are comparable to the 25 billion
dollar yield requirement here presented. For further yield comparisons, see my article, "Three
Plans for Postwar Taxation," Federal Reserve Bulletin, December 1944, pp. 1163-1176.
From a fiscal policy point of view, there are compelling reasons against financing an
expanded social security program out of increased pay-roll taxes. However, at this stage,
there is an overruling political and social argument for retaining a moderate contributory
element in the system. The compromise here visualized is that the program would be supported half from pay-roll taxes and half out of the general budget. For a further discussion
of these problems see, Eliot Swan, "Economic Aspects of Social Security," in Housing, Social
Security, and Public Works, another pamphlet in this series.



of an expanded social security program (excluding unemployment insurance), the remainder to be supplied from general receipts.

(Head of family, one dependent)
Income tax liability, Revenue Act of:

Net income
before exemptions









Proposed 1



Exemptions of $600 per person and rates ranging from 20 per cent in the first bracket to 35 per cent for the
$10,000-$12,000 bracket, 40 per cent for the $20,000-$22,000 bracket, 50 per cent for the $50,000-$60,000 bracket,
62 per cent for the $90,000-$ 100,000 bracket, and 65 per cent for net income in excess of $100,000.

If 2.5 billion dollars is obtained from pay-roll taxes, 1 billion from a
thoroughly revised estate and gift tax, and 2 billion from miscellaneous
other revenue sources such as minor excises on luxury items and customs, 19.5 billion remains to be obtained from income taxes. A 35 per cent
corporation tax on retained earnings might provide for an additional 3.5
billion dollars, which leaves 16 billion for the personal income tax. To
obtain this yield, the rate reductions under the Revenue Act of 1945
would have to be repealed; only the increase in normal tax exemptions
provided for under that Act could be retained. If high bracket surtax
rates were to be reduced somewhat, other rates would in fact have to
be raised.
While the retention of a 16 billion personal income tax yield may be
the best arrangement from the economist's point of view, it will hardly
be a feasible plan. Some further reduction in liabilities for the lower and
middle income brackets will most certainly be enacted so that additional
revenue will have to be obtained from some other source. Retention of a
moderate, say 10 per cent, tax on total corporation profits is preferable
in this situation, as compared to the alternative of filling the entire gap
with higher excise rates. Allowing for a 30 per cent tax on retained earnings, this would raise the estimated corporation yield to 5 billion dollars



thus permitting a drop in the personal income tax requirements to 14.5
billion. Allowing further for the retention of excises on liquor and tobacco
at one-half their 1946 rates, the personal income tax quota may finally
be reduced to 13 billion.
On this basis, an increase in personal income tax exemptions to $600
will be permissible if the first bracket rate remains at 20 per cent. For
taxpayers in the lowest income brackets this will be preferable to a reduction in the basic rate. Surtax rates applicable to the higher brackets
may then be reduced somewhat and the maximum rate cut to 65 per cent.
If the yield objective is to be met, however, it is evident that liabilities
for the $2,000-$50,000 range will have to remain substantially above
prewar levels. Liabilities under the proposed schedule, as compared to
liabilities under prewar, wartime, and present conditions, are shown in
the table on page 50. The yield composition of our revenue program as a
whole is summarized in the table below, together with the yield under
the Revenue Acts of 1944 and 1945.
(In millions of dollars)
Type of tax
Personal income tax 2
Corporation income tax 3 ..
Excess profits tax
Capital stock tax . . . .
Estate and gift t a x . . . .
Excise taxes 4 :
Other 5
Miscellaneous receipts
Pay-roll taxes 6
Total yield

Act of 1944

Act of 1945

















Revenue change
Proposed plan
- 3,100


All estimates are based on the common assumption of a gross national product before excises of 180 billion
dollars. The corresponding levels of income payment are about 150 billion dollars.
Includes normal and surtax for the first column.
Profits of net income corporations prior to tax are estimated at 21 billion dollars for the first and second columns
and 18 billion for the third column, where a 10 per cent tax on total profits plus a 30 per cent tax on retained earnings
applies. For this case, dividends and retained corporation earnings after taxes of 5 billion dollars are estimated at
6.5 billion each.
4 Statutory reductions of wartime rates are allowed for in the first column.
Including jewelry, furs, and other luxury items.
Excluding State unemployment taxes. A rate of 2 per cent on employers and employees each is assumed.



Further Considerations. Specific recommendations made in earlier
pages will not be repeated here but certain additional points need be
raised. 26
(1) With greater reliance on the personal income tax, it will become
increasingly important to close loopholes, particularly those arising
from the community property provision and the option of filing separate
returns on incomes which in effect belong to one family budget. The community property provision should be eliminated for income tax purposes
and the filing of joint returns should be rendered mandatory. At the same
time, some further exemption for working wives might be granted.
(2) The estate and gift taxes are estimated to provide a yield of 1 billion
dollars. Before greater reliance can be placed on these revenue sources,
a thorough recasting of present provisions will be required, including (a)
closer coordination of both taxes so as to forestall estate tax evasion
through gifts in anticipation of death, and (b) closing of such loopholes
as are now offered through tax-free transfer of life estates. With these
reforms accomplished, a substantial reduction in exemptions from the
present $60,000 level to perhaps $10,000 might be considered and rates
might be revised. Even then, however, the volume of estates and gifts
will not be sufficiently large to provide a revenue source at all comparable
to the personal or corporation income taxes.
(3) The drastic reduction of excise taxes which we propose will be of
advantage only if it is passed on to the consumer through lower prices.
Before excises are reduced, a commitment should be obtained from the
manufacturers concerned that the repeal of these taxes will be followed
promptly by a corresponding reduction in price.
(4) As a corollary to an improved Federal tax structure, a closer coordination between Federal, State, and local taxes must be achieved.
The Federal Government may then collect certain taxes not provided
for in this program for transmission to the States, or share some of its
revenue sources with other governmental units. Coordination is not
achieved if State and local governments find it necessary to rely on bad
taxes which the Federal Government has discarded. 27 In particular, the
recommended withdrawal of the Federal Government from the excise
field would fail of its purpose if it were to be followed by a corresponding
increase in State excises.

See especially the proposals for carry-over of losses, p. 32; averaging of capital gains,
p. 35; exemptions under the tax on retained corporate earnings, p. 45, and under the general
corporation tax, p. 36; taxation of tax exempt securities, p. 37.
For a discussion of State and local taxation, see pp. 101-30 of this pamphlet.

Division of Research and Statistics, Board of Governors
On November 30, 1945 the Federal debt reached 265 billion dollars, a
magnitude without precedent in the history of this country. With the
present interest rate structure, it involves an annual service charge of
more than 5 billion dollars, an amount exceeded by only two peacetime
Federal budgets until 1934.1 I t is quite understandable that a debt of
this magnitude should cause considerable apprehension, and that a policy
of repaying at least a part of it should be advocated so often.
I t is true that our economy would be better off without so large a debt.
But this does not mean that our position can be always improved by
reducing the debt. The difficulty lies in the fact that the various components of our economy are interdependent, so that it is impossible to
change one without affecting the others. In particular, the debt problem
is more complex and difficult than it appears on the surface because
changes in the debt exercise a powerful effect on the size of the national
Effects of Debt Changes on Income. In general, when the debt increases, that is, when the Government borrows and spends, national
income is above the level where it otherwise would be; when the debt
is reduced, that is when tax yields exceed expenditures, the income level
is depressed. This rule does not necessarily hold. Should the Government
borrow funds which would be spent on goods and services anyhow, and
use them for expenditures which do not create income, such as a purchase
of land, national income would fall rather than rise. Similarly, a repayment of the debt does not always depress national income; if taxes come
from idle funds which would not be used anyhow, while the bondholders
whose bonds are redeemed use the proceeds for consumption or investment, national income will indeed rise. But with all these qualifications

In 1920 and 1921, respectively, 6.5 and 5.5 billion dollars were spent.




it is nevertheless true that as a general rule, Government borrowing aiid
spending raise income, while taxation and repayment of the debt depress it.
Debt and Fiscal Policy. These attributes of budgetary deficits and surpluses, which were discussed at greater length earlier in this pamphlet, 2
make them a powerful—probably the most powerful—instrument of
fiscal policy. Now that the war is over, our economic policy should be
directed toward achieving a high and stable level of employment and a
growing national income. But there is increasing agreement among
economists and others that stability will not maintain itself automatically, and that active Government intervention will be needed to eliminate the swings between prosperity and depression which characterized
our economy in the past. This does not yet mean that changing the magnitude of the debt will be the only or even the necessary instrument of
fiscal policy. A comprehensive program embodying a number of measures
will be required. 3 But it is very unlikely that it will be possible to balance
the budget in periods when private investment is low; indeed a deficit
will probably be required to prevent a slump. Similarly, when inflation
threatens, a budget surplus should be accumulated and a part of the
debt repaid. But trying to repay the debt at other times, and particularly when considerable unemployment already exists, makes little sense:
income will suffer a greater proportional decline than the debt, and the
debt "burden" of the economy will actually rise.
If times of low business activity are sufficiently compensated by years
of high private expenditures, Government deficits incurred during the
former periods will be balanced by surpluses created during the latter.
Roughly speaking, the debt will then fluctuate around the same average
level; over a period of time (without wars) its magnitude will not rise.
But what if this will not be the case? What if in spite of all our efforts it
will be impossible to accumulate sufficient surpluses to offset the deficits
—what kind of a debt problem shall we have to face then?
Secular Expansion of the Debt. We are considering here a situation in
which the average level of private expenditures, for some reason or other,
is not sufficient to maintain a stable level of full employment, and in
which Government borrowing is found necessary to achieve this goal.

See pp. 1-21.
For instance, tax incentives offered to private business to stabilize investment; various
methods for encouraging consumption; expanded social security; changes in the tax structure,
and so on. This is a field in which much work and exploration remains to be done.



Whether such a situation will actually arise is a different subject; it is
not discussed here. 4 Government borrowing, however, is not synonymous
with "make-work projects." There are many fields, such as urban redevelopment, public health and education, development of our resources,
scientific research, and many others, in which Government expenditures
are extremely useful, aside from employment aspects. That they create
jobs and raise national income is so much the better. I believe that our
actual experience during this war has well demonstrated that with sufficient Government expenditures national income can be raised to the
highest level permitted by our productive capacity. This is now recognized
by many competent authorities, including some opponents of Government borrowing. The latter object to the pursuit of such a policy on
other grounds. From a political point of view, they argue, continuous
Government borrowing will involve increasing regimentation and eventually destroy our democratic institutions; and from an economic point
of view, it will lead to an ever mounting debt which, among other things,
will necessitate higher and higher taxes with their well-known depressive
The political aspects of Government borrowing are not discussed in
this paper. In passing one can briefly remark that even in our most
prosperous years, such as 1929, our cities were blighted by slums; that
large areas of our country, particularly in the Southeast, have never had
anything even approaching a satisfactory minimum standard of health
and education, and that finally private business has not been able to
prevent the waste of our natural resources. Democracy will hardly be
endangered by projects such as the TVA which, moreover, create numerous opportunities for private investment; or by healthier cities and better
schools. As we can learn from the experience of other countries, it is
chronic depression and unemployment that endanger democracy.
Importance of Relative Magnitudes. From an economic point of view,
the existence and growth of a large public debt create a number of problems, not only in taxation, but in the fields of monetary and banking
policy as well. Some of them are discussed elsewhere in this pamphlet. 5
But in all of them (as in most other problems in economics and elsewhere),
absolute magnitudes taken by themselves have little meaning. What
matters is the ratio of the debt to other economic variables, such as
See Everett E. Hagen, "Output and Demand after the War," in Jobs, Production, and
Living Standards, the first pamphlet of this series.
See Roland I. Robinson, "Monetary Aspects of National Debt Policy," pp. 69-83.



taxable income, the resources of the banking system, the volume of private securities outstanding, and so on. Most important in general is the
relation between the debt and the economic size, so to speak, of the
country. Is the 265 billion dollar debt shouldered by a country of the size
of the United States or of Nicaragua? The United States today, or 100
years ago? For purposes of analysis, it is necessary to express this economic size by means of some kind of an index, such as the national
The first economic variable which should be studied in connection with
the debt problem is the ratio of the debt to national income. It gives us
a good idea of the magnitude of the whole debt problem and is needed
for the study of any of its aspects. This ratio also allows us to compute
the ratio of interest charges to the national income, or in other words
the average tax rate which must be imposed to service the debt—a tax
rate which equals the ratio of the debt to income, multiplied by the interest rate on the debt.
The behavior of these two variables—the ratio of the debt to income,
and the average tax rate—constitutes the main topic of this paper. In
addition, some remarks about the effects of a growing debt on the distribution of wealth and income are made in the closing section.

Let us assume that the Government borrows in periods when private
expenditures are not sufficient to maintain full employment, and that
the deficits so incurred are not fully repaid. Under these conditions, the
debt will of course grow. But its ratio to national income will increase
or not, depending on whether the debt does or does not grow more rapidly than income.
When Income Remains Constant. If our fiscal and other policies are
pursued in such a manner as to result in a constant or even falling income,
the ratio of the debt to income will rise. The ratio of interest charges to
income will rise as well (unless the interest rate falls at the same time),
so that higher and higher tax rates will be needed to service the debt. A
numerical example would show, however, that under fairly reasonable
circumstances, the tax rate will rise quite slowly, so that after some 25
or 50 years it will still be within manageable limits. But the fact of a
rising tax rate remains. It is questionable whether the public will agree

1 am using the term "national income" here in a broad rather than technical sense.
Gross national product or some variation of it can be used just as well if not better.



to pay ever higher tax rates for the sole purpose of servicing the debt
and its repudiation may become a serious issue.
Growing Income. The situation is markedly different if we succeed in
achieving a growing national income. As in the preceding case the debt
will grow. Its ratio to income, however, will depend on the rate of growth
of income. The more rapidly income grows, the smaller will be this ratio.
If the Government borrows on the average a certain percentage of national
income, and if income grows at some constant percentage rate (such as
2 or 3 per cent) per year, then it can be demonstrated that the ratio of
debt to income will gradually approach the expression
percentage of income borrowed
rate of growth of income

The ratio of interest charges to income, or the average tax rate, equals
the product of the debt and the interest rate, divided by income. This of
course equals the ratio of the debt to income, multiplied by the interest
rate. Since the ratio of debt to income approaches expression (1) the
average tax rate will approach
percentage of income borrowed

X interest rate on the debt
rate of growth of income

The derivation of the expression (1) itself requires some mathematics,
but perhaps it can be somewhat clarified by a non-mathematical explanation. 7 The nature of its numerator is obvious—if the deficits are large in
relation to income, the ratio of the debt to income will be also large. The
nature of the denominator is less easily explained. If national income
grows at a rapid rate, its magnitude in the past will be small as compared
with that of today. The debt is simply an accumulation of past deficits
each of which, according to our assumption, constituted a constant percentage of income at the time when the deficit was incurred. Therefore,
if income in the past was relatively small, the deficits were small, and the
present debt must be small as compared with present national income.
That is the reason why the rate of growth of income appears in the denominator of expression (1).
We thus see that the greater is the rate of growth of income, the lower will
be the ratio of debt and of interest charges to income. The essence of the debt
problem is a problem of an expanding national income.
For a more complete treatment of the problem and for an actual derivation of the formulas see my article "The 'Burden' of the Debt and the National Income," American Economic
Review, December 1944, pp. 798-827.



Numerical Magnitudes. I t will be interesting to see what numerical
magnitudes are involved here. They will depend on our assumptions regarding the rate of growth of income, the extent of Government borrowing, and the interest rate paid on the debt.
Let the interest rate on the debt be 2 per cent. In view of our past
history (see p. 60) it is not unreasonable to suppose that, with proper
fiscal and other policies, national income can grow at 2 or 3 per cent per
annum for some time to come. But how much will the Government have
to borrow? This will depend on the magnitude of the community's savings
and the extent to which these savings are not absorbed by private investment. Over the period 1879-1941 our savings averaged about 12
per cent of national income. 8 This percentage rises in prosperity and falls
during depression. What it will be in the future is very hard to tell. Let
us suppose that it will remain 12 per cent. What part of this 12 per cent
will have to be absorbed by the Government? A pure guess will have to
be ventured. Suppose the Government takes one-half of total savings,
i.e. 6 per cent of the national income. The 6 per cent is taken as the
average percentage. When private expenditures are high, borrowing will
stop entirely, and a part of the debt may be repaid; when private expenditures are low, a larger fraction than the 6 per cent will be borrowed.
This 6 per cent represents quite a pessimistic assumption. I t has been
estimated that, with a high level of employment, a 140 billion dollar
national income can be expected soon after the war. We are thinking
then about an average deficit of some 8 to 10 billion dollars in early postwar years—a much larger magnitude than is assumed in most current discussions. Anyhow, all these numerical magnitudes are given solely as
illustrations and do not represent an attempt to forecast. The derivations of the formulas on page 57 do not depend on any particular numerical magnitudes; the reader can make his own numerical examples
and obtain similar results.
When our numerical assumptions are inserted into expressions (1)
and (2), we find that if the rate of growth equals 2 per cent, the debt
will eventually be three times the size of national income and the interest
charges will constitute 6 per cent of the national income. If we succeed
in achieving a 3 per cent growth of income, the ratio of debt to income
This estimate of savings is based on the ratio of net capital formation to national income.
Sources: Simon Kuznets, National Product Since 1869, National Bureau of Economic Research (mimeographed, 1945) p. 11-89, and the Survey of Current Business, May 1942 and
April 1944.



will approach two, and interest charges will constitute only 4 per cent of
the national income.
For practical purposes it is more interesting to know, not what these
ratios will eventually become, but rather how they will behave in the
next 25 or 50 years. Such a calculation is presented in the table below.
Original debt = $300 billion
Original income = $140 billion

Deficit=6 per cent of national income
Interest rate on the debt = 2 per cent
Interest charges as percentage
of income

Ratio of debt to income

Income increasing Income increasing
at 2 per cent
at 3 per cent

Income increasing
at 3 per cent

Income increasing
at 2 per cent













This table is based on the assumption that we start with a 140 billion
dollar income and a 300 billion debt; that thereafter 6 per cent of national
income is borrowed each year; and that the interest rate on the debt is
2 per cent. As expected, a 3 per cent rate of growth produces more favorable results than a 2 per cent rate. In neither case, however, are the results disturbing. The economy will hardly be impeded from effective
functioning by a debt service equal to some 4 or 6 per cent of its national
Implications for Fiscal Policy. The examination of the case when income
increases at 3 per cent per year brings out a very interesting point. The
table shows that the ratio of the debt (and also of interest charges) to



income actually declines in spite of the fact that the Government continues
to borrow, and that the debt continues to rise. This fact has important
implications for fiscal policy. I t shows that the repayment of the debt
is not the only available method of reducing the debt burden. This aim
can also be achieved, and in a much safer way, by promoting a more
rapid growth of income. That the latter is desirable of itself is evident.
I t is important to make a clear distinction here between the growth of
productive capacity and the actual growth of national income. Too often
it is assumed that an increase in productive capacity automatically
creates an increase in income—an assumption which is completely unwarranted by our experience.
Productive Capacity and Realized Income. Actually, the real productive
powers of an economy establish the limit beyond which real national
income, at any given time, cannot go, but whether or not it will reach
this limit depends on the volume of monetary expenditures and the level
of prices. Theoretically speaking, it is possible to have a rising real income
with constant or even falling monetary expenditures provided a continuously falling price level can be assumed. I t is very unlikely, however,
that in our economy such a price policy can be pursued without heavy
unemployment. Its success would require much greater price flexibility
than can be realistically relied upon. And even if we did achieve falling
prices without unemployment, it is very doubtful whether such a development would be desirable in the first place in view of the large magnitude of existing public and private fixed obligations whose burden would
accordingly rise. Similarly, it would be just as well to avoid rising prices,
even though there are some reasons to think that a slowly rising price
level might be advantageous from the point of view of stimulating expenditures on investment and consumption. The selection of the proper
price policy is too complex a subject to be discussed here. We shall assume that it is desirable and possible to achieve a constant price level.
If then a rising national income is desired there must be both rising productive capacity and a rising volume of expenditures. To the extent that
a stated part of these expenditures is undertaken by the Government
out of borrowed funds, the amount borrowed must increase as well.
Over the period 1879-1941 real national income in the United States
grew at an average annual rate of some 3.3 per cent. 9 Compared with

See Table V, p. 818, and App. B, pp. 826-27 in my paper cited in note 7, p. 57.



other countries, this rate was relatively high, but not exceptional. I t was
due to accumulation of capital equipment, technological improvements,
growth of the labor force, and the discovery of new resources. I t is of
course impossible to say whether much reliance can be placed on resources still to be discovered. Improved technological methods, however,
permit new applications of known resources and thus may have the same
effect as an actual discovery of new ones. But the rate of growth of the
population has been slackening ever since about 1850, and the various
estimates of future population growth predict a practically stationary
if not declining population by 1980.
Need for Technological Progress. We have to recognize that the main,
and later on the only, propelling force in the economy will be technological improvements which should result in an ever rising productivity
per man-hour. Only technological improvements can offset the diminishing productivity of investment which would be caused by a stationary
labor force and absence of new natural resources. Whether new inventions will be forthcoming in sufficient numbers and whether they will be
applied fast enough is hard to tell; one often gets the impression that the
scientific age is just beginning, and that once monetary problems are
solved, technological advance will proceed at a tremendous rate. The
recent discovery of the use of the atomic power certainly opens up most
spectacular possibilities. On the other hand, one also cannot escape the
impression that certain institutional developments, particularly the
growth of monopolies, are not conducive to rapid technological change,
and that the mere assurance of an adequate effective demand will not
solve the whole problem. A thorough reform of the process of industrial
research and particularly of the application of inventions may be needed
as well.
According to our assumption the Government absorbs a part of the
community's savings. The community must decide how these savings
should be allocated among the various possible uses, and in particular
what part (if not all of them) should be directed toward increasing our
productive capacity. But whether a given expenditure is productive in
the present sense or not has nothing to do with such questions as whether
or not the project undertaken makes a direct contribution to the Federal
Treasury or is self-liquidating. What matters is the effect of the project
on the productive capacity of the country as a whole. I t is well known
that education and training are usually not self-sustaining financially.
There are few, if any, other expenditures, however, which are as im-



portant for the growth of our productive capacity. The same can be said
about industrial and scientific research. In 1940 total private and public
expenditures on industrial and scientific research in the United States wras
less than 500 million dollars. What would be the result if this amount
were doubled, tripled, or multiplied ten times? Indeed, large-scale Government participation in industrial and scientific research could become one
of the major propelling forces in the economy. 10
But it must again be emphasized that technological progress and other
developments which raise our productive capacity make it possible for
income to rise. They do not assure an actual rise in income. If they are to
result in a growing income rather than in greater unemployment, monetary expenditures must grow as well.11
Cyclical Drop in Income. We have established that the debt "burden"
will remain within reasonable limits if national income grows fast enough.
But suppose that in spite of all our efforts a depression takes place and
national income falls. Since interest on debt is a fixed charge, wTill not the
economy be crushed under the tax load, which is suddenly increased
relative to income?
We are familiar with a somewhat similar problem in corporate finance.
So long as everything goes well, a corporation meets its fixed obligations.
But let a depression come, and the corporation fails because of its inability to pay interest and to redeem its currently maturing debt. This
is why heavy reliance on borrowing is not recommended in corporate
The corporation finds itself in this difficult position because its credit
resources are limited and also because it can exercise relatively little
control over its sales. The Federal Government, however, through the
Federal Reserve System, possesses credit powers which are practically
unlimited. By means of fiscal policy it can raise national income. The
Expenditures on industrial research made by private business in 1940 amounted to about
300 million dollars. To this should be added some 50 million spent by universities; the latter
figure includes their expenditures on research in social sciences as well. The figures for Federal
expenditures on scientific and industrial research in 1940 are not available; in 1938 they
amounted to some 52 million dollars, the largest share going to the Department of Agriculture.
See U. S. National Resources Committee, Research—A National Resource, Vol. I; U. S.
National Resources Planning Board, Research—A National Resource, Vol. II.
Since the beginning of the war, Federal expenditures on research, particularly in the fields
connected with the war effort, have shown a great increase. Several bills have been recently
introduced in Congress to obtain Federal aid for scientific research in peace time. The amounts
suggested by them are rather small, but may prove to be a good beginning.
This does not mean that hours worked per week should not be reduced if the community
prefers more leisure to a higher income. The discussion in the text refers to an increase in productive capacity achieved in spite of a possible reduction in hours worked.



question discussed here appears so difficult only because of an implicit
assumption that the Federal budget must be always balanced, or at least
that service charges on the debt must always be raised by taxation.
Neither assumption need hold true. During a depression the budget
should not be balanced: the deficit is needed to bring the economy out
of the depression. In general it is very hard to allocate revenues to individual expenditure items and thus to determine which expenditures
are financed by borrowing and which are tax financed. So it is impossible
to say just when debt charges are paid from borrowed funds. But the
answer to the problem is not affected by this difficulty: until a high level
of employment is reached, service charges as well as other expenditures
should be financed wholly or partly from borrowed funds.
Declining Rate of Growth. A more difficult problem arises if the secular
percentage rate of growth declines. If this development is not caused by
a shortage of productive capacity, but only by the failure of monetary
expenditures to expand at the proper rate, the remedy is still relatively
simple (at least in theory): larger expenditures (both public and private)
should be made. Failure to do so simply means that the productive powers
of the economy go unused, creating unemployed men and resources. But
if it is the productive powers that fail to expand at a sufficiently rapid
rate, the situation is more serious. It means that technological progress
has not been sufficiently rapid to offset the limitations imposed on income growth by a stationary population and existing natural resources.
Therefore further additions to our productive equipment increase its
capacity at a diminishing rate.
In general it is hard to visualize national income (or any other economic
variable) as growing forever at a constant percentage rate, 12 even though
it has grown at some 3.3 per cent per year in the past 70 years or so.
However hard we try, and however much attention we give to technological progress, it is probable that the limitation of our human and
natural resources will eventually force output to grow at a declining
percentage rate. 13 The mere fact, however, that the rate of growth declines is not so important: as far as the debt burden is concerned, it is
not the rise or fall of the rate of growth that matters, but the actual
magnitude of the rate of growth at any given time. So long as the rate,

For instance, one cent invested at 2 per cent 1945 years ago would now amount to something like 783,000 billion dollars.
Our present ideas about the rates of growth possible in the future may have to be radically revised if a new technological revolution is brought about by the use of atomic power.



even though falling, remains above, say
income will be smaller than it would be
2 per cent. So for quite a number of years
of income need not create any difficulties

2 per cent, the ratio of debt to
if the rate were always fixed at
a slowly declining rate of growth
as far as the debt is concerned.14

So far we have been mainly concerned with the relationship between
the public debt and the level of income. Now we shall consider the possible effects that the growth of the debt may have on the distribution of
The Argument. I t is known that the ownership of the debt is not distributed equally among the various income groups. I t is concentrated
(directly or through banks and other corporations) in the hands of the
upper income groups, who therefore receive a large share of interest
payments on the debt. Hence an argument is often made that the growth
of the debt directs more income to the upper income groups, and thus
creates a greater inequality of income and wealth. The objections to such
a development on political and welfare grounds have been made for a
long time and are well known. From a strictly economic point of view it
may be added that since upper income groups save a relatively large
share of their incomes, a greater inequality of income distribution increases total savings made out of any given national income. In a welldeveloped country like the United States where fiscal policy has not yet
been sufficiently accepted as an important method for maintaining full
employment, larger savings can easily result in idle hoards and lead to
Comparison between Public and Private Investment. Whether or not
Government borrowing results in a greater concentration of income and
wealth is by its very nature a question of comparison. For practical purposes the most meaningful comparison should be made not with some
ideal income (and wealth) distribution, or with distribution of today or
some other date, but rather with the distribution that would result from
some alternative economic policies. The problem can be stated in the
following form: the community desires to save a part of its income.
Everyone will agree that in order to maintain a high level of income and
employment these savings must be invested. The investment can be
done either wholly by private business or in part by private business

The possibility of reducing the interest rate on the debt should also be kept in mind.



and in part by the Government. Will the second method necessarily result
in a greater concentration of wealth and income than the first?
For a variety of reasons some individuals receive larger income than
others; and those who receive relatively high income usually save a substantial part. If all investment is done privately, the savers acquire,
directly or through the purchase of securities, houses, factories, stores,
banks, and other forms of private wealth. If part of the investment is
undertaken by the Government, some savers acquire Government bonds.
But each saver can use a given dollar of his savings to purchase either a
piece of private wealth or a Government bond. He cannot use the same
dollar first to buy a private security and then again a Government bond.
Therefore as far as primary effects of Government borrowing are concerned, the distribution of wealth will not be affected by the fact that
part of the investment is done by the Government.
There are secondary effects. They depend on the rate of return which
the saver can obtain from the ownership of private wealth as compared
with that of Government bonds, and on the source of his income.
Average Rate of Return. The average return on the Federal debt is
at present about 2 per cent. The return from private investment is of
course subject to very great variations, ranging from 100 and more per
cent down to a complete loss of the principal. The estimate of its average
magnitude is quite a task, both statistically and conceptually, but for
our purposes a very rough calculation will suffice.
Over the period 1919-41 the percentage of national income derived
from the ownership of private wealth was somewhere around 16-20
per cent.15 I t also appears that, speaking very roughly, national income

Property income consists of dividends, interest, undistributed corporate profits, rents,
royalties, and a part of entrepreneurial income, i. e.y income derived by owners of unincorporated businesses. To obtain private property income, i. e., income derived from ownership of
private wealth, interest received from the ownership of Government debt must of course be
excluded. The most difficult problem is created by the presence of entrepreneurial income, because it is very difficult to decide what part of it should be treated as compensation for personal services, and what part as property income. If all of it (over the period 1919-41) is
treated as compensation for personal services, private property income will constitute only
some 14 per cent of national income. If on the other hand all of it is added to other forms of
private property income, the combined total will constitute some 31 per cent of national
income. There are reasons to believe that the major part of entrepreneurial income represents
compensation for personal services. If we assume, as a rough guess, that only one-fourth of
it is property income, the total private property income will constitute some 18 per cent of
national income. This is the basis for the 16-20 per cent estimate used in the text.
Sources: U. S. Department of Commerce, Bureau of Foreign and Domestic Commerce:
National income and its components during 1919-28, unpublished materials prepared by the
National Income Unit; the same during 1929-41, Survey of Current Business; interest on
Government debt during 1919-41, unpublished materials described above.



over the same period was on the average some 25-30 per cent of private
wealth (excluding stocks in the hands of consumers). It therefore follows
that the average rate of return from privately owned wealth was somewhere in the vicinity of 4-6 per cent.16
Crude as this estimate is, it shows that on the average public investment pays a lower rate of return per dollar invested than private investment. Nor is there anything strange about this result. The investment in
private wealth by its very nature involves considerably more risk than
the ownership of Federal securities. One should therefore expect that
private investment should offer a higher rate of return. But as far as the
present discussion is concerned, public investment will result in a smaller
concentration of wealth and income than private investment does.
Source of Property Income. Finally, we should discuss the source of
property income derived from private wealth or from the ownership of
Government bonds; in other words, we want to inquire as to who pays
the property income.
This statement of the problem sounds rather unusual, because we do
not ordinarily think of property income in this manner. An exception is
almost always made, however, for that part of property income which is
derived from Government bonds. Here it is recognized that the income
is taken away from the taxpayers and given to the bondholders. The
This is a very rough approximation. Estimates of national wealth are quite unreliable
not only due to statistical difficulties, but also because of the vagueness of the concept itself.
The figures given in the text are based on estimates made by the National Industrial Conference Board for the period 1922-38 and published in the Conference Board Studies in Enterprise and Social Progress (1939), p. 60, and in the Economic Almanac, 1944-45, P- 64- To obtain
the figures for private wealth from which a return can be derived, real property and improvements exempt from taxation, which belong to Federal, State and local governments and to
non-profit organizations, as well as stocks of goods in the hands of consumers, were deducted
from the totals. Several other items might have been excluded, but they were not sufficiently
large to affect the results.
The estimates for the periods 1919-21 and 1939-41 were based on those for the years 1922
and 1938 adjusted for net private capital formation which took place prior to 1922 and after
1937 respectively. The figures for this capital formation were obtained from Mary S. Painter
"Estimates of Gross National Product, 1919-28," Federal Reserve Bulletin, September 1945,
pp. 872-73; Solomon Fabricant, Capital Consumption and Adjustment (1938), pp. 147 and 160
and the Survey of Current Business, May 1942, April 1944, and February 1945. While this
method brought some inconsistency into the data, the whole procedure is so rough that a
difference of a few billions would be of hardly any significance. The actual ratio of national
income to private wealth obtained was 27 per cent.
It must again be emphasized that the results should not be interpreted as an exact measurement of the return from private investment. That task would require such serious adjustments of the original data (to account for capital gains and losses, for instance) as to be
entirely beyond the scope of this paper. I do not think, however, that these adjustments
would change the estimates to such an extent as to reverse the basic conclusions reached in
the text.



idea that a domestically held debt is not a burden because "we owe it
to ourselves" has been vigorously objected to. The transfer of income
from taxpayers to bondholders is usually looked upon as a kind of an
"evil" which should always be minimized. As a matter of fact, the main
part of this paper was devoted to showing that, with growing national
income, this "evil" will not be large. Actually, there is little difference,
from this point of view, between income receipts from the public debt
and income derived from the ownership of private wealth. 17
In one sense, both private property income and interest on Government bonds, as well as wages, salaries, and all other forms of income,
represent a cost of production—the cost of achieving a given level of
national income or output. In another and more hypothetical sense, all
these elements of income are "burdens": if the same level of total national
income could somehow be achieved without the payment of a part of it
to bondholders, or to wage-earners, or to private property owners, more
would be left for the rest of the community. Which of these two approaches is taken depends on one's views. I t appears to me that under
our institutional conditions it is necessary to pay all these elements of
income, though not invariably in the same proportions, in order to produce the required volume of goods and services. Very often, however,
one hears an argument, stated or implied, that the recipients of all forms
of income, with the exception of that from Government bonds, perform
some productive services, while the owners of Government bonds somehow manage to get paid for doing nothing. I t is further explained that
owners of private assets take risks and that their return depends on the
success of their enterprises; owners of the public debt, on the other hand,
take no, or very little, risk and are paid a fixed return. 18
As was shown on pages 65-66, holders of public debt receive a much
smaller average return than private property owners. If this return is
regarded as too high compared with the services rendered by them, this
may be a good argument for reducing it, or even abolishing it altogether
if, under our institutional conditions, the Government finds it both feasible and desirable to obtain funds interest free. But today this is not the
case, and so long as the Government has to pay interest on borrowed
funds, there is no reason to place this kind of income in a special "un17

The question whether the payment of interest on the debt creates more or less friction
than the transfer of private property income is net discussed here.
See for instance B. U. Ratchford, "The Burden of a Domestic Debt," American Economic
Review, September 1942, pp. 451-67.



productive'' class, and to treat it as a "burden," while voicing no objections to other forms of property income. One is just as much a "cost"
or a "burden" as the other.
Let us return to the source of property income. Private property income comes from proceeds from the sale of goods and services in the
market. These proceeds are paid out to factors of production in the form
of wages and salaries on the one hand, and various kinds of private
property income on the other. The magnitude of property income relative to the total depends on the amount of capital used relative to labor,
on the intensity of competition, and other factors. There do not appear
to be any a priori grounds for thinking that the goods and services
purchased by the lower income groups generate proportionally more or
less property income than those sold to the upper income groups. So in
the absence of evidence to the contrary, we can think of private property
income as being generated by a sort of cost or tax borne by everyone in
rough proportion to his expenditures.
The origin of the property income derived from Government bonds
depends on the kind of taxes imposed for servicing the debt. If the debt
is serviced by means of a sales tax, there will be little difference between
the sources of the two kinds of property income. But if, as is more likely
to be the case, the debt is serviced by means of a progressive income tax,
then the interest charges on the public debt will fall less heavily on the
lower income groups and more heavily on the upper income groups than
would be the case with private property income. From a point of view
of achieving a more nearly equal distribution of income and wealth, this
attribute of public investment represents a considerable advantage.
I t is hoped that this paper has shown that:
1. With a growing national income, the ratio of the public debt to
income will remain relatively small.
2. Similarly, the ratio of interest charges to income will be within
manageable limits.
3. Public investment is likely to result in less concentration of income
and wealth than private investment would because:
(a) The Government pays a smaller rate of return per dollar
(b) The Government obtains a large share of its revenue by
means of progressive income taxes.




Division of Research and Statistics, Board of Governors
The primary objective of postwar management of the public debt
must be economic stability, but this in turn, if it is to be achieved, requires monetary stability. The wartime expansion of the Federal debt
has already caused a vast increase in money holdings and has weakened
the resistance of the economy to further monetary expansion. If large
postwar demands for capital outlays and deferred consumption should
create the initial conditions of inflation, the money supply, already large,
could under present conditions expand further and so prevent the realization of even approximate monetary stability.
There are indeed other objectives of debt management than monetary
stability. The budgetary problems of the Federal Government would be
simplified by a low debt service charge. Other considerations permitting,
it would be desirable to avoid instability in the market value of Government securities. The large debt should not be permitted to create a new or
expanded rentier class. But all of these objectives are subsidiary; if conflicts between objectives should emerge, they must be resolved in favor
of monetary stability.
Discussion of the effect of the national debt and its management on
monetary stability is focused on the long-range possibility of inflation,
not because inflation is more likely than deflation, but because it is the
powers of the credit authorities to resist further credit expansion that
have been impaired by the wartime increase in the Federal debt. Unavoidable inertia toward modifying the debt structure and the overhang
of contractual rights and obligations probably means that the structure
of the debt cannot be modified quickly enough to meet transitional postwar inflation should it develop. The wartime tax structure and such direct
controls as are still in effect are much more suitable weapons for that
purpose. For the longer term, however, these instruments will be much
less potent and unless the problems of debt management are met, the
possibility of unwarranted monetary expansion will persist.




If a general inflationary problem in the postwar should arise from a
steady excess of business and consumer capital expenditures over savings,
the appropriate offset would be a budget surplus which would be used to
retire public debt held in the banking system and therefore to limit the
growth or possibly even contract the volume of deposits and currency.
But if inflationary developments should come rapidly, the retirement of
debt with budgetary surpluses would be too slow to be an effective control. The direct controls which have been instrumental in preventing
excessive use of monetary holdings during the war could not and should
not be revived at such a time. It is to prepare for the contingency of
marked inflation in the absence of direct controls that there is advanced
at the end of this paper a series of suggestions for stabilizing Government
security ownership and revitalizing the quantitative credit controls.
The wartime expansion of the Federal debt has been responsible for a
very large growth in currency and deposits. Great efforts have been made
in the War Loan drives and through pay-roll deduction plans to sell securities to individuals and corporations and other nonbank buyers. But
what could not be sold this way had to be sold to the banks. Either
directly or indirectly new funds so created passed into the hands of
private owners and were held as demand deposits, savings accounts, or
currency. In a very broad sense, the proportion of the Federal debt sold
to the banking system is an index of the proportion of wartime savings
in money form. The distribution of Federal security ownership and of
its wartime increase is shown in the accompanying table.
Almost half of the United States Government securities held outside
of the Federal Government are owned by the banking system and about
the same proportion of the increase in net Federal debt since the end of
1939 was absorbed by the banking system. A little over one-quarter of
the increase has been taken by individuals and about one-seventh by
corporations (excluding banks and insurance companies). Insurance
companies and mutual savings banks have accounted for about one-ninth.
Some expansion of deposits and currency would, of course, have been
appropriate to the wartime growth of production and income. Expanded
production and income call for larger working balances. Even a more
than proportionate growth in cash balances is justified. In the first place
the uncertainties of war are legitimate grounds for larger precautionary



balances. Furthermore, in the case of business concerns the inability to
make capital expenditures as great as depreciation allowances and other
business reserves has tended to build up cash balances.

Holders of debt

Total Federal debt outstanding..
Held by U. S. Government
agencies and trust funds
Held outside Federal Government
Commercial and Federal Reserve Banks
Insurance companies and mutual savings banks. .

Percentage distribution
of debt held
outside Government

Dec. 31,
(In billions
of dollars)

Sept. 30,
(In billions
of dollars)

















Sept. 30,

Dec. 31,
1939 to Sept.
30, 1945

SOURCE.—Published regularly in the Treasury Bulletin; corporation includes "other associations," dealers'
brokers, and foreigners. Individuals include unincorporated business. The "other" category consists mainly of State
and local governments.

But the creation of new money has very substantially exceeded the
growth of production and national income and some further expansion
seems unavoidable. The present (late-1945) levels of demand deposits
and currency are more than three and one-half times prewar levels, and
total liquid assets have grown by the same proportion. Over the same
period, gross national product at current prices and income payments to
individuals have both expanded about two and one-half times, as is shown
in the accompanying table.
In the postwar period, presumably, the need for idle or precautionary
balances will not be as great as it is now, since gross national product
and income payments presumably will recede moderately from wartime
levels even if full employment is maintained. In other words, present
money levels are probably adequate, possibly excessive, for a number of



(1935-1939 = 100)



Total liquid
assets of









1945 (Est.)






(June dates for
liquid assets,
deposits, and

. .

years to come. The problem then is that of so managing the public debt
that it does not lead to further monetary expansion.
Without further growth, the public debt could be the basis for considerable further expansion of the money supply. The selling of Government securities held outside the banking system to banks (including redemption of nonmarketable issues) and a growth of private indebtedness
to banks would occasion such expansion. And banks would be able to
expand credit in these circumstances because they have virtually uncurbed
access to reserve funds.
Easy Access of Banks to Reserves. A necessary condition for bank
credit expansion is the access of banks to additional reserves. With the
present large volume of short-term Federal debt owned by the banks, it
is extremely difficult, if not impossible, for credit authorities to use
quantitative measures of monetary control to limit the access of banks
to additional reserve funds. If banks seek to replenish their reserves by
selling Government securities or by letting them mature without replacement, the banking system as a whole will secure an increase in reserve
holdings, unless either one of two conditions is met. The first condition
would be the existence in the Federal Treasury of adequate budget surpluses to retire debt equivalent in amount to the reduction of bank
holdings. The second condition would be the presence of nonbank buyers



for an amount equivalent to the reduction in bank holdings. But bank
holdings, particularly of short-term securities, are so large that the
amounts sold by the banking system could exceed any conceivable budget
surplus. And the discipline of market price decline and capital loss is not
very effective because banks can depend on maturing issues to supply
any conceivable need for reserve funds. At present, commercial banks
have more than 25 billion dollars of securities maturing within one year.
Furthermore, in a period of emerging inflation it is not likely that nonbank buyers would appear in sufficient numbers, even with a considerable rise in interest rates. Consequently, net sales of securities by the
commercial banking system would probably mean net purchases of securities by the Federal Reserve System and therefore an expansion of
member bank reserve balances.
With reserves freely available about the only limitations on credit expansion by the banks would be either that demand was lacking or that
the banks were reluctant to expand credit because of a shrinking ratio
of capital to deposits. Even though the reliance of corporations upon
bank credit has shown a secular tendency to decline, a private demand
for bank credit could emerge under inflationary circumstances. We have
no experience which would warrant reliance upon decreasing capitaldeposit ratios to limit bank lending. Without an effective control of the
access of banks to reserves, further credit inflation would be possible.
Insecure Ownership of Government Securities. Further monetary expansion could occur if nonbank holders of short-term or redeemable
issues were to show a general disposition to convert their holdings into
cash. This would force the Government into further financing through
the banks. If there is reasonable economic stability, this threat may not
materialize; but inflation would change the picture. Fixed dollar obligations are not attractive when the price level is rising. And, if a price
decline in Government securities or difficulties in refunding were given
much publicity, the holders of savings bonds might redeem them in large
volume, even though these holders were not directly affected by the fall
in price of marketable securities.
Critical Matter Is Not Interest Rates Alone. The critical issue is not
solely or even primarily, as it is sometimes argued, whether interest rates
on the public debt should be stabilized or whether there should be flexibility in market rates: the structure of the debt itself—that is, the types
of securities that evidence the debt—is equally important. With the
present debt structure, dominated by short-term marketable debt and



by nonmarketable issues redeemable virtually on demand, neither a
stable nor a flexible interest rate policy will establish the conditions of
monetary stability.
The policy of maintaining stability of interest rates and prices of
Government securities makes virtually the whole public debt equivalent
to money. I t assures individual holders that they can convert their
securities into money without appreciable capital loss. I t would be hazardous to base monetary policy on the rather tenuous hope that this
right would not be used. Banks, particularly, would be left as free agents
since there would be no effective central control of their reserves. By
selling Government securities, they could replenish reserves and finance
private credit expansion.
Although stability of interest rates and bond prices might well impede
monetary stability, it is by no means clear that a policy of permitting
fluctuations in the rates and prices of Government securities would
promote stability as long as the present public debt structure is retained.
To be effective against inflation, higher interest rates would have to result in the conversion of idle or excess monetary balances into holdings of
Government securities or into time deposits. In the long run, the rate of
interest probably has a great deal of influence both on the employment
and holding of money. But in the face of short-run inflationary developments of any real magnitude, a very great increase in interest rates
might be necessary to resist the conversion of Government securities into
deposits. Interest rates of 5 and 6 per cent on Government securities following the last war were not an adequate curb on credit expansion by
banks and did not promote nonbanking absorption of Government
securities to any significant extent. When prices of commodities can increase more than 10 per cent in a year, high interest rates probably do
not have much effect.
Even with advancing rates, banks could afford to use Federal Government securities to replenish reserves. They could probably obtain higher
rates from their customers, for rising interest rates are probably a very
weak impediment to private credit demands. The influence of short-term
interest rates on business decisions may be slight, since in many cases
interest is a small part of business costs. Speculative and expansionary
activities in the past may have been inhibited less by high rates than by
the underlying scarcity of funds.
Furthermore, flexible interest rates and fluctuating Government security prices present an obstacle to stable ownership of securities. Stable



ownership of Government securities is itself a desirable goal because it
minimizes the chances of concentrated periods of sale and redemption
which lead to periods of concentration in expenditures. Some holders are
no doubt attracted by the very fact of stability and would hesitate to
hold any investment, no matter what the yield, if it were not
"dependable." One practical problem is that banks often seem to be very
sensitive to Government security prices, probably because of their capital
position. Changes in the level of interest rates and therefore security
prices in the past have sometimes led to concentrated and panicky selling
of securities by banks. Offerings have sometimes come to the market so
precipitously that buyers could not be found without rapid and unnecessarily large markdowns in prices. In other words, once a change in prices
is set in motion it may tend to go a considerable distance without finding
an automatic corrective in the mechanisms of the market. And Federal
Reserve buying in such circumstances, though "for the purpose of maintaining an orderly market," expands reserves and creates the potential
of credit expansion.
I t is sometimes maintained that there is a compromise policy that can
be pursued even with the existing debt structure—a policy of maintaining
"reasonable" stability in the long-term interest rate while permitting
rather larger fluctuations in short-term interest rates. No appraisal of
this compromise policy can be made without more exact definition of
what is meant by "reasonable" stability in long-term yields. If this sort
of stability means relatively narrow price fluctuation with a guarantee
for a long period in the future, it is doubtful whether many shortterm securities could be sold except at yields very close to the long-term
rates. Why should investors hold short-term securities and accept an
appreciably lower return if the long-term rate is held within fairly
narrow margins? On the other hand, would the Treasury go to the
short-term market if rates there were above the long-term rate? And
in the absence of Treasury demand, and with prospective stability of
the long-term rate, could a short-term rate higher than the long-term
rate prevail?
Existence of fluctuation in the short-term rate requires that the longterm rate also move within margins wide enough to produce appreciable
capital losses or gains and to endow longer term investment with enough
risk to deter some investors. But, expanded to this range, the policy becomes essentially one of fully flexible interest rates and, as such, is subject to the limitations discussed above.



The first part of this essay has been devoted mainly to diagnosis of the
shortcomings of the present debt structure for purposes of monetary control. The remainder will be devoted to prescription. Before undertaking to
make concrete suggestions for changing the debt structure it is necessary
to recollect a variety of practical considerations that must weigh in any
public debt planning. Some of these considerations are more political
than economic. The leading ones are:
(1) Planning for financing the public debt must be done as a whole
since special limitations or restrictions in one sector of the Government
security market have immediate repercussions in all other sectors. In
other words, such proposals as are later discussed for limitation of bank
ownership carry with them an equally important corollary that dependable markets must be developed in other sectors of the economy.
(2) The kind of new securities issues will have to allow for substantial
changes in the structure of public debt ownership. Nonfinancial corporations, State and local governments, and some other groups cannot be expected to hold large amounts of the public debt indefinitely. Holdings may
be liquidated by these groups at a greater rate than they can be absorbed
by budget surpluses and may therefore have to be absorbed by individuals
or by financial institutions. Public debt plans in the postwar period, therefore, should look toward not only steady but increasing ownership of
Government securities by individuals, insurance companies, and savings
(3) Other factors being equal, the interest cost of carrying the Federal
debt should be as low as possible. Practical budgetary considerations argue
for low cost. Also, as explained in another paper in this pamphlet, interest
payments on the Federal debt probably support consumption less than
othej types of Government expenditures. 1
(4) The sentiment to require price stability for all marketable Government securities must be recognized. The fact that Liberty Bonds declined
to the low 80's following the last war is still pointed to as a breach of
faith by the Government. I t is not clear that a politically sensitive administration could afford to permit much price fluctuation in marketable
(5) The credit authorities should have freedom of action to deal with
either inflationary or deflationary circumstances. The proper preparation

Henry C. Wallich, "Public Debt and Income Flow," pp. 84-100.



of the credit authorities is to secure a strategic position that will permit
tactical operations against whichever kind of condition emerges.
The changes in the public debt structure proposed in this essay have
been framed with the idea of establishing the minimum prerequisites for
effective monetary control while meeting the other objectives of debt
management as far as possible, i.e., permitting the changes in public
debt ownership that are needed to facilitate business financing, avoiding
wide fluctuations in Government security prices, and minimizing the cost
of the public debt. The greatest change would concern bank ownership
of Government securities.
The burden of proof must be on any proposal for change in the structure of the public debt. Change is itself unsettling. I t may foster irrational doubts and create unsettled markets. Change must not only offer
real advantages but the advantages must be clearly evident. The fact
that nonmarketable issues sold so far are redeemable practically on demand and the fact that prices of nonmarketable issues have been stabilized have vested holders with rights that are hard to withdraw or negate.
Without compulsion the only way to do this is to offer holders even
more attractive rights in other forms.
In the proposals that follow, the only economic interests that might
appear to suffer any loss of rights are the commercial banks. But if the
case is considered broadly they also will gain by the change. Banks stand
to lose from monetary instability as much as any group. Moreover, settlement of the vexing problem of public debt financing opens up the prospect
for a flexible interest rate policy with respect to private bank loans and
investments. To the extent this meant higher interest rates, banks might
profit greatly from the change. Without some modification of the present
financing arrangements, interest rates would possibly not be allowed to
rise, and hence the whole awkward paraphernalia of restricted issues and
similar devices would be retained and even extended in the effort to keep
banks from profiting unreasonably from holding Government securities.
Public Debt in the Banking System. Stabilization of interest rates on
Government securities reduces the effectiveness of credit control. Ownership of a large volume of short-term Government securities by banks,
even without interest rate stabilization, has almost the same effect since
banks can secure additional reserve funds and with them take an active,
even an aggressive, role in expanding deposits. Any plan to put bank



reserves under control must in some way subject bank ownership of
Government securities to direct control. The banking system must earn
its living and justify its existence by supplying credit for business and
consumption, not by relying upon its ability to monetize the public debt.
The exact means for accomplishing this end cannot be specified without
a great deal of further study. To be fair to the banks the device adopted
should allow for substantial differences among banks in present holdings
of Government securities and should permit legitimate private demand
for credit to be met. Some of the possible devices that have been suggested are as follows:
(1) Require banks to invest an amount equal to some proportion of
demand deposits in a special nonmarketable Government security redeemable only to meet deposit losses.
(2) Require banks to hold an amount of a special nonmarketable
Government security equal to increases in demand deposits after some
base date such as December 31, 1939. A variant of this device would be
to "freeze" holdings as of some recent base date but to permit each bank
to vary its holdings as it lost or gained deposits.
(3) Raise reserve requirements on demand deposits (and extend requirements to all commercial banks) but pay interest on reserve balances.
Banks would meet these requirements by selling marketable Government securities to the Federal Reserve Banks. This would be akin to
the 100 per cent reserve proposal.
This proposal is not made for the purpose of limiting bank earnings.
The question is rather one of equity and it should be resolved by deciding
which social group should bear the costs of operating the money system.
For credit control purposes, the earnings permitted on bank holdings of
Government securities might well be generous, though probably below
the levels paid other holders of Government securities.
This much interference with the "rights" of private commercial banks
cannot verjr well be avoided. In modern economic systems, the supply
of money must be subject to Government regulation, if monetary instability is to be avoided. Because money has come to consist predominantly of the demand deposit obligations of commercial banks, these
institutions—though privately owned—are unavoidably in the public
sector; they must be subject to public regulation to a degree that is true
of no other part of the business community.
One special reservation must be made for the commercial banks. The
savings institutions should be permitted to carry Government obliga-



tions with an interest return at least as high as the present one- Since
commercial banks also transact a large volume of savings business, they
should have equal rights to participate in such types of investment to
the extent that they hold savings deposits. Thus far, commercial banks
with time deposits have not had access to as liberal supplies of long-term
Government securities as pure savings banks have had.
Other Holders of Government Securities. If bank holdings of Government securities are to be restricted to special issues, it is equally important
that adequate provision should be made for marketing the remainder of
the debt. The ideal circumstance to be sought is one in which there would
be such a steady and active demand that the new money and refunding
needs of the Treasury could be fully met by the market outside the banking system at all times. I t means that the securities offered should be
made attractive and convenient for the class of holders for which ownership can be expected and should be encouraged.
I t would probably be unwise to apply measures of compulsion to the
holding of Government securities except in the case of commercial banks.
The measures proposed, therefore, are more by way of added inducements, intended to increase the stability of ownership. So far as possible,
these inducements should not increase the service cost of the public debt.
While the primary objective in the treatment of nonbanking investors
is to secure stability of ownership, other worthwhile ends can be served.
To the extent that business concerns own Government securities, they
are a source of funds for financing capital outlays that should not be
closed off. For institutional investors such as insurance companies and
savings banks, these securities offer relatively liquid reserves that permit
the companies more freedom in the management of other assets. For
individuals the securities offer a savings vehicle and a supplement to
social and personal security that should help to encourage more adequate
consumption from current income. Planning of debt ownership for individuals should offer incentives for steady and well-maintained consumption while at the same time penalizing excessive concentration of consumption expenditures at irregular intervals of time.
Because the circumstances of ownership vary for the important holder
groups—corporations, insurance companies and savings banks, and individuals—the plan of offering for each group is set forth separately.
In the long run, it is doubtful whether corporations should be expected
to continue to be substantial holders of Government securities. Business
corporations are normally net demanders of capital, not suppliers. Re-



duction of the great tax liabilities incurred during the war period together
with postwar capital expenditures should tend to reduce corporate ownership. No doubt a small residual amount will continue indefinitely. Government issues intended for purchase by corporations are now dominated
by certificates of indebtedness and tax savings notes and might very
well be left pretty much in their present form.
Ownership of Government securities by insurance companies and savings
banks tends to be stable and there might be relatively little advantage in
refunding the sort of obligation they now hold. For ordinary purposes, a
stable market could probably be assured for outstanding issues by adjustment of the Government's trust accounts whose holdings are now
largely in the form of special issues. Except in periods of depression these
trust accounts will continue to be absorbers of Government securities.
Buying and selling for these trust accounts, perhaps through the agency
of the Federal Reserve open market account, could be used to stabilize
the market for securities now held by insurance companies and savings
I t may be reasonably expected after the aggregate debt has stopped
growing that some important groups of holders of Government securities, such as nonfinancial corporations and State and local governments,
will tend to draw on their cash and Government security holdings. I t is
doubtful if budget surpluses sufficient to absorb this net selling can
reasonably be expected for some time after the war. For this reason
plans should be made so that individuals will continue to absorb more of
the public debt, in order to keep this part of the debt from gravitating
into the banking system and creating more deposits and currency. Of
course, some individuals will be sellers but for the group as a whole
continued absorption must be planned. Although to prevent inflation it
would be desirable to assure adequate savings by individuals, in order
to prevent deflation the savings incentives should not be set too high.
The following proposals, therefore, attempt to provide assurance of normally stable holding by individuals together with some incentives for
further acquisition, but they also have various features providing longrun encouragement to stable consumption. The proposals look toward
conversion of present holdings and shaping of new offerings in three
general forms:
(1) The Treasury could offer to sell unemployment insurance which
would be in addition to (and in no case restrictive of) unemployment
compensation provided under the social security provisions of the



Federal Government and the States. This insurance could be administered through existing channels. Purchasers could be permitted to exchange present holdings of savings bonds for the insurance or to pay for
it out of future savings. The exchange offer could be held open for a
fixed period only and the sales offering of insurance for new savings
could be made only when there was need for encouraging savings.
Government receipts and expenditures under this plan would have a
stabilizing effect on the economy. If reasonably full employment prevailed,
public debt would be retired; if unemployment increased, the payment
of insurance benefits would encourage consumption. Both actions would
come at the right time to smooth fluctuations in economic activity.
(2) The Treasury could offer life and beneficiary annuities in exchange
for present holdings of savings bonds and, in periods when additional
savings are needed, through special offerings for cash. Cash offerings
could be made through the insurance companies if Government competition in the insurance field were feared. This sort of arrangement serves
the purpose of promoting stability in ownership while ultimately tending
to encourage stable consumption.
(3) The Treasury could offer stable purchasing power bonds in exchange
for any Government security held by an individual. New offerings could
also be made in this form. Since stability of real values is unavoidably jeopardized by the after effects of war finance, this sort of offering is equitable.
Stable purchasing power bonds could and probably should be nonmarketable in form and if so should be redeemable only with some penalty. A sliding scale of interest rates such as now applies to savings bonds
might be utilized. This plan would be aimed mainly at investors for
whom maintenance of purchasing power is important. I t is possible, of
course, that the stable purchasing power provision might also be made
on each of the other two types of offerings outlined above.
Even with the considerable attractiveness of these offers, all of the
outstanding issues held by individuals would not be converted. Those
not converted but not redeemed or marketed need cause no concern.
The money raised by the new plans might be sufficient to absorb issues
redeemed for cash before maturity. Market operations for the Treasury
trust funds might be used to take up any remaining slack.
If the public debt should be refunded largely into nonmarketable obligations as these proposals contemplate, the Reserve System would no



longer effect its credit policy mainly through open-market operations.
Credit policy would then be a direct function of debt management (which
it is indirectly, in any event). When expansion was desired, an additional
supply of the special bank securities could be made available to the banking system. When monetary contraction was in order, the special issues
held by banks could be retired and replaced by issues sold to nonbanking
holders. Under some circumstances these direct adjustments of money
supply would no doubt have to be coordinated with or used to offset
open-market transactions by the Federal Reserve System for other
purposes. The result would be firmer control than now exists. When
open-market operations are used to influence the price of Government
securities as well as to adjust the volume of reserve funds, it is not always
possible to reconcile precisely these two objectives. If prices on Government securities were no longer at stake, credit operations could either
tighten or relax the money market much more precisely. By removing
Government securities from the market, it would make possible the revival of credit policies which would vary the cost and availability of
funds to private borrowers.
With credit policy effected mainly through direct adjustment of the
Government securities held by the banking system, it would be possible
to coordinate credit and monetary policy, on the one hand, and general
requirements of fiscal policy on the other. When inflationary factors
predominated, appropriate fiscal policy would presumably result in budget
surpluses. These surpluses could be used to reduce bank holdings of
Government securities, which would reduce the money supply or at least
curb its growth. Conversely, in periods in which depression elements
predominated and in which fiscal policies resulted in deficits, the added
debt could be channeled mainly into monetary expansion, if such were
thought to be useful.
The proposals made so far have been intended mainly to meet the possibilities of inflation. Would they weaken the power of the monetary
authorities to cope with deflation? If deflationary circumstances arose,
the system of nonmarketable Government issues would still permit the
easing of bank reserves even if the aggregate of public debt were not
increasing. But if public deficits should accompany these developments,
as they probably would, the direct control of bank holdings of Government securities would furnish a vehicle for monetary expansion. New



reserves and new earning assets resulting from the increased debt could
be channeled into the banking system. The effectiveness of monetary
expansion in such circumstances is not the issue; the point is that the
credit authorities would have as effective powers to combat deflation as
they have with the present public debt structure.

H E N R Y C.


Research Department, Federal Reserve Bank of New York
For the first time in our history we are faced with a national debt so
large that, in all probability, we cannot count on being able to pay it
off within any foreseeable period of time. Like it or not, the debt will be
with us for a long while, and its magnitude is bound to make it an important factor in our economic life.
The effects of the debt upon the size and distribution of national income, with which this study will be concerned, are of several kinds. One
of them is the slowing up of the income stream which is likely to result
from the payment, from tax receipts, of large amounts of interest to debt
holders who may respend only a small fraction of it. In the first section
of this study an attempt will be made to measure this quantitative effect
within rough limits. More important perhaps, though not quantitatively
measurable, are certain changes in the psychological attitude of investors
and consumers which may result from the increased tax burden on one
hand and from the increase in holdings of Government securities and
cash balances on the other. These will be taken up later on. Various other
aspects, such as the unstabilizing influence of the debt under inflationary
conditions, its restrictive effect upon the freedom of monetary policy,
and certain problems raised by a further growth in the debt, are dealt
with in other parts of this pamphlet.
An existing public debt, as later pages will show, is not exclusively a
factor making for contraction of the economy. In some of its aspects,
particularly because of the increasing liquidity and financial security
which it gives to investors, it probably will prove to have stimulating
effects upon new investment and consumption. In an extreme case, this
stimulus may degenerate into dangerous inflation. Taken all in all, however, it is probably true that the large postwar debt will constitute a
burden for the economy.
I t is very important to note, however, that many of the effects flowing
from the debt are not attributable specifically to its public character but
would in some measure be produced also by the private creation of a




large volume of liquid and income yielding assets. If after 1929, instead
of running into the depression and subsequently the war, we had continued to enjoy a steadily expanding national income, supported by high
private investment and continued credit expansion, we might by now be
approaching an aggregate level of private debt, equity holdings, and
money supply comparable to what we are facing in the form and as a
result of the public debt. In consequence, we would be facing many of
the same problems, although perhaps in less serious forms. Basically,
therefore, the problems which we tend to blame on our large public debt
are those of a high income and high savings economy.

Interest paid on the Federal debt flows into three channels: (1) part
returns to the Government in the form of taxes; (2) part goes into cash
savings or such financial investments as do not add to the demand for
goods and services; (3) the rest goes into the income stream through expenditures for consumption or physical investment. An attempt has been
made to estimate the amount in each category as of December 31, 1944,
and to forecast it for the first approximately "normal" year after the war.
The results are shown in the table on the following page.
The postwar estimates in the table assume a Federal debt of 310
billion dollars at the close of 1947. This estimate should be adequate if
annual Government expenditures taper off toward a 30 billion dollar
level by that time. The composition and distribution of the debt after
the war is estimated on the basis of recent trends in Federal financing,
and attempts to take account, in some measure, of the shifts in ownership which are likely to occur during the reconversion period. The estimated interest on a 310 billion dollar debt of this composition amounts
to 5.7 billion dollars, of which one billion might be recouped by taxes
under the postwar rate structure assumed. 1 Of the remainder, 2.9 billion
might conceivably go into idle savings, leaving only 1.8 billion to go
back into the income stream. 2
For details of the assumed rate structure, see Richard A. Musgrave, "Federal Tax Reform," pp. 49-51 of this pamphlet.
The term "idle savings," in the sense here used, includes security purchases and other
forms of financial investment which merely lead to shifts of assets from one holder to another
and do not give rise to new physical investment. It is understood, of course, that these savings may indirectly be absorbed into new physical investment if some third party decides to
undertake such investment; but it is doubtful that the mere availability of these savings will
induce others to make physical investments which they would otherwise not have made. To
the extent that they fail to do so, the savings constitute a leakage.



of Government
Recipient of interest

of dollars)

of dollars)

Disposition of interest payments
(In millions of dollars)


Taxes 1


19443 19484 19445 19486 1944 1948 1944 1948 1944 1948
Commercial banks
Federal Reserve Banks
Individuals: 7
Savings bonds, Series E . . .
All other Government
Insurance companies...
Mutual savings banks

77.8 107.0 1,300 1,700
135 175
18.8 32.0





























770 1,000 2,250 2,900



1 19.6 28.0

! 27.7
State and local governments..
U. S. agencies and trust funds 1 21.7


230.4 310.0 3,850 5,700



Including taxes paid by individuals on dividends and interest received from institutional holders to the extent
that these dividends and interest may be regarded as derived from the institutions' income from Government security holdings. Both direct and indirect income from Government securities are treated as marginal income except
in the case of interest received by commercial banks.
Including amounts saved by individuals out of dividends and interest described in note (1) above. All income
except that of commercial banks is treated as marginal income.
As of December 31.
As of January 1.
Annual amounts for the year ending Dec. 31, 1944, on the debt outstanding as of that date, except interest on
Series E bonds, for which the accrual of redemption values during the calendar year 1944 is given.
Annual amounts for the year 1948 on the debt outstanding at the beginning of the year.
7 Including partnerships, personal trust accounts, and unincorporated business.
Including dealers and brokers, and foreign balances in this country.
Amount negligible.

Slowing Down of Income Stream. On the basis of the data in the table,
it is possible to estimate very roughly the degree to which the postwar debt
service is likely to slow down the income stream. Since as much as one
billion of the estimated interest charge of 5.7 billion dollars is likely to
be recouped under assumed postwar tax rates, the remaining 4.7 billion
must be financed (if not by loans) by taxes paid out of income from
sources other than Government bonds. These 4.7 billion dollars are the
"gross leakage" from the income stream occasioned by interest service



on the Federal debt. From this must be deducted, however, the approximately 1.8 billion which receivers of interest on the Federal debt are expected to put back into the income stream. The leakage is thus reduced
to 2.9 billion, the estimated amount of idle savings out of interest on
Government bonds. Almost 0.5 billion of this leakage is due to interest
accruing on E bonds, which is neither currently paid to nor spent by
the holders. Given certain arrangements (of which more will be said
later), the Treasury, for the time being, can avoid levying taxes to meet
these accruals, since the funds are not currently needed. The amount
which the Treasury would have to collect to finance the debt service
would thereby be reduced from 4.7 to about 4.2 billion dollars and the
leakage would be cut to about 2.4 billion. A further deduction must be
made in view of the fact that a good part of taxes is paid out of money
that would otherwise be saved. I t has been estimated that, for the postwar revenue structure, about one-third of total taxes paid may come out of
idle savings, assuming that individual income taxes make up a substantial
part of total revenues. 3 We may assume, therefore, that in raising about
4.2 billion dollars through general taxation, i.e. taxes on income other
than from Government interest, the Treasury would be taxing away at
least 1.5 billion of money that would otherwise be saved. This part of
taxes, therefore, merely absorbs an already existing leakage, and may be
deducted from the 2.4 billion leakage arrived at above. There remains a
net loss from the income stream of slightly over 0.9 billion dollars. 4 The
computation is summarized below:
of dollars

Total interest charge
Recouped by taxes upon interest income
Net interest charge (gross leakage)
Deduct—Interest respent by recipients
Non-collection of taxes to cover interest on
E bonds
Idle savings taxed away out of income other
than from interest
Net leakage.

. . . .4.7


See p. 28 of this pamphlet.
The loss from the income stream as here estimated does not take into account the adverse
effects which additional taxation may have upon investment. This aspect will be taken up



A net leakage from the income stream of less than one billion dollars
as a result of a Federal debt service of 5.7 billion would be gratifyingly
small, and would seem to suggest that the adverse effects of interest payment on the level of private expenditures, though undoubtedly requiring
attention, could be handled without too much difficulty. The problems
created by the debt in this direction do not appear to be serious.
In appraising the tax and idle savings estimates, it must be borne in
mind that interest income (except that of commercial banks) is treated
here as marginal income. The tax estimate is based, therefore, not on
the average rate applying to the taxpayer, but on the rate applying to
each taxpayer's top bracket. Similarly the savings estimate is based, not
on the percentage of total income saved by each income receiver, but on
the percentage saved of the marginal income represented by interest receipts. These procedures are logical, since to evaluate the effect of the
debt a comparison must be made with a hypothetical situation in which
there is no debt (or at least no interest charge) and in which individual
and corporate income is lower by the amount of interest otherwise received from the Government.
The savings estimate is necessarily somewhat problematical, because
of our rather limited statistical knowledge of the subject and also because
of other and more fundamental reasons. Briefly put, these reasons have
to do with our inability to visualize just what level of income, savings,
distribution of assets, and other conditions would prevail if there were
no public debt and hence no saving out of the interest thereon. I t might
well be that at least part of the savings now made out of this interest
would still be made in the absence of the debt, due to a different distribution and quantity of private assets. I t cannot be taken for granted,
in other words, that the savings which come out of Government interest
are causally attributable to it.
I t should be remembered that our savings estimate covers only cash
savings and savings employed in financial investment that does not add
to the demand for goods and services. A certain amount of corporate and
individual savings assumed to be directly employed for new physical investment is excluded; this amount is added to interest payments which
are returned to the income stream through private expenditures. The
savings estimate is arrived at, in the case of individuals, on the basis of
budget studies, after estimating the average income bracket to which
holders of each type of security might typically belong. In the case of



corporations it is based on assumptions which appear reasonable, but
the uncertainty here is even greater than in the case of individuals.
I t may be added, however, that we are not so much interested in establishing an absolute leakage estimate as in giving a reasonable upper limit.
The important point is that our assumptions regarding tax shifting and
the impact on savings are in general rather conservative; they tend to
exaggerate the net leakage rather than to minimize it. Even if it were
assumed that the amount to be recouped by taxes upon interest income
and the amount of savings taxed away, where over-estimates might most
easily have occurred, were both 25 per cent too high, the net leakage
would be increased to only 1.4 billion. This figure would still warrant the
conclusion that the slowing down of the income stream caused by the
redistributive effects of the debt service is not a major problem.
Redistribution of Income. So far, we have been concerned with the
effect which taxes and interest payments arising from the increased debt
are likely to have upon national income in the aggregate. We have not
paid close attention to the way in which these taxes and interest payments are likely to affect individuals in particular income brackets. To
do this, it would be necessary to compare the interest receipts of each
income class with the taxes paid by that class for the purpose of debt
A calculation of this sort would require fairly accurate knowledge of
the ownership of the Federal debt by income classes and of the incidence
of the tax burden. The required data are not available. On the basis of
estimates taking into account the probable increase in liquid assets at
various income levels, as well as the volume of securities of lower denominations outstanding, one may assume very roughly that individuals
with incomes below $5,000 will be holding 25-30 billion dollars of Government securities. The great majority of these will be E bonds. If the
latter were held to maturity, yielding 2.9 per cent, an average yield of
perhaps 2.7 per cent might be assumed for all Government securities
owned in these lower brackets. Their holders would then receive in the
neighborhood of 0.75 billion dollars in interest. Against this it may be
estimated that under the assumed postwar tax structure, at a national
income of 140 billions, individuals with incomes up to $5,000 would contribute to the financing of the Federal interest charge something like
2.5-3.0 billion.5 The debt service, therefore, may cost individuals in
* For the assumptions underlying this estimate, see notes to the table on p. 90. For further
qualifications, see pp. 91-92.



these brackets about 2 billion. If substantial redemption of E bonds
occurs within a few years of 1948, the loss to the brackets up to $5,000
will probably be more than this. 6
A somewhat more detailed estimate of the tax load upon individuals
imposed by the debt at assumed postwar rates is given in the table below, which also shows what amount of E bonds the occupants of brackets
up to $10,000 would need in order to offset the tax cost.

before tax 2

$ 1,000

taxes 3



taxes 4

$ 40

Total taxes
paid out of



to debt
service out of
$ 11

E bonds




For details of diis system, see pp. 50-51 of this pamphlet.
Gross income before exemptions; excludes appreciation of savings bonds held.
Exemptions of $2,400 assumed for couple with two dependents. Deductions of 10 per cent from income after
Taxes other than personal income taxes have been accounted for as follows: Excises plus 50 per cent of corporation taxes are distributed in accordance with the average propensity to consume at each income level; the remaining 50 per cent of corporation taxes is distributed in proportion to dividend receipts at each level. A small
allowance has been made for gift and estate taxes.
Assumed to be 28.5 per cent of the individual tax burden, this being the proportion of estimated total tax
revenue (20 billion before pay-roll taxes, at a national income of 140 billions) which will be absorbed by the 5.7
billion dollar debt service. The figures would remain unchanged if a higher but equally distributed tax burden were
At cost price. The amount of E bonds required is calculated to make the income from them equal to the contribution to debt service out of other income plus the added income taxes occasioned by this extra income. An
average yield of 2.9 per cent to maturity is assumed, and it is likewise assumed, for purposes of illustration, that
the holder accrues interest income at that rate on his tax return.

Applying the figures in the table, we find that if an individual with an
annual income of $4,000 before taxes had set out at the beginning of the
war to buy E bonds over the next six years sufficient to make the interest
thereon balance his prospective 1948 tax contribution to the debt, that is,
* I t should be noted that a heavier tax burden than that implied by the assumed postwar
tax system would not affect this calculation, provided the burden is distributed in the same



equal $131, he would have had to save for this purpose about one quarter
of his pre-tax income. For an individual with an income of $8,000, added
savings of about 40 per cent would be required. These are pretty impressive feats of economizing, and probably beyond what the average
individual has been able to achieve in the face of high wartime taxation.
The figures assume, moreover, that the taxpayer is fortunate enough to
have a wife and two further dependents; otherwise, his tax burden would
be correspondingly heavier. 7
The table also shows that a person with an income of $2,000 contributes relatively little to the financing of the debt, and that he could
acquire the appropriate amount of bonds (or other securities of similar
yield) by saving less than 10 per cent of his income for a six-year period.
It may be that a good many people in this class will have protected themselves in this way against the postwar burden of the public debt. The
situation would seem more difficult for those in the $1,000 group. One
cannot rely too firmly upon these data, however, since the estimate of
the tax burden borne by the lower brackets, consisting mainly of excise
taxes, and of one-half of the corporation tax assumed to be shifted, is
necessarily very rough.
Quite generally, moreover, the implications of these estimates must be
regarded with some reservations. In the first place, a taxpayer's direct
holdings of Government obligations do not necessarily indicate the full
extent of his participation in ownership of the public debt. Through demand and savings deposits, insurance policies, or currency holdings, he
may have an indirect participation in, and in some cases an indirect income from, the debt. The increasing complexity of these ramifications
discourages any attempt at tracing them, but their existence must be
acknowledged. 8
In the second place, we are not necessarily justified in assuming, as we
did in estimating the amount which taxpayers contribute to the debt
service, that the debt service takes an equal percentage out of everybody's
tax dollar. In other words, it does not follow that because the debt
service takes 28.5 per cent of tax revenues, 28.5 per cent of everybody's
It is important to distinguish the effects upon individual incomes of an already existing
debt, which are discussed above, from the effects brought about by the creation of the debt.
An individual may have enjoyed a high income and substantial savings as a result of the
Government's debt-financed war expenditures, but may have invested his savings in assets
other than Government bonds. In that case, he will obviously have benefited by the creation
of the debt, although he will not receive any interest from it to offset his increased tax burden.
Holders of demand deposits, for instance, derive a kind of negative income from the
relative absence of service charges which the bank's large debt holdings make possible.



taxes are attributable to the debt. If the debt were refinanced on an
interest-free basis, for instance, it is very unlikely that after the ensuing
congressional wrangle everybody would find his tax burden reduced by
28.5 per cent. Likewise, it is perfectly obvious that the rise in the tax
burden associated with the rise in debt service (and sundry other budget
items) since 1939 has not been proportionately the same for different
income brackets. 9
There is in effect no precise way of stating what portion of a taxpayer's
liability is attributable to the debt service. Moreover, it should be
stressed again that many of the statistics presented in this section are
highly tentative and must be subjected to further investigation before
important policy conclusions can safely be drawn from them.
Tax Effects. The leakage of 0.9 billion dollars arrived at above means
that investment will have to be greater by the same amount than would
otherwise be necessary in order to attain a given level of employment
and income. If the additional investment is not forthcoming, and if the
gap is not filled by Government expenditures, income will be lower by
perhaps twice the leakage, taking into account its secondary effects.
In addition to this rather moderate effect caused by income redistribution, certain other impacts of the additional tax load must be considered. A great deal has been said about the manner in which investment is discouraged by taxation, and most new tax proposals aim at
minimizing this deadening influence, partly through the character and
level of the taxes proposed, partly by permitting more complete offsets
of gains and losses. Granting that our present tax laws are capable of
much improvement, it remains doubtful whether even a perfect system
of loss offsets would completely neutralize the adverse effects of taxation
upon risk taking, wherever the profit motive is dominant. Even though
his investment odds remain unchanged, the more and more heavily
taxed investor finds himself tying up his money for increasingly small,
though not more uncertain, returns. He is therefore driven increasingly
to postpone the commitment of his funds in expectation of a more promising opportunity. Aggregate investment inevitably then must suffer.10
On the other hand, where competitive position and prestige play a
more important role than the profit motive, as may often be true of
corporate and wealthy individual's investments, a high tax rate accom9
It is not suggested, of course, that this would have been a fair distribution; for some
brackets, it would have raised income taxes above 100 per cent.
See above, pp. 32-34.



panied by adequate loss offset provisions may actually stimulate investment beyond what it might be in the absence of taxation. The reduction
in the size of the possible loss in these cases is more important than the
possible profit.
An important point not always sufficiently stressed is the impact of
corporate taxes upon liquidity, particularly of smaller corporations.
Under certain conditions this may so increase the risks as to become a
more potent deterrent to new investment than is the reduction in possible profits.
All these effects are qualitative and not subject even to rough measurements; nevertheless they may be dealt with by appropriate tax policies.
Another possible implication of the debt, which has frequently been discussed, is the discouragement of effort through relatively high rates on
marginal income. If a man receives a fairly substantial part of his income
from interest on Government securities, and if the wages he earns are
cut substantially by the income tax, he may come to prefer a little more
leisure at the expense of a certain sacrifice in earned income. Since at
present debt levels the interest income of the great majority of people is
in fact negligible, the effort-restraining effect of the taxes required by
the debt is probably minor.
Some of the major blocs of security holdings which make up the public
debt exhibit various features worth commenting upon. The items here
singled out for attention are (1) commercial bank holdings, (2) holdings
of individuals, and (3) holdings of insurance companies. Together these
three blocs account for 70 per cent of the estimated postwar Government
debt and for 74 per cent of the interest charge.
Commercial Banks. The most important aspect of the 107 billion dollars of Government securities expected to be held by the commercial
banks in 1948 is the enormous volume of money thus created. If our
estimate proves approximately correct, the volume of demand deposits
and currency may exceed 130 billion, which would represent an increase
of close to 100 billion over 1939. Since national income at an estimated
140 billion would be little more than twice its 1939 level, the money
supply would be running close to 60 billion dollars ahead of the relationship prevailing in 1939. Even in that year the money supply was generally regarded as greatly in excess of business needs; in 1948 the excess
will be enormous.



There is little prospect that anything but a moderate fraction of this
excess can be eliminated. To do this it would be necessary to induce the
banks, by means of credit restriction, to sell part of their holdings to the
public, thus wiping out deposits. Because of their great liquidity, investors
probably would be willing to absorb a certain volume of securities, particularly since the return to more stable conditions may make the holding of large cash reserves less desirable. Nevertheless, it is unlikely that
more than a moderate fraction of the banks' holdings could be disposed
of in this way, unless credit restriction is carried far enough to raise
interest rates very substantially. Such a policy probably would not be
feasible for reasons of debt management as well as on more general
grounds. 11
Barring such measures, the only way to eliminate the excess money
supply will be "to grow into it," a process which, with a constant price
level, would take several decades even if further bank-financed Government deficits are avoided. A money supply in excess of business needs,
however, is not necessarily an unmitigated evil. Its inflationary aspect,
true enough, is a distinct danger, but the thirties have taught us that
high liquidity, while it permits inflation and may accelerate it, does not
by itself produce it, unless other elements, chiefly an excessive volume
of investment, start the ball rolling. In the absence of such factors the
high postwar liquidity is more likely to act as a permanent gentle stimulus to the economy, making it easier to approach full employment I t
will be a powerful factor in keeping interest rates low. If we can control
temporary bursts of excessive investment, the great postwar money
supply may turn out to be a net advantage.
As to the partial leakage from the income stream resulting from large
interest payments to banks, it needs to be pointed out that this particular
leakage is the inevitable consequence of high business activity no matter
whether the boom is brought about by Government spending or private
enterprise. High activity requires a large money supply. If the Government, in recent years, had not supplied this money by its own borrowings
from the banks, business would have found itself short of cash and would
have been compelled to borrow on a large scale. Very probably the degree of credit expansion would have been less than what we shall actually
face, but interest rates on commercial loans are higher than on Government securities, and bank earnings from business borrowing might have
See Roland I. Robinson, "Monetary Aspects of National Debt Policy," pp. 69-83 of this



gone even higher than they are likely to do because of Government
For the banks themselves their high Government portfolios pose a
serious question. With interest receipts on Governments close to 1.7
billion dollars, probably a good deal more than half of their total 1948
income will come from this source. Unlike other war-expanded enterprises, the expansion of their earnings will probably be permanent.
What does this mean for the banks?
In one sense, a period of abnormally high bank earnings might be
desirable, because the ensuing surplus accumulation, probably well over
600 million dollars annually, would help the banks to build up their
depleted capital ratios. This, in turn, would probably increase their willingness to make more venturesome loans and to assume risks which they
would avoid with a weaker capital position. Conceivably, the increase
in productive credit might much more than offset the leakage resulting
from surplus accumulation. This, of course, is a matter about which no
definite predictions can be made.
On the other hand, the banks are becoming increasingly aware that
with more than half of their income derived from the Government they
may find themselves in a precarious political position. Serious thought
has therefore been given to methods of limiting bank earnings, not only
by critics of the banks, but also by their friends, as a means of protection
against political attacks and, incidentally, to reduce the leakage from
the income stream. The income stream problem could, of course, be solved
in part by the payment of higher dividends, but this solution would only
serve to aggravate the political problem. Higher expenses in the form of
a revision of salary scales for lower bank employees would do good in
more than one respect without, however, making great inroads upon the
main problem. A reduction in service charges would help. Expenses could
also be legitimately raised by the payment of higher interest on time
None of these proposals, however, goes to the core of the problem,
which lies in the fact that the banks receive the greater part of their
income from the taxpayer. A moderate reduction in this income could
be brought about if Federal Reserve policy should induce banks to dispose of part of their holdings to the public, but, as said before, not too
much can be expected in this way. To limit bank earnings more effectively
it has been suggested that when corporations in general are relieved from
the excess profits tax, a special tax of this character should be retained



for the banks. Although at the present time a majority of the banks are
barely touching the excess profits bracket, a large number may find
themselves well within it if their Government portfolios continue to expand. A tax along present lines, therefore, would not cut bank earnings
in general below the current level but would prevent them from going a
great deal higher. Rates and exemptions could be adjusted, of course, to
achieve whatever results seem desirable. The main objections to this
proposal seems to be the undestrability, in more than one respect, of
singling out an individual industry for this type of taxation. However,
no such objections exist to excise taxes upon individual industries; an
excise instead of an excess profits tax might therefore be feasible.
Another possibility that has been suggested is the freezing of a certain
volume of very low-interest debt into the banks by means of bond reserve
requirements. 12 To require banks to hold an amount of Government
securities in specified proportion to their deposits would allow the Treasury to cut down bank earnings by exchanging part of the present holdings
against instruments bearing only a nominal interest rate. This would
also help to solve some of the problems of debt management. The main
difficulty would lie in the unequal distribution of public debt holdings
among the banks, which would make it difficult to fix a bond reserve
ratio high enough to achieve its goal without forcing some banks to call
loans. To fix reserve requirements on the basis of existing holdings would
probably be regarded as inequitable. Another and probably more important objection is that the spectacle of one class of holders being deprived of the free disposal of their securities might give the appearance
of tampering with the public credit, something to be avoided at all costs.
Still another way of partly getting the banks off the Government's
pay roll would be to let the Federal Reserve System buy up an appropriate amount of their securities, the interest being turned back to the
Treasury. Alternatively, the same effect could be achieved over a very
short period of years by simply refinancing all maturing issues through
the Federal Reserve. The resulting excess reserves of the member banks
would have to be absorbed by means of higher cash reserve requirements.
The operation, however, would be a tremendous one and, if none of the
other procedures to reduce bank earnings is adopted, might have to be
carried to the point where cash reserves exceeded 50 per cent of demand
and time deposits. A banking system with reserves so obviously exceeding

See, for instance, Lawrence Seltzer, "The Problem of Our Excessive Banking Reserves,"
Journal of the American Statistical Association, March 1940, pp. 24-36.



anything required by liquidity considerations probably would still remain in a politically vulnerable position.
Finally, there exists the possibility of simply restricting the issues available to banks to very low-coupon securities, say Treasury bills, leaving it
to the banks whether they prefer to acquire these as their present portfolios mature or to hold excess reserves. Of course this would resurrect
some of the problems of excess reserves experienced during the thirties.
Ultimately, the problem of excessive bank earnings may perhaps be
solved by the joint application of several of the methods mentioned above.
Intrinsically, the problem is not a pressing one; concern over it arises
mainly from the recognition that their high earnings expose the banks
to political dangers.
Individuals. Government securities other than E bonds accumulated
by individuals, although estimated at 41 billions for 1948, will constitute
only a relatively minor addition to the great volume of securities already
owned by more or less well-to-do individuals and should offer no particular problem. The estimated 33 billions of E bonds, on the other hand,
present a completely new situation: for the first time in their lives a
great many people in the lower income brackets find themselves in the
role of security owners, and the Government in consequence finds itself
in debt to a group of creditors whose future reactions are singularly difficult to foresee. Although the situation offers a variety of interesting
features, attention here will be centered on its income flow aspect.
Present methods of accounting for the interest accruals on these bonds,
an estimated 850 million dollars in 1948, create a discrepancy between
the cash budget and the bookkeeping budget, similar to the familiar discrepancy originating in the building up of the social security trust funds.
The Treasury charges the monthly accruals to interest and must collect
an equivalent amount in taxes if the bookkeeping budget is to be balanced. Since this amount is not paid out to the bondholders—it could be
used to redeem other securities in order to offset the growth in the redemption value of E bonds—the balancing of the bookkeeping budget
would overbalance the cash budget and create a corresponding leakage. 13
If the cash budget is,balanced instead of the bookkeeping budget, the
leakage can be avoided. Eventually, however, the large volume of bonds
sold during the war will mature, and unless business activity at that time
The leakage is reduced by payments of accumulated interest on bonds currently being;
redeemed. This, however, is unlikely to become a complete offset, unless redemption should
turn out to be unexpectedly large.



should be very intense, it is doubtful that the accumulated interest could
be raised out of taxes. Almost inevitably then the interest would have to
be funded along with the refunding of the principal of the bonds. This
means that the interest would be paid with borrowed money.
In the estimate of the total leakage attributable to the debt service,
it is assumed that some such arrangement will be resorted to. It might
be argued that this assumption is illicit, because if the interest on E bonds
can be borrowed, why should not the entire leakage be made to disappear
by borrowing sufficient to finance all interest charges? In practice, however, the assumption made in this paper probably will prove sound. The
character of the E bonds, combined with their war-conditioned maturity
distribution, is such as to leave us very little choice other than to suffer
an income leakage, if we collect the interest gradually, or to borrow the
interest upon maturity. If conditions make it desirable to avoid leakages,
we shall probably choose the second way out.
Whatever is done, however, it seems clear that for a while at least the
savings bonds will be a source of net expansion rather than contraction.
For several years there is every reason to expect that redemption of bonds
for consumption needs will exceed the amount of interest accruing. If the
Treasury does not collect taxes against these accruals, the expansionary
effect will be all the greater. In addition, one may expect that the security
provided by a backlog of bonds will induce people to spend more freely
out of their current income. The increase in expenditures may well be a
multiple of the interest accruing on the bonds.
There is a school of thought which believes that many people who now
for the first time find themselves with a fairly substantial nest egg will
have acquired a taste for saving and will save more rather than less. No
doubt this will be true in some cases; that it will be the rule seems rather
unlikely. The outcome to some extent will depend on whether the payroll deduction system is maintained. As long as the inflation threat persists, efforts should be made to hold the deduction system together. If
contractive tendencies appear, it would be better to scrap it. Similar
considerations apply to the refunding of the bonds, that is, to the continued sale of this type of obligation and the offering of facilities to convert maturing bonds into new ones.
The possibility might also be considered of offering to consolidate the
very cumbersome portfolios of bonds maturing at weekly or monthly
intervals which most holders are accumulating. The ease with which the
present components of this portfolio can be turned into cash undoubtedly



encourages spending for consumption. Their staggered maturities are
likely to have the same result once this point is reached. Consolidation
into a single security for each holder, taking account of the age of all his
individual bonds, could be used as a device to discourage spending for
Under depression conditions, however, the consumption stimulating
character of the present bonds would be an advantage. One might then
even consider increasing their liquidity by making them eligible as collateral for bank loans. More drastically, the Treasury might offer to redeem all bonds at prices which would give the holder a yield to date of
2.9 per cent, equal to the stipulated yield of the bonds to maturity.
These prices would be somewhat above current redemption values, since
the 2.9 average yield is reached only during the last year. An offer of this
kind would probably stimulate redemptions and hence consumption.
Insurance Companies. To be on the conservative side, the interest
receipts of insurance companies in the table on page 86 have been classified in their entirety as savings which do not add to the demand for
goods and services. Very probably, however, a part of them should be
regarded as indirectly returning to the income stream through the payments which the companies are constantly making to policy holders.14
Moreover, it is clear that if the companies did not happen to hold Government securities, they would probably be owning other earnings assets
and might save just as much.15 If such other assets should be so hard to
obtain that the companies could not secure an equivalent income, they
would be forced to raise their premia and reduce their dividends. In that
case policy holders would have to increase their own current insurance
saving and probably reduce consumption expenditures, unless they
should decide to take out less insurance. A new source of savings and a
The best way of looking at the matter would probably be to regard most of the interest
currently received as being saved, but to deduct from it whatever accumulations of past
interest are currently being paid out. In that case, savings out of interest would be much less
than the rather pessimistic assumptions made above indicate, but it would remain to be
investigated how much of the payments which the companies make on matured policies is
saved by the policy holders. Statistically, however, this approach would be extremely uncertain, and its justification might possibly be questioned because there is no direct connection between current receipts of Government interest by the companies and their outpayments of accumulated interest.
A large part of the alternative assets which insurance companies might have acquired
in the absence of a Federal debt would have been bid away from other investors, whose income and saving in that case would have been lower than otherwise. Saving, in other words,
would be less somewhere in the economy; how much less depends on the taxes and the saving
habits of the investors whose securities might have been bid away.



further leakage from the income stream would thus be opened up, offsetting at least in part lower accumulation by the companies out of investment income. Here again, the public debt cannot altogether be regarded as the cause of savings, even though the savings are technically
made out of Government interest.
More significant perhaps than the interest and saving angle is the influence of insurance companies upon investment activity. As long as life
insurance concerns are free to buy unlimited amounts of Treasury 2 ^ ' s ,
they are only occasionally driven beyond the peaceful confines of the
Government bond market by the need to average their net returns up
to 2$4 or 3 per cent. It seems logical that at a time when we are hard
pressed to find ways of converting our savings fully into investment, the
institutions which manage one of the nation's largest savings pools should
be asked to cooperate as fully as is compatible with the safety of their
assets. On one side this means to extend the range of assets which now
are legal for life insurance companies, and on the other to limit somewhat
the easy alternative of buying Government obligations.

Preceding papers have dealt with the role that government fiscal policy
plays in the attainment of economic stability and the full utilization of
human and capital resources. They have specified the contribution that
can be made by the Federal Government and have delineated the problems involved in shaping Federal revenue and expenditure practices to
such an end. I t is apparent that the government elements of a national
economic policy must in large measure be supplied by the National
Government. Nonetheless State and local governments play an important
role in the entire economy, and the fiscal policies of these governments
if integrated with a Federal program can aid in securing the goal of full
employment and economic stability.
In terms of the aggregate of expenditure during the period 1920-40,
the local and State governments had a greater impact on the economy
than had the Federal Government. In no year did their expenditures
constitute less than 40 per cent of total government disbursement, as
indicated by the chart on page 102, and in some years these units accounted for as much as 70 per cent of the total. Through many of these
years the expenditure practices of the State and local governments were
directly counter to those of the Federal Government. This divergence,
prevailing during a period characterized by extremes of prosperity and
of depression, largely deprived the economy of the beneficial effects of a
consistent and integrated government expenditure and revenue pattern.
I t is the purpose of this paper to examine the characteristics of State
and local finance with a view to ascertaining how and to what extent the
State and local units can pursue fiscal policies of the type urged in earlier
chapters. The obstacles to such a course of action are associated with
* Mr. Mitchell and Mr. Litterer are members of the staffs of the Research Departments of
the Federal Reserve Bank of Chicago and Federal Reserve Bank of Minneapolis, respectively,
and Mr. Domar is on the staff of the Division of Research and Statistics, Board of Governors.




the character of State and local expenditure, the great diversity in the
capacity of States and localities to finance expenditure programs adequate to achieve the fullest use of the economic and manpower resources







NOTE.—For data, see the table on p. 115.

within their boundaries, and the nature of their revenue systems. These
obstacles and the means by which they can be overcome or circumvented
will be examined in terms of the record of State and local fiscal practice
during the period between the wars.
State and local units of government have financed and administered a
far wider range of public services during the past two decades than has
the Federal Government. In considerable measure this is due to the fact
that the States and the 165,000 local governments are political institutions through which popular control of taxation and expenditure policies
is most directly and intimately exercised. The very character of the
State and municipal governments, concerned as they are with such daily
needs and requirements of citizens as the education of children, transpor-



tation, water and sanitary facilities, police and fire protection, and a
variety of miscellaneous functions of lesser fiscal importance, brings
these levels of public administration into frequent and close contact
with the citizenry.
The States have created large numbers of local governments of diverse
types and character and with varying restrictions have delegated to these
units many important functions. This has made possible a degree of
diversity both as to character and extensiveness of government service,
as is indicated by the wide variety of services and range of costs within
the individual States. Delegation of authority has also created in government services conditions of disparity that are incompatible with present
concepts of collective responsibility for the health, education, and welfare of the population generally.






H L500






NOTE.—For data, see the table on p. 104.

Although provisions for the existence and continuation of many of
these local units are written into State constitutions, the overwhelming
majority of them are subject to the authority of the State legislatures and



may be abolished, have their powers expanded or contracted, or have
their boundaries altered as legislative wisdom dictates. By the creation
of special-purpose units of government, legislatures in many States have
taken the responsibility for performing new and rapidly growing functions from the established general-purpose units. The specialized functions most often so treated are education, road construction and mainEXPENDITURES OF STATE AND LOCAL GOVERNMENTS, BY FUNCTION, 1941
(Dollar items are in millions)


Cost payments—Total 1
Old age and unemployment insurance .
Health and hospitals
Police and fire
General administrative, legislative, and
All other
Debt retirement 2




of total









SOURCE.—U. S. Department of Commerce, Bureau of the Census, Financing Federal, State and Local Governments: 1941, p. 54. This table includes payments from funds received from other governments.
Excludes net addition to reserves of 544 million dollars, for old age and unemployment insurance, and 142
million for contributions to pension funds.
Not included in the total.

tenance, provision for sanitary facilities and recreation, and a variety of
functions of a semi-public nature.
The quantitative significance of State and local expenditure is indicated in the accompanying table and chart. Education is the largest
single item in the combined State and local budget. Welfare expenditures,
including benefit payments for the unemployed and pension payments
for the aged, dependent children, and blind, were in 1941 roughly equivalent to the costs of constructing and maintaining highways, streets, and
alleys. These three main functions accounted for 60 per cent of State and
local expenditures.




Until World War I, the property tax was almost the exclusive source
of revenue for both State and local governments. With the advent of the
automobile the States expanded their revenues by the adoption of highway user taxes; as a consequence of the collapse in real estate values
during the thirties and the expansion of State services in the field of relief
and social security, the States rapidly diversified their tax systems so as
to become relatively independent of the property tax, leaving this source
of revenue to the localities. Abandonment by the States of their levies on
property occasioned little relief to either taxpayers or the local units,
because of the far greater importance of the remaining local rates. The
localities continued to suffer the disadvantages of a tax system inade.
quate to meet steadily increasing demands for public services. Moreover
few local units were able to develop new independent revenues capable
of making significant contributions to their fiscal requirements. In consequence, localities generally are restricted to the property tax, a levy
which is admirably suited in many respects to the characteristics of local
government but which has most unfortunate features from the standpoint of flexible and responsive fiscal policy.
Sources of Taxes. Typically, the property tax is used to defray the
cost of the more stable and unvarying demands for government service:
for debt charges, for general administration, for police and fire protection 9
for sewerage and sanitation facilities, for a portion of road services, and
for schools. As a result, the sums required from the property tax are not
subject to large year-to-year changes. On the other hand, the base against
which the tax is levied—largely real estate—fluctuates rather sharply in
value over a period of several years. This combination of circumstances
results in effective property tax rates increasing sharply in depression
and decreasing in prosperity.1 Furthermore, even if local governments
had other sources of revenue, existing administrative mechanics of the
tax would make it a virtual impossibility to adjust the rates quickly
enough to stabilize property tax burdens. In most States assessment and
levy dates precede the collection period by 12 to 18 months and, typically,
the assessments on real estate stand for a period of at least three to five



The almost universal practice of undervaluation of property for assessment purposes enables assessment officials to maintain assessed valuations at constant levels through periods of
wide fluctuation in real estate values; thus, the nominal tax rates remain relatively stable.
As the market value of the property changes, however, the effective tax rate—that is, the
ratio of the tax paid to the market value—changes in the opposite direction.



Such inflexibility in the only important source of revenue of localities
suggests that important changes in the administrative characteristics of
the tax must be made before the tax policy of these units can be made to
further rather than obstruct a more flexible over-all fiscal policy. These
changes would require some such device as a replacement grant by the
Federal Government for property tax revenues in depression, and the
use of quarterly or monthly pre-billing with periodic settlements when
revenue requirements are definitely determined. Local governments also
derive minor revenues from business licenses, utility franchise taxes,
special assessments, and a large variety of miscellaneous fees. Few of
these have fiscal significance excepting in particular localities and, with
the exception of special assessments, none seems to have the attributes
essential to a flexible fiscal policy.
The States are usually regarded as somewhat more fortunately situated with respect to their revenue systems than are their subdivisions.
Within constitutional provisions of varying restrictiveness, they can
impose a great variety of taxes if they so desire. In the past two decades,
however, they have confined further development of sources of revenue
almost exclusively to the field of general and selective sales taxes. The
method adopted for financing unemployment compensation has also
provided an important addition to the regressive character of State tax
systems, and as a result at least two-fifths of State revenues can be regarded as coming from the least satisfactory revenue alternatives from
the standpoint of equity and fiscal policy.
The sources of State and local revenues in the fiscal year 1941 are set
forth in the chart and table following. It will be noted that taxes on individuals (personal net income, inheritance, estate and gift levies) are of
nominal importance, comprising 4 per cent of the total yield and 7.5
per cent of the State yield. Constitutional provisions have prevented the
imposition of personal income taxes in some States, and by and large
this source of revenue has been neglected by most of the States during the
past two decades in favor of sales taxes. These levies, apart from the highway user taxes, were adopted during the thirties when, because of acute
financial embarrassment and strained credit resources, the States placed
a considerable premium on stability of yield and frequency of payment.
Under the circumstances, excises came closest to meeting what the States
regarded as their fundamental requirements. Whether or not State tax
systems will become more or less dependent upon these sources in the
future is problematical, but having incorporated excises into their sys-



terns, the States probably will not be inclined to discard them.2 One important sales tax is on motor fuel and it is regarded as an effective means
for apportioning the cost of highivay service.







[ N O T E . — F o r data, see the table on p. 108.

Aggregate Revenue. As may be observed in the table on page 115, the
annual revenue collected by local government units has far exceeded the
amount collected by States through the mid-thirties and is still the larger
figure. During the twenties and thirties, with the exception of the aftermath of World War I, local revenues also exceeded those of the Federal
Government. Local revenues rose from 3.1 billion dollars in 1920 to
Many considerations not susceptible to appraisal account for the failure of States to expand their dependence on net income and death taxes. Regularity and stability of yield were
important and timely factors when new revenues were being adopted and before the withholding device for income taxes had been used by the Federal Government. Exploitation of
the fields of personal taxation by the Federal Government and resistance to demands for a
Federal sales tax no doubt diverted the same pressures into the State field. Problems of multiple taxation, particularly in death levies, may have had some bearing on the choice. Fear of
repelling wealthy residents was also important. In certain States, such as Florida, freedom
from inheritance and personal income taxes was advertised as an advantage of residence.




(Dollar items are in millions)

Source and type of revenue

Sales and gross receipts
General sales
Alcoholic beverages
Tobacco products
Public utility receipts
Miscellaneous excises
Pay rolls
Corporation and business
Corporate net income
Corporate license and privilege
Insurance premiums
Alcoholic beverages..
Severance and other
Net income
Inheritance, estate and gift
Highway user
Motor vehicle fuels
Motor vehicle licenses and operators
Special assessments
All other

State 2



of total







Adapted from U. S. Department of Commerce, Bureau of the Census, Statistics of States, 1941, and Financing
Federal, State and Local Governments, 1941.
The amounts include local shares of State collected taxes.
3 Less than $500,000.

6.3 billion in 1931. After a decline for two years they remained stable at
a new high in the vicinity of 5.5 billion dollars.
In 1920 the States collected 800 million dollars; by 1930 this amount
had much more than doubled. Most of the increased revenue came from
highway users' revenues—motor vehicle licenses and motor fuel taxes—
and increased business taxes. Net income taxes on individuals, property
taxes, and inheritance taxes accounted for the remainder of the increase.
During the thirties the revenue collected by the States again more than
doubled. In 1940 nearly 4.5 billion dollars were collected as compared
with 2.1 billion in 1930. General and selective sales taxes accounted for
roughly one-third of the increase, unemployment compensation taxes



for another third, and highway user and net income taxes for the rest.
The revenue from levies on property and from inheritance and gift taxes
declined significantly during the decade.
Grants-in-aid and shared revenues have assumed an important role in
intergovernmental fiscal relations. The States are both grantors and
grantees in this relationship, i.e., they receive substantial sums from the
Federal Government for specified programs and they disburse even larger
amounts to the local units—again largely for expenditure on particular
(In millions of dollars)
States to localities

Federal Government to States
Vocational education and rehabilitation; defense training; agricultural colleges,
experimental stations, and








Public assistance:
General relief, old age assistance, aid to dependent children, aid to blind




Health and hospitals:
Crippled children, maternal
and child health, venereal
disease control, public health


Employment security:
Unemployment compensation
administration and public
employment offices



Health and hospitals:
Crippled children, maternal
and child health, venereal
disease control, public health




Unspecified purposes

SOURCE.—U. S. Department of Commerce, Bureau of Census, Statistics of States, 1941.


Elementary and high schools..

Public assistance:
Old age assistance, aid to dependent children, aid to
blind, child welfare. . . .

Unspecified purposes





functions. The Federal Government is the recipient of neither State nor
local aid, and the local units make few payments to the States that are
not properly regarded as reimbursements for special services.
The aggregate of major grants-in-aid and shared revenues for the year
1941 is indicated in the table on page 109. I t will be noted that Federal
grants are largely for public assistance, highways, and education, and
that these are also the major functions for which States use their funds
to assist localities; there are, however, important differences in the specific activities aided, particularly in the field of education. All Federal
aid is given for specified purposes, whereas the States in 1941 granted to
localities approximately 200 million dollars which was unrestricted as to
purpose of expenditure.
There has been a sharp upward trend in the amount of Federal and
State aid during the period under review. In 1925 the Federal Government transferred nearly 114 million dollars to the States, and by 1941
this amount stood at over 6^2 times the former total. Similarly, State
aid to local governments in 1925 was approximately 500 million dollars;
in 1941, it aggregated about 1,700 million dollars. These data reveal a
pronounced tendency for the Federal and State governments to collect
more taxes than needed for their own activities in order to finance other
government functions under more localized direction. This arrangement
enables the larger units of government to exert a decided influence over
the amount and character of the expenditures of the smaller ones.
Basically the borrowing capacities of the States and localities are functions of their respective revenue resources and they are thus limited in
the same degree. They contrast vividly with the capacity of the Federal
Government to incur debt since it possesses (in addition to extensive tax
resources) control of the currency and credit system of the nation. For
the vast majority of State and local governments, however, limitations
on the use of government credit are measured not in terms of taxable
capacity but of constitutional and statutory prohibitions, regulations,
and restraints. These limitations for the most part are arbitrary and
capricious in their operation and provide no real measure of the capacity
of the government unit to service debt. Furthermore, debt administration in the States and localities has frequently been in the hands of officials who are inexperienced and inept in these matters. The debt record



of many State and local governments is such as to make the market for
funds skeptical even of debt issues which can safely be purchased.
If the duration of a depression could be charted, many local governments could obtain the credit necessary to finance their deficits during
the period of stress, but the very uncertainty of the situation makes them
reluctant to seek such credit even if it were obtainable. Most large bond
issues require time-consuming referenda before issuance, and the popular
prejudice against issuance of debt for funding unpaid bills and for current
operation is firmly established. Furthermore, much local debt is in the
form of serial bonds that are paid on a fixed and unvarying schedule, thus
making for an additional element of inelasticity in revenue requirements.
In the present interrelations of Federal, State, and local governments
one factor conducive to more favorable financing operations by the latter
is the tax exemption extended to State and local securities under the
Federal income tax. Because of this exemption a person in the higher
income brackets needs to find an investment yielding upwards of 20 per
cent to obtain yields equivalent to those available on tax-exempt securities of State and local governments. This creates a special market for
State and local securities and materially lessens the interest burden but
has little effect on the quantity of securities that may legally be issued
because debt limitations are ordinarily expressed in terms of assessed

The earlier analysis of the economic effects of government fiscal operations—expenditure, taxation, and borrowing—on the volume of production and employment develops the thesis that the cyclical characteristics
of expenditure and of taxation have a vital bearing on the problem of
making the maintenance of full employment an objective of fiscal policy.3
For an indication of the quantitative aspects of these relationships, the
fluctuations of public expenditures and revenues during the past two
decades are examined below.
Local Expenditures. During the twenties and thirties, as indicated by
the chart on page 113 and the table on page 115, the trend of local expenditures followed with some variation the major movements of general
business activity. In the earlier decade from the recession in 1921 through
1929 there was an almost continuous expansion in general business ac3
See Richard A. Musgrave, "Fiscal Policy, Stability, and Full Employment," pp. 1-21
of this pamphlet.



tivity. From 1921 through 1929 gross national product rose by 40.8 per
cent whereas local disbursements paid from revenues (excluding grants)
and borrowings expanded by 97.3 per cent. The growth in local government disbursements was quite regular since the expenditures in each
successive year tended to exceed those of the preceding year. 4 The prosperous business climate set the stage for the acquisition of new facilities
and for the adoption of a wider scope of activities. The larger expenditures, in turn, augmented the growing volume of general economic activity. In the years of precipitous business decline (1929-32), on the
other hand, the contraction in disbursements lagged significantly, somewhat moderating the downward spiral. Since appropriations often precede actual expenditures by months or even by a year or more, such a lag
is expected. Local officials, moreover, in many instances endeavor to
complete the program initiated while in office and dislike the task of
contracting services, for such action always arouses opposition. During
the years of recovery (1933-40) and another period of general business
expansion, the local units of government maintained after 1935 a relatively constant level of expenditures from their own revenue at about
three-fourths of the 1929 peak year. 5 The increased expenditures for
local facilities and activities came from grants initiated by both the
State and the Federal governments.
State Expenditures. State expenditures during the period between the
wars differ from either local or Federal spendings in that they have
markedly and consistently expanded. 6 They rose at a fairly stable rate
Since it was necessary to interpolate a large number of the annual figures on expenditures
for local units of government given in the table on p. 115, this statement is based primarily on
the following p ublished data on net governmental cost payments of 146 cities with a population of over 30,000.

Millions of dollars

1925 .

, .

. . .



1928. . .

Millions of dollars

. .


SOURCE.—U. S. Bureau of the Census, Financial Statistics of Cities, 1931, p. 28.
I t is difficult to draw any conclusions from a year-to-year comparison between local
government expenditures and the gross national product, as the local expenditures (shown in
the table on p. 115) represent fragmentary annual data and interpolations between the
scattered years for which more complete data were available. Also, the fiscal years of local
units of government vary widely. Even if such a comparison could be made, it would have
little validity, for there is often a lag of months or even a year or more between the plans and
appropriations for a new project and the actual outlay.
For footnote, see opposite page.










NOTE.—For expenditures payable from government revenues see the table on p. 115. The data for gross national
product are those prepared by Mary S. Painter and published in "Estimates of Gross National Product, 1919-28,"
Federal Reserve Bulletin, September 1945, p. 873.
This holds also for the amount of revenue collected, as may be observed in the table on
p. 115. It is true also of net indebtedness incurred, as indicated by the following figures:


Millions of dollars
. . . . 1,328


Millions of dollars

SOURCE.—U. S. Bureau of the Census, Financial Statistics of States, 1931, p. 31,



through the entire period, with the exception of the years 1932 and 1933.
From 1920 through 1931 the increase was two and one-half times, and,
following the two years of leveling off and decline, the expansion by 1941
had more than doubled the disbursements as measured by the 1933 level.
This steady growth in State expenditures moderated somewhat the depressed business conditions in the thirties.
Cyclical variations in State disbursements have been minor and of
little influence on the cyclical swings in the private sector of the economy.
The contraction, even in 1932 and 1933, was relatively insignificant.
Federal Expenditures. Federal expenditures have followed a course
generally counter to that of gross national product and at variance with
the cyclical contours described above for local and, to a lesser extent, for
State governments. During the middle twenties expenditures reached a
low point and then rose gradually until 1933. To alleviate the distressed
conditions caused by the low level of employment in the early thirties,
expenditures were augmented rapidly, reaching a peak in 1936. After a
two-year decline they again rose sharply and to new peacetime heights.
The cyclical variations in Federal and local government disbursements
tended to neutralize each other over the two decades, as is revealed in
the chart on page 113. The large Federal appropriations to stimulate
business during the early thirties did little more than offset the contractions in local expenditures following 1931. By 1935, however, both State
and Federal expenditures were expanded enough to counterbalance the
contraction in local outlays and to raise the aggregate volume of government disbursements materially above levels attained in the past.
Public Construction. Most of the expenditures made by local and State
governments are for functions which require relatively inflexible operation and maintenance charges: education, welfare, health, sanitation, and
police and fire protection. Public construction, on the contrary, is a major
type of expenditure which is readily expanded or contracted from year
to year. These capital outlays are important outlets for investment.
Since changes in the rate of investment are a dominant cause of the major
swings in the business cjrcle, public construction may be used to aid in
stabilizing general business activity and employment. 7
For this purpose the volume of public construction must be planned
well in advance and timed to offset the oscillations of private business.
For a discussion of the role of investment in the business cycle, see Alvin H. Hansen,
Fiscal Policy and Business Cycles (1941), p. 250.


AND F E D E R A L GOVERNMENTS, 1920-1943 *

(In billions of dollars)







Revenue 3



Expenditures 8

Revenue 7











































Intergovernmental transfers were treated as expenditures of the jurisdiction making the transfer. Debt repay
ments are excluded from expenditures.
2 Expenditures for 1920, 1925, 1930, 1931, 1933, 1934, and 1935 were secured from Carl Shoup et al, Facing the
Tax Problem (1937), p. 100 as revised. Those for 1932 and 1941 are from Statistical Abstract of the United States, and
for 1942 from Extracts from Governmental Finances in the United States: Census of Governments, 1942, U. S. Summary; both sources are issued by U. S. Bureau of the Census. For other years estimates were made from a logarithmic
curve drawn on the basis of the available data.
Revenue for 1932 and 1941 were taken from Statistical Abstract of the United States, and for 1942 from the
Census of Governments, The Local Revenue. The annual tax collections of local governments from 1920 to 1943 were
estimated by the Tax Institute in Tax Policy, November 1943, p. 3. The ratios between tax collections and total
revenues in 1932, 1941, and 1942 were used to inflate the tax collections to include other revenue.
* Cost payments from 1922 to 1932 and from 1937 to 1943 were taken from the U. S. Department of Commerce,
Bureau of the Census, Financial Statistics of States. The grants secured from local and Federal governments were
subtracted. Cost payments for 1920 and 1921 were interpolated. Those from 1933 through 1936 were estimated on
the basis of the figures presented by Carl Shoup, et al., op. cit., p. 100. Local shares of State collected revenues, in
eluded in the original data beginning with 1940, were excluded here.
For sources and procedure, see note (4) above.
• U. S. Treasury Department, Annual Report of the Secretary of the Treasury on the State of the Finances for the
Fiscal Year Ending June 30,1943, Table II, pp. 468-71. The figure excludes debt retirement.




Unless this condition is satisfied, construction initiated by local and State
governments may well accentuate (as it so often has done in the past)
rather than moderate the amplitude of business cycles.8 In 1929, municipal
governments spent 2.2 times as much for new public construction as in
1920; the rate of expansion in the decade exceeded greatly the rise in the
gross national product.9 Following 1930, these expenditures dropped rapidly as private business contracted, and by 1933 capital outlays were
approximately one-fifth of the comparable aggregates for the peak years
of the latter twenties. It was not until 1938 that expenditures again approached those of the preceding decade. The expenditures initiated by
State governments for new public construction followed a similar course.
Accordingly., local and State governments absorbed a large volume of
employment during the prosperous years of the twenties when private
business was in a position to employ nearly all potential workers, and
added noticeably to the army of unemployed during the thirties.
The Federal Government, by accident or choice, has followed a countercyclical course in its expenditures for new public construction. From 1920
through 1929 this activity was at a low ebb. As the volume of business
in the private economy declined in the early thirties, these expenditures,
including those for work relief, were increased rapidly. The policy had a
stabilizing influence on employment. As in the case of total disbursements, however, the expansion and contraction in Federal expenditures
for new public construction did little more than offset the fluctuations in
such expenditures initiated by State and local governments. Not until
1936 did the aggregate government expenditures for new public construction equal those of the peak year 1930. Thus, a major part of the
large Federal appropriations for construction during the thirties merely
replaced those which had been made during the former decade by the
States and local units. Failure of the State and local governments to
recognize the economic effect of their fiscal policies on public investment
and their inability to adopt counter-cyclical timing for new public construction activities enlarge the problem of achieving economic stability
confronting the Federal Government.
Financing; Government Expenditures. The cyclical fluctuations of
There is, however, a lag of nearly two years between the trend of new public construction
activity and of the general business cycle.
This analysis is based upon Department of Commerce data for local, State, and Federal
government expenditures for new public construction, 1920-38, published in Construction
Activity in the United States, 1Q15-37, P- 19 and "Recent Developments in Construction Activity," Survey of Current Business, August 1939, p. 12.



government expenditures have had a greater effect on the economy than
appears on the surface. During the twenties a large share of State and
local expenditure was financed by borrowing. The effect of deficit financing is to disburse more income than is collected in taxes. In the thirties,
as a result of depressed business conditions, a contrary fiscal policy was
adopted by the States and localities in many instances to liquidate the
indebtedness contracted during the preceding decade. In the retirement
of public debt, tax collections took more income from individuals in lower
income classes than was disbursed to them. Debt repayment to bondholders, which as a group may be expected to retain the proceeds as
savings rather than spend them on consumption, reduced the demand
for privately produced goods and services. The net effect on the private
economy of the transfer of funds from individuals in lower to those in
higher income classes was deflationary, since in these years there were
fewer opportunities for profitable investments to offset reduced consumer
I t is apparent that not only the amount of taxation as distinguished
from borrowing is significant but also the kinds of taxes employed. If tax
systems tapped the same sources as borrowing, the economic effects would
be similar; but the State and local systems in particular derive their main
support from property, pay-roll, and excise taxes, all of which are regressive and restrict consumer expenditure. At no time in the past two
decades have economic resources been so fully employed and inflationary
pressures so strong as to warrant the dominant position of such taxes in
the over-all tax system as a whole. Obviously even the prewar scale of
government expenditure could hardly have been financed exclusively out
of personal income taxes on the high brackets, but a better balanced
revenue system in terms of its effect on the full utilization of the nation's
economic resources would have drawn a smaller tax contribution from
the lower income groups.
The net effect on the economy of the fiscal policies of the three tiers of
governments is revealed clearly by an examination of their annual surpluses or deficits. These measure the excess (positive or negative) of taxes
and other collections from individuals and businesses over payments by
governments. Expenditures comprise the payments made for goods,
services, pensions, interest, and grants to other units, and revenue is the
total tax and miscellaneous collections from the unit's own resources.
Borrowings and debt repayment are obviously excluded. The surpluses
and deficits shown are not accumulated balances as of given dates but



annual additions to or deductions from a hypothetical surplus account
that result from revenue raising and expenditure operations.
Local Deficits and Surpluses. Local governments, as may be observed
from the following chart, incurred continuous deficits from 1920 through
1932. These annual deficits ranged from 100 million dollars to 1,500
AND FEDERAL GOVERNMENTS, 1 9 2 0 - 1 9 4 0










NOTE.—Surpluses and deficits are the differences between revenue receipts from taxes plus miscellaneous earnings
and expenditures for government activities. Neither revenues from borrowing nor expenditures for debt repayment
axe taken into account. For basic data, see the table on p. 115.

million. From 1933 through 1936 these government units accumulated
surpluses ranging from 200 million dollars to 500 million. In the latter
thirties they again incurred deficits. From these data it is evident that
the pattern of local income and outlay augmented the disposable income
of individuals in the twenties when it was already high owing to prosperous business conditions, and, due to the lag between appropriations
and actual expenditures, it bolstered up the declining income during the
early depression years. The net effect of such a fiscal policy is to accentuate the amplitude of the prosperous phase of the general business cycle
and reduce somewhat the amplitude of the depression phase.



State Deficits and Surpluses. The fiscal policy of State governments
has had a similar effect. From 1920 through 1932 they incurred annual
deficits and in subsequent years accumulated surpluses. The deficits in
the former decade, however, were smaller than those incurred by local
units, and the surpluses in the latter decade rose with the improvements
in business conditions. Consequently, State policy has had less influence
on cyclical swings of private business than has that of the local units.
Federal Deficits and Surpluses. The trend of surpluses and deficits of
the Federal Government has been decidedly counter to the general business cycle. During the twenties an average annual surplus of 800 million
dollars was accumulated, while during the thirties deficits averaging
2,700 million were incurred. Surpluses and deficits computed on the basis
of aggregate expenditures and revenues of all three levels of government
reveal deficits for all of the years studied with the exception of 1922-24.
Summary. The cyclical swings of local government expenditure are in
rough conformance with those of the whole economy. Periods of business
prosperity are accompanied by conditions favorable to the expansion of
local services and investment; collections from property taxes are high
and the market is especially favorable for the issuance of lower grade
municipal bond flotations that may of necessity have been postponed
due to the combination of an unfavorable market and statutory regulation of sale price and coupon rate. As a result, local political units widen
the scope of their services. Schools, fire stations, hospitals, and other
public buildings are erected; streets are improved; parks and playgrounds
are developed; water and sewage systems are installed or extended. On
the other hand, during depressed times localities are forced to contract
their activities. Property tax delinquencies rise sharply and the market
is unfavorable for issuing bonds.
State governments are in a much better position than local governments to maintain their scale of services in depression periods. They
have a wider choice of taxes and their credit is more stable. Over the
past two decades the small cyclical swings of their annual expenditures
have had less influence on fluctuations in general business activity.
The course of annual Federal expenditures has been largely counter
to the trend of aggregate spending in the economy as a whole. During
the twenties such expenditures declined significantly and remained at a
relatively low level until the early thirties, after which they expanded
rapidly. The fluctuations in these expenditures have exerted a stabilizing



The Federal Government serves areas having widely different requirements for service and equally divergent capacities to pay taxes. By and
large, however, it can attain relative uniformity in the services it supplies directly, and it collects tax revenues in conformance with standards
of nation-wide application. State governments, although not typically
confronted with as great a disparity in requirements for service or capacity to support it, have the kinds of functions to perform which raise
the issue of State-wide uniformity in standards. They continuously face
the task of finding objective criteria of need for service that can be used
to establish minimal requirements. Or they may be called upon to evaluate equalization proposals which often rest on the assumption that a certain level or minimum of dollar expenditure is to be preferred to the
flexibility inherent in a system which leaves the level of expenditure in
large degree to the discretion of local government officials.
The three levels of government in the United States exist in recognition
of the fact that a large number of problems in a given area can best be
solved by the people of that area, rather than by directions from elsewhere; that the various areas are sufficiently different from one another
to have peculiar problems of their own; and that in general freedom can
be made more secure by not concentrating too much power in the hands
of a central government. But this argument can be given too much weight;
carried to the extreme, opportunities which should be available to citizens generally are limited to residents of areas with adequate taxable
Our well-being is largely based on unfettered interstate commerce.
Profits made by a New York corporation may arise from the purchase
of raw materials in Mississippi, processing in Nebraska, and the sale of
finished goods in Oregon. Wealth and income are created by a process in
which the whole country participates, but they are distributed very unevenly among the States and within the States. A number of the States,
particularly in the Southeast, find themselves unable to perform most
essential services.
The essence of the problem lies in the fact that the government unit
which, for reasons of tradition or efficiency, is regarded as best fitted to
perform a certain function, is not necessarily the one which can most
conveniently raise the funds to finance that function. In many cases it
cannot raise the funds at all.



This disparity is created by two sets of forces. Most important is the
growing recognition that the nation can well afford to furnish every individual with a certain minimum of service in such fields as education,
public health, and welfare, irrespective of the individual's own wealth
and income, or of the wealth and income of his community or State. But
many States and communities do not possess the resources from which
taxes can be raised to pay for these services. I t is well known that wealth
and incopie are spread very unevenly both among the several States and
within the States. Thus, per capita income payments in 1941 ranged from
$1,101 in the District of Columbia and $1,059 in Connecticut to $283 in
Mississippi, the richest States having almost four times as large a per
capita income as the poorest one. Such disparities are bound to exist for
some time to come, and the problems created by them cannot be solved
by tax measures alone.
The second factor is of a more technical nature. The smaller government units encounter greater difficulty in utilizing for revenue raising
purposes the wealth and income located in their territories. Often they
can do so only through regressive and repressive taxes.
Our 48 States present striking contrasts. The differences in their industrial structures and in economic development are reflected in the differences in public expenditures for education and welfare in 1941. The
amount spent on five students in Arkansas or Mississippi was not sufficient to educate one student in New York or California. Monthly
expenditures per recipient of public assistance went as high as $32.52
in California and $31.24 in New York, and as low as $7.28 in Alabama
and $6.72 in Arkansas. Many other examples of similar disparities
can be easily given.
I t should be made clear that inadequate services in the poorer States
do not arise from the unwillingness of these States to utilize their tax
resources. As a matter of fact, tax collections as a percentage of income
payments are on the whole somewhat higher in the poorer than in the
richer States. I t is the absence of wealth and income to be taxed that
constitutes the core of the problem.
The relative poverty of some States is usually explained by the scarcity
of valuable resources, the under-development of those resources which
are present, and shortage of capital. Two other factors should be added:
first the low health and educational standards of the population; secondly,
the fact that all these causes are cumulative and that they mutually reinforce one another. Undeveloped resources mean poverty; poverty breeds



ignorance and disease. A poorly educated and not too healthy labor force
will obstruct full development of resources.
The components of fiscal policy for State and local governments which
would contribute to economic stability and full employment are: (1) a
desirable pattern of public expenditure involving (a) a degree of flexibility which will permit counter-cyclical expenditure to offset ii\ part at
least contraction or expansion in the economy generally, and (b) a minimum level of government service throughout the nation that will insure
a healthy, well educated and equipped population capable of fully utilizing the country's resources; (2) a tax system which is flexible in the same
respect as the pattern of expenditure and which is neither restrictive nor
likely seriously to distort the allocation of economic resources.
The attainment of these objectives by any substantial number of State
and local governments is difficult, if not impossible, unless they have the
assistance and guidance of the Federal Government. A compensatory
policy of expenditure implies substantial credit resources which are available to neither State nor local units. It also implies a unity of fiscal policy
so far as the major units of government are concerned. A single State or
local government can do little to combat the forces of depression because
so much of jts expenditure—whether it be for maintaining a predepression level of public expenditure or an expanded program of public works
—tends to be dissipated over a larger area than that which the unit serves.
The ensuing leakage in the direct and indirect effects of an expenditure
policy which is out of step with the private economy and that of other
government units would shortly exhaust the resources of the government
in question without having accomplished the intended economic effects.
Indeed, all State and local governments acting in harmony would hardly
furnish the necessary stimulus on a retarded private economy unless their
efforts were supplemented by those of the Federal Government, which
possesses the requisite credit controls and instruments of financial policy.
Only the Federal Government has the ultimate resources to stabilize the
level of State and local expenditure. In one manner or another such resources must be provided if these governments are to contribute to national economic stability and full employment. Similarly, support of a
minimum of government expenditure to maintain a healthy, efficient
population lies beyond the fiscal capacity of many local governments.
Their resources must be supplemented, at least during a period of economic



development, by taxes from wealthier communities. Finally, the use of
fiscal policy as an aid in combating economic instability entails a large
program of public education and economic guidance. Responsibility for
these functions rests primarily with the Federal Government, particularly in the formulation of general economic policy. The educative task
involved in public acceptance of the policy of maintaining expenditures
in the face of shrinking revenues or reducing them when revenues expand
is one in which the State and local governments may well share. Government fiscal policy in relation to a full employment policy must have
general public understanding and acceptance if it is to be an accepted
criterion in determining the financial policies of State and local governments.
Obstacles to Counter-Cyclical Policy for State and Local Governments.
The earlier review of the revenue raising, spending, investment, and borrowing practices of the State and local governments during the period
between the wars indicated that in the main the financial practices of
these governments have tended to aggravate rather than alleviate cyclical
swings in business and employment, and that the mildly counter-cyclical
fiscal policy of the Federal Government has been in considerable measure
offset by State and local financial management.
To what extent do State and local governments have real alternatives
in their fiscal management which permit policy makers to consider the
effect of government finance on fluctuations in economic conditions?
Until recently, few of the States, if any, and certainly none of the local
governments, have given much consideration to the contribution that
their fiscal policies could make to attaining a higher degree of economic
stability. In the selection and use of revenue alternatives, the timing of
expenditure, and new construction, they have been little influenced by
the effect of these operations on the economy generally. Rather, policy
has turned on questions of a statutory, constitutional, or political nature.
The extent to which these levels of government can give any real consideration to adopting a compensatory fiscal policy depends in large
measure upon the nature of the services which they render, the character
of their tax systems and the economic resources on which they depend,
their credit position, and the institutional framework in which they
It is apparent that many important demands for government service
are completely unassociated with swings in business conditions but depend upon a variety of unrelated factors. For example, education is one



of the largest expenditure fields, and within it the cost of elementary and
high-school facilities and instruction is of overwhelming importance.
Education should be relatively unaffected by conditions of prosperity or
depression. Its cost depends upon the school population and the quality
and amount of instructional service that the community desires to render.
I t is not likely that any community would wish to circumscribe such
services in times of prosperity or expand them in times of depression.
Similarly, in the field of welfare expenditures there are large segments
which are either completely or relatively unrelated to changes in economic
conditions. This is particularly true for institutional care of all kinds,
including hospitals, mental and correctional institutions, aids to the
blind, and, to a lesser degree, dependent children and the aged. Only in
the field of general relief arising out of unemployment does there appear
to be an opportunity for a large range in State and local expenditures,
and even this is not likely to assume the proportions characteristic of the
thirties because of the development of social security programs for the
aged and unemployed.
In the field of highway and street construction and maintenance, there
exist larger possibilities for timing of expenditure. Maintenance programs
and policing of streets and highways are relatively inelastic, but major
construction programs theoretically can be expanded and contracted to
have a counter-cyclical effect. The opportunities in this regard, however,
are circumscribed by the political problems of holding down such expenditures in prosperous times and having available resources to carry
them on in depressed periods.
Taking the field of expenditure as a whole, State and local governments, if unaided, have limited opportunities to adjust their programs
so as to minimize cost payments in prosperous times and maximize them
in depressed times. The fields in which this policy can even theoretically
be accomplished have been limited mainly to construction of such public
improvements as highways, water and sewerage systems, and to a lesser
extent, in welfare. I t is, of course, possible to undertake substantial expansion of State and local services with Federal subsidy inducements in
depressed times, but to the extent these enlarged services cannot be discontinued in prosperous times because the demand for them continues,
the policy is not counter-cyclical but is only one of steadily enlarging
the scope and character of government service.
Taxing and borrowing policies offer even less opportunity for independent State or local action than expenditure policies. Though in



recent war years many States have pegged their tax rates at the level
established late in the thirties and thus have accumulated surpluses, it
does not follow that they could be persuaded to refrain from increasing
(let alone to reduce) excise rates, for example, in times of depression. To
pursue such a policy they need far larger credit facilities than they now
possess, or substantial grants from the Federal Government to maintain
Other barriers to compensatory fiscal policies on the part of the States
and local units are related to their institutional characteristics. Local
government is widely decentralized, and its fiscal policies as well as
those of many of the States depend upon points of view and backgrounds
of hundreds of thousands of part-time officials, legislators, and citizens.
The framework in which these governments operate is inherited from an
age to which it may have been well adapted but today it is certainly
awkward and cumbersome. Many fiscal policies are bound by tradition
and are set in an unvarying pattern that reacts stubbornly to changes in
economic conditions. Some of these policies have been incorporated into
constitutional and statutory enactments which make them even more
difficult to discard or alter. The effect of numerous restrictions on local
government in particular is such as to thwart the effective and economical
management of public affairs. If these attitudes toward State and local
government are to be changed while preserving its essence and form,
the change must come through educational processes affecting not only
officialdom but citizens generally. This is of necessity a slow and difficult
process and is rendered even more so because changes in statutory and
constitutional provisions tend to lag far behind the trend in public discussion and thinking.
Federal Grants for Counter-Cyclical Expenditures. Obstacles to compensatory fiscal policy for State and local government should not obscure the possibilities that can be realized if such factors are understood
and taken into account. Thus, one of the tools of Federal financial policy
—grants-in-aid—can be used to supplement the tax and credit resources
of the State and local units in such a degree as to overcome in large measure the handicaps to counter-cyclical expenditure inherent in a policy of
State and local expenditure and taxation. The provision for countercyclical grants to be available in times of depressed economic conditions
overcomes many of the conditions that restrict freedom of the States
and localities to pursue a more enlightened tax and expenditure policy.
Such grants manifestly would be in addition to and apart from those de-



signed to achieve minimum national standards of government service,
and they should not be contingent on any fixed local contribution. They
might also be differentiated from grants aimed at expanding normal
State and local expenditures, particularly in the field of public works.
At or near full employment they would disappear, as under those conditions other grant programs and State and local tax resources would be
Outright grants rather than credit pools or Federal loans would be far
more effective in sustaining existing levels of expenditure because of the
traditional reluctance of these governments to use loans for current
operations. A program of this nature involves practical and administrative difficulties which in turn depend upon some reorganization of
local government, looking to a more realistic identification of areas of
service for particular functions and to more adequate local tax support.
These aspects of the issue are not of such moment, however, as to nullify
the advantages inherent in a grant program of a counter-cyclical nature.
Rationalization of Federal, State, and Local Fiscal Relations. The constitutional grant of autonomy to the Federal and State governments and
the traditional preference accorded local government for the performance
of certain public services have given rise to a system of taxation and
public expenditure in the United States that is so poorly coordinated
that it frequently has led to competition and conflict among the three
levels of government. Formal efforts at fiscal integration between Federal
and State governments have been largely confined to grants-in-aid programs, pay-roll taxes, and the estate tax. Between the Federal Government and localities there has been virtually no attempt to define the
character of the relationship, and between the States and localities
integration has been accomplished in a preponderance of instances with
inadequate recognition of local requirements. The problem of intergovernment relations is becoming increasingly important as the role of government in the life of the nation expands and increased tax demands
become more onerous and apparent to taxpayers. Functions and tax
resources of the various levels of government need more formal definition
and delimitation. In view of the natural advantages of the Federal Government—and, to a lesser extent, of the States—as tax collecting agencies, the issue of greatest immediate importance is the solution of the
problem of raising funds at one level of government and expending them
at another. The devices most satisfactory in resolving the dilemma are
grants-in-aid and shared revenues. Grants-in-aid typify the relations be-



tween the Federal and State governments, and both devices are used by
the States in their association with the local governments.
One alternative to some form of sharing or grant is the transference of
functions from local to State governments and from the States to the
Federal Government. This suggests a fundamental change in intergovernment relations in the United States and is an alternative less likely to be
used extensively than the sharing devices. The fact that some local government units have been able to raise revenues from taxes other than
the property tax has given rise to some opinion that these additional
revenues (business licenses, income taxes, and sales taxes) provide a possible source of revenue which will enable the local governments to continue or even expand their functions with relative independence of aid
from the States or the Federal Government. I t must be borne in mind
that quite apart from the administrative problems of locally administered
taxes of this type such alternatives are available to only a small fraction
of the local governments not including some of the more hard pressed.
Moreover, such additional complication in the over-all revenue structure
is offensive to the taxpayer. All things considered, a thoroughgoing attack upon the question of grants-in-aid seems the most likely to produce
satisfactory results. The rationalization of government fiscal relations
need not stop, however, with a more complete and well-balanced system
of grants-in-aid. I t can well extend to a higher degree of integration of
State and Federal tax systems and a more clear-cut definition of functional division of Federal, State, and local authority. The policy directed
toward integrating all the fiscal relationships of governments will be
productive of sounder taxpayer relationships and better public services.
Tax Reform. Whatever methods are followed in rationalizing taxation by
the three levels of government, the most important consideration to be
held in mind is the economic effect of the tax structure taken as a whole.
While taxes inevitably have a deflationary influence on the economy,
this effect may be minimized through the use of less regressive taxes.
From this point of view, personal income taxes should be the main
sources of revenue. Ideally, many taxes now common to the State and
Federal Governments should be abandoned. Sales and excise taxes have
no place in the Federal budget and, if used at all, should be reserved for
the State governments. The property tax has unique advantages as a
source of local revenue and is also relatively stable. However, the stability of this and other taxes should not be exaggerated. When national
income falls, the consumption of all articles, including necessaries, falls,



and hence excise tax yields are reduced. Property owners are often unable to pay property taxes.
The solution to the revenue problems of State and local governments
should lie not in encouraging the use of repressive taxes because they can
be easily collected or because they are cyclically stable, but in creating
conditions under which these units of government can derive sufficient
revenues without complete disregard of equity considerations. A compensatory fiscal policy can eliminate or at least smooth the cycle.
The efforts of the Federal, State, and local governments to raise revenues from the same sources create conflicts. Sometimes the taxpayer
finds himself paying higher taxes because the governments concerned
cannot agree on some equitable manner of sharing the tax proceeds.
These conflicts result in distorted tax structures; they are inequitable;
they require the taxpayer to fill out a multiple of tax forms; above all,
they are expensive.
Some conflicts could be avoided by a separation of tax fields, that is,
by allocation of each of the several types of taxes to no more than one
level of government. This method, however, can be used more as an exception than as a rule. Other devices must be found to allow more than
one level of government to obtain revenues from a given source.
In general, the tax should be collected by that government unit which
can do it most easily and efficiently. But this does not mean that the unit
which collects the tax must necessarily be the one to utilize it; the revenue may be partly or wholly turned over to other governments.
The relatively small utilization of personal income and estate taxes by
the States is not due to difficulties of collection. To a great extent it is
caused by the fear of the States that higher and more progressive taxes
will repel wealthy residents. I t is very important that a greater use of
these taxes be made.
The fear of interstate competition can be lessened or eliminated altogether by means of the crediting device. The tax credit is already used
in connection with estate taxation. The Federal Government allows the
executor of an estate to pay 80 per cent of the liability which would exist
under the 1926 Federal tax schedule by presenting a receipt for the payment of a sufficient amount of State death (estate or inheritance) taxes.
This device allows the State governments to impose death taxes up to
the amount of Federal credit without fear of interstate competition, because the presence of such a State tax does not increase the total amount
of taxes, Federal and State, paid by the estate. I t is unfortunate, how-



ever, that the tax credit applies to the 1926 tax schedule. Under that
schedule Federal estate taxes were low, with a flat exemption of $100,000.
Since then the rates have been raised several times, particularly in the
middle brackets, and the exemption lowered to $60,000. But as the tax
credit applies only to the 1926 tax rates, the States did not gain from
these revisions. Besides, the 1926 tax schedule works toward giving the
States a larger share of taxes on very large estates and a smaller share
on the smaller ones. As there are comparatively few very large estates,
an unnecessary instability in State revenues is introduced. In addition,
the tax credit does not apply to the Federal gift tax inaugurated in 1932.
Since the Federal law actually encourages the transfer of property by
gift rather than by bequest, the States lose a part of the revenues to
which they would otherwise be entitled. An integration of the Federal
estate and gift taxes, a lowering of exemptions, and a general increase in
rates are extremely desirable. Together with this reform, the tax credit
to the States should be readjusted and applied to the new Federal tax
schedule. I t may also be desirable to allow the States a higher percentage
credit on smaller estates and a lower percentage on larger ones in order
to achieve a greater degree of stability in State revenues.
The application of the crediting device to personal income taxation
would open up great possibilities for the utilization of this tax source by
the States. Within the limits established by the tax credit, the fear of
interstate competition would disappear entirely because the taxpayer's
total liability would not be increased by the State tax. The States could
set up their own tax rates or they might simply impose a tax equal to
the Federal tax credit. In any case, the credit would not affect their
freedom to tax; if they should want to do so, they could impose taxes
in excess of the credit.
Multiple Taxation. The boundary lines separating our States do not
divide the country into 48 economic compartments. The whole economy
is based on interstate trade. A large number of firms are engaged in it.
Many individuals own property located in several States. In their taxation of businesses and persons whose enterprises are interstate in character, the States have employed a variety of exclusive situs rules and
allocation methods. Non-uniformity of practice has eventuated in countless instances of onerous multiple taxation. These artificial barriers to a
free flow of business throughout the nation can be eliminated through
the adoption of uniform methods of allocation of exclusive situs rules by
the several States. Such rules should be developed for all types of taxes



affected by situs conflicts. A State-Federal fiscal authority acting as an
arbitrator between the States and with congressional authority based
upon the interstate commerce clause could effectively implement such
a program.10

«T» ' P



The generally accepted canons of State and local finances are adapted
from those for the individual or business enterprise. They ignore the
responsibilities of public policy by failing to recognize that monetary and
financial operations of any government inevitably (however unconsciously) affect employment and economic stability. It is conceivable
that State and local units will continue traditional policies with their
haphazard economic effects, but if greater stability in economic conditions becomes the determining factor in Federal policy it is highly desirable that the integration of State and local policies with those of the
Federal Government be accomplished. Acting in isolation, a State or
local unit of government does not possess the resources and flexibility
available to Federal fiscal policies. Yet, an integrated system of Federal,
State, and local finances linked by a developed system of Federal grantsin-aid will greatly increase the ability of State and local units to pursue
expenditure and tax policies which will materially assist in combating
For a proposal along these lines applied to a single industry, see U. S. Department of
Commerce, Civil Aeronautics Board, Multiple Taxation of Air Commerce (House Doc. 141,
79 Cong. 1 Sess.).

Consultant, Board of Governors
A number of very interesting reflections are brought out in Mr. Wallich's
able chapter on "Public Debt and Income Flow." While doubtless it is
extremely difficult to make any accurate statistical appraisal of the impact of the debt on the income flow in terms of (a) the distribution of
bond holdings, and (b) the tax structure which finances the interest
charges, nevertheless I think the attempt made is illuminating. For one
thing it stresses a point frequently overlooked, that the net tax burden
incident to the public debt is considerably less than the total interest
charges in view of the fact that the holders of the bonds will pay a considerable tax (about a billion dollars in 1948) on the interest earnings
received. Moreover, in terms of the disposal of the interest payments as
between saving and expenditures, the data point to the conclusion that
the net deflationary effect of the total transfer from taxpayer to interest
recipient is relatively small.
To be sure this conclusion does not take account on the one side of the
contractionist effect of the impact of the added net tax burden upon new
investment and new industry, nor on the other side of the expansionist
effect of increased liquidity and financial security upon the propensity to
spend out of current income. After taking account of all factors, I think
it is highly probable (and this seems to be the general view one gains
from financial writers) that the net effect of a large public debt is likely
to prove, on balance, expansionist. Indeed, there is the widespread opinion
that the expansionist effect may prove strong enough to develop into
general inflation.
In the event of a rather violent restocking boom such as we had after
World War I, the high degree of liquidity which the large public debt
has given us may indeed contribute to an inflationary development. I
believe, however, that the underlying factors following this war point
toward pronounced scarcities in special areas (automobiles, household




equipment, housing) rather than over-all boom. There is only one way
in which the price situation can be controlled in these special areas and
that is by increasing production of the scarce products as rapidly as possible and by a continuation of price control until supply catches up with
demand. In other words, what we are likely to be confronted with, it
seems to me, is a selective inflationary situation which requires specific
measures. An over-all inflationary development such as the speculative
inventory boom of 1919-20 could be controlled partly by direct measures
and partly by a budgetary surplus, or in other words a reduction in the
public debt.
Looking beyond the restocking boom to the longer run period, I believe that the widespread holding of bonds can scarcely fail to cushion a
possible decline in business activity. This is true in terms of the sustained
buying power which the liquidation of bonds in such a period would provide and also in terms of the higher propensity to spend by those who
through ownership of bonds feel a greater degree of financial security.
On balance, the debt is likely to make the postwar employment problem
easier, not harder.
There are indeed problems of management arising out of the very large
volume of liquid claims resulting from the large public debt. As Mr.
Wallich points out, much the same type of monetary control problems
would result from an equivalent increase in property claims arising from
a private creation of debt and other property claims. Yet I think Mr.
Wallich has confused the problems of a high-income society with those
of a society rich in terms of large holdings of liquid assets. A high-income
society tends, on balance, to be a society which saves a large part of its
current income; on the other side, one with high liquid assets tends, on
balance, to spend a large part of its current income. Indeed, the tendency
toward over-saving of a high-income society can, in no inconsiderable
measure, be overcome by fiscal policies which cause such a society to become also rich in its liquid asset holdings. The more liquid the society,
the more it will tend to become a high consumption society.
Mr. Wallich makes a rough calculation of the probable excess in the
money supply in 1948. He probably does not sufficiently recognize that
the term "excess" can have no precise meaning unless one assumes a
given rate of interest. A high degree of liquidity will result in a low rate
of interest and at that rate of interest, the money supply is not in excess.
The money supply can only be said to be in excess if the rate of interest
is artificially held at a higher rate. But in this event the excess money



supply would probably disappear since such a condition would induce
investors to give up liquidity in exchange for securities, and thus the
excess wrould tend to disappear. One could, of course, say that the money
supply was so great that it produced a rate of interest so low as to stimulate an undue expansion and in that sense the money supply was "excessive." In the event that a low rate of interest tended to promote inflationary developments, a large budgetary surplus permitting a reduction of the public debt would be in order. Under these conditions a
budgetary surplus would surely be a more appropriate policy to adopt
than that of raising the rate of interest.
In discussing the alleged "excess/' Mr. Wallich says that we are likely,
in fact, to eliminate it by gradually growing into the money supply; but
this process, he says, would take several decades. This seems to be unduly pessimistic with respect to the probable growth of real income. In
our past history it appears that our gross national product has doubled
every 20 or 25 years. If we maintain this rate of growth, we should in a
very few years reach the "normal" ratio of income to money supply and
indeed before very long we should need further increases in the money
supply. But this part of Mr. Wallich's discussion again is rather unsatisfactory in that it fails to define wThat this "normal" ratio is and how it
relates to the level of the interest rate. Mr. Wallich does in the section
immediately following call attention to the fact that liquidity is a factor
in keeping interest rates low, but he does not seem to have integrated
this analysis with his previous remarks.
In connection with the long-run need for an increase in money supply,
as real income rises, one faces up squarely with public debt policy and
in particular with future increases in the debt financed by borrowing
from banks. Under modern conditions when commercial loans are relatively negligible, an increase in the money supply adequate to maintain
high liquidity and low interest rates could hardly be achieved without
Government borrowing from the banking system unless, indeed, straight
currency issues were resorted to. This is a matter which deserves much
more discussion than it has thus far received.
The fact that our money supply is currently based largely on bank
holdings of Government bonds is discussed at some length in these papers.
There is a good deal of concern that the earnings of the banks are derived
in so large measure from the interest on Government bonds. Critics of
the current banking situation not infrequently assert that the interest
which banks receive is unjustifiable payment for the simple act of creating



credit. Looking at it from the standpoint of the general economy, it would
probably be more accurate to say that these interest earnings help to
cover the cost of operating the monetary and checking-deposit system,
which cost has to be covered somehow or other. Those who are eager to
reduce the interest receipts of banks must recognize that the alternative
is high service charges. It is certainly not obvious on the face of it that
this is a better way of financing the operation of the monetary and banking system. It is, of course, true that abnormally high earnings by banks
cannot be tolerated, but there are ways in which this can be managed.
In my own judgment, taxation of excess earnings deserves consideration.
But first, certain reforms are surely urgently needed. Wages and salaries
for bank employees should be raised; bank employees are, as everyone
knows, incredibly underpaid. Service charges might well be eliminated or
drastically reduced; this would not only contribute to good public relations since such charges are generally regarded as a nuisance, but it would
also stimulate the widest possible use of checking deposits by the public.
Possibly also, somewhat higher interest rates should be paid for time
deposits. Such interest rates should, however, be well below the rate on
the Series E savings bonds. In addition, it is desirable that the banks
should be permitted to build up their depleted capital ratios. These
measures combined would go far toward the elimination of abnormally
high earnings. To the extent that such abnormal earnings materialize,
some form of taxation would seem desirable. Banking is not an ordinary
private enterprise. It is in a very special sense a public utility. It is entitled to a fair profit for efficient operation but no more. Taxation as a
means of getting at excess earnings seems to me less objectionable than
the various other proposals discussed by Mr. Wallich.
Mr. Wallich suggests that so long as the threat of inflation persists it
will be desirable to continue the pay-roll deduction system for purchase
of Series E bonds, but that if contractionist tendencies appear, it will be
better to scrap the system. It is hardly possible that these pay-roll deductions could be used in any systematic way as a cyclical device. If unemployment was increasing, those still employed would probably wish
to save all the more. As a long-run measure, a continuation of the payroll deduction system might indeed operate rather seriously to reduce
the ratio of consumption expenditures to income payments. This would
have a deilationary effect upon the economy unless the standard income
tax rate affecting the mass of the population were reduced by a corresponding amount. To overcome this tendency and still retain the benefits



of individual thrift, a part of the Federal budget could be financed from
the pay-roll deductions (thrift bonds), thereby permitting a reduction of
the basic income tax rate. By this method we would facilitate individual
thrift and raise the level of financial security for the mass of our citizens
and at the same time prevent the deflationary effect of such pay-roll deductions upon consumption and total effective demand. The increasing
achievement of financial security would moreover progressively tend to
raise the community's propensity to consume.
I have mentioned above the possibility of combining the pay-roll deduction savings plan with a reduction in the standard income tax rate.
Professor Haberler has recently called attention to the advantages in
what he calls the "revenue method"; namely, tax reduction as a means
of increasing total effective demand. 1 He deprecates "the idea, now gaining in popularity, that aggregate effective demand can be stimulated
sufficiently to eliminate unemployment by increasing public expenditure
without deficit financing" He calls attention to the now generally admitted
fact that in order to achieve a given increase in aggregate outlay, public
expenditures must be increased more if they are financed by taxes than
if they are financed by loans. He doubts, as an anti-depression policy,
the wisdom of tax-financed expenditures as compared with deficit financing. He concludes with this statement: "This may sound paradoxical to
many, for what most conservatives are afraid of is a deficit and a growing
public debt. Their obsession with the public debt may thus lead them
into a much more dangerous alley." While Professor Haberler is directing
his statement mainly to anti-depression policy, his analysis may (under
certain conditions at any rate) be equally applicable to longer run considerations.

Review of Economic Statistics, August 1945.


Vice President, Federal Reserve Bank of Kansas City
The fundamental issues with which this pamphlet deals may be clarified
by a brief comparison of its major assumptions with the principles of
"sound finance" which were developed during the nineteenth century and
almost universally accepted, at least in English-speaking countries, until
the middle thirties of this century. Had the pamphlet been written between 1875 and 1930 it would certainly have argued that in times of peace
the budget should always balance; and that if borrowing became necessary, the Treasury should avoid borrowing from banks, and especially
from a central bank. Other recommendations would have included the
maintenance of the gold standard, if necessary by credit contraction;
independence of central banks from political, especially Treasury control;
and a central bank policy of lending only at rates "above the market."
The tax program would have been designed to encourage thrift rather
than consumption. Unemployment, if mentioned at all, would have been
assumed to reflect a wage scale too high rather than too low.
The nineteenth century concept of sound finance still claims many
followers, but it has been displaced to a large extent, especially in academic
and governmental circles, by what is in many respects its doctrinal and
practical opposite. According to this newer view, budget deficits are
desirable under conditions that occur frequently, even continuously, in
times of peace. Managed currencies and flexible foreign exchanges are
preferred to a rigid gold standard. Central banks, private banks, and
paper currencies are regarded as merely convenient instrumentalities of
Treasury finance. Several of the present group of essays reflect the newer
type of economic theorizing.
Because of differences in unstated premises, adherents of each philosophy
often find the views of the opposing school incomprehensible. A brief
analysis may help toward a mutual understanding even though it does
not effect a reconciliation.
The main characteristic which unifies the series of fiscal and monetary
practices that are considered "sound" in the older system is that they all




tend to prevent inflation; in the newer program the unifying purpose is
the avoidance of deflation. The historic code of balanced budgets, gold
standard, and high interest rates is a proven bulwark of stability against
inflationary pressures. The principal contents of the new orthodoxy—
encouragement of consumption, deficit spending, artificially low interest
rates, flexible exchanges—are effective ways of resisting a tendency of the
money flow to shrink in volume, with downward pressure on incomes,
production, employment, and prices. There is little dispute about this;
the quarrel is really about the relative importance of permanent precautions against upward and against downward disturbances of the
value of money.
In part the change of objective is a reflection of the tendency of mankind to be influenced most by the experience that is most recent. Most
wars of modern times were accompanied or followed by violent inflation,
and wars were frequent enough to keep the inflation danger fresh in
people's minds as the standard sequel to unsound fiscal policy. But in the
thirties of this century, deflation was so severe that "soundness" came to
mean anti-deflationary, especially in the English-speaking countries where
the postwar inflations of the twenties had been comparatively mild.
However, the conflict involves more than a change of financial practice
in response to a change in the phase of the business cycle; it involves the
underlying economic analysis. The classical economics of the nineteenth
and the first quarter of the twentieth centuries was a realistic description
of a society operating as it actually does operate at a peak of prosperity,
with full employment of resources and automatic clearance of markets
through the operation of the price system. That system never succeeded
in fitting depressions neatly into its own framework; it treated them as
mere episodes, temporary deviations from a normal state of prosperity.
Indeed, it came close to proving depressions to be impossible. It rationalized a system in which financial practice was geared to the expectation
of continuous growth of capital (financed by thrift) and hence of productivity, income, and living standards.
The rival body of theory which has developed since about 1930 (rapidly
since about 1936) posits as normal a chronic failure of the price system
to keep market demand equal to production without a large volume of
unemployed resources. It is a rationalization of the behavior of a society
suffering from chronic depression. Prosperity is the temporary deviation
from normal that requires a special explanation in each case. (Compare
Musgrave, pages 1-7).



The essential points explaining the supposed chronic tendency of industry to run at low speed may be summarized as follows: First, in a
wealthy community with shrinking opportunities for new investment,
people tend to take more funds out of the income stream as savings than
they put back into the income stream as investments. Second, there is
no necessary connection between an individual act of saving and an individual act of investment, so that changes in savings and in investment
respectively can occur independently of one another.1 Third, the rigidity
of costs makes it impossible for industry to adjust itself to falling money
receipts without curtailing employment and the volume of production.
Fourth, changes in the level of income lead to proportionately greater
changes in the level of savings.
Since the difficulty starts with an excess of current savings over current
investment, public policy should be directed to the replacement of money
that is drawn out of the income stream by the excess of individual savings
and to the discouragement of thrift. Public deficit finance is needed as an
offset to private "surplus finance" to the end that money income may be
stable and resources be fully utilized. Higher wages, lower profits, progressive taxes, social security, and other equalitarian measures help to
discourage saving. Hence they maintain or increase the total volume of
activity and encourage investment. Thus higher wages, at levels near
those historically significant, actually increase the demand for labor.
Many, perhaps most, adherents of the newer school accept the older
analysis with reference to a "young" economy with expanding population,
advancing frontiers, and rapidly changing technology, and the newer
analysis for a "mature" economy. Since they believe our economy, as
well as that of Western Europe before the war, to be mature, they apply
the newer analysis to present-day problems without necessarily denying
the accuracy of the older analysis under nineteenth century conditions.
Space does not permit a discussion of the whole range of assumptions
and evidence supporting the two economic philosophies just described.
I have stated elsewhere (American Economic Review, March 1942, pp.
106-10) my reasons for rejecting the thesis of economic maturity. I have
argued there that the slowness of the recovery from the depression of
the thirties should be explained largely by national tax policies and

Investment, in this analysis, is usually assumed to be financed by expansion of currency
or bank deposits, while saving withdraws currency from circulation, or stops the turnover of
deposits. Hence, though an approximate balance between saving and investment is necessarv
to prevent inflation or deflation, either can expand or contract independently of the other.



wage policies which grow out of what I have called above the newer
school of economics.
I also distrust the recommendations in the pamphlet in so far as they
are based on (1) the dissociation of the volume of investment from the
availability of a flow of savings (discussed below, page 144); (2) the effect
of changes in the level of income on the volume of saving which I believe
to be greatly exaggerated; and (3) the tendency of high wages to increase
employment, which I believe to be fallacious.
Since space does not permit discussion of all the conclusions of the
pamphlet that are affected by these basic issues, I shall here merely
record a general dissent and devote most of my space to the consideration
of other doubtful points in the various papers.
Fiscal Policy, Stability and Full Employment. Aside from my reservations concerning the fundamental theories on which they are based,
I have very little criticism of Mr. Musgrave's and Mr. Domar's papers.
Mr. Domar's discussion of the relation between increasing productivity
and the trend of prices (page 60) and Mr. Musgrave's comment on the
same point (page 4, footnote 1) seem to me unsound. Prices that fall
because of falling real costs have no tendency to create unemployment,
nor do they increase the burden of debt. Mr. Domar suggests that a
policy of stable money income with sporadic falling prices would require
more price flexibility than is likely to exist. I suggest that his ideal (a
stable price average maintained by part-way lowering of prices of the
goods whose real costs fall, with compensatory raising of other prices
and of wages) would require more flexibility than is necessary if changes
in costs are reflected wholly or partly in the prices of the goods affected,
and there are no compensating changes in other prices or wages.
I regret that, having decided not to discuss the relation of public
spending to the maintenance of democracy and the merits of private
enterprise, Mr. Domar has digressed to argue one side of the case by
innuendo (page 55). If there are deficiencies in the provision which has
been made in this country for public health, education, and conservation
of resources, these deficiencies are indictments of public planning more
than of private enterprise. The last sentence of this paragraph is a gross
overstatement, since many countries have maintained democracy in the
face of severe unemployment and many others have gone authoritarian for
other reasons. Germany is really the only illustration of Mr. Domar's point.
Monetary Aspects of National Debt Policy.—The most important innovation which Mr. Robinson suggests is the requirement of a reserve



against demand deposits, consisting of nonmarketable low-yield securities (pages 77-78). Three alternative plans are proposed. Mr. Robinson
does not state precisely what purposes are to be accomplished by these
measures, though he indicates that the purpose is not to reduce bank
earnings. Inferentially, the aims are to reduce bank speculation in securities, to reduce the interest burden on the Treasury, and/or to improve
the machinery of credit control.
The proposals all seem sound in so far as their purpose is cheapening
the cost of Treasury borrowing. When the note-issue privilege was attached to Government bond issues under the old national banking system, the Treasury was enabled to borrow more cheaply than other sound
borrowers; a similar saving could be made by attaching special privileges
to bonds as coverage for deposits, as Mr. Robinson suggests.
In their details, the plans are open to several objections. First, as a
means for eliminating speculation in Government bonds the plans cannot be very effective so long as the banks are free to trade in marketable
securities on the basis of .their time deposits.
Second, the plans put a much greater premium on the deposit of funds
in time accounts than does the present differential in reserve requirements.
I t will be remembered that in the period of very active demand for loans
in the twenties, deposits were shifted extensively from the demand to
the time category although the only gain to banks was a reduction in
cash reserve requirements.
Third, I do not see that any of the three plans really accomplish the
purpose of giving the monetary authorities more effective control than
they already have, since, so far as indicated, the Reserve System or other
monetary authority is not to have discretion to raise and lower the level
of required bond reserves. Moreover, even if the control authorities are
given power to change reserve requirements, they cannot exercise restraint
without tightening money markets; if that cannot be allowed now, it
cannot under the new system.
I confess that I do not understand the section "Credit Policy with
Proposed Debt Structure" on pages 81-82. If an additional supply of
special bank securities were made available to the banking system in dull
times the banks would have no need for them unless deposits were increasing. They would have no way to pay for them without liquidating
outstanding credits unless they already had excess reserves. If they did
buy them no purchasing power would be created; excess reserves would
merely be shifted from one form to another. Vice versa, for the Treasury



to retire the special bonds in times of expansion would make the banks'
bond reserves deficient and their cash reserves excessive. I t would seem
more sensible to make the cash reserves deficient since that would bring
direct pressure on each individual bank to call its loans or sell its assets. A
bank which was short merely of bonds, not cash reserves, could bring down
its deposit liabilities by inducing depositors to take cash in exchange for
demand deposits, but that would merely substitute one form of money
for another without correcting the monetary situation at all. Sale of
marketable securities would reduce deposits somewhere in the system
but not primarily in the selling bank. Calling loans, likewise, would not
help the individual bank except as its debtors might pay by check on the
bank itself.
I do not see any argument for the proposal that the price of marketable
securities held outside the banking system should be stabilized by openmarket operations on the part of the Government trust accounts. To
perform this function the trust accounts would have to carry normally
a large balance of uninvested cash so as to be ready to intervene on the
buying side of the market. They would thus become a second central
bank, buying bonds when interest rates are rising and selling them when
interest rates are falling. This would run directly counter to the use of
Federal Reserve credit policy to check monetary expansions and contractions, since open-market sales for credit control ordinarily occur
when interest rates are rising and open-market purchases when rates are
falling. This dilemma is not resolved by the provision that the operations
might be "conducted" by the Open Market Committee of the Federal
Reserve System, so long as the purposes conflict. As the author states
on page 74, stabilization of interest rates and bond prices is an impediment to monetary stabilization; it is not desirable to have one central
bank responsible for stabilizing bond prices and another for stabilizing
monetary conditions.
Mr. Robinson's three plans for stabilizing individual holdings might
lead to absorption of some of the current excess of individuals' purchasing
power. But the volume so absorbed would probably be insignificant if
the Treasury insisted on getting its funds even as cheaply as it does now.
If the life annuities are to carry no privilege of redemption, the rates will
have to be lower than those now offered by life insurance companies
with redemption privileges; and annuities can be bought now at yields
higher than those of bonds. I do not see how the cost of the Treasury
could be less than 3 per cent in the current market.



As to the offer of unemployment insurance, it is true, as the author
states, that Government receipts and expenditures would have a stabilizing effect on the economy. But a plan of voluntary unemployment
insurance would have to be very expensive for the Treasury in order to
be attractive to the individual. If the insurance was paid for currently
and was immediately effective, like fire insurance, individuals would
naturally postpone purchase until they expected to be unemployed in
the near future. It would be like life insurance without any medical
examination; the dying would all want it. On the other hand, if an individual had to participate for a long time in order to build up his benefit
claim, and had no right of redemption, it is hard to see how the insurance
could be sufficiently attractive unless the rates were too low to cover the
losses. Moreover, it does not seem practicable to withdraw the offering
of unemployment insurance in a time of deflation, as suggested, since
that is just the time in which popular demand for it, if any, would be
The proposed stable purchasing power bond would offer the investor
a hedge against changes in the cost of living, which would perhaps be
accepted as an offset to a low coupon rate. But the risk taken off the
investor would be transferred to the Treasury, and this would be the
equivalent of a higher rate on the debt. The stable purchasing power
bond needs further explanation before its merits can be determined.
Would the bond be redeemable on a sliding scale, varying with the cost
of living, or would only the interest be stabilized in purchasing power?
If the former, the bonds would offer a grand opportunity for speculation,
the holder redeeming the bonds when he believed that the cost of living
was going to fall, and buying them when he thought it was going to rise.
However, if the redemption value were fixed in dollars, at or slightly
below the issue price, and only the interest disbursements adjusted to
the purchasing power of the dollar, this objection would not hold. But
the plan would work in direct opposition to the cyclical stabilization feature of the proposed unemployment insurance, since the disbursements
would be greatest in periods of inflation and least in periods of deflation.
At present we have two institutions which will powerfully reinforce any
inflationary movement that may start: the farm price parity program
and the principle that wages should be adjusted upward with the cost of
living. Mr. Robinson's proposal makes it complete. The rentier too will
have his income automatically raised by inflation and there will be no
one whose reduced purchasing power will serve as a check on the inflation.



I think Mr. Robinson has attempted the impossible. He is trying to
eliminate inflationary pressure while perpetuating its principal prospective causes. One of these is the principle that whenever the Treasury is
a borrower it must have access to cheap money, obtained if necessary by
inflating the volume of liquid funds in the hands of the public. For the
bulk of wartime borrowing this decision is irremediable; Mr. Robinson
would continue it whenever the Treasury is a borrower in time of peace.
The second is the policy recommended by Mr. Robinson of stabilizing
the price of marketable Government securities for an indefinite period
after the war financing is finished (page 76). I do not believe that there
is now any necessity for this, moral or political. I never heard anyone
refer to the decline of bond prices in the early twenties as a breach of
faith. But if the market is kept stable for a few years an implied commitment will be made, from which it will be hard to recede. A high bond
yield may not of itself stop inflation, but it is a necessary by-product of
the only measure that is sure to stop it; namely, the creation of an underlying scarcity of money.
Public Debt and Income Flow. The heart of Mr. Wallich's paper is
the table on page 86, in which the most important items are the last four
columns. Here gross income derived from Government bonds by various
classes of holders is broken down into estimates of the respective amounts
that will be returned to the income stream (as consumption or investment
expenditure) or will be held uninvested. Most of the discussion relates
to, or is based on, these items. The value of these computations, either
as a contribution to methodology or as specific forecasts, seems tp me
The most serious error is the treatment as leakage of all financial investment, apparently including bank loans and mortgage lending by
insurance companies. The only investment recognized is that which is
made by the saver himself in the production or purchase of physical
goods. This is not realistic. Financial investments are neutral; they
neither furnish an outlet for savings into the income stream nor divert
them from it. There may be some presumption that the money so transferred to sellers of securities is not used by them for consumption expenditures, but there is none whatever that it remains uninvested. In
fact, new securities are bought chiefly by people who have sold other
securities, rather than those who have just saved the funds out of income.
The savings are often at one end and the investment at the other end of



a long chain of financial transactions. 2 While I know no way to estimate
the amount of hoarding that results from the receipt of marginal income,
I think it may be fairly assumed to be about the same for interest paid
to different classes of income receivers, since most of the resultant hoarding occurs after one or more turnovers. There should be differences at
the first turnover, but the magnitudes at that stage are small.
This error appears on both sides of the summary on page 87, since it
affects both the spendings of recipients and the "savings taxed away out
of income other than interest." The latter item of 1.5 billion would be
very much smaller and on the other side the item of 1.8 billion, "interest
respent by recipients," would be very much larger if this error were eliminated. However, the figures to be substituted would be sheer guesswork.
The difference between Mr. Wallich's concept of the investment
process and mine is reflected in his comment in footnote 2 on page 85:
" I t is doubtful that the mere availability of these savings will induce
others to make physical investments which they would otherwise not
have made." I infer from this statement and from his treatment of
financial investment as leakage that Mr. Wallich accepts the current
view that investment goes on independently of the availability of a fund
of savings seeking investment, the volume of bank credit expanding to
meet the demands of borrowers. This view seems to me to confuse the
mountain and the molehill.
The minor role of new bank credit in providing industry with new
capital in prosperous times is evident from the record of the twenties.
Through the six years 1924-29 the expansion of bank loans and investmenfs in this country was less than 15 billion dollars. In the same period
the securities market supplied the demands of industry for new capital
to the extent of over 50 billion dollars. New municipal issues totaled over
8 billion dollars, and foreign governments over 3 billion. This is in addition to the expansion of business working capital which absorbed a considerable fraction of the expansion of bank credit. All the excess of new
financing above the expansion of bank credit had to be financed by
investment of individual and corporate savings, except for the funds
released by the reduction of the Federal debt, amounting to less than
7 billion.
At most times the reserve of unused lending power of the commercial

Mr. Wallich mentions (p. 99) the complication arising from the shifting of the decision
to hoard or spend, but only in connection with payments to insurance policy holders. He
ignores the effect of marginal income on expenses and on the investments of insurance



banks is small, and can be increased only by gold imports, by expansion
of central bank credit, or by the investment of individual savings in new
issues of bank capital. The state of the capital market, which at times
discourages and at other times encourages new issues, is not primarily
determined by the state of bank reserves, but by the balance between
the supply of funds appearing as new savings and the demand for funds
coming from new borrowers. Moreover, bank lending power is closely
tied up to the flow of savings into the capital accounts of borrowers.
The amount of credit which any borrower can expect to get is a function,
among other things, of his capital, and when a concern wishes to increase
its line of credit it must ordinarily secure new capital from nonbanking
sources to broaden its credit base.
Even if we follow Mr. Wallich in treating financial investments (which
presumably include debt repayment) as leakage, his figures lack plausibility. For 1948, for example, the proportion of "savings" to total revenue
derived from Government bond interest (after deduction of income
taxes) ranges from zero in the case of State and local governments to
100 per cent in the case of insurance companies. Does Mr. Wallich believe
that no State or local government will apply its marginal revenues to
security purchases or to debt reduction? Or that no insurance company
will draw on its interest earnings to finance housing projects?
The point made in footnote 15, page 99 is, I think, unsound. Saving
would not necessarily have been less anywhere in the economy if, in the
absence of a Federal debt, insurance companies had acquired other
assets. The funds released by the purchase of securities from other investors might have been hoarded or used for consumption, but they
might equally well have been used to finance some new investment that
would have yielded as much as the bonds and hence generated as much
income and saving.
Another unjustifiable assumption of this paper is that 50 per cent of
the corporation income tax is passed on to the consumers of corporations'
services. (Mr. Musgrave suggests 33 per cent.) The presumption from
well-established economic |heory is that a net income tax falls on profits,
and I know of no factual evidence that casts doubt on the theory. The
tax certainly does not change the most profitable level of monopoly price,
and it does not enter into the costs that determine the competitive level
of prices. Of course when prices over a wide area are fixed by negotiations
with Government purchasing agencies, or controlled by price ceilings, the
tax is passed on to the extent that control agencies make allowance for it.



But this factor is not relevant to the peacetime situation except as to
public utility rates fixed by regulatory bodies.
The second sentence in the last paragraph generalizes for peacetime a
special wartime situation which has in fact been promoted by public
policy. There is no presumption that when corporations re-enter the
market as sellers of high-grade securities, life insurance companies will
be driven only occasionally "beyond the peaceful confines of the Government bond market."
State and Local Finance. My major criticism of this paper relates to
the use of statistical data, especially in the section beginning on page 111,
to support conclusions which do not seem to me to be supported either
by the data the authors publish, or by other data which are available.
On page 111 it is stated that during the twenties and thirties the trend
of local expenditures "followed with some variation the major movements
of general business activity." On page 116, with reference to construction,
reference is made to the possibility that "construction initiated by local
and State governments may well accentuate (as it so often has done in
the past) the amplitude of business cycles." In the summary on page 119
it is stated that the cyclical swings of local government expenditures
are in rough conformance with those of the whole economy, and on
pages 117-19 it is indicated that the financial practices of both State and
local governments have tended to aggravate cyclical swings in business.
With reference to State governments, other passages might be quoted
which qualify away the conclusion, but for local governments at least
the authors' position is clear.
These conclusions are based on an analysis which ignores entirely all
cyclical changes in business activity in the twenties and thirties except
the catastrophic decline of 1929-32 and the subsequent recovery. No
attention is paid to the recessions of 1921, 1924, 1927, or 1937. The
entire basis for these conclusions, therefore, is that in the profound depression of the early thirties, State and local governments reduced
expenditures, curtailed construction activity, and for some years after
1933 showed an actual excess of revenue over expenditures.
This single episode, which was part of the most violent liquidation
that had occurred in nearly 60 years, does not of course prove anything
as to the typical relation between State and local finance and the phase
of the business cycle. The point would not be worth arguing at length,
however, if it were not that in fact expenditures, borrowings, deficits,
and construction activities of local governments do show a definite



correlation with the fluctuations of business activity during the twenties,
but it is an inverse correlation precisely the reverse of that alleged by
the authors.
The data for local expenditures shown in the table on page 115 tell us
nothing about cyclical movement of local expenditures during the
twenties, for the reason that the only years for which the expenditure
figures rest on authority are 1920, 1925, and 1930 (see footnote 2 to
table). The other items are interpolated on the basis of a smooth curve.
A series so constructed can, of course, show no cyclical movement; the
noncyclical character of the expenditures is assumed.
As to State expenditures, although the cycles are obscured by a very
strong upward trend, the data for the twenties do reveal consistent
fluctuations inverse to the business cycle. The years of business recession
were 1921, 1924, 1927, and 1930, the recession of 1927 being very mildThe three items in the State column which show the largest increases
over the preceding year are, in order, 1930, 1921, and 1924, while 1927
ranks sixth. Of the total increase from 1920 to 1930, 1.3 billion dollars,
0.8 billion dollars occurred in the four depression years and only 0.5
billion in the six good years.
I t is probable that local expenditures actually fluctuated in similar
fashion. This is indicated by the data for public borrowing for capital
purposes, which are available only for State and local governments
combined {Survey of Current Business, February 1938, page 14). In each
of the four depression years, State and local borrowings of new capital
were bigger than in any of the two years preceding or the two following.
In three of the four depression years, borrowings were higher than in
any of the good years except 1929, and even 1929 was topped by 1927
and 1930. The average for the four depression years was 1.37 million and
for the seven good years 1.18 million.
The statistics of construction expenditures, which are shown in the
Department of Commerce study cited on page 116, also contradict
the authors' conclusions. A table there published shows that from 1920
through 1930, over 68 per cent of the increase in construction expenditures of municipal governments, and over 87 per cent of the increase in
construction expenditures of State and county governments, occurred
in the four depression years.
Finally, the data with regard to deficits and surpluses discussed on
page 118 fail to support tfye authors' conclusions, since they show that in
the recession years 1931-32 (the only recession years taken any account of



by the author) the deficits of local and State governments operated to
sustain income, while in the recovery years 1933-36 there were surpluses.
Another criticism of this paper relates to the recommendation (pages
125-26) that Federal subsidies be used extensively to enable State and
local governments to maintain expenditures in periods of recession. The
authors point out in the section preceding this one that most State and
local expenditures are of types that do not lend themselves to expansion
in bad times and contraction in good times. The only reason given for
outright grants to finance additional expenditures in times of depression
is the fact that such expenditures would tend to expand income. Obviously, however, a given amount of expenditure of Federal funds does
no more to increase income if made through State and local governments
than it would if made directly by the Federal Government. There may
be administrative reasons why it is preferable to have such payments
channeled through State and local governments rather than made directly
but no such reasons are given by the authors. On the face of it, it would
seem likely that such expenditures could be cut off more readily when
no longer needed if only the Federal Government were involved in the
administration of the activities financed.

Chairman of the Board, Federal Reserve Bank of Chicago
This collection of essays is a notable contribution to the literature of
fiscal policy. The essays are interesting and important. They are full of
timely suggestions and contain many novel proposals. So comprehensive
is the coverage of the essays that it is impossible to review each or to
comment on more than a few of the points raised by the authors. The
reader will do well, however, to study the articles with care.
If the essays as a whole have a bias it lies in the direction of a belief
that deflationary tendencies will be operative once war-contract terminations become effective and the level of Federal spending is drastically
reduced. This emphasis is explicitly stated, by Musgrave, for example,
since techniques for meeting depressions are believed to be more controversial than those for preventing inflation. Inflationary possibilities, however, are not entirely left out of account in the various papers. Robinson's
essay on "Monetary Aspects of National Debt Policy" is primarily concerned with debt management during periods of monetary expansion.
Nevertheless the underlying current of thought running through the
volume is that government spending or investment will be required to
maintain a satisfactory level of employment. Thus, the point of view is
predominantly Keynesian or Hansenesque. This ghost being out, the
authors appropriately attempt to allay economic fears, by concerning
themselves spatially more with the public debt than with other topics.
Whether depression rather than inflation eventuates in the period ahead,
time will tell. Meanwhile neither all of the forces, as Robinson clearly
shows, nor all of the economists, are arrayed on the side of probable
deflation. Conditions in the future may also change, as may the reality
of one's point of view. If the prevailing point of view of the essays is
correct, the authors will have sounded adequate warning; should they
be mistaken the emphasis in their volume will be remembered.
Should depression be our lot in the post-transition era, the authors
have outlined general policies to meet it. Musgrave, for example, recog-




nizes the failures of pump priming but comes dangerously close to saying
that he sees no way, for some years, to avoid continued deficits. As reflationary tools, increased public expenditures are said to be more effective than tax reduction. Public works are said to be too slow in producing desired economic effects. These primary lessons, illustrated from
recent experience, many planners have not yet learned; too many antidepression policies are simply larger and brighter models taken over from
the period of the 1930's. The requirement of a self-propelling industry to
afford optimum employment is largely absent from these plans. Musgrave
does, however, emphasize the role investment and spending must play
in maintaining an economy capable of providing full employment. He
indicates the conflict involved in attempts to stimulate consumption and
also improve investment by the use of the same tax devices. Many advocates of progressive taxation have not faced this dilemma.
Fiscal policy to Musgrave, however, "is primarily an aggregative approach, operating upon the general level of expenditures and prices rather
than the direction of expenditures or the structure of prices" (page 18).
Perhaps it is correct to neglect "the structure of prices" but it is doubtful
if fiscal policy is a conception of aggregates, except to statisticians who
look at the economy mainly through the gross national product. Fiscal
policy does take account of the effects flowing from levels of taxation,
expenditure and borrowing. I t also takes account of the effects of particular taxes, of different allocations of expenditures and of varying
methods of borrowing. I t attempts to be selective in the devices employed,
the choice being made largely on the basis of the economic effects produced by the techniques selected. This is far more than a question of
aggregates—witness the words spilled in the condemnation of retail sales
taxes because of their deflationary consequences, or the approbation of
public works for their multiplier effects. To some writers, fiscal policy
even embraces central bank policy via the domination of private credit
policy by the public treasury.
Fiscal policy is eclectic, not merely an aggregate control. For example,
the effects of all public expenditures are not identical. The primary velocity of different types of expenditures, as well as the multiplier effects,
are not identical. Cyclical budgeting, therefore, cannot be concerned
merely with the volume of expenditures. The average citizen is vitally
concerned with the specific character and scope of government services.
The dollar spent "for the services of the construction worker or for additional groceries" is not the same, even to the recipient of public relief



payments. If fiscal policy is to be merely a faucet analysis—so much to
be turned on and off at different seasons—it falls far short of its potentialities. I t will never get at the causes of trouble nor recognize its own
shortcomings. That nonfiscal forces are at work and need correction,
Musgrave clearly states. Fiscal policy only supplements or complements
other well-known tools.
The essay by Wallich on the "Public Debt and Income Flow" is mainly
concerned with the slowing up of the income stream because of taxes imposed for interest and debt retirement. The total volume of debt, public
and private, he believes is about what it would have been, "if after iQ2gy
instead of running into the depression and subsequently the war, we had
continued to enjoy a steadily expanding national income, supported by
high private investment and continued credit expansion." 1 The "if involved in that assumption is of more than normal size. I t overlooks the
tremendous industrial and credit expansion due entirely to the war.
Projections of trends on the basis of data from the late twenties hardly
seem to produce figures of present magnitudes. Nor were projections
presented to prove the point. The blame for the problem of a 300 billion
dollar debt should rest squarely on the war, not on "a high income and
savings economy." I t may even be doubted if the expansion in private
indebtedness would have been as great as heretofore, corporate saving
having played a continually more important role. There is no doubt,
too, but that the forced and patriotic saving of the war years was of far
greater magnitude than any normal saving to be expected from comparable levels of income in the absence of war and the restricted outlets
for spending imposed by the war.
Wallich makes an excellent case for the collection of data on distributions of bond ownership and interest payments by income classes. Such
a study is needed if the economic effects of debt payments are to be accurately measured. I t is a sorry comment that writers who deal with
fiscal policy, the incidence of taxation or the distributional effects of debt
payments have to base their conclusions on inadequate data, buttressed
merely by implications and assumptions. Similarly, it would be worth
knowing what bondholders actually do with interest and principal payments made to them, as well as the use policy holders make of insurance
refunds and other payments. No data are available save those which can
be applied indirectly from studies of consumer expenditures. The behavior
of bondholders is, therefore, largely assumed.

P. 85 above. Italics my own.



A similar gap exists in the data covering the fiscal operations of State
and local governments. Census data partially supply the need but the
coverage is not complete for local units and the time lag, though greatly
reduced in recent years, still remains. What is needed are actual data and
indexes of current receipts, expenditures and borrowings, by aggregates,
functions and objects if possible, made available monthly and with no
more delay than is involved in the presentation of business statistics.
Time was when the volume of fiscal operations of State and local governments exceeded those of the Federal unit. Whether this is likely to happen
in the future is not as important as the fact that similar economic trends
should be achieved among the governmental units, as Mitchell, Litterer
and Domar make clear. If data are currently available showing trends in
fiscal operations in each level of government, with aggregates for each,
the possibilities of fiscal planning will be much improved. The United
States Department of Commerce and the appropriation committees of
the Congress should take note of this.
The high earnings of banks from Government securities present several
problems with which Wallich carefully deals. When he says that "a good
deal more than half of their total 1948 income will come from this source''
(page 95), he does not exaggerate the probable situation. If, as seems
likely, interest on " Governments" will soon more than cover all bank
expenses it may be wondered whether the banks will effectively discharge
their function as risk takers, or whether they will prefer to leave the
financing of business ventures largely to "speculators" and established
business firms, the latter through corporate saving. I t may be doubted,
too, if the extra earnings will be so continuously plowed back into capital
accounts as to make banks, in the aggregate, more venturesome. When
the bulk of bank earnings comes from the most riskless of all securities,
increased complacency seems a more probable outcome than increased
Wallich indicates several methods by which bank earnings may be
decreased. A little more competition among banks seems to be overlooked, yet continued high earnings will undoubtedly bring about the
organization of more banks. An excise tax, rather than an excess profits
tax directed at banks is preferred because excises can more easily single
out individual industries for discriminatory taxation (page 96). This is
certainly a tenuous thread on which to hang tax policy, especially taxes
for nonfiscal ends.
The case against the direct sale of securities to the Federal Reserve



System is also weak. Emphasis is on political vulnerability and the high
reserve ratios such a policy might require. But why not high reserves
when occasion indicates their need? Reserves of conventional percentages
are a part of the folklore of banking and need to be recognized as such.
Why not allow the monetary authority to fix reserves from time to time
at whatever point produces the desired effects?
When, however, the growing debt charges in the face of declining
national income becomes a reality—one of the situations assumed by
Domar—more and more pressure to cut Federal interest costs may be
envisaged. Special securities, issued only to banks, carrying lower interest
rates than now prevail, loans from the "Fed" and other means to reduce
interest burdens may be utilized by the Treasury. The authors seem not
to have fully emphasized this phase of debt management, nor to have
integrated it with relevant monetary controls.
In connection with the continuation of pay-roll deductions for the sale
of E bonds in the years to come, Wallich suggests the discontinuance of
the plan "if contractive tendencies appear" (page 98). Of course, what is
desired at such times is the maintenance of aggregate spending. Nevertheless it should be recognized, as Wallich undoubtedly would, that the
doctrine advocated clashes with tenets of personal thrift. Perhaps at such
times postal savings and mutual savings banks should also be handicapped, and life insurance sales made more difficult. Individual and collective economics clash at such times but other ways for meeting the
situations are so effective that deterrents to individual saving, such as
those suggested, may well be neglected as inconsequential.
Domar follows Hansen in his approach to the problem of the relationship of the national debt to income. He weaves into his discussion both
public investment and the mature economy thesis. He also favors, as
does Robinson, deficits during depressions and debt repayments during
prosperity. In view of the economic effects which Domar and his associates desire, a better fiscal policy cyclically conceived would be to tax
heavily for debt repayment during prosperity (and to keep the revenues
thus collected out of the banks and security markets) but make the repayments of principal during depressions. This would help depress booms
and prevent debt repayments from feeding them. I t would also increase
the flow of funds for expenditure or investment during depressions. On
the whole, however, Domar is more concerned with showing that under
certain assumptions a continuously increasing debt not only is not ruinous
but may be carried at a declining relative cost. His preference for the



ethics of the ability-to-pay theory of taxation leads him to prefer public
to private investment, in areas not too clearly defined, because under
private capitalism the rich and poor are charged the same price for
bread—if purchased in the same wrapper and at the same place, an occurrence which modern merchandising has done much to prevent. The
private enterprise system sells the same products under too many wrappers, at prices designed to tap various income levels, to give Domar's
argument unqualified validity. And along with the different wrappers, of
course, go other "services" and prestige. In spite of this the higher charges
to the well-to-do are not identical with progressive tax rates on income.
This is the old controversy between needs and means, between commerce
and ethics, between uniformity and progression. Should all prices or
rates be fixed according to a single notion? Should all charges—whether
in the public or private economy—be based on the faculty theory of
Robinson's essay is primarily concerned with the problems arising from
the postwar ownership of Government securities by the banks, especially
the short-terms. He suggests several plans designed to "freeze" the holdings of banks in the interest of promoting monetary stability, but prefers
the use of voluntary "inducements" rather than the force of law to bring
this about. He would encourage bond purchases by individuals and their
retention to maturity. This is desirable but just how it is to be done is
not clear. Differential interest rates to other holders of Government bonds
than commercial banks are mentioned, but it is doubtful if the quantity
of bonds requisite for holding by individuals to keep them out of banks
and to keep down credit creation could be accomplished by such means.
I t should be recalled, too, that individuals, especially the rich who could
buy "Governments," are also needed by society to provide the venture
capital required by private enterprise. Individuals can hardly do both.
Far more rigorous action than that espoused by Robinson seems to be
called for, if monetary expansion is to be avoided, should individuals and
corporations sell "Governments" in substantial volume. The most probable buyers will be the banking system. Only the failure of the private
demand for capital to be supplied by banks will prevent increased credit
expansion (mentioned by Robinson, page 73) as not much faith can be
put in the reluctance of banks to decrease their capital-to-deposit ratios
(also mentioned, page 73).
Credit policies for the nation are subordinated by Robinson to the requirements of debt management, whose primary objective is said to be



monetary stability. This may be only saying that the two should be one.
I t may mean that the requirements of the Government take precedence
over those of the private economy, if those requirements can be assumed
to be different. Certainly the Government as a borrower and payer of
interest may be dominated by desires to save interest and debt administration expenses, whereas the rest of the economy may be better off,
under certain circumstances, if higher interest payments are the rule.
When credit policy is made the function of debt management, control of
both seems logically to pass to the Treasury. But, as the needs of the
Treasury as a borrower and the rest of the economy as producers, consumers and lenders may not coincide, how will the Treasury balance these
interests? At present, the needs of the Government determine the policies
of the banking and credit system. In the long run, neither the commercial
nor the central banks can follow policies inimical to the requirements of
the Government, whatever they are, for their powers flow from the
Government itself, which can control bank activities as well as the length
of life of these institutions. The issue is centralization vs. decentralization
of fiscal and monetary power. Where the powers should reside is a problem
for the future, unless the status quo is the solution. However, when Robinson makes credit policy a function of debt management, he does not
discuss these problems of the division of power and responsibility for administration, nor the relation of the Treasury to the Reserve System, nor
the pros and cons of making the Treasury the responsible monetary and
fiscal authority for the nation.
Two essays on taxation are included in the symposium. Musgrave, dealing with Federal taxation, is concerned primarily with avoiding or minimizing the deflationary aspects of such taxation. Mitchell, Litterer and
Domar ably describe the position of State and local governments, as
well as the obstacles encountered in attempts to synchronize State-local
fiscal actions with national policies. A strong case is made for the use of
Federal grants-in-aid to overcome some of the rigidities in fiscal practices, as well as to provide a national minimum of essential public services.
In the achievement of both aims grants-in-aid not only hold great promise
but, if sharing is included, constitute the most practicable way in which
the benefits of a good tax system, maintained by the Federal Government,
can be utilized to help meet the service needs of the fiscally more impotent
units. I t is to be hoped that not all grants will be conditional; some should
stimulate extensions in current services as well as improvements in quality, without reference necessarily to cyclical policies; a few should pro-



vide "free" funds (unconditional grants) to subordinate units to encourage
initiative and to provide revenues for activities in which local groups are
interested, safeguarded, of course, by appropriate eligibility requirements.
The main difficulties with grants have been the way they change the
marginal value of dollars spent by the grantees and their tendency to
preserve the life of marginal governments, marginal services and marginal
areas. Closer attention to effects produced might lead to improvements
in the form and type of aid extended. Nevertheless the role of grants
espoused by the authors is to be applauded.
In the implementation of State-local counter-cyclical expenditures,
especially the financing of capital improvements, more consideration
might have been given to intergovernmental loans, credit pools and banks,
the guarantee of State-local credits and even to the possibilities of improving the market for and the liquidity of State-local credits via discounts and advances from the Federal Reserve System to member banks
on the basis of such collateral. These possibilities need careful exploration. There is much darkness and prejudice in this corner of public finance
and banking directed against State-local borrowing. There is a crying
need, too, for a reorientation of Federal, State and local fiscal relationships and the development of constructive long-term policies.
Regressive taxes are roundly condemned throughout the symposium^
in part through the authors' emphasis upon the avoidance of deflationary
tendencies. Hardly a good word is uttered as to the usefulness of these
taxes, especially sales and pay-roll taxes, as weapons for countering inflation. Mitchell, Litterer and Domar even go so far as to state that "at
no time in the past two decades have economic resources been so fully
employed and inflationary pressures so strong as to warrant the dominant
position of such taxes in the tax system as a whole . . . A better balanced
revenue system in terms of its effect on the full utilization of the nation's
economic resources would have drawn a smaller tax contribution from
the lower income groups" (page 117). What about the speculative period
of the 1920's—would not substantial sales taxes have been useful to
help stop that inflation? The so-called Mellon income tax reductions
of that period were irrational, all will agree. Even despite these reductions,
however, sales taxes would have helped combat the boom. Then during
World War I I Federal taxation was not the effective anti-inflation force
it should have been. Not enough purchasing power was taken from lowincome groups either by way of bond sales or income taxes to counter
upward pressures on prices. Sales taxes and increased pay-roll taxes



would have been anti-inflationary in their effects. When the problem is
to check inflation, taxation, as an instrument of policy, should be directed
against the accumulating forces. During World War I I that spot was in
the lower income brackets. Notions of tax justice based on faculty theories
are not satisfactory standards for price or monetary controls.
Part of the same argument is involved in the discussion which led to
the repeal of the lower exemptions for the normal Federal income tax.
The effect of this is to raise the exemption levels for income taxation.
(See Musgrave, table on page 50). This has made the personal income
tax a less effective weapon for fighting inflation than it was. And one of
the real problems, economic as well as political, year in and year out, has
been to get income taxes into the low brackets and to keep them there.
The raising of exemptions returns the income tax to its role as a class tax,
the groups affected becoming more restricted with each increase in exemptions. This is desirable neither from the point of view of political
democracy, where those above the subsistence level should be called upon
to make direct payments to the support of government, nor from the
economic standpoint of maintaining an instrument to reach mass income
and purchasing power. The real question is the rate of taxation to be
employed, not whether citizens with positive income should be taxed.
In 1940, for example, income tax returns numbered 14,700,000; the number of taxpayers was only 7,505,000—double the record for any previous
year in tax history. The exemptions were $2,000 for married couples and
$800 for single persons. In 1944, when exemptions for married couples
were reduced to $1,200 and those for single persons were cut to $500, the
tax returns jumped to 48,000,000 and the number of taxpayers to 43,000,000. About one-third of the population thus became direct supporters
of the National Government. This is a healthy condition and should be
preserved. Let it not be forgotten that the state is a political as well as
an economic institution.