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FEDERAL RESERVE B A N K O F S T. L O U IS JULY 1979 Vol. 61, No. 7 The R e v i e w is published monthly by the Research Department of the Federal Reserve Bank of St. Louis. Single-copy subscriptions are available to the public free of charge. Mail requests for subscriptions, back issues, or address changes to: Research Department, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, Missouri 63166. Articles herein may be reprinted provided the source is credited. Please provide the Bank’s Re search Department with a copy of reprinted material. Rising Farm Exports and International Trade Policies CLIFTON B. LUTTRELL HEXPORTS of farm commodities in 1978 totaled $29.4 billion, almost 27 percent of the value of all cash farm receipts, and a further increase in farm exports is expected this year. Farm exports have in creased rapidly and consistently during the past decade both in nominal value and as a percent of cash farm receipts. The nominal value of such ex ports last year was more than five times that of 1969 and such exports, as a percent of cash farm receipts, more than doubled over the period. Despite this sharp increase, however, farm exports as a per cent of cash farm receipts have only recently regained the levels that existed in the early 1920s. those of the 1920s and early 1930s, many farm groups have supported such restrictive policies in the past and continue to support them today. FARM EXPORTS ASSOCIATED WITH TOTAL IMPORTS Farm exports tend to move in the same direction as total exports, and both tend to move in the same direction as total imports. Chart 1 shows that, aside from World War II and the immediate post-war years when foreign aid was a major portion of total ex ports, exports and imports as a percent of GNP gen erally have moved in the same direction. Chart 2 shows the same general movements for exports of This article suggests that much of the increase in the proportion of farm The im pact of rising demand for products exported in re U .S. farm exports on the price cent years is a result of and production of U.S. farm major changes in U.S. and products is demonstrated in the other nations’ foreign trade following diagram : S = su p p ly policies. The restrictive curve for U .S. farm products, D ; = dem and curve of domestic trade legislation of the consumers for such products, 1920s and 1930s sharply re D 2= domestic plus export duced imports which, cou dem and for U .S. farm products, pled with retaliatory re and D 2 - D x= export demand. strictions imposed by other The price and production of farm products without exports nations, also reduced U.S. is P, and Q „ respectively. With exports. This reduction exports and higher overall hurt the farm sector se demand ( D 2), price and verely (see box). This arti production of farm products is cle further demonstrates P2 and Q2, respectively, and any increase in foreign demand will that despite the damage to increase total dem and (D 2), farmers caused by restric and price and production. tive trade policies such as Page 3 FEDERAL RESERVE BANK OF ST. LOUIS JULY 1979 Chari I Exp o rts a n d Im p o rts of G o o d s a n d S e rv ice s (A s a P ercent o l G ro ss National P ro d uct) farm products as a percent of cash farm receipts. Sta tistical analysis confirms these relationships; the changes in imports and exports are highly positively correlated as are the changes in farm exports and total imports.1 Given constant levels of real income in the trad ing nations, two factors tend to produce similar movements in exports and imports of goods and serv ices. First, tariff changes by one nation usually are reciprocated by other nations. For example, following the enactment of the Smoot-Hawley Tariff Act of 1930, higher U.S. duties on imports were quickly followed by higher import duties in Canada, Cuba, Mexico, France, Italy, Spain, Australia, and New Zealand. The following year India, Peru, Argentina, Brazil, and China also levied higher duties.2 Second, under a flexible exchange rate system, movements in the exchange rate tend to balance xThe annual change in exports of goods and services over the period 1901-78, excluding the years of 1939-50, is positively correlated with the change in imports; the correlation coeffi cient is .88. Over periods longer than a year, the correlation of changes in imports and exports is even higher. Using twoyear averages, the correlation coefficient is .93 and with fiveyear averages, the correlation is .99. Similarly, the annual change in farm exports is positively correlated with the change in total imports; the correlation coefficient is .69. Using twoyear and five-year averages, the correlation coefficients are .77 and .93, respectively. 2P. T. Ellsworth, The International Economy (New York: The Macmillan Company, 1950), p. 501, and Allan H. Meltzer, “Monetary and Other Explanations of the Start of the Great Depression,” Journal of Monetary Economics (November 1976), p. 460. Page 4 trade over an extended period of time even without reciprocity of tariff rate changes. The exchange rate — the value of the dollar in terms of other currencies — like the price of any other good, is determined by the supply and demand for dollars. Over a period of time, changes in the supply of dollars in foreign exchange markets reflect the value of U.S. imports plus U.S. investments abroad. When such imports and investments rise relative to U.S. exports plus foreign investments in the United States, the supply of dollars in foreign exchange markets increases rela tive to the demand for dollars and the exchange value of the dollar falls. Conversely, when exports of U.S. commodities and foreign investments in the United States rise, the quantity of dollars supplied to foreign exchange markets decreases and the exchange value of the dollar in these markets rises. These fluctuations in the value of the dollar tend to equate the dollar value of U.S. exports and imports through the domestic currency prices of internationally traded goods.3 For example, if the value of the dollar 3In contrast to the current method in which trade plus net investment flows are balanced between nations, under the gold and gold exchange standards, the flows were balanced through gold specie or gold bullion transfers. During those periods in which the stock of money in a nation was influenced by the quantity of gold held, the flow of specie or bullion out of a nation in payment for excess imports led to a reduction in domestic prices relative to world prices and thereby to a reversal in trade and the balance o f payments. During much of the gold exchange standard period following 1933, revi sions in the exchange rates were made by governments in response to unequal rates of inflation in the various nations. Such revisions often served to reverse imbalances in trade. FEDERAL RESERVE BANK OF ST. LOUIS JULY 1979 Char* II latest data plotted: 1978 Sources: U.S. Department of Agriculture, U.S. Department of Commerce and Council of Economic Advitert falls relative to the value of the Japanese yen, prices of Japanese television sets to U.S. consumers will rise; consequently, fewer Japanese television sets will be purchased. But the Japanese, finding that U.S. wheat and soybeans can be purchased for fewer yen, will import more of these products. Similarly, if the value of the U.S. dollar falls relative to all foreign curren cies, foreign residents will find U.S. goods cheaper than before, and U.S. exports will increase. Con versely, if the value of the dollar rises relative to other currencies, U.S. citizens will find that the dollar prices of foreign goods have fallen relative to U.S. goods, and imports will increase.4 Given the tendency for the exchange rate mechanism to equate the dollar value of exports and imports, attempts to reduce im ports will have a similar effect on the demand for exports including exports of farm products. RESTRICTIVE IMPORT POLICIES LED TO DECLINES IN TOTAL IMPORTS, FARM EXPORTS, AND FARM INCOME As shown in Chart 2, exports as a percent of cash farm receipts declined throughout most of the twenties 4While Kravis and Lipsey found sizable differences in the dol lar prices of foreign traded goods in various countries for an extended period of time, exports rose at the highest rate in those nations where prices were lowest. I. B. Kravis and R. E. Lipsey, “Price Behavior in the Light of Balance of Payment and thirties from an average of 25.2 percent in 192022, to 13.4 percent in 1930-32, to 8.4 percent in 193840. This decline in exports followed the adoption of more restrictive trade policies by the United States and other countries. The sharp decline in farm com modity prices in 1921, which followed the domestic business recession and the European agricultural re covery from World War I, prompted Congress to attempt to “protect” farmers with an emergency tariff on farm products. The duties on wheat, com, meat, wool and sugar were raised. In 1922 the FordneyMcCumber Tariff Bill was enacted, raising the aver age ad valorem (percent of value) rates on dutiable imports to about 40 percent — back to the levels of 1913. Duties were increased on numerous farm prod ucts including wheat, corn, beef, eggs, reindeer meat, peanuts, beet and cane sugar, wool, and acorns. Ad ditional “concessions” to farmers were the removal of duties on agricultural implements such as plows, har rows, reapers, cotton gins, etc. The Smoot-Hawley Tar iff Act of 1930, initiated as another measure for “pro tecting” agriculture from foreign competition, raised import duties to the highest levels in the nation’s hisTheories,” Journal of International Economics (May 1978), p. 230. Henry Goldstein found that relative domestic price levels have a substantial and significant impact on the ex change rate. See “Floating Exchange Rates and Modified Pur chasing Power Parity: Evidence from Recent Experience Us ing an Index of Effective Exchange Rates” published in West Coast Academic/Federal Reserve Economic Research, Fed eral Reserve Bank of San Francisco, 1978, p. 174. Page 5 FEDERAL RESERVE BANK OF ST. LOUIS JULY C h a rt lit Decline in Imports Follow ing Tariff Acts of 1922 an d 1930 (Dutiable is a Percent of Duty-Free Imports) ll 1979 demanded and generally received greater protection than the nonfarm sector. Farm exports declined from 22 percent of cash farm receipts in 1922 to 8.4 percent in 1936. One statistical study of U.S. demand for imports found evidence that the tar iffs were a major factor in the decline of imports during the 1920s and early 1930s. The study demonstrated that the tariffs caused a greater reduction in dutiable imports (imports on which tariffs were levied) than in duty-free imports. After eliminating the effects of shifts in im ports from duty-free to dutiable, and vice versa, the study found that dutiable imports as a percent of duty-free imports declined sharply following the higher duties in both 1922 and 1930 (Chart 3). During the three years following the 1922 Act, the index of the quantity of dutiable imports declined to 77 percent of the index of duty-free imports, and in the three years following the 1930 Act, the index of dutiable imports declined further to 53 percent of the duty-free imports.6 Since exports are closely associated with imports, the tariffs were indirectly a major factor in the decline of farm exports. Sou rce: J. H o n * A d le r, "U n ite d S ta te s Im port D e m a n d D u rin g the Interw or P e rio d ," A m e ric a n E con o m ic R eview (June 1945). U. D u tia b le im p o rts ore c om m od ities on w hich a tariff is levied. A ll other im ports a re c la ssifie d duty-free. tory. Although already high by historical standards, rates were further increased on more than 800 items.5 The initial 1921 emergency tariff had little effect on the volume of foreign trade or on farm commodity exports. The United States was a net exporter of most of the commodities being protected and remained so. Hence, the protective features of the act were largely illusory. The Fordney-McCumber Tariff Act in 1922 and the Smoot-Hawley Act in 1930, however, signifi cantly reduced import growth, thereby setting in mo tion forces that reduced exports of farm products. Imports as a percent of GNP declined from 7.3 per cent in 1920 to about 5.4 percent in 1922. They re mained near that level until 1930 when they declined even further as a result of the Smoot-Hawley Tariff and the Great Depression. They dropped to 3.6 percent of GNP in 1932 and remained near this level through out the remainder of the decade (Chart 1). Total exports followed the same general pattern. Exports of farm products, however, declined faster than ex ports of nonfarm products as farmers in other nations 5F. W. Taussig, The Tariff History of the United States (New York: Augustus M. Kelley, 1967), pp. 452, 455, 504-11. Rates were increased on numerous farm products including sugar, cotton, cattle, beef, sheep, mutton, swine, com, milk, cream, eggs, live poultry, hides, leather, onions, tomatoes, cabbages, turnips, and blueberries. Page 6 Since exports accounted for such a large portion of U.S. farm commodity sales (15 percent in 1929), the decline in farm exports had a greater impact on farm income than the decline in nonfarm exports had on income in the nonfarm sector. Hence, farm incomes declined more dramatically than did nonfarm income. For example, farm income declined at an average an nual rate of 31 percent during the 1929-32 period, compared with a 17 percent rate for total personal income. If the tariff accounted for the difference between the percentage decline in total personal income and farm income during the period, about 40 percent of the decline in farm income during 1929-32 can be attributed to it. If farm income had declined only at the rate of the national aggregates, net farm income in 1932 would have totaled about $3.6 billion instead of $2.0 billion. 6J. Hans Adler, “United States Import Demand During the Interwar Period,” American Economic Review (June 1945), pp. 418-30. FEDERAL RESERVE BANK OF ST. LOUIS RISING FARM EXPORTS AND INCOMES FOLLOWED FREER TRADE POLICIES Much of the increase in farm exports since the mid-1950s can be attributed to a gradual reduction in foreign trade restrictions.7 Beginning with the Reciprocal Trade Agreements Act of 1934, a series of tariff-reducing acts and negotiations have led to major reductions in international trade barriers. Initially, these bilateral reductions achieved only limited suc cess since duties on most dutiable imports were well above the minimum levels that provided incentives for trade. Since the war and the General Agreement on Tar iffs and Trade (GATT) in 1947, a number of major reductions in average ad valorem rates have been negotiated. The permissible reductions and average duties on dutiable imports are listed in Tables I and II. Studies indicate that these reductions have had a major impact on U.S. imports. Kreinin analyzed the effect of the tariff reductions granted in the 1955 negotiations (which resulted in a 23 percent reduc tion in the 1954 rates on the covered group of com modities) and found that the volume of imports of commodities on which tariffs were reduced rose 59 percent, whereas imports of the nonreduced group rose only 17 percent. Similarly, following the 1956 negotiations ( which resulted in a 15 percent reduction in rates for the affected group), imports of the re duced group increased 12 percentage points more than the nonreduced group.8 A study by Stem, based on the import demand for 226 commodity groups, concluded that total imports in 1960 would have been $4.1 billion (about 25 per cent) more than the actual level had no tariffs or quotas existed.® A study in 1965 by Balassa found 7Domestic price support programs and crop production con trols, which caused the prices of some products to rise above free market levels, were factors that tended to reduce exports of some crops, especially wheat, cotton, and tobacco. These supports ana controls, however, had little impact on the prices of such major export crops as feed grain and soybeans, indicating that the removal of trade restrictions was a major factor in the rise in exports of these products. U.S. Govern ment holdings of feed grain and soybeans through price support operations did not exceed 15 percent and 30 percent of production, respectively, at the close of any year follow ing 1963. Furthermore, the holdings of both were almost as large in the recent years of rising exports as in the early 1960s. 8Mordechai E. Kreinin, “Effect of Tariff Changes on the Value and Volume of Imports,” American Economic Review ( June 1961), pp. 314-16. 8Robert M. Stern, “The U.S. Tariff and the Efficiency of the U.S. Economy,” American Economic Review (May 1964), p. 464. JULY 1979 Table 1 Tariff Cuts A u thorized by the V ario u s T rade Acts T ra d e A g re e m e n ts Acts M a x im u m P erm issible Reduction Act o f 1 9 3 4 5 0 percent o f J u ly 1, 1 9 3 4 rate A ct o f 1 9 4 5 5 0 percent o f J a n u a r y 1, 1 9 4 5 rate A ct o f 1 9 5 5 15 percent o f J a n u a r y 1, 1 9 5 5 rate A ct o f 1 9 5 8 2 0 percent o f J u ly 1, 1 9 5 8 rate A ct o f 1 9 6 2 5 0 percent o f J u ly 1, 1 9 6 2 rate A ct o f 1 9 7 4 6 0 percent of e x istin g rate SOURCE: U nited States T ariff Commission. T a b le II A v e ra g e Level o f Tariffs on Imports R atio o f D uties C ollected to: D u tia b le Im ports A ll Im ports 1 9 1 9 -2 8 3 3 .2 % 12 .3 % 1 9 2 9 -3 8 4 1 .9 1 6 .9 1 9 4 4 -5 3 1 8 .7 7 .2 1 9 5 0 -5 3 1 2 .6 5 .6 1 9 5 5 -5 9 1 1 .7 6.3 1960 1 2 .2 7 .3 1962 1 2 .3 7 .6 1964 1 1 .9 7 .4 1966 1 0 .7 6 .8 1968 1 1 .3 7.1 1970 1 0 .0 6 .5 1971 9 .2 6.1 1972 9 .0 * n.a. P eriod ♦excludes petroleum. SO U RC E: U nited S tates T ariff Commission. that effective duties (the degree of protection for the manufacturing process) in the United States were generally higher than nominal rates, and with poten tially higher supply elasticities in the United States than in other industrial countries, imports would rise faster here with the elimination of tariff duties. He concluded that, if such elasticities are 50 percent higher here than elsewhere, imports would rise by 54 percent with the elimination of duties.10 Reductions in tariff duties do not effectively in crease trade immediately. The effect of such actions lag, and in some cases the reductions do not result in any change in trade. Many of the rates in the mid10Bela Balassa, “Tariff Protection in Industrial Countries,” Journal of Political Economy (December 1965), p. 593. Page 7 FEDERAL. RESERVE BANK OF ST. LOUIS J LILY 1979 T a b le III C o n g re ssio n a l Vote on the Sm oot-H aw ley Tariff Act o f 1930 Section of N a tio n Percent o f W o rk e rs In In A gricu ltu re M a n u fa c t u r in g For R ep resen tatives A g a in s t For S e n a to rs A g a in s t N e w E n g la n d 6 .2 % 4 3 .1 % 27 3 11 1 M id d le A tla n tic 5 .3 3 6 .3 64 27 4 2 East N o rth C en tral 1 4 .4 3 5 .7 60 21 8 2 W e st N o rth C en tral 3 3 .6 1 9 .8 33 23 3 11 So u th A tla n tic 3 2 .5 2 4 .2 14 39 7 9 East S o u th C en tral 4 7 .8 1 6 .9 8 30 1 7 W e st So u th Central 4 0 .5 1 6 .9 11 30 2 6 M o u n ta in 3 0 .8 1 8 .3 11 2 8 8 Pacific 1 4 .5 26.1 18 1 5 1 U nite d States 2 1 .4 2 8 .9 246 176 49 47 SOURCE: U.S., Congress, Congressional Record, and U.S. D epartm ent of Commerce. 1950s were well above the minimum prohibitive trade level (the tariff level at which no trade will occur) and the reductions only reduced the excess protection. Furthermore, as lower rates provided incentives for trade, foreign producers still needed time to arrange for merchandising and distributing facilities in the United States. Exporters of goods to the United States had been effectively shut out of the U.S. market for about 25 years — in the 1930s because of the SmootHawley Tariff, in the 1940s because of the war, and in the early 1950s because of the time required to pre pare for increased exports.11 By the mid-1950s, U.S. tariff rates on a large num ber of commodities had been reduced to a level which provided incentives for trade, and several international organizations were established to in crease exports to the United States. Imports of goods and services as a percent of GNP increased moder ately in the early 1960s from 4.5 percent to 6 per cent in 1970 and to 10 percent in 1978 (Chart 1). By 1978, imports as a percent of GNP were the largest for any year since the turn of the century. Total exports and farm commodity exports followed the pattern of total imports. As a percent of GNP and of farm cash receipts, respectively, they started up in the 1950s, continued moderately up through the 1960s, and rose at a sharply higher rate in the 1970s. Exports of farm products rose from about 10 percent of cash receipts in the early 1950s, to about n Kreinin, “Effect of Tariff Changes,” p. 319; also William P. Travis in “Production, Trade and Protection When There Are Many Commodities and Two Factors,” American Eco nomic Review (March 1972), pp. 100-02. Page 8 15 percent in the 1960s, to about 25 percent since the mid-1970s. The sharp increase in farm exports had a favorable effect on farm income. Gross farm income rose at an 8.4 percent rate from 1969 to 1978, about the same rate as GNP growth. In contrast, during the previous 10 years when farm exports were rising more slowly, gross farm income rose only 4.0 percent per year com pared with a 6.8 percent rate of GNP growth. THE FARM SECTOR HAS NOT CONSISTENTLY OPPOSED RESTRICTIVE TRADE POLICIES Despite the fact that protective tariffs have gen erally harmed the well-being of farmers, elected rep resentatives from major farming states have in some cases supported highly protective tariff legislation. Such support apparently was obtained by imposing duties on imports of farm products that would not have been imported even without tariffs and exempt ing farm implement imports from tariffs even though none were imported anyway. The Secretary of Agri culture’s report to the President in late 1930 pointed out these “favorable” aspects of the Smoot-Hawley Tariff Act. He showed that the schedule for farm products was increased an average of 69 percent, whereas all schedules were increased an average of only 20 percent. He argued that a protective tariff must become a more integral part of our national agricultural policy.12 Such arguments apparently gained support for the Act. 12U.S. Department of Agriculture, Yearbook of Agriculture 1931 (Government Printing Office, 1931), p. 42-44. FEDERAL RESERVE BANK OF ST. LOUIS The voting record in Congress indicates that sizable support for this highly protectionist measure came from some of the leading farm states. The House of Representatives opposed the act in only three of the nine major sections of the nation, and the Senate opposed it in only four. The vote in the Senate, how ever, was close (Table III). Support for the act was strongest in New England and the Middle Atlantic states, where the percentage of workers in agricul ture was relatively small and the percentage in man ufacturing relatively large. The proportion of workers in agriculture averaged 6.2 and 5.3 percent, respec tively, in the two regions. On the other hand, a majority of representatives supported the act in such agricultural areas as the West North Central and Mountain states, and large majorities supported it in both the House and Senate in the Pacific states. RESTRICTIVE POLICIES STILL RECEIVE MUCH FARM SUPPORT Despite the major shrinkage both in the market for U.S. farm products and in farm income resulting from the ill-advised tariff of 1930, and despite the expansion of exports following the reduced tariffs in the 1950s and 1960s, recent actions of farm groups are not un equivocally opposed to protectionist policies. Evidence indicates that farmers still are sensitive to possible in creases in agricultural imports. Organized and highly articulate groups of fanners, while largely interested in the protection of specific farm products, still sup port foreign trade policies which would result in high tariffs for farm products in general. Sugar cane and sugar beet producers, for example, still insist on legislation to maintain domestic prices above world prices and to protect growers from “lowprice” foreign sugar.13 The National Livestock Feeders Association has gone on record against the “ivory tower” free trade philosophy that has characterized U.S. trade policy for the past several years. The ex ecutive vice president of the association, in hearings before the Senate Committee on Finance in 1974, argued that our free trade policy has brought irre parable harm to U.S. agriculture and industry and opposed proposed legislation to “wipe out” any duty of not more than 5 percent ad valorem, since this would permit the free entry of a number of meat products.14 Despite his contention that the U.S. dairy 13See John Valentine, “President’s Sugar Price-Support Plan Welcomed as End to a Key Uncertainty,” The Wall Street Journal, February 21, 1979. 14U.S., Congress, Senate, Committee on Finance, The Trade Reform Act of 1973, 93rd Cong., 2nd sess., March 25, 1974, pp. 947-64. JULY 1979 industry is, as a whole, among the most efficient in dustries in the world, the secretary of the National Milk Producers Federation argued strongly against free trade. He stated in the above hearings: “Despite all the fine sounds of free trade and expanded inter national cooperation we must first take stock of our own national interests.”15 While reaffirming the Na tional Farmers Union’s traditional position in support of expanding foreign trade, its national secretary in the same hearings opposed any further reduction of tariff and nontariff barriers. He contended that fur ther reductions in trade restrictions would undermine farm prices in both the United States and the Euro pean Economic Community.16 The American Farm Bureau Federation, although making a strong state ment for free trade in general, recommended at the hearings that Title II of the act be amended so that farmers could more readily obtain relief from injury caused by import competition.17 The Agricultural Adjustment Act is indicative of the strong support for protection for specific farm prod ucts, delegating sufficient authority to limit the im ports of almost any product that is competitive with U.S. farm products. The act directs the Secretary of Agriculture to advise the President when he believes that any farm commodity or product is being im ported in quantities that will interfere with farm price support or other USDA programs. The President may then direct the International Trade Commission to conduct an investigation, after which he may pro claim new duties or quantitative restrictions on the imports.18 The maintenance of such a pattern of protection for farm commodities places this nation in an unfav orable bargaining position for free trade in farm commodities. The United States has just concluded the Tokyo Round of negotiations which will take ef fect starting in January 1980. In these negotiations, the United States obtained a broad range of tariff and nontariff concessions that are expected to sig nificantly increase agricultural exports over the next decade. Among those products on which trade bar riers were reduced are beef, pork, poultry, tobacco, fruit, vegetables, oilseeds, and nuts.19 Nevertheless, agricultural trade barriers are perhaps the most diffi 15Ibid., pp. 964-89. 16Ibid., pp. 1030-31. iTIbid., p. 1011. 18United States International Trade Commission, “Operation of the Trade Agreements Program,” 26th Report, 1974, p. 32. 1UU.S. Department of Agriculture, Agricultural Outlook (May 1979), p. 10. Page 9 FEDERAL RESERVE BANK OF ST. LOUIS cult of all restrictions to remove. For this reason, a positive view toward free trade in farm products by this nation is highly desirable. The argument often given in support of farm com modity protection is that this country has lower duties on farm products than most other nations. This argu ment, however, is meaningless in view of our com parative advantage in production. A more appro priate way of measuring relative duties is to compare this nation’s duties on farm products with other na tions’ duties on products in which they have a com parative advantage. In only a few farm commodities, such as sugar and wool where we do not have a com parative advantage, is such a comparison with other nations meaningful. Significantly, our policies with re spect to sugar cannot be considered liberal by either foreign producers or domestic consumers. Apparently the farm sector is willing to accept free trade policies only if “reasonable” restraints are established on im ports of competitive products. Such a posture, if all nations maintained it at the bargaining table, would not permit the resource adjustments necessary for trade or for the attainment of the potential gains to U.S. agriculture from exports. Given the U.S.’s comparative advantage in the pro duction of farm products, most farmers have little to fear from imports. The alleged protection for crops such as wheat, rice, com, cotton, soybeans, tobacco, and livestock products, where net exports are realized, is actually little protection. Such products are gener ally more valuable when exported and when the pro ceeds are exchanged for foreign goods than when sold on the domestic market; hence, these products will not be imported except possibly along the Canadian or Mexican borders which have special transportation advantages. Protection for other major products that may ex perience minor competition from imports (such as beef, other processed and frozen meats, and dairy products) could be self-defeating, especially if such regulations trigger retaliatory protective measures abroad. Any loss of foreign markets for the major ex ported crops, such as cotton, tobacco, wheat, feed grain, soybeans, and rice, will lead to lower domestic prices for such products and eventually will result in a shift of farm resources from these products into the production of tariff-protected products such as beef, other meats, and dairy products. In other words, those sectors which experience minor competition from imports under free trade practices would realize more competition from domestic farmers whose products can no longer be sold in the export market. 10 Digitized forPage FRASER JULY 1979 Another argument often made for protection is that, given a protected market for industrial goods, we will have more workers employed by nonfarm industries and an expanded domestic market for farm products.20 With such policies, however, gains from international specialization of labor and resource use would be lost. In other words, each nation without trade must depend upon its own resources for the production of each good even though it may be rela tively inefficient in producing some goods. The total quantity of goods available for consumption will thus be less for both farm and nonfarm sectors without trade than with trade. Consequently, it is inconsis tent with the general well-being of the farm sector, as well as the nation at large, for farm groups to pur sue protectionist policies. SUMMARY The U.S. farm sector potentially has more to gain from free international trade than virtually any other sector of the economy. Exports of farm products con stitute about 30 percent of the market for U.S. farm products. In contrast, exports account for less than 10 percent of the value of manufactured goods. Never theless, many farm groups have left a record of con fusion with respect to their position on foreign trade policies. They have failed to recognize the link between imports and exports. Changes in imports are closely associated with changes in total U.S. exports. Conse quently, they are closely associated with the level of farm exports given the comparative advantage of the United States in farm production. U.S. imports pro vide foreigners with income to purchase U.S. farm products. Free trade policies, therefore, tend to di rectly increase imports and thereby enhance farm commodity exports. In addition, they induce other nations to adopt similar policies which further en hance trade. 20If domestic price supports and production controls were a major factor in the current levels of farm incomes, it could be argued that fanners are making rational decisions in trading some of their foreign market exports for the short-run gains from domestic price supports. Such supports, however, nave been much smaller in recent years relative to farm income, and losses in the export market from pro tectionist policies would not likely be offset. Only relatively small sectors of the agricultural industry (largely sugar and tobacco producers) have received major benefits from the price supports and production controls in recent years. Fur thermore, prior to 1933, when farm support for protective tariffs was perhaps as great or greater than today, the na tion had no farm production controls and no price supports for most farm products. Government Debt Financing — Its Effects in View of Tax Discounting NEIL A. STEVENS T H E virtues of a balanced government budget have long been a subject of controversy among economists, politicians, and the general public. Debate on this sub ject again has heated up in view of the persistence of inflation and what some consider the inadequate growth of private investment and the excessive growth of government. Recently, a widespread movement has developed to institutionalize the balanced budget doctrine via a constitutional amendment.1 The current debate provides an opportunity to examine the issue of debt- versus tax-financed govern ment expenditures. The discussion centers on the dif ferential economic effects of debt versus tax financ ing of a given level of government expenditures.2 In particular, this article will show that the difference between public debt financing and current taxes de pends upon whether taxpayers correctly anticipate the future taxes that debt issuance implies. This dis 'Many supporters of the constitutional amendment to require a balanced Federal budget are interested in reducing the level of government expenditures rather than simply eliminating the possible adverse effects of debt financing. 2The assumption of a given level of government expenditures allows the discussion to center solely on the differential im pacts of taxes and debt, and thus, to avoid the possible effects of changes in the composition or level of government expendi tures on the economy. cussion has important implications for the pre sumed evils of debt issuance including reduced investment and economic growth, debt burden on future generations, increased inflation, and greater growth of the government sector, as well as the efficacy of fiscal policy actions. In addition, to the extent that movements in interest rates are related to changes in government borrowing, the issue of debt financing versus current taxation has important im plications for the conduct of monetary policy due to the use of interest rate targeting by the Federal Reserve. The Rise in Federal Debt The amount of government debt outstanding is the total of past expenditures financed by the issuance of government debt instead of current taxes. Outstanding gross Federal debt at the end of 1978 stood at about $750 billion. Until World War II, there was a marked tendency to incur deficits during wartime and to run surpluses following wars to reduce the size of the outstanding debt. Following World War II, little attempt was made to reduce the debt; in fact, debt issuance became a standard means for the Federal government to finance Page 11 FEDERAL RESERVE BANK OF ST. LOUIS JULY part of its budget outlays.3 For example, the Federal budget on a unified basis has been in surplus only twice in the past 20 years and, since 1970, the amount of Federal debt has more than doubled.4 1979 Figure I TRADITIONAL VIEWS ON GOVERNMENT DEBT VERSUS TAXES Government can finance a given amount of outlays by either levying taxes in the current period or by issuing interest-bearing debt.5 Virtually all economists consider the choice of debt versus taxes to have differ ent economic effects, although differing views have developed about the specific economic consequences. Investment and Economic Growth Some economists have emphasized the negative effects of deficit financing on private investment.6 In their view, debt issued by the public sector adds to and competes with the private sector (investment) demands for saving. As a consequence, interest rates are bid up and some crowding out of productive private investment occurs. This scenario is demonstrated by the saving and investment diagram in Figure I. Investment is assumed to be negatively related to interest rates, whereas sav ing is assumed to be positively related to both the interest rate and the level of disposable income. The initial saving and investment schedules (S 0 and I0) are drawn under the assumption that government expenditures are tax-financed and that the economy is at full employment. When debt is substituted for taxes to finance a given level of government expenditures, the increased government demand for funds is added to that of the private sector, as shown by the shift in the investment schedule from I0 to Ia. In addition, as a result of the 3Some analysts blame the views of Keynes and his followers on deficit financing as the key ingredient in changing the tradi tional approach of reducing government debt outstanding following periods of wars. See J. M. Buchanan and R. Wag ner, Democracy in Deficit: The Political Legacy of Lord Keynes (Academic Press, New York, 1977). 4Although the Federal debt has grown rapidly in recent years, Federal debt when measured relative to Gross National Product (GNP) has not grown. In fact, the Federal debt outstanding as a percent of GNP has generally fallen since World War II. In 1978 Federal debt was about 36 percent of GNP, down slightly from 1970, and down substantially from 62 percent in 1958 and 98 percent in 1948. substitution of debt for currently levied taxes, current disposable income in the private sector is increased. If the private sector perceives this change to represent solely an increase in current disposable income, saving will increase by only a small percentage of the in crease in disposable income. As a result, the shift in the saving schedule, shown by the movement from S0 to Si, will not be as large as the shift in the investm ent schedule. The effects of a substitution of debt for taxes are an increase in interest rates (from r0 to rx) and a reduction in private investment (from X0 to X2). With a given level of total income, as assumed in this example, private consumption will be increased (by the amount X2X0). Thus, private capital forma tion is lower in the debt-financed government expendi ture case than in the tax-financed one and the growth rate of the economy is reduced.7 Unlike the classical views described above, Keyne sian economists have argued that the economy does not automatically self-adjust to full employment. These economists stress the short-run impact of govern ment budgetary policies and deemphasize the poten tially adverse longer-run effects of debt financing on investment and economic growth. 5A third alternative, money creation, is not discussed here. ®For a presentation of the classical theory of public debt, see Richard A. Musgrave, The Theory of Public Finance (New York: McGraw-Hill Book Company, Inc., 1959), Chapter 23. Page 12 7If saving is responsive to interest rate changes, but invest ment completely unresponsive, debt financing results in a reduction in consumption and no change in investment. FEDERAL RESERVE BANK OF ST. LOUIS F i g u r e II JULY 1979 prices from rising, the money stock must be reduced, which results in a shift of the LM curve to the left. If a reduction in the money stock shifts the LM curve precisely to LM X, income is reduced to a level con sistent with full employment, Y f. However, interest rates would be raised from r0 to n and the mix between private consumption and investment is altered in a fashion similar to that described by classical analysis. Inflation Classical economists viewed the choice between debt and taxes as unimportant in determining infla tion. Since debt financing, in their view, results in the crowding out of private investment, no additional demands are created with debt-financed over taxfinanced expenditures. Inflation, in their analysis, is directly related to the growth rate of the money stock. So long as this growth in money is not altered, inflation is not affected by the debt/tax choice.9 In the context of an underemployed economy with rigidity in wage rates, for example, Keynesians view debt-financed government expenditures as an im portant tool for achieving a level of aggregate de mand consistent with full employment and price stability. When debt is substituted for taxes, they argue, consumer incomes will be increased by the amount of the tax cut and, since resources are not fully employed, crowding out of private expenditures by higher interest rates would not occur. In the case of full employment, of course, the effects of substituting debt for taxes are similar to those of classical analysis, except that Keynesians view this substitution as inflationary unless accompanied by a reduction in the money stock. This can be shown by the standard IS-LM analysis used in most economic textbooks.8 Assuming a given level of gov ernment expenditures, a tax decrease results in an increase in disposable income and, in terms of the IS-LM model, the IS curve shifts to the right (to ISi in Figure II). If, by assumption, Yf represents full employment, then income has been increased beyond a level consistent with stable prices. In order to keep 8For a standard treatment of the IS-LM model, see Colin Campbell and Rosemary Campbell, An Introduction to Money and Banking ( Holt, Rinehart, and Winston, 3rd Edition, 1978) Chapters 18 and 19. For a more sophisticated presentation of the IS-LM model, see Thomas M. Havrilesky and John T. Boorman, Monetary Macroeconomics ( AHM Pub lishing Corporation, 1978), Chapters 11-13. Both modern-day Keynesians and modern-day followers of the classical school (sometimes known as monetarists) often connect deficit spending with inflation — for entirely different reasons, how ever. Keynesian analysis, as noted earlier, implies an increase in aggregate demand when substituting debtfinancing for current tax-financing of government ex penditures. If resources are fully employed, this in crease in demand tends to raise nominal income and prices. Some monetarists, on the other hand, have noted an indirect mechanism relating an increase in deficit financing to inflation.10 To the extent that deficit spending leads to an increase in credit demands, up ward pressure on interest rates results. If the central bank operates with an interest rate target and is re luctant to raise this target when credit demands in crease, the increased deficit will become financed in 9An assumption often made in the classical framework is that the velocity of money (or the demand for money) is con stant and, in particular, is not responsive to changes in interest rates. In terms of the IS-LM model shown above, the classical assumption can be shown by a vertical LM curve. 10“Federal deficits tend to produce pressure for monetary ex pansion. Increased Federal borrowing when added to the credit demands of the private sector, places upward pres sure on interest rates. The monetary authority, however, can resist these pressures for a short period of time by buying government securities. Thus, to the extent that ‘low’ interest rates assume a role as an objective of the monetary authorities, deficit financing tends to accelerate the rate of monetary expansion.” Keith Carlson, “Large Federal Budget Deficits: Perspective and Prosperity,” this Review (October 1976), pp. 2-7. Page 13 FEDERAL RESERVE BANK OF ST. LOUIS F i g u r e III JULY 1979 This view of debt burden prevailed until 1958 when James Buchanan’s book, Public Principles of Public Debt, was published. In the series of articles that followed the publication of this book, the view emerged that a burden on future generations could result from debt financing.12 The “burden of the debt” literature revealed that, although the withdrawal of resources by government must occur in the period in which the expenditures are made, the method of fi nancing government expenditures affects the level of income that future generations inherit. Thus, to the extent that deficit financing reduces private investment and, consequently, inherited capital, a burden is placed on future generations in the form of a lower capital stock (and a smaller income stream). THE CRITICAL ISSUE OF TAX DISCOUNTING part by monetary creation. As shown in Figure III when debt rather than current taxes is used to fi nance government expenditures, the IS curve shifts to ISi and, as a result, the interest rate will rise. If the central bank attempts to maintain interest rates at r0, it will expand bank reserves and, hence, the nation’s money supply. The LM curve, which represents equi librium points in the monetary sector, will shift to LMi. This results in upward pressure on prices as aggregate demand expands above the level consistent with full employment at stable prices, Yf. Burden of the Debt Deficit financing, it has often been suggested, im poses a burden upon future generations. Other economists, primarily Keynesian, have argued that domestically-held debt imposes no such burden. These economists argued that government expenditures, whether debt- or tax-financed, result in a withdrawal of real resources in the period in which expenditures are made and that interest payments on domesticallyheld debt simply result in income transfers between taxpayers and debt holders rather than transfers from one generation to another.11 n E. J. Mishan, “The National Debt is a Burden,” Twenty-one Popular Economic Fallacies, 2nd ed. (New York: Praeger Publishers, 1973), pp. 61-73. Page 14 Recent economic literature has focused on the critical assumptions which give rise to the differential economic effects of debt versus tax financing. In the preceding discussion, it was assumed that disposable income rises by the amount of the reduction in taxes whenever debt is substituted for taxes. This occurs only if consumers treat this increase in income like any other increase in income. Recent discussion, how ever, centers upon whether and under what circum stances taxpayers would fully anticipate the future taxes implicit when the government issues interestbearing debt. This issue, sometimes referred to as tax discounting, is critically important for the differential effects of debt versus taxes. As Bailey pointed out, “If indeed households forsee their own and their heirs future taxes, then given government expendi tures have the same effect on private consumption whether they are financed by taxes or borrowing.”18 Private Versus Government Debt The essence of the tax discounting issue can be demonstrated by contrasting private and public debt. Debt instruments are a mechanism for transferring saving (current income not spent on consumption goods) from one individual or organization to another. In the case of privately issued debt, the borrower 12A number of these articles are contained in J. M. Ferguson’s book Public Debt and Future Generations (Chapel Hill, North Carolina: University of North Carolina Press, 1964). 13Martin J. Bailey, “The Optimal Full-Employment Surplus,” Journal of Political Economy (July/August 1972), p. 652. FEDERAL RESERVE BANK OF ST. LOUIS gains purchasing power over currently produced goods and services, but at the same time incurs an obligation to pay back the loan to the lender in the future. Thus, on net, private debt creation does not result in the perception of increased wealth in the aggregate. The partial t-accounts in Exhibit I demonstrate these statements. Suppose a large corporation decides to borrow $1 million by issuing short-term notes, such as commercial paper, which promise to pay $1 million plus interest to the lender. The lender, for instance, may exchange demand deposits for another asset, the commercial paper certificate. The borrower, on the other hand, receives $1 million in bank deposits, but at the same time incurs a liability to pay back the borrowed funds. Thus, on balance, the owners of the corporation feel no wealthier than before. The bottom of Exhibit I illustrates the case where government issues debt whose proceeds are redistrib uted in some manner back to the private sector. As in the case of private debt creation, the private lenders feel as wealthy as they did initially since the government promises to pay interest and principal to the private debt holders. Whether taxpayers foresee the future taxes that must be levied in order to service the debt, however, is unclear. In the case of private debt, the borrower feels no wealthier since an obligation to pay interest and principal of the loan is recognized. However, if taxpayers do not anticipate any of (part of) the future tax liability associated with the issuance of government debt, then all (part of) government debt is perceived as an addition to wealth. Are Government Bonds Perceived As Net Wealth? Since David Ricardo, economists have recognized that, if taxpayers perfectly anticipate the future taxes associated with government debt issuance, tax financ ing and debt financing are essentially equivalent; that is, taxpayers would consider a tax levy of $1 million today equivalent to the issuance of $1 million in perpetual bonds. Taxpayers would recognize that, with the issuance of the $1 million in bonds ( at an as sumed interest rate of 10 percent), they have incurred an obligation to pay $100,000 per year in taxes — the present value of which is $100,000/.10, or $1 million — the equivalent of the present value of $1 million of taxes levied currently. While economists have recognized the possible equivalence between debt and taxes, many economists JULY 1979 Exhibit I Private Debt Creation Lender - $ 1 m illion B a n k D ep osits B orrow e r * f $ l m illion B a n k D ep osits 4 - $ l m illion Com m ercial Pap er O u t s ta n d in g + $1 m illion C om m ercial Paper N et W o rth — unchanged N e t W o rth — unchanged G overnm ent D ebt Creation P rivate Sector (L e n d e r) G o ve rn m e n t Sector (B o rro w e r) - $ 1 m illion B a n k D ep osits + $1 m illion B a n k D ep osits + $1 m illion T re a su ry b o n d s —$1 m illion B a n k D e p o sits + $1 m illion G o ve rn m en t T ra n sfe r P aym ents N e t W o rth — Liabilities — + $1 m illion T re a su ry B on d s u p $1 m illion u p $1 m illion have assumed that the conditions under which com plete discounting of the tax liability would take place are not likely to hold. For example, even if taxpayers correctly anticipate their share of the tax, complete discounting requires that they not be able to escape this liability either by dying or moving from the government’s jurisdiction.14 In the case of a tax on property income, the tax most often used by local governments, this possibility is less of a problem since the levy of a tax on property income is likely to result in a decline in property values equal to the issuance of government bonds. Since the value of an asset is the discounted value of its future income stream, a tax upon that stream 11In the case of taxes on human income, the possibility exists that current taxpayers can avoid their share of future gov ernment taxes by moving from a government’s jurisdiction. This option is extremely limited for citizens of a nation but less so for local government jurisdictions. The clearest case is that where currently produced government services are debt-financed. Current taxpayers will benefit from the cur rently provided government services but will bear little of the cost in terms of future taxes if they move from the area. In the case of deficit-financed capital expenditures, current taxpayers cannot necessarily shift the cost to other taxpayers, since the future taxes associated with debt finance will likely be incorporated into property values. The possibility that the cost of debt-financed government expenditures for current • services can be shifted to others by moving out of the taxing jurisdiction of the government helps to explain why local governments often avoid deficit financing of current budget expenses. Local governments, instead, often use deficit fi nancing for capital expenditures and rely on taxes from property income, both of which reduce the possibility that tax burden will be shifted disproportionately to others. Page 15 FEDERAL RESERVE BANK OF ST. LOUIS reduces its market value. For example, a perpetual asset that is expected to yield $100 a year and for which the going interest rate is 10 percent has a market value of $1,000 ($100/.10). A tax of 5 percent on the expected yearly income would reduce that income stream to $95 a year, and the market value would fall to $950 ($95/. 10). For the economy as a whole, increasing government debt by $1 million ac companied by an increase in property taxes of $100,000 per year to pay the 10 percent interest rate on the increased debt would immediately reduce the value of this property by approximately $1 million ($100,000/.10). In this case, the increase in govern ment debt does not result in a perception of increased wealth; taxation and debt are equivalent. It is less clear that full discounting of future tax liability of debt issuance occurs in the case of taxes levied on labor income, even when a taxpayer cor rectly anticipates his share of the tax liability. The in dividual taxpayer will not fully discount his tax liabil ity to the extent that future tax payments He beyond his life expectancy. He also will not fully take into ac count the welfare of his descendants. In this case, an individual taxpayer will perceive that his lifetime in come has risen more (i.e. that he is wealthier) with debt financing than tax financing of government expenditures. Suppose, for instance, that an individual’s share of the government expenditure is $1,000. The taxpayer is faced with the choice of a once-and-for-all tax of $1,000 in the current period or $100 a year to service interest on a $1,000 government debt ( at the assumed current interest rate of 10 percent). Under the taxfinanced case, the individual meets the tax burden of $1,000 by reducing his assets by $1,000 (which are also assumed to yield 10 percent, the going interest rate). The taxpayer must forego an income of $100 a year, as in the debt-financing option. But suppose that the individual expects to pay taxes for only 10 years. Under the debt-financed case, the present value of the tax claim for 10 years is only $614; thus, the individual taxpayer perceives his wealth to be $386 greater than in the tax-financed case. As a matter of arithmetic, the greater the life expectancy, the smaller the perceived wealth effect. For example, with a life expectancy of 20 years, the debt financing option re sults in a $149 increase in wealth while a 30-year life expectancy yields a $57 increase in wealth. In effect, wealth is created with debt issuance because some of the tax liabilities needed to pay future interest pay ments are shifted to members of later generations. To the extent that this increases the taxpayer’s per Page 16 JULY 1979 ceived wealth or lifetime income stream, greater cur rent expenditures result from debt financing than from tax financing. This wealth effect from debt financing will dis appear, however, if the tax liabilities shifted to future generations are taken into account when current tax payers plan their bequests and other wealth transfers. Barro has demonstrated that “finite lives will not be relevant to the capitalization of future tax liabilities so long as current generations are con nected to future generations by a chain of operative intergenerational transfers ( either in the direction from old to young or in the direction from young to old).”15 This is a complicated way of saying that parents and children can make wealth transfers at times other than death. For example, parents make transfers to their children in the form of education, living expenses, and bequests, and children some times provide support for their aged parents. In effect, these transfers between generations allow cur rent taxpayers to act as if they are immortal. Barro argues that these intergenerational wealth shifts are sufficient to restore the balance of wealth across gener ations that would have been deemed optimal if all government expenditures had been financed by cur rent taxes.16 EMPIRICAL EVIDENCE FOR TAX DISCOUNTING The issue of tax discounting cannot be settled solely by theoretical arguments. Recently, several empirical studies have attempted to discover the extent to which tax discounting actually occurs. Existing evidence is immense since each economic model that contains fiscal variables also generates implications for tax dis counting. Several large models of the economy have found, for example, that tax reductions financed by debt issue have significant effects on income. This pro vides indirect evidence that less than complete tax discounting occurs. Evidence from some reduced-form models, such as the St. Louis model, shows that fiscal policy actions, as measured by the high-employment 15Robert J. Barro, “Are Government Bonds Net Wealth?” Jour nal of Political Economy, November/December 1974, pp. 1095. 16Other complications can result in the nonequivalence of debt and taxes including uncertainty about future taxes and imperfect capital markets. Barro analyzes these possibilities and concludes that “there is no pervasive theoretical case for treating government debt, at the margin, as a net com ponent of perceived household wealth. The argument for a negative wealth effect seems, a priori, to be as convincing as the argument for a positive effect.” Ibid., p. 1116. FEDERAL RESERVE BANK OF ST. LOUIS budget deficit, have no lasting effect on aggregate de mand and income. This tends to provide indirect evidence in favor of full tax discounting.17 This evi dence, however, is inconclusive since fiscal effects can be washed out through such other mechanisms as the crowding out of private expenditures by higher in terest rates.18 Recently, several studies have directly tested the extent of tax discounting by specifying consump tion functions where such variables as the government deficit and outstanding government debt are tested for their effects upon consumption. One of the first of these was by Kochin.19 His study was motivated by the casual observation that the saving rate as meas ured by National Income Accounts (NIA) data and the level of the deficit are positively correlated — an observation consistent with the notion of tax dis counting. For example, when a deficit results from a tax cut, measured disposable income rises. In the case of full tax discounting, consumers realize that the debt issued to finance the deficit implies future taxes for themselves or their heirs and, accordingly, that their lifetime income or wealth is unaltered. Thus, consumption expenditures are unchanged and measured NIA personal saving, defined as disposable income minus consumption expenditures, rises. Kochin specified consumption of nondurables and services as a function of disposable income, the Federal deficit, and lagged consumption. Using an equation estimated in first differences over the period, 1952-71, he found that a $100 increase in the Federal deficit results in approximately an $11 de cline in consumption. Kochin interpreted this as an indication that consumers have at least partially taken into account the future taxes associated with government deficits. Kochin’s study generated several criticisms. Yawitz and Meyer criticized Kochin’s study for misspecification because it did not directly include a government wealth variable.20 Using a life-cycle model in which consumption is specified as a function of disposable 17See Leonall C. Andersen and Keith M. Carlson, “A Mone tarist Model for Economic Stabilization,” this Review (April 1970), pp. 7-25, and Keith M. Carlson, “Does the St. Louis Equation Now Believe in Fiscal Policy?” this Review (Feb ruary 1978), pp. 13-19. 18Keith M. Carlson and Roger W. Spencer, “Crowding Out and Its Critics,” this Review (December 1975), pp. 2-17. 19Lewis A. Kochin, “Are Future Taxes Anticipated by Con sumers?” Journal of Money, Credit and Banking (August 1974), pp. 385-94. 20Jess B. Yawitz and Laurence H. Meyer, “An Empirical In vestigation of Tax Discounting,” Journal of Money, Credit and Banking (May 1976), pp. 247-54. JULY 1979 income, the market value of private sector holdings of government securities, and household net worth (other than government securities), Yawitz and Meyer observed small positive coefficients on the private wealth and U.S. Government debt variables which were not significantly different from each other. They interpreted these results to indicate that no discount ing occurred since government debt outstanding ap peared to have an effect on consumption similar to that of other private wealth. They pointed out that their results were “inconclusive,” however, “because of the extremely narrow variability of the Government debt series.”21 A review of the existing evidence on tax discount ing ( or, as they call it, debt neutrality) by Buiter and Tobin also criticized the Kochin study.22 First, the authors noted that the negative coefficient on the deficit variable was not as large as the value on the disposable income variable, and thus the equation did not support complete discounting. They also ob jected to Kochin’s equation because of the simultane ity problems with some of the variables used and the inclusion of the Federal deficit rather than the total government deficit. When they reran Kochin’s equation, adding data for 1972-76, they found the results substantially changed; the coefficient on the deficit variable, although negative, was not signifi cantly different from zero. When Buiter and Tobin made several refinements to Kochin’s equation, trans forming the variables into per capita terms and intro ducing the deficit of the public sector in addition to that of the Federal government, they found again that the deficit variable had the correct sign ( —) but was insignificantly different from zero. In another recent study, Tanner utilized a consump tion function of the life-cycle type which also included a number of variables not specified in the Yawitz and Meyer study.23 The unemployment rate was included to adjust disposable income for cyclical variation; the stock of consumer durable goods was added because it was expected to have a negative relationship with current consumption expenditures. Additional vari ables included were corporate retained earnings, pri21With only small changes in the real value of Government debt held by the private sector and given the low propen sity to consume out of wealth, only minor effects on aggre gate consumption could have been expected. Ibid., p. 253. 22William Buiter and James Tobin, “Debt Neutrality: A Brief Review of Doctrine and Evidence” (Cowles Foundation Discussion Paper No. 497, Cowles Foundation for Research in Economics, September 15, 1978). 23J. Ernest Tanner, “An Empirical Investigation of Tax Dis counting,” Journal of Money, Credit and Banking (May 1979), pp. 214-18. Page 17 FEDERAL RESERVE BANK OF ST. LOUIS vate wealth as measured by the net stock of fixed nonresidential business capital and residential housing, the total government surplus ( or deficit), and the mar ket value of government debt. Again, the reasoning behind this equation, similar to that of Kochin’s, is that “current Government defi cits may depress current expenditures because these deficits imply higher future taxes. This hypothesis implies that current taxpayers will not consume at the expense of their heirs but rather will increase their personal savings so that their bequests, inclusive of the Government debt, would be the same as if the Government deficit had not occurred.”24 The hypoth esis that full tax discounting occurs, or alternatively, that government debt is not perceived as net wealth implies a zero coefficient on outstanding government debt and a positive (negative) coefficient on the cur rent government surplus (deficit). The coefficients for Tanner’s equation estimated for U.S. data over the period 1947-74 are consistent with the complete discounting hypothesis. The coefficient on the gov ernment surplus variable was positive and significant; the coefficient on the Government debt variable was quite small and not significantly different from zero. Tanner’s study is subject to criticism, however, since the private wealth variable also does not have a coefficient significantly different from zero. This out come is doubtful given the large amount of evidence that has found private wealth to influence current consumption expenditures. Tanner’s result, however, may have resulted from the inclusion of retained earn ings in his equation. Since retained earnings are a major source of change to the capital stock, this vari able could well reduce the significance of the private wealth variable. Similarly, the inclusion of both the government surplus (or deficit) and the outstanding stock of government debt is a doubtful specification since the surplus or deficit largely represents the change in the government debt series. IMPLICATIONS OF TAX DISCOUNTING The implications of full tax discounting as sug gested in Tanner’s equation are quite important to the way economists have traditionally viewed a num ber of macroeconomic issues. Most basic is the effect of government debt upon the consumption/saving mix. As discussed earlier, with a given level of govern ment expenditures, both classical and Keynesian econ omists thought that government debt financing dis 24Ibid., p. 215. JULY 1979 couraged private investment relative to the alternative of current taxation. But, if taxpayers view government debt and taxes as equivalent, consumption is not al tered from the tax-financed case, and private invest ment and economic growth is not hindered. With full discounting, the effects of fiscal actions also disappear. In terms of the IS-LM model shown in Figure III, fiscal actions, such as a tax cut with government outlays unchanged, do not shift the IS curve to IS, as standard analysis shows. Rather, with full discounting, the subsequent increase in disposable income is not viewed by the public as an increase in net wealth, and therefore, demand for current con sumption is not stimulated. On the other hand, less than full discounting of future taxes leaves open the possibility that fiscal actions have economic effects. Even in this case, fiscal policies do not necessarily have effects on aggregate demand. Various arguments other than tax discounting have shown how fiscal policies may be impotent in stimulating aggregate demand.25 The connection between government deficits and inflation is also questionable if the issuance of govern ment debt is neutral. One connection between deficits and inflation relies on the premise that governmentissued debt places upward pressure on market inter est rates. When the Federal Reserve conducts mone tary policy by targeting an interest rate, any upward pressure on interest rates will induce the Federal Reserve to make open-market purchases of govern ment securities in order to maintain its target. As a result, undesirable increases in the money stock can result and eventually inflation will be exacerbated. If the tax liability associated with deficit spending is fully anticipated, however, the public will “save” commensurately with the increase in the demand for credit resulting from the issuance of government debt. In this case, interest rates are not bid higher than they would be in the case of tax-financed government expendi tures, and therefore the connection between deficits and inflation via the reaction of the Federal Reserve to interest rate movements breaks down. In addition, it has been argued that deficit spend ing encourages a larger government sector than would result from a balanced budget policy. In fact, this belief underlies the reasoning of many of the current supporters of the balanced budget constitutional amendment. Buchanan and Wagner, recent propo nents of this view, argue that deficit financing reduces the perceived cost of government services to current 25See Carlson and Spencer, “Crowding Out,” pp. 2-17. FEDERAL RESERVE BANK OF ST. LOUIS taxpayers.26 As a result, government services increase at a faster rate than actually desired by citizens. This explanation of the growing size of government de pends crucially upon the assumption that less than full tax discounting occurs.27 CONCLUSION Traditionally, economic analysts have found that the choice between debt and taxes has a significant effect on the economy. To the extent that taxpayers do not take into account the tax liability associated with government debt, they will perceive increased income and wealth when government debt is substi tuted for current taxation. As a result, current con sumption is encouraged and investment discouraged in comparison with tax-financed government expendi ture. Under this scenario, private capital formation and the long-term growth of the economy are reduced. Some recent theoretical and empirical studies have questioned the analysis underlying these results. These studies point out that taxes versus debt is really a choice between taxation today versus taxation tomor row. If the future taxes required to service the debt 26J. M. Buchanan and R. Wagner, Democracy in Deficit: The Political Legacy of Lord Keynes (Academic Press, New York, 1977). 27For a study that finds evidence opposing these views, see William A. Niskanen, “Deficit, Government Spending, and Inflation — What is the Evidence?” Journal of Monetary Economics (August 1978), pp. 591-602. JULY 1979 are widely perceived by the public, no increase in private wealth occurs with deficit financing. In this case, the choice between debt and taxes is essentially neutral and the presumed benefits of a balanced bud get disappear. Also, the argument for a link between inflation and deficits is not as strong if tax discounting is assumed. If the issuance of government debt does not result in the perception of increased wealth, a given level of government expenditures financed by debt is no more expansionary than the same outlays financed by taxes. Furthermore, since interest rates do not rise in this case, the mechanism by which deficits raise overall credit demands and encourage the Federal Reserve to expand the money supply at a greater rate is also suspect. In essence, complete discounting of tax liabilities implies that the arguments over the relative merits of balanced and unbalanced budgets are irrelevant. With complete discounting, neither the potential of un balanced budgets (changing taxes with a given level of government expenditures) to influence aggregate demand nor the adverse effects of unbalanced bud gets on investment, inflation, or the size of govern ment exist. Although recent theoretical and empirical studies lend support to the incorporation of tax dis counting into the analysis of debt financing, the evi dence does not appear strong enough for one to completely disregard the possibility of less than full discounting. Page 19
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