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____________ R e v ie w ____________
Vol. 69, No. 6

June/July 1987

5 The Growing Share of Services in the
U.S. Economy — Degeneration or
Evolution?
23 rltix Reform and Investment: Blessing or
Curse?
34 The Macroeconomic Effects of the
Recent Fall in Oil Prices

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Federal Reserve Bank of St. Louis
Review
June/July 1987

In This Issue . . .

In the first article in this Review, “The Growing Share of Services in the U.S.
Economy — Degeneration or Evolution?" Mack Ott examines the growth of the
U.S. service sector relative to agriculture and manufacturing employment and
output to determine the answers to two key questions: Are recent changes in
employment patterns fundamentally different from those undergone in the 19th
century transformation of the United States from an agrarian to an industrial
economy? And, are either the recent or long-term U.S. developments different
from the recent and long-term economic history of other industrial economies?
The author shows that the recent growth in services neither differs from that of
other industrial economies nor diverges from long-standing trends in U.S. eco
nomic history.
*

Many analysts of the Tax Reform Act of 1986 fear that repeal of the investment
tax credit and the imposition of less generous tax depreciation deductions for
capital investment will reduce the U.S. capital stock and, as a result, damage the
economy.
In the second article in this Review, “Tax Reform and Investment: Blessing or
Curse? ” Steven M. Fazzari analyzes the effect of recent changes in corporate and
personal taxation on the economic efficiency of the U.S. capital stock. Because
investment imposes costs on the economy as well as generates benefits, Fazzari
shows that investment reductions caused by tax reform are not necessarily bad
for the economy. To the extent that tax reform removes special investment
subsidies in the old tax law, it could enhance the efficiency of the capital stock.
After studying the implementation of recent tax changes and their effect on the
cost of capital, Fazzari concludes that some aspects of tax reform removed special
investment subsidies and, thus, by themselves, could enhance the efficiency of
U.S. capital formation. When all the changes due to tax reform are considered
together, however, the author shows that the overall impact may reduce capital
spending below the economically efficient level.
*

The decline in the price of oil in 1986 sparked a renewed concern over how oil
prices affect the economy and whether such an oil price decline has effects on the
economy that are equal and opposite to those of previous oil price increases. In
this issue’s third article, “The Macroeconomic Effects of the Recent Fall in Oil
Prices,” John A. Tatom reviews the theoretical channels of influence of energy
prices and provides some evidence on how previous oil price increases have
affected production in seven nations. Although economic theory generally indi
cates that energy price effects are symmetric — that is, the effects of an oil price
decline are equal and opposite to those o f an oil price increase — Tatom reviews
some recent arguments suggesting that an oil price decline like the one in 1986
could have either adverse, or opposite but smaller, macroeconomic effects than
previous experience might suggest.

In This Issue . . .

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Tatom emphasizes that oil and energy prices had been falling since early 1981,
when measured in dollar prices or, more importantly, when measured relative to
the prices of the nations’ output. Thus, he argues, there is ample experience to
test whether price declines have different effects than increases. Tatom describes
various tests that indicate that oil price declines have symmetric effects on U.S.
economic activity.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

The Growing Share of Services in
the U.S. Economy — Degeneration
or Evolution?
Mack Ott
Surely the American people are not willing to become merely a service economy.
The American character is as much built around the sinews and muscle o f the
factory line as the white-collar office.'
— Editorial, Christian Science M onitor

"ince World War II, the production of services as a
share of U.S. real gross national product (GNP) has
risen from 58 percent to 68 percent. The concomitant
shift in the distribution of the labor force has been
much larger: about half of U.S. workers were em
ployed in service industries in 1948; this proportion
had increased to nearly three-fourths by 1985. These
momentous changes have given rise to fears that the
United States is fast becoming a nation of people who
are "serving each other hamburgers or taking in each
other’s laundry.”2
The irony in this view is that it embodies a profound
misinterpretation of U.S. economic history, both re
cent and long-term. It has been the strength, rather
than the weakness, of the manufacturing sector that
has precipitated the shifts in employment and output
toward services. Put simply, high productivity growth
in manufacturing and agriculture and the long-term

Mack Ott is a senior economist at the Federal Reserve Bank of St.
Louis. James C. Potetti provided research assistance.
'See Christian Science Monitor (1987).
2Murray (1987). Of course, many economists and commentators
have countered this simplistic characterization of rising service
employment and output; for example, see Browne (1986), Krugman
and Hatsopoulos (1987), McUsic (1987), Shelp and Hart (1986),
Tatom (1986, 1987) and Seaberry (1987). The phrase has become
so idiomatic that Browne used it as the title of an article debunking its
thrust. She points out that the share of employment in the narrow
service sector ("other services" in this article) has been rising faster
than manufacturing for some time.

effects of American investment in education have
made the faster growth of the service sector possible.
These forces have persisted not just since World War
II, but for a century or more. Similar trends in output
and labor characterize the last century of economic
history in other industrial nations as well.
The purpose of this article is to document these
long-run trends and to highlight some of the forces
driving them. The conclusion from this overview is
that, far from indicating a decline in the U.S. economic
outlook, the rising share of services reflects the in
creasing productivity and well-being of workers, both
inside and outside of U.S. factories and mills.

OUTPUT, LABOR AND CAPITAL
EMPLOYMENT IN THE UNITED
STATES SINCE 1948: A BRIEF REVIEW
During the postwar era, output of the U.S. economy
as measured by real GNP has more than tripled, from
$1.1 trillion (in 1982 dollars) in 1948 to $3.7 trillion in
1986. Meanwhile, civilian employment nearly dou
bled, from 58.3 million to 109.6 million. Since the
economy has been growing, analysis is greatly facili
tated by considering proportional shares rather than
levels of output and labor. Chart 1 shows that, while
the services share of output has risen and, conse
quently, the commodities share has fallen, the share of
real GNP in manufacturing output has remained virtu-

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

C hart 1

Distribution of R e a l G N P

1948—1985

wmtm
ally unchanged at roughly 21 percent.3Consequently,
the widespread perception of U.S. deindustrialization
is puzzling.
In 1948, 31.4 million Americans were gainfully em
ployed in service industries and 26.9 million in com
modities production. Service sector employment
since then has grown apace with total employment,
rising to 83.2 million in 1985. Concurrently, employ

3The commodities sector includes agriculture, manufacturing, mining
and construction industries; agriculture, in turn, includes forestry
and fishing. The services sector includes transportation, communi
cations, utilities, wholesale trade, retail trade, finance, and other
services industries; finance includes banking, thrift, finance and real
estate, and other services includes personal services, business
services, auto repair, health services, legal services and miscellane
ous professional services. To mitigate the unavoidable confusion
between the services sector and its other services subsector, the
subsector will be referred to as other services unless the context
makes this unnecessary.

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ment in the commodity sector has grown much more
slowly. In particular, agricultural employment de
clined by over half, from 6.6 million workers to 3.0
million, mining fluctuated around 1.1 million, con
struction varied between 3 million and 5 million, and
manufacturing grew from 16 million to a peak of 20.9
million in 1979, then declined to around 19.2 mUlion
in 1985.
As a result of its faster growth, the share of employ
ment in the services sector has risen during the four
postwar decades, from about 54 percent in 1948 to 72
percent in 1985. As table 1 shows, the postwar rise in
the share of labor (L) in services and its fall in com
modities has been persistent and general across sub
sectors. Among the service subsectors, other services
rose from a 13.2 to a 23.2 percent employment share;
government employment rose from 11.7 to 18.3 per
cent, then tailed off to 16.3 percent; and finance nearly

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1

U.S. Input and Output Shares by Industrial Sectors, 1948-85
1948
L
C O M M ODITIES

Agriculture
Manufacturing
Mining
Construction

1956
Y

1964
Y

1972
Y

1980
Y

1985
Y

46.2%* 41.2% 41.2% 41.7% 42.5% 41.3% 37.2% 40.0% 39.3% 33.9% 38.1% 35.8% 31.2% 38.8% 32.7% 28.1% 35.6%
11.4*
7.5
4.4*
5.7
6.7
5.5
8.2
7.8*
3.3
3.9
6.3
2.7
3.4
2.4
6.5
2.9
4.9
27.4
23.0
21.3
26.6* 22.6
22.6
25.1
21.7
22.7* 21.5
21.6
23.6
21.1
22.5
18.7
20.9
21.1
1.8*
8.0
1.4
6.5*
10.2
6.3
0.9
9.9*
5.3
0.8
7.3
5.2
1.1
7.7
4.3
0.9
8.1
5.7
2.6
8.0
2.0*
9.2
5.5
5.6
6.4
5.6
1.8
9.3*
1.9
5.6*
2.1
5.7
1.4
5.1

53.8%
Transportation
5.2*
Communications
1.3
Utilities
0.9
Wholesale Trade
4.9
Retail Trade
13.5
Finance,Insurance,
Real Estate
3.2
Other Services
13.2
Government
11.7

SERVICES

100.0

59.3% 58.8% 58.3% 57.4% 58.7% 62.8% 59.9% 60.7% 66.1% 61.8% 64.2% 68.8% 61.3% 67.3% 71.9%* 64.4%*
25.8*
6.8*
4.6
18.3
4.9
3.8
13.3
4.1
3.5
4.2
10.1
3.2
8.9
4.1
3.1
7.6
3.5
0.8
1.3
4.4
1.0
1.2
1.4
5.6
1.2
6.5
1.8
1.3
7.8
2.5
1.2*
8.4*
11.0
1.2
0.9* 13.5
1.7
0.9
13.9*
2.2
0.9
13.9
2.5
0.8
12.8
2.7*
0.9
12.0
1.5
5.2
2.7
6.7
5.0
5.1
1.6
5.1
2.1
5.6
5.3
5.6
6.7
3.2
5.6*
4.2*
4.4
13.7
9.5
4.2
9.2* 13.7
4.7
9.0
14.1
5.2
9.2
14.6
5.5
9.0
15.5*
6.1*
9.6
3.5
—

9.6
11.5
13.8

3.9
13.5
15.3

11.0
4.5
-

100.0

10.9
10.4
14.6*
100.0

4.4
16.1
17.5

14.0
6.2
—

12.4
11.6
13.8

100.0

5.0
17.8
18.3*
100.0

15.9
7.5
—

13.5
12.3
13.1

5.7
20.4
17.1

15.6
7.5
—

14.6
13.9
12.0

100.0

6.2*
23.2*
16.3
100.0

17.5*
8.5*
—
100.0

32.4%
2.6
21.6
3.6
4.5
67.6%*
3.5
2.6*
2.9
7.4*
9.5
14.6*
15.0*
11.1
100.0

NOTE: * Denotes maximal share attained within the preceding eight years; labor force is total employment, full and part-time; capital stock is real private, net reproducible tangible
wealth in 1982 dollars.
SOURCE: The National Income and Product Accounts ot the United States, 1929-82; for capital stock — Survey of Current Business, January 1986; for 1985 — Survey of
Current Business, July 1986.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

doubled, from 3.2 to 6.2 percent. Only transportation
declined appreciably as railroads lost their domi
nance in freight and passenger markets to trucking
and airline firms.
In commodities production, the share of labor in
agriculture fell from 11.4 percent in 1948 to 2.9 percent
in 1985, and mining’s share halved, from 1.8 to 0.9
percent. Manufacturing employment, rising in abso
lute terms until 1979, fell persistently throughout the
period in share terms, from 27.4 to 18.7 percent. Only
construction had the same employment share, 5.7
percent, in 1985 as in 1948.
Table 1 also delineates the shifting capital (K) and
output (Y) shares in the postwar U.S. economy. As was
shown in chart 1, the commodities output share de
clined from 41.2 percent to 32.4 percent, but the de
cline was virtually all in agriculture, mining and con
struction. In services, the distribution of rising output
shares during 1948-85 was quite diverse: Communi
cations and utilities shares doubled and tripled, re
spectively, and financial services had the largest share
increase — 5 percentage points — while government
services and transportation had declining shares.
The decline in the transportation output share from
1948 (6.8 percent) to 1985 (3.5 percent) made the shift
in the capital from commodities to services smaller
than it otherwise would have been. As the railroad’s
share of transportation output fell from 1948 to 1985,
there was a substitution of public for private capital in
the transportation sector. The privately owned rail
road capital stock — equipment and rights-of-way —
was supplanted not only by privately owned trucks
and aircraft but also by the publicly owned highways,
airports and air control networks used by trucking
companies and airlines.4If transportation capital were
excluded from table 1, the change in the distribution
of the capital stock from 1948 to 1985 would reveal a
much greater rise in the service sector's capital share:
from 44.5 percent in 1948 to 70.1 percent in 1985.
In sum, the postwar shift of the U.S. economy to
ward services has been pervasive: all sectors of ser-

4The rising share of capital in the truck and air carrier sectors has not
been commensurate with their rising proportion of transport ser
vices. In 1948, the railroads accounted for about one-fifth of the
entire U.S. capital stock, but by 1985, this share had shrunk to less
than one-thirtieth. In terms of the transportation sector’s capital
stock, the railroad share fell from 78 percent in 1948 to 37 percent in
1985. Over this same period, the share of transportation output in
GNP (1982 $) from railroads fell from 38 percent to just over 17
percent, while the share of truck and air carriers rose from 14.5 to 60
percent. Yet, the share of transportation capital in the truck and air
carrier industries rose from about 7 to 36 percent, a much smaller
increase than the decrease in the railroad capital stock.

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JUNE/JULY 1987

vices other than transportation and government have
become proportionally larger and more capitalintensive. Thus, while it maybe provocative to speak of
the rising share of services as being produced by
short-order cooks and laundiy workers, it is grossly
inaccurate (see opposite page): As illustrated in the
postwar breakdown of the other services subsector,
the service activities which have grown fastest since
1948 have been those in which capital investment —
both in human skills and in physical equipment —
have been substantial. More important, the shift to
ward services, did not commence in the 1970s, but
characterizes the entire postwar era, and reflects a
substantive shift in the occupational characteristics of
the U.S. labor force as well.

WHY HAS THE SERVICE SECTOR
EMPLOYMENT SHARE RISEN SINCE
1948?
There are two fundamentally interrelated reasons
for the rise in the service sector’s share of employment
in the postwar era: slower growth in labor productivity
and faster growth in the demand for services.5

Slower Productivity Growth in Services
Labor productivity is measured by the ratio of out
put per hour of labor input (Y/H). As table 2 shows,
overall labor productivity in the U.S. economy rose at
an average rate of 1.8 percent per year, from $11.23 per
hour (in 1982 dollars) in 1948 to $21.66 per hour in
1985.6 Productivity growth was much slower in the

5The relatively rapid productivity growth in manufacturing has been
widely documented as an explanation for the declining labor input;
see for example, Tatom (1986,1987), McUsic (1986) and Krugman
and Hatsopoulos (1986). The OECD’s ongoing estimation of Pur
chasing Power Parity also provides support for optimists about the
level of U.S. productivity. Real GDP per capita for the United States
in 1986 is 41 percent greater than for Japan and 33 percent larger
than for Germany. These ratios are essentially unchanged from
1985; see BIS (1987).
6When productivity is measured on a per worker basis, the results are
even more divergent than the per hour basis shown in table 2 —
1.85 percent annual growth rate overall with 2.32 percent in com
modities vs. 1.47 percent in noncommodities; however, the per
worker data include self-employed, while the hourly data in table 2
do not. By reporting on a per hour basis, the distortion due to the
divergent patterns of hours per week in different sectors are
avoided, but at the cost of omitting data on entrepreneurs, proprie
tors and especially farmers who are the most important class of
owner-operators (Indeed, the agriculture sector data underlying
table 2 imply half-time employment throughout the 1948-85 period
— 929 annual hours in 1948 and 1,068 in 1985.). When agriculture’s
productivity is measured per worker (including the self-employed
owners), its growth rate during 1948-85 is 3.33 percent compared
to the table 2 figure of 2.95 percent.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

Is the Growth in Other Services Hamburgers
and Laundry?
The most prominent service subsector in the post
war rise is “other services.” Its labor share increase,
10 percentage points, is about equal to the employ
ment share decline in manufacturing, and its rise in
capital and output shares are exceeded only by
those in finance, insurance and real estate (table 1).
Clearly, it is this subsector that critics have in mind
when they rail about rising service output being
equivalent to U.S. industrial decay, and, in particu
lar, declining job content for U.S. workers. A closer
look (table below) at the other service sector, how
ever, belies this characterization of both its output
and employment trends. Hamburger cooks (actu
ally enumerated in the retail subsector) and laun
dry attendants are by no means the primary force in
the surge in service employment, in particular in
other services.'

The table below reveals that the share of personal
services — where laundry is reported — has actu
ally declined. In fact, the 3.5 percentage-point rise
in the other services share of output is more than
accounted for by the rise in professional services.
During the 1948-85 period, the share of U.S. GNP
emanating from business, medicine, legal and mis
cellaneous professional services rose from 4.9 per
cent to 10.1 percent o f GNP. Moreover, the 10
percentage-point rise in the service employment
share is about the rise in employment in these
professional services, an increase of 9.6 percentage
points, and the rise in capital in business, medical
and legal services accounts for 57 percent o f the
capital share increase.2

same five years. The longer-term implications of this shift of
occupational choice has been articulated by others; for example,
see Freeman (1980), U.S. Congress (1984), Shelp and Hart
(1986), Browne (1986), Seaberry (1987).

’For example, during 1977-82 (the most recent data available by
occupation within industries), employment in eating places (wait
ers, waitresses and cooks) rose about 900,000; however, health
services (non-hospital) rose over 600,000, legal services
150,000 and business services over 800,000, while laundry and
dry cleaning establishments’ employment fell by 8,000 during the

Miscellaneous professional services include the services of ar
chitects, decorators, veterinarians and consultants not elsewhere
classified. Capital in miscellaneous professional services is not
separately measured.

Output, Labor and Capital Shares in Other Services
1948

ither Services
Personal
Business
Auto Repair
Health
Legal
Misc. Prof.
Other

1972

1960

11.6%
1.3
1.0
0.4
2.2
1.0
0.7
4.9

13.2%
2.1
0.7
0.6
1.9
0.4
0.4
7.1

3.6%
0.3
0.3
0.3
0.3
0.2
N.A.
2.2

11.4%
1.1
1.4
0.5
2.6
0.9
0.9
4.0

15.1%
1.9
1.3
0.6
2.7
0.5
0.7
7.5

5.3% 12.3% 17.8%
0.4
0.9
1.6
0.7
2.0
2.3
0.7
0.7
0.9
0.7
3.4
4.3
0.2
0.9
0.5
N.A. 1.1
1.0
2.5
3.4
7.4

1985
K

7.5%
0.5
1.5
1.1
1.1
0.1
N.A.
3.2

15.0%
0.6
3.3
0.8
4.3
1.0
1.5
3.3

23.2%
1.5
4.5
1.1
6.0
0.9
1.6
7.7

8.5%
0.4
2.2
1.5
1.3
0.2
N.A.
3.0

SOURCE: The National Income and Product Accounts of the United States, 1929-82; for capital stock —
Survey of Current Business, January 1986; for 1985— Survey of Current Business, July 1986.

JUNE/JULY 1987

Table 2

U.S. Output-Labor Hour and Capital-Labor Hour Ratios by Industrial Subsectors, 1948-85
(thousands of 1982 dollars)__________________________________________
Overall

Y/H 1948
Y/H 1985
Growth Rate
K/H 1948
K/H 1985

FEDERAL RESERVE BANK OF ST. LOUIS

Growth Rate

$11.23
21.66
1.79%
$10.99
24.26
2.16%

Commodities
Total

AG1

$10.74
22.54

$9.95
29.17

2.02%
$ 8.94
24.67
2.78%

2.95%
$11.57
55.34
4.32%

M IN

$ 38.16
67.79
1.56%
$ 40.06
150.83
3.65%

Services2
CONS

M FG

Total

TRAN

$19.82
17.78

$7.84
20.81

$11.57
20.78

$12.50
22.75

-0.29%
$ 4.29
5.64
0.73%

2.67%
$ 7.16
20.24
2.84%

1.60%
$13.05
24.02
1.66%

1.63%
$39.93
49.67
0.99%

COM

$ 6.59
38.38
4.87%
$ 24.21
123.28
4.49%

U T IL

$ 12.88
60.95
4.29%
$101.46
248.52
2.45%

W HO

$10.22
24.65
2.41%
$ 2.56
14.05
4.70%

RET

$8.03
12.88
1.29%
$ 3.14
8.28
2.65%

FIN

$32.84
49.38
1.11%
$27.62
58.9
2.06%

SERV

$10.29
14.02
0.84%
$ 2.67
7.95
2.99%

1 Capital is real fixed reproducible nonresidential capital— equipment and structures. Since land is also a form of capital and of key importance in agriculture, the omission of land
implies that the capital-labor ratios for agriculture are understated.
2 Output, labor and capital exclude the government subsector.
SOURCE: The National Income and Product Accounts of the United States, 1929-82 and Survey of Current Business, July 1986 for real GNP and labor hours; for capital stock—
Survey of Current Business, January and July 1986.

FEDERAL RESERVE BANK OF ST. LOUIS

service sector (1.6 percent per year) than in the com
modity sector (2.0 percent per year).
The slower productivity growth in services was not
at all uniform across its subsectors. Labor productivity
growth in communications (COM) was the fastest o f all
subsectors, and it was nearly as fast in utilities (UTIL).
At the same time, wholesale trade (WHO) labor pro
ductivity grew faster than the average rate of the com
modity industries. Yet, as noted earlier, the employ
ment shares in these service categories did not rise
appreciably during the postwar era. The subsectors
that accounted for virtually the entire increase in the
service employment shares — other services, retail
trade and finance — had average annual productivity
growth rates o f only about 1 percent.
Perhaps some of this slower productivity growth
resulted from the shorter average work year in services
(measured in hours), implying a large component of
part-time employment. In 1985, the average hours per
employee in commodities, 1,783 hours, was nearly
three weeks longer than the average in noncommodi
ties, 1,672 hours; moreover, in the service sector an
nual hours varied considerably. For example, com
munications and utilities workers averaged 1,986 and
1,936 hours in 1985, roughly the same as the average in
manufacturing, 1,942 hours; in contrast the other ser
vices, finance and retail sectors each had average
employee hours of less than 1,670 hours. Conversely,
construction (1,575 hours) and agriculture (1,068
hours) also had low annual hours. Both industries are
seasonal and susceptible to the vagaries o f weather,
but construction has had negative productivity
growth while agriculture’s productivity growth has
been very high. Thus, low hours in and of themself do
not provide an explanation for slow productivity
growth.
Rising labor productivity results from either an in
crease in the proficiency of workers — an increase in
human capital — or an increase in plant and equip
ment — nonhuman capital.7Focusing for the moment

rTheodore W. Shultz is the economist most influential in developing
the notion of “ human capital" for the reservoir of skills, proficiencies
and knowleoge, for which he was awarded the 1979 Nobel Prize in
Economics; see Shultz (1961). The rise in this productive capacity of
workers comes from two sources. Experience, some'times referred
to as the learning curve, enhances the rapidity and accuracy of
workers in completing assigned tasks. Formal training, both class
room and on-the-job, increases the understanding and insight of
workers, which leads to rising facility and quality through better
methods and product innovation.

JUNE/JULY 1987

on nonhuman capital, table 2 shows that during 194885, capital-labor ratios (K/H) have at least doubled in
every sector of the U.S. economy except construction
and transportation, and that productivity (Y/H) gener
ally has grown faster in those sectors with faster capi
tal growth (K/H).8As with productivity, however, these
ratios have risen more slowly in services (1.7 percent
per year) than in commodities (2.8 percent per year).9
While productivity growth has been slower overall
in services, it has resulted from neither a dearth of
investment nor intrinsically lower capital intensity of
services; indeed, as noted earlier, if one omits trans
portation, capital grew much more rapidly in services
than in commodities production. As shown in table 2,
capital-labor ratios have been consistently higher in
four of the seven service sectors than in manufactur
ing, and the capital-labor ratios in the communica
tions and wholesale categories were the fastest grow
ing o f all sectors. Moreover, in every industrial sector,
capital has grown more rapidly than labor since 1948.10
In particular, the capital-labor ratio in other services
grew faster than that in manufacturing — 3.0 percent
vs. 2.8 percent — even though the other services share
of labor was rising while the manufacturing share of

8The rank-order correlation between the 1948-85 sectoral growth
rates of Y/H and K/H in table 2 is .46; if transportation is omitted
(given the distortion in the capital-labor-output relations entailed in
the shift from railway to airline and trucking), the rank order correla
tion is .53. Both correlation statistics are significant at the 5 percent
level.
Evaluating the impact of the increased capital input fully would
require a consideration of the quality of capital and technological
change. Also, the real price of a machine with given capacity may
have declined during the 1948-85 period; if so, the quantity of
capital would be understated. More important, technological ad
vances occurred during this period, especially in computercontrolled manufacturing processes. For example, numerical con
trol and multi-axis omnimills have made possible the manufacture of
aircraft and rocket engines to tolerances not feasible at the begin
ning of the period. These applications also have reduced the labor
input required in design and engineering processes through the
automation of drafting and modeling procedures. Proliferation of
these changes can be sampled by a glance at want-ads for CAD/
CAM workers— computer-aided design and computer-aided manu
facturing. Moreover, the growth of capital-labor ratios is driven both
by capital growth and labor growth. As table 1 shows, the share of
both capital and labor have risen in services, while labor has fallen
and capital has risen in commodities, especially agriculture. Thus,
labor shifts may amplify or attenuate the accompanying capital
increases in terms of the capital-labor ratios.
,0Since the employment share fell in manufacturing, it is possible that
the increases in capital-labor ratios, were due to falling employment
rather than rising capital. Yet, as table 1 shows, the share of private,
net U.S. nonresidential capital in manufacturing, like its share of
output, has remained relatively constant at about 22 percent during
the postwar period. Thus, capital invested in manufacturing indus
tries has grown apace with its output.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

Table 3

Relative Prices of Commodities and Services in U.S. GNP, 1948-86 (1982 = 100)
1948

1952

1956

1964

1968

19 72

19 76

1980

1984

19863

100.0%
187.2
69.1

100.0%
77.8
73.5

100.0%
82.5
81.3

100.0%
91.8
86.0

100.0%
100.2
94.1

100.0%
102.9
112.2

100.0%
101.5
116.2

100.0%
73.5
57.7

100.0%
78.0
60.1

100.0%
85.6
68.9

100.0%
90.6
80.3

100.0%
94.7
98.9

100.0%
100.0
100.0

100.0%
113.5
98.8

1960

Implicit G N P Deflator, Prices of Durable Goods as Num eraire1

Consumption
Durable Goods
Nondurable Goods
Services

100.0%
76.8
53.1

100.0%
76.1
58.1

100.0%
74.3
64.6

100.0%
74.5
68.0

Fixed-W eight G N P Price Index, Prices of Goods as Numeraire2

Goods
Services
Structures

100.0%
70.9
59.4

1 Nondurable goods are those with assumed useful lives of three years or less, such as clothing, food and publications.
2 Not available prior to 1959.
3 1986 based on preliminary IV/1986 data.
SOURCE: Survey of Current Business, tables 7.4, 7.2.

labor was falling. In summary, capital investment was
rapid in each service sector except transportation."

Faster Demand Growth in Services
There is substantive evidence that the postwar rise
in the share of U.S. output in services reflects a relative
shift in final demand for services and away from com
modities. Output of services has risen as a share of
total output (table 1); a rise in the relative price of
services, then, can only mean that the demand for
them also has increased relative to commodities. As
shown in table 3, the relative price of consumption
services measured in terms of the price of durable
goods has more than doubled since 1948.12More gen
erally, the lower half of the table indicates that the
relative price of all services (producers’ as well as

"As table 1 shows, except for transportation and utilities, the service
subsectors’ capital shares all attain their maximums (denoted by
asterisks) at the most recent observation; in contrast, in the com
modities sectors, the maximum capital share in each subsector
occurs considerably earlier.
'2That is, construct a bundle of consumer durable goods (such as
televisions, electric mixers and bowling balls) and a bundle of
consumer services (such as dentist’s visits, movie tickets and auto
mobile servicing) each costing $1,000 in 1982. Thus, by construc
tion, the relative price of the services in terms of the durable goods
was 100 percent in 1982 prices. Comparing the same bundles in
1948, table 3 implies that the price of the service bundle was only 53
percent of the durable goods bundle, while in 1985 its relative price
was 116 percent.

http://fraser.stlouisfed.org/
12
Federal Reserve Bank of St. Louis

consumers’) measured in terms of the price of goods
has risen by about two-thirds since 1960.
Why has the demand for services risen as a share of
output even though their prices relative to commodi
ties have risen? One plausible answer is that the qual
ity of services has risen, and the data, unadjusted for
the quality improvement, understate quantity and,
therefore, overstate price.13
Another answer that has been advanced by develop
ment economists and economic historians is that, as
economies mature, rising income is progressively di
rected toward purchases of “higher-order” or luxury
goods of which services predominate. Thus, Clark
(1951) found that:

,3Service output is primarily measured in terms of inputs; thus, if
inputs, especially labor, increase in their productivity — e.g., physi
cians or accountants and lawyers assisted by computer — their
hourly charges will rise and, uncorrected for the quality rise, the unit
price will incorrectly be raised by the same amount. Such errors
would also lead to understated productivity growth in table 2. Marimont (1969), who provides a detailed description of the methods
and shortcomings of the U.S. Commerce Department’s accounting
procedures for services, eloquently encapsules this measurement
problem (p. 16):
The industries that are the subject of this paper do not make a pair of
shoes, a refrigerator, or a drill press; all of which are tangible and can be
counted, although with varying degrees of ambiguity. Instead, they pro
vide services, that is, they safeguard savings, insure lives, lend money,
advertise businesses, audit books, restore health, repair cars, and so on.
Conceptual questions that are extremely difficult to answer are raised
when one attempts to count such units of output or measure changes in
their quality in order to provide a meaningful and consistent measure of
their contribution to total GNP.

FEDERAL RESERVE BANK OF ST. LOUIS
. . . in the m ost advanced countries the dem and for
m anufactured goods tends to settle down finally at
about 20—25 percen t of the national incom e. The de
m and for farm products falls to 10 percen t of national
incom e, and will fall lower as incom e advances further.
It follows that in the m ost advanced countries the
dem and for services, including building and handi
crafts and the products of small-scale manufacture,
will rise to 70 percent or m ore of national incom e.14

LONG-RUN TRENDS IN THE
DISTRIBUTION OF OUTPUT AND
INPUT SHARES
The discussion of the U.S. postwar economy, the
data in tables 1-3, and the shaded insert on page 9
clearly establish five characteristics about the evolu
tion of output and input shares:
• The share of U.S. output in services has risen steadily
over the entire 1948-85 period;
• Labor productivity has grown faster in the com m od
ities sector than in the services sector;
• The shift in output has reflected a relative shift in
consum er dem and tow ard services;
• Labor and capital inputs have persistently risen in
services production;
• The shift of labor into the services subsector of
“other services” production has been primarily into
activities requiring specialized skills, not into u n
skilled activities.

These observations raise questions about the long-run
character of U.S. economic development:
• How long has the relative rise in service production
and employm ent been going on?
• W hat has happened to the distribution of U.S. labor
by occupation over longer time periods?
• Are the other m ajor industrial econom ies experienc
ing similar or parallel employment and output evo
lutionary patterns?

Output and Labor Shares in the U.S.
Economy, 1800—1985
The main currents driving the evolution of U.S. out
put and labor distribution since 1800 have been the
rising productivity of labor successively in agriculture
and manufacturing. Agriculture absorbed nearly
three-quarters of the labor force in 1800 (persons aged

'4Clark (1951), p. 366. Clark first advanced the notion of higher-order
goods (luxury goods) in the initial, 1940 edition of his book, which
argued that the service output share would rise with economic
development; he presented international and historic evidence to
support his assertions. See Beeson and Bryan (1986) for a discus
sion of higher-order goods.

JUNE/JULY 1987

10 years and older, free and slave) with the residual
being poorly accounted for.15By 1840, agricultural em
ployment still occupied between 60 and 70 percent of
American labor; however, the share of employment in
manufacturing and construction had risen from 3
percent in 1810 to about 14 percent. In 1860, agricul
ture’s share was still about 60 percent of the free labor
force compared with more than 18 percent in manu
facturing and construction.16While pre-Civil War data
are not available for an analysis of output by industry
in constant dollars, it has been estimated that in 1879
prices, the 1839 and 1859 agricultural shares of total
commodity output were 72 percent and 55 percent,
respectively, while manufacturing’s shares in the
same years were 17 percent and 32 percent.17
More consistent data are available on the distribu
tion of output and labor for the period from 1870 to
1940. Unfortunately, the output data are for national
income in current prices, which distort the distribu
tion of shares among sectors.18 Nonetheless, with
these caveats, the data on national income and em
ployment shares by industry for 1870-1940 are pre
sented in table 4.
The most obvious characteristic of the data in table
4 is the steady rise in the proportion of the labor force
in service production over the 70-year period, along
with the concomitant decline in the proportion of
labor in commodity production. The proportion of the
labor force in agriculture fell from one-half in 1870 to
about one-sixth in 1940. Although the manufacturing
share rose over this period, most of the labor released
from agriculture went to services production, whose
share roughly doubled. While the distribution of em
ployment gains varies across the various service cate
gories, eveiy category’s share rises strongly.

15Lebergott (1964), table A-1, p. 510.
16Lebergott (1964), table A-1 and Fabricant (1949), table 2, p. 42.
,7Table F-238-249, p. 239, U.S. Historical Data Colonial Times to 1970.
,8Gross National Product (GNP) less capital consumption allowance
(estimated depreciation) equals Net National Product (NNP). NNP
less indirect business taxes plus subsidies less current surplus from
government enterprises equals National Income (Nl). Nl is conven
ient for some analyses because it is equal to the sum of all payments
to factors of production — wages and salaries plus profits plus rent
plus interest. Two distortions are introduced by taking shares of Nl in
current dollars rather than GNP in constant dollars: First, if produc
tivity in agriculture and manufacturing grew faster than in other
sectors, the resulting decline in unit prices over the 70 years in these
sectors will overstate their share in real terms in early years and
understate it in later years. Also, since national income omits depre
ciation, indirect taxes and subsidies, the data also may distort the
shares relative to total value added on a real GNP basis. For an
illustration of how changes in the relative price of manufacturing
affects shares of real GNP, see table 3 in Perna (1986), p. 32.

JUNE/JULY 1987

Table 4

U.S. Labor and Output Shares by Industrial Sector, 1870-1940_____________________________
1870

1890

1900

1910

1920

1930

1940

74.9%
49.7
1.5
5.8
17.4

44.0%
22.2
1.5
5.7
14.6

74.8%
50.0
1.8
4.8
18.2

39.4%
19.0
2.1
5.0
13.3

70.9%
42.8
2.0
6.1
20.0

41.1%
14.2
2.1
5.0
18.9

67.7%
37.5
2.6
5.7
21.8

43.7%
18.8
2.8
3.9
18.2

62.8%
31.5
2.9
6.2
22.3

46.5%
19.8
3.4
4.0
19.3

61.7%
27.4
3.0
5.2
26.1

47.1%
15.4
3.8
3.2
24.6

53.1%
22.1
2.4
6.2
22.5

38.0%
9.3
2.6
4.0
22.0

48.2%
17.2
2.1
6.6
22.4

38.8%
9.7
2.5
2.6
24.0

Services Production
23.9%
Transportation,
4.8
Communications, and
Utilities
Retail and Wholesale
6.1
Trade
Finance, Insurance
0.3
Real Estate
Other Services
10.7
Government
1.9

56.0%
10.9

24.0%
4.7

60.6%
12.9

28.3%
6.2

58.9%
11.2

31.1%
7.0

57.2%
10.5

35.1%
8.2

53.5%
10.7

37.4%
9.6

52.4%
11.7

44.2%
9.3

61.9%
11.8

45.5%
7.2

61.2%
10.4

Commodity Production
Agriculture
Mining
Construction
Manufacturing

FEDERAL RESERVE BANK OF ST. LOUIS

1880

Industry Not Specified

1.2%

15.2

6.6

16.1

7.7

16.8

8.5

16.8

9.1

16.0

9.8

14.7

12.4

14.7

13.5

12.1

11.5

0.4

12.0

0.7

13.1

1.0

12.4

1.4

12.5

1.9

11.3

2.9

14.7

2.9

11.8

14.2
4.2

10.0
2.3

15.2
4.5

11.3
2.5

12.5
5.2

11.8
2.8

11.0
6.5

12.9
3.5

9.1
5.3

11.6
4.5

7.9
7.3

14.7
4.9

10.9
7.8

16.2
5.7

10.3
16.7

—

1.1%

—

0.7%

—

1.2%

—

2.0%

—

0.9%

—

2.7%

—

6.2%

—

NOTE: Totals may not add to 100.0 percent due to rounding. For 1870-1930 labor includes persons 10 years and older; 1940 includes 14 years and older.
Income is current dollars national income for one year earlier than column heading, except for 1940 which is 1937.
SOURCE: National income, U.S. Department of Commerce, Long Term Economic Growth, 1860-1970, Series 141-151; Labor, Carson (1949), table 1.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

C h a rt 2

Share of Employment in U.S. Service Sector

1870-1985

NOTE: Logistics curve b a s e d on service sector share em ploym ent; fo r d e ta ils , see fo o tn o te 19.

Overall, the shift of employment from commodity to
services production has been both persistent and rela
tively steady. An examination of the data from 1880 to
1930 reveals that the share of employment in services
grew at an average annual rate of about 1.8 percent.19
Applying this 1880-1930 trend growth rate to the 1880
labor share and projecting it over the succeeding 105
years, as chart 2 does, fits the rising labor share rea
sonably well. The predicted 1985 services labor force

19By definition, the employment share in services must lie between 0
and 100 percent; consequently, a simple trend exponential growth
rate is not relevant in forecasting the share. A logistic growth curve,
S, = [1 + exp {a + b (t-1880)]-', meets the boundary constraints
and is easily fit to the data in table 4. The parameters (a = 1.1527, b
= -.0184) were computed using the observed shares for 1880 and
1930; these years were used to avoid the labor market disruptions
following the Civil War and World War I and the distortions of the
1930s.

share is 68.5 percent, while the actual labor share in
services production for 1985 (from table 1) is 71.9
percent. Apparently, the shift from commodities to
services has been proceeding fairly steadily for more
than a century.20

The Distribution o f U.S. Labor By
Occupation, 1900-80
The analysis thus far has categorized output; labor
and capital by industrial sector. Yet, industrial firms in
commodities employ a wide variety of support staff as

“ Less can be said about the pattern of relative production since the
national income data are in current prices; however, there was
clearly a shift from agriculture to manufacturing within commodities
and a moderate shift from commodities to services, both starting
around 1920.

FEDERAL RESERVE BANK OF ST. LOUIS

well as industrial craftsmen, operatives and labor —
including lawyers, nurses, accountants, gardeners,
and even cooks and laundry workers. Consequently,
any change in the amount of support work accom
plished outside of the corporation by subcontracting
for services will change the distribution of employ
ment even if the set of tasks being accomplished
overall is unchanged.21
On the other hand, the set of tasks to be accom
plished in any production activity has evolved during
this century due to innovation and capital investment,
particularly investment in human capital.22For exam
ple, in the production of machine tools since 1900, the
relative labor inputs of engineers, designers, computer
operators and the like have risen relative to machin
ists, other craftsmen and operatives. Thus, a more
complete picture of the distribution of the U.S. labor
force can be obtained by considering its occupational
as well as its industrial distribution. The occupational
breakdown of U.S. employment based on the U.S. de
cennial censuses for 1900-80 is given in table 5.
Several features of the occupational distribution’s
evolution are clarified by the data in table 5 which
shows U.S. census percentage distribution of workers
by standard occupational categories.23 First, as indi
cated earlier, the share of employees in agricultural
occupations has declined precipitously — from 37.6
percent in 1900 to 2.8 percent in 1980 (the sum of
farmers and farm labor entries in table 5). More strik
ing, however, is the rise in the share of technical and
managerial occupations and the decline of unskilled

21That subcontracting of services is a key impetus in the rise of service
employment was emphasized by several experts testifying in the
congressional hearings on service industries. See U.S. Congress
(1984). For example, Kravis argued:
The other factor pushing up employment in the service industries is the
tendency of commodity-producing industries to contract out services
formerly performed in-house. . . . The advantages of employing outside
specialists increase as technology becomes more complicated — for
example, computerized accounting and — more capital intensive —
cleaning office buildings, catering employee meals; the hiring of in-house
[sic] lawyers to handle labor negotiations and tax matters, (p. 426)

“ This implies the increasing importance of human capital in produc
tion, which, in turn, has been facilitated by a rise in the schooling of
the average American worker. In 1900, the average American
worker had completed 7.7 years of schooling; in 1957, schooling per
worker was 11.0 years and in 1984, it was 12.1 years. Moreover, the
school year, measured in average attendance per pupil, has in
creased by over 60 percent, from 99 days in 1900 to 159 days in
1957 to 162 days in 1970. See Shultz (1971) and U.S. Department
of Commerce (1986), table No. 671, p. 397.
“ One tacit measure of rising U.S. welfare is the increase in the age at
which labor force entry is presumed to take place, from 10 years of
age in the 19th century to 14 years in the mid-20th century to 16
years in the late 20th century. In part, this reflects the increasing
investment in human capital through formal schooling.

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16
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JUNE/JULY 1987

or unspecialized labor. In 1900, private household
workers plus farm plus nonfarm labor accounted for
35.6 percent of employment, while technical and man
agerial occupations absorbed about 10.1 percent; in
1980, these low-skill labor categories constituted only
6.6 percent of the labor force, while management and
technical occupations had increased to a 27.3 percent
share.24Although skilled manual trades — craftsmen,
foremen and operatives — made up a larger share of
the labor force in 1980 than they did in 1900, this share
had declined markedly from its peak in 1950 — from
34.4 percent to 26.7 percent. Most of this decline was
in operatives, especially from 1970 to 1980; some may
reflect the upgrading in job skill requirements to pro
fessional and technical, a category whose increase
occurred primarily during these three decades.
A more informative taxonomy is to divide the occu
pational types into the following three categories:
information provision and decisionmaking, direct
production, and non-information services. These
groupings, the subheadings in table 5, divide the cen
sus categories according to the primary form of output
generated by the worker. The first category encom
passes the production of information by decisionma
kers and all the supporting design, analysis and
record-keeping occupations and sales staff. The sec
ond comprises labor directly involved in production
of goods and public utility services such as transport
and electricity. The third consists of services other
than information or utilities: private household ser
vices, police and fire services, and food and cleaning
services. The evolution of labor shares within these
more inclusive categories is rendered in chart 3 for the
years 1900,1950 and 1980.25
The data from table 5, summarized in chart 3, show
that during this century the information and decision
making occupations have grown from about one-sixth
of all employment to well over half. Direct production

“ Considering only nonagricultural employment (that is excluding both
farm management and farm labor), the share of unskilled labor fell
from 28.7 percent of U.S. nonfarm employment in 1900 to 5.2
percent in 1980. During these eight decades, management, techni
cal and other information occupations rose from 28.2 percent to 54.5
percent of persons employed in nonfarm occupations.
25The information category of employment was emphasized by sev
eral witnesses in the Congressional hearings on Service Industries
[U.S. Congress (1984)], especially Levinson and Roach, pp. 26187. This taxonomy does not quite conform to the commodities/
services division used earlier since technical occupations include
both medical diagnosis and treatment, while operatives include
transportation and some other services such as occupations in
public utilities.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

Table 5

Occupational Distribution of the U.S. Labor Force
1900

1910

1920

1930

1940

1950

I9605

1970

1980

Information Provision/Decisionmaking
Professional and Technical
Managers, Officials
and Proprietors (nonfarm)
Clerical and Administrative
Support1
Sales Workers

17.6%
4.3

21.4%
4.7

24.9%
5.4

29.4%
6.8

31.1%
7.5

36.6%
8.6

40.1%
10.8

47.4%
14.5

53.0%
18.0

5.8

6.6

7.4

7.3

8.7

8.1

9.3

3.0
4.5

5.3
4.7

8.0
4.9

8.9
6.3

9.6
6.7

12.3
7.0

14.1
7.1

17.8
7.0

17.3
8.4

Direct Production
Farmers (including managers)
Farm Labor
Craftsmen and Foremen
Operatives
Nonfarm Labor2

73.3%
19.9
17.7
10.5
12.8
12.5

69.1%
16.5
14.4
11.6
14.6
12.0

67.1%
15.2
11.7
13.0
15.6
11.6

60.8%
12.4
8.8
12.8
15.8
11.0

57.2%
10.4
7.0
12.0
18.4
9.4

52.9%
7.4
4.4
14.2
20.4
6.6

43.7%
3.7
2.3
13.6
18.9
5.2

39.6%
1.8
1.3
13.9
18.0
4.7

34.1%
1.3
1.5
12.9
13.8
4.5

9.0%
5.4
3.6

9.6%
5.0
4.6

7.8%
3.3
4.5

9.8%
4.1
5.7

11.7%
4.7
7.1

10.5%
2.6
7.9

11.2%
2.7
8.5

12.8%
1.5
11.3

12.9%
0.6
12.3

100.0%

29,030

37,921

42,206

48,686

51,742

58,999

67,990

79,725

97,460

Non-information Services
Private Household Workers
Other Service3

Labor Force (millions)4

’ Includes computer equipment operators, secretaries, stenographers, typists, financial record processing occupations, and mail and
message distributing occupations.
2Mine labor included from 1970; prior to 1970, mine labor included in operatives.
includes protection (police, firefighters, private security), food service, and cleaning and building service occupations.
"Economically active population, from decennial census; prior to 1940, includes gainfully employed civilians 10 years and older, for 1940
and 1950 14 years and older, from 1960 on 16 years and older.
5Labor force includes workers not classified by occupation; occupational percentages computed on total of classified workers.
SOURCE: Historical Statistics of U.S. Colonial Times to 1970, Table Series D233-682; and 1980 Census of Population, General Social and
Population Characteristics, U.S. Summary, Table 104.

labor, meanwhile, has fallen from about three-fourths
of employment to about one-third. The principal
source of the decline in production occupations has
been agriculture, whose share fell from 37.5 percent in
1900 to less than 3 percent in 1980. Nonagricultural
production occupations have a slightly lower share in
1980 than in 1900, but are well down from their maxi
mum share of 41.1 percent attained in 1950. The noninformation services share has increased slightly; in
fact, since 1940, its share has risen by 1.2 percentage
points with the decline in household services being
slightly more than offset by the rise in other services
(primarily protection — fire, police and security).
The data from table 5 also can be used to illustrate
the relatively steady evolution of the U.S. occupational
distribution in this century. A growth curve is fit to the

labor share in information provision/decisionmaking
occupations as it evolved during 1900-30. Projecting
the share of employment in this category can then be
used to determine if there have been abrupt shifts
during the 1930-80 period.26 As chart 4 shows, the
projected share based on 1900-30 data fits the occu
pational distribution quite well, growing at an annual
rate of about 2.2 percent: the predicted 1980 share is
55.9 percent, compared with its actual share of 53.0
percent (table 5). A similar exercise for the direct

26Since the employment share in inform ation provision/
decisionmaking must lie between 0 and 100 percent, a logistics
curve is appropriate to assess the trend; see footnote 19. The fitted
logistics curve using the 1900 and 1930 shares (S,) from table 5 is
S, = [1 + exp(1.544 - 0.022 (t-1900) ) ] 1.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

C h a rt 3

U.S. Employment Distribution by Occupation

1900-1980

In fo /D e c is io n

Direct production

In fo /D e c is io n

O th e r services

O t h e r services
Direct pro duction

1900

Direct production

1950

production labor share predicts a 1980 share of 37.4
percent compared with the observed 34.1 percent.
Table 5 and charts 3 and 4 show that the functional
role of the typical American employee is progressively
moving away from the final mechanical step of com
modities production — that is, fabrication assembly,
or packaging.27More than 50 percent of employment is
now concentrated in analysis, design, managing and
recording processes, and sales, while, by inference,
U.S. capital (or foreign labor) is occupied to a larger
extent in mechanical production. Some observers de
cry this as the initial symptom of industrial calamity:
The result is the evolution of a new kind of company:
manufacturers that do little or no m anufacturing and
are increasingly becom ing service-oriented. They may
perform a host of profit-making functions — from
design to distribution — but lack their own production
base. In contrast to traditional m anufacturers, they are
hollow corporations.2*

27This notion — that innovation and investment make the production
process more roundabout or lengthen the period of production — is
the focus of a long-standing debate in economic theory. It is at the
core of the Austrian approach to capital theory; see “The Austrian
Theory of Capital and Interest,” chapter 12 in Blaug (1985).
2eBusiness Week (1986), p. 57. Ironically, the same article positively

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18
Federal Reserve Bank of St. Louis

Other services

1980

Yet this evolution simply reflects the operation of
the law of comparative advantage. As U.S. labor has
become more productive — due to increased human
and nonhuman capital — the opportunity cost of its
use in lower-valued stages of production has risen.
Those production processes in which capital cannot
sufficiently substitute for (or augment) labor must be
ceded to foreign lower-cost labor.29This view of labor
complements the conclusion of an analysis of the
performance and competitiveness of U.S. multina
tional corporations by Lipsey and Kravis:

assesses several companies whose primary activities are product
research and development distribution with production done in
foreign countries due to high domestic labor costs: Nike Shoe
(German), Emerson Radio Corp. (U.S.), Pitney Bowes Inc. (U.S.)
and IBM (U.S.).
^The process works in reverse as well. Feder (1987) quotes Steven
Walleck, head of manufacturing consulting for McKinsey & Co. in
Cleveland, as claiming “ major shifts from labor intensive overseas
plants to the United States usually follow the design of new products
especially suited for automated manufacturing and the introduction
of new manufacturing systems.” An interesting example of this is the
recent agreement between Inland Steel (U.S.) and Nippon Steel
(Japan) for a joint venture, a cold-roll steel mill to be built in South
Bend, Indiana; see Kotlowitz (1987). This announcement followed
by less than three months the Nippon Steel decision to close 12 of its
steel mills in Japan; see Cullison (1987).

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

C h o rt 4

Share of U.S. W orkers in U.S. Information Provision/Decision M aking

1900-1980

N O TE : Logistics curve based on p e rc e n ta g e sh a re o f in fo rm a tio n services occupation e m p lo y m e n t 1 9 0 0 —19 30; for
d e ta ils , see footnote 26.

This record is consistent with the view that American
management and technology remained competitive,
and is at variance with the argument sometimes made
that the fall in the share of the U.S. in world manufac
tures exports was due to management failures and
declines in technology. Perhaps the greater integration
of the world economy with respect to transport and
communications, and hence to the ease of managerial
control" over activities in distant locations, facilitated
the expansion of affiliate exports in the 1957-77 period,
but even so, American management should be cred
ited with taking advantage of these opportunities. And
since 1977, American-controlled firms abroad have
maintained their shares in a rapidly growing world
market, with powerful competition from Japan and
some other industrial countries and the advent of new
competitors.30

“ Lipsey and Kravis (1986), p. 24.

The Lipsey-Kravis hypothesis is consistent with the
persistent downward trend of the postwar share of
manufacturing employment. Yet, since the share of»
U.S. output in manufacturing has been constant over
this period, this trend does not imply the demise of
the manufacturing sector. Moreover, if the other in
dustrial economies have experienced similar trends in
employment and output shares, these trends can be
interpreted as a normal stage of advanced industrial
ization.

International Comparisons o f Output
and Labor Distribution
Throughout the 20th century, all advanced econo
mies have undergone parallel transformations in their
output and employment distributions. In each of the
advanced economies, the shares of labor and output

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

in agriculture have diminished greatly. For example,
as table 6 shows, the Japanese share of output in
agriculture was more than 54 percent in 1890 and the
corresponding employment share was 76 percent.
These shares were somewhat smaller for France and
the United States, and considerably smaller for Ger
many and Great Britain. Over the succeeding 60 years,
in these countries agricultural activity declined, while
their goods production sectors’ share rose.
From 1950 to 1984, while the specific patterns of the
production and output evolution vaiy somewhat, the
five industrial economies share three key features.
First, the proportion of goods production to real gross
domestic product (GDP) peaked between 1960 and
1970, and has fallen to less than 40 percent for each,
with the decline smallest for Japan.31Second, the share
of employment in goods production, which also
peaked between 1960 and 1970, has declined for each
country from 1970 through 1984,32Third, by 1984, each
nation had similar output and employment shares in
services production.33
Some semblance of these long-term output and
labor shifts can be seen in the three developing econo
mies included in table 6: Greece, Spain and Turkey.
Over the 1960-84 span, employment and output
shares declined most in agriculture; while these pro
portions rose for both goods and service production,
the largest increases were in the service sectors. This
pattern resembles the shifts during 1870-1940 in the
U.S. economy (see table 4).

CONCLUSION
The postwar rise of the U.S. economy’s service sec
tor continues trends in output and employment that
reach back well over a century in U.S. history. The
employment shift has much to do with slower pro
ductivity growth in services, the causes of which are
not well understood. This evolution is not unique to
the economy of the United States, but parallels
changes in other industrial nations and, to some ex
tent, developing economies as well.
The rising share of output and employment in the
U.S. economy’s services sector is even more pro
nounced when analyzed in terms of occupational
categories. Moreover, the capital distribution in the
United States also has been shifting toward service
production. These are not symptoms of impending
disaster for the U.S. economy. Rather, they are evi
dence of its efficient long-term evolution, propelled by
the relatively more rapid growth of labor productivity
in commodities than in services. Clearly, this evolu
tion enhances the economy’s capacity to provide ris
ing standards of living for consumers and occupa
tional satisfaction for workers.

REFERENCES
Bank for International Settlement. “ Bank of Japan Presents an Over
all Picture of Economic Developments in Japan,” Press Review
No. 23, February 1987, pp. 5-6.
_________ “ Purchasing Power Parities and International Compari
sons of Price Levels and Real Per Capita GDP in OECD Coun
tries,” Press Review No. 29, March 1987, pp. 4-5.

31GDP is GNP less net factor income from abroad.
320nce again, the Japanese decline is slight, but Japan began the
1960s with by far the largest reservoir of agricultural employment, a
reservoir that over the next 24 years declined by 21.3 percentage
points. This employment outflow contributed a large low-cost inflow
into manufacturing which the other industrial economies had long
since absorbed. This pattern is similar to the decline in U.S. agricul
tural employment during 1870-1940; see discussion above, p. 12
and table 4.
“ This similarity probably will become even closer as Japan reduces
its inefficient share of agricultural labor. Declining Japanese agricul
tural employment and protectionist inefficiencies were the topic of
recent reviews in the Wall Street Journal (Darlin (1986)) and The
Economist (1987). Also, the Bank of Japan was recently quoted
[Bank of International Settlement (1987) ] as describing its economy
in terms of duality, with relatively more rapid expansion expected in
the service sector: “sluggish mining and industrial production, de
clining business activity in the manufacturing sector” contrasting
with the fixed investment by non-manufacturers: “which have benefitted from the effects of the year’s appreciation and low oil prices,
are showing unexpected firmness, and they are limiting the deceler
ation of the economy as a whole... With the sustained increase in the
non-manufacturing sector, the total number of employees will grow
modestly.”

http://fraser.stlouisfed.org/
20
Federal Reserve Bank of St. Louis

Beeson, Patricia E., and Michael F. Bryan. “The Emerging Service
Economy,” Federal Reserve Bank of Cleveland, Economic Com
mentary (June 15,1986).
Blaug, Mark. Economic Theory in Retrospect 4th ed. (Irwin: 1985).
Browne, Lynn. “Taking In Each Other’s Laundry — The Service
Economy,” New England Economic Review (July/August 1986),
pp. 20-31.
Business Week. “The Hollow Corporation” (March 3, 1986), pp. 5785.
Carson, Daniel. “Changes in the Industrial Composition of Manpower
Since the Civil War," in Studies in Income and Wealth, Volume II,
1949, pp. 5-49.
Christian Science Monitor. “Getting America Moving Again,” January
20, 1987.
Clark, Colin. The Conditions of Economic Progress, 3rd ed. (London:
McMillan and Co., 1951).
Cullison, A.E. “ Nippon Steel to Close Plants,” New York Journal of
Commerce, January 9,1987.
Darlin, Damon. “Japanese Farmers Use Political Clout to Win Protec
tion, Subsidies,” Wall Street Journal, December 4, 1986.
The Economist. “Japan’s Bed of Unsavoury Rice,” May 23, 1987,
pp.65-66.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

Table 6

International Comparisons of Output (Y) and Employment (E) Percentage Distributions
among Agriculture (A), Goods (G) and Services (S), for Some OECD Economies
1890
A

1950
S

developed Economies1
France Y 37.0 32.0 30.0
27
E 48
25
Germany Y 19.6 25.0 55.4
E 36
39
25
Japan
Y 54.3 16.2 29.5
E 76
10
13
U.K.
Y 9.7 36.9 53.4
54
E 15
31
Y 17.1 25.6 57.3
U.S.
E 42
28
30
Developing Economies2
Greece Y
E
Y
Spain
E
Turkey Y
E

23.0 46.0
27.0 26.2
10.4 43.7
16.9 46.6
24.4 31.5
42.4 23.9
5.6 46.2
5.6 49.0
7.2 37.7
11.4 33.8

1960

1970

31.0
25.9
45.9
36.4
44.1
33.7
48.2
45.4
55.1
54.7

9.9
22.4
6.5
10.3
13.3
30.2
3.3
4.2
3.9
8.3

43.1
38.1
48.7
57.5
37.5
28.0
36.9
47.2
32.3
34.6

47.0
39.5
45.8
32.2
49.2
41.8
59.8
48.5
63.8
57.1

6.7
13.5
3.8
8.6
6.4
17.4
3.1
3.2
3.4
4.5

23.0
53.9
30.7
42.3
36.9
78.3

20.0
18.6
37.6
31.3
18.7
10.1

57.0
27.5
31.7
26.3
44.4
11.6

16.2
38.9
12.4
29.5
28.0
67.6

1984

1980
S

44.0
37.2
51.7
48.6
41.4
35.2
36.0
43.2
30.9
33.2

49.3
47.2
44.5
42.8
52.2
47.4
60.9
53.6
65.8
62.3

5.0
8.7
2.0
5.8
3.7
10.4
1.9
2.6
2.9
3.6

32.4
35.9
37.8
43.5
36.5
34.8
31.6
36.3
28.2
29.3

62.6
55.5
60.1
52.7
59.8
54.7
66.6
61.1
68.9
67.1

5.4
7.9
2.2
5.6
3.4
8.9
1.9
2.6
2.4
3.3

30.7
33.0
36.0
41.3
38.2
34.8
31.6
32.9
29.8
28.5

64.3
59.1
61.9
53.1
58.4
56.3
66.6
63.6
67.8
68.2

22.7
25.5
28.5
36.5
27.1
14.1

61.1
35.6
59.2
34.0
44.8
18.3

12.8
30.7
10.0
18.9
22.9
60.7

22.8
28.1
30.8
35.3
26.7
15.5

64.4
41.2
59.2
45.9
50.4
23.8

12.2
29.4
N.A.
18.0
21.0
57.9

19.9
27.8
N.A.
32.7
26.5
17.1

67.9
42.8
N.A.
49.3
50.5
24.9

'The data for 1890 and 1950 vary in time of observation by as much as 5 years before or 1 year after column headings. Also, the output data
are centered averages of several years' observations whose mean time of observation is at or slightly earlier than given date. See
Long-Term Economic Growth, Tables D67-79 and D130-144 for details. For 1960 and later, the OECD data include utilities with
manufacturing, mining and construction — the Goods column; prior to 1960, utilities are included in Services.
2Not available prior to 1960.
SOURCE: 1890 and 1950: U.S. Department of Commerce, Long-Term Economic Growth 1860-1970, Series D-67 to D-81 and D-130 to
D-144; for 1960-84: OECD National Accounts of OECD Countries, Constant Dollar (1970 Prices) Gross Domestic Product;
Labor Force Statistics', OECD Economic Surveys 1985/1986— Greece, Spain, Turkey.

Fabricant, Solomon. “The Changing Industrial Distribution of Gainful
Workers: Comments on the Decennial Statistics, 1820-1940,” in
Studies in Income and Wealth, Volume II, 1949, pp. 5-49.
Feder, Barnaby J. “ Production Returning to U.S." New York Times,
February 18,1987.
Freeman, Richard B. “The Evolution of the American Labor Market,
1948-80,” in Martin Feldstein, ed, The American Economy in
Transition (University of Chicago Press, 1980).
Kotlowitz, Alex. “ Inland Steel Sets Mill Construction with Japan Firm,”
Wall Street Journal, March 24,1987.

Marimont, Martin L. “ Measuring Real Output for Industries Providing
Services: OBE Concepts and Methods,” in Victor R. Fuchs, ed.,
Production and Productivity in the Services’ Industries, (Columbia
University Press, 1969), pp. 15-40.
McUsic, Molly. “ U.S. Manufacturing: Any Cause for Alarm?” New
England Economic Review (January/February 1987), pp. 3-17.
Murray, Alan. “The Service Sector's Productivity Problem,” Wall
Street Journal, February 2, 1987.
Perna, Nicholas S. “The Shift from Manufacturing to Services: A
Concerned View,” New England Economic Review (January/Feb
ruary 1987), pp. 30-37.

Krugman, Paul R., and George N. Hatsopoulos. “The Problem of U.S.
Competitiveness in Manufacturing," New England Economic Re
view (January/February 1987), pp. 18-29.

Seaberry, Jane. “Growth in Service Sector Cuts Broad Swath,”
Washington Post, March 22,1987.

Lebergott, Stanley. Manpower in Economic Growth: the American
Record Since 1800, (McGraw-Hill, 1964).

Shelp, Ronald K., and Gary S. Hart. “ Understanding A New Econ
omy,” Wall Street Journal, December 23,1986.

Lipsey, Robert E., and Irving B. Kravis. “The Competitiveness and
Comparative Advantage of U.S. Multinationals,” NBER Working
Paper No. 2051 (October 1986).

Shultz, Theodore W. “ Investment in Human Capital — 1960 Presi
dential Address to American Economic Association” American
Economic Review, March 1961.

FEDERAL RESERVE BANK OF ST. LOUIS
_________“Three Measures of the Stock of Education,” in his
Investment in Human Capital, (Free Press, 1971).

JUNE/JULY 1987
“ Service Industries: The Future Shape of the American Economy,"
Serial 98-104, (Government Printing Office, June 8-28,1984).

Tatom, John A. “Why Has Manufacturing Employment Declined?”
this Review, (December 1986), pp. 15-25.

U.S. Department of Commerce, Bureau of Economic Analyses. Long
Term Economic Growth, 1860-1970 (GPO, 1973).

______ “ Domestic vs. International Explanation of Recent U.S.
Manufacturing Developments," this Review, (April 1986), pp. 5 18.

_________United States Historical Statistics, Colonial Times to 1970
(GPO, 1972).

U.S. Congress, Committee on Banking, Finance and Urban Affairs.

http://fraser.stlouisfed.org/
22
Federal Reserve Bank of St. Louis

U.S. Department of Commerce, Bureau of the Census. Statistical
Abstract of the United States: 1986, 106th ed. (GPO, 1985).

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

Tax Reform and Investment:
Blessing or Curse?
Steven M. Fazzari

number of recent studies have concluded that
the Tax Reform Act of 1986 will reduce capital spend
ing incentives in the United States.’ Many analysts fear
this result.

There is, however, an alternative view. By removing
special subsidies for various kinds of investment, tax
reform may encourage firms to invest in projects be
cause they have high economic returns, rather than
large tax benefits. If economic returns more closely
reflect social values than the previous tax subsidies,
investments could be better suited under tax reform to
produce goods and services that people want and
enhance the productivity of the economy. Thus, the
recent reform of capital taxation may actually improve
economic welfare, even though it reduces the aggre
gate capital stock and investment. This paper investi
gates the welfare implications of the new capital tax
system.

Steven M. Fazzari, an assistant professor of economics at Washington
University in St. Louis, was a visiting scholar at the Federal Reserve
Bank of St. Louis. The author thanks James C. Poletti for research
assistance and Chris Varvares for helpful discussion.
'See, for example, Prakken (1986), Henderson.(1986), Aaron
(1987), the Economic Report of the President (1987) and Fazzari
(1987).

THE EFFICIENT ALLOCATION OF
CAPITAL RESOURCES
In many popular discussions of taxes and invest
ment lurks an implicit assumption that more invest
ment is always better than less. After all, investment
causes the capital stock to expand, increases potential
output growth and enhances labor productivity. While
these outcomes are undoubtedly desirable, the simple
view that investment is always beneficial ignores the
costs imposed by greater capital accumulation. By
investing resources in more productive capital, people
forego the opportunity to consume some goods and
services. Thus, investment generates opportunity
costs.2
To evaluate whatever changing levels of investment
improve social welfare, one needs a criterion that
incorporates both the costs and benefits of changes in

2The opportunity costs associated with investment may be best
illustrated by an extreme case. Suppose all of a society’s output
were invested in capital goods. Growth would be maximized, but
there would be no current consumption at all. This perspective
emphasizes the trade-offs between investment and consumption.
One could also consider the efficiency of the allocation of total
investment among different capital projects; this topic, however, is
outside the scope of this article.

FEDERAL RESERVE BANK OF ST. LOUIS

the capital stock. The most widely used criterion that
meets this objective is economic efficiency.3A particu
lar level of investment is efficient if the benefits of all
projects undertaken exceed their cost while the
benefits of investment projects foregone fall short of
their costs. Let us consider this concept in more
detail.
The benefit gained from a marginal investment has
two dimensions: the amount of new output the in
vestment produces and the length of time it takes for
this additional output to become available. Consider
an investment project that increases output by Y units
at the end of its first year of production. Assume that
the project depreciates at a constant annual rate
d < 1, so that it produces (1 —d) Y units of output at
the end of the second year, (1 —d)2Y units at the end of
the third year, etc. In general, the project will produce
(1 —d),_1Y units of additional output at the end of
year t.
Let P represent the market price of the output that
individuals are willing to pay for additional units of
this good. According to the economic efficiency cri
terion, this price represents the current value of a unit
of output.4 Thus, the social value of an investment
project in any year will be the quantity of additional
output it produces multiplied by the goods’ market
price.
The concept of time preference implies that for a
variety of reasons (impatience, uncertainty and atti
tude toward risk, for example), individuals would pre
fer to have goods and services sooner rather than later.
Thus, the value of a given bundle of goods is smaller
the further in the future it becomes available.
A simple way of expressing this idea formally is to
assume that individuals discount the value of output
available in the future, relative to the value of current
output, at a constant rate r, where r is a positive
fraction. Thus, if a bundle of consumption goods avail
able today has a value of $10, the present value of the
same bundle delivered a year from now will be $10/
(1+ r). If it is delivered in two years, it will have a lower
present value, $10/(1 + r)2. In general, the present value

JUNE/JULY 1987

of output that is worth PY at a time t years in the future
is PY/d + r)'.
These concepts allow us to construct an expression
for the present value (V) of an investment project that
increases output in each future period t by (1 —d)t_1Y
units. The output has a constant market price of P. The
present value is:
00

V =

S ( 1 - d ) - 1PY (1 + r)
t= l

which simplifies to:
V = PY/(r + d).5
To attain economic efficiency, any project should be
undertaken that has a present value exceeding its
present cost, the market price of the capital project
denoted by Pc. Thus, efficiency requires investment up
to the point where the least-valued project under
taken has a productivity Y that satisfies:
Pc = V = PY/(r+ d), or
(1)

(r + d )P c = PY.

The efficiency condition given by equation 1 has a
natural graphical interpretation. Rewrite equation 1 as:
(2)

PY - dPc = rPc.

The right side represents the cost of deferring con
sumption. In figure 1, this cost rises as the capital
stock expands because the more resources that are
deferred away from consumption into capital, the
greater the premium individuals require to compen
sate them for their time preference. The left side of
equation 2 represents the net output created by an
investment project after allowing for the depreciation
of capital. In figure 1, this net marginal benefit from the
least productive investment falls as the capital stock
increases.

3Although efficiency is the most widely used welfare criterion, it does
not address some significant welfare issues. Most important, the 5This simplification is based on the fact that the geometric series
efficiency criterion does not deal with the equity of changes in wealth
oo
distributions caused by policy changes.
2 a* is (1 - a ) -1. Thus,
“There are important limitations to the view that the market price
measures the value of output because this measure does not
incorporate any concept of distributional equity. The efficiency criterion remains meaningful for any given distribution of wealth, but it
cannot be used to evaluate the implications of changing wealth
distributions.

*
oo
v _ PY ^
1
,t _
1—d t = .j 1 + r
_ PY ... 1 - d , - 1
1-du
1+r'

oo
PY . ^ , 1 - d ,t
1- d ( = Q 1+ r

_ PY 1 - d _ py/M + r\
1-dd + r
'
''

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

earnings foregone by investing funds in fixed capital
rather than financial assets.6
F ig u r e 1

Capital Stock and Economic Efficiency

A firm’s capital investment will be profitable if:
PY > Pcd + Pci,
where i represents the real rate of interest the firm
foregoes by investing in fixed capital. Thus, firms will
invest up to the point where
(3)

PY = Pr (d + i).7

Note that equation 3 looks almost the same as equa
tion 1. They will be the same if the real market rate of
interest (i in equation 3) equals individuals' discount
rate (r in equation 1). This point will be addressed
below.
In spite of their close similarity, it is important to
understand the conceptual distinction between equa
tions 1 and 3. Equation 1 defines a welfare standard for
investment and the capital stock according to the
efficiency criterion. On the other hand, equation 2
describes the level of investment profit-maximizing
firms will undertake in the market.

Suppose the capital stock is KLas shown in figure 1.
New investment, on net, will produce new output
valued at VHin the market, but individuals are willing
to release the current resources necessary to carry out
the investment for a payment of only VL. Unexploited
gains to new investment exist, therefore, and KLis not
the efficient capital stock. On the other hand, the
marginal costs of the least-valued investment project
exceed its net benefits at a capital stock of K„. Ef
ficiency then requires a decrease in investment and
capital. Only at K*, where equation 2 is satisfied, have
all gains from changing the capital stock been ex
ploited. This level gives an economically efficient capi
tal stock.

Profits and Firm Investment Decisions
A market economy has an efficient rate of invest
ment and level of capital stock if firms undertake
projects up to the point where the least productive
investment satisfies equation 1. Firms, of course, are
motivated by profit; they will invest in projects that
increase their shareholders’ wealth. An investment
project will be profitable if its net revenue exceeds its
cost to the firm. The revenue gained from investment
will be the net output produced by the new capital (Y,
initially) multiplied by the price of output (P). The cost
to the firm consists of depreciation and real interest

Much economic analysis has been devoted to un
derstanding the conditions under which economic
efficiency will be attained by the market. To obtain this
result for the market analyzed here, the interest rate
must equal individuals’ discount rate. The real inter
est rate represents the opportunity cost to firms of
borrowing funds for capital investment. It also is the
return to savers who give up the chance to consume
today by lending, either directly or through financial
intermediaries.
Suppose individuals decide that they want to con
sume more today. They reduce their saving, decreas
ing the supply of funds flowing into credit markets,
driving up interest rates. This continues until individ
uals are satisfied with the current level of saving at the
prevailing market interest rate. Thus, the interest rate
measures individuals’ discount rate at the margin, the
premium they require to exchange some consump
tion now for consumption in the future in the absence
of personal taxes on interest income. Under these
circumstances, the interest rate equals the discount
rate (i = r), and equations 1 and 3 determine identical
levels of the capital stock. That is, firms will have profit

6For a further discussion of the revenues and costs that determine
the profitability of investment, see Fazzari (1987).
'This condition is equivalent to the maximization of net present value,
under the assumptions made here. I have also assumed that the
firm is a price-taker, in both input and output markets.

FEDERAL RESERVE BANK OF ST. LOUIS

incentives to invest in capital just up to the efficient
level.8

EFFICIENCY AND NEUTRAL TAXATION
The main result of the previous section suggests
that the market outcome of firms’ independent, selfinterested investment choices leads to an efficient
capital stock. The analysis that led to this result, how
ever, ignores the effect of corporate taxes on invest
ment incentives. This section introduces the in
fluences of corporate taxes; it provides a theoretical
basis for evaluating the implications of tax reform for
efficient capital investment.
As a general rule, taxes change the economic incen
tives faced by firms. In the case of the corporate
income tax, however, it is possible, at least in theory, to
structure the tax so that capital investment decisions
do not change. Rewriting equation 3, we see that firms
will invest up to the point where the economic profits
from a marginal investment project equal zero:
(4)

0 = PY - Pc(i + d).

The right side of equation 4 represents the eco
nomic profits from a marginal investment. Suppose
these profits are taxed at a rate t .Then firms will invest
up to the point where after-ta\ profits from a marginal
investment are zero,
0
(5)

—t ) [PY - Pc(i

d)], or

(1 —t ) PY = (1 —T)[Pc(i + d)]

The level of capital investment that satisfies equation 4
will also satisfy 5; the same'actions that maximize 100
percent of profits will maximize 80 percent, 60 per
cent, or any non-zero proportion of profits. In this
case, the corporate tax rate affects the portion of a
firm’s profits that go to the government, but it does not

8The result that unrestricted market interaction leads to efficient
outcomes is often used to argue for the normative position that
market results are socially desirable. This conclusion, however, is
limited in general. Again, the idea that the willingness of individuals
to save at the margin represents the social discount rate takes the
distribution of wealth as given. The efficient capital stock level would
likely change for different wealth distributions. Also, investment may
have external social costs or benefits not recognized by the private
firms that make investment decisions. Thus, private market invest
ment incentives might differ from social incentives. Finally, this
analysis applies only to general economic equilibrium with full
utilization of resources. Existence of involuntary unemployment or
idle capacity would change the structure of the analysis. Despite
these qualifications, efficiency analysis is widely regarded as rele
vant to evaluate the long-term impact of the tax system.

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26
Federal Reserve Bank of St. Louis

JUNE/JULY 1987

affect the firm's incentives to invest efficiently.9
Economists call this kind of tax neutral. A neutral
tax does not change the allocation of economic re
sources. The key to neutral taxation in this context is
that all revenues are taxed while all economic ex
penses are fully deductible.10 This result is clear in
theory, but difficult to implement in practice, as we
will now discuss.

U.S. CORPORATE TAXATION
The U.S. corporate tax system is not nearly as simple
as the tax analyzed above. In general, it is not neutral.
The next section summarizes the effect of the tax code
on the cost of capital. Then, three important non
neutral aspects of U.S. tax law are discussed: tax de
preciation schedules, the investment tax credit, and
the deductions allowed for the opportunity cost of
invested capital. Some non-neutralities arising from
personal taxes are considered later.

The Cost o f Capital in the
U.S. Tax System
The efficient capital stock condition given by equa
tion 5 under neutral taxation assumes that the eco
nomic costs of capital are fully deductible from taxable
income. For a variety of reasons, however, the U.S. tax
code does not allow deductions based strictly on.
economic costs. This introduces a number of nonneutral aspects into the tax code. To understand the
source of these non-neutralities, we must compare
the determination of capital investment under the U.S.
tax law with the efficiency standard of a neutral tax
given by equation 5.
Let k represent the investment tax credit rate, z the
present value of a one-dollar tax deduction for depre
ciation, and L the proportion of a marginal investment
financed with debt (the debt leverage ratio). Suppose
the expected inflation rate is ire. Profit-maximizing
firms will invest up to the point where the least-valued

This result assumes that the firm is indifferent between internal and
external sources of finance. If this is not the case, investment may
be affected by reduced cash flow caused by higher corporate taxes,
even if the tax is neutral in the sense discussed in the text. See
Fazzari (1987) and Fazzari and Athey (1987) for further discussion.
'“Economic expenses include all the opportunity costs of buying and
using capital. They may differ in important respects from accounting
costs used by firms in their financial statements. Interest foregone
on shareholders’ equity, for example, represents an economic op
portunity cost but is not deducted from the firm’s accounting profit.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

unit of capital purchased satisfies,
(6)

(1 —t ) P Y =

P c( l - k - T z ) [ i

+ d -

TL(i +

ir.)].11

The left side of equation 6 is the after-tax benefit
gained from investment, as presented earlier. The
term Pc(l —k —t z ) on the right side represents the fact
that each dollar spent on investment generates an
investment tax credit of k and a depreciation deduc
tion with a present value o f z.
The other change in equation 6 relative to the neu
tral tax case in equation 5 is that only explicit interest
costs are deductible from taxable income. Thus, if the
firm finances investment with debt, the explicit inter
est expense can be deducted from taxable income, but
the opportunity cost of interest foregone on rein
vested internal funds or proceeds from new equity
issues cannot be deducted. Furthermore, because
nominal interest is deducted, changes in the inflation
rate will affect the value of the interest tax deduction,
to the extent that markets anticipate inflation in the
nominal interest rate.
As equation 6 indicates, the U.S. tax system may
introduce non-neutralities. The complicated expres
sion on the right side of equation 6 reduces to the
efficient neutral tax given by equation 5 only under
special circumstances. We shall now consider this
point in greater detail.

Depreciation Allowances

To make equation 7 equivalent to the condition de
scribing efficient investment from equation 5, the mar
ginal cost of a new unit of capital must be the same in
each case. This implies that the right side of equation 4
equals the right side of equation 6:
(1 —r)Pc (i + d) = Pc(l

)[(1

)i + d].

This equation can be solved for the efficient present
value o f depreciation allowances (z*), that is,
(8 )

d / [ ( l — T )i +

d ] . 12

Intuitively, z* is the present value of a perpetual
depreciation flow d per dollar of investment. The
discount rate consists of the after-tax real interest rate
plus the depreciation rate. The latter term appears
because the amount of depreciation declines as the
asset deteriorates.
The present values of depreciation schedules pre
scribed by the tax code can be compared with the
efficient benchmark given by z*. The first column of
table 1 gives the efficient present value under the old
and new tax laws.13 The efficient present value
changed after tax reform because the corporate tax
rate fell from 46 percent to 34 percent.
The present value of actual depreciation allowances
prescribed by the tax code are presented in the sec
ond, third and fourth columns of table 1, again for the
old and new tax laws.14 Expected inflation plays an
important role here. Neither the old nor the new tax
law indexes depreciation deductions for inflation. As
suming that higher expected inflation increases nomi

In the neutral tax equation 5, economic deprecia
tion is deducted from taxable income in every period.
In equation 6, the present value of depreciation allow
ances (z) is treated as a lump-sum deduction that
reduces the after-tax price of capital goods up front.
The two approaches will lead to equivalent results,
however, if the depreciation schedule underlying the
calculation of z is the same as economic depreciation.

,2Equivalently, z* can be derived by computing the present value of
economic depreciation deductions discounted at the after-tax real
rate of return (1 —x)i. This analysis is complicated if one explicitly
considers the differential tax treatment of dividends and capital
gains where corporate income is distributed to shareholders. See
Auerbach (1983) for further discussion.

To find the present value of depreciation allow
ances that leads to neutral taxation, suppose that
there is no investment tax credit (k = 0), the firm
finances marginal investment with debt alone (L = l)
and expected inflation is zero (Tre = 0). Then equation
6 reduces to:

13The efficient present value (z*) calculations in table 1 assume a real
discount rate of 3 percent, before taxes. The economic depreciation
rates for autos and light trucks, office computing and accounting
equipment, and communications equipment were estimated by
Gravelle (1982) as .33, .27 and .12, respectively. The average
economic depreciation rates for equipment and business structures
were .14 and .06 from the Washington University Macro Model
maintained by Laurence H. Meyer and Associates, Ltd.

(7)

( 1 — t)PY

= Pc(l —t z )[(1 —T)i + d].

"The original reference for the form of the cost of capital given in
equation 6 is Hall and Jorgenson (1967). Further references and a
more-detailed explanation of the components of equation 6 can be
found in Fazzari (1987).

14See Ott (1984) and Fazzari (1987) for a discussion of how these
present values are computed and the details of the tax depreciation
schedules. These calculations do not account for the fact that the
depreciable base for an asset eligible for the investment tax credit
was reduced by one-half of the credit, under the old tax law. This
simplification is made to focus on the effect of changing the depreci
ation schedules alone. It is formally equivalent and conceptually
simpler to think of the reduction in the depreciation base due to the
investment tax credit as a reduction in the value of the credit rather
than in the present value of depreciation deductions.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

Table 1

Present Values of Tax Deductions for Depreciation
Actual Present Value
Efficient
present value

0%
Inflation

5%
Inflation

10%
Inflation

Efficient
inflation rate

Old tax law
Autos and light trucks
Office, computing and accounting equipment
Communications equipment
Equipment average
Business structures

.953
.943
.881
.896
.787

.982
.968
.968
.970
.881

.954
.919
.919
.925
.730

.928
.874
.874
.884
.619

5.2%
2.5%
9.2%
8.5%
2.9%

New tax law
Autos and light trucks
Office, computing and accounting equipment
Communications equipment
Equipment average
Business structures

.943
.932
.858
.876
.752

.967
.967
.952
.960
.745

.918
.918
.882
.899
.494

.874
.874
.822
.847
.357

2.4%
3.5%
6.9%
7.1%
-0.1%

Asset

NOTE: The calculations are based on a 3 percent real, before-tax discount rate.

nal interest rates, the present value of a fixed, nominal
depreciation flow decreases with rising expected in
flation, as shown in table 1
With no expected inflation and nominal interest
rates equal to real rates, the tax depreciation sched
ules generally lead to more generous present values
than the efficient present value. Thus, the rapid write
offs of capital goods allowed by the tax code subsidize
investment in the absence of inflation. Although the
new tax law reduces this subsidy somewhat, the dif
ferential still remains.
As expected inflation rises, however, the present
values of actual depreciation allowances decline and
approach the efficient level. The final column of table 1
gives the expected inflation rate at which the present
value of the depreciation deduction allowable for tax
purposes equals the efficient level. Under the old tax
law, equipment deductions, on average, would have

,5For the calculations in table 1, the before-tax nominal discount rate
is assumed to rise by one percentage point for each percentagepoint increase in the expected inflation rate. A number of econo
mists have argued that nominal interest rates must increase by
more than the rise in expected inflation to maintain real returns
constant because of personal taxes levied on nominal interest
income. See Darby (1975) and Feldstein (1976), for example. If this
is the case, the present values of depreciation allowances will
decline more than the figures in table 1 indicate when expected
inflation rises.

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28
Federal Reserve Bank of St. Louis

been efficient with an expected inflation rate of 8.5
percent. After tax reform, this declined to 7.1 percent.16
The results for business structures are somewhat
different. The rapid structure depreciation allowed
under the old tax law led to a substantial subsidy at
zero expected inflation. Because of its slow deprecia
tion, however, the present value of nominal deprecia
tion allowances for structures is especially sensitive to
any changes in nominal interest rates caused by rising
expected inflation. Thus, under the old tax law, the
accelerated structures deduction was efficient at a
moderate 3.1 percent expected inflation rate.
Tax reform sharply reduced the present value of
structures depreciation; it increased the tax service
life from 19 to 31.5 years and replaced an accelerated
depreciation schedule with a straight-line schedule.
As table 1 shows, this pushes depreciation allowances
for business structures to the efficient level at an
expected inflation rate close to zero. Even at moderate
levels of expected inflation, however, the slow write-off
mandated by the new tax law causes a substantial

'T h is result is sensitive to the assumption made about the real
before-tax discount rate. If this rate increases from 3 percent to 5
percent, the efficient expected inflation rate for the equipment aver
age rises from 7.1 percent to 12.0 percent.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

disincentive for structures investment relative to the
efficient level.

Debt Financing and Capital
Cost Deductions

The Investment Tax Credit

In the neutral tax system represented by equation 5,
the opportunity cost of capital given by the real inter
est rate (i) is fully deductible from taxable income. It
does not matter whether the interest expense involves
explicit payments to debt holders or implicit opportu
nity costs of foregone interest earnings by equity hold
ers.-8 The tax law, however, allows deduction of ex
plicit interest expense, but does not allow deduction
of interest foregone when investment is financed
through internal cash flow or new equity.

The depreciation deductions allowed in the tax
code correspond to one aspect of the economic cost of
using capital. In a neutral tax system, the economic
value of these costs should be deducted from taxable
income. Inefficiency arises from depreciation deduc
tions only to the extent that the tax depreciation
schedules are more or less generous than economic
depreciation.
The investment tax credit, on the other hand, repre
sents a direct subsidy to investment. It does not cor
respond to any aspect of the economic cost of capital.
By itself, the investment tax credit provides incentives
for firms to purchase more of the eligible assets than
the efficiency criterion would dictate. The repeal of
the credit in the new tax law moves the tax system
closer to neutrality.
The investment tax credit applied to only a subset of
capital assets. Thus, the subsidy not only distorted the
amount of investment, but also the composition of
investment. A detailed analysis of this issue lies out
side the scope of this paper, but efficiency gains from
the repeal o f the credit may result from a more effec
tive allocation of investment among different assets
and activities. Furthermore, inefficient investment
that took place as a result of the subsidy competed for
scarce funds and raised the interest rate. This could
have crowded out other efficient projects that may
have been undertaken in the absence of the subsidy.17
Of course, given other distortions in capital taxation,
some kind of subsidy may be appropriate to offset the
disincentives to investment arising from other aspects
of the tax system. As the previous analysis showed, the
equipment assets eligible for the investment tax credit
generally benefit from rapid depreciation deduction
subsidies at low inflation rates even with the changes
due to tax reform. Thus, the investment tax credit is
not needed in the current environment to offset the
distortions caused by tax depreciation schedules. The
credit, however, may offset another distorting aspect
of the tax code: firms' inability to deduct the full
opportunity cost of funds tied up in capital invest
ment.

To the extent that new capital spending is not
completely debt-financed, the after-tax cost of capital
rises and investment falls relative to the efficient level.
This effect is reflected in equation 6 by the fact that the
deduction for interest expense is multiplied by the
marginal proportion of investment financed by debt
(L). This introduces an important non-neutrality into
the tax system.
At a zero inflation rate, this effect alone gives firms
an incentive to employ less than the efficient level of
capital. But inflation mitigates this distortion. The
economic cost of capital depends on the real interest
rate. The tax code, however, allows firms to deduct
nominal interest expense. As expected inflation and
nominal interest rates rise, therefore, the real value of
tax deductions for interest expenses increases.
At a sufficiently high inflation rate, the tax benefit
from deductions for nominal interest will offset the
increase in the after-tax cost of capital arising because
interest foregone on internal financing cannot be de
ducted from taxable income. One can solve for the
expected inflation rate that leads to this efficient result
(it*) by equating the deductions for interest expense in
the neutral tax system from equation 5 with the de
duction in the actual tax system from equation 6:
Ti =

TL(i +

TT*).

This gives
(9)

tt*

= i ( l —L)/L.

With a real interest rate of 3 percent and the debt
leverage ratio 30 percent, the efficient inflation rate
from equation 9 is 7 percent.19

18See Fazzari (1987) for a further discussion of debt and equity
finance for capital spending.
17The author thanks Milton Friedman for comments on an earlier
paper that emphasized these points.

19The average corporate debt leverage ratio in the second quarter of
1986 was 30.6 percent according to data from the Washington
University Macro Model.

FEDERAL RESERVE BANK OF ST. LOUIS

Tax reform has a subtle effect on this problem. The
new tax code, like the old law, does not allow deduc
tions for interest foregone by shareholders. But the
new law eliminates preferential personal tax rates for
capital gains income. Thus, corporations will have an
incentive to pay out a greater proportion of their
income as dividends and finance more new invest
ment with debt. This reduces the efficiency distortion
caused by the non-deductibility of foregone interest
from internal finance at low inflation rates.20

INVESTMENT NON-NEUTRALITIES
FROM PERSONAL TAXES
The discussion to this point has focused primarily
on the corporate tax system. But, ultimately, corporate
profits accrue to shareholders who are liable for per
sonal taxes as well. We shall now consider the effect of
personal taxes on the firm’s incentive to invest in fixed
capital.
If personal taxes on all corporate-source income
were uniform, they would not directly affect corporate
investment decisions because, again, the same actions
that maximize 100 percent of profits will maximize any
constant proportion of profits.21Personal taxes on cor
porate income, however, are not uniform. In particu
lar, income from capital gains has been taxed at lower
rates than dividend and interest income.
This lower rate provides a rather subtle subsidy for
investment. Suppose individual capital gains are taxed
at a rate T cg while interest income is taxed at the regular
personal rate Tp. If capital markets equate the after-tax
rate of return on earnings retained by the corporation
with the after-tax interest rate on debt, then:
(1 — T cg) ( i cg +

i t .)

(1 — Tp) ( i +

JUNE/JULY 1987

The favorable treatment of capital gains income leads
to a subsidized rate of interest for investment financed
with retained earnings.
Let us integrate this effect into the cost of capital
formula. As before, assume that the firm finances a
fraction L of marginal investments with debt and 1 —L
with retained earnings. The weighted average nominal
opportunity cost of funds the firm faces is:
(10)

The firm’s cost of capital is then:
(11)

Pc ( l —k —tz )(c — TTe + d).

Equation 11 reduces to the right side of equation 6
when the personal tax rate on capital gains equals the
personal tax rate on regular income (Tcg = t p).

Capital Gains Taxation After
Tax Reform
Tax reform has fundamentally changed the terms of
the capital gains subsidy by repealing the 60 percent
exclusion for capital gains income. This change, how
ever, does not mean that the personal tax advantages
of capital gains income has been removed. Sharehold
ers that receive capital gains income still benefit from
the deferral of tax until the time the asset is sold and
the capital gain is realized.
The effective tax rate on capital gains income, there
fore, depends on the length of time an investor holds
an asset. One can compute Tcg as the present value of
the tax paid at realization per dollar of capital gain
discounted at the individual's after-tax real interest
rate:

ir j,

(1 2 )

where icg is the implicit real interest rate on corporate
retentions.22Thus, as long as:
Tc8 <

1 - t„
c = (1 —L)(--------)(i + 7Te) + L d - T X i + irJ.23
1 _ Tcs

Tcg — (1

(X) Tp/ [ 1 + (1 - T p ) i f ,

where |x is the proportion of capital gains income
excluded from tax and H is the holding period.24

Tp,

ic* + TTe = (i + iT jd - T p l/ d - T j < (i + ir„).

“ Debt finance is beneficial in the sense that it pushes the economy
closer to efficiency at the microeconomic level. On the other hand,
higher debt ratios can make the macroeconomic system as a whole
less stable. This issue is outside the scope of this paper. For further
discussion, see Caskey and Fazzari (1986).
21Even uniform personal taxation could have an indirect effect on
investment because the tax on the return from saving will reduce
individual incentives to defer current consumption. This tends to
raise real interest rates and increase the opportunity cost of capital.
This issue is considered later in the article.
“ This approach follows Henderson (1986), p. 23. It ignores any risk
premium required by investors in corporate equity.

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30
Federal Reserve Bank of St. Louis

“ Equation 10 is based on two simplifying assumptions. First, no
marginal investment is financed with new share issues. According to
Henderson (1986), new shares account for only 4.9 percent of the
U.S. capital spending finance. Second, and more importantly, equa
tion 8 assumes that the earnings from marginal, internally financed
investments are completely retained and will be taxed as capital
gains. This analysis is complicated by dividends. See Auerbach
(1983) for further discussion.
24This equation is a simplification. In general, the accrual-equivalent
capital gains tax rate depends on the rate of growth of the asset’s
value and the holding period in a more complicated way. Further
complications arise because capital gains not realized before the
asset holder’s death may escape taxation. Also, much capital gains
income is realized by tax-exempt or tax-deferred funds such as
pensions or individual retirement accounts. See Auerbach (1983),
pp. 919-20 for further discussion and references.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

As we can see from equation 10, the effect of the
capital gains personal tax subsidy depends on the
ratio (1 —Tp)/(1 —Tcg). If the personal tax rate on interest
income equals the tax rate on capital gains income,
this ratio will be unity, and equation 10 gives the same
opportunity cost of funds that was derived in the
absence of personal tax considerations.
This ratio, however, is not equal to unity. Assuming
an average marginal personal tax rate on ordinary
income of 28 percent, a 60 percent capital gains exclu
sion, a 3 percent real after-tax discount rate, and a 10year holding period for long-term capital gains, the
ratio (1 —Tp)/(1 —t^) was 0.78 for the old tax law. This
figure is based on an effective capital gains tax rate of
8.3 percent from equation 12. Removing the 60 percent
capital gains exclusion and lowering the personal tax
rate to 22 percent gives an effective capital gains tax
rate of 16.4 percent and a ratio (1 —t p)/(1 —Tcg)of 0.93 for
the new tax law.25
Under a completely neutral tax system, all personal
income would be taxed equivalently; so (1 —t p)/(1 —t c(,)
would equal unity. Thus, tax reform moves the system
toward neutrality from this perspective alone.

TAX REFORM AND EFFICIENCY: AN
OVERALL ASSESSMENT
The preceding sections of this article analyzed a
number of non-neutral features of U.S. capital taxa
tion. The effect of tax reform on each of these non
neutralities was considered separately. This section
provides an overall assessment of whether tax reform
has brought capital taxation closer to the efficiency
standard.
Table 2 provides one perspective on the efficiency of
the tax law, before and after tax reform. The figures
show the ratio of the actual after-tax cost of capital to
the efficient cost of capital under neutral taxation. The
calculations are based on the assumption that the real
interest rate firms face in the market reflects the social
opportunity cost of providing capital.26Thus, this ratio
^These results were not changed much by increasing the real, after
tax discount rate to 5 percent, or shortening the holding period to 5
years. With the maximum marginal personal tax rates, however,
greater subsidies result. The (1 - tp)/(1 - t^) ratio was 0.59 for the
old law and 0.89 for the new law.
“ This ratio is computed as the actual cost of capital from equation 11,
(1 - k - tz)(c- n. + d), where c is defined in equation 10, to the cost
of capital under neutral taxation from the right side of equation 5,
(1 - T ) ( i + d). The investment tax credit rates are adjusted to reflect
the fact that the depreciation base for an asset eligible for the credit
was reduced by one-half of the credit. Thus, k = k,(1 - 0.5 t z ),
where kg is the statutory investment tax credit rate.

Table 2

Tax Distortion of the Cost of Capital
(Real Interest Rate Equals Social
Opportunity Cost)
Ratio of Actual to
Efficient Cost of Capital
Asset category
Autos and light trucks
Office, computing and
accounting equipment
Communications equipment
Equipment average
Structures average

Old tax law

New tax law

0.90

1.01

0.85
0.79
0.80
0.94

1.00
0.98
0.99
1.11

NOTE: Calculations are based on a 3 percent real interest rate, a
4 percent expected inflation rate and a 30 percent debt
leverage proportion.

provides a measure of the extent to which the capital
taxation system alone distorts investment incentives.
This ratio measures the extent of the tajc distortion
of capital costs. If the ratio is unity, there is no distor
tion, and the tax system is neutral for that class of
asset. A ratio less than one indicates that the tax
system encourages investment relative to the efficient
rate; a ratio greater than one shows that the tax system
discourages investment relative to the efficient rate.
The effects of tax reform on equipment tax distor
tions are striking. Under the old tax law, the system
provided a subsidy to equipment investment: the ra
tios are less than one. This was due primarily to the
investment tax credit. Under the new law, the treat
ment of equipment approaches remarkably close to
tax neutrality. The results presented in table 2 are
based on a 3 percent real interest rate, a 4 percent
expected inflation rate and a 30 percent marginal debt
leverage ratio. Qualitatively similar results for equip
ment asset classes are obtained for a wide range of
assumptions about these parameters.
For business structures, the result appears less fa
vorable. The generous depreciation allowances for
structures under the old tax law caused the after-tax
cost of capital to fall below the efficient level for struc
tures as well as equipment. By sharply reducing the
value of structures’ depreciation allowances, however,
tax reform pushes the after-tax cost of structures’
capital well above the efficient level.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

The excessive taxation of business structures, how
ever, may not be as large as the figures in table 2
suggest. The calculations assume that all investment
is financed with the average 30 percent debt leverage
ratio. But structure debt leverage ratios are probably
higher than the average, because collateral value pro
vided by structures is more easily realized than the
values of firm-specific equipment. Higher leverage ra
tios reduce the cost of capital because interest ex
pense is tax deductible. If the leverage ratio for struc
tures reaches 50 percent to 70 percent (the exact value
depends on expected inflation), structures taxation
will be neutral, even under the new tax depreciation
schedules.27
The results presented in table 2 reflect the efficiency
of taxes on firms’ capital alone because the real market
interest rate was assumed to reflect the social oppor
tunity cost of capital. As mentioned earlier, however,
individuals pay personal taxes on interest income.
Thus, the market interest rate exceeds the return
required by savers. Suppose that savers require an
after-tax rate of return of r. Because nominal interest is
taxed, the nominal market interest rate (i + TTe) must
satisfy:
(13)

r = (i + TJ-Jll-Tp) - 7Te

to give savers an after-tax real rate of return equal to r.25
This changes the comparison between the actual
and efficient cost of capital in a fundamental way. The
efficient cost of capital is based on the social discount
rate r, while firms must pay a higher real interest rate
in the market to compensate savers for the personal
taxes they pay on interest income. To reach efficiency
according to this perspective, therefore, investment
must receive tax subsidies that stimulate capital
spending sufficiently to offset the disincentives to sav
ing arising from taxes on personal interest income.
Table 3 presents tax ratios that incorporate this
effect. The results are different from those in table 2 for
the capital tax system alone. The investment subsidies
for equipment in the old tax law led to an effective cost
of capital that still fell below the after-tax opportunity

27lf the leverage ratio is higher than average for structures, it must be
lower than average for equipment. For example, a 50 percent
structures leverage ratio would imply about 20 percent equipment
leverage to obtain a weighted average of 30 percent because
approximately two-thirds of investment consists of equipment. Re
ducing the leverage ratio to 20 percent for equipment, however,
does not substantially change the results presented in this article.
“ This issue is discussed in detail by Darby (1975) and Feldstein
(1976).

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32
Federal Reserve Bank of St. Louis

Table 3

Tax Distortion of the Cost of Capital
(Real Interest Rate Increased to Offset
Personal Interest Tax)________________
Ratio of Actual to
Efficient Cost of Capital
Asset category
Autos and light trucks
Office, computing and
accounting equipment
Communications equipment
Equipment average
Structures average

Old tax law

New tax law

0.96

1.06

0.93
0.93
0.92
1.25

1.07
1.11
1.10
1.35

NOTE: Calculations are based on a 3 percent after-tax rate of
return to savers, a 4 percent expected inflation rate and a
30 percent debt leverage proportion. The real interest rate
is obtained from equation 12.

cost of savers, although the tax ratios for the old law in
table 3 are closer to unity than in table 2. The cost of
capital for structures that were ineligible for the in
vestment tax credit, however, was well above the ef
ficient level, even with the old law's generous depreci
ation allowance. By removing the capital subsidies, tax
reform increased the cost of capital above the efficient
level in all cases. To the extent that investment subsi
dies are desirable to offset the disincentive to saving
caused by personal taxes on interest, tax reform does
not improve efficiency.
One also should note that the tax distortions for the
new law become worse at higher expected inflation
rates. This is because personal taxes are levied on
nominal interest income. As expected inflation and
nominal interest rates rise, therefore, the premium
required to maintain individuals’ after-tax real return
on saving rises even faster.

CONCLUDING REMARKS
This article has analyzed the effect of the Tax Re
form Act of 1986 on the efficiency of U.S. capital forma
tion. The results leave little doubt that the old tax law
subsidized equipment investment. Tax reform re
moved these subsidies, especially the investment tax
credit. Now, the tax system causes the after-tax cost of
capital to correspond closely to economic deprecia
tion and market rates of interest. Tax reform appar
ently moves equipment taxation close to neutrality, in

FEDERAL RESERVE BANK OF ST. LOUIS

the sense that the after-tax cost of capital reflects real
economic depreciation and real market interest rates.
For structures, however, an apparent subsidy due to
generous depreciation allowances under the old tax
law was more than offset by tax reform. Now the tax on
structures is substantially higher than the level con
sistent with neutrality.
From a broader perspective, however, some invest
ment subsidies were necessary to attain an efficient
allocation of resources between consumption and
capital formation. Because personal interest income is
subject to tax, many economists have argued that the
market interest rate overstates the social opportunity
cost o f investing in capital. Thus, investment subsi
dies, like those in the old tax law, can offset the
disincentive to saving arising from personal taxes.
One might argue that the distortion caused by per
sonal taxes on interest income should be dealt with
directly rather than by subsidizing capital investment.
The lower personal tax rates resulting from tax reform
accomplish this to some extent, although this effect is
offset by higher taxes on capital gains and tighter
restrictions on IRA benefits. Thus, tax reform’s impli
cations for the efficient allocation of current resources
between investment and consumption remain ambig
uous.

REFERENCES
Aaron, Henry J. “The Impossible Dream Comes True: The New Tax
Reform Act,” The Brookings Review (Winter 1987), pp. 3-10.
Auerbach, Alan J. “Taxation, Corporate Financial Policy and the
Cost of Capital,” Journal of Economic Literature (September 1983),
pp. 905-40.

JUNE/JULY 1987
Darby, Michael R. "The Financial and Tax Effects of Monetary
Policy on Interest Rates," Economic Inquiry (June 1975), pp. 26676.
Economic Report of the President.
Office, 1987).

(U. S. Government Printing

Fazzari, Steven M. “Tax Reform and Investment: How Big an
Impact?” this Review (January 1987), pp. 15-27.
Fazzari, Steven M., and Michael J. Athey. “Asymmetric Informa
tion, Financing Constraints, and Investment," Review of Eco
nomics and Statistics (forthcoming, 1987).
Fazzari, Steven M., and John P. Caskey. “Macroeconomics and
Credit Markets,” Journal of Economic Issues (June 1986), pp. 42129.
Feldstein, Martin. "Inflation, Income Taxes and the Rate of Interest:
A Theoretical Analysis,” American Economic Review (December
1976), pp. 809-20.
Gravelle, Jane G. “ Effects of the 1981 Depreciation Revisions on
the Taxation of Income from Business Capital.” National Tax Jour
nal (February 1982), pp. 1-20.
Hall, Robert, and Dale Jorgenson. “Tax Policy and Investment
Behavior," American Economic Review (June 1967), pp. 391-414.
Henderson, Yolanda. “ Lessons from Federal Reform of Business
Taxes,” New England Economic Reyiew (November/December
1986), pp. 9-25.
Prakken, Joel L. “The Macroeconomics of Tax Reform," presented
at the American Council for Capital Formation conference entitled
“The Consumption Tax: A Better Alternative?” September 3-5,
1986, Washington, D.C.
Ott, Mack. “ Depreciation, Inflation and Investment Incentives: The
Effects of the Tax Acts of 1981 and 1982,” this Review (November
1984), pp. 17-30.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

The Macroeconomic Effects of the
Recent Fall in Oil Prices
John A. Tatom

B
e t w e e n the end of 1985 and the second quarter
of 1986, oil prices fell by about half the reverse of the
near doubling of oil prices in both 1973-74 and in
1979-81.1 This decline prompted a renewed debate
about the effects of oil price changes- and whether the
effects of oil price declines are simply the reverse of oil
price increases; that is, whether the effects are sym
metric. This article examines these issues. A theoreti
cal analysis of oil and energy price effects on the
economy is presented first, along with some evidence
on the actual effects of oil price increases on the
United States and other countries. While the theory
indicates symmetric effects, several arguments sug
gest the 1986 oil price decline will not have equal and
opposite, or symmetric, effects on the economy.

oil prices, could affect the economy. The first is
through its effect on aggregate supply; this has.come
to be called a “price shock.” In this view, an oil price
increase results in an initial upward shift in the aggre
gate supply curve that will raise prices; output falls
along a downward-sloping aggregate demand curve.
Subsequent wage adjustments, however, can restore
the initial level of output and price. This analysis can
be found in many textbooks.2
The effect of oil price shocks on aggregate supply is
more involved than simply a rise in the cost o f output,
however. Energy price shocks are changes in relative
prices; to make such changes effective, the supply of
energy must be altered.3To the extent that energy is a
factor of production, the production possibilities and
aggregate supply conditions of the economy are al

THE THEORETICAL CHANNELS OF
OIL PRICE EFFECTS
There are several channels through which an oil
price “shock,” an unanticipated change in the level of

John A. Tatom is an assistant vice president at the Federal Resen/e
Bank of St. Louis. This article draws heavily upon an earlier paper
prepared for the Carnegie-Rochester Conference on Public Policy,
April 1987, Tatom (1987). Michael Durbin, Tom Pollmann and Anne
Grubish provided research assistance at various stages of this work.
'This paper pays little attention to the rise in U.S. oil prices from about
$13.40 per barrel in the fourth quarter of 1986 to about $17.00 per
barrel in March of 1987. The adjustments in early 1987 are not large
enough to affect the arguments below.

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34
Federal Reserve Bank of St. Louis

2See, for example, Hall and Taylor (1986, pp. 134-35). Despite the
unique fit of past experience with the emerging “ real business cycle
theory” which emphasizes productivity shocks, such theorists tend
to ignore oil price changes as a source of such shocks; for example,
Prescott (1986) maintains that oil price shocks do not affect a
country’s production possibilities.
Alternatively, many transitory price shocks occur from quantity
shocks that are transmitted through transitory relative price
changes. The characterization of price or quantity shocks is unim
portant in theory. Quantity shocks, however, are typically transitory
and associated with transitory relative price changes, while perma
nent macroeconomic shocks of a “cost-push” type tend to be
associated with permanent changes in relative prices that also
affect potential or natural output.

FEDERAL RESERVE BANK OF ST. LOUIS

tered.4 Energy price shocks alter the incentives for
firms to employ energy resources and alter their opti
mal methods of production. Energy-using capital is
rendered obsolete by an energy price increase, opti
mal usage of the existing stock is altered, labor re
sources are diverted to economize on energy use and
production switches to less energy-intensive technol
ogies.5 Thus, existing capital and labor resources are
incapable of producing as much output as before. The
reduced capacity output of the economy is usually
referred to as a decline in potential or natural output.
A second channel emphasizes an effect on aggre
gate demand. Analysts use a “tax analysis” in which
domestic aggregate demand is affected due to a
change in net imports of oil. In this analysis, the
direction and extent of effects depend on the coun
try's net oil export status. Countries that are selfsufficient in oil are unaffected by oil price shocks,
while net exporting countries experience an increase
(decrease) in aggregate demand when oil prices rise
(fall). The effect on net oil importing countries is ex
actly the opposite.6
Such a simple characterization, however, ignores
the effects of oil price changes on productivity, which
tend to work in the same direction regardless of the oil
trade status of the country. Thus, a focus on trade
status would suggest that Canada, whose net oil ex
ports equaled 0.4 percent of GDP in 1973, would have
had a boost to aggregate demand, or output and
employment, from the 1973-74 oil price rise, and that
the United Kingdom, which became a net oil exporter
in 1979, would have had a similar gain from the 197981 oil price hike. Neither conclusion is supported by

4This is the emphasis in Rasche and Tatom (1977a, b, c and 1981).
Hickman (1984) discusses this channel in a study of 14 macroeco
nomic models. He indicates that the participants in the study gener
ally agreed there is such an effect, but that formal estimates of it
were included in only six ot the 14 models. Phelps (1978) and
Gordon (1975) implicitly recognize the shift in production possibili
ties in models that treat a supply shock as a shift in a fixed supply of
resources. Related theoretical and empirical analyses are dis
cussed in Tatom (1987).
5Baily (1981) and (1982) emphasizes the capital obsolescence argu
ments. Fischer (1985) incorporates this effect in a model of aggre
gate supply. Wilcox (1983) successfully tested the interest rate
implications of the energy-induced decline in the marginal productiv
ity of capital.
6Hickman (1984) breaks this aggregate demand shift for an oil price
increase into a domestic “terms of trade" effect that reduces domes
tic disposable income and a net export effect due to reduced foreign
income. His argument for an aggregate demand shift also includes a
shift due to a discretionary policy response in the face of an oil price
shock.

JUNE/JULY 1987

evidence on real output, employment or productivity
growth.7 Similarly, while this argument suggests that
output and employment in the United Kingdom
would have been adversely affected by the 1986 de
cline in oil prices, the evidence again does not support
the conclusion.
In most models of the economy, price shocks oper
ating through aggregate supply have the dominant
effect. Hickman (1984) examines 14 large and small
scale econometric models and finds that aggregate
prices respond quite similarly to an oil shock and that
the models are linear and symmetric so that aggregate
price level responses are proportional to the magni
tude of the oil price shock.8The Hickman (1984) study
also indicates that oil price shocks affect aggregate
demand only minimally in several models of the U.S.
economy because:
incipient deterioration in the term s of trade from the
increase in the price of oil im ports is partly offset by
the induced rise of export prices, and because the
decline of world production does not impinge heavily
on U.S. exports (p. 91).

The channels of influence on aggregate supply can
be seen in figure 1, which shows the aggregate supply
and demand for aggregate real output. Initially, the
price level is P0and output is y0. A higher oil price for
an oil-importing country would reduce aggregate net
exports and shift the aggregate demand curve, AD0, to
the left, according to the aggregate demand channel
above. If this were the only effect, both output and the
price level would fall. This effect is not included in the
figure because of its dubious merit and to focus on the
aggregate supply channel. The “price shock” raises
the supply price of aggregate output for any level of
output, thus, the aggregate supply curve, AS0, shifts
upward to AS,. Figure 1 also incorporates the capacity
output; thus, the aggregate supply curve, AS0, shifts
with a relatively steep slope at the initial level o f real
output (y0) to reflect the notion that at y0, existing
supplies of domestic capital and labor resources are
fully employed, and price level variations cannot in
duce larger use of energy, given the relative price of

7See Rasche and Tatom (1981) and the evidence below.
“The linear and symmetric issues were addressed by comparing
simulation outcomes for a number of energy shocks including a 20
percent increase or decrease in the price of oil and a 50 percent
increase in the price. Hickman also notes that most models have
unitary price elasticities of aggregate demand so that “the relative
magnitude of the output and price responses to an oil shock is
similar across models, with big output reductions accompanying
large price increases and vice-versa” (p. 93).

FEDERAL RESERVE BANK OF ST. LOUIS

energy, or increase supplies of other resources. When
energy prices rise, the aggregate supply curve shifts
upward, but the level of output corresponding to full
utilization of existing labor and capital resources also
shifts to the left, y , 9

JUNE/JULY 1987

Figure 1

The Aggregate Supply Effect of
a Rise in Energy Prices

In capital and labor markets, this productivity loss is
manifested in lower real wages and, over time, in a
smaller capital stock relative to labor. The latter effect
reinforces the initial productivity loss and shows up as
a reduction in growth of the capital stock and eco
nomic capacity during the period of adjustment to a
lowered desired capital-labor ratio. Since the theoreti
cal channel is reversible, energy price reductions have
equal and opposite effects to those of an energy price
increase; in figure 1, an equal-sized energy price re
duction shifts aggregate supply from AS, to AS0.‘° Thus,
this approach implies that energy price changes have
symmetric influences on the economy.

Some International Evidence From
Earlier Oil Price Changes
The theoiy presented above suggests that energy
price shocks should affect the productivity of capital
and labor resources similarly across countries. Sup
port for this view is provided by Rasche and Tatom
(1981), using production function estimates for Can
ada, the United Kingdom, Germany, France and Japan.
More recent evidence can be found using business
sector data for these countries and Italy prepared by
Helliwell, et al (1986) for the Organization for Eco
nomic Cooperation and Development (OECD).11 This
data can be used to demonstrate the significance of

9Analyses like that in figure 1, but which ignore the shift in capacity,
have upward sloping supply curves at (P,, y,) that suggest that the
former output level, y0, is achievable if government policy can raise
aggregate demand sufficiently; viewed another way, these analyses
suggest that the decline in output from y0to y „ involves a reduction
in employment of existing labor and capital resources.
10ln Rasche and Tatom (1977a, b, c and 1981), aggregate demand
shifts play no essential role. Shifts in oil imports or exports are
presumably offset by corresponding changes in other imports or
exports or by changes in other components of aggregate demand.
This analysis also emphasizes that optimal policy responses are
effectively limited or absent because economic capacity is changed,
and the economy adjusts to energy price shocks relatively quickly.
Output cannot be “ restored” to its original level through short-run
aggregate demand management. Moreover, such policies work
slowly relative to the dynamics of adjustment to a supply shock, so
that the effects of oil price shocks are largely completed before
monetary and fiscal policy effects could have an impact on them.
"These data, updated and revised from the original article, were
kindly provided by Mr. Peter Jarrett and Mr. G. Salou of the OECD.

http://fraser.stlouisfed.org/
36 Bank of St. Louis
Federal Reserve

Output

the general predictions of the theoretical analysis for
earlier energy price increases.12
The top panel of table 1 presents the annual average
growth rate of the relative price of energy from the
OECD data set.13Table 1 also shows the growth rates of
output per worker, capital per worker, and energy per
worker in the seven countries. Two periods including

12The OECD data on the business sector was prepared to develop the
supply-side of the OECD’s macroeconomic model for seven coun
tries. Two important characteristics of this data are the consistency
of measurement across countries and the development of the
energy purchases series. Helliwell et al. (1986) do not directly
address the symmetry issue or whether variations in energy pur
chases fully capture the effects of energy price shocks on aggregate
supply. Energy price effects work through changes in the relative
cost of capital and energy in their model, so the effects are implicitly
symmetric.
13These data are available from 1963 for all countries but Japan and
extend to 1983. The relative price of energy is constructed by
deflating the nominal price of business energy purchases by the
deflator for business sector gross output. Besides the United States,
only Italy, Germany, and Japan show declines for this measure after
1981. The only decline for the latter three countries is in 1983 and
ranges from a decline of only 3.1 percent (Japan) to 5.1 percent
(Germany). The decline in the relative price of energy in the United
States from 1980 to 1985 and rise in most other countries is one of
the reasons given in Tatom (1986) for the improvement in productiv
ity growth in the United States compared with other countries and,
therefore, the improved U.S. competitiveness and associated rise in
the value of the dollar in international exchange.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

Table 1

Annual Growth Rates
1973-79

1979-83

-0.1%
-0 .4
-3 .7
-2 .9
-1.1
-2 .0
-2 .7

8.2%
8.1
5.3
4.7
5.3
6.8
9.4

5.6%
6.8
15.5
3.8
9.3
5.7
9.8

Output per worker
United States
Canada
Japan
United Kingdom
France
Germany
Italy

1.5%
3.0
9.2
3.7
5.5
5.0
6.9

0.1%
0.8
3.0
0.9
3.5
3.3
2.2

0.3%
-0 .0
2.1
1.4
1.5
1.3
-0.1

Capital per worker
United States
Canada
Japan
United Kingdom
France
Germany
Italy

2.5%
2.5
10.51
4.6
5.1
5.9
6.5

1.7%
2.3
6.5
3.3
4.9
4.8
3.5

2.1%
4.6
5.1
4.8
4.6
4.5
3.2

Energy per worker
United States
Canada
Japan
United Kingdom
France
Germany
Italy

1.8%
3.8
10.9
2.8
5.0
6.8
8.0

-0.4%
0.7
-0 .2
-1 .4
3.0
1.8
-1 .9

-4.3%
-1 .8
-6 .4
-3 .0
-3 .3
-0 .5
-5 .4

Relative price of energy
United States
Canada
Japan
United Kingdom
France
Germany
Italy

1965-73

’ 1967 to 1973; 1967 is the earliest available data.
SOURCE: OECD data, except for the United States, where more
recent U.S. data on output, employment, and capital are used.

the 1973-74 and 1979-81 oil price shocks and their
aftermath are shown, along with the 1965-73 trend in
each variable. The second panel shows the slowdown
in labor productivity from the 1965-73 trend during
each period. Japan and Italy had the sharpest reduc
tions in the 1973-79 period. The slowdown in labor
productivity growth is more pronounced in all coun
tries, except the United States and United Kingdom, in
the 1979-83 period when compared with 1965-73.

The capital-per-worker growth rates also declined
in 1973-79 compared with those in 1965-73. Move
ments in the capital-labor ratio are not indicators of
the desired capital-labor ratio when cyclical move
ments in employment depart from labor force growth.
Nonetheless, over the 1979-83 period, four countries
showed a further deceleration; the growth of capital
per worker accelerated, however, in the United States,
Canada and the United Kingdom.
As the bottom panel of table 1 shows, the growth
rate of energy per worker slowed markedly in each
country for each period. The largest reductions in
1973-79 were in Japan and Italy, the two countries in
which the largest reductions in the growth of output
per worker also occurred. All countries showed larger
reductions in the growth of energy per worker in the
1979-83 period. The results in table 1 are consistent
with the theoretical predictions that a rise in the
relative price of energy reduces both energy and capi
tal per worker and, therefore, lowers output.
Over the period 1973-83, output per worker growth
slowed substantially in the seven countries when
compared to the 1965-73 period; reduced energy use
alone accounted for a substantial share of these re
ductions without taking into account the energy
price-induced reductions in capital per worker.14
Some analysts have suggested that these develop
ments will not be reversed, or at least not reversed in
proportional magnitudes, by the recent decline in the
relative price of oil and other energy resources. Some
of these arguments are examined in the next section.

DO OIL PRICE INCREASES AND
DECREASES HAVE EQUAL AND
OPPOSITE EFFECTS?
Previous studies of the effects of oil price changes on
the economy do not indicate that they are asymmet
ric. Existing models of oil price effects are not formu
lated in a manner that would reveal such asymmetric
effects, however. Besides, empirical models rely heav
ily on the experience in the 1970s, when real oil and

14The reductions in energy use per worker together with “output
elasticities of energy use,” the percentage change in output associ
ated with each percentage point change in energy use, can be used
to estimate the direct effect of the energy use reductions on output.
These elasticities, estimated in Tatom (1987), show that reduced
energy use had a substantial negative effect on output and produc
tivity growth in these seven countries.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

C hart 1

The R e la tive Price of O il

1974

energy prices did not decline.15There are some argu
ments, however, that suggest the recent oil price de
cline will not yield equal and opposite effects.

The Asymmetric Effects o f Transitory vs.
Permanent Oil Price Declines
If the recent decline in oil prices is only temporary,
there should be no long-run adjustments of methods
of production, prices or employment. At least one

,5Real oil prices and energy prices did decline through most of the
post-war period included in the estimation of most models, but on a
steady and moderate trend rather than abruptly. Hamilton (1983),
however, indicates that there were cyclical movements induced by
oil shocks before 1973.

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38
Federal Reserve Bank of St. Louis

1987

perspective on the recent declines, however, suggests
that they are not likely to be reversed. According to
this view, the decontrol of the U.S. crude oil market in
early 1981 lowered OPEC’s optimal price of oil. This
view also suggests that OPEC2 was due largely to
output changes associated with the Iran-Iraq war; if
correct, the OPEC2 price increase ultimately will be
reversed.16Consequently, the 1986 oil price reduction
is not a temporary aberration, but the continuation of
a downward oil price adjustment that began five years
earlier.

"The analysis in Ott and Tatom (1982a and b) and several of the
references cited there explain this argument.

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Chart 1 shows the relative price of oil from 1974 to
the end of 1986. The prices, measured relative to 1985
business sector prices, show the average U.S. refiner
acquisition cost for oil and for imported oil. The im
ported price is included to indicate the world price of
oil. The two prices differ until early-1981 because of
the entitlement system that held the U.S. price paid for
oil, whether domestic or foreign, below that in the
world market. Subsequent differences reflect minor
variations in the characteristics of domestic and im
ported oil. Note that the U.S. real price of oil in 1974—78
averaged about $19.50 per barrel (1985 prices) and
varied little. OPEC2 sent the world price up from $22
per barrel at the end of 1978 to about $46 per barrel in
the first quarter of 1981, when U.S. decontrol of the
domestic oil market occurred. Subsequently, the
world and domestic price of oil fell to about $27 per
barrel by late 1985, a decline of $17 to $19 per barrel,
then further declined to an average of about $14 per
barrel (1985 prices) in 1986.

An examination of chart 1 reveals three central
points: (1) the 1986 oil price decline is not unprece
dented — the decline began in 1981; (2) the 1986
decline was exceeded by the larger reductions that
occurred from 1981 to the end of 1985; and (3) not until
early 1986 had U.S. real oil prices fallen to their 1974-78
levels. Thus, the recent shock makes the 1981-86
change comparable in magnitude to the 1979-81 in
crease, except for the timing. These results are consist
ent with the view that the 1986 shock is permanent
and point to the fact that the United States has had at
least five years of experience with declining real oil
prices.17

Chart 2 shows the quarterly relative price of energy
(measured by deflating the quarterly average producer
price index for fuel, power and related products by the
business sector price deflator from 1970 to the
present); the price has been indexed to 1972. Energy
prices show the same pattern as the real price of oil in
chart 1, especially the relative magnitudes associated

"Since the initiating factor in OPEC2 has not totally disappeared,
further downward movement can be expected. In 1978, Iran and
Iraq produced 7.8 million barrels per day. This dropped to a low of
2.4 million barrels per day in 1981 and recovered Jo only about 4
million barrels per day at the end of 1985. Trehan (1986) presents
an “alternative" view of nominal oil prices, arguing that they are
driven by movements in the exchange value of the dollar. Bui
Trehan’s model only explains nominal price movements, given the
relative price of oil, it does not account for the sharp nominal price
changes associated with relative price disturbances.

JUNE/JULY 1987

with the OPEC1 and OPEC2 increases and the 1981-86
decline. From the end of 1972 to the third quarter of
1974, the logarithm of the relative price of energy rose
45.8 percent; from the first quarter of 1979 to the first
quarter of 1981, it rose 47.9 percent; finally, from the
first quarter of 1981 to the second quarter of 1986, it fell
51.8 percent. These changes were largely due to the
near doubling in real U.S. oil prices in each of the
earlier periods and the decline since early 1981.

OPEC’s incentive to maintain a lower price than
prevailed as recently as 1985 can be seen from produc
tion and consumption developments since OPEC2. In
1973-79, world oil production (and, roughly, con
sumption) ranged from about 59.7 million to 62.5 mil
lion barrels per day, o f which OPEC produced about
30.7 million (in 1973 and 1979, the figures were 31.0
and 30.9, respectively). OPEC output declined to 16.1
million barrels per day in 1985. World production also
fell, to about 53 million barrels per day in 1982-83, and
only recovered to about 54 million barrels per day in
1985. Thus, OPEC’s market share plummeted from
about 50 percent during 1973-79 to about 30 percent
of a smaller market in 1985.

Comparing 1979 and 1985, world consumption fell
about nine million barrels per day or about 14.5 per
cent, while non-OPEC production rose about six mil
lion barrels per day, or about 20 percent. The decline
in the OPEC share arose from both a relatively large
increase in rest-of-the-world production and a de
crease in world consumption. OPEC, by late 1985, had
not adjusted fully to its lowered optimal price. In
1985—86, Iran and Iraq's joint production level of about
3.6 million barrels per day, while 50 percent larger
than in 1981, was well below their 1973—78 joint pro
duction level of 8 million barrels per day.
Since 1980, oil market developments have lowered
OPEC’s optimal price of oil. The actual price was
reduced gradually in an attempt to increase the quan
tity of oil demanded and reduce competitors' sup
plies. By the end of 1985, such efforts had not been
successful; moreover, even if the price reductions
since then become somewhat successful, the rest of
OPEC will face a future problem — a decline in market
share and stronger incentive to lower prices — to the
extent that Iran-Iraq production eventually rises fur
ther back toward pre-war levels. Thus, the recent
decline in world oil prices is not likely to be temporary
and its effects should not be asymmetric, at least not
on this account.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1987

Chart 2

U.S. R e la tive Price of En ergy

Do Oil Price Changes Have Asymmetric
Effects on Capital Obsolescence?
When oil prices rise, energy-using capital is ren
dered obsolete, unless (1) product prices adjust suf
ficiently, (2) product demand is unaffected, and (3)
other lower-cost methods of production are unavail
able. In the absence of these conditions, increased
scrapping and/or alterations in the optimal employ
ment of capital resources occurs. One approach to
obsolescence emphasizes "putty-clay" technology,
where the capital stock embodies a technology that is
premised on expected factor and product prices and
“fixed” relative factor proportions, for example, labor
and energy employment per unit of capital. When

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40
Federal Reserve Bank of St. Louis

factor prices change, the existing capital stock is no
longer optimal; any relative factor price change can
make the existing capital stock obsolete. Oil price
shocks (or other factor price shocks) reduce produc
tivity by effectively destroying capital resources re
gardless of the direction of change.
The concept of putty-clay capital suggests that
short-run relative factor proportions are insensitive to
factor price changes; it appears that output and em
ployment can be altered only after sufficient time has
passed so that capital can be changed. But inelastic
factor proportions increase the short-run output loss
associated with a rise in energy prices. Firm and
industry output adjustments and industiy product

FEDERAL RESERVE BANK OF ST. LOUIS

prices are larger when factor substitution cannot oc
cur in the short run because of a change in the price of
one resource.18 The asymmetric result from a puttyclay perspective rests on the assumed relative ease of
shutting down the use of existing plant and equip
ment compared with the adjustment cost of installing
new capital or reemploying obsolete and idle capital.
But this difference, if it actually exists, is one of the
relative timing of effects. Thus, the putty-clay assump
tion does not yield differences in the response of the
desired capital-labor or capital-energy ratios when the
relative price of energy changes. These determinants
of output and productivity respond similarly whether
capital is putty-clay or not.

Are Firms’ Responses to Cost
Reductions and Cost Increases
Asymmetric?
Another argument is that firms respond differently
to factor price reductions than to increases. A factor
price increase forces adjustments because profitabil
ity and survival are threatened. A factor price decline
gives rise to less pressure to change production meth
ods; profits rise for energy-using firms even if they
don’t alter their behavior. A related argument is that
adjustments to energy price shocks depend on the
state of the economy, especially the state of the busi
ness cycle. Capacity utilization was relatively high and
unemployment rates were relatively low when OPEC1
and OPEC2 occurred. These conditions have not been
observed since 1981. Thus, current incentives to ex
pand production due to factor price reductions or
even to reduce product prices could be viewed as
weaker. Incentives to expand the employment of
energy-using plant and equipment, especially
through new purchases, could be more limited in light
of supposed weak demand for output.
These views ignore maximizing behavior or even
minimal interest in achieving efficiency in the pursuit
of firms’ goals. Moreover, they ignore the effects of
competition from other firms. Again, this argument
suggests, at best, a difference in the timing of adjust

18lt is curious that some analysts appear to ignore the short-run
pressure that the putty-clay assumption puts on reducing capacity
utilization through shutting down, arguing instead that the effects of
oil shocks work relatively slowly over extended periods of time as
the capital stock is adjusted. How individual product prices or the
price level can adjust relatively rapidly, as considerable evidence
shows, in the face of the changes in “fixed” costs in the putty-clay
case, is not typically addressed.

JUNE/JULY 1987

ments to a lower energy price shock, not an asymme
try in the direction or magnitude of the effects of lower
energy prices.

Do Inter-Industry Effects Result in
Asymmetric Macroeconomic Effects o f
Oil Price Changes?
Another suggestion is that adverse effects on do
mestic oil-related industries dominate the positive
developments for other industries when oil prices fall,
despite a recognition that the reverse effects do not
occur, or are not dominant, when oil prices rise. The
importance of reductions in oil exploration and devel
opment activity and oil-related loan losses for the
macroeconomy have been overstated, however. The
effects are symmetric in that the domestic oil market
boomed following both OPEC1 and OPEC2, while the
dominant effects were on other producers.18 More
importantly, however, reductions in such activity in
1986 reflected short-run responses that reverse when
factor prices in exploration adjust to the permanently
lower oil price.
Part of the confusion over the dominance of domes
tic oil effects could arise from the apparent relatively
slow growth of employment following the 1986 oil
shock, especially early in the year. Yet this result is
consistent with the earlier experience with oil price
increases. In the initial period of a shock, the domi
nant effect is on productivity and supply, given prod
uct prices; with little price level adjustment, aggregate
demand changes little. Thus, when oil prices rise
sharply and unexpectedly, desired output falls more
than sales, resulting in undesired inventory reduc
tions that create upward pressure on prices and, ini
tially, downward cyclical pressure on the unemploy
ment rate.20Proponents of an asymmetric response in
1986 may be relying on an inaccurate comparison of
the adverse cyclical experience that followed past oil
price increases after a few quarters and the immediate
cyclical developments that followed the 1986 oil price
reduction.

19Some analysts contend that the U.S. experience in 1973-74 was
not comparable because of price controls on domestic crude oil.
See Trehan (1987), for example. This ignores the 75.3 percent rise
in domestic crude oil prices that occurred from 111/1973 to 111/1974,
despite the existence of controls, or the 196 percent increase from
January 1979 to January 1981, a period of similar controls.
^Seethe unemployment rate discussion in Tatom (1981,1983b) and
more recent evidence in Ott and Tatom (1986).

FEDERAL RESERVE BANK OF ST. LOUIS

DO OIL PRICE REDUCTIONS HAVE
ASYMMETRIC EFFECTS? THE
EVIDENCE
Empirical macroeconomic models can provide evi
dence on the symmetry issue because real oil and
energy prices have been falling for nearly six years. A
simple reduced-form model is used [see Tatom (1981,
1983b), (1987)] to analyze the short-run effects of oil
price shocks. In addition, evidence from production
function estimates that have been used to assess the
productivity effects of adverse oil shocks is examined.
The evidence from these models on GNP, price and
output effects of energy price changes is presented
below. Finally, some evidence on symmetric tempo
rary surges in inflation in seven countries is discussed.

The Model
The Andersen-Jordan GNP equation (1968) ex
pressed in growth rates and augmented to account for
effects of the energy price changes is used in the
model. While such effects could be either permanent
or transitory, estimates reveal that the statistically
significant effects are only transitory. The price equa
tion for the GNP deflator in this model is a reducedform equation in which the principal determinant of
inflation is the rate of growth of the money stock (Ml);
price controls and energy price changes, however,
also influence the level of prices and, temporarily, the
inflation rate. Since real GNP is the ratio of nominal
GNP to the price deflator, the growth rate of real GNP is
the difference between the growth rates of nominal
GNP and the GNP deflator.
The GNP equation includes a strike measure (the
change in the quarterly average of days lost due to
strikes deflated by the civilian labor force), current and
four lagged values of money (Ml) and federal expendi
ture growth, and six previous quarter’s changes in the
relative price o f energy, (the quarterly average pro
ducer price index for fuels, related products and
power, deflated by the business sector price deflator).
The price equation includes the current and 20 lagged
growth rates of the money stock, dummy variables for
wage-price control (for II/1971 to 1/1973) and decontrol
periods (1/1973 to 1/1975), and changes in the relative
price of energy for the past four quarters.
The model was estimated over the periods 1/1955 to
III/1980 and to III/1986, respectively, in Tatom (1987).21

2’0ver the longer period, adjustments were made for systematic
overpredictions of GNP and price growth. These overpredictions are

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42
Federal Reserve Bank of St. Louis

JUNE/JULY 1987

The model and energy price effects are stable and two
tests rejected the hypothesis that energy price reduc
tions since 1981 have had different effects, either in
sign or size, on GNP, price, or indirectly, output
growth. The two tests involved allowing post-1980
declines to have different effects on GNP or price
growth and, second, allowing energy price declines
throughout the sample to have different effects from
increases in energy prices.22

Oil Price Shocks and Real GNP
The effect of an oil price shock on output is deter
mined from those on nominal GNP and prices. Since
the effect of an energy price shock on the growth rate
and level of GNP is zero after six quarters, its effect on
output after that time is the inverse of its effect on the
price level. The model described above yields esti
mates that indicate the responsiveness of the price
level to energy price changes has not changed since
1980; thus, the permanent responsiveness of output to
such changes, has not changed. In addition, the tim
ing and magnitude of the short-run output effect has
remained unchanged as well. The elasticity of the
price level with respect to an energy price change (that
is, the percentage rise (fall) in the GNP deflator associ
ated with each percentage point rise (fall) in the rela
tive price of energy) is estimated to be 0.050 to 0.058.23
Thus, a doubling in oil prices led to about a 40 percent
energy price rise during OPEC1, OPEC2, that, in turn,
resulted in a permanent increase in the price level and
decrease in output of about 2 percent to 2.3 percent
[(40)1.05) to (40M.058)] in each instance; the same size

uncorrelated with the right-hand-side variables or other factors that
various analysts claim explain a fall in velocity since 1981; see
Tatom (1983a). The intercept shift in each equation was chosen by
finding the shift that minimized the standard error of each equation
where the shift was allowed to occur in any quarter since 1978.
Christiano (1986) has shown that a trend velocity shift of this type is
supported by the stability of difference-stationary models. The shifts
used here begin in 11/1981 for the GNP equation and in 111/1982 for
the price equation.
third test involves testing an asymmetry hypothesis suggested by
Neumann and von Hagen (1987). They argue that, given wages and
prices, relative price uncertainty reduces aggregate supply. Thus,
an energy price change can reduce output and raise the price level
regardless of whether energy prices rise or fall if it also raises
relative price uncertainty. For energy price increases, the direct
effect on aggregate supply and the uncertainty effect would rein
force each other, but for energy price reductions, they work in
opposite directions. This hypothesis was tested by introducing the
standard deviation of the relative price of energy and its lags in the
equation estimates; these measures are not significant in either
equation.
“ This elasticity is the sum of the coefficients on the rate of change in
the relative price of energy in the inflation equation.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

decline in oil prices from IV/1985 to III/1986 is esti
mated to result in the same size reduction in prices
and rise in output as in these earlier instances.

Oil Price Shocks and Productivity
The effect of energy price changes on productivity
can be evaluated by estimating an annual business
sector production function in which business sector
output, X, is regressed on business sector hours, h„ the
product of the lagged net capital stock (constant dol
lars) and Federal Reserve capacity utilization rate, k,,
the relative price of energy, p', a constant, a trend, t,
and trend breaks in 1967, t67, and in 1977, t77.MThe
production function is “Cobb-Douglas,” or linear in
logarithms and estimated with a “constant returns to
scale” restriction.
The estimate for the period 1948-80 is (t-statistics
are given in parentheses):
(1) In X, = 0.299 + 0.690 In h, + 0.310 In k - 0.053 pf
(0.80) (13.18)
(5.90)
(-2.49)
+ 0.019 t - 0.006 t67 - 0.008 t77
(10.97) (-3.41)
(-1.96)
R2 = 0.97

SE = 0.90%

DW = 1.88

p = 0.25

(2) In X, = 0.377 + 0.701 In h, + 0.299 In k, - 0.055 p?
(1.15) (15.01)
(6.41)
(-3.40)
+ 0.019 t - 0.006 t67 - 0.006 t77
(11.57) (-3.87)
(-3.09)
SE = 0.86%

DW = 1.84

The output elasticity of the energy price in equation
2 is —5.5 percent, smaller than earlier estimates where
trend shifts were not statistically significant and, thus,
were omitted. Without the trend shifts in firstdifference estimates of equation 1 and 2, the short-run
output elasticity of the energy price is 8 percent.25Over
short periods, such as the past ten years, it is not
possible to determine whether trend shifts represent
truly permanent changes or whether they are simply
capturing residual effects due to energy price shocks
or other transitory effects on productivity trends. In
either case, the estimated output elasticity is in line
with the estimate from the reduced-form model
above.26

Oil Price Shocks and The Rate o f Price
Increase

The production function, estimated for the period
1948 to 1985, is:

Rs = 0.97

difference is 0.0016 (t = 0.94); while the change in the
coefficient is positive, indicating a smaller impact on
output, the difference is tiny and statistically insigni
ficant. When equation 2 is used to predict business
sector output in 1986, the error is 0.05 percent; that is,
business sector output grew 3.31 percent from 1985 to
1986, nearly the same as the 3.36 percent predicted by
equation 2.

Price developments across the seven countries re
ferred to earlier provide more casual evidence of a
symmetric response to the recent decline in oil prices.
The top panel of table 2 shows that, during the period
of the previous two oil price increases, inflation rates
temporarily surged upward from levels in the preced
ing year and subsequently fell back. Since the timing of
the peak rate of increase for a four-quarter period
varied among the countries, inflation measures for

p = 0.28

There are no statistically significant differences be
tween the estimates in equations 1 and 2. Hence,
adding five additional years of data during which
energy prices declined sharply produces no changes
in the estimates. Such evidence is only suggestive,
however. A more direct test is to allow the coefficient
on the energy price to be different after 1980. When
equation 2 is estimated permitting energy prices from
1981 to 1985 to have a different effect on output, the

24Rasche and Tatom (1977b, c and 1981) test a popular hypothesis
that the trend growth of productivity declined in 1967. The hypothe
sis is rejected but, the results indicate a smaller size for the output
elasticity of energy prices when the insignificant trend-shift is in
cluded. When recently revised NIPA data are used, however, the
1967 trend break cannot be rejected.

25Tatom (1987) reports the results of both of the tests used in the GNP
and price equation above for the first-differenced production func
tion. First, the energy price declines from 1981 to 1985 were allowed
to have differential effects on business sector output growth. Sec
ond, energy price increases and decreases in the period 1948 to
1985 were treated as two separate variables. A test of whether the
coefficients of these variables are equal and opposite in sign is a test
of symmetry. Both of these tests fail to reject symmetry. Finally, the
standard deviation of real energy price changes (measured over the
current and previous two years) was added to the level equation 2
and its first-difference was added to the first-difference equation. It is
not significant in either case and does not alter the other coefficients.
“ The emphasis above is on the output elasticity of the relative price of
energy, given capital and labor employment. Rasche and Tatom
(1981, p. 13, and elsewhere) explain that the desired capital-labor
ratio falls (rises) due to an energy price rise (decline), and that, given
potential employment, the long-run response is larger by a percent
age equal to sk/s„ where s„ and s, are the shares of capital and labor
in value added. In equations (1) and (2) this increment to the output
elasticity is 44.9 percent and 42.6 percent, respectively.

JUNE/JULY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

Table 2

Oil Shocks and Rates of Increase of Consumer Prices
Pre-OPEC1
111/1972111/1973
Canada
France
Germany
Italy
Japan
United Kingdom
United States

United States
France
Germany
Italy
Japan
United Kingdom
Canada

8.1%
7.6
6.9
10.8
16.9%**
9.1
6.8

OPEC1*
111/1973111/1975

Post-OPEC1
111/1975111/1976

10.9% (12.0)
12.7 (14.9)
6.6
(7.4)
18.3 (25.7)
16.8 (23.8)
21.7 (26.6)
10.1 (12.1)

December/1984-85
3.8%
4.7
1.8
8.6
1.8
5.6
4.4

6.5%
9.5
3.9
16.5
9.1
13.7
5.5

Pre-OPEC2
IV/1977IV/1978
8.7%
9.5
2.4
12.0
4.4
8.1
8.9

December/1985-86
1.2%
2.1
-1.1
4.3
0.1
3.8
4.2

OPEC2*
IV/1978IV/1981
11.0% (12.7)
13.0 (14.1)
5.9
(7.1)
19.4 (21.5)
5.2
(7.7)
14.8 (21.6)
11.6 (14.4)

Post-OPEC2
IV/1981IV/1982
9.7%
9.5
4.7
16.8
2.8
6.2
4.5

December-June 1987
5.4%
5.4
2.3
5.1
3.0
6.8
5.0

'Peak four-quarter rate given in parentheses.
**1/1973-111/1973.

two- and three-year periods are given along with the
peak increase over four quarters (in parentheses).
The bottom of table 2 illustrates the symmetric
response associated with the 1986 oil price decline.
Consumer price increases slowed sharply in each
country, except Canada where the slowing was slight.
During the first six months of 1987, however, the rate
of price increase rose sharply in all seven countries. In
all the countries except Italy, inflation was higher in
early 1987 than it had been in 1985, the year prior to
the oil shock.

CONCLUSION
The decline in oil prices in 1986 raised the question
of whether oil price shocks have symmetric effects on
macroeconomic variables. The analysis presented
here indicates that energy price shocks matter be
cause they affect economic capacity and hence pro

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44 Bank of St. Louis
Federal Reserve

ductivity of labor and capital resources, or aggregate
supply. Their specific effects on other macroeconomic
variables follow from the effects presented here. This
view suggests that oil price increases or decreases
have symmetric effects on the economy.
The United States had experienced a relatively large
decline in the relative prices of oil and energy from
1981 to 1985, a decline that exceeded the recent one in
1986. Thus, evidence on the adjustments of spending,
prices, output and productivity is available and de
scribed here that bears on the symmetry question. The
evidence suggests that energy price shocks have sym
metric effects. Formal tests o f changing energy price
coefficients in reduced form equations and an aggre
gate production function reject the asymmetry hy
pothesis. Finally, consumer prices for the United
States and six other countries exhibit symmetric tem
porary movements surrounding the 1986 oil price
decline.

FEDERAL RESERVE BANK OF ST. LOUIS

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Full text of Review (Federal Reserve Bank of St. Louis) : June/July 1987

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