Full text of Review (Federal Reserve Bank of St. Louis) : May 1977

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FEDERAL RESERVE B A N K
MAY 1977
OF ST. L O U IS




The Effects of the New Energy Regime on
Economic Capacity, Production, and Prices
ROBERT H. RASCHE and JOHN A. TATOM

1 HE quadrupling of OPEC oil prices in late 1973
and early 1974 had a profound and permanent impact
on the U.S. economy. The initial impact was an explo­
sion in the prices of most goods and services, as well
as the longest and most severe decline in national
output since the 1930s. The recession trough occurred
over two years ago and the rate of inflation has fallen
substantially since 1974. While the inflation rate re­
mains quite high by historical standards, the primary
focus of concern, at least in official circles, seems to
have shifted toward the persistence of an unacceptably high unemployment rate and the associated loss
of national output. More importantly, the mounting
concern over the immediate problem posed by un­
employment seems to have obscured the permanent
effect of the energy price revision.
The large increase in the price of energy in 1974
permanently reduced economic capacity, or the poten­
tial output of the U.S. economy, by four to five per­
cent. The productivity of existing capital and labor re­
sources was sharply reduced. Policy discussions which
fail to account for the permanence of these changes,
especially in the face of persistent unemployment,
contribute to an overstatement of the benefits to be
obtained from a conventional policy of aggregate de­
mand stimulus.
In order to clarify the gains which may be expected
from a stimulative economic policy and the accom­
panying inflation risks, it is useful to examine the
impact of the energy price revision on prices, produc­
tion and employment.1 To facilitate this discussion,
'M ost of the discussion of the economic impact of the OPEC
action has focused upon its effects upon aggregate demand.
However, several recent studies have indicated that the na­
tion’s excess capacity may not be as large as some data shows.
Among these studies are: Denis S. Kamosky, “ The Link Be­
tween Money and Prices — 1971-76,” this Review (June
1976), pp. 17-23; A. Nicholas Filipello, “ A Question of
Capacity,’ Business and Government Outlook (Fall 1976),
pp. 1-3; and Barry Bosworth, “ Capacity Creation in BasicMaterials Industries,” Brookings Papers on Economic Activity
(2 :1 9 7 6 ), pp. 297-341. A contrary view is presented by
Albert J. Eckstein and Dale M. Heien, “ Estimating Potential
Output for the U. S. Economy In a Model Framework,”
Achieving The Goals of the Employment Act of 1946 — Thir­
tieth Anniversary Review, U.S. Congress, Joint Economic
Committee, 94th Cong., 2nd sess., December 3, 1976,
pp. 1-25.

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we will first develop the concept of a firm’s capacity
output. This concept allows for analysis of the effects
of a change in the price of energy on a firm’s cost
structure, capacity output, employment, and product
price using a standard microeconomic model of the
firm. Such an analysis is basic to an understanding
of potential output and the transitional and perma­
nent impacts of the OPEC price actions since 1973.

Microeconomics and Capacity Output
The notion of economic capacity is fundamentally
a short-run concept. There is no limit to the output
a firm could produce efficiently if it could command
sufficient amounts of each of the resources it employs.
From a long-run perspective, an efficient firm would
tend to use more of each of the resources it employs
to produce at a higher output rate. However, some
resources are, as a practical matter, fixed or given for
some period into the future. This fixed nature of some
resources characterizes the short run. For any amount
of fixed resources only one output rate can be pro­
duced using an efficient long-run method. This out­
put rate is the economic capacity of the firm. Firms
have a cost-saving incentive to produce at capacity
output or to have an amount of fixed resources that
allow the production of their desired output at the
lowest cost possible.
The concept of a firm’s capacity may be seen more
clearly by looking at the cost structure of the hypo­
thetical firm of economic theory.2 The cost structure
is derived from the “production function” of the firm
and the prices of resources used by the firm, such
as labor, capital and energy. A production function
defines the maximum output attainable given the
-Such a cost structure is more fully discussed in the microeconomic section of most principles of economics texts. A thor­
ough development of the cost structure o f the firm may also be
found in C. E. Ferguson and S. Charles Maurice, Economic
Analysis, rev. ed. (H om ew ood, Illinois: Richard D. Irwin,
Inc., 1974), Chapters 6 and 7, pp. 161-232. The best discus­
sion and argument for the concept of economic capacity used
here is that by George Stigler, The Theory of Price, 3rd ed.
(N ew York: The Macmillan Company, 1966), pp. 156-58.

FEDERAL RESERVE BANK OF ST. LOUIS

state of technology, for any set of resources.3 For
each rate of output, technology and the prices of re­
sources dictate the lowest cost method or combination
of resources required.

MAY

1977

F ig u r e I

A Firm's C o st Structure an d the
Effect of a H ig h e r V a ria b le R e so u rce Price

Figure I shows the relevant long-run and short-run
cost structure of the firm. In the long run, when the
firm is free to change the employment of all resources,
the unit cost or long-run average cost (LAC) of any
output rate is constant.4 Given the price of each
resource, the firm can choose the method of produc­
ing any output rate at the lowest total resource cost
or unit cost (C in Figure I). Any other output rate
could be produced by varying proportionately each of
the resources used with the lowest cost method. Since
total resources cost is also proportionate to resource
employment, unit cost (C ) is independent of output.
In the long run, the cost of producing an additional
unit of output, the marginal cost, is the same as the
average cost of a unit of output.
For any amount of fixed resources, the output rate
which can be produced with the minimum long-run
cost method is capacity output. In the short run, any
output, other than capacity, will require a higher cost
method of production than that indicated by the longrun average cost. Thus, for any level of capital which
is fixed in the short run, the short-run average cost
of output, SAC, is above the long-run average cost
curve, except at the capacity output level.5 Of course,
the larger is the amount of capital the firm has, the
larger is its capacity output. In the short-run, higher
cost methods are required to obtain additional out­
put since only variable resources may be increased.
As output expands, each unit of a variable resource
has less of the fixed resource with which to work so
the productivity of variable resources declines. Cor­
respondingly, the cost of additional output, the shortrun marginal cost (SM C), rises as the output rate
expands. This cost is only the same as the long-run
■!The production function is based upon technical efficiency.
The more popular notion of capacity, the maximum output
attainable for a given set of resources is, by definition, in­
cluded in the production function and does not depend upon
resource prices.
4The production process, for simplicity, is assumed to be char­
acterized by “ constant returns to scale,” or proportionate
changes in the use of each resource (change in scale) will
allow output to be changed proportionately.
®The SAC curve is U-shaped. At low rates of output, the major
component of cost is the cost of the fixed resources. As output
expands, the firm “ spreads its overhead” over more units pro­
ducing a larger output at a lower unit cost. As output is ex­
panded beyond the capacity level, the unit cost of variable
resources becomes an increasing share of unit cost and the cost
effect of using higher cost (low er productivity) methods of
production is dominant and raises the unit cost.




P e r P e r io d

marginal cost at the output which uses the optimal
long-run method of production, or capacity output.
The cost structure is a major factor in the output
decision of a firm. For example, consider the profit
maximizing competitive firm which is a “price-taker,”
able to sell as much as it chooses at a given market
price. For such a firm, the relevant short-run supply
curve is the SMC curve in Figure I. For any given
market price, the firm maximizes profit by produc­
ing the output rate where marginal cost, SMC, equals
price.B The cost structure is important in the longrun as well. The firm will not continue operating in
an industry where losses (the inability to cover the
cost of using capital, labor, and energy resources) are
incurred. The minimum long-run supply price is (C )
in Figure I. Moreover, if the firm earns economic
profit in the short run, it has an incentive to expand
its capital and capacity output. In addition, the exist­
ence of economic profit attracts new firms into the
industry. As output expands, the product price tends
to fall to induce customers to buy the larger output.
tech n ica lly , the short-run supply curve is only defined above
the minimum level o f unit expenditures on variable resources.
If the market price were below this level, there would be no
output at which the firm could cover the cost of its variable
resources. The profit-seeking firm would shut down, restricting
losses to the cost of the fixed resources. Note also that if the
market price equals ( C ) in Figure I, the firm maximizes profit
by producing the capacity output rate. W hile the firm “ breaks
even” there, it earns a competitive rate o f return on its capital
since this return is included in the unit fixed cost and SAC.

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FEDERAL RESERVE BANK OF ST. LOUIS

The product price will tend to fall to (C ) where the
long-run incentive to expand capital and capacity
output is eliminated.7

The Determinants of Capacity Output
Capacity output is determined by the stock of capi­
tal which a firm has, and its long-run average cost.
The latter, in turn, depends upon the market price
of each resource employed and technology. Changes
in either resource prices or technology will change
the economically efficient means or production in the
long run and shifts the long-run average cost curve.
Moreover, such changes, except for a change in the
price of the fixed resource, will shift the firm’s shortrun supply.8
The effect of a one percent increase in the price
of a variable resource on the cost structure and capac­
ity output of a firm is also shown in Figure I. An
increase in the price of a resource raises the long-run
average cost and supply price of output. The extent
of the rise in long-run average cost depends upon the
share in total cost of the resource whose price has
increased. A change in the price of a resource whose
cost is a very minor proportion of total output cost
will have very little impact on unit cost, as compared
to a resource whose cost is a major share of unit cost.
In particular, each one percentage point rise in the
price of a resource will add K percent to the longrun average cost, where K is the share of this re­
source in total cost.9 For example, a one percent in­
crease in the market wage rate of workers in a firm
where labor costs account for half of total costs will
tend to raise the long-run unit cost by one-half of one
percent.
The short-run supply decision also is affected by
an increase in the price of a variable resource. An
increase in the price of a variable resource raises the
cost of the resources necessary to produce more out­
put. Thus, the short-run marginal cost of output also
increases. Moreover, it increases more than short-run
7The concept of capacity is not restricted in its relevance to the
cases of competitive firms having constant-retums-to-scale pro­
duction processes. For any market structure and regardless of
returns to scale, any firm has a cost-saving incentive to manage
capital resources so that production of any desired output
occurs at capacity.
8Since we are primarily concerned with the effect of changes in
resource prices on capacity, the analysis of technological
change is not pursued here.
"A rise in the price of capital increases capacity output. Fixed
costs do not affect the marginal cost of output in the short
run. Since average cost, both short- and long-run, rise,
capacity rises to the output level where long-run average cost
intersects the initial short-run marginal cost curve.

Digitized for Page
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MAY

1977

average cost.10 If there is more than one variable
resource, changes in the mix of variable resources
affect the size of the upward shift in each cost and
the result is more difficult to specify. However, when
the resource whose price increases is a “substitute”
for capital in the production process the analysis of
the simple case and the results depicted in Figure I
hold.11 The percentage reduction in a firm’s capac­
ity output is identical to the percentage rise in its
long-run average cost. At the new capacity output,
the firm possesses its optimal amount of capital, given
the new set of resource prices, and it employs exactly
the capital and labor which were efficient before the
rise in the price of energy. Only energy employment
declines as capacity output declines.11!
The effect of a rise in the price of a variable re­
source such as energy is to reduce capacity output
and raise the long-run supply price, the changes be­
ing greater, the greater is the share of energy in the
total cost of each product. Products which rely more
heavily upon energy have larger losses in capacity
output and their long-run price is increased relatively
more than that of other goods.

Estimates of the Change in Manufacturing
Capacity as a Result of the 1973-74
Change in Energy Prices
The discussion above suggests that an estimate of
the capacity loss in U.S. manufacturing due to the
10A simple example illustrates why this is the case. Suppose
labor is the only variable resource in the short run. A given
percentage increase in the wage rate will proportionately
increase the cost of both the labor currently employed per
unit of output, and the labor necessary to produce an addi­
tional unit of output, the marginal cost. Since the fixed cost
of output is unchanged, the unit cost of any level of output
rises less than the percentage increase in labor costs. If each
firm initially operated at capacity output, the marginal cost
rises more than short-run average cost at that output, and
capacity output declines.
11A resource is a “ substitute” for capital, if efficient production
of some output requires that a rise in the price of the re­
source lowers the optimal employment ratio of the resource
to capital. For example, energy and capital are substitutes if
a rise in the price of energy relative to that of capital services
causes the efficient firm to lower its employment of energy
per unit of capital services to produce a given rate of output.
1-The results in this paragraph are derived in our unpub­
lished paper, “ Firm Capacity and Factor Price Changes.”
The conclusions require that production is characterized by
a “ partial elasticity of substitution” between energy and cap­
ital and between energy and labor equal to one. This means
an X percent rise in the price of energy relative to the price
of capital ( or labor) causes least-cost production of any out­
put to require X percent less energy relative to capital (or
labor) employment. This appears to be an accurate charac­
terization for production in nine industrial nations, including
the United States. See J. M. Griffin and P. R. Gregory, “ An
Intercountry Translog Model of Energy Substitution Re­
sponses,” The American Economic Review (D ecem ber
1976), pp. 845-57.

MAY

FEDERAL RESERVE BANK OF ST. LOUIS

sharp increase in the price of energy could be ob­
tained if measures were available on the change in
capacity by industries. The discussion of the micro­
economics of capacity indicates that information would
be required on parameters of the production func­
tions of these industries, and on the size of expendi­
tures on energy by industry, as well as a measure of
the increase in energy prices over the period. Unfor­
tunately, no complete set of estimates of the relevant
production function parameters by industry exists.
An alternative is to consider estimates of the pro­
duction function parameters for the aggregate of all
manufacturing. A recently published study, which
overcomes a number of statistical problems inherent
in previously published estimates, provides estimates
of the required information concerning the aggregate
production function for manufacturing in nine indus­
trial countries, including the United States.13 This
study supports the conclusion above that the per­
centage response of capacity output to a one percent
change in the price of energy is just equal to the
share of energy costs in total factor costs. The study
suggests that this cost share was quite stable through­
out the 1960s at around twelve percent of total fac­
tor costs. Thus, an unexpected ten percent increase in
energy costs, given wages and the capital stock,
should produce approximately a 1.2 percent decrease
in capacity of the U.S. manufacturing sector.
The behavior of the price of energy relative to the
price of output is presented in Chart I, where a rela­
tive price index has been constructed by dividing the
wholesale price index for fuels, related products, and
power by the deflator for private business output,
adjusted to a basis of 1972 = 1.0. As can be seen
from the Chart, this relative price series trends down­
ward through the 1960s, is fairly stable from 1968
through 1972, rises sharply from the fourth quarter of
1973 through the third quarter of 1974, and then
becomes relatively stable around a value of 1.6 until
mid-1976. The wholesale price of energy increased
45.3 percent from the fourth quarter of 1973 through
October 1974. This increase, multiplied by a cost
share of 0.12 suggests a loss in manufacturing capacity
of about 5.4 percent.
13See J. M. Griffin and P. R. Gregory, “ An Intercountry Trans­
log Model of Energy Substitution Responses.” They conclude
that production can be considered to be of the Cobb-Douglas
form in the energy resource. Their estimates are constructed
under the assumption of constant returns to scale. Under
these conditions, the partial elasticities of substitution be­
tween capital and energy and between labor and energy are
both equal to one, as required in the analysis in the previous
section.




1977

C h a rt I

The Price of Energy R e lative to the Price of O u tp u t*
Ind e x

Index

So u rc e s : U.S. D e p a r t m e n t of L a b o r a n d U .S . D e p a r t m e n t o f C o m m e rc e
’The W h o l e s a l e P rice In d e x o f fu e ls, p o w e r a n d re la te d p r o d u c t s d iv id e d b y the Im p lic it P ric e
D e fla t o r for th e p r iv a t e sector.
L a te st d a t a p lo tted : 1st q u a rt e r 1977 p re lim in a r y

Energy prices were not the only factor prices which
were observed to rise during this period. Over the
period (IV/1973 through III/1974), actual hourly
compensation rose by 7.9 percent. According to the
Griffin and Gregory estimates, an increase of labor
costs of this magnitude in the manufacturing sector
of the U.S. economy should have reduced capacity
by an additional 0.4 percent. In total, the change in
economic capacity as a result of changes in factor
prices over this period of time can be estimated to
be on the order of five percent.14
It is generally accepted that the U.S. economy was
operating at effective capacity during the latter half
of 1973. The important question is where did the
economy operate relative to its new, lower, economic
capacity in the latter part of 1974. Employment in
14The sum of the effects from energy price changes and wage
changes is 5.8 percent. This estimate implicitly assumes that
the price of capital services remained unchanged over this
period. Alternatively, it could be assumed that the price of
capital services rose proportionally to the increase in wages.
Such an increase would offset ( see footnote 9 ) the computed
reduction in capacity by 1.4 percent, for a net reduction of
4.5 percent. The five percent reduction chosen above repre­
sents a midpoint of this range.

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FEDERAL RESERVE BANK OF ST. LOUIS

manufacturing declined by 1.8 percent from the fourth
quarter of 1973 through October 1974. Over the same
period, the average work week (of production work­
ers) in manufacturing declined by 1.5 percent for a
reduction in total hours per week of about three per­
cent. The Griffin-Gregory estimates suggest that the
reduction in capacity of the order of magnitude sug­
gested above should have been accompanied by a zero
to 1.5 percent reduction in employment. Given the
statistical error associated with the production func­
tion estimates, the data on the behavior of employment
over this period appear to be roughly consistent with
a movement from one point of full capacity utiliza­
tion to a second point of full capacity utilization.
The Federal Reserve Board’s Index of Manufactur­
ing Capacity Utilization was 87.8 and 87.7 percent in
the last two quarters of 1973, respectively. By October
1974, the month immediately prior to the sharp drop
in industrial production and the sharp rise in unem­
ployment which characterized the rest of the 1973-75
recession, this index had fallen to 83.4 percent. If this
index does not capture the impact of changes in rela­
tive factor prices, and if the economy was operating at
full economic capacity in October 1974, then the index
should understate capacity utilization by the amount
of the capacity loss. The decline of the index to this
point in time is 5.1 percent which is the same order
of magnitude as suggested by the Griffin-Gregory
production function estimates.

The Effect of Energy Price Changes
on Measures of Capacity Utilization
A crucial question is whether or not the conven­
tional capacity utilization indices measure the impact
of a change in relative factor prices. There is no ques­
tion that the Wharton Index fails to measure such
effects, since it measures capacity by extrapolating
peak-output to peak-output trends.15 The Federal
Reserve Board Index is constructed by utilizing data
from periodic surveys on capacity utilization such as
the McGraw Hill capacity survey and interpolating
using the behavior of the Federal Reserve Industrial
Production index for manufacturing. As a result the
Federal Reserve capacity utilization index has two
general properties: (1 ) the cyclical movements ap­
proximate those of the industrial production index,
with the growth trend removed; and (2 ) the average
15A description of this series may be found in F. Gerard Adams
and Robert Summers, “ The Wharton Indexes o f Capacity
Utilization: A Ten Year Perspective,” Proceedings of the
Business and Economic Statistics Section, 1973 (Washington,
D .C .: American Statistical Association, 1974), pp. 67-72.


Page
6


MAY

1977

utilization rates over time and the long-term move­
ment in such rates are determined by the estimates
of utilization rates as reported in the various surveys.16
The important question is, therefore, whether the
survey data would pick up the change in the utiliza­
tion of economic capacity.
The concept of capacity which the surveys attempt
to measure has been labeled “maximum practical
capacity.”17 This approach seems to ask how much
could be produced with existing facilities if they were
run under normal “full-time” operating conditions. It
does not seem to ask whether such a level of opera­
tions would be efficient given existing factor prices.
This interpretation is reinforced by the testimony of
Mr. Douglas Greenwald of McGraw Hill before the
Joint Economic Committee. In discussing the notion
of capacity in the McGraw Hill Surveys he stated:
Thus it was d e c id e d to let com panies set their ow n
definitions o f capacity, and w e on ly asked that the
respondents stick to their definitions. This, o f course,
leaves open such questions as num ber o f shifts o f
operations, treatm ent o f low grade, standby capacity,
and final assem bly versus interm ediate capacity. But,
in general, com panies fo llo w a com m onsense defini­
tion o f capacity, such as maxim um ou tp u t under
normal w ork conditions.18

The authors of the description of the recent revision
of the Federal Reserve Board (FRB) capacity utiliza­
tion index appear to agree that the concept of capac­
ity measured by the survey data does not capture the
effects of changes in relative factor prices: “This
version of capacity (maximum practical capacity) is
similar to our prior notion of engineering capacity in
that no explicit recognition is given to the effects of
changing price relation over the cycle.”19 Thus, it
would appear that the measured indices would not
capture the impact of changes in economic capacity
as defined above, and that the measured utilization
indices would underestimate utilization by the amount
16Federal Reserve Bulletin (November 1976), p. 894.
17See Survey of Current Business (July 1974), pp. 54-5. This
measure is defined as the maximum output which could be
>roduced using existing facilities while at the same time “ folowing the company’s usual operating practices with respect
to the use of productive facilities, overtime, work shifts,
holidays, etc.,” and assuming “ product mix at capacity which
is most nearly similar to the composition of your actual
output.” Ibid, p. 50.

f

18U.S. Congress, Joint Economic Committee, Subcommittee on
Economic Statistics, Measures of Productive Capacity, 79th
Cong., 2nd sess., May 14, 1962, p. 4.
1®L. Forest and R. Raddock, “ Federal Reserve Measures of
Capacity Utilization,” unpublished memorandum, (W ashing­
ton, D .C .: Division of Research and Statistics, Hoard of G ov­
ernors of the Federal Reserve System, 1977), p. 13.

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FEDERAL RESERVE BANK OF ST. LOUIS

of the factor price effect.20 Adjusting the Federal
Reserve Board index for October 1974 up by five
percent gives an estimated utilization rate of 87.6 per­
cent, essentially the same as in the fourth quarter of
1973.
Two strategies could be adopted for adjusting the
published figures since the end of 1974. It could be
assumed that the survey respondents gradually adjust
their concept of “normal operating conditions” over
time. In the near term it seems unlikely that this
would happen. First, the emphasis in the survey con­
struction is on historical conditions in the particular
industry. Second, the emphasis is on inertia: respond­
ents should choose whatever definition of normal op­
erating conditions they wish, but then they should
“stick to that definition.” Over a longer period of time,
some reduction in the bias of the measured index will
take place as the capital which suffered the capacity
loss depreciates, and is replaced by new capital. Chart
II is constructed assuming a constant downward ad­
justment in capacity as measured by the Federal Re­
serve Board equal to five percent of the capacity
measure for October 1974. The revised capacity meas­
ure is divided into the industrial production index to
give the adjusted index of capacity utilization plotted
in the figure. It is difficult to know how to handle the
first three quarters of 1974, since the relative price of
energy was changing rapidly during this period of
time, and since the published index of capacity utili­
zation is based on interpolations between the survey
dates. For lack of a better alternative, we show the
utilization rate as constant over these quarters.

Aggregate Capacity, Potential Output,
and Supply
Construction of an aggregate or economy-wide
measure of capacity is not, in general, a straightfor­
ward adding of the capacity measures of the individ­
ual firms. The attempt by all iirms to move to opera­
tions at their computed capacity levels, may cause
changes in factor prices. Such changes in factor prices
would shift all of the cost curves of the individual
20The recent revisions in the FRB index might be cited as evi­
dence that this index captures some or most of the permanent
loss in capacity because of the change in the relative price
structure. An examination of the relationship between the
FRB index and the Wharton index before and since 1974
fails to provide any strong support for such a hypothesis. The
annual FRB capacity utilization index was regressed on the
annual Wharton capacity utilization index from 1951 through
1973. Linear and log-linear specifications were constructed
in level and first difference forms. When any of these specifi­
cations is used to simulate the FRB index from 1974 through
1976, the prediction errors are less than one standard error
from the actual value o f the index in all three years.




1977

C h a rt II

C a p a c ity Utilization Rate

firms and, hence, would alter capacity. The computa­
tion of aggregate capacity requires the summation of
the capacity estimates of all individual firms based
on the factor prices which would actually be realized
if all of the firms operated at their capacity level.21
Nevertheless, the aggregative problems may be par­
tially avoided and the effects of an energy price
change on United States production can be analyzed,
by proceeding in stepwise fashion. Assume that aggre­
gate output is produced by firms like the hypothetical
firm described above. Energy prices are, since late
1973, determined on a world market, so it can be
assumed that the United States faces a perfectly
elastic supply curve for this resource.22 Finally, as­
sume the labor supply curve of the traditional text­
book Keynesian model, namely that the aggregate
labor supply is perfectly elastic at a given nominal
wage rate, at least up to some “full-employment”
quantity. Under these circumstances the aggregation
problem discussed above is avoided, and the appro­
priate measure of aggregate economic capacity in the
model is the summation of the economic capacity of
the individual firms. Aggregate capacity is only one
point of the short-run aggregate supply curve of the
economy. Under the assumed conditions regarding
factor markets, it is possible to construct an aggregate
supply curve such as S,S, in Figure II, for the entire
economy by summing the relevant portions of the
21This problem is discussed by Lawrence R. Klein, “ Some
Theoretical Issues in the Measurement of Capacity,’ Econometrica (April 1960), pp. 272-86.
"T h is is the traditional small-country assumption frequently
found in the international trade literature. In this particular
market, it appears to be an appropriate description of be­
havior over the past few years. Initially w e shall assume that
the nominal price of energy is given; in the next section this
assumption is altered to more accurately reflect the recent
situation where the relative price o f energy is determined
abroad.

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FEDERAL RESERVE BANK OF ST. LOUIS

F ig u re II

Aggregate Supply Under Alternative
Nominal Energy Prices
[P E'-|l+a|PE°]

short-run marginal cost curves across all firms.23 Thus,
along SiS,, nominal wages, W 0, the nominal energy
price, PB° and the stock of capital, K0, are held
constant.
An important constraint, for the aggregate econ­
omy, remains to be taken into account. The economy
is only a price taker in the labor market up to the
existing supply of labor or “full employment.” At­
tempts to expand output beyond that produced with
full utilization of capital and labor, result in higher
wages and prices with little or no impact on aggre­
gate production. This level of output is generally
referred to as “potential output.” It has become com­
mon to consider the aggregate supply curve being
vertical at potential output. Such a vertical segment
would occur along S,S, in Figure II at the output Xp.
In the context of the discussion here, the appropri­
ate supply curve, once full utilization of labor js
reached, is not vertical. While attempts to expand out­
put beyond Xp result in higher wages and prices, with
23Changes in one of the two variable factor prices still pose
aggregation problems. The results for the firm indicate that
an increase in the price of energy would reduce capacity out­
put and raise the long-run supply price of a product more,
the more important (as measured by the cost share) energy
is to production. Hence, relative commodity prices will be
affected in both the short run and long run due to the higher
energy price. W e may abstract from the interindustry
changes in relative prices and focus on potential output and
capacity changes by considering the aggregate production
function implicit in discussions of potential output.


Page 8


MAY

1977

no additional labor or capital entering production, the
economy is free to expand its employment of energy.
Given a nominal market price of energy, higher out­
put prices can lead to increased output through the
use of more energy intensive operations. The aggre­
gate supply curve beyond Xp will be steep but not
vertical, as along S2 in Figure II.
Suppose that initially every firm is producing its
capacity output and the economy fully utilizes capital
and labor, producing output Xp in Figure II at its
corresponding price level at the kink in the supply
curve SiSa. An a percent rise in the nominal price of
energy, PE, will shift the aggregate supply curve. The
shift in the Si segment of the aggregate supply curve
may be found by the same reasoning as applied to the
firm supply curve. The relevant parameter is the share
of energy, KE, in the total factor cost of aggregate
output. Capacity output falls initially by KE percent
for each percentage point increase in PE, to Xp' in
Figure II. Moreover, as in the case of the firm, capital
and labor employment will be the same at Xp' as at
Xp, and the price level of this output will rise by a
percentage equal to the factor share, KE, for each
percentage point rise in PE. The reduction in output
is associated with a reduction in energy usage. Since
both capital and labor would be fully utilized at
output Xp', the kink in the new aggregate supply,
St'S/, occurs at that output.
It should be noted that output Xp could still be
produced and would be, if the price of output were
sufficiently higher, at P2. If the output price and other
resource prices rise by precisely the percentage in­
crease in the nominal price of energy, firms would be
willing and able to produce exactly their original out­
put, Xp, utilizing the original methods of production.
An analysis of how this may come about is shown
in Figure III. As the supply curve shifts and the price
level rises above P„, less output will be demanded.
Policymakers may take actions such as monetary ex­
pansion to maintain real output at Xp, by shifting ag­
gregate demand. While full employment would exist
at output Xp', policymakers might face pressures to
expand demand since output and the real return to
capital and labor owners will have fallen at price
level P,.
As the level of prices rises to P2, increased compe­
tition for fixed capital and labor resources raises their
nominal prices and shifts the S,' curve to S " The
higher price of output and other resources reduces
the relative price of energy, providing an incentive
to adjust energy employment back toward its original

FEDERAL RESERVE BANK OF ST. LOUIS

MAY

F ig u r e III

F ig u r e IV

Demand Management and a
Higher Nominal Energy Price

Aggregate Supply and the
Effect of a H igher Relative Price of Energy

O u tp u t

rate of usage. Thus, to maintain real output at its
original level, commodity and factor prices must rise
by the same percentage as the increased energy cost
to restore all relative prices to their original values.
The two essential ingredients of this result are the
accommodative expansive demand management pol­
icy and the fixed and higher nominal price of energy
in world markets.

OPEC and Aggregate Output in the
United States
The relative price of energy presented in Chart I
indicates a large jump in late 1973 and 1974 which
has not been eroded by demand growth and increases
in the price level. In the analysis above, the relative
price of energy initially rises, but the accommodative
demand management policy is able to effectively
erode the gain to energy producers through inflation.
The relative price of energy is restored to its original
level.
The pricing actions of OPEC apparently were not
intended to be so easily frustrated. The relevant price
which OPEC is able to dictate as the dominant energy
producer is the price of energy relative to that of
output. Attempts by U.S. firms to move along the S2'
curve in Figure III are frustrated by further increases
in the nominal price of energy. The appropriate ag­
gregate restriction on the supply curve St (or S/) is
not that indicated by S2 (or S2') . Instead, after the
institutional change imposed on the world energy



1977

O u tp ut

market, the appropriate restriction is a given relative
price of energy. Given this relative price and an exist­
ing amount of capital, full utilization of labor occurs
at a price level where labor costs relative to output
prices warrant hiring all the labor available. Increases
in output prices, beyond this point, result in no in­
centive to expand energy employment and merely bid
up the nominal prices of the fully employed labor,
capital, and energy. Such a supply restriction implies
the vertical segment of the aggregate supply curve
discussed earlier. In Figure IV, this supply restriction
is depicted as S3 at the capacity output level, Xp. The
aggregate supply curve is S ^ .
An increase in the nominal price of energy raises
the SjSj segment of aggregate supply in precisely the
same manner and amount as in Figure II. Again, at
output X,,' and price level Pj, there is the same utiliza­
tion of capital and labor as at Xp. However, in this
case, the new relative price of energy shifts the verti­
cal segment of the aggregate curve to S3'. Thus, there

is no price level at which the economy may produce
its original level of potential output. Both capacity
output and potential output fall to Xp'. If excess de­
mand exists at P1; or if policymakers create an excess
demand at price P, through expansionary policy,
nothing happens to aggregate output. In such situa­
tions, the price level will simply rise inducing em­
ployers to bid up nominal resource prices for the
fully-employed capital and labor resources as well as
the dollar prices of energy.
Page 9

FEDERAL RESERVE BANK OF ST. LOUIS

MAY

The increased relative price of energy, according
to this analysis, caused a permanently higher level of
prices and permanent reduction in potential output,
as well as reducing firms’ capacity output and alter­
ing relative commodity prices. These effects occur in­
dependently of changes in the level of employment
of labor and capital and may not be offset by demand
management policies. The only way to recover the
loss in potential output and capacity would be the
restoration of the prior relative price of energy.24

1977

Real G N P in R e cession/R ecovery Periods*
Ratio

Ratio

(P rior C y c lic a l P e a k = 1 0 0 )

11 0r-

- l 110

A V E R A G E O F F O U R P R E V IO U S
R E C E S S IO N / R E C O V E R Y P E R IO D S

The Loss of Potential Output in 1974
and the Economic Outlook
Data on potential output, recently constructed by
the Council of Economic Advisers (CE A), indicate
that the economy was operating essentially at its po­
tential in late 1973. Table I shows potential output
and actual real GNP (1972 dollars) since IV/1973.
From IV/1973 to IV/1974, real output fell 4.1 percent
(about $51 billion) while potential GNP was esti­
mated to rise 3.5 percent or about $44 billion. Thus,
in the fourth quarter of 1974, there is an estimated
“gap” of $96.7 billion.

-

3

-

2 - 1 0 1 2 3

Q U A R T E R S TO A N D F R O M T R O U G H S
S o u rc e : U .S. D e p a r t m e n t o f C o m m e rc e
•P rio r P e a k Q u a r t e r s : 111/1953 111/1957 11/1960 IV / 1 9 6 9 IV / 1 9 7 3
T r o u g h Q u a r t e r s : 11/1954 11/1958 1/1961 IV / 1 9 7 0 1/1975
La te st d a t a p lo tte d : 4th q u a rt e r 1 9 7 6

T a b le 1
O ffic ia l
Potential G N P *
( 1 9 7 2 d o lla rs)

A ctual G N P
( 1 9 7 2 d o lla rs)

1973

IV

1 2 4 4 .3

1 2 4 2 .6

1974

1

1 2 5 5 .2

1 2 3 0 .4

II

1 2 6 6 .2

1 2 2 0 .8

III

1 2 7 7 .2

1 2 1 2 .9

IV

1 2 8 8 .4

1 1 9 1 .7

1

1 2 9 9 .7

1 1 6 1 .1

II

1 3 1 1 .1

1 1 7 7 .1

III

13 2 2 .6

1 2 0 9 .3

IV

1 3 3 4 .1

1 2 1 9 .2

1

1 3 4 5 .8

1 2 4 6 .3

II

1 3 5 7 .6

1 2 6 0 .0

III

1 3 6 9 .5

1 2 7 2 .2

IV

1 3 8 1 .5

1 2 8 0 .4

1975

1976

•Source: Unpublished data supplied by the Council o f Economic
Advisers.

The growth in potential output reflects growth in the
labor force, adjusted for its age-sex composition, and
growth in the capital stock over the year. In particu­
lar, the estimate assumes constant or trend growth in
240 f course, over time labor force growth and capital accumu­
lation would increase potential output so that eventually the
old level of potential output is restored. The conclusion
above is that the labor and capital existing at any time could
produce a larger potential output, in the absence of the
energy price increase.


Page
10


productivity of resources. Thus, the potential esti­
mates do not include changes in potential output due
to a change in the relative price of energy and the
consequent decline in the productivity of capital and
labor described above.26
Since some growth in the capital stock occurred in
1974, it may be inferred that the effect of the OPEC
mandated energy price change (IV/1973 to IV/1974)
reduced U.S. capacity and potential output by more
than the actual 4.1 percent decline in real Output. An
estimate of five percent is roughly the order of magni­
tude indicated by a monetarist model of 1974 price
and output developments.26
A five percent estimate of the loss in potential output
or reduction in the productivity of capital and labor
resources is also the correct size to explain an “output
25The Council of Economic Advisers, Economic Report of the
President, 1977, pp. 52-5, indicates an awareness of this
permanent decline in productivity, and even suggests the
magnitude of the decline in potential output to be about
$30 billion (1972 dollars) by 1976. The CEA indicates that
over the near term, productivity data should demonstrate
whether or not the productivity decline is permanent, and
that such proof will determine the need for a revision of
its estimates of potential GNP.
26See Karnosky, “ The Link Between Money and Prices.”

FEDERAL RESERVE BANK OF ST. LOUIS

gap” recently noted by the Congressional Budget
Office (CB O ).27 The CBO pointed out that, after six
quarters of recovery, real GNP was about five percent­
age points below the rate indicated by the experience
in prior recoveries. Furthermore, the CBO attributes
two percentage points of the unusually high unem­
ployment rate to this output gap.28

MAY

1977

C h e r t IV

C iv ilia n E m p lo y m e n t
in R e c e s s io n / R e c o v e r y P e r io d s *

Chart III shows the pattern of previous recessions
and recoveries discussed by the CBO. Real GNP is
measured relative to its rate at the prior cyclical peak
and an average of this index of output is given for the
four prior recession-recovery periods. The chart shows
that on average, after six quarters of recovery, real
GNP was 7.5 percent above its rate at the cyclical
peak. In contrast, output was only 2.4 percent higher
than the prior cyclical peak after six quarters of the
most recent recovery. The difference of about five per­
cent in this pattern since the recession trough (1/1975)
is called the "persisting output gap” by the CBO.
Chart IV shows the corresponding developments
for civilian employment. The employment pattern in
the recent recovery is not different from that of prior
recoveries. The shortfall of output is not associated
with a shortfall of employment. Recent unemployment
experience is not explained by unusual employment
developments but rather is apparently due to unusual
labor force behavior. Thus, it appears that the “output
gap” might better be termed a “productivity gap.”
The decline in labor productivity of about five percent
would be expected due to the impact on actual and
potential output of the higher relative price of energy.
A more conservative estimate of the loss in potential
output may be found using the earlier evidence on
the loss of economic capacity in manufacturing. About
20 percent of real GNP is comprised of compensation
of government employees, output originating in the
rest of the world, and output produced by the resi­
dential housing stock. There is little reason to expect
that these components of output are as severely lim­
ited by the change in the energy price as the output
of the rest of the economy. Assuming the manufactur­
ing result is representative for the remainder of the
private economy, a conservative estimate of the loss
in potential output is four percent.
The theory above indicates that the rise in the
relative price of energy would cause a percentage rise
in the minimum price level associated with potential
27U.S. Congress, Congressional Budget Office, The Disappoint­
ing Recovery, January 11, 1977, pp. 1-3.
28Ibid., p. 3.




Q UARTERS TO A N D FROM TRO U G HS
Source-. U.S. D e p a rtm e n t o f L a b o r
• P rio r P e a k Q u a rt e rs: 111/1953 111/1957 11/1960 IV / 1 9 6 9 IV / 1 9 7 3
T ro u g h Q u a rt e rs: 11/1954 11/1958 1/1961 IV / 1 9 7 0 1/1975
Latest d a t a plotted: 4th q u a rte r 1 97 6

output, equal in size to the percentage loss in poten­
tial output. Thus, a minimum four percent and per­
haps a five percent rise in the price level over 1974
would be expected based upon supply considerations
alone. The actual rate of price increase, as measured
by the GNP deflator, was 11.5 percent. If roughly four
percentage points of this increase is accounted for by
the one-time price level effect of the increase in the
relative price of energy, the remainder, 7.5 percent,
must be accounted for by other factors, such as
growth in aggregate demand.
The impact of a four percent reduction in potential
GNP may be seen in Chart V, which measures actual
real GNP relative to potential output with and with­
out the four percent reduction. The Chart indicates
that in the fourth quarter of last year the economy was
producing 92.6 percent of the CEA’s measure of po­
tential output. To account for the effect of the energy
price change, the CEA estimate of potential output
is lowered after the fourth quarter of 1973 so that,
by the fourth quarter of 1974, potential output is four
percent lower. The CEA estimate of the growth rate
of potential output (3.5 percent) is maintained in the
adjusted curve after the fourth quarter of 1974. As
the Chart indicates, by the end of 1976 the economy
Page 11

FEDERAL RESERVE BANK OF ST. LOUIS

C h art V

R atio of A c tu a l to Potential G N P (1 9 7 2 Prices)

N o t e : O u t p u t g r o w t h is p r o je c t e d a t a 6 p e rc e n t a n n u a l ra te f ro m IV / 1 9 7 6 . T h e e ffe c t o f
e n e r g y p ric e s is to r e d u c e P o te n tia l G N P b y 4 p e r c e n t b e g in n in g in th e fo u rth
q u a rte r o f 1974.
L a te st d a t a p lo tte d : 4th q u a r t e r 1 9 7 6

was producing 96.5 percent of potential output or the
gap is less than half as large as the official measures
indicate.
Recent policy discussions seem to assume that de­
mand management policies can close the official gap.
Obviously, policy measures which are sufficient for
this size task would be far too great for the resources
at hand. The biggest output gain achievable through


Page 12


\

MAY

1977

stabilization policy is about $46 billion in the fourth
quarter of 1976. Attempts to close the official gap of
over $100 billion reflect a failure to recognize that the
implied production rate is unattainable and that such
efforts will add to the rate of price increase.
More importantly, Chart V illustrates the import­
ance of accounting for the loss in potential output
in assessing both the prospects for closing the gap,
and the desirability of policy stimulus. How quickly
the gap closes depends upon the rate of growth of
actual output. In Chart V each measure of potential
output grows at 3.5 percent and actual real GNP is
allowed to grow at a six percent annual rate, a growth
goal which has been the subject of considerable re­
cent discussion. When account is taken of the effect
of the energy price increase on potential output, the
Chart indicates that six percent growth closes the gap
early next year. Of course, beyond that point real
output growth would be limited to the 3.5 percent
growth in potential output. If the official estimates of
potential output are correct, achieving the growth
goal would not close the gap until 1980. Thus, much
of the current debate over the need for fiscal stimulus
rests upon an awareness of the permanent loss in po­
tential output since 1973.29
2flEven if real output grows at about a five percent annual rate,
less than the average annual rate of growth of real output
achieved during the recovery (1/1975 to IV /1 9 7 6 ), the gap
would be eliminated by the end of next year, rather than
in 1982, as the official gap would indicate.

The Growing Link Between the
Federal Government and State and
Local Government Financing
NANCY AMMON JIANAKOPLOS

X HE growth of the state and local government
sector and its increasing reliance on Federal revenues
warrant consideration in discussions of stabilization
policy. State and local government expenditures and
taxes have been growing rapidly in recent decades,
both absolutely and relative to that at the Federal
level. In addition, grants-in-aid from the Federal Gov­
ernment have become an increasingly important
source of funds for state and local governments.
Concern about stabilization policy has been focused
primarily on monetary and fiscal policies of the Fed­
eral Government. Many analysts would agree that this
focus on Federal policy is not misplaced since stabili­
zation policy is not a major responsibility of state and
local governments.1 Whether or not one believes that
state and local governments can or should actively
pursue policies to affect national income, state and
local government spending and taxing decisions do in
fact constitute a part of total government fiscal policy.
State and local fiscal activities do influence economic
activity, although there remains some controversy over
the nature, degree, and duration of these effects.
A full evaluation of government stabilization policy
requires consideration of the impact of the state and
1The rationale behind this distribution of government func­
tions among levels of government is discussed by Richard A.
Musgrave and Peggy B. Musgrave, Public Finance in Theory
and Practice (N ew York: McGraw-Hill Book Company, 1973),
Chapter 26, pp. 595-621.




local sector on aggregate economic activity. Do state
and local policies reinforce or compete with Federal
policies? Is the financing of state and local govern­
ment spending carried out under different constraints
than at the Federal level? Has the increasing reliance
on Federal aid altered the character of state and local
government financing?

STATE AND LOCAL FINANCE
IN PERSPECTIVE
Expenditures
A more detailed examination of the data on govern­
ment expenditures gives a perspective on the relative
size of and functions performed by the different levels
of government. Since 1960, state and local expendi­
tures on a national income accounts (NIA basis have
increased at an average annual rate of 10.5 percent,
compared to a 9.3 percent rate of increase in Federal
expenditures. Purchases of goods and services ac­
counted for 94 percent of state and local expenditures
in 1976, compared to 34 percent at the Federal level
(Table I). These expenditures represent the purchase
of goods and services by the public sector and are the
government component of GNP. Currently, state and
local purchases represent 14 percent of GNP, com­
pared to 8 percent represented by Federal purchases.
Other expenditures by government determine not
so much what goods will be produced, but rather who
will decide what goods to produce. In particular,
Page 13

FEDERAL RESERVE BANK OF ST. LOUIS

MAY

1977

T a b le 1

G overn m ent Expenditures1
(B illio n s o f D o lla rs)
1960

Federal
Purchases o f G o o d s a n d Services
T ra n sfe r P aym ents

19 7 6 p

Am ount

Percent of
Total
Exp e nd iture s

Am ount

$ 5 3 .7

5 7 .7 %

$ 1 3 3 .4

Percent of
Total
Exp e nd iture s
3 4 .3 %

A n n u a l Rate
of C h a n ge
1 9 6 0 -1 9 7 6
5 .9 %

2 3 .4

2 5 .2

1 6 2 .2

4 1 .7

1 2 .9

G r a n t s -in -A id

6.5

7 .0

6 0 .2

1 5 .5

1 4 .9

N et Interest P aid

6.8

7 .3

2 7 .5

7.1

9.1

1.4

4 .9

S u b s id ie s Less C urrent S u rp lu s o f
G o ve rn m e n t Enterprises
T O T A L E X P E N D IT U R E S

2.6

2.8

5 .6

$ 93.1

1 0 0 .0 %

$ 3 8 8 .9

1 0 0 .0 %

$ 4 6 .5

9 3 .4 %

$ 2 3 2 .2

9 .3 %

State a n d Local
Purchases of G o o d s a n d Services

9 4 .3 %

1 0 .6 %

T ra n sfer P aym ents

5 .4

10.8

2 5 .2

1 0 .2

10.1

N et Interest Paid

0.1

0 .2

-6 .6

— 2 .7

— 6 .6

— 1.8

-2 .0

S u b s id ie s Less C urren t S u rp lu s of
G o ve rn m e n t Enterprises
T O T A L E X P E N D IT U R E S

— 2.2
$ 4 9 .8

— 4 .4

— 4 .4

1 0 0 .0 %

$ 2 4 6 .4

1 0 0 .0 %

1 0 .5 %

1National income accounts basis
p — preliminary
Source: Department o f Commerce, Bureau o f Economic Analysis.
N O T E : Data may not add due to rounding:.

transfer payments represent government actions to
redistribute income, and thereby spending decisions,
from one sector of the economy to another. The Fed­
eral sector plays a more important role in these types
of expenditures than do state and local governments.
Transfer payments to individuals represent 10 percent
of state and local expenditures, but account for 42 per­
cent of Federal expenditures and currently are the
largest category of Federal expenditure.
Grants-in-aid, which are counted as Federal expen­
ditures but are receipts of state and local govern­
ments, transfer resource-use decisions from the private
sector to state and local governments by way of the
Federal Government. Federal grants accounted for
only 7 percent of Federal expenditures in 1960, com­
pared to the current 16 percent. Of course, both of
these types of transfers (to individuals and to other
levels of government) frequently are accompanied by
stipulations as to how these resources are to be used.

Personal income taxes account for 10.2 percent of state
and local receipts, while corporate income taxes pro­
duce 3.3 percent of total receipts. Contributions for
social insurance, which include various employee re­
tirement funds and contributions to workmen’s com­
pensation, represent another 6.5 percent of state and
local receipts. T h e greatest change in the com position

of state and local tax receipts from 1960 to 1976 has
been the relative decline in receipts from property
taxes (32.5 percent of total receipts in 1960 versus 22
percent in 1976) and an increase in income tax re­
ceipts (5 percent in 1960 versus 10.2 percent in 1976).

Receipts

While these five taxes produce 64 percent of state
and local receipts, approximately 91 percent of total
Federal receipts are derived from only three sources:
individual income taxes (42.3 percent), corporate in­
come taxes (16.8 percent) and contributions for social
insurance (32 percent). Thus, in general, state and
local governments derive their revenues from a differ­
ent group and a greater variety of taxes than does the
Federal Government.

State and local receipts increased at an average
annual rate of 10.9 percent from 1960 to 1976, while
Federal receipts have increased at an 8 percent aver­
age rate (Table II). Major sources of tax receipts for
state and local governments currently include sales
taxes (22.1 percent) and property taxes (22 percent).

Since 1960 Federal grants to state and local govern­
ments have grown faster than every source of tax
receipts except personal income taxes. Federal grants
currently constitute 23.1 percent of total receipts at
the state and local level, compared to 13 percent in
1960. Table III shows the current composition of


Page
14


FEDERAL RESERVE BANK OF ST. LOUIS

MAY

1977

T a b le II

G overn m e nt Receipts1
( B illio n s of D o lla rs)
1960

Federal
P erson al Incom e Tax

1976

Am ount

Percent of
Total
Receipts

$ 4 1 .8

4 3 .5 %

Am ount

Percent of
Total
Receipts

A n n u a l Rate
of C h a n g e
1 9 6 0 -1 9 7 6

$ 1 3 9 .8

4 2 .3 %

7 .8 %

C o rp o ra te Profits T ax

2 1 .4

2 2 .3

5 5 .6

16.8

6.1

C o n trib u tio n s for S o c ia l In surance

1 7 .6

1 8 .3

1 0 5 .8

3 2 .0

1 1 .9

O th e r P e rso n a l T ax a n d N o n -t a x
Indirect B u sin e ss T ax a n d N o n -t a x A ccru als
T O T A L REC EIPT S

1.8

1.9

5 .5

1 .7

7 .2

1 3 .4

1 4 .0

2 3 .5

7.1

3 .6

$ 9 6 .1

1 0 0 .0 %

$ 2.5

5 .0 %

$ 3 3 0 .3

1 0 0 .0 %

8 .0 %

1 0 .2 %

1 6 .0 %

State a n d Local
P e rso n a l Incom e T ax

$

2 6 .7

C o rp o ra te Profits Tax

1.2

2 .4

8 .7

3 .3

1 3 .2

C o n trib u tio n s fo r S o c ia l In surance

3 .4

6.8

1 7 .0

6 .5

1 0 .6
1 0 .2

Sa le s T ax

1 2 .2

2 4 .4

5 7 .6

22.1

P rop erty T ax

16.2

3 2 .5

5 7 .2

2 2 .0

8.2

O th e r P erson al T ax a n d N o n -t a x

4.2

8.4

2 1 .6

8.3

10.8

O th e r Indirect B u sin e ss T ax

3 .6

7.2

1 1 .4

4 .4

7 .5

G r a n t s -in -A id

6 .5

1 3 .0

6 0 .2

23.1

1 4 .9

$ 4 9 .9

1 0 0 .0 %

T O T A L REC EIPT S

1 0 0 .0 %

$ 2 6 0 .5

1 0 .9 %

*National income accounts basis
Source: Department o f Commerce, Bureau o f Economic Analysis.
N O T E : Data may not add due to rounding.

Federal grants, which include funds earmarked both
for special purposes, such as highways and education,
and general purpose funds, such as revenue sharing.
Some grants require matching funds from the receiv­
ing government.

view of analysts, requires movement away from sur­
plus during recession (expenditure growth exceeding
Table III

C om po sitio n o f Federal A id to
State a n d

STATE AND LOCAL FINANCE
AS A COMPONENT OF
STABILIZATION POLICY
Direction of Fiscal Policy
Given the differences in the growth and composi­
tion of state and local receipts and expenditures rela­
tive to those at the Federal level, the behavior of these
items over the course of economic cycles is a factor
which should be considered in discussions of govern­
ment stabilization efforts. A useful measure of this
behavior is the net change in state and local expendi­
tures and receipts — that is, changes in budget sur­
pluses and deficits.2 Appropriate fiscal policy, in the
2Studies using this approach include Robert W . Rafuse, Jr.,
“ Cyclical Behavior of State-Local Finances” in Essays in
Fiscal Federalism, Richard A. Musgrave, ed. (Washington:
The Brookings Institution, 1965), pp. 63-121 and Ansel M.
Sharp, “ The Behavior of Selected State and Local Govern­
ment Fiscal Variables During the Phases of the Cycles
1949-1961,” Proceedings, National Tax Association, 1965,
p p . 599-613.




Local G overnm ents,

Fiscal

1976 est.

( M illio n s o f D o lla rs)

Function
N a tu ra l resources, e n viron m e nt
a n d e n e rg y
A gricu lture

Am ount

$ 3 ,0 8 8

Percent of
Total

5 .2 %

499

0 .8

Com m erce a n d tra n sp o rta tion

8 ,2 7 7

13.8

C o m m u n ity a n d re g io n a l
d eve lop m en t

4 ,0 0 8

6 .7

Education, em p lo ym e n t tra in in g
a n d social services

1 4 ,4 2 2

24.1

H ealth

1 0 ,0 3 2

16.8

Incom e Security
(P u blic a ssista nce, fo o d sta m p s)

1 1 ,2 1 2

18.8

Law enforcem ent a n d iustice

838

1.4

Revenue sh a r in g a n d ge n e ra l
fiscal a ssista n c e

7 ,1 6 6

1 2 .0

O th e r

295
$ 5 9 ,7 8 7

0 .5
1 0 0 .0 %

Source: U.S. Office of Management and Budget “ Special Analysis of
Federal Aid to State and Local Governments’ ' derived from
“ The Budget o f the United States Government.”
NO T E : Data may differ from original due to rounding.

Page 15

MAY

FEDERAL RESERVE BANK OF ST. LOUIS

growth of receipts).3 Likewise, appro­
priate government fiscal policy during
expansion would require movement
toward surplus (growth of receipts in
excess of expenditure growth).
In postwar business cycles, state and
local expenditures have tended to in­
crease relative to receipts during reces­
sions (Table IV). On average, expendi­
tures grew at a 12.7 percent rate during
the five previous recessions, while re­
ceipts increased at an average 8.5 per­
cent rate. In the most recent recession
expenditures increased at a 12.9 percent
rate, while receipts increased at a 10
percent rate. The net effect of these
relative growth rates was to move state
and local budgets away from surplus
positions during recessions. This is the
appropriate policy (fiscal stimulus es­
poused by fiscal activists, and such stim­
ulus reinforces similar movements at the
Federal level.

T ab le IV

C Y C L IC A L C H A N G E S IN
G O V E R N M E N T E X P E N D IT U R E S A N D

RECEIPTS

A n n u a l Rates o f C h a n g e
Federal

State a n d Local

Exp e nd iture s
IV / 4 8 - IV / 4 9 (R )

6 .2 %

Receipts

E xp e nd iture s

Receipts

— 1 1 .6 %

1 5 .3 %

IV / 4 9 - 111/53 (E )

1 7 .8

1 8 .6

7.3

111/53 - 111/54 { R)

— 10.3

-1 0 .3

1 1 .6

5 .8

111/54 - 111/57 (E )

5.1

9 .2

9 .4

9 .8

111/57 - 11/58 (R )

8 .7 %
9.1

1 3 .6

-1 0 .7

1 1 .8

8 .7

11/58 - 11/60 (E )

2.5

1 2 .8

6 .4

9 .6

11/60 - 1/61 (R )

9 .4

2.8

10.1

7 .9

1/61 - IV / 6 9 (E)

8.0

8.8

9 .9

1 0 .5

IV / 6 9 - IV / 7 0 (R )

8 .7

IV / 7 0 - IV / 7 3 (E )

9 .0

AVERAGE

(R)

5 .5
8.5

-

—

—

3 .9

1 4 .5

1 1 .2

1 2 .0

1 0 .4

12.2

7 .9

1 2 .7

8 .5

1 2 .3

8 .7

1 0 .2

IV / 7 3 - 1/7 5 (R )

1 8 .9

6 .3

1 2 .9

1 0 .0

1 / 7 5 - 111/76 (E )

1 0 .4

1 0 .5

9 .5

1 1 .6

R — recession
E — expansionary phase

Over expansionary phases, state and local receipts
have increased at a faster pace than expenditures,
moving state and local budgets towards surplus posi­
tions. On average, receipts have increased over the
course of previous economic expansions at a 10.2 per­
cent rate, while expenditures have grown at an 8.7
percent rate. Since the first quarter of 1975, the be­
ginning of the current recovery, state and local re­
ceipts have increased at an 11.6 percent rate, com­
pared to a 9.5 percent rate of increase of expenditures.
Thus, in the current as well as in past expansions,
state and local budgets have moved toward surplus,
the movement prescribed by many fiscal policy
proponents.

Magnitude of Fiscal Policy
Although there remains some controversy concern­
ing the nature of the effects, the impact of govern­
ment stimulus or restraint on the level of economic
activity depends not only on the direction of budget
changes, but also on the magnitude of these changes.
It is important to remember, however, that while
changes in the Federal budget position may reflect
deliberate actions to influence economic activity, the
■!For example, see Otto Eckstein, Public Finance, 3rd ed.
(Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1973),
p. 121.


Page 16


1977

state and local budget position is aggregated over
80,000 governmental budgets. Changes in state and
local budgets constitute an implicit fiscal policy which
can be taken into account, but which would be diffi­
cult to coordinate with actions at the Federal level,
especially given the different character of expendi­
tures and receipts which was discussed above.
One method of measuring the degree of fiscal stim­
ulus or restraint produced by governmental finances
is by changes in the NIA budget surplus or deficit
(see Chart).4 Table' V presents the dollar change from
the previous year in the Federal and state and local
budgets on an NIA basis. For example, changes in the
Federal NIA budget between 1975 and 1976 produced
about $13 billion of fiscal restraint. State and local
budgets accounted for an additional $7 billion of re­
straint, or about a third of total government fiscal
restraint.
Changes in the full employment budget can also be
used to assess the degree of government fiscal impact
on economic activity. The full employment budget
concept was developed in an attempt to eliminate the
automatic influences of economic fluctuations on the
4For a discussion of various methods of calculating the impact
of budgets on GNP, see Saul H. Hymans and J. Philip
W emette, “ The Impact of the Federal Budget on Total
Spending,” Business Economics (September 1970), pp. 29-34.

FEDERAL RESERVE BANK OF ST. LOUIS

MAY

1977

T a b le V
G o v e rn m e n t Sector of N a tio n a l Incom e A ccou nts
(+ ) S irp l« s ; (-)Deficit

C h a n g e s in

Bu dgets T o w ard s Stimulus

N IA

a n d Restraint

(

—

{ —|— )

)

($ b illio n s )
C a le n d a r Y e a r

Fed e ral

19/0

$ + 2 0 .6

1971

+

9 .9
4 .7

State a n d Local
$ -

0 .7

—

0 .9

1972

-

1973

-1 0 .6

+

1974

-f

4 .8

+

5 .7

1975

+ 5 9 .7

+

0 .4

1976p

— 1 2 .9

-

7 .0

— 1 0 .0
0 .7

C h a n g e s in Full Em ploym ent Budgets T o w ards
Stimulus

(

+ ) a n d Restraint

( - )

( $ b illio n s )
C a le n d a r Y e a r

budget. For example, tax receipts generally decrease
during an economic downturn, while expenditures for
unemployment benefits at the Federal level increase.
By eliminating these “passive” elements of the budget,
more attention is focused on “active,” or discretionary,
changes in the budget.5 Realizing the implicit fiscal
policies of state and local budgetary policies, the
Council of Economic Advisers has attempted since
1974 to measure the full employment budget position
of both the Federal and state and local governments.6
The combined impact of both budgets gives a more
complete picture of the extent of government fiscal
activity. Based on changes from the previous year, the
1976 Federal Government budget on a full employ­
ment basis exercised $2.2 billion in restraint, while
state and local full employment budgets contributed
an even greater $3.1 billion of restraint.7 As the exam­
ples illustrate, whatever the ultimate impact of fiscal
policy on the economy and however it is measured, an
assessment of the degree of fiscal stimulus or restraint
is incomplete without consideration of the state and
local sector.
5See Keith M. Carlson, “ Large Federal Budget Deficits: Per­
spective and Prospects,” this Review (O ctober 1976), pp. 2-7.
6Economic Report of the President 1974, pp. 80-81. Recogni­
tion of the significance of state and local budget positions in
the assessment of fiscal policy can be found in Donald L.
Raiff and Richard M. Young, “ Budget Surpluses for State
and Local Governments: Undercutting Uncle Sam’s Fiscal
Stance?” Business Review, Federal Reserve Bank of Phila­
delphia (M arch 1973), pp. 19-28; Nancy H. Teeters, “ Cur­
rent Problems in the Full Employment Concept” and Robert
C. Vogel, “ The Responsiveness of State and Local Receipts
to Changes in Economic Activity: Extending the Concept of
the Full Employment Budget” in Studies in Price Stability
and Economic Growth, Paper Nos. 6 and 7, Joint Economic
Committee, June 30, 1975, 94th Cong. 1st Sess.
7Economic Report of the President, 1977, p. 76.




Federal

State a n d Local
*•

1970

$ +

6 .3

19 7 1

+

6 .6

$ —

2.3

1972

+ 1 2 .3

—

7 .4

1973

-1 3 .6

+

3 .3

1974

— 2 2 .0

-

4 .0

1975

+ 2 6 .5

— 1 1 .7

19 7 6 p

—

—

2.2

3.1

'"‘ Data unavailable.
Source: Economic Report of the President, 1977.
p — preliminary

FINANCING GOVERNMENT SPENDING
The way in which government spending is financed
affects both the impact of the spending on aggregate
economic activity and the perception of taxpayers
concerning the costs of government programs. If the
costs of government are affected by the method of
financing, this can ultimately influence the size of
government and, hence, the magnitude of fiscal effects
on the economy.

Methods of Financing
Both Federal and state and local government
spending can be financed directly by taxes or by bor­
rowing from the public. In addition, Federal Govern­
ment spending can be financed by borrowing indi­
rectly from the Federal Reserve. The Federal Reserve
buys Federal Government securities with newly cre­
ated money. Thus, the Federal Reserve can, in fact,
finance expenditures by printing new money or, more
formally, “monetizing the debt.” While the Federal
Reserve does not operate in the market for state and
local debt, these governments have the Federal Gov­
ernment, through grants-in-aid, as an additional source
of revenue and thus, in an indirect manner, have ac­
Page 17

FEDERAL RESERVE BANK OF ST. LOUIS

cess to all the methods of financing available to the
Federal Government including debt monetization.

Taxes — Spending financed by tax revenue, whether
at the Federal or state and local level, results in a
direct transfer of resources from the private sector to
the public sector. The costs of government spending
financed by taxes are explicitly known to taxpayers.
The imposition of taxes alters private consumption and
investment decisions, and this will ultimately affect
the composition, if not the level, of output and
employment.
Borrowing from the Public — When government
spending is financed by borrowing from the public,
control over resources is also transferred from the pri­
vate sector to the public sector. The costs of govern­
ment spending financed by borrowing from the public
are less directly known to taxpayers than if the spend­
ing were financed by taxes. However, taxpayers will
eventually become aware of the costs if the principal
and interest are repaid through tax revenue.
Government borrowing represents an increased de­
mand for credit. If there is no increase in the public’s
desire to supply credit (savings) or no offsetting de­
crease in private credit demand, the effect of the
government borrowing will be to put upward pressure
on interest rates. At higher interest rates, some private
borrowers will be crowded out of the market.8 Some
state and local governments, which have restrictions
as to the maximum interest rate at which they can
borrow , w ill also b e forced out of the m arket. H igher

interest rates increase the cost of mortgages, con­
sumer loans, and loans for capital investment. Again,
private consumption and investment decisions will be
altered. This will change the composition, if not the
level, of output and employment.

Borrowing from the Federal Reserve — When
there is an upward movement in interest rates, there
can be pressure on the Federal Reserve to resist such
movements given current operating procedures. In the
short run the Federal Reserve can ease pressure on
interest rates by purchasing Federal debt. The Fed­
eral Reserve generally does not purchase Federal debt
directly from the Treasury, but rather in the open
market. By purchasing the debt the Federal Reserve
increases reserves in the banking system and mitigates
the initial upward pressures on interest rates. At the
8See Roger W . Spencer and William P. Yohe, “ The ‘Crowding
Out’ of Private Expenditures by Fiscal Policy Actions,” this
Review (O ctober 1970), pp. 12-24 and Keith M. Carlson
and Roger W . Spencer, “ Crowding Out and Its Critics,” this
Review (Decem ber 1975), pp. 2-17.


Page
18


MAY

1977

same time, this action increases the rate of monetary
expansion which, over an extended period, leads to
higher rates of inflation and eventually higher interest
rates. Of course, the decision to monetize the debt has
been at the discretion of the Federal Reserve.
The costs of financing government spending through
monetary expansion are even less clearly discemable
than financing through taxes and borrowing. While the
costs of inflation are less apparent, they are no less real
than the imposition of taxes or the costs of borrowing.
The ultimate monetary authority is at the Federal
level. State and local governments do not have direct
authority to create money and the Federal Reserve
does not purchase state and local debt. Nevertheless,
the initial source of upward pressure on interest rates
may have been increased credit demands by either
the Federal Government to finance Federal spending,
by state and local governments to finance their spend­
ing, or by the private sector to finance its spending.
Thus, while state and local debt is not directly pur­
chased by the Federal Reserve, it can be indirectly
accommodated by Federal Reserve actions to hold
down interest rates in the short run.
The combination of the more indirect access to
money creating powers and certain legal restrictions
on borrowing tend to make state and local govern­
ments operate under a tighter budget constraint than
the Federal Government. This is evidenced by the
fact that state and local government budgets in the
aggregate have been in surplus on an NIA basis in 14
of the last 17 years, compared to only 4 surpluses
incurred by the Federal Government over this period.
Since expenditures are more likely to be financed by
available receipts than by monetary expansion at the
state and local level, taxpayers are more aware of the
costs of state and local spending than the costs of
Federal spending.

Implications of Federal Grants-in-Aid
When state and local government spending is
financed by Federal aid, the impact on economic
activity depends on how this Federal spending is
financed. The fact that spending in this instance is
one step removed from paying for the programs
makes the net benefit of the state and local govern­
ment expenditures more difficult to assess. In particu­
lar it is more likely that the real costs of spending will
be underestimated.
To the extent that Federal aid is financed by Fed­
eral taxes, resources are transferred from the private
sector to the public sector. In this case it becomes a

FEDERAL RESERVE BANK OF ST. LOUIS

MAY

1977

T a b le V I

FEDERAL A ID

IN

P R O P O R T IO N T O FEDERAL T A X
Fiscal

Fed eral A id
Per D o lla r of
F ed e ral T a x B u rd e n 1
A la b a m a

B U R D E N S BY STATE

1974
Fed e ral A id
Per D o lla r of
F ed e ra l T a x B u rd e n 1

Fed eral A id
Per D o lla r o f
F ed e ra l T a x B u rd e n 1

$ 0 .2 8

K entucky

$ .2 9

A la s k a

.5 3

L o u isia n a

.2 9

N o rth D a k o ta
O h io

$ .28

A riz o n a

.20

M a in e

.3 0

O k la h o m a

.2 4

A rk a n sa s

.3 0

M a r y la n d

.1 4

O re go n

.23

C a lifo rn ia

.18

M a ssa c h u se tts

.1 7

P e n n s y lv a n ia

.1 7

C o lo r a d o

.18

M ic h ig a n

.1 6

R h o d e Is la n d

.22

Connecticut

.1 4

M in n e s o ta

.21

So u th C a ro lin a

.25

.1 4

D e la w a re

.1 4

M is s is s ip p i

.4 4

So u th D a k o ta

.3 9

Dist. o f C o lu m b ia

.51

M is s o u r i

.1 6

T en n e sse e

.2 2

F lo rida

.1 4

M o n ta n a

.3 0

Texas

.18

G e o r g ia

.2 4

N e b ra sk a

.1 7

U tah

.2 7

H a w a ii

.2 3

Nevada

.1 6

Verm ont

.3 4

Id a h o

.2 7

N e w H a m p sh ire

.1 7

V ir g in ia

.16

.1 2

W a s h in g t o n

.2 0
.36

Illin o is

.1 5

N e w Je rse y

In d ia n a

.12

N e w M e x ic o

.3 6

W e s t V irg in ia

Io w a

.1 5

N e w Y o rk

.2 0

W is c o n s in

.1 7

K a n sa s

.1 6

N o rth C a ro lin a

.2 0

W y o m in g

.2 9

U.S. A v e r a g e $ 0 . 1 9

1Federal aid comprises Federal funds, trust funds, and general revenue sharing funds transferred to state and local governments. Federal tax
burden by state was estimated by the Tax Foundation on the basis of a formula designed to show where tax dollars originate, rather than
where they are collected. For further explanation see Tax Foundation, “ Allocating the Federal Tax Burden Among the States," Research Aid
No. 3. 1957.
Sources: U.S. Dept, o f the Treasury, Federal Aid to States, annual and Tax Foundation, Facts and Figures on Government Finance, 1975.

two-stage process; resources are first transferred to the
Federal Government and then to state and local gov­
ernments. The costs of any particular state and local
program are borne across the economy in proportion
to taxpayers’ Federal tax liabilities, rather than their
state and local tax liabilities. Private spending and
investment decisions will be altered, but in a manner
corresponding to the impact of Federal taxes, rather
than in a manner resulting from the same expendi­
tures being financed by taxes at the state and local
level. As Table VI indicates, rough estimates suggest
that the Federal aid received by states does not cor­
respond closely with the Federal tax burden of the
people in the respective states. The average amount
of Federal aid per dollar of Federal tax burden na­
tionally is 19 cents. However, Federal aid ranges from
12 cents per dollar of Federal tax burden in Indiana
and New Jersey to 53 cents per tax dollar in Alaska.
To the extent that Federal aid is financed by Fed­
eral borrowing from the public, resources are also
transferred from the private sector to the public
sector. Without compensating changes in the supply
or other demands for credit, the Federal borrowing



will put upward pressure on interest rates and alter
private investment and consumption decisions.
If Federal aid is financed by borrowing from the
Federal Reserve (monetization of the debt), then
Federal aid to state and local governments is ulti­
mately financed by increased monetary expansion and
a faster rate of inflation in the future. Federal aid, in
effect, gives state and local governments greater ac­
cess to Federal powers of money creation. The costs of
spending financed in this manner are not obvious.
However, these costs take the form of a higher rate of
inflation distributed over the entire economy.

CONCLUSION
Although there is much concern about the increas­
ing size of government, attention is usually focused on
the Federal Government, whereas the state and local
sector represents a larger portion of GNP and is grow­
ing more rapidly. Likewise, the impact of fiscal policy
on economic activity is generally centered on explicit
Federal Government decisions. However, the spend­
ing and taxing decisions of state and local govemPage 19

FEDERAL RESERVE BANK OF ST. LOUIS

MAY

1977

ments, although operating under somewhat different
circumstances than the Federal Government, do con­
stitute an implicit fiscal policy.

pressure on interest rates resulting from increases in
state and local credit demands can lead to accommo­
dation by the Federal Reserve.

The influence of state and local governments on
economic activity depends both on the size of the
stimulus or restraint reflected in budget changes and
on the method in which spending is financed. The
amount of fiscal restraint or stimulus reflected in state
and local budgets in recent years has been of suffi­
cient magnitude to merit consideration in conjunction
with Federal fiscal policies. Likewise, examination of
the ways in which state and local spending is financed
shows that it can influence economic activity in much
the same way as Federal spending. In particular,
state and local spending can be financed by monetary
expansion, even though the ultimate monetary author­
ity is at the Federal level. Although the Federal Re­
serve does not purchase state and local debt, upward

The increasing importance of Federal aid as a
source of state and local revenue means that state and
local governments have access to Federal sources of
financing. The ability to spend at the state and local
level with funds raised at the Federal level makes it
more difficult to correctly determine the desired level
of state and local government spending. The complete
costs of state and local spending are not readily
apparent and, therefore, more spending may take
place than taxpayers would be willing to pay for if
they were fully informed of the costs. To correctly
assess the net benefit of state and local spending
financed by Federal aid, it is important to be aware
of the possible costs: higher taxes, higher interest
rates, and/or a higher future rate of inflation.


Page
20


So Wliat, It’s Only a Five Percent Inflation
LEONALL C. ANDERSEN

I n recent years there has been an apparent willing­
ness on the part of many individuals to accept the
present five percent rate of inflation as a more or less
permanent feature of our economy. This view may be
exemplified by the expression “So what, it’s only a
five percent inflation.”
Some individuals argue that a five percent rate of
inflation is relatively satisfactory when compared with
the recent double-digit rate or with the higher rates of
inflation in most other countries. Others argue that, if
inflation is stabilized at this rate, individuals would
take actions in the market place such that their
money income would also rise at a five percent annual
rate. Consequently, a permanent five percent rate of
inflation would have little effect over time on the
ability of individuals to buy goods and services.
Rut such is not the case. Even if an individual’s
money income rises as fast as the rate of inflation and
his real income received (actual purchasing power)
thus remains unchanged, his after tax real income
decreases. The reason for this result is the progressive
nature of the existing personal income tax structure
which causes an individual’s tax payments to rise
faster than money income.
Indexation of the Federal personal income tax struc­
ture — altering the structure each year according to
the rate of inflation that has been experienced — is
a prominently mentioned method for preventing such
a decrease in after tax real income. Indexation for
inflation would maintain the degree of progression
provided in the existing personal income tax structure,
but progression would be based on real income re­
ceived instead of money income. With such a pro­
gram, tax payments as percent of income would
increase only when a worker receives a real wage rate
increase (purchasing power of money wage rate) for



a given job, or moves into a job paying a higher real
wage rate. Effective tax rates would not rise as in the
case where wages were rising because of the per­
nicious effects of inflation.
This article illustrates the impact of the 1976 per­
sonal income tax structure on after tax real income dur­
ing a prolonged period of five percent inflation. The
example used is that of a worker currently holding a
job paying $3.00 an hour and a worker holding the
same job at a later date. Income taxes are calculated
for a married couple who have two dependent chil­
dren, take the standard deduction, and file a joint
return. The article also presents the changes in the
parts of the 1976 personal income tax structure appli­
cable to this worker if there were indexation for the
rate of inflation.1

IMPACT OF THE 1976 PERSONAL
INCOME TAX STRUCTURE
The effect of inflation on after tax real income can
be illustrated by three simple examples — a 5 percent
rate of inflation and no growth in real income, a 3.5
percent rate of growth in real income and no inflation,
and both a 5 percent inflation and a 3.5 percent rate
of growth in real income. The time period considered
is the next 45 years, the expected number of remaining
years of work for a twenty year old worker.

Five Percent Inflation
In this case, it is assumed that the money wage rate
for this job increases over the next 45 years at the
same rate as inflation; thus, there is no increase in the
real wage rate. Table I presents the implications for
iOther provisions would also be indexed, but they are not con­
sidered in this article.

Page 21

FEDERAL RESERVE BANK OF ST. LOUIS

MAY

T a b le 1

Influence o f 1976 Federal Personal Incom e Tax
on E arn in gs From a Job Currently P a y in g $3 Per Hour
Level A fte r 4 5 Y e a rs
B e g in n in g
Level
H o u rly M o n e y W a g e

$

A n n u a l In co m e 1
T ax

3 .0 0
6 ,2 4 0
{1 5 5 )3

5 Percent
Inflation
$

2 6 .9 6

3 .5 Percent
G ro w th in
Real Incom e
$

14.11

5 6 ,0 7 7

2 9 ,3 4 9

1 7 ,0 1 9

5 ,3 3 6

A fte r tax incom e:
C urrent Y e a r D o lla rs

6 ,3 9 5

3 8 ,0 5 8

2 4 ,0 1 3

C o n sta n t D o lla rs
(1 9 7 7 )

6 ,3 9 5

4 ,3 4 6

2 4 ,0 1 3

30%

18%

T a x a s a Percent
o f Incom e

(— 2 . 5 ) 3

1Based on 2080 hours annually o f work and paid vacations and holidays.
2Subject to 50 percent marginal rate on earned income.
3Refund as a result o f earned income credit.

after tax real income and for taxes as a percent of
income.
The money wage rate would increase from $3 to $27
per hour (Table I), and annual money income re­
ceived would increase from $6,240 to $56,077.2 Never­
theless, as a result of inflation the higher money in­
come received 45 years from now would purchase
only the same amount of goods and services as in
1977. On average, the prices of most items purchased
would rise as much as money income. Exhibit I pre­
sents the prices of selected items at the end of the
period, assuming that all prices increase at the same
rate as inflation.
Although real income received by a person holding
this job remains unchanged, after tax real income de­
creases from $6,395 to $4,346. The reason for this re­
sult is the progressive nature of the existing personal
income tax structure in which taxes as a percent of
income received rises from —2.5 percent to 30 percent.3

In fla tion &
G ro w th in
R eal incom e
$

1 1 7 .8 9
2 4 5 , 2 1 12

1977

would be considerably less. This result
is accounted for by the rise in taxes as
a percent of income shown in the table,
but this is the normal result of the pro­
gression provided in the existing per­
sonal income tax structure.

Inflation and Growth in
Real Income

1 1 1 ,5 8 6

A more realistic assumption is that the
money wage rate for this job rises at a
rate reflecting both the rate of inflation
1 4 ,8 6 9
and the increase in productivity (the
real wage rate). In this case it is as­
46%
sumed that the money wage rate in­
creases at an 8.5 percent annual rate —
the sum of the assumed 5 percent rate
of inflation and a 3.5 percent rate of
growth in productivity (that is, the real wage rate).
1 3 3 ,6 2 5

According to Table I, the level of after tax real in­
come of a worker holding this job would be $14,869
compared with $24,013 in the previous case, even
though the real wage rate rose the same in each case.
Also, taxes as a percent of income are 46 percent comT a b le II

In d e xation o f 1976 Federal Personal Incom e T ax
Structure for a Five Percent Rate of Inflation
O v e r the N e x t Forty-Five Y ears
Present
E xem p tion Per D e p e n d e n t

$

A fte r 4 5 Y e a rs
$

750

6 ,7 3 9

S ta n d a rd D eduction
1 6 % of A d ju ste d G r o s s Incom e:
M in im u m

2 ,1 0 0

1 8 ,8 6 9

M a x im u m

2 ,8 0 0

2 5 ,1 5 8

35

315

180

1 ,6 1 7

S ta rtin g Incom e

4 ,0 0 0

3 5 ,9 4 0

Cut-off Incom e

8 ,0 0 0

7 1 ,8 8 0

T a x Credit:
Per D e p e n d e n t
or

Three and One-Half Percent Growth
in Real Income
This case assumes that the money wage rate of a
worker holding this job and, hence, the real wage rate,
increases at a 3.5 percent annual rate. Table I indi­
cates that, while money income would increase from
$6,240 to $29,349, the increase in after tax real income

2 % of T a x a b le Incom e
W ith a M a x im u m of
Ea rn ed Inco m e Credit:

M a r g in a l T a x Rate

M o re
Than:
14

-Based on pay for 2080 hours of work, paid vacation, and
holidays.
3The — 2.5 percent figure results from the 1976 provision for
an earned income credit for low income families with de­
pendent children.

DigitizedFage
for FRASER
22


Present T a x a b le
Inco m e

15

$

T a x a b le Incom e
A fte r 4 5 Y e a rs
M o re
Than:

le s s
Than:

0

1 ,0 0 0

1 ,0 0 0

2 ,0 0 0

$

Less
T ha n :
0

8 ,9 8 5

8 ,9 8 5

1 7 ,9 7 0

16

2 ,0 0 0

3 ,0 0 0

1 7 ,9 7 0

2 6 ,9 5 5

17

3 ,0 0 0

4 ,0 0 0

2 6 ,9 5 5

3 5 ,9 4 0

19

4 ,0 0 0

8 ,0 0 0

3 5 ,9 4 0

7 1 ,8 8 0

MAY

FEDERAL RESERVE BANK OF ST. LOUIS

pared with 18 percent. The increase in tax burden
reflects the effect of inflation transferring resources
from the taxpayer to the government under the exist­
ing personal income tax structure.

E xh ib it 1

Influence o f Perm anent Five Percent Rate
o f Inflation on Selected Prices1
B e g in n in g
Level

INDEXATION REQUIRED FOR FIVE
PERCENT INFLATION
Table II presents the provisions of the 1976 per­
sonal income tax structure applicable to the worker at
the beginning of the period and these same provisions
at the end of 45 years if they were indexed for a 5
percent rate of inflation. Such indexation would main­
tain the tax payment of a worker holding the assumed
job as a percent of income received at the same level
as in 1977 in the case of inflation and no growth in
real income, and at the level implied at the end of 45
years in the case of growth in real income without
inflation.

CONCLUSIONS
The simple examples considered here give results
that may appear to be extreme. But that is the point.
Acceptance of the view — “So what, its only a five
percent rate of inflation ” — because it is believed
that individuals can take actions in the market place
to protect their real income fails to take into consid­
eration the existing personal income tax structure.
Even if increases in an individual’s money income re­
flect fully the rate of inflation, the gap between real
income and after tax real income tends to widen. The
reason for this result is that taxes as a percent of in­
come increases as money income incorporates the rate
of inflation.
Indexation of the existing personal income tax struc­
ture for the rate of inflation would eliminate the wid­




A fter
4 5 Y e a rs

G ro c e ry Item s
B re a d

2%

(1

lb. lo a f)

m ilk

(1

$

g a llo n )

A -L a rg e e g g s

(1 d o z e n )

G ro u n d b eef

(1

lb.)

C hu ck roast (1 lb.)

.2 5

$

2 .2 5

1 .3 9

1 2 .4 9

.85

7 .6 4

.9 9

8 .9 0

.6 9

6 .2 0

W h o le frye r

(1

lb.)

.4 9

4 .4 0

R o u n d ste ak

(1

lb.)

1 .4 9

1 3 .3 9

Cabbage

lb.)

.33

2 .9 7

(1

Potatoes (1 lb.)

.13

1 .1 7

C a n n e d tom atoes ( 1 6 oz.)

.35

3 .1 4

P eanut butter

( 2 8 oz.)

Butter (1 lb.)
Toilet P a p e r

( 4 rolls)

1.35

1 2 .1 3

1 .2 5

1 1 .2 3

.7 9

7 .1 0

C lo th in g
W o r k p a nts

The table indicates that substantial changes in the
tax provisions would be required to accomplish these
results. For example, the exemption per dependent
would be $6,739 and the minimum standard deduc­
tion $18,869. The lowest marginal tax rate would
apply to taxable income up to $8,985.

1977

$ 8 .9 8

W o r k shirt
W o r k sh o e s
W o r k jacket (lig h t )
W o r k jacket

(h e a vy)

M a n 's suit
M a n ’s coat

(a ll w e a th e r)

$

8 0 .6 9

7 .9 8

7 1 .7 0

2 6 .0 0

2 3 3 .6 1

9 .9 8

8 9 .6 7

1 3 .9 8

1 2 5 .6 1

8 5 .0 0

7 6 3 .7 3

6 0 .0 0

5 3 9 .1 0
2 2 4 .6 3

M a n ’s d re ss sh o e s

2 5 .0 0

W o m a n 's sla cks

1 4 .0 0

1 2 5 .7 9

W o m a n ’s dre ss

3 0 .0 0

2 6 9 .5 5

W o m a n 's coat (a ll w e a th e r)

3 9 .0 0

3 5 0 .4 2

W o m a n ’s d re ss sh o e s

1 6 .9 9

1 5 2 .6 6

$ 3 4 ,9 8 0

$ 3 1 4 ,2 9 6

H o u s in g
N e w H o u se
1 B ed roo m A p a rtm e n t

135/
month

1 ,2 1 3 /
m onth

A u to m o b ile
Pinto

$

M a lib u coupe
R e g u la r g a s

(1 g a llo n )

3 ,1 7 5

$ 2 8 ,5 2 7

4 ,5 8 8

4 1 ,2 2 3

.5 9 9

5 .3 8

*St. Louis prices in early 1977.

ening of the gap between real income received and
after tax real income. There is also another method
available for accomplishing the same objective. That
method is the elimination of inflation by reducing the
present excessive rate of monetary expansion.

Page 23