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The Classical Gold Standard:
Some Lessons for Today
MICHAEL DAVID BORDO

HE widespread dissatisfaction with almost two
decades of worldwide inflation has prompted interest
in a return to some form of a gold standard.1 Some
crucial questions must be answered, however, before
such interest can be taken seriously. Two questions
immediately come to mind: How did the actual gold
standard operate? What was its record for providing
stable prices and overall economic stability?

ular, both the price level and real economic activity
were more stable in the pre-World War I gold stand
ard era than in the subsequent six-and-one-half
decades. Much of the relatively poor performance of
the post-World War I period, however, occurred in
the interwar period, a period characterized by defla
tion, real output instability and high unemployment.

This article attempts to answer these two questions.
It focuses primarily on what is commonly referred to
as the “Classical Gold Standard,” which prevailed in
its most pristine form between 1880 and 1914.2

WHAT WAS THE GOLD STANDARD?

The first section discusses some fundamentals of the
gold standard. This is followed by a discussion of the
“Managed Gold Standard” which characterized much
of the pre-World War I period. Following that is a
brief narration of the history of the gold standard.
Next, some empirical evidence is presented on the per
formance of the economies of the United States and
the United Kingdom under the gold standard. Finally,
the case for a return to the gold standard is examined.
The evidence presented in this article suggests that,
in several respects, economic performance in the
United States and the United Kingdom was superior
under the classical gold standard to that of the subse
quent period of managed fiduciary money.3 In partic
The author, professor of economics at the University of South
Carolina, Columbia, is a Visiting Scholar at the Federal Reserve
Bank of St. Louis.
indeed, the recently appointed federal Gold Commission has
been established to consider the case for a greater role for
gold in the U.S. monetary system. For a recent discourse on
the case for a return by the United States to some form of
the gold standard, see Robert M. Bleiberg and James Grant,
“For Real Money: The Dollar Should be as Good as Gold,”
editorial commentary, Barron’s, June 15, 1981.
2However, aspects of the gold standard persisted in various
forms until the 1971 breakdown of the Bretton Woods System.
3“Managed fiduciary money” means a monetary standard under
which the government is not committed to maintain a fixed price
of gold. The United States had such a standard from 1861

The gold standard essentially was a commitment by
participating countries to fix the prices of their domes
tic currencies in terms of a specified amount of gold.
The countries maintained these fixed prices by being
willing to buy or sell gold to anyone at that price.
Thus, for example, from 1821 to 1914, Great Britain
maintained a fixed price of gold at £3, 17s, 10 l/2d;
the United States, over the 1834-1933 period, main
tained the price of gold at $20.67 per ounce (with
the exception of the Greenback era from 1861 to
1878).

Why Gold?
Gold has the desirable properties of money that
early writers in economics have stressed. It is durable,
easily recognizable, storable, portable, divisible and
easily standardized. Especially important, changes in
its stock are limited, at least in the short run, by high
costs of production, making it costly for governments
to 1878, and has been on one since 1971. Under such a stand
ard, monetary authorities have complete control over the
domestic money supply. An alternative situation, often char
acterized as “managed” money, occurs when monetary author
ities, though committed to maintaining a fixed price of gold,
engage in a systematic policy of sterilizing (or neutralizing)
the influence of gold flows on the domestic money supply by
using offsetting open market operations. Although the United
States was still on the gold standard, the period from 1914
to 1933 in U.S. monetary history can thus be viewed as a
period of “managed” money because of the frequent sterilizing
activity of the Federal Reserve System. See Milton Friedman
and Anna Jacobson Schwartz, A Monetary History o f the
United States 1867-1960 (Princeton University Press, 1963).

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

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1981

to manipulate.4 Because of these physical attributes,
it emerged as one of the earliest forms of money.

tunity cost of producing an additional unit of gold
money.

More important, gold was a com m odity money, and
a commodity money standard, regardless of the com
modity involved, has a very desirable property: it en
sures through the operation of the competitive market
a tendency toward long-run price stability.5 Under a
commodity money standard, the purchasing power of
a unit of commodity money, or what it will buy in
terms of all other goods and services, will always
tend toward equality with its long-run cost of
production.

To see how this works, consider what happens when
a technological advance improves productivity in the
non-gold-producing sectors of the economy. This im
provement leads to a rise in real economic activity,
an increase in the demand for money (gold coins)
and, with an initially given stock of money, a fall in
the price level (a rise in the purchasing power of
gold money). The fall in the price level means that
gold producers will be earning economic profits.
These profits will encourage existing owners to in
crease production and new entrepreneurs to enter the
industry, resulting in an increase in gold production.7
At the same time, people will take gold previously
used for nonmonetary purposes and convert it to
monetary uses ( e.g., they will sell gold jewelry to the
government and have it coined). These forces will
increase the gold coin supply, reversing the initial
decline in the price level.8

The Gold Standard and a Closed Economy
Consider first the example of a closed economy —
one that does not trade with any other country — that
produces gold and uses only gold coins as money. In
this country, the government is commited to purchase
gold from the public on demand at a fixed price and
to convert it into gold coin. Similarly, the government
will sell gold to the public at the fixed price.6 The
price level ( the average of the prices of all goods and
services produced in the country) will be determined
by the equality of the quantity of gold coins de
manded and supplied.
The supply of gold coins is determined by the sup
ply of gold in the economy and by the amount of gold
used for nonmonetary purposes. The supply of gold in
the long run is determined by the opportunity cost of
producing gold — the cost in terms of foregone labor,
capital and other factors engaged in producing an ad
ditional unit of gold. The fraction of gold devoted to
nonmonetary uses is determined by the purchasing
power of gold in terms of all other commodities. The
demand for gold coins is determined by the commu
nity’s wealth, tastes and the opportunity cost of hold
ing money relative to other assets (the interest rate).
In the long run, competition in the gold-producing
industry ensures that the purchasing power of gold
money in terms of all other goods will equal the oppor
4Of course, in earlier times, governments have manipulated gold
by debasement, clipping, etc. Such practices, however, were
the exception. See Anna J. Schwartz, “Secular Price Change
in Historical Perspective,” Journal of Money, Credit and
Banking (February 1973, Part 2 ), pp. 243-69.
5For a lucid discussion of the theory of commodity money, see
Milton Friedman, “Commodity-Reserve Currency” in Milton
Friedman, Essays in Positive Economics (University of Chi
cago Press, 1953).
eIn actuality the buying and selling prices will differ, reflecting
the cost of certifying and minting coins. This difference is
referred to as brassage.

In a similar manner, increases in the price level,
caused, for example, by a gold discovery which in
creases the stock of gold and the supply of gold coins,
will, by reducing the purchasing power of gold money,
cause the community to shift gold from monetary to
nonmonetary uses, and will eventually reduce produc
tion in the gold-producing industries. Both factors
will tend to reduce the gold money supply and reverse
the initial rise in the price level. Thus, under a gold
standard, one would expect to observe long-run price
level stability, though it may take several years for a
declining or rising price level to be reversed.9

The Gold Standard and Open Economies
If, instead of a closed economy, we have a world
in which a number of countries are on a gold coin
"In addition, exploration for new sources of gold and attempts
to more efficiently mine existing sources will result.
8Also, rising prices will be accompanied by rising wages and
other costs, making gold mining a less profitable activity. This
analysis assumes constant costs; with increasing costs the pur
chasing power of gold will be higher and the price level
lower.
aThis analysis is static. In a dynamic context, growing real out
put will produce a tendency towards secular deflation unless
gold output expands at the same rate as real economic
activity. This will happen if the rate of technological advance
is the same in the gold-producing sectors of the economy as
in the rest of the economy or if the opening of new mines
proceeds apace with real growth. In a world characterized by
purely stochastic events such as major gold discoveries, the
price level will diverge from its long-run trend for a very
long time, giving the appearance of long-run price instability.
However, to the extent that gold discoveries are not random
events but occur in response to rises in the purchasing power
of gold, these extended periods of inflation and deflation are
part of the equilibrating process of a commodity standard.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

standard, a mechanism is introduced that ensures uni
form price movements across these countries.
Consider, for example, two countries that were on
the gold standard, the United States and the United
Kingdom. As mentioned above, each country fixed the
price of its currency in terms of gold — the United
States fixed the price of one ounce of gold at $20.67,
while the United Kingdom set it at £3, 17s, 10 l/2d.
Thus, the dollar/pound exchange rate was perfectly
determined. The fixed exchange rate of $4,867 per
pound was referred to as the par exchange rate.10
Under the gold standard fixed exchange rate sys
tem, disturbances in the price level in one country
would be wholly or in part offset by an automatic
balance-of-payments adjustment mechanism called the
price-specie-flow mechanism. Consider again the ex
ample where a technical advance in the United States
lowers the U.S. price level. The fall in U.S. prices
will result in lower prices of U.S. exports, which will
decline relative to the prices of imports, determined
largely by prices in the rest of the world. This change
in terms of trade (the ratio of export prices to import
prices) will cause foreigners to demand more U.S.
exports, and U.S. residents to demand fewer imports.
A U.S. balance-of-payments surplus will be created,
causing gold to flow into the United States from the
United Kingdom.11 The gold inflow will increase the
U.S. money supply, reversing the initial fall in prices.
At the same time, in the United Kingdom, the gold
outflow will reduce the U.K. money supply, thus re
ducing its price level. In final equilibrium, price levels
in both countries will be somewhat lower than they
were prior to the technical advance in the United
States. Thus, the operation of the price-specie-flow
mechanism served to keep prices in line across the
world.12
10The U.K. definition of an ounce of gold was 11/12 of the
U.S. definition. Actually, under the gold standard, the ex
change rate was never exactly fixed. It varied within a range
bounded by the gold points —the costs of transporting gold
between the United States and the United Kingdom. Thus, if
Americans reduced their demand for British goods and hence
for pounds to pay for them, the dollar price of the pound
would decline. When the dollar price of the pound declined
to, say, $4.80, it would pay to melt down English gold sov
ereigns into bullion, ship the bullion to the United States
and convert it into U.S. gold coins.
n In this simple example, the increased British demand for U.S.
goods lowers the pound to the gold export point. As a con
sequence, British importers convert pounds into bullion and
ship them to the United States, converting them to U.S. gold
dollars to pay for the American goods.
12An alternative to the balance-of-payments adjustment mecha
nism described above is called the Monetary Approach to the
Balance of Payments. See Harry G. Johnson, “The Monetary
Approach to Balance of Payments Theory” in Jacob A.
Frenkel and Harry G. Johnson, eds., The Monetary Approach
to the Balance of Payments (Allen and Unwin, 1976). Ac

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1981

In sum, the gold standard as a commodity money
standard provided a mechanism to ensure long-run
price level stability both for individual countries and
groups of countries. Each country had only to main
tain a fixed price of gold.

THE MANAGED GOLD STANDARD
The simple model of the gold standard just de
scribed was seldom followed in practice. The pure
gold coin standard had two features that caused most
countries to modify its operation: (1 ) very high re
source costs were required to maintain a full commod
ity money standard and (2 ) strict adherence to the
“iron discipline” of the gold standard required each
country to subsume its internal balance (domestic
price and real output stability) to its external balance
(balance-of-payments equilibrium). Thus, if a country
was running a balance-of-payments deficit, the “rules
of the game” required it to deflate the economy until
“purchasing power parity” was restored at the par ex
change rate.13 Such deflation leads to a reduction in
real output and employment. Consequently, a mean
ingful discussion of how the gold standard actually
operated before World War I requires a discussion of
the ways in which nations modified the gold standard
to economize on gold and to shield domestic economic
activity from external disturbances.

The Use of Fiduciary Money
As mentioned above, high resource costs are re
quired to maintain a full commodity money standard.
Discovering, mining and minting gold are costly ac
tivities.14 Consequently, as nations developed, they
evolved substitutes for pure commodity money. These
substitutes encompassed both government-provided
paper money (referred to as fiat money) and privately
cording to this approach, through the process of arbitrage —
the buying and selling of similar commodities in different
markets —the prices of all internationally traded goods, ex
ports, imports and close substitutes, will be the same around
the world expressed in similar currency units. Moreover, the
prices of domestic goods and services (non-traded goods) will
be kept in line with prices of internationally traded goods
by domestic arbitrage. Hence, instead of U.S. prices falling
first in response to an excess demand for money, and the
terms of trade subsequently changing, the excess demand for
money will be satisfied directly by the import of gold
(through a balance-of-payments surplus) with no change in
the terms of trade.
13Purchasing power parity is the ratio of the domestic country’s
price level (value of money) to that of its principal trading
partners.
'•Friedman estimated the cost of maintaining a full gold coin
standard for the United States in 1960 to be more than 2%
percent of GNP. See Milton Friedman, A Program for Mone
tary Stability (Fordham University Press, 1959).

MAY

F E D E R A L R E S E R V E B AN K O F ST. L O U IS

produced fiduciary money (bank notes and bank de
posits). As long as governments maintained a fixed
ratio of their notes to gold, and commercial banks
kept a fixed ratio of their liabilities to gold ( or to gov
ernment notes and gold), a gold standard could still
be sustained. This type of standard prevailed through
out the world before World War I.
One aspect of this “mixed” gold standard system
was that one unit of a country’s gold reserves could
support a multiple number of units of domestic money
(e.g., the U.S. ratio of money to the monetary gold
stock was 8.5 in the 1880-1913 period). This meant
that in the short run gold flows had powerful effects
on the domestic money supply, spending and prices.15

International Capital Flows
So far, the discussion abstracts from the role of
capital flows between countries. In the pre-World
War I gold standard era, most international trade was
financed by credit, the issuing of short-term claims in
the London money market.36 In addition, economic
projects in the less-developed economies were gener
ally financed by long-term loans from investors in
England, France and other advanced countries.17 The
influence of these capital flows significantly reduced
the burden of gold flows in the adjustment mechanism.
Consider the example of a gold discovery in a par
ticular country. The discovery would lead to a rise in
the domestic money supply, which both raises domes
tic price levels and reduces domestic interest rates in
the short run.18 The reduction in domestic interest
rates relative to interest rates in other countries would
induce investors to shift their funds to foreign money
markets. This produces a gold outflow, thereby reduc
ing the amount of adjustment required through
changes in the terms of trade. Also, to the extent that
short-term capital serves as a substitute for gold as
an international reserve asset, and domestic financial
intermediaries hold balances with correspondents
16It also meant that changes in the composition of the money
supply between high-powered money (gold coins and gov
ernment paper) and bank-provided money (notes and de
posits) could be a source of monetary instability.
16See Arthur I. Bloomfield, Short-Term Capital Movements
Under the Pre-1914 Gold Standard, Princeton Studies in
International Finance No. 11 (Princeton University, 1963).
17See Arthur I. Bloomfield, Patterns of Fluctuation in Interna
tional Investment before 1914, Princeton Studies in Interna
tional Finance No. 21 (Princeton University, 1988).
18This is the so-called liquidity effect. To induce the commu
nity to hold a larger fraction of its wealth in the form of
money rather than interest-bearing securities, the price of
securities must rise ( the interest rate must fall).

1981

abroad, smaller gold flows would be required to set
tle international payments imbalances.
Finally, consider the role of long-term capital move
ments. In the pre-World War I era, the real rate of
return on capital was higher in developing countries
such as the United States, Canada and Australia than
in European countries such as the United Kingdom
and France. As a consequence, British investors, for
example, invested heavily in American industries and
utilities by purchasing long-term securities. The de
mand by British investors for American securities
(other things equal) created an excess demand for
dollars at the par exchange rate ( or equivalently an ex
cess supply of pounds). The resulting gold inflow into
the United States raised the U.S. money supply, lead
ing to a rise in the U.S. price level. The resultant rise
in export prices relative to import prices led to an in
creased demand by U.S. residents for imports (prima
rily manufactured goods from the United Kingdom).
Thus, the transfer of capital resulted in a transfer of
real resources from the United Kingdom to the United
States. Indeed, in the pre-World War I era, it was
normal for a developing country such as the United
States to run a persistent balance-of-payments deficit
on current account (imports of goods and services
exceeding exports of goods and services), financed
primarily by long-term capital inflows.

The Role of Central Banks in the
Gold Standard
Under a strict gold standard, there is no need for
a central bank. What is required is a governmental
authority to maintain the fixed domestic currency
price of gold by buying and selling gold freely.19 In
deed, many countries on the gold standard prior to
World War I (e.g., the United States and Canada)
did not have central banks. Most European countries,
on the other hand, have had central banks that pre
dated the gold standard. These institutions, in most
cases, had evolved from large commercial banks that
served as bankers to the government (e.g., the Bank of
England, founded in 1697) into institutions serving
as lenders of last resort to the banking community.
Under the classical gold standard, central banks
were supposed to follow the rules of the game — to
speed up the adjustment of the domestic money sup
ply and price level to external gold flows. The classical
model of central bank behavior was the Bank of
England, which played by the rules over much of the
19However, a substantial gold reserve is required to do this
effectively.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

1870-1914 period.20 Whenever Great Britain faced a
balance-of-payments deficit and the Bank of England
saw its gold reserves declining, it raised “bank rate,”
the rate of interest at which it was willing to discount
money market paper. By causing other interest rates
to rise, the rise in bank rate was supposed to produce
a reduction in holdings of inventories and a curtail
ment of other investment expenditures. The reduction
in investment expenditures would then lead to a reduc
tion in overall domestic spending and a fall in the
price level. At the same time, the rise in bank rate
would stem any short-term capital outflow and attract
short-term funds from abroad.
For most other countries on the gold standard,
there is evidence that interest rates were never allowed
to rise enough to contract the domestic price level —
that these countries did not follow the rules of the
game.21 Also, many countries frequently followed
policies of sterilizing gold flows — attempting to neu
tralize the effects of gold flows on the domestic money
supply by open market purchases or sales of domestic
securities.22

Reserve Currencies and the Role of Sterling
An important addition to the gold standard story
is the role of key currencies.23 Many countries under
the pre-World War I gold standard held their inter
national reserves in gold and in the currencies of
several major countries. The center of the international
payments mechanism was England, with the Bank of
England maintaining its international reserves pri
marily in gold. Most other countries kept reserves in
the form of gold and sterling assets. Between 1900
20However, most other central banks apparently did not. See
Arthur I. Bloomfield, Monetary Policy under the International
Gold Standard: 1880-1914 (Federal Reserve Bank of New
York, 1959).
21Noted examples are France and Belgium. See P. B. Whale,
“The Working of the Pre-War Gold Standard,” Economica
(February 1937), pp. 18-32, and Bloomfield, Monetary
Policy under the International Gold Standard.
22Usually, gold outflows were offset by open market purchases
of domestic securities. For the U.S. experience, see Friedman
and Schwartz, A Monetary History of the United States.
For other countries see Bloomfield, Monetary Policy under
the International Gold Standard. Such behavior could not
persist, however, if a country wished to maintain its link
with gold, because if the disequilibrium producing the gold
flow were permanent (e.g., the domestic price level were
higher than world prices), then gold outflows would con
tinue until all of the country’s gold reserves were exhausted.
(In the case of an inflow, it would continue until the mone
tary base consisted entirely of gold.)
23Much of this discussion derives from Peter H. Lindert, Key
Currencies and Gold, 1900-1913, Princeton Studies in Inter
national Finance No. 24 (Princeton University, 1969).

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1981

and 1914, two other major European capitals also
served as reserve centers — Paris and Berlin, each of
which held reserves in gold, sterling and the other
country’s currency. Finally, a number of smaller Eu
ropean countries held reserves in the form of francs
and marks.
In addition, an elaborate network of short-term fi
nancial arrangements developed between private fi
nancial institutions centered in the London money
market. This network of reserve currencies and short
term international finance had two important results.
First, England (the Bank of England) could act as
an umpire (or manager) of the world gold standard
system without having to hold excessive gold re
serves.24 By altering its bank rate, the Bank of England
caused repercussions around the world.25
Second, much of the balance-of-payments adjust
ment mechanism in the pre-World War I period did
not require actual gold flows. Instead, the adjustment
consisted primarily of transfers of sterling and other
currency balances in the London, Paris, Berlin and
New York money markets.26 In addition, short-term
capital flows accommodated the balance-of-payments
adjustment mechanism in this period.27 Indeed, the
pre-World War I gold standard has often been de
scribed as a sterling standard.28
In sum, the gold standard that emerged before
World War I was very different from the pure gold
coin standard outlined earlier. Unlike the pure gold
coin standard, countries economized on the use of
gold both in their domestic money supplies and as a
means of settling international payments imbalances.
In addition, to avoid the iron discipline of the gold
standard, central banks in some countries did not fol
low the rules of the game, and some countries even
24Indeed, England’s total gold reserves in 1913 only accounted
for 9.5 percent of the world’s monetary gold stock while the
Bank of England’s holdings accounted for 3.6 percent. See
John Maynard Keynes, A Treatise on Money: 2, The Applied
Theory of Money, in Elizabeth Johnson and Donald Moggridge, eds., The Collected Writings of John Maynard Keynes,
vol. VI (Macmillan, 1971).
25It likely caused monetary crises in the United States in the
1838-43 period and 1873. See Peter Temin, The Jacksonian
Economy (W. W. Norton, 1969) and Friedman and
Schwartz, A Monetary History o f the United States.
2eAlso in the period after 1900, instead of gold actually being
transported between centers, the practice of “earmarking”
gold holdings in major centers gained importance.
27See Bloomfield, Short-Term Capital Movements.
28See Melchior Palyi, The Twilight of Gold, 1914 to 1936:
Myths and Realities (Henry Regnery Co., 1972) and David
Williams, “The Evolution of the Sterling System” in C. R.
Whitdesey and J. S. G. Wilson, eds., Essays in Money and
Banking in Honour of R. S. Sayers (Clarendon Press, 1968).

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

abandoned the gold standard periodically.29 The final
modification to the pure gold standard was the key
role played by the Bank of England as umpire to the
system. The result was a “managed gold standard,”
not the pure gold coin standard often extolled as the
best example of a commodity money system.

CHRONOLOGY OF THE GOLD
STANDARD: 1821-1971
This section briefly sketches the chronology of the
gold standard from the end of the Napoleonic Wars
to the collapse of Bretton Woods.

The Classical Gold Standard: 1821-1914
In the 18th century, England and most other coun
tries were on a bimetallic standard based primarily
on silver.30 When Great Britain restored specie pay
ments in 1821 after the Napoleonic War inflation
episode, the gold standard was restored. From 1821
to 1880, the gold standard steadily expanded as more
and more countries ceased using silver.31 By 1880, the
majority of countries in the world were on some form
of a gold standard.
The period from 1880 to 1914, known as the heyday
of the gold standard, was a remarkable period in
world economic history. It was characterized by rapid
economic growth, the free flow of labor and capital
across political borders, virtually free trade and, in
general, world peace. These external conditions,
coupled with the elaborate financial network centered
in London and the role of the Bank of England as
umpire to the system, are believed to be the sine qua
n on of the effective operation of th e gold standard.32
29Argentina and other Latin American countries, for example.
See Alec George Ford, The Gold Standard, 1880-1914,
Britain and Argentina (Clarendon Press, 1962).
30Under a bimetallic standard, each of two precious metals,
gold and silver, serves as legal tender, and the two metals
are kept by the mint in a fixed proportion to each other.
The relationship between the official exchange rate of gold
for silver and the market rate will determine whether either
one or both metals is used as money. For example in
1834, the United States raised the mint ratio of silver to
gold from 15:1 to 16:1, hence valuing silver slightly lower
relative to gold than the world market. As a result, little
silver was offered for coinage and the United States was in
effect on the gold standard. See Leland B. Yeager, Interna
tional Monetary Relations: Theory, History and Policy, 2nd
ed. (Harper and Row, 1976), p. 296.
31The switch from silver to gold reflected both changes in the
relative supplies of the two precious metals resulting from
the gold discoveries of the 1840s and ’50s and a growing
preference for the more precious metal as world real income
rose.
32See Palyi, The Twilight of Gold and Yeager, International
Monetary Relations.

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1981

The Gold Exchange Standard: 1925-31
The gold standard broke down during World War
I,33 was succeeded by a period of “managed fiduciary
money,” and was briefly reinstated from 1925 to 1931
as the Gold Exchange Standard. Under the Gold Ex
change Standard, countries could hold both gold and
dollars or pounds as reserves, except for the United
States and the United Kingdom, which held reserves
only in gold. In addition, most countries engaged in
active sterilization policies to protect their domestic
money supplies from gold flows.
The Gold Exchange Standard broke down in 1931
following Britain’s departure from gold in the face of
massive gold and capital flows and was again suc
ceeded by managed fiduciary money.

The Bretton Woods System: 1946-71
The Bretton Woods System was an attempt to re
turn to a modified gold standard using the U.S. dollar
as the world’s key reserve currency. All other coun
tries — except for the sterling bloc — settled their
international balances in dollars. The United States
fixed the price of gold at $35.00 per ounce, maintained
substantial gold reserves, and settled external accounts
with gold bullion payments and receipts.
In the post-World War II period, persistent U.S.
balance-of-payments deficits helped finance the re
covery of world trade from the aftermath of depres
sion and war. However, the steady growth in the use
of U.S. dollars as international reserves and persistent
U.S. deficits steadily reduced U.S. gold reserves and
the gold reserve ratio, reducing public confidence in
the ultimate ability of the United States to redeem its
currency in gold.34 This “confidence problem” coupled
with many nations’ aversion to paying both seigniorage
and an “inflation tax” to the United States in the post1965 period, led to the ultimate breakdown of the
Bretton Woods system in 1971.35 The U.S. decision
in 1971 to abandon pegging the price of gold was
the final demise of the gold standard.
33The United States alone remained on the gold standard, ex
cept for a brief embargo on gold exports from 1917 to 1919.
■
14See H. G. Johnson, “Theoretical Problems of the International
Monetary System,” in R. N. Cooper, ed., International
Finance (Penguin Books, 1971), pp. 304-34.
35Seigniorage here refers to the return earned by the U.S.
monetary authorities on the issue of outstanding paper money
liabilities. It is measured by the interest foregone by foreign
holders of U.S. money balances. The “inflation tax” refers to
the depreciation in real purchasing power of outstanding
money balances.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

M AY

1981

W h o le s a le Price In d e x , U n ite d K in g d o m
R a tio scale

THE RECORD OF THE
GOLD STANDARD
This section briefly examines the stability of the
price level and real output for th e U nited Kingdom
and the United States under both th e gold and man

aged fiduciary money standards. Charts 1 and 2 por
tray the behavior of the wholesale price index from
1800 to 1979 for both countries.
From 1797 to 1821, during and immediately follow
ing the Napoleonic Wars, the United Kingdom was on
a fiat (or paper) standard; it officially joined the gold
standard in 1821, maintaining a fixed price of gold un
til 1914. There is little change in the U.K. price level
comparing the first year of the gold standard, 1821, to
the last, but over the whole period there was a slight
downward trend in prices, declining on average by
0.4 percent per year. Within that approximate 100year span, however, periods of declining prices alter
nated with periods of rising prices, a pattern con
sistent with the commodity theory of money. Prices
fell until the mid-1840s, reflecting the pressure of
rising real incomes on the limited stock of gold.
Following the California and Australian gold discov
eries of the late 1840s and early 1850s, prices turned

around and kept rising until the late 1860s. This was
followed by a 25-year period of declining prices,
again reflecting both rising real income and expan
sion of the number of countries on the gold standard.
This deflation ended after technical advances in gold
processing and major gold discoveries in the late 1880s
and 1890s increased world gold supplies.
The United States followed a pattern similar to
the United Kingdom, experiencing a slight downward
trend in the price level with prices declining on aver
age by 0.14 percent per year from 1834-1913. The
country adopted the gold standard in 1834 (it had
been on silver for the preceding 35 years) and re
mained on it at the same price of gold until World
War I, with the exception of the Greenback episode
from 1861 to 1878.36 During that period, the country
abandoned the gold standard and prices increased
rapidly until 1866. To restore convertibility to gold,
prices had to fall sufficiently to restore the pre-war
purchasing power parity. This occurred in the rapid
deflation from 1869 to 1879.
The period since World War I has not been charac3eAlso to be excluded from the gold standard are the turbulent
years 1838-1843, during which specie payments were gen
erally suspended.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

MAY

1981

W h o le s a le Price In d e x , U n ite d States
R a tio scale
1972=100

G O LD S TAN D AR D A

G O LD S TAN D AR D i l l

1 8 3 4 -1 8 6 1

1 8 7 9 -1 9 3 3

Wholesale price Index

96 1900 0 4 08

56 6 0

761979

[J_ E xclu de s 1838-1843 w he n specie p a y m e n ts w e re s u s p e n d e d .
12 U n ite d States im p o s e s g o ld e x p o r t e m b a r g o fro m S e p te m b e r 1917 to June 19)9.
[3 B ro k e n lin e in d ic a te s y e a rs e x c lu d e d in c o m p u tin g tre n d .

terized by price stability except for the 1920s under
the Gold Exchange Standard, and the 1950s and early
1960s under the Bretton Woods System. Indeed, since
the end of the gold standard, price levels in both coun
tries have on average been rising. The U.K. price
level increased at an average annual rate of 3.81 per
cent from 1914 to 1979, while U.S. price level increased
by an average annual rate of 2.2 percent.
Charts 3 and 4 present further evidence on the
operation of a commodity money standard and on
the long-run price stabilizing character of the gold
standard.
Chart 3 compares the purchasing power of gold for
the world (measured by the ratio of an index of the
price of gold to the wholesale price index for the
United Kingdom) in relation to its trend with the
world monetary gold stock in relation to its trend over
the period 1821-1914.37
The purchasing power of gold index presented here
varies inversely with the wholesale price index pre
sented in chart 1. This inverse association is a reflec37The United Kingdom was chosen to represent the pre-1914
world because it was a large open economy with few trade
restrictions. Hence the wholesale price index would be domi
nated by internationally traded goods.

tion of the fixed price of gold over this period.38 The
trends of both series were rising over the whole pe
riod. The upward trend in the purchasing power of
gold series reflects a more rapid growth of world real
output and, hence, in the demand for monetary gold
than could be accommodated by growth in the world’s
monetary gold stock.
In comparing deviations from trend in the purchas
ing power of gold to that in the world monetary gold
stock, one would expect that deviations from trend in
the monetary gold stock would produce correspond
ing changes in the price level and, for a given nominal
price of gold, would inversely affect the purchasing
power of gold. A comparison reveals this negative
association, with deviations from trend in the world
monetary gold stock leading deviations from trend in
the purchasing power of gold.39
38Indeed, this inverse relationship prevailed virtually until the
late 1960s. Since the freeing of the price of gold in 1968,
the purchasing power of gold has varied directly with the
wholesale price index. This primarily reflects rising demand
for gold as a hedge against inflation, and increasing world
political and monetary instability.
39The highest statistically significant negative correlation in the
1821-1914 period occurred with deviations from trend in
the monetary gold stock leading deviations from trend in the
purchasing power of gold by two years. The correlation
coefficient, —
.644, was statistically significant at the 1 per
cent level.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

M AY

1981

M o n e ta r y G o ld Stock a n d Purchasing P o w e r o f G o ld In d e x , W o rld
R atio sea e
1 9 7 2 = 1 .0 0

R atio scale
M illio n s o f pounds

20 00

1000

Stock Li
S C A L E ^-

Trend monetary gold stock
s c a le )

1821

30 32

34 36

40 42

46 48

56 58

62 64

66 68

72 74

78 8 0

82 84

86 88

94 96 9 8 1 9 0 0 0 2 04 0 6

12 1914

11 B ro k e n lin e in d ic a te s in te r p o la te d d a ta .
__
[2 M e a s u re d b y th e r a tio o f a n in d e x o f th e p ric e o f g o ld to th e w h o le s a le p ric e in d e x fo r th e U n ite d K in g d o m .

In addition, according to the operation of a com
modity money standard, movements in the purchas
ing power of gold would be expected to precede
movements in the monetary gold stock — a rising
purchasing power of gold would induce both a shift
from nonmonetary to monetary uses of gold and in
creased gold production. Such a positive association
between deviations from trend of the two series is
observed.40 Thus the 1820s and ’30s were largely
characterized by the purchasing power of gold ex
ceeding its long-run trend. This was followed by a
rapid increase in the world monetary gold stock after
1848 as the output of the new California and Aus
tralian mines were added to the world’s stock. Sub
sequently, the purchasing power of gold declined
from its peak above trend in the mid-1850s and was
succeeded by a marked deceleration in the monetary
gold stock after 1860. The same pattern can be ob
served comparing the rise in the purchasing power of
40The highest statistically significant positive correlation in the
1821-1914 period occurred with deviations from trend in
the purchasing power of gold leading deviations from trend
in the world monetary gold stock by 25 years. The correla
tion was .436, statistically significant at the 1 percent level.

gold in the 1870s and ’80s with the subsequent in
crease in the monetary gold stock in the mid-1890s.
Chart 4 compares the U.S. purchasing power of
gold in relation to its trend with the U.S. monetary
gold stock in relation to its trend over the 1879-1914
gold standard period.41
In this period, the trends of the two series moved
in opposite directions. The declining trend in the pur
chasing power of gold series, reflecting more rapid
growth in the U.S. monetary gold stock than in real
output, was a consequence of two developments: the
accumulation of monetary gold from the rest of the
world early in the period following the resumption of
specie payments, and the effects of gold discoveries
in the 1890s.
As in chart 3, a negative association between
deviations from trend in the monetary gold stock and
41An important difference in comparing the behavior of the U.S.
monetary gold stock with that of the world is that short-run
movements in the U.S. series would reflect, in addition to
changes in gold production and shifts between monetary
and nonmonetary uses of gold, gold movements between the
United States and other countries.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

MAY

1981

C h art 4

M o n e ta r y G o ld Stock a n d Purchasing P o w e r o f G o ld In d e x , U n ite d States
Ratio Scale
M illio n s o f D o lla rs

Ratio Scale
M illio n s o f D ollars

2000

1000
900
800

Trend monetary gold

700
600

Monetary gold stock
500
400

300

200
R a tio scale
1 9 72= 1.00

R a tio scale
1 9 7 2 = 1.00

--------2.01
Purchasing power ol gold index

the purchasing power of gold is observed.42 Also,
similar to the evidence in chart 3, deviations in trend
in the purchasing power of gold preceded deviations
from trend in the monetary gold stock with a lead.43
Thus, declines in the purchasing power of gold from
1879 to 1882 preceded declines in the monetary
gold stock below trend in the late 1880s and early
1890s, w hile rises in th e purchasing pow er of gold

One important implication of the tendency for price
levels to revert toward a long-run stable value under
the gold standard was that it insured a measure of
predictability with respect to the value of money:
though prices would rise or fall for a few years, infla
tion or deflation would not persist.44 Such belief in
long-run price stability would encourage economic
agents to engage in contracts with the expectation

after 1882 can be associated with a rising monetary
gold stock after 1896. Finally, a declining purchas
ing power of gold in the mid-1890s can be associ
ated with a falling monetary gold stock after 1903.

significant at the 1 percent level. The considerably longer
lead observed over the 1821-1914 period in footnote 40
above likely reflects a longer adjustment period in the early
part of the 19th century.

42The highest statistically significant negative correlation in
the 1879-1914 period occurred with a contemporaneous
relationship between deviations from trend in the monetary
gold stock and deviations from trend in the purchasing power
of gold. The correlation coefficient, —
.656, was statistically
significant at the 1 percent level.
43The highest statistically significant positive correlation in the
1879-1914 period occurred with deviations from trend in
the purchasing power of gold leading deviations from trend
in the monetary gold stock by 14 years. The correlation
coefficient was .793, which was statistically significant at the
1 percent level.
The highest statistically significant positive correlation in
the 1879-1914 period occurred with deviations from trend
in the world purchasing power of gold leading deviations
from trend in the world monetary gold stock by 16 years.
The correlation coefficient was .863, which was statistically

44See Benjamin Klein, “Our New Monetary Standard: The
Measurement and Effects of Price Uncertainty, 1880-1973,”
Economic Inquiry (December 1975), pp. 461-84 for evidence
of long-run price stability for the United States under the
gold standard. His evidence that positive (negative) auto
correlations of the price level are succeeded by negative
(positive) autocorrelations is consistent with the hypothesis
that the price level reverted back to its mean level. A con
sequence of this mean reversion phenomenon was that yearto-year changes in the price level were substantial for each
country. However, the standard deviations of year-to-year
changes in the wholesale price index were still considerably
lower in the pre-World War I gold standard era compared
with the post-World War I managed fiduciary money era. For
the United Kingdom, the standard deviations were: 1821-1913,
6.20; 1919-79 (excluding 1939-45), 12.00. For the United
States, the standard deviations were: 1834-1913 (excluding
1838-43 and 1861-78), 6.29; 1919-79 (excluding 1941-45),
9.28.

F E D E R A L R E S E R V E BAN K O F ST. LO U IS

MAY

1981

C h a rt 5

R e a l Per C a p ita Inco m e, U n ite d K in g d o m

that, should prices of commodities or factors of pro
duction change, the change would reflect real forces
rather than changes in the value of money.
Belief in long-term price level stability has appar
ently disappeared in recent years, as people now
realize that the long-run constraint of the gold stand
ard has vanished.45 As a consequence, it is more diffi
cult for people to distinguish between changes in
relative prices and changes in the price level. Such
absolute vs. relative price confusion has increased the
possibility of major economic losses as people fail to
respond to market signals.46
Finally, evidence on real output stability for the
United Kingdom and the United States is presented.
It is frequently argued that under the gold standard,
45Indeed, evidence presented by Klein, “Our New Monetary
Standard,” shows a marked decline since 1960 in long-term
price level predictability, the belief about long-term price be
havior (measured by a moving standard deviation of changes
in the price level). At the same time, short-term price level
predictability, the belief about price level behavior in the
near future, has improved in the post-war period.
46See Friedrich August von Hayek, A Tiger by the Tail, Hobart
Papers (Institute of Economic Affairs, 1972); Milton Fried
man, “Nobel Lecture: Inflation and Unemployment,” Journal
of Political Economy (June 1977), pp. 451-72; and Axel
Leijonhuvud, “Costs and Consequences of Inflation,” in
Axel Leijonhuvud, Information and Co-ordination: Essays in
Macro Economic Theory (Oxford University Press, 1981).

when countries had to subordinate internal balance
considerations to the gold standard’s iron discipline,
real output would be less stable than under a regime
of managed fiduciary money. Charts 5 and 6 show
the deviations of real per capita income from its longrun trend over the period 1870 to 1979.
For the United Kingdom, chart 5 shows both a
single trend line for the 1870-1979 period and
separate trend fines for each of the pre- and postWorld War I subperiods. The U.K. data was split into
two subperiods because the trend line for the entire
period results in real output after 1919 being virtually
always below trend. This suggests that World War I
permanently altered the trend growth rate of real
per capita income in the United Kingdom and, hence,
the two periods should be handled separately. Exam
ining the deviations from trend (using the subperiod
trends) suggests that real per capita income was less
variable in the pre-World War I period than subse
quently. The mean absolute value of the percentage
deviations of real per capita income from trend was
2.14 percent from 1870-1913 and 3.75 percent from
1919-79 (excluding 1939-45).
As in the U.K. case, U.S. real per capita income
was more stable under the gold standard from 1879
to 1913 compared with the entire post-World War I

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

MAY 1 9 8 1

C ha rt 6

R e a l Per C a p ita Inco m e, U n ite d States
Ratio scale
Ratio scale
1972 D o lla rs
1972 D ollars
7 0 0 0 --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------17 0 0 0

5000

4000

3000

Trend real per capita income

2000

1000

111111 i i ; 11111111111n 1111111 n 11111111111 n n 1111111111111111 ii 1111 i 1111111111111111111111111111 in it

80
0

! 80 82 84 86 88 9 0 92 94 96 981900 02 04 0 6 0 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 4 0 42 4 4 46 4 8 50 52 54 56 58 60 62 64 66 68 70 72 74 76 1979

period. The mean absolute values of the percentage
deviations of real per capita income from trend were:
6.64 percent from 1879-1913 and 8.97 percent from
1919-79 (excluding 1941-45).
Moreover, unemployment was on average lower in
the pre-1914 period in both countries than in the postWorld War I period. For the United Kingdom, the
average unemployment rate over the 1888-1913 pe
riod was 4.30 percent, while over the period 191979 (excluding 1939-45) it was 6.52 percent. For the
United States, average unemployment rates by sub
period were: 1890-1913, 6.78 percent and 1919-79
(excluding 1941-45), 7.46 percent.
Thus, the evidence suggests that the managed fi
duciary money system superceding the gold standard
generally has been associated with less real economic
stability.

crucial in determining what we might expect should
we return to some form of commodity standard.
One dominant feature of that period was long-run
price stability. This contrasts favorably with the be
havior of the price level under the managed fiduciary
money standard for much of the period since World
War I. Also, though real output varied considerably
from year to year under the gold standard, it did not
vary discemibly more than it has in the entire period
since the first world war.47
One problem with comparing the pre-World War I
gold standard to the managed fiduciary money stand
ard after World War I is that the latter period in
cludes the turbulent interwar years, a period that may
bias the case against managed fiduciary money. To
account for this, table 1 compares several measures of
performance of the price level, real output and money
growth for three time periods: the pre-World War I

THE CASE FOR A RETURN TO GOLD
The pre-World War I gold standard was the closest
thing to a worldwide commodity money standard.
Hence, an examination of the record for that period is

47The standard deviations of year-to-year percentage changes in
real per capita income for the United States were: 1879-1913,
5.79; 1919-79 (excluding 1941-45), 6.34. For the United
Kingdom: 1870-1913, 2.62; 1919-79 (excluding 1939-45),
3.24.

F E D E R A L R E S E R V E BANK O F ST. LO U IS

MAY

1981

Table 1
A Comparison of the Behavior of Price Level, Real Output and Money Growth in
the United Kingdom and the United States
The Gold Standard1

The Interwar Period

U.K.

U.S.

U.K.

U.S.

U.K.

U.S.

1870-1913
(1821-1913)

1879-1913
(1834-1913)

1919-38

1919-40

1946-79

0.1%
(-0 .1 )

-4.6%

-2.5%

5.6%

2.8%

-3.8

-5.2

1.2

1.3

4.9

5.6

1.4

1.6

13.3%

11.3%

2.5%

6.0%

(1 ) The average annual percentage
change in the price level
(2 ) The coefficient of variation
of annual percentage changes
in the price level (ratio)

-0.7%
(-0 .4 )
-14.9
(-16 .3 )

17.0
(6.5)

Post-World War II

(3 ) The coefficient of variation
of annual percentage changes
In real per capita income
(ratio)

2.5

3.5

(4 ) The average level of the
unemployment rate

4.3% 2

6.8% 3

(5 ) The average annual percentage
change in the money supply

1.5%

6.1%

0.9%

1.5%

5.9%

5.7%

(6 ) The coefficient of variation of
annual percentage changes in
the money supply (ratio)

1.6

0.8

3.6

2.4

1.0

0.5

Notes: Rows 1 and 5 calculated as the time coefficient from a regression of the log of the variable on a time trend.
Rows 2, 3 and 6 calculated as the ratio of the standard deviation of annual percentage changes to their mean.
•Data for the longer periods (in parentheses) were available only for the price level. Years 1838-43 and 1861-78 were ex
cluded for the United States.
21888-1913
31890-1913
Data Sources: See data appendix

gold standard period, the interwar period and the
post-World War II period.48
First, row 1 presents evidence on long-run price
level stability as measured by the average annual rate
of change in the price level over the period. As can
be observed, the interwar period in both countries
was characterized by substantial deflation in both the
48In this comparison, both World Wars are omitted. This was
done for two reasons. First, both wars were accompanied by
rapid inflation in both countries, and in each case wartime
government expenditures were largely financed by the issue
of government fiat money. Hence, a comparison of the pricestabilizing characteristics of the two monetary standards —in
cluding two major wars in the case of the managed fiduciary
money standard and none in the gold standard —would bias
the case against the fonner. Second, measured real output
would tend to be higher than otherwise in wartime to the
extent that resources (both employed and otherwise unem
ployed) are devoted to (nonproductive) wartime use. Hence,
including wartime real output would bias the case in favor of
managed fiduciary money.

United States and the United Kingdom, while the
post-World War II period has been characterized by
inflation. This performance is in marked contrast to
the near price stability of the gold standard period.
However, price variability, measured in row 2 by the
coefficient of variation of percentage year-to-year
changes in the price level, reveals a slightly different
picture. Prices were more variable under the gold
standard than in both post-gold-standard periods, with
the least variability occurring in the post-World War
II period.
Second, row 3 presents evidence on real output sta
bility as measured by the coefficient of variation of
year-to-year percentage changes in real per capita
output. Real output was considerably less stable in
both countries in the interwar period than in either
the gold standard or the post-World War II period,

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

with the latter period having the best record. In addi
tion, the evidence on average unemployment rates in
row 4 agrees with the evidence on real output stabil
ity: unemployment was by far the highest in the
interwar period and by far the lowest in the postWorld War II period in both countries.49
Finally, a comparison is made across periods in the
average annual rate of monetary growth in row 5, and
in the variability in monetary growth measured by the
coefficient of variation of percentage year-to-year
changes in the money supply in row 6. According to
monetary theory, a reduction in monetary growth be
low the long-run trend of real output growth will
produce deflation, while a rise in monetary growth
above the long-run trend of real output growth will
lead to inflation. In the transition between different
rates of monetary growth, both the levels and growth
rates of real output will deviate considerably from
long-run trend. Thus monetary variability will lead to
real output variability.50
The rate of monetary growth was lower in both
countries in the interwar period than in both the postWorld War II and the gold standard periods. In the
case of the United Kingdom, the post-World War II
period exhibits more rapid monetary growth than un
der the gold standard, while for the United States,
monetary growth rates are similar in both the post
war and gold standard periods.
Finally, monetary growth was more variable in both
countries in the interwar period than in the other two
periods, with the post-World War II period display
ing the least variability in monetary growth.
The poor economic performance of the interwar pe
riod compared with either the preceding gold standard
period or the post-World War II period has been
attributed to the failure of monetary policy. Indeed,
the attempt by the Bank of England to restore con
vertibility to gold at the pre-war parity has often
been characterized as the reason for British deflation
49A comparison between the two unemployment rates and the
measures of real output stability reveals an interesting dif
ference. Real output was less stable in the United States, but
unemployment was higher in the United Kingdom. One ex
planation offered for the high and persistent unemployment
in the United Kingdom in the interwar period is that it was
caused by significant increases in the ratio of unemployment
benefits to wages. See Daniel K. Benjamin and Levis A.
Kochin, “Searching for an Explanation of Unemployment in
Interwar Britain,” Journal of Political Economy (June 1979),
pp. 441-78.
50See Milton Friedman, A Theoretical Framework for Monetary
Analysis, Occasional Paper No. 112 (National Bureau of Eco
nomic Research, 1971).

MAY

1981

and unemployment in the 1920s.51 Likewise, the fail
ure of the Federal Reserve System to prevent the dras
tic decline which occurred in the U.S. money supply
from 1929 to 1933 has been blamed for the severity of
the Great Depression in the United States.52 One could
well argue that the greatly improved performance of
monetary policy and economic stability in the two
countries in the post-World War II period reflects
learning from past mistakes. This suggests that in
considering the case for a return to the gold standard,
a meaningful comparison should really be made be
tween the post-World War II period and the gold
standard. In such a comparison, the gold standard
provided us with greater long-run price stability, but
at the expense of both short-run real output and price
stability. The higher rates of inflation and lower vari
ability of real output (and lower unemployment) in
the two countries in the recent period likely reflects
changing policy preferences away from long-run price
stability and toward full employment. Indeed, the
strong commitment to full employment in both coun
tries likely explains the worsening of inflation in the
post-war period.53
In assessing the case for a U.S. return to a gold
standard, the benefits of such a policy must be
weighed against the costs. The key benefit of a return
to a gold standard would be long-run price stability.
The costs, however, are not inconsiderable. A com
modity money standard such as the gold standard
involves significant economic costs: (1 ) the resource
costs of maintaining the standard and (2 ) the shortrun instability of both the price level and real output
that would accompany the adjustment of the com
modity to changing supply and demand conditions.
Moreover, the history of the pre-World War I gold
standard suggests that it worked because it was a
“managed” international standard. In addition, the
concentration of world capital and money markets in
London and the use of sterling as a key currency
enabled the system to function smoothly with limited
gold reserves and to withstand a number of severe
external shocks. Perhaps of paramount importance for
the successful operation of the managed gold standard
51See John Maynard Keynes, “The Economic Consequences of
Mr. Churchill,” in Johnson and Moggridge, eds., Collected
Works of John Maynard Keynes, vol. IX (1972).
52See Friedman and Schwartz, A Monetary History of the
United States.
53Friedman forcefully argued this point in his 1968 presidential
address to the American Economic Association. See Milton
Friedman, “The Role of Monetary Policy,” The American
Economic Review (March 1968), pp. 1-17.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

was the tacit cooperation of the major participants in
(ultimately) maintaining the gold standard link and
its corollary, long-run price stability, as the primary
goal of economic policy.54 This suggests that one
country alone on the gold standard would likely find
its monetary gold stock and hence its money supply
54Other conditions amenable to the successful operation of the
gold standard were the free mobility of labor and capital, the
absence of exchange controls and the absence of any major
wars.

MAY

1981

subject to persistent shocks from factors beyond its
control.
A fiduciary money standard based on a monetary
rule of a steady and known rate of monetary growth
could provide both greater price level and real output
stability than a return to the gold standard. The key
problem with a fiduciary system, however, is to ensure
that such a rule is maintained and that a commitment
be made to the goal of long-run price stability.

Data Appendix
Chart 1

Chart 3

United Kingdom

World

1. Wholesale Prices 1800-1979. (1972 = 100). Data for
1800-1938 and 1946-1975 from Roy W. Jastram, T he
G olden Constant (John Wiley and Sons, New York,
1 9 7 7 ), Table 2, pp. 32-33; 1939-1945 from B. R.
Mitchell, E uropean H istorical Statistics 1750-1970
(Columbia University Press, New York, 1975), Table
I I , p. 739; 1976-78 Central Statistical Office, E conom ic
Trends Annual Supplem ent 1980 E dition (Her Majes
ty’s Stationery Office, London, 1979), p. 112, series:
Wholesale Prices for All Manufactured Products, 1976
figure used was an average of the CSO 1976 value and
Jastram’s 1976 value; 1979 from CSO, Monthly Digest
o f Statistics (Her Majesty’s Stationery Office, London,
Nov. 1980), p. 159, series: same as 1976-78.

1. United Kingdom Purchasing Power of Cold 1821-1914.
(1972 = 1.0 0 ). 1821-1914 from Roy W. Jastram, T he
G olden Constant (John Wiley and Sons, New York,
1977), Table 3, pp. 36-37.
2. World Monetary Cold Stock 1821-1914. Data for 182138 represent interpolation between values for 1807,
1833 and 1839. These values, along with the 18391914 values, from League of Nations, Interim R eport
o f th e G old D elegation and R eport o f th e G old D ele
gation (Amo Press, New York, 1 9 7 8 ), Table B, col.
( 1 ) , series: Monetary Stock of Gold, end of year,
millions of pounds at 84s llVfed per fine oz.

Chart 4
Chart 2

United States

1. Purchasing Power of Cold 1879-1914. (1972 = 1.00).
Data for 1879-1914 from Roy W. Jastram, T h e G olden
Constant (John Wiley and Sons, New York, 1 9 7 7 ),
Table 8, pp. 147-48.

1. Wholesale Prices 1800-1979. (1972 = 100). Data for
1800-1975 from Roy W. Jastram, T he G olden Constant
(John Wiley and Sons, New York, 1977), Table 7,
pp. 145-46; 1976 from U.S. Dept, of Labor, Bureau of
Labor Statistics, W holesale Prices an d Indexes S upple
m ent 1977 (1 9 7 7 ), Table 4, series: All Commodities;
1977 from Dept, of Labor, BLS, Monthly L a b o r Review
(April 1978), Table 26, series: All Commodities; 1978
from M onthly L ab or Review (April 1979), Table 27,
series: All Commodities; 1979 from Dept, of Labor,
BLS, Supplem ent to P roducer Prices an d Price Indexes
D ata fo r 1979 (1980), Table 4, series: All Commodities.

2. Monetary Gold Stock 1879-1914. Data for 1879-1914
from Phillip Cagan, D eterm inants an d E ffects o f
C hanges in th e S tock o f M oney 1875-1960 (Columbia
University Press, New York, 1 9 6 5 ), Appendix F , Table
F -7, col. ( 1 ) , current par value = $20.67 per oz.
Cagan’s sources include the following: 1879-1907,
Annual R eport, Mint, 1907; 1908-1913, Circulation
Statem ent o f U nited States M oney; 1914, Banking and
M onetary Statistics, FR B , 1941.

MAY

F E D E R A L R E S E R V E BANK O F ST. L O U IS

1981

Chart 5

(1 9 6 0 ). This series was then adjusted in the following
way:

United Kingdom

[Y/(P X N ) ] t = exp [ln (F St) + (In (SC B 1950) ln (F S 1950) ) ], t = 1 8 7 0 ,. . 1949

1. Real Per Capita Income 1870-1979. (1972 pounds).
(a ) Nominal Income 1870-1979. Data for 1870-1975
from Milton Friedman and Anna J. Schwartz,
forthcoming Monetary Trends in the United States

and the United Kingdom: Their Relation to In
come, Prices, and Interest Rates 1867-1975, Na
tional Bureau of Economic Research, Chapter 4,
Table 4-A-2, col. ( 2 ). Nominal income for 197679 computed as GNP at factor cost less consump
tion of fixed capital. 1976-78 GNP at factor cost
from CSO, Economic Trends Annual Supplement
1980 Edition, Table 36, col. ( 2 ) ; 1979 GNP at
factor cost from CSO, Monthly Digest of Statistics
(Jan. 1981), Table 1.2, col. ( 2 ). 1976-79 Con
sumption of fixed capital from O ECD , National
Accounts of OECD Countries (Paris, 1981), Vol.
1, p. 70, series # 3 6 : Consumption of the Fixed
Capital.

(b) Implicit Price Deflator

1870-1979. (1972 = 100).
Data for 1870-1975 from Friedman and Schwartz,
Monetary Trends, Chapter 4, Table 4-A-2, col.
( 4 ) ; 1976-79 from International Monetary Fund,
International Financial Statistics (Jan. 1981), p.
404; deflator calculated as P = 100 X (nominal
GDP/real G D P ), real and nominal GDP appear
ing in IFS.

(c ) Population 1870-1979. Data for 1870-1965 from
C. Feinstein, National Income, Expenditure and
Output of the United Kingdom, 1855-1965, Table
44, col. ( 1 ) ; 1966-75 from CSO, Annual Statistical
Abstract; 1976-79 from CSO, Monthly Digest of
Statistics (Nov. 1980), p. 16.

Chart 6
United States
1. Real Per Capita Income 1870-1979. (1972 dollars).
This series is the result of splicing together two series,
the earlier based upon data from Friedman and
Schwartz, Monetary Trends and the later based upon
data from U.S. Dept, of Commerce, Survey of Current

where F S t = Friedman-Schwartz value of real per
capita income in time t and SCBt = Survey of Current
Business value in time t. The adjusted series was then
joined to the 1950-1979 series computed from the
following data in the Survey of Current Business:
nominal NNP, average of quarterly figures, seasonally
adjusted and NNP implicit price deflator, average of
quarterly figures, 1972 = 100; population data (resi
dent population less armed forces, average of monthly
figures) from U.S. Dept, of Commerce, Bureau of the
Census.

Other Data Used
1. U.S. Unemployment Rates 1890-1979. Data for 18901900 from Stanley Lebergott, “Changes in Unemploy
ment 1800-1960,” in Robert W. Fogel and Stanley L.
Engerman, eds., The Reinterpretation of American
Economic History (Harper & Row, New York, 1 971),
p. 80, Table 1; 1901-57 from Dept, of Commerce,
Bureau of the Census, Historical Statistics of the United
States (1 9 6 0 ), series D -47; 1958 from Dept, of Labor,
BLS, Monthly Labor Review Statistical Supplement
(1 9 5 9 ), Table 1-1; 1959-62 from MLR Statistical Sup
plement (1 9 6 2 ), Table 1-1, p. 1; 1963 from MLR
Statistical Supplement (1 9 6 3 ), Table 1-1; 1964-79
from Dept, of Labor, BLS, Monthly Labor Review
(Jan. 1 9 8 1 ), Table 1.
2. Great Britain Unemployment Rates 1888-1979. Data
for 1888-1966 from B. R. Mitchell, European Histori
cal Statistics 1750-1970 (Columbia University Press,
19 7 5 ), Table C2, series: U K :G B; 1967-72 from
CSO, Monthly Digest of Statistics (March 1973),
Table 21, series: Percent unemployed of total employ
ees for Great Britain; 1973-77 from same publication
as for 1967-72 (Oct. 1 9 7 8 ), Table 3.9, series: same as
that for 1967-72; 1978-1979 from same publication as
1967-72 (Nov. 1 9 8 0 ), Table 3.10, series: same as that
for 1967-72.

Business.

3. U.S. Money Supply 1879-1979. Data for 1879-1975
from Friedman and Schwartz, Monetary Trends, Chap
ter 4, Table 4-A -l, col. ( 1 ) ; 1976-1979 from Board of
Governors of the Federal Reserve System, Statistical
Release: Money Stock Measures, H.6, series M2, annual
average of monthly figures, seasonally adjusted.

For 1870-1949, a real per capita income series was
computed using the following data: nominal income,
Friedman and Schwartz, Monetary Trends, Chapter 4,
Table 4-A -l, col. ( 2 ) ; implicit price deflator, 1972 =
100, Chapter 4, Table 4-A -l, col. ( 1 ) ; population,
U.S. Department of Commerce, Historical Statistics

4. U.K. Money Supply 1870-1979. Data for 1870-1975
from Friedman and Schwartz, Monetary Trends, Chap
ter 4, Table 4-A-2, col. ( 1 ) ; 1976-79 from CSO, Fi
nancial Statistics (Her Majesty’s Stationery Office, Lon
don, Nov. 1 9 8 0 ), p. 144, series: M3, not seasonally
adjusted, end of second quarter.

We Are All Supply-Siders Now!
JOHN A. TATOM

A H E latest sensation in the popular press and
among policymakers is the discovery of “supply-side
economics” and the exciting promise of supply-side
policies.1 To provide a perspective on the current de
bate, this article reviews the conceptual basis for sup
ply-side economics and examines the fundamentals of
supply performance in the United States.

WHAT IS SUPPLY-SIDE ECONOMICS
ALL ABOUT?
Supply-side economics is growth- and efficiencyoriented. It covers the entire range of economic de
cisions : what gets produced, how, for whom, and how
fast production and consumption possibilities expand.
The supply-side approach is not novel in economic
analysis. Indeed, it has been the core of economic
analysis since the first systematic analysis of scarcity
and aggregate supply, Adam Smith’s pioneering In
quiry into the Nature and Causes of the W ealth o f
Nations, was published over 200 years ago.2
The recent emphasis on supply is novel, however,
in at least one respect — the assertion that supply
!One of the first major policymaking endorsements of supplyside economics is contained in Outlook for the 1980’s, Midyear
Report and Staff Study of the Joint Economic Committee of
the Congress (August 1979).
2For an historical perspective on supply-side economics, see
Robert E. Keleher and William P. Orzechowski, “Supply-Side
Effects of Fiscal Policy: Some Historical Perspectives,” re
viewed in the Federal Reserve Bank of Atlanta Economic Re
view (February 1981), pp. 26-28.
Digitized for18
FRASER

effects are of central importance in evaluating gov
ernment efforts to improve the functioning of the
economy. The conventional view of the functioning of
the economy emphasizes a role for the management
of aggregate demand as an appropriate macroeco
nomic policy for stabilizing the economy. The normal
tools for influencing aggregate demand are mone
tary and fiscal policy, including spending for goods
and services, transfer programs and taxation policies.
By influencing demand for output, such policies are
presumed to affect the levels of the nation’s output,
employment and prices, as well as their rates of
change. Expanding the growth of the money stock
or government expenditures for goods, services or
transfer programs is viewed as “expansionary” in its
effects on output and employment. Supply-siders
reject such arguments as woefully incomplete. They
emphasize that standard expansionary macroeconomic
policies can significantly redu ce the economy’s ability
to produce. In particular, they stress that individual
choices affect the current and future availability of
resources, as well as the efficiency of resource employ
ment, effects that often are ignored in both macroeconomic analysis and policy decisions.
The supply-side view can be explained using a
simple introductory economics framework. Suppose an
economy has a given quantity of resources such as
labor and capital (plant, equipment, knowledge, etc.)
and an existing array of technologies for producing two
goods called product X and product Y. At any time,
resources can be completely devoted to the production
of one or the other good, or both. If resources are

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

MAY

F ig u re 1

f ig u r e 2

A Simple Production Possibility Frontier

1981

A Shift in the Production Possibility Frontier

Q u a n tity o f

p e r u n it
o f tim e

used so that the largest production of X is obtained,
for any given output of product Y, the production and
consumption possibilities of the economy can be de
picted as the curve AB in figure 1. Combinations of
product X and Y output beyond AB ( such as point C )
are unattainable, given the technology and resources
available, while those inside the curve (such as point
D ) are possible, but involve either unemployed re
sources, the use of inferior technologies, or both.
Given individual preferences and the distribution of
resource ownership among individuals, an economy
with free markets will tend to attain some equilibrium
point ( E ) , where the value of goods reflects the cost
of production and where full employment of existing
resources occurs. Competition among resource owners,
the producers of the two goods and consumers will de
termine the prices of the products and resources, how
much of each of the goods are produced, which of the
available resources and technologies are used to pro
duce each good, the incomes of individuals, and the
distribution of goods produced among individuals.
An economy can improve its possibilities for con
sumption by shifting out its production possibility
frontier (AB in figure 1). This occurs when the
supply of labor or capital resources is increased or
when technology is improved. Thus, individuals make
choices that determine the rate of growth of income
or the supply of goods producible under high-employment conditions. These choices involve foregoing pres

ent consumption so that resources can be used for
research and development, innovation or the produc
tion of new capital goods. Figure 2 shows such a
shift in production (and consumption) possibilities.
When the production possibility frontier shifts from
AB to A'B', individuals choose the opportunity to con
sume an output mix such as E'.
Supply-side economics focuses on two aspects of
the simple framework above: first, that economic
policy directly affects the rate of growth of resource
supplies and the pattern of innovation, impinging on
the rate at which the economy’s production possibili
ties improve; second, that economic policy can alter
the position of the current production possibility
frontier.3

Supply-Side Effects of Regulation
Economic policies to regulate business can affect
supply. In a market economy, the government can
promote efficiency by regulating efforts to achieve mo
nopoly control in resource or product markets. Such
regulatory policies can also promote faster output
growth by policing business practices that limit com
petition, technological development and innovation.
3A detailed discussion of the supply-side approach to macro
economic policy may be found in Laurence H. Meyer, ed.,
The Supply-Side Effects of Economic Policy (Center for the
Study of American Business and the Federal Reserve Bank of
St. Louis, 1981).

FEDERAL. R E S E R V E BANK O F ST. L O U IS

Regulatory policies can adversely affect consump
tion possibilities, however. Regulatory programs that
mandate the use of inefficient technologies or that
restrict the use of resources in some or all production
processes cause the production possibility frontier to
shift inward (for example, from A 'B' to AB in figure
2 ). Such regulations can slow the rate of growth by
retarding technological innovation or by reducing
incentives to accumulate resources or improve their
quality.

Supply-Side Effects of Government Spending
The decision to provide more of one good through
government provision involves attracting resources
away from the production of other goods (a move
ment along the production possibility frontier). Supply-siders emphasize, however, that the increased
taxes levied to pay for the new goods can reduce the
total resources available, shifting the frontier inward.
Suppose the economy is initially producing and con
suming at point E ' in figure 2. An attempt by the
government to increase the output of good X, moving
along the frontier A'B', can lead to fewer available
resources so that (1 ) the frontier shifts inward to a
new frontier such as AB, and (2 ) production occurs at
a point like C. The shift occurs because owners of
human resources can forego supplying these resources
in the marketplace, choosing instead to use labor re
sources at home or in leisure when confronted with
larger taxes on labor income. Similarly, owners of
capital resources can avoid taxes by reducing the use
of existing plant and equipment, lengthening the use
ful life of assets, and spending the proceeds from
current use of capital services on consumer goods
instead of replacing the plant and equipment or in
vesting in new assets. In the case of taxation of income
of capital resources, the effects on the production pos
sibility frontier tend to show up more heavily in the
future through reduced growth of resources, rather
than in immediate inward shifts of the frontier.
Taxation can also give rise to other forms of tax
avoidance that shift die frontier inward. When taxes
on resource incomes are different depending on the
use of the resources, resource owners may continue
supplying resources in the marketplace, but divert
these resources to lower-taxed, less-efficient uses.
While this lowers the total productivity of the re
sources, the after-tax incomes are larger than they
would have been if resources were used in the high-tax
sectors. Such t£tx avoidance leads to an inward shift of
the frontier, even if the total supplies of resources
remain the same.

MAY

1981

Supply-Side Effects of Redistribution
Similarly, an economic policy aimed at changing
the distribution of consumption goods among indi
viduals can affect supply. A program that taxes in
come recipients in order to transfer existing output
to particular groups can reduce the total consumption
possibilities of the community. For example, increased
unemployment benefits, food stamps and social secu
rity benefits involve increased transfers and taxes.
Higher taxes can reduce the supply of resources avail
able both now and in the future; in addition, higher
transfer payments reduce some individuals’ incentives
to accumulate and supply resources in the market
place. Both the programs and the higher taxes to sup
port them can reduce resource supplies.4 Reductions
in resource employment reduce output. Government
policies to transfer more of the goods produced at
point E in figure 1 to a particular group can shift the
overall production and consumption possibilities of
the economy inward, as the higher taxes to pay for
the redistributed goods and the increased availability
of transfer payments reduce the total resources avail
able for use in production.
Supply-siders emphasize that the critical factor in
government transfer and spending decisions is that
such expenditures are financed either by taxation, bor
rowing from the public or increasing the money sup
ply. These methods of finance lead to reductions in the
total supply of resources available for production.
Higher tax rates discourage individuals from work,
saving and productive investment. Financing through
government deficits (borrowing), simply postpones
taxes and “crowds out” private-sector investment in
plant, equipment and consumer durables such as hous
ing and autos, as financing costs are raised.

Supply-Side Effects of Monetary Policy
Attempts to finance expenditures by printing money
similarly reduce the nation’s production possibilities.
A faster rate of money growth increases the rate of
inflation (the rate at which the value of money de
clines). Inflation interferes with economic efficiency.
For example, it creates uncertainties about the mean
ing of price changes. When a product’s price is
raised or when wages in an industry rise, it is
4These considerations do not imply an aversion to redistribu
tion schemes on the part of supply-siders. From a strictly posi
tive view, however, supply-siders would tend to emphasize
that the nation’s distributional objectives can be accomplished
more or less efficiently depending on the supply-side incentives
involved.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

less clear whether the increase reflects the scarcity
of the product or resource, or the inflation process.
Inflation also distorts the allocation of resources, as
people employ scarce resources to economize on the
higher cost of holding money. The disproportionate
growth of resource employment in banking, financial
intermediaries and financial management services is
an example of such an inefficiency.
The supply-side effects of inflation also arise through
the U.S. tax system. The principal characteristic of the
tax system that creates supply-side disincentives when
inflation occurs is its basis on historical nominal ac
counting of income. For the individual income tax,
this has two important implications. First, when infla
tion is higher, investors require higher rates of return
to compensate for the erosion of purchasing power of
both future interest payments and the original sum
loaned. These higher interest rates simply allow the
maintenance of the purchasing power of investors’
portfolios. The added interest is compensation for a
maintenance expense, not income. Nonetheless, these
higher interest payments are taxed as income. The
higher taxes on these non-income payments reduce
the incentives to save and invest.
Second, the individual income tax is applied against
nominal income in a progressive fashion. As a result,
when wages and other income simply keep pace with
inflation, individuals find themselves in higher and
higher tax brackets, so that the purchasing power
of their income declines. This process, sometimes
called “bracket creep,” subjects individuals to increas
ingly higher taxes on existing and any prospective ad
ditions to purchasing power. Consequently, workers
have less incentive to work or save, despite the tend
ency of wages to keep pace with inflation.
For business, tax accounting again is based on
historical nominal magnitudes. Thus, inventory ex
penses and depreciation are computed on the basis
of the past dollar expenditures on goods, equipment
or plant, instead of the current dollar costs of replac
ing the inventory or plant and equipment currently
being used up in production. As a result, inflation
leads to an understatement of the true costs and
therefore an overstatement of business income and
artificially inflated taxes. Since historical cost account
ing subjects a given real cash flow of a business to
higher taxes, businesses are discouraged from adding
new productive assets during inflationary periods. Of
course, the result of reduced savings and investment
is to slow the pace at which the production possibility

MAY

1981

frontier shifts outward. For a given labor force, the
growth of output per worker slows.

SUPPLY-SIDE POLICY IMPLICATIONS
AND PROPOSALS
An immediate policy concern of supply-siders is to
redress the destructive effects of policies created by
demand management and regulatory strategies over
the post-war era, particularly since the early 1960s.
This redress involves slower monetary expansion, reg
ulatory reform, tax reduction and tax reform that re
duce the disincentives to produce, work, save and
invest.
To deal with the disincentives created by inflation,
many supply-siders recommend indexing the tax sys
tem. For example, replacement cost accounting would
permit firms to deduct from receipts the true cost of
depreciation in computing income, avoiding the dis
incentives to invest posed by inflation. Second, infla
tion premia in interest rates could be excluded from
taxation for firms and individuals. Finally, tax brackets
for computing the individual income tax can be tied
to the inflation rate to avoid bracket creep.
To reverse the disincentives created by past policy,
some policymakers influenced by supply-side eco
nomics have recommended large reductions in tax
rates on additional individual income, specifically a
Kemp-Roth tax rate cut of 10 percent per year for 3
years. To reverse disincentives due to under-depreci
ation in the past, they have recommended a “10-5-3”
capital cost recovery plan that accelerates the depre
ciation of physical assets to 10 years for structures, 5
years for business equipment and 3 years for cars and
trucks used by business. Since capital expenditures
under this plan are deducted from receipts as an ex
pense sooner than otherwise, the additional income
accruing from new capital expenditures is smaller in
the earlier years of the life of an asset and larger
later on. For the same additional receipts over the
useful life of an asset, measured income is unaffected
by accelerated depreciation; less of the income, how
ever, is measured in the early years, while more is
measured later. Therefore, taxes on income from as
sets are postponed, providing a greater incentive to
invest today.
These two tax proposals have been the subject of
controversy for several years. The intensity of the de
bate has increased dramatically since the proposals
became the centerpiece of the initial tax package of
the Reagan administration. It is ironic that the debate
has become so tightly linked to arguments about

MAY

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

supply-side economics. While both of these proposals
arose out of concern for the disincentive effects of
bracket creep and historical cost depreciation in an
inflationary environment, neither confronts the source
of the disincentive — nominal income taxation. In
stead, both are aimed at redressing the disincentives
created by past inflation.
The Kemp-Roth plan focuses on the importance of
cutting “marginal tax rates,” the rates applied on ad
ditional income, instead of simply cutting average tax
rates. This distinction is of critical importance to supply-siders. The average tax rate is simply the total
tax paid divided by the tax base, the adjusted gross
income in the case of the individual federal income
tax. For the income tax, the tax rate (marginal) on
successive dollars of income is a rising percentage of
additional income. The tax rate applied to additions
to income (marginal rate) exceeds the average tax
paid at any level of income. The marginal tax rate is
the rate that influences decisions to earn more income
by increasing work or savings. A rise in the marginal
rate from 20 percent to 30 percent means that an
additional $100 of income will net only $70 after
taxes instead of $80, so the incentive to forego leisure
or consumption to work or save to earn this $100 is
reduced.
Chart 1 shows measures of the marginal and aver
age tax rates over the past two decades. The average
tax rate has changed little over the years shown. Pe
riodic tax reductions have offset the effect of bracket
creep on the average tax bill. The marginal rate, how
ever, has risen sharply since 1970.

1981

future taxes from the ravages of inflation.6
Perhaps the greatest irony of the debate over these
two proposals is that neither proposal is a path-break
ing supply-oriented innovation. Many claim that such
policies are unproven and that their effects are un
known. While this may be the case for some supplyoriented policies, it is untrue of the Kemp-Roth pro
posal or “10-5-3.” Experiments with these two types
of tax changes were the hallmark of the “New Eco
nomics” of the sixties. Much was written before and
after such changes about their effectiveness. While
supply-siders differ in the analytical approach to such
tax changes, the evidence is certainly available.7

THE SUPPLY-SIDE RECORD
What has happened to the supply side of the econ
omy during the last 30 years? A review of the record
should show whether the changes in economic policy
of the past two decades have yielded evidence of the
disorders discussed by supply-siders. At the same
time, such a review can indicate whether the removal
of the disincentives accumulated in the past could
radically affect the economy. There is no question that
the growth of supply of the nation s output has slowed
markedly, at least since 1973, in large part due to the
stagnant growth of productivity. This stagnation is
supply-related, in that it arises from the astronomical
rise in the price of energy resources relative to the
price of business output and consequent losses in
economic capacity (an inward shift of the production

The Kemp-Roth proposal, however, does not legis
late automatic insulation of marginal rates from the
inflation rate, a fundamental tenet of supply-side
economics. Moreover, the “10-5-3” proposal, a simpli
fied accelerated depreciation plan, is unrelated to the
continuing disincentives created through the use of
historical cost accounting in an inflationary environ
ment.5 Neither of these proposals insulate current or

6The spirit of the tax proposals in correcting for past inflation
effects rather than breaking the link between inflation and tax
rates can be seen in Paul Craig Roberts, “For Supply-Siders,
The Focus is Incentives,” Washington Post, April 13, 1981,
where it is emphasized that the administration plan “. . .
doesn’t turn the tax clock back to 1965, but it is a big step
in the right direction.” Roberts notes that the marginal rate
faced by the median-income family of four was at most 17
percent in 1965 and a family with twice the median income
faced, at most, a 22 percent rate. These figures will rise to 32
percent and 49 percent, respectively, in 1984, without the
President’s proposal, according to Roberts. These figures,
Roberts notes, ignore social security and state taxes and their
increase since 1965.

B
There are alternative proposals that reflect concern over these
supply-side issues. For example, the Black Caucus proposes
indexing tax rates on so-called earned income while the Jorgenson-Auerbach plan embodied in House Resolution 2525
attempts to eliminate the effects of inflation on depreciation
expenses and business tax burdens. On the former, See Bureau
of National Affairs, Inc., Daily Report for Executive, DER No.
82, April 29, 1981, p. LL-12; the jorgenson-Auerbach proposal
is discussed in Dale W. Jorgenson and Peter Navarro, “10-5-3:
‘Deeply Flawed’,” and the accompanying editorial “Real De
preciation, Real Inflation,” New York Times, May 5, 1981.
Note that, unlike the President’s proposals, these two pro
posals are aimed at avoiding future supply-side effects of in
flation but not at correcting for past disincentives.

7Unfortunately the existence of such evidence does not mean
that it has been intensely scrutinized or, if it has been, that
there is a consensus among policy analysts about the effective
ness of past policies. In the case of accelerated depreciation,
business tax cuts, or investment tax credits, debate usually
centers more on the relative merits of the three. See, for ex
ample, Richard W. Kopcke, “The Efficiency of Traditional
Investment Tax Incentives,” Public Policy and Capital Forma
tion, (Board of Governors of the Federal Reserve System,
April 1981), pp. 163-75. There is little question that these
three policies temporarily increase the pace of investment.
Whether such tax cuts temporarily reduce the inflation rate as
supply-side arguments imply, leave it unaffected, or raise it,
as Keynesians might expect, has been largely neglected.

Digitized for 22
FRASER

MAY

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

1981

Chart 1

Personal Tax Rates in the United States
Percent

Percent

Source: Steven Braun,"Discussion of the Evons P a p e r," The Supply-Side Effects of Economic Policy (Federal
Reserve Bank of St. Louis and Center for the Study of Am erican Business, 1981), p.95. The m argin al
tax rate series isth at com puted by M ich a e l K. Evans. Both series includes state an d local taxes and
social security taxes.

possibility frontier). This analysis has been detailed
elsewhere, along with an examination of the potential
contributions of traditional sources of productivity
growth to this stagnation.8 The emphasis here is on
the past macroeconomic policy effects on supply.
Chart 2 shows the civilian labor force and the stock
of nonresidential private structures and equipment
8See John A. Tatom, “The Productivity Problem,” this Review
(September 1979), pp. 3-16, and the references cited therein.

available since 1947.9 The civilian labor force has
grown more rapidly since the mid-sixties. From 1948
to 1965, the labor force expanded at a 1.2 percent
annual rate. From 1965 to 1980, it accelerated to a 2.3
percent rate. Capital stock growth shows about the
same acceleration up until 1973. From 1948 to 1965,
9The stock of plant and equipment is the constant dollar net
stock of fixed non-residential private capital, see John C.
Musgrave, “Fixed Capital Stock in the United States: Revised
Estimates,” Survey o f Current Business (February 1981),
pp. 57-68.

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F E D E R A L R E S E R V E BAN K O F ST. L O U IS

1981

C hart 2

Su p p ly of C a p ital and Labor in the United States
Millions of persons

Billions of 1972 dollars
1500

120

1400

115

1300

110

1200

//
//

1100

X /
~ /
/
r

1000
900

90
85

\ \\
\
\

700
600

100
95

/
Net cap ital stock availa lie y S r ✓
✓
pSCALE

800

105

Civilian labor fo ce*
sc>

500

400

i i

1 1
1 1
1 1
i i
i i
i i
i I
60
300
1948 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 1980
Sources: U.S. D epartm ent of Com m erce and U.S. D ep artm en t of Labor

the stock of plant and equipment rose at a 4.1 percent
rate. Such growth accelerated to a 4.9 percent rate
from 1965 to 1975, then dropped to a 3.0 percent rate
from 1975 to 1980.
Thus, when one looks at growth rates of available
resources, there appears to be no major deterioration
in the economy’s aggregate supply until after 1975. In
deed, from 1965 to 1975, supplies of resources were
expanding much faster than before. The factors cited
by supply-siders that reduce resource availability
( such as the increasing regulation of both technology
and the pattern of resource employment, inflation, ris
ing marginal tax rates on income, and a growing share
of government spending and transfer payments) do
not seem to have seriously impaired resource avail
ability, at least not before 1975.
Although this analysis is crude, a more detailed
analysis shows essentially the same patterns. In par
Digitized for 24
FRASER

ticular, labor force growth is a crude measure of labor
resource availability because it is heavily influenced
by population trends rather than short-term economic
factors. Supply-side policies can change the willing
ness of a given population of labor-force age to work
by increasing their participation in the labor force or
by increasing the effort of the labor force. Chart 3
shows the percentage of the population over age 16
in the labor force. There has been no apparent deteri
oration in overall participation in the labor force.10
Supply-side policies could also affect labor resource
10In a detailed study of the labor force participation rate,
Leonall C. Andersen, “An Explanation of Movements in the
Labor Force Participation Rate: 1957-76,” this Review (Au
gust 1978), pp. 7-21, found that an individual income tax
rate cut would have a small transitory effect of increasing
the participation rate. He also observed that social security
tax cuts would have small permanent effects, lowering par
ticipation, and that reduced social security benefits would
have permanent effects raising participation.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

MAY

1981

Chart 3

Labor Force Participation Rate
Percent

Percent

Source: U.S. Departm ent o f Labor

availability by altering the supply of work effort of a
given labor force, for example, by changing the aver
age hours worked per worker. Average hours worked
have shown a significant downward trend throughout
the post-World War II period, but this trend has not
significantly accelerated in recent years. Nonetheless,
studies of labor supply indicate that higher marginal
tax rates have small negative effects on working hours,
especially for wives with children.11
"See Jerry A. Hausman, “Labor Supply,” in Henry J. Aaron
and A. Joseph Pechman, eds., How Taxes Affect Economic
Behavior (Brookings Institution, 1981), pp. 27-83. Detailed
statistical analysis is required to support these results because
the effect is relatively small, given the increases in marginal
rates that have occurred in the post-war period. For reduc
tions in marginal rates to 1965 levels, the tax effect on labor
resource availability would be correspondingly small and
difficult to observe by simple statistical analysis. In addition,
unless the reductions were repeated in subsequent years, the
modest increase in hours would be of a once-and-for-all
variety.

Finally, the available supply of labor need not have
kept pace with the expansion of the labor force if
the unemployment rate associated with full employ
ment has risen significantly. While most analysts agree
that the unemployment rate associated with high
employment conditions has risen over the last 25
years, even the largest estimates of this increase would
not reverse the pattern of accelerated labor resource
growth shown in chart 2. More important, there is
scant evidence that the rise in such a “full-employment” unemployment rate has been associated with
growing supply-side disincentives.12 Some policies
presumably lead to a withdrawal from the labor force
12See, for example, Daniel Hamermesh, “Transfers, Taxes, and
the NAIRU,” in The Supply Side Effects o f Economic Policy.
The NAIRU is the non-accelerating inflation rate of unem
ployment and is comparable to (usually used as synonomous
with) the “natural rate of unemployment,” or the fullemployment unemployment rate.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

MAY

1981

C h a rt 4

Federal G o v e r n m e n t Share of O u t p u t a n d E m p lo ym e n t

194849 50 51 52 53 54 55 56 57 58 5960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 791980
Source: U.S. D e p a rtm e n t of Com m erce and U.S. Departm ent of Labor

of workers with relatively high unemployment rates
while others lead to withdrawal of individuals with
relatively low unemployment rates. An example of
the former is the rising minimum wage that reduces
opportunities for the young, resulting in their dropping
out of the labor force. An example of the latter is the
effect of an increasingly generous social security sys
tem that induces older workers who normally have a
more favorable employment record to quit earlier.
Changes in the composition of the labor force due to
demographic changes have been the primary source
of the increase in the full-employment unemployment
rate.
Another factor often accused of creating supply-side
problems is the rapid growth of government activity.
The expansion of the role of government in the econ
omy can draw resources away from the private sector

where productivity growth tends to be greater. Thus,
the rate at which the production and consumption
possibility curve shifts could be lowered. This view,
however, misstates the pattern of government growth
in the economy in recent years. Chart 4 shows the
share of federal government purchases of goods and
services in total output (GNP) and the share of fed
eral employment in civilian employment. Both of these
measures peaked some years ago.13 It is difficult to

l:!The same pattern holds for state and local governments. The
share of state and local government purchases of goods and
services in GNP rose steadily until 1971 when it reached the
13 percent level. In 1973-75, the share surged upward to
over 14 percent and has subsequently declined to below
13 percent. Employees on state and local government pay
rolls as a percent of the civilian labor force also climbed
steadily throughout the post-war period, peaking at about
13 percent in 1975, then declining slightly.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

MAY

1981

Chart 5

Federal Government Expenditures
and Transfer Payments as a Share of Output

Sources: U.S. Departm ent of Commerce

show that government has constrained output growth
by altering the allocation of resources away from the
private sector.14
How, then, has growth in the size of government
adversely affected the supply side of the economy?
14Other forms of capital formation, including government, show
the same slowing as that in the business sector. From 1960
to 1973, the growth of the federal government capital stock
was at a 1.1 percent rate; from 1973 to 1980, this growth rate
declined to a 0.4 percent rate. For state and local govern
ments, the decline was from a 4.8 percent to a 2.0 percent
rate from 1973 to 1980. The growth of the residential housing
stock declined from a 4.0 percent rate from 1948 to 1965, to a
2.7 percent rate from 1973 to 1980. Thus while inflation and
the tax system combined to reduce capital formation in busi
ness and divert some capital formation toward the housing
sector, there was a slowing there. Even in owner-occupied
housing, the sector with the greatest relative attractiveness,
the growth rate of the housing stock declined from a 5.0 per
cent rate from 1948 to 1965 to a 3.2 percent rate from 1973
to 1980. See Musgrave, “Fixed Capital Stock” for data on
these sectors.

Chart 5 shows the growth of federal government
expenditures (purchases of goods and services plus
transfer payments) and transfer payments alone, with
both measured as a share of GNP. The share of ex
penditures has grown due to the extremely rapid
growth of transfer payments. The growth in transfer
payments is the only likely candidate as a major
source of government disincentives for production
and growth.
Moreover, it is this type of fiscal development over
which there is the greatest difference between demand
and supply analysts. Demand analysts presume that
tax increases to pay for increased transfer payments
simply redistribute purchasing power with no real
effects on demand, prices or aggregate output. From
a supply analyst’s view, such a policy produces a
“double whammy,” as both increased transfers and
taxes provide disincentives to supplying resources in

F E D E R A L R E S E R V E BANK O F ST. L O U IS

the market. But it must be emphasized that the
trends in growth of resources do not indicate that
the growing share of transfer payments has severely
affected aggregate resource supplies.

THE OUTLOOK FOR
SUPPLY-SIDE EFFECTS
While the past record does not indicate the possi
bility of revolutionary developments on the supply
side of the economy, supply-oriented policies could
modestly affect resource availability, economic effi
ciency and growth. As noted earlier, for example,
higher marginal tax rates have negative effects on
work effort. Thus, reductions in marginal rates should
increase labor resource availability. In addition, supply-side policies can have modest temporary effects
on investment and productivity growth.

Investment
The growth of the capital stock accelerated mildly
(chart 2) following a move toward accelerated de
preciation and the introduction of the investment tax
credit in 1962, and the cut in individual and business
marginal tax rates in 1964-65. Similar actions in late
1971 also appear to have led to a mild subsequent
acceleration. When the investment tax credit was sus
pended from October 1966 to March 1967 and again
from April 1969 to December 1971, real producer
durable investment slowed. From the third quarter
of 1966 to the first quarter of 1967, real investment
in equipment declined at a 3.0 percent rate, sub
stantially slower than the 14.1 percent rate of expan
sion over the prior year or the 16.7 percent rate of
the prior two years. From the first quarter of 1969
to the fourth quarter of 1971, such investment slowed
to a 3.7 percent rate of growth. Over the prior year,
such investment had risen at a 10.1 percent rate;
it rose at a 9.6 percent rate for the two years ending
in the first quarter of 1969. In the year following the
end of each of these two suspensions, real investment
in producer durables accelerated — to a 9.1 percent
rate of growth in the first case, and to a 17.9 percent
rate of growth in the second. From the end of 1962
to 1974, the constant dollar net stock of private nonresidential fixed capital rose at a 4.8 percent rate,
much faster than the 3.5 percent rate of the prior
decade, or the 3.0 percent rate from end of 1974 to
the end of 1980.

MAY

1981

Productivity
Accelerations in capital formation affect productiv
ity growth. Nonetheless, improvements in the quantity
and quality of plant and equipment do not yield
massive changes in aggregate productivity. Most esti
mates of the impact of faster growth of plant and
equipment show that a 1 percent increase in the
growth rate of the capital stock adds no more than
0.3 percent to the growth rate of productivity. Thus,
a 3 percentage-point increase in the pace of capital
formation, extremely large by historical standards,
would likely add less than 1 percent to the rate of
advance of output per worker, or output per hour.
Also, most programs to cut the cost of plant and
equipment for firms or to increase returns from invest
ing in new capital only temporarily affect capital for
mation. Essentially, such policies raise the optimal
amount of plant and equipment available per worker.
According to economic theory, investment will accel
erate to reach the optimal proportions, but is subse
quently unaffected. This is important because it indi
cates that any added productivity growth from
supply-oriented policies is temporary.

Inflation
The greatest controversy concerning recent supplyoriented proposals concerns the effect on inflation.
Some advocates of supply-side economics contend
that supply-oriented policies will contribute to the
elimination of inflation.15 The source of confusion in
this analysis is a standard mark-up view of inflation
that equates the inflation rate (P ) to the rate of in
crease in wage rates ( W ) , less the rate of produc
tivity growth ( X ). In this view, if productivity growth
accelerates, then the rate of inflation slows (given
the rate of increase in wages, W ). Even were this
view correct, supply-oriented policies would provide
little assistance for the anti-inflation effort. For the
massive acceleration in capital formation and produc
tivity growth in the example above, the pace of price
increases would slow by less than 1 percentage point;
even this gain would be as temporary as the accelera
tion in productivity growth.
But this mark-up view of inflation really has little
to say about inflation. Instead, the equation tells
something about the wedge between inflation of prod
15See, for example, the analysis in the Joint Economic Com
mittee, Outlook for the 1980’s, pp. 11-14.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

uct prices and the rate of increase in resource prices,
especially prices of labor; that is, the rate of increase
in the purchasing power of wages, (W - P ), equals
the rate of increase in productivity, (X ) . Conse
quently, faster productivity growth will increase the
pace of growth of the purchasing power of wages,
with little or no effect on the pace of wage and price
inflation, per se. Since inflation is solely a monetary
phenomenon, the only workable solution is to slow the
growth in the supply of money.
At the other extreme, some supply-side critics argue
that tax cuts, like those in the administration proposals,
will lead to an increase in inflation.16 This conclusion
is based on the argument that tax cuts increase de
mand for the nation’s output, since only part of the
proceeds of a tax cut is saved, while the rest is spent.
Two corollaries of this view are that a tax cut raises
the deficit and that it causes higher interest rates.
Given the nation’s income or tax base, it is easy to
see that the deficit increases. Also, the government
must replace the funds involved in a tax cut by bor
rowing (assuming government expenditures remain
the same), but only part of the cut is available for
lending, that is, the portion saved. Consequently, in
terest rates will tend to rise to attract the additional
lending required and to bid funds away from private
sector borrowers.
The conceptual shortcomings of this view are
equally well known. The burden of government ex
penditures on household budgets is not measured by
current taxes, but rather by the expenditures them
selves. If current taxes are insufficient to pay for cur
rent expenditures, then either future taxes must be
raised to pay the interest costs on a larger debt, or
the debt can remain the same, if the Federal Reserve
finances the additional portion by expanding the
money supply faster. In the latter case, households pay
the remainder of current taxes through higher inflation
rates. Since the wealth and income of the economy is
unaffected by a tax cut, it cannot lead to higher spend
ing. A second problem is that even if individuals in
correctly perceive their wealth as larger after a tax
cut and attempt to spend more on goods and services,
a tax cut would indeed imply a shortage of funds in
financial markets to finance the larger deficit. Interest
rates would have to rise by enough to reduce spending
to its original level.
For example, if taxes were cut $50 billion and
neither government expenditures nor the Federal
16An example of this argument is found in “Ease Off KempRoth,” The New York Times, May 15, 1981.

MAY

1981

Reserve’s holding of government debt were changed,
the government would have to borrow an additional
$50 billion. Now if individuals initially planned to
spend $40 billion while saving only $10 billion of the
tax cut, the excess borrowing requirement would be
the amount of increased private spending, $40 billion.
As the government attempts to raise the additional
$40 billion in credit markets, interest rates would rise
to increase household savings or reduce the borrowing
and spending of other borrowers. Whether the $40
billion is attracted through more saving (less con
sumer spending) or less business borrowing (less in
vestment spending), total spending will tend to be
unaffected by the tax cut. In summary, a tax cut may
cause interest rates to rise, but is unlikely to affect
total spending demands and, therefore, inflation.
The difficulties encountered by the higher deficits/
interest rates/inflation argument are not simply logical
shortcomings. First, the tax cuts envisioned by the
administration are accompanied by spending reduc
tions, so there will tend to be little effect on the deficit
or on interest rates. Second, the Kemp-Roth “cuts” in
taxes are likely only to offset bracket creep over the
next three years; thus, they are not really cuts in
current taxes at all, simply offsets to keep average and
marginal rates from rising due to current and prospec
tive inflation.17 Finally, the experience surrounding
the 1964 Kennedy tax cut and the 1975 tax cut would
not support the higher deficits/interest rates/inflation
scenario even if the administration were proposing a
cut in taxes. In the 1964 case, the deficit rose very
slightly and briefly, but interest rates did not rise
until well after the tax cut.18 Inflation did begin to
worsen, but only in response to the acceleration in
money growth that began in 1963.
In 1975, federal taxes were reduced by increasing
exemptions and the standard deduction. In that in
stance, the deficit rose sharply but interest rates did
17This argument has been made by, among others, Martin
Feldstein, “ ‘No Real Tax Cut’ in Administration Plan,” Neiv
York Journal of Commerce, May 21, 1981. This point has
also been made recently by Walter H. Heller, “Supply-Side
Follies of 1981,” Wall Street Journal, June 12, 1981. Heller
uses this point as part of an argument against the Kemp-Roth
cuts. The cuts would keep marginal rates from rising further,
however, so they would avoid a further deterioration in in
centives over the next few years. This argument merely indi
cates that Kemp-Roth type cuts will have to be much larger
to eliminate the impact of past inflation on marginal tax rates
and incentives, not that such cuts are ineffective.
18Numerous studies have shown that the 1964 tax cut had no
effect on total spending. Also, a recent discussion by Paul
Evans, “Kemp-Roth and Saving,” Federal Reserve Bank of
San Francisco W eekly Letter, May 8, 1981, shows that more
than 100 percent of the tax cut was saved, that is, that
consumption actually declined relative to disposable income.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

not. The 1975 tax cut was not associated with a more
expansionary monetary policy. Instead, the growth
rate of money stock for the year ending in the fourth
quarter of 1974 was 4.7 percent; for 1975 it was
4.9 percent. These rates followed the rapid pace of
monetary expansion at a 6.1 percent rate during the
previous five years (ending in IV/1974). Consequently,
inflation ( GNP deflator) slowed, declining from a 7.7
percent rate in the year ending in the fourth quarter
of 1974 to 4.7 percent in the year ending in the fourth
quarter of 1975. Thus, even when a tax cut does not
lower marginal rates, and/or the deficit increases as
in 1975, it is not the case that interest rates must rise
or that inflation must accelerate.19

CONCLUSION
Traditional macroeconomic policies affect the allo
cation, efficiency and growth rate of the supply of
resources in an economy. These effects have been
central to discussions of stabilization policies for
centuries, but with few exceptions have been ignored
in the post-war era. The reemphasis of these effects is
what “supply-side economics” is all about.
There is little evidence to support the notion that
supply-oriented policies will work miracles in restor
ing productivity growth or in reducing inflation.
Indeed, it is difficult historically to see any major
disruptions of aggregate resource supply or allocation
that are sufficiently profound to explain the stagflationary performance of the U.S. economy since the
early ’70s. Only in the area of recent capital forma
tion is there a clear resource supply shortfall and this
is fully explained by supply forces other than govern
ment policy ( energy price increases) .20
19On the tenuous link between budget deficits and inflation, see
Scott E. Hein, “Deficits and Inflation,” this Review, (March
1981), pp. 3-10.
20The principal determinants of stagflationary developments
since 1973 and 1979-80 have been sharp increases in the
relative price of energy —supply shocks. These increases
fully account for the post-1973 decline in the pace of

Digitized 30 FRASER
for

MAY

1981

At the same time, however, the historical record
clearly indicates that supply-oriented policies can
modestly affect resource availability, especially capital
formation. Also, economic theory indicates a number
of disincentives created by the tax system in an infla
tionary environment. While the magnitude of these
disincentive effects is difficult to establish empirically,
few economists or policymakers disagree with the im
portance of remedying these defects in macroeconomic
policy.
The administration’s economic policy proposals have
incited a great popular debate over supply-side eco
nomics. Ironically, the proposals are quite modest in
their supply-side orientation. The initial proposals
address the disincentive effects of past policy and are
not aimed at breaking the link between inflation and
the supply of resources and output. Moreover, the
proposed individual income tax cuts are sufficiently
small so as to maintain marginal tax rates at current
levels, rather than lower them.
No doubt, the issues raised by supply analysts will
be of central importance for some time to come as
policymakers face the continuing challenges to break
the inflation-supply linkage, as well as to stay ahead
of the deterioration in incentives to work, save and
invest due to the cumulative effects of past fiscal,
regulatory and monetary policy. It is likely that, when
the smoke clears, it will be impossible to say that one
can disregard the supply effects of policy any longer.
But then the exaggerated claims or hopes of some
supply analysts will be forgotten as well. Over a
decade ago, Milton Friedman noted that, “In one
sense, we are all Keynesians now; in another, no one
is a Keynesian any longer.” It is likely that a simi
lar characterization will soon be an apt description
of supply-side economics.
capital formation as well. For a more detailed discussion,
see John A. Tatom, “Energy Prices and Capital Formation:
1972-77,” this Review (May 1979), pp. 2-11, and Tatom,
“The Productivity Problem.”

Trends in Federal Revenues: 1955-86
KEITH M. CARLSON

T h e Reagan administration has proposed some
major changes in the federal tax structure as part of
its economic plan for the early 1980s.1 Included in
the proposal are cuts in individual income taxes and
an increase in business depreciation allowances retro
active to January 1, 1981. These tax reductions are
intended to increase productivity by increasing the
incentives to save, work and invest in capital
equipment.2

and the component taxes as a percent of total re
ceipts. GNP provides a useful reference point because
discussions of the role of government focus on ex
penditure and revenue trends relative to growth in
the economy.4 An examination of component taxes rela
tive to total receipts yields information relating to the
elasticity of the tax structure, that is, the responsiveness
of the tax system to economic growth, and the inci
dence of the tax system, that is, who pays the taxes.®

This article discusses the effect of these tax cuts on
federal revenues. Because the exact form that the
tax legislation will take depends on the actions of
Congress, the focus of this article is on the effects of
the original proposal as presented in March 1981. By
way of background, trends in revenues for the last
25 years are summarized and discussed. This period
is chosen for historical reference for two reasons: (1)
it is long enough to encompass sufficient economic
experience so that trends in the federal revenue struc
ture are clearly discernible, and (2) by starting in
1955, it avoids the effects of distortions of the tax
structure resulting from World War II and the Korean
War.3 Although this period includes the Cold War of
the 1950s and the Vietnam War of the late 1960s,
it primarily reflects peacetime conditions in the U.S.
economy.

Tax revenues are determined by two factors: the
relevant revenue base and tax rates. Revenue trends,
as shown in charts 1 and 2, thus reflect both changes
in the revenue base and legislation affecting the effec
tive tax rate. Tables 1 and 2 summarize major tax
legislation over the past 25 years.

The changing nature of the federal revenue system
is analyzed in terms of receipts as a percent of GNP,
iExecutive Office of the President and Office of Management
and Budget, Fiscal Year 1982 Budget Revisions (March 1981).
On June 4, 1981, the administration modified the original
proposal.
2For further discussion, see Laurence H. Meyer, ed., The
Supply-Side Effects of Economic Policy (Center for the Study
of American Business and the Federal Reserve Bank of St.
Louis, 1981).
3For a perspective that includes the 1930s and 1940s, see
Donald W. Kiefer, “The Automatic Stabilization Effects of the
Federal Tax Structure,” in The Business Cycle and Public
Policy, 1929-80, A Compendium of Papers submitted to the
Joint Economic Committee, Congress of the United States
(GPO, November 28, 1980), pp. 172-208.

PAST TRENDS IN FEDERAL
REVENUES: 1955-80
From 1955 through 1961, revenues due to tax legis
lation changed very little (see table 1). The only
component of federal revenues that reflected changes
in tax rates during this period was social insurance
contributions, and these changes were quite small
(table 2 ). Otherwise, the composition of tax revenues
changed as a consequence of the differential response
of relevant tax bases to movements of the overall
economy, as well as the sensitivity of each tax to
changes in its base.
4A more complete analysis of the role of government and its
impact on the economy would stress the amount of resources
absorbed by way of expenditure. The financing of expenditure
includes taxes, borrowing and money creation. The latter is,
of course, a hidden tax, but is just as real as an explicit tax
in terms of transferring resources from the private sector to
the government. For a general discussion of the inflation tax,
see Carl S. Shoup, Public Finance (Aldine Publishing Com
pany, 1969), pp. 452-61.
5The incidence of a tax, that is, who bears the final burden of
the tax, is, of course, much more complex than indicated here.
Nonetheless, extending such an analysis for a tax system re
quires information on the types of taxes and their relative
importance. For further discussion, see Shoup, Public Finance.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

MA Y

1981

Table 1
Major Revenue Actions: 1954-80

Action

Date
enacted

Excise Tax Reduction
Act of 1954

March 1954

Internal Revenue Code
of 1954

August 1954

Federal Aid Highway Act
of 1956

Revenue
effect
(billions
of dollars)

Nature of action

$ -1 .0

Dismantled Korean War excise tax structure. All excise
tax rates in excess of 10 percent were reduced to 10
percent, except for 20 percent cabaret tax.

-1.4

Complete revision of Internal Revenue Code of 1939.
Included provisions for dividend credit and exclusion,
retirement income credit, and accelerated depreciation.
Changes in tax laws since 1954 have been enacted as
amendments to this code.

June 1956

2.5

Excise taxes were earmarked for Highway Trust Fund
to finance construction of federal highway system. In
creased rates on gasoline, diesel and special motor
fuels, trucks, tires. New taxes introduced on tread rub
ber and use of heavy trucks and buses.

Revision of Depreciation
Guidelines and Rules

July 1962

Revenue Act of 1962

October 1962

-0.2

Provided investment tax credit of 7 percent on new and
used property other than buildings.

Revenue Act of 1964

February 1964

-11.4

Provided for two-stage cut in personal income tax lia
bilities and corporate profits tax liabilities in 1964 and
1965.

Excise Tax Reduction
Act of 1965

June 1965

-4.7

Repealed excise taxes on several items and provided
for systematic reductions in the rates on transportation
equipment and communication services.

Tax Adjustment Act of 1966

March 1966

1.1

Restored excise tax rates on transportation equipment
and telephone service to rates in effect prior to Janu
ary 1966. Introduced graduated withholding on personal
tax collections.

Temporary Suspension of
Investment Tax Credit

November 1966

Restoration of Investment
Tax Credit

June 1967

-1 .7

As of March 10, 1967, restored investment tax credit
and raised permissible ceiling.

Revenue and Expenditure
Control Act of 1968

June 1968

10.2

Levied 10 percent surtax on personal income taxes
effective April 1, 1968, and on corporate taxes effective
January 1, 1968. Postponed reduction in excise tax
rates on automobiles and telephone service.

Extension of Surtax

August 1969

Extended 10 percent surtax on personal and corporate
incomes, previously scheduled to expire on June 30,
1969, to December 31, 1969.

Tax Reform Act of 1969

December 1969

-2.5

Increased personal exemption in stages from $600 to
$750 in 1973. Increased standard deduction in stages
beginning in 1971. Introduced maximum marginal rate
of 50 percent on earned income, with maximum rate on
unearned income remaining at 70 percent. Extended
surtax from January 1, 1970, to June 30, 1970, at 5 per
cent rate. Postponed scheduled reductions in excise tax
rates on automobiles and telephone service until Janu
ary 1, 1971. Repealed investment tax credit for property
acquired after April 18, 1969.

Increased rate at which businesses could write off plant
and equipment. Lives of machinery made 32 percent
shorter.

As of October 10, 1966, temporarily suspended 7 per
cent investment tax credit.

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

MAY

1981

Table 1 (Continued)

Action

Date
enacted

Revenue
effect
(billions
of dollars)

Nature of action

Excise, Estate and Gift Tax
Adjustment Act of 1970

December 1970

Treasury's Asset Depreciation
Range Guidelines

June 1971

Revenue Act of 1971

December 1971

Tax Reduction Act of 1975

March 1975

Revenue Adjustment Act
of 1975

December 1975

Tax Reform Act of 1976

October 1976

1.6

Tax Reduction & Simplification
Act of 1977

May 1977

Revenue Act of 1978

November 1978

-21.3

Reduced taxes for individuals and businesses. Con
tained some elements of tax reform. Extended several
temporary provisions of Tax Reduction and Simplifica
tion Act of 1977.

Energy Tax Act of 1978

November 1978

-0.8

Introduced taxes and credits for purposes of reducing
country’s reliance on foreign energy supplies.

Crude Oil Windfall Profits
Tax Act of 1980

April 1980

13.0

Levied windfall profits tax on domestic producers of
crude oil and provided several income tax credits to
encourage production and conservation of energy. Pro
vided partial exclusion of interest and dividend income
from income tax.

Omnibus Reconciliation Act
of 1980

December 1980

3.4

Imposed restrictions on use of mortgage subsidy bonds
plus other miscellaneous tax changes.

Extended excise tax rates on automobiles and tele
phone service until January 1972. Sped up collections
of estate and gift taxes.
Gave firms option of raising or lowering the guideline
lives of depreciable assets by up to 20 percent. Reserve
ratio test was abandoned.

$ -8.0

Accelerated by one year scheduled increases in per
sonal exemptions and standard deduction. Repealed
automobile excise tax retroactive to August 15, 1971;
on small trucks and buses to September 22, 1971. Re
instated 7 percent investment tax credit and incorpo
rated depreciation range guidelines.

-22.8

Provided for 10 percent rebate on 1974 taxes up to
maximum of $200 for individuals. Provided tax cuts
retroactive to January 1975 for both individuals and
corporations. For individuals it was in the form of in
creased standard deductions, $30 exemption credit and
an earned income credit for low-income families. Re
duced corporate income tax and increased investment
surtax exemption. Increased investment tax credit to 10
percent.
Provided tax reductions for first six months of 1976.
Extended corporate rate reductions enacted in Tax Re
duction Act of 1975. Reduced individual taxes in order
to maintain withholding rates that applied during last
eight months of 1975.
Provided extensive redrafting of tax laws. Restricted
use of tax shelter investments and made changes in
taxing of gifts and estates. Increased taxes on very
wealthy. Continued tax cuts passed in 1975.
Extended for one year the temporary provisions of the
Tax Reform Act of 1976, including the general tax
credit, the earned income credit and corporate tax re
ductions. Provided a temporary jobs tax credit. Re
placed former standard deduction with amount equal to
$3,200 for joint returns, $2,200 for single persons and
$1,600 for married persons filing separately.

"Indicates either that (1) the action was minimal in its effect, (2) such a calculation was not appropriate because the action
extended provisions of expiring legislation, or (3) official estimates were not available.
SOURCES: Joseph A. Pechman, Federal Tax Policy, 3rd ed. (The Brookings Institution, 1977); Federal Reserve Bulletin
(September 1978 and June 1973), Annual Report of the Secretary of Treasury, and The Budget of the United
States Government.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

MAY

1981

Table 2

Effects of Social Security Legislation
Year

Taxable
wage base
(dollars)

Combined
tax rate
(percent)
4.0%

Maximum tax
for employee
(dollars)
$

Effect on
federal revenues
(billions of dollars)

1955

$ 4,200

1956

4,200

4.0

$ 0.6
*

1957

4,200

4.5

1958

4,200

4.5

1959

4,800

5.0

120

1.5

1960

4,800

6.0

144

1.1
*

1961

4,800

6.0

144

1.9
*

1962

4,800

6.25

150

0.5

1963

4,800

7.25

174

1964

4,800

7.25

174

2.1
•

1965

4,800

7.25

174

•

1966

6,600

8.4

277

6.2

1967

6,600

8.8

290

1.2

1968

7,800

8.8

342

2.1

1969

7,800

9.6

374

1970

7,800

9.6

374

3.0
*

1971

7,800

10.4

406

3.2

1972

9,000

10.4

468

2.9

1973

10,800

11.7

632

10.8

1974

13,200

11.7

722

3.9

1975

14,100

11.7

825

1.4

1976

15,300

11.7

895

2.1

1977

16,500

11.7

965

2.1

1978

17,700

12.1

1,071

5.6

1979

22,900

12.26

1,404

9.5

1980

25,900

12.26

1,588

3.6

1981

29,700

13.30

1,975

16.6

"No change in legislation.
SOURCE: 1980 Statistical Abstract, except for effect in 1955 and 1957 estimated by Federal
Reserve Bank of St. Louis.

Since 1961, however, tax legislation has been fre
quent and oftentimes large in magnitude. Even so,
apart from the effect of legislation enacted during the
Vietnam War, total tax revenues as a percent of
GNP changed little from 1961 to 1976. Since then,
however, this trend appears to have been broken.
An examination of chart 1 indicates that since 1976,
total receipts have been rising faster than GNP. For
the entire 1955-80 period, receipts as a percentage of
GNP range from 16.8 percent in 1958 to 20.6 percent
in 1969. Since 1976, even though new legislation has

generally reduced tax rates, the tax base has grown
more rapidly than GNP; consequently, receipts as a
percent of GNP have trended upward.
Chart 2 summarizes each of the major taxes as a
percent of total receipts. Throughout the entire 195580 period, the individual income tax was the major
source of revenue to the federal government, provid
ing between 41 percent and 47 percent of the total.
As a proportion of total revenue, however, individual
income taxes have varied considerably over the years.
There are two reasons for this: One, the proceeds of

MAY

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

1981

Table 3

Administration Economic Assumptions
Calendar Years
Estimate
1980

1981

1982

1983

1984

1985

8.9%

10.8%

1986

Gross national product
Current dollars (percent change)
Constant 1972 dollars (percent change)
Deflator (percent change)
Unemployment rate (percent)

11.1%

12.8%

12.4%

9.8%

9.3%

-0.1

1.1

4.2

5.0

4.5

4.2

9.0

9.9

8.3

7.0

6.0

5.4

4.9

7.2

7.8

7.2

6.6

6.4

6.0

5.6

11.1

2.5

11.5

9.9

9.3

9.2

Proxies for tax bases
Personal income (percent change)
Wages and salaries (percent change)
Corporate profits (percent change)

8.7

10.7

12.0

11.2

9.8

9.1

8.8

-5.5

-0.4

16.1

16.0

12.6

11.2

11.5

SOURCE: Executive Office of the President and Office of Management and Rudget, Fiscal Year 1982 Budget Revisions
(March 1981).

this tax are highly sensitive to movements in economic
activity. Two, most of the major tax bills enacted in
the last 25 years contained provisions that directly
affected this particular source of revenue.
Aside from the individual income tax, the remainder
of the federal tax structure has changed significantly
since 1955. Social insurance contributions, for example,
replaced corporate income taxes as the second most
important source of revenue after 1966. The decline
in the proportion of corporate income taxes to total
receipts primarily reflects the downward trend of cor
porate profits relative to GNP. In addition, however,
the effective tax rate for corporate income has been
reduced several times since 1955.
The steady rise of social insurance contributions as
a percent of total revenues from 1955 to 1975 is the
result of frequent increases in the tax rate and the
expansion of the tax base (table 2 ). Since 1975, how
ever, social insurance contributions have stabilized at
about 31 percent of total revenues despite annual in
creases in the taxable wage base.
Excise taxes have become increasingly less impor
tant as a source of federal revenue for two reasons:
First, major reductions in excise taxes were legislated
in 1965 and 1971. Second, revenues from this tax do
not generally rise with inflation since they are usually
expressed as an amount per physical unit (for ex
ample, the federal excise tax on gasoline is 4 cents
per gallon).

Finally, other taxes, which include customs duties,
estate and gift taxes, and miscellaneous receipts, have
been rising in relative importance, with the average
rate of increase for the 1955-80 period exceeded only
by social insurance contributions.

PROJECTIONS OF FEDERAL
REVENUES: 1981-86
The administration has submitted a set of proposals
that affects the federal revenue system. Viewed
against the trends of the last 25 years, how would
these proposals affect the total and the composition
of federal tax revenues?

Economic Assumptions
As noted above, changes in the total and the com
position of federal revenues occur even without tax
legislation. Consequently, projections of future reve
nue depend, in part, on the nature of one’s economic
assumptions. The administration’s economic assump
tions are summarized in table 3.
The key assumption underlying the projected
growth of federal revenues is the growth in nominal
GNP. The administration has projected a relatively
rapid 11 percent average rate of growth in nominal
GNP for the 1980-86 period. Given the historical
relationship between money and GNP, this GNP

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

growth path implies that M IB will have to increase
at an average 8 percent rate over this period.6
The administration does not specify its assumptions
about the relevant tax bases for particular taxes. Cer
tain indicators, however, serve as proxies. For example,
personal income is a proxy for the tax base pertinent
to individual income taxes and, with consumption
dependent on personal income, it serves the same pur
pose for excise taxes. Corporate profits before taxes
provide a tax base proxy for corporate income taxes.
Wages and salaries are a proxy as a tax base for social
insurance contributions. The projected growth of each
of these tax bases depends primarily on the assumed
growth of GNP.
Although economic assumptions relating to prices
and output are important in and of themselves, they
are not so critical for tax projections. Nominal GNP,
regardless of the way it is divided between price and
output, is the most important determinant of revenue.7

MAY

1981

on a “10-5-3” year classification of property. Three-year
property consists of autos and light trucks plus ma
chinery and equipment used in research and develop
ment. Five-year property consists of other machinery
and equipment. Ten-year property includes factory
buildings, retail stores, warehouses and some public
utility property.
Social insurance contributions — The only proposal
affecting social insurance contributions is an increase
in railroad retirement payroll taxes. Otherwise, such
contributions are scheduled to increase through 1984
under existing legislation.8
Excise taxes — Increased charges are proposed for
aviation users and barge operators. These charges are
intended to recover most of the costs associated with
the movement of air traffic and the operation and
construction of new waterway facilities.

Projected Trends
Proposed Legislation
The administration’s economic program centers on
a reduction of individual income tax rates and depre
ciation reform. In addition, it proposes to increase
aviation-user taxes and user fees for barge operators.
Individual incom e taxes — Proposals that affect in
dividual income taxes include reducing marginal tax
rates by 10 percent each year for the next three years,
beginning July 1, 1981. Tax rates would be reduced
relative to 1980 by 5 percent for calendar 1981, 15
percent for calendar 1982, 25 percent for calendar
1983, and 30 percent for calendar 1984. Marginal rates
would be reduced from their present range of 14-70
percent to 10-50 percent as of January 1, 1984. In ad
dition, to the extent that depreciation reform applies
to unincorporated businesses, individual income taxes
would be further reduced through a reduction in the
taxable income of proprietors and partnerships.
C orporate incom e taxes — The proposed “accel
erated cost recovery system” enables corporations to
write-off capital expenditures faster, under simplified
and standardized rules, and liberalizes the laws relat
ing to the investment tax credit. The program centers
6For further discussion of the consistency of the administration’s
forecast of GNP and its monetary policy assumptions, see
Congressional Budget Office, An Analysis of President Reagan’s
Budget Revisions for Fiscal Year 1982, Staff Working Paper
( March 1981), pp. 9-11.
7See Congressional Budget Office, A Review of the Accuracy of
Treasury Revenue Forecasts, 1963-1978, Staff Working Paper
( February 1981).

The economic assumptions and the proposed legis
lation provide the basis for revenue projections. Since
the proposed legislation takes the form of either
changed tax rates or new taxes, revenue trends in the
absence of such legislation provide a useful basis for
analyzing the impact of the proposed changes. Reve
nue projections based on existing legislation are called
“current services estimates.”
Current services basis — Charts 1 and 2 show reve
nues projected on a current services basis as a per
cent of GNP, and the component taxes as a percent
of total receipts.9 The nominal GNP used for these
calculations are the administration’s estimates as of
March 1981. Although the split of GNP between prices
and output would probably be different if, in fact, no
tax changes were legislated, there is little reason to
think that nominal GNP would be any different.10
sThe existing legislative schedule for social security taxes in
cludes the following:
Calendar
Combined
year
Wage base
tax rate
1981
1982
1983
1984

$29,700
32,100
35,400
38,700

13.3%
13.4
13.4
13.4

9Current services estimates are derived from Fiscal Year 1982
Budget Revisions, pp. 122-23.
10This, of course, is a “monetarist” interpretation. For evidence
indicating that nominal GNP depends on the growth of
money stock, see Keith M. Carlson, “Money, Inflation, and
Economic Growth: Some Updated Reduced Form Results
and Their Implications,” this Review (April 1980), pp. 13-19.

C h a rt 1

Federal B u d g e t Receipts as a Percent o f G N P 1

LL E stim a te s fo r 1981-1986 a re a lte rn a tiv e p r o je c tio n s : s o lid lin e s a r e c u rre n t serv ic e s p ro je c tio n s a n d d a s h e d lin e s a r e a d m in is tra tio n p r o je c tio n s fro m F iscal 1982 B u d g e t R evisions (M a rch 1981).
[2 E state a n d g ift , c us tom s d u tie s , m is ce lla ne ou s re c e ip ts .

C h a rt 2

|_ _ E stim ates fo r 1981-86 a re a lte r n a tiv e p r o je c tio n s : s o lid lin e s a re c u rre n t se rv ic e s p r o je c tio n s a n d d a s h e d lines a re a d m in is tra tio n p r o je c tio n s fro m F iscal 1982 B u d g e t R evisions (M a rch 1981)
1
[2 E sta te a n d g ift , custom s d u tie s , m is c e lla n e o u s re c e ip ts .

F E D E R A L R E S E R V E BAN K O F ST. L O U IS

MAY

Table 4

Marginal and Average Tax Rates for
Individual Income Tax (percent)1
Calendar
year

Marginal
rate

Average
rate

1962

24.9%

12.9%

1963

26.1

13.1

1964

22.7

11.9

1965

21.8

11.5

1966

22.2

12.0

1967

22.9

12.5

1968

27.0
27.5

14.3

1970

24.5

13.3

1971

24.0

12.7

1972

24.4

12.5

1973

25.7

13.1

1974

26.2

13.7

1975

26.8

13.1
13.5

1976

27.8

1977

28.7

13.8

1978

29.7

14.2

1979

30.6

14.6

1980

31.4

15.3

Current
services

Adminis
tration
plan

1981

32.2%

31.4%

15.9%

15.6%

1982

34.3

28.3

16.8

14.4

1983

36.5

26.9

17.6

13.8

1984

38.9

26.2

18.6

13.6

1985

41.1

27.2

19.4

14.0

1986

43.7

28.8

20.4

14.6

Current
services

Adminis
tration
plan

'As applied to adjusted gross income.
SOURCES: Joint Committee on Taxation and Federal Re
serve Bank of St. Louis.

Chart 1 shows that, with no changes in tax legisla
tion, total receipts would rise to 24.1 percent of GNP
in 1986, compared with 20.3 percent in 1980. The rise
would largely be a result of the individual income
tax, which would rise from 9.5 percent of GNP in 1980
Digitized for38
FRASER

to 12.8 percent in 1986. When viewed in terms of
marginal rates as applied to adjusted income, the rise
is even more dramatic (see table 4 ). Because existing
legislation provides for increases in both the wage
base and tax rate, social insurance contributions would
also rise relative to GNP, from 6.3 percent in 1980 to
6.8 percent in 1986. The remaining taxes would change
little relative to GNP over the same period.
Chart 2 shows the distribution of taxes on a current
services basis. With no legislation, individual income
taxes would rise to 53.0 percent of total receipts by
1986, up from 46.9 percent in 1980. Social insurance
contributions would drop to 28.2 percent of total re
ceipts in 1986 from 30.9 percent in 1980. Corporate
income taxes would continue to decline as a propor
tion of the total, to 10.4 percent compared with 12.4
percent in 1980. Excise taxes would rise early in the
period because of the windfall profits tax, but would
then fall back, showing little change relative to total
receipts from 1980 to 1986.

13.8

1969

1981

Administration projections — The revenue impact
of the administration’s proposal is also shown in charts
1 and 2. Belative to GNP, total receipts would decline
from 20.3 percent in 1980 to 19.6 percent in 1986, a
decline that occurs because the tax cut primarily af
fects individual and corporate income taxes. Al
though individual income taxes relative to GNP de
cline only from 9.5 percent in 1980 to 9.1 percent in
1986, the tax cut is large relative to the current serv
ices estimate. Furthermore, the rapid rise in marginal
rates would be arrested (table 4 ). The decline in cor
porate income taxes is somewhat greater, 1.5 per
cent of GNP in 1986 compared with 2.5 percent in
1980. Social insurance contributions differ little from
current services estimates because the proposed legis
lation is not directed at these taxes. The remaining
taxes are projected to keep pace with GNP, that is,
their proportions change little from 1980 to 1986.
Chart 2 summarizes the distribution of total receipts
among the components. Although varying during the
projection period, individual income taxes in 1986
would be about the same proportion of the total as
they were in 1980 — almost 47 percent. Social insur
ance contributions on the other hand, would rise from
30.9 percent of total receipts in 1980 to 34.8 percent
in 1986. Corporate income taxes continue their fall
from the 1955-80 period to 7.7 percent of total receipts
in 1986. Excise taxes, after rising relative to the total
in 1981 and 1982, end up somewhat higher in 1986
than in 1980. Other taxes and revenues are essentially
unchanged as a percent of total receipts.

F E D E R A L R E S E R V E BANK O F ST. L O U IS

SUMMARY
This article summarizes trends in federal revenues
over the past 25 years, examining the potential impact
of proposed legislation on these trends for coming
years. Only tax receipts are considered explicitly; funds
raised by borrowing and money creation are ignored.
Furthermore, no attempt is made to evaluate the pro
gram in terms of conventional criteria such as impact
on economic growth, resource allocation, distribution
of income or economic stabilization. Nevertheless, the
simple description of developing trends is a starting
point for a more complete economic analysis.
Examination of revenue trends for the period 195580 indicates that, for most of the period, total receipts
essentially kept pace with nominal GNP, though they
have accelerated recently. Even so, 1980 total receipts
as a percent of GNP were still below the proportion
reached in 1969 when a surcharge was added to indi
vidual and corporate income taxes during the Viet
nam War. Though total receipts remained relatively
stable, its composition changed dramatically over the
1955-80 period. Individual income taxes as a per
cent of total receipts fluctuated within a fairly nar
row band, but social insurance contributions rose from
11.9 percent of the total in 1955 to 30.9 percent in

MAY

1981

1980. Both corporate income taxes and excise taxes
declined throughout the period.
The administration has proposed legislation that
would significantly affect these trends. The relevant
comparison against which to measure the impact of
these proposals is the current service estimates, that
is, projections based on the existing tax structure. On
a current services basis, total receipts would rise sharply
to 24.1 percent of GNP in 1986. The effect of the pro
posed legislation, which affects mainly individual and
corporate income taxes, would be to reduce the rise
of total receipts relative to GNP. However, the pro
posed tax cuts would be insufficient to lower the per
centage of total receipts to GNP to its 1955-80 aver
age of 18.6 percent.
With respect to the relationship of specific taxes to
total receipts, the legislation appears roughly to keep
past trends intact. In other words, individual income
taxes would rise slightly relative to total receipts,
while social insurance contributions would continue
the rising trend established in the 1955-80 period.
Corporate income taxes would continue downward,
but excise taxes would reverse their 1955-80 down
ward trend and rise in the 1980-86 period.