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When the economy is close to full employment and the utilization of plant capacity is high, a Federal budget deficit can add to short-run inflationary pressure by increasing aggregate demand for goods and services, and can exacerbate long-run inflationary tendencies by crowding out private investment needed to expand productive capacity. In the late 1960's, for example, unemployment was low and factory operating rates were high. Nevertheless, because of increased spending for the Vietnam war and an unwillingness either to curb other Government spending or to raise taxes significantly, the Federal deficit rose sharply. Not surprisingly, the inflation rate tripled between 1965 and 1969. Requiring budget balance in this period would have helped to avoid overheating the economy and accelerating inflation.

But those circumstances do not always exist. When the economy is sliding into a severe recession, attempting to balance the Federal budget will almost certainly make the recession significantly worse. Deficits occur automatically in recession since declining incomes produce lower Federal revenues and spending for unemployment compensation rises. At such a moment, raising taxes or cutting spending in order to balance the budget would reduce aggregate demand further and throw additional people out of work.

In fiscal year 1975, for example, the Federal budget deficit rose sharply as the economy turned downward in response to escalating oil prices and other shocks. The Federal deficit offset part of the decline in aggregate demand and helped to reduce the depth of the recession. Simulations on the econometric model of Data Resources Incorporated indicate that balancing the Federal budget in both 1975 and 1976 would have raised the jobless rate by more than 3.5 percent—that is well over 3 million people--to about 11 percent of the labor force and would have delayed the recovery a full year. The additional economic slack, on the other hand, would have reduced the inflation rate by perhaps 2 percentage points in 1976 and 1977.

To require that the Federal budget always be balanced is to give up a powerful tool for influencing the economy, especially at the beginning of a severe recession, and to shift the responsibility for stabilizing the economy entirely onto monetary policy. Rather than cast aside such a potent tool for fear that it will sometimes be misused, the Congress should explore ways to preserve discretion over fiscal policy while making it less vulerable to misuse. The debate and explicit votes on budget deficits that are part of the new budget process should reduce the frequency of ill-timed budget imbalance.


Finally, constitutional limitations on Federal spending or budget deficits would probably not reduce pressures for new Federal activities, but might well change their form. The Congress could avoid the budget limits altogether by using the regulatory power of the Federal Government to force the private sector or state and localities to bear the cost of new programs. Employers, for example, could be asked to bear the major cost of national health insurance. New offbudget agencies or Government-sponsored corporations could be created. Increasing use could be made of Federal loan guarantees or other devices to allocate private credit to activities deemed especially desirable by the Federal Government. A constitutional límit on expenditures would also be likely to encourage the use of tax expenditures to provide subsidies to particular activities. Indeed, even without such a limit, subsidies granted through the tax code have been increasing at a faster rate than outlays in recent years—to an estimated $169 billion in fiscal year 1980.

One effect of the new budget process has been to draw congressional attention to the current magnitude of tax expenditures, off-budget agencies and credit activities of the Federal Government and to increase efforts to bring these activities within the purview of the budget process. CBO believes that congressional control of the full range of Federal activities would be enhanced by bringing off-budget spending agencies back on budget, by compiling a credit budget showing various loan and loan guarantee activities of the Government, and by reviewing tax expenditures on the same basis and with the same frequency as direct expenditures. Public decisionmaking is improved and accountability is enhanced when the activities of government are as visible as possible and tradeoffs among them can be explicitly considered.

From this point of view, it seems to me, a constitutional amendment would be a step backward It would encourage the Congress to hide Federal activities in off-budget agencies, to control through regulation, and to subsidize through the tax code The power of the Federal bureaucracy might well increase as accountability to the public was reduced.

In sum, Mr. Chairman, I believe that the Congress has made enormous progress since the passage of the Congressional Budget Act of 1974. I would urge those who believe in balancing the budget and holding down Federal spending to work to strengthen and improve the present process, to use it, and to give it a chance before turning to a fixed rule that might set back progress toward accountable government and that could not be changed without the agreement of twothirds of the House and the Senate and three-fourths of the States.

Thank you, Mr. Chairman.

Senator Bayh. Thank you, Ms. Rivlin. You, really more than any of our witnesses, have had a very close working relationship with what the Congress has been trying to do to come to grips with this problem.

You mentioned the consideration of tax expenditures. How do you differentiate those? What objective were you referring to there, whether they should be included in the spending process?

Ms. Rivlin. Tax expenditure is a term used to designate a subsidy to a particular group of taxpayers through the tax code rather than through direct expenditure.

Senator Bayh. Let me just give you a specific example. I think maybe I know what you mean by what you said. There is a measure now which is picking up a considerable amount of support that would accelerate the time period over which machinery investments could be depreciated. Would that be in that category?

Ms. Rivlin. That is not the kind of provision I primarily have in mind. I am thinking primarily of alternatives to expenditures. For example, the Federal Government subsidizes housing in a number of different ways, some of them through direct expenditures-for example the various #ÚD programs that subsidize housing for low- and middleincome groups—and some of them through the tax code provisions, of which the most obvious are the deduction of mortgage interest, which subsidizes almost everybody's housing, and various tax provisions for investing in housing.

Various provisions regarding medical expenses are other examples of tax expenditures. The largest of these is the provision whereby employers can exclude from employees' taxable income insurance premiums and other medical benefits paid by employers. This is an alternative to Federal direct spending to finance health insurance.

This is not to say that tax expenditures are bad. They may be the best way to achieve some objectives. But the set of tax expenditures should be reviewed and looked at carefully along with direct expenditures.

Senator Bays. We are deeply concerned-you are and all of us, the country is increasingly concerned about inflation. I notice that you say: "Recent escalation in inflation--even though it is largely associated with world oil prices and other events outside the control of the Federal Government, attention has been focused on the inflationcreating potential of Federal deficits.” Now it seems to me from the standpoint of just making good sense, we ought to try to get a balance between expenditures and income. One of the concerns I have is that there has been so much misrepresentation by those in the political process, to the people. There is a great deal of frustration and lack of confidence in the political process. There are a lot of people running around saying all we have to do is balance the budget and that is going to whip inflation. You seem to conclude there are significant other factors that are, as of now, to quote your statement, "largely associated" with other factors. Could you give us a more detailed breakdown of that, please?

Ms. Rivlin. Yes. The basic point is that inflation has different causes at different times. In the 1960's Government deficits clearly were fueling inflation, and since then Government deficits have been identified by the public as the prime cause of inflation.

However what we are dealing with at present is an inflation largely caused by shocks to our economic system that the U.S. Government could have done very little about. The principal shocks have been the rising oil prices over the last several years. And we are dealing with an inflation that, like all inflations, is self-perpetuating. It gets built into the expectations of the people as inflation rises, as the cost of living rises. Then people feel that they want to keep up their real incomes, they want their wages to go up as fast as the cost of living, and that builds in another round of inflation.

The escalation of inflation over the last year or so has not been due either to excess demands for goods and services or to excess wage demands. Wage demands have become rather moderate really. It has been due to outside forces--primarily to energy price increases, and also to an increase in the price of food, especially beef, which is part of the natural cycle that really can't be controlled by the Federal Government. And yet we persist in imagining that if we could just balance the budget this would all go away. Clearly, a large Federal deficit at a time of high employment puts additional pressure on product markets and prices. But at the moment just balancing the budget would not make inflation go away.

Senator Bayh. A situation you point out, on page 7 of your testimony, with respect to the impact that a limitation of certain kinds of budget-balancing amendments would have, where balancing the Federal budget in 1975 and 1976 would have raised the jobless rate by more than 3.5 percent, well over 3 million, to 11 percent of the labor force and would have delayed the recovery a full year. I guess the problem I have in how to deal with this is not that we don't become austere and face up to the need to balance, but the tool we are using or might be tempted to use would create a bigger problem. How does one get out of that situation? You said it would have delayed recovery a full year. If you have 3 million more people unemployed and you take $16, $17 billion as a tradeoff revenue in increased unemployment and welfare, you get up to $50 billion in a hurry. How do you keep this kind of thing from feeding on itself? You have revenue falling off if more people are unemployed, thus more people are unemployed. How do you escape the throes of something like that?

Ms. Rivlin. That is exactly the problem I see in requiring annual balance. Although it would often be good, there would be momentsprimarily while you are sliding into a recession, especially a recession caused from the outside, such as the one in 1975—when, if you had to balance the budget, you would be really making the situation progressively worse. At the moment if unemployment went up a full percentage point over our forecast for next year, it would increase the deficit automatically by about $18 billion. Around $12 billion less revenues would come in and about $6 billion in additional expenditures would be mandated and the deficit would go up. Then the question would be what to do. Presumably, if one were faced with a mandate to balance the budget, the answer would be to raise taxes. But this would have to be by a substantial amount and it would put more people out of work. Or one could cut other expenditures, but it is hard to see what one would cut by $18 billion quickly. That presumably would mean you would cut back on entitlement or other domestic expenditures. But that in turn would throw more people out of work and it might escalate inflation.

Now, there is another tool. There is monetary policy. And the Federal Reserve would be under tremendous pressure to counteract the recession with easier monetary policy. But monetary authorities have problems of their own. They have got to deal with the international scene and it might be very awkward and difficult to run a loose monetary policy at this moment in international circles.

Senator Bayh. What is your estimate, right now, as to what the deficit will be in the current fiscal year?

Ms. RIVLIN. Just under $30 billion.

Senator Bayh. Just under $30 billion. That compares with just about the same as last year, doesn't it?

Ms. Rivlin. Yes, if economic forecasts are correct. As you know, the House and Senate conferees are now meeting on the budget resolution for fiscal 1980. The deficit will end up around $30 billion, which is slightly higher than the deficit for 1979.

Senator Bayh. Here we have been able to hold out the congressional budget process. Now we are slipping back. As you assess the kind of condition we are going to be in, what do you think the next fiscal year's deficit will be?

Ms. RIVLIN. Fiscal 1981?
Senator Bayh. Yes, ma'am.

Ms. Rivlin. It depends entirely on what happens to the economy, on how bad the recession turns out to be. CBO has forecast a relatively mild recession, with unemployment rising over the next few months, but with positive growth resuming in the first part of calendar year 1980. If we are right, then it would still be possible to balance the budget in fiscal 1981, which is the plan that the Senate Budget Committee and the Senate as a whole have voted on. If the recession turns out be a good deal worse then we have forecast, then the deficit will increase automatically, and a balanced budget won't be possible.

Senator Bayh. You still think that your predictions as far as the recession are accurate?

Ms. Rivlin. It is very hard to tell at the moment. It is a very difficult moment for forecasting. But yes, our current assessment is still that the recession is likely to be mild and short lived.

Senator Bays. And how many people will be unemployed at the peak?

Ms. Rivlin. Our estimates have been that the unemployment rate would not go above the low 7's, say 7/4 percent. That is around 7 million people unemployed.

Senator Bayh. Does your projection take into consideration the 14.5 percent prime interest rate?

Ms. Rivlin. No. The developments of the last week were not foreseen by us-indeed, they were not foreseen by very many peopleand they may well alter the situation.

Senator BAYH. I understand the difficulty of absolute and specific answers to this, but certainly with your training and your experience you are more qualified to give us an expert judgment on questions like this, whereas political people tend to do a lot of talking. What do you think the impact of that kind of monetary policy is going to have on unemployment and inflation?

Ms. Rivlin. I think it is very hard to tell yet. The reason for applying such policy is to mitigate the inflation. If that works, and particularly if it shocks the international community into behaving more orderly in the financial and foreign exchange markets, these high interest rates may prove to be temporary. If it is just the beginning of a further tightening of monetary policy, then it could make the recession a good deal worse than we have been predicting. I think it is too early to tell.

Senator Bays. What about the impact of that kind of monetary policy on inflation?

Ms. Rivlin. There are really two impacts. There is the unfortunate impact that the initial effect of raising interest rates is sometimes greatly inflationary; the cost of money is part of the cost of living and the cost of doing business.

On the other hand, there can be a counterinflationary impact. The reasoning behind the Federal Reserve's move must be that those initial impacts will be overcome by a general discouragement to investment and by a limiting of economic activity.

Senator Bayh. I know you can't answer specifically, and I am sure you didn't. I am sure Mr. Volker of the Federal Reserve and others don't want to cause hardship and they do want to fight inflation. You suggest in your testimony that the major cause of inflation is oil prices and other forces outside of the system which we are trying to deal with here by balancing the budget. Is running that interest rate up to 14.5,

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