he effect of the 1965 income tax cut was not only to prolong a period of
prosperity but also to consolidate a revolution in economic thought. The
federal government had undertaken deficit financing in the past, but always in
times of depression or war. This time it purposely pursued a budgetary deficit
when the economy was still in the throes of a protracted peacetime expansion,
when wise men of a previous generation would have urged a prudent surplus in
order to reduce the national debt. The unbalanced budget, which had so recently
been an object of revulsion, had taken on respectability. Government deficits
had ceased to be a sin and had themselves become the mark of a shrewd
This upheaval in applied economic theory is one of the most significant social
developments in modern times. The intellectual innovations which led to its
adoption can take their place with the more spectacular discoveries in the
physical sciences in terms of potential importance to man's welfare. This was
not the case of a government stumbling onto a good thing and then converting a
political accident into an economic principle. It came as a planned maneuver,
based on new concepts which were partly fashioned by the cadre of young
economists who came to Washington with the Kennedy Administration but who--as
in most such cases--were building on the work of contemporaries and
The history of this remarkable development can be traced most simply in three
stages of thought concerning the government's budget and when it should be
balanced. We commit only slight violence to the facts by treating these as
three neat and successive intellectual epochs, as future historians will
doubtless do anyway.
The first period lasted longest, from the earliest conception of a nation's
governmental budget almost to World War II. During it, the federal budget was
regarded as an instrument of governmental housekeeping, performing the same
function as a family's budget. The government had certain functions to perform,
which had been assigned to it by society: keeping order, carrying the mails,
running the courts, providing a monetary system, regulating interstate and
foreign commerce, manning the army and navy. A well-administered government
would see to it that in carrying out these functions it lived within its means,
a feat of good housekeeping comparable with that of the prudent household.
Taxes were levied only to provide the revenue needed for the performance of the
services which society required. If special circumstances--most commonly a
war--obliged the government to borrow funds, this was to be viewed as an
unfortunate but temporary expedient. The sooner the debt was extinguished, the
better. To produce a surplus at the end of the fiscal year, which could be
applied against the national indebtedness, won for a government a crown of
This conception of the budget as a device which disciplined a government to
strive systematically to live within its means, year by year, took such firm
hold of the popular and political imagination that the few professional
criticisms leveled against it were scarcely heard. As iconoclastic an
individual as Franklin D. Roosevelt resorted to deficit financing in the Great
Depression with reluctance and a resolve to end the nation's fiscal disgrace at
the earliest opportunity. Indeed, even John F. Kennedy, who was probably the
most economically literate President in U.S. history, made the annually
balanced budget a policy objective.
The ground for professional criticism of this housekeeping conception of the
federal budget lay in the limited view which it took of governmental functions.
It conceived the government's economic role in the same terms as it would any
other economic unit, private or public: private business performed certain
economic functions, such as providing goods; households performed other
economic functions, such as providing labor services; and similarly, the
federal government performed still other economic functions. The federal budget
was the largest of all budgets, to be sure, even though not by the same margin
as today, but this was a difference in degree and not in kind.
Or was it? Was there something about the government's budget that distinguished
it from that of the Jones family and of U.S. Steel? Was there some special
function connected with it which gave it a purpose other than the economical
provision of particular services? There was indeed, said a school of
economists, whose minority voice failed to attract much notice until the late
1930s, when John Maynard Keynes became its spokesman. Their view gained
ascendancy largely as a consequence of the Great Depression, which lingered on
until finally dispelled by wartime activity, and memories of which provided the
emotional undertow on which full employment policies rode to legislative
approvals in post-war Western Europe and North America. The second stage of our
budgetary history was thereby ushered in.
This second-stage school of economic theorists looked on the budget as
performing not just one function--proper federal housekeeping--but two. The
second function was to preserve the economic health of the nation as a whole.
It was the government's duty, said this group, to see that the nation remained
prosperous, a duty no less important than preserving law and order and
maintaining courts and other such time-honored governmental services. The
nation's economic health was the business of the government because no other
agent or institution could serve as doctor.
The doctor's implements were not only monetary policy--making money cheaper to
use in depressions so that businesses and households would use more of it,
hopefully returning the nation to prosperity; the instrument kit of the federal
government as economic doctor included its budget as well. In times of
depression, it could spend more than it took in, thereby directly putting
people and plants to productive use. It did not have to wait for businesses and
households to become optimistic enough to borrow money at lower rates of
interest. It could put money in their pockets directly by cutting its tax take,
or it could itself spend on a variety of projects, or it could increase the
amount of money it transferred to people who could be counted on to spend it.
All these ways would put the government budget in the red, but it would
increase the nation's economic activity. It would put people and plants to work
whose services would otherwise be irretrievably lost.
All very well, said more traditional economists, but how long could this go on?
How many times could the medicine be repeated? If the government persisted in
deficit spending, its debt would double, its credit would crumble, and it would
find no buyers for its bonds. Fiscal responsibility could not be evaded. The
balanced budget was not a luxury to be dispensed with under pressure but a
necessity of a solvent government.
The economic freethinkers had an answer. It might be true that the government
could not afford to go on piling up new debt on old every time there was a
downturn of business activity. But it would not have to; the fear that
government credit would sooner or later go under, in a persistently rising sea
of debt, was unwarranted. The alarmists were ignoring the existence of the
business cycle, with its alternating phases of boom and depression.
If the economy was depressed at times, experience showed that this was followed
by periods of excessive--inflationary--activity. The government as doctor was
no less needed in the one case than in the other, but the remedy for one was
the opposite of the remedy for the other. In depressions it would spend more
than it took in and use budget deficits to bring the economy back to normal. In
inflations it would take in more than it spent, and use budget surpluses to
restore economic normality. And the surpluses of the inflation end of the
business cycle could be used to pay off the deficits of the depression phase of
Was it necessary to balance the budget? Yes, but only over the period of a
business cycle. Annual balancing was an error, since it ignored the cyclical
rhythm of the nation's health. Outgo and income could be matched over an
appropriate span of years, in which the minuses of some were wiped out by the
pluses of others.
The cyclical-balancing solution did not satisfy very long. For one thing, the
nation's needs seemed to expand with time, so that the federal budget tended to
rise in good years as well as bad. For another, THE cycle was really a myth. If
cycles existed, there were a number of them--inventory cycles, building cycles,
short cycles, long waves, and a variety of others. Which one should be used as
the period for budget balancing, especially when they all overlapped? Moreover,
there was reason to doubt the regularity of any cycles. Average cyclical
durations could be determined, but these would hardly do for purposes of budget
balancing, which should be guided by the actual state of the economy and not
some arithmetic abstraction.
A more daring set of economists began to feel their way toward a different
answer. The nation could not count on regular budgetary surpluses to wipe out
regular deficits. There was no reason to expect that such cyclical balancing
would ever occur. But if the budget were balanced in the good years, then one
could afford to run deficits in those years when the economy slowed down. This
would mean that the national debt would steadily rise over the years, but this
need not cause alarm, since the nation's assets and income were also growing.
Not annual budget balancing, not even cyclical balancing, but balancing only in
the years of plenty was looked on as the appropriate policy.
The primitive nature of this first formulation of stage-three philosophy is
apparent even to the nonprofessional. When is a year a "good" one? How judge
the amount of stimulation which the government should inject into a depressed
economy by means of its unbalanced budget? The answers could scarcely be left
to casual judgment.
A number of theoretical developments, still not fully accepted by all
economists, prepared the way to a new solution. We shall have to deal with
these once over lightly. First was a more systematic method of defining what
was a "good" year, when the government's budget should presumably be in
balance. For some time--at least since the closing years of World War II--the
"good" year had become synonymous with full employment. Now came the
realization that full employment was itself an elastic concept. If it meant
that every person wanting a job was to be put to work, this could probably be
achieved only at the risk of inflation. An English economist, A. W. Phillips,
ran a correlation of unemployment and price levels in England back as far as
1861, and found that when unemployment dropped below 2.5 percent of the labor
force, prices rose. Similar statistical studies showed that the "Phillips
effect" operated in the United States as well, though the upward pressure on
prices came even earlier, when unemployment was at a higher level.
This appeared to imply that if we wanted to avoid unemployment and inflation,
we could do so only in terms of a marginal trade-off of one for the other. At
what degree of "full employment" would the upward pressure on prices still be
tolerable? A compromise point could be selected on the "Phillips curve"--say a
3 percent rate of unemployment accompanied by a 2 percent rise in prices, or a
4 percent rate of unemployment with perhaps only a slight price creep.
Second, with such a compromise determination of what is to be considered full
employment, it is then possible to project "potential GNP." This is the total
income, in gross terms (that is, not making allowance for the capital used up
in producing it), that the economy would be capable of turning out if it were
operating at full employment.
Third, we can estimate, using existing tax schedules, how much revenue the
federal government would collect if the economy were producing the potential
GNP. We can also estimate, on the strength of ongoing governmental programs and
anticipated new appropriations, how much the federal government would be
spending at the same level of national economic activity.
We can be almost sure that revenues would generally exceed outlays, and
sometimes by a considerable margin. Our potential GNP is constantly rising,
owing to an expanding population, longer life expectancies, better education,
automation, and other influences. If we were to attain our constantly rising
potential GNP, the tax take at this always higher figure would mount rapidly.
Besides paying taxes on additional income earned, individuals would move into
higher income tax brackets.
But government expenditures could not be expected to rise by a similar amount,
in part because many of its needs (notably defense) do not automatically expand
just because national income has gone up, and in part because philosophically
we still tend to limit the role of government--the things for which it can
spend its revenues. Thus if the nation were to operate at its potential, the
government would run a substantial budget surplus--a "full employment
And, contrary to our old beliefs, that would not be good but harmful. It would
mean that the government would be taking money out of the spending stream so
that operations at the potential GNP couldn't be sustained--unless, indeed, the
private sector was spending an equivalent amount in excess of its own receipts.
The surplus could be used to retire debt, but that would, for the most part,
simply extinguish bank loans and put nothing in their place.
In short, the full-employment surplus measures the amount of "fiscal drag" on
the economy. It reveals by how much the government's budget is deterring the
economy from reaching or maintaining its desired level of performance.
The only point at which the government budget should be in balance is when the
nation is operating at its full potential. The only point at which it should
seek a surplus is when the economy is attempting to produce more than its
potential, generating inflationary pressures. But more than this is implied.
Even if the government is running a deficit, it may not be running enough of a
deficit to give the stimulus that will carry the economy to its potential. This
would be true if, with rising GNP, the federal goverment's budget would come
into balance before the potential was realized. It would then be taking in more
money than it was spending, thereby acting as a brake on economic activity
before its destination was reached.
This was the general line of reasoning behind the income tax cut of 1965 and
the excise tax cuts projected for the next few years. By reducing taxes to a
level which at full employment would produce only as much revenue as would be
needed to cover expenditures, the government necessarily collects less now. It
leaves more money in the business and household sectors; if they spend it, as
they will in large proportion, this augments economic activity and brings us
nearer the full-employment goal.
TAX-CUTTING: NEW FISCAL TOY
It is this phenomenon that has given rise to the colorful description of the
new fiscal policy as "spending our way to prosperity." In effect, we can buy
more and be better off for doing so.
Skeptical politicians have wondered whether such a policy courts inflation.
They are uneasy with a policy which appears to reward profligacy. An amusing
instance of this attitude occurred during Senate hearings over the proposed
income tax reduction A New England lawmaker asked Walter Heller, then chairman
of the President's Council of Economic Advisers, why so many people resisted
the new fiscal philosophy if, in effect, it promised reward for
self-indulgence. Heller said he supposed any public disapproval stemmed from a
residual Puritanism--to which the New England senator, still dubious but not
doleful, replied that he himself was more of a Puritan than a Heller.
But any earlier doubts now seem largely to have been dispelled as a result of
the success of the 1965 tax reduction, and an increasing number of legislators
appear to embrace the new approach with enthusiasm. What politician can for
long resist the appeal of voting for tax reductions? Is there, then, danger
that the new fiscal toy will be overused with inflationary consequences?
Any policy is of course subject to abuse, but as long as the size of budgetary
deficits is geared to the full-employment surplus, there is a built-in monitor.
In the final analysis, the new fiscal policy is based less on deficit budgeting
than on budget balancing. When the potential GNP is reached, the government's
outlay will be in line with its income, since that is the point at which the
government's budget is planned to be in balance.
Balance the budget? Of course, but what budget? The answer which is now being
given is the full-employment budget. At levels short of full employment this
means balancing not an actual but a hypothetical budget, the budget as it would
be if we were operating at potential GNP. This is not a matter of running in
the red in a vague hope that this will do the economy some good, as the
bloodletting of earlier days was expected to restore a patient's health. It is
the incurring of deficits in an amount which is guided by calculations of
potential GNP, which in turn is based on computations of the level of
acceptable compromise between unemployment and price increases.
NATIONAL DEBT NO MORTGAGE
Resistance to the new economics comes from several sources. On the popular
front there is still a widespread conviction that the national debt is like a
mortgage on the house, with all the attendant hazards. At least part of the
initial opposition to last year's income tax reduction stemmed from a belief
that adding to the national debt when the economy was running strong was piling
up a burden on future generations for the self-gratification of the present.
Aside from failing to grasp that present gratification was not the object, but
only the removal of a budget barrier to future economic progress, those of this
persuasion persisted in believing that future generations would somehow have to
pay off that larger debt to someone else. But except for the relatively small
proportion of the debt held abroad, the future generations will not have to pay
someone else but only themselves. All will pay taxes to the government in
varying amounts, and some will receive interest from the government on the
bonds which they hold. Some will pay more and receive less than others,
proportionately, and vice versa, but what is involved is a redistribution of
the income at that time and not a transfer among the generations. The
composition of the debt is of course important--who holds it in what amounts
and how much they get paid for holding it. The tax structure is also
important--who pays into the federal coffers the funds which must be used to
pay interest on the debt. This is why federal financing is always open to
review and reform. But this is a different matter from looking on the debt as a
mortgage on the nation which must be paid to avoid some Simon Legree's
The nation's taxing power permits it to redistribute the national income so
that those holding the debt will always be provided for. This does not mean
that size of our national obligations is of no consequence; tax collection even
for purposes of redistribution always involves more pain to some people than to
others. But it does mean that deficits which are economically advantageous to
society as a whole need not be avoided because of superstition that we are
"mortgaging" the future.
A second reason why the new economics is sometimes resisted is the belief that
the statistical calculations which are called for cannot be made with
sufficient accuracy to be used as the basis for fiscal policy. The potential
GNP of which we talk so glibly, as well as estimates of actual GNP, involves
questionable assumptions in regard to business investment, people's
employability, productivity, bargaining power, and other variables. The need
for guesswork and the possibility of error are evident.
Nevertheless, our knowledge, while imperfect, is improving, and the refinement
of our economic understanding serves to pinpoint the areas in which further
improvement is most urgent. Arthur Okun, one of the three economists currently
composing the Council of Economic Advisers, has said, "All I would claim is
that we can do better using our knowledge than ignoring it. We'll make mistakes
some of the time, but we'll be pushing in the right direction most of the
There is of course no basis for believing that economic "truth" about budget
balancing has now, finally, been divulged. We can be sure that a fourth stage
in our thinking lies somewhere over the horizon. We might even surmise that it
has something to do with the relative advantages of tax cuts versus government
expenditures, a matter which so far has been more the subject of vocal
inflection than cerebral reflection.
But of one other thing we can also be sure. Our present stage-three thinking
represents a vast improvement over its predecessor stages. And whether it
appears excessively simplistic to some or dubiously synthetic to others, it is
a product of contemporary social science no different in its fundamental
importance from current innovations in the physical sciences.
Copyright © 1966 by Neil W. Chamberlain. All rights reserved.