Fiscal Analysis in the Federal Republic of Germany: The Cyclically Neutral Budget

Use of government revenue and expenditure powers to promote stability is a principle that gained popular acceptance slowly in the Federal Republic of Germany. However, a considerable change of attitude took place during the 1960s, and fiscal thinking has become much more activist-oriented. The Stabilization Law of 1967 obligates the Federal Government and the states to “observe the requirements of overall economic equilibrium in their economic and fiscal measures.”1 The Act arms the Federal Government with a wide variety of discretionary fiscal powers. Included among these are surcharges on individual and corporate income, authority to adjust an investment tax credit and to alter depreciation rules, and authority to force postponement of the public investment projects of the lower levels of government.


Use of government revenue and expenditure powers to promote stability is a principle that gained popular acceptance slowly in the Federal Republic of Germany. However, a considerable change of attitude took place during the 1960s, and fiscal thinking has become much more activist-oriented. The Stabilization Law of 1967 obligates the Federal Government and the states to “observe the requirements of overall economic equilibrium in their economic and fiscal measures.”1 The Act arms the Federal Government with a wide variety of discretionary fiscal powers. Included among these are surcharges on individual and corporate income, authority to adjust an investment tax credit and to alter depreciation rules, and authority to force postponement of the public investment projects of the lower levels of government.

I. Introduction

Use of government revenue and expenditure powers to promote stability is a principle that gained popular acceptance slowly in the Federal Republic of Germany. However, a considerable change of attitude took place during the 1960s, and fiscal thinking has become much more activist-oriented. The Stabilization Law of 1967 obligates the Federal Government and the states to “observe the requirements of overall economic equilibrium in their economic and fiscal measures.”1 The Act arms the Federal Government with a wide variety of discretionary fiscal powers. Included among these are surcharges on individual and corporate income, authority to adjust an investment tax credit and to alter depreciation rules, and authority to force postponement of the public investment projects of the lower levels of government.

A law of 1962 created the Council of Economic Experts—Sachverständigenrat (SVR)—charged with reviewing the economic situation and issuing periodic reports. While obliged to consider and to reply to these reports, the Government itself is under no obligation to adopt either the recommendations or the system of analysis employed by the SVR. Nevertheless, the SVR is an influential body, and its system of fiscal analysis represents a potentially important contribution to longer-range fiscal planning, as well as to budget impact analysis.

A theme that runs strongly in SVR reports is that expenditure and revenue policy should be planned on a longer “intermediate-term” basis, not on a yearly piecemeal basis. Short-term emergency action should then be conducted against the backdrop of the longer-range plan. In the words of the SVR

A policy aimed at steadying the cyclical trend should be shaped in the light of the development of productive capacity…. Medium term financial planning should ensure that the decisions and planning of the State that reach into the future meet this requirement.2

To implement these aims, the SVR has developed a set of budgetary guidelines which it calls the cyclically neutral budget (CNB). The CNB has both long-range and short-range functions and implications. Its long-range implication is that it specifies a budgetary posture consistent with and supportive of steady growth of potential output. Its short-range function is that it specifies a hypothetical cyclically neutral budgetary posture against which the countercyclical impact of the actual budget can be assessed.

The basic idea behind the CNB can be introduced by considering appropriate fiscal planning within an environment of perfect certainty and accurate forecasting. Under such conditions, the fiscal planner should first calculate the time path of potential output. Then, taking the existing tax structure as given, he should forecast the associated private expenditure components—consumption, investment, and net exports—that are implied by this tax structure and by the projected potential output levels. The resulting differences between potential output and the sum of these expenditure components are the successive “fiscal gaps.” These gaps may be thought of as the levels of government purchases of goods and services that would cause actual and potential output to coincide and that therefore would maintain full employment over the planning period. It is not, of course, implied that levels of government purchases must be set to equal the gaps. Although this is one possibility, many others are available. Monetary policy may be used to change the level of investment. Taxes and government transfer payments may be adjusted to affect private consumption. Balance of payments policies may be used to alter the balance of trade. And combinations of these policies may be employed in such a way as to eliminate a gap and thereby set aggregate demand to equal potential aggregate output.

The fiscal gap approach attempts to prescribe budgetary policy that is optimal from a macroeconomic point of view. In practice, however, simplifying devices, such as planning for a zero full employment surplus or for a cyclically neutral budget, are frequently employed. These simplifications may in part indicate that perfect information is absent and that forecasting is highly unreliable. Under such conditions alternative procedures of varying degrees of sophistication assume importance. One such procedure is budgetary planning which is based on the assumed constancy of certain economic parameters that have come to be called “the great ratios” of economics. For example, past experience may indicate that under normal circumstances investment and saving bear fairly stable proportionate relationships to potential gross national product (GNP). Experience might also show that the trade balance generally has some “normal” surplus or deficit. Full employment in a particular year implies that the government’s budgetary posture was appropriate. Furthermore, if the historical great ratios correspond to the actual ratios for that year, it can then be inferred that this budgetary posture should be continued into the future in the sense that expenditures and taxes should be projected so as to maintain their base year proportionality to potential output.

This somewhat simplified introduction represents the conceptual foundation on which the cyclically neutral budget is constructed. First, a base year of full employment is selected. Cyclically neutral government expenditure is then calculated as a fixed proportion of potential output, the factor of proportionality being the base year ratio of government expenditure to potential output. Similarly, cyclically neutral taxes are defined as a fixed proportion of actual GNP, the factor of proportionality in this case being the base year ratio of taxes to actual GNP.

Fiscal projections that follow these basic guidelines are designed to assure that secular excesses or deficiencies of private demand will tend to be offset by the budget. Moreover, the coordination of expenditure and revenue growth protects against fiscal drag, in the sense that it prevents a tendency for revenue growth to outstrip expenditure growth. The cyclically neutral budget therefore has the important property that the budget itself cannot become the source of a divergence between actual and potential output. Indeed, if actual and potential GNP remain equal through time, expenditure and revenue will both grow at the rate of growth of potential output and the budgetary deficit (or surplus) will remain constant as a proportion of potential GNP.3 Moreover, although this budgetary policy provides no guarantee that full employment will be maintained at all times, it will yield that result if the great ratios maintain their base year values. Finally, it should be noted that this budgetary posture might imply a secular deficit or it might imply a steady surplus. There is no reference to budgetary balance either annually or cyclically.4

The formal statement of the CNB expenditure and revenue rules is as follows:

The expenditure side of a public authority budget is… cyclically neutral when the percentage increase in expenditure keeps pace with the growth of productive capacity.5

Implied, therefore, is a fixed ratio of expenditure to potential output.

Second, with respect to revenue,

The revenue side of the public authority budgets… is cyclically neutral when, the tax system remaining unchanged, it is to be expected that tax receipts—in a situation in which the growth of the national product keeps pace with the growth of productive capacity—will increase at the same rate as the national product.6

This formal statement is not clear as to whether neutrality implies revenue growth at a rate equal to growth of potential or actual GNP. However, actual GNP is in fact utilized in the calculation of neutral revenue. Neutral revenue, then, is that level of revenue which would be generated if the buoyancy of taxes with respect to GNP is maintained at unity.7

The definitions of neutral revenue as proportional to actual GNP and of neutral expenditure as proportional to potential GNP are critical. When actual GNP falls short of potential, the maintenance of actual revenue as equal to neutral revenue implies that the relative share of national income which accrues to the public and private sectors remains constant. Were neutral revenue to be defined as proportional to potential GNP, growth of actual GNP at a rate less than potential GNP would raise the proportion of national income which accrues to the public sector, provided that equality between actual and neutral revenue is maintained.

It does, however, seem appropriate to define neutral expenditure as proportional to potential rather than actual output. When actual output falls short of potential output, the government does not encroach on the share of output available to the private economy if the government follows its neutral expenditure path. Indeed, to lower its expenditure at such a time would, because of multiplier effects, lower even more the output received by the private sector.

In combination, the expenditure and revenue rules imply a posture of proportionality between the public and private sectors. The expenditure rule maintains a constant fraction of potential output for public sector use, while the revenue rule maintains constancy of the relative share of actual income that accrues to the respective sectors.

The implication of permanent rigidity of shares is one which the SVR seems to wish to avoid. It therefore states a third rule which allows for cyclically neutral changes in the proportion of potential output and income accruing to the public sector.

A change in the “State quota” is cyclically neutral when the cyclical effects that arise from the expenditure side are matched by equivalent effects in the opposite direction arising from the revenue side.8

In this way some flexibility in the planning of expenditure shares is allowed for, and the concept of cyclical neutrality is broadened to include a situation in which the overall budget is cyclically neutral even though the individual expenditure and revenue rules are violated. The revenue system of the Federal Republic of Germany is highly income elastic. Therefore, growth in GNP often brings with it revenue growth that exceeds the cyclically neutral amount. However, if expenditure also grows by an amount equal to the growth in revenue, the overall budget would still be regarded as cyclically neutral by the SVR.

An important attribute of the CNB that will be discussed in Section III is its ability to serve as a backdrop against which the magnitude and direction of countercyclical fiscal policy can be ascertained. For example, measured against the SVR’s concept of neutral government expenditure growth, an increase in expenditure would be viewed as expansionary in a cyclical sense only to the extent that it exceeds the rate of growth of potential output. Therefore, even if expenditure grows faster than actual GNP, this would still not be regarded as expansionary if the rise in expenditure were below the rate of growth of potential GNP. The CNB therefore helps to avoid misdirection by calling attention to the need to assess short-range budgetary policy against the backdrop of the growth of potential output.

This paper continues with an evaluation of the CNB as an instrument for supporting steady growth of potential output. It is shown in Section II that CNB rules are consistent with the rules implied by the fiscal requirements of steady growth at potential output, and in this respect they are superior to full employment budget rules. Section III discusses the cyclically neutral budget in its role as a yardstick against which countercyclical policy can be measured. In Section IV, the CNB is compared with the full employment budget, and CNB calculations for the economy of the United States are presented.

II. The Cyclically Neutral Budget and Longer-Range Budgetary Planning

The so-called medium-term planning period in the Federal Republic of Germany was to have been for five years, commencing with a base year. If one had to plan fiscal policy for such a period, one might follow the suggestion presented in Section I by starting with a projection of potential output; moving from there to an attempt to measure the fiscal gap; and then turning to the CNB as a simpler alternative. The present section begins in this way—formalizing the earlier argument more precisely and in greater detail—and it then moves on to consider the problems that arise in connection with use of the CNB as an instrument of longer-range budgetary planning.

A basic input into longer-range fiscal planning is a projection of potential output over the planning period. The SVR potential output projections are made, not with reference to full employment, but rather with reference to full capacity. There is probably good reason for this choice of reference, since labor input in the Federal Republic of Germany has been quite elastic as the result of the extensive use of foreign labor. Under these conditions, output limitations depended primarily on the size of the stock of capital. When labor supply is highly elastic, it becomes reasonable to assume that potential output is proportional to the stock of capital, and in fact this is how the SVR approaches the estimation of potential output.9

Following the lead of the SVR, let potential output be proportional to the stock of capital so that,


where P is potential output, k is the average productivity of capital, and K is the stock of capital. Next assume that net investment is proportional to potential output, so that


where I is net investment, and a may be described as the investment rate. It then follows from equation (1) that


so that, on substituting equation (2), the rate of growth of potential output


and the solution for potential output as a function of time


both follow directly.

The next problem is the calculation of the fiscal gap. The fiscal gap may be defined as the level of government purchases that, given the existing tax structure, would be sufficient to make aggregate demand equal to potential output. Calculation of this gap is accomplished by subtracting aggregate private expenditure associated with potential output from the level of potential output. In other words, it is desired to make


where G is the required level of government purchases, and C, I, and (XM) are, respectively, the levels of consumption, investment, and exports minus imports, that would be observed if actual output equaled potential output.

Equation (2) permits I to be replaced by aP. Similarly, if consumption is proportional to disposable income, the level of consumption at potential output will be


where b is the marginal (and average) propensity to consume and T is the level of tax yield. Using these relations in equation (5) and dividing both sides by potential output P gives the relative fiscal gap as


where f=XMP is the ratio of the trade balance to potential output (henceforth referred to as the trade-balance ratio).

In principle, equation (7) solves the fiscal problem since it prescribes on the left-hand side the appropriate level of government purchases provided that all of the information on the right-hand side is at hand. However, economies are not as simple as here depicted, and there will be considerably more than three relevant parameters that need to be measured and incorporated into the solution for the fiscal gap.

To see how the CNB deals with this problem, first move the term b(TP)

to the left-hand side of the equation. This gives


and thereby translates the requisite fiscal gap into the requisite weighted budgetary deficit expressed as a proportion of potential GNP. In these terms the rule for the maintenance of equality between actual and potential output states that the weighted budget deficit relative to potential output should be made equal to the difference between the fraction of disposable income saved and the sum of the investment rate and the trade balance ratio. Very strong investment relative to saving and/or a trade surplus imply that the budget should be in surplus in order to avert inflationary pressure, whereas the opposite situation will require a deficit to avert underutilization of resources. Equation (8) then sets down the requirements for appropriate fiscal policy expressed in terms of the weighted deficit, rather than the fiscal gap.

As suggested above, the problem is that one may know very little about the right-hand side of equation (8). What can then be done is to search for some past year during which potential output was actually attained. Having found such a base year, one can then assume that the budgetary deficit (or surplus) that existed in that year was appropriate. Then, and this is the crucial step, if constancy of the great ratios found on the right-hand side of equation (8) can be assumed, one can also assume that the base year deficit relative to potential GNP should be maintained throughout the planning period. Thus, the step that permits complicated estimation problems to be bypassed is the assumption that it is appropriate to replace the unknowns on the right-hand side of equation (8) by the known weighted deficit of the base year. This step, then, transforms equation (8) into


where, for example, G0 is the base year level of government purchases. This, then, is the basic equation that provides the backdrop against which the SVR rules can be evaluated.

The rate of growth of potential output has already been calculated and is equal to ak. Since the ratio of the weighted deficit to potential output must remain constant, the rate of growth of the weighted budget deficit must also be ak. Moreover, it would not be possible for the overall weighted deficit to grow at a constant exponential rate while the individual tax and expenditure components are growing at different constant exponential rates. It follows that neutral expenditure and revenue growth must proceed at equal rates; that these rates must be equal to the rate of growth of the weighted deficit; and that this common rate must, in turn, equal the rate of growth of potential output. It also follows that the ratio of government purchases to potential output and the ratio of taxes to potential output must remain constant. Indeed, when contemplating the fiscal requirements of steady growth, one can hardly conceive of exponential expenditure and revenue paths that do not conform to this requirement.10

The SVR expenditure and revenue rules are consistent with the foregoing model. However, they are not the only set of rules implied by it. If actual and potential output are the same, it does not matter whether expenditures and taxes are made proportional to potential output or to actual output. Thus, a rule that requires both taxes and expenditures to be proportional to actual output is equivalent to a rule that makes them both proportional to potential output; and these two, in turn, are equivalent to the mixed SVR rules which set the neutral expenditure path proportional to potential output and the neutral revenue path proportional to actual output. The particular choice of the SVR reflects a desire to provide a set of guidelines simultaneously consistent with a concept of fiscal neutrality that applies both when actual output equals potential output and when it does not. As shown in Section III, it therefore also provides a frame of reference for short-run fiscal impact analysis.

From a long-run perspective, the cyclically neutral budget implies that a fixed relative share of resources will be devoted to the public sector. Nevertheless, the SVR attempts to avert the rigidity thus implied by allowing for so-called cyclically neutral changes in the state quota. While this appears inconsistent, since fixed relative shares are at the heart of cyclical neutrality, a state quota change can be interpreted as a once-for-all change in initial conditions. In other words, a cyclically neutral change in the state quota may be regarded as any instantaneous change in government purchases whose aggregate demand effects are immediately offset by corresponding tax changes. Within the present framework, this means that at a moment of time a neutral change in the state quota meets the requirement that the weighted budget deficit must remain constant.

As implied by this analysis, the weighting of budgetary items in accordance with their aggregate demand impact would appear to be of considerable importance. Nevertheless, the SVR makes no attempt to distinguish the aggregate demand impact of different components of the budget. Expenditures are not distinguished as to purchases or transfer payments, and both are given equal weight with taxes. Although the absence of weighting is clearly a shortcoming, it causes no problems if there are no changes in the relative composition of the budget. As long as this is the case, the actual budget deficit and the weighted deficit will both grow at the rate of growth of potential output. Changes in the relative composition of the budget are another matter. An increase in expenditure, matched by an equivalent rise in taxes, will not in general be cyclically neutral. The same might well be the case if there is a shift from indirect to direct taxation.

These discrepancies may be too small to cause serious concern when considered against other potential sources of discrepancy. In any case, there appears to be no good reason why suitable weighting cannot be directly incorporated into neutral budget concepts and calculations. The model presented in this section would appear to show how completely compatible the cyclically neutral budget would be with the weighting of individual components.

Critics have been swift to call the SVR to task for its apparent naiveté.11 The SVR, however, is well aware of the problem,12 but it contends that it has too little precise empirical information to make budget weighting reliable. It has not been thought worthwhile to weight the full employment budget of the United States, because drastic structural budgetary shifts are not likely to occur during a five-year planning period.13

The adequacy of the cyclically neutral expenditure and revenue rules as a guide to policy depends on the adequacy of the assumption that the great ratios of the system are stable. If the investment ratio is unstable and unpredictable, it may be impossible to project neutral longer-term expenditure and revenue paths that are not in need of constant revision. This may not have been a problem for the Federal Republic of Germany since the ratio of real gross fixed capital formation to real gross domestic product (GDP) shows considerable stability. This ratio averaged 25.6 per cent over the period 1960–68. It deviated from the average value by more than 1 percentage point in only two years; it exhibited a standard deviation of only 1.0 percentage point; and it showed no discernible trend over the period.

The trade balance ratio is considerably more troublesome. Even if imports, which depend upon domestic demand, maintain a proportional relation to GDP, exports depend upon foreign demand. The ratio of exports to GDP has not been constant; it has showed fairly steady growth during the period 1960–68. Since the ratio of exports to GDP continued to rise after 1966,14 the selection of that year by the SVR as a base from which to project neutral expenditure and revenue paths would have imparted an inflationary bias to fiscal policy if the neutral expenditure and revenue paths had been rigidly adhered to.

The most difficult problem associated with the CNB is the selection of an appropriate base year. Even if the important great ratio parameters show little variation over time, there is no guarantee that the base year values will be representative of the norm. The first requirement for a base year is that actual and potential output should be as close as possible. Equally important is the requirement that the base year should be a year during which the saving-investment rates, the trade-balance ratio, and the budget were representative of the longer term.15 For example, it is possible that the first requirement could be met in a year of investment weakness if an extraordinarily large budgetary deficit, or trade surplus, existed to offset this weakness. Or, if investment is stronger than usual, this might still be compatible with the absence of inflationary pressure, provided that the trade balance deteriorates or the budget is more than usually restrictive. In the former case, neutral expenditure and revenue projections from a base so selected would impart an inflationary bias to the longer-range budget, whereas in the latter case a fall in investment to more normal relative levels would cause the budgetary bias to be deflationary.

In its report for 1969 the SVR selected 1966 as its base year. Inasmuch as a recession began during that year, this seems to have been more a practical decision than one based on economic considerations. It seemed appropriate to commence with that year because

… it was the desire of the Federal Government that from then on budgetary policy be shaped in the light of the development of the “overall power of the economy,” i.e., productive capacity as is also required by the cyclically neutral budget concept.16

Some attempt to justify the selection of 1966 as a base year on economic grounds is also made.

In 1966, the “State quota,” measured by State expenditure in relation to productive capacity (at current prices) was very close to the average of the preceding four years (1966: 28.5 per cent; average 1962 to 1965: 29.0 per cent); there was no rising or declining trend in this period.17

In some respects, 1966 appears to have been a reasonable base year when compared with earlier years. It is puzzling, however, that this base was not established until 1969 and that it was retroactively selected despite the fact that the trade balance ratio jumped significantly in 1967 and remained high throughout the next three years. Also of concern is the fact that there was a GNP gap—that is, a discrepancy between actual and potential GNP—of some 19.1 billion deutsche mark (3.7 per cent of potential GNP) in 1966. Since cyclically neutral revenues were projected with actual GNP as a base, the projected path represents a revenue shortfall below the path that would have been projected if 1966 had been a year of full potential activity. On both counts, therefore, it would appear that the neutral budget projections contained an inflationary bias. The SVR does recognize that

A base that was once right can become wrong when the actual developments lastingly deviate in one direction from the path that is substantially co-determined by the old base.18

In consequence of this recognition, it is somewhat surprising to find no reference to the implication of the sharp change in the trade balance ratio or to the revenue shortfall on selection or revision of the base year.

A brief comparison of the longer-range normative implications of the cyclically neutral budget with the norms generally associated with the full employment budget of the United States is instructive. While problems such as the selection of a base year and the stability of the parameters, as well as the deflator problems yet to be considered, may make it difficult to project appropriate neutral expenditure and revenue paths in practice, it nevertheless remains true that the budgetary philosophy attempts to accommodate economic growth. Certainly, the SVR would reject any budgetary strategy that called for a zero deficit (or surplus) over the interim planning period merely as a matter of principle. However, this is precisely what the full employment budget appears to do.

The full employment budget is calculated by estimating revenues as they would have been realized under the existing tax structure if the economy had been at full employment. Expenditures are then taken as given, except for adjustments to cyclically sensitive transfer payments. The resulting revenue excess is denoted as the full employment surplus. The chief virtue of this measure is that it calls attention to the fact that the budget may be restrictive, even when the actual budget shows a deficit. Despite differing official economic philosophies, it is fair to say that throughout its history the full employment budget has carried with it the normative proposition that an appropriate longer-range budgetary posture is an expenditure-revenue path that yields balance or a “moderate surplus” at full employment.19 Officials of the Nixon Administration took this stricture very seriously, and they habitually referred to “high employment” deficits as “inflationary.”20

To assume that full employment balance is generally appropriate ignores all of the ways, enumerated previously, in which this can misfire and become a recipe either for secular stagnation or for secular inflation. If it is in any sense optimal strategy, it must carry with it the assumption that imbalances between saving and investment and exports and imports will quickly right themselves automatically, or that monetary policy can be counted upon to correct these imbalances. From the vantage point of a base year relationship, the full employment budget assumes that the appropriate base year deficit is zero, whereas the cyclically neutral budget makes no such restrictive assumption. This is the crucial difference between the two philosophies.

Among more sophisticated budgetary thinkers in the United States, the idea that a moderate surplus should exist at full employment arose from the desirability of attaining a growth-oriented policy mix. By taxing more heavily than the amount that would yield full employment budgetary balance, and by offsetting the resulting deflationary effects by expansionary monetary policy, a bonus would accrue in the form of faster growth. In the words of Okun and Teeters: “Most longer-term projections of a desirable and feasible pattern of economic activity provide for some moderate positive full employment surplus to avoid excess demand and tight money.”21 Thus, the moderate surplus at full employment target can be interpreted as implying a strategy for growth which involves an active attempt to alter the investment rate by altering the mix of policy.22

No such attempt is implied by the cyclically neutral budget. It takes the parameters of the economy as given and attempts to adjust the budget so as to create minimal interference with the growth process. This is evident from the rules on cyclically neutral expenditures and revenues, and it is also evident from the SVR’s prescriptions with respect to public borrowing. The concept of cyclically neutral long-term government borrowing is introduced in the SVR report for 1972, where long-term government borrowing is defined as cyclically neutral when it grows at the same rate as the actual national product. It was felt necessary to add this rule because

The taking up of longer-term credits by the Government may possibly produce certain effects on the demand on productive capacity made by the private sector. To that extent, longer-term borrowing stands side by side with tax receipts and other receipts that are intended to keep free for the State that portion of productive capacity that is to be employed by government expenditure.23

The intention of the rule is to promote sectoral balance and to provide a repository for surplus private saving.

If the longer-term net indebtedness increases at the same rate as the national product, then, if the saving ratio … remains constant, the Government takes up a constant share of private saving.24

If the base year relationship implies the need for a deficit to sustain potential output over the planning period, this implies an excess of private saving over investment. If the Government issues long-term debt proportional to the amount of this projected full-employment deficit, it supplies the assets which, in combination with the new securities supplied by investment, will remain proportional to the demand for these securities as provided by new saving. The presumption then is that interest rates will tend to remain stable, and the share of investment in national product will therefore tend to remain constant. Debt policy, therefore, appears to be conceived as one means of holding the great ratios constant is such a way as to support the expenditure and revenue rules based on this assumed constancy.

It should be noted that long-term borrowing is to proceed at the rate of actual, rather than potenial, GNP growth. When actual GNP grows less rapidly than potential GNP, the supply of saving is less than at potential output so that the demand for new securities is also less. The essence of neutral borrowing, then, is to prevent a change in the relative public-private competition for loanable funds.

As noted above, the cyclically neutral budget does not incorporate an activist growth policy inasmuch as it is frozen to its base year great ratios. This implies, among other things, constant interest rates and therefore no active attempt to raise investment’s share of GNP. The SVR does not specify a desired growth target nor does it appear concerned with changing the potential growth rate. One can speculate that with the extraordinarily high ratio of gross fixed investment to GNP that has characterized the economy, activist growth policy could hardly have been a high priority item.

There is a further difficulty. One would imagine that any outline of a cyclically neutral macroeconomic government program ought to contain, as an essential ingredient, a rule to specify a cyclically neutral rate of monetary growth. Yet no such rule is found in the SVR reports. What we do find is a note of pessimism with respect to the potential effectiveness of monetary policy.

There are times in which the supply on the capital market is very elastic; under such conditions, even a large additional demand is met at the prevailing interest rate or a slightly increased rate. This may have cyclical causes and be due to credit policy. It may also be the result of international capital movements.25

The reference to international capital movements seems crucial. The Federal Republic of Germany has a highly open economy in which it was difficult to control the supply of money and the level of interest rates prior to the abandonment of the fixed exchange rate.26 An increase in the money supply brought about by central bank open market purchases will initially lower interest rates. But if international capital is highly mobile this will induce an outflow of capital. If the monetary authority is committed to a fixed exchange rate, it must then sell foreign exchange and, in so doing, repurchase the domestic money that had originally been sold in exchange for government securities. Since the abandonment of fixed exchange rates carries with it an increase in the degree of monetary autonomy, more attention to the subject of a neutral rate of monetary growth can be expected in the future.

Meanwhile it is appropriate to speculate as to what a cyclically neutral rate of monetary growth should be. The rule which seems to be closest to the spirit of cyclical neutrality as conceived by the SVR is that a cyclically neutral rate of monetary growth equals the rate of growth of potential output—provided that the income elasticity of the demand for money is unity, and provided that there are no secular improvements in the efficiency of the monetary system of a sort that increase the secular velocity of money. If these provisos are met, the real rate of interest will tend to remain constant as long as actual output equals potential output.

From a cyclical perspective, this rule prevents monetary contraction when actual output falls below potential output, and it would not imply monetary expansion when actual output is tending to exceed potential output. The rule tends, therefore, to avoid the worst kinds of monetary policy mistakes. This would not be the case if neutral money supply were made proportional to actual output. In that event the rule would imply fixed interest rates at all stages of the business cycle, and this would increase the amplitude of fluctuations in economic activity.

A total package of cyclically neutral fiscal-monetary policy would require borrowing, monetary growth, expenditures, and revenues all to proceed at the rate of growth of potential output when actual and potential output coincide. However, when there is a GNP shortfall, it becomes difficult to visualize a consistent set of cyclically neutral policies. If the expenditure, revenue, long-term borrowing, and monetary growth policies are followed, the GNP shortfall widens the actual budgetary deficit and, given the other neutrality constraints, this must imply a nonneutral increase in the level of short-term borrowing. It would appear then that borrowing can only be cyclically neutral if the rate of monetary growth is not, and vice versa. It seems appropriate to suggest that the SVR abandon its rule on cyclically neutral borrowing and that it replace this with a suitable rule to define the cyclically neutral rate of monetary growth.

III. The Cyclically Neutral Budget as an Instrument of Short-Run Analysis

This section focuses attention on the cyclically neutral budget as an instrument for measuring the cyclical effects of fiscal policy. It commences with a description of its use in this regard by the SVR, and then considers some of the issues that are raised by this approach to fiscal analysis.

With the concept of the “cyclically neutral budget” the Council of Experts has developed a yardstick which makes it possible to measure the cyclical effects of budgetary policy as deviations from that budgetary policy, which, if steadily pursued, as such does not change the utilization of productive capacity.27

At the outset it is important to recall that cyclically neutral government expenditures are calculated by multiplying the base year ratio of expenditure to potential output by the potential output estimates of subsequent years. Cyclically neutral revenue is calculated by taking the ratio of tax revenue to actual GNP in the base year and then multiplying subsequent actual GNP values by this ratio. Therefore, when actual GNP falls short of potential, cyclically neutral revenue is reduced in proportion to the GNP shortfall while cyclically neutral expenditure remains unchanged. The cyclically neutral budget therefore shows what would happen to the budget if expenditures continued along their projected course, and if the buoyancy of taxes with respect to GNP were unity.

Table 1 provides background data that serve as inputs into the calculation of cyclically neutral budget concepts. Table 2 then shows the calculations. This table duplicates portions of Table 28 of the SVR report for 1972.28 The wide excess of expenditure over revenue is accounted for by the exclusion from the calculations of the social security system, which runs sizable surpluses, and of the substantial volume of nontax revenue.29 To provide a picture of the overall budgetary posture, the overall surplus is entered as an addendum in Table 2.

Line 1 of Table 1 shows potential GNP in 1962 prices; line 2 reports the implicit price deflator for GNP, and line 3 gives potential GNP expressed in current prices. Lines 7 through 11 show the annual percentage rates of growth of these and other magnitudes. Actual GNP is entered in line 5, and the GNP gap (defined in the conventional sense as the difference between potential and actual GNP) is shown in line 6.

Line 4, which shows potential GNP adjusted for cyclically neutral price change, requires explanation. In order to calculate the cyclically neutral expenditure path, it is necessary to adjust potential GNP for changes in the price level. What is wanted is a deflator series that shows how the price level would have behaved if budgetary policy had actually been handled in a cyclically neutral manner. These assumed rates of price increase are shown in line 10 of Table 1.

The difficulty with applying such a neutral deflator series to real potential GNP is that if prices are actually rising more rapidly, the resulting inflated series would show a progressive divergence between potential GNP so adjusted and potential GNP expressed in current prices. To deal with this problem, the SVR takes a let-bygones-be-bygones attitude and suggests that “realistically one has to base oneself on at least the price level that has already been reached.”30 Line 4 of Table 1, which shows potential GNP inflated by cyclically neutral price rises, is therefore calculated as follows. Take real potential output for year t, Ptr, and write this up by the preceding year’s deflator, dt1a. The resulting product measures nominal potential output in year t on the assumption that there is no price increase between t — 1 and t. Then write this figure up by an estimated neutral rate of price increase (rtn), so that


where Ptn is potential GNP inflated by cyclically neutral price rises. This procedure adjusts the base in line with the actual deflator path, and it then applies the cyclically neutral change to the adjusted base. The neutral deflator growth rates are judgmental values that attempt to take into account the fact the different actual past rates of inflation will cause a different neutral rate of inflation to be associated with subsequent cyclically neutral policy. As can be seen in line 10 of Table 1, neutral deflator growth was estimated at 2 per cent for 1967, but this was revised upward to 3.5 per cent for 1970 and 1971 in view of price developments.

Table 1.

Federal Republic of Germany: Background Data for Cyclically Neutral Budget Computations

(In billions of deutsche mark)

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Source: SVR (1972), pp. 91–92, and statistical appendix, p. 258 (see footnote 2 of the text for explanation of SVR).

SVR estimates.

Table 2.

Federal Republic of Germany: Computation of Cyclically Neutral Budget

(In billions of deutsche mark)

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Sources: SVR (1972), pp. 91–92; total budget data from Statistisches Bundesamt, Wirtschaft und Statistik [Economy and Statistics], various issues; Deutsche Bundesbank, Monthly Report, various issues; and Jahreswirtschaftsbericht 1972 der Bundesregierung [Annual Economic Report of the Federal Government for 1972],(Bonn, 1972).

The calculation of the cyclically neutral expenditure path is now a simple matter. The ratio of actual expenditure for 1966 to potential output in nominal terms was 0.285. This fraction is then applied to subsequent potential GNP, adjusted for neutral deflator rises. The resulting series is entered in line 2 of Table 2.

Neutral tax revenue is calculated as a constant fraction of the actual GNP series, and the resulting neutral revenues are entered in line 5 of Table 2. Actual expenditure is shown in line 1 and actual revenue in line 4. The difference between actual and neutral revenue is the non-cyclically-neutral component of revenue and is entered in line 6. This component, plus neutral expenditure, makes up the “cyclically neutral budget volume,” which is entered in line 7. This figure is the amount which, if exactly equaled by actual expenditure would leave the total budget cyclically neutral. The difference between actual expenditure and neutral budget volume (line 10) then represents the cyclical effect of the budget. If this is positive, the budget is regarded as cyclically expansionary, and if it is negative the cyclical effect is regarded as restrictive.

Inasmuch as this way of looking at the budget is somewhat unusual, it may be instructive to trace these concepts by means of a diagram. In Chart 1, taxes are measured on the vertical axis and GNP (income) is measured on the horizontal. Let T0 and P0 be the base year tax and potential (equal to the actual) output levels, respectively. A straight line drawn through the origin and the point where T0 and P0 meet specifies neutral tax revenue as a function of GNP. If the tax system has a built-in elasticity of unity, Tn would represent the actual tax function, and taxes would always automatically be cyclically neutral, provided that there are no discretionary changes. In a subsequent year, let potential and actual output rise to P1. Since the actual built-in elasticity of taxes in the Federal Republic of Germany exceeds unity, revenue in this subsequent year can only be neutral if there occurs, in the meantime, a discretionary tax reduction that shifts the actual revenue function to where it intersects the Tn function at T1 and P1. Now assume that such a discretionary change, designed to offset fiscal drag, has in fact taken place, and let the actual tax function therefore be denoted as Ta. Next assume that potential output remains at P1 but that recession lowers actual income to Y1 Neutral tax revenue falls to T1n, whereas actual revenue falls to T1a. The total tax shrinkage of T1 - T1a is divided into two parts: (1) the cyclically neutral portion, that would have occurred

Chart 1.
Chart 1.

Illustration of Cyclically Neutral Revenue

Citation: IMF Staff Papers 1975, 003; 10.5089/9781451969382.024.A008

with unitary tax elasticity (T1T1n); and (2) the nonneutral portion (T1nT1a), that is due to a fall in the effective tax rate. If a discretionary change also takes place, the additional revenue loss from this source would be lumped together with the automatic portion of the nonneutral component. In effect, then, all revenue changes other than neutral changes are viewed as components of countercyclical fiscal policy.

The economic meaning of the entries in Table 2 can now be more easily interpreted. Using the symbols employed in Chart 1, (Ta - Tn) is shown in line 6. This is then added to cyclically neutral expenditure (Gn) and gives the neutral budget volume (line 7) as

Vn = Gn + (TaTn)

which may be interpreted as the volume of actual expenditure that would leave the budget cyclically neutral. The magnitude of the countercyclical fiscal stimulus is then measured by the cyclical effect of the budget (CEB, line 8), defined as

CEB = GaVn = GaGn(TaTn).

If the CEB is positive, the budget adds to aggregate demand beyond the neutral level, and if it is negative, the opposite is the case.

Some implications of this system of measuring budgetary impact may now be explored. The splitting of the automatic revenue loss due to income shrinkage into neutral and nonneutral components should not be confused with the common distinction between automatic (passive) and discretionary (active) revenue changes. The neutral component of revenue loss is a function of cyclical change because neutral revenue is a function of actual GNP, and all revenue changes may include both automatic and discretionary elements. This contrasts with the full employment budget where the attempt is to abstract from automatic revenue loss and thereby focus attention on discretionary changes. The full employment budget would regard the entire revenue loss (T1T1a of Chart 1) as a passive phenomenon not to be regarded as indicative of the presence of countercyclical fiscal policy.

Despite the SVR’s lack of interest in the automatic-discretionary distinction, there is a certain resemblance between the cyclically neutral budget and the full employment budget, because both avoid focusing on the actual deficit as a measure of budgetary impact. Notice that the expression for the CEB can be arranged as

CEB = (GaTa)(GnTn)

and it therefore represents the difference between the actual deficit and the cyclically neutral deficit. If income shrinks, the actual deficit increases and thus the CEB increases. However, the cyclically neutral deficit also increases, and this offsets a portion of the effect on the CEB of the increase in the actual deficit. Unlike the full employment deficit, which is not affected at all by fluctuations in GNP, the CEB is affected because built-in tax elasticity exceeds unity. Nevertheless, the misleading signal provided by an increase in the actual deficit is partially averted by the CEB and would be entirely averted if built-in tax elasticity were unity.

The most common concept of a neutral budget is that of one that provides no net contribution to aggregate demand. In this view the budget is neutral when the weighted deficit is zero. If the weighted deficit is positive, the budget contributes to aggregate demand, and if there is a weighted surplus, the budget subtracts from aggregate demand. The German cyclically neutral budget, by contrast, measures the cyclical impact against a neutral budget that may, or may not, imply a substantial weighted deficit. Whether or not such a weighted deficit exists depends upon whether it existed in the base period. The cyclical deviation is therefore measured against the base year. Unfortunately, this may cause the CEB to give a biased picture of the posture of the budget. As illustrated in Section IV, if private demand is weak during the base year, but potential output is attained due to a large budget deficit; and if private demand subsequently revives to more normal levels, subsequent figures on the CEB will tend always to be negative.

All measures of the cyclical effect of the budget must be interpreted with care, and this is no less true of the cyclically neutral budget. Cyclically “correct” policy implies that when GNP lies below potential, the CEB should be positive, correctness here being defined as a directional improvement over a neutral posture where that, in turn, is based on a suitable base year. Moreover, a positive CEB does not necessarily indicate the presence of discretionary countercyclical policy, because a positive CEB will tend to be generated automatically if the built-in elasticity of the tax system exceeds unity. It should also be noted that the cyclically neutral budget does not answer the question of the adequacy of countercyclical fiscal policy. A positive CEB indicates that the direction of the budget is cyclically correct, and a year-to-year increase in the CEB at a rate which exceeds the rate of growth of potential output may be thought of as expansionary. But a GNP gap may continue to exist. An adequate fiscal program can only be prescribed by calculating the budgetary requirements associated with a return to potential output.

Actual fiscal policy in the years since 1966 has a mixed record when evaluated against the backdrop of the cyclically neutral budget. During the recession year of 1967, tax revenue was permitted to rise over the cyclically neutral amount, and the budget was prevented from being restrictive only because of a modest excess of actual expenditure over cyclically neutral expenditure. In 1968 the GNP gap dropped from DM 38 billion to DM 20 billion, but this improvement can hardly be attributed to fiscal policy. Actual revenue fell short of cyclically neutral revenue by DM 2 billion, but expenditure fell short of neutral expenditure, so that the total budget was essentially cyclically neutral. The fall in the GNP gap was therefore attributable to revival in the private sector and appears not to have been assisted by fiscal policy. Full potential output was restored in 1969, and the budget appropriately became more restrictive. Some stimulus occurred because of an excess of expenditure over neutral expenditure, but this was more than offset by a DM 6.6 billion rise in taxes over the neutral level. Full capacity output continued into 1970, but the budget became inappropriately expansionary, due to rapidly rising expenditure. In the subsequent two years the economy again slowed down, and since this was accompanied by continuing inflation, fiscal policy found itself in the same dilemma that has plagued other industrial countries in recent years. The budget showed substantial expansionary cyclical effects in 1971 and 1972. However, sharply restrictive fiscal policies were imposed in 1973.

In conclusion, the German system of fiscal analysis provides an economical way of measuring the cyclical impact of the budget. Unfortunately, the neutral revenue and expenditure paths may themselves contain inflationary or deflationary biases, depending on the degree to which the base year falls short of the ideal conditions specified in Section II. Moreover, whether actual expenditure and revenue are viewed as cyclically correct or incorrect in direction depends on what values are regarded as cyclically neutral and therefore on base year relationships.

IV. The Cyclically Neutral Budget Applied to the United States

One of the most attractive aspects of the SVR’s system of fiscal analysis is that the CNB and its by-products are so easy to calculate. A question that naturally comes to mind, therefore, is whether the CNB accomplishes the same end as more complicated systems of analysis and therefore represents a suitable replacement for them. Since ready-made estimates of the full employment budget of the United States are available, it will be instructive to compare these estimates with the cyclically neutral budget.

Full employment budget computations are difficult and time consuming. The base for each tax must be estimated as a function of GNP, and the appropriate tax rates must then be applied. Simple proportionality rules do not apply, since the tax bases do not move in such a convenient manner. Full employment revenue from the corporate income tax is particularly difficult to estimate because of the volatility of the profit share and because changes in this share will differ for a given change in GNP, depending on how this change is apportioned between real growth and inflation.31 A simpler device which accomplishes the end of estimating the short-run impact of the budget would therefore be welcome, especially when quick results are desired.

A basic requirement for the computation of both the full employment and the cyclically neutral budget is a potential output series. Methods of estimating potential output are beyond the scope of this paper.32 For present purposes, the estimates of the U.S. Council of Economic Advisers are used (the same series as employed by Okun and Teeters).33

Both sets of budgetary computations encounter difficult price level problems. The SVR marks up potential output by last year’s deflator and then again by a cyclically neutral deflator. A similar procedure has been advocated by Okun and Teeters,34 although their suggestion has not been employed either by them or in U. S. full employment budget estimates that are, in some sense, official. In practice, the actual deflator has been used. The estimates presented in this section follow this procedure.

Beyond these two requirements, full employment budget calculations involve the innumerable tax base rate estimation problems alluded to earlier. The cyclically neutral budget, on the other hand, requires only that a suitable base year be selected. But this in itself becomes a formidable problem. The nature of the problem can best be appreciated by calling attention to the data for the U.S. economy which are summarized in Table 3 for the decade 1960–69.

The concern here is with ex post analysis. Consequently, it is per-missable to select any year as a base and then to project forward and backward over the period covered by the data. If the GNP gap is used as a criterion for base year selection, the years 1961–64 are immediately eliminated, because these were all years during which actual output was substantially below potential. The years 1966 and 1968 should also be eliminated because actual output exceeded potential output. The year 1969 looks reasonable, but recession began in that year and the budget was sharply restrictive. Indeed, the more one puzzles over the problem of selecting a base year, the more difficult it becomes to find a “normal” year. The year 1967 comes closest to showing the absence of a GNP gap, but this year is unsuited as a base year, since the budget was, by any reasonable standard, excessively stimulative. Nevertheless, it is desirable to give 1967 a trial run, since this will illustrate both how dangerous selection of a faulty base year is, as well as how unimportant it may be.

Table 3.

The Cyclically Neutral Budget Applied to the United States, 1960–69

(In billions of U.S. dollars)

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Sources: Actual data, Economic Report of the President (Washington, January 1973), Tables C-1 and C-3, and Appendix Table C-66; potential output, Executive Office of the President, Council of Economic Advisers (Washington); and full employment surplus, Arthur M. Okun and Nancy J. Teeters, “The Full Employment Surplus Revisited,” Brookings Papers on Economic Activity, No. 1 (1970), pp. 104 and 105.

If any year comes close to meeting requirements for an adequate base year, it would have to be 1965. The economy reached full employment at mid-year and then moved into boom conditions in the second half of the year. The year, in fact, was anything but balanced. Nevertheless, it is the most suitable year available.

Table 3 shows the computations. Lines 1 through 7 provide background information. Lines 8 through 10 show cyclically neutral budget calculations with 1967 as the base year. The display is here simplified by limiting it to three lines—neutral revenue, neutral expenditure, and the cyclical effect of the budget (CE3) as defined previously. The entire negative bank of figures in line 10, purporting to show the cyclical effect of the budget, is striking. This strange result shows quite clearly that the mere absence of a GNP gap is not an adequate criterion for the selection of a base year. Demand in the private economy was below normal great ratio expectations, but this was offset by the abnormally large contribution to aggregate demand which emanated from the federal budget. The result, as recorded in line 10, highlights the fact that the CEB measure recorded at any one time actually represents the cyclical effect as measured against the base year.

Neutral budget computations for 1965 are shown in lines 11 through 13. Here the CEB (line 13) begins to approximate other measures of the record of fiscal policy in the United States. The negative CEB value of $8.1 billion for 1960 reflects a sharply restrictive budget.35 Rising expenditures produced a cyclically neutral budget in 1962. The year 1963 was then marked by budgetary tightening as President Kennedy, in an effort to persuade Congress to reduce taxes, held back federal expenditure. The cyclical effect of the budget therefore fell to a negative $4 billion. The positive figure of $1.3 billion for 1964 reflects the effect of the tax reduction that took place early in the year. By 1966 rising defense expenditure caused the CEB to swing to a positive value of $4.9 billion. This then increased to $15.3 billion in 1967. Some lowering took place in 1968, due to the imposition of the surtax at mid-year. The budget then became restrictive in 1969 (CEB = -$5.7 billion) as a consequence of further tax increases and a reduction in expenditure growth below the cyclically neutral level.

Year-to-year changes in the full employment surplus also reflect the various policy changes. These changes are reported in Table 4, where they are compared with year-to-year changes in the actual surplus and changes in the CEB. In inspecting this table, note that lines 3 and 4 are similar. The reason is that the level of the CEB is sensitive to selection of the base year, while the year-to-year change in the CEB is only marginally affected by the choice of the base year.36 Note also that the year-to-year change in the full employment surplus (with its sign changed) is also very similar to the change in the CEB. And note, finally, that year-to-year changes in the actual surplus generally point the direction of fiscal impact. However, as shown by the zero change in the actual surplus between 1962 and 1963, this is not always the case. All of the other measures suggest that the budget’s contribution to aggregate demand was increasing at that time. The lack of growth in the actual deficit reflects the fact that expenditure growth was matched by automatic revenue growth generated by the rapidly expanding economy. From this simple perspective, fiscal policy was roughly neutral. However, the cyclically neutral budget and the full employment budget both show that this was not the case.

Table 4.

Year-to-Year Changes in Selected Budgetary Measures

(In billions of U.S. dollars)

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Source: Table 3.

V. Summary

Many industrial countries have made attempts to measure the impact of budgetary policy with short-cut methods that are better than simple budget deficit references and yet do not require full-scale econometric analysis. The cyclically neutral budget of the German SVR is one such method.

Its unique character is that it views fiscal planning within a context of a growing economy. Consequently, it seeks to redefine a neutral deficit as one which grows at a rate equal to the growth of potential output rather than in terms of some absolute level of deficit.

From a longer-range perspective, cyclical neutrality and budgetary adequacy are equivalent, inasmuch as the longer-range plan implies an explicit attempt to fill the fiscal gap. If the rules are followed, the budget itself cannot become a source of discrepancy between actual and potential GNP. From a short-run cyclical perspective, cyclical neutrality implies a budget posture under which neither the private economy’s potential share of output nor its relative share of actual income is permitted to be encroached upon by the public sector.

The CNB as currently presented by the SVR is not without its limitations. First, it has not been established that projection from a base year is an adequate substitute for projection based on fiscal gap analysis. Even if a full employment year has occurred in the recent past, this circumstance alone is not sufficient to qualify that year as a base. There is no assurance that the relationships of that year are representative of the longer-term ratios of saving, investment, and the trade balance to potential output. Full employment in the base year might have been achieved precisely because the budget was cyclically nonneutral.

Second, the rule on neutral borrowing is inconsistent with an appropriate rule that specifies the cyclically neutral rate of monetary growth. As suggested earlier, it would seem appropriate to replace the borrowing rule with a rule which specifies a cyclically neutral rate of monetary growth.

Third, the SVR’s approach fails to weight budgetary items. This is not an inherent defect of the concept of cyclically neutral budget; indeed, the measure of the cyclical effect of the budget could be sharpened up considerably by an attempt to weight the various budget items in accordance with their respective aggregate demand contributions.

Finally, the cyclically neutral budget does not permit the separation of the automatic and discretionary changes in budget items. Therefore, it is not possible to judge the magnitude of active policy at a given time. Nevertheless, and assuming the absence of discretionary policy, the CEB is not as sensitive to cyclical fluctuation as the actual deficit. It therefore contains an element of the income standardization which characterizes the full employment budget.

Despite its limitations, the cyclically neutral budget is a most attractive budgetary idea that may prove to be particularly useful in countries that lack the detailed data needed to calculate alternative measures of budgetary impact. The ease with which it can be calculated adds to its attractiveness.

One final point deserves to be made rather emphatically. Among economists in the Federal Republic of Germany,

The cyclical-policy aspect of the concept has been variously misunderstood to mean the government should always act in a cyclically neutral fashion.37

However, quite clearly the CNB does not contain any bias in favor of actually following a neutral fiscal policy over the course of the business cycle. What the CNB does is to provide a frame of reference against which actual policy can be assessed. It is a tool of budgetary analysis that would be useful whether one believed in fiscal fine tuning at one extreme, or on complete reliance on automatic stabilizers, at the other. The SVR itself seems biased in the activist direction. According to the experts

While the medium-term finance planning should be shaped solely in the light of the growth of productive capacity, and hence should not take account of cyclical influences…, the current handling of budgetary expenditure should support the other branches of stabilization policy in counteracting fluctuations in the degree of utilization of productive capacity that may arise from fluctuations in private demand.38

SUMMARIES The 1967 Devaluation of the Pound Sterling1

Jacques R. Artus

This detailed investigation of the effects of the devaluation of sterling by the United Kingdom in 1967 examines the critical economic relationships involved in a devaluation and estimates them over a period which spans the devaluation (1960–72). The main relationships considered are: (1) the devaluation effect on import prices; (2) the effect of import price changes through the cost of living on the wage-price spiral; (3) the induced effect of wage and other cost changes on the price of U. K. traded goods; and (4) the response of domestic and foreign demand to changes of the relative price of U. K. and foreign goods. Finally, a model was built and simulated to estimate the devaluation effect on the U. K. full employment current balance.

Devaluation effects were found to have been favorable and large. Results indicate that the devaluation effect accounted for an improvement of about £1,300 billion (US$3,100 billion) in the U.K. current balance by 1971, £940 million (US$2,501 million) in the trade balance, and £331 million (US$614 million) in invisibles. Nearly 3 per cent of gross domestic product was transferred into the balance of payments as a result of the devaluation.

Devaluation effects came through relatively rapidly. Perverse effects on the trade balance which occurred in the first half of 1968 were more than compensated for by favorable effects on private services and other invisibles. The “cost” of the devaluation in terms of inflationary pressures and welfare losses was also high. By 1971, the devaluation had raised both consumer prices and hourly labor earnings by about 5 percentage points and had worsened the terms of trade by about 4½ per cent for goods and 1 per cent for private services.

The paper concludes that the favorable effect of the devaluation on the U. K. current balance has been seriously underestimated by the London Business School and to an even greater extent by the National Institute of Economic and Social Research in their well-known studies on the 1967 devaluation. They underestimated the effect mainly because they assumed, on the basis of econometric work at a very aggregative level, that U. K. imports were not affected by relative price changes. Estimates of import price elasticities obtained at a more disaggregated level do not support this contention.

Adjustment of Taxable Profits for Inflation1

George E. Lent

Financial statements increasingly depart from reality during periods of inflation. Unless they are adjusted for changes in the price level, earnings subject to income tax tend to be inflated because costs lag behind prices. More than 20 countries have provided for the revaluation of business assets to reflect the higher price levels since World War II.

The traditional approach has been mainly a revaluation of plant and equipment to reflect current market cost. Similar measures eliminate inventory profits attributable to rising prices. Price level accounting that recognizes the effect of a decline in the value of money not only on fixed assets and inventories but also on monetary accounts has been employed in only two countries—Brazil and Chile. Several countries have imposed taxes—ranging up to 10 per cent—on the surplus arising from revaluation of assets, but such a tax partly offsets the tax savings expected to finance new investment.

Wide variations in revaluation schemes make it difficult to assess their effects. Capital-intensive industries and those with a large investment in inventory realize the greatest tax benefits from revaluation of nonmonetary assets. Schemes also requiring the indexation of monetary assets and liabilities would greatly reduce aggregate tax savings and would increase the taxes of companies with heavy debt. Either plan, however, would add to inflationary pressures.

Other techniques for adjusting taxable business income to inflation may be more suitable on grounds of efficiency, equity, and administration. Accelerated depreciation (and/or investment allowances) can yield substantially the same aggregate tax benefits as replacement cost depreciation. All companies would benefit, and the timing of the tax relief would be better synchronized with investment plans. The choice of techniques depends largely on the inflationary situation. Revaluation of assets is well adapted to the re-establishment of realistic values following a period of rapid inflation. Periodic revaluations may be necessary if inflation persists at a high rate, but accelerated depreciation and the last-in, first-out (LIFO) method for adjusting inventory profits may be more appropriate for moderately rising price levels. Price level accounting deals more comprehensively with the distortion of taxable profits under persistent inflation, and it has appeal on both economic and equity grounds.

Wage Indexation, Inflation, and the Labor Market1

Morris Goldstein

This paper provides an eclectic review and analysis of some of the potential costs and benefits likely to be associated with the implementation of wage indexation in an industrial economy. It suggests, inter alia, that few meaningful generalizations can be drawn about the probable effects of wage indexation, because these effects vary with the type of wage indexation under study (for example, full, partial, or threshold indexation) and with the assumptions on labor-market behavior in the absence of indexation.

With regard to the probable impact of wage indexation on the rate of inflation, it is argued: (1) that full wage indexation is likely to be more inflationary if implemented during a period of low or moderate inflation than during a period of high and prolonged inflation; (2) that partial and threshold indexation are likely, ceteris paribus, to be less inflationary than full wage indexation; (3) that a wage-price spiral will exist with or without indexation, but that wage indexation may affect the size of this spiral; (4) that threshold indexation may help insulate wage determination from small, temporary price changes; (5) that wage indexation may help to moderate inflation (by substituting actual for expected inflation rates) when workers hold erroneously high expectations about the future inflation rate and when workers are powerful enough to embody these expectations in their wage contracts; and (6) that wage indexation may increase the effectiveness of anti-inflationary stabilization policy by reducing the time-lag between aggregate demand changes and price changes.

Other topics discussed include the likely effects of wage indexation on the variability of real wages, on the duration of labor contracts, on aggregate strike activity, on the functional distribution of income, and finally, on the efficacy of exchange rate policy.

Separate Exchange Markets for Capital and Current Transactions2

Anthony Lanyi

The essential feature of a dual exchange market system is a separate “financial exchange market” for capital transactions. However, its operation depends on the type of official intervention policy used on the financial exchange market. The case in favor of a dual exchange market system is shown to depend on the assumptions that a “neutral” intervention policy is being pursued and that such a policy can be effectively implemented.

Recent European experience with dual exchange markets sheds some doubt as to whether a neutral intervention policy would be feasible. In practice, important links between the two markets appear to be inevitable. Moreover, the terms of payments for trade and nonresident balances used for current account transactions provide channels for speculation in the official exchange market. The authorities in European countries have not pursued neutral intervention policies, and they have found it necessary to resort to direct controls to stem large-scale speculative capital movements.

With regard to balance of payments adjustment, a dual exchange market system makes it more difficult than it is under alternative systems to perceive the need for adjustment. It also exerts less of a pressure for adjustment than is exerted under a fixed exchange rate system.

A dual exchange market does not necessarily involve lower administrative costs than quantitative restrictions over capital transactions, and the latter have practical advantages during exchange crises.

Final judgment cannot be made as to the efficacy of dual exchange markets to stem heavy speculative pressures without a neutral intervention policy having been attempted in practice.

Inflation in an Open Economy: A Case Study of the Philippines1

Ichiro Otani

The acceleration of price increases in a number of countries in the past few years has evoked active discussion of imported inflation in open economies. Several theoretical studies on the subject have appeared, but few empirical studies have been made. In the case of particular countries, it is often argued that the recent acceleration of inflation is due largely to external rather than to domestic factors. However, in the absence of adequate empirical work to support this contention, it remains open to question.

The purpose of this study was to extend and modify a monetary model of inflation in an open economy, using the studies of Laidler (1972) and McCallum (1973) as a starting point, and to test the model with Philippine data for 1951–73. The estimated behavioral equations of the model generally describe movements in the demand for real cash balances, output, prices, and imports. It was found that the model traces the rates of inflation and the changes in the money stock very well. It was less successful in explaining the changes in output and imports, but this was expected, since it was not specifically designed to explain such changes.

Because of the inclusion of lagged endogenous variables in the model, it was difficult to separate clearly the effects of domestic and external factors on the price level. However, it does appear that external factors played a small role in price increases occurring in the Philippines in most of the years from 1951 to 1972. In contrast, the large price increase in 1973 was attributable mainly to external factors, and in that sense, the 1973 inflation was largely imported.

Under long-run steady-state conditions, credit expansion appears to play no part in influencing real output, but it increases prices and imports considerably. However, these implications of credit expansion for output, prices, and imports in the steady-state condition should be interpreted cautiously, since the present study is not based on a growth model.

Inflationary Expectations and the Trade-Off Between Unemployment and Inflation in the United States1

Erich Spitäller

From the mid-1950s to the late 1960s, the record of prices and unemployment in the United States supports the notion of a trade-off between unemployment and inflation, and econometric models based on this notion have accordingly performed reasonably well in tracing the fluctuations of prices in those years. Thereafter, however, the trade-off not only worsened but—as rising unemployment coincided with accelerating inflation in the years 1969 and 1970—ceased to exist. It was clear that the conventional model of inflation had to be modified.

In this paper a price equation is presented that contains, among other arguments, a proxy for inflationary expectations allowing for a threshold effect. The implications of this effect for the trade-off between unemployment and inflation are analyzed on the basis of alternative assumptions about the size of the coefficient on past price movements, which serve as proxy. The price equation is then estimated for the United States over the period from 1957 to 1972 inclusive, using annual data.

The empirical results confirm the hypothesis of a threshold effect which apparently applies as inflation reaches and exceeds a rate of 4 per cent. At this rate the dependence of current prices on past price movements rises, as demonstrated by the increase from 0.53 to 0.70 in the coefficient of past price changes. Even the latter value appears, on the basis of a statistical test, to be significantly different from unity.

The implications of the empirical results are assessed for the trade-off between unemployment and inflation in the long run (steady state) as well as in the short run, and there is evidence that unemployment must not be lowered to 4 per cent or below if the threshold effect on inflation is to be avoided. It is shown that the equation can explain both a worsening of the trade-off between unemployment and inflation and a situation where rising unemployment and rising inflation occur simultaneously.

An Econometric Model of U.S. Merchandise Imports Under Fixed and Fluctuating Exchange Rates, 1959–731

Isher J. Ahluwalia and Ernesto Hernández-Catá

The model of U. S. merchandise imports presented in this paper is based on a framework which integrates the demand-oriented features of traditional foreign trade models with a theory of import price determination. The equations are estimated for total U. S. imports, as well as for various end-use categories, for the period 1959–73. Since this period extends into the era following the 1971 Smithsonian Agreement, imports must be explained and projected in periods of flexible as well as fixed exchange rates. Accordingly, the model must take into account various problems that had not been dealt with in previous econometric models of U. S. trade, such as the currency denomination of import contracts and the possibility of absorption of exchange rate effects.

The basic framework can be reduced to a system of two equations. The first is a demand relationship expressing the volume of U. S. imports as a function of import prices, domestic real expenditure, domestic prices, and a nonlinear function of the gap between actual and potential gross national product. The second is a reduced form equation relating U. S. import prices to current and lagged values of foreign prices, domestic prices, exchange rates, and foreign capacity utilization variables.

Partly because of the lack of comprehensive and reliable data on import prices, most econometric models of U. S. trade have bypassed the problem of import-price determination. This was usually done by constructing averages of the wholesale prices in partner countries and by combining the price and exchange rate variables into a single “relative price variable,” which was then used to explain the value of U. S. imports. The paper shows that this procedure may introduce a serious specification error, because changes in foreign prices (even when adjusted for movements in exchange rates) can differ substantially from changes in import prices in periods of wide exchange rate fluctuations.

Fiscal Analysis in the Federal Republic of Germany: The Cyclically Neutral Budget2

Thomas F. Dernburg

The West German Council of Economic Experts has proposed an intermediate-range view of fiscal policy which they describe as the cyclically neutral budget (CNB).

The first step in constructing the CNB is to select a base year of full employment during which the posture of fiscal policy was, presumably, appropriate. Cyclically neutral expenditures are then projected as a constant proportion of the ratio of expenditure to potential gross national product (GNP) in the base year. Neutral revenues, by contrast, are projected as a constant proportion of actual GNP, the factor of proportionality being the ratio of taxes to GNP in the base year.

As a longer-range planning device, the CNB provides the government with a fixed share of potential GNP and a fixed share of actual national income as revenue. Therefore, it neither encroaches on the relative share of income and output of the private sector nor offsets cyclical deficiencies of demand in the private sector; in this sense, it is neutral. Finally, it has the advantage that it frames budgetary policy in a long-run context. Increases in expenditure are thus not viewed as expansionary unless their rate exceeds the rate of growth of potential GNP.

The CNB is also useful for estimating the expansionary impact of the budget. The cyclical effect of the budget (CEB) is defined as the difference between the actual deficit and the neutral deficit. When GNP falls during a recession, both the actual and the neutral deficits increase so that CEB shows little change and fiscal policy is not therefore credited with the expansionary thrust that actual deficit references would suggest. Comparisons of changes in CEB with changes in the full employment surplus suggest that the two measures provide roughly equivalent estimates of the demand impact of the budget. CEB, however, has the advantage that it can be easily calculated, since it assumes a tax to GNP elasticity of unity, whereas the full employment budget requires estimation of the various tax elasticities with respect to GNP.

In statistical matter (except in the résumés and resúmenes) throughout this issue,

Dots (…) indicate that data are not available;

A dash (—) indicates that the figure is zero or less than half the final digit shown, or that the item does not exist;

A single dot (.) indicates decimals;

A comma (,) separates thousands and millions;

“Billion” means a thousand million;

A short dash (–) is used between years or months (e.g., 1971–74 or January-October) to indicate a total of the years or months inclusive of the beginning and ending years or months;

A stroke (/) is used between years (e.g., 1973/74) to indicate a fiscal year or a crop year;

Components of tables may not add to totals shown because of rounding.

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Mr. Dernburg was an Assistant Division Chief in the Fiscal Affairs Department at the time this paper was written. He graduated from Swarthmore College and received his doctorate from Yale University. He has taught at Purdue University, the University of Michigan, Oberlin College, and the American University, where he is now Professor of Economics. He has served as Senior Economist with the Council of Economic Advisers and the Senate Budget Committee. He is the author of numerous journal articles.


Fritz Neumark, “The German Stabilization Law: A New Experiment,” in Modern Fiscal Issues: Essays in Honor of Carl S. Shoup, edited by Richard M. Bird and John G. Head (Toronto, 1972), pp. 225–46. This paper presents a very useful description and analysis.


Jahresgutachten 1970 des Sachverständigenrates zur Begutachtung der gesamt-wirtschaftlichen Entwicklung [Annual Report for 1970 of the Council of Experts for the Assessment of the Overall Economic Development] (Bonn, 1970). The author has relied heavily on the Fund’s translation of the 1970 report. Hereafter, the German original is referred to as SVR and the Fund’s translation is referred to as Translation. Accordingly, the quotation here is SVR (1970), p. 91; Translation, p. 1.


This is similar to the Netherlands budget impulse analysis, according to which a neutral budget deficit is one that remains constant relative to potential GNP. For an analysis of Netherlands fiscal thinking and practice, see Daryl A. Dixon, “Techniques of Fiscal Analysis in the Netherlands,” Staff Papers, Vol. 19 (November 1972), pp. 615–46.


“An increase in the public debt… is unobjectionable from the point of view of stabilization policy when it is a corollary to additional private savings,’” SVR (1970), p. 96; Translation, p. 18.


SVR (1970), p. 91; Translation, p. 2.


SVR (1970), p. 91; Translation, p. 3.


It is customary to distinguish tax elasticity from buoyancy. Elasticity refers to the proportionate increase in revenue that automatically accompanies a proportionate change in GNP. Buoyancy represents the proportionate change in revenue that results from all sources, automatic or discretionary.


SVR (1970), p. 91; Translation, p. 3. The SVR treats expenditures and taxes as having equivalent impact on aggregate demand. The effect of a failure to weight budget items is discussed in Section II of this paper.


The report of SVR states that


where P*t is potential output, (Kt+Kt12) is the average stock of capital during year t, and k*t is the full capacity trend ratio of output to capacity. See SVR (1972), p. 181.


If government purchases grow exponentially and at a rate that exceeds the rate of growth of potential output, government purchases would eventually exceed potential output. Since government purchases are a component of GNP, this is a logical impossibility.


“… it is impossible for a budget in which the expenditures utilize the productive capacity at the desired rate to be identical with a budget in which the expenditures compensate the demand-dampening effect of a rising tax load ratio.” Quoted from Fund translation of Gerold Krause-Junk, “Zum Konzept des konjunkturneutralen öffentlichen Haushalts” [“The Concept of the Cyclically Neutral Budget”], Finanzarchiv, Vol. 30, No. 2, 1971, p. 214.


“… personal expenditure has a smaller expansionary effect than expenditure for investments or interest subsidies, and payments that produce effects outside the country may be without significance for the domestic cyclical development.” SVR (1970), p. 97; Translation, p. 22.


Ibid., pp. 97 and 22.


The ratio of exports to GDP increased from 21.2 per cent in 1966 to 25.9 per cent in 1970. Moreover, the overall trade ratio as defined here jumped from 1.9 per cent in 1966 to an average of over 3.5 per cent in the following three years, but then fell to 1.7 per cent in 1970.


“The base is cyclically neutral when the extent of utilization of the productive capacity by government expenditure conforms to that laid down for the medium term by the legislative bodies for a full employment situation…”, SVR (1970), p. 91; Translation, p. 2.


SVR (1970), p. 92; Translation, p. 6.


Ibid., p. 92 and pp. 6–7.


Ibid., pp. 93 and 7.


See Arthur M. Okun and Nancy H. Teeters, “The Full Employment Surplus Revisited,” Brookings Papers on Economic Activity, No. I (1970), pp. 77–110 for an interpretation of the normative aspects of the full employment surplus concept. A detailed analysis of the full employment surplus is provided in Daryl A. Dixon, “The Full Employment Budget Surplus Concept as a Tool of Fiscal Analysis in the United States,” Staff Papers, Vol. 20 (March 1973), pp. 203–26.


In his July 1970 budget message, President Nixon said:

There is one basic guideline for the budget … which we should never violate: except in emergency conditions, expenditures must never be allowed to outrun the revenues that the tax system would produce at reasonably full employment. When the Federal Government’s spending actions over an extended period push outlays sharply higher, increased tax rates or inflation inevitably follow.

See Executive Office of the President, Office of Management and Budget, The U.S. Budget in Brief (Fiscal Year 1972), p. 6.


Okun and Teeters, op. cit., pp. 80–81.


It was, of course, not possible to put this strategy into practice during the early 1960s because of heavy unemployment combined with the persistence of a deficit in the U.S. balance of payments.


SVR (1970), p. 96; Translation, p. 17.


Ibid., pp. 96 and 19.


SVR (1970), p. 97; Translation, p. 21.


The theory of stabilization policy in an open economy under conditions of capital mobility is developed by R. A. Mundell, “Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates,” Canadian Journal of Economics and Political Science, Vol. 29 (November 1963), pp. 475–85. For an empirical analysis of the difficulty of controlling monetary and credit conditions in the Federal Republic of Germany, see Deena R. Khatkhate and Delano P. Villanueva, “Some Aspects of the Money Supply Process in an Open Economy: The German Case” (unpublished, International Monetary Fund, April 23, 1973).


SVR (1970), p. 91; Translation, p. 2.


SVR (1972), pp. 91–92.


The nontax revenues include rents, interest, and proceeds from the sale of assets. They also include dues, contributions, and charges for the use of public facilities. In view of this diversity, the SVR excludes them from the neutral budget computation. According to the SVR, experience has shown that deviations of individual components from implied neutral values have tended to cancel one another.

The social security system is not subject to the requirement of the stabilization law that all levels of government be required to use fiscal policy to achieve stability. Potential GNP in nominal prices grew at an average annual rate of 8.6 per cent between 1966 and 1972. Over the same period social security taxes grew at an annual rate of 12.9 per cent, while government transfer payments to persons (nearly all in the form of social security benefits) grew at a rate of 9.4 per cent. Thus, the social security system has not been cyclically neutral.


SVR (1970), p. 93; Translation, p. 10.


See Okun and Teeters, “The Full Employment Surplus Revisited” (cited in footnote 19) for a detailed discussion of estimation problems.


See Arthur M. Okun, “Potential GNP: Its Measurement and Significance,” American Statistical Association, Proceedings of the Business and Economic Statistics Section, 1962, pp. 98–104.


The data were kindly supplied to the author by Mrs. Nancy H. Teeters, then of The Brookings Institution.


Okun and Teeters, “The Full Employment Surplus Revisited” (cited in footnote 19), pp. 90–98.


In his budget message of 1960, President Eisenhower stated that appropriate budget policy would be one that “not merely balances expenditures with revenues but achieves a significant surplus for debt retirement.” See Economic Report of the President (Washington, January 1960), p. 54.


The source of the discrepancies in the year-to-year changes shown in Table 4 is that the year-to-year changes are affected, in a minor way, by differences in the base year neutral expenditure and tax ratios. At any time t

CEB(t) = Ga(t)Ta(t)[gbP(t)tbY(t)]

where gb is the base year ratio of expenditures to potential output, and tb is the base year average tax rate. It can easily be inferred from this expression that for given changes in actual and potential output, the change in the CEB will differ depending upon the base year selected, since this choice will determine the values of gb and tb.


Klaus-Peter Fox, “Noch einmal: Zum Konzept des konjunkturneutralen öffentlichen Haushalts” [‘Once More: The Concept of the Cyclically Neutral Public Budget”], Finanzarchiv, Vol. 31, No. 1 (1972), p. 24.


SVR (1970), p. 91; Translation, p. 2.


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IMF Staff papers: Volume 22 No. 3
Author: International Monetary Fund. Research Dept.