Case Scenario: THE FAILURE OF THE 1968 TAX SURCHARGE
In the mid-1960s, many economic commentators thought the US economy was heading into an era of unending prosperity. Real GDP was rising at an average of almost 6% per year, yet the inflation rate remained under 2%. In 1966, however, the rapid increase in defense expenditures for the Vietnam War caused the inflation rate to rise to almost 4%. The Fed alertly stepped on the brakes, boosting interest rates and temporarily bringing real growth to a halt. Somewhat perturbed by the slowdown in the growth rate, and prominently and publicly castigated by Lyndon Johnson, Fed Chairman William McChesney Martin quickly shifted gears. The Fed quickly eased, and both real growth and inflation started to rise again. By that time the increase in defense expenditures had generated a substantial budget deficit, but the Fed was apparently unwilling to raise interest rates enough to finance that deficit, perhaps fearing that would end the expansion, or perhaps bowing to political pressure.14 After much debate, Congress and the Fed finally agreed on a joint solution: a temporary 10% surcharge on personal and corporate income taxes would be put into place in mid-1968, and as a quid pro quo, the Fed would agree to hold the funds rate steady at 6% and boost growth in the money supply.
The argument by government economists at the time was that the tax increase would serve as a non-inflationary way to pay for the war, while monetary easing would keep the economy from stalling out. While this agreement was being hammered out, real GDP growth zoomed to an exceptionally rapid 7.5% annual rate during the first half of 1968. The tax surcharge was put into place, and the Fed carried out its part of the bargain: it held the funds rate at 6%, and boosted growth in M2 from 6% to 9%. However, the impact on the economy was precisely the opposite of what Washington economists expected.15 The real growth rate sharply declined to 1%, and the rate of inflation rose from 4% to 6.3%. Eventually the Fed was forced to raise the funds rate and reduce the growth in the money supply, plunging the economy into its first recession in almost ten years by the end of 1969. Perhaps it is easy enough in retrospect to point out that a shift to monetary ease at a period of rapid growth and overfull employment sharply boosted inflationary expectations, making it almost inevitable that the Fed would have to reverse course and tighten, causing a recession to occur shortly thereafter. Whether that is true or not, it seems clear enough that the Fed was forced to bow to political pressure: after almost bringing the economy to a halt in mid-1967, it did not tighten again until inflation was clearly spiraling out of control. Hence this program was actually a joint failure of monetary and fiscal policies. We have, however, listed it in the fiscal policy section because the surcharge was the principal mistake; without that bill, the Fed would not have been forced to hold interest rates constant and increase the growth in the money supply. Additional monetary policy errors of the 1970s are discussed in the next section.