Routledge Library Editions

THE ECONOMIC THEORY OF FISCAL POLICY

ECONOMICS
 Routledge Library Editions – Economics

PUBLIC ECONOMICS
In 5 Volumes

I Principles of Public Finance Dalton

II Problems of Economic Planning Durbin

III e Economic eory of Fiscal Policy Hansen

IV An Expenditure Tax Kaldor

V e Principles of Economic Planning Lewis

THE ECONOMIC THEORY OF FISCAL
POLICY

BENT HANSEN
 First published in 1958

Reprinted in 2003 by
Routledge
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© 1958 Bent Hansen, this translation

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is available from the British Library

e Economic eory of Fiscal Policy

ISBN 0-415-31396-1 (set)
 ISBN10: 0-415-31399-6 (hbk)
ISBN10: 0-415-48904-0 (pbk)

ISBN13: 978-0-415-31399-5 (hbk)

ISBN13: 978-0-415-48904-1 (pbk)

Miniset: Public Economics

Series: Routledge Library Editions – Economics

 BENT HANSEN
Director of the Konjunkturinstitutet, Stockholm

e Economic eory of Fiscal policy

TRANSLATED BY

P. E. BURKE
B.SC.(ECON.), F.R.ECON.S.
 ENGLISH EDITION FIRST PUBLISHED IN 1958

This book is coppght under the Berm Convention. Apart from any fair
dealing for the purposes of private shrdy, research, critiGism or review, as
permitted under the Copyright Act, 1956, no portion may be reproduced by
any process without written permission. Enquiry should be rnade to the
publisher.

e Swedish original
Finanspolitikens ekonomiska teori
was published by Statens Offentliga Utredningar
in 1955

is translation © Bent Hansen 1958

 PREFACE

THIS book was originally submied to the Swedish Government as one of a

series of reports prepared by the members of a commiee appointed by the
Swedish Minister of Finance to investigate the possibilities of keeping the
value of money stable at full employment. Professor Erik Lundberg was the
airman of this commiee (Penningvärdeundersökningen), whi began
work in 1951 and continued until December 1955. My task within this
commiee was to prepare a monograph on fiscal policy, the manuscript of
whi was finished towards the end of 1954, and published in July 1955 as a
Governmental report (S.O.U. 1955: 25) with the title Finanspolitikens
ekonomiska teori. Although the monograph was wrien for this commiee
and published by the Government, I am solely responsible for the views
expressed in it.
During the course of my work I profited from the continuous criticism of
the other members of the commiee, Messrs. Guy Arvidsson, Ragnar
Bentzel, Tor Fernholm, Lars Lindberger, Erik Lundberg, Bengt Metelius and
Gösta Rehn. Among them I want especially to mention Erik Lundberg, who
scrutinized the manuscript at all stages, and pointed out many weaknesses
in my analysis, and Ragnar Bentzel, with whom I had almost daily
discussions for three years on literally every problem dealt with in this book.
I must also anowledge the help I received from Professor Erik Lindahl,
with whom I have discussed the major topics in Parts I and II, and Professor
Herman Wold, who read and criticized the first dra of the manuscript of
Chapters VII and VIII.
I want also to express my gratitude to the Swedish Ministry of Finance for
the true academic freedom enjoyed by the commiee, for the generous
material help provided, and for permission to publish this translation.
e translation was carried out by Mr. P. E. Burke, assisted by Miss B.
Halvorsson. It was revised by Mr. Alan Williams of Exeter University, to
whom I am also greatly indebted for pointing out several weaknesses in the
Swedish edition and for recasting the Introduction. e translation was
made possible by grants from the Swedish Council of Social Resear and
the Royal Academy of Science; it follows the original Swedish edition
closely and in general no aempt has been made to take into account
literature published aer 1954.

Stockholm, October 1957 B.H.

 CONTENTS

PREFACE
INTRODUCTION

PART I. GENERAL THEORY OF FISCAL POLICY

I Ends and Means in Economic Policy
II e Means of Fiscal Policy
III e Balance of the Budget
IV Economic Fluctuations and the Budget
V On Incidence
VI A Classification of the Means of Fiscal Policy

PART II. MICRO-ECONOMICS OF FISCAL POLICY

VII Planning by Households
VIII e Effects of Taxation on the Consumption and Saving Plans of
Households
IX Further Observations on Fiscal Policy and Household Planning
X e Importance of Fiscal Policy for Planning by Firms
XI Organizations and Fiscal Policy

PART III. MACRO-ECONOMICS OF FISCAL POLICY

XII Stable Value of Money and Full Employment
XIII Neutral Fiscal Policy
XIV Direct versus Indirect Taxation
XV Fiscal policy and Internal Disturbances
XVI Long-Term Problems of Fiscal Policy
XVII Fiscal Policy and Wage Policy
XVIII Views on Fiscal Policy and Foreign Trade
XIX Full Employment and a Stable Value of Money in a World of
Uncertainty
INDEX OF AUTHORS
INDEX OF SUBJECTS
 INTRODUCTION

Summary and Conclusions

THE aim in this book is to assess the possibility of using fiscal policy to
secure a stable value of money at full employment. In this introduction I
shall outline the general considerations that have determined my treatment
of the problem. e plan of the book should then become clear, for although
this plan seems quite natural, perhaps even obvious, it does differ greatly
from what is usual in the field of public finance. Moreover, the book itself
has turned out to be so extensive that a synopsis of its contents and
conclusions would seem to be called for in any case.
Reading through the literature on public finance and fiscal policy, the
subject maer covered falls into three quite sharply differentiated sections.
e first of these, whi is particularly prominent in the older writings, is
mainly normative, and covers topics su as the fundamental principles of
taxation, the meaning of equity, and so on. In this group would also be
included the work on the theory of public expenditure of welfare economists
both ancient and modern. is aspect of public finance is not our concern
here. e second section treats problems associated with the micro-
economic effects of particular fiscal policy measures, and here too the
classical economists made important contributions. Writers in this field have
aempted to isolate the partial effects in particular markets of individual
measures by analysing their impact on the plans of individual economic
units, and classical incidence theory is an example of this sort of approa.
e third section of the subject, whi is iefly represented in more recent
writings, concerns the general macro-economic effects of fiscal policy, and is
concerned with aggregative concepts su as the national income, the level
of employment, the general price level, total saving and investment, the
balance of payments, etc. ose working in this field seem to have taken
lile interest in the problems facing micro-economic analysis, and an
aempt has been made to distinguish the two fields by aracterizing the
micro-economic approa as being concerned with the ‘discriminatory’
effects of fiscal policy, while the macro-economic approa is concerned
with ‘circulatory’ effects. In this book, however, we shall tale both these
aspects of the problem in our aempt to appraise the role of fiscal measures
in an effective economic policy.
It is obvious that a complete and exhaustive analysis is only possible if a
detailed model is available whi describes the economy accurately—a
Laplace ‘World Formula’—whi would include all economic entities, all the
relationships between them, and a description of all external forces whi
may influence the system. If su a model were available, then our task
would be one of mere meanical calculation. e fact is, however, that we
have no su model, as is amply demonstrated by the conspicuous failure of
most of the rather pretentious aempts to forecast postwar economic
developments. For this reason, it is important, when using models based
upon our present level of knowledge, to present the results tentatively, with
proper qualification, and not as comprehensive and exhaustive descriptions
of reality. is is not to deny the usefulness of special models in revealing a
la of general validity in certain propositions, or as a means of
demonstrating how particular economic relationships may operate, but the
part played by these models is then very different from that ascribed to the
‘World Formula’.
e aim of economists must nevertheless be to aieve a model of the
economy whi will provide, among other things, reasonable accurate
information about the effects of fiscal policy. In view of the constant anges
that occur in the social structure, and in the behaviour paerns of individual
economic units, this is a difficult task, and it is of great importance to find
out how to construct models, whi will give fairly realistic results in
specified fields, like fiscal policy. e first two parts of this book are
concerned with this exacting task, but we do not pretend that we have
arrived at anything like a complete and definitive solution—far from it!
is la of a ‘correct’ model puts us in rather a dilemma for if we study
fluctuations in the value of money and in the level of employment, and
aempt to discover the possibilities of counteracting them, without using an
explicit model for this purpose, then it may well be that our results turn out
to be inaccurate, ambiguous, or just wishful thinking. A ‘second-best’ model
on the other hand, osen more or less by intuition and based on what are
believed to be the significant entities and economic relationships for the
problem in hand, will probably not give results that are immediately
applicable to the economy in question. Su ‘second-best’ models
successfully osen may however yield conclusions that contain a ‘kernel of
truth’ about the functioning of the economy, and may suggest how analysis
should proceed in certain typical cases.
In oosing a ‘second-best’ model there are two main alternatives: an
econometric model may be selected, whi has already been tested
statistically and found satisfactory or a model may be built up on a priori
grounds. e first method runs into the difficulty that su models are
scarce, and for some purposes non-existent, so that it is likely to be a maer
of adapting a model that was constructed for something else, or relates to a
different economy from the one being studied. is opens up so many
additional sources of error, that the second method has been adopted here,
in spite of the fact that a priori models are necessarily rather abstract, and
their relationships to reality very uncertain.
e work is divided into three parts, ea of whi will now be discussed
in turn, at the same time outlining the methodological considerations that
led to this particular arrangement of the material.
It is obviously impossible to say anything about the effects of fiscal policy
without first discovering what fiscal measures the State has at its disposal.
is involves an analysis of the behaviour of the State (whi here comprises
the various governmental agencies and local authorities as well as the
central government itself) in relation to the model that has been osen. is
apparently simple task has far-reaing consequences, and for that reason
the whole of Part I—e ‘General eory of Fiscal Policy’—is devoted to it.
is Part therefore consists of a fairly tenical discussion of the general
ends-means problem in a budgetary context, whi runs, almost inescapably,
along lines similar to those followed by Fris and Tinbergen. e
relationship between ‘ends’ and ‘means’ in the solution of an economic
problem is examined with a view to determining the meaning that can be
aaed to various assertions about causality and the incompatibility of
certain ends. If a meaningful question is defined as one to whi an answer
is possible, at least in principle, (i.e. if the system of equations specifying the
economy has a unique solution in the given conditions), then many
questions that are posed in fiscal policy debates must be considered
meaningless, or at best ambiguous. Among the specific topics upon whi
aention is centred in this analysis are the implications of balanced (and
unbalanced) budgets, and the incidence of particular taxes. It is found that as
the State sets up more policy requirements, it generally has to take more
measures in order to satisfy them, and the basic rule of thumb is introduced
(whi is, however, not without exception) that the number of means
required to secure any given set of ends is the same as the number of ends.
Once it has been decided what entities in the system are to be considered
as means (State action parameters) of fiscal policy, their role in the models
has to be investigated. is is the subject maer of Part II—‘Micro-
Economics of Fiscal Policy’—in whi we aempt to find out how fiscal
policy measures (i.e. anges in State action parameters) affect the planning
and behaviour of individual economic units. Our object here is to derive
hypotheses about the place of State action parameters in household demand
functions, in the price and output decisions of firms, and in the activities of
organizations. us Part II is a tentative and incomplete examination, at the
micro-economic level, of the discriminating effects of fiscal policy measures
on the planning of private economic units. Our aention has mainly been
concentrated upon households (cf. Chapters VII to IX) and especially upon
their decisions about consumption and saving, and since this is closely
connected with the effects of anges in the rate of interest, these too have
been brought into the picture, as have variations in the supply of labour and
the progressiveness of the tax structure. Our analysis of all these problems
indicates that many commonly held ideas about the effects of fiscal policy
on the behaviour of households find lile support in economic theory. In
many cases no definite hypotheses at all can be formulated on purely
theoretical grounds, and extensive empirical work seems to be required if
answers are to be found to these questions. e reactions of firms are dealt
with more summarily (Chapter X), the discussion being mainly confined to
reporting the more important current views. In the case of labour market
organizations etc. so lile systematic resear has been carried out that all
that has been found possible here (Chapter XI) is a brief indication of the
importance of the problems they pose for economic policy.
In Part III—‘Macro-Economics of Fiscal Policy’—the first task should be to
construct a model whi will help us to analyse the total effects of fiscal
policy, based upon the results obtained earlier concerning the influence of
fiscal measures upon the behaviour of households, firms and organizations.
Until the partial effects have been analysed and utilized in the construction
of a total model, it is impossible to discuss the total effects on a sensible
basis, for to do so would mean conducting a detailed analysis with a model
in whi the properties of the individual equations are not known. Our
definite model (first presented in Chapter XIII, and completed in Chapters
XVI and XVIII) does not claim to be realistic, in the sense of giving a
reasonably accurate description of any particular economy; at best it
provides an abstract, very simplified, qualitative indication of certain major
relationships between some of the main elements in a modern economic
system of the Swedish type. e results will therefore be of the same
abstract, simplified and (until tested by empirical resear) preliminary
nature. is tentative quality is enhanced by the fact that the connection
between Parts II and III is rather weak, since few definite hypotheses about
the reactions of individual economic units emerged from our micro-analysis.
Before the model is presented, however, the ends themselves are
discussed, for without a careful definition of the meaning of a stable value of
money and full employment, discussion of the means of aieving them is
likely to prove unrewarding. e selection of definitions that are appropriate
in a fiscal policy seing is no simple maer, and from among the many
possibilities we eventually adopt the following: a stable value of money is
defined as constancy of an index of the market prices of consumer goods, i.e.
taking account of indirect taxes and subsidies, but not direct taxes and
subsidies, while full employment is defined as equilibrium in the labour
market (the implications of this definition are explored in Chapter XVII). In
the subsequent analysis it has oen been assumed that the State also has
other ends, concerning the balance between consumption and investment, or
the state of the balance of payments. Fiscal policy measures are combined
with interest-rate and exange-rate anges at times to aieve these ends
in the most appropriate manner.
Part III has been so arranged that Chapters XIII, XIV, XV and XVII deal
with methods of neutralizing disturbances arising internally, su as anges
in public expenditure, in the tax structure, in propensities to save and invest,
in productivity, in money wages, etc., while Chapter XVIII deals with
disturbances originating abroad. In Chapter XVI some of the long-term
problems concerning the accumulation of capital are indicated, and Chapter
XIX introduces some of the problems that arise through the uncertainty of
our knowledge about the economy, the way it functions, and the nature and
timing of the disturbances to whi it is subjected.
In both Part II and Part III considerable space has been devoted to the
‘direct vs. indirect taxation’ question. e reason for this is not only the
prominence given to this topic in discussions of fiscal policy, but also, and
mu more important, the radically different roles played by the two types
of tax in a policy designed to secure a stable value of money at full
employment (at any rate in the way we have interpreted these terms). e
common notion that from the point of view of general stabilization policy
there is nothing to oose between them, since they both have a
contractionary effect, seems mu too superficial a standpoint, for it ignores
the difference in the ways in whi these taxes enter the process of price
formation. While the immediate effect of indirect taxes falls on the cost side,
the immediate effect of direct taxes is on the demand side (see section 2 (ii)
of Chapter XIII). is significant fact has been considered at some length,
and forms the basis of mu of the later analysis. It turns out that the
elimination of the effects on the price level and on the level of employment
of a good many of the disturbances that affect the economy depends upon
simultaneous (and usually opposite) variations in both direct and indirect
taxes. Moreover, it should be noted that su variations can be effected
without any undesirable effects upon the distribution of incomes, as is
shown in Chapter XIV, where the question of incentives is also toued
upon.
Another major question, to whi we have devoted mu more space
than is usual in writings on public finance, is the problem of money wage
rates. In Chapter XVIII we have not only shown how any undesirable effects
of anges in money wages may be neutralized by means of fiscal policy, but
we have also outlined a proposal for controlling money wages indirectly, so
that in a certain institutional seing the State will be able to bring about
appropriate anges in money wages by monetary and fiscal means, without
abandoning the principle of free wage negotiation and yet without
jeopardizing the ends of full employment or a stable value of money. In the
long run an appropriate development of money wages is undoubtedly
necessary if economic policy is to be successful, and in this connection the
concept of ‘room for wage increase’ is critically examined, indeed, the whole
problem of national budgeting is considered in some detail from this point of
view.
is work is no vade mecum for government officials or politicians. It does
not provide a straightforward, immediately applicable, policy programme
that will ensure the stabilization of the value of money at full employment.
If I were asked to venture some advice, however, based upon my own
personal conception of what this theoretical analysis of fiscal policy
requirements has shown, it would run as follows:
Since the economic system does not seem to be so constituted that it will
maintain a stable value of money at full employment by itself, and in spite
of the disturbances that affect it, then to set up su ends presupposes that
the State will take the necessary measures to ensure their fulfilment. ese
measures consist of certain simultaneous and co-ordinated anges in fiscal
and monetary policy, i.e. in tax and subsidy rates, expenditure policy, the
rate of interest, and exange rates. If we look at the structure of modern tax
systems, and consider especially the degree of flexibility (both upwards and
downwards) that is required of them in the policy seing we have outlined,
then it is clear that most of them fall far short of what is needed—indeed, the
possibility of upward adjustment, even on a short-term basis, is virtually nil
in many countries. Moreover, the direct and indirect taxes that are our main
concern are envisaged as general taxes to be imposed on broad groups of
households and firms. An indirect tax system whi consists to a large
extent of a collection of individual taxes on a small range of goods does not
fulfil this condition. It would therefore seem that to ensure both greater
flexibility and wider coverage it is necessary to reduce direct tax rates and
introduce a general indirect tax. Su a revision of the tax structure need not
jeopardize the redistribution of income that has been aieved with the
present system. e exact structure of the new direct tax system is a problem
in itself, but it is clear that if variations in rates are to be effective quily
then the ‘pay as you earn’ element has to be incorporated as widely as
possible; this is important also from the viewpoint of making the budget a
‘built-in stabilizer’. In order that anges in the general indirect tax shall
have the desired effect the new tax must be a non-cumulative gross one,
su as a tax on value-added, or wage-payments in all firms. Economic, as
well as purely administrative, considerations suggest a proportional tax on
all wage payments as a suitable means of aieving this.
 If the tax system is anged in this way so as to make it both more
general and more flexible, we have to face the problem that in making su
an adjustment some fall in the value of money may be caused, since the
price level that is to be stabilized includes indirect, but not direct, taxes. Here
the State could take advantage of the normal annual increases in
productivity to bring this adjustment about gradually without raising the
price level, for we find in Chapter XV that a reduction in direct and an
increase in indirect taxation is an appropriate method of counteracting the
effects on employment and the value of money of uniform increases in
productivity. is is subject to one important condition, however, namely
that money wages either do not rise at all during this period, or else rise
more slowly than productivity. us the State could, in a few years, have
reconstituted the tax system in su a way that it would provide an
adequate basis for the fiscal policy we have outlined.
It is only with the greatest hesitation that I make these suggestions,
however, for not only are they concerned with a special set of policy ends,
defined in a rather special way, but they are also derived from an analysis
based on a particular model of the economic system, whi may turn out to
be a poor representation of the actual working of any present-day economy.
Indeed, let me stress once more that the purpose of this book is not to
provide a definite programme for fiscal policy. It is rather to show how
problems of economic policy in general, and of fiscal policy in particular,
ought to be dealt with in economic analysis. e main purpose of this book
is therefore to expound and demonstrate an analytical method. If it should
so happen that some results are aieved that are of immediate practical
relevance then so mu the beer, but this should still be regarded as
incidental to the main task.
 PART I

GENERAL THEORY OF FISCAL POLICY

Problems and Methods
 CHAPTER I

Ends and Means in Economic Policy

1. ENDS AND MEANS IN ECONOMIC MODELS
THE question of how the stabilization of prices can be brought about at full
employment—whatever meaning is given to these terms—is a typical
example of the more general question of how certain ends can be realized by
using certain economic means. us there is good reason for discussing the
general relationship between ends and means in economic policy. It must be
said at once that the end-means problems whi will be investigated here
are not the deep or pseudo-philosophical problems that are oen discussed
under this heading. It is a purely tenical question of the relationship
between ends and means in economic models that is our concern here. e
discussion will take place on a rather formal plane, but it will be illustrated
to some extent by the ends of full employment and a stable value of money,
and certain means for aaining these ends—monetary and fiscal policy.

2. AN ABSTRACT MODEL
Let us consider a completely abstract, ‘exact’ model consisting of n
equations, φi = 0, containing m parameters, aj, and determining the value of
n unknowns, xi; thus:

e equations are supposed to be independent and consistent; the system

has only one solution in the xiS. With given values of the parameters the
value of x is determined. For example, let the m parameter values be a 0;
i j

the value of the n unknown variables are then, xi0.

 Model (I: 1) is supposed to contain all the a priori knowledge, that we
believe to be correct about the economy in whi we are interested. We
presuppose that our theory can be expressed in terms of su a system of
equations. e xiS are the variables we wish to explain: the endogenous
variables; the ajS are determined outside the system. e endogenous
variables may be dated or undated, i.e. the system may be dynamic or static.
e discussion throughout Part I deals with both static and dynamic
models.1
In order to illustrate this more closely we shall have to consider a simple
dynamic model with the equations for the period t (x1, t denotes the variable
x1 in time t, aj, t denotes the parameter aj in time t, etc.):

As can be seen we have dated the parameters. Even if these are

determined outside the system, there is no reason to presume that a certain
parameter, e.g. a1, should have the same value at all points of time.
Especially as the State has at its disposal some of the parameters (cf. section
3) it seems natural that the possibility must be recognized that the parameter
values ange from period to period.
If we are now interested in the happenings of the first three periods—the
horizon comprises those periods—we have for the determination of the six
endogenous variables
 When the dynamic system has been explicitly wrien down in this way
for all the periods within the horizon the system can be treated formally just
like any other system of simultaneous equations.2 e fact that the variables
x1, t, x1, t+1 etc. are separated in time is without relevance as far as the
purely formal method of analysis is concerned. Instead of taking x1, t and
x1, t+1 as different values of the same variable at two different points of

time, we quite simply interpret them as two different endogenous variables;

the dating will then only be a method of distinguishing the variables and in
our example we have six equations with six unknowns. e formal
treatment of static and dynamic systems will in this way be quite similar; so,
for example, the dynamic system above can be differentiated in the usual
way in order to get an expression for the effect on a certain variable some
time in the future of a current parameter ange, that is an expression like
∂x1, t+2/∂a2, t etc. us, when we use derivatives in the following apters

in order to denote the effects of parameter anges, the differential in the

numerator can very well be given a dating separate from the dating of the
differential of the denominator. en the analysis gets the aracter of a
‘comparative dynamics’. Another thing, of course, is that dynamic models
wrien down in this explicit way will have certain aracteristics differing
from those of ordinary static models, whi also consist of su systems of
equations. In a dynamic model derivatives having numerator differentials of
an earlier dating than the denominator differentials will always be zero.
In this context the concept of ‘exogenous’ variables or ‘exogenous’ factors
can be mentioned. It follows from the above that there is no room in the
system (I: 1) for ‘exogenous’ factors. All symbols were classified as either
endogenous variables or parameters. As we have osen to write down all
the equations as one system, we actually have no greater use for the concept
of exogenous factors; when and if su appear in the system they could be
included among the parameters. If, for instance, we consider the system (I:
1a) x2, t−1 is exogenous in the ordinary meaning; if ea equation is
considered on its own, x1, t is furthermore an exogenous variable in the
second equation. In the same way likewise with system (I: 1b). If we
consider this as a whole, x2, t−1 occurs as the only exogenous factor and it
could well be included among the parameters. e reason that we oose
this perhaps somewhat unusual method is of course that we wish to deal
with static and dynamic, interdependent and non-interdependent systems
together.

3. DEFINITIONS OF THE CONCEPTS OF ENDS AND MEANS

With the model (I: 1) as a baground we shall now define the concepts of
‘end’ and ‘means’. By an economic ‘end’ is meant a restriction on the
endogenous variables, e.g. that a certain variable, say xk, will take on a
definite value, say k. Every restriction on the endogenous variables, whi
is added to the system (I: 1) is an additional end. For example, if it is wished
to give three different endogenous variables certain definite values, this is
reoned as three ends. By ‘means’ on the other hand, we quite simply mean
the parameters of the model. Ea parameter is a means; the extent of a
ange in a parameter will then be an indication of the extent to whi the
means is used.
Where the definition of an ‘end’ is concerned there is hardly any
difficulty, at least, if by ‘end’ is meant economic end; whi variables that
should be counted among the endogenous variables, are decided by what are
conventionally considered as ‘economic’ variables. e identification
between ‘means’ and parameters, on the other hand, is perhaps more
difficult to accept. For that reason the meaning of the concept of a parameter
will be explained further.
A parameter symbolizes a factor whi influences the endogenous
variables, without being affected itself by them. So far the distinction
between endogenous variables and parameters is clear. It is of no real
importance, however, how one differentiates between parameters and the
function forms. Parameters can always be wrien explicitly or included in
the functional symbols, whi would then have to be anged. All
parameters are considered to be ‘autonomous’ in the sense that one can
always ange a certain parameter without thereby affecting the other
parameters (by reason of relationships that exist between the parameters
outside the model).
Having defined the concept of the parameter in this way, it is convenient
to classify parameters according to the following principles. We distinguish
between ‘controllable’ and ‘uncontrollable’ parameters and between
‘permied’ and ‘non-permied’ parameters. e dividing line between the
controllable and uncontrollable parameters is based on the fact that certain
parameters, the uncontrollable, may be considered to be given by ‘nature’,
while the remainder can be determined by those who determine economic
policy.3 e fact that a parameter is controllable does not however imply
that the policymaker can ascribe any value he ooses to it. His control over
it can be limited to a greater or lesser extent. e dividing line between the
permied and non-permied parameters is decided by the policymaker or
the individual himself, whose aim we are considering. Under laisser-faire
the dividing line between the permied and non-permied parameters is
quite different from that of a Socialist policy. As the dividing lines between
these two classifications of parameters do not coincide, we therefore get
three classes of parameters:
parameters whi are controllable and permied
parameters whi are controllable and non-permied
parameters whi are uncontrollable.4
As we have identified ‘means’ with ‘parameters’, the means will then
obviously have to be divided up in the same manner.
us those parameters are controllable whi may be influenced by those
who decide economic policy. ose parameters are controllable by the State
so we will oen call them ‘State parameters’.5 Part of the State parameters
are in su direct connection with public finance (the budget) that it will be
convenient to speak about parameters of public finance. How the dividing
line is drawn in practice between the parameters of public finance and other
State parameters, is to a large extent unimportant, cf. the distinction
between fiscal and monetary policy in Chapter II, 2. For example, if the State
determines the cash reserve percentage of the commercial banks this
percentage can hardly be reoned as a parameter of public finance but
rather as a monetary policy parameter; the rate of income taxation on the
other hand is a typical parameter of public finance. Where it is
comprehensible we refer only to fiscal or State parameters and by this is
meant parameters of public finance.
With these definitions we can now return to the model (I: 1).
4. PRELIMINARY REMARKS ON THE RELATIONSHIPS BETWEEN ENDS
AND MEANS

We begin with the parameters in the model (I: 1) having the values aj0 and
the endogenous variables consequently the values xi0. Let us set up, for
example, two economic ends, whi we wish to be realized, namely x1 = 1
and x2 = x3. With the given parameter values we assume that these ends
are not obtained. e task thus consists of anging one or more of the
parameter values in su a way that the new restrictions we have placed on
x1, x2 and x3 are satisfied. In this way x2, …, xn will take on values different

from x20, …, xn0, but as the ends only comprise x1 and the relation between
x2 and x3 this is of no importance. e question is now whi and how

many parameters one may oose as means and whi anges in the
osen parameters must be made to aieve the desired result.
Intuitively we may be led to the conclusion that as a rule we are obliged
to introduce anges in exactly the same number of parameters as the
number of ends. is result follows from the idea that the number of
equations and the number of unknowns ought to be equal if the system is to
have a definite solution. Our system is now:

We have now n+2 equations with n unknowns; the system is

overdetermined. For that reason two parameters may therefore be
considered as unknown; thus the number of unknowns and the number of
equations will be the same. Let us take as ‘means’ two parameters, whi are
permied and controllable, say a1 and a2. By solving the system (I: 2) we
find the values, say a11, a21, x11, …, xn1, of the n+2 factors, whi are now
considered as unknown, where x11 = 1, and x21 = x31. us we can say
that by using the means a1 and a2 to the extent indicated by the anges
from a10 to a11 and a20 to a21 we have aieved the two ends. In doing this
we obviously presuppose that the State knows the ‘true’ model for economic
development, whi means that we presuppose complete foresight on the
part of the State. If the State has not this foresight, it will be seen that the
State policy will not lead to the fulfilment of the ends. Even in this case our
method is relevant; the State cannot plan in other ways; however, see
Chapter XIX, 2 and 3.
According to this line of thought the method would be as follows. A
convenient number of means (parameters) is osen, generally the same
number as the number of ends.6 e remaining given parameters together
with the given ends will then determine to what extent the osen means
shall be used. Furthermore from this will follow—still according to this kind
of argument—firstly that as a rule several different sets of means can be
considered to be used in order to realize a given set of ends and secondly
that in a given set of means one cannot relate any particular means, and the
extent to whi it is used, to any particular end (or the size of it) in a given
set of ends. e use of the means is determined simultaneously by all the
ends.
In order to elucidate the ends-means relationships in dynamic systems we
can, using the model (I: 1b) as a basis, suppose that the State has as its aim to
keep x1 constant, = 1, over time (within the horizon) by using the
parameter a2. We then have three ends x1, t = x1, t+1 = x1, t+2 = 1, and
three means, namely a2, t, a2, t+1 and a2, t+2. By adding these three end-
restrictions to the model above and regarding a2, t, a2, t+1 and a2, t+2 as
unknowns together with the x1S and the x2S we obtain by solution the
values of a2, t, a2, t+1 and a2, t+2 leading to constant x1(= 1) over time;
hereby we find the path that the parameter a2 must take over time in order
that the end, x1 = 1, shall be realized. It can of course also be said that in
this case only one means has been used, but that three measures (i.e. anges
of means) are taken, cf. Chapter XVI, 4.
is argument, whi lies so close at hand, has however no general
validity. e fact that the number of equations and the number of unknowns
are the same, is in general neither a necessary nor a sufficient condition for
the definite solution of the system. Generally the above arguments are
actually only valid for a special type of equations namely linear, non-
homogenous, independent, consistent equations, where all the unknowns
appear in a significant way in all equations. In other cases the solution of the
problem will depend on the specific properties of the system and the ends in
question and nothing general can be said. eoretically certain cases can be
distinguished, however, and we shall show by selected examples that these
cases are by no means uninteresting.

5. NUMBER OF ENDS AND NUMBER OF MEANS

In the first place the number of ends and the sufficient number of means
need not be equal, indeed the number of means can be smaller than the
number of ends;7 this can be brought about by the fact that the ends need
not always imply any new restrictions on the model, in other words, the
end-restrictions are not always independent of the model. For simplicity’s
sake we will still suppose that only two ends are established. We will deal
with five different cases; in Part III numerous examples will be given when
the number of means is less than the number of ends.
(i) Models may exist that are of su a nature that the ends are always
fulfilled by the model without regard to the parameter values. If the model is
then subject to disturbances, for instance through the anging of the
uncontrollable parameters, this will never give rise to deviations from the
ends. If one supposes that the model is an equilibrium model of the Walras
type, where the production function is of the Douglas type and the ends are
full employment and constant distribution of income, the model will always
fulfil the ends. Here no means will have to be put in to aain the ends.
(ii) One can imagine that one of the ends is always fulfilled by the model
while the other one is not. Here one parameter at least must be anged—
consequently one means must be used—in order to aain the ends. Two
economic examples may be given. Firstly we may imagine that the model is
of the Walras type and that the ends are full employment and constant value
of money (price level). As the Walras’ system is aracterized by supply and
demand being equal in all markets there is consequently always full
employment in su a system. With regard to the determination of the price
level, it is supposed, as is well known, in the Walras’ system that while the
system in itself only determines the relative prices, the absolute prices are
determined by a special money equation. We need not concern ourselves
whether this line of thought really holds good; here it is only a question of
presenting examples. Although disturbances, su as a ange in some
uncontrollable parameters, leave the end of full employment unharmed,
they may well affect prices in su a way that the price level (at a given
quantity of money) is anged. However, by suitable anges in the amount
of money all fluctuations of the price level can be eliminated. Regulation of
the amount of money is thus a sufficient means to bring about the ends of
full employment and stable value of money. Secondly we can suppose that
the model is a primitive Keynesian model where the price level (explicit or
implicit) is assumed to be constant and where employment can be
influenced through anges in the level of investment. By varying
investment in a suitable way when there are disturbances in the model we
bring about fulfilment of the end of full employment as well as stable value
of money. us in this case investment is the sufficient means. Further
examples are given in Chapter XVIII.
(iii) A case can be imagined where none of the ends is automatically fulfilled
by the model, but where, on the other hand, the model and the ends are su
that if only one of the ends is fulfilled so will be the other. Here one
parameter ange, one means, is sufficient. Here also economic examples can
be quite easily given. Suppose that the model is of su a type that every
price and wage movement is brought about by an excess demand for the
goods in question, and that demand and supply are not automatically equal,
and that the ends are full employment and constant money wages. Here if
one end is aained the other is aained automatically and one parameter
ange, one means, will suffice.
(iv) Furthermore, it can be imagined that none of the ends is automatically
fulfilled by the model and that fulfilment of one of the ends does not
automatically imply the fulfilment of the other. Here evidently two
parameter anges, two means, are necessary. Numerous economic examples
of this can be given; in fact this would be the most common case. Without
going into details here we shall recall the fact that there is nowadays a
tendency to believe that the ends of full employment and constant value of
money belong to this class.
(v) Finally it can be imagined that fulfilment of the one end implies that the
other end cannot be fulfilled. en the ends are incompatible with ea
other. For instance, it is oen believed that stable value of money and full
employment are examples of su incompatible ends. We shall deal with this
possibility in a later section (9).

6. END—INDEXES
We have defined an end as a restriction on the endogenous variables, where
the restriction has hitherto had the form of an equation to be satisfied. e
end restriction may however be of another type. In many cases the ends of
economic policy can be formulated as a maximization-problem. us the
end is to make certain endogenous variables take on su values that a
certain function, sometimes called a welfare-function, reaes its maximum
value.8 In order to avoid misunderstandings, let us call su a function an
end-index. e end (task) will then be to maximize the value (to aain the
greatest value of) the end-index (end-index function),

In order to solve su a problem we have to consider the endogenous

variables as functions of the parameters, whi are used as means, i.e. the
parameters ‘permied’ in this context. Let these parameters be a1, …, ah. By
solving (I: 1) we arrive at the expression:

If these expressions are inserted instead of the xiS in (I: 3) the end-index
will be as follows

and the (necessary) conditions for the maximum

 Whether there is a maximum value or not, one has at the same time to
find out by other methods whether the end-index function has a greatest
value even if this is not an extremum.
Su a maximization can in certain cases be brought about under purely
arbitrary assumptions concerning the number of independent variables (the
number of ‘permied’ parameters). is however also supposes that the
number of means to be used in this case is wholly determined by the policy-
maker or person who sets the economic end (the end-index function). It can
indeed be said that the end is not fully formulated until it has been stated
explicitly whi means are to be used.
e ends of full employment and constant value of money may be seen as
two separate, absolute ends. ey will then theoretically be represented by
two restrictions of the type whi we have discussed in section 5. Very oen
politicians formulate these ends in su a way that the problem is to aain
as ‘high a level of employment with as stable a value of money as possible’
etc. If su a political programme—quite indefinite as it stands in itself—is to
be given a more precise meaning it should first of all be observed that the
formerly absolute ends have been made relative and dependent upon ea
other. Furthermore, it must be implicit in su a formulation that deviations
from both full employment and the constant value of money may possibly
occur, but that deviations from the one end may only be made if hereby we
simultaneously move towards the other end. e deviations from the
absolute ends shall be weighed against ea other. e end-index is a
summary expression of su considerations. is is also the reason for our
preferring to say that only one end exists in this case.
In actual policy, absolute ends as well as end-indexes usually appear
alongside one another. Su a mixed programme might be stated as follows:
‘We shall keep as high a level of employment and as stable a value of money
as possible, but the exange reserves must not decline’.9
A more general end-means problem sometimes arises when, in actual
policy, one oen weighs ends and means against ea other, and in su a
way that the question whether the means are permied is partly dependent
on what ends can be reaed using the means in question. Even if the means
(according to our definition) cannot be economic ends, they may very well
be significant in another way (ethical, religious and the like). Even this we
can take account of without difficulty in an end-index. (1: 3) may thus be
wrien as

where a1, …, ak denote all controllable parameters. e end will be to

maximize this function by giving the as suitable values. As above we find
the necessary condition (I: 6) where g goes from 1 to k.

7. SIGNIFICANCE OF THE MODEL STRUCTURE EXEMPLIFIED

Above we have discussed the relationship between ends and means by
asking the following question: whi, and how many, means have to be used
in order to bring about a given set of ends? It has been pointed out that cases
where, for instance, a certain number of ends can be realized through the
use of a greater or lesser number of means are not entirely without interest.
Several concrete examples will be given in Part III. However, in the
following we shall assume that the model and the ends are su that the
number of ends and means are equal and that the ends are absolute, cf.
section 5.
In section 4 it was maintained as a result of the preliminary arguments
that the means and the use of them must be expected to be determined
simultaneously, involving the consequence that as a rule—if there exists a
given set of means and a given set of ends—the use of a particular means
cannot be aaed to any particular end. is rule is not without exceptions,
however, and it must be modified with regard to the specific ends, and the
specific model under consideration. In certain quite special cases every
means can in fact be aaed to some particular end and in less special cases
certain means or groups of means can be aaed to certain ends or groups
of ends; thus the means can be classified according to the ends they are
intended for.
Before we go into more general discussion of this interesting subject we
shall illustrate it with a simple example where we suppose that the two ends
full employment and stable value of money have to be realized by the use of
fiscal policy and monetary policy; further examples are given in Part III, esp.
Chapter XVIII. In the political discussions of these questions it has been
maintained that the task here should be divided in su a way that the
central bank takes care of the value of money by means of monetary policy
while the State with its use of fiscal policy sees to employment. We shall use
this as a starting point for the discussion and our problem is then whi
meaning can be aributed to su a proposition. For the sake of simplicity
we assume that the means of monetary and fiscal policy ea consist of only
one parameter, su as the bank rate and the rate of income taxation
respectively.
(i) In the first case the model is

We presume that the parameter values are not zero and that the system
has one and only one solution in the xiS. Let x1 and x2 denote the price and
employment levels respectively; a15 and a25 the bank rate and the rate of
income taxation. With the given parameter values we assume that the price
level is at the desired height and that there is full employment. x3 and x4 are
endogenous variables the value of whi is of no interest to economic policy.
Model (I: 7) is purely illustrative; there is no particular theoretical reasoning
underlying the oice of variables, parameters and relationships.
In this system all the endogenous variables are interdependent and
simultaneously determined. If now there is a disturbance in the system in
that some (uncontrollable) parameter, say a43, anges value, the value of all
the endogenous variables will ange; the disturbance thus means that both
the value of money and employment are anged. If it is desired that price
level as well as employment be brought ba to the values they had at the
beginning, obviously the bank rate (a15) and the level of taxation (a25) must
be anged simultaneously in a way that can be determined according to the
method described in section 3.
 us if it is desired that full employment and a stable value of money are
kept up despite possible disturbances, the central bank and the State must
evidently act in co-ordination and simultaneously (with this system of
equations). If they act without regard for ea other’s action and without
regard for anything but their own end (the value of money in the case of the
central bank and employment on the part of the State) the result can very
well be that neither of the ends is realized (except possibly occasionally or
perhaps aer a long time.)
Consequently with the model under discussion it does not make sense to
say that the central bank shall take care of the value of money by means of
monetary policy and the State shall take care of employment by means of
fiscal policy. e central bank and the State (together) by the use of
monetary and fiscal policy means (together) rea the ends of stable value of
money and full employment (together). It may be said in this case that there
is equality of status among ends and means, none takes precedence over any
other.
With a very simple model, we shall study in detail the consequences of
la of co-ordination between the policies of the State and the central bank.
We suppose that the price level and the national product are determined
where an aggregate demand curve cuts an aggregate supply curve, as is
shown in Fig. I: 1. ese two curves are considered to be independent of
ea other. We shall not aempt to justify this assumption, whi is quite
unreasonable from an economic point of view; it has been osen for purely
didactic reasons in order to give a simple example. e model is a ‘moving
dynamic equilibrium’ one, where the meanism of motion consists of
anges in the parameters of the equilibrium system, i.e. by shis of the two
curves.
Along the ordinate we have x1, the price level, and along the abscissa, x2,
the national product, the size of whi also indirectly stands for the volume
of employment. With the given supply curve, S1, and the demand curve, D1,
the price level and the national product are and respectively. e
algebraic equivalent to the geometric model will then be
 However, we shall refrain from algebraic treatment as the geometric
method is completely satisfactory for our purpose.
Let us suppose then that two ends have been established so that the price
level x1 shall be = 1, and that the national product (employment) x2 shall
be = 2, cf. the point ( 2, 1) in Fig. I: 1. Can the ends be reaed, and how?

Fig. I: 1

In order to answer this question we have to make definite assumptions

concerning the central bank’s and the State’s respective parameters of action
and reaction-paerns.
Concerning the parameters of action we presume that the central bank,
e.g. through the bank rate can influence the supply curve in su a way that
when credit is restricted, the supply curve shis upwards; if, on the other
hand, credit is eased the supply curve moves downwards. Furthermore, we
suppose that the State can influence the demand curve by direct taxation
(the parameter is here the rate of taxation) in su a manner that when
income tax is increased (decreased) the demand curve moves downwards
(upwards).
Concerning the reaction-paerns we shall examine different possibilities:
(a) Co-operation between the State and the central bank. In this case the
central bank will move the supply curve by restriction of credit so that it
will pass through the point ( 2, 1) in Fig. I: 1; at the same time the State will
move the demand curve by easing taxation in su a way that this curve
will also pass through ( 2, 1). Both the ends, 2 and 1 will then be reaed
simultaneously.
(b) Central bank and State policies not co-ordinated. e central bank
presumes that the State does not do anything to influence the demand curve
and exclusively directs its policy towards aaining the price level 1
(without regard as to the effects on employment x2). e State acts in a
similar kind of way, presuming that the central bank is not doing anything
to influence the supply curve, thus wholly directing itself towards aieving
the national product 2 (without regard to effects on the price level 1). e
actions of the central bank and of the State are supposed to take place
successively in su a way that the central bank first anges its policy so
that the price level 1 is reaed: as a consequence the national product will
ange and take on a value different from 2. en the State anges its
policy so that the national product reaes the value 2; the price level is
anged as a result of this. e central bank then tries to bring the price level
ba to 1, etc. e development, whi is brought about in this way is
exemplified in Fig. I: 2, a and b and also Fig. I: 3, a and b.

Fig. I: 2
 Fig. I: 3

In Fig. I: 2a the starting point in period 1 is point ( , ) whi is the

point of intersection between D1 and S1. In period 2 the State is supposed to
act in order to make the national product 2. Here the State starts out from
the (correct) premise that the supply curve in period 2, S2, is unanged as in
period 1, S1. e State then anges the demand curve from D1 to D2 whi
intersects S2 (= S1) on the vertical line x2 = 2. Now there is full
employment, but the price level exceeds the end 1. In period 3 the
central bank will act, starting out from the correct belief that the demand
curve in period 3, D3, is unanged and the same as in period 2, D2. e
central bank will for that reason move the supply curve from S2 (= S1) to S3,
whi cuts D3 on the horizontal line x1 = 1. e price level will then have
acquired the desired height, but at the same time the national product will
have risen to . e State then in its turn in period 4 moves the demand
curve to D4, etc. e development is indicated by arrows, and in Fig. I: 2b
there are two curves whi show the developments in x1 and x2. In this case,
the development is obviously explosive. Although one of the ends is reaed
in ea period, the other at the same time becomes more and more distant. It
is clear that the means must be applied to a greater and greater extent.
 In Fig. I: 3, a and b, we have in just the same way illustrated the case
where the process is damped and the model is moving towards a state where
both ends are simultaneously fulfilled. Although in a given period only one
of the ends is exactly met, the model is successively approaing the end not
fulfilled at the moment. In this case the la of co-ordination between the
central bank and the State is obviously less inconvenient than in the
previous explosive case.10
ere is no difficulty involved in bringing about quite different
developments in the variables x1 and x2 over time by introducing other
suppositions about central bank and State action-parameters and paerns of
reaction. As an example of the case where neither the central bank nor the
State will aieve ‘its’ end in any period, we can imagine that both the State
and the central bank act simultaneously in ea period and take it for
granted that the other party is doing nothing to ange the curves of the
previous period, and where at the same time the central bank exclusively
directs itself toward making x1 = 1 and the State towards making x2 = 2.
e geometrical treatment of this case is simple; we shall only mention that
here also the result may be explosive, constant or damped fluctuations
around the ends.
Having now dealt in a detailed manner with the case where all the
coefficients in the model (I: 7) were non-zero—the completely
interdependent case—we shall now presume that some of the coefficients are
zero. e model is then, e.g.:

In the following four cases (ii)–(v), whi will now be dealt with, it will
be presumed that the model is (I: 8).
(ii) With the model (I: 8) as a starting point we shall presume that x1 is the
value of money, x2 employment, a15 the bank rate and x25 the rate of
taxation. Inspection of the model (I: 8) now shows that it has certain
qualities important to our problem. If we look first at the equation (8: 1) this
contains, as can be seen, only one endogenous variable, x1. us x1 can be
determined if one only knows (8: 1). Whatever happens in the other
equations of the system it will not influence x1. Consider next the group
consisting of the two equations (8: 2) and (8: 3); these two equations contain
only two endogenous variables, x2 and x2. us x2 and x3 can be
determined without regard to the equations (8: 1) and (8: 4), and anges in
the laer do not influence the values of x2 and x3. Finally, if it is desired to
determine x4, knowledge of all the equations in the system is necessary and
any ange whatever in the equations of the system will influence x4.
If now a ange in the uncontrollable parameter a11 occurs this will be of
significance to the value of money, x1, but not to employment, x2. By a
suitable alteration of the bank rate, a15, the central bank can bring ba the
value of money to the desired level without this policy measure affecting
employment. If on the other hand a ange of some uncontrollable
parameter in the equations (8: 2) and (8: 3), e.g. in a33, occurs, this will be of
significance for employment, x2 (and for x3 and x4), but not for the value of
money, x1. By anging the rate of taxation, a25, the State can return
employment to the desired level without effect on the value of money.
In this case where the value of money and employment are determined
quite independently of ea other, it is evidently quite reasonable to say, that
the central bank sees to the value of money by monetary policy means and
the State looks aer employment by fiscal policy means. e central bank
policy and the fiscal policy, i.e. the means, can be deployed quite
independently of ea other. e central bank and the State need not
concern themselves about ea other; ea of them has its end to aieve
and the means to aieve it with. Of crucial significance for this result is the
above-mentioned property of the model that no parameter ange
influencing the value of money affects employment, and no parameter
ange influencing employment affects the value of money.
In terms of the geometric model treated under (i), the case discussed here
is that in whi the demand curve is vertical and the supply curve is
horizontal, see Fig. I: 4.
 Fig. I: 4

It is clear that here the reaction paerns of the central bank and the State
are irrelevant to the question of when and how the ends are aieved. e
end 1, is arrived at in all circumstances by the central bank moving the
supply curve so that it will pass through ( 2, 1) and the end 1 by the State
moving the demand curve so that it will pass through the end-point. e
order in whi these movements take place is of no importance whatsoever.
(iii) We assume, as before, that in the model (1: 8) the value of money is x1
and the bank rate a15; but x4 is now employment and a45 the rate of
taxation. e situation is radically anged compared with (ii). A parameter
ange in the equation (8: 1) whi influences the value of money will also
affect employment. Parameter anges in the equations (8: 2), (8: 3) and (8: 4)
on the other hand influence only employment, not the value of money. If
there is a ange of the uncontrollable parameter a11 the value of money as
well as employment will consequently be anged. However, if the central
bank alters the bank rate, a15, in su a way as to bring the value of money
ba to its original value, it is obvious that employment too will be brought
ba to its original level.11 e State should obviously refrain from action.
If, on the other hand, the end itself is anged as far as the value of money is
concerned, and the central bank accordingly alters the bank rate,
employment will also be affected. If the end for employment policy remains
unanged, the State must ange the level of taxation so that employment
returns to the desired level. Finally, if a ange of some uncontrollable
parameter occurs in the equations (8: 2)–(8: 4), say in a32, employment is
affected but not the value of money. If the State anges the rate of taxation
in order to reestablish full employment, the value of money is le
undisturbed. e same is valid if the employment-end is anged and the
State accordingly adjusts the rate of taxation.
us it is clear that with this model the central bank is ‘sovereign’ in
relation to the State. If the central bank does not concern itself with
employment, it can direct its monetary policy towards keeping the value of
money stable without regard to the State’s fiscal policy. e State for its part
must in its aempts to maintain full employment by fiscal policy means,
always have regard to the monetary policy measures of the central bank.
e price-level end may in a certain sense be said to come before the
employment-end and fiscal policy must adapt itself to monetary policy. It
can be said that there is here a ranking of ends and of means, a system of
priorities, an order of precedence.
In this case it is still quite reasonable to say that the central bank looks
aer the value of money by monetary policy means. On the other hand, it is
not correct to say that the State looks aer employment by fiscal policy
means; it does so in some cases only by adapting its fiscal policy to the
monetary policy, and in other cases monetary policy will suffice to aieve
stable value of money as well as full employment, the nature of the
disturbances being decisive.
In the geometric model, case (iii) corresponds to that in whi the supply
curve is horizontal while the demand curve has a ‘normal’ slope, cf. Fig. I: 5.
 Fig. I: 5

In this case too, the paerns of reaction of the central bank and the State
will be relatively unimportant for the aievement of the ends. In all
circumstances both ends will be reaed aer two or at the most three
‘moves’, depending on whi makes the first aempt to rea ‘its’ end.
(iv) If we suppose instead that x1 is employment, a15 rate of taxation, x4 the
price level and a45 bank rate, the positions of the central bank and the State
will be precisely the reverse of those in case (iii). e State is now sovereign
in relation to the central bank, monetary policy has to be subordinated to
fiscal policy. All that has been said under (iii) is valid, mutatis mutandis,
here.
In the geometric model this corresponds to the case where the demand
curve is vertical while the supply curve has a ‘normal’ slope, see Fig. I: 6.
e commentary in connection with Fig. I: 5 concerning the significance
of the paerns of reactions of the central bank and the State is valid also in
this case.
(v) Finally, if x2 stands for the value of money, x3 employment, a25 bank
rate and a35 rate of taxation, we are ba at the same case that was dealt
with under (i) where the means are of equal status.

Fig. I: 6
 Cases (i)–(v) demonstrate in a simple way that the connection between
the use of the means and between the ends and the means are fully
dependent on the structure of the model whi forms the baground for the
policy. e model behind cases (i) to (v) was, however, of a special nature;
within ea single period the model was of a purely static nature. However,
we easily realize—by regarding the model (I: 1, b) in section 2—that by this
particular model we also have shown some of the possibilities whi arise in
dynamic models where the use of the means can have a different dating
from that of the ends; the dynamic aspects of the problem will be further
developed in Chapter XVI, 4–7.

8. EXCURSUS ON THE CONCEPT OF CAUSAL ORDERING AND THE

RELATIONSHIP BETWEEN ENDS AND MEANS
In this section we shall discuss in a more general manner the way in
whi the structure of the model is decisive for the relationship between
ends and means.
e possibility that certain means can be aaed to certain ends and that
certain means can be said to be subordinate to other means can be shown to
be based entirely on the fact that a definite causal ordering of variables (and
equations) is established in the model. We shall briefly outline this concept,
whi has been advanced by Herbert A. Simon,12 as it seems to be of central
importance for the relation between ends and means and between the means
themselves.
Simon’s arrangement of the equations and variables of a model is entirely
determined by whi endogenous variables are influenced by anges in the
various parameter values. It is this whi makes the concept of causal
ordering immediately relevant for our ends-means discussion.
Let us return to the four equations of model (I: 8). As we have already
pointed out, the equations are of su a nature that anges of any
parameter in the equation (8: 1) will influence the value of the endogenous
variables x1 and x4 (but not x2 and x3); x1 will be influenced directly and x4
indirectly by the ange in the value of x1. Similarly a ange of a parameter
in the two equations (8: 2), (8: 3) will influence the value of x2, x3 and x4.
Finally, parameter anges in the equation (8: 4) will influence the value of
x4 (but not of x1, x2 and x3). us it is reasonable to say that in the system

(I: 8) x1, x2 and x3 can be seen as causes of x4 and we get the following
parallel order of precedence between the equations of the system and causal
ordering of the endogenous variables of the system, where an arrow denotes
precedence or a causal relation, an asymmetrical relationship.

In the system considered there is, on the other hand, no possibility of

establishing any precedence between the equations (8: 2) and (8: 3) and
consequently no causal ordering between x2 and x3. ese two variables, it
can be said, are interdependently determined. In the same way in a system
su as (I: 7) above, it is not possible to establish any ordering between
equations and endogenous variables. In model (I: 7) any parameter ange
will simultaneously influence the values of all the endogenous variables; the
system is completely interdependent.
It is obvious from our example that the causal ordering consists in
dividing up the equations and endogenous variables of the model into
certain corresponding sub-groups or, in Simon’s terminology, ‘subsets’. Ea
subset is said to be of a certain order from zero upwards. ere is,
furthermore, a distinction between ‘minimal’ subsets and ‘complete’ subsets.
A minimal subset of the zero order is a group of equations whi fulfils the
condition of containing as small a number of equations as possible and
where the number of endogenous variables is the same as the number of
equations. In the above example the equation (8: 1) is a minimal subset of
the zero order, the equations (8: 2) and (8: 3) together form another minimal
subset of the zero order. All minimal subsets of zero order form together the
complete subset of zero order, in this case (8: 1) and (8: 2)—(8: 3). e
minimal subsets of the first order are aracterized by the fact that they
contain as few equations as possible and (just as many) su endogenous
variables that do not appear in any subset of the zero order, along with one
or more endogenous variables included in the subset of the zero order. In the
above example the equation (8: 4) is the only minimal subset of the first
order. Contained in (8: 4) is just one variable that is not found in any of the
minimal subsets of the zero order, i.e. in (8: 1) or (8: 2) and (8: 3). All minimal
subsets of the first order form the complete subset of the first order. us it
should be clear what is meant by subsets of the second and higher orders.
It is easy to understand that the largest possible number of subsets is the
number of equations (and endogenous variables) in the model. If the number
of subsets is exactly the same as the number of equations in the system, we
will have a completely recursive system.13 If the number of minimal subsets
is equal to one the system is completely interdependent (e.g. like the system
(I: 7) above). In all other cases the system is mixed interdependent-recursive.
Considering the causal ordering of the model it is realized that if a certain
endogenous variable, say xj, is causally dependent on another variable xi
then xj, must belong to a subset of a higher order than xi. However, this will
not be sufficient to create a causal relation. Su a condition is that
parameter anges influencing xi (and the minimal subset of endogenous
variables to whi xi belongs) also influences xj; a necessary condition for xj
to be causally dependent on xi is that there are parameter anges
influencing xj (and the minimal subset of endogenous variables to whi xj
belongs) without influencing xi.
If we give the same importance as before to the expression that the means
are independent, of equal status (rank), superior or subordinate, it will now
be understood that a means will be superior to another means, if the
fulfilment of an end necessitates a ange in an endogenous variable that is
in a causal relationship with some other endogenous variable in the system,
whi, in its turn, must also be anged in order that some other end may be
fulfilled. Depending upon the nature of the restrictions, many combinations
of independent, equal-ranking, superior and subordinate means are possible.
In general, however, one cannot say more than the following:
If all the endogenous variables that appear in the end-restrictions belong
to the same minimal subset, then all the necessary parameter anges must
be calculated simultaneously and all the means are thus mutually dependent
and of the same rank.
 If the restrictions can be divided into groups, with all endogenous
variables appearing in su a group belonging to the same minimal subset,
and with no causal relation connecting any of these subsets, then the means
can be divided into a corresponding number of groups so that the means
within ea group are of the same rank (and mutually dependent), while the
different groups of means are independent of ea other; in all other cases
precedence relationships will appear to a greater or lesser extent.

9. ‘THE CONFLICT OF ENDS’

Above we have mentioned the possibility that the ends may well be in
conflict with ea other. It might appear as if this very common expression
is self-evident and that it needs no further explanation; this, however, is not
the case. e expression can actually have many different meanings. We
shall first deal with the absolute ends and imagine that a set of ends, and
consequently a set of restrictions on certain endogenous variables, has been
laid down.
(i) A very natural way to interpret ‘the conflict of ends’ is to see it as an
expression of a la of inner logic in the set of ends. Certain ends are in
logical conflict with ea other.
Mathematically this means that the end-restrictions are inconsistent. As
an example of this the following three ends can be set up: x1+x2 = k; x1 =
x2/k; x1 = 1/(1−k), where k ≠ 1. No model can be constructed where the

solutions satisfy these restrictions.

To decide whether the ends are in conflict with ea other in this most
literal meaning of the term, is perhaps rather a question of logic than
economics, as far as the problem can be decided without knowledge of the
properties of the economic system. Normally the expression is used in a
wider sense, where it is supposed that ends can also be in conflict with ea
other in a more ‘economic’ or ‘factual’ sense.
(ii) us we have embarked upon the line of thought that considers the ends
and the model, conceived of as a single entity, to contain contradictions. is
also may be a question of pure logic. Although they are without
contradiction among themselves, when taken together with the definitional
relationships of the model, the ends may contain a contradiction. For
example, suppose that the following ends are established: the national
income for the coming year is to be £10 milliard, consumption is to be £8
milliard and investment £3 milliard. ese ends are not in themselves
contradictory. However, if they are considered together in a model of a
closed economy where by definition the national income is equal to the sum
of consumption and real investment, we will get a contradiction. If, on the
other hand, these three ends are considered together in a model in whi a
surplus or deficit in the balance of payments may arise it cannot be said, of
course, that the stated ends are in conflict with ea other by reasons of
definition. Here instead the problem is whether a deficit of £1 milliard in the
balance of payments can be considered to arise in the model; but this
question is not one of definition.
(iii) us we come to the interpretation of the expression ‘the conflict of
ends’ whi is most in accordance with the meaning usually aaed to it,
that the model and the means whi it contains do not allow the ends to be
fulfilled. e conflict of ends’ then means that no maer what set of
permied parameters we oose as new unknowns, i.e. no maer what
means we intend to use, the system has no solution that will satisfy the set
of end-restrictions that we have imposed upon the system. e expression
that the ends are in conflict with ea other will, however, always be
conditional. First of all it must be kept in mind that the model only indicates
‘known’ economic relationships. e reason why an end is not fulfilled
therefore may be that our knowledge of the economy is limited or even
wrong. What is ‘impossible’ today (with our present knowledge) may be
possible with the greater knowledge we will have in ten years time.
Secondly it is quite possible that the ends can only be fulfilled if the set of
necessary parameters (means) includes means whi are either
uncontrollable or non-permied (from the viewpoint of those whose ends
we are discussing).
(iv) If we leave the absolute ends and turn to the end-index the situation will
be different. e absolute ends are now relative and weighed together in an
end-index; the end is to find the greatest value for this end-index; As has
been pointed out above, the problem is not set out before we have specified
the means intended for use. In certain conditions14, whi can oen be
supposed to be fulfilled in economics there is always some greatest value of
the end-index, irrespective of whi set of means we intend to use. For that
reason it is impossible (in the above conditions) that the end in this case
should not be fulfilled. For the fulfilment of the end involves oosing the
‘best’ possibility from among the possibilities actually available.
(v) If, with the above as a baground, we discuss whether the ends of full
employment and stable value of money are in conflict with ea other or
not, it will be clear that to the extent that the ends are combined in an end-
index, they cannot conflict with ea other no maer what means we intend
to use in order to fulfil the end. If the two ends are absolute, it is clear that
they are not in conflict with ea other in the logical meaning indicated
under (i) and (ii), at any rate not according to the definitions normally found
in economic models. On the other hand these two ends can very well be
imagined to be in conflict with ea other in the sense indicated under (iii).
If an economist arrives at the conclusion that the ends of full employment
and stable value of money are in conflict with ea other, he has done so
under definite presumptions about the means intended to be used and
always dependent on his current knowledge of the economic universe. What
is not possible by the means permissible in an old-fashioned liberal society,
may very well be possible in a modern liberal society; and what is not
impossible in a modern liberal society may be so in a Socialist community.
What is ‘impossible’ today can be ordinary routine tomorrow.
e policy-maker will here oen face the problem of weighing economic
ends and policy means. It may well be imagined that the complete fulfilment
of the ends of full employment and stable value of money is only possible by
using (at least) one of the means whi in other cases only Socialist policy-
makers or communities allow. ose who want full employment and stable
value of money must then consider whether they will want to take this step
towards Socialism to aieve the end.15 It must not be forgoen that this
problem cannot be avoided by hiding behind an end-index. However, here
the work of the economist ends and that of the politician begins.

10. CONCLUSIONS
In this apter we have tried to show several circumstances of a wholly
general aracter whi are decisive for the realization of a given set of
ends. e result briefly is as follows. If economic reality could be described
by a completely interdependent model, e.g. model (I: 7), where ‘everything
depends on everything else’, a given end could in principle be fulfilled by a
ange of any parameter, that is by the use of any means, if only we are
willing to use this arbitrarily osen means to a sufficient extent. Hence the
rule of thumb that the number of means and the number of ends are equal.
When the question of the relationship between ends and means cannot be
supposed to be of this simple kind, however, the reasons are precisely those
that we have pointed out. Firstly, we cannot be sure that the model is
completely interdependent. Dynamic models (as formulated in section 2), for
instance, are normally not interdependent. For if this complete
interdependency is absent it can be supposed that only certain means can be
used in order to aain certain ends. If several ends are postulated whi it is
desired to fulfil at the same time or at different times, the problem arises
whether the means to be used can be regarded as of equal rank, or if certain
means are made subordinate to other means in su a way that the use of
the former must adapt itself wholly to the use that is made of the laer.
Secondly, it is not certain that all parameters in the model can be controlled,
and even if they are actually controllable it is not certain that is is regarded
as permied (from a political point of view) to employ them at all, or to the
extent necessary. Here the possibility that the ends cannot be fulfilled begins
to gain actuality. Even the greatest enthusiasts for interest policy would
surely shrink from raising the rate of interest some thousand per cent if this
should prove necessary in order to restrain an undesirable increase in
investment. If finally, different ends are combined together in an end-index,
most of the end-means problems no longer exist in a purely tenical sense.
We have to the greatest extent possible used the ends of full employment
and stable value of money as an example in our arguments. Considering the
close relationship that is likely to exist between these variables, we have, as
has been previously mentioned, every reason to believe that, if these ends
are to be aained, the means employed must be carefully co-ordinated.
Otherwise hardly any of the ends will be reaed. On the other hand, the
forces influencing employment and the price level are so different that it can
hardly be believed that the fulfilment of the one end would automatically
imply the fulfilment of the other. A priori we must therefore suppose that
several means, of equal rank and co-ordinated, must be used simultaneously
if the two ends are to be fulfilled.

POSTSCRIPT TO CHAPTER I
is apter was draed in its present form in the early spring of 1953; in
spring 1954 certain details were anged. In summer 1954, however, I
became aware of the existence of a book, published as early as 1952, entitled
On the Theory of Economic Policy by J. Tinbergen.
16 e ideas about the
general relationship between ends and means (targets and instruments in
Tinbergen’s terminology) in economic policy, on whi I was working and
of whi this work can be regarded as an application, appeared to coincide
in an astonishing way with Tinbergen’s treatment of the theory of economic
policy. Correspondence with Tinbergen has furthermore affirmed this fact.
At the end of 1954 a continuation of the above mentioned book was
published, entitled Centralization and Decentralization in Economic
Policy;
17 here too I have found thoughts quite parallel to mine. Tinbergen
was inspired by a memorandum by Ragnar Fris submied to the United
Nations in 1949 and published in Oslo in 1953 as a Memorandum from
Universitetets Socialøkonomiske Institu, Price-Wage-Tax-Subsidy Policies
as Instruments in Maintaining Optimal Employment; this work also had
escaped me.
I have osen to present my version as it already was when I became
aware of Tinbergen’s books, without making reference or paying specific
regard to them in any other way—this postscript should therefore be
considered a general reference to Tinbergen’s two books and Fris’s
Memorandum.
Besides the great similarity between Tinbergen’s works and this apter,
there are, however, certain divergencies. Among these I would especially
point out the following:
Firstly, my treatment is quite abstract while Tinbergen has had the
advantage of being in the position of applying his theories to real models of
the Dut economy used within the Netherlands’ Centraal Planbureau.
Secondly, the formal methods of presentation are somewhat different.
 irdly, Tinbergen generally confines his discussion to static systems,
while I have conducted my arguments in su a way that they are valid for
both static and dynamic systems.
Furthermore, I have treated certain possibilities for the relationships
between the number of ends and the number of means, whi Tinbergen has
not studied.
Summarizing, it might be said that Tinbergen, by referring mainly to
numerical, static, linear models has been able to aieve a detailed treatment
not possible by my more abstract and perhaps more general method. is,
however, is also a limitation on Professor Tinbergen’s work. For this reason,
if no other, I hope that my treatment may have a value of its own.

1. Further viewpoints of the end-means problem in dynamic models are

given in Chapter XVI. In Chapter XIX the end-means problem in
stoastic models is toued upon briefly.
2. e expression ‘simultaneous’ is to be taken in the usual mathematical
sense.
3. If ‘exogenous’ factors (as, e.g. x2, t−1 in the system (I: 1b)) appear in the
model, they are included, as has been mentioned, among the
parameters. It is to be understood that they belong to the group of
‘uncontrollable’ parameters.
4. It is hardly of interest to divide the uncontrollable parameters into
permied and non-permied.
5. Even private economic subjects may take part in policy through
commanding some parameters, su as money-wages determined
through labour-market organizations. Su parameters we include
among the uncontrollable.
6. If in order to aieve a given set of ends one ooses a set of means,
whi contains a larger number of means than the number of ends,
there are an infinite number of ways in whi this set of means can be
used to aieve the ends.
7. at the number of means can be greater than the number of ends is
obvious.
 8. See J. Marsak, ‘Statistical Inference in Economics: An Introduction’,
Chapter I in Statistical Inference in Dynamic Economic Models, Ed. T. C.
Koopmans, New York and London 1950. e task of maximizing the
welfare function is usually taken to imply that an extremum should be
reaed. See also P. A. Samuelson, ‘Principles and Rules in Modern
Fiscal Policy: a Neo-classical Reformulation’ in Money, Trade and
Economic Growth. In Honour of John Henry Williams, New York 1951.
9. e absolute end here constitutes a restriction in the form of an
inequality, the exange reserves ≥ a certain given value.
10. Whether the development in this model is explosive or convergent is
determined—as in the cobweb-theorem—by the relationship between the
absolute slopes of the demand and supply curves.
11. Here we have an example of the possibility mentioned in section 5 (iii),
that one means is sufficient to rea both the ends.
12. A rigorous description of this is to be found in Herbert A. Simon,
‘Causal Ordering and Identifiability’, Chapter III in Studies in
Econometric Methods, Ed. Wm. C. Hood and T. C. Koopmans, Cowles
Commission Monograph No. 14, New York and London 1953, also ‘Logic
of Causal Relations’ in Cowles Commission Papers N.S. No. 70, Chicago
1952.
13. See Wold’s definition of recursive systems, Herman Wold, Demand
Analysis, New York and Stoholm 1952, page 50. e system (I: 7)
above is anged to a completely recursive system if the coefficients a12,
a13, a14, a23, a24, and a34 are made equal to zero.

14. Namely, that the end-index function (in the form (I: 5)) is continuous,
and that the variations of the parameters take place within a closed
interval.
15. at in practical politics su end-means conflicts are oen ‘solved’ by
quite simply redefining the ends, hardly needs to be pointed out. e
development of the concept of full employment from Lord Beveridge
onwards is an example of this type of ‘solution’.
16. J. Tinbergen, On the Theory of Economic Policy, Amsterdam 1952.
17. J. Tinbergen, Centralization and Decentralization in Economic Policy,
Amsterdam 1954.
 CHAPTER II

e Means of Fiscal Policy

1. INTRODUCTORY REMARKS
WE shall begin this apter by examining more definitely the part public
finance can play in an economic system. As has been mentioned before, su
an investigation cannot be fully completed if the economic system is not
known in detail, that is to say, if there is no complete model to work with.
Here there is no su model, but it is nevertheless possible to get quite a way
without any closer knowledge of the ‘true’ model than those parts of it that
are fixed in budgetary practice, tax laws and other easily established
phenomena of this kind.
e discussion will proceed from the arguments of the preceding apter
on the relation between ends and means. e budget is oen spoken of as a
means of economic policy, but in fact the budget covers several economic
policy means—parameters—whi the State and other public authorities can
use in economic policy. It is a fundamental problem to find out what means,
in the true sense of the word, the authorities have at their disposal for their
fiscal policy.

2. FISCAL POLICY AND MONETARY POLICY

e first question that must be answered here concerns terminology rather
than principle, viz.: Whi of the government measures are to be assigned to
‘fiscal policy’? By government we mean of course the State and also local
authorities of all kinds. It must be specifically mentioned that the central
bank, the National Debt Office and public enterprises are also considered
parts of ‘the government’. Consequently we are here concerned with the
measures taken by all these governmental organs. Moreover it is obvious
that only su government measures as are directly connected with
payments to and from the government can be counted as fiscal policy.
Defined in this way fiscal policy will, however, cover certain measures
whi are usually considered monetary policy. It is not absolutely clear how
the line between fiscal policy and monetary policy should be drawn nor is it
altogether clear whether su a distinction on the whole is useful. On this
last point it is mainly a question of whether one can find a basis for
classifying governmental measures that gives rise to a division of work that
is both theoretically and practically relevant. e following two alternative
criteria seem to lie nearest to hand: governmental measures can either be
aracterized by the markets whi they directly influence, or else they can
be aracterized by the authorities deciding them.
Using the market criterion we can draw the dividing line between
monetary and fiscal policy so that monetary policy will consist of all those
measures directly connected with governmental transactions in the credit
market1; fiscal policy will then comprise those measures connected with all
the other governmental transactions. From a theoretical point of view this
division is both clear and simple. It will be seen that it corresponds closely to
that division whi states that fiscal policy has to do with the size of the net
national debt (in the most general sense), while monetary policy is a
question of the composition of the net national debt.2 For if the net national
debt is defined as the difference between (gross) national debt (including
notes in circulation and money at call) and the public claims (including
central bank exange reserves and claims on the private sector) and
furthermore if it is assumed that all official transactions imply a transfer of
means of payment in the form of notes or money at call, it is obvious that
transactions in the credit market can never in themselves involve any
ange of the net national debt; conversely, if regarded in isolation, every
other State payment or receipt will cause a corresponding ange of the net
national debt. e division according to markets has the disadvantage that
part of the payments provided for in the State (or local authority) budgets
will be considered as monetary policy; as an example the activities of the
State and municipal loan funds can be mentioned. is part of
Governmental activity does, of course, formally constitute credit
transactions, but as the actual structure of the loan policy is usually
determined by social, industrial and other considerations, monetary policy
defined in this way will obviously include measures that from other points
of view appear to be heterogeneous. On the other hand, part of the central
bank’s transactions will be considered as fiscal policy, e.g. its salary
payments.
Using the criterion of the policy-making organ as the means of
distinguishing between monetary and fiscal policy, and ignoring local
authorities for the moment, in Sweden it is the division between the State
administration (including investments in public enterprises etc.), i.e. the
Budget; the National Debt Office; and the central bank that is of interest. Of
course, it may be said that behind these official bodies Parliament stands as
the determining factor in the last instance. It is Parliament whi determines
the State Budget and determines the extent and direction of State activity; it
is also Parliament whi appoints the directors and controls the policy of the
central bank and of the National Debt Office. Practical experience shows,
however, that this formal consideration need not have great importance. For
this reason we are confronted with the alternatives of defining monetary
policy as central bank measures, or as the measures of the central bank and
National Debt Office together. Similarly, the possibility ought also to be
recognized that all three of these authorities can be regarded as a unit, or as
three separate bodies. e determining factor is the power and independence
that they enjoy; political considerations and even questions of personality
may be important here. It is quite conceivable that there may be complete
co-ordination between the State Budget and the National Debt Office
measures, while at the same time the central bank pursues its own policy; in
this case it seems quite appropriate to let fiscal policy cover the measures of
the National Debt Office as well as of the Government itself. e National
Debt Office and the central bank can also be imagined closely linked and
independent of the State administration; in this case it appears reasonable to
let monetary policy cover both National Debt Office and central bank
measures. It is evident that as far as the local authorities are concerned this
basis of division will lead to the principle that ea separate authority has to
be treated as a separate policy-making body with its own local policy.
e theoretical disadvantages of this basis of division are evident: exactly
the same transaction (say, sale of bonds) comes under the heading of fiscal,
monetary or local policy, according to who makes the transaction.
Furthermore, the practical application of this basis of division will to a large
extent be dependent on day to day shis in power, whi may be hidden
from all but a small inner circle of politicians and officials. It seems more
appropriate, therefore, to use the first-mentioned basis of division, according
to whi all official measures connected with credit market transactions are
considered monetary policy. Governmental measures connected with all
other economic transactions are thus regarded as fiscal policy. As a
consequence of this we will at times have to tou on monetary policy
questions; otherwise we would be obliged to disregard completely all
Governmental borrowing and lending and also all questions of foreign
exange. On the other hand, we will not concern ourselves with
transactions between various public bodies, e.g. between the State and local
authorities or between the State and the central bank. Su transactions we
will regard as internal bookkeeping maers.
Whenever a Governmental transaction occurs, anges take place in the
private sector’s command over State means of payment, defined as notes
and coins in circulation (outside the Government) plus (net) money at call
(from the Government). e problem will then be to decide whether the
anges in the amount of State means of payment are to be assigned to
monetary policy or fiscal policy, Usually this is regarded as a monetary
policy maer. As we have defined the dividing line between monetary
policy and fiscal policy, however, it will be understood that we consider the
anges in the amount of means of payment to be a fiscal policy maer in so
far as the anges are connected with a fiscal policy transaction, and a
monetary policy maer if it is connected with a monetary transaction. We
could say that we prefer to study the transactions from the ‘real side’ instead
of studying them from the ‘money side’; anges in the amount of State
means of payment are regarded as something passive (determined
endogenously), whi follow the various transactions (see Chapter III, 6).
A supplementary reason may be mentioned for having the division
between fiscal and monetary policy determined by the market on whi
policy is directly operating and not by the deciding authority. An important
tradition in the theory of public finance regards as an important task the
explanation of the extent and direction of public finance.3 Starting from the
marginal utility theory this tradition maintains that in certain circumstances
the State’s measures may be regarded as the expression of the will or oice
of the individuals. is leads to the idea that in principle all State behaviour
—policy—is to be explained within the framework of the economic model.
Without wishing to take sides as to the importance of this manner of
regarding the maer, as an explanation of reality or as a welfare norm for
fiscal policy, we will here consider the task of the theory of public finance to
be somewhat narrower. It is quite outside the scope of this treatise to give a
scientific explanation of any policy actually pursued in the past, not to speak
of a prognosis about future policy following disturbances in the economy.
Our problem is one of a more tenical economic aracter: if the State takes
certain measures, what consequences will result, and conversely, if certain
results are desired, what steps must be taken by the State? Or expressed in a
terminology whi we shall use below, what are the effects of different fiscal
policy means, and conversely, what means are required if certain economic
ends are to be reaed? With the problem formulated in this way, the
question whi public authorities are to take the political measures, and how
the political decisions are made will be of secondary importance; what is
decisive is the economic aracter of the measures.

3. THE STATE’S PARAMETERS OF ACTION—A PRIORI

CONSIDERATIONS
If by the term ‘State parameters of action’ is meant the parameters of action
of fiscal policy, it will be evident that these parameters are in some way
connected with the receipts and payments of public authorities. is is not
to say, however, that it is valid to regard these receipts and payments
themselves as parameters. An example may serve to elucidate this point.
Consider a general purase tax on all consumption goods; suppose this
amounts to tc per cent of the value (including tax) of the consumer goods. If
the total value of consumption in the country in question within a certain
period is denoted by C, there will appear in the theoretical model a relation
showing that State revenue (during that same period), Tc, from the
consumption tax is

Tc = C · tc/100.
 It will be obvious that C has normally to be regarded as an endogenous
variable; it is normally one of the entities that have to be explained.
Moreover, it is not possible to regard both Tc and tc as parameters; this
would involve the peculiar consequence that consumption, C, is determined
solely by the State (arbitrarily) fixing Tc and tc, that is without regard to the
rest of the system. In the present case it seems clear that tc, the indirect tax
rate, is the parameter, and that consequently Tc, the income derived from it,
must be an endogenous variable. us tc is a fiscal policy means and Tc is
not. Obviously, it is the tax rate, tc, whi is fixed by law and put into effect
by the administration. e income derived from it, however, is dependent on
the actual amount of consumption, whi the State does not control directly
(i.e. administratively). e yield of the tax is thus influenced by factors other
than the tax rate itself, among whi will be the State’s own measures in
other fields. For instance, if the State alters its expenditure on wages, this
will affect consumption and consequently also its income from consumption
taxes. If, on the other hand, exports are increased, this also affects
consumption and the State’s income from taxation. In this way the State’s
income from taxation, as opposed to the tax rate itself, may turn out to be
quite different from what is expected.
In certain cases State payments or receipts may of course be regarded as
parameters. For example, if the State imposes a per-capita tax, it is, of
course, still the actual tax rate per person whi the State primarily plans
and brings about, but if we can disregard unexpected fluctuations in the
number of people liable to tax, the total sum yielded can be reoned as a
parameter.
It is understood that a necessary condition for a variable to be regarded as
a parameter is that ex ante and ex post the values of this variable are always
the same. e controllable parameters, the State’s parameters of action, are
su variables; they are not subject to anges unexpected by the State. is
is, however, not a sufficient condition to distinguish budgetary parameters.
e model may be su that this condition is fulfilled for all variables. is is
the case if the State’s expectations just happen to be correct. Conversely, of
course, it is a sufficient condition for a variable to be regarded as an
endogenous variable that unexpected anges in the variable in question
may arise.
e only general rule that can be established for the oice of parameters
in connection with State receipts and payments is therefore, that wherever
the amount of the receipts and payments is not dependent solely on the
direct administrative measures of the State, but also on the size of some
endogenous variable the value of which the State does not control in a direct
administrative way, these receipts and payments cannot be regarded as
parameters. We must instead choose as the parameter some other variable(s)
connected with these receipts and payments, which the State does control
administratively.
Strictly speaking, in order to use this rule to decide whi factors ought to
be osen as State parameters, and consequently as State means, it would be
necessary to carry out penetrating empirical investigations of all the many
types of payments and receipts in whi the State is involved. Here we can
only go into a few of the more important items usually found in a modern
budget. We will begin with revenue:
(i) For all indirect taxes (customs and excise duties, etc.) the same arguments
apply as those we have advanced above concerning a general consumption
tax; the rates ought to be regarded as parameters and consequently the
yields of indirect taxes as endogenous variables. e same applies to all state
loeries, etc., and also for taxes on gis and inheritance.
As regards income taxes, the method of assessment will be a crucial
factor. Here there are two systems whi are quite different in principle. e
first, whi may be called the pure assessment system, is aracterized by
the fact that the income tax whi the individual has to pay to the State in a
given period, a fiscal year say, is calculated on the basis of the individual’s
income during some earlier period, say the calendar year immediately
preceding the fiscal year in question. For the period considered, the fiscal
year, the amount of income tax is thus calculated on the basis of a figure
whi was given and known at the beginning of the financial year. Here the
State fixes the amount of individual payments themselves, and enforces the
payment of the sums thus determined.4 It is of no practical importance
whether the amount of tax or the rate of taxation is taken as parameter; the
other factor need not be included in the model. In the second system of
assessment, whi may be called the pure withholding system, the payment
during a given period is determined by the income during the same period,
since the tax rates fixed by the State are applied to current incomes. It is
obvious that here the tax rates are parameters and the sum of money paid is
an endogenous variable, in exactly the same way as for the purase tax.
When it comes to revenues from business activity and from funds the
maer is more difficult. In Sweden, on the whole, only the net revenues
from these sources enter into the budget. ey cannot, of course, be treated
as parameters, but the system of net accounting makes it impossible to point
to any particular parameter governing these revenues. ey are determined
by the demand situation, together with the general business policy, price
policy, wage policy, etc. pursued and the parameters are obviously to be
sought here.
Finally we come to an item whi is usually important among State
revenues—borrowing. As this item applies to operations in the credit
markets we are now entering the field of monetary policy, cf section 2. e
parameters whi are connected with borrowing (and lending) are thus not
fiscal but monetary policy parameters. e parameters concerned are official
discount rates, prices of Government bills, etc.
(ii) In order to aracterize the determinants of public expenditure, a type of
parameter has to be introduced whi is hardly conceivable among the
revenue items. For a not unimportant part of State expenditure, the proper
parameter of action—the entity whi the authorities oose to make
effective or not—is the real project to be paid for by the expenditure. For
example, if the State starts some construction work, this will oen be
completed whether or not the costs remain within the limits set by the
estimated amounts. If the general price level rises during the period of
construction, State expenditure on this item will automatically rise at the
same rate. In all su cases we may use the real purases of goods and
services by the State as parameters.
Cases where the amount of expenditure itself can be used as a parameter
are also common. Expenditure on interest and wages is oen included here,
although with official wages regulated by the cost of living index we have to
use as a parameter the amount of the services purased from civil servants.
ere are also cases where certain rates may serve as parameters, e.g.
where those social services are concerned whi automatically make
payments at a given rate if certain conditions, su as unemployment, are
fulfilled.

4. THE EFFECTS OF FISCAL POLICY

When discussing the effects of fiscal policy, the division of the income and
expenditure items of the Budget into parameters of action and endogenous
variables is of central importance. While it is always possible to determine
uniquely the total effects of parameter anges from a given (complete)
model, it is generally meaningless to speak of the total ‘effects’ of anges in
endogenous variables. In this section we shall go into this more fully, as it is
important for the discussion whi follows.
Since the parameters in a model are those elements whi are determined
outside the system, anges in any one parameter will not influence the
values of the other parameters. By the expression ‘the effects of a parameter
ange’, therefore, can only be meant the anges in the (dated) endogenous
variables whi arise as a consequence of the given parameter ange. If we
are working with a dynamic system whi is in motion, these effects will
show themselves as the difference between the course whi it would have
taken without the parameter ange in question, and that whi it actually
takes as a result of the parameter ange.5 If the remaining parameter values
are given, these effects are uniquely determined by the system itself.
In the infinitesimal case the effects of the parameter ange are indicated
by the derivatives calculated by total differentiation of the whole system of
equations with respect to the parameter in question, all other parameters
being given. We must here emphasize the point that was made earlier, that
this does not imply that the argument is valid only for static systems and for
immediate, simultaneous effects. If the model is understood in the way
explained in Chapter I, 2, our conclusions will be valid in dynamic systems
both for the short run and for the long run effects. e derivatives can have
different dating in the numerator and denominator differentials. Generally
these derivatives are dependent on the initial situation, i.e. on the parameter
values. When we say that the effects of parameter anges are uniquely
determined, a given initial position is presupposed; with different initial
positions a given parameter ange can, of course, have different effects.
 us, if we wish to denote the effects on employment at point of time t,
t 0 0
N , of a certain ange in the parameter a at a point of time 0, da we find
j j

that dNt = (∂Nt/∂aj0)·daj0. Entities like ∂Nt/∂aj0 are sometimes called

‘dynamic multipliers’.
e method of approa described above cannot be applied to the
endogenous variables in the model. Here we cannot speak about uniquely
determined effects in the same way as we can when dealing with parameter
anges. An endogenous variable can only be anged if some parameter is
anged in su a way that the desired ange in the endogenous variable is
thereby brought about. Furthermore, a certain ange in a given endogenous
variable, e.g. a certain revenue item in the budget, can usually be brought
about by many different parameter anges, or combinations of parameter
anges. ese various anges, or combinations of anges, besides having
the desired effect upon the endogenous variables we are specifically
concerned with, are also likely to have effects upon the other endogenous
variables in the system, and the exact nature of these further effects will
differ according to the particular parameter anges that were employed.
From this it immediately follows that we cannot speak about definite
‘effects’ of anges in endogenous variables. Another consequence is that it
is generally meaningless to ask what would be the effects if a certain
economic end were realized; what it is possible to ask is what will be the
effects if a given end is realized by certain definite parameter anges; it is
not the desired end that is the deciding factor but the means by whi it is
aieved.
If we confine ourselves only to infinitesimal anges, the correctness of
these arguments will be most easily realized in the following manner.
Suppose that we consider the model (I: 1) in Chapter I and let x be the
endogenous variable the ‘effect’ of whi on another arbitrarily osen
endogenous variable, xh, we wish to study. We have thus
 If we now form the ratio between the two differentials, dxg and dxh (this
ratio is of course neither a derivative nor a multiplier in the usual sense)6 we
have

Since as a rule ∂xh/∂aj ≠ ∂xg/∂aj we can, by varying the size of the dajS,
make dxh/dxg take on any value whatsoever. us if we wish to make dxh =
k · dxg where k is an arbitrarily given number, we have the equation

whi is an equation with m unknowns, daj, so that the problem generally

has an infinite number of solutions. Expressions like dxh/dxg or the
‘elasticity’ dxh · xg/dxg · xh thus have no definite value (given the initial
parameter values) but depend entirely upon whi parameter anges have
brought about the anges in xh and xg.
It could be said that the reason why it is meaningless to talk about the
‘effects’ of anges in endogenous variables is that it is not possible to speak
about derivatives with respect to an endogenous variable.
us we conclude that while ‘the effects of a parameter ange’ is a well
defined concept, it is pointless to speak generally about the ‘effects of a
ange in an endogenous variable’. An indirect tax can be taken as an
example of this. According to the arguments in section 2, the rate of taxation
is the parameter here, and the amount of tax the endogenous variable. is
means that although we can talk about the effects of a ange in the rate of
taxation, we cannot do so about the effects of a ange in the amount of tax.
To avoid misunderstandings, we must here point out that we are
discussing the total effects in a given model. It is of course obvious that we
are in no way denying that in partial analysis variables whi are
endogenous in the total model may be ascribed definite effects on other
endogenous variables in the total model. For example, let us isolate from the
total model, say x1 =f(x2, x3) where x1, x2 and x3 are all considered as
endogenous variables in the total model. If we consider this relation
separately (as a maer of fact this will involve a new model with x2 and x3
as exogenously determined) it is clear that ‘partial’ derivatives can be
calculated with respect to x2 and x3, and definite effects on x1 due to
anges in x2 and x3 will be obtained. e risk with su a mode of
expression is, however, that we forget that x2, for example, can only be
anged through a parameter ange whi also affects x3. In a total model
where the effects of budgetary policy are being studied, it will therefore be
quite misleading to call su partial ‘effects’ the effects of fiscal policy.

5. CONCLUSIONS
A fruitful discussion of the possibilities of economic policy presupposes a
clear understanding of the means the State has at its disposal. is is again a
question of the State’s parameters of action. A division of these parameters
of action between monetary and fiscal policy, based on whether they are
directed towards the credit markets or towards other markets, seems
appropriate. rough this device we regard monetary policy, or credit policy
in the wider sense, as a policy separate from fiscal policy. We do not have to
take sides as to whether or not it is convenient to divide monetary policy
into exange policy and credit policy in the more usual sense.
In trying to discover what the State’s fiscal policy parameters are, we find
that the budget income and expenditure items cannot as a rule be regarded
as fiscal policy parameters. e fiscal policy parameters are in most cases the
rates of tax or subsidy, ‘real’ purase plans, etc.
 e division into parameters (means) and endogenous variables is of
central importance for the discussion of the effects of economic policy. For
while it is possible to speak of the effects of parameter anges, it is
meaningless to speak of the effects of anges in the endogenous variables.
is is fundamental for the discussion in the following apters.

1. is definition of monetary policy is very narrow in as mu as cash

reserve regulations and other credit market restrictions are not counted
as monetary policy; this is however unimportant for our purpose.
2. Erik Lindahl, ‘Teorin för den offentliga skuldsäningen’ (eory of the
Public Debt) in Studier i ekonomi och historia (Studies in Economics and
History) presented to Eli F. Heser, Uppsala 1945, p. 92.
3. As an exponent of this tradition can be cited Erik Lindahl, Die
Gerechtigkeit der Besteuerung, Lund 1919. See also P. A. Samuelson,
‘e Pure eory of Public Expenditure’ in The Review of Economics and
Statistics, Volume XXXVI, 1954.
4. Abatements, tax debts wrien off, etc., are ignored. eir amount may,
of course, depend on the trend of incomes, employment, etc., during the
tax year.
5. Cf. G. Myrdal, Finanspolitikens ekonomiska verkningar (e Economic
Effects of Fiscal Policy), SOU 1934: 1, Stoholm, pp. 8 ff.
6. P. A. Samuelson calls su a ratio a ‘pseudo-multiplier’ see ‘Simple
Mathematics of Income Determination’ in Essays in Honor of Alvin H.
Hansen, New York 1948.
 CHAPTER III

e Balance of the Budget

1. TRADITIONAL POINTS OF VIEW
IT seems to be a generally accepted idea that one of the most important
means the State1 has at its disposal to influence the economy is the budget
deficit or surplus, defined as the difference between certain incomes and
expenditures in the budget. e budget balance, that is to say the budget
surplus or deficit, and the anges therein, is oen taken to indicate whether
the budget works expansively or contractively.2 e reason for this is well
known and quite simple. Since State expenditure involves the creation of
purasing power in the private sector, and State income involves the
reduction of private purasing power, then a budget surplus (or perhaps an
increase in the budget surplus or a decrease in the budget deficit) is
considered to give rise to a contraction; while conversely a budget deficit is
considered the cause of expansion. From this it is concluded that the budget
balance and the anges in it are the State’s most important means. It can be
said without exaggeration that most theoretical as well as practical
discussions on budget policy during the past two decades have been
conducted on these lines.
Lately, there has been a tendency to abandon this train of thought,
especially inthepurelytheoretical literature. ere has been increasing
awareness of the possibility that the budget can have redistributive effects
whi are not expressed in the budget balance, but the first really decisive
step away from ‘balance thinking’ was taken by J. Gelting and T. Haavelmo,
who, independently of ea other (and of certain forerunners), discovered
the now well-known theorem of the balanced budget multiplier.3 is
theorem shows how a simultaneous increase of State expenditure and State
income, leaving the balance of the budget unaltered, can in certain cases
work expansively—quite apart from possible redistributive effects (see
below). Taking this into consideration, some writers have completely
abandoned the idea of the budget balance as an indicator of the effects of the
budget.4
at in older, and also (see below) in certain more recent, theories of
public finance it is regarded as quite obvious that equilibrium in the national
economy presupposes that the State’s budget shall be in balance is to a large
extent due to preoccupation with stationary equilibrium, where not only
every flow but also every sto is constant and is not tending to ange. It
certainly cannot be denied that a stationary equilibrium can only be
maintained if State saving is zero. Nevertheless, it is quite feasible to rea
the conclusion that equilibrium can exist even with an unbalanced budget,
and that an unanged budget balance in no way guarantees equilibrium.
is can be ascribed to the fact that the concept of equilibrium used is quite
different from that of stationary equilibrium, and there is, of course, no
reason why the notion of equilibrium should be reserved solely for
stationary equilibrium. See section 8 further on this point.
ese recent theoretical developments have erected some uncertainty as
to whether to consider the budget balance as an economic means or not. As
we shall try to show, however, it is evident that for complete clarity to be
aieved concerning the means available to the State in pursuing its fiscal
policy, and the State’s ability to influence economic life in a desired
direction by means of the budget, the idea of the budget balance as an
economic policy means must be abandoned. e budget balance may be the
subject of an economic policy goal, but it is not an economic policy weapon
(a means).

2. TWO BUDGET RELATIONS

Before proceeding to the discussion of budget balance it would be well to
account for two types of budget-identities, namely the definitional equation
of the budget balance and the ‘budget-restriction’.
In a model where regard is paid to public finance and where the budget
balance enters as a variable, a relation defining this variable will appear
among the equations of the model. If we denote the budget balance by B, the
various kinds of public incomes by Ti (i ranging from 1 to m), and the
various kinds of public expenditure as Uj (j ranging from 1 to n), the
equation defining the budget balance (budget surplus) is thus:

Whether this equation includes all items of public income and

expenditure or only selected items of income and expenditure determined in
one way or another, is of no importance in this context. e main thing is
that the budget balance is always defined as the difference between two
(unweighted) amounts of income and expenditure.
e economic transactions of every household and firm must be kept
within the limits of their resources. From this comes the notion of budget
restrictions. ese imply that for any economic subject the total of all
receipts must be equal to the total of all outgoings plus the increase of cash.
An analogous ‘budget restriction’ is, of course, also valid for the State. As we
have defined the State as including among other things the central bank, and
the ‘cash holdings’ of the central bank are an indeterminate sum, it is
convenient to give the State budget restriction a somewhat different
formulation. We have that the total outgoings from the State minus the total
of all receipts by the State are equal to the increase in the current note
circulation plus the increase of State debts at call (net); by official means of
payment we therefore understand not only central bank notes but also (net)
money at call by the private sector on the State (especially on the central
bank and the Post Office). As an increase of the current note circulation and
short term State debts represent an increase of official means of payment, i.e.
a cash increase, , for the private sector, we get the following budget
restriction for the State:

In accordance with the budget practice of most countries, we assume that

State budgets are cash budgets. us we can, as in (III: 2), continue to apply
the notation used up to now, and denote the receipts by Ti (S in number) and
outgoings by Uj (t in number). In a cash budget, income and receipts and
also expenditure and outgoings are synonymous. All values in (III: 2)
naturally refer to the same period. e identity holds both ex ante and ex
post.
As the identity (III: 2) includes all receipts and payments to and by the
State, while (III: 1) includes only a part of these, we immediately find the
following connection between budget balance and the increase of liquidity
in the private sector arising from the State’s transactions:

In the special case where n = t and m = s, i.e. where the budget balance is
defined as the difference between total receipts and total payments, a certain
budget surplus is identically equal to a decrease in private liquidity, B = — .
Since (III: 2) is a balance equation whi is valid in all circumstances, we
may, consequently, in defining the budget balance, start out either from
equation (III: 1) or from equation (III: 3); the other equation will then follow
automatically.

3. THE BUDGET BALANCE IS NOT A FISCAL POLICY MEANS

We can thus define the budget balance quite generally as the difference
between two (unweighted) sums of State income and expenditure. With this
limitation, the following argument is valid irrespective of how the budget
balance is defined, that is regardless of the actual oice of State income or
expenditure items in the definition of the budget balance. However, we will
also discuss later one special case, namely, that where the budget balance is
defined as the difference between total receipts and total payments, i.e.
where the budget balance is equal to the increase in liquidity of the private
sector, see section 6 below.
We can now point out the various circumstances whi go to show the
unsuitability of conceiving of the budget balance as a parameter in the
model.
Firstly, there is the well-known empirical fact that normally—with the
concepts of budget balance used in practice—unexpected anges will arise
in the budget balance. e budget balance given at the end of a period oen
differs from the budget balance expected (calculated) at the beginning of the
period. In many cases su large amounts are involved that we cannot
disregard this fact. To ignore this would be to disregard one of the basic
problems in budgetary policy. For this reason the budget balance cannot
generally be considered as a parameter, i.e. as an element completely
controlled by the State. at su unexpected anges in the budget balance
occur seems quite natural against the baground of what we have said in
Chapter II, 3. e budget balance is always anged if any income or
expenditure item included in the definition of the budget balance is anged,
and if these laer anges are unexpected the anges of the budget balance
will be so too. As we have already noticed, the fact is that a good many
(perhaps even the majority of) income and expenditure items cannot be
regarded as State action parameters, because unexpected anges in these
budget items are both possible and common.
Nevertheless, we cannot exclude the possibility that the definition of the
budget balance covers only budget items whi can be regarded as State
parameters of action. In this case unexpected anges in the budget balance
are impossible. Not even in this case, however, can the budget balance be
regarded as a parameter. For it should be stressed that in general if there is
included in the model an expression like the definition of the budget balance
(III: 1), not all the variables appearing in it can simultaneously be regarded
as parameters to whi arbitrary values can be aaed. For example, if all
TiS and UjS have been given definite values, then the value of B will be

determined by (III: 1); similarly, if all UjS, B and all TiS are aributed certain
definite values with only one exception (one Ti), the value of the last Ti is
also fixed, and so on. Since not all the factors included in (III: 1) can
therefore be regarded as parameters, then evidently one of them must be
regarded as an endogenous variable in the model.6 If, therefore, a priori
circumstances indicate that all income and expenditure items in (III: 1) are to
be considered as parameters, the budget balance must evidently be regarded
as an endogenous variable. It is also quite obvious that this is the case here;
if the State wants to aieve a certain ange of the budget balance it can do
so only by anging certain incomes and expenditures.
From this it follows that anges in the budget balance cannot have
uniquely determined effects. If the budget balance can only be anged by
anging some income or expenditure item, and if these different income
and expenditure anges have different effects, those anges in the system
whi appear simultaneously with a certain ange in the budget balance
will depend completely on whi income or expenditure ange lies behind
the ange in the budget balance (see the example below with the balanced
budget multiplier).
It must be observed that the formal standpoint that at least one of the
variables in (III: 1) must be taken as an endogenous variable is also relevant
for classifying the budget balance B, in the case where certain of TiS and UjS
are regarded as endogenous variables. Let us suppose that, for example,
income T1 is the income from a general tax on consumption, imposed as a
fixed percentage t1 on the total value of consumption C, thus

T1 = t1 · C/100.

and furthermore, that income T2 is the income from a general income tax,
imposed as the percentage t2 on disposable income (after tax, for the sake of
simplicity) Y, thus

T2 = t2 · Y/100.

If we now put these expressions for T1 and T2 in the equation (III: 1) and
assume that all other State income and expenditure and also the budget
balance (and naturally t1 and t2) are parameters this would mean that by
fixing its parameters directly, the State would be able to fix the ratio
between C and Y; this ratio is known as the average propensity to consume.
It is easy to see that su a result is unreasonable if, for example, it is
supposed that the model in question contains a consumption function whi
says that C = c · Y, for then the model will generally be inconsistent. e
consequence is that at least one other of the State income/expenditure items
or else the budget balance itself—and in this case, it must be the budget
balance—must be reoned as endogenously determined. Otherwise the
definitional equation for the budget balance will be transformed into a
hypothesis about the connection between certain non-State variables, whi
is not its role at all.
Let us present this argument in a more general manner. Suppose that we
have a complete (closed) model with as many equations as unknowns and
where the State is not considered. We then introduce that part of public
finance whi is included in the definition of the budget balance. is will
immediately give us, according to equation (III: 1), m+n+1 new variables
and one new equation. One of the new variables must therefore be regarded
as an endogenous variable, otherwise the number of equations will be larger
than the number of endogenous variables. Now if a priori considerations tell
us that all m Ti and all n Uj are parameters, B must be the endogenous
variable. If, on the other hand, a certain T or U, say Th, ought a priori to be
regarded as an endogenous variable, then the reason for this is always that a
priori considerations tell us that there is a relationship between Th, certain

other State parameters, and certain other (non-State) endogenous variables

in the model. us, if a priori considerations show us that a certain number
k, of the incomes and expenditures are endogenous, and that the remainder
are parameters, then we will also have an equally large number of new
equations in the model. e result will then be that the introduction of
public finance into the model will give us k+1 new equations, and then we
must also have k+1 new endogenous variables. Consequently we shall have
to regard B as an endogenous variable.
Finally we must mention one last circumstance whi also indicates that
the budget balance should not be taken as a parameter, even if we disregard
the previous arguments. Although we do not know in detail the model in
whi (III: 1) is included, we do know that it consists of a certain number of
equations of various types, whi can be divided into behaviour equations,
tenological relations, institutional relations and definitional relations. If
we consider the theories (consumption theory, production theory, etc.) on
whi all these different equations are based it is evident that B cannot very
well appear in any of them other than the definitional equation (III: 1),
unless B has been substituted into them. e budget balance in itself cannot
very well be included as an item in the planning of any individual planning
unit (other than the State) and it is precisely this planning whi is the
ultimate basis for all the behaviour equations in the system. Nor can it very
well be imagined to occur in tenological or institutional relations. In
definitional equations the entity B can certainly be imagined to occur (see
the example in equation (XVI: 3) of Chapter XVI, 3), but still only by being
substituted for the corresponding difference between receipts and payments.
On the other hand, in contrast to what is valid for B, all receipts by the State,
payments by the State, and anges in State liquidity must in some way be
directly incorporated in and relevant to private planning. e State’s
receipts, payments and anges in liquidity can for that reason occur
directly in individual plans, and thus in the behaviour equations of the
system.
e influence of the size of the budget balance on general expectations for
the future is quite a different maer. If the individual believes that there is a
connection between the size of the budget balance, or the anges thereof,
and future economic development, this may be utilized by the State in its
fiscal policy. It is frequently pointed out that a decrease in the budget deficit
—under the guise of ‘sounder finance’—can be sufficient to cause
expectations of inflation to disappear. However important connections of
this nature may be, they are usually outside the scope of an economic
model.
One consequence of this is that when one has to oose parameters and
endogenous variables, there is every reason to look for the parameters in
connection with receipts and payments and the anges in liquidity, and not
in the entity B. It is via receipts, payments and liquidity anges, and the
parameters connected with these that the State directly influences people’s
behaviour and thus the economy. A second consequence is that if the
identity (III: 1) is deleted from the model, one variable, i.e. B, is also
automatically excluded. us if B is regarded as an endogenous variable,
neither B nor the equation (III: 1) is essential for the way the model
functions and for the understanding of the model. B is a maer of internal
State book-keeping and (III: 1) a book-keeping relation, whi is of no
significance except possibly to the State itself.
e theorem of the balanced budget multiplier illustrates in a simple way
part of what has been said above. e theorem in itself is less interesting,
because it assumes that the State expenditure and income are parameters.
If Y denotes national income, I investment, U State expenditure on labour,
goods and services, C private consumption, T the amount of income tax, c
the marginal propensity to consume and k a constant (autonomous
consumption), we have:

Y = I+U+C and
C = c · (Y—T)+k together with
B = T—U.

e first two of these equations are now considered as a system for the
determination of the two endogenous variables Y and C, in whi I is
assumed to be constant and T and U State parameters. e first equation is a
definition of national income and the second a hypothesis concerning the
connection between disposable income, Y—T, and consumption. e third
equation, the definition of the budget balance, is of no significance for the
system.
us starting from this system of equations we immediately find that

e effect on national income of an increase of U by £1 million (i.e. a

decrease of B = T—U by £1 million) becomes £1/(1—c) million. e effect of a
decrease of T by £1 million (i.e. a decrease of B by £1 million) becomes on
the other hand £c/(1—c) million, a smaller amount. In this way it is clearly
shown that the ‘effect’ of a certain ange in B is wholly dependent on the
anges in income or expenditure whi lie behind the ange in B. If the
increase of U by £1 million is combined with an increase of T by the same
amount (i.e. an increase of expenditure as well as income at an unanged
budget balance) we will find that dY = £1 million. e national income is
consequently increased by exactly the same amount as the budget has
expanded, and the ‘balanced budget multiplier’ is in this very special model
= 1, irrespective of the magnitude of the marginal propensity to consume.
us our conclusion will be that the budget balance, B, however it is
defined, must be regarded as an endogenous variable in the model. As has
been explained previously, this will have the important consequence that the
budget balance cannot be considered as a fiscal policy means, and that one
cannot talk about the effects of anges in the budget balance.
It may be objected that the State, in its planning, does in fact pay regard
to the budget balance, and allows possible desires as to its size to determine
budgetary policy. However, this is in no way incompatible with our
approa. e size of the budget balance will then be one of the ends of the
State: the task for State planning will then be to arrange the State
parameters in su a way that (among other ends) this end will be realized,
see section 7.

4. IS THE BUDGET BALANCE AN INDICATOR OF THE EFFECTS OF

FISCAL POLICY?
In section 2 we defined the general concept of budget balance as the
difference between a sum of (unspecified) State income items and a similar
sum of State expenditures. Furthermore, we pointed out in section 3 that the
budget balance—irrespective of the actual selection of State income and
expenditure items—cannot be regarded as a parameter, i.e. as a means of
fiscal policy. e question still remains, however, whether the concept of
budget balance can be defined in a way whi makes it possible for the
budget balance to be taken as an indicator of the effect of budget policy, that
is as a summary expression—an index—of the effects of all those anges
whi the State allows its means (parameters) to undergo.
In order to show the difficulties of this method of approa,7 we will
discuss how su an indicator—a budget index—of the total effects of fiscal
policy might be constructed. In this apter we will only consider part of
this complex problem, namely the problem of how certain anges in a
given budget will influence the economic situation (or its development). We
are thus looking for an index whi shows the anges in the economic
situation (or its development) that are brought about by certain anges in
fiscal policy, that is in the fiscal policy parameters. In Chapter IV, section 4,
we shall deal more fully with the question whether anges in budget
figures can be considered to have any definite effects when the reason for
those anges in the budget figures is anges in parameters whi are not
controlled by the State. It is definitely established that in su cases the
concept of a ‘budget index’ is quite impossible.
Now in the first place it is obvious that anges in the budget balance can
at the most be indicative of the effects of su anges in fiscal policy as
appear in the budget balance. For example, if the definition equation of the
budget balance covers only items from the current budget, the budget
balance cannot very well indicate the effects of those anges in fiscal policy
whi show themselves exclusively in a capital budget. From this it
immediately follows that a concept of budget balance whi is to give
complete information about the effects of fiscal policy, must take into
account all types of income and expenditure in the budget (it is of no
importance whether only fiscal policy transactions are to be taken into
consideration, or whether monetary policy transactions are also to be taken
into account; in the laer case the effects of fiscal and monetary policy will
be discussed). Naturally this does not prevent some types of budget income
and expenditure being excluded from the models studied, because, on the
one hand, it is practically impossible in a model to consider every budget
item, and on the other, short term models may be set up where certain types
of State payments are considered of minor importance, and for that reason
are excluded.
However, even if the budget balance is defined as a algebraic sum of all
budget incomes and expenditures (the laer with negative signs), and even if
it is in fact possible to regard all income and expenditure as parameters, the
anges in the budget balance could still not in themselves be expected to
give information about the total effect of fiscal policy. As has been pointed
out before, there is no reason to expect that the effects of anges in different
types of State income and expenditure should be the same. If the concept of
the budget balance is really to be employed as an indicator of the total
effects of anges in the different types of income and expenditure, these
must be weighted before they are aggregated into a budget balance. e
weights whi are used here must obviously be proportional to the separate
effects of ea respective type of income or expenditure.
Suppose that we want an expression for the effects of fiscal policy on
employment N.8 e ange in N, whi comes about through a small
ange in any particular item of State income, is measured by the derivative
∂N/∂Ti (calculated on the whole model). If no parameters are anged, other
than fiscal policy parameters (whi are for the moment supposed to consist
of all items of income and expenditure), we have:

If the ange, dB*, in the budget balance is defined as

or in a more general way as

the anges in employment dN, will be proportional to the ange in the

budget balance dB*, or at least will vary in the same direction. us we have
the budget balance (or more correctly, the budget balance ange) defined so
that it can be used as an index of the effects of fiscal policy on employment.
Instead of an algebraic sum of income and expenditure, we now have a
weighted sum of income and expenditure, where the weights are the
‘employment multipliers’ of the individual income or expenditure items in
question. Only if all these multipliers happen to be of equal size (with
opposite signs for the multipliers of income and expenditure) will this
concept of the budget balance coincide with the usual type of budget
balance concept.
A certain ange in State income or expenditure may have an effect on all
the endogenous variables, and different endogenous variables need not, of
course, be affected to the same extent. When we speak of the effect of fiscal
policy we must consequently specify whi endogenous variable we have in
mind. e way in whi income and expenditure items are weighted in
order to make the budget balance indicate the effects of fiscal policy will
thus depend entirely on whi endogenous variable—employment, price
level, imports etc.—is the object of our investigation. If an exhaustive answer
is to be given to the question of the effects of fiscal policy, then, in principle,
as many concepts of budget balance must be used as there are endogenous
variables in the model.
If we desire to express the effects of fiscal policy on the price level P, by
use of a budget balance concept, we start from

consequently we are obliged to use the following definition of the ange of

the budget balance (in the general case)

whi is obviously different from the one we have to use where employment
is concerned.
So far in this section we have considered income and expenditure items as
State parameters. As we have pointed out, however, income and expenditure
items cannot generally be regarded as parameters, and consequently cannot
be aributed definite effects. e notion of establishing a concept of budget
balance in whi income and expenditure items have been weighted in su
a way that an index for the effects of fiscal policy on some definite
endogenous variable will emerge, is therefore wreed by the difficulty that
the weights to be aaed to the income and expenditure items are
dependent on the underlying parameter anges (see Chapter IV, 4).
erefore, if we want to produce an index of fiscal policy effects on a certain
endogenous variable, we are obliged to add up the effects of the different
parameter anges. e ‘index’ will then become a straightforward
calculation of those effects, and consequently not a real budget index at all.
If we call the State parameters ai, where i = 1, 2, …, h. and the aiS can be
the tax rates, amounts of expenditure, etc., we have as an expression for the
effect of fiscal policy on employment
if we want to know the effect on the price level then we get

etc.
ese expressions cannot very well be considered budget balance
concepts, and we have consequently abandoned the idea of expressing the
effects of fiscal policy with the aid of budget figures.
Finally, it must be emphasized that the effects of a given parameter
ange are not the same in the short run and in the long run, at least if the
model with whi we work is a dynamic one. An index whi shows the
effects of fiscal policy measures whi are introduced at a given point of
time (that is the effects of anges in a number of different State parameters
that are brought about at a definite point of time) must therefore be wholly
dependent on how mu time is supposed to have elapsed before the effects
are to be observed.
Consequently, it is clear that, however selected, neither a simple sum nor
a weighted sum of income and expenditure items (the laer with negative
sign) can be expected to give any information of value about the effects of
fiscal policy. e reason for this can be said to be that we are here
confronted with a variant of the common aggregation problem whi
generally cannot be solved by simple addition. A given ange in the budget
balance, defined in the usual way, can have a positive or negative ‘effect’, or
no ‘effect’ at all, on a certain endogenous variable (say employment),
depending on the way in whi the ange in the budget balance has arisen;
and a given ange in the budget balance, defined in the usual way and
arising in a certain given manner, may affect one variable positively, and
another negatively. Consequently, the budget balance, in its usual meaning,
is generally of lile interest when it comes to judging the effects of fiscal
policy. e general effects of economic policy cannot be discussed in terms
of budget surplus or deficit.
 It ought perhaps to be pointed out that one can, of course, imagine models
whi are so simple that in a certain sense one can talk about definite effects
of anges in the budget balance, for instance, a model like this (the symbols
are the same as above):

Y = I+C
C = c(Y—T)+k
B = T,

where only income tax appears in the budget and where the amount of
income tax is considered as a parameter. As the effects of anges in T are
definite, and a certain ange in T is equivalent to a ange in B, the ‘effects’
of anges in B will also be definite. T and B are identical, and in the model
B can be substituted for T and the last equation can be omied. But even in
this model it is necessary that B be substituted for T, and it is difficult to see
anything rational in this. Furthermore, su a simple model as the above
will, of course, be of no great interest in the discussion of fiscal theory.

5. SOME BUDGET BALANCE CONCEPTS OCCURRING IN PRACTICE

Looking at Swedish budgetary practice, and at the fiscal policy debates
created upon the Swedish State budget, against this baground is both
fascinating and terrifying. We shall, therefore, comment briefly on various
budget balance concepts whi have been used in Sweden in recent years.
A basic consideration in the Swedish budget reform of 1937 was that the
budget balance should give information about the net wealth of the State.9
e surplus on the current budget (aer some adjustments for anges in
reserves, and with a suitable division between the current and the capital
budget) is equal to the increase in the net wealth of the State. Since
developments in the State’s holdings of capital are a determinant of basic
importance when it comes to estimating the future trend of net income from
capital, there is every reason to make use of this concept of budget balance.
But, on the other hand, it is equally obvious that su a concept of budget
balance cannot tell us mu about the effects of the budget on the economy.
is follows directly from our earlier argument.
 Aempts have been made to reconstruct the 1937 budget balance concept
so that it would give expression to some ‘national balance’ of the
economy.10 is reconstruction involves a less rigid boundary between the
current and the capital budgets, so that some expenditure, whi according
to the 1937 practice was not included in the current budget, could be
included there; this concerns expenditures for the purase of assets whi
cannot be expected to yield a ‘normal’ profit (in the private economic sense),
but whi can still be considered useful from a more social economic
viewpoint. It is obvious that su a reconstruction of the budget balance
concept may be justified if it is found desirable to work with some other
concept of net capital, but there is no reason whatever to connect this budget
balance concept with any form of ‘balance’ in the national economy. For one
thing, the reconstructed budget balance shares the same fate as the 1937
budget balance concept inasmu as it does not tell us anything about the
effects of the budget on the national economy or on its overall ‘balance’ or
la of ‘balance’. Moreover, it las the sole advantage enjoyed by the 1937
budget balance concept: that it was of importance in evaluating the future
net capital incomes in the budget.
In connection with national accounting and the calculation of national
income, there is a place for the budget balance in a ‘real economic’ sense. As
a maer of fact we can here use various concepts of budget balance. On the
one hand, the budget balance can be defined as equivalent to State saving.11
e budget balance will then be defined as the difference between taxes
minus subsidies (in a certain sense) plus the State’s income from capital on
one side, and public consumption on the other. Another kind of ‘real
economic’ balance can be defined, however, as the difference between so-
called ‘income destroying’ State incomes and ‘income creating’ State
expenditures (here again the whole budget or only the current budget may
be considered).12 ese balance concepts too are vulnerable to our earlier
argument if they are taken as expressions of the effects of fiscal policy, but,
as has been mentioned, they may possibly be of independent interest for
national accounting.
On occasions concepts of budget balance have been used whi disregard,
for example, income of a temporary (or ‘non-recurring’ nature,13 and on
other occasions, especially in times of crisis, the budget has been divided
into an ordinary and an extraordinary budget. e budget balance concept is
of course affected by this. However, if political considerations are
disregarded, su manipulations are obviously irrelevant in the appraisal of
the effects of fiscal policy. Changes of this aracter in the budget balance
concept can be of no economic importance.
As was mentioned in Chapter II, 2, all State operations in the credit
markets are to be regarded as monetary policy. If in accordance with this, all
items in the budget whi represent lending or borrowing (to and from the
private sector) are excluded, the balance of the remaining budget items will
express the ange in the net public debt. Since this residual item is,
formally, a special budget balance concept, it therefore follows that we
cannot generally speak of definite effects of anges in the net public debt.
In fact, this conforms closely to Erik Lindahl’s treatment of the effects of
State borrowing. As the net debt can only be anged by anges in income
or expenditure, regard must always be paid to the particular anges in
expenditures or incomes that give rise to the anges in the net debt when
discussing the effects of the laer. Lindahl further supposes ‘that the loans
are always issued on the open market, but that at the same time, the central
bank takes the necessary steps to secure the degree of liquidity in the market
that is required if the monetary policy programme is to be fulfilled.’14 us
the problem dealt with by Lindahl is: Suppose that the State takes certain
steps whi lead up to a ange of some income or expenditure item(s) in
the budget. is will be financed by the National Debt Office going into the
market for a loan. At the same time, the central bank buys or sells claims on
the market in a manner so as to secure a certain monetary policy end. e
joint effects of these measures will thus depend on: 1. Whi State parameter
ange lies behind the original expenditure or income ange. 2. In whi
way the National Debt Office borrows money on the market. 3. Whi
monetary end the central bank tries to aieve. 4. In whi way, that is by
means of what operations, the central bank tries to aieve this end. If, for
the sake of simplicity, we assume that only one type of market operation is
possible, we can disregard the complications under 2 and 4. e fact still
remains, however, that the effects will depend firstly on the cause of the
expenditure and income anges, and secondly on the monetary policy end.
Lindahl assumes that the monetary policy end is to keep a stable value of
money. at it can be of great interest to deal with the effects of su a
complex of actions is obvious; but to call these particular effects ‘the effects
of anges in the net debt’ is not very meaningful, for the net debt itself is
one of the results (effects) of these actions. is will be even more obvious if
one imagines that the causes of the primary anges in expenditure and
income are quite outside the control of the State. For example, if exports
increase and this automatically leads to an increased yield from taxation, the
net debt will probably decrease automatically as a result. In su cases the
problem of the ‘effects’ of the anges of the net national debt will be quite
indeterminate, see the treatment of su problems in Chapter IV, especially
section 4.

6. FISCAL POLICY AND PRIVATE LIQUIDITY

In the above we have not explicitly considered the important question
whether the anges in liquidity in the private sector brought about by the
transactions of the State can be regarded as a State means, i.e. as a
parameter in the model, or whether liquidity must be regarded as an
endogenous variable to whi definite effects cannot be aributed. We shall
now proceed to discuss this problem.
In order to arrive at the identity

we are obliged to include among the Us and Ts all public borrowing and
lending (including foreign exange transactions). us (III: 2) includes not
only fiscal policy but also monetary policy payments. e State’s net
contribution to the cash-holdings of the private sector is obviously
dependent on the monetary policy measures that are taken as well as on the
fiscal policy ones. Circumstances outside the public sector may also
influence via the endogenously determined State incomes and
expenditures. It might be asked whether it would not be convenient to
assume that monetary policy transactions were to be kept unanged in
dealing with the importance of fiscal policy for the liquidity in the private
sector. In defining regard would then only have to be paid to the anges
in the fiscal policy transactions. However, this procedure would be upset by
the fact that monetary policy transactions, like fiscal policy transactions,
cannot generally be regarded as parameters of action for the State. e
monetary policy parameters are oen rates of interest, exange rates, etc.,
and the receipts and payments in direct connection with these parameters
must be regarded as endogenous variables. is is especially clear when
buying and selling of foreign exange is concerned. If then the monetary
policy transactions are to be kept constant despite anges in fiscal policy,
this presupposes that suitable variations are brought about in the monetary
policy parameters; but in that case we shall not have isolated the effects of
the fiscal policy measures. At this point we cannot therefore discuss fiscal
and monetary policy transactions separately.
Now in general it is necessary to regard , like the budget balance, B, as
an endogenous variable. , the increase of cash in the private sector, is not
an action parameter for the State—it is neither a fiscal nor a monetary policy
means.
If the identities (III: 1)—the definition of the budget balance—and (III: 2)
are studied, it will be seen that (III: 2) can be regarded as a special case of
(III: 1). In discussing the definition of budget balance we made no
assumptions concerning the number or nature of the income or expenditure
items included in (III: 1). In principle B can be considered as so defined that
B and coincide (i.e. m = s and n = t). e arguments that led to B being
regarded as an endogenous variable therefore also imply, mutatis mutandis,
that should be regarded as an endogenous variable and not as a parameter.
We can briefly repeat the arguments by whi we reaed this conclusion.
Firstly, the State cannot ange its contribution to private cash-holdings
without anging some receipt or expenditure item (if, moreover, the
initiative for ange is to lie with the State, this will require that it be a fiscal
or monetary policy parameter that is anged). Secondly is in practice an
entity in whi anges not expected by the State normally take place (this
cannot happen with a controllable parameter); if it is desired to include these
unexpected anges in the theory, the ange in liquidity cannot be taken as
a parameter—i.e. as a means.
If we accept this result—that ought to be regarded as an endogenous
variable in the model—this will, as explained above, have the consequence
that the State’s contribution to anges in private cash-holdings cannot be
aributed definite total effects in the model. Endogenous variables have no
‘total effects’. Consequently, we cannot work with any special ‘liquidity
effect’ of fiscal or monetary policy. For example, if the payment Uj is a State
parameter and if the State carries through an isolated increase in this
payment, this will involve a liquidity increase outside the State by the same
amount. If the ange in Uj is regarded as a parameter ange and the
anges of liquidity as a resultant ange, the total effect of the expenditure
and liquidity ange is fully described when the effect of the parameter
ange, ΔUi, is described. e ‘effect’ of a given ange in liquidity will
depend on whi type of public receipt or payment it is connected with; or,
if the receipt (or payment) is not to be regarded as a paramenter, on whi
parameter ange forms the basis of the ange in the receipt (or payment)
from whi the ange in liquidity arose.
It will be appreciated that this is not theoretical refinements without
practical relevance when we consider an interesting investigation of the
anges in bond prices brought about by anges of the net debt of the
commercial banks to the central bank (i.e. the commercial banks monetary
reserves). By a multiple correlation analysis of Danish time-series, Jørgen
Gelting15 found that ‘a decrease of the net debt of the commercial banks by
10 million kroner as a result of (1) an increase of the foreign exange
reserves of the central bank (will) increase the price of bonds by 0·72 points;
(2) an increase of the central bank’s bond holdings (will) raise the price by
1·08 points; (3) seasonal decreases of note circulation and net claims of the
Treasury (will) increase the price by 0·07 points’. Even though Gelting does
not discuss the statistical significance of these differences they may,
nonetheless, be regarded as powerful empirical support for the practical
relevance of our theoretical arguments.
us by quite analogous arguments we rea the conclusion that both the
budget balance B and the ange in private liquidity ought to be regarded
as endogenous variables in the ‘true’ model. It is, however, not at all difficult
to find examples of other procedures in economic literature. As was
mentioned earlier, to regard B as a parameter (or at any rate as a means with
definite effects) is the usual procedure. too is oen regarded as a
parameter. Although we are in complete accord with recent theory in our
conclusion that the budget balance ought to be regarded as an endogenous
variable, we are, on the other hand, breaking with the major part of modern
writing in denying the validity of treating the increase in private liquidity as
a parameter. Reference could here be made to many models, both classical
(quantity theory) and Keynesian. We do not wish, of course, to deny that
models may be constructed in whi the quantity of money (the liquidity of
the private sector) is taken to be a parameter (an exogenously determined
variable)—to deny this would, indeed, be ridiculous. What is emphasized is
that when su models are constructed two circumstances of crucial
importance from the viewpoint of economic policy are neglected: firstly, the
possibility of unexpected (i.e. not expected by the central bank) anges in
liquidity brought about by disturbances in the system,16 i.e. the possibility
of an ‘elastic supply of money’, and, secondly, the precise ways through
whi the anges of liquidity are brought about. ese shortcomings make
su models bad descriptions of reality and poor analytical instruments.
In comparing the budget identities (III: 1) and (III: 2), and B and , the
analogy fails on one point. In section 2 we pointed out that the budget
balance B is simply an accounting concept, whi does not itself enter the
system except in (III: 1); if, accordingly, the equation (III: 1) is le out of the
system, one endogenous variable, B, is also le out. is obviously does not
apply to (III: 2) and . denotes something quite material, namely a ange
of the amount of notes in circulation and short-term State debts, whi
appear at other points of the system as anges in liquidity for private
economic subjects. For this reason will have a significance for the system
quite different from B’s (apart, of course, from the special case where B ≡ ).
e fact that certain subjects will receive an increase in cash (suffer a
reduction in cash) means that in a certain partial sense the effects of a
ange in State cash holdings can be discussed. Assume that the State’s
‘cash’ has decreased by a certain amount and that we know that this has
brought about a certain increase in the cash-holdings belonging to certain
economic subjects. We can then, no doubt, put the question of how the
behaviour of these economic subjects is affected by the ange in their cash-
holdings. However, this in no way upsets our conclusions. e point is that
we still do not know which subjects will have a ange in liquidity and when
they will have it, if we do not know in whi ways (i.e. in connection with
whi income or expenditure items) the State has brought about the ange
in the amount of notes in circulation and/or in its short term debt.17
What we are here seeking to establish is not, therefore, that anges in
liquidity are of no importance. Liquidity is, of course, just as significant for
the functioning of the model as are all the other endogenous variables
included in it, su as employment, imports, etc. e point is that liquidity,
like employment, imports, etc., cannot in general be regarded as an action
parameter for the State, and no definite total ‘effects’ can therefore be
aributed to it. Consequently the discussion here is not concerned with the
significance of anges in liquidity, but only with the way they ought to be
dealt with in the analysis.
Kjeld Philip18 has aempted to analyse the connection between fiscal
policy and economic activity from the point of view that the activity of the
State consists primarily in taking liquidity from and giving liquidity to the
private sector of the economy. It was not possible for Philip, however, to
specify the effects of a certain ange in private liquidity, without stating
precisely what type of payment to or by the State is the basis for the
liquidity transfer, so that this liquidity-approa is a quite unnecessary
detour.

7. THE STATE BUDGET AS A CASH-BUDGET

It has already been mentioned that in most countries the State budget is
normally a cash-budget.19 is fact in itself makes it extremely difficult to
use the budget income and expenditure figures as parameters. e event
whi the State budget registers—the selement in cash of an economic
relationship between the State and a private person or firm—is not the only
(and oen not even the most important) circumstance whi is of relevance
to the actions of private persons or firms. In the sale of goods by a private
firm to the State, the firm normally registers its income from the sale at the
moment when delivery takes place, and not later when payment is made (or
earlier in the case of payment in advance). It can be said that the State
budget registers the liquidity aspect of transactions between the State and
other sections of the economy, but not the income or the cost aspects. e
laer can very well occur long before the payment whi the budget
registers. A more refined method of accounting whi allowed registration
of all debts and claims at the precise moment when they arise would greatly
facilitate the interpretation of the budget.20

8. ‘SOUND FINANCE’ AND ‘INTERVENTIONIST’ FISCAL POLICY

In older writings on the theory of public finance the need for so-called
‘sound finance’ was so obvious that it hardly had to be discussed. e
concept of ‘sound finance’ means that the State budget ought to be of su a
form that the net capital position of the State (defined in a suitable way)
does not deteriorate (at least not relatively and viewed in the long run,
according to later formulations).21 Behind the need for ‘sound finance’ there
is, on the one hand, the idea that equilibrium in the national economy is
impossible if the budget is not balanced, and on the other, the desire to avoid
an increase in future (net) interest payments from the State to individuals.
Recent literature,22 especially that influenced by the stagnation hypothesis,
has strongly opposed the maxim of ‘sound finance’, from the belief that an
active employment policy, especially a full employment policy, requires a
permanent budget deficit. At all events, it is considered that there is nothing
to guarantee that a fiscal policy whi pursues the end of full employment
will also involve unanged State net capital, either in the short run or in the
long run. ere is thus rather a pronounced gap between the advocates of
‘sound finance’ and of ‘interventionist’ fiscal policy, and the aempts that
have been made to bridge this gap have set out to show that a deficit has to
be very large and continue for a long time if it is to have quantitatively
significant disadvantages, or that there are perhaps no disadvantages at all.
It follows from the above that there is no reason to regard the maxim of
‘sound finance’ and the demand for ‘interventionist’ fiscal policy as
incompatible in principle, either in the short or long run. is antagonism,
although quite meaningless on a theoretical plane, has arisen because the
starting point has, quite wrongly, been the idea that the budget balance is
the means, and the only fiscal policy means, by whi the State can
influence employment and economic activity generally. As we have pointed
out, the budget balance cannot be regarded as an economic policy means, i.e.
as a parameter, but has to be regarded as an entity determined by the
economic system as a whole, i.e. as an endogenous variable, whi can, at
the most, be an objective of policy. ere is therefore no reason in principle
why, for example, the three ends, full employment, stable value of money,
and ‘sound finance’, should not be set up as policy objectives
simultaneously, and it is even conceivable for all three to be realized solely
by fiscal means. If these three ends should be ‘in conflict with ea other’—
whi is, of course, quite possible—then it must obviously be in the sense
that the model is su that the ends cannot be simultaneously aieved by
the means that are permied (Chapter I, 9). Nothing can be said about this
until the model and the means are known, and the variations in the
controllable parameters whi are permied (or possible) are specified. All
that we wish to establish here is that there is in principle no contradiction
between the demand for ‘sound finance’ and the desire for an
‘interventionist’ fiscal policy; on the contrary, everything indicates that if
sufficiently large anges are allowed to take place in fiscal (and possibly
monetary) policy parameters, ‘sound finance’ can always be maintained in
spite of the fact that the budget is being used for an anti-cyclical policy.
e theorem mentioned in section 2, dealing with the balanced budget
multiplier, is an example of how a budget can develop expansive or
contractive effects without any ange in the budget balance. In general, it
can be said that (with the budget balance defined as in the Scandinavian
countries) a budgetary policy with ‘sound finance’ will be restricted to
variations in the composition and size of the capital budget, and to su
variations in the size and composition of the current budget as do not
ange its balance. We can illustrate this line of thought by the following
example, where it is supposed that the economic system has come to rest
with employment and prices differing from their desired levels. As we
confine ourselves to regarding the infinitesimal case, the ends for the
economic policy can be expressed as:

dN = kN,

and
 dP = kP.

N represents employment and P the price level, kN and kP are given

constants (the ends). We add to this the restriction that these adjustments of
employment and price level shall be brought about only by use of fiscal
policy means and that the budget balance B, is not to be anged, thus

dB = 0.

e means of fiscal policy consist of anges of certain parameters say ai,

i = 1, 2, …, h. We make no assumptions as to the nature of the State
parameters, they can be amounts of income and expenditure, or tax rates,
excise duties, etc. If now the derivatives mentioned below are calculated on
the total model of the economic system in question, we get:

and

and finally, see equation (III: 1) in section 2 above, dB = ΣdTj—ΣdUj = 0, or,

We have here three linear equations with h unknowns—the daiS. If the

number of fiscal policy parameters is three or more, the problem can in
general be solved (though possibly in many different ways), unless the
model itself, i.e. the size of the partial derivatives appearing in the equations,
puts obstacles in the way. If the number of parameters exceeds the number
of ends (in this case three), special restrictions can be imposed upon the use
of the fiscal policy parameters without the possibility of solving the problem
necessarily being removed. e restrictions on the use of the parameters we
are considering here might take the form of su ‘practical’ limitations as
that parameter anges shall be kept within certain narrow limits, etc., or
political limitations su as that social policy must not be disturbed (whi
means, in fact, that more than three ends are taken into consideration).
As has been mentioned, the demand for a balanced budget—‘sound
finance’—is to a certain extent based on the idea that equilibrium in the
national economy cannot be established unless the budget is in some sense
balanced. It can be objected, however, that from the view of establishing a
stable value of money at full employment, it is immaterial whether total
equilibrium has been established in the national economy. It is quite
conceivable—indeed it may be difficult to imagine otherwise—that these two
ends are brought about in an economic world whi in other respects is in
continuous flux. However, if for the sake of argument we disregard this, and
assume that the ends really are identical with the desire for complete
equilibrium in the national economy, it cannot be denied that there is a
certain amount of truth in the traditional argument that equilibrium is
impossible with a budget deficit. For even if all the flows in the economy
and all prices are constant over time, it does not necessarily follow that all
stos in the community are constant, too. e flows can always be
conceived of as anges in stos; for the laer to be constant over time, it is
not only necessary that the flows are constant, but also that they offset ea
other in certain respects. And if the stos ange over time, it cannot be
denied a priori that this may have an influence on the determinants of the
flows, so that in this way anges in the flows tend to arise. e national
economy is thus not in equilibrium.
It should be noted, however, that the equilibrium concept whi forms the
basis for this line of thought is that of stationary equilibrium in the
extremely long run, where no anges at all occur and consequently where
not only variables like income, employment, prices, etc., are constant, but
also the formation of net real capital is equal to zero. Su an equilibrium
can hardly be considered to be an ideal for economic policy. To this one
might add that it can very well be imagined that anges in stos only
affect the situation in the long run, so that a shortrun equilibrium analysis
may be conceived whi quite rightly disregards anges of stos, etc., see
Chapter XVI, 2 and 3. We will use that approa in this work. Whether it is
justified or not is a question whi has been mu discussed in debates on
monetary theory during the past decade.
ese points are significant for the budget balance in so far as la of
budget balance in the ‘real economic’ sense means that outstanding amount
of Government debt and/or the amount of notes in circulation together with
net claims at call on the State will continually ange. e question then is
whether the models we construct should pay regard to this fact, by
including these variables directly in the behaviour equations of the model,
so that the behaviour of the economic subjects cannot remain unaffected so
long as these variables are anging. It will readily be seen that this is, in
principle, quite a different question from the one discussed earlier, i.e.
whether the liquidity increase, , ought to be regarded as a State parameter
or as an endogenous variable. As has just been indicated, our argument will
in the main be based on the assumption that relationships of this kind can be
disregarded in the short run, but we are fully conscious of the dubious
nature of this premise.
General reference may here be made to the discussion of the ‘Pigou
effect’, and to the Patinkin discussion. An illuminating example is to be
found in A. P. Lerner’s ‘functional finance’.23 Lerner considers an economy
with a tendency towards permanent unemployment, and assumes that an
expansionary policy leading up to full employment will also involve a
certain budget deficit. e public debt, in the broad sense of the term, must
then continually increase. If, now the budget deficit is financed by loans
from the central bank, so that the increase of State debt shows itself as a
continuous increase of the amount of notes in circulation and debts at call,
this circumstance in itself (i.e., even if a possible fall in the rate of interest
has no effect) will lead to increased purases of consumption goods by
households, and increased purases of capital goods by firms, whi in turn
means that a smaller budget deficit will be necessary. e successive
accumulation of liquid assets by the private sector would, in this way, lead
to su a large propensity to spend that the budget deficit would be
superfluous. Not until then would a real equilibrium have been aieved.
 9. CONCLUSIONS
In Chapter II certain conclusions were drawn from the distinction between
parameters and endogenous variables in the model. e fundamental
implication of this distinction was that constant relationships can generally
only be expected between parameter anges and anges in endogenous
variables, not between the anges in the endogenous variables themselves.
In this apter we have pointed out the consequences of this for many
different concepts of budget balance, including that whi registers the
liquidity increase in the private sector. e budget balance is not an action
parameter for the State, no maer whi items of official income and
expenditure are included in its definition. For that reason we should not
expect to find simple connections between anges in the budget balance
and other anges in the economic system. As we have seen, both generally
and in simple examples, we cannot even expect simple rules of thumb like
‘when the budget balance deteriorates, there arises a tendency towards
expansion’ to hold. In other words, no definite effects can be aributed to
anges in the budget balance. In discussing the effects of fiscal policy we
are obliged to abandon all simple summary expressions of the budget in su
forms as the budget balance. e fault with these is not just that they are
approximations but rather that they are not approximations of the anges
in the State’s fiscal policy action parameters. If approximations of the
anges in the State’s fiscal policy are to be sought—and this, of course, is
necessary as a rule when dealing with practical problems—su expressions
should instead be sought for the anges in taxation principles, real
expenditure plans, etc., that the State makes.

1. We use the term ‘State’ as the collective term for all official
organizations and public authorities.
2. Erik Lindahl seems to have been the first to discuss the possibility of a
systematic use of variations in the budget balance as a means of
economic policy, in Penningpolitikens medel (Monetary Policy Means),
Lund, Sweden, 1929, pp. 62–67.
 3. Jørgen Gelting ‘Nogle bemærkninger om financiering af offentlig virk-
somhed’ (Some Remarks on Financing State Activity),
Nationaløkonomisk Tidsskrift, Copenhagen 1941, and T. Haavelmo,
‘Multiplier Effects of a Balanced Budget’, Econometrica, Chicago 1945.
4. E.g. Harold L. Somers, Public Finance and National Income, Philadelphia
1949, Part V.
5. e amount of notes in circulation excludes those in the hand of the
State, as well as the central bank.
6. Cf. Ingvar Svennilson, Ekonomisk planering (Economic Planning),
Uppsala 1938, Chapter I, §6.
7. See Erik Lundberg, Konjunkturer och ekonomisk politik (Business
Cycles and Economic Policy), Stoholm 1953, p. 387, and Ralph Turvey,
“Some Notes on Multiplier eory”, Part II, The American Economic
Review 1953.
8. For the sake of simplicity we exclude dating, cf. Chapter I, section 2.
9. See the survey in Riksräkenskapsverkets årsbok 1948 (Swedish Treasury
Yearbook 1948), ‘Översikt av det statligabudget systemets utveling
sedan år 1911’ (Survey of the Development of the State Budget System
since 1911), Stoholm 1948.
10. Dag Hammarskjöld, ‘P.M. angående principerna för budgetens
balansering’ (Memorandum on the Principles of Budget Balancing) in
1946 års statsverksproposition (the 1946 Budget Proposal) Inkomster å
dris-budgeten, Bihang D (Current Budget Incomes, Appendix D), also
the criticism by Carsten Welinder in ‘Budgetpolitiken inför kravet på
samhälls-ekonomisk balans’ (Budget Policy in Relation to the Demand
for Balance in the National Economy) in Ekonomisk Tidskrift, 1946,
Stoholm, and the discussion between Hammarskjöld and Welinder in
the same journal.
11. Erik Lindahl, Penningpolitikens medel (Monetary Policy Means), p. 64.
12. E.g. Carsten Welinder, ibid., p. 92. Jørgen Gelting, Finansprocessen i det
økonomiske kredsløb (Public Finance in the Circular Flow System),
Copenhagen 1948, Chapter 3, also Meddelanden från
konjunkturinstitutet (Stoholm), Series A: 17, Chapter XII, Stoholm
1949.
13. E.g. Statsverkspropositionen 1952 (Swedish Budget Proposal 1952).
14. Erik Lindahl: ‘Teorin för den offentliga skuldsäningen’, p. 92. (e
eory of the Public Debt.)
15. Jørgen Gelting, ibid., p. 101 f.
16. See my criticism of Eri Sneider’s Einführung in die
Wirtschaftstheorie, III (Tübingen 1953), published in Ekonomisk
Tidskrift, 1954.
17. is is also the main objection to the quantity theory, whi just takes
the amount of money as a State action parameter, and as the ‘cause’ of
price anges. is objection was first formulated by Knut Wisell in
his Lectures on Political Economy, London 1935, Vol. II, pp. 159 ff; see
also Lloyd Metzler, ‘Wealth, Saving and the Rate of Interest’, Journal of
Political Economy, 1951, and Eri Sneider, Einführung in die
Wirtschaftstheorie, III, Tübingen 1953, pp. 167–8.
18. Kjeld Philip, Bidrag til Læren om Forbindelsen mellem det offentliges
Finanspolitik og den økonomiske Aktivitet (Contribution to the Study of
the Connection between State Fiscal Policy and Economic Activity),
Copenhagen 1942.
19. Bestämmelser och praxis rörande statens budget (Regulations and
Practice of the State Budget), Swedish State Resear Publication SOU
1952: 45, p. 22. Stoholm.
20. Cf. Lars Lindberger’s discussion in Investeringsverksamhet och spa ande
(Investment Activity and Saving), Swedish State Resear Publication
SOU 1956: 10.
21. e weakening of the concept of ‘sound finance’ to concern only
unanged net wealth of the State in the long run was made by Gunnar
Myrdal in Finanspolitikens ekonomiska verkningar (e Economic
Effects of Public Finance). e idea that ‘sound finance’ only implies
unanged net wealth in relation to the national income is found in Erik
Lindahl, ‘Teorin för den offentliga skuldsäningen’.
22. Jørgen Pedersen, ‘Einige Probleme des Finanzwissensa’ (Some
Problems of Public Finance) Weltwirtschaftliches Archiv 1937, also a
number of other economists, e.g. Alvin H. Hansen, Fiscal Policy and
Business Cycles, New York 1941.
23. A. P. Lerner: The Economics of Control, New York 1946, Chapter 24. Cf.
also D. Patinkin ‘Keynesian Economics and the antity eory’ in
Post-Keynesian Economics, ed. K. K. Kurihara, New Brunswi 1954.
 CHAPTER IV

Economic Fluctuations and the Budget

1. THE INTERACTION BETWEEN BUDGET AND NATIONAL
ECONOMY
DURING times of inflation, su as the years aer the two world-wars, we
get strong evidence to support the well-known observation that the
connection between the budget and economic life is not a one-way affair in
whi the impulses go only from the budget to the rest of the economy.
Economic developments in their turn influence the budget.
is point of view accords well with our position in not regarding all
incomes and expenditures in the budget as State parameters or State means.
For if all items of income and expenditure in the budget are regarded as
State parameters, this is virtually equivalent to saying that there is no
mutual interaction between the budget and economic developments, except
perhaps, indirectly if the State is stimulated by certain economic
developments to undertake anges in income or expenditure items for the
purpose of modifying these developments. e connection would then be
completely one-way, and go from the budget to economic developments and
never the opposite way. ere would be no automatic (endogenous) effects
from the rest of the economy to the budget, about whi economic ‘laws’
could be formulated. e very idea that the budget outcome is directly and
automatically dependent on the condition and development of the private
sector of the economy implies that at least some of the budget income and
expenditure items are not State parameters, but are instead endogenous
variables in the model describing the economic system.
It is the general aracter of this interaction between the budget and
economic developments that will be the subject maer of this apter; the
fiscal policy means (the parameters) influence the course of the economy,
whi in turn is decisive for the budget outcome (or at least, for the outcome
of the budget items whi can be regarded as endogenously determined). It
will appear that an understanding of this interdependence is of fundamental
importance when it comes to interpreting the significance of a certain budget
jor economic developments during the period of time the budget covers.
Furthermore, in modern writings on business cycle policy this interaction
has been considered to be one of the most important policy ‘means’, because
it makes possible the establishment of certain automatic stabilizing effects.
In order to deal with these problems, it seems suitable to begin with some
discussion of the distinction between the budget ex ante and the budget ex
post. is will enable us to clarify the points we have already made in
previous apters about the means of fiscal policy. When we speak of the
budget below we generally have in mind only income and expenditure items
connected with fiscal policy. e arguments are on the whole also valid,
however, for a budget including monetary policy transactions (lending and
borrowing).

2. THE BUDGET EX ANTE AND EX POST

Up to now we have discussed the budget without defining the concept
except as a collection of income and expenditure items (possibly receipts and
payments). However, we have reason in this field, as elsewhere in economic
theory, to make a distinction between ex ante and ex post; between the
budget in the ex ante sense and the budget in the ex post sense. ere is an
important reality behind this distinction. In most modern states, parliament
at the beginning of the financial year approves the budget, whi is a
detailed account of income and expenditure whi the State expects to
receive or make during the coming financial year. It is reasonable to regard
the estimated budget as an ex ante budget. At the end of the financial year
the State makes up the actual account of the budget, whi in principle
includes all State incomes and expenditures as they actually were during the
course of the year. It is reasonable to regard the accounted budget as an ex
post budget. In the terminology of period analysis, the planning period of
the State would then coincide with the financial year. e whole conceptual
apparatus used by the Stoholm Sool would thus get a very definite
meaning when applied to that part of the State activity whi is given
expression in the budget. e simple application of period analysis to State
activity gives rise to certain difficulties however; e.g. it is not unusual for
parliament to ange the budget during the course of the financial year. In
su cases it is difficult to maintain the idea that the planning period
coincides with the financial year, though, on the whole this ought to be a
reasonably realistic simplification. e fact that the financial year is the
State’s planning period does not imply, of course, that the financial year can
be regarded as the unit-period for any model whi includes the State’s
finances.
e estimated budget, the ex ante budget, includes all income and
expenditure that the State reons to receive or make during the financial
year. ese budget items expressed in monetary terms have thus the
aracter of planned or expected variables. In order to aracterize ex ante
entities more closely we usually make a distinction in period analysis
between so-called parameters of action, i.e. variables the size of whi the
economic subject in question has at some point of time been able to fix, and
expectation variables, i.e. variables the size of whi the economic subject in
question has not been able to determine.1 Although this distinction is
related to the distinction between parameters and endogenous variables in a
complete model, they do not coincide. Certainly the variables whi are
parameters in the model must also be parameters of action for individual
subjects (in so far as they are not determined by ‘nature’) but the parameters
of action of a subject may well enter the model as endogenous variables.
is will be the case whenever the behaviour of the subject is ‘explained’
within the framework of the model; in planning theory, for example, the
planned purases of consumer goods by households are naturally regarded
as parameters of action for the households, but this does not prevent those
consumption plans being ‘explained’ by current prices, previous incomes,
etc., in a complete model. What is an expectation variable for one individual
can be a parameter of action for another individual, and thus also be a
parameter in the complete model.
Since, as a rule, parliament (or the law) does not require the
administration to carry out the ex ante budget exactly—in any case the
administration generally does not even have the necessary powers to do so—
the figures of the ex ante budget evidently have more or less the aracter of
expectation variables. e duties of the administration oen consist of
puing into effect certain tax rates, customs duties, etc., and to carry out
certain real projects, and not always to effect certain fixed receipts or
payments. e State’s parameters of action then consist of these tax rates,
etc., see the discussion in Chapter II, 3.
It is obvious that the nature of the accounted budget is that of an ex post
budget and the interpretation of it does not generally involve any great
problems of principle.

3. THE EX ANTE BUDGET AND THE EFFECTS OF FISCAL POLICY

A basic idea of period-analysis is that developments are determined by ex
ante relationships; it is the plans existing at the beginning of the period
whi will determine the actual course of events and thereby the results ex
post. e ex post results, on the other hand, are of importance inasmu as
differences between the results ex post and the plans and expectations ex
ante may cause revision of plans for the following period, and thereby also
lead to anges in subsequent developments. From this point of view, it
might look as if the ex ante budget is the primary one, as far as estimating
the effects of fiscal policy are concerned. is is to a certain extent in conflict
with what has been said previously, and for that reason we shall now
aempt to point out why the figures in the ex ante budget are generally of
no real interest in a discussion of the effects of fiscal policy. Naturally we are
only discussing the ex ante budget as the explanation of a given
development.
Firstly, on the basis of a very simple model, we shall introduce a
definitional relationship between the State’s planning and private planning.2
We imagine a closed economy consisting of capitalist entrepreneurs (firms),
workers and the State; credit transactions are disregarded.
e expected incomes of the ‘capitalists’ (entrepreneurs, firm-owners) will
then be determined by

Purases and sales of goods are measured at market price; the indirect
taxes are consequently considered as costs for the firms. e equation gives
the expected income of the firms (E0f) as equal to the expected sales of
goods (gA0f) minus planned purases of productive goods (gB0f), hire of
labour (lB0f) and expected indirect tax payments to the State (iT0f) plus

planned investment (I0f).

e workers’ expected incomes (E0w) are equal to their expected sales of
labour (lA0w):

Capitalists and workers together plan to use their expected incomes on

consumption (C0f+w), direct taxes (dT0f+w) and saving (S0f+w):

Finally we have the expected budget surplus (= the State’s planned saving,
in the usual sense) (S0s) equal to the difference between the sum of the
direct and indirect tax receipts (dT0s and iT0s) expected by the State, and the
sum of the purases of goods and hire of labour (gB0s and lB0s) planned by
the State, plus the State’s planned investments (I0s):

rough a suitable combination of these four equations we get the

following expression:
 e difference between planned investment and planned saving is thus
equal to the surplus of planned purases of goods and labour over their
expected sales, plus the difference between the taxpayers’ and the State’s
expectations of the size of tax payments. e question now is what
importance can be ascribed to the ex ante budget figures in this connection.
Firstly, we have to observe that the equations above must obviously be
valid for a certain unit-period in the meaning used by the Stoholm Sool.
Generally it cannot be assumed that this unit-period is as long as a financial
year, but is normally a mu shorter period, say a week. As the ex ante
budget figures must also be valid for the same period in this context, we are
obviously obliged to assume that the expected income and expenditure items
for the financial year are specified as to weeks. From the beginning of the
financial year to the beginning of the period under consideration a certain
development can be assumed to have taken place. is development cannot
generally be assumed to have been correctly anticipated by the State.
Let us first regard the first two parts—(gB0+C0—gA0)+(lB0—lA0)—of the
right-hand side of the equation (IV: 5), i.e. the difference between planned
purases and expected sales of goods and labour. Here the State’s planned
purases of goods and hire of labour are included in gB0 and lB0. In the
case where the State’s expenditures on purasing goods and labour are
really action parameters for the State, in the sense that the State spends
exactly those sums whi are given in the estimated budget, the figures of
the ex ante budget (estimated at the beginning of the financial year) will of
course be included in equation (IV: 5). On the other hand, in those cases
where this is not valid, and the State’s parameters of action are instead
purases of certain real quantities of goods and labour, the sum of money
the State actually spends in the period under consideration depends entirely
on prices during this period.
In order to clarify this, it is convenient to use the concepts of conditioned
and unconditioned plans.3 Conditioned plans are those plans whi the
planning subject has made dependent on (functions of) certain later events.
e demand curve is an example of a conditioned plan. However, as soon as
the price is fixed and known, and thereby a definite point is fixed on the
demand curve, the plan is unconditioned and can result in action. At the
beginning of the financial year the State obviously fixes a good many
conditioned and unconditioned plans for its purases throughout the
financial year; we assume that they are specified for ea single period. For a
given single period within the financial year the State at the beginning of
the financial year may accordingly have a fixed plan, whi can be
interpreted as a demand curve, see Fig. IV: 1.
If this demand curve has the form D1 (a rectangular hyperbola) this will
mean that no maer what the price happens to be in the unit-period under
consideration, the State will spend a certain amount of money fixed
beforehand: here the plan in terms of money is unconditioned, and the
expenditure amount of the ex ante budget can be taken as a parameter. If the
demand curve instead has the form D2 (a vertical line) this will mean that
the State will buy a certain quantity irrespective of the price; here the plan
expressed in real terms is unconditioned, but in terms of money is
conditioned: the State parameter is the given quantity, and the actual
expenditure amount during the unit-period is then determined by the actual
price in the period. If the price for this unit-period expected by the State at
the beginning of the financial year is p0, in both cases the ex ante budget
expenditure amount is p0q0. If the actual price for the period t is pt, in the
first case the quantity purased is qt′ and the actual expenditure ptqt′ (=
p0q0); in the second case the purased quantity is qt″ = q0 and the actual

expenditure ptqt″. If the demand curve has the form D4 (a horizontal line)
the price evidently becomes a parameter. Demand curves of this kind can be
imagined in cases where the State keeps a buffer sto for price-stabilizing
purposes. Intermediate cases between the two extreme cases D2 and D4
(other than D1) can easily be imagined, e.g. the demand curve D3; here the
demand curve itself must be regarded as a State parameter.

Fig. IV: 1

e reason why we are interested in knowing the size of the

unconditioned purasing plans in equation (IV: 5) is that (apart from
certain inflationary situations)4 we can reon that these purasing plans
will be realized, and will therefore determine the extent to whi the sales
expectations of the private sector (the firms and workers) prove false. In this
way unexpected sto anges, profits and losses, etc., will arise whi are
decisive for future developments. As regards the State’s purases of goods
and labour, therefore, there is good reason to suppose that the expenditures
whi are registered in the ex post budget are of greater relevance than the
figures in the ex ante budget.
We now turn to the last part (iT0f+dT0f+w—iT0s—dT0s) of the right-hand
side of equation (IV: 5), the difference between the tax payments (subsidies)
as expected by the taxpayers and by the State. What significance can
properly be aributed to this element? Firstly, it is obvious that it will not
normally determine the extent of either the taxpayers’ or the State’s
unfulfilled expectations concerning tax payments; the actual taxes of the
period may well differ from the expectations of both the taxpayers and the
State. e plans of both the State and the taxpayers on tax payments during
the period usually have the aracter of expectation variables, or perhaps
more correctly conditioned plans. What determines the taxpayers’
unexpected tax payments (or tax rebates) is the actual amount of tax (whi
in its turn is determined by the current tax rates in conjunction with the
actual size of the tax base) minus the amount of tax they expected to have to
pay. e State’s ex ante estimate of its income from taxation in the estimated
budget will, on the other hand, generally have no direct relevance for the
unfulfilled expectations of the taxpayers, and will thus have no influence on
further developments.
On the other hand, of course, the ex ante budget figures of both income
and expenditure are of importance for the extent to whi the State’s budget
expectations go wrong. e question now is in what way can the State’s
wrong expectations in themselves be of importance to subsequent
developments. It is obvious that we cannot generally establish an analogy
with the importance that the unfulfilled expectations of private economic
subjects have for later developments. With firms, for example, we usually
suppose in theory that they act so as to maximize their profits (in the short
or the long run). is is why we are interested in unexpected sales, because
an unexpected increase in sales can normally be considered to make the
profit-maximizing firm increase its production and/or raise its prices. If
unexpected sales are observed, therefore, this gives us some possibilities of
forecasting future developments in the system. When it comes to the State,
things are quite different (with the possible exception of State enterprises).
Firstly, su a simple and relatively constant reaction-paern for the State
can hardly be established. Even if the State has su a simple aim as, for
example, the maintenance of a certain net capital (in the short or in the long
run) whi naturally implies that unfulfilled expectations as to the budget
must play an important part in future fiscal policy, the State has altogether
at its disposal so many different parameters that it is impossible to say
anything about whi parameters it will use in order to bring ba its net
capital to the desired value. Secondly, the State’s ends are oen completely
outside the budget, and concern entities other than those whi are directly
included in the budget, su as employment. Unfulfilled expectations as to
the budget will not necessarily imply that the State’s expectations as to
employment (the end) have failed. irdly, and lastly, we are here not in any
way aempting to explain the behaviour of the State, this is assumed to be
determined outside the economic model. erefore even if the State actually
allows itself to be influenced in its budget policy by previously unfulfilled
expectations concerning the budget, we do not include su relationships in
our model. It is not our task to explain the actions of the State, cf. Chapter II,
2.
e conclusions to be drawn from this discussion are obviously that the
figures of the estimated (ex ante) budget are not in themselves of any value
in estimating the effects of the budget on economic developments, unless the
State’s calculation of future incomes and expenditure is completely correct.
If there is su complete foresight, however, the ex ante budget coincides
with the ex post budget and the figures of the ex post budget could just as
well be used. Furthermore, as the ex post budget always shows the actual
activity of the State during the financial year, the question naturally arises
whether an expression for the influence of fiscal policy on economic
developments cannot be found in the ex post budget figures.

4. THE EX POST BUDGET AND THE EFFECTS OF FISCAL POLICY

We now proceed to the question whether, on the basis of the ex post budget
figures, anything can be said about the effects of budget policy on the course
of economic events. e argument in this section is a continuation of the
argument advanced in Chapter III, 4, concerning the construction of an
index whi shows the ‘effects of the budget’. e question will then be: If a
certain development in the economy and certain anges in the budget have
taken place during the period for whi an ex post budget has been drawn
up, what can be said to be the significance of the observed anges in the
budget for those economic developments? Against the baground of what
has been said in Chapters II and III about the impossibility of ascribing any
definite effects to a given ange in a certain type of public income or
expenditure, unless this type of income and expenditure can be regarded as
a State parameter, the question seems impossible to answer. e question is
not a legitimate one as it has been posed here. For that reason, we shall try
to specify it more closely in a way whi also seems to correspond to what
are usually regarded as the ‘effects of the budget’.
Firstly, we will get rid of the ambiguity that arises from the fact that
budget anges can have different effects on different endogenous variables
in the model. We assume that we are only interested in the effects on one of
them, su as employment.
Secondly, we assume for the sake of simplicity that the economy is in
equilibrium; all the parameters of the system, controllable and
uncontrollable, are given and unanged and the system has come to rest. At
a given point of time (at the beginning of a financial year) we now imagine
certain uncontrollable parameters to be anged, bringing about a
development where the endogenous variables in the system, including State
income and expenditure, are anging. At the end of the year certain
anges in the ex post budget, compared with the ex post budget of the
previous year, can be observed. Our question will then be: what would the
economic development have been like if the State (if it had anticipated the
development) had anged its parameters of action in a way that ea
separate type of income and expenditure had remained unanged in value,
irrespective of the ange in the uncontrolled parameters.5 is would imply
that the economic development would have been different from the actual
course, but not necessarily that the old equilibrium would have been re-
established. If now we compare the actual course of development with the
hypothetical course of development whi would have arisen if the State
had anged its parameters of action in the way indicated above, would that
not constitute a measure of the ‘effects’ of the budget anges, and thereby
also of the ‘effects’ of fiscal policy.
e answer to this question is in the affirmative insofar as the ‘effects’ of
the budget may certainly be defined in this way, but in the negative on the
other hand insofar as no unique measure of the ‘effects’ of the budget is
obtained in this way. e fact is, of course, as has been pointed out already,
that anticipating a certain given economic development, whi would affect
the income and expenditure items of the budget with unanged public
parameters, the State can only maintain all income and expenditure items
unanged by anging a suitable number of State parameters in a suitable
manner. However, if the number of State parameters is sufficiently large, it
ought to be possible to bring about constant income and expenditure items
through a number of different combinations of parameter anges, and these
will generally have different effects on the relevant endogenous variables
(employment). In brief: the ‘effects’ of the budget in the sense defined above
will wholly depend on the particular way in whi all the income and
expenditure items in the budget are supposed to be kept constant. erefore
if it is desired to talk about the effects of the budget in a more precise way, it
has to be explicitly indicated whi combination of parameter anges is to
be used to keep all incomes and expenditures constant; and it is clear that
we do not have mu reason to denote any particular combination of State
parameter anges out of all the possible ones as being more ‘natural’ than
the others.
is line of thought can be expressed more accurately in the following
manner. For the starting point we will as usual take the model (I: 1) in
Chapter I, and for the sake of simplicity we will omit the dating of the
variables. Suppose that certain uncontrollable parameters, say ak, where k =
i, i+1, …, m are subject to certain anges, say dak, with the result that

employment is anged by

e budget income and expenditure items are anged at the same time—
if the State parameters are unanged—in the following way:

and
 We now look for the ‘effects’ of the budget on employment in the
following sense: how would employment have been affected if, along with
the parameter anges dak, we had anged the State parameters ag (g = 1,
…, h) in su a way that all income and expenditure items in the budget
return to the same size as they were before the parameter anges dak took
place. e State parameter anges, dag, whi are necessary in order that
all State income and expenditure items will have unanged values, in spite
of the anges in the uncontrollable parameters, must evidently satisfy the
following system of equations:

We thus have s+t linear equations with a number of unknowns equal to

the number of State parameters, i.e. = h. Σ(∂Tj/∂ak) · dak and Σ(∂Uj/∂ak ·
dak are given in the problem and we shall assume that the equations fulfil

certain standard conditions. e solution of the system then depends

entirely on the number of State parameters h. It will immediately be seen
that h must always be at least as large as s+t; to ea State income and
expenditure item there corresponds at least one State parameter. If there is
exactly one parameter for ea income or expenditure item, we have h = s+t
and the system of equations has one and only one solution, say . e
‘effect’ , of the budget on employment is then

and consequently of a uniquely determined magnitude.6

However, if the number of State parameters exceeds the number of
income and expenditure items in the budget, i.e. h > s+t, the system of
equations above will have a number of solutions, and the expression is
not uniquely determined. In this case, the State income and expenditure
items can be kept unanged by applying many different combinations of
State parameter anges; the effect on employment depends entirely on
whi of these different combinations is osen.
e number of State parameters thus determines whether the question put
above can be answered definitely. As has already been said, the number of
State parameters is at least as large as the number of income and
expenditure items. If there is no other parameter connected with a certain
State income or expenditure item, then that income or expenditure item
itself is to be regarded as a parameter. It will also readily be seen that the
number of State parameters is generally larger than the number of State
income and expenditure items. is will be the case as soon as any type of
income and expenditure is ‘controlled’ by more than one parameter. is is
always the case with income from taxation, for here there are at least two
parameters, one whi refers to the calculation of tax (the tax rate) and one
for the time of payment. Another typical example of an income item whi
is controlled by a number of parameters, is provided by the income tax
where both tax rates and allowances are controlled by the State.
Furthermore, if the actual forms of the functions, say the income tax scales,
are anged, this will mean that an arbitrary number of State parameters
will be available for use.
It should be pointed out that the difficulties indicated here in the
determination of the ‘effects’ of the budget do not depend on any problem of
aggregation whi could be solved by the application of some index. No
maer how detailed a specification of State income and expenditure items is
made, there remains the possibility that an income or expenditure item may
be directly influenced by several State parameters. is is evidently the
opposite of the usual problem of aggregation, whi always disappears in a
sufficiently detailed model.
e result of these considerations can thus be said to be that the figures of
the ex post budget will not in themselves be any help in estimating the
effects of fiscal policy in an historical development. It is obvious that this
applies a fortiori to any budget items that are calculated as residuals from
other budget items, e.g. the budget balance B, the ange in private cash-
holdings , or the net debt position, see the discussion in Chapters II and III.
In all circumstances it is necessary to consider the underlying anges in the
State’s action parameters.

5. THE BUDGET AND THE DIFFERENCE BETWEEN INVESTMENT AND

SAVING
In section 3 the importance of the budget items for the difference between
investment and saving was indicated. Other things being equal, the larger
the budget surplus the smaller will be the difference between investment
and saving, see equation (IV: 5). is is the fundamental reason why the
budget surplus is believed to be an indication of the possibly expansive or
contractive effects of the budget. e defect in this line of thought is the
assumption that other things will be equal. As we have explained in the
section above, the State cannot ange its saving, ex ante or ex post, without
altering one or more of its parameters. However, if the State at the beginning
of a period anges any of its parameters, say a tax rate, and this is known
to private economic subjects, it will also exert an influence on private
purasing plans and sales expectations in the same period; thus the proviso
that other things will be equal is broken.7 Furthermore, since any given
ange in State saving (ex ante) can be brought about by many different
combinations of State parameter anges, whi in their turn have various
effects on private purasing plans and sales expectations, it is obvious that
conclusions cannot immediately be drawn from the size of a given ange in
State saving, about the size of the resultant ange in the difference between
total investment and total saving. e State parameter anges whi bring
about an increase in State saving may for instance very well bring about an
even greater decrease in private saving, and thus a net increase in the
difference between total investment and total saving. ere is, furthermore,
the general question whether the difference between investment and saving
is at all a reliable indicator of future trends in the economic system; we need
not deal with this question here, however.
A further reason for avoiding the use of the terms investment and saving
(in the meanings we have given them) when analysing the ‘effects’ of the
budget is, as we have already pointed out, that the term (iT0f+dT0f+w—iT0s
—iT0s), included on the right side of the equation (IV: 5) for the difference
between investment and saving, does not seem to have any immediate
significance for subsequent developments.

6. THE BUDGET AS A STABILIZER

In modern writings on public finance, be they theoretical or practical, the
inherent power of the budget to act as a stabilizer or destabilizer of the
economy holds a central position.8 e budget is referred to as a ‘built-in
stabilizer’. Here it is not the fact that modern fiscal policy is oen
deliberately planned and continually anged so as to exert an influence on
the present or expected development that is discussed. What is being
considered is the fact whi forms the basis for the discussion in the whole
of this apter: that most of the income and expenditure items in the budget
have a tendency to ange automatically according to the development of
the economy.
In its simplest form the idea is as follows: During the course of an
upswing in the business cycle, with given State parameters all tax yields will
show a tendency to rise because of rising incomes, increased production and
higher prices. On the expenditure side some items will show a tendency to
decrease and others to increase. Rising employment tends to reduce the
expenditure on unemployment relief, etc., while rising prices and possibly
wages tend to increase the expenditures on the purase of goods and
services. Other expenditures will in the main be uninfluenced by the
improving economic situation, e.g. interest payments. e overall result is
generally held to be that, because of the progression in the income tax rates,
those State incomes whi can be regarded as income-destroying will rise to
a larger extent than those expenditures whi can be regarded as income-
generating. An upswing in the economy thus tends automatically to bring
about an increase of the budget surplus (decrease of the budget deficit)
whi in its turn is considered to work contractively and thus to moderate
the upswing. e advantage of su an inherent stabilizing effect lies in the
fact that it is automatic, requiring neither specific decisions by the State, nor
the possibility of forecasting future developments. It is obvious that from the
point of view of a stabilization policy whi is intended to maintain full
employment and a constant price level, it would be very convenient if the
budget had, or could be given, su stabilizing effects.
Without exactly doubting the importance of this idea, we must
nevertheless examine it more closely, as it is rather vague in several respects
(see also Chapter XIX, 4, where other aspects of the question are discussed).
e notion of ‘automatic’ adaptation of income and expenditure items in the
budget, or, using Myrdal’s terminology,9 ‘automatic budget reaction’,
presupposes what we have called unanged State parameters of action (tax
rates, tariffs, real purasing plans, and, in certain cases, income and
expenditure amounts). e automatic budget reaction thus requires complete
passivity in the law-making authorities but not, of course, in the
administration. us it appears impractical to speak about automatic budget
reaction except within a given financial year. At least once a year the law-
making authorities decide on the form of the budget and thus, in fact, also
on the question of whether the State parameters shall be anged or remain
unanged. Of course the stabilizing effects of the budgets over several
financial years may be studied, provided that all State parameters of action
are unanged. Since, however, some anges of parameters will always take
place, primarily for reasons quite unrelated to business cycle policy but, of
course, always with the economic effects in mind, it will in practice be the
stabilizing effects of the budget within the planning period (the financial
year) that is of most interest.
e view that the stabilizing effects of automatic budget reactions ought,
in the first place, to be limited to the financial year (or more correctly, the
State planning period), becomes even more obvious when one aempts to
explain what is really meant by the expression ‘stabilization’. If one is to say
that the budget works in a stabilizing manner, some measure of this effect
has to be given. Let us assume that we are interested in the development of
employment, and that employment has developed over time according to
Fig. IV: 2 in two different courses, 1 and 2.
 Fig. IV: 2

Both courses are imagined to start at the beginning of the financial year 1
with employment at . Both courses are supposed, in the long run, to come
to a stop again at the employment . Course 1, at the beginning, shows a
greater divergency from than course 2, but approaes more quily
than 2. If course 2 is the development with ‘automatic budget reaction’ and
course 1 is the development without, does the automatic budget reaction
then work in a stabilizing manner or not? When the question is put in a
general way like this, it just cannot be answered.10 If, however, we oose,
from the many possible bases of comparisons, say the average employment
in the alternative courses during a certain period of time, an answer will be
possible. e course, whi has, on average, the least divergence from
during the period in question, is the most stable. It then seems natural to
oose the first financial year as the period for the comparison.
From what has been said above it also follows that there must be a certain
basis for comparison before one is able to say whether a certain fiscal policy
works in a stabilizing manner. e problem then turns upon the set of fiscal
policy that should be imagined, in order to provide the course of
development, that is to form the basis of comparison. In the literature the
comparison is oen made between a course with ‘automatic budget
reaction’ and another course with a ‘natural budget reaction’. e course
with automatic budget reaction will then be a course during whi the State
keeps its action parameters constant and lets income and expenditure
develop ‘automatically’; the course with a ‘natural budget reaction’ is (in the
extreme case) a course where the State anges its action parameters in su
a way as to keep ea income and expenditure item constant in spite of the
development.
Behind the discussion of the stabilizing effects of the budget there is oen
the idea of a development with a ‘neutral budget’, that is, a course of
development whi is not influenced by State finances at all.11 is is most
obvious in the Douglas Report,12 whi seems to maintain that an
‘automatic budget reaction’ works in a stabilizing way while a ‘natural
budget reaction’ works in a destabilizing way; here, evidently, a third course
of development uninfluenced by State finances is imagined as a basis for
comparisons. Jørgen Gelting13 starts from the course with a ‘natural budget
reaction’ and seems to be of the opinion that a ‘natural budget reaction’ is in
the main equivalent to a ‘neutral’ budget. Gunnar Myrdal14 starts from the
case with ‘automatic budget reaction’ as a basis for comparison, and states
that the ‘natural budget reaction’ works destabilizingly while an anti-
cyclical fiscal policy works stabilizingly. Here it seems as if the ‘automatic
budget reaction’ policy is regarded as ‘neutral’, and there is hardly any
doubt that if an idea su as ‘neutrality’ is to be used at all, it must be
defined in this way. To be neutral in the face of an economic development
could hardly mean anything else but keeping constant the parameters of
action one has at one’s disposal. Using su a ‘neutral budget’ as a basis for
comparison, it simply becomes meaningless to ask whether the ‘automatic
budget reaction’ works in a stabilizing way; ‘neutral budget’ and ‘automatic
budget reaction’ will then be synonymous.
Let us assume that for some reason or other it is considered of particular
interest to compare courses with ‘automatic budget reaction’ and with
‘natural budget reaction’. Can it then be determined whether an ‘automatic
budget reaction’ works stabilizingly compared with a ‘natural budget
reaction’? Actually we have already given the answer to that question in
section 4, where we discussed the possibilities of determining the budget
effect on the basis of the ex post budget figures under the assumption of
unanged State parameters during the financial year. ere we arrived at
the conclusion that the difference between the course with constant State
parameters, i.e. with ‘automatic budget reaction’, and with constant income
and expenditure items cannot be determined unless it is specified how the
constancy of the various income and expenditure items is brought about.
us one is obliged to specify whi State parameter anges are considered
to lie behind the ‘natural budget reaction’. ‘Natural budget reaction’ does
not uniquely define a fiscal policy, not even if as here, it is regarded as a
policy where ea separate item of income and expenditure is kept constant.
us the possibility of deciding generally whether an ‘automatic budget
reaction’ works stabilizingly as compared to ‘natural budget reaction’ or not
disappears.
e only thing to be done when the stabilizing effect of the budget is
concerned, is to compare alternative courses where the State parameters
have different values and are constant, or ange in some way more closely
indicated. Here it will generally be found that various courses with constant
State parameters will differ from one another according to the actual
parameter values osen. e fact that there is ‘automatic budget reaction’
does not itself imply anything as to the nature of the development, until the
nature and size of the State parameters are indicated. Furthermore, it will be
found that some types of parameter anges reinforce and others moderate
the fluctuations in the economic development within the period in question.
us it seems quite pointless in general to say that ‘automatic budget
reaction’ works stabilizingly and ‘natural budget reaction’ destabilizingly.
It will readily be seen that the above argument is strengthened if we
define ‘natural budget reaction’ as a fiscal policy whi is only directed at
keeping the budget balance unanged, thus easing the more severe
restrictions we have hitherto placed on su a policy, namely that ea
separate type of income and expenditure is to be kept constant. e fiscal
policy of the ‘natural budget reaction’ then becomes even vaguer, and can be
aieved by still more combinations of State parameter anges.15
It is now obvious that the mere fact that with ‘automatic budget reaction’
an increase in the budget balance tends to arise during an upswing in
business activity, and a decrease during a recession, cannot be taken as a
proof that a budget with ‘automatic budget reaction’ works as a stabilizer.
Finally, we must point out that it is not even obvious that the budget balance
with an ‘automatic budget reaction’ is normally influenced as has been
supposed. If we imagine a situation of full employment, rising prices and
incomes, and a system of taxation where the income tax every financial year
is based on the incomes of a previous period, i.e. where the amount of
income tax can be taken as a State parameter, and where the indirect taxes
are based on the quantities produced, sold, etc., the automatic effect on the
tax revenues during the financial year will be zero. If the expenditures rise at
the same time due to the rise in prices, there will obviously come about an
‘automatic’ decrease in the budget surplus.16 Even if the ‘automatic budget
reaction’ extends over several financial years, the result may very well be a
permanent deterioration of the budget balance due to the time lag of the
income tax.

7. AUTOMATIC SELF-FINANCING
e budget automatism just discussed has an importance for the financing of
anges in the budget whi seems worthy of further consideration. A given
increase in expenditure (we are considering an expenditure item that
appears as a parameter) will, as a rule, by its influence on the economic
system, automatically lead to anges in other expenditures and in tax
receipts. e need for finance, whi arises in connection with the given
expenditure ange, will therefore as a rule be of a completely different
magnitude than the given primary expenditure ange. It is commonly
considered that in normal stable economic systems the result of an increase
in expenditure will, other things being equal, always be an increase in the
amount of notes in circulation plus State debts at call, but of a lesser amount
than the increase of expenditure. It can easily be proved that this does not
hold in general. ere is nothing to prevent an increase of expenditure
resulting in a straightforward decrease in the amount of notes in circulation
plus State debts at call, even if we keep exclusively to stable static models.
We shall show this by a few simple models, the first of whi is taken
from Eri Sneider, who seems to be the first to have observed the
possibility of increasing State expenditures resulting in a budget surplus in
an ordinary ‘stable’ Keynesian model.17 ese models also illustrate in an
impressive way the impossibility of using either a budget surplus or the
ange of notes in circulation plus State debts at call as an indicator of the
effects of the budget; since we disregard credit transactions and interest
payments, the budget surplus is identical with a decrease in notes in
circulation plus State debts at call.
(i) Sneider’s case occurs in models like the following, where the symbols
are: Y = national income, I = investment, C = consumption, Uv = State
expenditure on the purase of goods, Ut = State transfer payments, Tp =
personal income tax, B = budget deficit, tp = marginal rate of taxation and tt
= marginal rate of transfer:

us the model is an ordinary Keynesian model with two sectors, a public
and a private one. Firms and households are under the same heading. State
expenditures are partly purases of goods and labour, and partly direct
transfers; State income consists exclusively of personal income tax. State
expenditure on the purase of goods is regarded as a parameter. Transfer
expenditures and personal income tax are, on the other hand, considered
endogenous variables, i.e. functions of national income Y. e marginal rate
of transfer tt, is of course negative. us the system has as its endogenous
variables Y, C, Tp, Ut and B. Uv is the only parameter in the system whi is
anged. All other symbols are constants. If we write
Furthermore, it is seen that

If, therefore, the sum of the marginal rate of income taxation and the
(negative) rate of transfer exceeds 1, whi is of course a practical
possibility, an increase in State expenditure on the purase of goods will
lead to a decreased budget deficit (increased surplus) via the automatic
decrease in transfer payments and the increase in income tax. On the other
hand, if the sum mentioned is less than one, the increased purases of
goods will lead to an increased budget deficit, as in the usually considered
case. ∂Y/∂Uv is positive whenever μ exceeds zero, so that whether the budget
surplus is increased or decreased, we thus get an expansion of income, but it
is worth noting that in the case where tp+(—tt) > 1 the national income
multiplier is less than one.
(ii) We now transfer our aention to the following model in whi firms are
explicitly included. In addition to the symbols above, we have L = total
amount of wages, Tf = profits tax from firms and tf = rate of tax on profits:

is is a three-sector model with separate accounts for firms and

households. In explaining the model, we must point out firstly that the State
only has expenditures for purase of goods and services from the firms and
income from the taxation of profits, and secondly that no dividend payments
are made by the firms. Personal income will then be equal to the wage
incomes L; no income tax is paid on these and indirect taxation is also
excluded from the model. e third equation whi determines the wage
incomes, can be considered as a cost equation, where a is the fixed costs and
l the variable wage costs. If we write

Stability (or perhaps more correctly, a positive income multiplier) requires

that ∊ > 0, whi implies that

It is reasonable to suppose that c, l and tf are all positive and less than 1; i
must then be positive but may exceed 1. us it is found that

As tf is positive and less than 1, tf/(1—tf) is positive. It is then found that if

an increase in expenditure will lead to an increase of the budget deficit. If

an increase in expenditure will not affect the budget deficit. If, on the other
hand, i lies in the interval
the increased expenditures will lead to a decreased budget deficit (increased
surplus).
It is easy to see why this simple model leads to the seemingly paradoxical
result that an increase in State expenditure may have as its result an increase
in national income and a smaller budget deficit (larger surplus). When the
State increases its purases of goods, the profits and production of the firms
increase. us the wage payments made by the firms grow and household
consumption and saving rise. e growing profits within the firms—and it
should be noted that the profits grow in greater proportion than the national
income—provide taxes for the State and also incentives for increased
investments by the firms. It may obviously be imagined that investments
react more (absolutely) to the increase of profit than the saving within the
households does to the increase of wage incomes. e increase in
investments may also exceed the increase in the savings of the firms (whi
are equal to profits minus profits taxes). In comparing the increase in
investments and the increase in total private saving, the system may look
unstable, for private investment increases faster than private saving. ere
is, however, obviously nothing to prevent total private saving plus profits tax
from growing more rapidly than private investments. e system is then
stable and a new equilibrium may be aieved. In this new equilibrium with
an increased national income, an increased State saving must have been
brought about, because the increase of private investment exceeds the
increase of private saving; this, however, means that the increase in the tax
on profits must exceed the initial increase in the purase of goods by the
State.
Obviously, it may also be imagined in a model like this that an increase of
the rate of taxation, tf, leads to a lowering of tax-payments and an increased
budget deficit, while the national income is reduced.

8. CONCLUSIONS
e development of the various income and expenditure items in the State
budget over time is determined partly by the values of the State parameters
and partly by general economic developments. is has important
consequences.
In the first place there is no doubt that the fact that the budget is in itself
part of the economic development, must be of significance for the way in
whi this development takes place. It cannot be said in general whether the
budget in itself works in a stabilizing or a destabilizing manner on the
courses of economic developments. Su a question is mu too indefinite to
allow any definite answer. What can be done is to compare alternative
courses of economic development when fiscal policy parameters differ. is
possible power of the State budget to modify automatically the course of the
economy is a fact whi ought to be taken into consideration in economic
policy (and, of course, in economic theory as well). Is there not here the
possibility of creating an artificial ‘invisible hand’, whi, when it comes to
stabilizing the economy might be a great deal more reliable than the
economy’s own ‘invisible hands’? If this question can be answered
affirmatively, a rather important step will have been taken towards the
solution of the problem of full employment with stable value of money.
Secondly, this interaction between the budget and economic
developments serves to underline once again that it is not possible to
determine the effects of fiscal policy on the economy simply by reference to
the development of either the estimated or the final budget figures. e
budget is part of the economic development, but it is not among the basic
determinants of that development.

1. Ingvar Svennilson, Ekonomisk Planering (Economic Planning), Chapters

1 and 3; Erik Lindahl, Studies in the Theory of Money and Capital,
London 1939, Part I.
2. Cf. Bent Hansen, A Study in the Theory of Inflation, London 1951,
Chapters 2 and 7. e symbols are: A = sales, B = productive purases,
E = income, C = consumption, S = saving, I = investment, T = direct
d

taxes (subsidies), iT = indirect taxes (subsidies), 0 and 1 as subscripts

mean ex ante and ex post respectively. w, f and s as super-scripts to the
 right of the symbol mean workers, firm-owners and the State
respectively, g and l as superscripts to the le of the symbol mean goods
and labour respectively.
3. Erik Lindahl, Studies in the Theory of Money and Capital, p. 45. See also
Ragnar Bentzel and Bent Hansen, ‘On Recursiveness and
Interdependency in Economic Models’, The Review of Economic Studies,
1954–55.
4. Bent Hansen, A Study in the Theory of Inflation, pp. 29 ff.
5. As I understand it, su a policy falls under what Gunnar Myrdal called
‘natural’ budget reaction in his Finanspolitikens ekonomiska verkningar.
6. It seems to be this special case whi R. Turvey has in mind when he
thinks himself capable of constructing the ‘effects’ of the budget: see
‘Some Notes on Multiplier eory’, pp. 283 ff.
7. Lindahl in Penningpolitikens medel (Monetary Policy Means) is well
aware of this relationship, but does not observe that it may upset the
conclusion that an increase in State saving (Lindahl defines the budget
balance as being identical with State saving) also leads to an increase of
total saving ex ante, cf. p, 64.
8. Gunnar Myrdal, Finanspolitikens ekonomiska verkningar, third and
fourth sections, also Jørgen Gelting ‘Finansproces og konjunkturmodel’
(Fiscal Policy and Business Cycle Model), Nationaløkonomisk Tidsskrift,
Copenhagen 1943, and Lundberg Konjunkturer och ekonomisk politik
(Business Cycles and Economic Policy), Chapter 13. On the more
practical plane may be mentioned the Douglas Report, Monetary, Credit
and Fiscal Policies, Report of the Joint Commiee on the Economic
Report, Congress of the United States Senate, 81st Congress, 2nd Session,
Doc. No. 129, Washington D.C. 1950, also Förslag till ändrad
företagsbeskattning (Proposals for Revising the Taxation of Firms),
Swedish State Resear Publication SOU 1954: 19.
9. Gunnar Myrdal, Finanspolitikens ekonomiska verkningar. Section 2.
Chapter 2.
10. In certain special cases it can certainly be seen whether a stabilization of
the development has taken place. is is the case if the development
without ‘automatic budget reaction’ follows a sine-curve, while the
development with ‘automatic budget reaction’ is of the same type and
with the same periodicity, but with a smaller amplitude. Su cases will,
 however, be very special ones. Even very small parameter anges can
completely ange the dynamic properties of a system.
11. It hardly need be pointed out that we have used the term ‘neutral
budget’ in a completely different meaning from that common in the
bulk of the literature, where a ‘neutral budget’ is considered to be a
budget constructed in su a way that it corresponds to the individuals’
wishes concerning the composition and the size of the budget; see Erik
Lindahl, Die Gerechtigkeit der Besteuerung (e Justice of Taxation),
and Tibor Barna, Redistribution of Incomes through Public Finance in
1937, Oxford 1945, p. 11 f.
12. Monetary, Credit and Fiscal Policies, pp. 13 ff. See also Milton Friedman,
Essays in Positive Economics, Chicago 1953.
13. Jørgen Gelting, Finansprocessen i det økonomiske kredsløb, pp. 75 ff.
14. Gunnar Myrdal, Finanspolitikens ekonomiska verkningar, pp. 166 ff.
15. is is also admied by Myrdal in Finanspolitikens ekonomiska
verkningar, p. 167.
16. During galloping inflations this may be strengthened if the taxpayers
speculate by postponing their tax payments for as long as possible, see
The Course and Control of Inflation, e League of Nations, 1946,
Chapter 3.
17. Eri Sneider, Einführung in die Wirtschaftstheorie, Teil III, pp. 206–7.
 CHAPTER V

On Incidence
1. NEO-CLASSICAL INCIDENCE THEORY
NO doubt the most important contributions made by the older theory of
public finance lie within two limited areas: the theory of the extent and
structure of public finance (including the principles of taxation), and the
theory of the shiing and incidence of taxation. e former will not be dealt
with here,1 but incidence theory cannot be disregarded. It is of basic
importance in discussing the effects of fiscal policy and also admirably
illuminates the need for clarity in the question of means. We can thus start
from the neo-classical incidence theory,2 and study and criticize its
formulation of problems, in order to find out how incidence problems should
generally be dealt with. A survey of the literature shows that incidence
theory has not departed far in essence from the fundamental ideas to be
found in Marshall and Edgeworth—good representatives of neo-classical
partial incidence theory—and in Wisell—the creator of neo-classical total
incidence theory.
e partial incidence theory is well known. It is based on the usual partial
theory of price formation. e shape of the demand and supply curves (cost
curve) is decisive for the extent to whi the tax in question leads to an
increase in price, and also for the other effects of the tax (capitalization of
the tax, etc.). In this way we discover the extent to whi the tax is finally
paid by the buyers and the producers respectively.
If now the price elasticity of supply is denoted by ES, the price elasticity
of demand by ED, the amount of tax per unit by t, and the price increase by
Δp, we get the well-known Dalton formula3

Δp/t = ES/(ES+ED)
whi gives an approximate expression of that part of a (per unit) tax that is
shied to the consumers, via an increase in price, under perfect competition.
In the infinitesimal case, where t is ‘small’, the formula is exact.
e same sort of argument is applied to cases of pure monopoly and
imperfect competition. is part of incidence theory has of course developed
in step with the discovery of new forms of market, the invention of new
forms of taxation, and the development of the tenique of analysis itself.4
e partial incidence theory has been applied to all types of goods, factors,
claims, etc.
e neo-classical total theory of incidence has received less aention. e
reason for this may be that it is considerably more primitive than the partial
one, and also that its results have been given a mu more relativistic form
than the partial theory, due to certain methodological difficulties. us the
theory of total incidence oen is given the agnostic and not very useful
formulation that depending on the premises anything can be imagined to
happen, and the number of possible premises is so large that it is hardly
worth while examining any of them more closely.
To the economists of the neo-classical sool the special difficulty
involved in total incidence theory is that the effects of a tax cannot be
examined without determining how the tax revenues are to be used by the
State. is difficulty, first pointed out by Wisell,5 was further emphasized
by the Italians6 among others, and is nowadays quite a common point of
view.7 e neo-classical standpoint is that a balanced budget is a natural
assumption of the analysis; thus the income from taxation must either be
used wholly for new expenditures or to replace other State incomes. In
general, therefore, according to this way of looking at the maer, it is
impossible to examine the incidence and effects of a given ange in
taxation unless some definite assumption is made as to the nature of the
compensating budgetary ange. e most usual procedure has been to
oose a ange of income tax as the compensating ange, possibly due to
the conviction that income tax is ‘neutral’ with respect to consumption and
production. is method of analysis has, however, among other things, the
disadvantage that it excludes all discussion of the effects and incidence of
the income tax itself. Whatever way we look at the question of the total
incidence of a certain tax, there seems to be no definite answer. Although
Wisell himself pointed out the importance of this difficulty, he still
maintained that the question of how the State uses its tax funds has to be
distinguished from the problem of tax incidence. Against the baground
provided by Wisell himself it is difficult to understand how this is going to
be done. Even if we admit that in discussing the incidence of a tax there
must always be a compensating ange on the income side of the budget,
arbitrariness is not avoided; the compensating tax-ange can be made in
many different ways. It is obvious that the weakness of the neo-classical
total incidence theory is that the neo-classical economists never succeeded
in formulating the problem in a clear and unambiguous manner. is
ambiguity and relativity in posing the problem is, no doubt, the main reason
for the quite common, but basically faulty, opinion that the neo-classical
economists never succeeded in creating a total incidence theory.
e significance of the ‘Keynesian revolution’ for incidence theory is
negligible. Keynesian theoreticians have, oddly enough, believed themselves
capable of studying the ‘circulatory’ effects of taxes without taking any great
interest in the ‘discriminatory’ effects.8 Once the importance of fiscal policy
for the expansion or contraction of the national income has been discovered,
it is natural that questions of tax incidence seem less important (and less
interesting). Only a few aempts9 have been made to regenerate incidence
theory on a Keynesian basis. Although these go beyond the neo-classical
incidence theory, they have the disadvantage, shared by other Keynesian
theories, that the supply side is seriously neglected, just as with the neo-
classical economists it was the demand side whi was disregarded.

2. THE CONCEPT OF INCIDENCE

WITHIN the neo-classical theory of public finance we find a distinction
between the incidence of taxes and the effects of taxes. e terminology is
not very fortunate, and with many writers it is not at all clear what meaning
is to be aributed to the concept of the incidence of taxes in
contradistinction to their effects. e most reasonable interpretation, and
that whi accords best with neo-classical intentions, is that the expression
‘tax incidence’ refers to the influence of the tax upon the real net incomes of
the various individuals, or groups of individuals, or factors while the
expression ‘effects’ refers to all other effects of the tax. Incidence thus
becomes one particular effect among all the other effects of a tax.
Having defined the concept of tax incidence in this way, there is
obviously no reason to speak of incidence only in connection with taxes and
other State incomes. We could just as well speak about incidence in
connection with the State expenditure; we could then investigate how the
actual incomes of various individuals (or groups of individuals, or factors)
are influenced by measures taken on the expenditure side of the budget.
Instead of speaking of tax incidence therefore, we can speak about incidence
in a more general sense meaning the effect of a certain fiscal policy measure,
other things being equal, upon the real incomes in society in the long or
short run. It will now be evident that the whole problem depends on the
requirement that other things be equal. Starting from the discussion in the
previous apters on the part that fiscal policy and the budget play in the
economic system, and their place in the economic model, we shall now
examine more closely the expression ‘a certain fiscal policy measure, other
things being equal’ and try to arrive at a quite general—and consequently
also quite abstract—presentation of the total incidence theory.

3. THE GENERAL THEORY OF INCIDENCE

Having now defined incidence as the effects of fiscal policy on the real
incomes in society, it is obvious that our earlier discussion of the question of
whi variables ought to be counted as State parameters and whi ought to
be counted as endogenous variables is of immediate relevance. We can only
speak of effects in connection with parameter anges; to speak about the
effects of anges in some endogenous variable is quite pointless. If a certain
item of income or expenditure can itself be counted as a parameter, we can
therefore generally speak about the effects of a ange in that item, and thus
consequently about its incidence—its effects on real incomes. If the income
item in question is not a State parameter, but instead an endogenous
variable in the model, then a ange in that budget item cannot be ascribed
any definite ‘effect’, unless the parameter anges whi lie behind it are
specified, and for this reason it is pointless to speak about the incidence of
this budget ange in any general sense. Furthermore, whether a given
budget item is a State parameter or not, a ange in this item will normally
involve (or, be accompanied by) other (induced) anges in the budget, since
most of the budget income and expenditure items are endogenous variables.
is will mean that we cannot simply assume that one budget item is
anged and all others (apart from State ‘cash holding’) are kept constant,
and then look for the incidence of this budget ange.
Let us now suppose—to take the simplest case—that we wish to discuss
the incidence of a given ange (say, £ one million) in a budget item that is
itself a State parameter. If all other State parameters are kept constant all
budget items whi are endogenous variables in the model will be anged
in some way determined by the structure of the model. If, on the other hand,
all budget items other than the one whose incidence we are examining (with
the exception of notes in circulation and net debts at call) are to be kept
constant, this is possible only by suitable anges in certain of the other
State parameters; as a rule this can be done in many ways by means of
many diflferent combinations of anges in State parameters, see Chapter
III, 4. It then follows that the assumption of ‘other things being equal’,
cannot simultaneously cover unanged State parameters and unanged
budget items, excluding of course the parameter (budget item) in whi we
are interested. We are compelled to make a oice. If we oose to let ‘other
things being equal’ mean unanged budget items (apart from the budget
item studied), the difficulty will arise that the incidence of the ange in any
given budget item will be indefinite, as the other budget items can usually be
kept constant in many diflferent ways, by means of many different
combinations of parameter anges. It thus seems evident that, when
investigating the incidence of a ange in a budget item whi is itself a
State parameter, ‘other things being equal’ has to mean unanged State
parameters and not unanged budget items. Otherwise the effect on real
incomes of the ange in the selected parameter (budget item) cannot be
developed.
If we now proceed to the case where the budget item whose incidence we
wish to study is not itself a State parameter, we immediately meet the
difficulty that the ange in the budget item in question can be brought
about by State parameter anges of many diflferent kinds. Furthermore, if,
along with a certain ange in su a budget item it is desired that all other
budget items remain unanged, we have to select a set of State parameter
anges whi has the power of bringing about the desired ange in the
selected budget item while leaving all other budget items unanged; in
general there are many different sets of State parameter anges whi have
this power but their respective effects on the remaining endogenous
variables in the model may be quite different. is case, therefore, shows not
only that we ought to let ‘other things being equal’ mean unanged State
parameters (apart from the one studied), but also that the primary concern
of the theory of incidence must be to study the incidence of anges in the
State parameters, and not the incidence of anges in the budget income and
expenditure items.
Naturally the incidence of a certain fiscal policy measure will not
generally be the same in the short and in the long run, see Chapter II, 4. If
we examine a dynamic system in movement, the development of incidence
over time can be studied; if we are considering a system whi shows no
tendency to become stationary, then obviously we cannot speak of any
definite ‘final’ incidence.
e conclusion to be drawn from this is that when we define incidence as
the effect on the real incomes in society of fiscal policy measures, other
things being equal, ‘fiscal policy measures’ ought to be interpreted as
anges in State fiscal policy parameters, and ‘other things being equal’
ought to be interpreted as implying that all State parameters other than the
one being investigated are kept constant. Incidence theory thus becomes a
special part of the study of the effects of anges in the State parameters.

4. SOME PROBLEMS OF INCIDENCE THEORY

It is, therefore, clear that the groundwork of incidence theory ought to be
the study of the effects on real incomes in society of particular anges in
the fiscal policy parameters. is is wholly in accordance with the neo-
classical partial incidence theory, whi, I believe, always examines the
effects of isolated anges in entities whi can be regarded as fiscal policy
parameters in the true sense (tax rates, etc.). is in no way implies,
however, that it is not legitimate to study the joint effects of combinations of
parameter anges. Interest is doubtless oen concentrated on su
combinations of parameter anges (whi are not necessarily exclusively
anges of fiscal policy parameters—monetary policy parameter anges can
also be taken into account), whi if taken together have the power to fulfil
certain conditions under whi it is desired to investigate anges in real
income. is particularly concerns the problems of total incidence theory.
Let us briefly recapitulate what it means to let isolated parameter anges
serve as a starting point for incidence theory. If, for example, we enquire
into the incidence of income tax, this means that we wish to know the
effects on real incomes (at some definite point of time or over time) of a
certain increase in the rate(s) of income tax, other things being equal as
regards all other parameters. e increase in the rate(s) of taxation may lead
to a certain contraction of production and employment and to a certain
reduction in total disposable real income (aer taxation) and a redistribution
of incomes to the advantage of the wage-earners, to certain anges in State
income and expenditure (and in the budget balance), e.g. an increase in the
amount of income tax, a decrease in receipts from indirect taxation an
increase of social welfare payments, etc. In this way, the effects on real
incomes of an increase in the level of taxation can be isolated. In section 3
this was stressed as an obvious aim of theory. But it does not always follow
that it is these isolated effects whi are required in economic policy. e
problems of economic policy will oen take the form of a complex of many
different parameter anges; see the treatment of su problems in Chapter
I. In the example just mentioned (the increase in the rate(s) of income-tax)
many (indirect) anges arose in other budget items. But the problem might
have been to aieve the effects that arise from an increase in the amount of
income tax, brought about by an increase in the rate(s) of income taxation
combined with su other fiscal policy parameter anges as will keep all
other budget items unanged. Su a problem becomes definite as soon as
the parameter anges that are to be applied are specified. None of this
conflicts with the conclusions of the previous section. e overall effect of a
complex of parameter anges is (at least for small anges) equal to the
total of the effects of the separate parameter anges; therefore it is
important to investigate these as necessary for the treatment of more
complicated problems.
Similarly, it is obviously also quite legitimate to put the following
question, whi is closely related to the neo-classical (Wisellian)
formulation of total incidence theory: what will be the incidence of a certain
increase in the rate(s) of income tax when combined with certain other
specified State parameter anges, whi, taken together, have the effect that
the yield of income tax will rise by a certain amount while, say, the yield of
a general consumption tax falls by the same amount, all other items in the
budget remaining unanged, so that the budget balance remains
unanged. e assumption of a balanced budget is self-evident in neo-
classical total incidence theory (but obviously not so in neo-classical partial
incidence theory). It need not, however, be in conflict with other types of
premise for the investigation of incidence, su as the more ‘modern’
assumption that employment shall be maintained at a certain level. For
instance, the problem can be posed in this way: how are real incomes
affected if the rate of income tax is raised so as to increase its yield by a
given amount, while at the same time other specified fiscal policy
parameters are altered in su a way that both the budget-balance and
employment are kept unanged?
Let us illustrate the laer problem more formally starting from the
general model (I: 1) in Chapter I. e amount of income tax Tp, is to be
increased by, let us say, k, while the budget balance B (defined in a certain
way) and employment N, are to be unanged; thus we have three
conditions to be met by anges in the State parameters:

dTp =k
dB = 0
dN = 0.

If the rate of income taxation is denoted by a1, and we also select for use
the two State parameters a2 and a3, we get the three following equations to
determine the extent of the anges in these State parameters (the
derivatives are calculated with respect to the whole model in the usual way):
 If the solutions of this system of equations are da1*, da2*, da3*, and the
real income of a certain factor is denoted by x1 we find the incidence dx1,
with respect to this factor from the expression:

It is obvious, however, that the size of dx1 will depend entirely on whi
State parameters we oose to supplement a1 in order to aieve the three
ends (conditions). It is for this reason that specifications of the State
parameter anges will be necessary if unambiguous answers are to be
obtained on questions of incidence.
Many conditions can be imagined whi are to be satisfied by the State
parameter anges whose incidence is to be examined. It cannot be said here
that any particular problem or problems would be more natural or general
than any others. e way the problem was formulated by the neo-classical
economists (when clarified) is just one among many.10 However, it is of
special interest in this context to study the condition that employment must
not be affected by anges in the fiscal policy parameters (or is perhaps to be
affected in some special way); then incidence is investigated on the
condition that a certain level of employment, especially full employment, is
maintained. Su an investigation of incidence is of obvious interest when it
comes to estimating the effects on the price level of a fiscal policy whi is
intended to maintain full employment in all circumstances.11 If one further
condition is added, namely that the price level (in some well-defined sense)
is to be kept constant, we obtain valuable knowledge concerning the State’s
possibilities of influencing real incomes under a policy of full employment
where the price level is also to be kept constant. Conditions of this type will
thus play a prominent part when we proceed in Part III to study in more
detail how real incomes are affected by fiscal policy.
An important consequence of this is that normally one cannot talk about
the incidence of the income and expenditure amounts in the budget, in the
sense that the incidence should indicate how these amounts are ‘distributed’
among the real incomes of the various economic subjects. e sum of the
anges in real incomes caused by a certain fiscal policy measure may, of
course, amount to a quite different total from the aggregate anges in the
income and expenditure items in the budget. Let us examine the example
given above where a certain increase in the yield of income tax is brought
about by an increase in the rate of taxation combined with su other fiscal
policy parameter anges as keep all other budget items unanged. e
model can very well be imagined to be su that this complex of fiscal policy
measures brings about a total reduction of real incomes, whi, due to a fall
in employment, etc., greatly exceeds (or perhaps falls short of) the increase
in the amount of income tax. It is meaningless to say here that incidence
expresses the way in whi the amount of income tax is shied and finally
comes to rest as a ‘burden’ (of equivalent amount) on certain economic
subjects. e neo-classical economists were, with their partial incidence
theory, well aware of the fact that the total ‘loss’ following the introduction
of a tax may differ from the State’s income from the tax,12 but this is oen
forgoen in discussions of total incidence (see below).
Finally, let us look at a question in incidence theory, whi, in spite of its
apparent importance, has no definite answer. e reason for this is its
ambiguity. Let us assume that the fiscal policy parameters are kept constant,
and that a certain expansive course in the economic system leads to an
(automatic) increase in the tax revenues and in certain expenditures in the
budget. en we may ask who is ‘hit’ by these budget anges, especially by
the increase in tax revenues; what we are seeking is thus the incidence of the
budget anges. From our previous discussion in Chapter IV it is clear that
put in this general way the question has no definite answer. We are here
concerned once more with the problem of the automatic effects of the
budget. e question is, really, what real incomes would have been if the
State, by appropriate parameter anges, had kept all budget items constant,
with the consequent effects on the course of the economic development
itself. As has been stated earlier in Chapter IV, 4, the answer to su a
question depends entirely on whi means (parameters) are osen to
maintain the unanged budget, and normally many su combinations of
means are possible. Even if we specify su a combination of parameter
anges, we still have to contend with the fact that the sum of the anges in
real incomes does not stand in any simple relationship with the budget
anges.
What has just been said about the impossibility of ascribing to a certain
ange in the budget, a definite incidence (equal in amount to the budget
ange), is of great importance for a certain type of empirical investigation
into the effects of fiscal policy. ite oen the question arises of how public
finance, especially taxes and subsidies, affects the distribution of income in
the community.13 Here, one starts from the given distribution of ‘pre-tax
income’ and then, according to certain simple assumptions about the
incidence of taxation, distributes taxes and subsidies quite meanically
among different income groups in order to arrive at their ‘disposable
incomes’. A comparison between the pre-tax incomes and the disposable
incomes in a certain year is then taken as an expression of the State’s
influence on the distribution of income.14
As has been pointed out elsewhere, it is extremely dubious what su a
method of procedure really involves, and how the statistical results are to be
interpreted. We will not go further into this question here, but only indicate
that it is not possible in this way to get to know either what the total
amount of disposable incomes would be, or what the distribution of
disposable incomes would be, if all taxes and subsidies were removed.15 It is
even more dubious to start comparing different points of time, between
whi anges in State income and expenditure items have taken place. As
these anges have normally been caused not only by anges in the fiscal
policy parameters but also by exogenous disturbances and by economic
developments in the meantime, the observations we have been making
above become immediately relevant. Under the above conditions, whi are
almost always fulfilled, there is just no definite answer to the question of
how the taxes and subsidies have influenced the distribution of incomes
from one point of time to another.
For the sake of completeness we must also add that this type of empirical
investigation obviously cannot be taken as supporting one or other
hypothesis of how the shiing of the tax burden takes place in reality. Here
it is assumed that the shi takes place in a certain way, but these exercises in
national accounting involve no test of the hypotheses. On the whole,
empirical investigations into incidence are practically non-existent.

1. As examples, see Erik Lindahl, Die Gerechtigkeit der Besteuerung, and

A. C. Pigou, A Study in Public Finance, ird ed., London 1947.
2. A detailed description of classical incidence theory is to be found in E.
R. A. Seligman, The Shifting and Incidence of Taxation, Fourth ed., New
York 1921.
3. Dr. Hugh Dalton, Principles of Public Finance, London 1929, pp. 51 ff.
4. See O. Mehring, The Shifting and Incidence of Taxation, Philadelphia
1942; H. M. Somers, Public Finance and National Income, Philadelphia
1949, Part III; P. Nørregaard Rasmussen, ‘Nogle Træk af
Overvæltningslæren’ (Some Notes on the eory of Incidence),
Nationaløkonomisk Tidsskrift, 1947.
5. Knut Wisell, Finanztheoretische Untersuchungen (Inquiries into the
eory of Public Finance), Jena 1896, p. 6 f.
6. See D. Bla, The Incidence of Income Taxes, London 1939.
7. Frederic Benham, ‘Taxation and the Relative Prices of Factors of
Production’, Economica, London 1935; R. W. Shephard, ‘A Mathematical
eory of the Incidence of Taxation’, Econometrica, 1944.
8. Gelting’s term; see his Finansprocessen i det økonomiske kredsløb, p. 41.
9. M. Kalei, ‘A eory of Commodity, Income and Capital Taxation’,
Economic Journal, London 1937. C. Welinder, ‘Grundzüge einer
dynamisen Incidenztheorie’ (e Basis of a Dynamic Incidence
eory), Weltwirtschaftliches Archiv 1940. See also the discussion on the
effects of a ‘sales tax’ in the Journal of Political Economy.
10. See R. W. Shephard, ‘A Mathematical eory of the Incidence of
Taxation’ cited above.
11. See Bent Hansen, ‘E bidrag till incidensläran’ (A Contribution to
Incidence eory), Ekonomisk Tidskrift 1954.
12. With a per unit tax the total amount of the tax is less than the total of
loss of ‘consumers’ surplus’ and ‘producers’ surplus’, according to a
well-known line of thought.
13. Su investigations have been made in many countries. We may refer
here to Erik Lindahl, Undersökningar rörande det samlade skattetrycket
i Sverige och utlandet (Investigation into the Total Burden of Taxation in
Sweden and Abroad), Swedish State Resear Publication SOU 1936: 18;
Tibor Barna, Redistribution of Incomes through Public Finance in 1937;
Ragnar Bentzel, Inkomstfördelningen i Sverige (Income Distribution in
Sweden), Stoholm 1952.
14. See, for instance, Ragnar Bentzel, Inkomstfördelningen i Sverige.
15. See my review of Ragnar Bentzel’s ‘Inkomstfördelningen i Sverige’, in
Ekonomisk Tidsskrift 1953.
 CHAPTER VI

A Classification of the Means of Fiscal Policy

1. ECONOMIC MODELS AS DEMAND-SUPPLY SCHEMES
THE previous apters have taken as their starting point the completely
abstract model (I: 1) of Chapter I, where neither the form of the equations
nor the endogenous variables and parameters have been specified. Together
with a certain prior knowledge of the actual behaviour of the State and the
peculiarities of economic life, this abstract model was sufficient for the
discussion of several basic questions. If we want to continue further a more
definite form must be given to the model. To ease the transition to Part II,
where we shall investigate the manner in whi fiscal policy parameters
may be included in the equations of the model, in this apter we shall
conclude our general theory of fiscal policy by aempting, on the basis of a
definite but still quite general description of the model, to aracterize the
fiscal policy measures, regarded as disturbances in this model. In this way
we arrive at a (by no means exhaustive) classification of fiscal policy means.
Starting from the usual conception that all economic entities either consist
of prices or quantities (or relations between them), we immediately conclude
that all equations in the model, however constructed, must have something
to do with the determination of prices and/or quantities. In accordance with
this all equations of the neo-classical interdependence system are equations
of supply and demand (plus conditions for equilibrium between the
quantities demanded and supplied). In addition to equations whi explain
supply and demand, whi must be defined here as purasing plans, sales
expectations, production plans, etc., equations explaining price fixing are
also necessary within the general dynamic theory presented by the
Stoholm Sool, but the theory can still be said to be essentially a supply
and demand theory. Turning to the more recent, and especially the
Keynesian, macro-theories, we find that here too the equations in the models
are to be regarded as being based on and developed from supply and
demand relationships, although this is not always made clear. erefore, it
seems natural to put the fiscal policy parameters in relation to su general
supply and demand semes in order to arrive at a classification or, perhaps
more correctly, a list of types of budget policy parameters whi differ from
this point of view. Thus we shall use the ‘immediate’, ‘partial’, effects of the
parameter changes as the criterion for classifying the parameters.
We shall
also make some mention of certain aempts that have been made to deal
with the total effects of su parameter anges in general interdependent
systems of the neo-classical type.
e ‘immediate’ or ‘partial’ effects whi we referred to above have to a
certain extent been dealt with in the classical theory of the incidence and
other effects of fiscal policy. We have thus already toued upon the problem
in the previous apter.
In order to clarify maers, let us start from the general model of Chapter I
and link it with the illustration of the neo-classical theory of the incidence of
a unit-based commodity tax. e supply curve represents the first equation,
φ2 = 0, and the demand curve the second equation, φ1 = 0, in the model (I:
1); the endogenous variables x1 and x2 denote price and quantity
respectively of the good in question. e neo-classical discussion of a
commodity tax then corresponds to the first and second equations being
extracted from the model and regarded as an independent model (consisting
of two equations) where other endogenous variables, x3, …, xn are kept
constant and where, say, the parameter a1 represents the tax rate. e neo-
classical theory then examines the terms ∂x1/∂a1 and ∂x2/∂a1 calculated by
total differentiation of these two simultaneous equations: for this is
equivalent to studying the way in whi the equilibrium point is affected.
ese two derivatives are of no interest in the total analysis. e neoclassical
theory, however, also examines the four derivatives ∂x1/∂a1 and ∂x2/∂a1
calculated for ea separate equation (this means that we study how supply
and demand curves are moved), and these derivatives are naturally of
fundamental importance not only to the partial but also to the total analysis.
e neo-classical economists, it is true, wanted to find the effect on price and
quantity by comparing the two equilibrium positions, before and aer the
introduction of the tax, but in order to arrive at that, the effects of the tax on
the supply curve and the demand curve had first to be examined, and the
effects of the tax in this sense remain, of course, in a total analysis as a basis
for determination of the total effect of the tax. It is in this sense that we
speak about the ‘immediate’ or ‘partial’ effects of the State parameters.
In section 2 we will deal with the case in whi the State budget
parameters directly influence prices, that is, the case where the State
parameters themselves consist of certain prices, and in section 3 the case
where the State directly influences supply or demand. In sections 4 and 5 we
shall then deal with the cases where the fiscal policy parameters have an
indirect effect on prices or supply and demand respectively, by influencing
the plans and actions of private economic subjects. In the remaining sections
we will deal, among other things, with the inadequacies of the usual
demand-supply seme as an instrument of analysis.

2. OFFICIAL PRICE POLICY

In some cases the State directly determines the prices of certain goods and
services; we disregard for our purposes here general and special price
controls whi cannot normally be reoned as a fiscal policy means.
Consequently certain prices can be considered as State fiscal policy means.
is, of course, presupposes that the State itself buys or sells the goods in
question and is in some way a monopolist (monopsonist) in the market. As a
significant example of this we can mention the rates and prices arged by
State undertakings, whi in Sweden, for example, are normally determined
by the State (whi includes public enterprises). Even if the State industries
are not directly accounted for in the budget other than by net profit,
depreciation and investments, it is no doubt reasonable to regard the State
industries’ rates (prices) as fiscal policy means. We also ought to regard as
State selling prices the fees that are arged for the many services whi the
State puts at the disposal of the private sector. In addition to these cases
where the State itself is a producer, the State can also be considered to
regulate a market price by purases for and sales from buffer stos, so that
su prices must also be regarded as State parameters and fiscal policy
means.
 In all su cases naturally both the primary and the ultimate effect on the
price is obvious, and the primary effect on the price level is also quite clear.
On the other hand, it is not obvious what the effect on the price level will be
when regard is paid to all relationships in the system and to the
development of the system.
In its function as a buyer the State also determines prices in certain cases,
especially where the hire of labour is concerned. In many countries the State
determines (at any rate in the final instance) civil service salaries and the
wages of other State employees. If the call-up of national servicemen to the
army is regarded as hire of labour, then the State in this case determines
both price and quantity. As to purases of goods, it is perhaps less common
for the State to determine the prices (if purases for buffer stos are
excluded). However, in times of general price control the State will in
principle determine all prices and thereby also the prices of its own
purases. If it is the duty of firms to deliver goods to the State (whi is by
no means unusual in times of war) it can be assumed that the State
determines both the quantity and the price. As in the case of the national
servicemen, the State thus has two parameters for controlling one
expenditure item: see the discussion in Chapter IV, 4, on the number of
budget items and the number of parameters.
Wherever the State directly determines prices, the immediate effect on the
quantities involved can in theory be read off from the ordinary (partial)
demand curve. What the effects on the amounts involved will be if regard is
paid to everything in the system is more uncertain.

3. THE OFFICIAL DEMAND AND SUPPLY

It is perhaps more unusual for the State directly to determine the total
turnover of a given commodity in a community. If we exclude rationing,
whi in general cannot be regarded as a fiscal policy means, this would
involve that the State is the sole buyer or seller of the good concerned. In
cases where the State is in this position in the market, as a rule, it uses price
as the parameter and, if we exclude the special cases mentioned in the
previous section, this implies that it has refrained from determining
turnover.
 On the other hand, the State obviously has a direct influence on turnover
(but not by means of the prices) in those cases where it demands and
supplies definite quantities of goods. As we have already mentioned, this is
true of an important part of the purase of commodities by the State. For
instance, an increase in purases by the State has the same effect as a shi
to the right in the demand curve for the good in question. Moreover, in those
cases where definite quantities are not involved but where the State’s
demand curve for the commodity in question must be considered the State
parameter (see Chapter IV, 3, Fig. IV: 1), then the ange in the State
parameter can be regarded as a shi in the market demand curve.
Now it is a very usual, and indeed a very reasonable, hypothesis that the
immediate effect of su an autonomous increase in the demand from the
State is that the firms in the market raise their prices and/or increase the
amount produced. With the variety of different types of market whi occur
in real life it is not possible, however, to take it for granted that this
hypothesis will always be correct. Falling marginal costs may mean that an
increase in demand leads to a decrease in price; or a baward sloping
supply curve of labour can mean that an increase in demand leads to a fall
in the amount supplied, etc.
It is, of course, even more difficult to say anything about the total effects
of an autonomous increase in demand. However, it is worth noting that
aempts have been made to answer this very question within static
equilibrium theory, in connection with the discussion of the properties of
general interdependence systems of the Walras type. e question can be
answered given certain conditions. J. R. His1 has shown that in a general
static interdependence system whi fulfils certain stability conditions, and
whi is disturbed through an isolated increase in demand (or reduction in
supply) in the market for a certain good, the new equilibrium price (relative
to all other prices) of the good concerned will be higher than in the initial
state of equilibrium. Under similar conditions this conclusion, whi is one
of the few general conclusions whi have been arrived at within the
general interdependence theory, will also hold for a special type of dynamic
development in a general interdependence system whi is not in
equilibrium.2
 Unfortunately, the value of this is limited. His’s solution is valid for
static systems, while fiscal policy ends are oen concerned with correcting a
particular disequilibrium so as to regulate a dynamic course of development.
As has been mentioned, His’s results will also hold for certain dynamic
models, but they are of a very special nature. Furthermore, closer
examination will show that His’s results are based on several explicit or
implicit assumptions of a less obvious nature.3

4. INDIRECT INFLUENCE BY THE STATE ON SUPPLY AND DEMAND

Even when the State does not influence supply or demand in the market by
its own supply or demand, the effect of State parameter anges can in
many cases be treated as the effects of anges in supply or demand. is
holds for all those items in the budget whi usually come under the
heading of direct taxes and direct subsidies. Here money is given to or taken
from households or firms either in fixed amounts or by the application of a
tax scale. e immediate effects of anges in the parameters whi are
connected with su items can therefore be dealt with via the anges in the
supply and demand of households and firms that they indirectly bring
about. If these basic anges in supply and demand are known—the most
important task of Part II of this work is to examine them—the argument can
follow the same lines as in the previous section.
In this group of State parameters must also be included the public
consumption whi benefits households in the form of free services from the
State. It is obvious that services, su as free sool meals, received from the
State may affect the disposal of household incomes just as mu as the
receipt of ildren’s allowances.
Perhaps we should explain more closely what we mean when we call
public consumption a fiscal policy parameter. We consider that what is
usually called public consumption is divided firstly into the ‘production’ of
public services and secondly into the ‘consumption’ of public services. e
production of public services necessitates purases of goods and labour; the
fiscal policy parameters in connection with this have already been discussed
in section 3 (and 2). e consumption of public services will, to a great
extent and more or less directly, be to the advantage of private economic
subjects; here it is sufficient to point out that in certain cases it is quite
obvious that public consumption is in fact private consumption provided
free, and in su cases it is also reasonable to say that the State has at its
disposal parameters consisting of public consumption.

5. THE EFFECTS ON BUSINESS COSTS

Indirect taxes and subsidies may be regarded as working via the planning of
the firms, and as a rule an indirect tax or subsidy is considered as an
addition to or reduction of the costs of the firm. e actual form of the tax or
subsidy will be decisive for the effects on the amount produced or the price.
It is well known from neo-classical partial theory that an indirect tax will
‘normally’ raise the price somewhat and an indirect subsidy will bring about
a certain reduction in the price of the commodity in question. It would be of
interest if the result could be extended to cover also the total effect when
regard is paid to all relationships in the economic system.
L. A. Metzler4 has shown that for a static model of the Leontief type,
under certain conditions whi have a certain similarity to His’s stability
conditions, an indirect tax (subsidy) on the production of a certain
commodity will always bring about a price increase (decrease) for the
commodity concerned, even when regard is paid to all the secondary effects
in the system. It seems probable, although it has not been proved, that this
result can also be extended to apply to static interdependent systems of the
Walras type, and also for dynamic developments of the type mentioned in
section 3, in su a way that it could be said that an indirect tax on some
goods will normally bring about an increase in the relative price of the
goods concerned and (in the dynamic case) to a reduction in the excess
demand (increase in the excess supply) of all goods, and a decrease in the
speed of price rise for all goods. is applies at least to certain special cases.5
As a complement to His’s result, Metzler’s result could have great
importance in public finance. In addition to the arguments to be advanced
against His’s theory, Metzler’s disregards all forms of substitution.
at part of public consumption whi comprises the provision of free
services to firms, thus reducing their costs, must also be included within the
same group of State parameters as indirect taxes and subsidies. e effect of
su public consumption should obviously be partly of the same nature as
an indirect subsidy.

6. THE EFFECTS ON THE BEHAVIOUR OF ORGANIZATIONS

Up to now the classification of the means of budget policy has been outlined
on the basis of the fundamental idea that all relationships in the model are,
in the last analysis, based on the concepts of supply and demand. Behind
these demand-supply relationships, including the price-ange equations, we
find active economic subjects who by their actions try to place themselves in
as favourable a position as possible. ese subjects are the households and
the firms whi are assumed to aempt to maximize utility or profit
respectively.
However, it is obvious that in a modern capitalist society there are
economic subjects whose actions cannot easily be fied into the framework
of an ordinary demand-supply seme; these economic subjects may be
called ‘institutions’ or ‘organizations’. ey are oen treated as non-
economic subjects, and their activities are thus considered as ‘shos’ whi
the economic system receives from outside. e explanation of the activities
of institutions and organizations is simply omied from the framework of
the model. In certain cases this may be both convenient and necessary—
indeed the State is and must be treated in su a way here—but in many
cases it is unsatisfactory to leave these activities unexplained.
As an example of this we may take wages, i.e. money wages, whi in a
modern community are to a great extent determined by negotiations
between the organizations in the labour market. To explain the movement of
money wages exclusively by reference to supply of and demand for labour is
hardly possible due to the fact that it is not the trade unions that supply
labour and the employers’ associations whi demand it. It is the households
whi supply labour and the firms whi demand it. By this is not meant
that the trade unions and employers’ associations cannot try to influence the
households’ supply of labour and the firms’ demand for it. During a strike or
lo-out obviously su influence occurs, and something similar takes place
when the organizations come to an agreement on the number of
apprenticeships there are to be within a trade. Nor is it to be denied that the
demand-supply situation in the labour market can exert an influence on
wage negotiations. But it is still obvious that a general reference to the
supply and demand for labour does not normally suffice to explain the
outcome of a wage negotiation. Here other theoretical tools must be used.6
Game theory is one example.7 But from this it is clear that fiscal policy
means may have effects whi do not emerge from an examination of
anges in supply and demand. A fiscal policy means tending to reduce the
demand for labour may, if it also raises the price level, very well tend to
raise money wages through the reactions of the trade unions. An exhaustive
description of the effects of using fiscal policy means must accordingly pay
regard to the reactions of all organizations and institutions to fiscal policy.

7. STATE LOAN POLICY

In Chapter II, 2 we drew a distinction between fiscal policy and monetary
policy according to whi State loan policy belongs to monetary policy.
ere we tried to distinguish between monetary policy transactions, whi
include all State purases and sales in the credit markets (including the
exange market), and all other transactions, whi are called fiscal policy
transactions. In connection with fiscal policy transactions there exists a
greater or lesser number of so-called fiscal policy parameters (means); in
connection with the monetary policy transactions we have monetary policy
parameters. On this is based our classification of State parameters between
monetary policy and fiscal policy: the monetary policy parameters
symbolize measures in connection with monetary policy transactions, the
fiscal policy parameters symbolize measures in connection with other
transactions. Both the fiscal policy and the monetary policy transactions in
the overall budget (comprising all the transactions of all public institutions)
will be reflected in the current amount of notes plus official (net) debts at
call, i.e. in the private sector’s quantity of State means of payment. A
difference between fiscal policy payments and receipts implies a ange in
the State’s net debt (if the current amount of notes and the State’s debts at
call are included in the debt); the monetary policy transactions, on the other
hand, do not imply any ange in the net debt.
It is tempting here to come to the conclusion that we have successfully
defined away the entire problem of the public debt from the realm of fiscal
policy and transferred it to monetary policy. Since anges in net debt
appear quite simply as a result of all the fiscal policy transactions, the
ange in net debt may be regarded as a particular concept of budget
balance (see Chapter III, 4), and thus cannot in itself be ascribed definite
total ‘effects’. e payments whi are decisive for the composition of the
net debt, on the other hand, seem to belong to monetary policy. However, no
‘iron curtain’ has in fact been drawn between questions concerning the size
of the net debt and questions concerning its composition.
For if we turn from the transactions themselves to the fiscal and monetary
policy means (parameters), it is soon realized that the State generally cannot
ange its fiscal policy parameters without also affecting the composition of
the net debt. Even if all monetary policy transactions were themselves State
parameters, anges in fiscal policy parameters would normally lead to a
ange in the current amount of notes and/or debts at call. However, if these
are included in the net debt, its (relative) composition will thus
automatically have been anged by the ange in the size of the net debt
itself. And it is obvious that fiscal policy can influence the rate of interest,
through its effects on private saving and investment and the demand for
cash, and, accordingly, on private demand and supply of credit, just as
monetary policy can. On the other hand, if not all monetary policy
transactions are parameters in themselves, those monetary policy
transactions whi are endogenously determined will normally be affected if
some fiscal policy parameter is anged; for instance, if the monetary policy
authorities maintain certain interest rates (in connection with State loan
activities, sale of treasury bills, etc.) or exange rates, the monetary policy
transactions in connection with these will, of course, be affected by all the
anges in the system, and thereby the composition of the net debt will be
influenced. In the same way, the anges in monetary policy parameters will
normally have an indirect influence on the size of the net debt, by its
influence on the whole of the economic system and thereby on the fiscal
policy transactions.
We have osen to make a distinction between the parameters of fiscal
policy and those of monetary policy. e question arises, however, whether
the effects of these two groups of parameters are really so different that they
justify any sharp distinction between the two kinds of policy.
 Even if there is good reason for classifying the State’s parameters
according to the immediate effects of anges in them, a classification on
those lines need not necessarily lead to the result mentioned. An increase in
the level of income tax need not necessarily lead to a decrease in the
demand for consumer goods or capital goods (if income is used directly for
financing of private real investment); the effect may also be a decrease of
private (planned) monetary saving and with that a decreased supply of
credit and a tendency for interest rates to rise. An increase in the level of
taxation can, therefore, very well be a step whi primarily affects the credit
markets. Normally an increase in taxation would be expected to bring about
a decrease in the demand for both consumer goods and claims; and in
special cases the whole effect may even be a decreased demand for (or
increased supply of) claims, with a consequent tendency for the rate of
interest to increase; death duties and property taxes are typical examples of
this and taxation of windfall profits and progressive income tax may also be
imagined to have their major effects on the credit markets.
On the other hand, cases may be imagined where State borrowing leads
primarily to a decreased demand for goods and leaves the credit market
untoued. Even if compulsory saving imposed on smaller incomes is
disregarded, (here it is quite evident that the most important effect may be a
reduction in the demand for consumer goods), it can very well be imagined
that the credit market is organized in su a way, and reacts in su a way,
that an increase in State borrowing outside the central bank will lead to a
corresponding decrease of credit facilities given to private firms and
households by the credit institutions. e primary effect of the State
borrowing will then be a decrease in demand for capital goods by the firms
and/or purases of durable consumer goods by the households. ere is not
necessarily any effect on the rate of interest. Furthermore, the credit market
is not altogether homogenous, but is divided into a number of more or less
‘non-competing’ sections. ere are, then, several rates of interest, and it is
possible that on some of these taxation may have a stronger effect than State
loans. is may be the case if there is a special section of the credit-market
where households normally deposit their saving, while the State turns to
other sections when borrowing.
ite formally the effects of both fiscal policy and monetary policy (loan
policy) are analysed in the same way, namely by studying the effects of
certain State parameter anges. But since there is some reason to expect
that the dissimilarities between the effects of anges in the various tax
parameters are greater than the dissimilarities between the effects of anges
in certain tax parameters on the one hand and loan parameters on the other,
there is also some reason to question the distinction between fiscal policy
and monetary policy, especially loan policy. However, it is likely that the
effects on the level of interest will be stronger (both in the short and in the
long run) with monetary policy measures than with fiscal policy measures
in general, and this may justify the distinction. If it is desired to influence
the level of the rate of interest, monetary policy measures are generally the
more efficient.
It will now be realized that the distinction, so favoured in the literature of
public finance, between ‘expenditure finances by taxes’ and ‘expenditure
financed by loans’ is hardly likely to prove a very fruitful basis for the
analysis. On one hand, the effects of these two types of budget anges are
quite indefinite as long as the parameter anges whi led to them have not
been specified. On the other hand, in certain cases the effects of the two
types of budget ange can be expected to be quite similar: see above.
Despite this, it is, of course, still possible to formulate the problem so that it
consists in comparing two situations in whi a certain expenditure increase
is combined with su other parameter anges that all budget items
(including the current amount of notes and debts at call) are kept
unanged, except for a certain kind of tax revenue on the one hand and a
certain type of loan on the other. Su problems are not, however, primary
in the analysis; for we are here concerned with the problem of comparing
the joint effects of certain combinations of State parameter anges. What is
basic to the theoretical analysis of both loan policy (monetary policy) and
fiscal policy is of course the study of isolated parameter anges.

8. STATEMENTS AND EXPECTATIONS

In dealing with the means of monetary policy8 it is oen asserted that
among the most important means of the central bank for influencing the
development of business activity are its statements on monetary policy. e
restraining effect of a rise in the bank rate is sometimes explained by the fact
that businessmen regard this as a warning of harder times, and this may
cause a sufficient amount of pessimism to slow down or reverse a boom.
Fiscal policy statements may well be assumed to have the same effect on
people’s thinking. e device discussed in Chapter XVII to control money
wages is based upon su fiscal policy statements. If a Chancellor of the
Exequer or Minister of Finance declares that a budget will act in a
contractive manner, this statement may in itself bring about a certain
amount of contraction. Even if no su declaration is expressly made, the
belief of the public concerning the effect of the budget as a whole—even if
this impression is ‘in fact’ wrong—may be sufficient to have an influence in
the desired direction. us beliefs about the budget balance may give it
independent and distinctive effects not apparent in an ‘ordinary’ economic
model, where no regard is paid to su ‘irrational’ factors in the economic
system.

9. SUMMARY
In this apter we have aempted to classify fiscal policy means according
to the way in whi they influence the relationship of supply and demand in
the economic system. An important distinction was found to exist between
those fiscal policy means having a direct influence on prices and on the
quantities demanded and supplied, and those fiscal policy means whi have
only an indirect effect on these entities. It is now clear that the first
mentioned category of fiscal policy means does not differ in principle in its
effects from the actions of private economic subjects; here general economic
theory is sufficient to explain the effects, and no special treatment is
necessary. On the other hand, when we come to the effects of those fiscal
policy means whi work indirectly, it is obvious that general economic
theory is insufficient. Here we come into the realm of micro-economic fiscal
theory. Part II is entirely devoted to this subject. It examines how these
indirect fiscal policy means influence the planning and actions of private
economic subjects—households and firms—and how the activities of
organizations can be influenced by fiscal policy.
1. J. R. His, Value and Capital, Oxford 1939, Chapter VIII and
Mathematical Appendix to Chapter VIII.
2. Bent Hansen, A Study in the Theory of Inflation, Chapter VIII and
Appendix to Chapter VIII, esp. pp. 214–5.
3. P. A. Samuelson, Foundations of Economic Analysis, Cambridge, Mass.
1947, Chapter IX, pp. 269 ff. and the literature quoted therein.
4. Lloyd A. Metzler, ‘Taxes and Subsidies in Leontief’s Input-Output
Model’, The Quarterly Journal of Economics, Vol. 65, 1951.
5. Bent Hansen, A Study in the Theory of Inflation, p. 180.
6. F. Zeuthen, Problems of Monopoly and Economic Warfare, London 1930,
esp. Chapter IV.
7. Cf. G. Nyblén, The Problem of Summation in Economic Science, Lund,
Sweden 1951.
8. Erik Lindahl, Penningpolitikens medel, Chapter II, Section 1.
 PART II

MICRO-ECONOMICS OF FISCAL POLICY

The Impact of Fiscal Policy on the Behaviour of Households, Firms
and Organizations
 CHAPTER VII

Planning by Households
1. THE HOUSEHOLD AS PLANNING UNIT
THE course of economic events in a society may be said to be determined by
the actions of all the individual bodies, both private and public. In economic
theory it is usually supposed that these actions are based on the plans of
ea economic subject. Ea subject makes plans for current and future
activities. If we wish to know the influence of policy on the course of
economic events we must know its influence on the actions of all economic
subjects, but this in its turn requires a knowledge of how policy influences
the planning of the subjects. e theory of the influence of policy measures
on the planning of the individual economic subject must therefore be
fundamental to the whole theory of the economic effects of fiscal policy.
It is usual in economic theory to divide private economic subjects into
two main groups—households and firms. In practice, it is easy in most cases
to determine whether a certain subject is to be alloed to one group or the
other. Certain border-line cases exist, however, where it is difficult to
distinguish between households and firms—primitive subsistence farming is
an example of this. We will take it for granted, however, that the distinction
between households and firms has been made in some way. On the one
hand we shall then have households, whi have incomes from the sale of
labour or other factor services to the State, to firms or possibly to other
households, while on the other hand we shall have firms, producing goods
and services for profit.
When treating the planning of households and firms, economic theory is
uniform in so far as it assumes that both will try to place themselves in as
favourable a position as external circumstances permit. e households are
supposed to maximize their ‘utility’ or standard in some sense, and the firms
to maximize their profits in some sense.
 To these two ‘classical’ groups of private economic subjects, it seems
necessary in modern times to add a third whi has been increasing in
importance, namely economic organizations (institutions). ese have not
yet gained any definite place in ordinary theory, but there is a tendency to
try to fit them in. From a theoretical point of view, the importance of
organizations lies particularly in the fact that many of the functions whi
were previously carried out by households and firms, su as the
determination of wage rates, have now been taken over by organizations
whi oen have their own aims, and are not necessarily guided by the
utility-maximization of households or the profit-maximization of firms.
It might be questioned whether the purely theoretical division into
households, firms and organizations is always suitable from the point of
view of the theory of public finance. To a certain extent it is. For example, a
classification of taxpayers by different types of taxes (or subsidies) will oen
coincide with the division into households and firms (or sub-divisions of
them). It is quite reasonable to say that from an economic point of view the
household is the taxpayer, if husband, wife and ildren living at home are
taxed together under the system of personal income tax. With indirect
taxation, it is mostly the firm whi is the taxpayer. On the other hand, with
certain taxes the taxpayer can be found in both households and firms, the
taxation of motor vehicles is an example of this, just as the same household
may include several taxpayers. Su complications are, by and large, no
concern of ours here.
In this and the two following apters we shall discuss the planning of
households and the influence of fiscal policy measures upon it. Naturally we
aa great importance to the question of the effect of income tax and
indirect taxation on the households’ distribution of disposable income
between consumption and savings; the whole of Chapter VIII is given over
to this problem. In Chapter IX, a number of other problems concerning the
influence of fiscal policy measures on household planning will be dealt with
briefly. Before commencing the analysis of the importance of fiscal policy
measures to household planning we must, however, introduce a theory for
this planning. is will be done in the remainder of this apter.

2. HOUSEHOLD PLANNING FOR CONSUMPTION AND SAVING

In the neo-classical theory of public finance it was self-evident that
investigations in this field must start from the theory of household planning.
It might even be said that the most important contribution of the neo-
classical theory of public finance was the exploitation of utility theory for
this purpose. Best known is probably the role that the marginal utility
theory has played in the establishment of principles of taxation.1 e
principles of equal sacrifice, minimum sacrifice, etc., are all based on the
concept of a measurable and interpersonally comparable marginal utility of
income. Other fields where utility theory—in its more modern form of
preference theory—has come to be used, are the question of whi tax
(income tax or consumption tax) is to be preferred from a welfare point of
view, and the question of the effects of taxation on the supply of labour.
Against this baground it seems natural to aempt to solve the problem
of the influence of fiscal policy measures on consumption and saving on the
basis of preference theory. It appears that nobody has tried this approa
before, and this seems all the more strange in view of the fact that the task
of preference theory is precisely to explain the disposal of a given household
income. e reason for this neglect is to be found in the somewhat grudging
treatment of savings in modern preference theory. e modern ‘static’
preference theory is primarily a theory of ‘consumer’s oice’, of the oice
between different consumer goods. e capital theory of Böhm-Bawerk and
his followers2 contained among other things a theory of saving whi was
evidently based on considerations of utility theory; Irving Fisher3 also
treated the question of the determination of the rate of interest by means of
an intertemporal preference theory where the determination of the amount
of saving was fundamental. J. R. His and J. Mosak,4 both evidently
independent of Böhm-Bawerk and Fisher, have lately used intertemporal
utility theories where regard is paid to saving. None of these economists has,
however, paid regard to taxation in this connection.5 e aempt by J. S.
Duesenberry6 to renew the theory of consumption and saving completely
will be dealt with later.
e reason why we have to employ intertemporal theory in the discussion
of the determination of saving is obvious. Firstly, saving can be regarded as
a postponement of consumption to the future. If saving is to be included in a
theory of income disposal by households, then this theory must embrace
several time periods; the usual consumption theory deals with only one
period of time. We shall not restrict ourselves, however, to the idea that
saving is future consumption; saving may be an end in itself. Secondly, in
the literature on saving it is usually considered necessary to take account of
expectations concerning future economic conditions, su as prices, incomes
and interest. ese elements are the obvious ingredients of an intertemporal
theory of income disposal.
Since this intertemporal theory of income disposal by households is going
to be used in a somewhat unfamiliar manner, it will first be explained in
greater detail. Let us imagine an individual or a household at a given point
of time. Time is divided into periods, numbered from 1 to n. e individual’s
economic horizon extends over n periods. If the individual is at point of time
0, i.e. at the beginning of the first period, he is assumed to have expectations
concerning all possible relevant economic factors, prices, interest, income,
levels of taxation, etc. On the basis of these expectations he plans his
consumption, tax payments, savings, lending, borrowing, etc. for ea of the
n future periods to his horizon. We suppose this planning has taken place in
su a way that it can be described as a maximization of a utility function
(preference function) and in this maximization is included not only present
but also expected future circumstances. In order to avoid the problems of
risk we imagine that the expectations of the individual are quite definite; he
expects certain events to occur in the future and ascribes them the
probability 1.
We are primarily interested in the planned consumption, saving, etc. of
the households for the first period, period 1. e plans for the periods whi
follow are of less interest, because while the plans for period 1 have
immediate relevance for the actions of the individual during period 1, the
plans whi are made at the beginning of period 1 for periods 2, 3, etc., will
not as a rule immediately determine the actions of the individual during
these periods. For it may be supposed that when the individual has
experienced the actual course of events of period 1, he will, in the light of
these new experiences, make a new general plan at the beginning of period 2
for the following n periods (i.e. for the period 2 to n+1). e plans for
consumption, saving, tax payment, etc. for period 2 (whi is now the
immediate planning period) will then possibly differ from the previous plans
for this period. e essence of this argument is not anged by the fact that
the new plan may be conditioned in various respects by previous plans and
actions. Regarded in this way, the intertemporal theory for the disposal of
household income is a necessary element in the general period analysis.7 It
could be called at ‘partial dynamic’ theory.

Fig. VII: 1

Fig. VII: 1 illustrates the general plans for successive periods of time. Ea
horizontal line shows the interval of time embraced by the plan. Within ea
general plan, our main interest is on the part shown by the heavy line. In
order to determine the plans for the first part of the planning period we
must, however, know the planning for the entire period, for all the partial
plans included in a certain general plan are determined simultaneously.
We can now proceed to a presentation of the intertemporal theory of
income disposal.

3. GEOMETRICAL EXPOSITION OF THE INTERTEMPORAL THEORY OF

INCOME DISPOSAL
In presenting this theory it is easier to begin with a geometrical treatment of
the simplest possible case, where two periods and two ways of using the
income are considered: consumption and saving. e geometrical treatment
is based on a tenique introduced by Irving Fisher.8 Despite the fact that
Fisher’s tenique is a very versatile instrument of analysis, very
reminiscent of ordinary indifference map tenique, it seems, by and large,
to have been overlooked in the literature. In the following apter we shall
base our analysis of the effect of taxation partly on this tenique. As
geometry demands greatly simplified assumptions, we shall also give a more
general mathematical exposition of the theory, whi will be used in the
following apter.
In the simplest case of multi-period analysis, the household-planning is
imagined to extend over two periods, 1 and 2. e planning at the beginning
of period 1—the period under consideration—consequently only concerns
these two periods. Fisher’s hypothesis is now that the household plans to
maximize a preference function (utility function)

where q1 and q2 are the quantities of consumer goods planned for

consumption in period 1 and period 2 respectively. Consequently, only one
kind of consumer good appears in ea period. According to (VII: 1), it is
only consumption whi produces ‘utility’, saving in itself produces no
‘utility’. It is obvious that the ‘utility’ is a prospective, expected ‘utility’ from
prospective, planned consumption. If we put U(q1, q2) = a (where a has all
values from 0 to+∞) we can draw up a system of indifference curves in the
usual way in a diagram with the consumed quantity of period 1 on the
abscissa and the consumed quantity of period 2 on the ordinate axis. e
meaning of these indifference curves is that all the combinations of
(planned) consumption in period 1 and period 2 whi are ‘equivalent’ for
the household, form an indifference curve. All combinations of consumption
in period 1 and 2, whi lie on a ‘higher’ indifference curve, are preferred to
all combinations whi lie on a ‘lower’ indifference curve. is indifference
map (preference map) is no different in principle from those of ordinary
consumption theory, and the rules whi are established for drawing up
su maps9 may, with a few insignificant exceptions, be transferred to the
intertemporal indifference map.
Let us now suppose that at the beginning of period 1 the household has no
assets, but expects that it will receive income from labour sufficient to
purase 1 consumer goods if it consumes the entire income during the
same period. In the same way, the household expects to receive during
period 2 labour income sufficient to purase 2 consumer goods. It is
evident that the household also has certain expectations concerning the
price of consumption goods during periods 1 and 2. e quantities of
consumer goods for period 1 and period 2 respectively are measured in su
a way as to make the expected price, exclusive of possible indirect tax, equal
to 1 in both periods.
Now if the household plans to save the amount S1 in period 1,
consumption10 within the same period will be q1 = 1—S1 as S1 expresses
the nominal amount as well as the ‘real’ saving (due to the fact that we have
osen the unit of consumer goods so that the price will be equal to 1). We
now suppose that the ‘savings goal’ of the household is to have its net
wealth once more at zero by the end of period 2. e household ‘saves in
order to consume’. is means that the saving that goes on within ea
period is of the same absolute size, but of opposite sign. is assumption is
applied throughout the whole geometrical formulation of the intertemporal
theory of income disposal. From this formulation it now follows that if
saving within period 1 is S1 the total consumption within period 2 will be q2
= 2+(1+r)S1. r is the expected rate of interest and saving is imagined as
being invested in su a way that both interest and the loaned (borrowed)
amount is due for payment at the beginning of the next period.11
Point A = ( 1, 2) in Fig. VII: 2 obviously represents one possible
combination of consumption within the two periods with zero saving in
both periods. Point ( 1—S1, 2+(1+r)S1) represents another possible
combination of consumption within the two periods; saving here is S1 in
period 1 and —S1 in period 2. It is immediately realized that all points on the
straight line L, whi passes through point A with the slope —(1+r)
represents all alternative consumption possibilities of the household. Line L
is called the budget line; the equation for the budget line is
 If the rate of interest is above zero, the angle between the budget line and
the abscissa will be greater than 45° and the greater the rate of interest the
steeper will be the budget line; in the special case where the rate of interest
is zero, the angle will be 45°.
Normally, it can be assumed that the rate of interest is positive. However,
for purely theoretical reasons, it may be worth noting that at an interest rate
of —100 % the budget line becomes horizontal and at an even lower interest
rate the budget line assumes a positive slope. From a very theoretical point
of view, an interest rate of —100% is a more interesting borderline case than
if the rate of interest is zero, whi has been very oen discussed in the
literature, but does not offer any particular peculiarities.

Fig. VII: 2

Similarly in discussing the determination of capital values, i.e. in

investment calculations, it is the rate of —1 (or less) and not zero, whi
causes difficulties. It is sometimes maintained that an interest equal to zero
is unreasonable as it involves infinitely high capital values; this, however, is
a misunderstanding. If we consider a capital value to be the present value of
an expected future income stream, and if we denote this capital value by K0
and the expected income in the coming year i by Ei, we have
where n is the number of years within the economic horizon. We exclude
risk.
With a zero rate of interest the expression becomes

If the expected future incomes are all of finite size the capital value of a
stream of income at interest rate zero can become infinitely large only if the
economic horizon contains an infinite number of years. From this, it
immediately follows that if it is regarded as unreasonable that the capital
values become infinitely high, this does not necessarily imply that the
assumption of a rate of interest = 0 is unreasonable; what is unreasonable is
obviously imagining economic subjects with an infinitely distant horizon.
If the rate of interest is between zero and —1, and if the economic horizon
embraces only a finite number of years, K0 is here definite and of finite size.
If, on the other hand, the rate of interest is —1, it follows that:

Here evidently the capital values (numerically) will be infinitely high (or
more correctly K0 → | ∞ | when r → —1 irrespective of the number of years
within the economic horizon.
What has been said up to now concerns the subjective capital values, but
the results may be immediately transferred to the market values of future
streams of income. If ea economic subject’s subjective capital value is
finite, the market value must also be finite; if the subjective capital values
are infinite, market value will be so too.
e point of tangency between the budget line and the indifference curves
will now be decisive for the household’s consumption and saving. If the
point of tangency lies to the le of A, e.g. at B, the household is lending, i.e.
saves in a positive way in period 1, and consumes so mu more in period 2.
If the point of tangency lies to the right of A, e.g. at C, it borrows, i.e. saves
in a negative way in period 1 and pays its debt together with interest on the
debt in period 2. As has been mentioned in the previous section, it is period
1 that is of particular interest. For that reason, we call a household at point B
a lender and a household at point C a borrower.
In the above argument, a number of simplifying assumptions are implicit,
of whi we shall here consider some of the more important; for the others,
see Chapter IX, section 9.
We suppose that the household has given expectations as to labour
(factor) incomes during the various periods. e incomes from interest in the
various periods are, on the other hand, determined by the household’s own
planning. Here we ignore the possibility that households can oose
between alternative forms of factor-income.12 is means that we ignore the
complications whi arise if regard is paid to the disutility of work, or
alternatively, the delights of leisure, in the utility function. e length of the
working day, etc. is consequently taken as given. is assumption seems
quite reasonable in a modern society, if the household (individual) in
question is a household of wage-earners. We shall return to this question
later, however.
e assumption that no assets exist at the beginning of period 1 is, on the
other hand, of material importance to the argument and we will return to
this in due course.
Purases and consumption of consumer goods are considered to be the
same thing. We consequently disregard the possibility that the households
store up consumer goods and we also ignore speculative purases of
consumer goods, and the existence of durable consumer goods, all of whi
present special problems.
Finally, we have to note that the household is assumed to be able to
borrow and lend unlimited amounts at the given interest rate. is means
that we assume perfect competition in the loan market and that only
interest-bearing investments are possible here. e difference between the
rates of interest for borrowing and lending is ignored, and thus also the
possibility that saving is in the form of cash, i.e. hoarding. e laer
assumption is of special importance in the discussion of negative interest. Of
great importance is also the general possibility of obtaining a loan.

4. THE SIGNIFICANCE OF INTEREST FOR CONSUMPTION AND

SAVING
We shall now briefly discuss the old question of the connection between the
rate of interest and the volume of saving based on the geometry of the
previous section 3. On the one hand this will give us an opportunity to show
how Fisher’s geometric tenique is applied, while on the other hand, the
question of the rate of interest and saving has a significance of its own for
the discussion in the following apters of the effects of taxation on
consumption and saving.
Let us begin with a certain rate of interest r, see Fig. VII: 2. is rate rises
to r′. e increase in the rate of interest involves a rotation of the budget line
(in negative direction) around point A. e slope of the new budget line L′,
is —(1+r′). e new budget line will consequently be above the old budget
line to the le of A, and below the old budget line to the right of A. e
point of tangency between the new budget line and the indifference curves
determines the ange of consumption and saving. Let the point of tangency
for the old budget line be B and the quantities consumed q1* and q2*. If the
new point of tangency is B′ an increased rate of interest means a reduction
of consumption and an increase in saving in period 1. If the point of
tangency is B″ instead, the increase in the rate of interest means an increase
of consumption and a reduction of saving in period 1. Similar results are
valid if the point of tangency of the old budget line lies to the right of A. e
conclusion must then be that the effects of the interest anges on current
consumption are uncertain.13
If the rate of interest is continually anged (from —100 to+∞%), with the
result that the budget line is rotated around point A (in a negative direction)
from a horizontal to a vertical position, the point of tangency with the
indifference curves will follow a curve passing through A within the
intervals q2 ≥ 2, 0 ≤ q1 ≤ 1 and q1 ≥ 1, 0 ≤ q2 ≤ 2. is curve can be
called the interest-consumption curve, using an analogy from consumption
theory. e equation for this curve is
where U′q and U′q are the partial derivatives of the utility function with
1 2
respect to q1 and q2. Fig. VII: 3 has been constructed to show the course of
this curve in a special case. e utility function is assumed to be U = q1 · q2
and point A = (10, 5).

Fig. VII: 3

e indifference curves here are hyperbolas. e interest-consumption

curve is also a rectangular hyperbola with the asymptotes q1 = 5 and q2 = 2
. e arrows show the direction of movement with a continually increasing
rate of interest. In this particular case, the higher rate of interest will
obviously always lead up to increased saving; on the other hand, saving can
never be made to exceed 5, irrespective of the level of the interest rate.
As we have seen, increased interest rates may lead to increased
consumption and reduced saving (in period 1). If interest is regarded as
reward for saving, this means that the supply curve for saving may have a
negative slope. Here the question naturally arises whether there are any
limits to the increase of consumption and decrease of saving whi may
follow a rise in the level of interest?
 Inspection of Fig. VII: 2 shows that an increase of the rate of interest can
never make a lender a borrower, and consequently can never ange positive
saving into negative (or zero) saving. If the point of tangency of the old
budget line with the indifference curve lies to the le of A, the point at
whi the new budget line is tangential to an indifference curve must lie
between the points at whi the new budget line is intersected by the
indifference curve whi toued the old budget line. If the indifference
curves are convex (to the origin) both of these points of intersection and
accordingly also the new point of tangency, must lie to the le of A. On the
other hand, an increase of interest rates may very well make a borrower a
lender, thus transforming negative saving to positive saving. An interest
reduction has the opposite effect. For an individual who previously saved
nothing, an increase in the rate of interest will always call forth positive
saving—i.e. his saving will increase—and a reduction in the rate of interest
will always lead to negative saving—i.e. his saving will decrease.
It immediately follows from these results that if we consider a given
number of individuals whose A-points are spread over the q1q2-plane (is the
‘normal’ distribution onion-shaped around the 45°-line?), then in general, an
interest-rate increase can never lead to an increase of the number of
individuals who save negatively, and it is likely to lead to an increase in the
number of individuals who save positively. Moreover, from what follows in
the next paragraph, it can be concluded that it is always possible to imagine
an increase in the rate of interest so great that the number of individuals
saving positively is increased (provided that before the increase of the rate of
interest there is somebody who saves negatively or zero). e fact that the
number of persons saving positively is increased does not, however, imply
that total saving is increased. Generally, no conclusions can be drawn about
the size of, and anges in saving, simply from the number of individuals.
In order to arrive at something definite about the total size of the amount
saved, we shall first point out that for a given individual (if we ignore the
particular cases where the A-point of the individual is on one of the axes),
there is always a rate of interest at whi he will save positively, and a
(lower) rate of interest at whi he will save negatively. is is due to the
fact that the A-point of a given individual will always be on some
indifference curve. If the budget line is given a slope equal to the slope of
this indifference curve at the A-point, the individual’s saving is zero. At a
higher rate he will then always be a lender and at a lower rate, a borrower.
On this result we can base the following statement: ere always exists a
rate of interest low enough and a rate of interest high enough that an
increase from the lower to the higher rate will bring about an increase of the
total amount saved. From what has just been said, it follows that there is
always a rate of interest low enough to make everybody save negatively, and
a rate of interest high enough to make everybody save positively. If the rate
of interest is increased from this low rate to the high one, then the total
amount saved will become positive instead of negative. is statement is,
however, rather weak, partly because the necessary increase in the rate of
interest may extend over quite impractical intervals. e (highest) low rate
at whi everybody dissaves may be negative and may be as low as —
100%,14 and the (lowest) high rate at whi everybody saves positively may
in principle be as high as several thousand percent.
As these arguments do not exclude the possibility of a negatively sloping
supply curve for saving, it may be asked whether further a priori knowledge
of the indifference curves might lead to more definite conclusions. One
obvious course would be to exclude the possibility of anything
corresponding to what are called ‘inferior goods’15 in consumption theory.
‘Inferior goods’ are aracterized by a negative income-elasticity of demand.
e equivalent of ‘inferior goods’ in the intertemporal analysis would be
that consumption decreases within a certain period if the budget line is
subject to a parallel movement away from the origin (this corresponds to an
increase of the present value of the stream of income at a given interest-
rate). It is very difficult to imagine su a thing with the assumptions made
here.16 However, not even an assumption of absence of ‘inferior periods’ is
sufficient to exclude the possibility of a negatively sloping supply curve for
saving. e effect of a ange of the interest-rate can be divided into a
substitution and an ‘income’ effect; for a lender, however, the substitution
and ‘income’ effects work in opposite directions. Even if we ignore the
possibility of ‘inferior periods’, the effects of an increase of the rate of
interest may thus be that the lender reduces his saving. For borrowers,
however, the substitution effect and the ‘income’ effect always work in the
same direction if ‘inferior periods’ are disregarded. For borrowers, if inferior
periods can be ignored, a higher rate of interest leads to increased saving
and a lower rate to reduced saving. On the other hand, this does not
immediately apply to lenders. In order that a higher rate of interest shall
always lead up to increased saving, the substitution effect of a ange of the
rate of interest must always be stronger than the ‘income’ effect. ere is no
reason why this condition should be fulfilled; a priori su an assumption is
hardly justified.
It will also be seen that Böhm-Bawerk’s first two ‘grounds’17 are not
sufficient to ensure that a higher rate of interest brings about increased
saving either. If a 45°-line is drawn in Fig. VII: 3, Böhm-Bawerk’s first
‘ground’ can be interpreted to mean that the A-points of all individuals lie
within the angle between the 45°-line and the positive part of the ordinate
axis. Böhm-Bawerk’s second ‘ground’ can be interpreted to mean that at the
point of intersection with the 45°-line, the slopes of all indifference curves
are (numerically) larger than 1. From this it follows that zero-saving by ea
separate individual and by society as a whole requires a positive rate of
interest. Possibly this could be combined with the previous argument and it
could then be said that the highest (low) rate of interest at whi everybody
saves negatively is definitely positive if Böhm-Bawerk’s first two ‘grounds’
hold. Furthermore, if we suppose that Böhm-Bawerk’s second ‘ground’ does
not have too strong an effect, it seems likely that the lowest (high) rate at
whi everybody saves positively lies within the practical limits of interest
rates. en it can be concluded that with sufficiently large variations in
interest rates (within the practical limits of variation), it would be fairly
certain that total saving anges its sign, and consequently that an increase
of the rate of interest leads to increased saving and lowering of interest rates
reduces saving. e la of realism of Böhm-Bawerk’s first ‘ground’ is
enough, however, to make the conclusion uninteresting (e.g. the usually low
incomes of old-aged pensioners).

5. THE GENERAL INTERTEMPORAL THEORY OF INCOME DISPOSAL

BY HOUSEHOLDS
e geometrical method, whi we have used in the two previous sections,
has rather severe limitations. On the one hand, it deals only with two (or
possibly three) periods—though this is not of great importance when only
the first period is being studied—while on the other hand, the postulated
savings goal—that households ‘save in order to consume’—is a special one.
at is why we shall now give a more general presentation of this theory
where the number of periods may be of any size and where several different
savings goals can be considered. e following version of the theory is not
completely general however. We have to make some special assumptions
about the savings goal; furthermore, we shall regard consumption as well as
saving within ea period as aggregates, whi shall not be split up into the
separate consumer goods or, in the case of saving, into the various
possibilities for financial investment.
Although we naturally take Fisher, His and Mosak as a starting point,
the formulations of the theory will still differ somewhat from their
formulations. It is especially in the formulation of the savings goal that our
theory differs from theirs. It is obvious that the geometrical representation
(in sections 3 and 4) is a special case of this more general version.
As before we consider the simultaneous planning of a household (an
individual) for the whole of the time up to the economic horizon. is is
supposed to extend up to and including the nth period (year). At the outset,
i.e. at the beginning of period 1, the household has no assets and no debt.
For ea period there is only one kind of consumer good and the households
do not have a store of consumer goods. All entities are to be regarded as ex
ante entities, and it is supposed that they are given by the individual the
probability 1. In order to simplify the argument we suppose that the
individual expects the same interest-rate during all future periods. As to the
price level, we shall make no special assumptions for the present.
us as long as payments to the State are ignored, we shall use the
following (ex ante) entities:
Budget restriction

For period 1, the individual’s total expected money-income Y1, is the

same as his expected labour income (factor income), Y1a. Of this income, C1
is spent for consumption, the expected price being p1 and the planned
quantity to be consumed q1. Saving will then be S1, and according to the
budget restriction, the total value of planned consumption and saving is
equal to the total expected money-income.
At the beginning of period 1, the expected total income for period 2, Y2, is
equal to expected labour income Y2a, plus the expected interest rS1, from
the planned saving of the previous period (for we are still supposing that the
planned saving is to be invested in interest-bearing assets at the beginning
of the period, and the interest received at the beginning of the next). e
expenditure on consumption is q2p2 and saving S2. is period has its own
separate budget restriction.
For period 3 the same applies as for period 2; but it must be remembered
that in period 3 interest is received on the total savings of periods 1 and 2,
and so on.
With this in mind, we assume that an individual’s general plan, whi is
drawn up for n periods at the beginning of period 1, is directed towards
maximizing a utility function (preference function), in whi regard is paid
to the anticipated utility of the planned consumption, q1, …, qn, in all future
periods. In general, this is not, however, sufficient to solve our problem
concerning the distribution of the income in the various periods on
consumption and saving. Savings (final capital) must have its own
‘determining ground’.
Various assumptions are now possible. We shall oose to consider those
savings-goals that have been discussed in the theory of saving, and whi in
the main must also be supposed to play a part in real life. us we arrive at
two alternative versions of the intertemporal theory, (a) and (b).
(a) We first present a relatively general method, where real final capital is
directly included in the utility function. If Kn is the planned capital at the
end of the nth period the utility function will then be

Instead of the real final capital, it is also possible to let the real saving of
ea period (i.e. S1/p1, etc.) or the real capital of ea period (i.e. S1/p1,
(S1+S2)/p2, etc.) be included in the utility function. Into the uses that are
here made of our theory, all these alternatives give quite similar results, so
we will therefore use only the simple form (VII: 3). e fact that we include
the real, and not the nominal, final capital in the utility function is partly
due to an analogy with consumption, where only real consumption appears
in the utility function, and partly because of desire to avoid all assumptions
of ‘money-illusion’ in the behaviour of the households. It is, however, clear
that all our results will be dependent on the assumption that it is the real
values and not nominal values whi give utility.
By means of ordinary utility maximization18, we now find the following
2n+1 equations for the determination of the 2n+1 unknowns: q1, …, qn; S1,

…, Sn and Kn:
 19

In the first n of these equations U′qi and U′Kn/pn denote the partial
derivatives of the utility function with respect to qi and Kn/pn; pi* denotes
the present value of the price for period i at the rate of interest r, i.e. pi* =
i—1
p /(1+r)
i . ese n equations then say that the marginal rate of
substitution between the planned real consumption for an arbitrary period
and the planned real final capital shall be the same as the ratio between the
present values of the prices for the corresponding periods. e other set of n
equations comprises the budget restrictions, and the last equation is the
definition of the nominal final capital.
If now equations (VII: 4) are solved for saving within the first period, S1,
the following ‘saving function’ is found:20

If instead q1, the real consumption, or S1/p1, the real saving in period 1, is
solved from the equations (VII: 4), a ‘consumption function’ or a ‘saving
function’ of the following type will be arrived at:

Finally, if we let p1 = … = pn =p—this means that we assume that the

price whi is expected to exist in period 1 is also expected to continue for
all the following periods—we get certain expressions for q1 and S1/p1 whi
are suitable for use in the discussion of the effect of taxation:
 e reason why it is convenient to assume the household to expect the
same price for all periods will be considered more closely when discussing
the place of taxes in these expressions for consumption and saving.
(b) Another—and rather more usual—method is to make some explicit
assumption as to the saving-end of the individual; as long as we let Kn/pn be
directly included in the utility function, as was the case above, it can be said
that the savings goal is implicit in the form of the utility function. We shall
consider the following three traditional savings goals, i.e. bases for
determining the size of Kn.
(i) e household ‘saves in order to consume’, i.e. it always plans to have a
net capital of zero at its economic horizon. What the household plans to save
during certain periods it also plans to consume during certain other periods.
is means that Kn = 0. It can be. said here that the household saves
exclusively in order to redistribute its consumption over the various periods.
is assumption was behind the whole of the geometrical exposition.
(ii) e savings goal is to collect a certain real capital, say at the
economic horizon. us . is assumption about the savings
goal naturally does not exclude the possibility that the household may,
within the various periods, save positively or negatively in order to
redistribute consumption over time.
(iii) e savings goal is to aieve a given real income from interest, , per
period, from the nth period (beyond the horizon). We then have Kn = (
pn)/r. In this case too, the redistribution of consumption may play a part in

determining saving within any individual period.

If the utility function is

where neither final capital nor saving during the various periods appears,
then for case (b) the following 2n equations are found by maximization of
utility to determine the 2n unknown factors, q1, …, qn and S1, …, Sn
 With the same symbols as above, the first set of n—1 equations in (VII: 9)
shows that the marginal rate of substitution between planned real
consumption of any two periods shall be the same as the relation between
the present values of the prices of the periods. ese n—1 equations are
analogous to Fisher’s well-known conditions for optimum: that the rate of
interest shall equal the individual’s time-preference.21 Furthermore, we have
the n budget restrictions and the definition equation for Kn.
Unlike case (a) we now take Kn as a parameter, whi can be given the
three values (or more if it is desired to study more savings goals):

Provided that all prices are equal to p, we can immediately write the
solutions for q1 and S1/p1 in their general form as:

e discussion of the properties of the expressions (VII: 5), (VII: 6), (VII:
7), (VII: 9) and (VII: 10) will be postponed to the following apter. It is the
homogeneity properties of the expressions whi are of special interest.

1. Erik Lindahl, Die Gerechtigkeit der Besteuerung and A. C. Pigou, A

Study in Public Finance.
2. E. von Böhm-Bawerk, Kapital und Kapitalzins, Vienna 1884 and 1889,
and Knut Wisell, Lectures on Political Economy I, pp. 212 ff.
 3. Irving Fisher, The Rate of Interest, New York 1907 and The Theory of
Interest, New York 1930. Henceforth only the laer will be cited, as it is
a revision of the first work.
4. J. R. His, Value and Capital, Chapter XVIII and J. Mosak, General
Equilibrium Theory in International Trade, Bloomington, Indiana, USA,
1944, Chapter VI. When Part II of the original Swedish version was
finished in manuscript a significant new work in this field appeared: F.
Modigliani and R. Brumberg, ‘Utility Analysis and the Consumption
Function: An Interpretation of Cross-Section Data’ in Post-Keynesian
Economics, edited by K. K. Kurihara, New Brunswi, N.J., 1954.
5. Certain authors discard utility theory completely. Consider, for instance,
the following argument of Gunnar Myrdal, whi seems quite obsolete
against the baground of modern preference theory: ‘e marginal
utility deductions, whi to a certain extent replace empirical
knowledge, comprise mainly a restatement of the questions themselves
in now outdated rationalistic psyological terms’, Gunnar Myrdal,
Finanspolitikens ekonomiska verkningar (e Economic Effects of Fiscal
Policy), p. 61.
6. J. S. Duesenberry, Income, Saving and the Theory of Consumer Behavior,
Cambridge, Mass. 1949.
7. Erik Lindahl, Studies in the Theory of Money and Capital, pp. 40–60.
8. Irving Fisher, The Theory of Interest, Chapters X–XI.
9. Herman Wold, Demand Analysis, Stoholm and New York 1952, Part II,
especially Chapter IV.
10. For the sake of simplicity we omit the adjective ‘planned’, where there is
no possibility of being misunderstood. All entities in the intertemporal
theory are of course planned (expected) entities.
11. e interest on the saving of the first period is reoned as income for
the following period, and so on. If instead this interest is reoned in the
income of the first period, this would not be 1 but 1+( 1—q1)r, and the
savings of the first period would not be q1—q1, but ( 1—q1)(1+r). Su a
procedure would not upset the main results.
12. Irving Fisher, The Theory of Interest, Chapter XI.
13. is has already been pointed out by Fisher, The Theory of Interest, p.
286.
14. e (highest) rate of interest at whi all save negatively, cannot be
below —100 %. If the rate of interest is below —100 % a household’s
consumption can be increased in both periods by borrowing in the first
period and ‘repaying’ in the second period. In su a position everybody
will obviously borrow in the first period. We would then have a case
with a positively sloping budget line.
15. J. R. His, Value and Capital, p. 28.
16. Cf. however, what is said in Chapter XI, 9 on the significance of risk and
limited borrowing opportunities.
17. Guy Arvidsson, ‘Om räntans grunder’ (e reasons for the rate of
interest), Ekonomisk Tidskrift, Stoholm 1953; reprinted in
International Economic Papers, 6.
18. Maximization of U under the joint restrictions given by the budget
restrictions and the savings goal.
19. If it is desired to pay regard to the assets, K0, at the beginning of period
1, the third equation can be wrien as . Y1a thus includes
interest due at the beginning of period 1. K0 will then appear in all
consumption and saving functions, unless we prefer to regard Kn—K0 i.e.
the total net increase in wealth as an unknown; this would imply,
however, that it is also Kn—K0 whi appears in the utility function,
whi is perhaps less reasonable.
20. e expression means that i under the function symbol will have
values from 1 to n.
21. Irving Fisher, The Theory of Interest, pp. 510–2.
 CHAPTER VIII

e Effects of Taxation on the Consumption

and Saving Plans of Households
1. PROBLEMS
THE previous apter was entirely devoted to a presentation of the
intertemporal theory of the disposal of household income in a way suitable
for the study of certain effects of taxation. In debates on fiscal policy,
discussion has always centred on the question of how various forms of
taxation affect consumption and saving; it is generally held that the tax
system ought to be su that saving is hindered as lile as possible. e
motives behind this opinion are very varied. For instance, there is the point
of view, that saving determines the amount of investment and thus
determines the development of the standard of living in the long run. e
most usual point of view is, however, that the function of taxation is to
provide the State with goods and services, and that taxation fulfils this
function by reducing demand for consumer goods from the households. It is
then natural to oose those taxes whi aieve this end most effectively;
for in this way resources are released for use by the State with the least
possible burden of taxation.
In the literature on public finance there has, as far as I know, been no
systematic analysis of this problem. Consequently, it seems necessary to
concentrate investigations of the effects of fiscal policy on household
planning upon this point. e present apter is thus devoted to an
investigation of, and a comparison between, the effects of direct and indirect
taxation on the planned consumption and saving of households. Not all
direct and indirect taxes are dealt with here. As a maer of fact, we shall for
the present let direct taxation be represented by a proportional personal
income tax,1 and indirect taxation by a general purase tax on consumer
goods, whi is imposed at the same percentage on the prices of all
consumer goods and services. (In what follows, the expressions, purase tax
and consumption tax will be used for this tax.) ese two types of tax may,
perhaps, seem not very representative of direct and indirect taxation in
general. However, it will be seen that our treatment of the proportional
income tax is of su a nature that in certain cases, it also shows the effects
of anges in a progressive (or regressive) income tax, and a general
purase tax can surely, in this connection, be taken to represent a system of
indirect taxes imposed on a good many consumer goods.
e reason why we have osen to treat a proportional income tax and a
general purase tax on consumer goods is that these two types of tax can be
treated by comparatively simple means; among other things, it is possible
with a general purase tax to treat all consumer goods in a period as one
commodity, thus facilitating the analysis. In the following apter we will
discuss in greater detail the effects of income tax progression.

2. THE BASES FOR COMPARISON

If we desire to investigate the effects of various taxes (tax anges) with the
intention of comparing these effects, we are immediately faced with a
question of how large should the taxes (tax anges) be that are to be
compared. It may seem obvious, that the comparison must be between taxes
of the same magnitude, but it is not quite so obvious what is meant by ‘of
the same magnitude’. Normally, the magnitude of the taxes is expressed by
the size of the tax amount (reoned in £) or by the rate of tax where this is
defined as the relationship between the size of the tax amount and the size
of the tax base. In our case, where the tax bases (income and consumption
expenditure) are as a rule of different sizes, it is obviously not unimportant
whether we compare the effects of equally large anges in the rates of
taxation or equally large anges in the tax amounts, although the results in
both cases are of course related.
e answer to this problem has actually been given in Part I. We ought to
use as a basis of comparison primarily those entities whi would naturally
be regarded as State parameters in the economic system in whi the
household planning takes place. Where purase tax is concerned, the tax
rate is undoubtedly the natural State parameter. As to (proportional) income
tax, it is true that the tax amount may be regarded as a parameter under a
certain taxation system, but as a rule, the rate of taxation is the natural State
parameter here too.
In the scanty theoretical and empirical investigations on this subject,
sometimes the one and sometimes the other of these bases of comparison is
used. Usually it is the tax amount that is used as the basis of comparison. In
principle, there is nothing against this; it does involve, however, certain
complications in connection with the fact that the tax amounts are not the
natural parameters—not even if we remove household planning from the
model and study it in isolation. For what we wish to compare here are the
effects of an isolated ange of the income tax amount by £a, and the effects
of an isolated ange of the amount of purase tax by £a. No difficulty is
involved in bringing about su an isolated ange of the amount of
purase tax; for if (the expected) income is given, the income tax amount is
not affected by a ange in the purase tax. If, on the other hand, the
amount of income tax is anged, normally (with a given income) the
planned consumption is affected and consequently also the total amount of
purase tax. erefore, if the income tax amount is to be altered alone, we
are compelled to ange the rate of the purase tax at the same time if the
total amount from purase tax is to remain the same (see the general
discussion of su problems in Part I, Chapters III and V). If we wish to
avoid this complication, it is also possible to compare the effects of a ange
in the amount of tax paid by the household in question of £a, whi, in one
case, is due to an isolated ange of the income tax rate and in the other
case, to an isolated ange of the rate of purase tax. e income tax rate
would thus be anged so that the ange in the yield of income tax differed
from the £a by exactly the amount by whi the yield of purase tax (at a
given rate of tax) has been anged due to the anged income tax rate. is
possibility has not been considered in the literature, however.
It thus follows that the oice of the basis of comparison is to some extent
arbitrary. For the reasons given above, we will primarily use the tax rates (or
entities directly connected with them) as the basis for comparison. For the
sake of completeness we will, however, also treat the tax amounts as bases
for comparison, but it will already be clear from what has been said that the
analysis here will be somewhat more complicated.
e purpose of the analysis in this apter is to study the effects on
household planning of an income tax or a general consumption tax. Since
the household’s plans for consumption and saving are determined among
other things by its expectations as to incomes and prices (see the previous
apter), when we examine the importance of taxes for this planning, we
must make some assumptions concerning the shiing of the taxes under
consideration. For instance, if the consumption tax is paid by the firms (the
sellers), the households will not be immediately affected by this tax, if it is
not shied via prices; and if the consumption tax is paid by the households,
they will not be affected by the tax if it is shied ba to the sellers. In the
same way, income tax will not influence household planning if it is shied
to employers. In a total analysis, the incidence of taxation will, of course, be
determined by the complete model. Here, however, we are looking at the
planning of a household at a certain moment, ignoring the rest of the model,
and must therefore make some assumptions as to the household’s
expectations about shiing. We shall oose the simplest possible
hypothesis, and suppose that households always expect the consumption tax
(if it is paid by the firms) to be completely transferred to prices, so that the
price of any commodity, excluding the consumption tax, is independent of
the size of the consumption tax.2 On the other hand, we suppose that
households always expect income tax not to be shied; this means that the
expected incomes before taxation are assumed to be independent of the level
of income tax. Furthermore, we suppose that households always expect that
the rates of taxation in force at the time of planning will also be in force for
all future periods.3 ese assumptions involve an elasticity of expectations
equal to 1 for both tax rates and the price level: see section 8 below.
From these introductory remarks, we now proceed to introduce taxation
into the intertemporal theory of income disposal.

3. THE EFFECT OF INCOME TAXATION ON PLANNED CONSUMPTION

AND SAVING
Beginning with the income tax, we take as a starting point the simple, two-
period-analysis of Chapter VII, section 3, with all the assumptions the same
as before.
Firstly, we suppose that an income tax is introduced and that the income
tax rate, tp, is given, and expected by the households to remain unanged
during the two periods. us the problem is to determine how the budget
line is affected by this income tax. Before income tax is introduced, the
budget line L (in Fig. VIII: 1) is:

If the income tax rate is tp, the income tax amount for period 1 will be tp
1, and the disposable income, i.e. the income aer taxation, for period 1 will
be (1—tp) 1. e factor (1—tp) will, for the sake of simplicity, be called the
residual fraction. Now if all of the disposable income is consumed during
period 1, the tax amount in period 2 will be tp 2, and the disposable income
and consumption in period 2 will consequently be (1—tp) 2. e point A = (
1, 2) representing the combination of consumption whi corresponds to
zero saving, is thus moved along the diagonal OA to A′ = (1—tq · ( 1, 2). If
now the household saves the amount S1 out of its disposable income (1—tp)
1, the consumption during period 1 will be equal to q1 = (1—tp) 1—S1, and
the income before taxation in period 2 will amount to 2+rS1. Income tax in
period 2 is tp( 2+rS1) and consumption in period 2 will consequently be
. us it
immediately follows by elimination of S1 in the expressions for q1 and q2
that all alternative combinations of consumption aer the introduction of
income tax will be on the straight line L′:
 Fig. VIII: 1

whi is the new budget line; it passes through A′ with the slope—(1+(1—
tp)r). e slope of the new budget line is thus (numerically) less than the

slope of the original budget line.4 As can easily be shown, the new budget
line must remain under the original budget line over its entire length.
e effects of income tax can thus be regarded as the effects of a
combination of a parallel shi downwards of the budget line (to the doed
line L″), and a rotation (in a positive direction) of the budget line L″ around
point A′ over to budget line L′, i.e. a combination of a decrease of the
expected labour (factor) incomes proportional to the tax rate, and a lowering
of the interest rate.
e point of tangency between the new budget line L′, and an indifference
curve is decisive for the effect on consumption and saving. Since
consumption and saving (in the nominal as well as the real sense) together
amount to (1—tp) 1, it is easily seen that if the distribution of 1 (income
before taxation) between consumption and saving were determined by the
point of tangency B, then aer the introduction of the tax, the following
three possibilities will arise, depending on the position of the new point of
tangency.
B′—consumption decreases (or remains unanged) and saving decreases;
B″—consumption increases and saving decreases;
B′′′—consumption decreases and saving increases.
Consequently, a priori, we can only state the rather obvious fact that the
effect of an income tax cannot be an increase of both consumption and
saving. Tt is important to note that the assumption that there are no ‘inferior
periods’ (see Chapter VII, section 4) will not lead to definite conclusions
concerning the direction of the effects of an income tax either. e absence
of ‘inferior periods’ means that with a parallel shi downwards of the
budget line (the budget plane) consumption in all periods will decrease. e
effect of an income tax can, however, as we have shown, be divided into a
parallel shi of the budget line and a rotation around point A, representing a
decrease of the rate of interest. In Chapter VII, 4, we found that a ange in
the interest rate involves a substitution effect whi can work in the
opposite direction to the income effect, so that it is obvious that the effect of
income tax may be an increase in consumption in period 1 even with
absence of ‘inferior periods’. ere has to be a very strong substitution
effect, however, if the result is to be an increase of consumption.
Without going further into the question, we may note here that if the
income tax is progressive, so that a higher expected income is expected to
bear a higher rate of income tax, the budget line will be concave. Similarly, a
regressive income tax will give a convex budget line; here, there is a
possibility that the optimum budget cannot be uniquely determined because
several points of tangency are possible. In the geometrical treatment,
however, we ignore progressive and regressive income taxes; the more
general treatment in section 8 does cover these cases to a certain extent.
For the sake of completeness, we shall also consider the case, where the
aim of income taxation is to take from the household a given sum of money
in the first period. As the income in this period is given (= 1) the rate of
income tax is also given. If the household, according to our general
assumptions, whi in this respect seems to be quite reasonable, expects the
same rate of income tax for period 2 as for period 1, it will be seen that this
case is illustrated by exactly the same figure as above, Fig. VIII: 1. ere will
be no troubles of the type mentioned in the preceding section, namely the
amount of consumption taxes paid by the household anging as a
consequence of the ange in consumption; for in the initial position, the
rate of consumption taxation is supposed to be zero.

4. THE EFFECTS ON PLANNED CONSUMPTION AND SAVING OF A

GENERAL CONSUMPTION TAX
In connection with the diagrammatic representation of the consumption tax,
the question arises of how to bring prices into a diagram, when only real
quantities are shown. However, this involves no difficulty as we have
defined the units in su a way that the price exclusive of consumption tax
is 1 in both periods. e quantities measured along the axes can be
interpreted as expressions for value-units. Furthermore, it will be found
suitable in this connection to define the consumption tax rate, tc, as the
relationship between tax per unit of goods and price per unit inclusive of
tax. In the initial position, before the introduction of the consumption tax,
the budget line L, is

us our problem is to construct a new ‘budget line’, whi shows whi
combinations of real consumption in the two periods the household has at
its disposal aer the introduction of the consumption tax.
Let us suppose, for the moment, that the household does not save
anything during period 1. At the given income of 1, the value of its
consumption during period 1 is equal to 1, irrespective whether the
consumer goods are taxed or not. With the taxation rate tc, the tax with
zero-saving will be tc 1, and real consumption will be (1—tc) 1. For period
2, the consumption expenditure with zero-saving will be 2, the tax tc 2 and
real consumption (1—tc) 2. Point A = ( 1, 2), whi represents the real
consumption at zero saving, is moved along the diagonal OA to A′ = (1—tc) ·
( 1, 2), see Fig. VIII: 2. Let us further imagine that the household in period
1 plans to save S1. e value of its consumption then amounts to 1—S1, the
consumption tax to tc( 1—S1) and the real consumption to q1 = (1—tc)( 1—
S1). For period 2, the consumption expenditure amounts to 2+(1+r)S1, the

tax to tc( 2+(1+r)S1) and real consumption to q2 = (1—tc ( 2+(1+r)S1). If S1

is found from the expression for q1 and the result is inserted in the
expression for q2, it is found that all alternative combinations of real
consumption are on the straight line L′:

e new budget line accordingly passes through A′ and has the same
slope, —(1+r), as the original budget line. e effects of the consumption tax
are then found by comparing the respective points at whi the old and the
new budget lines are tangential to indifference curves.
 Fig. VIII: 2

In this case, we obviously have to distinguish between nominal values

and real amounts, both as regards consumption and saving. e real
consumption q1, is indicated directly on the abscissa. Consumption
expenditure is calculated as q1/(1—tc); for in the way we have here defined
tc, the price including tax is 1/((1—tc). Real saving, (1—tc) 1—q1 is also

shown directly on the abscissa, while nominal saving is found from the
expression 1—q1/(1—tc).
It can easily be seen that the amount consumed may decrease in greater
or lesser proportions to the rise in the price level, and this is decisive for
determining whether consumption expenditure rises or falls as a
consequence of the consumption tax. We find the following four possibilities
exemplified by the four points of tangency:
B′: quantity consumed decreases, real saving decreases, nominal
saving decreases;
B″: quantity consumed decreases, real saving decreases, nominal
saving increases;
B′′′: quantity consumed decreases, real saving increases, nominal saving
increases;
B″″: quantity consumed increases, real saving decreases, nominal saving
decreases.
e border line between cases B′ and B″ is the point where the real
consumption decreases in the same proportion as the price level rises, that is
in the proportion 1/(1—tc). e border line between cases B″ and B″′ is the
point where real consumption decreases so mu that nominal saving
increases in the same proportion as the price level.
So far, with a consumption tax we will not arrive at a definite result as to
the effect on planned consumption and saving. If, however, we make the
assumption of absence of ‘inferior periods’, the result will be definite as far
as consumption is concerned, although the effect on saving is still uncertain.
e introduction of a consumption tax is aracterized, as has been shown,
by a parallel shiing of the budget line downwards to the le. e absence
of inferior periods means that with su a movement of the budget line,
consumption in both periods will decrease. us it follows that the absence
of inferior periods means that only the possibilities B′, B″ and B′′′, need be
taken into account, but, on the other hand, none of these possibilities is
excluded. As can be concluded from the above, real saving may therefore
increase or decrease as may nominal saving, but real consumption will
certainly decrease.
We will next deal with the case where the aim of the taxation policy of
the State is to get a given amount of consumption tax c, from the
household in the first period, irrespective of the amount of consumption
during this period; at the same time, we assume that the State plans to apply
the same rate of consumption tax in period 2 as in period 1.5 As the price
per unit excluding tax is 1, the tax amount that the State wishes to receive
can obviously be expressed as the value excluding tax of a certain quantity
of goods. We know that the real consumption during period 1 is q1 = — c
—S1, and in period 2, q2 = (1—tc)( 2+(1+r)S1), where tc is determined by the
expression tc = c/(q1+ c). us it is immediately obvious that all those
combinations of real consumption whi actually become possible for the
household lie on the curve M in Fig. VIII: 3:

whi we may call the real possibility curve. e taxation policy of the State
makes the individual oose between one point or another on this curve. e
real possibility curve starts at the origin, from whi it rises sharply, reaes
a maximum and then falls, intersecting the diagonal OA and meeting the
abscissa at the point q1 = 1+ 2/(1+r)— c, see Fig. VIII: 3; in order to
simplify maers, we have made 1 = 2 = 100, c = 20 and r = 0.

Fig. VIII: 3

e question now is whi point on this real possibility curve will be

reaed by the household maximizing its utility. If the household realizes the
intentions of the State, it will, of course, oose the point on the real
possibility curve where this curve toues the highest indifference curve.
Su a point normally exists, but if there is no point of tangency, the
household will place itself at the point where the real possibility curve
intersects the abscissa axis. Nevertheless, we ignore this solution of the
problem. On the one hand, it involves a break with the usual theory, for it
implies that the household does not base its utility maximization on given
prices, but rather observes and takes advantage of the fact that prices are
here not independent of the magnitude of the household’s consumption.
Furthermore, it is unreasonable to aribute to individual households su an
insight into the State’s taxation policy.
We shall here assume therefore, in complete accordance with our general
assumptions in this apter, that no maer what tax rate is decided upon by
the State (in order to receive the desired amount from taxation), the
household will always expect that this rate of taxation will remain in force
for both periods, irrespective of the size of its own consumption. To the
household, the tax rate, tc, will then appear as a constant; to the State it will
be an action parameter. e household will then reon on a budget line
whi is parallel to the initial budget line (see Fig. VIII: 2). e solution of
our problem will therefore be found where the point of tangency between
the household budget line and an indifference curve coincides with the real
possibility curve. is can also be expressed in the following manner: the
solution is to be found where the household’s expansion line (i.e. the locus
of the points of tangency between the indifference curves and all budget
lines whi are parallel with the budget line L) cuts the real possibility
curve. erefore the State will have to fix the rate of consumption tax so as
to fulfil this condition. As can be easily seen, this condition may be fulfilled
at a number of points; it is also possible that there may be no su point. If
the curve E in Fig. VIII: 3 is the expansion line, point B′ is one definite
solution.
As to the effects on consumption and saving, exactly the same conclusions
apply as we found for the previous case, where the policy of the State was
concerned with fixing a certain rate of tax. In the general case, it is uncertain
how both consumption and saving (real and nominal) are affected; if we
exclude the possibility of ‘inferior periods’ (this means that the expansion
line E is continuously rising), then it is inevitable that real consumption
decreases, but the effect on real and nominal saving continues to be
uncertain.

5. A COMPARISON BETWEEN THE EFFECTS ON PLANNED

CONSUMPTION AND SAVING OF AN INCOME TAX AND A
CONSUMPTION TAX
We are now equipped for a comparison between the effects on household
planning for consumption and saving of an income tax and a consumption
tax in the simple two-period case.
Let us first examine the case where the basis for comparison is equally
large tax rates, the consumption tax rate being defined as the relationship
between tax per unit and price including tax. us, we compare Figs. VIII: 1
and VIII: 2. With the same tax rates (tp = tc) point A′ in the two figures will
coincide. Both the budget line aer the introduction of income tax and the
budget line aer the introduction of consumption tax will pass through this
point. e budget line aer the introduction of consumption tax is parallel to
the initial budget line; the budget line aer the income tax has rotated (in a
positive direction) corresponding to the decrease in the rate of interest net of
tax. In Fig. VIII: 1 the doed line L″, can be regarded as the budget line aer
the introduction of consumption tax, while the line L″ is the budget line aer
the introduction of income tax. From this follows the conclusion:
If we choose equally large tax rates (as defined above) as the basis for
comparison, the difference between the effects on the household’s planned
real consumption and saving of an income tax and of a consumption tax will
be the same as the effect of a decrease of the rate of interest proportional to
the tax rates; and the effects on consumption and saving of a decrease in the
rate of interest are uncertain.
is result can be regarded as a more exact expression of an argument
whi was advanced by L. Einaudi, Erik Lindahl, A. C. Pigou and others,
and is also found in the writings of John Stuart Mill. All these economists
discuss the question primarily as a normative problem concerning taxation
principles. John Stuart Mill6 maintained that a person who saves suffers
comparatively more from income tax than from consumption tax, because
income tax involves ‘double taxation’ of saving; Lindahl7 further develops
this idea, but argues that it is actually a question of a ‘Doppelbesteuerung
der Zinzenkonsumtion’ (‘double taxation of interest consumption’) and
draws the conclusion that reducing the ‘effective rate of interest’ by income
tax implies that ‘in all those cases where interest on savings influences the
amount saved, income tax can be expected ceteris paribus to lead to less
saving than would a consumption tax’.8 e laer part of this conclusion is
too hasty. Pigou9 follows the same lines in his argument, although his
definition of saving is not very clear.
We can now turn to the case where the basis for comparison is equally
large tax yields. We here compare Fig. VIII: 1 and Fig. VIII: 3. Since with
equally large tax amounts point A′ of the two figures coincides, it is easy to
see that we cannot generally decide whether it will be the income tax or the
consumption tax whi will affect consumption or saving to the greatest
extent.
 However, if we ignore the existence of ‘inferior periods’, and furthermore,
bring in the assumption that when the income tax is introduced, the rate of
interest is increased just sufficiently to keep the net rate of interest the same
as it was before the imposition of the income tax (the rate of interest is thus
increased in the proportion tp(1—tp)), then we arrive at an interesting result.
e absence of inferior periods will mean that the household’s expansion
line (income-consumption line) at a given net rate of interest has a positive
slope over its entire length. e condition that the imposition of income tax
should be accompanied by an increase in the rate of interest in the
proportion indicated will mean that the budget line aer the introduction of
the income tax (and with the ange in the interest rate) is parallel to the
initial budget line. In Fig. VIII: 3, the doed budget line L″ has been inserted
to illustrate this assumption. Under these two assumptions, it follows that:
If we choose as a basis for comparison equally large tax yields, and if
saving (after the introduction of consumption tax), is positive, then the
consumption tax will lead to a greater decrease of real consumption than the
income tax would; on the other hand, if saving (after the introduction of
consumption tax), is negative, then the income tax will lead to a greater
reduction of real consumption than consumption tax would. The same
applies to real saving; while for nominal saving the opposite applies.
In the stated circumstances, this result follows immediately from the fact
that if saving is positive, L′ will always be below L″ (see Fig. VIII: 3); the
consumption tax rate is in this case larger than the income tax rate—
otherwise the two taxes will not yield the same amount of tax. In the same
way, L′ is always above L″ if saving is negative. us even if the basis for
comparison is equally large tax yields, it is obviously still the rate of tax
whi determines the result.
is result has a great similarity with that whi E. Carry Brown10
reaed by considering an ordinary simple Keynesian static macro-model.
His result can be shown in more general form by regarding the following
Keynesian consumption function
where q is the quantity consumed, Y is income, Tp is the personal income
tax amount, and p is the price level. According to this consumption function,
real consumption is a function of real disposable income. We define the price
level as p = (q+Tc)/q and get, for any given value of Y, real consumption as a
function of the amounts of income tax and consumption tax:

By means of partial differentiation of this expression we find, if we make

dTp = dTc and pq = C, that

Expressed in words: if saving is negative (positive) the ange in the

consumption tax will make real consumption decrease less (more), and at
zero saving the two taxes have the same effect on consumption. is is
Brown’s conclusion, although here it is shown in a somewhat different
manner.
If, in order to proceed, we deduce the function for real saving, S/p, and
nominal saving S, from the consumption function above in connection with
the well-known identity

whi is exactly the same result as we got for real consumption. For nominal
savings, on the other hand, (if dTp = dTc) we get:
 is says that if saving is negative (positive), the ange in the
consumption tax will make nominal saving decrease more (less). e
relationship is thus the opposite of the one that holds for real consumption
and real saving.
We have thus obtained two important results by comparing the effects of
an income tax and a consumption tax on the planned consumption and
saving of households. As we shall show in section 8, these results are still
valid under more general conditions.

6. ON THE BURDEN OF TAXATION

e concept of the ‘burden of taxation’ has been used in many ways in
economic literature.11 It is very common to form a ratio between the State’s
total income from taxation and the total amount of income from whi taxes
are paid (private factor income, national income, total taxable income, etc.);
this ratio is then taken as an expression of the burden of taxation. e sense
in whi su a ratio can really be said to indicate the ‘burden of taxation’ is
rather dubious, however. For instance, if it is said that a ratio of 0.2 between
tax and income means that the taxes themselves lower the standard of living
by 20 %, the statement is clearly meaningless; for if all taxes were removed,
ceteris paribus, this would hardly bring about a 25 % increase in the
standard of living. At full employment, the result would perhaps only be to
bring about a process of price increases with an unaltered standard of living
for those who had paid taxes previously; with substantial unemployment,
the result might perhaps be an increase in production and in the standard of
living by more than 25%. Su considerations do not necessarily mean that
the concept of the burden of taxation is to be discarded. If we are concerned
with an individual household, it is quite meaningful to ask how mu higher
the standard of living of this individual household would be if it did not pay
the taxes it actually pays. It is the burden of taxation in this individual sense
that we will deal with here.
 When we study the behaviour of the individual household from a utility
theory point of view, the standard of living of the household is measured by
the indifference curve on whi the household happens to be. No absolute
measure of the standard of living is obtained in this way if we refrain from
using cardinal utilities, whi we do. However, this does not prevent a
comparison between two situations from showing whi of them gives the
household the higher standard of living; a ‘higher’ indifference curve always
represents a higher standard of living, even though it does not indicate how
mu higher. erefore, if we compare the standard of living of a given
household under the various forms of taxation, we can discuss whi type of
taxation lowers the standard of living of the household most (least), i.e.
whi implies the greatest (least) burden of taxation.
Continuing the discussion of the previous sections, we can now contribute
to the solution of the old problem whether direct or indirect taxation hits
households hardest; more specifically, does an income tax or a general
consumption tax impose the heaviest burden of taxation, and the lowest
standard of living? To answer su a question we must again have a basis of
comparison. We shall take the two bases of comparison used up to now,
equally large tax rates and equally large tax yields.
e question can be answered immediately on the basis of the analysis in
sections 3 and 4 on the effects of an income tax and a consumption tax; the
answer is that taking these two bases of comparison it cannot generally be
said whether income tax or consumption tax involves the greater burden of
taxation.
Firstly, let us take the case of equally large tax rates as the basis of
comparison. In Fig. VIII: 1, L′ represents the budget line aer the
introduction of income tax and L″ the budget line aer the introduction of
consumption tax. e question is, then, whi of these two budget lines is
tangential to the lowest indifference curve. As a special case, we have the
possibility that L′ and L″ tou the same indifference curve; the two types of
taxation will then bring about the same standard of living and cause the
same burden of taxation. In other cases, if saving (in period 1) is negative
aer the introduction of consumption tax, L′ toues a higher indifference
curve than L″. If saving aer the introduction of income tax is positive, L″
toues a higher indifference curve than L′. If saving aer the introduction
of income tax (consumption tax) is negative (positive), L′ may tou a higher
or lower indifference curve than L″. ite analogous arguments can be
advanced in the case where equally large tax amounts are used as the basis
of comparison, for here too, we have two budget lines whi intersect.
Against the baground of these negative results it is interesting to note
that in the usual one-period consumption theory the result that is obtained
is that the consumption tax will, under certain circumstances, place the
household on a lower indifference level than income tax, and that the
income tax is therefore to be preferred to a consumption tax12 from a
welfare point of view. Since the usual consumption theory ignores saving,
the comparison there is really between a general and a partial consumption
tax; furthermore, in su a theory, the basis of comparison is equally large
tax yields. is result can therefore, at best, only mean that a general
consumption tax leads to a lower burden of taxation than a partial
consumption tax yielding the same amount of tax. As su, the result is,
nevertheless, of obvious interest.
It is, however, possible to formulate the problem of the effects of taxation
on consumption and saving, and of the burden of taxation, in a way that
seems more rational than the traditional methods we have been using so far.
It is more rational in so far as it is more directly related to the problems of
modern fiscal policy. For instance, the use of the tax yield as the basis of
comparison obviously originates in fiscal policy considerations of a purely
‘financial’ nature. e following formulation seems to be beer suited to a
business-cycle policy approa.
To begin with, we will suppose that the State wishes for a certain period
to bring household consumption down to a certain level (whi is lower
than that whi the household would oose if there were no taxation). e
problem then is to find the tax whi, while bringing about the level of
consumption sought by the State, will
(a) place the household on the highest indifference curve;
(b) involve the lowest tax yield (or tax rate);
(c) allow the greatest amount of saving.
e first of these three considerations obviously concerns the subjective or
real burden of taxation. e second can be said to concern the nominal
burden of taxation. e third can also be said to concern the burden of
taxation in a certain sense; it could be said that with a given real
consumption the tax burden is less the larger is the household’s (real or
nominal) saving.
e situation can be illustrated by Fig. VIII: 4 where A = ( 1, 2) has the
same meaning as before, and where point B = (q1*, q2*) is the household’s
optimum point before it is taxed. e aim of taxation policy will then be to
reduce the household’s planned real consumption for period 1 to 1.
As it is intended that the household shall voluntarily oose to consume
the amount 1 in period 1, taxation must be arranged in su a way that the
household’s optimum point is on the vertical line through 1. Taxation thus
has to move the budget line so that it is tangential to an indifference curve
on the vertical line through 1.
Now it is clear that if the State could use arbitrary (positive or negative)
rates of taxation, whi could be different for the two periods or, more
correctly, could make the household expect and reon on appropriate (and
possibly different) tax rates for the two periods, then it would also be
possible to place the household on an indifference curve of any height with
the level of consumption 1, for example, at point C. e task would then be
to determine tax rates for periods 1 and 2 su that the budget line just
toued the indifference curve passing through C. Su tax rates are always
to be found; but this possibility is hardly of any great practical interest. We
will therefore keep to the assumptions whi we have worked with up to
now, namely, that the household expects the same rate of taxation for the
two periods.
 Fig. VIII: 4

In order to deal with these problems we will introduce two auxiliary lines
called ‘expansion lines’. Firstly, there is the consumption tax expansion line,
whi shows the way the household’s optimum point will move when the
tax rate is decreased from 1 to 0. Secondly, there is the income tax expansion
line, whi shows the way the optimum point will move when the income
tax rate is reduced from 1 to 0. ese expansion lines are denoted by K.E.
and I.E. in Fig. VIII: 4. Both these expansion lines start from the origin and
end at point B and throughout their entire courses are under the original
budget line (only positive tax rates are considered here). By comparing the
consumption tax expansion line and the income tax expansion line, it will be
seen that the courses of these lines are su that if we move along the
expansion line of the consumption tax from the origin to B, the expansion
line of the income tax will always lie to the right (if we look along the
indifference curves).
e reason for this is that K.E. is the locus of the points of tangency
between the indifference curves and a family of budget lines, whi are all
parallel to the initial budget line, while I.E. is the locus of the points of
tangency between the indifference curves and a family of budget lines
whose slopes become (numerically) less the nearer they are to the origin.
e various budget lines whi determine I.E. are brought about by a
parallel shiing downwards of the initial budget line combined with a
continuous rotation of the budget line (in a positive direction) around the
point on the budget line whi lies on the diagonal OA. As the budget line
approaes the origin, its slope approaes —1.
If we now consider any indifference curve (lower than that whi is
tangential to the initial budget line), it will have two points of tangency, for
it will tou one budget line from ea of the two families of budget lines.
As every budget line whi belongs to the consumption tax family has a
greater (numerical) slope than any budget line belonging to the income tax
family (except for the case where the income tax rate = 0), the point of
tangency between the indifference curve and the consumption tax budget
line must be higher up (i.e. further le) along the indifference curve than the
point of tangency with the income tax budget line. us it is obvious that
I.E. is to the right of K.E. when we move along K.E. from the origin to B. We
ignore the special cases where the expansion lines coincide with the axes, or
where there are kinks in the indifference curves; in these cases the expansion
lines may coincide for a part, or perhaps for all of their courses.
We are looking for those optimum points whi are on the vertical line
through 1. e points of intersection of the two expansion lines with the
vertical line through 1 gives us these optimum points. Ea expansion line
must intersect the vertical line at least once, but a number of points of
intersection is also possible. Irrespective of how many points of intersection
there are, the highest point of intersection will always be a point of
intersection with the consumption tax expansion line—because of the
relationship between the expansion lines that we have just mentioned—and
the highest point of intersection corresponds of course to the highest
indifference curve. us we have arrived at the answer to our first question:
If the household’s consumption is to be reduced to some given quantity,
the household is placed on the highest possible indifference curve if the
reduction in consumption is brought about by a general consumption tax. In
this sense, the consumption tax can thus be said to impose the lowest
burden. From a welfare point of view, the conclusion is thus arrived at that
consumption tax is to be preferred to income tax. is conclusion is exactly
the reverse of the findings of ordinary consumption theory mentioned
earlier.
Let us assume that in Fig. VIII: 4, D and F are the (highest) points at whi
the expansion lines of the consumption tax and the income tax respectively
intersect the vertical line through 1. In order to find the tax amounts
corresponding to these two points, the consumption tax budget line through
D and the income tax budget line through F have to be drawn. As the
income tax budget line has the numerically smaller slope, we cannot decide
a priori whi of these two budget lines will cut the diagonal OA nearest to
A; nor can we say whi of the two tax rates will be the lower. From this, it
immediately follows that we cannot determine whi of the two points D
and F implies the lower tax amounts; for the consumption tax the yield is tc
1/(1—tc) and for the income tax tp 1.
us we have the answer to our second question: If household’s
consumption is to be reduced to some given quantity, we cannot say in
general whi tax is to be preferred from the viewpoint of keeping the tax
yield (or tax rate) as small as possible.
Furthermore, saving amounts to 1—q1* before the household is taxed.
Saving (real as well as nominal) aer the introduction of income tax is 1(1
—tp)— 1; aer the introduction of consumption tax, real saving is 1(1—tc)—
1 and the nominal saving 1— 1(1—tc). By comparing these two
expressions, it will be seen that it is not possible to say how saving is
affected. We do not know whi tax rate is the larger. Consequently we
cannot determine whi method of taxation falls most heavily on saving
within the framework of this problem. is will then be the answer to our
third question.
All the concepts of tax burden discussed here may be of interest. From the
household point of view, naturally, the tax burden defined from the utility
standpoint ought to be decisive; it shows how the household feels itself hit
by the different types of taxation; it indicates whi form of taxation the
household would prefer if it were to oose freely. In other connections, the
tax amounts or the tax rates may be of more importance.

7. TAXES AND THE INTEREST-RATE AS MEANS OF LIMITING

CONSUMPTION
We shall now try to compare taxes with interest as means of influencing
household’s consumption plans. We shall examine in particular whether it
can be said to be ‘beer’ from a utility standpoint to use interest-rate policy
in order to bring about a given decrease in consumption. When interest-rate
policy is used, households are influenced through the ‘ordinary’ price
meanism, and this is oen believed to lead to greater welfare than ‘direct’
intervention.
In order to make the comparison we assume, as in the previous section,
that the aim of the State is to reduce household consumption to 1, see Fig.
VIII: 5, where the household’s A-point and the rate of interest are given, so
that the budget line will be L and the optimum point B in the initial
situation. e reduction of consumption is to be brought about by a suitable
ange in the rate of interest. For the sake of simplicity we shall only
consider the tax whi places the household on the highest indifference
curve at the level of consumption 1, and according to the previous section,
this will be a consumption tax. We assume that this consumption tax places
the household at point B′ with the budget line L′.

Fig. VIII: 5

In order to find the ange of the rate of interest whi will also make the
household reduce its consumption to 1, the budget line L is rotated around
the point A until it toues an indifference curve on the vertical line through
1. We see firstly that it is not absolutely certain that there will be any rate
of interest at all whi leads to the desired result (see Fig. VII: 3, page 125).
However, if there does exist a rate of interest whi makes q1 = 1, it is easy
to see that the interest ange may place the household on an indifference
curve whi is lower than the indifference curve on whi the household is
placed through taxation (see point B″ on the budget line L″); or on an
indifference curve whi lies higher than the indifference curve on whi
the household is placed through taxation but lower than the indifference
curve on whi the household initially stood (see B′′′ on the budget line L′′′);
or even on an indifference curve whi lies higher than the indifference
curve that the household was on in the initial position (see BIV on the
budget line LIV). Finally, the points B″, B′′′ and BIV can very well be
imagined to exist simultaneously, whi means that different anges in the
rate of interest may all lead to the desired result.
e outcome will then be firstly that we cannot tell whether a fall in the
rate of interest or a rise in the rate of interest is necessary to bring about the
reduction of consumption, or whether it is possible to obtain the result at all
solely by a ange in the rate of interest; secondly, we cannot determine
whether the relevant ange in the rate of interest or in the tax affects the
household more, in the sense of placing it on a lower indifference curve. A
priori we cannot decide whether it is ‘beer’ to bring about the reduction in
consumption by a ange in the rate of interest or by means of taxation.

8. THE GENERAL CASE: THE EFFECTS OF TAXES ON CONSUMPTION

AND SAVING
It will now be shown how taxes can be brought into the more general
intertemporal theory of income disposal by households. We shall proceed
directly from the theory presented in Chapter VII: 5, and we are using the
same symbols as there. e intention is to show how very general some of
the previous results really are.
e household’s horizon is imagined to extend as far as the nth period.
Now that we are concerned with the income tax and the general
consumption tax, we have to use the following prospective entities and
relations:
 As previously, we assume that the household expects the same rate of
interest and the same rate of income tax for all future periods. By applying
the theory of Chapter VII, 5, we obtain the following:
(a) If the utility function is

real saving, S1/p1, and real consumption, q1, will be determined by

expressions of the type

where pi* = pi/(1+(1—tp)r)i−1. If we let p1 = …. = pn = p the expression for

S1/p1 and q1 will be of the form

(b) e other alternative is that the utility function is

and that we introduce savings goals explicitly. We shall here consider three
su goals: Kn = 0, Kn = ( )pn and Kn = pn/(1—tp)r. It will be seen that
the third savings goal is to have a certain real disposable income from
wealth at the end of the nth period. For the sake of simplicity we shall just
give the general expression for real saving and real consumption on the
assumption that all expected future prices are the same:

An examination of (VIII: 6), (VIII: 7) and (VIII: 9) immediately shows that

the income tax only influences the expressions for real saving and real
consumption through the so-called residual fraction 1—tp, whi only
appears as a multiplicative factor of the rate of interest r, and of expected
labour incomes Yia.
e consumption tax does not appear explicitly in the expressions for real
saving and consumption, but only implicitly through the expected price
level pi. Up to now, we have made the assumption that the consumption tax
leads to an increase in the price of goods by exactly the same amount as the
tax. If we maintain this assumption, but now let the consumption tax rate tc
be defined as the ratio between the tax per unit and the price per unit
excluding tax (whi seems more convenient in this connection), we can
express the price level for any period as pi = 1+tc, if we define the consumer
goods units so that the price excluding tax is equal to 1. In the expressions
(VIII: 7) and (VIII: 9) p can now be replaced by 1+tc, and it is these two
expressions we are going to study. e reason for proceeding in this way is
as follows. We are especially interested in the effects of anges in tp, tc and
possibly r. e expected anges in the price level, whi we are enquiring
into in this connection, are those price anges that occur as a consequence
of anges in the consumption tax. erefore, if we assume that the price
level is only expected to ange as a consequence of anges in the
consumption tax rate, and furthermore, that the household is convinced that
the consumption tax is always shied to its entire amount, and finally, that
the household always reons that the consumption tax rate whi is valid
for the first period will also be valid for all future periods, then obviously, all
expected future market prices will be anged in the same proportion. It can
then be assumed, without further loss of generality, that the price level will
be the same for all future periods. Since we are here only dealing with the
question of the household’s expectations as to the effect on the price level of
anges in the rate of the consumption tax, the assumed connection between
the price level and the consumption tax anges is perhaps not entirely
unrealistic.
As with the geometrical presentation, it might seem natural to begin by
examining the effects on planned consumption and saving in the first period
brought about by separate anges in tax rates, in tax amounts, and in the
rate of interest. However, since the geometrical presentation is a special case
of this more general model, and furthermore, the geometrical representation
of the two-period case reaed the result that generally nothing at all can be
said about the direction in whi consumption and saving are influenced by
anges in taxation and the rate of interest, it seems rather pointless to
generalize the analysis in this respect.13 It is, however, worth mentioning
that the assumption of the absence of ‘inferior periods’ involves, in the
general case too, that an increase in the consumption tax will always lead to
a decrease in real planned consumption, while the effect of a fall in the rate
of interest (and therefore also of an increase in the income tax) is still
uncertain. Instead of continuing with this problem, we now proceed directly
to a comparison of the effects of anges in income tax and consumption
tax. e peculiar form of the expressions (VIII: 7) and (VIII: 9) makes it
possible to carry out this comparison without our having to know the
isolated effects of separate tax anges.
As has already been mentioned, the residual fraction 1—tp, does not
appear in the expressions for real consumption and real saving, other than as
a multiplicative factor of the rate of interest and of the expected labour
a
income; the entities 1—tp, r and Yi thus only appear in the form of the
following products
 From this it immediately follows that if we study the effects of a certain
increase in the income tax rate Δtp, or more simply, a certain decrease of the
residual fraction —Δ(1—tp), this decrease of the residual fraction will always
be equivalent to a combined reduction of the rate of interest and of expected
labour incomes, where both the reduction in the rate of interest and the
reductions in labour incomes are proportional to the decrease of the residual
fraction.
If we turn now to the effects of a consumption tax, we immediately see
that in the expressions (VIII: 7) and (VIII: 9), the prices p appear only as
divisors of the expected earned incomes. In the expression Kn/pn, according
to our assumptions about savings-goals, pn will disappear. If we let p = 1+tc,
it will immediately follow that the ange in real consumption, or in real
saving, whi will occur as a result of a certain increase in 1+tc, will always
be equal to the ange in real consumption, or real saving, respectively,
whi would result from a decrease in expected incomes proportional to the
price increase.
Comparing the above propositions leads us to the following conclusion:
The difference between the effect on real consumption or on real saving of
a certain reduction in the residual fraction and an increase in the price level
of the same proportion (e.g. by means of a consumption tax), is equal to the
effect of a fall in the rate of interest also by the same proportion.
us, if the basis for comparison is proportional anges of residual
fraction and price level, the question whether it is income tax or
consumption tax that has the strongest influence on real consumption or real
saving will be a question of the effect of the rate of interest on real
consumption or real saving. is conforms to the findings of section 5. It is
easily seen that our conclusion would be valid even if the tax rates were
different in the different periods. e condition is only that all residual
fractions shall be anged proportionally. So far, the argument is also valid
for progressive taxation (see Chapter XIV).
However, nothing has been said about nominal saving. If we imagine both
the residual fraction and the price level to be increased by the same
percentage and the rate of interest reduced by the same percentage then real
saving will be unaffected; nominal saving has thus increased by the same
percentage as the price level. It thus follows that with this basis for
comparison the effects on nominal saving cannot be described only as the
effect of a corresponding ange of the rate of interest.
As the basis for comparison we have up to now used proportional anges
of the residual fraction and the price level, i.e. of 1—tp and 1+tc. As in the
two-period analysis we shall also consider the case of equally large anges
of tax yields as a basis for comparison. Here, too, we must assume that the
rate of interest varies, in inverse proportion to the variation in the residual
fraction whi caused the ange in the yield of the income tax.
Furthermore, we ignore the possibility that the savings goal is dependent on
the residual fraction or independent of the price level. We can thus derive
the following rule, the proof of whi is given in the paragraph in small type
below.
When household saving is positive (negative), a change in the yield of
income tax by a given amount will (a) affect real consumption to a smaller
(larger) extent, (b) affect real saving less (more) and (c) affect nominal
saving more (less), than a change in the yield of consumption tax by the
same amount, although with the modification (the direction and size of
which are unknown) implied in a change in the rate of interest, which is
proportional to the change in the residual fraction corresponding to the
change in the income tax yield. If household saving is zero, real
consumption, real saving and nominal saving will each individually be
affected in the same way by changes in the yields of income tax and
consumption tax by the same amount, although with the modification
implied in the above-mentioned change in the rate of interest.
is result strengthens those of section 5. Irrespective of the basis of
comparison osen, we have to know the effects of the interest-rate ange
on consumption and saving in order to solve the problem definitely.
If we imagine the rate of interest as being varied in inverse proportion to
1—tp, the entity r(1—tp) can be regarded as a constant and the expressions
(VIII: 7) and (VIII: 9) may be wrien thus:
In this system of three equations we let q1, tp and tc be dependent variables,
a
while Tp1 and Tc1 are independent variables and Yi constants. We then
a
find that if denotes the partial derivative of F with respect to Yi (1—

tp)/(1+tc)

Under the above assumptions, where the assumptions as to expectations

and the savings-goal play an especially decisive role, we thus find that both
the classical and the “Keynesian” view on the relationship between the
effects of income tax and consumption tax on saving and consumption, with
certain perhaps not entirely inessential modifications, are in conformity with
the intertemporal utility theory of income disposal by households. at this
is so is quite natural, for inspection of the expressions (VIII: 7) and (VIII: 9)
will show that they can take the form

whi is the Keynesian consumption function of section 5, or the form

whi corresponds to what is oen (but not entirely justifiably) believed to

be the classical saving function; real saving and real consumption are
completely determined by the net rate of interest (i.e. aer allowance has
been made for income tax) according to the reasoning of Lindahl and Pigou
as inspired by John Stuart Mill.

9. THE TAXES IN THE CONSUMPTION FUNCTION

Finally we shall treat one of the questions that we shall be trying to solve
in Part II: in what way will the parameters of fiscal policy enter into the
equations of the ‘correct’ model? Here the problem concerns the way in
whi tax policy parameters enter into the consumption function of the
individual household. We will, however, not concern ourselves here with the
problem of how the subsequent aggregation of the many different individual
consumption functions into a consumption function for all households of the
society, or groups of them, is to be brought about.
Now if we are to produce an explicit consumption function on the basis of
utility theory as outlined above, rather than the quite abstract functions
discussed there, we have to know the form of the utility function. For that
reason, all we can do is to give examples. In order to get a simple case,
whi will nevertheless be sufficient to illustrate the fact that the ordinary
Keynesian consumption function (VIII: 10) is not at all self-evident a priori,
we shall now consider a household whi plans for two periods and whi
has the utility function:

where α1 and α2 are positive constants. e savings goal K2 is assumed to

be p2/(1—tp)r. Finally, if we assume p1 = p2, then we arrive at the
consumption function

It is natural to compare this consumption function with the Keynesian

one (VIII: 10). We then have to imagine that current income Y1a varies, and
consequently that q1 also varies.
a
If now we can assume that Y2 and will remain constant with
variations in Y1a, the consumption function (VIII: 13) may be wrien thus

where c = α1/(α1+α2), i.e. a constant, while b is equal to the difference

between the last two terms on the right hand side of equation (VIII: 13,) and
thus independent of anges in Y1a. We have then aieved a consumption
function whi resembles the Keynesian one in so far as the marginal
propensity to consume, c, is constant and lies between 0 and 1, and an
‘autonomous’ consumption is included in the function, whi is independent
a
of the size of current income Y1 . e ‘autonomous’ consumption is not,
properly speaking, a constant, however, for it depends on (is determined by)
several other factors, viz. Y2a, , p, tp and r.
e ‘autonomous’ consumption in the Keynesian consumption function is
oen explained by reference to the fact that a certain minimum
consumption must be kept up even if current income is at zero. Here we can
see that (in our case) ‘autonomous’ consumption is determined, among other
things, by expected future incomes and by the planned savings goal, in so
far as the larger the expected future income and the smaller the saving goal,
the larger will be the ‘autonomous’ consumption. e savings goal may, of
course, be negative.
e fact that the price level p appears in the expression for autonomous
consumption is of special interest. If we assume that the savings-goal is zero
(i.e. = 0), the consumption function (VIII: 13) can obviously be wrien
thus:

where k is independent of Y1a and of the price level p. Here, we get the
consumption function in a form whi has sometimes been said to imply a
so-called ‘money illusion’: the consumption expenditure is a (linear)
function of the money income, in su a way that consumption expenditure
is not affected by anges in the price level with a given money income.
Furthermore, if current income and the price level were to be anged in the
same proportion, real consumption would not be unanged. Nevertheless,
there is no assumption of a ‘money illusion’ hidden in our derivation of this
consumption function. In the utility function there are only real quantities,
and the savings-goal too is a real entity.
In order to discover the significance of the rate of interest and of income
tax for ‘autonomous’ consumption, let us first consider the product (1—tp)r.
is product appears in two ways. Firstly in the discount factor 1/(1+(1—
tp)r), and secondly in the capitalization factor 1/(1—tp)r in the saving end.

As long as the discount factor does not appear raised to a high power, we
can ignore it as insignificant, at least with anges in the rate of interest and
in the rate of income tax of any normal size. e capitalization factor, on the
other hand, can obviously not be disregarded. If there exists a savings-goal
of the type described here, it is obvious that the rate of interest will appear
in an ‘essential’ way in the autonomous parts of the saving and consumption
functions, even for quite short-term saving. But in other cases, the rate of
interest can be ignored when short-term saving is concerned; the boy who
saves up to buy a motor-cycle is not influenced to any great extent by the
rate of interest. If, on the other hand, the saving is long term (for old age),
then regardless of the actual form of the savings-goal, the discount factor
cannot be ignored a priori, for it will appear raised to a higher power the
further away is the planning horizon.
e distinction we have been making here between short-term and long-
term saving ought to be taken into account in empirical resear into the
importance of the rate of interest for saving. As with investment, long-term
saving may be expected to be mu more interest-elastic than short-term
saving. If we ignore the case where the savings-goal is to obtain a certain
income from interest, then the same rule applies to short-term saving as
applies to short-term investment; it is interest in-elastic.
Lastly, it ought to be observed that—quite apart from its combination with
the rate of interest—the residual fraction appears independently and in a
significant way in the expression for autonomous consumption.
It is questionable, however, whether it can always be assumed that
expected future incomes and the planned savings-goal will not be influenced
by anges in current income Y1a. is would involve an elasticity of
expectation equal to zero for these incomes (and a similar cross elasticity for
the savings-goal). Very oen there is obviously a more or less close
connection between present and expected incomes, and the savings-goal can
hardly be supposed always to be unrelated to current and expected future
incomes. Let us suppose, therefore, as an interesting possibility in su
situations, that the elasticity of expectations is exactly 1 for future incomes
and the savings-goal. is will mean that if Y1a is anged by a certain
percentage, all future incomes and the savings-goal will be anged by the
same percentage (and in the same direction). e consumption function
(VIII: 13) can then be wrien
where d is dependent, among other things, on the size of expected incomes
and the savings-goal. us we have arrived at a consumption function whi
superficially resembles one of the oen-used homogeneous consumption
functions. But there is a crucial difference; for the ‘marginal propensity to
consume’, α1d/(α1+α2), firstly, is not constant, but depends in an essential
way on Y2a/Y1a, /Y1a, tp, p and r; and, secondly, it may now very well
exceed 1 if Y2a exceeds Y1a, and may even be negative if the savings-goal
exceeds Y2a.
We have not, so far, dealt with the question of how the consumption tax
is to be included in the consumption function, instead, we have just
mentioned anges in the price level in general. But it is obvious that it must
be the price level and not the consumption tax that appears in the
consumption function for the individual household whi is included in the
‘correct’ model. e price level may be expected to ange for reasons other
than anges in indirect taxation. On the other hand, it must, of course, be
possible to deduce from the model the way in whi the price level is
connected with the rate of consumption tax, but this is a question of the
policy and planning of firms, not of households.
We shall not go further into all the problems whi arise in connection
with this simple example of the derivation of a consumption function for an
individual household. From what has already been said, it may be
concluded, however, that it is impossible to decide whi hypothesis about
the consumption and saving functions should be used in a given case, if it is
not specified how future expectations as to income, prices, tax rates, etc. are
determined. Most of these problems have been completely ignored above,
but it is obviously best to include all these expected future entities explicitly
in the consumption or saving function. By seing up simple hypotheses of
how future expectations are influenced by earlier events,14 we rea the sort
of hypotheses about the consumption function that have been advanced by
Duesenberry15 and Modigliani.16
 1. e Swedish municipal income tax is approximately this sort of tax.
2. is implies that our assumption that in ea period only one consumer
good exists does not involve any restriction in the results’ generality.
Commodities, the relative prices of whi are constant, can always be
regarded as one single commodity, as has been shown by J. R. His,
Value and Capital, pp. 312–3.
3. We ignore speculations as to future tax anges.
4. Here, and elsewhere in what follows we are assuming a positive rate of
interest; if the rate of interest is negative the slope of the new budget
line will naturally be (numerically) greater than the slope of the initial
budget line.
5. is assumption is, of course, quite arbitrary, and could be
supplemented by other possibilities, su as the State in period 2
desiring the same amount of tax as in period 1. However, we restrict
ourselves to dealing only with the case mentioned in the text.
6. John Stuart Mill, Principles of Political Economy, Book V, Chapter II,
Section 4, Fih London edition. A general survey of the Anglo-Saxon
and Italian ‘double taxation’ discussion is to be found in D. Bla, The
Incidence of Income Taxes, Chapter XIX.
7. Erik Lindahl, Die Gerechtigkeit der Besteuerung, pp. 213 ff.
8. Erik Lindahl, Kompendium i finansvetenskap (Compendium on Public
Finance), Uppsala 1952, p. 31.
9. A. C. Pigou, A Study in Public Finance, Chapter X.
10. E. Carry Brown, ‘Analysis of Consumption Taxes in Terms of the eory
of Income Determination’, The American Economic Review, 1950.
11. Erik Lindahl, Undersökningar rörande det samlade skattetrycket i
Sverige och i utlandet (Investigations into the total burden of taxation in
Sweden and abroad), Swedish State Resear Publication SOU 1936: 18,
Stoholm; and Kjeld Philip, Det offentliges Finanspolitik, Chapter XIII.
12. J. R. His, Value and Capital, p. 41, and M. F. W. Joseph, ‘e Excess
Burden of Indirect Taxation’, The Review of Economic Studies, VI, 1939.
e problem has been discussed in a number of later articles, of whi
the following may be especially mentioned: I. M. D. Lile, ‘Direct versus
Indirect Taxes’, The Economic Journal, 1951; R. K. Davidson, ‘e
Alleged Excess Burden of an Excise Tax’, The Review of Economic
Studies, XX, 1953.
13. e expressions ∂q1/∂Tp1 and ∂q1/∂Tc1 are calculated below under a
certain special condition. In general, nothing can be said about their
signs.
14. See His’s treatment of interest expectations, J. R. His, ‘Mr. Hawtrey
on Bank Rate and Long-term Rate of Interest’, The Manchester School, X,
1939, and the discussion whi followed with Hawtrey in the same
journal.
15. J. Duesenberry, Income, Saving and the Theory of Consumer Behavior,
Chapter V.
16. F. Modigliani, ‘Fluctuations in the Savings-Income Ratio: A Problem in
Economic Forecasting’, Studies in Income and Wealth, Vol. XI, N.B.E.R
1949.
 CHAPTER IX

Further Observations on Fiscal Policy and

Household Planning
1. INTRODUCTION
IT is our task to study how anges in the fiscal policy parameters influence
the plans of the household in order to find out something of the ways in
whi the household may be expected to react to anges of fiscal policy.
e whole of the previous apter was devoted to problems connected with
income taxes and consumption taxes. Income taxes and indirect taxes are
doubtless the most important items on the revenue side of the budget of
every modern State. However, there are other types of State income of
immediate relevance to households, and a large part of State expenditure
represents payments to households. ese budget items are also controlled
by parameters, whi are decisive elements in the planning of households.
Of course, we cannot deal here with all the various ways in whi the State
can influence household planning and behaviour. In the first place, they
ange from time to time and from place to place; in the second place, the
possibilities of using different methods to influence the households are
almost unlimited. For that reason we shall confine ourselves to indicating
some standard examples.
Another circumstance whi makes the analysis in the previous apter
too limited in scope is the fact that household planning covers other things
than planning for consumption and saving. In the previous apter, we took
it for granted that households had certain definite expectations as to their
future labour (factor) incomes, and that these expectations were not
influenced by anges in tax policy. As a maer of fact, it is not unusual for
the households to be able to oose between a number of different expected
income-streams and this oice may quite considerably be influenced by
fiscal policy. is problem must, therefore, also be dealt with.
 e ideal analysis of the place of fiscal policy parameters in household
planning would, of course, establish su a generally valid expression for
household planning that it would include all fiscal policy parameters. For
purely practical reasons, this is impossible, however, as gigantic formulæ
would be needed. It is therefore inescapable that our analysis of the
importance of the different parameters for households is of a partial nature,
in the present apter as in the previous one.

2. CIVIL SERVICE SALARIES, DIRECT SUBSIDIES, ETC.

A number of quantitatively important fiscal policy parameters may be
immediately brought into the analysis of the previous apter on the effects
of income tax and consumption tax. ere we assumed that the expected
future factor incomes (disregarding income from interest), of households,
a
Yi , were given. Certain budget policy parameter anges may, however, be
regarded as anges in the households’ expected factor incomes. Civil
servants’ salaries are an example of this. If the amount of su salaries is
regarded as a State parameter; if the households of civil servants have an
elasticity of expectations of 1 as to their factor incomes; and if it may be
supposed that the planned labour supply of su households is not
influenced by wage anges; then a certain ange in the salary of a civil
servant will simply have the same effect as an increase of all Yia. If,
furthermore, ‘inferior periods’ can be disregarded, an isolated increase in
Civil Service salaries will bring about an increase of both planned
consumption and planned saving in the civil servants’ households. With
other assumptions concerning expectations there may be other results, of
course.
In a similar way, other payments by the State to households or vice versa
can be dealt with, provided they are not directly related to the size of the
factor incomes of the households Yia. Several direct subsidies may be
mentioned here, su as family allowances, whi are not, as a rule, in any
fixed proportion to the household income. However, it must be pointed out
that many subsidies are dependent on income being within a certain limit. If
that is the case, the income from interest may be decisive in border-line
cases in determining whether a household is to receive the subsidy in
question or not. For that reason, direct subsidies may have an effect on the
net return from saving similar to that of income tax. Normally, however,
direct subsidies can be treated as additions to the expected incomes in the
planning calculations of the household.
On the income side of the budget, the poll tax might serve as an example
of State revenue that can be treated exclusively as a deduction from Yia, the
factor incomes; this tax is of mere historical interest, however, but apart
from it, there is hardly an item of State income of this aracter. Death
duties will be dealt with below.
It is obvious that the group of State payments usually called indirect
subsidies can be treated quite analogously to indirect taxes. If they influence
household planning at all, it is via the price level.

3. TAXES ON CAPITAL
Certain taxes whi are imposed on households cannot be included in our
intertemporal analysis of the effects of taxes quite as easily as those in the
previous section. e taxes we are concerned with here are primarily taxes
on capital or on income from capital, and estate and inheritance taxes. For
that reason, we shall dwell upon the effects of these taxes on consumption
and saving in somewhat more detail.
We will begin by studying how a tax on capital or on income from capital
can be treated in our two-period analysis. e household under
consideration has the expected (real) labour income of 1 and 2, see point
A in Fig. IX: 1. At the beginning of period 1, the house-hold has no capital;
the savings-goal is to have capital again equal to zero at the end of period 2;
the assumptions are just the same as in the earlier two-period analysis. In
the initial position there are no taxes; the budget line is then the line L, the
equation for whi is
 Fig. IX: 1

and the optimum point B.

We now suppose that a property tax has been imposed; the tax rate is tpr
and the tax payment of one period is based on the net capital at the end of
the previous period. With negative capital the tax is, of course, zero; thus it
can be said that with negative capital tpr = 0. Using the same symbols as
before, we then find that consumption during period 1 will be q1 = 1—S1
and during period 2 q2 = 2+S1+rS1—tprS1. By eliminating S1 we get the
new budget line L’ aer capital tax:

us the new budget line coincides with the old one to the right of A; to
the le of A, the new budget line has a (numerically) smaller slope than the
old one. Accordingly the new budget line has a kink at point A.
Let us instead suppose that a tax on income from property has been
imposed; the tax rate is tpi and the tax is to be deducted on the payment of
interest. With negative capital and at a negative rate of interest the tax is not
imposed; thus in these cases tpi = 0. Consumption during period 1 will then
be q1 = 1—S1 and for period 2, q2 = 2+S1+(1—tpi)rS1. e new budget line
L′ (aer the tax on income from capital) will then be:

If the interest rate r is positive, the budget line aer tax on capital income
is illustrated by L′ in Fig. IX: 1.
us, whether we are considering a capital tax or a tax on income from
capital, the following rule is valid; if the optimum point before tax, B, is at or
to the right of A, household planning is not influenced by the tax; the
household is a borrower with negative capital and negative capital income.
If the optimum point before tax is to the le of A—whi means that the
household is a lender with positive capital and a capital income—both taxes
have the same effect as a certain lowering of the rate of interest. It
immediately follows, see the discussion in Chapter VII on the effects of
anges in the rate of interest, that we cannot in general decide whether
planned consumption q1, and planned saving S1, increase or decrease as a
result of the introduction of the tax.1
However, we have only considered one case, where the savings-goal is of
a particular nature (final capital = 0) and where there is no initial capital. If,
for instance, the savings-goal is instead to have a certain disposable capital
income at the economic horizon, it is evident that the introduction of a
capital tax or a tax on income from capital must tend to increase saving. In
order to aieve a given income from capital, larger amounts of capital are
required. If the savings-goal is to accumulate a certain amount of capital,
saving is not influenced in any definite direction by these taxes.
Let us also consider briefly the case where there exists a certain (positive)
capital at the beginning of period 1 and let us imagine that the savings-goal
is to have the same capital at the economic horizon. If nothing is saved
during period 1, the household will have a certain given capital and income
therefrom in ea period. From the total incomes of periods 1 and 2 certain
amounts of tax are deducted. If now something is saved in period 1, further
tax will be imposed on this amount (or on the income therefrom); while, on
the other hand, since there is some capital from the beginning of the
planning period, negative saving means less tax, for it is normally the net
capital or the net capital income whi is taxed. e capital tax and the
capital income tax can, for that reason in this case, be regarded as a
combination of a certain income tax during the two periods (the tax rates
would probably be different, if capital or capital income are in different
proportions to the labour income during the two periods) and a certain
lowering of the rate of interest (the budget line is rotated more than the
income tax in itself would bring about). ere is, therefore, no reason here
either to say a priori that taxation of capital affects saving more than
ordinary income tax does.

4. DEATH DUTIES
If we turn next to death duties, these are a form of taxation whi differs
from that dealt with previously, for a bequest is something that happens
only once, and is more or less unexpected. e inheritance in itself consists
of a transfer of capital from the deceased person to the heir. e effect of this
transfer of capital depends on the differences in the behaviour of the two
households concerned, whi is outside the scope of our enquiry. e effect
of inheritance tax, on the other hand, depends on the behaviour of the
household that receives the inheritance (see below).
If we now start with the case where the inheritance comes quite
unexpectedly, the inheritance will mean that the household will, at the
beginning of a period, have some capital whi it has not saved up itself.
Naturally this will influence the general planning of the household.
Everything will depend on how the savings-goal is influenced by the
inheritance. For instance, if the household anges its savings-goal in su a
way that the desire to have capital equal to the inheritance at the economic
horizon is added to the previous savings-goal (‘the inheritance is not to be
toued’), the planned consumption and saving of the household will only
be influenced by the fact the inheritance may possibly give a certain capital
income, whi in its turn (disregarding ‘inferior periods’), must lead to
increased consumption for all periods, even the first. However, it is uncertain
how saving during the first period will be influenced. If, on the other hand,
the savings-goal of the inheriting household is unanged, this will mean
that the household must plan to consume all of the inheritance, whi
(disregarding ‘inferior periods’) will imply an increase of consumption
during the first period (and during the following periods, too, of course), and
(probably) a large decrease of saving. ese two examples show that the
consumption of the inheriting household will tend to increase and that this
increase will be larger, the larger the inherited capital and capital income. It
thus immediately follows that a tax on inheritance tends to decrease
consumption and possibly increase the saving of the inheriting household.
Other households than those actually involved in inheritance may be
affected by death duties. If the savings-goal of a household is to leave a
certain amount of capital to its heirs, death duties may influence the
savings-goal. One possibility is that the savings-goal is raised with the
intention of securing a given net capital for the heirs, another possibility is
that the households find it pointless to save for their heirs and reduce their
savings-goal. Furthermore, death duties may bring about capital transactions
between living persons. e field would then be open for all sorts of possible
effects on planned consumption and saving.

5. THE SIGNIFICANCE OF SOCIAL SECURITY

State welfare provisions play quite a significant part in the modern State
budget, and will obviously influence willingness to save;2 private saving
may, to a certain extent, be regarded as a sort of private social security. We
shall consider briefly one special form of social security, old-age pensions,
whi, in Sweden, are paid at a fixed rate aer the age of 67 has been
reaed and whi are to a large extent financed out of certain fixed annual
payments to the State from all under the age of 67. If we consider the two-
period case and let the line of division between the two periods be denoted
by the pensionable age, this form of welfare can be studied in our ordinary
diagram, see Fig. IX: 2. During period 1 (before the pensionable age), the
expected (real) factor income is 1 and during period 2 (aer the pensionable
age) 2, where in most cases 1 > 2. e interest-rate is r. e optimum
point is B with positive saving during the first period and negative saving
during the second period: the saving is intended to supplement the small
income of old age. e savings-goal is zero.
If now the State takes a fixed amount, say T, from the household in period
1 and gives a fixed amount, say P, in period 2, the A point whi represents
zero saving, will be shied. If P = T(1+r), the new A point, A′, will be
situated on the old budget line L; the new budget line L′ then coincides with
the old one. If P > T(1+r), the new A point, A″, and consequently also the
new budget line L″, will be above the old budget line. If, on the other hand, P
< T(1+r), the new A-point, A″′, and the new budget line, L″′, are below the
old budget line. All budget lines are parallel.
If we ignore ‘inferior periods’, it will be seen that in the first case the
planned consumption (during the first period) will not be influenced by the
introduction of insurance; saving is decreased by exactly the amount of the
pensions contribution T. If this is regarded as compulsory private saving,
then total private planned saving will be unaffected. In the second case, the
pension seme may be said to imply an expected subsidy equal to the
difference between T(1+r) and P; the standard of living of the household is
raised, the planned consumption increased (we disregard ‘inferior periods’)
and private planned saving will decrease (even if T is included in private
saving). In the third case, an expected taxation equal to T(1+r)—P is implied;
planned consumption decreases and planned saving increases (if T is
included in private saving).
Unemployment insurance, where the ‘premiums’ are fixed amounts per
period and relief is paid in given amounts per period of unemployment, may
be regarded in a similar manner. Here, too, it is crucial whether the
‘insurance’ implies a subsidy or a tax.
More complicated welfare provisions where, for example, participation is
voluntary, or where ‘premiums’ and relief are in some fixed relationship to
the income of the household, may also be treated within this framework.
 Fig. IX: 2

6. THE SIGNIFICANCE OF TAX PROGRESSION

In the previous apter we generally ignored the question of the progression
of income tax, except for one very special case whi lent itself very easily
to analysis there. In this section, we will supplement the results of the
previous apter on this point.
It is not an uncommon point of view that income tax falls more heavily
on saving the more progressive it is. As so oen in tax debates, it is not at all
clear how this viewpoint is to be interpreted. It is obvious, however, that one
is to conceive of two income tax scales, one of whi is more progressive
than the other, and compare their effects on consumption and saving. On the
other hand, the two tax scales whi are to be compared ought to be similar
in some respect, otherwise the comparison is pointless. Progressive taxation
means that the marginal rate of taxation increases with the size of the
income; the more rapid the growth of the marginal rate of tax as income
increases the greater is the progression. If, therefore, a more progressive
scale of income tax rates is used, in whi the marginal rate of tax for ea
slice of income is larger than the corresponding marginal tax rate in the less
progressive scale (whi is the basis for comparison), then it is easy to see
why the more progressive tax affects savings more severely than the less
progressive one. For the more progressive tax, the average tax rate, and
consequently the total tax amount as well, is everywhere larger than for the
less progressive one; but this does not tell us anything that is aracteristic
of or peculiar to progressive taxation.
e obvious thing to do seems to be to begin by comparing two tax scales
whi, though different in all other respects, have the same average tax rate
for the household in question (and thus the same tax yield) at the actual
income received in the period in question. For the sake of simplicity we will
let one of the taxes be a proportional one, where the average and marginal
tax rates are equal and constant for all levels of income. e other tax is
progressive in the sense that the marginal rate of taxation is increasing as
income increases. From this, it follows that the progressive tax has a lower
average tax rate for incomes whi are smaller than the current income of
the household in question, and a larger average tax rate for larger incomes,
as compared with proportional taxation. We will make use of this fact.
e household discussed in section 9 of the previous apter will be used
here as an example. It had a planning horizon extending over two periods,
with expected labour incomes of Y1a and Y2a and with a utility function U
= q1α1q2α2. If we assume that the rate of interest is zero and the savings-
goal is zero, and that the rate of income tax at income Y1a is tp1 and at
income Y2a is tp2, then the consumption function will be (see Chapter VIII,
section 9)

With the proportional income tax tp1 = tp2. With progressive taxation tp1
has the same value as with proportional taxation, while tp2 > tp1 if Y2a >
a
Y1 , and tp2 < tp1 if Y2a < Y1a. en it immediately follows that if Y2a <
a
Y1 consumption, q1 will be less with proportional than with progressive
taxation; if Y2a > Y1a consumption will be less with progressive than with
proportional taxation. Since according to the assumptions the tax yield in
the first period is the same with both tax scales, then it follows that if Y2a >
 a
Y1 , saving will be greater with progressive than with proportional taxation;
if Y2a < Y1a saving will be greater with proportional than with progressive
taxation.
ese results can be applied more widely and hold even in the more
general case where the horizon ranges over an arbitrary number of future
periods and the rate of interest is greater than zero. As usual, we disregard
‘inferior periods’, whi means that we assume that an increase in income
for an arbitrarily osen future period will always imply increased
consumption during the first period. en if the expected incomes (averaged
in some way) for the periods 2 to n are greater than the expected income of
the first period, planned consumption will be larger with proportional than
with progressive taxation; if the expected incomes (averaged in the same
way) are less than the expected income of the first period, planned
consumption will be larger with progressive than with proportional taxation.
To use an expression from J. R. His,3 in the first case expected incomes
show a crescendo, in the second, a diminuendo. e results can then be
summarized thus:
If the expected stream of (factor) incomes shows a crescendo, the planned
consumption of the individual household will be affected less and its planned
saving more with proportional income taxation than with progressive
taxation. If the expected stream of (factor) incomes shows a diminuendo, the
planned consumption of the household will be affected more and its planned
saving less with proportional income taxation than with progressive
taxation.
If we return for a moment to the discussion (in Part I, Chapter IV) on the
possible stabilizing effects of the budget, the important role to be played here
by progressive income taxation will readily be appreciated. For it can be
concluded from the above that if, with given current incomes, expectations
about future incomes become more optimistic, then current consumption
will be influenced less by this the greater is the progression of income
taxation. e same applies if households begin to expect falling incomes.
us progressive income taxation has qualities that are very desirable from
the stabilization viewpoint, for it tends to eliminate the effects on current
consumption of anges in expectations. is quality of progressive income
taxation must not be confused with the frequently pointed out fact that
progressive taxation may help to subdue an inflationary development by
taking away an ever greater part of rising current incomes. Progressive
income taxation begins to operate at the expectation stage, before current
incomes have begun to ange.
In the above we have only been concerned with the effect of progression
on the planned consumption and saving of the individual household. When
it sometimes is said that more progressive taxation affects saving more than
less progressive taxation, it applies rather to a comparison between the total
saving of households with different current incomes taxed at scales differing
in progression. In the simplest case, we can consider two households of
whi the first has a high current income, the second, a low current income.
It is assumed that the two households are taxed according to the same
progressive tax on the one hand, and according to the same proportional tax
on the other, where the two scales are constructed in su a way that at the
given current incomes they yield the same amount of tax. It may then be
asked whether the joint saving of the two households will become larger or
smaller with progressive taxation than with proportional taxation? It is
immediately obvious that the answer depends entirely upon the
consumption functions of the two households, and also on the form of the
expected income streams of the two households. A priori no definite answer
can be given; for instance, it is quite conceivable that progressive taxation
will result in greater saving than proportional taxation. One special case
worth noting is that where the consumption function is of the usual
Keynesian type with the same constant marginal propensity to consume for
all households. Here, joint saving and joint consumption will be quite
uninfluenced by the way in whi a given amount of income tax is
distributed between households with different incomes. us tax progression
is of no importance here to the amount of saving. We shall return to the
question of tax progression in Chapter XIV.

7. PUBLIC CONSUMPTION
As has already been stated (Part I, Chapter VI, section 4), we distinguish
between public production and public consumption. Public production is
connected with su fiscal policy parameters as civil service wages,
purases of finished goods and raw materials, etc. But the distribution and
consumption of public production is also utilized in fiscal policy, that is to
say, provides the State with fiscal policy parameters. With exactly the same
public product, that is, with given ‘production parameters’, the State can
influence the standard of living of households in many different ways by
means of public consumption, especially by regulations as to whi sections
of the community are to participate in the consumption of the public
product. Income limits, geographical limits, occupational criteria, etc. may
be used by the State when it wishes to benefit special groups. e effects of
public consumption will, of course, depend upon whi sections of the
community receive the free services of the State.
When we begin to introduce those parameters whi are connected with
the distribution of the public product, we approa the frontiers of fiscal
policy in the true sense of the term. It is obvious that all governmental
actions in themselves can be aracterized as ‘distribution of the public
product’, and if it is so desired, then in principle all State activity may be
taken into account when the effects of fiscal policy are to be determined,
including the judicial system, the armed forces, etc.4
We are here interested in the possibilities of the State influencing
household planning directly. Clearly a great deal of production by the State
does not do this. e internal administration, whi the households
generally have nothing to do with, is an important field. Another field is that
part of public production whi is freely put at the disposal of the firms. is
part of State consumption can, at the most, influence the household through
the reactions of the firms. Instead of talking about public consumption in
general (= public production), one ought to say that the public product is
distributed for collective consumption by households, for collective use by
firms5 and finally for public consumption in the real sense when it cannot
reasonably be aributed to households or firms (the free services whi the
State provides abroad are an example).
Here we are only interested in that part of public consumption whi we
called collective consumption within the household. e question is now, in
line with the above, how a certain increase in collective consumption within
households affects the disposal of money incomes (aer taxation) on
consumption and saving. An important circumstance here is whether the
actual services from the State, whi represents collective consumption, are
competing with or complementary to the goods that the household buys for
its consumption. For example, if the State puts beer roads at the disposal of
households, this may possibly involve su a great increase in motoring by
the household that it increases its total spending on consumption (despite
possible decreases in other consumption expenditures) and therefore save
less. If a free health service is introduced by the State, this may possibly
involve su a great reduction of money going to pay doctors’ bills that the
household is able to reduce its total spending (despite possible increases in
other consumption expenditures) and thus save more.
Lastly, it should perhaps be pointed out that not all the public
consumption whi has a direct influence on the household’s standard of
living necessarily raises it. State activities oen involve trouble and
inconvenience, and some State action may even directly serve to subdue the
citizens, e.g. the secret police, the censor, and the like.

8. FISCAL POLICY AND THE SUPPLY OF LABOUR

We have been assuming that the household’s expected stream of future
labour incomes is given and uninfluenced by fiscal policy measures. at
part of the income stream whi consists of interest receipts is, on the other
hand, planned and determined by the household itself. However, it is clear
that the assumptions about given expected labour incomes are dubious. A
household may oen oose between a number of expected streams of
labour income, and fiscal policy may very well be decisive in determining
what this oice shall be. With given wage rates, this oice is a question of
deciding the nature and amount of the supply of labour that the household
hopes to be able to dispose of. us we enter upon the problem of the effects
of fiscal policy on the supply of labour.6
When analysing the supply of labour, it is convenient to distinguish three
different types of oice that households are confronted with concerning the
supply of labour.
Firstly, it may be asked, whi occupation is to be osen. For older
people, this is oen given and in practice no oice arises. If the pensionable
age is not fixed by contract or in law, the household nevertheless always has
to deal with this problem. For younger people, however, the oice of a
profession is a real problem and connected with it there is also the question
of whi sort of education to oose—that is, if there are alternatives
available. e income stream and the supply of labour are distributed very
differently over time in different trades and professions. People who oose
the ‘professions’ are not in a position to supply labour before the age of 25–
30. On the other hand, su people do not abruptly cease to offer their
services at some fixed pensionable age; but, from the age of 60, let us say, the
supply of labour gradually begins to decrease. People who ‘oose’ unskilled
work offer a comparatively fixed supply of labour from sool-leaving age
right up to the pensionable age; aer this, the supply of labour oen ceases
altogether.
Having once osen a trade, the question arises of how many working
hours (per day, week or year) one is willing to work and what intensity and
skill one wishes to devote to the work. It is oen said that in a modern
society very large groups of people have no oice in this maer. e
working time is fixed by law or by agreements made by their trade unions,
the intensity and quality is determined by the tenical process in whi the
worker in question merely assists. While there is mu truth in this, it must
not be overlooked that most wage-earners still have some opportunities of
controlling their own supply of labour. ere is the possibility of taking or
refusing overtime work, the possibility of taking a day off, the possibility of
deciding the working pace on piece-work, and the ance of anging jobs.
ese are all examples of a certain potential elasticity in the supply of labour
even in a thoroughly organized society. e extent to whi an individual
wage-earner can make use of these possibilities increases with the level of
employment, and at over-full employment become a very important factor.7
We now enter upon the third question of importance for the supply of
labour. When the household is used as the planning unit, as it is here, even
when the supply of labour is concerned, there arises the question of how
many of the members of a given household will seek employment. Roughly
speaking, this is mostly a question concerning the employment of married
women. is is undoubtedly the factor whi gives the supply of labour its
highest potential elasticity in a modern society. We do not know mu about
what determines how many members of a household will seek employment.
It is obvious that economic circumstances play their part; but at the same
time, non-economic factors, sociological and psyological, are of great
importance.
Fiscal policy can obviously be expected to influence the oice made by
the household in all the three respects mentioned above. Mu has been said
about this in practical policy as well as in theoretical literature.
eoretical writings, however, have mostly dealt with the problem of the
importance of taxation for the length of working time. Let us assume that
the quantity of work offered, the length of working time or, alternatively, the
length of leisure time is directly included in the utility function. e problem
of the quantity of work offered may then be treated by analogy, and in
connection with consumption and saving, see the paragraph in small type
below. We will not make any formal analysis here, but only refer to existing
works and to section 4 of Chapter XIV,8 and give the more important
results. Generally one cannot tell whether taxation will lead to an increase
or decrease in the supply of labour; however, it seems likely that the more
progressive an income tax is, the greater are the possibilities of a decrease in
the supply of labour.
In practical policy debates prey well all the aspects of the importance of
fiscal policy for the supply of labour, the so-called labour incentive, have
been the subject for extensive speculations. e importance of tax
progression and the joint taxation of husband and wife have aracted
particular aention. e greater part of this discussion, however, is based on
neither careful theoretical nor empirical analysis.
A few theoretical observations concerning the treatment of the supply of
labour would not be out of place here. As has been said, the supply of labour
is normally dealt with by including some expression for the amount of
labour in the preference function. If this amount is called A (we do not have
to go into units of measurement, whi may be working hours, working
pace, the number of units produced, etc.) we get the following preference
function
where w is the wage per unit of labour, pi price and qi quantity of consumer
goods.
is traditional approa can obviously also be extended to the
intertemporal case; the preference function is then anged so that both
quantities consumed and the work offered are dated, and thus the preference
function becomes dependent on consumed quantities and work during
several future periods; a ange must also be made in the budget restrictions.
e traditional theory of the supply of labour can, however, also be
extended in another direction, whi with the treatment of certain types of
tax problems, especially joint taxation problems, seems to be fruitful and
very natural. If we regard the preference function as the preference function
of the individual household, in accordance with the traditional theory of
consumption, we ought, when discussing the supply of labour by an
economic subject, to consider that the household can offer several different
kinds of labour at the same time. Both the husband and the wife can offer to
work and perhaps also ildren living at home. is means formally that in
the static one-period theory, where saving is ignored, the preference
function will be

where the AiS now represent the various kinds of labour the household can
supply.
Without going into detail it may be pointed out that if the preference
function is simplified into U = U(q, A1, A2) where q is total consumption
(the ‘real income’), A1 the work done by the husband, and A2 the work done
by the wife (outside the home), it is possible to deal with the effects of joint
taxation on the supply of labour in a geometrical (three-dimensional) way.
As will readily be understood, in principle a treatment of all the three
aspects mentioned above—oice of profession, the quantity of labour, and
number of members of the household offering labour—could be given within
the framework of an intertemporal theory of household consumption, saving
and supply of labour.
 Finally, it may be worth pointing out that there is nothing in economic
theory, or more especially in welfare theory, to imply that fiscal policy
should be directed towards increasing the incentive to work. is is purely a
political question and it is quite conceivable that a reasonable policy may
wish to lessen the willingness to work for welfare reasons. More leisure may
perhaps be considered to be of greater value than an increase in the national
product.

9. A CRITICAL SURVEY OF CHAPTERS VII TO IX

Chapters VII–IX have dealt exclusively with various aspects of household
planning and the direct effects of fiscal policy on this planning. Before
turning to planning by firms, it seems appropriate to undertake a critical
survey of our treatment of households. In the first place, this survey will
serve to counter part of the criticism whi our analysis of household
behaviour will undoubtedly arouse. Moreover, we shall, in this way, discover
some of the points in whi the analysis could and should be carried further.
We will proceed by dealing first with the pure theory, and later turning to
the question of the empirical relevance of the theory.
e object of the analysis of household planning was to try to show how
the fiscal policy parameters are included in that part of the equation system
of the ‘true’ model whi describes the behaviour of the household. is end
has not been reaed in so far as we have not, for example, established any
consumption function, or any function for the supply of labour, etc., in
whi all the relevant fiscal policy parameters are included. e only
aempt of that sort that we have made is in the discussion of a consumption
function, where both the income tax and the consumption tax appear
(Chapter VIII, 9). e reason for not aempting any further integration of
the results is quite simply that su an integration is a very complicated
business whi would stret our very tentative discussion too far.
Another aracteristic of our analysis is that we only consider two ways
of using income: consumption and saving (except for tax payments, of
course). Consumption has been assumed to concern a homogeneous
consumption good with a uniform price (within ea period). is weakness
in our analysis is, however, quite unimportant from the point of view of
method; our intertemporal theory of income disposal can, without any basic
anges, be extended to cover an arbitrary number of consumption goods. It
is more serious, that we have also considered saving as homogeneous in the
sense that all saving (positive or negative) is assumed to be invested in a
particular way with one fixed rate of interest (for ea period). It is true that
we could take account of the form in whi savings are held within the
framework of our analysis by distinguishing between a number of different
types of loans granted for different periods and at different interest rates,
and also between lenders’ and borrowers’ interest rates, and by making
various assumptions as to the interest expectations of households. However,
it can hardly be denied that su an analysis of savings, and thereby also of
the household’s liquidity would be somewhat meagre. Especially as the
question of the risk element is a decisive one at this point.
Here, we are up against the third aracteristic deficiency of our analysis;
the over-simplified assumptions about expectations. It has already been
pointed out in Chapter VII that we assume throughout that all expectations
of households about the future are completely certain (but not, of course,
necessarily correct). us the whole problem of risk has been eliminated. If
we drop this assumption and work with probability distributions of
expectations and also take account of the problem of ‘objective risk’ and
‘subjective risk evaluation’ the analysis takes on a new form at some points.
As an example of this we may mention the assumption of absence of so-
called ‘inferior periods’—an assumption lying behind some of our results—
whi is not so obvious when regard is paid to the element of risk.
We can show this by means of a simple example, see Fig. IX: 3. We
assume that in a two-period analysis the interest rate is given and that the
household has in the initial position the A-point A′, the budget line L′ and
the optimum point B′ with planned consumption q1 for period 1. Now let
the income expectations of the household be anged in su a way that the
A-point is shied to A″ on the budget line L″. e absence of ‘inferior
periods’ then implies that the new optimum point B″, lies north-east of the
old optimum point B′, that is between the points C and D on the budget line
L″.
If the expectations are absolutely certain and the possibilities of
borrowing unlimited, the optimum point of L″ is independent of where A″ is
situated on L″. If regard is paid to risk and its evaluation, this will not be the
case.
Suppose that point is expected with absolute certainty.
Suppose also that point is associated with risk in su a
way that 1″ the expected income of the first period, is expected with
absolute certainty while 2″ the expected labour income of the second
period, is not quite certain. 2″ must then be regarded as the mathematical
expectation for the income of period 2, with a certain distribution around
this expectation. If now A′ and A″ are situated as in Fig. IX: 3, and
furthermore, the evaluation of risk is su that ‘uncertainty is an evil in
itself’, it can quite reasonably be imagined that the household, despite the
fact that the budget line has been shied to the right, decreases its
consumption for period 1, whi in turn will mean that the assumption of
the absence of ‘inferior periods’ cannot be maintained (or at least must be
given quite a different formulation).

Fig. IX: 3

Finally, before leaving this survey of pure theory, we shall ask the
fundamental question whether we have osen the right theory at all—in
using Fisher’s intertemporal theory for the disposal of household income as
the basis for the analysis. ere is hardly any doubt that the intertemporal
theory in this connection is to be preferred to the usual ‘static’ one-period
theory; for otherwise, we would not be able to include future expectations.
Moreover, the one-period theory is simply a special case of the general
intertemporal theory. From this point of view our oice of theory is
perfectly correct. e traditional consumption theory has, however, been
aaed lately on other grounds, one of whi is directed against the fact
that it is purely a flow analysis; all stos are disregarded in the utility
function. e problem of introducing cash-holdings into the utility function
has especially been mu discussed.9 Even if we take stos into
consideration to some extent by introducing the savings-goal into the utility
function, it is still justifiable to criticize the theory from this angle. On the
other hand, it should be noted that the consequence of this is that all kinds
of stos should be drawn into the analysis, including claims of all kinds and
possibly also real capital. Another argument concerns the assumption that
ea household (individual) has a given indifference map, whi is not
influenced by economic factors. e indifference map in the traditional
theory is exogenously determined and various objections may be raised to
this. Here we may refer the reader to the arguments of J. Duesenberry.10
Duesenberry’s idea is that the behaviour of the individual household is
influenced by the behaviour of other households. Changes in neighbour’s
consumption influences the preference map of the household under
consideration, and consequently also the consumption plans of that
household, even if all its other circumstances (expected incomes, prices,
savings goals, etc.) are unanged.11 Duesenberry supposes that the
propensity to consume (save) of the household is wholly dependent on the
position of the household in the distribution of income.12 Accordingly, it is
relative income that determines the individual household’s income disposal
between consumption and saving. It is not clear how taxes are to be
introduced into this hypothesis, but it seems natural to suppose that it is the
distribution of the real disposable incomes (aer taxation) whi is decisive.
From this point of view a general purase tax cet. par. could hardly be
expected to involve any anges in total consumption outlay. e
distribution of income is not influenced (see also Duesenberry’s equation
system). e price elasticity of total consumption is 1. Total monetary saving
would thus not be influenced. On the other hand, it is very difficult to
determine the effects of a progressive income tax in the Duesenberry
consumption theory. Everyone keeps his position in the distribution of
income and so propensity to save should be unanged for everybody.
However, this unanged propensity to save is applied to a smaller income,
and will involve a decrease in money saving. On the other hand,
Duesenberry himself13 deals with a case in whi he imagines that a
complete levelling of incomes has been brought about by means of taxation
and subsidies, and considers that in this case, whi (although rather
extreme) resembles the case with progressive taxation as far as relative
distribution is concerned (the distribution is squeezed together), increased
saving is possible.
However, it still remains to be shown whether consumption and saving
theories of the Duesenberry type can describe the actual behaviour of the
household beer than the traditional intertemporal theory. Duesenberry’s
own experiments in this field are not fully convincing.14 No doubt
Duesenberry’s hypothesis is so interesting that there would be some
justification for repeating the whole analysis of the previous apters using
his hypothesis as a basis. However, we refrain from doing this because most
of our results are formulated in su a way that they are not influenced by
interdependence between the behaviour of individuals.
Finally, a few words about empirical relevance. We have hardly anywhere
referred to empirical resear; the fact is, however, that there is hardly any
empirical investigation whi sets out directly to illustrate the importance of
fiscal policy for household planning. It is true that hypotheses as to the
importance of taxation are normally implicit in empirical resear on the
demand for consumer goods, especially those concerned with the
consumption function. For instance, a common hypothesis about the
consumption function is that total real consumption is determined by real
disposable income, whi implies an obvious hypothesis as to the
importance of income tax and indirect taxes. However, as these
investigations never discuss the validity of that part of the hypothesis whi
concerns the budget policy parameters, they are of no great value to us. As a
rule, these investigations also ignore the importance of expectations.
Although resear into the theoretical aspects of the importance of fiscal
policy for household planning has been, and still is, deficient, this is even
more true on the empirical side. No amount of theoretical work, no maer
how polished, can make empirical studies superfluous. Firstly, because one
can never know if the theory is of any practical relevance, and secondly,
because theory does not always provide qualitatively determinate results. If,
therefore, fiscal policy is to be saved from working in the dark in this
respect, detailed empirical resear seems not only to be desirable but to be
absolutely necessary; however, su resear is outside the framework of
this study.

1. e result is well known in the literature, e.g. O. Mehring, The Shifting

and Incidence of Taxation, pp. 197 ff.
2. See C. Welinder, Socialpolitikens ekonomiska verkningar (e Economic
Effects of Social Policy), Swedish State Resear Publication SOU 1945:
14, Stoholm, p. 16 f.
3. J. R. His, Value and Capital, p. 187 f.
4. A logical aempt to explain the size and composition of the budget by
reference to the wishes of individuals and the utility they derive from
State activity leads to this standpoint, see Erik Lindahl, Die
Gerechtigkeit der Besteuerung, Part I.
5. Compare the distinction made in national accounting between
consumption-promoting and production-promoting State consumption,
see Ingvar Ohlsson, On National Accounting, Stoholm 1953, pp. 223–
30.
6. Certain related questions are more conveniently dealt with elsewhere,
see Chapter XIV, sections 3–5, whi can be read in conjunction with
this section.
7. R. Meidner, Svensk arbetsmarknad vid full sysselsättning (Full
Employment in the Swedish Labour Market), Stoholm 1954.
8. See the very thorough analysis of G. Cooper, ‘Taxation and Incentive of
Mobilization’, The Quarterly Journal of Economics, 1952, and the
discussion with O. Mehring whi followed.
9. D. Pantinkin, ‘Reconsideration of the General Equilibrium eory of
Money’, Review of Economic Studies, 1950–51, also ‘Further
 Considerations of the General Equilibrium eory of Money’, Review of
Economic Studies, 1952–53.
10. J. Duesenberry, Saving, Consumption and the Theory of Consumer
Behavior.
11. Ibid., p. 14.
12. Ibid., p. 3.
13. Ibid., pp. 44 f.
14. Ragnar Bentzel’s review of Duesenberry’s book in Ekonomisk Tidskrift,
Stoholm 1951.
 CHAPTER X

e Importance of Fiscal Policy for Planning

by Firms
1. INTRODUCTORY REMARKS
WE pointed out in discussing the importance of fiscal policy for household
planning that this question has not hitherto been dealt with in a systematic
way. e literature in this field is very scanty. It is a different maer,
however, when we turn to the question of the importance of budget policy
for the planning of firms. Right from the beginning of the theory of public
finance interest has centred upon the effects of fiscal policy, and especially
taxation, on the size and composition of production as well as on prices. It is
true that parts of this theory have been formulated as incidence theory in
the partial equilibrium sense, but with simple re-interpretations we can
easily produce a theory of the effects of fiscal policy measures on the
planning of firms. e problem of the planning of firms is, of course, just as
important to the problem of fiscal policy as is household planning.
Aer a short summary and discussion of the ‘pure’ theory of the planning
of firms, we will proceed to give several examples, showing how this theory
can be used to determine the effects of budget policy.

2. A BRIEF SURVEY OF THE THEORY OF PLANNING BY FIRMS

e theory of planning by firms in a modern capitalist society is built on the
basic assumption that the task of planning is to maximize the profits of the
firm. e theory of planning by the firm thus centres on the solution of a
maximization problem, and so will have considerable formal similarity to
the theory of household planning.1
In its most general version, the theory of planning by firms takes the form
of an intertemporal theory whi shows how the firm plans its purases
and sales, its borrowing and lending, its stos of goods, real capital, money,
etc., for all periods within the economic horizon, in order to maximize its
expected net income within this horizon, expressed as the anticipated capital
value of the firm.2 e planning theory of the firm in this general version is,
however, of su an abstract nature that it is hardly worth discussing the
effects of fiscal policy on the planning of firms on this basis.
A simpler type of planning theory is the intertemporal production theory,
whi studies the planning of the firm’s production processes when they
extend over several future periods, where the input of services from the
original factors and the emergence of the finished product are separated in
time. is is the field of ‘capital theory’.
e fact that the firms have a mu larger number of action parameters
than the household, makes the theory of planning by firms very mu more
complicated than that of household planning. It may be assumed as a close
approximation to reality that normally the individual household cannot
exert any influence on the prices at whi it purases goods for
consumption, on the rate of interest at whi it deposits its savings (or takes
a loan), or the prices at whi it supplies its services. Furthermore, the
household’s supply of labour services can sometimes also be regarded as
determined externally. What remain as action parameters for the household
are its purases of consumer goods and its plans about saving, and these are
then the only things to be determined by the theory of household planning.
For the firm, it is different. As far as selling is concerned, the firm can oen
determine its selling prices (this is probably the most usual case) or the
quantities of its finished products that are sold. As to buying, the firm can
normally determine the quantities of raw materials purased and the
amount of labour hired, etc., and in certain cases, possibly exert an influence
on the purase prices. Between buying and selling, production takes place;
if the sto of raw materials and finished goods permit, the firm can even
pursue a production policy concerning the method, volume and composition
of production whi is independent of expected sales and purases.
In order not to have to consider all these action parameters in the same
analysis (whi is what is aempted in principle in the very general
planning theory mentioned earlier), the theory of the planning of firms is
usually dealt with in three stages.3 Firstly, a production theory and the cost
theory associated with it, are set up under very simplified conditions.
Among the simplifying assumptions, the most important is the omission of
the time factor, as production is supposed to be instantaneous; thus it may
be said to be a one-period analysis. e theory of production examines the
optimum factor combination for a given volume of production, and also the
variations in the quantities of factors employed with anges in the volume
of production and in factor prices. e cost theory, whi is a direct and
obvious consequence of the production theory, examines how costs vary
with the volume of production. Marshall’s distinction between short run and
long run analysis4 is a rather crude aempt to extend this theory so as to
take account of the importance of the time factor; cost theory in particular
has developed in this direction. Secondly, the price and production policies
of firms are, as a rule, treated in connection with the theory of price, whi
is oen a partial static equilibrium theory for different types of market, and
not in itself a theory of planning by firms. It is a comparatively simple
maer, however, to convert the theory of price into a planning theory.
Thirdly, a theory of investment is set up based on an investment calculus
and extending over several future periods; this is a pure planning theory.
Now if these three types of theories are used as a description of the
behaviour of firms, on the one hand, they la the necessary coordination
between the various descriptions of the different activities of the firms, and,
on the other, they leave a wide field whi is not covered at all. e disposal
of profits by firms is one su field for whi hardly any theory exists.
eories of the type we have been discussing have been called
‘marginalistic’.5 Some authorities are of the opinion—based on various
empirical investigations6—that even though the ‘marginalistic’ theories are
in themselves logically correct behavioural norms for firms in their efforts to
maximize profits, they still do not have any great value as descriptions of the
actual pricing policies of firms, whi are considered to be guided by certain
primitive rules of thumb, whi are said to conflict with the prescriptions of
‘marginalistic’ theory. For instance, according to these rules of thumb, price
is determined on the basis of some kind of ‘normal’ cost by adding a
‘normal’ or ‘reasonable’ profit. e empirical grounds for this criticism of
the ‘marginalistic’ theory are, on the one hand, interviews with
businessmen, and on the other hand, observations of the prices actually set
by firms, whi very oen show an astonishing constancy.
 e defenders of the marginalistic theory have answered these criticisms
with a number of arguments. Among other things, it has been maintained
that businessmen’s ideas on what is ‘normal’ cost and profit have a tendency
to vary with the business situation, in su a way that the simple rules of
thumb do, in spite of everything, involve actions whi are in the main in
accordance with the actions suggested by the marginalistic theory.
Furthermore, the oen observed tendency towards prices that are fixed
irrespective of demand can very well be explained by reference to special
risk factors, etc., whi arise in some pricing situations, or to long-run
maximization, and this in no way conflicts with the marginalistic theory.
It is, of course, fundamental for our problem, whi of these two
descriptions of the behaviour of firms is the correct one. We cannot aempt
to sele this problem here, however, we shall simply consider both theories.

3. EFFECTS OF A RAW MATERIALS TAX ON THE DEMAND FOR

FACTORS AND THE SUPPLY OF FINISHED PRODUCTS
Let us first turn to the demand by firms for factors of production, or to put it
another way, to the connection between the prices of these factors of
production and the amount of them that a firm wants to buy. is is a
question of importance for all fiscal policy measures whi are in any way
concerned with firms’ purasing prices. Typical examples are customs
duties whi are paid by the importer-producer. It seems probable that a
producer, who is confronted with lowered customs duties on a raw material
used by him, has to reon with the fact that in many cases the prices of
su raw materials will fall by the same amount as the reduction in the duty.
His demand function for the raw material in question then will indicate how
he anges his purases; we thus get to know something of how the balance
of payments is likely to be affected by su a ange in customs duty.
In order to simplify the discussion, we will imagine a producer, who only
produces one final product, the price of whi is expected by the producer to
be quite independent of the size of his own production. is means that we
assume that there is perfect competition in the market for his product. e
producer is assumed to direct his production so that his expected profit will
be at the maximum. e maximization of the expected profit is brought
about on the one hand by means of variations in the volume of the
production and on the other hand by variations in the tenique of
production, i.e. the combination of the factors of production.
We now assume that the firm is at its optimum position and that the price
of a raw material (factor of production) is reduced, for example, as a result
of a lowering of customs duties. At an unanged level of production, there
is no doubt that the reduced price of this factor will result in its being
substituted for other factors. e demand for the eaper factor will
consequently increase and the demand for all other factors (taken together)
will decrease. So far, everything is obvious. e fall in the price of the factor,
in connection with the new combination of factors, however, implies that
the costs of production of the firm (at various levels of production) have
decreased, whi under our assumptions should lead to an increase in
planned production. It would perhaps be natural to argue that this will
further increase the demand for the eaper factor of production, and slow
down the decrease in the demand for the other factors (or even bring about
an increase in the demand for these factors). However, su reasoning would
not be valid, for cases can be imagined where at a higher volume of
production, a combination of factors becomes optimal that involves a
decrease in the demand for the eaper factor. e final result may then be
that if a factor is made eaper, this leads to a decrease in the demand for
that factor. J. R. His says that in this case, factor and product are
‘regressive’.7 is phenomenon obviously corresponds to the Giffen paradox
in the theory of consumption. From the point of view of the balance of
payments, it will mean that the introduction of a duty on raw materials may
involve an increase in the imports of these raw materials.
 Fig. X: 1

We will not give a rigorous mathematical proof of the above proposition

but will confine ourselves to illustrating the ain of thought by means of
isoquants, see Fig. X: 1.
In Fig. X: 1, we show the quantity of factor 1, x1, along the horizontal axis
and the quantity of factor 2, x2, along the vertical axis. e ‘indifference
curves’ or isoquants denote combinations of factors whi lead to the same
level of production. In the initial position, where the profit is imagined to be
at the maximum, the level of production may be considered to be P. is
level of production corresponds to the isoquant I. e relationship between
the prices of the factors of production is indicated by the slope of the iso-
cost line L. e combination of factors osen and the amounts of factors
employed are then determined at the point of tangency A between the iso-
cost line and the isoquant I. We now suppose that the price of factor 2 is
reduced. e slope of the iso-cost line is anged in su a way that it
becomes steeper, as L′ for example. With unanged production, the new
combination of factors will be determined at point B; the quantity of x2
increases and the quantity of x1 decreases. Production will now increase,
however. e optimum is thus found to be on an iso-cost line, let us say L″,
whi is parallel to L′, but further to the right. e only thing that can be
said in general is that the optimum point will lie on L″ between the points
where it is intersected by the isoquant I. In Fig. X: 1, three different
possibilities have been indicated, C′, C″ and C′″ for the position of the new
optimum point. By comparing these with the initial position A, it will be
seen that the optimum point C′ involves an increase in factor 1 and a
decrease in factor 2—this is a case of ‘regression’; the optimum point C″
involves an increase in both factor 1 and factor 2; while optimum point C′″
involves a decrease of factor 1 and an increase of factor 2. e only
possibility that can be excluded is that both factor quantities decrease (or are
unanged); at least one of them must increase.

4. THE IMPORTANCE OF FISCAL POLICY FOR THE PRICE AND

PRODUCTION POLICIES OF FIRMS WITH GIVEN CAPITAL
EQUIPMENT
In this section we shall give some examples of how various fiscal policy
measures can influence the planning of firms with given capital equipment.
Mostly, it is the price or production policy of these firms that aracts our
aention. We distinguish between different kinds of markets, or rather
between the various opinions that businessmen have about the markets they
are selling in. If the businessman knows that he is the only seller in the
market, and can fix his price according to his own wishes without risking
competition, we have a case of perfect monopoly. If the businessman thinks
that he himself cannot exert any influence on that price, whi he imagines
is determined by ‘the market’, we have a case of perfect competition. Finally,
if the businessman knows that although he is not alone in the market and
has to consider his competitors, he can, nevertheless, exert an influence on
price, we have a case (or cases) lying between monopoly and perfect
competition. In the following, we will only go into the cases of monopoly,
perfect competition and one special case between monopoly and perfect
competition. is presentation is consequently far from exhaustive.
Furthermore, we make several simplifying assumptions, in particular that all
conditions on the cost side (tenique and factor prices) appear as given to
the entrepreneurs, and also that planned anges in stos are completely
disregarded (so that planned production and expected sales are the same).

(i) The Monopoly Case

 e treatment of this case is, in effect, nothing more than another version
of the usual static, partial equilibrium analysis of monopoly price.
We assume that the entrepreneur is at the beginning of a period and in a
given cost situation. His problem will then be to oose the price and
quantity of the product for the coming period. Now if we can assume that
the firm has a given expectation as to the connection between prices and
sales, that is as to the shape of the demand curve, we shall find the optimum
position where (expected) marginal cost and (expected) marginal revenue
are equal, in complete analogy to the static price theory, see Fig. X: 2.

Fig. X: 2

If the expected demand curve is D0 and the (expected) marginal cost

curve m.c., the monopolist determines the price for the period as p1 and the
quantity q0 will be produced. Now if the actual demand curve, that is the
purasing plans of the buyers as conditioned by the various prices, is say
D1, the actual sales will be q1. If stos are sufficient, they will be decreased

by q1—q0; otherwise the purasing plans will, to a certain extent, remain

unrealized. is discrepancy between the firm’s expectations and actual
conditions is of importance for the firm’s planning for the next period. It is
reasonable to suppose, for instance, that the firm will ange its expectations
about the shape of the demand curve for the following period. On the other
hand, the ex post results and the mistakes made by the firm during a period
are not relevant to the firm’s planning for this period. As long as we do not
try to explain the expectations, we can predict the price and production
policies of the firm on the basis of its (expected) cost curve and expected
demand curve. is will mean that all the results of the partial equilibrium
theory concerning the importance of taxation and other fiscal policy
measures for prices and quantities produced can be transferred unanged to
the theory of planning, provided it is borne in mind that here it is a maer of
determining, not an equilibrium price or an equilibrium production, but the
planned (expected) optimum price and optimum production.
For instance, let us take the effects of a unit tax on the finished product.
As in equilibrium theory, we can find its effects by adding the tax per unit to
the marginal cost curve and then making marginal cost plus tax equal to
expected marginal revenue. We then find a decrease in the planned
production and an increase in the price. It should be pointed out that the
price (including tax) may be imagined to rise by a larger or smaller amount
than the amount of tax. e possibility that the price will rise by just the
amount of tax per unit is a special case.
Let the expected profit be V, the price p, the quantity of goods q, the
amount of tax per unit t, and (expected) total costs K, being a function K(q)
of q; we then get

Furthermore, if the expected demand curve is q = q(p), we find the

condition for maximum profit to be

Using this expression as a starting point we shall find the effect on price
dp of a ange of tax, dt:
the coefficient of dt may obviously be greater than, equal to or less than 1.
According to the necessary conditions for maximum d2V/dp2 < 0, the
denominator in the expression for dp is negative; if also q′ < 0, dp must
always have the same sign as dt. Under the same conditions, it may be
understood that dp may be > dt, that is the price may rise by more than the
amount of tax. What decides the effects of taxation on the price is the height
of the marginal cost K′, its slope K″, and the slope q′, and curvature q″ of the
demand curve.
Certain special cases are worth noting:
If both the marginal cost curve and the demand curve are straight lines
(i.e. q″ = 0) we get

and in order that the price rise will be the same as (or more than) the
amount of tax, it will be necessary that q′ K″ ≥ 1, that is the numerical slope
of the demand curve towards the price axis must be equal to or larger than
the inverted value of the slope of the marginal cost curve (towards the
quantity axis). At a true maximum this is not excluded.
If we have constant marginal costs and a straight-line demand curve (i.e.
K″ = 0 and q″ = 0) we get the well-known result:

that is, the price rises by half the amount of the tax irrespective of the slope
of the demand curve.
Lastly, if marginal costs are constant (K″ = 0) then

and the condition for price increasing by the amount of the tax (or more) is
then
whi means that the relationship between the slope of the expected
demand curve and its curvature must be equal to or less than the profit
margin. is condition may very well be fulfilled.
Ad valorem indirect taxes and those subsidies whi are related to output
or price may be dealt with in a quite analogous manner.
Taxes on the net profits of a monopolist do not affect price and planned
production, according to this method of analysis, whether the profits tax be
proportional or progressive. e points of intersection between the marginal
cost curve and the marginal revenue curve are the same with or without the
tax.
ese quite different effects of net profits taxes and gross taxes on
production have oen been used as the basis of proposals to control the price
and production policies of monopolistic firms. By granting subsidies whi
are proportional to production, and by financing these subsidies by means of
taxation on the net profit of the monopolist himself, increased production
and decreased prices could be brought about, while monopoly profits are cut
down.
e effects of increased purases of goods by the State are obvious and
do not need to be explained here. We may observe that an increase in ‘public
consumption’ in the form of production-increasing collective consumption
within the firms will naturally lead to decreased costs and all that this
implies. e lower costs have to be discovered by the firms, however, before
they can have any effects on price and production policy. e immediate
effects may, therefore, be unexpected profits brought about by unexpected
reductions in costs.

(ii) The Case of Perfect Competition

In the case of perfect competition, the partial equilibrium theory cannot
be transferred to the theory of planning by firms in the same way as with
monopoly. Here, the individual firm determines its production for a given
period on the basis of the price expected for that period, and the firm does
not consider itself capable of influencing this price. Planned production is
determined so that (expected) marginal cost will equal the expected price for
the period.
 If we introduce a unit tax the reaction of the individual firm with regard
to planned production will depend entirely upon how the firm expects the
price for the period to be affected by the tax. If all the firms have had
exaggerated expectations as to the price increase, they will suffer losses (the
price does not cover the marginal cost plus tax); in the opposite case, they
will receive unexpected profits (the price exceeds the marginal cost plus tax).
e only thing we can say generally is that the higher the price expected by
the firms, the lower will be the actual price for the period. Further
developments will then depend on how the firms ange their price
expectations during subsequent periods.
As in the monopoly case, a tax on net profits does not affect the optimum
production of the firm.

(iii) The Case between Monopoly and Perfect Competition

Here there are many different cases to consider—duopoly, oligopoly,
imperfect competition, non-price competition, etc.—whi are usually ea
treated with special tenique.8 From all these cases we shall select one of
the simplest, the mu-discussed case with a ‘kinked’ demand curve.9
When there are few competing firms conscious of ea other’s existence,
it can be assumed that ea su firm will reon that if it should increase its
price, its competitors may not necessarily increase theirs; if the firm
decreases its price, on the other hand, it will expect that its competitors will
do likewise. e demand curve expected by the firm will then have a sharp
bend in it at the actual price p1, see curve DD in Fig. X: 3.
Now what is decisive is that su a ‘kinked’ expected demand curve
implies an expected marginal revenue curve, m.r., whi is discontinuous at
the quantity q0, corresponding to the price p1. An important consequence of
this is that shis in the marginal cost curve, within certain limits determined
by the vertical part of the marginal revenue curve, will not lead to anges
in the price or in the planned production. In this way it can be explained
why many firms keep their prices constant in spite of substantial cost
anges.
 Fig. X: 3

What effects does a unit tax have in this case? A meanical application
of the usual tenique (see Fig. X: 3) will show that if the marginal cost plus
tax per unit at production q0 is not greater than the highest point of the
vertical section of the marginal revenue curve, the tax will not involve a
price increase. is result, however, does not conform with the well-known
observation that even products whi usually have stiy prices, have their
prices increased when they are taxed, and the prices of su products
usually rise by exactly the amount of tax. We will show, however, that these
observations, far from contradicting the theory of the ‘kinked’ demand
curve, can, in fact, be given a reasonable explanation within it.

Fig. X: 4
 It must be recalled, in the first place, that the demand curve DD in Fig. X:
3 is an expected demand curve. e expectations concerning its particular
form depend on the firm’s expectations about the reactions of competitors
when it alters its own price. However, these expectations are no longer very
reasonable when a tax is imposed on production whi affects all the firms
competing in the sale of that particular good. It is perhaps more reasonable
to assume that the firm will reon that if it increases its price by an amount
up to the amount of the tax, competitors will increase their prices to the
same extent. On the other hand, if it raises the price by a larger amount than
the amount of the tax, competitors will probably only follow up to the point
where the price increase covers the tax. e introduction of the tax then
brings about a ange in the expected demand curve from DD to D′D′ see
Fig. X: 4. e marginal revenue curve is thus shied from m.r. to m.r.′. Only
in the lower part of the old marginal revenue curve do the curves coincide.
If the vertical part of the marginal revenue curve is substantial and the tax is
moderate, it is thus probable that the price will rise by exactly the amount of
tax, from p1 to p2. e planned production will then decrease from q0 to q0′.

(iv) Non-marginalistic Pricing

Cases (i)—(iii) are based entirely on the so-called marginalistic theory. If it
is asked how taxes will affect the planning of firms if one adopts the view
that firms apply certain simple rules of thumb in fixing their price, the
answer will quite naturally be that this will depend on the nature of the rule
of thumb. If the firm determines its price on the basis of a ‘normal’ unit cost
plus a ‘normal’ unit profit, it is natural to expect that a production or sales
tax will bring about a price increase equal to the amount of tax per unit. e
fact that, with the introduction of su a tax, prices actually tend to be
immediately increased by the amount of tax, has sometimes been taken to
support the non-marginalistic theory of price formation. As we have pointed
out, however, this empirical fact does not contradict the marginalistic
theory. In all three cases stated above it was possible, and in case (iii) even
probable, that price would rise by the amount of tax.
Here again, it depends on the nature of the rule of thumb as to what effect
a tax on net income will have. Of course, it is possible that the firms will
always determine the price so that a certain ‘normal’ unit profit will remain
aer taxation; in that case, su taxation will evidently bring about a price
increase.
Since the planning of firms is concerned not only with price
determination but also with the level of production, the firms must also
gauge the size of the demand for their products. e planned production
must be based on an expected demand curve, or at least on one point of su
a curve.

5. THE DISPOSAL OF PROFITS BY FIRMS

How the net profit of the firm is to be defined is a difficult question, the
main difficulty being that no objective rules exist for the determination of
depreciation. It is a well-known fact that taxation policy can affect the
reported current profits through its influence on the distribution of
depreciation allowances over time. Here, we shall only be concerned with
the disposal of a given net profit by the firm, and the way in whi this may
be influenced by different types of fiscal policy; naturally it is taxation
policy, profit freezing, etc. that will be our main interest.
Our discussion of the disposal of profits by firms concerns only companies
and only those taxes that are proportional to profits. With a firm whi is
directly owned by one person, the firm’s profit is automatically included in
the net income of the owner and is thus taxed according to personal income
tax regulations. In the discussion of the effects of fiscal policy on planning
by firms, one ought probably always to distinguish between companies and
privately-owned businesses. e behaviour of the one-man business
depends, among other things, on the effort the owner puts into his business,
and the theory of planning and behaviour of these firms should in fact be
linked with the theory of household planning. e aim of the planning of
these firms should actually not be to maximize the firm’s profit, but to
maximize the owner’s utility function. However, this complicated aspect of
the planning of firms is ignored here altogether.
With a given profit aer taxation, the firm is faced with the problem of
how the profit is to be distributed among the shareholders and the company
reserves. e factors whi are decisive for this distribution of the profit are
of an extremely complicated nature and are oen considered to be of a more
or less non-economic aracter. e owners’ interests and managerial
interests, for instance, oen lead to quite different views as to the amounts
to be distributed; the actual distribution then appears either as a compromise
between these interests or as the result of an open conflict. However, even if
the interests coincide (e.g. in family concerns), it is still difficult to indicate
the factors whi determine the size of the dividends. It is obvious that tax
considerations play an important part here as (in Sweden, at least) the
shareholders will have to pay personal income tax on their dividends. e
desire to ‘consolidate’ firms so that future investments can be financed
without borrowing is also of great importance. It is hardly possible, however,
to bring all su points together into some more precise hypothesis about the
distribution of profits. Instead, ‘empirical laws’ have sometimes been sought
to explain this distribution, e.g. that the distribution tends to constitute a
certain constant percentage of profits, or that dividends tend to be constant,
etc. Empirical resear provides hardly any support for any su ‘laws’,
however. It is therefore an open question how taxes on profits, profit-
freezing, etc., affect dividends.
We now proceed to a question whi only partly concerns the distribution
of profit. It is oen maintained that taxation of the profit of firms may
induce increased expenditure by firms; firms may be inclined to make
expenditures whi they would not otherwise have considered. According to
this argument, su expenses as can be deducted in calculating taxable profit
will, from the viewpoint of the firm, in fact, be reduced in the same
proportion as the tax rate that is applied. Part of the increased expenditure is
‘paid by the State’ through lower tax yields, and this would mean that
expenditures whi otherwise would not be justified may actually become
profitable because of the tax. However, su reasoning is obviously suspect.
For let us suppose that there is no tax on profit. Profit maximization will
then require that the firm spends just so mu in ea direction that
marginal expenditure will equal marginal revenue (if the marginal revenue
brought about by the marginal expenditure comes at a later point of time
than the expenditure itself, then that expenditure is to be made equal to the
discounted marginal revenue). Now if we introduce tax into su an
optimum situation and assume that this tax will take, say, half the profit, any
increase in expenditure over and above the spending of the earlier optimum
position will be reduced by half owing to the reduced tax payments, but the
additional income brought in by this extra expenditure will also be reduced
by half owing to the increased tax payments. Moreover, since under our
assumptions any additional spending in the earlier optimum position will
not be covered by additional receipts, the same thing will obviously also
apply when the profits tax has been introduced. A profits tax reduces the
loss whi is inevitable if the firm extends its spending over the previous
optimum position, but cannot transform the loss into profit. Consequently, if
it is purely economic considerations whi determine the expenditure policy,
the tax can only lead to increased spending if deductable expenditures result
in revenue whi will never be taxed. is is the case if the additional
income is expected to accrue in a period when the net income is expected to
be negative. On the other hand, there is the opposite possibility that current
profit is negative (the additional spending is not halved in this case) but
future profit is positive (the additional profit is halved); in this case, a
decrease in expenses is called for. Another possibility is that the additional
income is not included in the taxable profit; however, this is a problem of
quite a different nature.
e firm may also make expenditures whi will be ‘advantageous’ only
to the managers or the board of directors, however, and whi will in no
way bring about an increase in receipts or decrease in costs for the firm
either now or in the future; decoration of the board room, gis to arity,
etc., are examples of this type of spending. If su expenditures could be
deducted in the calculation of taxable profit, the statement that ‘the State
pays half’ could be applied, but still only with an important qualification
whi may be decisive. Let us conduct this argument in the abstract, but in a
manner whi, although not fully rigorous, does indicate the essential
features. Imagine that the board of directors has a sort of ‘utility function’,
whi is valid only within the firm and whi expresses the ‘utility’ to the
board of directors of ‘business luxuries’ and other non-economic uses of the
profit. Optimum in this respect would mean that the costs of the objects
whi give this kind of ‘utility’ are proportional to their respective ‘marginal
utilities’. If the costs of one sort of ‘business luxury’ are reduced, then its use
will be extended. An increase in taxation may now be imagined to reduce
the net cost to the firm of ‘business luxuries’ and this implies a tendency to
extend su ‘luxuries’. However, an increase in taxation also means that the
total disposable profit will be reduced, and this in itself should tend to
reduce the ‘business luxuries’. e ‘marginal utility’ of the profit will rise.
e effect of taxes on the firm’s expenditure on ‘business luxuries’ will
therefore depend on whi of these two tendencies has the strongest effect.
It will be seen that this discussion is quite analogous to the ordinary
treatment of the effects of a wage reduction (income tax increase) on the
supply of labour. Here too, there are two conflicting tendencies. e
argument is also valid for the question of the reaction of firms to wage
increases. Here it is oen maintained that an increased tax on the profits of
firms will make the firms more likely to increase wages because ‘the State
pays’ part of the increase via lower tax yields; the argument against this is
that this same tax increase will reduce total profit irrespective of whether
wages are increased or not and this fact in itself will make firms less willing
to consent to wage increases.

6. REAL INVESTMENT BY FIRMS

Within the theory of investment planning by firms,10 an investment is
regarded as an expected flow of future revenue brought about by an
expected flow of expenditures; the difference between these two flows for a
certain period is the expected net income for that period. If the present value
of this flow of net income is positive at the current rate of interest, the
investment will be profitable. is may also be expressed thus: if the rate of
return on the investment (i.e. the rate of interest that makes the present
value of the net income flow equal to zero) exceeds the loan rate of interest,
the investment will be profitable. How taxation or other fiscal policy
measures influence the opinions of firms as to whether a certain investment
is to be made or not, will depend, on the one hand, on how the rate of return
and, on the other, how the net loan rate of interest is affected by the fiscal
policy measure in question. If we ignore the complicated risk problem for
the moment, and have in mind only real investments of the firm, it can be
said that the loan rate of interest is the rate of interest on alternative
financial investment of the money, or on borrowing for financing the real
investment. e loan rate of interest should, of course, be reoned net, aer
possible taxation, etc.11
It is obvious that a general income tax will reduce the net loan rate of
interest as well as the rate of return. If an income tax is thus to make an
otherwise profitable investment plan unprofitable, it has to reduce the rate of
return more than the net loan rate of interest. Since the laer is associated
with a stable (constant) flow of taxable income, everything will depend on
the shape of the expected taxable income flow connected with the
investment. is may, of course, differ greatly from the expected net revenue
flow. It is mainly the depreciation regulations that are decisive here. To the
extent that firms are free to oose the timing of depreciation allowances,
they can obviously themselves determine (or plan) the shape of the taxable
income flow connected with a given investment.12
If we suppose that the depreciation allowances are determined so that the
taxable income flow connected with any particular investment is given, an
income tax may reduce the rate of return more than the net loan rate of
interest if the taxable income stream belonging to the investment is
fluctuating. With a proportional tax, this will be true if certain of the future
periods have a negative expected taxable income; the profitable years are
then taxed without any compensation for the unprofitable years, and this
will reduce the rate of return more than would otherwise have been the
case. In general, the rule is that with progressive taxation, the rate of return
will normally be reduced more with a fluctuating than with a constant
taxable income flow. Without going further into the question of so-called
‘free write-offs’13 it is obvious that the rate of return will always be reduced
less by a given income tax with free depreciation than with fixed
depreciation. For the depreciation flow can be so osen by the firm that the
rate of return, with a given total amount wrien off, is maximized; the firm
has, on the one hand, to level out the expected taxable income flow in some
appropriate manner, while, on the other hand, allocating the amounts
wrien off in some appropriate way in the earlier periods.
An independent question of great importance is how investments with
different degrees of risk are affected by income tax. e fluctuations in the
expected income flows and the expected taxable income flows do not
necessarily mean that the investment is risky. e risk is rather a question of
the certainty with whi the future revenues and expenditures are expected.
If ea future income and expenditure is seen as the mathematical
expectation in a probability distribution, we may express the risk associated
with every individual revenue or expenditure as the standard deviation of
this distribution. e total risk associated with the whole investment seme
may then be regarded as an average of all these standard deviations
weighted in a certain way, and expressed as a certain percentage whi can
be compared to the rate of return and the loan rate of interest. How su a
given expected risk influences the investment decisions will in turn depend
on the firm’s aitude towards risk. How taxation influences investment
calculations for investments with different risk is therefore a complicated
question. In certain circumstances, it can be shown that investments with
small risk may suffer more from income tax than investments with great
risk.
Special investment duties, whi are imposed on real investments as a
percentage of initial outlay, will of course reduce the rate of return. As the
loan rate of interest is not affected, su a tax must tend to reduce the
number of profitable investments. It is interesting to compare the effects on
investments of an investment tax with the effects of an increase in the loan
rate of interest. It is evident that there is always some increase in the rate of
interest whi would reduce investments just as mu as any given
investment tax. For that reason, nothing can be said as to whether an
investment tax or an increase in interest rates is more effective as a means
for slowing down investments. However, there is a significant difference
between the effects of these two measures. It can be shown that an increase
in the rate of interest will affect long-term investments relatively more than
short-term investments; whereas the investment tax will affect investments
with large ‘initial’ investment expenditures relatively more than investments
with low ‘initial’ investment expenditures.
Let us explain this more precisely. We regard an investment as consisting
of a (positive) ‘initial’ investment expenditure a, and a flow of n (positive or
negative) expected future net incomes iτ, whi are assumed to be received
or paid out at the end of the year. e current rate of interest, i.e. the loan
rate of interest, is r and it is expected to remain unanged in the future. e
expected profit v, from the investment is then
 Now if the amount a is taxed at the rate ta, the ‘initial’ investment
expenditure will be anged to a(1+ta) and the profit from the investment
will be

From this expression we find that with an unanged rate of interest

and with a given rate of taxation we get

If we define the average period of investment T, for the subjective ‘initial’

investment expenditure I, as

and insert this expression for T into the expression for dv (with fixed ta), we
get

From these (partial) expressions for the ange in the profitability of

investment when the investment tax or the rate of interest are increased, it
will be seen that both tax increases and increases in the rate of interest will
involve a reduction in the expected profit from investment, if a and TI are
positive.
If we now oose a certain arbitrary investment (aracterized by the size
of a and the iτS), with a positive expected profit from investment, there is
obviously always a certain increase in tax and a certain increase in interest
rates whi separately will make the expected profit from this investment
equal to zero, so that this investment will not be made. In this case,
obviously

Rearrangement of the expression for dv with a constant tax rate, however,

gives

and having thus determined the (relative) increase in the rate of interest and
in the tax rate, whi, for the investment under consideration, will mean the
disappearance of investment profit, we can then establish the rule that for
investments with a smaller T, this (relative) interest ange will have a
weaker reducing effect and for investments with a larger T it will have a
stronger reducing effect on the subjective profit rate v/I, that is on the profit
from investment measured against the subjective ‘initial’ investment
expenditure. Furthermore, if all investments with the same I and a are
compared, then with the indicated increase in the rate of interest,
investments with smaller T will have a positive investment profit and thus
will be made while investments with larger T will have a negative
investment profit and thus will not be made.
We have now shown in what sense it can be said that an investment tax
affects short term investments more, and long term investments less, than an
increase in the rate of interest; in other words, compared with an investment
tax an increase in the rate of interest discriminates against long term and in
favour of short term investments. In the same way it can be shown that
compared with an increase in the rate of interest, an investment tax will
discriminate against investments with a large ‘initial’ investment
expenditure and in favour of investments with a small ‘initial’ investment
expenditure.
Up to now we have dealt with the question of the effects of taxation on
investment plans of firms under the implicit assumption that the expected
incomes and expenditures associated with a certain investment can be
assumed to be given beforehand. However, it may be asked whether the
introduction of a tax may not involve anges in the expected incomes and
expenditures whi form the investment itself. For example, if we imagine a
production tax imposed on the goods whi are to result from the
investment in question, is it not reasonable to expect that future prices and
sales will be affected by this, and that planned expenditures are anged
accordingly? Of course, this is very probable, and no exhaustive treatment of
the planning of the firm and its actions can be made if su factors are not
taken into account. As soon as one begins to deal with su questions,
however, the true field of investment theory (in the strict sense) is
abandoned and one enters the field of the general intertemporal planning
theory of firms mentioned earlier.
is may be explained as follows: if by the expression ‘investment’ is
meant a given flow of revenue and expenditure, then obviously a ange in
any expected revenue or expenditure item will mean that we are faced with
a new investment; normally a firm can oose between many different
investment alternatives at any given point of time and the one whi has the
highest rate of return will be preferred, if the various opportunities exclude
ea other; up to now we have assumed in the traditional manner, that the
oice facing the firm is simply that of deciding whether to make a given
investment or not, while the important possibility that the firm may ange
its investment plan altogether has been ignored. Indeed, if an investment
plan is conceived of as a combination of purasing, production and sales
plans, the firm will, as a maer of course, always have to oose some
investment plan, assuming that it does not act shortsightedly and concern
itself with the current period only and disregards the future altogether.
However, it is precisely the study of su questions that is the task of the
general intertemporal planning theory.
 7. THE ESTABLISHMENT OF FIRMS
In contrast to households, or at least to individuals, it is purely economic
considerations in the main whi are decisive for the formation and
liquidation of firms, and also for their legal form. For that reason, we do not
get a complete picture of the importance of fiscal policy until we have
considered this aspect of the planning of firms.
It is obvious that the legal form of the firm can be affected by fiscal policy
and especially by tax policy; if fiscal policy discriminates between the
different legal forms of firms, then firms will naturally prefer the most
favoured forms. e taxation of limited companies is an example of this. e
formation and liquidation of firms is also influenced by fiscal policy. Here,
we are not considering the simple fact that the State can influence various
sectors of business differently by means of indirect taxation, customs duties,
subsidies, etc., but the mu more pervasive influences, su as the
possibility that taxation may paralyse initiative, hamper enterprise, reduce
the flow of venture capital, etc. It is obvious that an answer to these
problems is of importance in several respects, su as in discussions on the
problems of incidence and shiing, etc. Since we are mostly concerned with
short-run problems, however, we shall not go further into these maers
here.

1. P. A. Samuelson, Foundations of Economic Analysis, Cambridge, Mass.

1947, Chapter 1.
2. See Ingvar Svennilson, Ekonomisk planering (Economic Planning),
Uppsala 1938, also J. R. His, Value and Capital, Part II and IV.
3. Eri Sneider, Pricing and Equilibrium, London 1952.
4. Alfred Marshall, Principles of Economics, eighth ed., London 1946, Book
V.
5. See the discussion between F. Malup and R. A. Lester in the American
Economic Review, 1946 and 1947.
6. R. L. Hall and C. J. Hit, ‘Price eory and Business Behavior’, Oxford
Economic Papers, 1939.
7. J. R. His, Value and Capital, p. 93 ff.
 8. P. Nørregaard Rasmussen has dealt with su a case in respect to
taxation, see ‘Træk af overvæltningslæren’.
9. P. M. Sweezy, ‘Demand under Conditions of Oligopoly’, The Journal of
Political Economy 1939; Hall and Hit, ‘Price eory and Business
Behavior’.
10. See Eri Sneider, Investering og Rente (Investment and Interest),
Copenhagen 1944.
11. A special point here is that it is important for the loan rate of interest,
whether self-financing is possible or whether borrowing is necessary.
See e.g. Lars Lindberger, Investeringsverksamhet och sparande
(Investment Activity and Saving), Swedish State Resear Publication
SOU 1956: 10, Stoholm.
12. See Förslag till ändrad företagsbeskattning (Proposals for Changing the
Taxation of Firms) issued by Företagsbeskaningskommién (the
Swedish Commiee on the Taxation of Firms), Swedish State Resear
Publication SOU 1954: 19, Stoholm.
13. See N. Västhagen, De fria avskrivningarna 1938–1951 (e free writing
off of capital 1938–1955), Stoholm 1953, Chapter 1.
 CHAPTER XI

Organizations and Fiscal Policy

IN the hypothetical competitive society of pure economic theory, all
economically relevant decisions are supposed to take place within the
households and the firms, and in principle, the same thing is valid even if
certain firms or households have a monopoly or a monopsony position in
the markets. Furthermore, the decisions of the individual household or firm
are supposed to aim at maximizing the ‘utility’ of the household or the
‘profit’ of the firm. is simplified view of the basic driving forces of
economics is not necessarily disturbed if the State comes into the picture at
several important points as a decision-making unit. Under certain (perhaps
unrealistic) assumptions, the whole of State activity may be regarded as a
kind of pricing process of basically the same nature as that based on the
decisions of households and firms; so that we can still assume, as a
reasonable approximation, that the desire of households to maximize their
utility and the desire of firms to maximize their profits lie behind all
economic decisions. As soon as we consider the activities of the State in the
society in whi we are actually living, however, this picture of the ultimate
basis of economic decisions seems rather idealized and unrealistic.
Moreover, if we consider the fact that in a modern capitalistic society, many
important decisions are made by private organizations whi are neither
households nor firms in the true sense, it becomes obvious that not all
economic decisions can be aributed to the desire to maximize utility or
profit in the decision-making units.
A aracteristic of modern capitalist societies is that several of the
decisions previously made by firms and households have been transferred to
organizations, whi have been created for this purpose. It could be said that
households and firms have relinquished certain action parameters—oen
voluntarily but sometimes under pressure—to organizations of whi the
household or firm is a member. Price determination in particular has been
taken over by organizations in this way. Wage determination on the labour
market is the classic example, but many examples can also be given
concerning prices of commodities, e.g. of agricultural products in many
countries. Production and quantities supplied are also determined in certain
cases by organizations.
e big question raised for economic theory by the establishment and
existence of these economic organizations is what principles form the basis
for the decisions made by them concerning the action parameters at their
disposal. Above all, the question arises whether there exist simple norms of
action for organizations, like the maximization of utility for the households
and the maximization of profits for the firms, from whi deductions could
be made concerning the reactions of the organizations to various anges in
the economic system. Organizations could then be taken into account in
economic models quite analogously to households and firms, and their
actions could be ‘explained’ within the framework of the economic model. If
there are no su constant norms (ends) for organizations, economic ‘laws’
cannot be established for their activities. ese must then be regarded as
being exogenously determined. Consequently, we can no longer aempt to
explain the actions of organizations within the framework of an economic
model. It is obvious that this would be highly unsatisfactory, for the more
thoroughly organized a society becomes, the less would economic theory be
able to explain economic developments.
Economic theory is faced with the same problems with the reactions of
the State as with the activities of organizations. As has been pointed out
before, however, the problem of explaining the behaviour of the State
disappears in the theory of fiscal policy because we expressly want to treat
State actions as exogenously determined.
Certain modern economists have aempted to solve the problem of the
organizations by means of the hypothesis that (in the long run, at any rate)
organizations, in fact, do nothing that the ‘market itself’ would not have
done if no organizations existed. Let us take the labour market as an
example. According to the theory of perfect competition, the price of labour
tends to remain at su a level that a balance between supply and demand of
labour is brought about. e labour market organizations would then be
regarded as an institutional equivalent to the ‘auctioneer’ of the theory of
perfect competition, who determines the price in the market. With su a
view of the role of organizations, they could simply be ignored in economic
theory, at least in the long run.
Still considering the labour market, we find that in the older theory
aempts were oen made to construct an analogue between trade unions
and private households or firms by assuming that the aim of the trade
unions is to maximize the total income of their members. If then the trade
unions base their plans on a given demand curve for labour, wage
determination is simply an ordinary monopoly problem. Even within the
modern theory-of-games treatment of these problems, a certain maximizing
condition is used. Other simple objectives of this type may also be imagined,
for example, that trade unions always try to make the real income of the
individual worker’s household as large as possible, that the trade unions try
to keep the wage-earners’ share of the national income constant, etc.
It is obvious that in discussing the reactions of organizations to various
kinds of fiscal policy, the norm they base their calculations upon will be
decisive.
Certain important objections can, however, be raised against summarizing
the aims of an organization in su simple terms as those mentioned above.
Firstly, economic organizations are oen connected in some way with a
political party. Here there is room for every kind of relationship from open
coalition to a hidden unconscious bias whi exists only on the emotional
level. Su a political outlook in economic organizations may mean that the
reactions of the organization to a given fiscal policy measure may depend on
whi political party is behind the measure. Socialist trade unions perhaps
do not react in the same way when a Labour or a ‘bourgeois’ Government
effects a given tax increase, and Socialist, Communist or ‘bourgeois’ labour
organizations will probably not react in the same manner when a Labour
Government makes a certain tax increase. ere is no doubt that the manner
in whi organizations react is to a very large extent influenced by their
political ideas and by the current political situation in the country.
Secondly, the motivations of organizations may ange from time to time.
In order to understand this, one has only to look at the statements of the
Swedish trade unions concerning wage negotiations during the post-war
years. Naturally, statements of this kind are oen tactical and the argument
whi will have the best effect in the given situation is the one osen, yet it
seems as if the ‘true’ aim of the trade unions has not been quite the same in
all the negotiations. At one time, distribution of income was the centre of
interest and at another time, employment. However, this certainly does not
mean that one is necessarily obliged to give up working with su simple
ends as the above, nor that the aims of the trade unions have necessarily
anged. It is possible that phenomena of this kind can be treated by
assuming that the aims of the organization have the nature of an end-index,
see Chapter I. If this is the case, it is quite reasonable for the organization in
question to stress different ‘goals’ in different situations. However, it is
obvious that su an end-index cannot in general be regarded as invariant
when political anges inside or outside of the organization take place.
Lastly, we have to face a very intractable problem. Even if we happen to
know the norm whi is decisive for the activities of an organization, it is
not certain that we shall be able to deduce the activities of the organization
in various situations, using only this norm as a starting point. e
organization may well have its own logic. Assuming that a trade union has
as its primary aim the prevention of unemployment within that trade, let us
suppose that the trade union starts negotiating in a situation where a certain
amount of unemployment has already appeared. Can we then draw the
conclusion that the trade union will moderate its wage demands and may
even consent to a certain reduction in wages? is conclusion, whi is
perfectly natural to the economist, may be completely wrong for the simple
reason that the trade union believes that increased wages bring about rising
employment. Very oen, modern economic organizations are so large that
they have to consider the general economic effects of their decisions.
Normally, organizations are aware of this; but consideration of the effects on
the economic system of any particular decision requires detailed knowledge
of the economic system, and here the field is open to all kinds of
peculiarities. As long as Economics have not arrived at any unique
explanation of the manner in whi the economic system functions, why
should anything of the sort be requested from economic organizations?
Sometimes organizations even have their own economic theories.
Continental trade unions supported the Marxist theory at the beginning of
the century. Nowadays, the tendency seems to be for organizations to accept
current economic theory, but it cannot be denied that the uncertainty of
modern economic theory, when confronted with macro-economic problems,
gives organizations plenty of opportunities of always finding some authentic
economic reasoning to support the policy they wish to pursue.
ere is, within economic theory, no general theory of the behaviour of
organizations corresponding to the theory of the behaviour of households
and firms. Whether su a general theory could be created remains to be
seen; perhaps the problem is a sociological one. e empirical studies of
trade union activities that have been made point in that direction.
So far we cannot do anything but state that in this respect economic
theory is deficient and that it will be quite difficult to find simple general
norms for the way economic organizations react. But although it is
necessary to take rather an agnostic aitude towards the general problem of
the way in whi organizations react when confronted with anges in the
economic system, this does not necessarily mean that we shall have to avoid
considering the behaviour of organizations in relation to our main problem:
the establishment of a stable value of money with full employment. It is well
known that it is the actions of labour market organizations above all whi
create problems at full employment. It is intuitively obvious that in any
situation, there will always be a particular level of money wages whi will,
in some sense, facilitate the Government’s policy as mu as possible; su
as, for instance, the well-known idea that money wages ought to rise at the
same rate as productivity. Even if we now are unable to gauge the reactions
of the labour market organizations, and thereby the movements of money
wages, in any given situation, we can nevertheless, by means of alternative
analyses, demonstrate the task of the policy, firstly with a wage development
as unfavourable as possible from the point of view of the given ends, and
secondly with a wage development as favourable as possible. Furthermore,
with a policy whi will, in all circumstances, secure full employment and a
stable value of money, i.e. irrespective of the development of money wages,
several of the motives whi might otherwise be considered important for
wage determination by labour market organizations, would lose their
significance. As we shall try to show in Part III, Chapter XVII, this fact
makes it possible for the State by indirect means to force labour market
organizations to behave in su a way that the development of money wages
will be that desired by the State.
 PART III

MACRO-ECONOMICS OF FISCAL POLICY

Fiscal Policy for Full Employment and a Stable Value of Money
 CHAPTER XII

Stable Value of Money and Full Employment

1. DEFINITION OF ENDS IS A POLITICAL PROBLEM
As an introduction to Part III, we shall tou upon the question of ends and
means. It is not primarily a maer of pursuing the abstract discussion in
Chapter I of the relationship between ends and means on a more concrete
level, although it is true that it is this problem that occupies the rest of Part
III. e solution of the practical problems of policy does, however, require
some discussion of how the particular ends of practical policy are, in fact, to
be interpreted.
e problem here is, therefore, the actual meaning to be aaed to the
concepts ‘stable value of money’ and ‘full employment’. ere is no
intention of aempting to lay down an ‘objectively correct’ definition of
these concepts. Because of the political nature of su goals, there is no
definition of these concepts whi can be said to be ‘correct’ from the
viewpoint of economics. In principle, it is the task of the politician to decide
the exact meaning of the ends, and different political opinions may—quite
rightly—put quite a different meaning into the definition of terms. Our task,
in this connection, will be to consider different possible definitions of the
ends, and to discuss their relevant properties from the point of view of fiscal
policy. In so doing, we will not aempt any thorough investigation of the
interesting, but very intricate problem of what politicians really aim at when
they establish ends of the type discussed here, as that would be outside the
scope of this work. On the other hand, it is rather unfortunate that there are
no generally accepted definitions of the concepts of stable value of money
and full employment. In order to venture a precise analysis of the
possibilities of employing fiscal policy means to stabilize the value of money
at full employment, we must work with well-defined concepts. We are
forced to oose certain particular definitions of stable value of money and
full employment with whi to work. Our first task will be to make this
oice, whi in a certain sense must be arbitrary.

2. STABLE VALUE OF MONEY AS A FISCAL POLICY PROGRAMME

e expression ‘value of money’ nowadays means the purasing power of
money. e more one unit of money will buy, the higher the value of money
will be. If all prices expressed in money always stood in fixed relationship to
ea other, the value of money would obviously be uniquely defined.
However, that is not the usual case. e value of money must therefore be
expressed as the inverse of some price index. e question is then, whi
price index is to be used as an expression of the value of money: the price
index of consumer goods, the various types of cost-of-living index, the
wholesale price index, the price index of raw materials, the price index of
gilt-edged securities, or some other index? As we have already pointed out,
there is no particular index—not even in theory—whi is the ‘correct’ one
to use in this connection. Whi index is to be used must depend on what
lies behind the desire for a stable value of money. Hardly anybody wishes to
have a stable value of money simply for its own sake. Many reasons may
exist for it being desired that money should not have a fluctuating
purasing power. As soon as all price relationships are not constant over
time, the purasing power of money saved will depend entirely on what is
later purased with it. e person who saves his money to buy farming
land may see it weakened, while at the same time, money saved to buy
consumer goods may increase in purasing power. ere is hardly any
doubt that in the general discussion on su questions, savings mean money
put away for future consumption, e.g. pensions; the price index relevant to
the value of money then becomes a consumption price index or a cost-of-
living index. It is in su price indices that we are mainly interested.
However, it should be pointed out that there are authors who have thought
it beer to use universal price indices in this connection, so as to cover
everything that has a market price, but not even with su an approa as
this is arbitrariness avoided.
It may be appropriate here to refer to the older Swedish discussion on the
ends of monetary policy. e monetary policy discussion was mainly
occupied with anges in the value of money and the price level, but the
problems were there aaed from the point of view of monetary policy.
Here, the demand for a stable value of money (= constancy of some price
index) is regarded from a fiscal policy point of view. We shall show that as
soon as we regard the problem of the value of money from a fiscal policy
point of view, certain difficulties arise, whi have hardly been noticed in
the monetary policy discussion.
Briefly, the rival standpoints in the earlier Swedish monetary policy
debate were as follows:1 Wisell originally advocated a constant price level
for consumer goods; if there were any anges in productivity, this was held
to require corresponding fluctuations in money wages. Davidson, on the
other hand, advocated constant money wages, whi, in turn, was held to
require that the price level of consumer goods fluctuates in the opposite
direction to productivity. Lindahl, for his part, recommended (with given
quantities of factors of production) constant money incomes, whi also, in
the long run, was held to require that the price of consumer goods fluctuate
in the opposite direction to productivity, but not that money wages would
necessarily be constant. Only in those special cases where the productivity
anges were “uniform” would the above monetary policy programmes of
Davidson and Lindahl coincide. If the market forces did not fulfil these
programmes themselves, their authors relied on interest (credit) policy to do
so.
If it is assumed that instead of interest policy (monetary policy) we use
fiscal policy to realize these ends, certain problems of interpretation arise.
Suppose that indirect taxes ange. Will it then be the price level of
consumer goods including or excluding these taxes that is to be kept
constant according to Wisell and be made to vary in the opposite direction
to productivity according to Davidson? Is it the total money income ‘at
market price’ or ‘at factor cost’ whi is to be kept constant according to
Lindahl? If direct income taxes are anged, will it then be incomes before
or aer tax whi are to be kept constant according to Lindahl? If civil
service salaries are anged, is this against Davidson’s programme? Several
other problems of this nature arise as soon as we rely on fiscal policy
measures to secure the fulfilment of su programmes.
If we interpret Wisell and Davidson, as if in seing up their respective
norms, they had, in fact, considered the possibility of anges in indirect
taxes and subsidies, it seems obvious that the price level that they discussed
must have been the consumer price level excluding indirect taxes and
subsidies, that is the consumer price level ‘at factor cost’. When Wisell
advocated a constant price level and thus drew the conclusion that money
wages must be varied in direct proportion to productivity, this conclusion
implies that the price level must be that based on the net prices of firms, that
is their prices excluding indirect taxes. In the same way, Davidson’s idea
that money wages should be constant and prices of consumer goods
fluctuate in inverse proportion to productivity, implies that it is a maer of
the prices of consumer goods excluding indirect taxes. Otherwise their
arguments would be incorrect. e incomes that Lindahl wishes to keep
constant—with constant factor quantities—seem to be ‘earned’ incomes, that
is incomes before direct taxes and subsidies. If the price level is at the same
time to vary in inverse proportion to productivity, while pre-tax incomes are
kept constant, the price level must be interpreted as being exclusive of
indirect taxes, otherwise the argument is faulty again. Briefly, if the
relationships between wages and prices or incomes and prices indicated by
Wisell, Davidson and Lindahl are to be valid, wages and incomes have to
be interpreted as gross wages and gross incomes, i.e. before deducting
income tax, etc., while prices have to be the net prices of firms, i.e. prices
aer deducting indirect taxes, etc.
ese problems were not taken up in the former discussions for the simple
reason that they were devoted to monetary policy, and fiscal policy was
largely ignored2 or was supposed to remain unanged in some sense. e
fundamental ideas behind the norms were partly the desire for equity and
partly the desire to stabilize the economy. It is not immediately obvious
what modifications these writers would possibly have made in their
monetary policy programmes if they had taken the influence of fiscal policy
into consideration. e comparatively simple conceptions of ‘justice’ that
Wisell, Davidson and Lindahl worked with become very complicated as
soon as taxes and other State activity is introduced into the picture, and the
desire to stabilize economic activity does not give any simple answer to
questions of the sort indicated above. However, it is obvious that the
possibilities of using fiscal policy for the aievement of these ends greatly
depends on whi interpretation the ends are given. e possibilities of
using indirect taxes cannot be the same when the aim is to stabilize a price
level including indirect taxes as when the aim is to stabilize a price level
whi ignores these taxes. In the same way, the use of direct taxes must
depend entirely on whether it is intended to stabilize total money incomes
or total disposable incomes in a community.
If we now turn from this theoretical debate to the price indices whi
have been compiled in practice, we are faced with similar problems.3 Even if
we regard it as being quite obvious that the relevant price index is that
concerned with consumer goods, there are several types of index available
from the point of view of fiscal policy.
In Sweden, various indices of retail prices have been calculated over a
number of years, namely the general consumption price index calculated
first by the central bank (Riksbanken) and now by the Social Board
(Socialstyrelsen), and also the Social Board’s cost-of-living index and
consumer price index, with or without consideration of direct taxes and
social welfare benefits. All these indices use ‘market prices’, i.e. include
indirect taxes. In other countries examples are to be found of cost-of-living
indices, where certain indirect taxes have been removed in the calculation of
the index; the result is (at least partly) a price index at ‘factor cost’.
Starting from the question of whether regard shall be paid to direct or
indirect taxes in the calculations, four different types of index emerge. Let q
denote the quantities of consumer goods, pm the market prices of consumer
goods, pf the prices of consumer goods ‘at factor cost’, i.e. exclusive of
indirect taxes, and T the income tax amount. 0 and 1 as subscripts denote
two different situations. We then get the following index formulæ:
 Index formula 1 represents an index of the same kind as the consumption
price index of the central bank and the cost-of-living index of the Social
Board, exclusive of direct taxes and social welfare benefits. Formula 2
represents an index of the same kind as the Social Board’s cost-of-living
index including direct taxes and social welfare benefits. Formulæ 3 and 4
represent the same types of index as 1 or 2 if indirect taxes were removed
from them.
Even if we feel convinced that the price level expressing the value of
money is an index of consumer prices or of the cost-of-living, in oosing
one particular index we are faced with problems whi are quite similar to
those whi arose in the connection with the interpretation of the older
monetary policy programmes. We have a price index ‘at market prices’ or ‘at
factor cost’, and one whi indicates the purasing power of pre-tax income
and another for disposable income.
If we believe that the relevant price index is the cost-of-living index,
another problem arises, namely that a cost-of-living index is very oen
constructed for a certain income class. is is of both practical and
theoretical importance from a fiscal policy point of view. e different
income classes, and their cost-of-living indices, are influenced quite
differently by both direct and indirect taxation. For example, if we oose a
cost-of-living index for the lower income classes, indirect taxation of luxury
goods will not have any direct significance for the price level, a fact whi
has oen been decisive in the actual formation of policy.
Finally, it must be noted that it is not altogether self-evident whi taxes
are to be included in the price level if a price level ‘at market price’ is
desired. e distinction between so-called direct and indirect taxes is
arbitrary in several respects. Sometimes the tax-subject is the decisive factor.
If the buyer-consumer is himself responsible for the tax payment, the tax is
not always included in the price level. However, this is an arbitrary basis for
distinction. e question who is responsible for the payment of tax is in
many cases of very small importance. For example, compare a general
turnover tax of 5% on consumer goods and a general consumption tax whi
is imposed at a rate of 5% on declared income minus saving. If we ignore
evasion and the point of time when the payment takes place, there is no
difference between these two taxes. Despite this, the former will, other
things being equal, raise the price level (‘at market prices’) by 5%, while the
laer will leave the price level unanged.
If we look at the actual policy, we shall find that at different times it has
been interested in different price indices. In the ’thirties, the consumption
price index of the Central Bank was at the centre of Swedish monetary
policy action.
It is of great interest for our problem that the monetary policy norm of
the Swedish central bank aer the withdrawal from the Gold Standard in
the early ’thirties was not to keep the consumption price index of the central
bank completely unanged. ere were three important exceptions to the
rule of a constant consumption price index.4 In the first place, it was
considered that anges in the index due to anges from direct to indirect
taxation should be ignored. Taxes were regarded as payments for
participation in the collective consumption of public services, whi were
included in the consumer price index through an item indicating civil
service salaries. As we have already mentioned, direct taxes and social
welfare benefits were not included in the index; if the system had been
completely logical it would have excluded indirect taxes as well. Now the
prices of commodities were reoned at market price, and as a result,
anges in the index caused by shis in indirect taxation were allowed for in
the monetary policy norm. e central bank’s norm at the beginning of the
’thirties thus actually involved a constant consumption price index ‘at factor
cost’, in whi regard was paid to the ‘prices’ of public services.
In the second place, seasonal price anges were allowed. And finally,
allowance was made for the consumption price level to differ ‘within narrow
limits’ from the 1931 average, if su divergencies were necessary to
alleviate depression. e laer exception to the rule of constant consumption
price level is interesting because it clearly shows that the stabilization of the
purasing power of money—at least provisionally—was considered a
secondary aim compared with a reduction of unemployment.
Cost-of-living indices, both inclusive and exclusive of direct taxation,
have had special importance at times when money wages have been index-
regulated in some way or have otherwise been directly dependent upon the
costs of living. Cost-of-living indices that ignore certain indirect taxes have
also been considered in connection with wage regulations. Behind all the
more or less successful aempts at keeping some of these index types
constant, there has, of course, always been the desire to secure the stability
of prices, that is a stable value of money. is is also the reason why an
investigation into the intentions of politicians themselves would hardly lead
us to any definite answers as to the interpretation of the concept of stable
value of money. Perhaps, for practical policy, it is of no great importance if it
is one kind of index or another that is kept constant, providing all indices are
kept fairly constant. Of course, there is very oen a very high correlation
through time between the various indices of retail prices, but this is
irrelevant from our point of view, since we are particularly interested in
various economic means that disturb su a correlation.
In the rest of this book we shall use the following definition of the concept
of stable value of money: Stable value of money is equivalent to a (fairly)
constant consumer price index, whi in principle covers all consumer goods
and services reoned at market price, that is, including all those
consumption taxes where the formal incidence is upon the sellers (or at
some earlier stage of production) but whi, on the other hand, does not
include direct taxes or subsidies. us we have a price index at market price
whi is relevant for judging the purasing power of disposable incomes. In
Sweden, we can refer to the consumption price index of the central bank or
Social Board, or the consumer price index of the Social Board. As we have
already pointed out, this oice of index is in no way obvious and we will,
from time to time, refer to the development of other types of index. Our
oice can doubtless be criticized from many different angles, and we
ourselves have given examples of other possible types of index. It may,
therefore, be appropriate to present some of the arguments supporting the
various oices of price index, i.e. the different definitions of the concept of
the value of money.
It is obvious that the price index relevant to the value of money is to be an
index whi in some way refers to consumption. e question is simply how
one is to deal with direct and indirect taxes (subsidies) in the index. All the
other special problems associated with indices are ignored here. Two facts
have determined our oice. Firstly, this concept of the value of money is
simple and clear in the sense that its position in theoretical analysis is
obvious. From a theoretical point of view, the most difficult indices to use
are those whi pay regard to direct taxes and subsidies. What we have in
mind here is not only theoretical convenience, but also the problem of
determining the consequences and possibilities of stabilizing the value of
money. Secondly, it seems clear, to me at least, that when the man in the
street is actually discussing the value of money, he thinks of the price level
at market price, that is including indirect taxes and subsidies. On the other
hand, it is more doubtful whether we are entitled to ignore direct taxes and
subsidies from this point of view, i.e. if we want to apply a concept of the
value of money as close as possible to that used in practical policy. To the
trade unions, for example, it is quite natural that the value of money means
the standard of living (consumption) that can be aieved by the workers
with certain money wages. Here, the natural index is one concerning factor
income and for that reason, one whi takes into account direct taxes and
subsidies. In general, the rule is that if we regard money as being
synonymous with factor income, and if we are primarily interested in the
purasing power of factor income vis-à-vis consumer goods, i.e. real
disposable income, then the relevant index is one at market prices whi
also includes direct taxes and subsidies.
Accordingly, it is not difficult to provide arguments why both direct and
indirect taxes (subsidies) should be taken into account in the price index.
Arguments may also be advanced, however, for ignoring taxation altogether,
both direct and indirect. We have already pointed out that the price level
employed in former Swedish discussions on monetary policy and in the
practical policies of the ’thirties, must be regarded as an index excluding all
taxation. is in itself is, of course, no decisive argument. A more important
consideration is that the view that the value of money is a maer of the
purasing power of factor incomes, may entail an index ‘at factor cost’ and
without direct taxes and subsidies. For if taxes are regarded as payments for
the services whi households receive directly or indirectly from the State, it
will obviously be unreasonable to include taxes in the consumer price index
in the usual way, at any rate with given civil service salary scales and with a
balanced budget (in the sense of zero-saving by the State). An increase in
taxation does not then imply a price increase but an increase in the standard
of living. e fact that more of a given factor income is taken up by direct
and indirect taxation does not mean that the consumption of the wage-
earner has decreased, but that his consumption of State services has
increased. e purasing power of his money (factor income) has not
declined but his demand is directed towards State services to a greater
extent than previously and to a smaller extent towards ordinary consumer
goods. Ideas of this nature were behind the consumption price index of the
Swedish central bank and the norm established in connection with it.
However, it is obvious that an interpretation of taxes as payments for
services provided by the State encounters certain difficulties. On the one
hand, it is difficult to introduce subsidies into su a seme, and on the
other hand, anges in taxation do not necessarily stand in any simple
relationship to the provision of services by the State for the private sector.
is is particularly so when fiscal policy is used to influence the general
level of economic activity. On the other hand, it is also unreasonable not to
take into consideration the well-known fact that State services, public
consumption, are normally of great importance to the standard of living.
With a fiscal policy whi follows Lindahl’s norm, regarding taxes as
voluntary payments for the purase of State services, then taxes (or
possibly a more directly calculated ‘price’ of State services) and the volume
of State services ought in principle to be included among the p’s and q’s of
the consumer price index; in this way taxes enter the index again although
in a different way from usual. Public services and their prices are then taken
into account directly. Strictly speaking, this procedure is only correct for
those services provided by the State directly to households. If the services
are provided through firms instead, in the form of ‘production promoting
public consumption’, and if all those indirect taxes whi are not levied on
sales to consumers are regarded as payments by the firms to the State for
these services, these indirect taxes should obviously not be taken out of the
index. e difficulty with this way of looking at the maer is that Lindahl’s
norm hardly gives a satisfactory description of actual taxation policy in a
modern democracy.
An examination of these arguments immediately shows that the reasons
that can be given in favour of using a price index ‘at factor cost’ in
connection with the concept of the value of money are of a very
sophisticated nature, while it seems quite natural to use a price index at
‘market price’. It is difficult to understand who would be interested in
keeping a consumer price index ‘at factor cost’ constant, unless
consideration is given to State services and their ‘prices’. If this possibility is
ignored, the oice between a price index ‘at market price’ and ‘at factor
price’ will not be difficult. On the other hand, the oice between a price
index inclusive or exclusive of direct taxes and subsidies will be more
difficult and our oice open to criticism. at we, finally, prefer to work
with a general consumer price index rather than a cost-of-living index is, of
course, related to the fact that there is very lile reason for associating the
concept of the value of money with the purasing power of incomes in any
particular income group.

3. FULL EMPLOYMENT AS A FISCAL POLICY PROGRAMME

We have now shown how the interpretation of the concept of a stable value
of money from a fiscal policy point of view gives rise to awkward problems.
When defining the concept of a stable value of money we are forced to
specify how one part of fiscal policy, namely taxation, is to be regarded in
the price level relevant for the value of money. Does the concept of full
employment regarded as a fiscal policy programme give rise to similar
problems? is question may be answered in the affirmative, as we shall
now try to show.
In defining the concept of full employment, we are faced with two
different aspects of employment: its total size and its composition. Let us
begin with the laer.
e State may influence employment in the country in two different
ways, by influencing employment in the private sector on the one hand, and
by altering State employment on the other. In a situation where there is
unemployment, however, the politician is not always willing to accept an
increase in State employment as a ‘real’ decrease in unemployment. If the
State employment consists of quite useless unemployment relief jobs
(‘digging holes and filling them up again’), this will perhaps only be
regarded as a kind of subsidy. In the same way, private activity may be of a
kind not accepted as employment (begging, selling shoe-laces, etc.). is is
called disguised unemployment.5 ose who set up the goal of full
employment usually have a concept of full employment in mind whi
excludes disguised unemployment, both in the public and private sector.
Employment should not only be full in some formal sense, but also be full in
a commonsense way; all workers are to be employed on ‘productive work’.
e question then is what exactly is meant by a ‘commonsense’ or
‘productive’ sort of employment. Ultimately, this is equivalent to the mu-
discussed welfare question of the best allocation of resources. Here again,
there is no answer whi is the correct answer as far as economics is
concerned. e fact that welfare theorists have deduced rules for economic
activities, whi can also be applied to the public sector,6 and whi are
based on certain simple ‘almost self-evident’ political premisses, does not
alter the fact that we are confronted with a decidedly political question. One
of the questions whi arises here is that of the desirable extent of State
employment; another is that of the desired distribution of private production
between consumer and capital goods. e laer problem in particular has, in
the post-war period, aracted more and more aention in economic policy.
Many other su allocation problems of great importance could be indicated.
Here, we shall concentrate on the distribution of employment between the
Government sector, the consumer goods industries and the capital goods
industries. Most fiscal policy measures may be assumed to influence the
activities of the various industries. We shall not try to deduce general
principles to determine when any activity is to be called employment in the
real sense, or to determine the ‘correct’ distribution of employment. We shall
simply postulate that there are certain political aims in these respects, aims
whi have to be considered in fiscal policy.
If we now leave the composition of employment and proceed to the
question of the total amount of employment at full employment, it is
obvious that here too, the exact meaning of this aim must be specified in
connection with the fiscal policy being pursued. In order to get to the root of
the maer, let us assume that labour is a quite homogeneous factor of
production, whi has a supply curve of the ordinary sort. e supply of
labour will then be determined, other things being equal, by the money
wage rate, see Fig. XII: 1. It is obvious that in the assumption of ‘other things
being equal’ whi lies behind su a supply curve, S1, is also implied an
assumption about the structure of fiscal policy with regard to income-
taxation, for instance. e first question is whi point on su a supply
curve is to be regarded as ‘full employment’. Now if we draw a demand
curve, D1, for labour, whi, other things being equal, also is a function of
money wages, then at money wage w1 the demand for labour will be equal
to the supply. At this money wage rate there is no unemployment in the
sense that there is no labour offered at the current wage whi is not taken
up, and there is no shortage of labour power at this wage. Su a situation
could reasonably be called full employment. Let us, for the time being, adopt
this quite traditional definition of full employment.

Fig. XII: 1

e demand curve as well as the supply curve is drawn with fiscal policy
(fiscal policy parameters) being given. A ange in fiscal policy may, for that
reason, be assumed to affect the demand as well as the supply curve. A
ange in the income tax rate may move the supply curve to, say S2. A
ange in the indirect taxation may move the demand curve to, say, D2.
Now if full employment means that demand for and supply of labour are to
be equal, then the intersection of S2 and D2 will also determine a situation
of full employment. Employment here is larger than in the first situation.
Are these two situations of full employment equivalent? Or does the
demand for full employment also require some absolute amount of
employment in addition to requring that supply and demand are to be equal.
In the laer case, the goal of full employment evidently has to be specified
with regard to the intended fiscal policy.
We are here confronted with the question of the incentive or disincentive
effects of fiscal policy upon economic activity, and especially upon work.
is oen plays a dominant part in general discussions of tax policy, and it
is oen taken for granted that fiscal policy should be so designed as to
provide a strong incentive to work. e reasoning behind this political view
normally is not given, and even though it oen seems to be a political
axiom, it may be that it is based on certain vague Benthamite propositions.
On the other hand, some welfare propositions also assert that not too great
an incentive to work should be created; leisure time has a value of its own.
Possibly the politicians have some ideas about an optimum incentive? e
dependence of the level of full employment upon fiscal policy is not only a
question of the incentive to work, i.e. the supply curve, however; the
position of the demand curve is also decisive as to whether equality of
supply and demand for labour will be brought about with a higher or lower
volume of employment.
To the extent that the structure of fiscal policy influences the supply and
demand for labour, the definition of full employment must take account of
this, either by declaring that full employment means supply of labour =
demand for labour, irrespective of the structure of fiscal policy, or else by
specifying more closely the restraints upon the total amount of employment
at full employment, for example, that the level of full employment is to be
optimal in some sense. In the main, we shall keep to the former alternative.
Even if greatly simplified premises as to the homogeneity of labour are
made, we have seen that there arise certain problems concerning the
definition of the concept of full employment due to our regarding full
employment as a particular fiscal policy programme. As soon as the
assumption of homogeneous labour is removed, further difficulties arise, but
these problems are not particularly associated with full employment as an
aim of fiscal policy, so that we shall not consider them further here, but
return to them in Chapter XVII.

4. CONCLUDING REMARKS
We have osen to define stable value of money as equivalent to a constant
consumer price index ‘at market price’ and excluding direct taxes and
subsidies. It is, however, an open question whether a consumer goods price
index ‘at market price’ and including direct taxes and subsidies would not
really give a beer expression of what is normally meant by a stable value
of money. Full employment has here been defined as equivalent to equality
between the supply and demand for labour, irrespective of how the absolute
level of employment is influenced by a fiscal policy aiming at full
employment. In this way the question of incentives is ignored, together with
certain complications specially connected with the la of homogeneity in
the labour market; su problems will be considered in the discussion whi
follows, however.
In oosing these definitions, we have not worried ourselves about
whether the ends, so defined, conflict with one another or not (see Chapter I,
9). If they do, then they cannot both be aained simultaneously. Su a
conflict may be due, firstly, to the interpretation whi is placed upon the
ends, i.e. their definition, or secondly, to the framework of the actual society,
or more correctly its model, within whi the ends are to be brought about,
or thirdly, to the nature of the controllable means whi are considered
permissible in bringing about these ends. Even though we may now have
defined the ends of stable value of money and full employment fairly
precisely, the question whether the ends are in conflict with ea other or
not cannot be answered until the model and the means have been specified.
Finally, we must emphasize once more that the definition of the ends of
stable value of money and full employment is a political question, whi
only politicians can answer. e fact that we have osen two particular
definitions must not be taken to mean that these two definitions are the
correct definitions from the viewpoint of economics. e fact is, quite
simply, that an exact analysis must be based on exact definitions, and as
time and space do not allow a discussion of all possible alternative
definitions, I have osen to confine the analysis to two particular
definitions whi seem to play an important part in practical discussions.

1. Dag Hammarskjöld gives a detailed description in ‘e Swedish

Discussion on the Aims of Monetary Policy’, International Economic
Papers, Vol. 5. Originally published as ‘Den svenska diskussionen om
penningpolitikens mål’ in Studier i ekonomi och historia (Studies in
Economics and History) presented to Eli F. Heser. See also Erik
Lundberg, Konjunkturer och ekononomisk politik (Business Cycles and
Economic Policy), Chapter X
2. See, however, Erik Lindahl, Penningpolitikens medel (e Means of
Monetary Policy), p. 62.
3. E.g. Konsumentprisindex (Consumer Price Index), SOU 1953, 23,
Stoholm 1953, Chapter 6.
4. Cf. Erik Lindahl, ‘Sveriges Riksbanks konsumtionsprisindex’ (e
Swedish Riksbank’s Consumption Price Index), Ekonomisk Tidskrift
1933, pp. 83–91.
5. Joan Robinson, Essays in the Theory of Employment, London 1937, pp.
82 ff.
6. Erik Lindahl, Die Gerechtigkeit der Besteuerung (e Justice of
Taxation) and P. A. Samuelson, ‘Principles and Rules in Modern Fiscal
Policy: A Neo-Classical Reformulation’ and ‘e Pure eory of Public
Expenditure’.
 CHAPTER XIII

Neutral Fiscal Policy

1. THE ENDS OF FULL EMPLOYMENT AND STABLE VALUE OF MONEY
AS RESTRICTIONS ON THE STATE’S FREEDOM OF ACTION
AN analysis of the great inflations in history, especially those in time of war,
would no doubt show that nothing has contributed so strongly to the
deterioration of the value of money on these occasions as the behaviour of
the authorities themselves. It seems obvious that an indispensable condition
for the stabilization of the value of money is that the State does not by its
own actions bring about undesirable anges in the value of money. As
regards the major lapses from full employment that economic history
records, the State is perhaps not directly responsible in the same way. Here
too, it is quite obvious, however, that a basic condition for the aievement
of the end is that the State does not directly contribute towards its undoing.
is statement is perhaps commonplace, but it is not less important for that,
for the way in whi economic policy has been conducted at times shows
that to point it out again is by no means superfluous. Irrespective of any
disturbances that may upset the national economy, the ends of full
employment and a stable value of money in themselves put certain
restrictions on the overall economic policy of the State, and thus also on
fiscal policy; the State cannot behave in any way it ooses. It is the nature
of these restrictions that is the subject maer of this apter.
In order to simplify the problem, we shall assume that the national
economy is in perfect balance at the desired level of consumer goods prices
and of employment and with a given fiscal and general economic policy. No
endogenous forces in the private economic sector are tending to ange the
price level and employment, and there are no external disturbances. As long
as the State does not then ange its economic policy, for example by
anging its fiscal policy parameters, the ends of full employment and stable
value of money will not be upset. Conversely, as soon as the State anges
its fiscal policy parameters in any way, divergencies from one aim or both
may occur. Now, if the State had no other aims than these two, it would not
in these circumstances have any reason to ange the fiscal policy
parameters. However, our problem here concerns what will happen if the
State establishes ends additional to the two primary ends, and aempts to
bring these other ends about by fiscal policy or other means. Even in a
situation of perfect economic equilibrium, anges in social welfare policy,
trade policy, defence policy, etc., may involve anges in fiscal policy. To
what extent can su aims exist together with the aims of full employment
and a stable value of money? is is, in fact, the crux of the problem of
neutral fiscal policy. Put another way, we may suppose that the constancy of
employment and of the value of money is upset by a ange in a certain
fiscal policy parameter, and then ask what other anges in fiscal policy
parameters will the State be obliged to make in order to counteract the
effects on employment and the value of money—if this can be done at all?
A first rule of thumb that can be set up here is that if the State anges a
certain (arbitrary) number of fiscal policy parameters in order to bring about
certain ends, it will generally have to be ready to ange two more at the
same time in order to prevent anges of the value of money and
employment. is follows from the general discussion in Chapter I about
ends and means, a discussion whi is obviously relevant to this problem.
One fiscal policy measure will, as a rule, require two further compensating
fiscal policy or monetary policy measures. Sometimes, however, less than
two additional parameter anges may suffice to secure the given levels of
employment and prices while at other times there will be no additional
parameter anges that are capable of doing so. e existence of the two
basic ends of full employment and a stable value of money obviously makes
government policy mu more complicated.
We have been mainly concerned with fiscal policy measures, but the
argument is also relevant to all other State measures of economic
significance. us we shall, in the following, take some account of State
measures other than fiscal policy ones, and we shall pay special aention to
the interplay of monetary and fiscal policy.
In order to deal with these problems, we will have to treat them in
connection with a complete and explicit model. Fortunately, it will be
possible to illustrate many varied aspects of fiscal policy by means of a
comparatively simple model, whi can later be supplemented verbally ad
hoc in various respects. is model is presented in section 2, and will also
form the basis for the discussion in Chapters XIV–XVII. e model applies
to a closed society. Foreign trade is not introduced into the model until
Chapter XVIII; as we shall show there, the validity of the results derived on
the basis of the model for the closed society is not materially influenced by
taking account of foreign trade.

2. A MODEL FOR A CLOSED SOCIETY

We shall devote this section entirely to the presentation and discussion of a
model whi seems suitable for considering the theory of fiscal policy.
Firstly, in subsection (i), we set up the model as a static short-term one, and
then, in subsection (ii), discuss some of its properties. In Chapter XVI it will
be shown how the static short-term model may be seen as part of a larger
dynamic model whi describes a long-term development; this dynamic
model is in fact a mixed static and dynamic model.

(i) Static Short-term Model

In addition to the State, our model contains four sectors, namely the
consumer goods industry, the investment or capital goods industry,
capitalists’ (entrepreneurs’) households, and wage-earners’ households.
Payments are made between all these sectors and the State whi make
fiscal policy or other State measures possible. Both the consumer goods and
the capital goods industries are taxed ‘indirectly’ either by means of taxes on
the value of production or on their wage bills; from both these industries the
State buys goods for use by the State, both consumer goods and capital
goods. Both the capitalists’ and the wage-earners’ households pay income
tax and receive direct subsidies, and the State hires labour from the wage-
earners’ households. e State will thus have the following ten fiscal policy
parameters:

tC = rate of tax on consumer goods (calculated on the price including

tax)
tI = rate of tax on capital goods (calculated on the price in-including
 tax)
tL = wage-earners’ income tax rate
tV = capitalists’ income tax rate
No = number of State employees (civil servants)
wo = money wage of State employees per person per period
= State purases of consumer goods (quantity)
= State purases of capital goods (quantity)
TL = direct subsidies to wage-earners’ households (a sum of money)
TV = direct subsidies (interest payments) to capitalists’ households (a
sum of money).

In addition to these ‘purely’ fiscal policy parameters, we assume that the

State has at its disposal one monetary policy parameter, viz. the rate of
interest r. We shall comment on the different parameters below.
Firms whi are always planning to maximize their profit, will try to
conduct their production and price policies in an optimum way from this
point of view. Let us consider the short-term planning within a firm with
given fixed capital equipment and let this firm be producing consumer goods
with labour as the only variable factor of production. e production
function of the firm is q = f(n) where q denotes quantity of consumer goods
produced and n employment within the firm. If p denotes the price of the
goods produced, a the fixed costs and w the wage per worker per period, the
firm’s profit is v = pq—wn—a. e maximization of profits will then yield the
well-known optimum condition

where g denotes the marginal revenue. Under perfect competition g = p and

(XIII: 1) then says that the firm always plans so that the wage-rate will be
equal to the (expected) value of the marginal product. From now on we will
suppose there is perfect competition, but see subsection (ii).
We now suppose that the State has imposed an indirect tax on the firm.
e tax is assumed to be either a certain fixed percentage, tC · 100, on the
price of the goods (including the tax) or a certain fixed percentage, tw · 100,
on the wages paid (excluding the tax); the laer tax is mu the same as a
tax on employment, and we shall return to this type of tax in a different
context. e formula (XIII: 1) in the first case will then be

and in the second case

By analogy we now suppose that su relationships exist also between the
macro-entities in the community. We shall not, however, go into the
question of how these macro-economic variables, su as the price index,
the quantity index, etc., are to be defined in order to make this analogy
legitimate.
Now if we confine our aentions to the case of free competition, the
optimum condition for the consumer goods industry is

and for the capital (investment) goods industry

where w denotes the money wage-rate (assumed to be the same in the

consumer and capital goods industries), pC and pI denote the price levels of
consumer and capital goods respectively, f and φ the production functions
and NC and NI the levels of employment within these respective industries.
If instead, the indirect tax is a tax on wages paid, these equations take on the
same form as equation (XIII: 3) above. We assume that there is decreasing
marginal productivity within both consumer and capital goods industries,
i.e. f″ < 0 and φ″ < 0.
e quantity of consumer goods produced, qc, is determined by the level
of employment NC, and the production function
and similarly the production of capital goods, qI, is

At a given money wage-rate, given prices and indirect tax rates, these
four equations are sufficient to determine employment and production, i.e.
supply, in the consumer and capital goods industries.
We turn next to the demand for consumer and capital goods. For this
purpose we first determine the factor and disposable incomes of wage-
earners’ households.1
e total factor incomes L of wage-earners’ households, are equal to the
total wages paid out by the consumer and capital goods industries and the
State (we disregard financial incomes):

e disposable incomes of the wage-earners’ households, Ld, can then be

found by adding possible direct subsidies to the factor incomes and
subtracting income tax, thus:

e total factor incomes of the capitalists’ households, profits, is then

found as the total income from sales of the consumer and capital goods
industries minus the indirect tax payments of those industries minus their
total wage payments, thus

e fixed costs are taken to be payments of interest, etc., whi go

exclusively to other capitalists’ households; we disregard depreciation. In a
calculation of the total income of the capitalists, therefore, this item
(financial income) will disappear.
 e disposable income of the capitalists’ households, Vd, will thus be:

e fact that we work with different tax rates for capitalists’ incomes and
wage-earners’ incomes can be explained in various ways. Firstly, the
average income may be different for capitalists and wage-earners. Normally,
it can be supposed that the incomes of the capitalists exceed, on average, the
incomes of wage-earners. By working with a higher tax rate for the
capitalists’ incomes, therefore, some regard has been paid, in a primitive
way, to income tax progression. e fact that income tax rates in the model
are formally independent of the size of incomes, is of no practical
importance to the discussion in this apter. e discussion will only
presume that if incomes are reduced the amount of tax will also be reduced
in one way or another. Secondly, we have not aempted to distinguish
between the incomes of the firms and their owners. All the incomes of firms
are assumed to be handed over to their owners’ households. By working
with a higher tax rate for the incomes of capitalists, we also consider in a
primitive way the taxation of limited companies.
We now suppose that real disposable incomes are decisive for households’
demand for consumer goods. If we add the State’s purases of consumer
goods to the demand by the households, we find the total demand for
consumer goods, dC, as

Since we are working with a static model, the conditions for equilibrium
are, of course, that supply and demand for consumer goods are equal

So far, the theory of macro-economics is quite well established. When we

turn to the demand for capital goods, it is quite another maer. It is obvious
that the rate of interest is important for the determination of the demand for
capital goods, and it is equally obvious that the price of capital goods is
included in the demand function. Conditions within the consumer goods
industry will also be of relevance. e output of consumer goods or their
prices, or possibly both, ought surely to be included in the demand function
for capital goods. e demand function for capital goods is necessarily quite
complicated, even in su a simple model as ours. Here, we shall confine
ourselves to indicating the demand for capital goods dI as

where r is the interest-rate.

e condition for equilibrium within the capital goods market is
obviously

e equations (XIII: 4)–(XIII: 15) together determine the twelve

endogenous variables pC, qC, dC, NC, pI, qI, dI, NI, L, Ld, V and Vd.
Accordingly, we have the same number of equations as unknowns. Money
wages w, are considered as a parameter, although not as a State parameter.
If we want an expression for total employment N, we have the identity

As can be seen from the above, we have not made any use of State income
and expenditure, with the exception of the expenditure parameters TL and
TV. However, if an explicit expression for these magnitudes is desired, we

have
 For the sake of convenience, we have here defined the budget surplus as
the ‘real economic’ balance mentioned in Chapter III, 5; that is the difference
between income-destroying and income-generating budget items. Due to the
simplicity of the model, this budget balance also becomes identical with the
State’s net borrowing (including ange in the amount of notes in
circulation and debts at call). If it is desired to define the budget surplus
according to the official Swedish budget principles, expenditure for the
purase of capital goods plus su wage expenditures as are made by the
State for investment purposes would have to be taken out of the above
equation, and furthermore, a negative item would have to be introduced for
depreciation.
In the model we have considered, neither the credit market nor the
quantity of money appears. Instead, the rate of interest has been introduced
as a State (monetary policy) parameter. Our procedure in this maer may be
interpreted in the following manner: in ea period the claims on the State
of the private sector (in the form of interest-bearing claims or notes or
claims at call) are reduced by an amount equal to the budget surplus B. e
budget surplus corresponds to the private sector’s surplus of investment over
saving. At a given rate of interest, the private sector is then supposed to
distribute its savings between interest-bearing claims and cash holdings
according to its preferences for these assets. e State supplies these in the
necessary quantities. It should hardly be necessary to point out that from a
monetary policy point of view, this summary and implicit treatment of the
credit market is not very satisfactory. Our main interest is, however, in fiscal
policy and its methods.
For the sake of simplicity we shall reformulate the model in the following
‘abbreviated’ manner.
Firstly, we have the optimum conditions for the two industries:

Furthermore, we have the definitions of the disposable incomes:

e conditions of equilibrium in the markets for the goods are

ese six equations are sufficient to determine the variables pC, pI, NC,
NI, Ld and Vd. If we want to know total employment, it can be obtained

from the identity

e budget balance B is found from equation (XIII: 17) whi we shall not
recapitulate.
Despite the fact that we are here working with an extremely simple
system, it is still so complicated that formal calculations are troublesome
and the results not very informative. As we have established the model, it is,
however, possible to see in whi direction the different variables of the
model will be influenced by different parameter anges, without resort to
formal calculations.
e method of procedure used in the remainder of this apter and in the
following apters will be as follows. We suppose that the various functions
of the model and parameters are su that total employment determined
according to (XIII: 7°) is exactly ‘full employment’, that is equal to the
quantity of labour offered, whi is given beforehand and regarded as
constant, and that the price level of consumption goods is also the one
desired. Supposing that circumstances outside our field of interest makes the
State ange one or more of its fiscal policy or monetary policy parameters,
we then pose the question: what other State parameters have to be anged,
and in whi direction, if the price level of consumer goods and total
employment are to remain unanged? It is convenient to call these
parameter anges the ‘compensating measures’. Oen there exist several
different combinations of parameter anges whi can all bring about the
desired result. We shall make no aempt to give a systematic account of all
su parameter combinations. It will readily be realized that the number of
parameters is so great that su an exhaustive treatment would require a
very comprehensive volume. We shall only indicate here those combinations
of parameters whi seem to be of the greatest interest.

(ii) Some Observations on the Treatment of Indirect Taxes, Income

Tax and Interest in the Model
e model set up in subsection (i) is greatly simplified in many respects.
For that reason, we shall dwell somewhat upon certain aracteristic
features of the model whi are particularly important for a policy whi is
to keep the level of consumer goods prices constant at full employment.
Expressions like (XIII: 4) and (XIII: 5) or (XIII: 1°) and (XIII: 2°) are to be
found in a very wide class of models, in dynamic as well as static short-term
models. In (XIII: 1°), we shall now, for the sake of argument, consider the
price level of consumer goods, pC, as constant, this being the aim of fiscal
policy under consideration here. (XIII: 1°) can then quite simply be regarded
as providing the basis upon whi the State determines the rate of tax on
consumer goods. If the price level of consumer goods is to be constant and
(XIII: 1°) satisfied, the rate of tax (or subsidy) on consumer goods has to be
varied in the opposite direction to possible anges in money wages. and in
the same direction as possible anges in the marginal productivity of
labour. Put more precisely: with a given marginal productivity (given f′
(NC)), then (1—tC) has to be varied in direct proportion to the money wage-
rate w; while with a given money wage, (1—tC) has to be varied in inverse
proportion to the marginal productivity of labour.2
is self-evident relationship can also be expressed in terms of costs
instead of in terms of productivity as above. If wages are increased or
marginal productivity falls, the marginal costs will rise for any given output;
an unanged price will then require a reduction in the indirect tax rate.
We shall not dwell further on the case of a ange in w. Changes in the
marginal productivity of labour f′(NC) may be of various kinds. Marginal
productivity may be anged either by a ange in employment NC, or by a
ange in the production function itself. In the first case the marginal
productivity is anged by a movement along a given production function;
in the second case, the production function itself shis. With perfect
competition, at any rate, it is generally assumed that an increase in
employment will lead to lower marginal productivity, i.e. f″(NC) < 0.
We have now covered those cases where the rate of indirect tax on
consumer goods may and must increase (decrease) if the price level of
consumer goods is to be kept constant. If money wages are raised, if
employment increases in the consumer goods industry or if marginal
productivity of labour decreases (at a given level of employment) the rate of
indirect tax on consumer goods has to be lowered. Conversely, if money
wages fall, employment within the consumer goods industry falls, or
marginal productivity rises, then the indirect tax rate has to be increased.
Finally, if money wages, employment, and marginal productivity in the
consumer goods industry are constant, the indirect tax rate cannot be
anged if the consumer goods price level is to be constant.
If raw materials are used as a variable factor in the consumer goods
industry, these conclusions will naturally have to be modified accordingly.
From the cost point of view, it can generally be said that if the marginal
costs are increased, regardless of the cause, the indirect tax rate must be
decreased, and vice versa, if the price level for consumer goods is to be kept
constant. Only if the marginal costs are anged can the indirect tax rate be
anged.
With perfect competition these conclusions are valid without regard to
the other equations of the model and without regard to other anges that
may occur. With certain modifications the results are also valid for the
monopoly case.
In the perfect monopoly case the equation (XIII: 1°) is still valid if pC is
replaced by the marginal revenue g, though the significance of this concept
in macro-economics is open to dispute. As it is the price and not the
marginal revenue whi is to be kept constant, it may be asked whether this
would not give the State a new opportunity of anging the indirect tax rate
without jeopardizing the requirement of a constant price level. Under
monopoly the relationship between price and marginal revenue is
determined by the elasticity of demand, according to the formula g = pC(e—
1)/e, where e is the elasticity of demand. According to (XIII: 1°), an isolated
ange in (1—tC) is to be met by a proportional inverse ange in (e—1)/e, if
the price level is not to be affected by the ange in the indirect tax rate. is
means that the flexibility of the demand (or price) will have to ange in a
direct proportion to the indirect tax rate. Now if a ange in the indirect tax
rate had the remarkable property of influencing the demand for consumer
goods via the rest of the model in su a way that this condition (given the
quantity of consumer goods) was just fulfilled, then any ange whatever in
the indirect tax rate would be quite compatible with an unanged price
level of consumer goods, unanged wages, unanged employment and an
unanged production function. However, if this very special eventuality is
ignored, the rule is obviously that at a given price level the indirect tax
cannot be anged when money wages or employment or marginal
productivity in the consumer goods industry are not anged at the same
time, unless the rest of fiscal policy is so designed that the elasticity of the
demand for consumer goods (at the given quantity demanded) is anged in
the manner indicated above. us it seems as if the pure monopoly case
offers more opportunities of using indirect taxes and subsidies in the
consumer goods industry without affecting the price level. On the other
hand, it is clear that if it is practically impossible to aieve the ange in
the elasticity of demand mentioned, the use of indirect taxes will be just as
limited in the monopoly case as in the case of perfect competition, and the
difference between the two cases will then only be that the simple rules of
proportionality in the case of perfect competition cannot be transferred to
the monopoly case, for it cannot be guaranteed in advance that the elasticity
of the total demand for consumer goods will not be affected by the fiscal
policy measures that are taken.
Under monopolistic conditions, the equations (XIII: 1°) and (XIII: 2°) are
sometimes considered unrealistic as descriptions of the behaviour of the
firms. Instead of using ‘marginalistic’ calculations, the firms are assumed to
apply certain average calculations in determining selling prices. It is easy to
see that with su behaviour by firms, anges in indirect taxes on consumer
goods are only compatible with an unanged price level if there is a ange
in the production function or in money wages. So far, the monopoly case
offers the same possibilities of using indirect taxes as did the case of perfect
competition. However, we may observe certain differences from the case of
perfect competition. In the marginalistic case, anges in employment are in
themselves a reason for anges in the indirect tax rate if the price level is to
be kept constant. at is not the case with an average calculation.
Furthermore, in the marginalistic case, the anges in marginal productivity
are relevant to the level of indirect taxation; with an average calculation it is
the anges in average productivity whi are decisive.
Under a programme of full employment and a stable value of money, the
use of indirect taxes and subsidies on the production of consumer goods will
thus be determined in principle according to very simple rules. If we ignore
the very special monopoly case mentioned above, the task of indirect
taxation on consumer goods can quite simply be said to be to neutralize all
marginal cost anges in consumer goods production. alitatively, the
monopoly cases (with both marginalistic and non-marginalistic pricing) will
resemble the case of perfect competition with respect to the State’s use of
indirect taxation on consumer goods. is is the real reason why we
maintain the premise of perfect competition, for it makes scarcely any
important difference to the qualitative results.
In discussing the use of indirect taxation, it should further be noted that
the way the model is constructed makes the indirect taxes discussed here
equivalent to value-added taxes in the consumer and capital goods
industries disregarding depreciation whi has not been taken into account
in the model. Nor has any regard been paid to the ‘Staffelung’ of production.
Strictly speaking, the firm’s incomes considered are gross incomes, just as
the tax on capital goods is a gross investment tax. Finally, it should be noted
that the indirect taxes are imposed in principle as taxes on production and
not on turnover. In a closed economy with no anges in stos this is,
however, of no importance, but when it comes to the open model having
foreign trade the difference between a tax on production and a tax on
turnover will be crucial (see Chapter XVIII, 7 (iii)).
If we examine income taxation in the same way, we see that, as the model
is constructed, the only function of income tax is to affect the demand for
consumer goods in su a way that equilibrium is established in the
consumer goods market at the desired price. e possibility that income
taxation may affect the supply of labour or the demand for capital goods has
not been allowed for in the model.
e rate of interest also has rather a special function in the model; interest
influences directly only the demand for capital goods, and its immediate task
is to establish a balance between production and demand in the capital
goods market. e position of interest in the model is naturally of very great
importance to the part to be played by monetary policy, and may very well
be open to criticism. In the first place, interest may be considered a
determining factor in the demand for consumer goods; this will be the case
as soon as the rate of interest influences saving to any great extent. In
accordance with a widely accepted belief, we have, however, assumed that
interest plays no great part here; there would, however, be no great difficulty
in taking it into account. Secondly, and of far greater importance, is the
question whether the role of interest may not exert a direct influence on
production and employment. is will be so, of course, when production
takes time. If the rate of interest is r and the periods of production τC and τI,
the optimum conditions (XIII: 1°) and (XIII: 2°), will become

and
 An increase in the rate of interest with given prices, wages, tax rates and
productivity, will reduce production and employment, while with given
wages, tax rates, productivity and employment, it will raise the level of
prices. We shall, however, assume that the periods of production are so short
that this complication can be ignored. is may be justified if we only think
of monetary policy in the form of interest anges. However, if we imagine
that the parameter r represents both interest anges and anges in the
availability of credit, so that an increase of r means a general tightening of
the credit market, with ‘credit rationing’ as well as an increase in the rate of
interest, then r may well have a direct effect on the volume of production
even though the production period be very short. In what follows, we shall
consider credit policy only as a ‘pure’ interest policy, and we can thus ignore
the possibility that credit policy has any direct influence on production and
employment; but the above qualifications ought to be kept in mind.
It will be seen from what has just been said concerning the place of the
indirect tax on consumer goods, the income tax, and the rate of interest in
the model, that the rate of tax on consumer goods must be primarily
directed to establishing equilibrium in the labour market at the desired price
level for consumer goods, while income tax and the rate of interest must be
primarily concerned with establishing equilibrium in the commodity
markets at the desired price level. is will become obvious in this and the
following apters, and especially in Chapter XVIII, where the model for the
closed society is completed by taking foreign trade into consideration.

3. PURCHASES OF LABOUR BY THE STATE

With full employment, purases of labour by the State will have pervasive
consequences for the economic system. ey will mean that there will be a
smaller amount of labour at the disposal of the private sector. As we shall
try to show, the compensating measures to be undertaken by the State in
this case will be rather complicated.
To fix ideas, let us first suppose that the purase of labour consists in the
call-up of national service men to the army, and that they get some
economic compensation from the State during their service. is example of
the ‘purase of labour’ is interesting for several reasons. Firstly,
mobilization may take place suddenly, and secondly, the case is interesting
from the analytical point of view as labour is here compulsorily moved from
private industry to the service of the State. e considered labourers will
then normally have mu lower incomes as national service men than they
had when employed by private industry. If, on the other hand, the
movement takes place on a voluntary basis, the State has to compete with
private industry, and this causes special problems whi we shall deal with
later. For the moment, we shall assume a compulsory call-up, whi brings
about reduced incomes for the workers involved. Due to the reduced supply
of labour and the reduction in private production that will follow, the
purase of labour by the State in this way will have an immediate effect on
both the labour and the commodity markets.
Let us begin by considering the consumption and capital goods industries.
One of these industries—possibly both—must reduce production because of
the decreased supply of labour. e outcome will naturally depend largely
on whi of these industries is obliged to restrict its production. us
alternative ways are open for the compensating policy.

(i) Unchanged Consumer Goods Production

For our first case, let us imagine that the decline in production takes place
entirely within the capital goods industry, while the consumption goods
industry continues producing to the same extent as originally. With
unanged employment and production in the consumer goods industry, the
marginal productivity of labour will remain unanged there. If the
consumer goods price level is to remain unanged, the indirect tax rate on
consumer goods must, at given wage-rates, remain unanged (see section 2
(ii) and the equation (XIII: 1°) in our basic model). In the capital goods
industry production will be reduced because of the decreased supply of
labour. Lower employment, however, involves an increase in marginal
productivity. If the capital goods industry is to be in (optimum) equilibrium
with the given wage-rate, the given tax rate on capital goods, and a lower
level of employment, then the price of capital goods has to be reduced in
inverse proportion to the ange in marginal productivity (see equation
(XIII: 2°)). e prerequisite for su a price reduction is that demand falls
just so mu that at this lower price it is equal to the production whi is
possible at the lower level of employment (see the conditions for equilibrium
(XIII: 6°)).
e conditions for an equilibrium with a constant price level of consumer
goods and with full employment are then, firstly, that the demand for
consumer goods at the unanged price level is exactly the same as
originally, and, secondly, that the demand for capital goods has been
reduced just so mu that the supply of and demand for capital goods
coincide at the lower price for the capital goods, this fall in price to
correspond to the increase in marginal productivity due to the lower level of
employment. If these conditions are fulfilled, both the markets for goods and
the labour market will be in equilibrium, and the policy ends will be
aieved. Let us therefore look at the demand conditions.
Firstly, there is the demand for capital goods. Here, we regard the demand
for capital goods as a function of the level of output of consumer goods, the
price level of capital goods, and the rate of interest (see equation (XIII: 60));
in addition, we have the State’s demand for capital goods. Assume now that
the production of consumer goods is unanged. With the reduction in the
production of capital goods corresponding to the increase in the purase of
labour by the State, the price level of capital goods would tend to rise, with
no ange in the rate of interest or in State demand, until demand had
decreased to the same extent as production. However, su a rise in price
would be an incentive for the capital goods industry to expand, and thereby
a tendency for a situation of overfull employment to arise. us the price
meanism of the capital goods market cannot be trusted as equilibrating
factor. Instead, we shall have to shi the demand curve for capital goods so
far to the le that equilibrium is aieved at the lower level of production
with a sufficiently reduced price of capital goods; this may be brought about
by means of an increase in the rate of interest, or a reduction of State
purases of capital goods, or by increasing the rate of tax on capital goods.
Fig. XIII: 1 illustrates these different possibilities. e original supply
curve for capital goods is S 0, the original demand curve is D 0, the quantity
I I

of capital goods produced is 0, and the price of capital goods

qI
0. Now, if
pI
the production of capital goods is decreased to I, equilibrium can be
aieved by shiing the demand curve from DI0 to DI1; the market price of
capital goods then falls from p 0 to p 1. Equilibrium can also be aieved by
I I

shiing the supply curve from SI0 to SI1; the market price will then rise from
0 2
P to p . e movement of the demand curve is naturally brought about by
I I
means of an increase in the rate of interest or decreased State purases; the
movement of the supply curve is brought about by a tax, the rate of whi is
100(p 2—p 1)/p 2. Combinations of these measures can also be applied.
I I I

Fig. XIII: 1

Next comes the question of equilibrium in the consumer goods market.

With an unanged production of consumer goods at an unanged price,
the demand for consumer goods obviously has to remain unanged. With a
given State demand for consumer goods we assume that the demand for
consumer goods depends on the real disposable incomes of the capitalists
and the wage-earners. If the price of consumer goods is to remain
unanged, a sufficient condition for equilibrium in the consumer goods
market is that nominal disposable incomes of both capitalists and wage-
earners are unanged.
Let us first see then how factor incomes are affected by the anges
already discussed. e total factor incomes of wage-earners depends wholly
on whether the workers who have been transferred to State employment
have higher or lower incomes now than previously. Here, we shall assume
that as conscripts, they will receive lower earned incomes. e incomes of
capitalists in the consumer goods industry are unanged. Within the capital
goods industry, capitalists’ incomes decrease however. is is a direct
consequence of the lower production and of the corresponding adjustment
of the price level. If then the disposable incomes of the capitalists and
workers are to remain the same as in the original position, either the direct
transfers by the State to these two groups of households will have to be
increased, or else direct taxation, income tax rates, will have to be decreased.
In this way equilibrium in the consumer goods market at an unanged
price level will be aieved.
Let us recapitulate briefly: If the State hires labour, and the production of
consumer goods is assumed to be unaffected by this, equilibrium in the
labour market is brought about by means of a decrease in the production of
capital goods. Equilibrium in the capital goods market is secured by a
decrease in the demand for capital goods brought about by an increased
investment tax or an increased rate of interest or reduced State purases of
capital goods. Equilibrium in the consumer goods market at an unanged
level of consumer goods prices can be aieved by a suitable reduction in
income tax rates or by an increase in direct subsidies.
How is the budget affected by these anges? e primary ange is an
increase in wage payments by an amount corresponding to the new
purases of labour. Furthermore, it is obvious that State revenue from
income tax will decrease or the expenditure on direct subsidies will increase
by an amount equal to the decrease in the factor incomes of capitalists and
wage-earners. How the rest of the budget is affected will depend on the
method whi has been employed to aieve equilibrium in the capital
goods market. For example, suppose that the State has aieved this
equilibrium by means of an increase in the rate of interest. In that case, the
State revenue from the tax on capital goods will decline, due to reduced
production, and so will the State expenditure on the purase of capital
goods, due to their lower prices. In the expenditure column of the budget,
we then get an increase in the wage expenditures and a decrease in the
expenditures on the purase of capital goods; in the revenue column of the
budget we get a decrease in the yields of income tax and investment tax.
However, it will be seen that the decreased cost of State purases of capital
goods must always be smaller than the total reduction in the incomes of
capital goods purducers, whi implies that the reduction in the State
expenditures on capital goods must also be less than the decline in revenue
from income tax. In this case, where the means are an increase in the rate of
interest and a decrease in the income tax rate, a deficit occurs in the budget.
However, a condition for this is that the tax on capital goods is positive not
negative, that means a tax and not a subsidy. If there is a subsidy on capital
goods, the amount of capital goods subsidies will decrease and if the subsidy
rate is sufficiently high the result may be a surplus in the budget.
If equilibrium in the capital goods market is aieved by methods other
than an increase in the rate of interest, the result may be a deficit or a
surplus. Let us look at the case where equilibrium is secured by means of an
increase in the tax rate on capital goods. e ange in the State revenue
from the capital goods tax will here (see Fig. XIII: 1) be dependent partly on
the original level of taxation (the decrease in production in itself involves a
tendency towards a decline in the amount of tax on capital goods) and
partly on the elasticity of the demand for capital goods. If the original tax is
very low or is perhaps even a subsidy, and the elasticity of demand is very
low, the amount of tax on capital goods may increase to su an extent that
the budget will show an increase in the surplus, despite the increased
expenditure on the hire of labour and purase of capital goods and the
reduced revenue from income tax. At some greater elasticity of demand,
income and expenditure in the budget will be anged by the same amount
and the balance is unanged; with an even greater elasticity, a budget
deficit will result.

(ii) Unchanged Capital Goods Production

We now proceed to the case where fiscal policy is assumed to be so
designed that production of capital goods remains unanged, while the
decline of private production affects the consumer goods industry only.
First, we observe that the reduction in employment in the consumer
goods industry necessitates an increase in the tax rate on consumer goods, if
the price level for consumer goods is to be unanged. How mu the
consumer goods tax rate is to be increased depends again on the size of the
increase in marginal productivity of labour within the consumer goods
industry whi results from the reduction in employment.
e decrease in the production of consumer goods will, according to our
basic model, tend to decrease the demand for capital goods. Since the
condition for full employment is now that the production of capital goods
continues at the same level as before, this shi in the demand curve must be
counteracted. is may be aieved either by a lowering of the rate of
interest or by an increase in the purases of capital goods by the State itself
or by the introduction of a subsidy on capital goods (lowering of the capital
goods tax).
Now there only remains the problem of securing equilibrium in the
consumer goods market at an unanged market price and with decreased
production. Here again, this is a question of the nominal disposable incomes.
For these are now, with given State purases of consumer goods, to
decrease just so mu that the total demand for consumer goods becomes
equal to the lower supply. Factor incomes of workers are anged in
accordance with the relationship between wages paid by the State and those
paid by the private sector. Let us suppose for the moment that State wages
are the same as private ones. e movement of labour to the State will not
then ange the total factor incomes of the wage-earners. e incomes of
entrepreneurs from the production of capital goods are unanged, for the
production of capital goods is not affected. e only ange in disposable
incomes therefore comes from the fall in profits in the consumer goods
industry. It is now evident that these profits may be reduced by an amount
larger or smaller than the value, at market price, of the decrease in consumer
goods production. It is a question of how marginal productivity in the
production of consumer goods is affected by the decline in employment. If
the employment elasticity of the marginal productivity is sufficiently great,
profits may decline by a larger amount than the market value of the
decrease in production, and there is nothing to prevent profits declining so
mu that the capitalists’ demand for consumer goods may fall more sharply
than the market value of the decline in the production of consumer goods
(despite the fact that the reduction in income is automatically followed by
some reduction in the amount of income tax paid and also by decreased
saving by capitalists). In that case, a reduction of the income tax rates is
necessary. is is all the more true if State wages are lower than private
ones. ere is one special case where the demand for consumer goods, at
given tax rates, decreases by just as mu as the supply of consumer goods.
In other cases, the income tax rates must be raised.
In this case, the means sufficient to secure full employment and constant
prices of consumer goods will be an increase in the consumer goods tax, a
lowering of the rate of interest (increase in State purases of capital goods
or decrease of the indirect tax rate on capital goods) and possibly a suitable
increase or decrease in income tax rates.
It will be realized that in this case, it cannot be said a priori whether the
budget balance will be improved, worsened or remain unanged.

(iii) Dynamic Short-term Considerations

Our treatment of the consequences of the State’s purases of labour has
up to now been completely static. We have sought the conditions for the
existence of a new short-term equilibrium position with unanged
employment and an unanged price level for consumer goods in
accordance with the basic model set out in section 2. e use of this static
argument seems justified in this context, but the question naturally arises of
how this new short-term equilibrium situation is actually established.
Another question whi crops up is whether it is reasonable to suppose that
labour is transferred to the State without affecting money wages within
private industry. In order to side-step this problem, we supposed that the
labour was compulsorily transferred (by conscription), but if we abandon
this assumption, whi is rather a special one in a modern democratic
society in peacetime, there arises the possibility that the transfer process
may create temporarily overfull employment, whi, in its turn, may upset
the assumptions of the static analysis.
In order to discuss problems of this nature, we must know the short-term
dynamic qualities of the system. Naturally these do not automatically follow
from the static model. One (obviously reasonable) standard dynamic
assumption is that excess demand tends to bring about a price increase and
excess supply, a fall in price. In the labour market, this dynamic meanism
is oen modified with respect to the influences of labour market
organizations and their functions, so that while excess demand (overfull
employment) tends to bring about an automatic upward wage-dri, the
downward effects on wages of excess supply (unemployment) are so small
that they may be ignored (see Chapter XVII). e consequences will
evidently be that if temporary overfull employment arises, money wages
will be permanently increased; temporary unemployment has no su effect
in the opposite direction. It is therefore a maer of some importance, if the
authorities wish to avoid an increase in money-wages, that the transfer
process takes place in su a way that possible divergencies from the full
employment equilibrium in the labour market are only in the direction of
temporary tendencies towards unemployment. However, this does not mean
that there are no fiscal policy means whi can counter-balance the effects
of an increase in money wages on the price level of consumer goods, or that
su a wage increase is necessarily undesirable; we shall return to these
questions in Chapter XVII.
Now if we return to the case where it is assumed that the reduction in
employment in private production takes place in the production of capital
goods, it will be obvious that the main problem will be to see that overfull
employment does not temporarily arise, especially in the capital goods
industries. e policy measures that were sufficient from a static point of
view were a rise in the rate of interest, whi reduced the demand for
capital goods to a suitable extent, combined with su anges in direct
taxation that the demand for consumer goods would remain unanged.
Now if it is assumed that State purases of labour are true purases, and
not a result of compulsory call-up, any policy of keeping the wage level from
rising must start with a rise in the rate of interest, in order to reduce the
demand for capital goods. is will, in due course, create a tendency
towards a fall in price and a decrease in production within the capital goods
industries, and also unemployment. State purases of labour may then
begin, and continue at the same rate as the capital goods industries are
contracting. If the process runs according to this sema, i.e. first the release
of labour from the capital goods industries and then the purase of labour
by the State, then the State purases of labour will not affect the wage level
within private industry, whether State wages are above the private level or
not. ere then remains the problem of anging direct taxation at the
appropriate time and to an appropriate extent. In this respect, the timing of
the fiscal policy measures is not quite so crucial, for in the short run, the
stos of consumer goods will probably bridge any possible gaps between
demand and production, and employment within the consumer goods
industry will not be immediately anged. In the labour market, however,
there are no reserve ‘stos’ at full employment, unless the concept of full
employment is one with whi there is still a certain amount of
unemployment.
In these brief notes, our object has simply been to indicate the nature of
the problems that may arise as soon as the purely static way of looking at
maers is abandoned. However, it is obvious that a compensatory fiscal
policy becomes complicated not only because several ends are to be realized
simultaneously, but also because careful timing of the various measures
seems to be necessary if the ends are to be aieved at all.

(iv) Other Complications

e model of section 2, whi has been the basis for the discussion up to
now, is simple in the extreme, even if we ignore its static nature. It is not
difficult to indicate complications whi may arise. We shall now briefly
outline the importance of some of these complications. It is hardly worth
while developing a more comprehensive model and making the necessary
formal calculations; the actual principles underlying su calculations have
been indicated in Chapter I.
(a) In establishing the optimum conditions for the consumer and capital
goods industries, we assumed that labour is the only variable factor of
production. We ignored the existence of raw material industries, and the use
of raw materials in production. If consideration is given to this, then
naturally the prices of raw materials will also be of importance to the level
of consumer goods prices. e higher the prices of raw materials, the higher
the prices of consumer goods, other things being equal. With given wages
and unanged taxation of raw materials, these prices will in turn depend on
the amount of raw materials produced. Now if anges in raw material
stos are disregarded, and if it is assumed that the raw material industry
supplies both the consumer and investment goods industries, obviously raw
material production must naturally tend to ange in the same direction as
total private production. In the case where the State purases labour and
total private production declines, raw material production will consequently
decline as well, and as a result, raw material prices (in equilibrium) must
tend to fall. Irrespective of whether we consider the case of constant output
of capital goods or constant output of consumer goods (or intermediate
cases), we thus get an independent reason for a fall in the prices of consumer
goods. However, this may be counteracted either through indirect taxation
on raw material production or by increased indirect taxation of consumer
goods or, finally, by that ange in the level of production of consumer
goods that anges marginal productivity within it just so mu as to
balance the ange in marginal productivity that takes place within the raw
material industries. e last alternative obviously implies a further ange in
the production of capital goods. A similar complication arises if the
production of consumer goods takes time. Interest is then included in the
optimum condition, and a fall in the rate of interest (with a given production
period) involves a reduction in costs whi will have to be counterbalanced
by an increase in the consumer goods tax.
(b) e oversimplification of our model is also obvious when it comes to
the determination of the demand for capital goods. is has, up to now, been
supposed to be determined by the level of production of consumer goods,
the price of capital goods and the rate of interest. It is obvious that the
production of capital goods may also be dependent on its own size, but of
greater interest to us here is the question whether the current disposable
income of the capitalists is of direct importance for the demand for capital
goods. It is oen pointed out that firms prefer to finance their investments
from their own resources rather than by loans. ere may be various reasons
for this. us if the current, or perhaps more correctly, the accumulated
business saving is large, investment demand will also be at a high level, and
vice versa. We have not dealt with business saving explicitly, but with given
dividends in the limited companies, or dividends that bear some relation to
the total disposable income of the firms, we may regard the maer as if the
total disposable incomes of the firms (capitalists) are the relevant items.
As we have pointed out, when the State purases labour, and this is
compensated for in some suitable way by fiscal policy or other measures,
then total profits will decline, for either the production of capital goods or
the production of consumer goods will decrease. In order to find the total
disposable incomes of firms, regard must also be paid to any anges in
income taxation. In the case of unanged production of consumer goods,
income tax policy may be conducted in su a way that the disposable
incomes of both wage-earners and capitalists remain unanged. is case
is, therefore, not complicated by a possible relationship between the
disposable income of firms and demand for investment goods. If we turn to
the case of unanged production of capital goods, it was necessary here to
decrease the disposable incomes in order to bring about the necessary
decrease in the demand for consumer goods. It was primarily the incomes of
firms in the consumer goods industries that were subject to reduction (and
possibly also the incomes of wage-earners). If this in itself has a dampening
effect on the demand for capital goods, the effect may quite simply be
balanced by accentuating the reduction in the rate of interest, or in the
taxation on capital goods, whi was necessary for other reasons to
maintain the demand for capital goods. e possibility that the size of firms’
incomes influences the current demand for capital goods therefore involves
no significant ange in the above argument.
(c) Up to now, we have assumed that the rate of interest has an effect only
via the demand for capital goods. However, if we consider interest r, in our
basic model, as an expression for the possibility of geing loans, the
question immediately appears as whether demand for consumer goods
should not also be regarded as dependent on the level of the rate of interest,
that is, on the ease or difficulty with whi credit is obtainable. Even if
interest in itself has no large and significant effect, it is obvious that in the
short run, at any rate, the possibility of geing credit for consumption at all
is of great importance for total purases of consumer goods. is applies
especially to purases of durable consumer goods, su as cars, etc.
In the case of unanged production of consumer goods, the decline in
demand for capital goods might be assumed to have been brought about by
a rise in the rate of interest, that is by a general tightening of the credit
market. If this also affects the purases of consumer goods, it is obvious
that if the demand for consumer goods is to be kept unanged, the income
tax rate has to be reduced so mu that disposable incomes will not simply
remain unanged, but actually increase somewhat. Further means do not
need to be employed, however. In the case of unanged production of
capital goods, the demand for capital goods was assumed to be kept
unanged by means of a lowering of the rate of interest. Here, it is
obviously necessary to have a higher taxation of income than would
otherwise have been the case.
 (d) We have assumed throughout that the quantity of labour is given, and
is not affected by fiscal policy measures. However, it is obvious that some of
the fiscal policy measures mentioned here may be assumed to affect the
supply of labour; in principle, even interest anges might possibly do so.
e purase of labour by the State may, in certain cases, affect the total
supply on the labour market. is especially applies to su State ‘purases’
of labour as are based on the military call-up. It is well known that the call-
up of married soldiers may involve a greatly increased supply of labour from
married women, either seeking to compensate for their lower incomes or for
other reasons. To the extent that the loss to private industries of men called
up to the army is made up by married women entering these industries, the
consequent decline in private production is naturally reduced.
Let us illustrate this by taking an extreme case. Let us suppose that only
married workers doing routine jobs are called up into the army, and that the
wives of these men take over their jobs and do exactly the same work for the
same wages. Neither the consumer goods nor the capital goods industry
need then reduce production. e effect of the State purase of labour will
then be the same as if a direct subsidy equal to the value of the soldiers’ pay
plus income in kind (as servicemen) had been paid to his household.
Equilibrium with an unanged price level of consumer goods and full
employment may then be secured simply by means of an increase in the
taxation of incomes. Other measures will not be necessary. Furthermore, if
we ignore the fact that a household consisting of a worker and housewife
will probably dispose of its income in a different way from the same
household when it consists of the husband in the army and the wife
working, and if we assume that the increase in income tax affects
households with the same consumption and saving habits as the service
households, we find that the yield from income tax will have to be increased
by exactly the same amount as the payments to servicemen. e balance of
the budget is thus unaffected. e reason why we have introduced this
specially constructed case is primarily to illustrate how completely the
means to aieve our ends may ange once we take account of maers
other than those considered in the model described in section 2.
We shall return to the importance of the effects of taxes on the supply of
labour in the following apter.
 (e) We have, so far, only dealt with policy in the short run, that is the
policy whi secures the ends within the period in whi the ‘disturbance’
occurs. e problem now is how policy has to be conducted in the long run.
Here, we must consider the more long-term effects on the short-term
systems for subsequent periods of both the ‘disturbances’ and the measures
taken to offset them. In order to pursue this, we must first investigate how
private real capital formation and the private sector’s claims on the State are
affected. For example, if we consider the case of State purases of labour
assuming unanged production of consumer goods, we found (from section
3 (i) above), that the result will be a decline in real capital formation and
possibly a deficit in the budget. In addition to the means employed in the
first period, further means must then be employed in the next period to
counter-balance the effects of the decline in real capital formation and
increased claims on the State. We shall defer further discussion of this until
Chapter XVI, where we shall consider exactly what these means are, but it
will be seen that in this way we can study the development of policy from
period to period.

4. STATE PURCHASES OF CONSUMER GOODS

We have dealt with the most complicated case, the purase of labour by the
State, first. If we now turn to the cases where the State purases
commodities, either consumer or capital goods, we shall find that, within
our basic model and with the simplest oice of means, these cases create no
great difficulties.
An increase in the State’s purases of consumer goods will immediately
cause the demand for these commodities to exceed the supply; no other
relationships in the model are affected immediately. is will naturally mean
that all the effects of the increased State purases may be counter-balanced
by a decrease in household purases of consumer goods—provided that it is
possible to bring about this decrease without affecting the system in other
respects. In our simple model, this is actually possible by an increase in the
income tax rates or a reduction in direct subsidies. Due to the structure of
the model, one means is thus sufficient to secure unanged employment
and unanged consumer goods prices. How the budget balance will be
affected depends on the marginal propensity to save of the households. If
this is positive for all those who have to pay the increases in income tax (or
receive reduced direct subsidies), a larger amount of money must be taken
up as income tax revenue (or a larger reduction must be made in outlay on
direct subsidies) than was paid out on increased purases of consumer
goods. A budget surplus tends to arise.
If it is not desired to raise direct taxes, interest (credit-rationing) can also
be used in this case. We then suppose that an increase in the rate of interest
is necessary. If the accompanying tightening of credit also affects private
demand for capital goods, it will be necessary to counter-balance this, whi
may be done through a suitable reduction in the rate of indirect taxation on
capital goods. Two means will obviously become necessary. e budget here
will be in deficit; the expenditures on consumer goods will increase, and the
income from the capital goods tax will decline.
Lastly, it may well be asked whether the indirect taxation of consumer
goods is not also a possible means. Naturally it is always possible to increase
the indirect tax on consumer goods so mu that household demand will be
reduced by the same amount as State purases have increased. e prices of
consumer goods will then rise, and it is precisely this price rise that becomes
the condition of equilibrium in the consumer goods market. But if a constant
price level of consumer goods is an indispensable policy requirement, then
this means obviously cannot be employed. We shall, however, show how
even indirect taxation on consumer goods can be brought into the picture.
In the foregoing, we have tacitly assumed that the State prefers a policy
whi leads to an unanged composition of output as regards its
distribution between consumer and capital goods. However, it is quite
conceivable that the State does not want household purases of
consumption goods (the ‘standard of living’) to be affected by the increased
purases of the State. ‘Room’ for the State purases of consumption goods
must then be made by increasing the production of consumption goods and
reducing the production of capital goods. However, if the production of
consumer goods is to increase without any price rise, a decrease in consumer
goods taxation is obviously necessary; this decrease will then correspond
(from a cost point of view) to the decrease in marginal productivity in the
consumer goods industry whi is caused by the increased level of output.
At the same time, the demand for capital goods has to decline just so mu
that the production of capital goods is reduced to a sufficient extent, that is,
so mu that the number of workers released for the consumption goods
industry is sufficient for the expansion in production there. is may be
aieved by a rise in the rate of interest or an increase in the capital goods
tax; it may be pointed out here that this increase in the rate of interest, or in
the tax rate on capital goods, will also have to be used to offset the tendency
for an increase in the demand for capital goods that will accompany the
increased production of consumer goods. Finally, if the factor incomes of
households, and thereby also their disposable incomes, are affected by the
shi from the production of capital goods to the production of consumer
goods, the effect of this on the demand for consumer goods can be
counterbalanced by a ange in income taxation; whether an increase or
decrease in the income tax rates becomes necessary cannot be determined a
priori without further knowledge of the relative anges of marginal
productivity within the two industries.
us we find the final result to be that, if purases of consumer goods by
households are to be maintained, three means will be necessary to secure
unanged prices of consumer goods and full employment: a reduction in
the tax on consumer goods, a rise in the rate of interest (or an increase in the
tax on capital goods), and a ange in the rate of income tax (either an
increase or decrease). How the budget balance in its turn is affected by all
this cannot be determined a priori. Expenditures on consumer goods will
increase; the yield of the consumer goods tax may rise or fall depending on
the elasticity of supply in the consumer goods industry; if the rate of interest
is employed to reduce the demand for capital goods, the amount of capital
goods tax will be reduced, but if, instead, the demand for capital goods is
reduced by increasing the tax rate on them, then the yield of the tax will rise
or fall depending on the elasticity of the demand for capital goods; while
with the higher rate of tax the State’s expenditure on capital goods will
increase; finally the yield of income tax will rise or fall depending on
whether an increase or decrease in the income tax rates becomes necessary.

5. STATE PURCHASES OF CAPITAL GOODS

Let us now suppose that the State purases capital goods. is case is very
similar to the preceding one. e immediate effect of the increased State
purases will be that the demand for capital goods will exceed the
production. e other relationships of the model are not affected. All the
effects of the State purases may for that reason be counterbalanced by a
corresponding decrease in the demands for capital goods of private firms.
Two alternative means can be employed here: an increase in the rate of
indirect tax on capital goods, or a rise of interest-rates. If other
complications are ignored, ea of these two means would be sufficient to
secure unanged prices of consumer goods and unanged employment. If
an increase in the rate of interest is osen, the budget balance will
deteriorate; for the only ange in the budget is then the increased
expenditure on capital goods. If the increase in the rate of indirect tax on
capital goods is osen, either a surplus or deficit may arise in the budget
depending on the elasticity of the private demand for capital goods.
Of the complications, we shall only mention that if the rate of interest is
also important for the household demand for consumer goods, a reduction in
income tax may be necessary to counterbalance the effect in the consumer
goods market of the rise in the rate of interest.
Naturally, other methods are also conceivable. Let us briefly consider the
case where the State does not want private investment to decline. is
obviously involves a reduction in the output of consumer goods. Labour
must be transferred from the consumer goods industry to the capital goods
industry. e decrease in the demand for consumer goods may be brought
about by an increase in income taxation; the tendency towards a fall in the
prices of consumer goods must then be counter-balanced by an increase in
the indirect tax on consumer goods. e reduction in the output of consumer
goods and the increase in the prices of capital goods, both necessary to bring
about the increase in capital goods production, tend however to reduce the
demand for capital goods. is may be prevented by a fall in the rate of
interest, or a decrease in the rate of tax on capital goods. ree means are
obviously necessary: an increase in the rate of income tax, an increase in the
rate of tax on consumer goods, and a fall either in the rate of interest or in
the rate of tax on capital goods. As can be easily realized, it cannot be
decided a priori whether the budget balance will be affected in one direction
or the other by these measures.

6. CHANGES IN MONEY WAGE-RATES OF CIVIL SERVANTS

e money wage-rate, wO for civil servants may also be regarded as a State
parameter, i.e. as a means of fiscal policy. When the State alters the salaries
of civil servants, the reason may either be that the State quite simply wishes
to ange the standard of living of civil servants, or that the State feels
obliged to alter salaries in order to obtain the amount of labour it wants.
Let us look at the first case, where the State raises salaries without
employing more labour. is case bears great similarity to the case where
the State buys consumer goods directly in the market. e effect of the
higher salaries will be that civil servants will increase their purases of
consumer goods to a certain extent depending on their marginal propensity
to consume. e effects may then be completely eliminated by an increase in
income tax rates. If the State does not desire other households to reduce
their consumption in order to make room for the increased consumption of
civil servants, the production of consumer goods must be increased,
although this may have an effect on the production of capital goods. e
means whi secure a constant price level for consumer goods at a constant
level of employment are the same as in the case of State purases of
consumer goods in section 4.
If the reason for the State’s increased salary payments is that it has not
succeeded in obtaining all the labour it needs, then we have also to consider
the transfer of labour from private industry to State service resulting from
the higher pay. is case, however, will simply be a combination of the case
where the State increases its purases of labour (see section 3) and the case
where it increases its purases of consumer goods and we need not go into
it further.

7. SOME COMMENTS FROM THE POINT OF VIEW OF INCIDENCE

THEORY
As has been indicated in Chapter V, incidence theory is concerned with the
problem of how the real incomes of different economic subjects or groups of
subjects, or different types of incomes, are affected by fiscal policy measures.
Analyses of incidence may be conducted under various basic assumptions.
e neo-classical method, advocated by Wisell, was to assume an
unanged balance in the budget or, what was perhaps the real assumption,
equilibrium with the full use of factors of production. If aention is
concentrated upon the anges in real income, the analysis in this apter
may also be considered as an analysis of incidence under the assumption
that the fiscal policy measures must neither affect full employment nor
ange the price level of consumer goods.
In our discussions we have considered two income groups, capitalists
(entrepreneurs) and wage-earners, and two types of income, factor income
and disposable income. Altogether, this will make four types of income in
whi anges can be studied. We shall not repeat here the results of the
investigation conducted in the sections, for the effects of the various
combinations of fiscal policy measures on real income are already set out,
though a closer specification of income tax anges is necessary.

8. CONCLUDING REMARKS
We have now aempted to illustrate how various anges in fiscal policy,
intended to aieve the aims of social welfare policy, defence policy, etc.,
may necessitate other compensating fiscal or monetary policy measures in
order to secure our primary aims: a stable value of money and equilibrium
in the labour-market at full employment.
We pointed out in the introductory section (1) that it can be taken as a
rule of thumb that two ‘compensating’ measures are necessary. An
investigation of the various cases we have dealt with, however, will show
that sometimes only one and sometimes even three are necessary. In certain
cases, more than two means become necessary because we have actually
considered three ends all the way through. As a subsidiary goal we have
made an additional assumption about the wishes of the State concerning the
composition of private production between consumer and capital goods. e
reason for this is not simply that presentation is made easier if we assume
that the production of consumer or capital goods is kept at a certain level,
but also that we have thus been able to illustrate cases where the State
actually ooses to determine the composition of the national product, for
nowadays ends of this kind are at the centre of fiscal policy in many
countries, and sometimes even seem to take priority over the ends of a stable
value of money and full employment. On the other hand, the fact that in
several cases a smaller number of means than three are sufficient to secure
the ends, including the end concerning the composition of production
between consumer and capital goods, is in its turn due to the structure of the
model under consideration; this possibility has already been noted in
Chapter I, and it is obviously of practical importance. However, it should be
pointed out that as soon as regard is paid to those complications whi are
excluded from the simple model in section 2, the number of means
necessary may well increase in certain cases. In the main, we can assume
fairly confidently that the more complications are introduced the more likely
it is that the number of means must be as large as the number of ends.
It is almost impossible to indicate any simple connection between the
anges in the budget balance and the measures carried out. How the budget
balance is affected depends on the primary disturbance, i.e. the disturbing
fiscal policy measure, and also on whi compensating measures are osen,
together with the structure of the model. However, one thing seems certain:
merely to concentrate on the State’s ‘financial position’, and consequently to
be solely concerned to ensure that the revenue items of the State are in some
manner anged to the same extent as the expenditure items, seems to be a
sure way of failing to fulfil the ends. It is not just the levels of revenue and
expenditure whi are of fundamental importance, but also the manner in
whi they are anged, and all this cannot be determined without paying
regard to the model whi is considered to be relevant for the economy in
question.
roughout this apter we have assumed given wages within private
industry, and have not considered the possibility that wages may be affected
when fiscal policy measures are undertaken, through the reactions of the
organizations in the labour market. Nor have we considered the possibility
that money wages are themselves coordinated with the economic policies of
the State. ese possibilities will be further examined in Chapter XVII. It
may just be mentioned here that in all the cases we have dealt with, it is
possible for the State to direct fiscal policy in su a way that the disposable
incomes of wage-earners are not affected. is can be brought about, as can
be easily seen, by the manipulation of income taxation and direct subsidies.
Finally, it must be pointed out that in this apter we have only
considered anges in taxes and subsidies as ‘compensating measures’. We
have not examined what the effects, for example, of a ange from direct to
indirect taxation would be in themselves and whi compensating measures
su a ange would require. e following apter has been devoted
entirely to questions of this nature.

1. On these concepts, see R. Bentzel, Inkomstfördelningen i Sverige (Income

Distribution in Sweden), p. 13 ff., and Erik Lindahl,
‘Nationalbokföringens grundbegrepp’ (e Basic Concepts of National
Accounting), Ekonomisk Tidskrift, Stoholm 1954.
2. Similar rules apply for a tax whi is calculated on wage expenditures,
cf. equation (XIII: 3).
 CHAPTER XIV

Direct versus Indirect Taxation

1. DIRECT AND INDIRECT TAXES IN FISCAL POLICY DEBATES
FISCAL POLICY discussions concerning direct and indirect taxation have
mostly dealt with three types of problems.
ere is no doubt that it has been the effects of taxation on income
distribution that has contributed most to making the question of direct and
indirect taxes by far the most controversial maer in tax policy. It is here a
question of whether the distribution of the incomes aer deduction of tax
payments (i.e. the distribution of disposable incomes) is more or less
‘uneven’ than the distribution of the incomes before tax. In other words, do
the taxes fall more heavily in some sense on large incomes or small ones?
Discussions are oen based on the well-known fact that while indirect taxes
tend to be regressive, direct taxes may in principle be made progressive, or
at least degressive, without great difficulty. e reason why indirect taxes
tend in practice to be regressive is partly that as income increases, income
tax plus saving normally increases more than proportionately, and partly
that the goods whi are traditionally subject to taxation, form a relatively
larger portion of the consumption of the groups with smaller incomes than
of those with larger ones. Since a regressive tax is aracterized by the fact
that the tax quotient (i.e. tax amount in relation to income) falls as income
rises, while a progressive (and degressive) tax has a rising tax quotient, the
traditional conclusion has been that the desire to reduce inequality in the
distribution of income commits one to a policy of relatively high progressive
income taxes and relatively low indirect taxes. Consequently, it has also
been considered self-evident that an increase in indirect taxation and
decrease in direct taxation will involve increased inequality in the
distribution of incomes.
Secondly, there is the question of the effects of taxation on incentives, to
work, to save, to take risks, etc. It is oen taken for granted that these
incentives ought to be as great as possible. Incentive considerations have
been used as arguments against income equalization ever since practical
policy began to consider the use of taxation as a means of redistributing
incomes. It was not until the level of taxation reaed the level obtained
during and aer the Second World War, however, that incentives came to be
accepted more generally as a serious problem. It is particularly the high
marginal rates of the progressive income tax whi have been considered
deleterious to the will to work and save. Among other proposals intended to
improve incentives, a revision of the tax system in favour of indirect and
against direct taxation has been strongly recommended during recent years
from various quarters.1 One of the reasons why these proposals for reform
have won some support is perhaps that it is considered possible to ange
the taxation system so as to improve incentives without thereby making the
distribution of incomes more unequal. According to this view, the incentive
problem and the distribution problem can be solved independently of ea
other. In this apter, we shall devote some time to this important problem,
and try to show that su ideas are misconceived. Furthermore, we shall
show that generally it is only under very special circumstances that we may,
with any certainty, reon on favourable incentive effects from a revision of
the tax structure in the direction of more indirect taxation, and even then
only if the inequality in the distribution of incomes is increased at the same
time. e answer of the problem of indirect versus direct taxation then
returns to its original position, whi seems to be the correct one: the desire
for a system of taxation whi will reduce the inequality in the distribution
of incomes and the desire for a system of taxation whi will increase
incentives to work, are normally incompatible, though with the important
reservation (both in theory and in practice) that the incentive effect of a
certain tax ange is very uncertain both as to its direction and size.
e third problem—and also the most recent—is the question of which tax
system is most suitable from the point of view of stabilization policy. e
actual structure of the tax system must always in itself affect the
development of the economy. From the point of view of stabilization policy,
what is required is a system whi, in some sense, tends automatically to
dampen fluctuations in economic activity. ese points, whi we have
already toued upon in Chapter IV, will be dealt with again later on.
 2. SOME PRELIMINARY OBSERVATIONS CONCERNING THE EFFECTS
OF A REVISION OF THE TAX SYSTEM FROM DIRECT TO INDIRECT
TAXES
First of all we want to see how a revision of the tax system from direct to
indirect taxes will affect employment and the price level within the
framework of a comparatively simple model. It is natural here to start off
with the model whi was used in the previous apter. It need hardly be
pointed out that what will be said here about direct and indirect taxes is also
on the whole true of direct and indirect subsidies, for these may be regarded
as negative taxes. e question of the effects of the tax revision will then be
a natural continuation of the argument of the previous apter. As a maer
of fact the problem here is of exactly the same nature as the problems dealt
with there. e State creates a disturbance in the system, say, through an
increase in the rate of indirect tax on consumer goods. Whi measures
must the State then undertake in order to prevent a ange in employment
and in the value of money? If the State only has one means at its disposal,
that is the rate of income tax, tL or tV or a scale of su rates, it cannot
generally be expected that price level as well as employment can be kept
unanged. As we shall show, the model is of su a nature that even if we
regard the income tax rates, tL, and tV, as two different means, this will not
be sufficient to secure the two ends in the case of a revision of the tax
structure. us, if both the price level of consumer goods and total
employment are to remain unanged with su a revision, some third
means must be employed.
However, let us first consider the effects of an increase in the indirect tax
rate on consumer goods, tc, and a certain decrease in the direct tax rates,
and let us suppose that this reduction in the direct tax rates is of su an
extent that employment is not affected. e question then is how the price
level of consumer goods is affected. A glance at the model (XIII: 1°)–(XIII:
7°) in Chapter XIII, 2 will immediately show that if disposable incomes rise
in the same proportion as the price level, the total quantity of consumer
goods demanded will remain unanged, see equation (XIII: 5°). At the same
time it appears that if the price level of consumer goods rises in proportion
to the increase in the indirect tax rate, production of consumer goods, with
given money wage-rates and productivity, will remain unanged. us it
immediately follows that, with an increase in indirect taxation on consumer
goods combined with a suitable decrease of personal income tax, in our
simple model the price level for consumer goods will rise by the whole
increase in the indirect tax rate; factor incomes are not affected, but
disposable money incomes will increase in the same proportion as the price
level. Production and employment within the capital goods industry are not
affected. How the budget is affected depends, among other things, on the
way in whi the yields of income tax and consumer goods tax ange; and
whi of these two is altered most depends on whether saving is negative or
positive, see Chapter VIII, 9. At the same time, the expenditure of the State
on purases of consumer goods will rise. If saving is positive the budget
surplus will in any case be reduced, while nominal private saving increases
(in real terms it remains unanged).
Before pursuing this line of argument further, it will be well worth while
to ask ourselves whether these results mean that an isolated shi from direct
to indirect taxation will cause a fall in the value of money. It cannot be
denied that the price level of consumer goods in the model must increase.
On the other hand, it is evident that this is valid only if the value of money
is identified with a consumer goods price level ‘at market price’ and without
regard to direct taxes, etc. A price level ‘at factor cost’, or a price index
whi includes both indirect and direct taxes, will, on the other hand, not be
affected. In cases like this the question of the ‘correct’ definition of the value
of money is of central importance. Earlier writers have considered it obvious
that su a revision of the structure should not be regarded as an increase in
the price level. us if a price index is osen that is not influenced by the
tax revision in question, this revision will not affect the ends of full
employment or a stable value of money. If, on the other hand, we retain as
our definition of the value of money the inverse of a price index ‘at market
price’ but without direct taxes, etc., then the question will arise, whether it is
possible by the simultaneous use of other policy means to secure not only
full employment but also a constant price level of consumer goods, in spite
of the revision of the tax structure.
It will easily be seen that it is not enough to regard the tax rate for wage
earners, tL, and the tax rate for entrepreneurs, tV, as separate means. Up to
now we have assumed that the tax rates were anged in su a way that
the total disposable wage income and the total disposable profits were
anged in the same proportion. Even if we abandon this assumption and
suppose that income tax rates are anged in some other way, so that
disposable wage incomes and profits are not anged proportionally, this is
important only for determining whi group is to profit from, and whi to
lose by, the tax revision. Within the framework of our model this has no
further effects, however. It is different if we go outside the model, and
consider su possibilities as the State geing labour-market organizations
to accept a decrease in wages by leing the disposable wage incomes rise in
relation to the price level and making the disposable profits fall in relation to
the price level. For the crux of the problem is that the price level for
consumer goods may be kept unanged in spite of the increase in taxation,
only if money wages fall or the marginal productivity of labour rises
simultaneously in proportion to the indirect tax ange, that is in proportion
to the ange of (1—tC).
If we ignore anges in money wages and in the production function, an
increase in marginal productivity may be brought about only by means of a
decrease in the production of consumer goods. Now, of course, it is not at all
certain that marginal productivity will rise sufficiently to counter-balance
the effect of the increase in the indirect tax, even if production decreases
almost to zero. In su circumstances it will obviously be impossible to keep
the value of money constant by this method. However, let us assume that
marginal productivity rises very quily with a decrease in production, and
that the marginal productivity will have risen in proportion to the ange of
(1—tC) with a not too large decrease in production. Equilibrium in the
consumer goods market then requires a decrease in real disposable incomes
—given the State demand for consumer goods. is means that an increase
in income tax is necessary whi will frustrate the aempt to revise the tax
structure in favour of indirect taxation.

3. A TAX REFORM WHICH DOES NOT AFFECT THE DISTRIBUTION OF

INCOMES
It has been pointed out in Swedish discussions on tax reform2 that a revision
of the tax structure from direct to indirect taxation can always be so
arranged that the decrease in personal income tax leaves the real incomes of
people with different money incomes unaffected. Let us assume, for the sake
of simplicity, that the indirect tax is a general consumption tax whi is
imposed on all consumer goods and services at the same rate. Now if we
assume that an increase in the indirect tax is shied entirely onto consumers
in the form of higher prices, and if we assume that individual pre-tax
incomes and the income tax rates for different levels of income are given,
then an increase in the indirect tax will bring about a proportional decrease
in all individual real disposable incomes. It is thus evident that if income tax
is reduced at the same time as the increase in indirect tax, in su a way that
everybody’s disposable money income—irrespective of its size—rises in the
same proportion as the price level, then all individual disposable real
incomes will remain unaffected by the revision of the tax structure. It is then
quite justifiable to say that the shi from direct to indirect taxation has not
anged the effects of the system on the distribution of real income; not a
single real income has been anged.
Let E denote an arbitrary household income before taxation, that is its
pre-tax income. Furthermore, let the tax amount be T = T(E), where T(E) is
the ‘tax-function’, relating the amount of tax to the size of income. We now
wish to ange the tax-function in su a way that all disposable incomes
will rise by the same percentage, 100(k—1). Let the new tax function be
*T(E). e following equation must then be valid for all values of E:

For small incomes the tax amount, *T, may become negative, that is be
transformed into a subsidy.
If we call T/E the average tax rate, we have,
and the condition for the tax amount to become negative is then that the
average tax rate in the initial position, T/E, is smaller than (k—1)/k. If the
average tax rate is zero when income is zero and then rises continually
towards 1 but without reaing any maximum value, then aer the tax
revision all incomes below a certain limit will receive a subsidy, the size of
whi is dependent on the income; above this limit income tax will be paid,
the amount increasing as incomes increase.
For the marginal tax rates, T′ and *T′ we have

It will be seen that the revision of the tax-function will decrease both the
marginal and the average tax rates at all levels, i.e. *T/E < T/E and *T′ < T′.
On the other hand, both the marginal and the average tax rates themselves
rise more rapidly with the revised scale than with the previous one, i.e.
(*T/E)′ > (T/E)′ and *T″ > T″. is will mean that both for the average and for
the marginal tax rates the reduction is greater for small incomes.
e ange in the income tax scale discussed here is illustrated in Fig.
XIV: 1, where we have assumed that k (the increase in the disposable
incomes) is 1·5.
It is obvious, therefore, that with a revision of the tax structure from
direct to indirect taxation of the sort discussed here, ea individual’s
disposable real income will be le unaffected while the marginal rate of
income tax will generally become smaller.
If saving is zero for all incomes, the State tax revenues will remain
unanged with the tax reform in question; ea individual will pay exactly
as mu more in indirect tax as he saves in direct tax. If, on the other hand,
saving is positive and increases more than proportionally to income, this
rule does not apply. e indirect tax amount is then comparatively smaller
the larger the income. Sometimes this is expressed by saying that the larger
propensity to save that accompanies the larger incomes makes the indirect
tax regressive. If by this is meant that because of the saving the indirect tax
hits the larger incomes relatively more lightly than it hits the smaller
incomes, then this would be wrong; for the real value of saving also
decreases when there is an increase in the price level. It is, on the other
hand, reasonable to speak about the regressiveness of indirect taxes in those
cases where the consumption tax is not imposed upon all consumer goods,
but only upon those goods that are consumed to a comparatively small
extent by the earners of larger incomes. For this implies that the price index
whi is to be used when a large income is deflated so that its real value
may be known, will rise comparatively less than the price index relevant to
a smaller income. e fact that indirect taxation is likely to be regressive in
this sense, is of no great importance to the above discussion. e only
difference is that the ange in the rates of income tax would have to be
su that disposable money incomes will rise relatively less the larger the
income. To this end the average and marginal rates of income tax will, to an
even greater extent, have to decrease most for small incomes. However, the
important fact still remains: that the marginal rate of income tax decreases
for all levels of income, while all individual real disposable incomes remain
unanged.

Fig. XIV: 1
 4. THE EFFECTS OF THE TAX REFORM ON INCENTIVES
Obviously the advocates of tax reforms of this kind expect an increased
incentive to work and to save to be the result.
e problem of the effect on saving of su a revision of taxation has
already been dealt with in detail in Chapter VIII. As we showed there, the
effect on the demand for consumer goods of su a tax revision is equivalent
to the effect of an increase in the rate of interest, but it cannot be determined
a priori whether an increase in the rate of interest will involve an increased
or decreased demand for consumer goods. us it is also impossible to say
whether this tax reform, other things being equal, will involve an increased
or decreased incentive to save. If it is assumed that interest-anges do not
influence the demand for consumer goods, nominal private saving will, as a
consequence of the tax reform, rise to the same extent as the price level if
saving is positive, and fall in the same proportion if it is negative. But ‘real
saving’ remains unanged.
e idea that the tax reform would involve an increased incentive to work
due to the lower marginal rates of income tax seems to be mistaken unless
very peculiar assumptions are made about the determinants of labour
supply. Briefly, it can be said that economic theory shows that the marginal
disutility of labour (the marginal utility of leisure) is to be equal to the
utility of the consumption (real income) whi—dependent on wages,
taxation and prices—follows a marginal ange in the quantity of labour, see
Chapter IX, 9. However, since the tax reform in question is expressly
constructed so that real incomes, and thus also marginal real incomes, are
not affected by the revision of the tax structure, it is evidently not likely to
lead to any ange whatever in the supply of labour. e mistake in the
notion that the supply of labour would be stimulated by the revision of the
tax structure is obviously that consideration is given only to the marginal
rate of income taxation, neglecting the fact that the indirect tax too
influences the real income at the margin; indirect taxes also have marginal
tax rates. What is decisive is the real income retained at the margin. e tax
reform will in fact involve an increased incentive to work, only if an
increase in the rate of interest would itself involve su an increase, whi is
hardly likely.
 is discussion may be conducted more formally by means of a
geometrical presentation.3 In Fig. XIV: 2, we have leisure per day on the
horizontal axis, whi may amount at the maximum to 24 hours. On the
vertical axis we have the income in real terms, that is money income minus
income tax, divided by the price level. In the diagram we draw indifference
curves, whi show combinations of real income and leisure whi are
‘equally good’.

Fig. XIV: 2

Working time may be read off lewards from the point (24, 0); maximum
working hours, 24, are at the origin. If the price level is given and equal to 1,
we may draw a budget line L, through the point (24, 0); the slope of the
budget line is then (numerically) equal to the money wage per time unit. If
the price level rises at any given wage rate per hour, the budget line will be
pushed downwards around the point (24, 0). e length of the working day
is determined by the point of tangency between the budget line and the
family of indifference curves, that is at the point A.
Let us now assume that a progressive income tax is imposed. e budget
line will then be L′ (with an unanged price level and wage-rate, whi for
the sake of simplicity are both put equal to 1 in the original position). e
vertical interval between L and L′ is equal to the amount of income tax (if
the period is one day) and is obtained directly from the tax-function T(E),
see Fig. XIV: 1. e optimum point will then be B, and the working time 24—
t. If we now ange the tax rate (with a given hourly wage and price level)
in su a way that the disposable income (the vertical interval between L′
and the horizontal axis) will increase at the same rate for all incomes
(working hours), the budget line moves upwards at the same rate. If then,
the price level rises at the same rate (due to an indirect tax increase), this
will involve a corresponding decrease in the budget line, returning it to the
original position. e budget line is thus uninfluenced by the tax reform; the
optimum point and the working time must then remain unanged in spite
of the tax reform.
It is obvious that if the tax reform in question is to bring about an
increased supply of labour, either an increase in the rate of interest must in
itself bring about an increased supply of labour, or else some kind of money-
illusion must exist. ose who supply labour have to ignore the increased
marginal rate of indirect tax, and only consider the decreased marginal rate
of income taxation. At the same time, however, they must take note of the
increased indirect tax from an ‘intramarginal’ point of view. For if the
individual completely ignores the increase in indirect taxation, the effects of
the tax reform may be illustrated by a proportional upward shi of the
budget line L′, and it cannot then be said a priori whether the result will be
an increase or decrease in the number of working hours. To be quite certain
that the tax reform will bring an increased supply of labour, the average tax
rate has to be unanged and the marginal tax rate to decrease
simultaneously at the existing level of income (see the next section). is
condition is, however, not fulfilled by the tax reform in question unless a
rather strange ‘partial’ money-illusion exists.
Let us now return to the discussion in section 2 where we studied
simultaneous anges in income taxation and in the indirect tax on
consumer goods su that disposable money incomes and the price level are
anged in the same proportion. Now this is exactly the same ange as in
the tax reform of section 3, so that the discussion in section 2 and that in this
section may be juxtaposed. We may therefore conclude that if the tax
structure is revised in the way set out in the tax reform we have been
discussing, if we allow the price level of consumer goods to increase, and if,
furthermore we assume that the effect on the demand for consumer goods of
a ange in the rate of interest is nil, then we shall find no real anges
whatever as a result of this tax reform. is is true even if we leave this
highly aggregated model and consider ea household and firm separately.
Since the real disposable incomes of the individual households are not
affected, then neither the supply of labour nor the demand for goods will be
affected. ere is no reason for shis to occur in relative prices or in the
demand for and production of the different consumer and capital goods. e
only consequence of the tax reform is that the price level of consumer goods
‘at market price’ will rise and that the marginal rate of income tax will be
reduced; real anges are conspicuous by their absence. It should be pointed
out, however, that nominal saving is anged in proportion to the ange in
the price level. is may involve either an increase or a decrease in nominal
saving; ‘real saving’ on the other hand is unanged. e problem of tax
evasion is ignored.

5. A REVISION OF THE TAX STRUCTURE WITH INCREASED

INEQUALITY IN THE DISTRIBUTION OF INCOMES
As has already been mentioned, we can only be sure that a decrease in the
marginal tax rate will involve an increased labour supply if at the same time
the average tax rate is unanged for the level of income under discussion.
Looking at Fig. XIV: 2 we immediately see that if the budget line L′ is
replaced by a budget line whi passes through the point B but lies above L′
to the le and below L′ to the right of B, the number of working hours will
no doubt rise. e new optimum point must lie to the le of B. is
movement of the budget line requires the tax structure to ange in su a
way that the overall average tax rate will remain unanged at the actual
income of the individual, will be reduced for larger incomes, and increased
for smaller incomes. Su a ange in the tax structure may, for example, be
brought about by anging a progressive income tax to a proportional
income tax (the budget line will then be a straight line through B and (24,
0)), or by means of combined anges in the income tax and the indirect
taxes on consumer goods.
However, su an increase in the supply of labour is aieved only at the
price of an increased inequality in the distribution of real disposable
incomes. Since incomes whi are smaller than the income of the household
in question will decrease, and the larger ones will increase, most existing
measures of the inequality of income-distribution will indicate increased
inequality.
Furthermore, as soon as (1) the incomes of individuals are unequal in size,
and also (2) the same tax scale is to be applied to all individuals, then the
conditions whi ensure that the supply of labour must necessarily increase,
cannot be simultaneously fulfilled for the majority of taxpayers. For under
these two assumptions, whi are normally fulfilled, it is impossible to keep
the average tax-rate unanged for everybody and at the same time to
reduce everybody’s marginal tax rate. If the individuals are distributed over
a range of incomes from zero to some upper limit, the average tax-rate
cannot be kept unanged for everybody without marginal tax-rates
remaining unanged for all incomes. If, as a compromise, tax rates are
anged so that the average tax rate remains unanged for the average
income, increases for incomes below average and decreases for incomes
above the average, it can no longer be determined whether the total supply
of labour will increase or decrease; it is true that the supply of labour will
certainly increase for the average income, but for both the larger and the
smaller incomes the effects are uncertain. If incomes are strongly
concentrated about the average income, that is if the distribution of incomes
is very even, it seems natural to assume that the net result will be an
increase in the total supply of labour; but in that case the conflict disappears
simply because income redistribution is of secondary importance anyway.
It is a very complicated business finding out how a more unequal
distribution of incomes will affect private demand for consumer goods and
saving. In addition to the ‘interest effect’ of the shi from direct to indirect
taxation, there is also a redistribution effect. Generally, it can only be said
that the result depends on the whole structure of taxation and on the
marginal propensity to consume in different income groups. In the special
case where all households have the same marginal propensity to consume,
the total demand for consumer goods will not be affected by the
redistribution, but once we leave this special case, many different
possibilities present themselves.4
In conclusion let us look at the total effects of su a ‘disequalizing’ tax
revision in connection with the model of the previous apter. We thus
consider an increase in the indirect tax rate and a reduction of the direct tax
rate whi will give an unanged average tax rate for the average income,
an increased average real tax rate for smaller incomes and a reduced average
real tax rate for larger incomes. For the sake of argument, let us assume that
the pure incentive effect of this is an increase in the total supply of labour
and a decrease in the demand for consumer goods. e total demand for
labour has then to be increased, if full employment is to be maintained. Let
this be brought about by means of a reduction of the rate of interest with an
accompanying expansion of the capital goods industries. e increase in
employment involves increased earned incomes, whi in their turn involve
an increased demand for consumer goods. Whether the net result will
therefore be an increase or a decrease in the demand for consumer goods
cannot then be determined a priori. e ange in the demand for consumer
goods whi actually appears may then be counter-balanced by a further
increase or decrease in the production of capital goods, and by a transfer of
labour between the industries. us whether the price level will increase
more or less than the increase of the indirect taxation cannot be determined
a priori.

6. NET TAXES VS. GROSS TAXES

In the previous sections we have considered the effects of a revision of the
tax structure intended to reduce personal income tax and increase the
indirect taxation of consumption, and the discussion has been concentrated
on the incentives to work and save. But in the current debate a somewhat
different type of tax reform has also been suggested, namely a revision of
the basis of ‘business taxation’ from so-called ‘net taxation’ to ‘gross
taxation’.5 As can easily be seen, this type of reform is in fact also a ange
from a direct tax to an indirect tax, that is from a tax on the income of the
firm to some kind of indirect tax, whi is reoned either as a certain
percentage of the sales receipts of the firm or of the expenditure of the firm
(or parts of it). Su a tax reform has been treated in Sweden mainly from
the point of view of business cycle policy. But su a revision would also
involve certain incidence effects whi are important in appraising it. We
shall now briefly discuss these effects with the model of Chapter XIII as a
basis, and considering especially the ends of full employment and a stable
value of money.
In Sweden the incomes of firms are normally taxed either by a company
tax (for limited companies) or by personal income tax (in the case of
personally owned firms); furthermore, profit distributions by limited
companies are taxed by the personal income tax. ere is, however, no
uniform general tax on the net incomes of firms. In the current debate it is
now very difficult to perceive how it is intended that this revision should
take place. If it is only the net tax in the sense of the tax on the incomes of
limited companies whi is to be reduced, then it seems obvious that the
gross tax, however constructed, should also be confined to limited
companies. But if both limited companies and personal businesses produce
the same kind of goods, this will mean that companies’ products will be
taxed but not those of the personal businesses. If, on the other hand,
entrepreneurial incomes from personally owned firms are also taxed less
severely, or possibly become exempt from income taxation, then the gross
tax must obviously also be applied to private firms. It is evident that the
possibilities of shiing will be quite different in these two cases. A third
possibility is for individuals to declare as their current personal income not
the whole net profit of the personally owned firms, but only that part of the
net profit whi they ‘withdraw’ from the firm in some sense, while that
part of the net profit whi remains in the firm is taxed according to rules of
the same type as apply to company incomes; in this way perhaps the
treatment of companies and personally owned firms would be more similar.
Until the notional ange from net to gross taxation of the firms has been
stated more precisely with respect to its scope and method of calculation, it
is impossible to study the effects of a ange from one system of taxation to
another. We shall not aempt to discuss here how su a ange might be
expected to take place in practice within the framework of the tax system
already in existence in Sweden. Instead, we shall refer to the model in
Chapter XIII, where no distinction has been made between the incomes of
firms and the incomes of their owners. e simplest thing is to assume that
all firms in the model are personally owned, and that their owners’
households have income only from the firms and no other (wage) income.
At the same time we must remember that the model is simplified in su a
way that in both the consumer goods industry and the capital goods
industry the value of sales (except for possible depreciation) is equal to value
added. e gross tax on the value of sales, whi we shall discuss below,
must then in fact be regarded as a tax on value-added. is also means that
the well-known problem associated with gross taxation, of tax-cumulation
from one stage of production to another, with the accompanying tendencies
to vertical integration of firms, does not arise. At the same time it should be
noted that we ignore anges in stos; this too simplifies maers a great
deal.
A reduction in the taxation of firms’ net incomes means, in our model,
quite simply that the income tax rate for firms, tV, will decrease. Now if the
gross tax on the firms is a tax whi is reoned as a certain percentage of
total sales, and if we furthermore assume that the gross tax is only applied to
the consumer goods firms, it is obvious that this case will be parallel to the
case of a decrease in the income tax and an increase in the consumption tax,
whi we dealt with in the previous sections. e only difference is that we
now bring about a ange in the distribution of incomes to the advantage of
the owners of firms and to the disadvantage of the wage-earners. e price
level rises in proportion to the indirect ‘gross tax’ and at the same time the
‘net tax’ on the owners of firms must be reduced to su an extent that, in
spite of the price increase, they will increase their demand for consumer
goods as mu as the wage earners decrease theirs (on account of the price
increases). Since neither the incomes of the wage-earners nor those of the
owners of firms will be affected when the tax anges are so designed that
the total demand for consumer goods remains unanged, then the real
disposable incomes of the owners of firms must consequently be raised by
an appropriate adjustment in the original decrease of the net tax. So far the
ange from ‘net taxation’ to ‘gross taxation’ does not differ from a general
revision of the tax structure from taxation of incomes to taxation of
consumer goods, except for the already mentioned redistribution of the real
incomes from wage-earners to the owners of firms. It goes without saying
that further effects may appear, however, due to relationships whi have
not been included in our model. It is, for instance, quite possible that the
demand for capital goods may be increased, but su an effect may be
counterbalanced by means of the rate of interest.
 e question of net taxes versus gross taxes has not been exhausted by
this example, however. On the one hand it may be assumed that the gross
tax is applied within all industries, and consequently also in the capital
goods industries, and, on the other hand, that it is imposed in some other
way than as a certain percentage of total sales revenue (value-added). We
shall therefore deal further with both these aspects of the net vs. gross tax
problem. Firstly, we shall enquire how a ange from the direct taxationof
the incomes of owners of firms to indirect taxation of capital goods (i.e. a
decrease in tV and an increase in tI) works out in the model, assuming that
fiscal policy is so directed that full employment equilibrium is not disturbed.
Secondly we shall enquire into the effects of constructing the gross tax as a
tax on wage payments instead of as a tax on the value of sales or value-
added.
An increase in the indirect tax (whi is here a tax on the value of sales)
on capital goods will lead to a decrease in the demand for these goods and
thus also to a decrease in their production. A decrease in the income tax rate
on the incomes of firms will lead to an increase in the demand for consumer
goods, with a rise in their prices and an increase in their production as a
result. It is then always possible so to adjust the increase in the tax on
capital goods and the decrease in the ‘net tax’ to ea other that
employment in the consumer goods industry increases by exactly the same
amount as it decreases in the capital goods industry. e price level for
consumer goods will then rise in accordance with the fall in marginal
productivity at the higher level of output. e distribution of disposable
incomes shis in favour of the owners of firms. e real disposable incomes
of wage-earners will decrease, not only relatively to those of the owners of
firms, but also in absolute terms due to the price increase. If the increases in
the prices and output of consumer goods are not desired, they may of course
be avoided, say, by lowering the rate of interest so mu that the demand for
capital goods will remain unanged in spite of the tax, but then the tax on
the incomes of firms cannot be reduced at all.
Let us see what has become of the value of money as a result of lowering
the net tax and raising the gross tax in both the consumer and capital goods
industries. If we keep to our standard definition, the market prices of the
consumer goods, it is clear that the value of money has deteriorated as a
result of the tax reform. If we turn to other definitions, the result is not so
clearcut. If we consider a price index whi takes direct taxes into account, it
may be concluded that as far as the wage-earners are concerned, the value
of money has still decreased—for the direct tax on the wage-earners remains
unanged both in rate and amount—but for the owners of firms the value
of money has increased. For the businessmen the decrease in income tax is
of greater importance than the increase in the indirect consumption
taxation. Looking at the situation ‘as a whole’, if we try to estimate how the
value of money has anged for the owners of firms and wage-earners in
general, it will be seen that, if regard is paid to both direct and indirect
taxes, the value of money must have increased. For it has already been
pointed out that the output of consumer goods must increase somewhat,
unless other measures are undertaken at the same time; but if the demand
for consumer goods is to be influenced only via the effects of tax anges on
real disposable incomes, then it is obvious that, if the demand for consumer
goods is to increase real disposable incomes must increase, and consequently
with given money incomes before tax the price index including all taxes
must have decreased. Finally, we may observe that the consumer goods price
level ‘at factor cost’ has risen, and the value of money has decreased in this
sense; this is a result of the increase in the output of consumer goods. It is
obvious that there is good reason to hesitate before commiing oneself to a
‘correct’ definition of the value of money when confronted with a case like
this! To argue that the value of money should be defined in su a way that
a revision of the tax structure will not in itself alter the value of money is
not very helpful if the tax reform actually implies real anges in the
economic system.
Up to now we have assumed that the gross tax has as its basis the value of
sales (or value-added—whi is the same thing in our model). Gross taxes
are however oen conceived as a duty on the total expenditures of a firm, or
on certain special kinds of expenditure. Of special interest in this respect is
the tax on wage payments. From an administrative point of view a gross tax
of this nature would probably be mu easier to cope with than either a
gross tax on the total sales receipts or a tax on value-added for it could be
associated with an existing P.A.Y.E. or withholding system for personal
income taxes. e employer would be obliged to pay to the State on his own
account a certain percentage of the wage payment on whi the personal
income tax is calculated, at the same time as he deducts the laer at source
from the employees. No significant ange in the present system of control
would be necessary. A gross tax on wage payments has the same effects on
the vertical integration of firms as a tax on value added, but is probably
mu easier to handle administratively.
If we consider the model from the previous apter, it may easily be seen
that the essential difference between a tax on gross income (value added)
and a tax on wage payments—if we imagine these taxes combined with su
a decrease of the ‘net tax’ on the owners of firms that employment is
unanged—concerns the distribution of incomes. With a given level of
production, and equilibrium in the market for consumer goods, in our model
both a 10 per cent tax on gross income (excluding tax) and a 10 per cent tax
on wage payments must involve a 10 per cent price increase. At the margin
gross in-come and wage payments are the same if there is perfect
competition. Intramarginally, however, the result will be that the firm’s
profit will as a rule be larger with a tax on wage payments than with a tax
on gross income. Even if wage costs are the only current costs of the firm,
current costs will of course always be below gross incomes, otherwise
production will cease. If the firms have a positive net profit, total labour
costs must also be below gross income. us if the same percentage is
reoned on gross income as on labour costs, the net profit of the firm for
any given price increase will be larger with the taxation of labour costs than
with the taxation of gross income. An analogous argument is valid even if
there are other current or fixed costs besides wage-costs. It can thus be
realised that if we calculate a tax percentage su that with unanged
production of consumer goods the price level for consumer goods will rise
by the same percentage (in equilibrium), the tax on gross income will leave
the net profit of firms unaffected, while the tax on wage payments will be
accompanied by an increase in the net profit. At the same time it can be seen
that the decrease in the ‘net tax’ whi there is ‘room’ for, in the sense that
demand for consumer goods is to remain unanged aer the revision of the
tax system, will be smaller when the gross tax is reoned on the wage
payments than when it is reoned on the gross income. In spite of the fact
that the distribution of factor income is shied to the advantage of the
owners of firms the distribution of real disposable incomes will not be
affected differently by a tax on wage payments as compared with a tax on
sales receipts. e real disposable incomes and the demand for consumer
goods of wage-earners will decrease to the same extent in both cases. If the
production of consumer goods is to be the same in the two cases, the
demand for consumer goods by the owners of firms must therefore also be
the same in both cases, if equilibrium is to be maintained. is condition is
secured by the State making the decrease in the ‘net tax’ of su a size that
the disposable incomes of the owners of firms will be the same in both cases.
In the case where the gross tax on wage-payments is also applied to the
capital goods industries, we may simply repeat the same modifications as we
made before in the case of a tax on sales receipts, and repeat the results
accordingly.

7. SUMMARY AND CONCLUSIONS

In this apter we have examined the effects of various kinds of revision of
the system away from direct taxation, especially income taxation, towards
indirect taxation, especially a general consumption tax. Our aention has
been concentrated on the effects of the tax revisions on income distribution
and incentives and on the value of money, on the assumption that the tax
reform is so constructed that employment is not anged. As we have
shown, su a reform will generally have the effect of lowering the value of
money; the price level for consumer goods ‘at market price’ will rise unless
further measures are undertaken. Now if we base our discussion on the fact
that a revision of the tax structure from direct to indirect taxation will in
itself involve a decrease in the value of money, then it is obvious that a pre-
requisite for puing su a tax reform into effect is that it has other
repercussions whi are considered to be so favourable that they more than
compensate for the disadvantage of a reduced value of money. Furthermore,
if it is considered that these other effects cannot be brought about otherwise,
then it is natural to bring them about by su a tax reform. e objectives of
the State are then in the nature of an end-index (see Chapter I) in whi
there are other components than a stable value of money and full
employment.
e ‘other effects’ whi are usually expected from a tax reform from
direct to indirect taxation, are enhanced economic incentives. Among other
things an increase in the supply of labour and saving are expected. Our most
important result has been that it is, in any case, doubtful whether incentives
are increased by su a tax reform and that the possibility of bringing about
su an increase in incentives depends on the tax reform simultaneously
increasing the inequality of the income distribution. In appraising the
suitability of su a tax reform regard must consequently be paid not only to
the reduced value of money, but also to the increased inequality of the
income distribution. At the same time it must be stressed that while the
decrease in the value of money and the increase in the inequality of income
distribution seem to be quite certain results of the tax reform, even under
the most favourable circumstances the increase in incentives is uncertain.

1. Betänkande angående den statliga direkta beskattningen (Report on

Direct Taxation by the State), Swedish State Resear Publication, SOU
1951, 51, Chapter VII, esp. p. 105 ff.
2. Op. cit., p. 108 f.
3. H. Wold, Demand Analysis, p. 129 f. e argument can also be put more
generally, so that notice is taken not only of working hours but also of
other aracteristics of the supply of labour, cf. K. Boulding, Economic
Analysis, rev. ed., New York 1948, p. 742 ff.
4. See Bentzel’s study of the connection between total consumption and
income distribution in Inkomstfördelningen i Sverige, Bilaga 3, ‘P(e)
funktionen’, (Income Distribution in Sweden, Appendix 3, ‘e P(e)
Function’).
5. See Företagsbeskattningskommitténs Förslag till ändrad
företagsbeskattning (e Business Taxation Commiee’s ‘Proposals for
Revised Business Taxation’), Swedish State Resear Publication SOU
1954, 19, pp. 54–65. e question is discussed extensively by Leif Mutén
in ‘Om bruobeskaning’ (On Gross Taxation), Ekonomisk Tidskrift,
Stoholm 1955.
 CHAPTER XV

Fiscal Policy and Internal Disturbances

1. INTERNAL DISTURBANCES
IN the previous apters we have dealt with those anges of fiscal (and
monetary) policy that are neutral as regards the value of money and total
employment. As we there pointed out, su neutral revisions of fiscal policy
may always be regarded as a combination of a disturbance in the economic
system, deriving from the finances of the public sector itself, and certain
compensating fiscal or monetary policy measures. When we now proceed to
deal with what we have called ‘internal disturbances’ we have thus already
discussed those whi have been caused by the Government’s economic
policy. ere then remain those disturbances whi appear spontaneously in
the private sector—spontaneous anges in the behaviour of the firms,
households and organizations—and disturbances whi come from abroad.
e foreign disturbances will be dealt with in a later apter.
e disturbances to be described in this apter are spontaneous anges
in the production functions of the consumption and capital goods industries
(section 2), spontaneous anges in demand (section 3), spontaneous anges
in stos (section 4) and finally (section 5) spontaneous anges in the
supply of labour. All these disturbances are assumed to be completely
foreseen by the State, whi is consequently assumed to plan and undertake
counterbalancing measures in good time. Chapter XVII will be devoted to
the problems whi arise in connection with anges in money wage-rates
in the private sector.
e means of State policy with whi we are concerned in this apter,
are mainly anges in the indirect tax rates for consumer and capital goods,
in the income tax rates, and in the rate of interest. is does not, of course,
imply that these means are the only legitimate or rational ones. Other means
too might possibly be considered. e fact that we are still concentrating on
analysis of the use of these means is due, on the one hand, to the fact that it
is impossible to treat here all conceivable combinations of means whi may
be osen in a certain situation, while, on the other hand, some fiscal policy
means, su as the purase of goods and the hire of labour, are oen in
practice linked with other ends, and for that reason are not always available
for securing the value of money and full employment. us the means whi
we shall consider in connection with the various disturbances only have the
nature of ‘sufficient means’; they indicate one possible solution among many
conceivable ones.
As in the previous apter we shall oen make certain assumptions as to
the desired distribution of labour between the consumer and capital goods
industries. is corresponds to the introduction of an extra objective. In this
way we shall kill two birds with one stone. In the first place, the analysis is
made mu simpler, and it can be pursued verbally. But mu more
important is the fact that we introduce an end whi is usually found
alongside the ends of a stable value of money and full employment. is is
of especial interest when discussing anges in productivity, for one of the
standing questions in economic policy nowadays is how possible increases
in productivity are to be used—as increased private consumption, increased
capital formation, or increased public consumption, etc. Here we cannot deal
with all possible cases, of course. We shall concentrate mainly on the
alternatives of an increased private consumption and increased private
capital formation.

2. SPONTANEOUS CHANGES IN PRODUCTIVITY

e conditions under whi production takes place are summarized in
economic theory in the so-called production function for the firm

where the q’s indicate the outputs of finished products and the x’s represent
the inputs of productive factors used up in the production process. In the
models we have used up to now we have assumed that there is only one
production function applicable to the consumer goods industry and one to
the capital goods industry, and both have also been greatly simplified, since
ea considers only one kind of finished product, consumer or capital goods,
and one variable productive factor, labour. Our production functions have
been

for the consumer goods and capital goods industries respectively.

In the previous apters we have already studied certain anges in
productivity, namely those connected with anges of employment in both
industries. If we define the total product, average productivity and marginal
productivity as qC and qI, qC/NC and qI/NI, and q′C and q′I, it will
immediately be seen that all these magnitudes are functions of employment.
e anges whi we are going to examine here are, on the other hand,
those that derive from ‘spontaneous’ anges in the functions f and φ
themselves. ese anges may in their turn be caused by climatic anges,
inventions, shis in the composition of output within either industry, etc. It
ought to be pointed out, however, that anges in the production function
may also be caused by anges in the amount of capital within the two
industries. is is important for the reason that in our model we have
ignored the fact that the purase of capital goods may affect production
conditions in both industries. is la of realism—or, more correctly, the
short-term assumptions—on whi the model has been based, will thus be
eliminated, so that it also becomes possible to draw more long-term
conclusions from the model, as in Chapter XVI, 2, below, where the question
of long term policy is considered.
e first step in our general programme is to study what measures should
be undertaken if productivity anges (i.e. anges in the production
functions) occur and the value of money and employment equilibrium are
not to be disturbed. Let us again take the model in Chapter XIII as a basis.
e anges whi now come up for discussion are anges in f, f′, φ and φ′,
that is anges in total product and marginal productivity at a given level of
employment, that is given NC or NI. e simplest and most natural method

here is to treat anges in these functions one at a time and assume that the
others are held constant at the given level of employment. ere is no reason
why the total product (average productivity) and marginal productivity
should develop in exactly the same way. Although it is probably true that
the normal tendency seems to be for them all to rise, especially in the long
run (it should, however, be noted that we actually have very lile empirical
knowledge of the development of marginal productivity), there are no a
priori reasons why they should ange proportionally, or even
approximately so. e reason why proportional anges of average and
marginal productivity are oen implicitly or explicitly assumed in
theoretical discussions is that in many models this assumption brings
welcome analytical simplifications.1 us we shall discuss this special case
here also, for the sake of completeness, but, as we said, there is no empirical
reason for concentrating upon it. What might be called the primary cases are
the cases of isolated anges in f, f′, φ and φ′ (with given employment); all
other cases may then be regarded as combinations of these four basic ones.
e cases of anges in f, f′, φ and φ′ are treated in subsections (i) to (iv)
below. For those readers who are tired of the model exercises at this stage,
subsection (v) provides a brief survey of the sufficient means in these cases.
Any reader not wishing to follow the argument in detail can therefore
ignore subsections (i)–(iv).

(i) Increase in the Marginal Productivity of Labour in the Consumer

Goods Industry
Now if with unanged employment, the marginal productivity of labour
in the consumer goods industry increases while marginal productivity in the
capital goods industry, and total product (average productivity) within both
industries, are unanged, then all that will be affected in the first place are
the optimum condition for the consumer goods industry

If employment in the consumer goods industry is given, at a given wage and

indirect tax rate, the price level must vary in inverse proportion to marginal
productivity if the optimum condition is to be fulfilled. ere are, however,
other possible variations. Employment in the consumer goods industry may
possibly be imagined to increase so mu that marginal productivity falls
again to its original level. It cannot, of course, be denied that su a policy
might be pursued; but it is quite possible that even if the whole labour force
were put to producing consumer goods, marginal productivity still would
not fall to its original level. To begin with, then, let us assume that the State
ooses a policy whi leads to unanged employment in the consumer
goods industry; this will therefore mean that the output of consumer goods
remains unanged, for it is only marginal productivity that has increased.
Not even with this assumption need the price level fall in proportion to the
increase in marginal productivity. If the money wage-rate, w, or the indirect
tax rate, tC, rise in proportion to the marginal productivity increase, the
price level, pC, may remain unanged. Changes in money wages will be
treated in the following apter, so that here we shall only deal with the case
where tC rises, i.e. where (1—tC) falls in proportion to the increase in
marginal productivity. With unanged employment and production, the
consumer goods price level ‘at factor cost’ will decrease, while the State
revenue from indirect taxes on consumer goods will increase.
Conditions within the capital goods industry are not affected by anges
of marginal productivity in the consumer goods industry; as long as the
production of consumer goods is unanged, we have no reason to expect
anges in the capital goods market, so that the incomes earned in the
capital goods industry will remain unanged. at leaves only the effects
on factor income in the consumer goods industry to be considered, and their
consequences for the demand for consumer goods. Wage payments in the
consumer goods industry are unanged, but the incomes of the owners of
firms in the consumer goods industry will fall. is is because sales revenue
(aer the deduction of indirect taxes) is reduced in the same proportion as
the increase in marginal productivity, and as wage costs are unanged, the
incomes of firms in the consumer goods industry must be reduced relatively
more than proportionately to the increase in marginal productivity. In
extreme cases the profits of firms may even be anged into losses. Since the
total incomes of firms before tax are reduced, then the incomes of firms aer
paying income tax must also decrease, although to a smaller extent in
absolute terms, for the amount of income tax on the owners of firms is
automatically reduced. With unanged levels of prices and production for
consumer goods, the whole output cannot therefore be sold unless the
income tax rates are reduced.
 Let us take an extreme case, where the whole reduction in income tax
rates will be to the advantage of the owners of firms. It will be seen, that if
this tax reduction is su that the fall in the State revenue from income tax
is equal to the increase of the State revenue from the indirect consumption
tax, then the disposable income of the owners of firms will be the same as in
the original position, and all of the production of consumer goods may be
sold at unanged prices, assuming here that the various owners all have the
same propensity to consume. e ends of unanged value of money and
full employment have then been aieved, and the only significant anges
in the system are a shi in the distribution of the (unanged) total
disposable incomes of the owners of firms, from those in the consumer
goods industry to those in the capital goods industry, together with a
revision of the tax structure from income taxes to indirect taxes on
consumer goods, the budget balance being unanged.
When it comes to reducing income tax rates in order to restore
equilibrium in the consumer goods market, however, the State has a free
hand. It may equally well restore equilibrium in the consumer goods market
by reducing the income tax rate on wage-earners to su an extent that the
wage-earners’ demand for consumer goods will increase by the same
amount as the consumer goods demand of the owners of firms has
decreased. e ange in the distribution of disposable incomes will then be
from the owners of firms in the consumer goods industry to wage-earners in
general, while the owners of firms in the capital goods industry will have
unanged disposable incomes. In this case total disposable incomes will
proably fall somewhat, for if wage-earners have a greater marginal
propensity to consume than the owners of firms, then the disposable
incomes of the former will not have to increase as mu as those of the
laer have decreased, in order to maintain an unanged level of demand
for consumer goods. e budget surplus will thus increase. If the State
cannot use the income tax rates to discriminate in this arbitrary way
between the two groups, wage-earners and owners of firms, but instead is
obliged to operate upon an income tax scale that is common to all income-
earners, these extreme solutions of the distribution problem are no longer
possible. Nevertheless, similar results can be obtained by lowering the
income tax for either the lower or higher incomes groups in isolation.
(ii) Increase in Average Productivity in the Consumer Goods
Industry
If the total product (and thereby average productivity) in the consumer
goods industry rises with unanged employment, while at the same time
the marginal productivity of labour in the consumer goods industry and
both the total product and marginal productivity in the capital goods
industry remain unanged, the optimum conditions in the consumer goods
industry will not be directly affected. With given money wages, indirect tax
rate and employment, the price level for consumer goods ‘at market price’
and ‘at factor cost’ remain unanged. e market for consumer goods is
nevertheless affected, in the first place because the output of su goods will
rise in the same proportion as average productivity has risen, and secondly
because disposable incomes, and thus also the demand for consumer goods,
will be affected.
Since wage payments at the given money wage and level of employment
are unanged, only the incomes of the firms will be affected. If we imagine
for the moment that the capital goods industry continues as before, we have
only to study the incomes of firms in the consumer goods industry. As will
be seen immediately, profits in the consumer goods industry will rise by an
amount whi is equal to the value of the increase in the output of consumer
goods (at unanged prices) aer the deduction of indirect taxes. e
incomes earned by the owners of firms will thus rise by a smaller amount
than the increase in the total sales value of consumer goods (unless the
production of consumer goods is subsidized instead of being taxed).
Furthermore, part of the increase in the incomes of owners of firms will go
in income tax at the given rates. e increase in the disposable incomes of
the owners of firms will thus a fortiori be smaller than the increase in the
sales value of consumer goods. Finally, if the marginal propensity to save of
the owners of firms is positive, their effective demand for consumer goods
will rise less than the increase in their disposable incomes. us if
equilibrium in the consumer goods market is to be secured with unanged
prices and unanged employment in the consumer goods industry, the rate
of income tax must be reduced.
In order to get some idea of the extent of the income tax reduction, let us
begin by assuming that the tax reduction will be only to the advantage of
the owners of firms, while, for the sake of simplicity, we shall ignore the
ange in the distribution of the increased total income of firms, whi shis
to the advantage of owners in the consumer goods industry. Now even if the
decrease in the income tax rates for the owners of firms is su that (in spite
of their higher incomes) income tax payments decrease in aggregate by the
same amount as the indirect consumption tax yield has increased (on
account of the increase in production) yet it goes without saying that the
demand for consumer goods will still be insufficient while the marginal
propensity to save is positive. us the income tax rates must be reduced
further, and as a result the budget surplus will decrease. As in the previous
case, however, the State has a free hand in directing the reduction in income
tax. e more the income tax decrease is to the advantage of the small
incomes (wage-earners), the smaller need the reduction of the income tax
amount be, provided that it can be assumed that the small incomes (wage-
earners) have a lower marginal propensity to save. If the income tax
reduction only affects households with a marginal propensity to save equal
to zero, then the budget balance will not be affected.
It will be seen that in this case wage-earners do not share in the increase
in productivity unless they profit by a reduction in income tax.
One remarkable feature of this case, so far, is that the State can secure
both of its ends, an unanged value of money and full employment
equilibrium, using only one means, a fall in the income tax, etc. We have,
however, ignored the possibility that the ange in average productivity in
the consumer goods industry may affect the market for capital goods.
According to the model as set out in Chapter XIII, the demand for capital
goods is dependent on the output of consumer goods. If this relationship still
holds when the cause of the increase in the production of consumer goods is
an increased average productivity, obviously the result will be an increased
demand for capital goods from the consumer goods industry. e same thing
applies if the increase in the incomes of firms involves an increased
propensity to invest. Su tendencies may be countered, however, by means
of an increase in the rate of interest, or by an increase in the rate of tax on
capital goods, so that there need be no ange in the production of capital
goods.
We may therefore conclude that within the framework of the model in
question an income tax reduction combined with an increase in the rate of
interest (or possibly an increase in the capital goods tax) will be sufficient
means to secure the two ends.
In economic policy we are oen confronted with the task of trying to keep
total consumption (‘standard of living’) constant at some particular level, so
that all increases in production may be used for the building up of capital
equipment. In our case su a policy means that when an increase occurs in
the total product of the consumer goods industry (at unanged
employment), we desire to decrease employment in the consumer goods
industry in spite of the increase in productivity there, and to transfer the
labour to the capital goods industry instead. If su a policy is successful, the
marginal productivity in the consumer goods industry will increase because
of the fall in the level of employment there. If, with unanged money
wages, the price level of consumer goods is to be kept unanged, the
indirect tax on consumer goods must therefore be increased. e transfer of
labour to the capital goods industries requires an increased production of
capital goods, whi in its turn requires an increased demand for capital
goods. is may be assumed to have been brought about by means of a
reduction in the rate of interest or by a decrease in the indirect tax rate on
capital goods. Finally we must consider the ange in incomes and thus
consequently also in the demand for consumer goods. Wage incomes are
unanged. e incomes of the owners of firms in the consumer goods
industry will rise because of the increase in productivity, but fall because of
the decline in employment. It cannot be determined whi of these factors
will have the dominating effect without making more specific assumptions
as to the nature of the ange in the production function. e incomes of the
owners of firms in the capital goods industry will rise because of the
increase in production in the capital goods industry. In aggregate the
incomes of owners of firms will quite probably increase. Due to income
taxation, however, disposable incomes will increase less, but so long as the
marginal propensity to consume is positive an increase in the effective
demand for consumer goods must take place. Equilibrium in the consumer
goods market will now require an unanged demand for consumer goods,
however, so that an increase in income tax rates is inevitable. If this increase
is imposed only on the owners of firms, it is obvious that the income tax
rates must be increased just so mu that their disposable incomes are the
same as they were before the increase in productivity. If the increase in
income tax is imposed on the wage-earners too, a ange in the distribution
of disposable incomes will take place, whi will be to the disadvantage of
wage-earners, who will also be subjected to an absolute decrease in their
real disposable incomes.
Our conclusion is, then, that if policy is to be conducted in su a way
that the production of consumer goods remains unanged in spite of the
increase in average productivity in the consumer goods industry, an increase
in the indirect consumption tax, together with an increase in income tax and
a decrease in the rate of interest (or decrease in the tax on capital goods),
will secure the ends of unanged value of money, full employment, and
increased production of capital goods.

(iii) Increase in the Marginal Productivity of Labour in the Capital

Goods Industry
We now turn to the anges in productivity in the capital goods industry,
and first assume that the marginal productivity of labour increases in the
capital goods industry with unanged employment, while the total product
(average productivity) in the capital goods industry, and both total product
and marginal productivity in the consumer goods industry, remain
unanged.
As in the case of an increase in marginal productivity in the consumer
goods industry, the optimum condition of the capital goods industry will be
affected. It will be remembered that this condition is:

With unanged money wages and increased marginal productivity (at

unanged employment), either the price level of capital goods must fall, or
the rate of indirect tax on capital goods be increased so that (1—tI) decreases,
in proportion to the increase in marginal productivity. With our definition of
the value of money, a decrease in the price level of capital goods will not in
itself influence the value of money directly. Among the possible measures
open to fiscal policy, therefore, two stand out as obvious: either to let the
price level of capital goods fall, or else to raise the rate of indirect tax on
capital goods. Let us first consider the laer possibility.
 If the rate of indirect tax on capital goods is increased so mu that, with
unanged levels of employment and wages, the price level of capital goods
‘at market price’ will remain unanged, then the capital goods market will
not be directly affected by the increase in marginal productivity. Both supply
and demand are unanged. e optimum conditions of the consumer goods
industry are not affected either if employment remains unanged and both
the price level and the output of consumer goods remain unanged. ere
then only remains the question of how the demand for consumer goods will
be affected. is is a question of how the incomes of the owners of firms in
the capital goods industry are affected, for profits in the consumer goods
industry and total wage payments are unanged. It will be seen that the
incomes of the owners of firms in the capital goods industry will decrease by
the same amount as the amount indirect tax on capital goods increases. Due
to the reduced income tax payment, however, disposable incomes will
decrease less. us if the income tax rate is reduced so mu that the
amount of income tax for the owners of firms decreases by the same amount
as that by whi the indirect tax on capital goods has increased, the total
disposable income of the owners of firms will remain the same as in the
initial position, and equilibrium in the consumer goods market is secured,
without affecting the budget balance. e reduction in income tax may also
be brought about, however, in su a way that the wage-earners share in the
decrease in income tax. is brings us ba to the discussion in paragraph
(i).
An alternative policy would be to let the prices of capital goods fall
without increasing the tax rate on capital goods. Employment and
production in the capital goods industry are then unaffected, but the
demand for capital goods will increase because of the fall in price. is
increase in demand may be prevented by means of an increase in the rate of
interest, whereby equilibrium in the capital goods market would be secured
at a lower price and unanged production and employment. In the
consumer goods market the effect will be the same as above (we ignore the
possible effects of the rate of interest on the demand for consumer goods)
and a reduction of income tax is necessary if equilibrium in the consumer
goods market is to be secured with an unanged price level and production
of consumer goods.
 us we find that in this case the sufficient means are an increase in the
rate of tax on capital goods, or alternatively increase in the rate of interest,
combined with a decrease in income tax.

(iv) Increase in Average Productivity in the Capital Goods Industry

Finally we have the case where the total product (average productivity) in
the capital goods industry increases, with given employment, while
marginal productivity in the capital goods industry, together with total
product and marginal productivity in the consumer goods industry, are
unanged.
We shall first deal with the case where State policy is so directed that
employment in the capital goods industry remains unanged, and
consequently no transfer of labour to the consumer goods industry takes
place.
e optimum conditions of the capital goods industry are not affected
directly by this type of ange in productivity. On the other hand, with an
unanged employment, the total output of capital goods will rise. If this
increased output of capital goods is to be sold, demand must be increased.
is may be brought about either by means of a decrease in the indirect tax
rate on capital goods (and in that case the price level for capital goods ‘at
market price’ will fall) or through a lowering of the rate of interest (here the
price level for capital goods ‘at market price’ is unanged). Wage payments
in the capital goods industry are unanged, but the incomes of the owners
of firms in the capital goods industry will increase by the same amount as
the increase in the total value of capital goods production (reoned ‘at
factor cost’). Since the incomes of both wage-earners and owners of firms in
the consumer goods industry are unanged with unanged levels of
employment and prices in this industry, there will be an excess demand for
consumer goods whi can be offset by means of an increase in the rate of
income tax. If this increase in the rate of income tax is concentrated on the
incomes of owners of firms, their total disposable incomes will return to the
same level as they were before—ignoring the consequences of the shi in its
distribution between the two industries. e budget balance is affected on
the one hand by the increase in the yield of income taxation, and on the
other by the ange in the yield of the indirect tax on capital goods. It
depends on the elasticity of the demand for capital goods whether the total
yield of the capital goods tax will rise or fall when the tax rate falls
(production has of course risen). For that reason it cannot be decided a priori
how the budget balance will be influenced in the case where the State
employs the indirect tax on capital goods to bring about equilibrium in the
market for capital goods. If, on the other hand, a decrease in the rate of
interest is employed, there will be an increase in the budget surplus; for in
this case the yields of both the income tax and the capital goods tax will
increase. However, if capital goods production is subsidized, the total
amount of the capital goods subsidies will increase, and the outcome for the
budget balance will then be uncertain.
Summarizing, we may say that if policy is so conducted that labour is not
transferred from one industry to the other, a decrease in the rate of interest,
or alternatively a decrease in the rate of indirect tax on capital goods,
combined with an increase in the rate of income tax will be sufficient means
to secure an unanged value of money and full employment.
However, it is also possible that the State may want to secure the two
primary ends in su a manner that so mu labour is transferred to the
consumer goods industry that the production of capital goods remains
unanged in spite of the increase in average productivity in the capital
goods industry. is policy then implies that the State wants the increase in
productivity to be exclusively used in the form of increased consumption, a
case parallel to that discussed under (ii) above.
According to our basic assumptions, at an unanged price level for
capital goods (if the tax rate for capital goods is unanged) employment in
the capital goods industry will be unanged while the production of capital
goods will rise. If the demand for capital goods is not in any way affected
the increased production of capital goods cannot be disposed of, the prices of
capital goods must be reduced, and the output of capital goods must fall. It
cannot be determined whether this decrease in the output of capital goods
will exceed or fall short of the increase in production with unanged
employment, without further knowledge of the elasticity of demand for
capital goods and of the shape of the marginal productivity curve. us, if
the decrease of production and employment in the capital goods industry are
to be of su a magnitude that the volume of production becomes the same
as in the original position (i.e. before the increase in productivity), then the
means to be employed may have to be either demand-stimulating or
demand-restricting, that is either a reduction or an increase in the rate of
interest on the one hand or alternatively either a decrease or an increase in
the rate of tax on capital goods on the other. Nor can it be decided a priori
whether the incomes of the owners of firms in the capital goods industry
will have increased or decreased in relation to their original levels.
Furthermore, if employment in the consumer goods industry is to increase
without increasing the price level of consumer goods ‘at market price’, it is
obviously necessary to reduce the indirect tax rate on consumer goods in
proportion to the decrease in marginal productivity that follows increased
employment. As production increases in the consumer goods industry, so
will the incomes of owners of firms. e problem now is simply whi
measures will be necessary in order to secure equilibrium in the market for
consumer goods. e supply has increased, while the price level ‘at market
price’ remains unanged. Wage incomes are unanged, the incomes of the
owners of firms in the consumer goods industry have increased, while it is
uncertain whether the incomes of the capital goods producers have
increased or decreased. Even if we assume that the total incomes of the
owners of firms have increased (whi is the most probable outcome) we
must still remember that, in the first place, part of the increase in the
incomes of the owners of firms are automatically deducted as income tax at
unanged rates, and, in the second place, part of the increase in the
disposable incomes of the owners of firms is probably saved. us it cannot
be said a priori whether the total demand for consumer goods will rise more
or less than the increase in the selling value of the supply of consumer
goods. Consequently we cannot decide a priori whether an increase or a
decrease in the rate of income tax is necessary to secure equilibrium in the
consumer goods market.
Nor can it be said a priori how the budget balance is affected. e only
certain thing is that the rate of consumption tax has to fall, but this does not
necessarily mean that the tax yield to the State will decrease. at depends
entirely on the employment elasticity of marginal productivity. And we do
not know whether income tax rates have to rise or fall. Furthermore, the
State has a free oice between the interest rate and the rate of tax on capital
goods tax in pursuing a policy to secure the desired transfer of labour to the
consumer goods industry, and even if the State uses a ange in the rate of
tax on capital goods, it cannot be said a priori in whi direction the ange
will be.
e conclusion is thus that if the total product (average productivity)
increases in the capital goods industry with unanged employment, and an
unanged price level for consumer goods and also full employment
equilibrium are to be secured, while capital goods production is to be kept
constant and the production of consumer goods to increase, then the
sufficient means will be some ange in the rate of interest (or a ange in
the investment tax) combined with a decrease in the tax rate for consumer
goods and some ange in the rate of income tax.

(v) Summary. The Case of a Uniform Increase in Productivity

We shall now try to give a short summary of the means whi have been
found sufficient to secure the ends of a constant value of money and full
employment, when the disturbances are the four elementary cases of
productivity anges dealt with in subsections (i)–(iv). Aer that we shall
deal with one special combination of these elementary cases, namely the
case of a ‘uniform’ increase in productivity.
e results of paragraphs (i)–(iv) are summarized in the following table:
 For using this table the ceteris paribus assumptions whi lie behind it
should be remembered, namely, that we are here concerned with increases
in productivity with an unanged level of employment under the
assumption that no other productivity anges occur at the same time.
e cases of anges in productivity shown in the table have been called
elementary cases because all other cases (within the framework of this
model) may be seen as combinations of these. Here we shall only deal with
the case that is most oen considered, where, with given employment, the
marginal and average productivities rise by the same percentage, k per cent,
both in the consumer goods and in the capital goods industries. In the first
place we shall consider the possibility that policy is directed so that
employment remains unanged in both industries, in the second place we
shall turn to the possibility that labour is transferred to the consumer goods
industry to su an extent that the production of capital goods remains
unanged, and finally we shall consider the possibility of labour being
transferred to the capital goods industry to su an extent that the
production of consumer goods remains unanged. We thus consider the
possibilities that the productivity increase is used to increase both private
consumption and private capital formation, or that it is used exclusively to
increase private consumption or exclusively to increase private capital
formation. A few words will also be said about the possibility of the increase
in productivity being used to increase public consumption or public capital
formation.
We first assume that the distribution of employment between the two
industries is to be unanged. If we consider the capital goods market, we
find that the output of capital goods has increased by k per cent. Demand
must then also increase by k per cent if equilibrium is to be maintained with
unanged employment. Another condition for equilibrium is that capital
goods prices ‘at factor cost’ decrease in the same proportion (see the
optimum condition (XIII: 5) p. 233). e simplest way of bringing this about
would be to allow the market price of capital goods to decrease in
proportion to the productivity increase, without anging the rate of indirect
tax on capital goods. At the lower price, the demand for capital goods is
greater, but by how mu will depend on the elasticity of demand for capital
goods. If the laer is equal to 1, demand will increase by k per cent due to
the price decrease, and to this extent equilibrium is automatically
established in the capital goods market. However, the increased production
of consumer goods will lead to an increased demand for capital goods,
whi will mean that with a price elasticity of demand for capital goods
equal to one, an increase in the rate of interest will be necessary to secure
equilibrium in the capital goods market. With an elasticity of demand for
capital goods greater than one, a rise in the rate of interest is even more
necessary; with a very low elasticity of demand for capital goods, a
reduction in the rate of interest may be necessary. Both the incomes of firms
and of wage earners in the capital goods industry will thus be unanged.
e same applies if the State secures equilibrium in the capital goods market
simply by an increase in the indirect tax rate on capital goods.
 In the consumer goods industry an increase in the tax rate on consumer
goods will be necessary if the price level of consumer goods is to be
unanged. Both wage incomes and the incomes of firms in the consumer
goods industry are unanged. us with unanged income tax rates,
aggregate disposable incomes in the community remain unanged, and
consequently so does the demand for consumer goods. e State must thus
decrease the income tax rates to su an extent that disposable incomes
increase just so mu that the demand for consumer goods increases by k
per cent. Total equilibrium is then secured.
If the State, instead of allowing the private sector to increase its
consumption and capital formation, prefers to take arge of the increase in
the production of capital and consumer goods itself, it will easily be seen
that it can aieve this end by modifying the policy outlined above in su a
way that, on one hand, the income tax rates are kept unanged while the
State increases its own purases of consumer goods, and, on the other hand,
the rate of interest is increased still more while the State increases its
purases of capital goods.
If now we assume instead that the production of capital goods is to be
kept unanged, in spite of the increase in productivity, it is obvious that the
rise in interest (or the increase in the tax rate on capital goods) must be
greater than in the previous case. In the consumer goods industry marginal
productivity will be reduced again, due to the increase in employment, thus
it can not be determined a priori whether a decrease or an increase in the
tax on consumer goods will be necessary, unless further assumptions are
made as to how the production function has been anged at levels of
employment other than the original one. e incomes of owners of firms in
the capital goods industry will be reduced, but those in the consumer goods
industry will rise, and without making further assumptions it cannot be
determined whi of these anges will be dominant. If we assume that the
total incomes of owners of firms are unanged, then income tax rates must
obviously be reduced even more markedly than in the previous case if
equilibrium in the consumer goods market is to be secured.
As compared with the previous case we thus find that the rate of interest
must be more strongly increased, the consumption tax rate be increased less
(or even be reduced), and the income tax rate be reduced more, if the entire
increase in productivity is to be used in the form of increased private
consumption.
Finally, if we consider the possibility that it is desired to keep the
production of consumer goods unanged, it is easy to see that a reduction
in the rate of interest (or a reduction in the tax rate on capital goods) may be
necessary to secure a sufficiently large demand for capital goods, partly
because the incentive to increased demand from the consumer goods
industry has disappeared, and partly because prices tend to increase in the
capital goods industry in connection with the increase in employment and
the consequent fall in marginal productivity in that industry. In the
consumer goods industry marginal productivity will increase further
because of the decrease in employment. An increase in the consumer goods
tax thus appears even more necessary than with unanged employment. If
the incomes of firms are not affected in aggregate by the shi in
employment, then the demand for consumer goods is not affected either.
Equilibrium in the consumer goods market thus requires no ange in the
income tax rates. If the incomes of firms increase (decrease) the income tax
rates must of course be raised (lowered).
If we compare this with the case where the distribution of labour is not
affected, we find that the rate of interest must be decreased, the tax rate for
consumer goods must be increased more and the income tax rates must be
decreased less (or possibly even be increased) if the whole increase in
productivity is to be used in the form of an increased private capital
formation.

3. SPONTANEOUS CHANGES IN DEMAND

e spontaneous anges in the demand for consumer or capital goods that
we are concerned with here, take place in the demand of private households
and firms, and correspond to what are oen denoted as anges in the
propensity to consume (or the propensity to save) and in the propensity to
invest. In the model in Chapter XIII they appear as anges in the functions
F and Φ. To a large extent these cases coincide with the cases dealt with in
Chapter XIII, where the State increased its demand for consumer goods or
capital goods. us we do not have to devote very mu space to these
spontaneous anges in the private demand, however important they may
be in practice.

(i) Change in the Private Demand for Consumer Goods

If we assume that the propensity to consume increases (or the propensity
to save decreases), while everything else remains the same, then in the
simplest case, where we also assume that the output of consumer goods is
unanged, the situation may be rectified simply by an increase in income
tax. Within the frame-work of our model, no other means will be necessary
to secure an unanged price level for consumer goods and an unanged
level of employment.
It is obvious that a decrease in the State demand for consumer goods will
also be a sufficient means to counterbalance the increase of the private
demand for consumer goods.
On the other hand, if there is a desire for increased consumer goods
production (for example, on the grounds that ‘the consumption-saving
paern is to determine the paern of production’) this will necessitate a
decrease in the indirect tax on consumer goods (in order to keep consumer
goods prices constant in spite of increased production) combined with an
increase in the rate of interest or in the indirect tax on capital goods (in
order to bring about a decrease in the demand for capital goods and in the
production here). Whether the income tax rate also needs to be anged or
not depends partly on how earned incomes are affected by the production
shi, and partly on how far it is desired to take this shi in production.

(ii) Change in the Private Demand for Capital Goods

If the demand for capital goods from private firms increases while
everything else remains the same, a rise in the rate of interest (or an increase
in the rate of tax on capital goods) may be sufficient to maintain equilibrium
with an unanged price level for consumer goods, an unanged
composition of output, and unanged total employment. Another sufficient
means is a reduction in the State demand for capital goods. If, besides the
increase in capital goods demand, it is desired to have a shi in production
from consumer goods to capital goods, an increase in the consumer goods
tax and (probably) an increase in income tax will be necessary.

4. SPONTANEOUS CHANGES IN STOCKS OF GOODS

Firms may increase their stos of goods by aempting to bring about either
a decrease in the flow of goods out of stos or an increase in the flow of
goods into stos. e former requires reduced sales; the laer requires
either increased purases of raw materials and semi-manufactures or
increased production. For the sake of simplicity we shall here only discuss
spontaneous sto anges in the consumer goods industry.
Now, if we consider the first type of sto increase, where sales are
reduced for a while, it is of course easy to indicate means whi are
sufficient to maintain the previous price level and volume of employment.
An increase in the rate of income tax will be sufficient, as also will be a
decrease in the purases of consumer goods by the State itself. When the
process of accumulating stos comes to an end and supply increases again,
the income tax rates (or the purases of consumer goods by the State) may
return to their former levels.
However, there is some doubt as to whether su a solution is practicable.
If the sto increase is brought about in, say, two or three months, then
obviously income tax rates must be anged for the same short interval,
whi may imply two anges of income tax during one financial year. is
may be difficult and with a tax-system of the Swedish type not even
permissible. Other methods must then be tried.
It may well be asked whether, in view of the transient nature of the
ange, the situation cannot be rectified merely by monetary policy means,
for example, by raising the rate of interest, i.e. by credit restrictions. If the
sto increase is the result of a desire by firms to have permanently larger
stos than before (larger ‘normal stos’), a permanent increase in the rate
of interest is necessary to prevent the temporary fall in sales whi the sto
increase will necessitate. If this rise in the rate of interest (credit restrictions)
cannot be made selective so that it will only affect credit to be used for
financing stos of consumer goods, then the demand for capital goods will
also be affected. If a production decrease is not to take place here, the
indirect tax on capital goods must be decreased just so mu as to
counteract the effect of the rise in the rate of interest on the demand for
capital. In order to prevent a short-term decrease in the supply of consumer
goods, whi will automatically disappear again if nothing else happens, the
State is accordingly obliged permanently to increase the rate of interest and
decrease the tax rate on capital goods. If the size of the disposable incomes
of the owners of firms is of direct importance for the demand for capital
goods, it is, of course, possible to reduce the rate of income tax on the
owners of firms as an alternative to the decrease in the tax on capital goods,
provided that this does not also open up the possibility of firms financing the
desired sto increase internally.
If the sto increase is only temporary, so that firms plan to follow it by a
comparatively rapid return to the earlier level of stos, it is perhaps more
natural to resort to monetary policy; the increase and decrease in stos
would require no less than four successive anges in the rate of income tax
if the price level were to be kept constant by that means. When the task is
not to hold in e a permanent tendency to increase stos, it is perhaps
easier to apply a selective interest policy whi will only affect the short
term tendencies to increase stos without affecting the demand for capital
goods. For instance, it is possible that sto anges are especially sensitive
to the short term interest rates (and the other conditions aaed to short-
term loans) while the demand for capital goods is to a greater extent
determined by long-term interest rates. A temporary increase in short-term
rates of interest, with unanged long-term rates, might then perhaps be a
sufficient means to cope with su temporary sto increases. If the short-
term rate of interest in itself is of no great importance to the size of the
stos, there still remains the possibility of applying selective ‘credit-
rationing’, whi only affects credit for financing sto anges.
Temporary increases in stos followed by sto decreases are as a rule
caused by speculation in future price movements. It is doubtful whether
su speculation will be of any great significance, once the State
demonstrates that it seriously intends to carry out the programme of
constant price level for consumer goods and full employment. With our
interpretation of the concept: value of money, namely a constant price level
of consumer goods ‘at market price’, speculation in price movements will
not be altogether excluded however. For net prices to firms, i.e. market prices
minus consumer goods tax, will not be constant with different types of
disturbance. In other words, speculation in future anges in the rate of
indirect tax on consumer goods will become possible. Su speculation
cannot, of course, be avoided by fiscal and monetary policy declarations.
However, this is nothing peculiar to our interpretation of the concept of
value of money. Even if we regard constant value of money as the same as
constant price level ‘at factor cost’, speculation in future anges of costs,
etc., may arise. It is difficult to decide a priori whi interpretation of the
concept of value of money will involve a minimum of speculation.
Moreover, stabilization of the price level of consumer goods does not prevent
shis taking place in the prices of capital goods and raw materials, and these
too may give rise to speculation. Finally, a constant price index for consumer
goods does not exclude anges in individual consumer goods prices.
If firms try to increase their stos by means of temporarily increased
production instead of by temporarily decreased sales, the situation when no
measures are taken will be quite different from the above. Instead of a
tendency for the price of consumer goods to increase, there will now be a
tendency towards excess demand for labour, and thus also a tendency for
wages to increase in the consumer goods industry, possibly with a decrease
in the production of capital goods as a result. e remedy will be the same,
however. For example, if we increase the rate of income tax, the turnover of
firms in the consumer goods industry will decrease, and their stos will
therefore increase. Since the desired sto increase will then have been
brought about, the consumer goods firms will not increase their production
above the previous level. And as soon as stos rea the desired level, then
a lowering of the income tax rate will restore the previous situation at the
old price level. Similar arguments are valid if credit policy is employed and
if the increase in stos is temporary.

5. SPONTANEOUS CHANGES IN LABOUR SUPPLY

If the total supply of labour is suddenly decreased, either private or public
employment must be decreased if full employment equilibrium is to be
maintained. If we assume that State employment is unanged, the whole
decrease in employment will take place in the private sector. We here deal
with only two special cases: firstly the case where the decrease in
employment occurs only in the capital goods industry, the production of
consumer goods being unanged and secondly the case where the decrease
in employment affects only the production of consumer goods.

(i) Unchanged Consumer Goods Production

With unanged production and employment in the consumer goods
industry, if money wages are unaffected, the indirect tax on consumer goods
must be kept unanged if the price level is to be constant. If the demand for
capital goods is to decrease so mu that equilibrium is maintained in the
capital goods market with the lower production, the rate of interest (or the
tax rate on capital goods) must be increased. e incomes of both wage-
earners and the owners of firms in the capital goods industry will fall. Even
though the income tax amounts will automatically decrease somewhat there
will be a decrease in the total disposable income for wage-earners as well as
firm-owners. us if equilibrium is to be secured in the consumer goods
market with unanged consumer goods prices, the income tax rates must
be decreased for the owners of firms and/or for wage-earners. Whether
disposable incomes will be the same in aggregate aer the reduction of the
income tax rates as in the original position, will depend partly on the shi in
the factor incomes whi takes place in connection with the decrease in
production, partly on the way in whi income tax rates are reduced (and
especially on whether it is the larger or the smaller incomes that are
favoured), and finally on the forms of the consumption functions of the
different income groups.
If the decrease of the demand for capital goods is brought about by means
of the rate of interest, the budget balance will probably deteriorate; the
income tax yield decreases, as does the yield of the capital goods tax. e
lower prices of capital goods will, however, involve lower State expenditures
on the purase of su goods.

(ii) Unchanged Capital Goods Production

If the production of capital goods is to be unanged, and the production
of consumer goods to decrease, the interest-rate must be lowered in order to
offset the tendency to reduce the demand for capital goods whi is
associated with the reduced production of consumer goods. Incomes earned
in the capital goods industry are not affected. Owing to the decrease in
production, an increase in the tax rate for consumer goods will become
necessary if the price level is not to fall. Incomes earned in the consumer
goods industry will probably decrease by a larger amount than the decrease
in the sales value of the production of consumer goods. e same thing
applies to disposable incomes. A reduction of income tax is thus necessary to
secure equilibrium in the consumer goods market with unanged market
prices. However, the income tax decrease will not be as large as in the
previous case. It cannot be determined a priori how the budget balance will
be affected. Whether the consumption tax amount rises or falls depends on
the slope of the marginal productivity curve; the amount of consumption tax
may rise or fall. e amount of income tax will decrease. Finally, if
equilibrium in the capital goods market is secured by means of a reduction
in the rate of tax on capital goods, the yield of the laer will decrease.
It is obvious that the effects of a decrease in the supply of labour on the
price level and on full employment equilibrium may also be offset if the
State reduces its purases of labour. Private production will then remain
unanged. However, if equilibrium in the consumer goods market is to be
secured, the demand for consumer goods whi previously came from the
former civil servants but has now disappeared, must be restored, and the
simplest way of doing this is to reduce the rate of income tax. Whether the
budget balance will improve or deteriorate in consequence depends entirely
on the propensities to consume of the dismissed workers as compared with
the marginal propensities to consume of the workers and owners of firms
who have their income tax reduced.

1. See e.g Bent Hansen, A Study in the Theory of Inflation, Chapters VI and
IX, and ‘Fiscal Policy and Wage Policy’, International Economic Papers,
No. 1, London 1951.
 CHAPTER XVI

Long-term Problems of Fiscal Policy

1. DYNAMIC LONG-TERM FACTORS
As has been pointed out several times already, the model (set out in
equations (XIII: 1°)–(XIII: 7°)) whi forms the basis of discussion in
Chapters XIII, XIV and XV, is a decidedly static, short-term one. e results
obtained concerning economic policy are therefore also decidedly short-term
ones. e static nature of the model is exhibited by the fact that all the
variables in the model have the same dating; there are no equations for
dynamic movements in the model. e short-term nature of the model is
exhibited particularly by the fact that no consideration is taken of the
importance of possible anges in the sto of real capital or in State’s debts
to the private sector. In the short-term model the output of capital goods,
and thus also gross investment, are positive. Since the model does not imply
that capital goods production exactly corresponds to capital depreciation
(whi is not taken into account in the model at all, in fact), net investment
may also be positive and thus the sto of real capital may be growing. is
must have effects sooner or later on the short-term production functions. If
we ignore Government investment, the net wealth of the private sector
(households) during ea period must increase by an amount equal to the
total growth of real capital plus the budget deficit (in the ‘real economic’
sense of the word), or, to put it in another way, by the private real capital
formation plus the increase in the private sector’s claims (including bank-
notes) on the State. Since the short-term model does not imply that the real
capital formation, or the budget deficit, or the sum of the two, is zero,
implicit in short-term equilibrium there may be a ange in the net wealth
of the private sector and in its liquidity structure and this may then have
certain consequences for later periods, for example on the demand for
capital goods, on private saving, and on consumption.
 In what now follows we shall demonstrate how both of these factors—
whi, in relation to the short-term model we have osen, we shall regard
as ‘long-term factors’—may be introduced into the model in su a way that
this is made dynamic and describes developments through time, yet at the
same time we need not, on that account, abandon the original model as a
short-term one. e long-term model whi we arrive at in this way shows
how short-term equilibrium is anged from period to period under the
influence of the long-term forces that are mentioned.
By thus developing the model, we also have an opportunity of discussing
the long-term problems of economic policy. We shall discuss how a long-
term economic policy with given ends may be conducted either as a short-
run or as a long-run policy, and finally we shall discuss certain problems
connected with the time aspect of the ends themselves.

2. CHANGES IN THE STOCK OF REAL CAPITAL

Let us first consider those complications whi are caused by an increase
through time in the sto of real capital. For the sake of simplicity we still
disregard wear and tear on existing real capital; the output of capital goods
is therefore equal to the amount of net investment.
us we are modifying the system of equations in Chapter XIII, 2 in the
way indicated below. Firstly, we imagine that the model is valid only for a
certain short period of time, so that we aa a time indicator, t, to ea
t
endogenous variable and to ea parameter; NC thus become NC , w

becomes wt, etc. e model then is explicitly concerned with a short-term

equilibrium situation in period t. Secondly, we ange the two production
functions from

to
where RCt and RIt denote the amount of real capital in the consumer goods
industry and the capital goods industry, respectively, for period t. If we
regard these two amounts of real capital in period t as being given
exogenously (that is, determined by the developments in previous periods)
and independent of events in period t itself, this ange in the production
functions will involve no material ange in our static short-term model.
We are now able to make the model dynamic by adding two new
equations to the others:

and

where and denote the purases of capital goods during period t–

1 by the consumer goods industry and by the capital goods industry
respectively. ese two equations simply say that the amount of real capital
used in production is increased in ea period by the net investment of the
previous period. Accordingly, we must also assume that the demand
function for the capital goods market

is split up, and specified in greater detail as three separate demand functions.
ere will be one for the consumer goods industry, say,

one for the capital goods industry, say,

and finally one for the State’s demand for capital goods:
 e dynamics of the model will then be as follows: if we consider some
given initial period, t, there will be a given amount of real capital,
distributed between the two industries. e system then aains (short-term)
equilibrium in period t with certain prices, levels of output and employment,
etc. is equilibrium implies a certain amount of output of capital goods and
certain purases of capital goods by the consumer goods and capital goods
industry, however, i.e. net investment is positive. is investment does not
affect production conditions in period t itself, but the additions to the
amount of real capital are employed in the production in period t+1, so that
in period t+1 new amounts of real capital will form the basis of production,
and this is equivalent to a shi in the production functions in the short-term
model. With these new given amounts of real capital a new short-term
equilibrium will be aained in period t+1, with new values for the
endogenous variables, and so on. us we bring about a typical dynamic
moving-equilibrium process, where ea period has a static short-term
equilibrium, like the ones discussed in the previous apters, but where the
system nevertheless generates its own development. e model will thus be
a mixed static–dynamic one.
It is not only the production functions whi make anges in the sto of
real capital important for the long-term development, however. e demand
for capital goods may also be influenced in the long run by the amount of
the real capital. For that reason, it would not seem unreasonable to assume
that the demand functions for capital goods specified earlier for the
consumer and capital goods industry be anged to:

and

What was said above about the dynamics of the model in the face of
anges in the short-term production functions, is also valid here, mutatis
mutandis.

3. WEALTH AND LIQUIDITY IN THE PRIVATE SECTOR

e short-term model in Chapter XIII is of su a nature that short-term
equilibrium does not exclude a ange in the private sector’s wealth and
liquidity. Wealth in the private sector increases during ea period by an
amount equal to saving in the private sector (we ignore capital gains), whi
in turn is equal to, and invested in, the increase in private real capital plus
the increase in the private sector’s claims on the State. e claims on the
State may consist of interest-bearing government bonds or money at call
(including bank-notes) on the State. As has been pointed out in Chapter
XIII, 2, we imagine the rate of interest in ea period to be fixed by the
State, whi must then buy and sell interest-bearing government bonds to
the extent required. Another way of puing this would be to say that given
the rate of interest desired by the State, it must, in ea period, adapt the
composition of the total national debt to the preferences of the private
sector. To this extent the private sector determines its own liquidity
structure. But the liquidity of the private sector is not only a maer of the
way in whi the total amount of claims on the State is divided into claims-
at-call and government bonds; it is also a maer of the division of total
private net wealth into claims on the State on the one hand and real capital
(shares and other equities) on the other. It seems reasonable to assume that,
other things being equal, the private sector will consider a ange in the
composition of a given amount of wealth towards more real capital and less
claims on the State as a reduction in its liquidity.
During recent years it has become an increasingly widespread opinion, in
theoretical as well as in empirical writings on economics, that the demand
for consumer goods for a certain period is influenced not only by the current
disposable real incomes of households but also by their wealth, and
especially by their more liquid assets. is is quite in accordance with the
general intertemporal theory of consumption set out in Chapter VII.
Similarly, it is natural to assume that the demand for capital goods is
influenced not only by the rate of interest and the current profits of
entrepreneurs, but also by the financial resources of the entrepreneurs,
particularly by their more liquid funds. It is these possibilities that we shall
consider next. By analogy with our treatment of anges in the sto of real
capital, our assumption here is that anges in the size and composition of
the wealth of the private sector in any given period do not influence demand
until the next period.
In order not to complicate the maer unnecessarily we shall only consider
the demand function for consumer goods (XIII: 12) and any anges in it
that may arise from our discussion. We shall also adopt the further
simplification that the distribution of the wealth of the private sector
between the owners of firms and wage-earners, and its composition between
real capital, interest-bearing government bonds and claims-at-call on the
State are of no significance. We need then only consider total private wealth,
H, and the anges in it (still ignoring capital gains). We then ange the
short-term function

to

We thus assume that the demand for consumer goods is determined not
only by the real disposable incomes of wage-earners and of the owners of
firms, but also by their total (real) wealth. If this wealth (at the beginning of
the period) is regarded as given for period t and determined by
developments in the previous periods, this ange in the demand function
for consumer goods will involve no material ange in the static short-term
model (at least not as long as State policy keeps the price level constant);
additions to wealth in that period have no effects in the period itself, but
only in the following period.
e model is now made dynamic through the following relationship:

whi says that net wealth (ignoring capital profits and losses) at the
beginning of period t is equal to the net wealth at the beginning of period t—
1 plus the value of net investment in the consumption and capital goods
industries in this period minus the budget surplus (see equation (XIII: 17)) in
this period.1
In a quite analogous manner, the size and composition of the wealth of
the owners of firms may be considered in the demand function for capital
goods.
What has been said about the dynamics of the model in the previous
section, when we were considering the importance of anges in the sto of
real capital for the production functions, is also valid here, mutatis
mutandis.
If now we summarize the anges in the short-term model whi have
been discussed in this and the previous sections, it may be said that for our
purposes and as a short-term model, it need not be anged. e short-term
equilibrium does, however, imply anges in the quantity of real capital and
in the size and composition of the wealth of the private sector, and this fact
may influence short-term production and the demand functions for
consumer and capital goods during the following period. us the short-
term equilibrium will tend to develop through time. e dynamic links
between the periods may, however, from a short-term point of view, be
considered as disturbances in the production functions and in the demand
functions. In Chapter XV we have already dealt with the question how the
effects of su (internal) disturbances upon the price-level of consumer
goods and upon employment may be offset. In principle, therefore, we have
already treated one of the problems whi the long-term dynamic system
presents to economic policy.

4. ENDS AND MEANS IN THE SHORT AND LONG RUN

A policy consists of certain measures whi are taken to realize certain ends.
us when it is said that a policy may be short-run or long-run, these
expressions may refer either to the ends or to the measures taken, or to both.
In themselves, however, these expressions are quite indefinite. In dealing
with questions of fiscal policy, it is usual to apply the term ‘short-run’ to
relationships within one financial year, but when dealing with monetary
policy problems there is no particular reason to let ‘short-run’ refer to the
financial year at all. If we are to get to gauge with problems of this nature, it
seems appropriate, and perhaps even necessary, to refer to a definite model
with a certain given period. Earlier we used the expression ‘short-term’ of a
model whi only gives an account of relationships within one given period,
while the expression ‘long-term’ was applied to a model whi explained the
development over several periods. But this, of course, still leaves the
question of the length of the period open, see section 8 below.
Against this baground we shall now speak about single-period ends, if
the ends are defined for a given period. For example, if the aim is to
maintain a certain price level of consumer goods, within one given period,
we are obviously confronted with a single-period end. ere is nothing to
prevent us from establishing single-period ends for several successive
periods, su as that the price level of consumer goods shall be at a certain
level within ea of a long succession of periods. Multi-period ends are, on
the other hand, ends that have been defined for a certain number of periods
hence and comprise variables from several periods. e aim of keeping the
average price level of consumer goods over four periods at a certain level, is
a multi-period end.
e short-term problems of policy will thus be to secure a certain group of
aims in the short run, that is to secure within a certain period those
objectives whi have been set for this period; su ends must necessarily be
single-period ends. The long-term problems of policy, on the other hand, will
be to secure the ends that have been set for the long run, that is to say for
several successive periods; the ends here may obviously be either several
successive single-period or else multi-period ends.
Finally, by short-term measures we shall mean measures (parameter
anges) whi are taken in a certain period only with regard to their effects
during the period in question, and without regard to their effects during the
following periods; when we speak about long-term measures, we mean
measures whi are taken not only with reference to possible effects in the
period in question, but also with reference to their effects in some future
periods.2 e short-term problem, whi concerns only single-period ends,
may obviously be solved either by short-term or long-term measures. Also
the long-term problem may, when several successive single-period aims are
concerned, be solved either by short-term or by long-term measures; if the
long-term problem concerns multi-period ends, it can only be solved by
long-term measures. e discussion in the rest of this apter concerns all
these possibilities.
Using this terminology as a basis, it can be said that the discussion whi
we have been conducting up to now (Chapters XIII–XV) concerns the
solution of the short-term problem (by short-time measures, of course). In
what follows we shall deal with the long-term problems. First of all, in
section 5 we shall discuss how the long-term problem, concerning several
successive single-period ends, may be solved by short-term measures. In
section 6 we shall then discuss how the same long-term problem—several
successive single-period ends—may be solved by more long-term measures;
and here we are confronted with an important question for fiscal policy.
Finally, in section 7, we shall proceed to a discussion of certain problems in
connection with multi-period ends.

5. LONG-TERM PROBLEM I: SUCCESSIVE SINGLE-PERIOD ENDS AND

SHORT-TERM MEASURES
We shall now deal with the simpler type of long-term problem, where the
ends to be realized are several single-period ends, and the measures taken
are purely short-term ones. It will be obvious that the task of policy here is
simply the continuous offseing of disturbances su as those we have dealt
with in the previous apters. e problems with whi policy will have to
deal here, are only combinations of the problems of previous apters. e
short-term measures that prove necessary will thus also be simple
combinations of the measures that we found suitable in the previous
apters. So far this long-term problem offers nothing new.
Let us illustrate this with the long-term dynamic model set out at the
beginning of this apter (sections 2 and 3). In order to simplify the problem,
we assume that in the initial position the economy is in equilibrium with
real (net) capital formation equal to zero, and the private sector’s claims on
the State constant from period to period; the situation is thus aracterized
by the fact that capital goods production corresponds exactly to the
depreciation of real capital, and the State budget is balanced in the ‘real-
economic’ sense; the private sector’s net wealth is then also constant
through time. It will be seen that this short-term equilibrium is identical
with stationary long-term equilibrium. e short-term equilibrium will
repeat itself unanged from period to period; all sto variables are
constant.
In this situation we now assume that the State will decrease its purases
of labour during a certain period. We furthermore assume that the measures
whi are going to secure the single-period ends of full employment and an
unanged price level for consumer goods are arranged in su a way that
employment in the capital goods industry will increase by the same amount
as the purase of labour by the State has decreased. Employment and
production in the consumer goods industry are thus unanged. By analogy
with the results obtained in Chapter XIII, 3, (i), where we dealt with the case
of an increase in the State’s purases of labour, a decrease in the rate of
interest (in order to stimulate the demand for capital goods) and an increase
in the rate of income tax (in order to prevent the increased incomes earned
from increasing the demand for consumer goods) will, in combination, be
sufficient to secure full employment and an unanged price level of
consumer goods. e budget will be in surplus.
As a result of the initial disturbance (the decrease in State hire of labour),
whi we assume to be permanent, and the compensating short-term
measures (decrease in the rate of interest, plus an increase in income
taxation), the amount of real capital will increase in connection with the
increase in the production of capital goods while the private sector’s claims
on the State will decrease in connection with the budget surplus. e net
wealth of the private sector will not be anged, for the production of
consumer goods is unanged according to our assumptions, and income
taxation must be increased so that the demand for consumer goods will also
remain unanged (in spite of increase in earned incomes); total saving of
the private sector will then also be unanged, that is still equal to zero, if
we ignore the distribution effects and the influence of the rate of interest on
saving. e decrease in the claims of the private sector on the State thus
corresponds to the increased amount of real capital. e net wealth of the
private sector, on the other hand, does ange in composition, and will
consist to a larger degree of real capital and to a smaller degree of claims on
the State. Let us assume that this is regarded by the private sector as a
decrease in liquidity, whi in turn may be expected to entail a tendency for
demand for consumer goods to decrease during the following periods, with
real disposable incomes unanged. e increase in the sto of real capital,
on the other hand, will probably involve increased productivity, and possibly
a decrease in the demand for capital goods.
But full employment and an unanged price level for consumer goods
are also to be secured during the following period. e short-term measures
whi must be taken here will be more complicated than those of the first
period. In the first place the effects of the reduced purases of labour by the
State on employment and the price level of consumer goods still have to be
offset; here a continuation of the policy of the previous period will, of
course, be sufficient, namely maintenance of the rate of interest and the
income tax rates applied in the previous period. In the second place,
however, the effects on employment and the price level of consumer goods
of both the increase in productivity and the decrease in the demand for
consumer and capital goods (called forth by the decrease in liquidity) have
to be neutralized. In the previous apter we have mentioned the ways in
whi su ‘disturbances’ may be mastered in the short run. e decrease in
the demand for consumer goods may be neutralized by means of a decrease
in the income tax rates (see Chapter XV, section 3 (i)). e decrease in the
demand for capital goods by means, say, of a decrease in the rate of interest
(see Chapter XV, section 3 (ii)). e neutralization of the ange of
productivity will, as we have shown in Chapter XV, 2, depend on how the
average and marginal productivities within the capital and consumer goods
industries are affected; with a ‘uniform’ productivity increase, and assuming
an unanged distribution of employment, some ange in the rate of
interest (either upwards or downwards), an increase in the indirect tax on
consumer goods and a decrease in income tax rates will be necessary.
Compared to the policy during period 1, viz. a decrease in the rate of
interest and an increase in the income tax rates, the policy during the
following period will consist of some ange in the rate of interest, a
decrease in the income tax rates, and a new measure, an increase in the
indirect tax on consumer goods. e production of capital goods, and thus
real capital formation, will increase further; it cannot be determined a priori
whether the budget will be in surplus or deficit during this period unless
further assumptions are made concerning the extent to whi the production
and demand functions have been affected.
 In this way the short-term measures may be studied from period to
period, and we may discover the way in whi a short-term policy must be
conducted if the effects on employment and the price level of the original
disturbance and of the compensatory short-term measures of the previous
periods themselves, are to be neutralized. e official parameters must
continually be anged from period to period unless the model happens to
return to a stationary equilibrium position. It will be seen that this type of
long-term policy will, in ea period, be aracterized by a certain number
of ends, and in ea period a number of measures equal to the number of
ends for that period must be expected to be necessary.

6. LONG-TERM PROBLEM II: SUCCESSIVE SINGLE-PERIOD ENDS AND

LONG-TERM MEASURES
We are still assuming that the established ends are single-period ends, and
that su ends have been set up for a number of successive periods.
It is obvious that the policy necessary in any one period depends not only
on the nature of the initial disturbance, but also on the measures whi the
State has osen to apply during the previous periods. It is natural, therefore,
when oosing the measures for any particular period, not only to consider
the ends set up for the period in question, but also the measures whi will
be necessary for securing the ends set up for future periods. We are then
concerned with long-term measures, whi are aracterized by the fact that
the State, in determining the measures to be taken in any particular period,
also considers their effects over several future periods. When several
alternative combinations of parameter anges are available for securing of
the ends of any given period, the task of long-term policy is then to oose
those measures (that combination of parameter anges) whi in some
sense makes the task of securing the objectives of future periods as simple as
possible; as an indicator of the degree of simplification we may take the
number (or magnitude) of the parameter anges that will be necessary in
the future. Su a long-term policy view may very well mean that in some
particular period the State will oose a more complicated and difficult
policy (that is a larger number of parameter anges) to aain the ends set
up for the period in question than was strictly necessary from a short-term
point of view.
By referring to the example used in section 5, we can illustrate fairly
simply the difference between short-term policy and long-term policy with
given successive single-period ends. In section 5 we assumed an initial
situation of stationary equilibrium whi is disturbed by a fall in State
purases of labour. e special long-term problem may then be posed
whether it is possible for the State to ange its parameters during period 1
(the first period, in whi the disturbance occurs) in su a way that the
ends of a constant price level of consumer goods and full employment,
during both the present and future periods, will be fulfilled without further
measures (parameter anges) having to be taken in the future. It is clear
that this result will be aieved if it is possible during the first period to
oose su measures that the sto of real capital and the claims of the
private sector on the State both remain unanged. If the State succeeds in
doing this, conditions in period 1 will be repeated unanged during all
subsequent periods (until a new disturbance eventually occurs). In this
particular case, the task of long-term policy is immediately to establish
another stationary equilibrium. is is aieved if to the original ends of the
first period (an unanged price leyel of consumer goods and full
employment), the State adds two new auxiliary ends, unanged production
of capital goods and balance in the budget (in the ‘real economic’ sense), and
if it then takes the appropriate measures to secure these four aims.3 e
reason why this long-term policy will, in its immediate impact, appear more
complicated than the short-term policy whi is only directed towards
securing full employment and unanged price level without regard to the
future, is that the number of ends, and thus also the number of measures, in
the first period are different with the two types of policy. If policy is directed
only to securing full employment and a constant price level in the period in
question, we have two ends, and generally two measures will be needed;
long-term policy, on the other hand, also seeks to secure unanged
production of capital goods and balance in the budget in that same period
(in order to secure the ends of the future periods), and this means that four
ends, and consequently also four measures, as a rule, are involved. In the
long run the difference between short-term policy and this particular long-
term policy is that although the short-term policy requires only two
parameter anges per period, it will require su anges within every
future period too, while the long-term policy requires four parameter
anges in the first period, but requires no further anges in future periods
(when the parameters need only be maintained at their new values).
If short-term policy and long-term policy are in this way confronted with
the same task, the same series of single-period ends, our example thus shows
that the aracteristic of long-term policy is that a larger number of
measures must be taken immediately than with short-term policy. Whi
type of policy is to be preferred thus seems to depend on the State’s
expectations for the future. For example, it hardly seems reasonable to
pursue the above mentioned long-term policy during any particular period
in order to secure the ends indefinitely if no other disturbances occur, when
it is already expected that further disturbances will in fact occur in the next
period (even if their nature is not yet known).
On the other hand, we should not ignore the fact that the State’s planning
horizon will generally also be crucial for the number of measures required
by long-term policy itself, although this fact did not emerge from the
example we have just been using. Even though things may be different in
special cases, su as the one we have just considered, the general rule of
thumb is that the number of parameter anges whi must be taken in
order to secure the single-period ends over a certain number of periods will
be the same, regardless of whether that policy is conducted by means of
long-term or short-term measures, that is regardless of whether the
parameter anges are made successively or all together during the first
period. is will be seen immediately from our general arguments in
Chapter I, see especially sections 2 and 4, and is the direct consequence of
the general rule of thumb about the number of ends being equal to the
number of means. All we have to do here it to count the ends in ea period
as separate ends, and ea parameter ange (even if it is the same
parameter whi is anged in different periods) as a separate means. Once
this has been understood, the question of the advantages and disadvantages
of long-term policy as compared to short-term policy will present itself in a
different light. It might be thought that if the number of parameter anges
is generally the same, it does not mu maer whi type of policy is
osen. As we shall see, however, there are nevertheless certain differences
between the two types of policy whi make the State prefer one type or the
other, or possibly a combination of both.
In order to fix our ideas we shall discuss a problem whi from a practical
point of view is very, important for fiscal policy. Let us assume that the unit
period of our model is three months and that the aim of the State is to keep
ea quarterly index of the consumer goods prices unanged; for the
moment we disregard the aim of full employment. Furthermore we imagine
that the State’s ‘horizon’ extends over one year, the financial year. ‘e short
run’ is then a quarter; ‘the long run’ one year consisting of four quarters.
Now if fiscal policy is built up of purely short-term measures, so that the
price index for ea quarter is kept constant without consideration of what
the index will be in the following quarters, the State must take four
measures, one in ea quarter, in order to secure an unanged price index
throughout the year. Naturally, there is nothing here to exclude the
possibility in principle that it is the same parameter whi is anged four
times during the course of the year. If, on the other hand, fiscal policy is
arranged as a long-term policy, the ends—an unanged index in the four
quarters—could be secured, if, at the beginning of the year, in the first
quarter, the State took four simultaneous measures whi together would
have the effect of securing an unanged price index during the four
quarters. It will, of course, be realized that in this case four different policy
parameters must be anged at the beginning of the year, and that the new
values of these parameters must then be maintained for the rest of the year.
From a fiscal policy point of view, su a long-term policy of anging the
fiscal policy parameters only once per annum, at the beginning of the
financial year, seems particularly appropriate. For purely legislative and
administrative reasons, the financial year (or possibly the calendar year) is
the natural planning period for a very large part of State revenues and
expenditures; it is difficult to ange income tax regulations except for a
year at a time, and the same thing applies to most other taxes; levels of
expenditure are also to a large extent fixed annually, or even over some
longer period. From a fiscal policy point of view, therefore, a policy whi
requires parameter anges during the course of the year is oen impossible
to put into effect in practice, and this is one of the most common arguments
used against fiscal policy as an instrument of economic policy. It is therefore
important to the understanding of the possibilities of fiscal policy, to
establish the fact that even though the ends involve the price level being
secured in every period (i.e. in ea quarter of the year), and even if the
variables to whi the ends refer form part of a dynamic model in
movement, and even if, finally, the ends are to be secured by use of fiscal
policy means, this still does not mean that the fiscal policy parameters must
necessarily ange continually during the financial year. It is possible in
principle to make certain parameter anges right at the beginning of the
financial year su that they will be sufficient to secure the aims during the
course of the financial year, in spite of the fact that the fiscal-policy
parameters are then kept unanged during the rest of the financial year.
e condition for this is generally that at the beginning of the financial year
the State shall have as many different parameters at its disposal as the
number of aims during the course of the year (whi equals the product of
the number of periods and the number of ends per period).
From a monetary policy point of view, however, short-term policy seems
to be preferable. If the price level is to be kept unanged from quarter to
quarter and if this can be brought about by means of one parameter ange
per quarter, there are (normally) no legislative or administrative obstacles to
leing the parameter whi is anged ea quarter be the rate of interest; in
principle, four successive interest anges during the year would suffice to
fulfil the ends.
When confronted with exactly the same series of single period-ends, there
is thus mu to be said for arranging fiscal policy as a long-term policy, with
parameter anges only at the beginning of the financial year, and for
arranging monetary policy as a short-term policy, with parameter anges
several times during the year. e ends whi are thus brought about by
fiscal policy or monetary policy may be exactly the same; for example,
unanged quarterly index numbers for the price level throughout the year.
As will be seen there is nothing to prevent long-term policy from
combining fiscal policy and monetary policy in various ways through time
in order to bring about a certain series of single-period ends. Suppose, for
example, that the State wishes to secure a constant price level and full
employment every quarter. For the whole financial year there are then eight
ends whi are to be aieved and this generally requires eight parameter
anges during the year. e State may then conduct either a purely short-
term policy, or a purely long-term policy (where parameter anges are
undertaken only at the beginning of the financial year) or, finally, a long-
term policy where certain parameter anges are undertaken at the
beginning of the year and certain parameter anges during the course of
the year. Suppose that with the purely short-term policy it is possible to use
the rate of interest and income taxation; in ea quarter the State must then
ange the interest-rate as well as income taxation in a suitable way. e
disadvantage of su a policy is that income taxation has to be revised
several times within the financial year. With a pure long-term policy the
State must make anges in no less than eight different parameters at the
beginning of the financial year, let us say the rate of interest, income
taxation, the direct consumption tax, etc. e disadvantage of su a long-
term policy is of course the comparatively large number of different
parameters whi has to be used. But with the other sort of long-term policy
the State still has to bring about anges in, say, four different fiscal policy
parameters at the beginning of the financial year, but also anges the
interest-rate once in ea quarter of the financial year; all these anges
must, of course, be co-ordinated and determined at the beginning of the
financial year. us the number of different parameters will be decreased,
without increasing the number of anges in the fiscal policy parameters.
e importance of this emerges particularly clearly if it is imagined that the
ends are constant quarterly index numbers for the price level, but full
employment every month. In principle, sixteen parameter anges would
here be necessary during the course of the year. e number of parameters
whi will be used need however not be larger than five, if the State is
willing to make appropriate anges in the rate of interest ea month; the
ends may then be secured by anging four different fiscal policy parameters
at the beginning of the financial year, and the rate of interest every month.
It therefore seems that the shorter (relatively to the financial year) the
period to whi ends refer, the more reason there is to include a fluctuating
interest-rate among the means used; the argument assumes, however, that
anges in the rate of interest are planned well in advance and in connection
with long-term fiscal-policy measures. e fluctuating rate of interest that
we have employed here is not a short-term means. Furthermore, it is
assumed that the effects of anges in the rate of interest appear very
rapidly, see Chapter XIX, 4.
 Finally, one particular circumstance may be pointed out favouring the use
of long-term measures in aieving a series of single-period ends. e model
considered may have su properties that with long-term measures the
number of parameter anges becomes less than with short-term measures.
e special case whi we considered at the beginning of this section had
precisely the quality that, if the number of periods is greater than two, the
long-term measures will involve a smaller number of measures (i.e. four,
irrespective of the number of periods) than the short-term measures (where
the number is two multiplied by the number of periods).
All the arguments in this section are based on the implicit assumption
that the State has a reliable prognosis over the number of periods to be
covered by the long-term measures. e possibility that the prognosis may
be wrong—either due to faulty appreciation of the relationships in the model
or due to unexpected disturbances from outside—is of course a fact whi in
itself favours a short-term policy. e State avoids the trouble of anging
parameters in every period only at the cost of anging a larger number of
parameters, and if unexpected events occur during the time when these
long-term measures were to have secured the ends, (some of) the long-term
measures will have been taken in vain. Uncertainty about the future always
favours short-term measures.

7. LONG-TERM PROBLEMS III: MULTI-PERIOD ENDS

In sections 5 and 6 we have discussed long-term problems under the
assumption of a given model, with a given period, and with only single-
period ends. If we maintain the idea of a given period, the establishment of
long-term ends will be identical with the establishment of multi-period ends.
Examples can easily be given; e.g. it is natural to formulate the end of a
stable value of money as a long-term end, requiring the average price level
of consumer goods for the (calendar or financial) year to be constant; su
an interpretation of the idea of a stable value of money would have the
advantage, among other things, that the State would not have to worry
about the regular seasonal anges in the prices of consumer goods;4 other
types of multi-period ends are, for instance, that during the course of a
certain number of periods, a certain price level, exange reserve, etc., must
be aained.
In a certain sense a multi-period end will always be easier to bring about
than a series of single-period ends extending over the same number of
periods. Compare, for example, the task of keeping ea quarterly index of
the level of prices constant during a financial year, with the task of keeping
the average of these four indices constant; the former task requires four
measures, the laer only one, irrespective of how many disturbances appear
during the course of the financial year (provided that these are correctly
foreseen).
On the whole, the general rule of thumb that ea end requires one means
(or more correctly, one measure), can be applied to multiple-period ends just
as to single-period ends. Just as single-period ends are restrictions imposed
on the endogenous variables within a period, multi-period ends are
restrictions embracing the values of endogenous variables over several
periods. And since a certain measure (as we interpret this concept) means
the determination of the value of a parameter not only for the period in
question but also for the relevant periods in the future, our general
argument as to the number of ends and the number of means (measures) has
an immediate relevance also for the multi-period problem. is will then
also mean that the more the ends are formulated as multi-period ends
instead of as series of single-period ends, the easier it will be to aieve these
ends, in the sense that the number of necessary parameter anges will
decrease.
As may be seen, the aainment of multi-period ends does not necessarily
require long-term measures, even if it seems natural, and in certain cases
may even be necessary, to apply su measures. If, for example, the State is
to ensure that the average price level during the financial year is kept at a
certain level, this may in principle be aained by the State allowing the
price level to move freely during the first three quarters of the year, in order
to make during the last quarter of the year whatever measure is necessary to
ensure that the ange in the price level in the last quarter will offset the
movements in the price level that occurred during the first three quarters; in
this case the measure taken in the last period will be a short-term one. Su
a policy will, however, in general hardly correspond to the intentions of
those who set up the end of a constant average price level.
 8. THE MODEL AND THE LENGTH OF THE PERIOD
In the foregoing we have side-stepped the question of the significance in
clock-time of the expressions ‘short-term’ and ‘long-term’ by using these
expressions in connection with a given model with the length of the period
given. Now if purely theoretical considerations led a priori to a determinate
period length, in principle our method would not involve anything arbitrary.
ere is, however, no theoretical length of period whi is the ‘correct’ one
in general. It is true that there exists in abstract dynamic theory a well-
defined (maximum) length: the period must be so short that plans are
unanged. But in models that are applied in practice, through aggregation
over time using certain approximations the period can be made arbitrarily
long. For practical purposes we are oen obliged to let the length of the
period be determined by the available statistics, or, what is of particular
interest here, by the time dimension of the ends that have been set up. It
may be asked whether this circumstance might not be of some importance
to the discussion of long-term problems; for what appears as a multi-period
end in a model with a short period, will be a single-period end in a model
with a longer period. is fact does not, however, in itself affect the
discussion above. As we pointed out there, the rule, that the State must
generally be prepared to take one measure for ea end, applies to both
single-period ends and multi-period ends. us it is of no great importance
to the outcome as regards the number of measures, if, when anging from a
series of single-period ends to a multi-period end, the length of the period
used in the model is also anged in su a way that the new multi-period
end will appear as a single-period end in the new model. Suppose, for
example, that the State has been pursuing the ends of unanged quarterly
indices of the price level during the financial year, and that the model has
been using a quarter as its period; four measures per financial year will then
be necessary in general. If the ends are now anged so that they refer to an
average of the quarterly indices, the number of measures will decrease to
one in the old model, and this will not be affected if, at the same time as the
ange in the ends, we ange to a model whi is more aggregated from the
point of view of time and in whi the financial year is the period, for here
too one means will be sufficient.
 On the other hand, the length of the period in the model may influence
the policy problem in a decisive way in other respects. When the length of
the period is increased by aggregation through time, the structure of the
model may ange fundamentally, e.g. from being purely recursive to being
purely interdependent, and it has already been shown in Chapter I that the
structure of the model may itself be important to the policy problem in
several respects.5

1. Regard should, in principle, also be paid to the fact that interest

payments by the State ange from period to period.
2. e reason why we do not use the expression ‘single-period measure’ in
the same way as the expression ‘single-period end’ is as follows. A
single-period end is an end whi only concerns entities within one
period. If a single-period end is realized, this would not mean that the
end-variables would automatically have the same values in the future.
By a measure is meant a parameter-ange; a measure therefore implies
that the value of the parameter is fixed not only for the period in
question but for all future periods until a new ‘measure’ is taken to
ange it. If a parameter is to take a certain value for one period only,
two measures are necessary; one when the parameter is given this value
and the other when it is restored to its original value.
3. From a formal point of view, the problem thus reduces, to some extent
at least, to that treated in Chapter XIII, 3 (ii), where the State is assumed
to increase its purase of labour, and an unanged price level and full
employment are secured on the assumption of unanged capital goods
production. By analogy with the result there, a reduction of consumer
goods taxation, a certain ange in income taxation, and an increase in
either the rate of interest or the indirect capital goods tax, should be
sufficient to aieve the end. A balanced budget now appears as a
further end. However, as the above set of means gives a free oice
between an increase in the rate of interest and in the indirect tax in
capital goods, it must be possible by simultaneous use to the appropriate
extent of both these means to make the budget balance.
4. Cf. the norm of the Swedish central bank during the early ’thirties; see
Erik Lindahl, ‘Sveriges Riksbanks konsumtionsprisindex’ (e Consumer
Price Index of the Swedish Riksbank).
5. is problem is further dealt with by Ragnar Bentzel and Bent Hansen
in ‘On Recursiveness and Interdependency in Economic Models’, Review
of Economic Studies 1954–55.
 CHAPTER XVII

Fiscal Policy and Wage Policy

1. MONEY WAGES IN THE ECONOMIC SYSTEM
UP to now we have regarded private money wage-rates as an externally
determined variable whi the State cannot control, and whi is not
immediately affected by anges in other variables in the economic system.
Expressed in our terminology, money wage-rates are regarded as an
uncontrollable parameter. In real life this corresponds to a situation where
money wage-rates are determined by agreements between organizations in
the labour market and where the results of wage negotiations cannot be
‘explained’ within the framework of an economic model. is treatment of
money wages is not entirely satisfactory, however.
In the first place, even in a modern democratic, private-enterprise,
capitalist society, the State may have a more or less direct influence on the
determination of wages. is is especially so in countries where the State has
assumed direct responsibility for wage-determination, either by means of
legislation or by special institutions su as courts or commiees, as for
example, in Australia and the Netherlands. e influence may be more
indirect, as when the State makes pronouncements or recommendations, or
if the labour market organizations know that the State may take action if
‘reasonable’ solutions are not arrived at by negotiation. e State may even
influence wage negotiations without taking any actual measure at all. In a
country su as Sweden, it may sometimes be possible for a Socialist
Government to influence the claims made by trade unions, whereas a
government comprising ‘bourgeois’ parties may have similar opportunities
of influencing employers’ demands. In all su cases, money wage-rates can
be regarded as a controllable parameter in models su as ours, that is as an
economic means. Money wages may then, to a greater or lesser extent, be
adapted to the general economic policy of the State and thus to the ends of a
stable value of money and full employment.
 Even so we have not yet considered all the relevant aspects of wage-
determination. To some extent, anges in money wages can doubtless be
explained from the development of other economic variables. e relation
between supply and demand in the labour market may, in certain situations,
affect money wage-rates; the development of the price level, anges in the
standard of living of the workers, anges in income distribution, the
expansion of the profits of firms, expectations of anges in productivity,
and other economic factors may directly influence the wage claims of
organizations and the results of negotiations.
It is difficult to include all these varying facets of the process of wage
determination in simple formulæ. It may be that it is necessary to use many
kinds of theoretical tools in order to deal with the various problems of wage
theory. It is from all this that the well-known difficulties encountered in
wage theory spring.1 In this apter we shall try to reveal at least some of
the more important aspects of the role played by money wages in our
problem, firstly (in accordance with the previous apters), by regarding
money wages as an uncontrollable parameter, whose movements the State
cannot influence at all, and whi tend to arise quite spontaneously (that is
without any economic explanation), then by regarding money-wages as a
parameter, fully controllable by the State, i.e. as a means of economic policy,
and finally by regarding money wages as a purely endogenous variable,
assumed to be fully dependent in some way upon the system under
consideration. We shall not try to aieve the difficult feat of bringing these
extreme cases together so as to describe, approximately, some actual process
of wage determination. Nevertheless, what follows should be of some help in
selecting a suitable fiscal policy for various wage-policy situations; we shall
also outline a proposed fiscal policy whi might give the State complete
control over the movements of money wages.

2. SPONTANEOUS CHANGES IN MONEY WAGES

Following our earlier method of exposition, we will now discuss
spontaneous anges in the average money wages both of all workers
employed in private firms and also of particular groups of workers, e.g.
workers in the consumer goods or capital goods industries. us by
regarding broad groups of workers, ‘spontaneous wage anges’ will include
anges in average wages due to the ‘inner dynamics’ of the wage structure.
is inner dynamic of the wage structure arises because wage anges for
certain groups of workers generate wage demands and thereby wage
anges for other groups, whi will then react ba upon the first group,
and so on. e general opinion seems to be that this ‘inner dynamic’ plays a
very important part in the development of average money wages.2 We shall,
nevertheless, ignore this type of problem, and consider only those broad
anges in average wages whi may reasonably be assumed to arise
spontaneously with respect to our model.

(i) A General Increase in Wages within Private Firms

If we imagine a uniform, proportional wage increase within all firms,
then, if we adhere to the short-term model of Chapter XIII, the prices of
consumer and capital goods must rise by the same percentage as wages have
risen, if full employment is to be maintained with an unanged distribution
of labour between the consumer and capital goods industries, and if no other
special compensatory measures are taken. Profits will then rise by the same
percentage, so that both total wage income from private industry and the
total incomes of entrepreneurs (before subsidies and taxation) will rise in the
same proportion as the price level of consumer goods. If the wages paid by
the State are not raised, total factor incomes will not rise as mu as the
price level of consumer goods; furthermore, if direct subsidies, including
interest on the national debt, are not increased, and income taxation is
progressive, this applies a fortiori to disposable incomes. With unanged
State demand for consumer goods, therefore, the total output of consumer
goods will not be sold at the higher prices, unless the rate of income tax is
reduced to su an extent that real disposable incomes are the same as in the
initial position. Obviously, households with income originating from private
industry will get an increase in real income at the expense of households
with incomes from the State. Even if both wages of civil servants and direct
subsidies, etc., are increased so as to keep step with wages in the private
sector, a reduction in income tax rates is still necessary if income taxation is
progressive.
 With our rather general assumptions equilibrium in the capital goods
market will hardly be disturbed. We have assumed that the demand for
capital goods from the private sector depends on the magnitude of consumer
goods production, on the price of capital goods, and on the rate of interest. If
equilibrium has been established in the consumer goods market with
production unanged, and furthermore, if the monetary authorities keep
the rate of interest constant, the demand for capital goods can only
conceivably be anged as a result of an increase in the prices of capital
goods. However, it should be remembered that properly speaking, our idea
was that the demand for capital goods be dependent on the relative prices of
consumer and capital goods, and not on the absolute price level of capital
goods; the reason why, for the sake of simplicity, we have only discussed the
effects of anges in the price level of capital goods, is that we have been
assuming throughout that the price level of consumer goods is constant. If
the demand for capital goods depends on the relative prices of consumer and
capital goods, there will consequently be no tendency for the demand for
capital goods to ange. us if we allow all prices to rise in the same
proportion as money wages, a decrease in income taxation is a sufficient
means to secure full employment equilibrium. In the case where the wages
paid by the State, and direct subsidies, rise in the same proportion as prices
and other wages, this revision of income taxation may be brought about in
su a way that the real disposable incomes of all households remain
unaffected, except for the shis between creditor and debtor households, see
Chapter XIV.
Our task, then, is to find some means of keeping consumer goods prices
constant too, despite the increase in wages. If we ignore the possibility of
restricting consumer goods production so as to increase marginal
productivity within that industry, the only means is to reduce the indirect
tax rate (or introduce a subsidy) on consumer goods. e indirect tax
(subsidy), whi is lowered (raised), can take the form of a tax (subsidy)
either on sales value or on wage costs; the particular form osen is of some
importance for the distribution of income.
Let us first consider a decrease in an already existing general tax on
consumer goods su that with unanged production the price level of
consumer goods will be the same as in the initial position despite the
increase in wages. e total sales value of consumer goods then remains
unanged, while with unanged income tax rates, total disposable incomes
will have risen somewhat. Income tax rates must therefore be increased.
Obviously in this case the revision of income tax can be brought about in
su a way that the (real) disposable income of ea household will remain
the same as in the initial position (disregarding the problem of creditor and
debtor households) if civil service wages, direct subsidies, etc., increase in
the same way as wages in the private sector. e capital goods market is
likely to be influenced rather as if consumer goods prices had been allowed
to rise. It is true that now the relative ‘market’ prices of consumer and
capital goods will have anged, but it is the relationship between these
prices ‘at factor cost’ that is relevant, and this remains unanged.
It is obvious that in both the cases now under consideration the ange in
income taxation can also be effected in su a way that the distribution of
real disposable income is shied to the advantage or disadvantage of the
lower income groups, but su a ange in the distribution of disposable
incomes is not in itself brought about by the underlying increase in money
wages. e distribution of wage incomes earned within the private sector is
not affected, for all these incomes increase in the same proportion. e
anges in income distribution whi arise in connection with the revision
of income taxation could just as well have been brought about by su a
revision in isolation. On the other hand, it must not be forgoen that this
revision of income taxation is part of the State’s policy of maintaining an
unanged price level at full employment, and consequently that some
revision of income taxation has to be made. At the same time, since the
outcome with respect to the distribution of incomes is indeterminate, in so
far as the State can bring about the desired size of the total demand for
consumer goods by means of many different variations in the distribution of
real disposable incomes (and total disposable incomes will probably also
have to be different with different tax scales), it will be seen that as regards
the distribution of disposable incomes, the final result of the wage increase
will be in the hands of the State. us if the State wishes a wage increase to
result in a ange in the distribution of incomes to the advantage of wage-
earners, or rather to the advantage of the lower income groups, it is quite
possible for the State to bring this about. In fact, as soon as the State has
ends whi must not be disturbed by a wage increase, in introducing certain
means in order to secure these ends, the State necessarily takes over the
solution of the problem of income distribution. However, it is clear that if
the idea of the wage increase was to bring about a ange in income
distribution to the advantage of wage-earners, and if the State then conducts
its policy so that with unanged levels of prices and employment this
ange is actually brought about, then the whole process is rather like
craing nuts with a sledge hammer; instead of the wage increase
accompanied by a decrease in the indirect tax rate on consumer goods and a
revision of income taxation as regards income distribution, an isolated
revision of income taxation could give the same results by mu simpler
means. However, our problem here is not to point out the simplest way of
aieving a certain ange in the distribution of income, but to discuss the
ways in whi the price level and the level of employment can be insulated
from a ‘spontaneous’ wage increase, whi is considered to be taking place
anyway.
e problem of distribution appears in another light if, as an alternative to
the decrease in the consumption tax (or increase in subsidies on consumer
goods), we consider the introduction of a wage subsidy (a decrease in the tax
on wage costs) within the consumer goods industry. For here a ange
occurs in the distribution of factor incomes, that is of incomes before direct
taxes and subsidies, to the advantage of the wage-earners. While wage
incomes before income tax, etc., emanating from the private sector will rise
in proportion to the wage increase, profits before income tax, etc., within the
consumer goods industry will be exactly the same as before the wage
increase.
 Fig. XVII: 1

is is most easily seen by reference to Fig. XVII: 1, whi represents a

consumer goods firm producing a quantity q at price p with a marginal cost
curve mc; only wage costs are assumed to enter the marginal costs. In the
initial position, before the wage increase, the marginal cost curve is mc1 the
quantity produced q1 and the market price p1. We now suppose wages to be
increased so that the marginal cost curve is moved from mc1 to mc2. If
production is still to be q1, either the net price (= market price+subsidy per
unit) has to be raised to p2, or else the marginal costs (= wage cost—wage
subsidy) have to be reduced from BD to BC. e wages paid out by the firm
will, in all circumstances—at production q1—rise from OBC to OBD. With a
subsidy (decrease in consumer goods tax) whi varies in proportion to
production, the entrepreneur’s income will increase from AOC to EOD =
AOBC—OBD+EACD, but with a wage subsidy (decrease in tax on wage
costs) it will remain unanged at AOC = AOBC—OBD+OCD. Since OCD
must always be less than EACD (otherwise gross profit is negative or zero in
the initial position and production will generally not take place) the
insulation of the effects of the wage increase by means of a subsidy on wage
costs will involve a ange in the distribution of factor incomes to the
advantage of the wage-earners), compared with the case where a decrease in
the tax (or increase in the subsidy) on consumer goods is used.
In the case of wage-cost subsidies, an increase in income tax rates will
again be necessary if the demand for consumer goods is not to exceed the
supply at the unanged market prices. e sales value of the output of
consumer goods is unanged, while total disposable incomes of workers as
well as of entrepreneurs will have risen (with income tax rates unanged).
However, with ‘equal’ anges in tax rates, there will still remain a ange
in the distribution of disposable incomes in favour of the workers, this
ange being due to the underlying wage-increase, or rather to the way in
whi its cost effect on the prices of consumer goods has been eliminated.
e real disposable incomes of workers will rise, those of entrepreneurs will
fall, while within the entrepreneur class itself, a further redistribution will
take place from those in the consumer goods industries to those in the
capital goods industries.
ere now remains for consideration the case where policy is conducted
so that simultaneously with the wage-increase, labour is transferred to the
consumer goods industries in order ‘to create room’ for the wage-increase. A
basic condition for su a transfer of labour is that the demand for capital
goods is decreased (for example via the rate of interest) so mu that the
capital goods market is in equilibrium despite lower production; because of
the higher marginal productivity, the price of capital goods will then fall
compared with the case where no transfer of labour takes place; the question
whether it will decrease as compared to the position before the wage
increase depends on the elasticity of supply within the capital goods
industry. In the consumer goods industry, marginal productivity will
decrease owing to the transfer of labour. e consumption goods tax rate (or
wage cost tax) must therefore be decreased more than the wage increase
itself. e sales value of the output of consumer goods will increase in
proportion to the increase in the volume of production of consumer goods.
e incomes earned by workers will rise in proportion to the wage increase;
the entrepreneurs’ incomes will also rise in proportion to the wage increase,
unless the cost-raising effect of the wage increase and the decrease in
productivity have been eliminated by means of a wage subsidy, in whi
case, the entrepreneurs’ incomes will rise less than proportionally. We
assume here that the shi in production will not in itself affect the
entrepreneurs’ total incomes; this will depend on the relationship between
productivity in the capital goods and consumer goods industries. If this
laer complication is ignored, it can be seen that with unanged prices and
income tax rates, some increase in the demand for consumer goods will arise
and this increase in demand will be independent of the magnitude of the
shi in production under the assumption mentioned above. On the other
hand, an increase in supply will occur in the consumer goods market, the
size of whi is dependent on the size of the shi in production. It is then
obvious that there will always exist a shi in production of su a size that
the consumer goods market will be brought into equilibrium with income
taxation unanged. en an increase in the rate of interest together with a
decrease in the consumption goods tax (wage cost tax), or possibly the
introduction of the corresponding subsidies, will be sufficient means to keep
the price level of consumer goods constant and maintain full employment
while production is shied to some extent. e disposable incomes of both
workers and entrepreneurs will increase. If income tax is progressive, and if
the average income of entrepreneurs is higher than the average income of
workers, the real disposable incomes of the entrepreneurs will rise less than
those of the workers. A ange in the distribution of income will thus be
brought about and this ange will be more marked if the State lowers a
wage cost tax rather than a consumer goods tax.

(ii) Partial Wage Increases

Let us first assume that wages only increase in the consumer goods
industry. If production and employment in this industry are to remain
unanged with unanged prices for consumer goods, a decrease in the
indirect tax on consumer goods must be brought about (here we are
disregarding the possibility of wage-cost subsidies, but the argument can
easily be extended to include this as well). ose wage incomes and
entrepreneurial incomes whi are derived from the consumer goods
industry will then rise by the same percentage as money wages have risen. If
employment and production in the capital goods industry are to remain
unanged, the price of capital goods must be unanged as well. Since the
demand for capital goods will probably rise, however, (because the price of
consumer goods ‘at factor cost’ has risen), some increase in, say, the rate of
interest will be necessary. But with higher total factor incomes, total
disposable incomes will have risen, even with progressive income taxation,
while the sales value of the output of consumer goods is unanged. Some
increase in income tax rates will thus be necessary (ignoring the effect of the
interest rate on saving), whi in turn will mean that the workers and
entrepreneurs in the consumer goods industry will get higher real disposable
incomes, at the expense of those engaged in the production of capital goods
and those households receiving their incomes from the State.
Alternatively, if wages rise only within the capital goods industry, the
production of consumer goods will not be affected immediately. If
production and employment in the capital goods industry are to remain
unanged, the price of capital goods must rise in the same proportion as
wages have risen. us sales tend to decrease; the demand for capital goods
must then be stimulated by a lower rate of interest. e factor incomes of
workers and entrepreneurs in the capital goods industry will then have risen
by the same percentage as money wages. Even with progressive income
taxation an increase in the total disposable incomes will be brought about,
and there will thus be a tendency for the demand for consumer goods to
increase. As the supply of consumer goods is unanged, income tax rates
must be increased. In this case the workers and entrepreneurs in the capital
goods industry will have higher real disposable incomes at the expense of
workers and entrepreneurs in the consumer goods industry and households
with incomes from the State.
A decrease in the indirect consumer goods tax combined with a rise in the
rate of interest and an increase in income taxation are therefore sufficient
means in the case of an isolated wage increase in the consumer goods
industry; with an isolated wage increase within the capital goods industry, a
fall in the rate of interest combined with an increase in income taxation are
sufficient means to ensure an unanged consumer goods price level and full
employment.

3. CHANGES IN MONEY WAGES AS A MEANS OF ECONOMIC POLICY

In this section we shall assume that the State has direct control over money
wages in the private sector—the State may have been given the legal right to
determine wage rates in the private sector. We also assume that the wages
laid down by the State become effective, so that the money wages are then a
State parameter, and may be used as a means of economic policy. e
relevance of arguments based on these assumptions is not restricted to this
rather special institutional case, however, for the effects of a certain ange
in money wages will be exactly the same in principle, whether the ange in
wages is brought about by official decree or by negotiations between labour
market organizations. Moreover, as we shall see in the next section,
determined by private organizations independently of the State, money
wages sometimes tend to ange in association with precisely those
disturbances in the economic system whose effects the State might possibly
counter by means of wage anges if the State had direct control over
money wages. By discussing money wages as a policy means, we shall come
across cases where privately negotiated wage anges will be regarded by
the State as a welcome reinforcement of its own actions. Endogenously
determined wage anges may, in certain cases, be considered to facilitate
the aievement of the ends of stable value of money and full employment—
the invisible hand envisaged by Adam Smith would then work via wage
anges to the advantage of the State, although the contrary may also be
imagined. We shall return to this subject later. Our problem here is simply to
discover those cases in whi a certain wage ange will facilitate the policy
of the State in the sense that the wage ange will make certain fiscal or
monetary policy measures superfluous.
ere is no great difficulty involved in giving general pictures of the cases
where a ange in money wages will appear as a suitable policy measure. It
is customary in wage theory to say that in a macro-economic model, the
effects of anges in money wages may be divided into cost effects and
demand effects. Money wages are simultaneously a cost-determining item
within the firms and a revenue item for the workers, and from the laer
viewpoint are consequently also a determining factor in the demand for
goods and services.3 We may illustrate this by considering the part played
by money wages in our model in Chapter XIII. Here, it will be seen that the
effects of a general increase in money wages by k% will be equivalent to the
combined effects of a k% tax on the wage cost of firms and of su a
reduction in the rate of income tax on workers that their disposable incomes
are the same as they would have been with a wage increase of k% and
unanged income tax rates (the average tax rate for a given household
must then be decreased by k/100 · (1—tm) where tm is the marginal tax rate
paid on the previous scale). It could then be said that the effects of the tax on
wage costs are an expression of the ‘cost’ effects of wages, while the effects
of the reduction in income tax are an expression of the ‘demand’ effects of
wages. Furthermore, since a general tax on consumer goods has the same
effect in our model as the wage tax (except for certain effects on income
distribution mentioned earlier) then, loosely speaking, the effects of a wage
increase are equivalent to the effects of a certain increase in the rate of
indirect tax (in whatever field of production is affected by the wage increase)
and a certain decrease in the rate of income tax. It will be seen that this is in
fact only another way of expressing the finding of the previous section that
the effects on the price level and on employment of a general increase in
wages can be offset by means of a decrease in indirect taxation and an
increase in income tax.
We therefore come to the following conclusion: a wage increase will be a
suitable means for stabilizing the level of employment and the price level for
consumer goods in those cases where the State would otherwise have to
apply an increase in the rate of indirect tax on consumer goods together
with a reduction in income tax. e converse is obviously true of wage
decreases. An examination of all the various types of disturbance treated so
far, will therefore indicate those cases in whi a wage increase and those in
whi a wage decrease would be a suitable means of stabilizing the value of
money and ensuring full employment. But this does not mean that in these
cases the wage ange would replace both the means mentioned. On the
contrary, in general the wage ange can only completely replace one of
these means, namely the ange in the tax on consumer goods. Nor does it
follow that these are the only cases where a ange in wages is a suitable
means, but this brings us to the question of the so-called ‘room for wage
increases’, whi can be best dealt with in a section of its own.

4. ECONOMIC POLICY AND THE ‘ROOM FOR WAGE INCREASES’

In post-war economic discussions in Sweden and other countries the
problem of the so-called ‘room for wage increases’ has become a central
topic. It is therefore appropriate to deal with the problem here as it can best
be analysed as an end-means problem in our sense of those terms. As we
shall try to show, the concept of ‘room for wage increases’ has an
unambiguous meaning only in connection with a definite set of ends and
when the means that are to be used to bring this set of ends about have been
specified. is has been demonstrated more precisely and with more
generality in the appendix to this apter ‘On National Budgeting and the
“Room for Wage Increases”’. In this section we shall first give a general
account of the conclusions reaed in the appendix, and then proceed to
examine a few concrete examples, where the disturbing factor is assumed to
be a ange in productivity.
If economic policy has no definite ends, it is obvious that the ‘room for
wage increases’ is completely indeterminate. e fact that there are no ends
means that the endogenous variables in the model may take on any values
whatever. If money wages are a parameter in the model, they may be
arbitrarily increased without causing any conflicts. It is true that increases in
money wages will lead to anges in the values of those variables whi are
endogenously determined in the model, but as no restrictions have been
imposed on these variables there are no limits to the ‘room’ for wage
increases.
Consequently, if the concept of ‘room for wage increases’ is to mean
anything, it must be in connection with certain given ends for economic
policy. is is also the way in whi the concept has been used in general
debate. Normally the ‘room for wage increases’ is indicated by the condition
that the balance of the economy must not be disturbed. e ‘balance of the
economy’ can thus be regarded as an end in this context. But this concept,
advanced by Dag Hammar-skjöld in Sweden, is rather vague. If we look at
the manner in whi the ‘room for wage increases’ is very oen calculated
(i.e. via a balance of resources, where all items except private consumption
are given certain values and the value of consumption appears as a residual
indicating the ‘room for wage increases’) it seems that it is calculated by
assuming a certain level of employment and a certain price level. e
expression ‘balance of the economy’ may accordingly be interpreted as if it
involved two ends, that of securing a certain price level for consumer goods
and that of maintaining full employment.
Consequently, we may treat the ‘room for wage increases’ as a question of
the possibility of varying money wages in a situation where these two aims
are to be realized. If we now assume that the economic system is in balance
meaning that there is full employment and the price level is at the desired
level and not tending to ange through anything that is happening inside
the system—it is obvious that there is no ‘room for wage increases’ in the
sense that wages could ange without frustrating the aievement of the
ends. On the other hand, provided that sufficient fiscal or monetary policy
means are available (normally two su means are required) the effects on
the price level and on employment of an arbitrary ange in money wages
can always be offset; in this sense the ‘room for wage increases’ is again
quite indefinite.
Let us now assume that an existing ‘balance of the economy’ is disturbed,
say by a ange in productivity of some sort. Let us then treat a possible
ange in money wages as a measure, or at least as a welcome ‘counter-
disturbance’, whi helps to realize both the ends. As two means are
generally sufficient to aieve the two ends, it is obvious that the
introduction of money wages as a means reduces to one the number of fiscal
or monetary policy means required. In this respect wage anges may
therefore be said to facilitate fiscal policy. A prerequisite, however, is that
the ange in money-wages is of the appropriate size—money wages must be
so adjusted that the ‘room for wage increases’ is precisely filled. But the
particular measure whi accompanies the ange in money wages will, in
principle, be decisive for the size of the ange in money wages that is
appropriate in any given situation. Even here, then, the ‘room for wage
increases’ will be indeterminate, for if the wage ange is regarded as a
means, its size to be determined so that the ends of a stable price level and
full employment are not disturbed, then the direction and extent of the
necessary wage ange will also depend on what other means are
introduced at the same time in order to secure the ends, and normally one
further means must be employed. On the other hand, if it has already been
decided whi other means is to be combined with the wage ange, then
the ‘room for wage increases’ will be fully determined.
If, beside the possibility of anging money wages, there are several
further means that may be employed, the ‘room for wage increases’ will
again be quite indeterminate, for money wages can then be arbitrarily
anged simultaneously with the original disturbance without jeopardizing
the possibility of aieving the ends in principle by using the other means.
is is a direct consequence of the fact that we can regard the wage ange
as a new disturbance, and that the number of means necessary (normally)
depends only on the number of ends and not on the number of disturbances.
So far we have based our discussion on the ‘normal’ case where the
number of means must be the same as the number of ends. As we have
pointed out earlier in Chapter I, and also shown from time to time with
concrete examples, the structure of the model may be su that a certain
number of ends may be realized by a smaller number of means. is
possibility cannot be ignored when dealing with the problem of the ‘room
for wage increases’. If the structure of the model is su that with a given
disturbance a certain wage ange is sufficient to counteract the effects of
the disturbance both on the price level and on employment, then obviously
the ‘room for wage increases’ is uniquely determined. However, it ought to
be emphasized that this requires the model to have a very special structure.
Finally, it ought to be pointed out that when the ‘room for wage increase’
is calculated by means of a balance of resources, it is very oen assumed
that su factors as public consumption, public investment, private
investment and the foreign balance, etc., are to have certain values whi
can, at least partly, be regarded as special ends. However, this does not upset
the previous argument, if the introduction of these extra ends is
accompanied by the introduction of a similar number of means.
ese briefly summarized views on the question of the ‘room for wage
increases’, whi are dealt with in greater detail in the appendix, are
obviously decisive for the use of money wages as a means for stabilizing the
price level at full employment. e main result can be said to be that the
State must, as a rule, be prepared to employ one further means, and that the
nature of this means may be decisive for the appropriate size of the wage
ange, that is for the ‘room for wage increases’. is will now be illustrated
by the use of a few examples.

(i) First Example

Let us first consider the special case of a ‘uniform’ increase in
productivity presented in section 2 (v) of Chapter XV. We showed there, that
with unanged wages and provided that the distribution of labour between
consumer goods and capital goods industries is to be unanged, both the
price level for consumer goods and total employment may be kept
unanged by an increase in the indirect tax on consumer goods and a
reduction in income tax rates, combined with whatever ange in the rate of
interest that is necessary to aieve equilibrium in the capital goods market.
Here, a wage increase would obviously be an appropriate substitute for the
tax anges. Let us assume then that wage rates are increased by the same
percentage as the average and marginal productivities have increased. With
unanged prices for consumer goods and for capital goods, employment in
the two industries will then remain unanged and full employment is
ensured. Furthermore, if we adjust the rate of interest so that the demand for
capital goods is equal to the new (increased) supply at the unanged price,
there only remains the problem of equilibrium in the consumer goods
market. If we disregard the salaries of civil servants, the incomes of workers
and entrepreneurs have increased in the same proportion as the production
of consumer goods. Now if income tax were proportional and the marginal
and average propensities to consume were the same, the demand for
consumer goods would also increase in the same proportion, and
equilibrium in the consumer goods market would be established without
further measures (strictly speaking, however, this requires that the public
demand for consumer goods should increase by the same percentage). In
su a model the wage increase could thus replace the anges in both the
consumer goods tax and the income tax. However, if income taxation is
progressive and/or if the marginal propensity to consume is less than the
average propensity to consume, income tax rates must be reduced in order
to make the demand for consumer goods rise in the same proportion as the
supply. In accordance with well-known reasoning, we shall find that in this
case there is ‘room’ for an increase in money wages proportional to the
increase in average and marginal productivity. How the disposable incomes
of the workers are affected depends on the nature of the income tax
adjustment. If the marginal and average propensities to consume are the
same for every household, the tax revision may be carried out in su a way
that the disposable incomes of all individual households rise in the same
proportion as productivity. If, as is normally the case, the marginal
propensity to consume is lower than the average, this no longer holds, and
income tax rates must now be reduced to su an extent that disposable
incomes rise more than proportionally to productivity. Real incomes (i.e.
disposable incomes divided by the price level of consumer goods) will then
obviously rise proportionally more than productivity. Real consumption has
risen by the same percentage as productivity, but the real saving of
households has increased by a larger percentage, for with increased real
incomes, saving rises comparatively more than consumption. If we also take
account of the unanged State demand for consumer goods, real incomes
must then increase so mu that private real consumption will increase by
an even larger proportion than productivity. e notion that with a uniform
increase in productivity, real incomes can and must increase in the same
proportion as productivity is evidently untenable.
is example is interesting for two reasons. Firstly, because it shows that
in general it cannot be expected that the wage increase alone will offset the
effects of the uniform increase in productivity on the price level and on
employment, and it cannot therefore replace both of the tax anges that are
necessary in the case of unanged money-wages. Secondly, because it
brings out so clearly the reason why quite different results are usually
obtained according to whether the ‘room for wage increases’ is sought in the
cost sense and in the demand sense.4 e fact that these two types of ‘room’
do not normally coincide is simply an expression of the fact that one single
means is usually not sufficient to secure two different ends; one further
means must consequently be included in the calculation of ‘room for wage
increases’ if it is to have any precise meaning.

(ii) Second Example

Moreover, it is not simply a maer of introducing one further means in
order to aieve the (two) ends, and thus to make it at all possible to speak
of some determinate ‘room for wage increases’, but also that this ‘room’
becomes dependent on whi particular supplementary means is used. In
order to demonstrate this important result, in the case of a uniform increase
in productivity, we need only relax the postulate (i.e. the end) of unanged
distribution of labour between the two industries, and assume alternatively
that the ends of an unanged price level and full employment have to be
aieved by either of the following combinations of means; (1) a wage
increase and an interest ange, or (2) a wage increase and an income tax
ange.
Let us consider a model, su as our basic model, where the optimum
condition for the consumer goods industry (using the same symbols as
before) is

e marginal productivity f′, with given employment is then anged by k

per cent, while the consumer goods price level p, and the indirect tax rate on
consumer goods tC remain unanged. If the optimum condition is still to be
fulfilled, then wages must obviously be anged by exactly k per cent if
employment in the consumer goods industry is not to be affected. e
possibility that the ‘room for wage increases’ will differ from the k per cent
by whi productivity has risen (uniformly)—and consequently that the
‘room for wage increases’ will be dependent on the nature of the other
means whi must necessarily be introduced together with the wage ange
—is associated in su a model with the possibility that employment in the
consumer goods industry will be different with different combinations of
means.
From the above treatment of the case where employment within the two
industries is assumed to be unanged, it will be recalled that with an
unanged price level of consumer goods, unanged income tax rates, and
with wage increases equal to the increase in productivity, the demand for
consumer goods tended to be less than the supply. For this reason, it was
necessary to lower income tax rates. If now income taxation must not be
anged, equilibrium in the consumer goods market can be brought about
instead by a decrease in employment and production in the consumer goods
industry and expansion of the capital goods industry. Since a contraction of
the consumer goods industry implies increased marginal productivity there,
every decrease in employment in the consumer goods industry must
obviously be accompanied by some increase in money wages, for otherwise
the price level of consumer goods will fall. If wages are increased to a
corresponding extent in the capital goods industry, the decline in the
production of consumer goods will obviously be accompanied by an increase
in the total disposable incomes of both workers and entrepreneurs. But this
means that with a certain decrease in the production of consumer goods and
a corresponding increase in money wages, equilibrium is established in the
consumer goods market at an unanged price level for consumer goods,
despite unanged income tax rates. e requirement for this is, of course,
that labour power, whi was previously in the consumer goods industry, is
taken over by the capital goods industry, whi in turn requires a suitable
reduction in the rate of interest. us our two ends have been realized
entirely through an increase in wages and a fall in the rate of interest.

(iii) Third Example

In the case of unanged employment in the consumer goods industry
and a rise in money wages equal to the increase in productivity, a certain
reduction in income tax rates is necessary to establish equilibrium in the
consumer goods market. At the same time, a certain ange in the rate of
interest was necessary to establish equilibrium in the capital goods market;
let us assume for the sake of argument that a reduction in the rate of interest
is necessary. Now, if the ends of an unanged price level for consumer
goods and unanged employment are to be aieved without altering the
rate of interest, this can obviously be done by an increase in employment
and production in the consumer goods industry, and a contraction of
employment and production in the capital goods industry. In this way, the
demand for capital goods is directly stimulated by the increased production
of consumer goods. It is also stimulated indirectly by the lower price of
capital goods whi follows on the one hand from the fall in employment
and the increasing marginal productivity in the capital goods industry, and
on the other hand, by the smaller wage increase, for if the consumer goods
industry expands, marginal productivity there will decline, and this means
that money wages cannot be increased quite as mu as the increase in
productivity with unanged employment would have permied. However,
if the increased production of consumer goods is to be sold at an unanged
price, income taxation must be further reduced. us our two ends can also
be realized by employing a wage increase and an income tax reduction.

(iv) A Comparison of the Second and Third Examples

If we now compare these last two examples, it will be seen that if the
wage increase is combined with a fall in the rate of interest (second
example), the appropriate wage increase will be larger than if the wage
increase is combined with a reduction of income tax (the third example).
With the former combination of means, the ‘room for wage increases’ will
thus be larger than with the laer, despite the fact that the initial
disturbance (a uniform increase in productivity) and the ends to be fulfilled
(unanged consumer goods price level and employment) are exactly the
same. It is true that the differences in the ‘room for wage increases’ are
based on opposite anges in the level of employment in the consumer
goods industry (and thus also in the capital goods industry), but unless the
relative sizes of the industries are included among the ends, this is simply
one more side-effect among many others.
 5. THE CAUSES OF CHANGES IN MONEY WAGES
Up to now we have treated money wages as a parameter, an exogenously
determined variable, anges in whi are not explained within the
framework of the model under consideration. is position of money wages
in the model is based on the fact that in a modern private-capitalist society
money wages are determined by labour-market organizations (or by the
State). Consequently they cannot be explained satisfactorily by an economic
model based on the notion that prices are determined by supply and
demand. In older theories, whi might justifiably have reoned with
perfect competition in the labour market, money wages were always
brought into the general explanatory system by introducing into the model
an equilibrium equation for the labour market. For instance, we could take
the model in Chapter XIII and consider money wages as endogenously
determined, and then add to the model the equation N = , where is the
(exogenously) given quantity of labour. Money wages would then be
determined together with the other unknowns in the model.5 Su a model
would, of course, make our whole problem mu simpler; the model would
imply full employment, no maer how it was subjected to disturbances. e
task of economic policy would then be limited to maintaining an unanged
value of money, and that could be done by employing only one means. Su
a model might be suitable for a society with perfect competition in the
labour market, but for societies where money wages are, to a greater or
lesser extent, dominated by monopoly organizations whose primary aim is
not that of regulating money wages so as to aieve equilibrium between
supply and demand in the labour market, su static full-employment
models are generally considered to be misleading. Instead, we now have
models of the type established in Chapter XIII, where money wages appear
as a parameter, as an exogenously determined variable, and the condition for
equilibrium in the labour market has been discarded. However, this does not
mean that we think that money wages are quite independent of the variables
included in the model, or from other elements whi are subject to economic
explanation; it only means that we believe that money wage movements are
not of su a nature that they may be reasonably explained within the
framework of a static short-term full-employment model.
 We shall consider briefly some important types of relations between the
economic situation and the development of money wages, in ea of whi
the direction of causation is assumed to go from the economic situation to
money wages; whereas, hitherto, we have treated the opposite causal
relationship, i.e. from money wages to the economic situation. In this way,
we come to the crucial question of anges in money wages at full
employment.

6. FULL EMPLOYMENT AND EQUILIBRIUM IN A HOMOGENEOUS

LABOUR MARKET
In Chapter XII we defined full employment as a situation where, with given
prices and money wages, the demand for and supply of labour are equal.
According to this definition, full employment is identical with ‘equilibrium’
in the labour market. e discussion of the previous apters is based on this
definition and it was not just by ance that we ose it. In the first place,
the definition seems to correspond to what is generally regarded in political
debate as the ideal of full employment, at least when the discussion is based,
as ours is, on the simplifying assumption of a homogeneous labour market
with perfect mobility. For in su a market, equilibrium means that there is
neither unemployment nor labour shortage in any part of the economy. In
the second place, this definition is a natural one from the stabilization
viewpoint, as it says that there must be neither excess demand nor excess
supply in the labour market.
e reason why the size of the excess demand in the labour market is of
great importance to our problem, is that as a rule it is assumed—and quite
correctly it seems—that with both perfectly competitive and monopolistic
wage determination, money wages tend to increase when there is excess
demand in the labour market, decrease with excess supply, and to remain
unanged at equilibrium. It can almost be taken for granted that su a
‘law of motion’ operates under perfect competition, but even when wages
are determined by organizations, an excess demand or supply may still
affect money wages. e so-called ‘wage-dri’ whi6 occurs at times
outside the agreements made by the organizations can be explained partly in
this way, while in the wage negotiations themselves both the wage claims
and the willingness of the organizations to compromise are influenced by
the demand and supply relationships in the labour market. When the
demand for labour is large relatively to the supply, the workers are in a
strong position and the employers are weak, whereas if there is relatively
lile demand for labour the positions are reversed, although political
considerations within the organizations can, of course, complicate the
picture considerably.
is hypothesis about the connection between excess demand and
anges in money wages may be expressed more precisely in the following
way. Let w0 and w1 be the money wage-rates at the points of time 0 and 1.
Money wages are assumed to ange only at the points of time 0, 1, etc. For
the period between 0 and 1, money wages are thus w0. Furthermore, we
have Δw = w1—w0. Let d0 and s0 be the demand for and the supply of
labour for the period between 0 and 1 at the given money wage-rate and
given prices. x0 = d0—s0 is then the excess demand in the labour market.
With this terminology the hypothesis about the dependence of money wages
on excess demand can be wrien

where k is a positive constant. e equation states that the relative ange in

money wages from the point of time 0 to the point of time 1 (Δw/w0) is
determined by the relative excess demand for labour during the interval
between them (x0/s0) multiplied by a certain constant k, whi is a
coefficient of flexibility for money wages. It will be seen that money wages
are constant, i.e. Δw = 0, when the excess demand is zero, and that Δw 0
as x0 0.
It cannot be emphasized too strongly that defining full employment as a
situation where the excess demand in the labour market is zero does not in
general imply constant money wages. Once the labour market is organized,
there are many different factors whi may influence money wages and
bring about anges in them. One of these is the la of equilibrium between
the supply and the demand for labour, and it is this, and only this, reason for
anges in money wages whi is eliminated by our equilibrium-definition
of full employment. Full employment in this sense is then at most a
necessary, but not a sufficient condition for money wages to be constant,
since other influences may also be assumed to be at work upon money
wages. It may be said that the equilibrium-definition of full employment
implies a situation where money-wage rates are not anged due to the sort
of wage-drift that results from inequality of demand and supply in the
labour market.
In current Scandinavian discussions on economic policy, ‘wage-dri’
plays a very important part, and we shall therefore try to introduce it into
our discussion here. Empirically, the wage-dri is measured as the difference
between the actual increases in money wages (i.e. in earnings) and the
wage-increases intended (foreseen) for the period in question by the
agreements between the labour-market organizations. is means that the
wage-dri includes anges in money wages other than those whi can be
explained by reference to a la of equality between demand and supply in
the labour-market. Increased earnings under unanged piecework rates in
the case of an increase in productivity is one example.7 For this reason, we
shall henceforth distinguish a ‘market-conditioned’ wage-dri from a ‘non-
market-conditioned’ wage-dri. To divide the total wage-dri statistically
into that part whi is ‘market conditioned’ and that whi is not, would of
course offer great difficulties, but the problem could be solved in principle.
Moreover, there is plenty of evidence to show that mu of the post-war
wage-dri in Scandinavia has, in fact, been ‘market conditioned’. at part
of the wage-dri has been caused by the intervention of the organizations in
seing new piece-rates in connection with new methods of production, etc.,
does not alter the fact that demand and supply relationships in the relevant
section of the labour market will have influenced their respective aitudes to
the piece-rates that are being set. However, in order to leave this question
open, we shall simply base our arguments on the assumption that the wage-
dri may be split into two parts, ‘market-conditioned’ wage-dri and other
wage-dri.
Up to now the analysis has been based on a definition of full employment
whi, on the one hand, coincides with the usual equilibrium concept in
economic theory, but whi, on the other hand, does not guarantee constant
money wages. In general, it can be said that this definition of full
employment implies the absence of market-conditioned wage-dri but not
of the other types of wage-dri; furthermore, it does not imply unanged
wage agreements. For the politician who sets up as policy ends both full
employment and a stable value of money, and who ooses to define stable
value of money as an (approximately) constant consumer price index ‘at
market price’, it is of course important to be sure that the realization of full
employment is compatible with the laer. A primary condition for any
definition of full employment to be acceptable to the politician is
accordingly that it will not conflict with his aim of a stable value of money.
e first question whi arises then is whether this condition is fulfilled with
the equilibrium-definition of full employment whi we have osen.
As the equilibrium-definition of full employment means that the market
situation does not in itself tend to create wage-dri, we are faced with the
question whether constant money wages are consistent with a policy whi
is to maintain a constant consumer price level ‘at market price’ and full
employment in the equilibrium-sense. is question has already been
answered in the affirmative, inasmu as we devoted Chapters XIII–XVI to
showing just how these two ends could be secured by various fiscal and
monetary policy means with constant money wages. Full employment in the
equilibrium meaning of the term is therefore, within the framework of the
particular model and with the disturbances there considered, quite
compatible with the aim of a constant consumer price level ‘at market price’.
On the other hand, equilibrium in the labour market does not guarantee
the absence of ‘spontaneous’, i.e. non-market-conditioned, wage anges.
We must, therefore, also deal with the question whether the ends of full
employment in the equilibrium sense and a constant consumer price level ‘at
market price’ can really be maintained simultaneously, if full employment
(in the equilibrium-sense) is accompanied by a continuously rising wage
level due to a non-market-conditioned wage-dri and to wage increases that
are agreed between the labour market organizations.
is question too has already been answered in the affirmative. Firstly, we
have just shown in section 2 of this apter that the Government has means
at its disposal for offseing the effects on the price level and in employment
of increases in money wages; for example, a revision of the tax structure
from direct to indirect taxation may be sufficient means here. Even if money
wages rise continuously, su as in the form of a continuous non-market-
conditioned wage-dri, the effects on the price level and on employment can
still, in principle, be offset by means of a continuous rise in income taxation
and a continuous fall in the indirect tax on consumer goods (or a continuous
increase in the indirect subsidy on consumer goods). In the long run, the rate
of indirect subsidy on the production of consumer goods may have to rise
towards infinity, while for all income groups both the average and marginal
tax rates may approa 100 per cent. Although during su a process the real
disposable income of ea individual household may be unanged, ignoring
creditor-debtor relationships, administrative difficulties will no doubt ensure
that sooner or later su a policy has to be abandoned.
Secondly, we have also seen in sections 3 and 4 of this apter, how, in
certain situations, wage increases may be a suitable means, a welcome help,
for a policy whi is to aieve the two ends discussed here. e standard
example of a disturbance against whi wage increases may be a suitable
means is an increase in productivity. If then, non-market-conditioned wage-
dri arises in connection with the introduction of new production methods
and anged intensity of work, then the wage-dri whi exists with full
employment will facilitate policy, and is a positive consequence of the
equilibrium definition of full employment. Just as wage-dri may assist
policy, so may negotiated anges in money wages. e problem is to ensure
that the wage-dri and the agreed anges in money wages that occur when
the labour market is in equilibrium, are of an appropriate magnitude, for the
mere existence of full employment in the equilibrium sense does not, of
course, guarantee this.
us we come to the conclusion that the end of full employment and a
stable value of money are not in conflict with ea other within the
framework of the model that we are considering, if stable value of money is
defined as a constant price level of consumer goods ‘at market price’, and
full employment is defined as equilibrium in the labour market. But
obviously these definitions may make the policy measures required very
complicated if no means are created for ‘controlling’ money wages and
bringing about a ‘suitable’ development there. We shall return to this
problem in sections 9 and 10.
e fact that the ends of a stable value of money and full employment are
not in conflict with ea other when these two interpretations are employed
does not, of course, mean that other interpretations cannot be imagined in
whi the ends would be in conflict with ea other, nor that there are no
other interpretations where the ends would be compatible. Compatibility
depends partly on the particular model used, partly on the ends themselves,
and finally on the permied means (see section 7 of Chapter I). Without
going too far afield into the many problems that arise in dealing fully with
this maer, we shall here briefly tou upon one special circumstance whi
may give the politician reason to prefer a definition of full employment
whi differs from the equilibrium definition.
From a stabilization viewpoint, the equilibrium definition of full
employment seems natural for a homogeneous labour market. is is not
only due to the fact that equilibrium in the labour market involves absence
of market-conditioned wage-dri, but also to the fact that deviations from
equilibrium are usually considered undesirable in themselves for various
reasons. For instance, social considerations ensure that deviations from
equilibrium in the direction of unemployment are almost unanimously
disliked; deviations in the other direction are oen considered undesirable as
well because shortages of labour involve disorganization of production due
to ‘bole-nes’, absenteeism, etc. Excess demand in the labour market may
even lead to levels of employment and production that are less than that
associated with equilibrium in the labour market. e basic idea here is
vaguely Benthamite: ‘the larger the production, the more there is to
distribute’. Following out this idea, however, it may be necessary to
recommend situations where the labour market is not in equilibrium, but
where there is either a shortage of labour or unemployment. e supply-
demand relationships in the labour market may in fact be of su a nature
that employment will be larger with excess demand or with excess supply
than with equilibrium in the labour market, and when employment is
greater than at equilibrium, then production may also be larger.8
In general, it is not possible to draw conclusions about the level of
employment or anges therein from the size of the excess demand or excess
supply in the labour market. is is easily understood if we consider a
labour market and suppose everything else to be given. en we can draw a
ceteris paribus demand curve and supply curve for labour, as in Fig. XVII: 2,
where cases a, b and c are different possibilities for the shapes of the demand
and supply curves.
It will be seen that demand will be equal to supply in all three types of
market, if the money wage is . Excess demand is then zero. At a lower
wage, w1, excess demand will appear in all three cases, while at a higher
wage, w2, there will similarly be excess supply, so that all three market types
are ‘stable’. Now, if we assume that with excess demand employment will be
equal to the supply, and with excess supply will be equal to the demand, it is
obvious that, in case a, both excess demand and excess supply involves less
employment than in the equilibrium position; in case b, excess demand
involves less employment and excess supply more than in the equilibrium
position; and finally, in case c, excess demand involves more employment
and excess supply less than in the equilibrium position.

Fig. XVII: 2

It therefore follows that in general, it cannot be decided whether the

situation without a market-conditioned wage-dri represents a situation
with more or less employment than a situation with a market-conditioned
upward wage-dri. Two situations with no wage-dri on average may
involve quite different levels of employment. is circumstance may also be
relevant for the politician’s valuation of the concept of full employment. e
definition of full employment suggested by Bertil Ohlin, may be interpreted
as meaning the level of employment that gives maximum national product.9
It obviously cannot be decided a priori whether this implies a situation with
market-conditioned wage-dri in an upward or downward direction.

7. FULL EMPLOYMENT AND EQUILIBRIUM IN A HETEROGENEOUS

LABOUR MARKET
Up to now, we have considered only a homogeneous labour market with
perfect mobility. is is too mu of a simplification; one of the main
reasons why the meaning of the concept of full employment has been the
subject of so mu discussion is precisely that the labour market is not at all
homogeneous, but rather heterogeneous. A number of factors, geographical,
occupational, personal, etc., make it difficult for labour to be transferred
from one part of the labour market to another. us we get frictional
unemployment, structural unemployment, etc., and difficulties in the
definition of the concept of full employment. If we assume that in the short
run the labour market is divided into several sub-markets ea with a
demand function, a supply function, and a money wage rate, it could, of
course, be said that if demand and supply are equal in ea sub-market, then
there is equilibrium and full employment. But in an extremely
heterogeneous labour market, a situation with equilibrium in ea
individual sub-market is only a utopian ideal. In practice, it is hardly
possible to aieve su perfect co-ordination of supply and demand. e
question will then arise as to how full employment is to be defined for a
heterogeneous market, and of the significance of this definition for the
realization of the ends of a stable value of money and full employment.
In order to get to the heart of the maer, let us start by considering the
equilibrium concept itself, and ask how the concept of ‘equilibrium’ can be
defined for a heterogeneous labour market, that is for a collection of sub-
markets, ea in itself homogeneous. Equilibrium, i.e. equality between
supply and demand in a homogeneous labour market, means that there is no
market-conditioned wage-dri. By analogy, it seems natural to speak about
aggregative equilibrium in a heterogeneous labour market, if the market
situation as a whole, i.e. the relationship between supply and demand in all
sub-markets, does not in itself give rise to anges in the average wage level.
Now, if, in ea sub-market, wages tend to rise with excess demand, to fall
with excess supply, and to remain unanged at equilibrium, it is obvious
that the condition for the average money wage rate to be constant is that the
effect on the average wage-rate of the excess demand in some sub-markets is
counter-balanced by the effects of the excess supply in other sub-markets.
‘Equilibrium’ for the heterogeneous labour market will then mean that a
certain weighted sum of positive and negative excess demands in the various
sub-markets is equal to zero.
Let us state this more precisely.10 For a given period t, the i’th sub-market
t t
is assumed to have a certain wage-rate, wi , a certain demand di , and a
certain supply sit, and excess demand xit. e number of sub-markets is n.
For ea sub-market we now assume, as in (XVII: 1), that

where the coefficients of wage flexibility ki, may be different for different
sub-markets, depending, say, on the aitudes of the organizations.
We now wish to formulate the condition for the average money wage-rate
to be constant from period to period. e wage level at the point of time 1,
1
W , we define as:

We thus oose a Laspeyres’ wage-index (ain index) with the quantities

supplied in the base period (the previous period) as weights; on the whole,
however, the following discussion does not depend essentially on the oice
of this particular index. e ange in the index from the point of time 0 to
the point of time 1, i.e. ΔW = W1—W0, thus becomes

If we insert (XVII: 1′) into (XVII: 3) we get

 It follows immediately that the condition for a constant wage level, i.e. for
ΔW = 0, is that

is condition is obviously fulfilled if all xi0 are zero. Otherwise, certain
x
0 must be positive and others negative. (XVII: 5) then states that if the
i
wage level is to remain constant, a weighted total of the money values of the
excess demands and supplies (the laer having a negative sign) in the labour
market has to be equal to zero. e weights are the coefficients of wage
flexibility in the different sub-markets. From (XVII: 4) it follows, moreover,
that

If the coefficients of wage flexibility are the same for all sub-markets
(XVII: 5) simplifies to . is simple unweighted value sum is well
known from so-called ‘gap-analysis’ and has been called the ‘factor gap’.11
‘Equilibrium’, as now defined, obviously does not imply that market-
conditioned wage-dri does not appear at all. It only implies that if upward
wage-dri appears in certain sub-markets, corresponding downward wage-
dri must take place in others. Su wage adjustments, induced by the
market situation itself, serve, moreover, to secure a more appropriate
distribution of labour between the different sub-markets. Markets with a
labour surplus will experience a downward wage movement and thus shed
labour, a process whi will be accentuated by the unemployment itself, of
course, while in markets with a shortage of labour wages will tend to be
higher, and labour will therefore be aracted.
It must not be forgoen, however, that in a highly organized labour
market, su as we have in Scandinavia, the market-conditioned wage-dri
is probably asymmetrical, for a given excess demand tends to cause an
upward wage-dri whi is larger than the downward wage-dri brought
about by an excess supply of the same absolute size. Solidarity between
workers seems to be greater than among employers. In extreme cases, it is
even conceivable that excess supply brings about no downward wage-dri
at all, while excess demand brings about marked upward wage-dri. In su
a case, ‘equilibrium’ cannot just be described as a situation without average
market-conditioned wage-dri; if downward wage-dri were absolutely
impossible, even a situation with 100 per cent unemployment would then be
called an equilibrium situation. It would then seem reasonable to define
‘equilibrium’ as a situation where at least some sub-market shows an
equality between supply and demand without any sub-market showing
excess demand; there will then be no (average) wage-dri, but on the other
hand, there is not unemployment in all sub-markets.
Having now defined the concept of ‘equilibrium’ for a heterogeneous
labour market by analogy with the homogeneous labour market equilibrium,
the following problem presents itself. Can we define full employment as
equivalent to ‘equilibrium’ in the above sense, without risking serious
conflicts with generally accepted political principles? e question is of vital
importance, for if the principles on whi politicians base definitions of full
employment preclude ‘equilibrium’ in the meaning discussed here, then
even at full employment the average wage level will move continuously
upwards or downwards due to market-conditioned wage-dri, and this is
crucial for a policy whi is to secure a stable value of money together with
full employment.
It will now be seen that as a general and complete definition of full
employment in a heterogeneous labour market, the established concept of
‘equilibrium’ cannot be accepted, either from the social view-point, whi
requires a more or less complete elimination of unemployment, or from the
production viewpoint, whi primarily requires maximum production. As a
maer of fact, our condition for ‘equilibrium’, i.e. absence of market-
conditioned wage-dri, equation (XVII: 5), does not imply any particular
levels of unemployment or labour shortage. e condition for ‘equilibrium’
is obviously fulfilled if every sub-market is in equilibrium and neither
unemployment nor shortage of labour exists; but ‘equilibrium’ may also
exist in principle with heavy unemployment, or with lile unemployment,
depending on whether the positive excess demands and shortages of labour
are correspondingly large or small. Finally, the condition may even be
fulfilled, in the case of the above-mentioned asymmetrical reaction paern,
when there is more or less unemployment, without any shortage of labour
existing at all; for if market-conditioned wage-dri is only possible upwards,
‘equilibrium’ merely implies that no upward market-conditioned wage-dri
takes place (if there is excess demand in only one single sub-market, the
average wage level will dri upwards), but on the other hand, at least some
sub-market is in equilibrium (some, but not all, may have unemployment).
In the above equation (XVII: 5), all positive excess demands can be
denoted by +xi0, and all negative excess demands by –xi0. e total
unemployment existing when (XVII: 5) is satisfied is Σ–x 0, and the
i

unemployment rate is 100 Σ–xi0/Σsi0. e number of vacant jobs in the

same way is Σ+x 0, and the ‘shortage rate’ is 100 Σ+x 0/S 0.
i i i

It is obvious that there is no simple connection between Σ–xi0, or the

percentage 100 Σ–xi0/Σsi0, and the market-conditioned movement of the
wage level. Regard must also be paid to the +x 0. is indicates that it is not
i
generally possible to establish simple relationships whi give wage
movements as a function only of the extent of unemployment.
Here it should be noted that it may very well be assumed that (XVII: 5) is
satisfied while

that is, while the number of vacant jobs exceeds the number of unemployed
workers. Lord Beveridge’s well-known definition of full employment,12 a
definition with a pronounced social motive, does not necessarily imply a
rising level of money wages, but may even be compatible with a falling level
of money wages. A close examination of (XVII: 4) reveals that if the positive
excess demands appear especially in sub-markets with low money wages
and no great wage flexibility, and the negative excess demands are
concentrated in sub-markets with high wages and considerable wage
flexibility, then the above inequality may be fulfilled with a constant, and
even with a falling, average wage level. ese remarks on Lord Beveridge’s
definition of full employment assume, however, that downward wage-dri is
possible.
Let us now imagine a heterogeneous labour market with asymmetrical
wage-dri, where only upward market-conditioned wage-dri can occur.
Furthermore, let us assume that in this labour market there is a sub-market,
quantitatively insignificant, su as the sub-market for watmakers, whi
is just in equilibrium, while there is heavy unemployment in all other sub-
markets. According to the definition, the labour market is then in
‘equilibrium’, but from both a social point of view, due to the heavy
unemployment, and from a production point of view, due to the low level of
production, it may seem grotesque to call su a situation full employment.
For if we consider a small increase in demand in all sub-markets, in other
words a general expansion, employment will increase in all sub-markets but
one (the watmakers’ market), total production will probably increase as
well. From both the viewpoints mentioned, therefore, this general increase
in demand in the labour market is obviously desirable. But if demand is
increased in this way, the average wage level will begin to dri upwards (as
there is a shortage of watmakers and their wages begin to dri upwards),
so that if market-conditioned wage-dri is to be prevented, the increase in
demand is not desirable.
If su a general expansion is continued, unemployment will decrease
continuously and total production will increase, but on the other hand, the
shortage of labour will also increase; more and more sub-markets go beyond
the equilibrium position and find themselves with a shortage of labour, and
in the sub-markets already having shortage of labour, the shortage becomes
greater than ever; consequently not only will there be market-conditioned
wage-dri but the well-known hampering effects of labour shortage on
production will also occur. At a certain point in the expansion process, while
there is unemployment in some fields and shortage of labour in others, the
total volume of production may stop increasing; thus from the viewpoint of
the norm whi seeks to maximize a certain production index, further
expansion and general increases in demand in the labour market are now
inappropriate: ‘full employment’ has been brought about when production is
at the maximum. However, as it is quite possible that maximum production
is brought about while there is still significant unemployment in particular
sub-markets, from the social point of view it may still be desirable to
increase the general demand for labour further; su an increase in demand
will thus directly reduce total production and further augment market-
conditioned wage-dri as unemployment decreases.
We have here aempted to describe what is generally considered to be the
dilemma of full employment. e desire to avoid inconvenient market-
conditioned wage-anges (this does not in itself flow from the desire to
stabilize the value of money, but rather from the wish not to make too
drastic the measures to secure the value of money), the desire to maximize
the production index, and the wish to reduce unemployment to a minimum,
do not generally lead to the same labour market situation, if the labour
market is heterogeneous. is has given rise to the many different political
opinions as to the meaning of the concept of full employment, and probably
also the belief that the ends of a stable value of money and full employment
conflict with ea other in practice, unless full employment is defined as a
situation without market-conditioned wage-dri. If the labour market is
heterogeneous, it is clear that the State may run counter to its own aims if it
tries to bring about simultaneously a situation in whi there is maximum
production, minimum unemployment, and no market-conditioned wage
movements. Nevertheless, without minimizing these problems, it may be
doubted whether this dilemma is really as serious as it is held to be in some
quarters.
Firstly, it can never be emphasized too strongly that the more
homogeneous the labour market is, the smaller the differences will be
between the situation whi just prevents market-conditioned wage-dri,
the situation whi gives maximum production, and that whi gives
minimum unemployment (see, however, what has been said in section 6 in
connection with Fig. XVII: 2). us, if we combine a policy whi creates
‘equilibrium’ in the labour market with special measures to make the labour
market more homogeneous, it may be possible to make full employment in
the ‘equilibrium’ sense, acceptable to those who wish to have maximum
production or minimum unemployment. ere seems to be great unanimity
on the desirability of su special measures as occasional retraining courses,
grants for removals, etc. Perhaps the very existence of high level of
employment may itself increase mobility, i.e. homogeneity, without
necessarily creating excessive movement.13
Secondly, wage-dri does not necessarily complicate the policy of
stabilizing the value of money. Sometimes wage-dri may even facilitate the
policy of the State. In section 6, we have already pointed this out in
connection with the non-market-conditioned wage-dri whi may appear
in seing piecework rates when new production methods are introduced
whi increase productivity; and similar effects may occur with market-
conditioned wage-dri too.
irdly, it must not be forgoen that even if the labour market cannot be
made completely homogeneous, State policy may, to a certain extent, be
conducted in su a way that the demand for labour of different qualities
will coincide with the supply in the various sub-markets. In fact, it is quite
natural to try to construct the general means whi are to aieve
‘equilibrium’ in the labour market in su a way that not only do they
aieve this aggregate ‘equilibrium’ but also help to aieve partial balance
between supply and demand in the individual sub-markets. For example, in
cases where a general decrease in indirect taxes on consumption is needed, it
seems reasonable to reduce the tax more (and possibly even to give
subsidies) on goods whi are produced by a type of labour that is in excess
supply, and decrease the tax less on goods whi are produced by scarce
labour. In one certain respect, our analysis in Chapters XIII–XVI, whi is
otherwise based on a homogeneous labour market, can be said to cover a
heterogeneous labour market as well. We have throughout distinguished
between the consumer goods industry and the capital goods industry, and
assumed in many cases that policy has to be conducted so that full
employment (zero unemployment) is aieved with an unanged
distribution of labour between the two industries. Now if the workers in the
consumer goods industry and the capital goods industry were, in the short
run, to form two sub-markets, the policy recommended in all these cases
would aieve full employment not only in the aggregate ‘equilibrium’ sense
of equation (XVII: 5), but also in the more special sense that full
employment (equilibrium) is aieved in ea of these sub-markets. us the
overall end of full employment may be said to have been divided into two
more partial ends, and this complicates policy somewhat, as has already
been mentioned in Chapter XIII, 8.
e conclusion to be drawn from these observations about the
heterogeneous labour market is, therefore, that while the ‘equilibrium’
definition of full employment is in general not acceptable from the points of
view of both social policy and production policy, it nevertheless should not
be forgoen that the general policy in connection with the labour market
can be arranged in su a way that our ‘equilibrium’ situation without
market-conditioned wage-dri will become acceptable in both these
respects. If the State succeeds in doing this, one of the most controversial
problems of full employment will have been solved.

8. WAGE ADJUSTMENT ACCORDING TO A CONSUMER PRICE INDEX

Index-regulated wages are oen considered a particularly disturbing
element for a stabilization policy. It is clear, however, that if wage-rates are
adjusted according to a certain consumer price index, and this index is kept
constant by means of a successful fiscal and monetary policy, then
automatic wage adjustment need not cause any trouble. e index is
constant, and in itself it does not conflict with the State policy if the labour
market organizations introduce su an automatic adjustment into their
agreements. e observed tendency of trade unions to pay regard to both the
actual past and the expected future price trends when formulating wage
claims, obviously gives a stabilization policy whi is intended to keep the
price level constant, a mu beer ance of succeeding than one whi
aims at keeping money wages constant. It even seems as if the possibility of
having wages automatically adjusted according to price index ought to make
the labour organizations ‘soer’ and thus make their wage demands more
consistent with the general policy. e existence of index adjustment, even if
it is never put into effect because the price-level is constant, must involve
less risk for the workers, and most people are willing to pay something for
that.
It seems clear that anges in the price level can be considered a specific
reason for anges in money wages on a fully organized labour market,
quite independent of the relationship between supply and demand for labour
on that market. e question is simply to decide whi price level is relevant
here. In Chapter XII we defined the price level as a general consumer price
index ‘at market price’ but excluding direct taxes and subsidies. It is not
difficult to indicate cases where wages have actually been adjusted
according to an index of the kind. ere are also plenty of examples of
automatic wage adjustments whi have been based on indexes in whi
direct taxes have been included; it is well known that in negotiations a great
deal of consideration is paid to direct taxation and social benefits. Even if
the ends of full employment and constant price level, in our sense, have been
aieved, the price level relevant for the labour-market organizations may
thus be assumed to ange. is specific reason for movements of money
wages has thus not necessarily been eliminated just because a constant
consumption price index ‘at market price’ but excluding direct taxes, etc.,
has been established. As we have indicated earlier, this fact may serve as a
basis for criticism of our definition of a stable value of money: it is not the
‘workers’ value of money’ that we have stabilized.

9. A PROPOSAL FOR THE INDIRECT CONTROL OF MONEY WAGES

e desire to prevent those wage increases whi complicate the aempts by
the State to aieve full employment and a stable value of money, perhaps
requires the concept of the value of money to be interpreted as the price
index that the trade unions consider relevant rather than as a general
consumer price index ‘at market price’ excluding direct taxes. A stable value
of money would then mean an approximately constant cost-of-living-index,
referred to some average worker’s income, and including direct taxes and
social benefits.
We shall, nevertheless, maintain the definition of the value of money
established in Chapter XII, and this for several reasons. Firstly, it is obvious
that the end of a stable value of money is usually established for quite
different reasons than those behind the avoidance, as far as possible, of
anges in money wages. A very important motive behind the wish to
stabilize the value of money is the desire not to affect debtor-creditor
relations, or to maintain the value of private savings, or however one wishes
to express it. In this respect, our definition of the value of money seems to be
the most relevant, as was pointed out in Chapter XII. Secondly, the
stabilization of a general consumer goods price index does not necessarily
and in all circumstances exclude the possibility of the State keeping the
index referred to by the trade unions constant at the same time, or at least
preventing an increase in the laer. Thirdly, what is important for money
wages is not that the index is kept constant, but rather that the index does
not rise. An increase in the cost-of-living index will almost always involve
the risk of wage claims by the trade unions, while a decrease in the cost-of-
living index can hardly be expected to bring offers of wage reductions from
the trade unions, or automatically to bring about threats of wage reductions
from the employers. e organized labour market is in many ways
asymmetrical as to its manner of reaction. Fourthly, and finally, it is doubtful
whether the State has a more effective weapon for ‘controlling’ wage
movements than the possibility of varying the price index referred to by the
trade unions, while at the same time, keeping the value of money, as defined
in Chapter XII, constant. It is true that ‘control’ of money wages is not
strictly necessary, for there will always be some means of offseing
unsuitable anges in money wages, but it will, nevertheless, facilitate the
policy of the State to a very large extent if wage movements are co-
ordinated with economic policy in general.

(i) Uniform Changes in Productivity

In order to make these notions more concrete, we shall concentrate in
what follows on a case oen discussed in practical policy; that of a ‘uniform’
ange in productivity. In this way, we hope to show the possibilities open to
the State of controlling money wages by indirect means.
We first assume that a certain uniform decrease in productivity has taken
place, and that the trade unions for that reason do not make claims for
increased money and real wages, but nor do they, on the other hand, intend
to accept a decrease in real wages. We suppose for the sake of argument that
the employers are passive. In this situation, the task of the State is to secure
the two main ends of full employment and a stable value of money (as we
have defined them), and furthermore to prevent the workers’ cost-of-living
index from rising. Now with a constant value of money (in our sense), the
workers’ cost-of-living index increases only if the workers’ income taxes
increase. In an analogous case in Chapter XV, 2 (v), we have shown how it is
possible with unanged money wages to realize the two main ends by a tax
revision involving some reduction in the rate of indirect tax on consumer
goods and an increase in the rates of income tax, possibly combined with a
certain interest ange. e increase in income taxation is here exclusively
intended to bring about some decrease in the demand for consumer goods
with given nominal factor incomes, whi in these circumstances remain
unanged. Within certain limits, at any rate, the entire decrease in
consumer goods demand can be forced upon households in the upper
income braets. us if the State revises the income tax rates in su a way
that the tax rates remain unanged for the lower income groups, while they
rise for higher incomes, the workers’ cost-of-living remains unanged as do
the workers’ real disposable incomes. According to our assumptions, the
trade unions then have no reason to demand increased money wages. It is
obvious that su a policy requires that it is possible both physically and
administratively to increase income taxation on the higher incomes so mu
that these households will reduce their consumption as mu as is necessary
to aieve equilibrium in the consumer goods market with reduced
production. is condition need not be fulfilled. e households in the
higher income groups cannot reduce their consumption below zero; it is also
possible that in the short run, the consumption of these households is not
closely associated with their current disposable incomes, and furthermore,
the tax rates may be so high already that for administrative reasons it would
be difficult to increase them further.
Moreover, it is not at all certain that entrepreneurial incomes exceed
workers’ incomes on average, and it is obvious that a considerable amount
of overlapping will always exist in any case, for there will always be some
entrepreneurs with lower incomes than the best-paid workers. If so, it may
be impossible to discriminate between workers’ incomes and entrepreneurial
incomes simply through applying different tax rates to higher and lower
incomes. Here it seems necessary to tax labour incomes and other incomes
according to different tax codes with different tax-rates for incomes of the
same size. A tax-discrimination of this type gives rise to other difficulties of
tenical nature, whi we shall not discuss here, however. Nevertheless, if
there is not too great a fall in productivity, a somewhat discriminating
policy should be possible.
We now turn to the opposite case, where a general uniform increase in
productivity has taken place, and assume that the trade unions consider it
fair that the entire increase in the production of consumer goods (with
unanged employment in the consumer goods industry) should go to the
workers. Now if the increase in productivity is k per cent, and we suppose
for the sake of simplicity that the workers have hitherto consumed half of
the total production of consumer goods and the entrepreneurs the other half,
then according to the usual ‘room-for-wage-increases’ argument, the trade
unions would demand a wage increase of 2k per cent. As we have already
seen in section 4, su a wage increase would be ‘inappropriate’ from the
State’s viewpoint and would not lead to an increase of 2k per cent in the real
wages of the workers; from the cost point of view, there is only ‘room’ for a
wage increase of k per cent. However, if the main purpose of the trade
unions is to increase the real disposable incomes of the workers, the
situation can be rectified without causing difficulties for the State. As we
have shown, the sufficient means in this case (with unanged money
wages) is a tax revision under whi the rate of indirect taxation on
consumer goods is raised just so mu that the price level of consumer goods
is le unaltered (whi also means that with an unanged distribution of
employment between the consumer and capital goods industries, the pre-tax
incomes of both the workers and the entrepreneurs will remain the same as
before the increase in productivity), together with su a decrease in income
tax rates that total consumption will rise by k per cent. Now if the whole of
this reduction of income taxation accrues to the lower incomes, and for the
sake of argument, we assume that the lower incomes are those of the
workers’ households and that the higher incomes go to the entrepreneurs, it
is obvious that all of the consumption increase will go to the workers
without jeopardizing the two main ends. It should be noted that this policy
does not require an increase in income taxation for any income group.
Economic policy will, in this case, aieve full employment and an
unanged value of money while the cost-of-living index of the workers
falls somewhat. It is clear that if the workers’ marginal propensity to save
exceeds their average propensity to save, their tax rates must be reduced so
mu that their cost-of-living index falls by somewhat more than the 2k per
cent. Even in this case, the workers’ claims may be met and an increase in
money wages avoided; for the limits on policy, whi were indicated in the
previous case, do not appear here. e lower income groups can probably
always expand their consumption rapidly with increased disposable income,
and administrative difficulties should not arise; if necessary, the income tax
rates may become negative for the lower incomes (the workers), so that the
income tax is here transformed into an income subsidy, see Chapter XIV.
Against the baground of these two examples, it will be seen that the
fact that anges in income taxation are included in any combination of
means gives the State some freedom of action, within the framework of the
policy securing full employment and a stable value of money, to manipulate
it in su a way that the index that the trade unions consider relevant is
affected in a particular direction or le unanged. Indeed, the same holds
true in principle even if income tax anges are not included in the
combinations of means whi secure the two main ends, provided that there
are several different combinations of means available to secure these ends,
having different effects on the real disposable incomes of the workers. Since
the State must always introduce some measures in order to secure its major
ends, and since there are in general different combinations of means whi
secure these main ends, ea of whi will, as a rule, have a different effect
on the real disposable incomes of the workers, and on the distribution of
incomes generally, then it is also clear that the State can, to a certain extent,
give the workers whatever increase in real incomes it considers appropriate.
is should make it possible for the State, by means of fiscal and monetary
policy, to ‘bribe’ the trade unions into making only su wage claims as the
State considers suitable. e development of money wages and of real wages
are in this way separated from ea other.
Here it should be noted that in the case of an increase in productivity the
State may actually offer the trade unions higher real disposable incomes if
they will accept unanged money wages, than if they keep insisting on an
increase in money wages. We have previously shown that if a ‘suitable’
wage rise, i.e. a wage increase of k per cent, is carried through in the case of
a uniform increase in productivity and if we assume for the sake of
simplicity that income taxation is proportional and that the marginal and
average propensities to save of households are equal, then with employment
and the price level unanged, equilibrium will be brought about without
further measures. us workers’ households as well as entrepreneurs’
households have a k per cent increase in real incomes. In the case where
money wages remain unanged and a revision of taxation is necessary, the
workers could secure a (more than) 2k per cent rise in real income. If both
the State and the trade unions realized this (and the employers were
passive), the State would be able to secure unanged money wages without
difficulty by ‘bribery’ if it so desired. It may be said, of course, that even in
the case of a k per cent wage increase with no further measures taken to
secure the main ends, a 2k per cent increase in real wages could be obtained
by the workers through an ‘independent’ ange in income taxation (in the
sense that it is not for the purpose of securing the main ends), involving
higher tax rates for the higher income groups and lower rates for the lower
income groups. As the entrepreneurs’ incomes will have risen by k per cent,
su a policy is obviously quite feasible. From a political and perhaps also
from an economic point of view, an important difference between the case
with wage increases and the case without is that in the laer the workers get
a 2k per cent increase in real income without any transfer of pre-tax income
occurring from the entrepreneurs to the workers (the entrepreneurs’ tax
rates are not increased), whereas su a transfer is necessary in the former
case (for the tax rate must be increased for the entrepreneurs). Irrespective
of the importance of this, the conclusion from what has been said up to now
should be clear:
In pursuing a policy intended to stabilize the value of money at full
employment the State will inevitably also influence the distribution of
incomes, and especially the real incomes of the workers, simply through its
oice of means to aieve these ends. It should be possible to exploit this so
as to influence the wage claims of the labour market organizations and the
outcome of wage negotiations.
is may be insufficient to secure the desired development of money
wages, however. For example, it may well happen that the trade unions
make claims for increases in real wages whi are either impossible to
realize (i.e. the model would not permit it whatever means are used) or else
considered unreasonable by the State. In su cases, the possibility of
anging the workers’ cost of living ad libitum despite the unanged value
of money comes into the picture again as a means of controlling the
development of the real disposable incomes of the workers, although in a
somewhat different manner. As has been pointed out above, the State always
has sufficient means at its disposal to counteract the effects on the value of
money and on employment of any wage ange. e standard example is a
tax revision whi involves a reduction of indirect taxes on consumer goods
and an increase in income taxation. Irrespective of how mu money wages
rise, income tax rates can always be increased in su a way that the
distribution of real disposable income is not affected (see Chapter XIV); this
applies in principle also to the extreme case where money wages tend to rise
without limit and consequently income tax rates for all income groups
approa 100 per cent. On the other hand, the State can also influence real
disposable income to a certain extent by the manner in whi it increases
income tax rates, for in this way it can bring about any given increase or
decrease in the real disposable incomes of the workers.
e result is that within the framework of the policy whi is to secure
full employment and a stable value of money, and as a component of it, it is
possible for the State to determine the real disposable incomes of the
workers arbitrarily within certain limits irrespective of the actual
development of money wages. e State may take advantage of this to bring
about the wage development it desires.

(ii) The Proposal in Detail

If the State is to exert successful control over anges in negotiated money
wages rates without having to resort to direct wage controls, then it will
obviously have to provide itself with some indirect means of influencing the
wage claims of the organizations and the outcome of wage negotiations. e
method suggested here is that the State makes a declaration of its plans
concerning future fiscal and monetary policy for the realization of full
employment and a stable value of money with alternative future money
wage rates. is declaration will include a promise that fiscal and monetary
policy will be constructed in su a way that at one certain money wage
rate, namely the one that the State considers suitable, wage earners will
aieve the highest real disposable income, whereas at both higher and
lower money wage rates their real disposable incomes will be lower.
Normally it ought to be possible to make the ‘bribe’ whi is promised to the
trade unions if they direct their wage claims according to the wishes of the
State, so high that the trade unions prefer this money wage rate to all others.
is declaration by the State means that by drawing up alternative
methods of pursuing its policy to secure full employment and a stable value
of money, the State puts before the trade unions a functional relationship
between money wages and real disposable wage income of the kind shown
in Fig. XVII: 3. Here the State has planned the relationship so that the curve
reaes its maximum at the money wage desired by the State , and so that
this maximum value coincides with the real disposable wage income ,
whi is considered reasonable by the State, and whi it wants the workers
to have. In practice this relationship can hardly be made a continuous
function, but this is no real obstacle. Indeed, it is an advantage for the
function to jump at the maximum point, so that at their best value money
wages seems to the trade unions to be much beer than at any of the
neighbouring values.

Fig. XVII: 3

In the previously considered case of a uniform increase in productivity by

k per cent, we may assume, as an example, that the State prefers unanged
wages (this may be suitable if the increase in productivity is expected to be
only temporary or if a reduction in income taxation is desired). With
unanged wages, the declaration would then commit State policy to being
planned so that real disposable incomes of wage earners will rise by
(somewhat more than) 2k per cent (if it is this increase in real disposable
wage incomes that the State wishes to bring about); at all other money wage
rates the State would promise and allow an increase of only k per cent. For a
trade union whi is trying to procure the maximum real disposable income
for the workers, the oice will then obviously be unanged money
wages.14
is method of controlling the outcome of wage negotiations, and thus
also movements in money wages, raises several problems whi we shall
now look at more closely.
(a) e first condition for the success of a policy of this kind is obviously
that the State announces its plans openly and then behaves in full
accordance with them, neither concealing its intentions nor hesitating to
carry out its declarations concerning the real incomes of the workers, even if
the trade unions do not oose the money wage desired by the State.
Obviously this requires a tough and consistent policy by the State, but this is
nothing new in the field of wage-determination. Consistency in economic
policy is indeed always necessary if the desired ends are to be realized.
(b) It is one thing to say that the State must act in accordance with its
declarations, but it is quite another to decide how closely the State has to
commit itself as to its future actions in su declarations. In an extreme case,
it is conceivable that the State may not only announce its wishes concerning
money wage rates for a certain future period and its intention to use
monetary and fiscal policy to ensure that different money wage rates result
in certain real disposable incomes (see the curve in Fig. XVII: 3), but it may
also give a detailed description of the alternative monetary and fiscal policy
measures whi will be taken in these various situations. By su a
declaration of alternative ends and means, the State will obviously tie down
its actions very closely, and perhaps even completely for the period
concerned. Another extreme case would be where the State only announces
its provisional ideas concerning money wage rates, and its intention by
means of certain monetary and fiscal policy measures, not yet determined,
to make different money wages result in certain real disposable incomes (the
curve in Fig. XVII: 3). In the laer case, the State only commits itself, at least
outwardly, to adding a conditional end concerning the real disposable wage
incomes to the ends of full employment and a stable value of money.
From the point of view of the State, this last extreme case seems to be
preferable; here, the State is completely free to take whatever ad hoc
measures appear necessary in order to fulfil its declared intentions. In this
way the State seems to have greater possibilities of actually keeping close to
its declaration, than if it had tied itself down to certain means. e other
extreme case with a detailed account of alternative measures must
necessarily be based on a forecast of economic developments, and unless this
forecast coincides closely with the actual course of events, the consequence
of oosing a certain wage-rate will not be that announced by the State. It is
just as important that the labour market organizations and the State should
base their acting upon the same forecast, for if their respective expectations
as to the future, and their opinions on the effects of different measures, are
not the same, the labour market organizations will have no reason to follow
the recommendations or to heed the threat implied in the official
declaration. If the trade unions have their own special ideas about the course
of economic events, and about the effects of the various State measures, and
if the trade unions know from the declaration the measures that are to be
taken with various money wages, they can obviously calculate an optimum
wage whi may differ from that whi the State desires, and hence from
that whi is optimal according to the official declaration. e solution of
this forecasting problem is therefore a very important prerequisite of a
wage-controlling policy whi is based on a declaration giving a detailed
account of the alternative measures whi are to be used with various
money wage rates. A wrong forecast obviously means that either the State
must abandon its own declared monetary and fiscal policy measures, or else
that real disposable wage incomes will not be those promised in the
declaration.
Against this baground, it may seem quite obvious that the second
extreme case, where the State does not give any information about whi
means will be used, is definitely preferable to the first one with a detailed
account of the means. But is this the way to avoid the consequences of a
wrong forecast? Unfortunately, the problem is not quite as simple; no maer
how the State formulates its declaration, it can never get rid of the
forecasting problem. All policy is policy for the future; the past cannot be
altered. us all the measures that are taken must be based on notions about
future conditions, and if the State has the wrong notions about the future
the measures that are taken will not serve to secure the established ends,
irrespective of what has, or has not, been declared.
Let us briefly consider a declaration whi does not give any information
about the measures to be taken, and examine the ways in whi the
forecasting problem enters into the picture. Firstly, it is obvious that if the
State is to form any opinion at all as to what money wage rates are suitable
for the near future, it must have a forecast at its disposal. If there is to be
any sense in controlling money wages, the desired direction must be known,
so that behind the desire for certain money wage rates there must be a
forecast. But does this forecast have to be as correct as with a declaration
giving a detailed account of the alternative measures? Would not the
advantage of su a declaration lie precisely in the fact that the State would
be at liberty to apply whatever measures it considered suitable at the time?
Here, it should be remembered that the basic forecast must, at all events, not
be so wrong that it proves quite impossible to fulfil the declared intentions.
Furthermore, unforeseen events will very oen mean that the end-variables
differ from their desired values for a shorter or longer period of time, until
the measures whi the State takes have had time to take effect. Irrespective
of whether the declaration contains details of the measures that are to be
used, if the declared intentions of the State are to materialize the State must
have some idea on the basis of a forecast of the measures to be introduced.
A correct forecast for the period of time with whi the policy is concerned
is then required for a successful policy, no maer how the declaration is
formulated, but see Chapter XIX, 3, however.
e difference between these two extreme cases is thus a difference of
degree rather than one of kind. e State may possibly be put in a more
difficult position when confronted with unanticipated events if the
declaration has specified particular means; on the other hand, a detailed
declaration may make a greater impression on the labour market
organizations. e type of declaration that is most suitable may ange from
situation to situation; its formulation will to a great extent be a maer of
political adroitness.
(c) e concrete formulation of the State’s declaration will also depend on
the meaning aributed by the State to the ends of a stable value of money
and full employment. In the above, we have discussed these problems using
the definitions of a stable value of money and full employment established
in Chapter XII and completed in this apter, but obviously the method
suggested for the control of money wages can be used with other
interpretations of these ends. We shall not go further into the problems that
may arise with other interpretations of these ends, but simply make the
following brief observations.
We have assumed wages to be fixed annually (for the financial year) and
the means announced in the declaration must also extend over a year. is is
quite natural from the point of view of fiscal policy. As has been pointed out
in Chapter XVI in connection with the long-term problems of fiscal policy,
this may very well be combined with ends concerning a shorter period of
time. Even if the ends are constant, quarterly indexes for the price level, and
full employment in ea month, the wage level and all fiscal and monetary
policy means (parameter values) can be determined at the beginning of the
financial year and be kept constant during the financial year in su a way
that all the ends are fulfilled within the year. On the other hand, there is in
principle nothing to prevent the State from preferring, and making the
labour market organizations oose, a certain wage development throughout
the year. If the State considers a certain wage development within the year
appropriate, from this point of view a definition of full employment other
than the equilibrium definition, whi we have used, may be more suitable.
For example, if the State forecasts a continuous increase in productivity
throughout the year, it may be possible that the State will consider it quite
appropriate if there is a continuous wage rise, that is a wage-dri. Wage-
dri need not therefore be a disturbing factor for the State in its planning.
e prerequisite for the wage-dri to be consciously employed by the State
as an element in its policy is, of course, that it is able to make accurate
forecasts of the wage-dri, see (b) above.
(d) We have talked about money wage rates as something uniform,
although in our discussions, they must in fact be regarded as average money
wage rates. As the discussion is concerned with average money wages, it
will follow that the policy suggested requires the labour market
organizations to think in terms of, and make decisions concerning, su
average money wages. is, in its turn, requires a high degree of
centralization within the trade union movement, indeed, it requires wage
negotiations to be common to all groups of workers and take place through
one central organization. If then, for example, the central trade unions
organization decides upon a certain average money wage ange, it must
then determine, or call forth, wage claims for the different groups of workers
within the framework of the given average. If there is no su central
organization to make decisions in this manner, the result may easily be that
the labour market organizations first decide on the many particular money
wage rates and that the average wage ange then emerges as the passive
algebraic result.
Simply as a maer of principle it is quite conceivable that the declaration
be formulated in su a way that it would not aim at an average money
wage rate for all workers, but instead, it would specify the average wages of
various groups of workers. It is obvious, however, that from the point of
view of the State it is preferable, perhaps even necessary, that the labour
market organizations be responsible for the determination of the many
special wage rates.
It need hardly be added that this subject bristles with many difficult
problems whi lie outside the scope of this book. Indeed, we have here put
aside the whole of the so-called problem of the ‘inner dynamics’ of the wage
structure.
(e) For the employers, a centralization of the kind whi is appropriate for
the workers is not absolutely necessary. However, it seems natural to assume
that centralization on the side of the workers will be copied by the
employers. en the problem arises that the money wages whi are
optimum for the workers must necessarily be the worst possible from the
employers’ point of view. Situations may, therefore, occur on whi the
workers claim the optimum money wage according to the declaration, while
the employers want a wage-rate whi is non-optimal for the workers, but
optimum for themselves, so that they may offer, say, large wage increases in
a situation where the workers prefer unanged money wages. is
complication is not as serious as it seems, however. e fact is that the
interests of the employers can hardly be expressed in su simple terms as
those of the workers. e overt reasons for employers’ wage demands, at
least, are not as a rule expressed in terms of the employers’ total real
disposable incomes, or a certain income distribution, etc. On the whole,
experience has shown that in situations of full employment, employers
usually display quite remarkable indifference or even resignation about the
determination of money wages. It is mainly this fact whi led us to assume
passivity on the part of employers. However, it must not be forgoen that
this indifference of the employers has, to a very large extent, been due to the
conviction that if money wages rise, entrepreneurial incomes will also
increase to the same extent and perhaps even to a greater extent via price
increases; this will not be the case with our policy. Here, workers’ and
entrepreneurs’ incomes will, as a rule, move in opposite directions as a
function of money wages. It may, perhaps, be possible to conduct policy so
that the real disposable income of entrepreneurs are maximized at the
money wage whi is optimum for the workers. is obviously requires
there to be some third group, whose real disposable income can be varied by
means of economic policy in su a way that it will be lowest at the
optimum money wage and will rise if money wage rates differ from those
desired by the State.15
(f) Finally, the whole policy obviously requires careful coordination of
timing in one important respect; it requires that wage negotiations and the
determination of the actual policy of the State are conducted in su a way
that, for any given future period, State policy is determined after wage
negotiations have been concluded, and that the wages so determined are
based on the declaration made by the State immediately before the wage
negotiations began. In practice, it could thus be imagined that wage
negotiations based on the financial year are conducted and concluded in
December, while the actual fiscal and monetary policies are finally
determined in January and February, on the basis of the forecast and
declaration made in November, and taking account of the outcome of the
wage negotiations conducted in December. is time table differs in several
respects from that whi is currently followed in Sweden.
We have now discussed some important pre-requisites of a policy whi
is to control wage movements in the way we have suggested and also some
of the more serious difficulties that may be encountered. Briefly we can say
that the difficulties are concerned firstly with the forecasting problem, and
secondly with institutional problems. e forecasting problem is a scientific
problem, a question of the possibility of our obtaining su knowledge about
the working of the economy, and about the disturbances to whi it will be
subjected in the near future, that an adequate picture of future developments
can be gained. e institutional problems, on the other hand, could in
principle, be solved by purely political measures, by legislation. Here the
problem is partly one of bringing about greater centralization of wage
negotiations, and partly one of arranging a suitable timetable for wage
negotiations and the final determination of State policy for the period. is
doubtless imposes certain restrictions on the labour market organizations,
but these restrictions only concern the form of the wage negotiations; the
determination of money wages is, in principle, still in their hands.

(iii) The Advantages of this Form of ‘Control’

It may be appropriate to indicate certain features of the policy
recommended here whi appear to be desirable by quite widely accepted
standards. Firstly, it must be emphasized that the responsibility for bringing
about the stabilization of the value of money at full employment belongs to
the State, whi anyway has the means at its disposal to realize this end. e
labour market organizations, especially the trade unions, are not responsible
either for the value of money or employment, but are assumed to be
aempting to aieve the best conditions and the highest standard of living
possible for their members in the circumstances. ere is no question of
‘loyalty to society’ etc.; everybody looks aer his own interests, irrespective
of whether this hurts the interest of other groups or not. e method by
whi the State induces the labour market organizations to oose the
money wage whi the State considers most desirable, consists in making
the distribution of disposable income dependent on the level of money
wages. Within the framework of a full employment policy with a stable
value of money (whi is carried through in all circumstances), distribution
becomes a function of the money wage level in su a way that in their own
interests the labour market organizations oose the money wage rates
desired by the State. Furthermore, this will also mean that the distribution of
private disposable incomes coincides with that desired by the State.
It is oen said that the only methods of solving the problem of money-
wages at full employment, and consequently of the stabilization of the value
of money are the following alternatives: direct State control of money
wages; or unemployment to su an extent that the trade unions cannot
raise wages too mu; or, finally ‘restraint’. All these ways have certain
disadvantages, and so a fourth method has been discussed here, whi is not
based on direct control, the creation of unemployment, or any form of
unnatural restraint. is proposal is based on the fact that the State, by
means of general fiscal and monetary policy, is able to determine the
distribution of disposable income completely—in this respect it is closely
related to the Rehn-Meidner policy, whi will be discussed in the following
section—and this is used as a carrot-and-sti means of aieving the desired
ends. It may of course be asked whether this does not go far beyond the ends
of a stable value of money and full employment; whether, indeed, a mu
more comprehensive set of ends has not been added to the ends of full
employment and a stable value of money. Su a criticism would not,
however, be justified. In the first place, it is a fact that beside the ends of full
employment and a stable value of money, in most of the countries of
Western Europe the State also strives to influence the distribution of income,
to make it more equal, in particular. us the combination of a policy of
stabilization and a policy of income redistribution is both natural and
rational. Mu more important, however, as a point of principle, is the fact
that when the State establishes the ends of full employment and a stable
value of money and realizes these ends by using appropriate means, this will
inevitably affect the distribution of income in some way. In these
circumstances there will no longer be any ‘natural’ distribution of income
independent of the policy of the State.

10. THE TRADE UNIONS AND FULL EMPLOYMENT

In the previous section we discussed a proposal for the indirect ‘control’ of
money wages. e problem was mainly dealt with from the point of view of
fiscal policy, and this particular solution is aracterized by the fact that the
distribution of real (disposable) income (rather than unemployment) is
assumed to be used as the means of control, and also that the labour market
organizations were assumed to act ‘egoistically’. Since our interest has
mainly been concentrated on the fiscal policy aspects, certain circumstances,
important for both practical policy and for purely theoretical discussions,
have not been considered at any great length. is is true especially of the
problems connected with the heterogeneity of the labour market, the
multiplicity of trade unions, and the decentralization of wage negotiations.
Consequently, with the present institutional situation in Sweden an
immediate application of our proposal is hardly conceivable.
e problem whi we have assumed to be solved institutionally, and
whi we have consequently disregarded, are at the centre of the debate that
has been going on in Sweden since 1948 about trade unions and wages
policy under full employment—a debate whi revolves around a report
published by the Swedish trade union movement called Trade Unions and
Full Employment.
16 e views expressed there will be referred to as the
Rehn-Meidner Policy (aer the main authors of the report), and it seems
reasonable to compare briefly some of the aracteristic features of their
policy with our proposal for the control of money wages. No aempt will be
made to give an exhaustive treatment of the Rehn-Meidner Policy here,
partly because it is concerned with rather different problems from ours. Our
proposal may be said to concern the question of how the State can induce a
strongly centralized trade union movement to oose the wage rate
convenient for the State. e basic theme of the Rehn-Meidner Policy, on the
other hand, is to discover how the policy of the State should be conducted if
the Swedish trade union movement, in its present form, is to be both willing
and able permanently completely to co-ordinate the wage claims of trade
unions, so as to form a wage policy whi is appropriate from the point of
view of stabilizing the value of money (it being generally assumed in the
discussion that an increase in the average wage level ‘in keeping with the
increase in productivity’ is appropriate from this point of view).
e essence of the Rehn-Meidner Policy is that a beer balance between
the supply and demand for labour than has generally been aained during
the post-war period should be brought about through measures whi also
involve squeezing the profit margins of firms, while at the same time
‘reasonable’ and ‘fair’ wage relationships are to be established and
maintained.17 It would then be possible for trade unions, having that aim in
mind, to contribute to the stabilization of the value of money; for they
would not be provoked into making wage claims whi would make price
increases difficult to avoid.
As the stability of the wage structure is to a large extent considered to be
dependent on the distribution and size of profits, we can here concentrate
our aention on the question of the role played by profits in the Rehn-
Meidner Policy; in this respect a comparison with our proposal is justified.
Equilibrium is to be established in the economy by a suitable general
economic policy—and in this respect the Rehn-Meidner Policy is of the
traditional type—so that there is no excess demand either in the labour
market or in the commodity markets. All ordinary general monetary and
fiscal policy means could consequently be brought to bear in any particular
situation. e existence of su an equilibrium situation requires, among
other things, that profits at the employment margin are ‘normal’ (from the
entrepreneurs’ viewpoint); with perfect competition this will mean that the
profit at the employment margin is zero, see the optimum conditions in
Chapter XIII. Here the intention is evidently to prevent ‘market-conditioned’
wage anges, especially market-conditioned wage-dri between the
agreements. Equilibrium in the labour market is held to be important for
two reasons: partly because market-conditioned wage-dri may disturb the
wage structure (if ‘fair’ wage relationships have already been established, or
if the wage anges go in the ‘wrong’ direction, so that they cause new wage
claims, a race may easily begin between different trade unions) and partly
because wage anges between (and outside) wage agreements are
considered inappropriate from the purely organizational point of view. It is
thus clear that relationships associated with our concept of ‘equilibrium’ (see
sections 6 and 7, and especially the definition in the case with asymmetrical
wage-dri) play a basic role in the Rehn-Meidner Policy. It is also clear that
su an ‘equilibrium’ can be aieved even in a heterogenous labour market
(through a suitable application of various general measures supported by
more partial ones to facilitate the transfer of labour in suitable directions,
etc.) without abandoning the requirement of minimum unemployment. In
this respect there is no basic difference between the Rehn-Meidner
viewpoint and that presented in the previous section; at the most it might be
said that preoccupation with the labour-market makes the Rehn-Meidner
policy even more dependent upon ‘equilibrium’ in the labour market than is
the case with our fiscal policy approa, whi does not exclude the
possibility that some wage-dri, perhaps even market-conditioned, might be
acceptable.
In the Rehn-Meidner view, however, the establishment of ‘equilibrium’ in
the labour market does not in itself mean that the wage claims of the
separate trade unions are automatically kept at a level suitable for the
stabilization of the value of money, so that the central trade union
organization is willing to work for su wage-anges. e size of the total
(average) profits may bring about claims for wage increases in the
agreements irrespective of the profit level at the employment margin.18 is
brings us to the point in the Rehn-Meidner analysis whi will be
considered in some detail here; it is not sufficient for profits at the
employment margin to be ‘normal’, it is also necessary at the same time that
total (average) profits are about the same in different trades, and also that
total (average) profits are generally rather low. e uniformity of profit
levels in different industries is considered necessary to prevent trade unions
in industries with high average profits from precipitating unsuitable wage
action whi may disturb the wage structure. A generally low level of profits
is also necessary because it is only if the distribution of income has been
shied, once and for all, sufficiently to the advantage of workers, that the
central trade union organization is considered to have any ance of
persuading its constituent unions to accept a wage policy whi supports the
efforts of the State to keep the value of money stable.
We shall not enter further into the question of how uniformity of profits
is to be secured; Rehn believes that monopoly control has a mission to fulfil
here. What is more interesting from our point of view is that the general
wage claims of the workers are assumed to be dependent on the total profits
of firms.
If we were to draw the extreme consequences of this theory, and put them
into a formula, the wage increase (or perhaps more correctly the workers’
claim for a wage increase), ΔW, from period 0 to the next period, 1, would
be an increasing function of the total profits, of the previous period, V0, thus

where f′ is positive, and f = 0 for a certain positive V = . Now if the

expected increase in productivity is k per cent, there is evidently always a
certain V0 whi ensures that 100 · ΔW/W0 = k.
e problem is then put in the following way. If the State has aieved
‘equilibrium’ in the labour market by various general means in su a way
that there is no excess demand for labour—this is a question of profits at the
employment margin, as has been mentioned above—will the total (average)
profits then be of su a size that the workers are induced, in accordance
with (XVII: 8), to ask for wage increases corresponding exactly to the
increase in productivity? Naturally, this cannot be known beforehand; as
Rehn says: ‘… average profits tend to be very high in a state of full
employment, unless measures are taken to reduce the general level of profits
without reducing employment. is is difficult, but necessary’.19 e
question is then whether total (average) profits can be reduced without
reducing employment.
Let us simplify the problem by assuming that production takes place
under conditions whi can be illustrated by an aggregate marginal cost
curve, m.c. in Fig. XVII: 4a. Money wages are given and wages are the only
variable cost. e amount of labour is given, and at full employment
production will be Q0. e labour market is assumed to be homogeneous. In
order that this level of output be produced, the price under perfect
competition must be p0. Total wage incomes are then A2OQ0B1 and profit
A1A2B1. If we disregard both investment and saving, the supply of

commodities A1OQ0B1, will be equal to the total demand without any

action by the State being necessary. Both the labour and commodity markets
are consequently in equilibrium; there is neither unemployment nor a labour
shortage.20

Fig. XVII: 4

Let us assume that this total profit, A1A2B1, is so large that it stimulates
claims for high wages, see equation (XVIII: 8). If we assume that
productivity is given, and that unanged money wages are desired, how
can the State bring about the necessary reduction of profit without affecting
employment? Obviously if the State causes a reduction in the total demand
for commodities, then profits will be lower when the new equilibrium has
been established, but at the same time a tendency towards unemployment
will arise through reduced production. is unemployment is undesired in
the Rehn-Meidner Policy, and it must therefore be counteracted without
thereby causing an increase in profits, and this may be aieved in at least
three different ways. Following Rehn, let us first assume that the basic
reduction in commodity demand is brought about by indirect taxation, and,
for the sake of simplicity, we shall also assume that the price level is not
affected at all in the short run. is last assumption is not made by Rehn, but
it is quite natural in our context.
(a) Assume then that in Fig. XVII: 4, b, the State introduces an indirect tax
of the amount t per commodity unit. If the price level, including tax, is to
remain unaffected, the net prices of firms must be so low that production is
reduced from Q0 to Q1. To bring this about the total commodity demand
will have to be simultaneously reduced from A1OQ0B1 to A1OQ1C1, see
below. Total profits will then fall from A1A2B1 to A3A2C2. By a sufficiently
high indirect tax profits may be reduced arbitrarily. At the same time
employment will fall in the private sector corresponding to the decrease in
wage payments from A2OQ0B1 to A2OQ1C2. Now if the State itself employs
the labour whi has been dismissed by the private firms, public wage
payment will be C2Q1Q0B1; private and public wage-rates are assumed to be
the same. Total wage incomes, at A2OQ0B1, will then be the same as in the
initial situation, and there will be full employment, while total profit is le
unanged at its lower level. e State has then brought about a decrease in
both the total and the average profit without reducing the level of
employment.
Let us for the sake of completeness also look at the commodity markets;
we said above that the State must secure a total commodity demand =
A1OQ1C1. Total profit is then A3A2C2; total wage incomes A2OQ0B1 and

total private income A3OQ0B1C2. If we disregard saving and investment, the

total commodity demand will obviously exceed (be less than) total private
production of commodities at price p0, if the State wage payments,
C2Q1Q0B1, exceed (are less than) the State income from indirect taxation,

A1A3C2C1; whi in turn depends upon the elasticity of supply.

21 e
requirement that equilibrium prevails in the commodity market at price p0
and with production Q1 may therefore necessitate certain direct taxes or
subsidies (or a ange in the interest rates if this would affect saving).
If saving and investment are disregarded then the budget balance will
obviously not be affected by this policy. If regard is paid to saving, the result
will be that workers’ consumption will not be affected, for the incomes of
the workers are unanged, while the entrepreneurs’ consumption is likely
to be reduced less than proportionally to the fall in profits; it will then be
necessary to have a budget surplus, by increasing direct taxation (or
reducing subsidies).
(b) Let us next assume, as in (a), that a general indirect tax, of the amount
t per unit, has been introduced, so that with an unanged price level,
production will fall to Q1. With the price level unanged we now wish to
maintain private production at Q0 despite the indirect tax and without
calling forth a larger profit than A3A2C2. is may be aieved if the State
simultaneously with the introduction of the indirect tax pays subsidies on
(marginal) production equal to C2B2B1, the shaded area in Fig. XVII: 4, b,
and sees to it that the total demand for commodities will be the same as in
the initial position, A1OQ0B1. In order to work properly, these subsidies
must of course be marginal subsidies,22 whi are calculated in su a way
that for ea unit produced between Q1 and Q0, the price minus the indirect
tax plus the indirect subsidy covers the wage cost of producing the unit in
question.
e measures whi have to be taken at the same time in order to aieve
equilibrium in the commodity market, are direct subsidies (or possibly
reductions in income taxation) in order to keep demand on a sufficiently
high level. Total incomes earned are A3OQ0B1C2, while the sales value of
production is A1OQ0B1. If we disregard private saving and investment, then
direct subsidies to the amount of A1A3C2B1 must be paid and we may
assume that these direct subsidies are only given to wage-earners. e
budget balance is not affected. If we consider saving, the rule is that if, and
only if, the workers’ marginal saving is lower than that of the entrepreneurs,
the amount of direct subsidies must be smaller than the indirect tax minus
the amount of indirect subsidies, and so there will be a budget surplus.
Consequently we have constructed a policy whi secures unanged
employment in the private sector despite a decrease in the total (and
average) private profits of employers. We have thus developed an important
feature of the Rehn Policy—that a certain basic general contraction
combined with a marginal sprinkling of production subsidies to industry
will provide the necessary decrease in total profits without reducing
employment in the private sector.
e difficulty with su a policy lies, of course, in the marginal
production subsidies, for they must be truly marginal if a reduction in
profits is to be brought about. e policy of marginal subsidies for
production played a certain role in both the theoretical and the practical
inter-war discussions on the prevention of unemployment and in some
countries even resulted in the introduction of su subsidies; these
experiments gave as a clear idea of the practical difficulties involved in this
task.23 On the other hand it is not at all certain, as has been maintained in
discussions on the Rehn policy, that it involves the ‘taking over’ of savings
by the State. It has already been pointed out above that this will only be the
result when a certain relationship exists between the marginal saving of
entrepreneurs and workers; generally it can only be said that the households
and the State will increase their saving, while the entrepreneurs (firms) will
decrease theirs.
(c) It is already obvious from the two previous cases that this policy will
affect not only factor incomes, including profits, but also disposable incomes,
including profits, aer the deduction of income tax. e problem whi then
arises is whether it is profits before or aer taxes (or subsidies) that are
decisive for the wage claims made by the workers according to (XVIII: 8)? If
it is profits aer taxation whi are decisive for the workers, whi seems
very reasonable, then there exists a mu simpler solution to our problem
than the two mentioned so far. If we start out from the initial position in Fig.
XVII: 4a, with profits too high, and if we introduce a direct tax on the net
profits of firms, the relevant profit will decrease without affecting the
employment margin. e assumption here is that demand is kept at the
previous level whi can be ensured by means of direct subsidies to the
workers, and this in itself will hardly provoke wage claims.
e fact that this solution plays a very modest role in Rehn’s policy is due
to his conviction that direct taxation has nowadays reaed su a high level
that the ‘room’ for further increases is limited or non-existent, if injurious
side-effects are to be avoided.
We have now described some of the leading ideas in the Rehn-Meidner
policy in terms of the type of model whi has been used in the previous
apters. Even though this description is far from complete, it is easy to see
both the similarities and the differences between the Rehn-Meidner policy
and our proposal for controlling money wages.
e similarities are firstly, that as a maer of principle unemployment is
not permied, secondly that the labour market is to be kept in ‘equilibrium’
so that purely market-conditioned wage-dri will not occur, and thirdly that
the distribution of incomes is employed as a means of controlling the
activities of labour market organizations. Further similarities, of course, are
fourthly, that both solutions involve great practical difficulties, and fihly,
that neither of them can give a complete guarantee that the workers really
do oose a ‘suitable’ wage policy.
e differences are also easy to observe. In the first place, the problem to
be solved by the Rehn-Meidner policy is different from the problem to be
solved by our proposal. e Rehn-Meidner policy takes the institutional
conditions for granted, and then asks how the policy of the State is to be
directed in order to make it psyologically possible for the trade unions to
establish a policy whi will be suitable for stabilizing the value of money,
not only temporarily but also in the long run. We assume that certain
institutional anges have been brought about, especially a centralization of
the wage negotiations, and then ask how the State is to make the trade
unions adopt a suitable wage policy. From this difference there also flows the
Rehn-Meidner hypothesis about the connection between total (average)
profit and wage-claims, whereas our proposal is not based on any su
assumption. On the contrary, we assume that by confronting the labour-
market organizations with an ultimatum seing out various policy
alternatives, the State abolishes relationships like (XVII: 8) and forces the
workers to oose their wage claims on the basis of these alternatives. ese
alternatives are constructed in su a way that whether the workers lay
emphasis on the relation between disposable profits and wage incomes, or
on the absolute level of disposable profits, or on the absolute level of
disposable wages (either in total or per worker), the wage rate desired by the
State will be the one whi is optimal for the workers in the situation in
whi they find themselves.
e Rehn-Meidner Policy assumes that the State accepts the income
distribution, and the size of profits, considered reasonable by the workers. If,
on the other hand, the State has any special desires in these maers, su as
that profits are to be large in order to secure large savings by private firms
and consequently a high degree of self-financing, then this policy cannot be
used. Our proposal does not presuppose that the wishes of the workers as to
distribution will necessarily be fulfilled. It is true that in our proposal the
workers may themselves oose their wage rates, within the framework of
the given alternatives, so as to minimize disposable profits and to maximize
the disposable wages, but whether this is to take place at a high level of
disposable profits and at a low level of disposable wages, or vice-versa, is for
the State to decide. Our proposal can thus be used by a policy maker who is
‘against profits’ as well as by one who is ‘for profits’, while the Rehn-
Meidner Policy can only be used ‘against profits’.

11. SUMMARY
In this apter we have tried to illustrate different aspects of wage formation
and anges in money wages from the viewpoint of a policy whi is to
stabilize the value of money at full employment. Firstly, we have shown
that, in principle, the State has at its disposal means to secure the two ends
irrespective of the anges whi may occur in money wages. On the other
hand, we have also shown that a co-ordination of anges in money-wages
with fiscal and monetary policy facilitates the laer to a very large extent. In
different situations different wage anges will appear ‘suitable’. To make
money wages ange in a suitable manner is usually considered to be the
greatest difficulty encountered by a policy whi is to secure a stable value
of money at full employment. In this respect our conclusions are quite
optimistic. ere are two reasons for this. Firstly, we consider it permissible
to define the concept of full employment so that so-called market-
conditioned wage-dri outside the wage agreements does not appear.
Secondly, we believe that we have found a method by whi the State can
control the movements of those money wage rates covered by wage
agreements between free labour-market organizations, without having to
compromise the ends of full employment and a stable value of money.

APPENDIX TO CHAPTER XVII

ON NATIONAL BUDGETING AND THE ‘ROOM FOR WAGE INCREASES’

In most countries the national budget takes the form of a balance of
resources, so let us begin by considering one of these containing the
following items:

Supply Demand

National product x1 Public investment x3

Imports x2 Public consumption x4

Exports x5

Private investment x6

Private consumption x7

Total supply ∑ Total demand ∑

e items included in this table, can either be regarded as ex post or ex

ante. If they are regarded as ex post entities for a past period, the table is a
balance of resources. If the entities are regarded as ex post for a future
period the account is a national budget. In both of these cases, the rule is
that the total supply is identically equal to total demand. Finally, if the
entities are regarded as ex ante for a future period, the table may be
regarded as an excess purasing power estimate; then the total supply need
not equal total demand and the difference equals the excess purasing
power, the inflationary gap. Here we shall be mainly concerned with the
national budget viewpoint, but the argument can be transferred without
difficulty to the ex ante viewpoint, see section 5.
 Our task here is not that of dealing with the practical problems of
national budgeting, but simply to aempt to define the basic problems of
national budgeting, and in so doing to get to grips with the concept of ‘room
for wage increases’. Our discussion of national budgeting coincides to a
large extent with that of Ingvar Ohlsson.1
All entities in the national budget are assumed to be generated by the
following model

where ea x is an endogenous variable and ea a is a parameter. All

entities in the national budget x1, …, x7 are consequently endogenous
variables in model (1). Let x8 be the price level of consumer goods and x9
employment, and a1 the money wage rate.
In the initial situation, that is in the year before the year of the national
budget, we assume for the sake of simplicity that model (1) is in stationary
equilibrium. In this situation a disturbance takes place, su as an increase in
productivity, whi appears as a ange in the parameter aj by daj. ese are
the basic conditions under whi national budgeting is assumed to take
place.
e condition of stationary equilibrium in the initial situation is not
essential in principle for what follows. e disturbance daj need not be
regarded as an exogenous disturbance. If it is assumed that model (1) is
dynamic, and has a period the same as the national budget year, it is clear
that if all parameters and lagged variables have the same values in two
successive periods, then the endogenous variables will also be the same
during the two periods. us, if in the initial position, (i.e. the year before
the year of the national budget) there is a la of equilibrium so that the
lagged variables of the budget year will be different from the initial position,
aj can be regarded as su a lagged variable, and daj as determined by the

previous development. If the model contains several lagged variables, we can

of course reon with the possibility of several ‘disturbances’, but this is of
no real importance.
 It is assumed throughout that the budget-maker knows both the ‘true’
model (1) and the disturbances whi will appear. If these conditions do not
hold, the national budget will, of course, be faulty in the sense that the
actual development will deviate from that described by the national budget.
To this ‘practical’ problem there is evidently no other solution than to get to
know the ‘true’ model and the disturbances whi will arise, if knowledge of
the laer kind is obtainable at all.

1. THE NATIONAL BUDGET AS A ‘METEOROLOGICAL’ FORECAST

To begin with we assume that the sole task of national budgeting is to make
a forecast of the anges in the balance of resources on the condition that no
State measures are taken, i.e. without State parameter anges. e forecast
then corresponds to what has been called a ‘meteorological’—or purely
passive—forecast.2 e anges in the different items of the balance of
resources, and also in the price level and employment, all considered as ex
post, are then obtained from the expressions,

where ∂xg/∂aj are the total derivatives (calculated on the whole of the
simultaneous equation system (1)) with respect to the disturbing variable.
In a situation su as this where there are no ends for economic policy, it
is obvious that the concept of ‘room for wage increases’ cannot have any
meaning; the ‘room for wage increases’ is something quite indefinite. It will
be recalled that an end was defined (in Chapter I) as a restriction on the
endogenous variables. e fact that there are no ends thus means that the
endogenous variables in the model may take on any values whatsoever. If
money wages are a parameter in the model, they can always be arbitrarily
anged without causing any conflict. It is true that a given increase in
money wages involves a ange in the variables included in the balance of
resources, and also in the price level and in employment, in accordance with
but as no restrictions have been imposed on these variables, there is no
‘limit’ for wage increases.

2. THE NATIONAL BUDGET AS ‘ENGINEERING’ FORECAST

If su expressions as the ‘room for wage increases’ are to have any meaning
at all and have any connection with the national budget, then national
budgeting must obviously be undertaken on the assumption that certain
ends have already been established for economic policy. is is the way in
whi the national budget is usually made up. In Sweden, at any rate, it is
postulated that a ‘general economic balance’ shall be ensured. is ‘general
economic balance’ could thus be regarded as an end in the drawing up of the
national budget. An examination of the methods of the drawing up of the
national budget and the calculations of the ‘room for wage increases’ in
Sweden shows, however, that normally the national budget is based on the
requirement of a certain level of employment and a certain price level. We
shall therefore base our discussion on the fact that the concept of general
economic balance can be interpreted as identical with two different ends,
namely the securing of a certain price level for consumer goods and a
certain level of employment.3 Obviously, the concept of general economic
balance may also include a requirement that the balance of payments be in
equilibrium, that foreign exange reserves be constant, etc. is means that
general economic balance is to be interpreted as three separate ends. e
main results whi follow will not be affected by this; accordingly, we
disregard the balance of payments. However, a quite different ex ante
interpretation of the concept of general economic balance is also possible,
and we shall return to this in section 5.
For the moment we thus assume that the national budget is a forecast of
the items of the balance of resources on the condition that a policy is so
conducted that the ends of an unanged price level and unanged full
employment are aieved despite disturbances in the model. Su a forecast
has been called an ‘engineering’ forecast, since the State operates with
certain of the parameters in the model.
We now assume that the State sets up the ends x8 = 8 and x9 = 9, or, if
the two ends are fulfilled in the initial position, that dx8 = dx9 = 0.4 In order
to secure these two ends, two means must normally be applied. Let these be
the fiscal or monetary policy parameters ah and ak.
e forecast of the anges in the balance of resources items is then

where dah and dak have been determined from the conditions for
unanged price level and employment, thus:

It will be seen that the national budget items are here determined not only
by the disturbance, daj, but also by the means that are osen in order to
secure the two ends of a constant price level and full employment. e
actual items in the balance of resources are not (for the moment) themselves
the subjects of postulated ends.
Let us now turn to the ‘room for wage increases’ in these circumstances.
If money wages are not one of the means ah and ak (i.e. h and k ≠ 1), and ah
and ak are determined according to the above system of equations, (5),
normally there is no ‘room for wage increases’; the ends have been aieved
on the assumption that money wage-rates are constant. Moreover, if money
wages are anged, the ends will be disturbed. us it is obviously wrong to
consider the value of dx7, the increase in private consumption, to forecast in
(4), as a measure of the ‘room for wage increases’.
Suppose, however, that money wages are actually anged by a certain
amount, and that we still have the two means ah and ak at our disposal.
e conditions for an unanged price level and employment, that is (5), are
anged to5

We can now consider two possibilities:

1°. (∂x8/∂a1, ∂x9/∂a1) ≠ (0, 0): With a given value of we can find the
values of dah and dak as before by solving (5)′ so as to secure the two ends
(unanged price level and employment) despite the original disturbance
and the increase in money wages. ese values of dah and dak will
generally deviate from the values obtained from (5). e forecast values for
the items of the balance of resources, including private consumption x7, will
also be anged as compared to the case without wage increases. As can be
seen, da1 may here be given completely arbitrary values (except any values
whi make the equations (5)′ inconsistent). In this sense the ‘room for wage
increases’ is still quite indefinite.
2°. (∂x8/∂a1, ∂x9/∂a1) = (0, 0): Here it is obviously immaterial what value is
aributed to ; dah and dak will be the same as in (5), in whi case
money wages were supposed to be unanged. e forecast values for the
items of the balance of resources will be affected, however, unless ∂xg/∂a1 =
0, where g = 1, …, 7. Also on the laer condition, whi among other things
means that private consumption is not affected by the wage ange, we
cannot obtain any ‘room for wage increases’ from the value of the private
consumption; on these assumptions, money wages can be fixed quite
arbitrarily without affecting the ends and the use of means. It hardly needs
to be emphasized that the conditions mentioned here under 2° will hardly be
fulfilled by any reasonable model.
us we see that if, in aieving the two ends, the State operates with two
means, neither of whi is money wages, the ‘room for wage increases’ will
be quite indefinite. If there is to be any sense at all in talking about a definite
‘room for wage increases’, money wages must be one of the two means
whi are used to secure the two ends; thus it is necessary, say, that h = 1.
Assume then, that in the system of equations (5), a1 is substituted for ah.
Solving this system of equations, we find the wage ange, whi together
with the ange of the means ak, secures the two ends; thus the ‘room for
wage increases’, da1, is

In this case the ‘room for wage increases’ is obviously uniquely

determined. On the other hand, it will be seen that the ‘room for wage
increases’ is dependent on
(i) the nature of the disturbance (aj);
(ii) the size of the disturbance (daj);
(iii) the nature of the means simultaneously employed (ak)
and, of course, on the qualities of the model as they appear in the values of
the various derivatives. With any given disturbance the ‘room for wage
increases’ is generally not determinate until we have defined the nature of
the simultaneously employed means, and one means, in addition to the
money wage ange, is necessary as a rule.
Of course, it is possible that the solution indicated for da1 will necessitate
that da1 becomes negative and that wages are to be reduced. If a reduction
in money wages is impossible for political reasons, either wages can no
longer be used as a means in this case—consequently another means must be
combined with ak and we are thus ba with the problem of (5) and (5)′—or
it must be investigated whether there is some other ak su that ∂x8/∂ak
and ∂x9/∂ak take on values that make da1 positive.
Having obtained da1 and dak, the forecasting of the items of the balance
of resources can be made according to (4) if a1 is here substituted for ah. In
this way we also find the ange in private consumption, dx7, and it is
obviously nonsense to try to calculate the ‘room for wage increases’ from
dx7.

If we use money wages as the only means, i.e. dak = 0, the two equations
(5), where a1 is substituted for ah, will be inconsistent unless the condition

happens to be fulfilled. is condition says that the price multipliers of the
disturbance and of money wages shall be in the same proportion as the
employment multipliers of the disturbance and of money wages, a condition
whi only very special models can be expected to fulfil. If, on the other
hand, this condition is fulfilled, then the ‘room for wage increases’ is
determinate and dependent only on the nature and size of the disturbance.

3. THE NATIONAL BUDGET AS A POLITICAL PROGRAMME

In the two previous sections we have assumed that the national budget is a
pure forecast of the items incorporated in the balance of resources. We
abandon this assumption now. It is oen not very clear to what extent the
national budget is to be conceived of as a programme (set of ends)
concerning the items incorporated in the balance of resources; but this
usually seems to be the case for certain of the items. erefore we will now
deal with the extreme case where all items in the balance of resources are
made into su ends, that is where the national budget is a purely political
programme. We retain the ends of an unanged price level and
employment as the basic assumptions behind the establishment of the ends
represented by the national budget.
e ends are thus nine in all, namely an unanged price level and
employment and also certain given anges in ea one of the seven items of
the balance of resources, thus
where . However, one of the ends dx1 to dx7 is not an
independent end. As the items of the balance of resources are still regarded
as ex post entities, we have

therefore we exclude in the following the end dx7, whi is automatically

fulfilled if the other ends are fulfilled; it can be said that the ange in
private consumption, dx7, is residually determined.
Now if the eight independent ends are to be secured, we must add six
further means to the previous means, ah and ak, say a2, …, a7. For the
determination of the use of the means we also have the eight conditions
(obtained by rewriting (8)),

From these eight equations we can determine the use of all eight means,
i.e. da2, …, da7, dah and dak.
If we now turn to the question of the ‘room for wage increases’, it is easy
to see that mutatis mutandis, the arguments and results will be just the same
as in section 2. e main result is that the ‘room for wage increases’ will be
quite indefinite if the money wage is not one of the eight means that are
used to secure the ends. Let us recapitulate briefly.
If money wages are not included among the eight means employed, and if
the use of these means is determined according to (10), money wages cannot
be anged without the ends being le unfulfilled. If, on the other hand,
money wages are anged by and the use of the eight means is
determined from the system of equations
all the ends will be fulfilled irrespective of what value is aributed to .
e ‘room for wage increases’ is still indefinite.
If we introduce the money wage, a1, as a means instead of ah, (10) is
anged to

From these eight equations da1 can be determined and we thus have a
determinate ‘room for wage increases’. However, this ‘room’ is now
dependent on
(i) the type of disturbance (j);
(ii) the size of the disturbance (daj);
(iii) the type of end (g);
(iv) the size of the ends ( ) and
(v) the nature of the remaining means (i′s and k).
It should be noted in particular that the ‘room for wage increases’ cannot be
determined until the remaining means have been osen, and if we ange
over from one combination of ‘remaining’ means to another, the ‘room for
wage increases’ will also be anged. Furthermore, it is obvious that the
‘room for wage increases’ still cannot be calculated on the basis of
knowledge of , the size of the increase in consumption; on the contrary,
(11) shows that in this case all (g = 1, …, 9) must be known, among other
things, in order for the ‘room for wage increases’ to be calculated.
For the sake of completeness, we must also point out that even if all the
items in the balance of resources can be regarded as parameters in model (1),
whi may be the case in a completely controlled society, this does not
ange the argument. e ends included in the national budget may then be
regarded as disturbances whi occur in addition to the original daj. In
principle, we are thus ba with the case whi was dealt with in section 2;
the number of disturbances is unimportant for the number of means, but
obviously not for their use.

4. THE NATIONAL BUDGET AS A COMBINATION OF FORECAST AND

POLITICAL PROGRAMME
Normally, certain of the items in the national budget will be regarded as
ends, and certain others as forecasts of the expected development. For
example, suppose that ends are set up for the anges in public investment
x3, public consumption x4, and private investment x6, while the anges in

the remaining items—the national product x1 imports x2, exports x5, and
private consumption x7—are to be regarded as forecasts. e ends of
unanged price level and employment are still assumed to remain as the
basis of the national budgeting. e number of means whi is normally
necessary then falls to five, the same as the number of ends, say a2, a3, a4,
ah and ak. e system of equations (10) will then be anged to

or, if a1 (money wages) replaces ah as a means

e forecast values of the anges in those items in the national budget

whi are not part of the political programme, i.e. x1, x2, x5 and x7, are then
obtained from
where da2, da3, da4 dah (possibly da1) and dak have been obtained from
(12), or (13) if wages are used as a means.
e result, as regards the ‘room for wage increases’, will obviously again
be the same as in section 2, and need not be repeated here.

5. THE ELIMINATION OF EXCESS PURCHASING POWER

Up to now we have considered the items in the balance of resources as ex
post entities in accordance with the claims of the national budget. e
concept of ‘general economic balance’ has then been regarded as a special
aim behind the drawing up of the national budget, consisting of the ends of
unanged price level and employment. However, if we consider all items in
the balance of resources as ex ante entities, so that in fact the balance of
resources is an estimate of excess purasing power for the commodity
markets, an elimination of the surplus purasing power may be taken to
mean that ‘general economic balance’ has been aained. is then is another
interpretation of the concept of ‘general economic balance’.
e object of economic policy will then be to ensure that

where every x is now regarded as an ex ante item, and dx is the amount by

whi the ex ante item for the coming year will differ from the
corresponding ex post item for the present year because of the disturbance
daj, Obviously, we have only one end here, namely (15), and in principle,

one means should be sufficient to secure this end. is means could be
money wages. For the determination of da1 we then have:
 If (16) has a solution at all for da1, we here find a determinate ‘room for
wage increases’. is ‘room’ may be negative, so that a wage reduction
becomes necessary. If some other means than money-wages is osen, a
relationship corresponding to (16) will then help to determine the use of this
means.
e question now is what does ‘general economic balance’ in this sense
mean for the price level and employment in the coming year, i.e. the year for
whi economic policy secures the fulfilment of (15). If the fulfilment of (15)
were to ensure an unanged price level and employment, the two
interpretations of the concept of the ‘general economic balance’ are the same
in this respect.
If da1 has been determined according to (16), we obtain the anges in the
price level and in employment whi will be the combined result of the
initial disturbance daj and the wage ange da1 (whi secured the
fulfilment of (15) despite the disturbance) from

Now if the model happens to be su that dx9 and dx8, determined in this
way, are both equal to zero, then ‘general economic balance’ in this ex ante
sense, obviously also implies unanged price level and employment.
However, this is a question of the properties of the model, and without
knowledge of the model nothing further can be said. It is obvious that if
alternative means may be used to secure (15), the effects on the price level
and employment need not be the same with different means.
Behind the idea of the elimination of excess purasing power as the
meaning of ‘general economic balance’ lies a theory the basic element of
whi is that if the right-hand side of (15) exceeds (falls short of) the le-
hand side the price level will tend to rise (fall), while if (15) is fulfilled, the
price level will remain constant. e price level in question here is the one
upon whi the ex ante values included in (15) were based. Now if this price
level is the same as it was in the previous period, and if (15) has been
fulfilled by means of economic policy, and, finally, if the price level anges
only if (15) is not fulfilled, it immediately follows that the ‘general economic
balance’, in the meaning discussed here, implies an unanged price level. A
similar argument cannot be conducted for employment, however.
From what has been said, it follows that the hypothesis that the price
level is only anged if there exists an excess (or deficiency) of purasing
power is of basic importance here. If this hypothesis holds, and if the ex ante
excess purasing power is assumed to have been calculated on the
assumption of an unanged price level, and if the State has taken su
measures that the excess purasing power is zero, the above argument
holds. However, sometimes in national budgeting the excess purasing
power is estimated on the basis of different price level to the current one.
e idea then is that factors other than an excess of purasing power may
affect prices, e.g. a wage increase or a rise in import prices. e problem then
seems to be that if rising costs make the price level rise by 5%, in connection
with, let us say, a wage rise of 10%, then an excess of purasing power will
occur whi may entail that the price level for the coming period rises by
more, or less, than 5%. Behind su reasoning there must be a model of a
different type to the one indicated above. In the laer case a wage increase
must affect the price level, partly in some direct manner, partly via its
influence on the excess purasing power (whatever prices are osen as the
basis for calculating this). erefore, if we have a model of this sort, if the
end is an unanged price level, and if the excess of purasing power is
made zero at an unanged price level by a certain wage ange, this is no
guarantee that the actual price level for the period will remain unanged.
e wage ange will have its own effect on the price level, an effect whi
is not indicated by the excess purasing power.
We thus conclude that the question whether the elimination of the excess
purasing power involves the fulfilment of the price-level end cannot be
solved without a more detailed study of particular models; without doubt,
there are certain special types of model where this question can be answered
in the affirmative. On the other hand, with the usual types of model, it is
hardly likely that the fulfilment of (15) also implies that employment will
remain unanged. is must, in all probability, always be a special end,
whi demands its own special means.

1. Cf. a standard work su as F. Zeuthen, Arbejdsløn og arbejdsmœngde

(Wages and Volume of Labour), Copenhagen 1953.
2. Here might be mentioned a number of contributions to The Theory of
Wage Determination, ed. by John T. Dunlop, London 1957.
3. In more general terms: the wage-rate is a price whi affects the planned
purases and sales of both firms and households.
4. Erik Lundberg, Konjunkturer och ekonomisk politik (Business Cycles
and Economic Policy), p. 218 f. and 397f.
5. It is clear that the model in Chapter XIII is not homogeneous in the
prices and money wages. e reason is that some of the State’s
parameters (direct subsidies and civil service salaries) are fixed in terms
of money.
6. See the detailed treatment of the Swedish wage-dri problem in Bent
Hansen and Gösta Rehn, ‘On Wage-Dri. A Problem of Money-Wage
Dynamics’, 25 Economic Essays in Honour of Erik Lindahl, Stoholm
1956.
7. For a more detailed analysis, see Bent Hansen and Gösta Rehn, ‘On
Wage-Dri. A Problem of Money-Wage Dynamics’, loc. cit.
8. e questions indicated here have been the subject of extensive debate.
Here we will only mention Bertil Ohlin, The Problem of Employment
Stabilization, New York 1949; F. Zeuthen, Arbejdsløn og arbejdsmœngde
(Wages and Volume of Labour); Rudolf Meidner, Svensk arbetsmarknad
vid full sysselsättning (e Swedish Labour Market at Full
Employment).
9. See Bertil Ohlin, The Problem of Employment Stabilization and my
review of it in Ekonomisk Tidskrift, Stoholm 1950.
10. e problem is obviously an ordinary aggregation problem, see Bent
Hansen, A Study in the Theory of Inflation, Chapter IX, 1–4; and the
contribution ‘Full Employment and Wage Stability’ in The Theory of
Wage Determination, edited by John T. Dunlop.
11. Bent Hansen, A Study in the Theory of Inflation.
12. Lord Beveridge, Full Employment in a Free Society, London 1944, p. 18 f.
13. See e.g. F. Zeuthen, Arbejdsløn og arbejdsmœngde (Wages and Volume
of Labour), p. 75 ff. and also F. Zeuthen’s contribution ‘Samtidig
bekæmpelse af arbejdsløshed og inflation’ (A Simultaneous Aa on
Unemployment and Inflation) in Axel Nielsen til minde (To the Memory
of Axel Nielsen), Copenhagen 1951.
14. With this type of policy, the problem of the ‘wage multiplier’ obviously
disappears. On the ‘wage multiplier’, see Erik Lundberg, Konjunkturer
och ekonomisk politik (Business Cycles and Economic Policy), p. 408 f.
15. It is worth pointing out that the ‘buffer’ used in the declaration need not
necessarily be the real disposable incomes of a particular group.
Investment or State expenditure or the balance of payments may also
appear in this role.
16. Fackföreningsrörelsen och den fulla sysselsättningen (Trade Unions and
Full Employment), Stoholm 1951. e viewpoints presented here were
advanced by G. Rehn, R. Meidner and others in Tiden in 1948, the organ
of the Swedish Social Democratic Labour Party, and were later
developed by Rehn in Wages Policy under Full Employment, edited by R.
Turvey, London 1952, with contributions by R. Meidner, G. Rehn, E.
Lundberg and K. Wiman; cf. also Erik Lundberg, Konjunkturer och
ekonomisk politik (Business Cycles and Economic Policy), Chapter 14,
and the discussion between Rehn and Lundberg in Ekonomisk Tidskrift,
Stoholm 1953.
17. e quotation marks around the words ‘fair’ and ‘reasonable’ indicate
that the authors are aware of the subjectivity of these terms, having in
mind wage-relationships whi do not provoke substantial wage
demands from various groups of workers.
18. It must be emphasized that we are here concerned with those special
aspects of the Rehn-Meidner argument whi can be dealt with on the
basis of assuming homogeneous production and a homogeneous labour
market. It is obvious that for Rehn and Meidner the measures for
bringing about this homogeneity (mating the supply of and demand
for labour) to a large degree coincide with the measures for reducing the
share of total profit in the national income.
19. Gösta Rehn in Wages Policy under Full Employment, pp. 30–31.
20. is model is the same as the one I used previously in a similar
connection, see ‘Fiscal Policy and Wage Policy’, International Economic
Papers, No. 1, and ‘E bidrag till incidensläran’ (A Contribution to
Incidence eory), Ekonomisk Tidskrift, Stoholm 1954, where the
basic premises of the model were given.
21. Bent Hansen, ‘E bidrag till incidensläran’ (A Contribution to Incidence
eory), Ekonomisk Tidskrifi, Stoholm 1954, p. 206.
22. Erik Lundberg in Wages Policy under Full Employment.
23. See F. Zeuthen Arbejdsløn og arbejdsløshed (Wages and Unemployment),
1939, p. 331 ff. However, it is not necessary to interpret the concept of
‘sprinkling’ so narrowly as the expression ‘marginal subsidies’ suggest
at first sight. Many of the ordinary measures taken to increase
employment in times of slump are of this kind or something between
marginal subsidies and direct provision of work. Typical is the policy of
subsidies for housing during the ‘thirties; and incentives to labour
mobility can also be reoned as marginal subsidies for employment
although these are not our immediate concern here with our assumption
of a homogeneous labour market and homogeneous production.
Realizing the difficulties, Rehn has stressed that the purpose of his
formulation of the problem has been to indicate the difficulty of having
full employment with a fixed value of money, and to advocate greater
administrative preparedness for the carrying out of any necessary
measures to secure full employment.

1. Ingvar Ohlsson, On National Accounting, Stoholm 1953, Chapter VIII.

2. W. H. Andrews and J. Marsak, ‘Random Simultaneous Equations and
the eory of Production’, Econometrica, Chicago 1944.
3. See Ingvar Ohlsson, On National Accounting, p. 280.
4. It may, of course, also be imagined that the goal is a certain ange in
the price level or in employment. en we have dx8 = and dx9 = .
e argument is not affected in principle by this. As will be easily seen,
(5) is then anged in su a way that or are added to the right-
hand side of the equations.
5. (5) and (5)′ are just alternative expressions of the ends dx8 = 0 and dx9 =
0.
 CHAPTER XVIII

Views on Fiscal Policy and Foreign Trade

1. INTRODUCTORY REMARKS
IN this work we have been applying the method of diminishing abstraction.
is is true not only as between the three main parts of the book, but also
within this final part itself, where in studying the possibilities of offseing
various types of disturbances we have up to now assumed a closed economy,
i.e. we have ignored foreign trade. It may seem quite meaningless to discuss
the problems of fiscal policy for a country su as Sweden in su a
restricted way. Obviously in a small country whi to a very large extent
has its economy based on foreign trade, the price level and employment will
be greatly dependent on foreign trade conditions, and all measures to secure
a stable value of money at full employment must have some effect on
foreign trade. Can a discussion, whi ignores all this, be of any value at all?
is is a fair question. Naturally a discussion on economic policy whi
disregards foreign trade is, to say the least, incomplete; on the other hand,
this does not mean that the findings are necessarily wrong, however, for
some of the main ideas may be perfectly valid, and all that is necessary is
some modification of them. is cannot be decided a priori; in order to
arrive at an answer to these questions we therefore proceed to examine the
policy problem in an open economy, where foreign trade is vital for the
functioning of economic life.
Our conclusions will ange somewhat when regard is paid to foreign
trade because we have to work with a model whi differs from the one we
have been using up to now. Just as important as the ange in the model,
however, is the fact that economic policy may also aim at influencing the
balance of payments, i.e. that certain ends may be set up in connection with
foreign trade. Here we are confronted with the problem of Gunnar
Myrdal’s1 ‘international room’ for domestic policy. It would obviously be
unreasonable to discuss the means for securing a stable value of money and
full employment assuming that foreign trade exists but ignoring the ends in
connection with foreign trade. If we did so we would miss the entire
significance of foreign trade for our problem. For that reason we shall
assume that in addition to the aims of full employment and a constant
consumer goods price index, the State also aims at aieving a certain
surplus (or deficit) in the balance of payments. We do not assume that the
end is necessarily to establish equilibrium in the balance of payments.
Amortizations on old foreign debts may necessitate a certain surplus in the
balance of payments if foreign exange reserves are to remain constant,
and new foreign loans may make a deficit possible in similar circumstances;
the end may also be to bring about a certain ange in the exange
reserves. e ends concerning foreign trade need not, of course, concern
only the deficit (or surplus) in the balance of trade (payments). e volume
of trade or its distribution between different types of goods may also be
included in the ends, but su problems will not be dealt with here.
In this apter no more than a very brief treatment of the problems of
foreign trade will be aempted. We will deal only with certain questions
whi are of immediate relevance to fiscal policy. e discussion here will
also be limited in another respect. Stress will be put upon the treatment of
what might be called an extremely open economy. Even in those countries
with relatively few restrictions on foreign trade the importance of foreign
trade to the national economy differs greatly from one to another. e model
for an extremely open economy, whi is discussed in the following
sections, might perhaps be relevant to economies with a large foreign trade
and a relatively small domestic production, su as Tangier or Hong Kong;
our model for the closed economy whi has been treated in the previous
apters may similarly be assumed to be relevant to economies with
relatively small foreign trade and huge domestic production su as the
U.S.A. One may perhaps assume that a country like Sweden is somewhere
‘in between’ these two extremes, and for that reason also that the results for
a country like Sweden lie ‘in between’ the results for the extreme cases.
Does it follow from this that all our results are without relevance for a
country like Sweden? Not at all, for it is interesting to note that the results
for the closed economy also apply to a large extent to the extremely open
economy, although problems arise and results appear in the extremely open
economy, of course, whi do not do so in the closed economy. It seems
natural to draw the conclusion that the results for the closed economy can in
the main be transferred to economies whi are ‘in between’ the closed and
the extremely open economy, but that the more special results for the
extremely open economy can be applied to ‘in between’ economies only
with modifications. In section 8 we shall aempt to defend this statement.
Furthermore, the premises of our model are of su a nature that they only
allow discussion of certain special types of disturbance in foreign trade
relations, namely those whi derive from export and import prices or from
domestic conditions. A more general discussion of the problem of foreign
trade is not intended, however. Finally, it should be pointed out that the
extremely open economy is of interest in itself anyway from a purely
theoretical point of view.
We assume that the State (or the central bank) sets exange rates and
makes these rates effective by appropriate purases and sales of foreign
exange. e exange rates are thus to be regarded as exange policy
means and as State parameters, and equilibrium (or a certain surplus or
deficit) in the balance of payments as an end. When we speak of exange
policy means in the future we will also include import duties and export
bounties; for it is immaterial whether these means are regarded as fiscal
policy or exange policy means. Furthermore, all restrictions on foreign
trade are ignored; all economic subjects can freely export and import all
types of goods and services.

2. AN ILLUSTRATIVE EXAMPLE
In order to give some idea of the nature and meaning of the simplifications
whi we will be making in the next section so as to extend the basic model
from that of Chapter XIII, 2, to one that will apply to an extremely open
economy instead of to a completely closed one, we will first consider an
example whi is aracterized by the same kind of simplifications. is
example is based on a simple model whi was examined previously in
another connection, see Chapter XVII, 10, Fig. XVII: 4.
We imagine an economy where only one commodity is produced and
where wages are the only variable cost. ere is perfect competition in the
commodity market. us we have an aggregate marginal cost curve, m.c.,
see Fig. XVIII: 1. Furthermore, it is assumed that there exists a ‘foreign
country’ whi is so large that imports to or exports from the economy we
are considering will not influence the ‘world market price’. is foreign
country also produces only one type of commodity, the same one that is
produced by the home country. e world market price, expressed in the
currency of the home country, is p1. e level of production in that country
will then be q1, and (ignoring the difference between net and gross) we
have:

As we are only operating with one commodity, either exports or imports

(or neither) must take place. e extent of the imports will be determined by
the total demand of the country. is demand is determined partly by the
consumption by workers and entrepreneurs and partly by private
investments whi must here consist of anges in stos. If the average
saving of the inhabitants is positive, total consumption will be smaller than
production, q1; however, if the size of the investments is not limited by total
savings, consumption plus investment may very well exceed q1. e result
will in that case be imports from the foreign country. With a total national
demand d1 there will be an import = M1, and with the demand d2, an export
= X1.
 Fig. XVIII: 1

e simplification of foreign trade is thus, firstly, that it is assumed to

make no difference to home consumers whether they buy goods of domestic
or of foreign origin—substitution in demand is perfect. Secondly, imported
goods are assumed to go directly to the consumers without creating either
wage incomes or profits in the community; imported goods do not enter into
domestic production. On the other hand, exports originate from firms, and
generate wage incomes and profits in the usual manner.
In order to demonstrate how the model works let us now assume that the
world market price rises, or that the exange rates are raised; the domestic
price will then increase correspondingly. Consequently there will be a
certain increase in employment and production; the extent of the increase
depending on the elasticity of the supply curve. So far the tendency is for
imports to decrease or exports to increase. Demand is also affected however.
If the supply curve is not vertical or employment full, there will be an
increase not only in the nominal but also in the real national income, whi
involves some tendency towards increased consumption. At the same time
the distribution will have anged. e result may be either an increase or
decrease in real consumption depending on the elasticity of the demand
curve and the marginal propensity to consume of the workers and
entrepreneurs. Moreover, if regard is paid to the fact that investment (i.e.
increases in stos) may possibly rise due to the increased production or the
increased profits, it is obvious that the total quantity of goods demanded
may increase or decrease as a result of the rise in world market prices (or
exange rates), see demand curve DD, where DD = D(p) other things being
equal. It is an open question how the balance of payments is affected by the
price increase (rise in exange rates); however, if the income elasticity of
saving exceeds that of investment an improvement in the balance of trade
must result.
Conversely, let us now look at a case in whi a certain measure is taken
whi, with a given world market price, given exange rate, money wages
and productivity, etc., will affect demand. For example, we can imagine a
rise in the rate of interest whi tends to reduce investments and/or increase
savings, or an income tax whi tends to reduce the disposable incomes and
whi is not spent by the State. Su measures will shi the demand curve
to the le and thus involve a reduction in imports (or increase in exports).
e balance of trade is consequently improved. It will easily be seen that the
price level, employment and production are not affected by these measures.
Employment is independent of the size of the effective home demand; for
this is only important for the deficit (surplus) in the balance of trade.
Employment and production are completely determined by the price level
(world market price) and the supply curve (i.e. productivity and wages). At a
given world market price the price level in the home country is only
influenced by anges in the exange rates or by import duties and export
bounties; and conversely the effects on production and employment of
anges in the world market price can only be counteracted by exange
policy means.
is means that, if regard is paid to foreign trade, the policy problem will
be anged in an important way as compared with the closed economy.
Exange rate policy appears as a necessary component of State policy—and
this is true even if no ends have been established with regard to the balance
of payments—and different types of policy will have different effects on the
end variables. We shall not go further into this subject in connection with
this simple model, but shall proceed instead to introduce foreign trade into
the basic model from Chapter XIII. e basic features of the simple model of
this section will remain unanged in the more complicated model but the
laer permits a mu more sophisticated analysis. Nevertheless, in order to
clarify certain points, we shall refer to the simple model now and then.

3. THE MODEL FOR AN EXTREMELY OPEN ECONOMY

In the model in Chapter XIII production was divided between a consumer
goods industry and a capital goods industry. e prices of consumer and
capital goods were assumed to be determined in su a way that equilibrium
was established in both the consumer and the capital goods market. We now
drop this assumption; firstly, we drop the idea that the domestic demand for
consumer or capital goods is equal to the country’s own production of these
two goods, in other words we abandon the equilibrium conditions (XIII: 5°)
and (XIII: 6°); secondly, we introduce the assumption (see the previous
section) that both consumer and capital goods can be freely imported or
exported and that there is a world market price for consumer goods and a
world market price for capital goods, these world market prices being
assumed to be unaffected by the size of our country’s imports and exports.
Let us reformulate the model from Chapter XIII under these assumptions.
We call the exange rates (the price of a certain amount of foreign
exange in terms of the domestic currency) v, and the world market price
(in foreign currency) for consumer goods pCM and for capital goods pIX (M
signifies imports and X exports, and for the sake of simplicity we suppose
that consumer goods will actually be imported and capital goods exported),
the rate of customs duty tCM and of export bounty tIX. us for the
determination of the consumer goods price in the home country, pC, we
have

and for the determination of the capital goods price in the home country, pI,
we have

Next come a series of equations similar to the equations for the closed
economy, see Chapter XIII, 2. In the same manner as in the closed economy,
there are the optimum conditions for the consumer goods industry, see
equation (XIII: 4).

and for the capital goods industry, see equation (XIII: 5)

Total employment, see equation (XIII: 7°) is

 For the determination of consumer goods production, qc, see equation
(XIII: 6), we have

and for the determination of capital goods production, qI, see equation (XIII:
7)

Disposable wage-incomes, see equations (XIII: 8 and 9), are determined

according to the following

while the disposable incomes of entrepreneurs, see equations (XIII: 10 and

11), will be

e consumer goods demand from the workers, entrepreneurs and the

State, see equation (XIII: 12), will be

and the total capital goods demand, see (XIII: 14) will be

For the determination of the volume and composition of foreign trade we

assume that consumer goods will in fact be imported and capital goods
exported; thus for imports
and for exports

As can be seen, imports and exports are quite simply determined as the
difference between home demand for and home production of consumer and
capital goods respectively. In principle MC may of course be negative, and
then consumer goods will be exported, or XI be negative, and then capital
goods will be imported.
Finally, we have the balance of trade surplus, S, reoned in foreign
currency, determined by

We have now fourteen equations, (XVIII: 1) to (XVIII: 14), to determine

fourteen variables.
e model whi we have now established, and whi may be regarded
as an adaptation of the model from Chapter XIII, is still static, and although
it does not contain any explicitly stated equilibrium condition, it is also in a
certain sense an equilibrium model. It is true that the domestic demand and
supply of consumer and capital goods need not be the same, nor need the
balance of trade and the labour market be in equilibrium in the ordinary
sense. However, domestic plus foreign demand is equal to domestic plus
foreign supply of both consumer and capital goods. And in the foreign
exange market demand must be equal to supply; otherwise the quoted
exange rates would not be effective. In the credit market demand and
supply must be equal; otherwise the quoted rate of interest would not apply.
And in the labour market the entrepreneurs’ planned purases of labour
and the workers’ expected sales of labour will have to be equal (whi will
prevent shortages of labour power but not unemployment). On the other
hand it is obvious that there is no sto equilibrium in the model: the
amount of real capital will rise by the current demand for real capital, dI;
exange reserves will increase by the surplus on the balance of trade (if
other foreign debts and loans do not ange), etc.
In order to get a clearer picture of the aracteristic qualities of the model
from the point of view of a policy to secure full employment, constant price
level of home consumer goods and a certain surplus (or deficit) in the
balance of trade, we shall proceed to draw a diagram illustrating what was
earlier called (in Part I, Chapter I, 8) the ‘causal ordering’ of the model
following Simon’s terminology. e causal ordering of the model is most
easily revealed by the use of an arrow diagram, whi is a generalization of
Tinbergen’s well-known arrow-seme. e reason why we need the causal
ordering is that it plays a significant part in the policy problem, especially
for what we have called the ‘ordering’ of the policy means.
If we look at Fig. XVIII: 2, where the ‘causal ordering’ of the model is
shown, we have all fourteen endogenous variables linked together in a
certain way by arrows, ea of whi corresponds to a certain equation in
the model. Furthermore, we have introduced into the figure all the
parameters, the uncontrollable as well as the controllable, these being placed
in rectangles. e broken lines whi lead from the parameters to the
endogenous variables also correspond to equations in the model. ere is no
simple correspondence between arrows and equations, however, in the sense
that ea equation corresponds to one and only one arrow, and vice versa—
in fact several arrows oen correspond to one equation.
Now if we begin at the top le-hand corner of the table, we find the
parameter group tCM, v, pCM from whi a doed arrow leads to the
consumer goods price. ere are no other arrows leading to pC. is means
that the price level is completely determined by these three parameters. One
need not know any of the other endogenous variables in the system in order
to determine pc. e consumer goods price level, pC, the parameter group
M M
tC , v, pC , and the doed arrow in between correspond to equation
(XVIII: 1), e situation is similar in the case of the price level of capital
goods, pI; if one knows the parameters tIX, v, pIX then pI is fully
determined; knowledge of other endogenous variables is not necessary, see
equation (XVIII: 2). ere are no other endogenous variables, however,
whi can be determined without knowledge of the other endogenous
variables. us the variables pC and pI make the complete subset of the first
order variables.
According to equation (XVIII: 3) the variable NC is determined partly by
pC and partly by the parameters w and tC, as shown by the arrow from pC

to NC and the broken arrow from the parameter group w, tC to NC. is
variable belongs to the complete subset of the second order, because this
subset consists of all endogenous variables whi can be determined with a
knowledge of certain parameters and endogenous variables of the first order.
It will easily be seen that NI also belongs to the subset of the second order,
see equation (XVIII: 4) and the arrows from pI and the parameter group w,
tI, to NI.

Now if we continue in this manner we find that qC, qI, N, and Ld form
the subset of the third order; Vd and dI form the subset of the fourth order;
dC and qIX form the subset of the fih order, the subset of the sixth order
and, finally, S is the subset of the seventh order.
If we look again at the table it will be seen that within ea complete
subset of variables, ea separate variable that belongs to the subset in
question can be determined without knowledge of the other variables in the
same group; according to the Simon terminology this means that ea
separate variable in the model is its own subset, i.e. ea variable forms a
minimal subset. is property of the model means that the model is purely
recursive or consecutive.2 In models of this type the policy problem is
greatly simplified and has certain aracteristic features whi we shall
explain in the following section.
 Fig. XVIII: 2

Finally, in Fig. XVIII: 2 we have indicated by circles the three variables

about whi the State has definite ends, i.e. the consumers goods price level,
pC, employment, N, and the surplus (or deficit) on the balance of trade, S; pC

belongs to the subset of the first order, N to the subset of the third order and
S to the subset of the seventh order.
us we have explained the structure of the model as regards the
endogenous variables.

4. THE ORDERING OF EXCHANGE, FISCAL AND CREDIT POLICY

MEANS
Next we proceed to examine the position of the policy parameters in the
model. In Fig. XVIII: 2 the parameters have been indicated by rectangles,
and they are linked immediately to the group of variables on whi they
exert a direct influence. e rule is now that if a certain parameter appears
for the first time in connection with variables of a certain order, this
parameter can influence variables in this subset and in groups of a higher
order, but never variables belonging to a subset of a lower order. Let us look,
for instance at the rate of interest, whi is our only credit policy parameter.
In the model the rate of interest appears as a determining factor for the
capital goods demand, see equation (XVIII: 11). In Fig. XVIII: 2 this
corresponds to the fact that the rate of interest appears with direct influence
only on the subset of the fourth order; if the model is extended so that the
rate of interest directly influences the consumer goods demand (saving), the
rate of interest will also exert direct influence on the group of the fih order.
us the rate of interest does not influence variables of the third or lower
orders but does affect, in an indirect way, variables whi are included in
the subsets of the fih and higher orders. is will mean that the rate of
interest will exert no influence on the price level of consumer goods or on
employment; the balance of trade is the only one of our three end-variables
whi are influenced by the rate of interest. As one can easily see, the same
thing applies to income taxation, direct subsidies and public purases of
goods.
Money wages, w, appear for the first time (in ascending order) in
connection with variables of the second order. Wage anges do not affect
the price level of consumer goods, but do affect employment and the balance
of trade. e same applies to indirect taxes on both consumer and capital
goods and to State purases of labour, see however section 7.
Finally among the policy parameters, we have the exange policy means:
exange rates, import duties and export bounties. ese parameters
obviously affect the consumer goods price level as well as employment and
the balance of trade; they appear in connection with the variables of the first
order. Strictly speaking we should exclude the export bounties, whi do
appear together with the group of the first order but only affect the capital
goods price level; however, we must recall the simplifying assumption that
MC and XI are positive; as soon as this is not the case the importance of

import duties and export bounties is different.

We may summarize these findings in the following table whi sets out
the spheres of influence of the different forms of policy:
 Exchange Policy Fiscal Policy and Credit
Wage Policy Policy

Consumer Goods
Price Level
Spheres of Employment Employment
Influence
Balance of Trade Balance of Trade Balance of
Trade

From this it immediately follows that there is an ordering between the

different means of policy. For if all end-variables deviate from the stipulated
ends, exange policy must first be directed so that the desired consumer
price level is aieved. Once the suitable exange policy has been
determined, wage policy or (indirect) fiscal policy (i.e. indirect taxes and/or
State purases of labour), must be directed so that full employment is
brought about. Finally, once it has been determined in this way how far
these forms of policy are to be used, then monetary policy and (direct) fiscal
policy (i.e. income taxes, direct subsidies and/or purases of commodities
by the State), must be directed so that the surplus (or deficit) in the balance
of trade will be of the size desired.
It could be said that in this extremely open economy, exange policy
must protect the value of money, (indirect) fiscal and wage policy must
protect employment, and monetary policy and (direct) fiscal policy must
protect the balance of payments. is may seem paradoxical if we compare
these results with the usual recommendations, namely that exange policy
is to protect the balance of trade (payments) and monetary policy the value
of money, etc. Our argument is not paradoxical, however; the results follow
from the premises. If the results are unusual it must be because the premises
are unusual. Obviously the model employed is unusual in the sense that it
differs somewhat from the simple models that are usually used in discussing
questions concerning foreign trade. Also it is obvious that the results ange
as the structure of the model anges, see sections 7 and 8. However, it can
never be sufficiently stressed that the stated order for the use of means
depends not only on the established model but is just as mu conditioned
by the established ends. For example, the result that exange policy ought
to be used to maintain the value of money and not to secure the balance of
payments, is due not only to the structure of the model but also depends on
the basic assumption that the ends of a stable value of money and a certain
surplus (or deficit) in the balance of payments have to be simultaneously
secured. If in our model for the extremely open economy, we had only
established the end of maintaining a certain surplus in the balance of
payments, it would be quite natural to use exange policy as a means;
however, a policy of this kind requires our abandoning the constancy of the
value of money and allowing the price level to be one of the variables in the
model, whi may be adapted so that the desired balance of payments is
realized. When exange policy is recommended as a means for regulating
the balance of payments, as it is normally, the value of money is not
assumed to be protected at the same time; conversely the desire to maintain
simultaneously an unanged value of money—even with models other than
extremely open ones—excludes, or at least greatly complicates, the use of
exange policy to control the balance of payments. We shall return to this
more general problem in section 8.

5. INTERNAL DISTURBANCES. COMPARISON WITH THE RESULTS OF

THE PREVIOUS CHAPTERS
Before we proceed to examine the disturbances originating from abroad
whi affect the value of money and employment and also the balance of
payments, we shall examine the effects of internal disturbances and how
they can be neutralized with respect to the end-variables in the model under
consideration. We shall try to show that in the main the results of Chapters
XIII to XVII are valid, despite the fact that we there considered a closed
economy and here are dealing with an extremely open one.
As is to be expected, certain differences appear now that the model has
been anged. Among the anges in the structure of the model whi
resulted from the ange from the closed to the open economy, one is
particularly important to our problem: in the extremely open economy the
consumer goods price level and the prices of capital goods are not affected
by internal disturbances. At given rates of exange, import duties and
world market prices, the price level is independent of whatever happens in
the domestic economy. Internal disturbances do not make it necessary to
take measures in order to secure the end of a stable value of money. at
this does not bring about a radical ange in the maer of the means
necessary to secure the given ends is due, on the one hand to the fact that
simultaneously with the introduction of foreign trade in the model we also
introduce a third end, the securing of a certain surplus (or deficit) in the
balance of payments, and on the other hand to the fact that the now
discarded conditions for equilibrium in the consumer and capital goods
market (i.e. an unanged relationship between home production of and
home demand for consumer or capital goods) also play a part in bringing
about a certain surplus (or deficit) in the balance of payments; for the
relationship between home production and demand now determines the size
of imports and exports. In the closed model it is necessary to control the
relationship between production and demand in order to secure stable
prices; in the open model it is also necessary to control the relationship
between production and demand, not for the sake of the price level, but for
the balance of payments. ese are the reasons why the result concerning
the policy directed against internal disturbances also apply in the main for
the extremely open economy.
Our closed model was interdependent; if we were to describe it in a way
similar to that of Fig. XVIII: 2, we would remove from the arrow diagram
those parameters whi influence pC and pI directly and also the
endogenous variables qCM and qIX and S. From qC and dC, and qI and dI
arrows would be drawn to pC and pI, respectively. is would mean that the
prices of consumer goods and capital goods must be so high that demand
and production will be equal for ea of the two commodities. us the
model is obviously interdependent. e fact that policy towards certain
types of disturbances, viz. most internal disturbances, will not have to be
altered with su a ange of the model can be easily seen from the
following example.
 Fig. XVIII: 3

Suppose that we have four endogenous variables in the model, namely x1,
x2, x3 and x4. Suppose also that the variables in the model are connected to

ea other by an interdependent ‘ring’, see Fig. XVIII: 3a, and finally
suppose that the model is anged so that the relationship from x4 to x1
disappears: x1 is determined by exogenous factors instead. e variables are
then connected in a recursive ain, see Fig. XVIII: 3b. Furthermore, we
assume that in the first model x1 and x2 are the end-variables; while in the
laer model x4 is also an end-variable. We denote the end-variables by small
circles.
Assume now that a disturbance occurs in the relationship between x2 and
x3; this relation is common to both models. If the State has at its disposal

some means, whi affects the relationship between x3 and x4 this

relationship also being common to both, the task with the former model will
be to ange this means in su a manner that x4 remains unaltered despite
the disturbance of the relationship between x2 and x3 and the consequent
ange in x3. e end-variables x1 and x2 will then not be affected. In the
laer model too, the task will be to ange the means in su a way that x4
is not affected by the disturbance—in this case, not because this will prevent
x1 and x2 being affected, for according to this model itself, these two

variables will remain unaffected anyway, but to aieve the end connected
with x4. us it is something of a coincidence that the policy against certain
disturbances happens to be the same in the two models; the ange in the
model was certainly very important, and so was the introduction of the new
end, but it so happened that these two anges cancelled ea other out.
 Finally, it should be mentioned that our closed interdependent model
certainly cannot be represented as a perfect ‘ring’ and nor is our open
recursive model a perfect ‘ain’ like the one discussed above, but these two
representative cases give the aracteristics of the two models where
internal disturbances are concerned.
Against the baground of these general arguments we shall examine
some typical examples of internal disturbances; and the similarities and
differences between the policies to be pursued in the closed and the
extremely open economy will then become apparent. Concerning the
ordering of the means we refer to the discussion in the previous section.
It is convenient first to consider disturbances that take the form of
spontaneous anges in domestic demand. On the one hand we may assume
a spontaneous increase in the total home demand for consumer goods due to
a decrease in the propensity to save or to increased purases of goods by
the State, and on the other hand a spontaneous increase in the demand for
capital goods caused by an increased private propensity to invest or by
increased purases by the State. As can be easily seen from Fig. XVIII: 2,
these two types of internal disturbance will only affect one end-variable, the
balance of payments, and not the consumer goods price level or
employment. It will then be appropriate to counteract the effects of these
two disturbances by means whi affect the balance of payments but not the
consumer goods price level and employment (thus following an ‘economy of
means’ principle). Su means do exist, namely the rate of interest and
income taxation (perhaps also direct subsidies from the State and purases
of goods by the State). Whether the State has to use the rate of interest or
income tax depends on the desired composition of home consumption and
investment. For example, increased demand for consumer goods involves
increased imports and this leads to a deterioration in the balance of
payments; if the State increases the income tax to prevent this, the demand
for consumer goods will fall and the increase in the deficit in the balance of
payments will be removed. Consumption and investment in the nation will
then remain unaltered, but public saving will be increased at the expense of
private saving; if the State raises the rate of interest instead, the demand for
capital goods will fall, exports will increase and the balance of payments
will be re-established, but in this case consumption increases while private
investment (as well as private and total savings) will decrease.
 As can be readily seen, one means, whether a ange in the rate of
interest or in income tax, is sufficient to counter-balance the effects on the
ends of the spontaneous anges in demand. is is in complete accordance
with the results obtained in Chapter XIII, 5 and 6, and also in Chapter XV, 3,
(i) and (ii). However, we must note that in the open economy the
possibilities of affecting total consumption and investment are greater also
in the short run; for this requires no revision of production or transfer of
labour between the industries as in the closed economy.
If we try to enumerate all the disturbances whi can affect the balance of
payments without affecting the consumer goods price level and
employment, we find that—apart from the spontaneous anges of demand
just discussed—a certain type of productivity ange also has this ability.
Changes in average productivity within the consumer or capital goods
industry with unanged marginal productivity (given world market prices,
rates of exange, customs duties, money wages, and indirect tax rates) will
not affect employment (NC and NI) but only production (qC and qI), and
consequently will indirectly affect the balance of payments, see Fig. XVIII: 2.
e effects on the end-variables of su anges in productivity may,
therefore, be neutralized by use of one means, say the rate of interest or
income tax (if the State is not concerned with the relative magnitudes of
consumption and investment—see above). is result differs from that in the
case of the closed society, where two means are necessary, see Chapter XV:
2, (ii) and (iv).
Even the State’s own policy may appear as a disturbance in the economic
system. For the closed society we treated su disturbances and the means to
prevent them, under the heading of ‘neutral fiscal policy’. e same sort of
disturbances may, of course, also occur in an open economy. e State
parameters whi affect the balance of payments without affecting the
consumer goods price level and employment, are commodity purases, the
rate of interest, direct subsidies, income taxation and also civil servants’
salaries (WO). e effects of anges in any one of them upon the end-
variables can obviously be offset by using one of the others, and this finding,
too, is in conformity with the results for the closed economy.
We now proceed to the disturbances whi affect both employment and
the balance of payments, but not the consumer goods price level. All anges
in productivity whi affect marginal productivity obviously belong to this
group; the same applies to anges in money wages in the private sector of
the economy (along with the world market price of capital goods, whi we
will disregard in this connection, however). If su disturbances occur, it
seems natural to combat their effects by means whi also affect only
employment and/or the balance of payments but not the price of consumer
goods (‘the principle of economy of means’). When looking for means whi
affect employment without affecting the price of consumer goods—we
disregard customs duties and export bounties on capital goods—only the
indirect taxes on the production of consumer and capital goods and State
employment, NO, are available. If we disregard variations in public
employment, then with world market prices and exange rates given,
indirect taxes on production are obviously the only available means of
ensuring labour market equilibrium, if the State cannot directly or indirectly
control money wages in the private sector of the economy. For example, if
there is an increase in marginal productivity within the consumer or capital
goods industry, the indirect tax on consumption or capital goods must be
increased if overfull employment with an upward wage-dri is not to arise.
Let us consider a uniform increase in productivity. If unanged
distribution of employment is desired (perhaps an inevitable premise in the
short run) both the consumer goods tax and the capital goods tax must be
increased in the same proportion as productivity has increased. us
equilibrium in the labour market will be secured. e production of both
consumer and capital goods will now rise by the same percentage as the
increase in productivity. If neither the home demand for consumer goods
nor for capital goods is affected, the balance of payments will improve as
imports decrease and exports increase. According to the model, neither
disposable wage incomes nor entrepreneurs’ incomes are affected; thus the
demand for consumer goods is not affected. On the other hand, the
production increase itself may influence the demand for capital goods and
thereby slow down the increase in exports. However, if we assume that the
balance of trade is improved in spite of the increase in the demand for
capital goods, a decrease in income tax rates or in the rate of interest, or the
use of some of the other means whi affect the balance of payments only,
will be necessary to secure an unanged balance of payments. Compared
with the closed economy, Chapter XV, 2, (v), we find that the results are in
accordance with the case of unanged distribution of employment between
the industries; here an increase in the indirect consumer goods tax and the
indirect capital goods tax combined with a decrease in income tax rates
were sufficient to secure the ends.
e analogy is not complete, however. In a closed economy, the
combination of an increase in the indirect consumer goods (production) tax
and in the rate of interest, together with a decrease in income taxation,
would be sufficient to secure the ends; this combination of means is not
available in the open economy, at least not if the distribution of employment
is to remain unanged. is example illustrates one of the most significant
differences between the policy problems of the two models. In all
combinations of means to be applied in the closed model, increases in the
rate of interest and in the indirect tax on capital goods could be regarded as
equivalent; the only difference between the effects of a combination of
means whi included an increase in the indirect tax on capital goods and
one including an increase in the rate of interest, ceteris paribus, was that
with the former the market price for capital goods happened to be above
that of the laer combination, but that is not relevant to our problem. In the
open model, increases in the rate of interest and increases in the capital
goods tax are not equivalent means; interest affects the demand for capital
goods and through that the balance of payments; the capital goods tax
affects the production of capital goods and thus affects employment as well
as the balance of payments. is difference between the open and closed
model is, in its turn, due to the fact that in the open model, the price level
for capital goods is determined from without; in the closed model, the price
of capital goods can be varied.
No su difference between the open and the closed models arises in
connection with the indirect tax on consumer goods. e reason for this is
that the price of consumer goods is also given in the closed model, in so far
as any variations in the indirect consumption tax whi might ange the
market price were out of the question. For this reason, the indirect tax on
consumer goods and income taxation were not equivalent means in the
closed model either.
For spontaneous increases in money-wages the same applies as for the
uniform increase in productivity, see Chapter XV, 2. In general the rule is
that all statements about wages can be transferred, mutatis mutandis, from
the closed model, Chapter XVII, to the open model.
Finally, it must be stressed that even in our extremely open economy we
have to make use of opposite variations in indirect taxes on consumer goods
and income taxation whi in so many cases were aracteristic of policy in
the closed economy.
We now proceed to phenomena that are peculiar to the open society,
disturbances from abroad and the policy to be adopted towards them, i.e.
exange policy. is was le out of the discussions on internal
disturbances, even when the task was to correct undesirable anges in the
balance of payments. is was done quite deliberately and rationally; we
shall now show why.

6. DISTURBANCES FROM ABROAD

Changes in the world market prices of consumer goods or of capital goods
are the only disturbances from abroad that can appear in our model. Under
(i) we shall first consider a proportional ange in both the consumer goods
price and the capital goods price; under (ii) an isolated ange in the world
market price of consumer goods; and finally, under (iii), an isolated ange
in the world market price of capital goods.

(i) Proportional Changes in World Market prices

If all world market prices rise in the same proportion, the effects of this
are easily offset by a reduction in the rates of exange in the same
proportion. e internal economy, including the ends, will then be
unaffected. However, the balance of payments will increase if the balance
was previously positive and decrease if it was previously negative; only in
the case of equilibrium is the balance of payments unaffected. is is
because the balance is measured in foreign currency and it is assumed that
the end concerning the surplus (or deficit) in the balance of payments is
expressed in terms of foreign currency. If instead the balance were to be
reoned in the home currency, this end would also be secured by the
reduction in the rates of exange. If we still have to secure at certain
surplus (deficit) measured in foreign currency, the simplest method is to
combine a reduction in the rates of exange with an appropriate ange in
the rate of interest and/or in income tax rates.
Proportional anges in the world market prices thus offer no great
problem, if the rates of exange can be altered ad libitum. If the exange
rates are fixed, e.g. by international agreements, the State still has the
possibility of counter-balancing the effects of the proportional anges in the
world market prices by means of anges in import duties and export
bounties. If the State does not have this possibility—the reason may again be
international agreements—it is impossible to prevent an increase in the
home price of consumer goods and consequently a fall in the value of
money within the framework of our model.3 e value of money must then
fluctuate in inverse proportion to the world market prices. is does not, of
course, prevent the realization of the ends of full employment and a certain
surplus (deficit) in the balance of payments; a rise in world market prices
would require an increase in indirect tax rates on home production of both
consumption goods and capital goods, combined with a reduction of income
tax or interest.

(ii) Increase in the World Market Prices of Consumer Goods

If the world market prices of consumer goods increase, while the world
market prices of capital goods remain unanged, the question of policy will
appear in a somewhat different light.
e simplest method to neutralize the effects of this on the policy ends
would be to decrease the import duties or increase the import subsidies on
imported consumer goods. By this means the domestic price level of
consumer goods as well as all other internal economic variables will remain
unanged. Only the balance of payments is affected; the level of imports,
exports and export prices in foreign currency remain unanged, but the
price, in foreign currency, of the imported goods has risen; the balance of
payments will deteriorate. is may be prevented by a rise in the interest-
rate or in income tax, whi will bring about increased exports or reduced
imports. In our model the deterioration in the terms of trade cannot be
counteracted of course.
If it is not possible to alter customs duties or import subsidies the problem
can still be solved by a reduction in the rates of exange in the same
proportion as the increase in the world market prices of consumer goods (the
imported goods). By this means the domestic price of consumer goods will
remain unanged and there will be no effects on the consumer goods
industry. On the other hand the reduction in the rates of exange will bring
about a fall in the domestic price of capital goods (we disregard the
possibility of offseing this by raising customs duties or reducing export
bounties on capital goods). If this decrease in the home price of capital goods
is not to have a depressing effect on the production of capital goods, the
indirect tax on the production of capital goods must be reduced to the extent
of the fall in the market price; the net price (market price minus indirect tax)
of firms will then remain unaffected by the fall in the rates of exange, and
employment within the capital goods industry will remain unanged. As
now prices of consumer goods as well as all disposable incomes remain
unanged, the home demand for consumer goods will not increase and
consequently neither will the import of consumer goods. On the other hand,
the demand for capital goods is stimulated by the lower price of capital
goods; thus exports will tend to decrease. Obviously a decrease in the
balance of payments will result; the import value, reoned in foreign
currency, will increase due to the higher world market price of the imported
goods, and the export value, also in foreign currency, will fall because of the
decreased volume of exports. A reduction in the demand for consumer
goods and/or capital goods, i.e. a decrease in the country’s consumption
and/or investment, will thus seem to be unavoidable.4 is decrease may be
brought about by increasing the income taxation and/or the rate of interest.
In this case a reduction in the rates of exange combined with a decrease in
the indirect capital goods tax and an increase in income taxation and/or
interest will be sufficient means.
If anges in customs duties as well as in exange rates are out of the
question, we find as in (i) that with an isolated ange in the world market
prices of consumer goods, it will be impossible, within the framework of the
model, to secure the end of a stable value of money; see however section 7,
(iii) on production tax and turnover tax.

(iii) Increase in the World Market Prices of Capital Goods

 Finally, we assume that the world market prices of capital goods increase
while the world market prices of consumer goods remains unanged.
Here the domestic price of consumer goods is not affected at all. Of the
end-variables, only employment and the balance of payments are affected.
us it seems irrational to try to offset the price increases of capital goods by
means of a reduction in the rates of exange; this would involve immediate
difficulties with the end of constant consumer goods prices. It would be
unreasonable to prevent a disturbance whi in itself does not affect the
prices of consumer goods, by using some means whi does do so. An
alteration in the rates of exange is therefore out of the question in this
case. On the other hand the State may try to prevent the domestic prices on
capital goods from rising by reducing export bounties or customs duties on
capital goods. If this is successful the domestic economy will not be affected
at all; only the balance of payments is affected, and this will be improved
because the prices of capital goods abroad will have risen. An unanged
balance will then require a reduction in income taxation and/or the rate of
interest.
If it is impossible to prevent the foreign price increase of capital goods
from spreading to the domestic economy by means of a reduction of export
bounties or the introduction of an export tax on capital goods, there will be
a tendency towards expansion in the production of capital goods with a
consequent tendency towards overfull employment. is may be prevented
by a suitable increase in the indirect tax on the production of capital goods.
Employment will then remain unanged, as will the production of
consumer and capital goods and disposable incomes. e demand for
consumer goods and thus imports will also be unanged. e demand for
capital goods will decrease due to the higher domestic price of capital goods,
whi implies increased exports. e balance of payments tends to improve,
but this can be offset by a reduction in income taxation and/or in the rate of
interest.

(iv) The Principle of ‘Economy of Means’

We have now dealt with the question of the means to be used to offset the
effects of disturbances from abroad, i.e. the fluctuations in the world market
prices. Exange policy, in a broad meaning of the term, plays an important
part here; furthermore, it is typical that exange policy is not primarily
directed towards correcting the balance of payments, but solely towards
preventing fluctuations in the world market prices of consumer goods from
affecting the price level of consumer goods in the home country; if the
balance of payments is affected in an undesirable way, it must be corrected
by other means, namely means whi affect the total demand for consumer
and capital goods. When dealing in section 5 with a policy to prevent
internal disturbances we did not find any use for exange policy; here too,
possible divergencies in the balance of payments had to be corrected by
means whi affected the demand for goods in the country. If we assume
that the customs duties and export bounties are unalterable in the short run,
whi seems reasonable with existing international conventions, the rule for
an extremely open economy, whi functions according to our model, will
be that the rates of exange are to be made to fluctuate in inverse
proportion to the fluctuations in world market prices of consumer goods;
and if the world market prices of consumer goods are constant, the rates of
exange must also be kept constant, irrespective of what happens to the
balance of payments. If the authorities do not follow this rule, the policy of
maintaining a constant value of money will fail.
is situation with regard to exange policy is naturally dependent on
the three ends that have been established and on the structure of the model
whi we have osen. As in section 4, where we were able to arrange the
means in a certain order, we can also arrange the disturbances in a certain
order. We have certain disturbances whi affect only the balance of
payments, certain disturbances whi affect both employment and balance
of payments, and, finally, certain disturbances whi affect the consumer-
goods price level as well as employment and the balance of payments. e
ordering of the means and of the disturbances is obviously analogous. Now
if it were a political axiom that a given set of ends should be realized in as
simple a way as possible—the principle of ‘economy of means’—and this is
held to mean that the number of means shall be as small as possible, the
ordering of the means and the disturbances will determine the oice of
means. A disturbance whi affects the balance of payments ought to be
eed by a means whi affects the balance of payments only; a
disturbance whi affects both employment and the balance of payments
ought to be eed by a means whi affects both employment and the
balance of payments, together (if necessary) with a means whi affects the
balance of payments only; and, finally, a disturbance whi affects the
consumer goods price level as well as employment and the balance of
payments ought to be eed by a means whi affects the consumer price
level, employment and balance of payments, furthermore (if necessary) by a
means whi affects employment and balance of payments, and a means
whi affect the balance of payments only. us, as a rule, the number of
means to be used to aieve the ends will be the least possible.5
is is the idea whi lies behind the above rule that the rates of exange
ought to be varied in inverse proportion to the world market prices of
consumer goods in order to aieve constancy of the domestic price level of
consumer goods, and that the rates of exange should not primarily be
varied with employment and the balance of payments in mind. To illustrate
the meaning of this rule we can take the problem oen discussed in practical
policy of how the State is to prevent large wage increases causing
unemployment so that the country’s competitive position in world markets
is weakened. Devaluation is very oen recommended as the only method.
is idea does not hold with our ends and our model. No doubt an isolated
increase in money wages in our model would lead to unemployment and
decreased production. It is doubtful whether the balance of payments would
deteriorate (the result depends partly on the extent to whi the production
of consumer goods or capital goods decreases as a result of the rise in wages,
and partly on the extent to whi the demand for consumer goods and
capital goods is affected by the reduction of income and production);
however, let us assume that it does. A rise in the rates of exange will then
re-establish the employment position and in certain circumstances even the
balance of payments; but this will only take place at the cost of a
deterioration in the value of money, i.e. a higher consumer goods price level.
If the value of money is really sacrosanct, this makes it impossible to
increase the rates of exange; instead the State must reduce the indirect tax
on the production of both consumer and capital goods in order to re-
establish full employment, and subsequently increase income taxation
and/or the rate of interest in order to correct the balance of payments.
Consideration of the consumer goods price level prevents the use of
exange rates in a case like this.
7. SUPPLEMENTARY REMARKS ON THE EXTREMELY OPEN ECONOMY
e findings of the previous sections refer to the specific model for the
extremely open economy and are, of course, dependent on the properties of
this model, or rather of this type of model. Certain of the findings, su as
the ordering of the means, whi is so important for the policy problem, are
thus linked to the particular recursive structure of the model. It is therefore
necessary to conclude this treatment of policy in the extremely open
economy by mentioning certain important modifications of the model whi
suggest themselves, paying special aention to the extent to whi these
modifications affect the structure of the model and consequently the
ordering of the means.
If we compare the closed model of Chapter XIII with the extremely open
model of this apter, it becomes quite obvious how the model has been
transformed into a ‘neo-classical’ one by the introduction of foreign trade.
e closed model is definitely Keynesian; it does not entail any automatic
tendency towards full employment; the ‘effective demand’ for commodities
occupies a central position in the model; it could be said that employment
and effective demand mutually determine ea other; the model is a purely
interdependent, static model. e extremely open model is in certain
respects extremely neo-classical; employment is determined by prices (given
from without) and money wages; unemployment or shortage of labour is
due to too high or too low (monopolistic) money-wages; the ‘effective
demand’ is of no importance whatsoever to employment but only to the
balance of payments; deficit or surplus in the balance of payments may be
said to be due to too sla or too tight a monetary policy and, possibly, fiscal
policy too; the model is a purely recursive, static one. is very important
ange in the structure of the entire model is connected with the special way
in whi we have introduced foreign trade; we thus have to discuss other
ways of introducing foreign trade into the model. However, we still
maintain the assumption of an extremely open economy without ‘home
market commodities’; this assumption, perhaps the most important of all, is
not abandoned until section 8.

(i) Price Formation in the World Market

 All the way through we have worked with the assumption that the
economy under consideration is so ‘small’ in relation to foreign countries
that possible variations in imports and exports do not affect the ‘world
market’ prices. is condition is fundamental to the structure of the model.
If it is assumed that the volume of imports affects the world market prices of
consumer goods (import goods), equation (XVIII: 1) is anged to

where pCM is now a function of MC. If the volume of exports is of

importance to the world market price of capital goods (export goods),
equation (XVIII: 2) is anged to

where pIX is no longer exogenously determined but is a function of XI.

With these anges the model is again interdependent: in Fig. XVIII: 2 we
would now put in an arrow from MC to PCM and an arrow from XI to pIX.
e ordering of the means established in section 4 then disappears, and the
policy problem becomes mu more complicated.
e question of how the prices of import and export goods are determined
thus becomes basic to our problem. We shall not venture any general answer
to this question; it seems probable that for a country like Sweden, import
prices are on the whole independent of the size of Swedish imports; the
analogous supposition concerning export prices is more dubious, however,
see below.

(ii) The Determinants of Exports and Imports. The Import of Raw

Materials
In our model both the volume of imports and the volume of exports are
mainly determined by internal conditions; indeed with given world market
prices and given exange policies they are entirely dependent on home
conditions.
 We defined the volume of exports as the difference between home
production and home demand for capital goods. e volume of production
was determined by the world market price, money wages and productivity
in the country (we ignore customs duties, taxes, etc.); the home demand was
determined by the price of capital goods, the volume of production, and the
rate of interest. e volume of exports then follows automatically. is
seems to be quite an obvious consequence of the assumption of given world
market prices. If the assumption of given world market prices is an
acceptable one—this means that perfect competition is prevailing in the
export markets—it follows that the very frequent assumption of the volume
of export as being exogenously determined cannot be accepted. In our model
only the prices are exogenously determined. In our model it is only price
anges in the world markets whi appear as disturbances from abroad.
However, it has oen been observed in Sweden that the quantity exported
will suddenly increase even though the export price is unanged and
without any decrease in Swedish demand or increase in Swedish
productivity being evident. Under free trade su a thing can happen only if
export firms have a sloping foreign sales-curve; the quantity increase with
an unanged price may then be explained by a certain shi in this demand
curve. is indicates that our assumption of perfect competition in the
export markets is not a very suitable one. ere is no great tenical
difficulty in taking account of this in the model by introducing an equation
to indicate the dependence of foreign demand on the prices of Swedish
exports, and also an equation to explain the price policy of the export firms.
However, we refrain from doing this here for reasons of space, but it should
be stressed that the model in its present form obviously cannot deal with all
types of disturbances from abroad.
e volume of imports is also determined as the difference between home
demand and home production (of consumer goods); thus the volume of
import is also in some sense passively determined by internal circumstances.
is way of determining the volume of imports is also related to the
assumption of given world market prices of the import goods, an assumption
whi seems reasonable, however, for a small country like Sweden. e
import goods were furthermore assumed to go directly to the consumers
without giving rise to home production and income. Moreover, we assumed
that there was perfect substitution in demand. ese assumptions create
problems just as serious as those concerning exports.
First it should be pointed out that it is hardly usual for the import goods
to go directly to the final consumers in the country, although this does
happen sometimes, as when capital goods (e.g. mainery) are imported
directly by the investor. Normally, however, import goods rea the final
buyers via domestic firms, who do a greater or lesser amount of work and
production in this connection, and also obtain a certain amount of profit.
Once this is admied we enter into the problem of imported raw materials
and semi-manufactures; as a maer of fact all imports, even ‘finished’
products, whi are handled by a domestic firm (even if it is ‘only’ a purely
trading concern) are to be regarded as imports of raw materials. us it is
evident that an important part of imports consists of raw materials, in the
extended sense of the word; so that there is reason to question the method
hitherto used for the determination of the volume of imports.
We shall not try to give a general treatment of this problem, but simply
indicate how the import of raw materials can be introduced into the model
without disturbing its aracteristic structure. We consider a certain type of
raw material whi is only produced abroad and whi has a given world
market price. is raw material is assumed to be necessary for the home
production of both consumer and capital goods (fuel is a good example) and
we assume that the quantity of raw material used up in production is in
direct proportion to the volume of production. At the same time we
maintain the assumption that the consumer and capital goods produced in
the country are of the same kind as the consumer and capital goods on the
world market; thus the world market prices determine the home prices (with
given exange rates, customs duties, etc.). is means that direct import of
finished consumer goods and capital goods by the final buyers may still take
place.
With these assumptions the optimum conditions for the domestic
industries, equations (XVIII: 3 and 4) in the model in section 3, will be
anged. If we call the world market price of raw materials pRM, and if we
assume that raw material consumption within the consumer goods industry,
C
MR , and within the capital goods industry, MRI, are determined thus
where aC and aI are constant tenical coefficients, it is easily seen that the
optimum conditions will be

Furthermore the definition of the balance of payments surplus (XVIII: 14)

is anged to

where MR, the total import of raw materials, is

Our model is thus anged in the following way, (see also Fig. XVIII: 2):
the new optimum conditions (XVIII: 3′) and (XVIII: 4′) are substituted for
the old ones (XVIII: 3) and (XVIII: 4). In the group of variables of the fourth
order we have, moreover, a new variable, the total raw material import, MR,
whi in Fig. XVIII: 2 would be determined by two arrows from qC and qI
respectively. Finally the new definition of the balance of payments surplus
takes the place of the old one (XVIII: 14), and in Fig. XVIII: 2 an arrow is
inserted from MR to S. ere are no other anges in the relationships
between the endogenous variables in Fig. XVIII: 2.
It may be concluded that the aracteristic recursive nature of the model
is not anged by the fact that we have brought imported raw materials into
the picture. Neither will the aracteristic placing of the policy parameters
in the model be affected. e ordering of the means is not affected and our
remarks concerning the policy problem in the open economy remain
undisturbed. What is new in this respect is that in those parameter groups
whi directly influence employment, NC and NI, we have to introduce the
world market price of raw materials. Analogous with the results of the
previous section it will be understood that it is unreasonable to try to
counteract fluctuations in the world market prices of raw materials by
means of the rates of exange: either customs duties or subsidies must be
used, or else indirect taxes on consumer and capital goods must be imposed.
Consideration of imported raw materials will thus not necessarily upset
the previous results. As will be understood this is also valid in the more
general case where the consumption of raw materials is not in any fixed
proportion to the volume of production, i.e. where a certain amount of
substitution between labour and raw materials is possible.

(iii) Production Tax and Turnover Tax

In dealing with the closed model we were not very careful in defining the
precise nature of indirect taxes, whether it was production taxes or turnover
taxes that were concerned. Under our general assumptions, whi implied
among other things that production and purases were equal, this
distinction was less important. e case is different in the open economy.
Here exports or imports creates a gap between production and purases. If
a general turnover tax is imposed on all domestic purases, whether of
domestically produced goods or of imported commodities, this tax will have
different effects from a general production tax, whi is only imposed on
goods produced in the country, but irrespective of whether those goods are
sold within the country or are exported. In the treatment of the extremely
open economy we have worked throughout with production taxes; indeed,
this is a necessary condition for the model to function in the way we have
assumed.
As regards the taxation of commodities whi are produced in
competition with the world market, the shiing of the two taxes will be
different. e production tax is not shied on to the price—but the turnover
tax is. It is easily realized that this is so by returning to our example in
section 2. We consider a case where only consumer goods are produced in
the home country. e world market price is, in terms of the domestic
currency, given at pCM and the rates of exange are also given. e
aggregate supply curve for the economy is m.c., see Fig. XVIII: 4, a. With the
absence of all taxes and customs duties, the home price will be pC (whi is
equal to the world market price, reoned in the national currency, pCM),
and the production q0. For the sake of argument let us assume that domestic
demand will exceed domestic production, so that imports will be required.
e demand is d0 and imports m0. We now suppose that a customs duty at
the rate of tCM is introduced. e home price will then be above the world
market price by the amount of the customs duty; the whole of the customs
duty is shied on to the prices and production is increased to q1; for the sake
of simplicity we assume that demand remains unanged as the question
here concerns another part of the problem, see Fig. XVIII: 4, b. e total
income of the State from the customs duty is indicated by the shaded area.
With a decrease in world market price, an increase in the customs duty will
ensure an unanged price in the home country and unanged production;
this fact was applied in the open model, see equations (XVIII: 1) and (XVIII:
2).
 Fig. XVIII: 4

We now introduce instead a production tax of tC per unit. is tax is not
passed on, because if the price of goods produced within the country is
increased, the whole demand will move over to the untaxed import goods.
e result must be unanged home price and reduced production from q0
to q2, and thus reduced incomes, see Fig. XVIII: 4, c. e amount of the tax
is indicated by the shaded area. We have also used this result in the open
model, see equations (XVIII: 3) and (XVIII: 4).
Lastly we assume that a turnover tax amounting to otc per unit is
introduced; this tax is to be imposed upon all imported goods and upon
those domestically produced goods that are consumed within the country.
e domestic price must thus rise by the entire amount of the tax, for if the
price were not to rise to this extent, the entire home production would be
sold abroad where the price pcM can be obtained. Production, employment
and incomes will then be unaffected. e total amount of the tax is shown
by the shaded area in Fig. XVIII: 4, d. As can be readily understood, the
turnover tax works as a combination of a customs duty and a production tax
at the same amount per unit imported or produced.
If instead we consider the case where the home demand is smaller than
production and where exports take place, the same arguments apply, if the
customs duty is imagined to be combined with an export bounty at the same
amount per unit. e export bounty and the (potential) customs duty will
then involve a corresponding price increase at home. e production tax is
not passed on while the turnover tax is completely passed on; the turnover
tax can be regarded as a combination of an export bounty and a production
tax.
It should be remembered that in all the reasoning in sections 5 and 6
concerning the structure of policy, we assumed that the indirect taxes were
primarily used as a means of aieving equilibrium in the labour market at
given home prices. e production tax fulfills this function, but a turnover
tax does not. Suppose, for example, that in Fig. XVIII: 4, the supply curve
m.c. is shied downwards; with a given world market price, production will
then increase, as will employment (at least, under certain assumptions). If
employment were full we might, without affecting the price level, prevent
the increase in (planned) production from becoming greater than the
amount of labour would permit, by the introduction of a production tax of
an appropriate size. If, in this situation, we were instead to impose a
turnover tax, the price level would go up by the amount of the tax without
puing a brake on the increase in production and employment (or demand
for labour).
On the other hand, it will be seen that the turnover tax, whi in virtue of
its very nature is shied completely, can play an important role in our policy
problem. For example, suppose that the world market price decreases, and
that for some reason neither exange rates nor customs duties can be
anged. Domestic prices and production will decline; the value of money
will thus appreciate, but this was not desired. If, in su a situation, we were
to introduce a turnover tax whi corresponds to the fall in international
prices, and at the same time reduce an existing production tax (or introduce
a production subsidy) to the same extent, obviously the home price level and
home production will not be affected by the fall in international prices. e
combination of an increase in turnover tax and a decrease in production tax
will operate in exactly the same way as an increase in customs duties or an
increase in export bounties. Since su experiments with internal tax
structures will not violate the international agreements whi may prevent
the use of the usual exange policy means, exange rates and customs
duties, it seems appropriate to work simultaneously with production and
turnover taxes on the same kinds of goods. Simultaneous anges in these
tax levels are obviously an excellent domestic means for the elimination of
the effects of fluctuations in the world market prices on the domestic price
level and employment.

(iv) Interest Changes and Credit Restrictions

Up to now we have taken account of credit policy by considering the rate
of interest as being directly determined by the State, and as affecting the
demand for capital goods and probably also the demand for consumer
goods. at the rate of interest is supposed to be directly determined by the
State without reference to the credit market is, of course, a simplification,
but this is of no great importance. What is more important is that interest is
only supposed to have a direct effect upon demand, and not upon
production.6 is simplification is decisive for the ordering of the means
whi was discussed in section 4. Credit policy can be considered to exert a
direct influence on production in two ways, partly by means of the level of
the rate of interest (with unlimited credit resources) and partly by means of
quantitative credit restrictions (at a given rate of interest), i.e. credit
rationing.
If production takes time, the rate of interest will be directly included in
the optimum conditions for the industries, see Chapter XIII, 2, (ii), equations
(XIII: 1°)′ and (XIII: 2°)′. An increase in the rate of interest with given prices,
money wages, tax rates and productivity, will then tend to reduce
production and employment. A disturbance whi would affect employment
and the balance of payments, su as a uniform increase in productivity,
could in principle be prevented from affecting employment by an increase in
the rate of interest. Be this as it may, it is clearly important that the rate of
interest may have more fundamental effects than on demand alone.
ere is, in contemporary theory, a tendency to assume that the period of
production in most branes of industry is so short that the interest factor
can reasonably be ignored in the optimum conditions. Even if this is true, it
does not immediately follow that credit policy is of no direct significance to
the size of production. Even if the production period is so short that in the
optimum conditions the rate of interest can reasonably be ignored, credit—
that is working credit—may be a necessary condition for production to start
at all. If there is any limitation of credit due either to imperfect competition
in the credit market or to official measures, credit policy itself can stop or
start production by a firm with poor liquidity. In this way credit policy—
irrespective of the rate of interest—may have a direct and important
influence on production and employment.
It seems probable that in the short run, interest anges have significant
direct effects only on the demand for commodities, and especially on the
demand for certain types of capital goods. antitative credit restrictions,
on the other hand, may influence not only the demand for capital goods and
the demand for certain types of consumer goods, namely durable consumer
goods, but also the production of both capital goods and consumer goods,
even in the very short run. is gives quantitative credit restrictions their
very special aracter, especially in connection with su a model as the
extremely open one, and makes su credit restrictions a special form of
policy with effects quite different from those of interest-rate policy. e
difference between interest-rate policy and credit restrictions is usually
assumed to be that the rate of interest operates diffusely while quantitative
credit restrictions operate more selectively (or consciously). Without doubt
this point of view is important. Yet if what has been said above is correct,
“the decisive difference in the short run is that quantitative credit
restrictions have ‘deeper’ effects than the rate of interest has; they influence
employment and production (second order variables in our model) directly,
whereas interest only affects demand (fourth order variable).
Finally, it may be asked whether credit policy may not have a direct
influence on the domestic price of consumer goods, even in the case without
particular home market goods. Up to now our case has been that, apart from
customs duties, etc., the price of consumer goods must be the same in the
home market as in the world market (reoned in the same currency). Now,
even if we ignore the fact that most imported commodities, even ‘finished’
goods, are handled by domestic firms and involve a certain amount of
production (transport, etc.), it is still a fact that normally a certain amount of
time must elapse between the purase of the imported commodity and its
sale; imports must be financed, and this may necessitate credit.
Consequently it becomes possible to exert a direct influence on the volume
of imports (and exports) by means of credit policy, and especially by
quantitative credit restrictions, and consequently also on the domestic prices
of these goods. Once imports (and exports) are not adjusted immediately
and without friction to the gap between home demand and production, this
gap will in its turn become significant for domestic prices in the same way
as in the closed model. However, it is not certain how great the effect on the
price level will be in an open model su as ours; this is especially a question
of whether su an effect can be other than temporary. A great many factors
are of importance here, including the possibility that foreign trade is
financed from abroad.
In our model income taxation and direct subsidies have a direct influence
only on the demand for consumer goods, and possibly (via the disposable
profits of the firms) on the demand for capital goods, and consequently are
significant only for the balance of payments. However, income taxation, like
credit policy, can be considered to have ‘deeper’ effects on the system. For
example, it seems probable that income taxation affects the supply of labour
directly and consequently is of importance to the end of full employment. If
the owner himself is working in the firm, production could be directly
affected by anges in income taxation. On the other hand, it seems
improbable that income taxation can directly affect the price level in our
model.

(v) The Ordering of Means Reconsidered

In section 4 we pointed out how the model under consideration there
implied a certain ordering of the means of exange policy, of fiscal policy
and of interest policy (credit policy). In paragraphs (iii) and (iv) we have
advanced arguments whi upset this ordering. In (iii) we showed how a
suitable shi between production taxes and turnover taxes can be used to
offset the effects of anges in the world market prices on the domestic
prices of consumer goods. In paragraph (iv) we advanced certain arguments
to show that credit policy, especially if it consists not only of interest policy
but also of quantitative restrictions, may affect employment and even the
price of consumption goods directly, just as income taxation may have a
direct influence on the supply of labour and production. If these arguments
are accepted, the ordering of the three main groups of means disappears:
exange policy as well as fiscal and credit policy may influence all the three
ends and may be used to secure all three ends. However, it must be
remembered that it is not fiscal policy in general whi can affect the
consumer goods price level, but only a very special type of fiscal policy; nor
is it credit policy in general whi can affect the consumption goods price
level and employment, but only certain special types of credit policy. Instead
of saying that the argument of the two previous paragraphs eliminates the
ordering of the means, it would be more correct to say that it is only
between the three wide categories of means (exange, fiscal and credit
policy) that an ordering cannot be established. If we divide the means into
smaller categories, the possibility still remains of establishing an ordering of
the sort shown in section 4; there are still certain means whi only affect
the balance of payments; certain means whi affect employment and the
balance of payments but not the consumer goods price level, and certain
means whi affect all three end-variables.

8. BETWEEN THE CLOSED AND THE EXTREMELY OPEN ECONOMY:

THE SIGNIFICANCE OF HOME MARKET COMMODITIES
In Chapters XIII–XVII we considered a model for a closed economy and in
this apter one for an extremely open economy. From a theoretical point of
view it seems justified to develop these two extreme cases first. But in a
small country su as Sweden ‘reality’ would lie somewhere in between
these two extremes. us the problem remains of linking together the results
of these two extreme cases. We have already seen that this task is not as big
as it seems at first sight, for the case of the extremely open economy can be
regarded as a modification of the closed economy and the results of the
closed society can on the whole be transferred to the extremely open
economy.
e closed economy was aracterized by a complete absence of foreign
trade; demand and production within the country tended to be equal. In the
extremely open economy exactly the same sorts of goods were produced in
the country as abroad, and consequently the home prices (when converted
to the same currency and with due regard to import duties and export
bounties) will always coincide with the world market prices, because there
exists the possibility of exports and imports. is means that the assumption
of perfect substitution in demand is decisive for the functioning of the open
economy, for if the prices of home produced commodities rise above the
prices of imported commodities, home demand immediately turns to the
imported commodities, and conversely if the home prices are below the
prices of the imported commodities. is applies both to consumer and to
capital goods. Our method of dealing with this maer obviously implies that
no aention is paid to what are called home market commodities, i.e. goods
whi (due to transport difficulties, etc.) cannot very well be imported and
exported, the standard example being buildings and the services they
produce. e fact that we have ignored goods and services whi cannot be
imported or exported is not significant in itself. ese goods may have
substitutes whi may be exported or imported. Normally every good has
substitutes of one sort or another; and this applies equally to houses and
industrial buildings. e main thing is that home produced and imported
goods are considered different by those who demand them, in other words
that the consumers have particular preferences concerning home produced
or imported goods. If this is the case, a certain shi in the relative prices of
home produced and imported goods will be required, according to the
familiar theory, if substitution is to be brought about. us if substitution in
demand is not perfect, the domestic prices of home produced goods may
differ from the prices of imported commodities. A certain increase in the
prices of imported commodities will then only result in a smaller increase in
the price of the home produced goods, due to the shi in demand from
imported to home produced goods, and possibly also to an increase in the
prices of imported raw materials for home production. e extent of this
shi in demand will depend partly on time; in the long run the substitution
in demand is probably mu greater than in the short run. e possibility of
complementarity ought of course also to be taken into account. Su
problems are fundamental to the type of foreign trade theory whi discuss
the balance of payments problem in terms of elasticities of supply and
demand.7 Up to now we have only considered the elasticities of supply of
home produced goods; there thus remains the question of the elasticity of
home demand.
e questions that confront us are then, firstly, how important home
market goods really are to the domestic economy, and secondly how closely
are home market goods and other goods (imported goods) substitutes, that is
to say, how extensive is the shi from home market goods to imported goods
when there is a certain small increase in the price of the home market goods,
and vice-versa. If the home market goods are actually of comparatively lile
significance, and if substitution is extensive, our model may be considered a
reasonable approximation on this point; if home market goods are important
and if substitution is difficult we have ignored an important factor.
e fact that in a country like Sweden the consumption of home produced
goods exceeds the consumption of imported goods several times is of no
importance in this context. We are here concerned with the potentialities of
commodities coming in from the outside. Only a small part of the goods
whi are actually produced and consumed in the home country can be
counted as home market goods in the sense that exports and imports are
practically impossible. Even if we assume, as an extreme case, that buildings
are the only true home market goods, it is obvious that home market goods
are still of considerable importance. We need only put the question thus:
does the level of rents affect the consumer goods price level or not? e
answer is then obvious.
As to the question of substitution between home market goods and
imported goods, it is probably more difficult to give a definite answer. at
substitution is smaller in the short run than in the long run is obvious, of
course. Furthermore, the fact that housing, etc., appears as a home market
good indicates that the possibilities of substitution at least in the short run
are severely limited.
Now, if it is recalled that our model is principally intended to be a short
run model, the conclusion seems to be that we have le out something
important by ignoring home market commodities and the limited
possibilities for substitution. So we shall briefly outline how these
commodities could be inserted into the model and what might be the
consequences thereof as far as the problem of policy is concerned.
As a first approximation the country’s housing may be considered as a
home market industry producing housing services. In the short run this
production is constant. e amount of labour power whi is used up in this
production can also in the short run be regarded as given. We emphasize
that the discussion concerns housing services and not the production of
houses. Part of the demand for consumer goods is now considered to be
directed towards housing services, and if equilibrium is to be aieved with
constant rents, then at the given rents the sales value of (the rents of) the
current amount of housing services must be equal to that part of the current
demand for consumer goods whi is directed by households towards
housing services. Production of housing services will in its turn create wage
incomes and profits. us by introducing housing services, interdependency
will arise in our recursive model, and this fact must be of importance for
policy. e two new factors whi enter the picture are, on the one hand,
that the consumer price level must now be regarded as an average of rents
(the home market price) and the prices of the other consumer goods (the
import goods prices), and on the other hand that policy must always be
formed so that there is equilibrium in the housing market at a suitable price
for housing services. Obviously neither rents nor the home price of imported
goods need be constant. If they ange in opposite directions the general
consumer price level can still be constant. Special housing policy ends may
of course prevent movements of rents however.
Let us imagine an initial situation where all three aims are fulfilled; the
average consumer price level is at the desired height, employment is suitably
full, and the balance of payments is satisfactory; the housing market is
considered to be in equilibrium at the existing level of rents. If disturbances
now arise in the economy, be they external or internal, these will affect the
housing market if, and only if, (a) the price relationships between housing
and other consumer goods are anged, or (b) the size (and distribution) of
disposable incomes is affected. us if the State directs its policy so that the
price of imported goods in terms of the home currency, and thus the price of
‘other’ consumer goods, is constant, and so that the size (and distribution) of
disposable incomes is also constant, despite the disturbances, then the
equilibrium in the housing market, the level of rents, and thus also the
average price level of consumer goods, will all remain unanged. It is no
new task for the State to direct policy so that the price of imported goods
will remain constant in terms of the home currency; the policy dealt with up
to now, in section 6, has aimed at that very thing. On the other hand the
obligation to keep the total disposable income (and its distribution) constant
—or expressed in more precise terms, the obligation to regulate its size and
distribution in su a manner that at given rents the total demand for
housing services is constant—is a new and important restriction on policy.
In order to demonstrate this we shall consider a case where both the
marginal and the average productivity within the consumer goods industry
suddenly increase uniformly. As can be realized, the means to offset this in
our extremely open model, see section 6, would consist primarily in an
increase in the indirect tax on the home production of consumer goods; this
would serve to aieve equilibrium in the labour market and, consequently,
disposable incomes would remain unaffected. Due to the increased home
production of consumer goods and the unanged demand, the balance of
payments would be improved through reduced imports. is could be
prevented by lower income taxation, in whi case the demand for
consumer goods (consumption) would increase to the same extent that
production of consumer goods has increased so that imports are unanged;
or it could be prevented by a fall in the rate of interest, in whi case the
demand for capital goods (investment) would increase and exports decrease;
or it could be prevented by some combination of these methods, according
to the relative amounts of consumption and investment desired in the
country by the State.
However, when we have to consider equilibrium in the housing market
too, as is the case now, the State is not at liberty in the same way to
determine the size of consumption and investment. If the State reduces
income taxation in order to bring about an increase in consumption in order
to aieve equilibrium in the balance of payments, it is unavoidable that the
demand for housing will increase and that there will be a tendency for rents
to increase. Instead, the State must reduce the rate of interest and only let
investment increase. While the three ends are aieved, the increase in
productivity within the consumer goods industry has thus been ‘spent’ in
the form of increased investment, via decreased imports of consumer goods
and exports of capital goods; from other points of view this development
may very well be considered undesirable.
However, this should not be taken to mean that it is impossible to pursue
a policy that ensures that the increase in productivity within the consumer
goods industry is ‘spent’ in the form of increased consumption. Su a
policy will now be briefly outlined, because it brings us into contact with the
problem, discussed in the theory of foreign trade, whi arises in connection
with anges in the relative prices of imported goods, exported goods and
home market goods. If, in the case under discussion, consumption is to rise,
disposable incomes must rise; however this will automatically involve an
increased demand for housing services and thus higher rents. If despite this
the average consumer price level is to remain unanged, the prices of other
consumer goods must fall to a corresponding degree (just how mu
depends on the weighting of the index), whi in turn necessitates a
decrease in the prices of imported goods. us a ange in the price
relationships seems to be necessary in this case. If we exclude decreases in
customs duties and subsidies and in the turnover and production taxes
mentioned in the previous section, this will necessitate an appreciation of
the currency. e size of this will in its turn depend on the elasticity of
demand for housing services and imported consumer goods (i.e. ‘other’
goods). For instance, if the income elasticity of the demand for housing is
low and the price (rent) elasticity of demand, and also the cross-elasticities
with respect to the prices of other consumer goods, are high, then with a
given increase in the disposable incomes there will only be a small rise in
rents, and the required appreciation will not be very great either. However,
the appreciation must be combined with a reduction of the indirect taxes on
home production of other consumer goods, as well as of capital goods in
order not to cause unemployment. In these circumstances income tax can be
reduced and the result will be increased consumption and higher rents
without affecting the average consumer price level or labour market
equilibrium. If the appreciation, the lowering of the indirect taxes on the
production of other consumer goods, and the reduction of income tax, are
brought about in a suitable way, the entire increase in productivity will be
‘spent’ in the form of increased consumption; the volume of imports will not
then be affected, for the production of consumer goods and the demand for
consumer goods have increased to the same extent—for the sake of
simplicity we retain the assumption that only consumer goods are imported.
e production of capital goods remains unanged; the increase in
productivity is assumed to be confined to the consumer goods industry, and
the effect of the appreciation on the production of capital goods is assumed
to be offset by a reduction in the indirect tax on the production of capital
goods. e decrease in the price of capital goods, together with the increase
of rents and possibly also the increased production of consumer goods, tends
to bring about an increased demand for capital goods (investment) and thus
reduced exports of capital goods. e size of the increase in demand for
capital goods and of the consequent decrease in exports depends, among
other things, on the price elasticity of the home demand. us, if the balance
of payments is to remain constant a certain increase in the rate of interest
will be necessary.
By these few examples we have aempted to indicate the type of problem
whi arises when regard has to be taken of purely home market
commodities. e analysis is far from complete, but it should bring out one
important fact: as in the extremely open economy, it is very advantageous if
the rates of exange can be regulated to preserve the price stability of
consumer goods. is not only applies to anges in world market prices, but
also to offseing the effects of those domestic disturbances whi create
anges in the price relationships between home market goods and imported
(or exported) consumer goods. Concerning the control of employment, the
indirect taxes on production have a central position, while measures whi
affect demand (credit policy and income tax policy) are used to control the
balance of payments. Compared to the extremely open economy, policy
becomes more complicated, but the ordering of the means established there
is still of some relevance when regard is paid to home market commodities.

9. INTERNATIONAL LIMITS TO DOMESTIC POLICY

Up to now we have assumed that fiscal and monetary policy in the home
country can be conducted without regard to fiscal and monetary policy
abroad. is assumption may very well be untenable. With free movements
of commodities, factors and money capital between countries, the policies of
other countries can impose definite limits on the freedom of manoeuvres of
the home country. For example, free capital movements mean that credit
policy in the various countries must be synronized to a certain extent—
this is familiar from the Gold Standard era and is so even today. Similarly,
taxation and subsidy policy can be forced to follow that of other countries
through factor and capital movements, at least in the long run. We shall not
go into these problems in any more detail here, but simply point out that
they may prove to be of significance if payments between countries are
made completely free.

10. CONCLUSIONS
e discussion in this apter on the significance of foreign trade to our
policy problem is neither exhaustive nor conclusive. Firstly, we have
concentrated our aention on an extreme case, namely an extremely open
economy without home market goods, i.e. with perfect substitution in
demand. In this model the policy problem was simplified in an interesting
way, as an order of precedence was set up between exange rate policy,
fiscal policy and credit policy. Various modifications, including
consideration of home market commodities, served to break down this
ordering somewhat. It would therefore be out of place to draw definite
conclusions as to policy in an economy of the Swedish kind on the basis of
the discussion in this apter. However, on one point the results seem to be
definite. In a small country with extensive foreign trade the task of keeping
the consumer goods price index constant will be difficult if not impossible
with constant rates of exange. As to the stabilization of the internal value
of money, it would greatly simplify State policy if the rates of exange
could be regulated with regard to the consumer price level in the country.
On the other hand, if the rates of exanges are primarily regulated with
regard to the balance of payments, or simply kept constant, then when
confronted with price movements in the world market, and also in certain
cases with disturbances at home assuming given money wages, the
stabilization of the consumer price level will require troublesome
manipulations of taxes (and subsidies) on turnover and production.

1. Gunnar Myrdal, Finanspolitikens ekonomiska verkningar (e

Economic Effects of Fiscal Policy), Part 4, Chapters 4 and 5.
2. In order to prevent misunderstanding I would like to point out that the
premises of the model were not osen deliberately in order that the
model be recursive. It was not until aer I had osen my premises that
I noticed that the model was in fact recursive.
3. Cf. the remarks on production and income taxes in section 7 below.
4. e results here and under (iii) concerning the balance of payments are
dependent upon our assumption that consumer goods are imported and
capital goods exported.
5. ‘e principle of economy of means’ might of course also be interpreted
in su a way that on the one hand the State should use as few means as
possible, while on the other hand, the State should also try to obtain the
smallest possible variations in the means. Here we have an impossible
double minimization problem, and a political weighting of number of
means and size of the variation of the means must take place. Of
importance is also the ordering of means. To the extent that more means
than are strictly necessary are applied in order to reduce the variation of
the means, it still appears suitable to oose means of the same order as
the disturbance, in order that the number of means will not be increased
too mu, see Chapter XIX.
6. It is understood that in principle, and within the framework of our
extremely open model, the effect of the rate of interest on sto holding
is no different from its effect on demand. In both cases the balance of
payments is the only end-variable whi is affected by anges in the
rate of interest.
7. See Bengt Metelius, Utlandstransaktionerna och den svenska ekonomin
(Foreign Transactions and the Swedish Economy), S.O.U. 1955: 13,
Stoholm, 1955, Appendix 2.
 CHAPTER XIX

Full Employment and a Stable Value of

Money in a World of Uncertainty
1. THE PROBLEMS
THE main task in Part III of this work has been to discuss the means by
whi the ends of full employment and a stable value of money (together
with a certain distribution of the national product between consumption and
investment, and, in the preceding apter, a certain balance of payments too)
may be realized when the economy is affected by certain typical
disturbances. We have started from certain given definitions of the ends, a
certain given model and certain given disturbances whi have undesirable
effects upon those ends; from this it is then shown whi measures may be
taken. Now if the results whi have been aieved this way are to be fully
valid as practical policy recommendations, then our knowledge of the way
in whi the economy functions and also of the disturbances to whi it is
exposed must, in some sense, be reliable, i.e. correct. If these two conditions
are fulfilled no problem will arise and the ends of full employment and a
stable value of money can be aieved, provided, of course, that with the
means considered permissible, the ends are not in conflict with one another
(see Chapter I, 9). On the other hand, if these conditions are not fulfilled,
problems will arise whi in the main we have disregarded, but whi are
fundamental for all practical policy. We shall devote this final apter to
some observations on these problems.
e first group of problems arises when our knowledge of the working of
the economy is uncertain, or, to put it in other words, if we are not sure
whi model is the ‘correct’ one. If the State acts on the basis of results
obtained through deductions from a misleading picture of the economy,
policy conducted to aieve a given set of ends will be unsuccessful to a
corresponding degree. Problems of this nature are discussed in section 2.
 Even if the ‘correct’ model is known, policy may still be unsuccessful if
the economy is affected by outside disturbances whi are unexpected, or at
least not anticipated in time. e results of su imperfect foresight may be
deviations from the ends, see section 3. e second problem to confront us is
whether it is possible to organize the financial and other economic activities
of the State in su a way that possible disturbances will involve deviations
from the ends that are as small as possible, without any particular measures
having to be taken, and even without the State having to observe the
disturbances as they occur. is problem of the automatic stabilizing effects
of State finances, whi has been toued upon before, will be dealt with in
section 4.

2. UNCERTAIN KNOWLEDGE OF THE WORKING OF THE ECONOMY

If the State has only an uncertain knowledge of the economic system, the
results of policy will be uncertain too. e measures taken in a given
situation, for example, in order to create a large improvement in the balance
of payments, will perhaps only give rise to a small improvement or even a
deterioration in the balance of payments. Moreover, it is not impossible that
the Government’s ideas on the way the national economy functions, may be
so misleading that the measures taken will involve deviations from the aims
even greater than they would have been had no measures been taken. For
example when the authorities in certain countries during the depression of
the ’thirties, tried to make the State’s finances ‘sounder’ in order to bring
about a subsequent improvement in the economic situation, the result was
probably instead a still deeper depression. If State policy is based on a
certain economic theory—as is always the case, be it in the form of a
mathematically defined model or of intuitive conception makes no
difference in principle—policy will be no beer than the theory on whi it
is based.
e level of factual knowledge is accordingly a basic problem for
economic policy, and awareness of our limited knowledge may in various
ways influence decisions as to whi measures ought to be taken to aieve
the established ends. is very limitation of our knowledge means that we
cannot expect the ends to be exactly fulfilled when we act on the basis of
this knowledge. e problem will then be to realize the ends as nearly as
possible acting on the knowledge available. It is an undisputable fact, whi
need neither be denied nor excused, that economic knowledge is vague—and
in several respects even very vague—especially where quantitative
statements are concerned. e question here is only in what way this fact
modifies the findings of the previous apters, where we based our
discussions on the assumption that perfect knowledge is available. e
question is not, of course, whether the models there established are
acceptable in themselves or not, but rather whether our actual method of
studying policy problems is acceptable or not.
Our general arguments about the relations between ends and means in
Chapter I, as well as the more detailed discussion in Part III on the
appropriate means for aieving the ends, were based on so-called exact
models; i.e. the models of Chapters XIII, XVI and XVIII. e general
opinion, however, is that quantitatively specified models must be
formultated as stochastic models, that is models whi do not only contain
the same endogenous variables and parameters (constants and exogenously
determined entities) as the exact models, but also certain stochastic variables
whi express the influence of unspecified entities and relationships. It
might be said that the existence of these stoastic variables, in itself implies
an admission of the fact that our knowledge is limited. e very fact that we
are practically forced to abandon exact models in favour of stoastic ones
does in a certain sense limit the validity of our arguments on the
relationship between ends and means, but it does not make them definitely
wrong. If we start with a stoastic model and calculate the parameter
anges and measures whi are sufficient to aieve certain ends, in just the
same way as with an exact model (see Chapter I, 4), we shall obviously not
find the parameter anges whi will fulfil the ends with absolute certainty,
but we shall find parameter anges whi will have the effect of making the
mathematical expectations with regard to the end-variables coincide with
the goals.1 In turn this will mean that we can no longer be sure that the ends
will be fulfilled—at the most we can calculate the probability that the
deviations from the ends will take on certain definite values; on the other
hand we can expect that repeated use of these means will aieve the ends
on the average.
 Let us illustrate this by a simple stoastic model. Assume that the model
is

where x1 and x2 are endogenous variables, a1, a2, b1 and b2 are constants or
parameters, and z1 and z2 are the stoastic variables.
We assume that the ends x1 = 1 and x2 = 2 are to be realized and that b1
and b2 are to be employed as means. Now if the necessary values for these
means are determined in the same way as before—i.e. ignoring the stoastic
variables—we find

If these values of b1 and b2 are inserted into equations (XIX: 1) we find

that the end-variables will become

If we now introduce the standard assumption, whi is usual in

connection with su models, that the expectation of z1 as well as z2 is zero,
the expectation of x1 will evidently be 1 and the expectation of x2 equal to
2. If we also know the distribution of z1 and z2, the expression for x1 and
x2 will give the distribution of x1 and x2.

No special problem arises if these stoastic deviations from the ends are
acceptable to the policy-maker. He will then have to define his ends in the
same form as the expressions (XIX: 2); the policymaker has thus allowed a
certain ‘margin of tolerance’2 conditioned by the uncertainty of economic
knowledge. If the policy maker will not make su an allowance, two ways
are open to aieve the ends more precisely.
Firstly, the State may try to obtain a beer knowledge of the national
economy, that is try to construct beer models whi make it possible to
approa the ends more closely. e reason for pointing this out is not the
banal fact that progress in economic knowledge is largely dependent on
State grants for resear, but the mu more important fact that policy itself,
and the effects of the policy, are the best material available for study by
economists. In the very act of aempting, by various means, to keep the
value of money stable and maintaining full employment the State makes it
possible, even if the policy is not very successful at the beginning, for beer
knowledge to be obtained about the economic relationships so fundamental
to su a policy, so that in the long run this must make policy more
successful. Here one could point to the continuous development and
improvement in the tenique of the gold standard during the laer half of
the nineteenth century. Scientific progress is of course only possible in the
long run, but it can have significance in the short run too inasmu as the
possibility of continually improving the ances of policy being successful
may outweigh the shortcomings whi may dominate the immediate scene.
Secondly, it may be asked whether there is no other set of means than
that selected by the State whi will bring about the ends with even greater
certainty. Our knowledge is not equally certain or uncertain in all spheres.
For example, while we are very sure that an increase in the tax rate with
given incomes will result in a decrease in the consumer goods demand, we
are not very sure how a reduction in the rate of interest will affect the
consumer goods demand with given incomes. As we have pointed out
before, there are as a rule many different sets of means whi will secure a
given set of ends. e problem whi may arise with uncertainty of
knowledge is thus to find the set of means whi will involve the smallest
‘stoastic’ deviations from the ends, and whi will thus allow the smallest
‘margin of tolerance’. It should be obvious that the best means from this
point of view are those we know most about.
Let us illustrate this with the model (XIX: 1). We have assumed above that
b1 and b2 were used as means. Let us suppose instead that a1 and a2 are
used as means. If, as before, we calculate the values of a1 and a2 whi in
the exact part of the model secure the ends x1 = 1 and x2 = 2, we get

By aributing these values to a1 and a2 we get the following values of x1

and x2

If, as in the above, we assume that the expectation of z1 as well as of z2 is

zero, the expectation of x1 will obviously be equal to 1 and the expectation
of x2 equal to 2. So far, the two sets of means are equivalent. However, if
we compare the distribution of x1 and x2 according to (XIX: 2) and (XIX: 3),
a difference arises between the two solutions of the problem. e
distributions of x1 and x2 will not be the same in the two solutions. Now if
one of the solutions has a smaller standard deviation for both x1 and x2 that
solution will be beer than the other. is could be put alternatively as
follows: regarding the policy problem in question, our knowledge of the
effects of one set of means is more certain than our knowledge of the effects
of the other set of means. If, on the other hand, neither of the two sets of
means gives a smaller standard deviation for both end-variables than the
other, one cannot say whi set of means is best, unless there is a ‘welfare
function’ or ‘end-index’ established by the policy-maker; with the help of
these, however, we would be able to weight the various distributions and
thus determine whi set of means is best, but this would involve even more
complicated problems connected with statistical decision making. It is even
conceivable that a number of means less than the number of the ends (or
even no means at all) may bring about ‘beer’ probability distributions of
the values of the end-variables, but only at the cost of the expectations for
all end-variables deviating to some extent from their desired values; the
policy-maker would perhaps prefer su a solution to a solution where the
mean expected values of the end-variables are exactly those desired, but
where, on the other hand, the dispersions are mu greater. Also to be
considered is the possibility that a greater number of means than ends will
involve ‘beer’ distributions and at the same time make the expectations for
the end variables coincide exactly with the ends.
e conclusion of this discussion is thus the rather obvious one that since
the given ends of full employment and a stable value of money can, in
principle, be aieved by various sets of means, the State should oose the
means of whi the effects are best known. On this basis one should perhaps
be able to resolve the old conflict of monetary policy versus fiscal policy (if,
say, the effects of the monetary policy means are beer known than the
effects of fiscal policy means, or vice-versa). However, the fact is that both in
monetary policy and in fiscal policy, the effects of any particular means are
usually rather well-known, in some respects, but only very slightly known
in other respects. us we can, for example, be quite sure that an increase in
the rate of interest will result in a decrease in investment, but we do not
know very mu about the effects of su an increase on private saving.
Also we may be quite sure that an increase in income taxation will involve a
reduction in the demand for consumer goods, but when it comes to the
question of how this increase in income taxation will affect investment or
the supply of labour, our knowledge is very slight. Many other examples
could be given of this uneven knowledge of the partial effects of the different
means. It is obvious that this gives no basis for oosing between fiscal and
monetary policy. In general the principle that, ceteris paribus, means with
relatively well-known effects should be preferred, will not indicate any
definite preference for certain means. In all probability the amount of certain
and uncertain knowledge is distributed fairly evenly over all policy means
regularly in use.
In addition to the problems created by the stoastic models, we have, of
course, even more serious problems when policy is based on a completely
incorrect theory, that is to say a theory whi is not even correct ‘on
average’. In all probability, mu of what is today considered as quite well-
established within economic theory, cannot be maintained as a satisfactory
description of reality. For various reasons, including the la of relevant
statistics, large parts of economic theory have never been tested empirically.
Furthermore, the way the economy functions is constantly anging, a
hypothesis suited to the circumstances of the past twenty years may be
without relevance for the future. When facing problems of this kind there is
nothing to do but to try to improve economic theory and render it more true
to reality.

3. UNCERTAIN KNOWLEDGE OF EXTERNAL CONDITIONS

Even if the State has a perfectly correct (exact) knowledge of the internal
relationships in the economy, its policy may be unsuccessful due to
unexpected anges in the external conditions under whi the economy
operates. is means that the uncontrollable parameters of the model may
be subject to anges whi are not known beforehand. If su a disturbance
occurs the result may be that the end-variables will temporarily deviate
from their desired values. As the national economy is always subject to
disturbances, knowledge of these disturbances become just as important as
knowledge of the internal relationships of the economy; as to the laer,
perfect knowledge is presumed in this section.
Correct anticipation of a disturbance is, as we shall now try to show,
neither a necessary nor a sufficient condition to avoid deviations from the
ends. e existence of time-lags in economic relationships may make it
impossible to avoid deviations from the ends even if the disturbance has
been foreseen; time-lags may, however, also mean that su deviations can
be avoided even if the disturbance was not discovered until aer it had
occurred.
e first time-lag that is relevant here is that between the moment when
the disturbance occurs and the moment when the disturbance affects the
end-variables; this interval might be called the disturbance time-lag; if the
State has several policy ends, a given disturbance can of course, have time-
lags of different lengths corresponding to the various intervals before the
different end-variables are affected. In a static single-period model, su as
the one in Chapter XIII, no su time-lags occur, but they do appear as soon
as dynamic models are used. For example, if export prices are exogenously
determined, an increase in the export price of some capital goods will, aer
a certain lapse of time, affect consumer goods prices via the rise in the sales
receipts of exporters, the increase in incomes, and the subsequent increase in
demand.
e second relevant time-lag could be called the policy time-lag. is may
be divided into three different intervals. Firstly, the disturbance itself and the
observation of it may differ in time; we then have an observation time-lag.
is may be negative if the disturbance is correctly foreseen or positive if
the disturbance occurs before it is observed. Furthermore, there may be a
certain amount of time between the observation of the disturbance and the
planning and puing into effect of the counter-measures; here we have an
administrative time-lag. Finally, there may be an interval between puing
the measures into effect and the point of time when they influence the end-
variables; this is the effect time-lag. us the policy time-lag is equal to the
sum of the observation time-lag, the administrative time-lag and the effect
time-lag.
It will now be readily understood that the condition for a successful
policy whi will prevent disturbances from causing divergencies between
the actual and desired values of the end-variables, is that the policy time-lag
is no longer than the disturbance time-lag. Whether the disturbance is
foreseen or not is not decisive in itself; the decisive thing is that the
disturbance has been observed in sufficient time for counter-measures to be
effective before the disturbance begins to affect the end-variables.
Naturally, the disturbance time-lags are not of the same length for all
disturbances and ends. Disturbances whi immediately affect the supply or
demand of consumer goods will, of course, affect the consumer goods price-
level more quily than disturbances whi have their immediate effect on
the capital goods markets; disturbances to agriculture will probably affect
employment less quily than disturbances to industry, etc.
e policy time-lag is dependent on the nature of the disturbances as well
as that of the ends and means. e observation time-lag will obviously differ
with the various types of disturbance. Let us consider anges in
productivity. For the country as a whole, or for certain large sectors of the
economy, anges in productivity can oen be foreseen well in advance,
though naturally with varying degrees of accuracy; anges in the harvest
can as a rule be estimated accurately at the time of, or even before, the
harvest; other types of anges in productivity, su as minor
rationalization, can only be observed long aerwards and then only by
careful statistical analysis e administrative time-lag is first and foremost
dependent on the nature of the means. Measures whi require
parliamentary approval generally require more time than measures whi
can be put into effect by the Government or the central bank directly. e
administrative time-lag is a good deal longer with the introduction of new.
taxes, because the administration has to prepare them, than with anges in
existing taxes. Finally, the effect time-lag is also dependent on the nature
both of the means used and of the ends. A ange in the number of public
employees has an immediate effect on employment but not until later does it
affect the consumer goods price level. An increase in indirect taxation on
consumer goods has undoubtedly a mu quier effect on consumer goods
prices than a fall in the rate of interest. us the total policy time-lag will be
of a greatly different length for various combinations of disturbance, ends
and means.
Most discussions on the possibilities of eliminating the effects of
disturbances have been concerned with the problems of the observation
time-lag and the administrative time-lag and how to make these lags as
short as possible. e recommendations made have, as a rule, been based on
the administrative time-lags of the various means: those means whi have
the shortest administrative time-lag are considered the best when measures
have to be made to meet an unexpected disturbance. Reforms made in order
to permit quier intervention have, therefore, as a rule aimed at shortening
the administrative time-lag, e.g. the existence of emergency legislation. It is
oen said that it is in this very respect that monetary (interest) policy is
beer suited to the purpose than fiscal policy. No doubt the administrative
time-lag is important, and, other things being equal, a means with a short
administrative time-lag is, of course, beer than a means with a longer
administrative time-lag. But other things are not always equal; means with a
short administrative time-lag may have a long effect time-lag and vice-
versa. e question of whi means are supreme from this point of view
cannot be decided merely on the basis of the length of the administrative
time-lag for the different means. With a given disturbance and end, the
comparison between the disturbance time-lag and the total policy time-lag
with different means will be decisive. Means whi make the policy time-lag
shorter than that of the disturbance are good, and between themselves are
equally good; means whi make the policy time-lag longer than that of the
disturbance are inefficient, and are the more inefficient the longer they make
the policy time-lag.
Since, with a given disturbance and end, the time-lag of the disturbance
remains the same irrespective of the means, and also since, with a given
disturbance, the observation time-lag is, or at least ought to be, the same
irrespective of whi authorities are responsible for puing the counter-
measures into effect, the decisive circumstance for the oice of means will
be the total length of the administrative time-lag and the effect time-lag of
the means. Now if we examine the question of interest policy versus fiscal
policy against this baground, the problem will be seen in quite a different
light than that in whi it appears when aention is concentrated
exclusively on the administrative time-lag. While interest policy normally
has a very mu shorter administrative time-lag than fiscal policy, certain
important fiscal policy means have a mu shorter effect time-lag than
interest policy. We have already pointed out that a ange in an indirect tax
on consumer goods will probably have a mu more rapid effect on the
market prices of consumer goods than can be brought about by a ange in
the rate of interest, and that a ange in the number of public employees
will affect employment more rapidly than a ange in the rate of interest.
Similarly, a ange in income taxation will probably affect consumer goods
demand mu more rapidly than a ange in the rate of interest, and will
thus also affect consumer goods prices and/or employment in the consumer
goods industries more rapidly than the ange in the rate of interest.
Examples can also be given of anges in the rate of interest whi have a
quier effect on the price level than certain fiscal policy measures; see the
discussion on debt policy measures in Chapter VI, 7. No aempt at an
exhaustive discussion of the problem will be made here. However, it should
be pointed out that it may in general be presumed that fiscal policy means
have a shorter effect time-lag than monetary policy means when it comes to
the ends of full employment and a stable value of money (in the sense of a
stable consumer price level) at least when we speak of ‘pure’ interest policy
means, as is the case here, for with quantitative credit market regulations
the case is different, of course. e reason for this is as follows. e effect
time-lag of the means is defined as the period from the introduction of the
means until the ends have been realized. With the ends of full employment
and a stable consumer price level the ends are economic variables, whi are
directly determined in the labour market and the consumer goods market
respectively. However, in the way we have defined fiscal policy and
monetary policy, the laer covers all measures whi are immediately
directed towards the credit markets, while the former covers all other
measures. But does it not then follow that fiscal policy measures may in
general be expected to affect the ends of full employment and a stable
consumer price level more quily than monetary policy measures. Could it
not be reoned that the ‘closer’ to the end-variables the measures are taken,
the more quily the end-variables will be affected? Let us test the opposite
case where the goal concerns a variable whi is immediately determined in
the credit market; assume that the goal consists of bringing about a certain
fall in the rate of interest on bonds. is goal could be realized either by
direct operations on the Sto Exange, i.e. open-market operations, or, for
example, by an increase of State expenditure on the purase of labour
(increase in civil service salaries), financing this by central bank loans; in the
laer case a general increase in liquidity will arise within the private sector
of the economy whi would affect the rate of interest on bonds. It is quite
obvious whi of the two methods has the quier effect.
e conclusion to be drawn from these considerations is that while
monetary policy means have a shorter administrative time-lag than fiscal
policy means, other circumstances are in favour of fiscal policy means,
whi oen have a shorter effect time-lag than monetary policy means as
far as the ends of full employment and a stable consumer price level are
concerned. erefore, it is an open question as to whether monetary policy
or fiscal policy will have the shorter total policy time-lag.
As we have pointed out above, policy need not be unsuccessful or become
inefficient, even if it is only possible to observe disturbances ex post facto; it
is sufficient that the policy time-lag is no longer than the disturbance time-
lag. On the other hand it is obvious that very oen divergencies from the
ends cannot be avoided because disturbances are discovered too late. Some
disturbances affect the end-variables very quily; in many cases the
disturbances are discovered from the very divergencies in the actual and
desired values of end variables of whi they are the cause. It may then be
asked whether this circumstance affects the conclusions concerning means
whi we arrived at in previous apters where the possibility of time-lags
was not considered. is need not be the case. For example, if the static
model of Chapter XIII gives a satisfactory description of the working of the
national economy, everything stated in relation to this model still applies
even if the means are not introduced until aer the disturbance has affected
the model. e means whi were there found to be sufficient to counteract
the effects of the disturbance, will still do the same here and restore the end-
variables to their desired values. It is quite another maer that the existence
of an interval between the disturbance and the counter-measures may
introduce short-term dynamic relationships whi we were able to ignore
when the disturbance and the means are synronized. However, we shall
not go further into this rather important question here.

4. THE ‘STABILITY’ OF THE ECONOMY

As soon as one admits the possiblity that fiscal and monetary policy
measures can only secure the established ends with a greater or lesser
degree of certainty, or to put it another way, that the ends can only be
realized if they are formulated as an average from whi certain
divergencies must be allowed, the question of the ‘stability’ of the economic
system arises. is question is of particular interest with disturbances whi
have not been discovered early enough to prevent the end-variables from
being affected. at temporary divergencies cannot be avoided is one thing;
quite another thing is how great these divergencies will be before policy
measures restore the end-variables to the desired values. Problems of this
type have given rise to the idea of the budget as a ‘built-in stabilizer’, as
mentioned in Chapter IV, 6. It should be observed, however, that this is not
only a problem of dynamic stability. e problem is just as relevant for static
as for dynamic systems, and can be most simply and generally formulated as
a multiplier problem. If it is unavoidable that disturbances give rise to
deviations from the ends, then obviously it is desirable that the static or
dynamic multipliers of the disturbances with regard to the end-variables
shall be as small as possible; in our case this means that the employment
multipliers and the consumer goods price level multipliers of the various
disturbances are to be as small as possible. Starting from a given economic
system with a given fiscal policy (that is with given tax scales, tax rates, and
expenditure levels, etc.) the question is then to what extent a ange in
policy may reduce the size of these multipliers. It is likely that difficult
problems of weighting will be encountered here, the solution of whi will
require a ‘welfare function’, or ‘end-index’ whi is determined politically. A
given ange in the economic system may increase the multipliers of certain
disturbances, and diminish those of others. Price-multipliers and
employment-multipliers need not be affected in the same manner; for
example, if we ange from an indirect unit tax to an indirect ad valorem
tax it is likely that the price-multipliers will increase and the employment-
multipliers decrease. Regard should also be paid to the frequency with whi
different types of disturbance arise.
Closer study of this problem of minimizing the multiplier effects requires
a model relevant to the economy as it actually is, so that from this model we
may calculate how different quantitative or qualitative anges in the
composition of the State’s finances will affect the relevant multipliers. For
reasons of space we shall not go further into the question, but just indicate
briefly certain circumstances whi will probably make the multipliers
smaller, and whi may thus further this policy. High marginal tax rates,
direct as well as indirect, and high transfer rates (if transfers vary inversely
with income) with short lags between anges in the tax (transfer) base and
tax (transfer) payments will generally involve low employment-multipliers.
Strongly progressive income taxation levied at the source, combined with
considerable unemployment benefit will consequently be desirable. It is
doubtful whether the same applies to price-multipliers. It is true that there is
a tendency towards simultaneous variation in the employment-multipliers
and in the price-multipliers; anges in employment involve anges in the
marginal costs of firms, and consequently also in prices, and the greater the
anges in employment the greater will be the anges in costs. Other
considerations work in the opposite direction, however, in certain cases the
fact that taxes are a cost element has a direct influence on prices, and
because of this, tax revisions involving lower employment-multipliers may
very well increase price-multipliers. Furthermore, it is oen considered that
the ‘money illusion’ in State expenditure may have a dampening effect on
economic fluctuations. is ‘money-illusion’ quite simply means that with
unexpected price anges, the State maintains the expenditure total as
originally planned, instead of allowing expenditure to fluctuate with prices
and incomes, see Chapter III where the demand curves of the State were
examined. With rising prices, State demand would then automatically
decrease in real terms and this is held to have a stabilizing effect. However,
the effects are not uniform, not even here. If we imagine a disturbance whi
will simultaneously involve a rise in prices and a fall in employment, su a
‘money illusion’ in State expenditure will naturally enough lessen the price-
multiplier of the disturbance, but at the same time the (negative)
employment-multiplier of the disturbance will increase (in absolute value).
e question of the budget as a ‘built-in stabilizer’ is accordingly, as these
simple examples should have shown, a great deal more complicated than is
usually assumed. In contemporary discussions it is oen taken for granted
that the degree of ‘stability’ can be measured by the anges in one single
entity, e.g. the national income reoned in money terms, or the gross
national product in real terms; what complicates the maer here is that we
have several ends, and consequently several measures of the degree of
stability, and these measures need not point in the same direction.

5. CONCLUSION
In this final apter I have tried to outline certain problems whi arise in
connection with the uncertainty of economic knowledge, and the difficulties
of foreseeing or observing the disturbances whi affect the economy. As I
have tried to show, these factors will in general exert some influence on the
oice of means. e element of uncertainty does not lead to any preference
for particular types of means; for instance there is no reason to believe that
the element of uncertainty would be decisive as to the oice between
monetary policy means and fiscal policy means. Up to now our fundamental
point of view has been that the ends have to be osen with regard to the
particular situation to be mastered, and this point of view is not influenced
by the fact that policy has to be pursued in an uncertain world.

1. is is valid at least with ordinary linear models.

2. e term is Erik Lundberg’s. e problem discussed here plays a large
part in Lundberg’s discussion of the end-means problem in economic
policy, see Konjunkturer och ekonomisk politik (Business Cycles and
Economic Policy), Chapters 8, 13, 14 and 16, it being obvious that the
larger is the margin of tolerance, the smaller need be the number of
means or the variations of means.
 INDEX OF AUTHORS

Andrews, W. H., 378

Arwidsson, G., 128

Barna, T., 83, 99

Benham, F., 91
Bentzel, R., 72, 99, 100, 185, 233, 271, 319
Beveridge, W. H., 27, 248, 349
Bla, D., 91, 146
Boulding, K., 268
Brown, E. C., 147, 148
Brumberg, R., 117
Böhm-Bawerk, E. von, 117, 128

Cooper, G., 179

Dalton, H., 90
Davidson, R. K., 150, 217, 218
Douglas, P.H., 80
Duesenberry, J. S., 118, 165, 184, 185
Dunlop, J. T., 322, 345

Edgeworth, F. Y., 90
Einaudi, L., 146

Fiser, I., 117, 120, 123–125, 129, 133

Friedman, M., 83
Fris, R., xi, 29

Gelting, J., 41, 55, 58, 80, 83, 92

Haavelmo, T., 41
Hall, R. L., 188, 196
Hammarskjöld, D., 54, 216, 331
Hansen, A. H., 39, 61
Hawtrey, R. G., 165
His, J. R., 105–107, 117, 127, 129, 138, 150, 165, 175, 187, 190
Hit, C. J., 188, 196
Hood, W. C., 23

Joseph, M.F.W., 150

Kalei, M., 92
Koopmans, T. C., 17, 23
Kurihara, K. K., 65, 117

Lerner, A. P., 65
Lester, R. A., 188
Lindahl, E., 31, 33, 41, 54–56, 61, 69, 72, 79, 83, 90, 99, 111, 116, 119, 146, 149,
162, 177, 217, 218, 220, 223, 225, 233, 317
Lindberger, L., 61, 202
Lile, I. M. D., 150
Lundberg, E., 49, 80, 217, 334, 360, 367, 373, 433

Malup, F., 188

Marsak, J., 11, 378
Marshall, A., 90, 188
Mehring, O., 91, 169, 179
Meidner, R., 179, 343, 366–369, 371, 374, 375
Metelius, B., 423
Metzler, L., 60, 106, 107
Mill, J. S., 146, 162
Modigliani, F., 117, 165
Mosak, J., 117, 129
Mutén, L., 272
Myrdal, G., 37, 61, 76, 80, 81, 83, 84, 117, 388

Nørregaard Rasmussen, P., 91, 195

Nyblén, G., 108
Ohlin, B., 343, 344
Ohlsson, I., 177, 377, 379

Patinkin, D., 65, 184

Pedersen, J., 61
Philip, K., 60, 149
Pigou, A. C., 90, 116, 146, 162

Rehn, G., 339, 340, 366–370, 373–375

Robinson, Joan, 224

Samuelson, P. A., 11, 33, 39, 105, 186, 225

Seligman, E. R. A., 90
Shephard, R. W., 91, 98
Simon, H. A., 23, 24, 395, 397
Somers, H. L., 42, 91
Smith, A., 329
Sneider, E., 59, 60, 86, 187, 201
Svennilson, I., 45, 69, 187
Sweezy, P. M., 196

Tinbergen, J., xi, 29, 395

Turvey, R., 49, 78, 367

Welinder, C., 54, 55, 92, 171

Wiman, K., 367
Wisell, K., 60, 90–92, 117, 216–218, 258
Wold, H., 24, 120, 268

Västhagen, N., 202

Zeuthen, F., 108, 321, 343, 350, 373

 INDEX OF SUBJECTS

A
Aggregate marginal cost curve, 370, 390
Arrow seme, Tinbergen’s, 395 ff.
Autonomous consumption, 163 ff.
Average tax rates, 265

B
Beveridge’s definition of full employment, 348
Budget, balance, def., 43, 53 ff., 60
cash, 60
ex ante, 68 ff.
ex post, 75 ff.
-index, 49 ff.
neutral, 83
reaction, automatic, 81 ff., natural, 76, 83 ff.
restriction, household’s, 130, 156, State’s, 43
Burden of taxation, 98, 149 ff.

C
Capital values and interest rates, 122 ff.
Causal ordering, 23, 395 ff.
Civil servants’ salaries, 167, 257
Compulsory call-up, 242 ff.
Consumption-tax, effects of, on saving and consumption, 141 ff.
Co-ordination of economic policy, 14 ff.

D
Dalton-formula, 90
Death duties, 170
Declarations, 111, 258 ff.
Demand for capital goods, anges in, and fiscal policy, 296, 403
Demand for consumer goods, anges in, and fiscal policy, 295, 402
Depreciation allowances and investment, 202
Douglas-report, 80, 83

E
Ends, conflicting, 25 ff.
defined, 5
-index, 11, 210, 435, 441
multi-period, 307
of organizations, 210
single-period, 307
Effects, circulatory, 92
defined, 37 ff.
discriminatory, 92
partial and total, 102
Excess, demand for labour, 248, 339, 343 ff., 348
purasing power, 385
Exange policy, 399 ff.
Export bounties, 392
Extremely open economy, 389 ff.

F
Factor gap, 346
Firm, eory of, 186 ff.
Fiscal policy, defined, 32, 109
Forecast, “engineering”, 379,
“meteorological”, 378
Free write-offs, 202
Full employment, defined, 227, 343, 345 ff.
in heterogenous labour market, 344 ff.
in homogeneous labour market, 224 ff., 338 ff.
“Functional finance”, 65
The Economic Theory of Fiscal Policy

G
Gross taxes, 272 ff.
“Grounds” of Böhm-Bawerk, 128

H
Home demand, elasticity of, 423 ff.
Home market commodities, 422 ff.

I
Import, duties, 392
prices, 393 ff.
Incentives, 260 ff.,
direct vs. indirect taxes and, 267 ff.
Incidence, defined, 93
theory, partial, 91, 95, 99, total, 91, 96, 257
Income distribution, 184, 260, 264 ff, 270 ff.
Income taxation, effects of, on comsumption and saving, 138 ff.
Inferior periods, defined, 127
Inheritance taxes, 170
Interest rate, negative and zero, 122 ff.
production optimum and, 241
“International room” for domestic policy, 388
Intertemporal, preference theory, 117 ff.
plans, 118ff.
Investment, duties, 203 ff.
period of, 205
theory of, 201

J
Joint taxation, 181

K
Kinked demand curve, 196 ff.

L
Lindahl’s norm, 223
Liquidity, and the budget, 44, 56 ff.
and fiscal policy, 304 ff.
Loan policy, 108 ff.,
effects of, 55 ff.
Long-term problems of policy, 307 ff.

M
Marginal, subsidies, 373
tax rates, 265, 268 ff.
Marginalistic vs. non-marginalistic pricing, 188 ff., 198, 240
Margins of tolerance, 433, 434
Means, and the balance of the budget, 44 ff.
defined, 8
economy of, 403, 409 ff.
ordering of, 20, 21, 23 ff., 398 ff., 421 ff.
long-term, 302
short-term, 302
Model, dynamic, 4, 302 ff.
exact, 3
for closed economy, 231 ff., 302 ff.
for extremely open economy, 393 ff.
interdependent, 23, 319, 401 ff.
recursive, 24, 319, 397
stoastic, 432 ff.
Money illusion, 163, 269, 442
Monetary policy, defined, 32
programmes, 216 ff.
fiscal policy vs., 439
Moving equilibrium, 303
Multiplier, and “built-in stabilizers”, 441
balanced budget, 41, 48
dynamic, 38
pseudo, 39

N
National budgeting, 377 ff.
National debt, defined, 31
Net profits tax, 194, 198 ff.
Neutral fiscal policy, 230

O
Organizations and fiscal policy, 107 ff.
Overfull employment, 248 ff.

P
Parameter, defined, 6
action-, 69
controllable, 6
fiscal, 7
monetary, 108
non-permied, 6
permied, 6
State, 7, 34 ff.
uncontrollable, 6
Pensions, 172
Period, of model and policy problems, 318 ff.
of production, 241
Pigou-effect, 65
Plans, conditioned and unconditioned, 72
Poll tax, 167
Production tax, 192 ff., 416 ff.
on capital goods industries, 233
on consumer goods industries, 233
on consumer goods industries and price level, 237 ff.
Productivity anges, fiscal policy and, 280 ff., 292, 403 ff.
“uniform”, 217, 292 ff. 333 ff., 354 ff., 404 ff., 425 ff.
Property taxes, 168 ff.
Public consumption, 105 ff., 176 ff., 195, 223
Public purases of labour and fiscal policy, 242 ff.

Q
antity theory of money, 59, 60

R
Rationing of credits, 252, 298, 419
Raw material tax, 189 ff., 250
Real possibility curve, 144
Reform of taxation from direct to indirect taxation, 261 ff.
Regression, 190 ff.
Regressiveness of indirect taxes, 267
Rehn-Meidner policy, 367 ff.
Residual fraction, defined, 138
Risk, 182 ff., 203

S
Saving, “double taxation” of, 146
goal, 121, 129 ff., 156 ff., 170, 171
rate of interest and, 124 ff.
short-term and long-term, 164
Short-term problems, 307 ff.
Social security, 171 ff.
Sound finance, 47, 61 ff.
Speculation, 298
Stabilizing effects, automatic, 80 ff., 175, 261, 440 ff.
State purases of, capital goods and fiscal policy, 256
consumer goods and fiscal policy, 254
Sto anges and fiscal policy, 296 ff.
Sto of real capital and fiscal policy, 302 ff.
Subsidies, direct, and saving, 167
Substitution in demand, 391, 422 ff.
Supply of labour, 178 ff., 224 ff., 252 ff., 268, 299 ff.

T
Taxation, principles of, 116 ff. progressive, 136, 140, 173 ff., 184 regressive,
140
Taxes, and the consumption function, 162 ff.
on capital, 168 ff.
on capital-income, 168 ff.
Tax-function, 265
Time-lag, administrative, def., 437
 disturbance, def., 436
effect, def., 437
observation, def., 437
policy, def., 437
Time-preference, 133
Turnover-tax, 416 ff.

U
Utility-function, intertemporal, 120, 130, 133, 156 ff., 162
Utility theory and taxation principles, 116

V
Value-added, tax on, 273 ff.
Value of money, def., 221
concepts of, 215 ff.

W
Wage, anges and fiscal policy, 332 ff., 406
anges, cost effects of, 329 ff.,
demand effects of, 329 ff.
claims, profits and, 369
control, Seme of indirect, 353 ff.
-dri, 249, 339 ff.
-dri, asymmetrical, 347 ff.
-dri, market conditioned, 340 ff.
-dri, non-market conditioned, 340 ff.
increase, Room for, 330 ff., 377 ff., and anges in productivity, 333 ff., 342,
355
-index, movements of, 345 ff.
index-regulated, 352
movements at equilibrium in heterogeneous labour market, 345
multiplier, 360n
structure, “inner dynamics” of, 321
tax, 232 ff., 276 ff., 325 ff., 329
Wealth, anges in, and fiscal policy, 304 ff.
Welfare-function, 11, 435
Working, time, 179 ff., 268 ff.
World-market prices, Changes in, and fiscal policy, 406 ff.