Economic Report of the President

increase demand pressures, especially in the years immediately followingit. While tax reductions that are effective in raising investmentare essential in a long-term strategy to promote economic growth,business tax cuts, like personal tax cuts, must be designed to fit intoan overall framework of fiscal restraint.CONCLUSIONSThis analysis of the macroeconomic effects of Federal tax reductionssuggests several conclusions for the development of fiscalpolicy:First, specific investment-oriented tax reductions for business arelikely to increase saving, investment, and productivity by a muchmore significant degree than cuts in personal income taxes.Second, productivity-oriented tax reductions will yield improvementsin the inflation rate that are helpful and significant, but still relativelymodest in the context of a 10 percent underlying inflation rate.Third, the supply response, while a critically important feature ofany tax reduction, will be substantially less than the demand response,particularly in the short run.Fourth, since reductions in both business and personal taxes will increasedemand faster than supply, they must be designed and carriedout in ways that are consistent with the demand restraint needed toreduce inflation.It is sometimes alleged that the potentially inflationary effects of alarge tax cut can be avoided if the Federal Reserve steadfastly pursuesits goal of keeping the growth of the monetary aggregateswithin tight targets. But if taxes are reduced while the Federal Reservepursues an unchanged monetary policy, aggregate demand willnevertheless increase, especially in the short run. The increase indemand would lead to a rise in interest rates that would dampen theincrease in aggregate demand but not eliminate it. Additional inflationarypressure would then result.A very large tax cut unaccompanied by the necessary spending cutswould lead to both an increase in inflation and a sharp rise in interestrates. Some, and perhaps all, of the stimulus to investment fromtax reductions would be undone by the higher interest rates and thegreater uncertainty engendered by a new round of inflation.Monetary restraint is an absolutely essential element of inflationcontrol and reduction. Tax measures focused on increasing supplycan make a significant contribution. But there will be a continuingneed for careful and prudent fiscal policies to restrain demand. Inrecent years the Nation has come to appreciate the potential value ofsupply-oriented tax policies. In the process of learning some neededlessons about supply-side economics, however, the Nation cannot83