Order Code RL31176
CRS Report for Congress
Received through the CRS Web
Financing Issues and
Economic Effects
of Past American Wars
November 7, 2001
Marc Labonte
Economist
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Financing Issues and Economic Effects of Past
American Wars
Summary
The increased government outlays associated with wars can be financed in four
ways: through higher taxes, reductions in other government spending, government
borrowing from the public, or money creation. The first two methods are unlikely to
have an effect on economic growth (aggregate demand) in the short run: the
expansion in aggregate demand caused by greater military outlays is offset by the
contraction in aggregate demand caused by higher taxes and/or lower non-military
government spending. The latter two methods increase aggregate demand. Thus, a
by-product of American wars has typically been a wartime economic boom in excess
of the economy’s sustainable rate of growth. This has occurred in part because the
American homeland has never been directly at risk in the conflicts discussed. Just as
wars typically boost aggregate demand, the reduction in defense expenditures after
a war typically causes a brief economic contraction as the economy adjusts to the
return to peacetime activities.
The economic effect of World War II stands in a class of its own. More than
one-third of GDP was dedicated to military outlays. Budget deficits were almost as
large; these large deficits were made possible through policies that forced individuals
to maintain a very high personal saving rate. Money creation was a significant form
of financing, but the inflation that would typically accompany it was suppressed
through widespread rationing and price controls. Private credit was directed towards
companies producing war materials. There was a significant decrease in non-military
outlays and a significant increase in taxes, including the extension of the income tax
system into a mass tax system and an excess profits tax. President Truman attempted
to avoid financing the Korean Conflict through borrowing from the public or money
creation – budget deficits were much lower than during any other period considered
– but the economy boomed anyway. Tax increases and a reduction in non-military
spending largely offset the increases in military outlays. President Truman relied on
price controls to prevent the money creation that did occur from being inflationary.
Neither Vietnam, the Reagan buildup, nor Desert Storm were large enough to
dominate economic events of their time. The beginning of the Vietnam Conflict
coincided with a large tax cut. Non-military government spending rose throughout
the Vietnam era. Budget deficits were used for most of the financing, although tax
increases occurred at the peak of the conflict. Inflation rose throughout the period,
and President Nixon turned to price controls to suppress it. The beginning of the
Reagan military buildup also coincided with a large tax cut, as well as an effort by the
Federal Reserve to disinflate the U.S. economy. Thus, borrowing from the public,
and later a reduction in non-military outlays, offset most of the rise in military
spending. Unlike earlier conflicts, liberalized international capital markets allowed the
U.S. to borrow significantly abroad for the first time, which many economists believe
caused the large trade deficits of the mid-1980s. Desert Storm took place among
rising budget deficits and rising taxes. It was the only military operation considered
to largely occur in a recession. At present, military outlays would have to increase
significantly as a percentage of GDP before they became similar in size to the smallest
episodes considered in this report. This report will not be updated.

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Contents
The Economics of War Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Borrowing from the Public . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Money Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Use of Price Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Equity Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Interpreting Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
World War II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Korean Conflict . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Vietnam Conflict . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Reagan Military Buildup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Desert Storm Operation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
List of Figures
Figure 1: Comparing the Size of Conflicts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
List of Tables
Economic Indicators in the World War II Era . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Economic Indicators in the Korean Conflict Era . . . . . . . . . . . . . . . . . . . . . . . . . 8
Economic Indicators in the Vietnam Era . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Economic Indicators in the Reagan Era . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Economic Indicators in the Desert Storm Era . . . . . . . . . . . . . . . . . . . . . . . . . 14

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Financing Issues and Economic Effects of
Past American Wars
In the aftermath of the attack of September 11, Congress has expressed an
interest in how wars have been financed historically, and what effects the wars had on
the economy. This report examines financing and economic issues in World War II,
the Korean Conflict, the Vietnam Conflict, the Reagan Military Buildup, and the
Desert Storm Operation. It considers developments concerning tax policy, non-
military outlays, the budget balance, economic growth, inflation, and interest rates
during these periods. It is worth noting that in none of the above mentioned conflicts
was the American homeland directly at risk to any meaningful extent.
The Economics of War Financing
The increased government outlays associated with wars can be financed in four
ways: through higher taxes, reductions in other government spending, government
borrowing from the public (the issuance and sale of U.S. Treasury securities to the
public), or money creation. Major wars have relied upon all four measures.
The first two methods are unlikely to have an effect on economic growth
(aggregate demand) in the short run. The expansion in aggregate demand caused by
greater military outlays is offset by the contraction in aggregate demand caused by
higher taxes and/or lower non-military government spending.
The latter two methods increase aggregate demand. Thus, a by-product of wars
has typically been a short-term economic boom in excess of the economy’s sustainable
rate of growth. Just as a military buildup in wartime typically boosts aggregate
demand, the reduction in defense expenditures after a war typically causes a brief
economic contraction as the economy adjusts to the return to peacetime activities.

Borrowing from the Public. If the economy’s resources are fully employed
when the government boosts aggregate demand, the increase in government spending
must be offset by a reduction in spending elsewhere in the economy. In the case of
borrowing from the public, prices and interest rates would be expected to rise, the
latter causing investment and other interest-sensitive spending to be lower than it
otherwise would be. Economists refer to this phenomenon as government purchases
“crowding out” private investment and interest-sensitive spending. Since private
investment is crucial to long-run growth, the long-run effect of these policies would
be to reduce the private capital stock and future size of the economy.
Once government controls on the international flow of private capital were
largely removed by the early 1970s, it became possible for government budget deficits
to be financed by foreigners as well as domestic citizens. If a budget deficit is
financed by foreigners, exports and import-competing goods rather than private

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CRS-2
investment are thought to be “crowded out” by government expenditures through an
appreciation of the dollar and a larger trade deficit.1
Money Creation. How does money creation help the government raise
revenues? When the government (through the Federal Reserve) prints money, it can
use that money to purchase real resources. But at full employment, the government
cannot increase the amount of real resources in the economy simply by printing
money. In this case, if the increase in the money supply increases the resources
available to the government, it must be offset by a decrease in the resources available
to other individuals in the economy. This occurs through inflation, which makes
money less valuable in terms of the amount of real resources for which it can be
exchanged. The individuals whose wealth is reduced are those who held a portion of
their wealth in the existing money at the time when the government increased the
money supply. That is because the existing money they hold can now be exchanged
for fewer real resources than before the new money was printed. For this reason,
using money creation as a form of government finance has often been characterized
by economists as an “inflation tax.”2
Unlike borrowing from the public, money creation would not be expected to
disproportionately crowd out private investment because expansionary monetary
policy is likely to have the effect of reducing interest rates in the short run. Instead,
the transfer of resources is likely to come about through higher inflation, affecting
individuals who are unable to protect their wealth and income from inflation.3 While
some price inflation may be associated with borrowing from the public, money
creation is typically a more inflationary method of finance.
In World War II, the means by which the increase in the money supply came
about was through the Federal Reserve’s purchase of government bonds. In effect,
the Federal Reserve made a loan to the government of newly printed money. In the
1950s, the Treasury- and Federal Reserve reached an “accord,” and the government
could no longer “borrow” directly from the Federal Reserve. But even if the
government could not sell its bonds to the Federal Reserve directly, it would still be
possible for the government to use money creation as a means of war financing
(assuming the Federal Reserve agreed). The government could sell its bonds to
private individuals, and the Federal Reserve could then purchase those bonds from
private individuals with newly printed money and return the proceeds of those bonds
to the Treasury. In both cases, the result would be the same – the increase in the
1 For a more detailed discussion, see CRS Report RL30583, The Economics of the Federal
Budget Surplus, by Brian Cashell.
2 Money creation also has the side effect of transferring wealth among private individuals from
those who suffer from higher inflation to those who benefit from higher inflation. In many
cases, it is particularly savers who suffer and debtors who benefit from high inflation.
3 Part of individuals’ private wealth is held in the form of U.S. Treasuries, government debt.
If individuals do not fully anticipate future inflation and cannot protect their holdings of
Treasuries from inflation, then manipulating the money supply can also reduce the
government’s burden of servicing its debt. (For example, holding long-term bonds exposes
an individual to future inflation risk.) One result of the high inflation after World War II was
a large reduction in the real value of government debt outstanding.

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CRS-3
money supply would transfer resources to the government by reducing the public’s
real wealth.4
World War II was the only conflict examined in which the government relied on
money creation as a significant source of revenue. And the amount of revenue
extracted from money creation in World War II pales in comparison with foreign
experience with hyperinflation. In parts of Central Europe in the inter-war period and
Latin America in the 1970s and 1980s, the tax collection system could not meet the
needs of the government, and the government relied primarily on money creation for
its revenue. In these countries, inflation often exceeded 100% a month and money
lost the useful functions it provides in a market economy. In other conflicts in which
inflation rose in the United States, such as the Vietnam Conflict, it would be unfair to
characterize the excessive money creation that occurred as being motivated primarily
by a desire to increase government revenue. It is fairer to say that excessive money
creation was influenced by a desire or belief by the government that the economy
could or should grow faster than was actually possible.
Use of Price Controls. Under normal circumstances, money creation as a
means of government finance would be expected to lead to price inflation. In major
wars, the government has attempted to suppress inflation through the use of
widespread price controls rather than forgo the benefits of inflationary monetary
policy. Economic theory suggests, and historical evidence supports, that the use of
price controls may be successful at suppressing inflation for a time, but prices will
eventually rise when those controls are removed, or even sooner if the administration
of controls break down. The suppression of inflation increases the government’s
purchasing power for a given change in the money supply, making monetary finance
more powerful. Strict price controls create significant market distortions and may
result in shortages for some goods because they do not allow relative prices to adjust
as supply and demand for individual goods change. When price controls are in effect,
black market activity typically expands as citizens attempt to avoid the distortions that
the controls create.
Equity Issues. All four methods of war financing raise equity questions, since
each method places the financing burden on different groups of individuals. The
burden of financing wars through higher taxes is borne by the individuals that have
their taxes raised. The burden of financing wars through a reduction in other
government spending is borne by the individuals to whom the spending was
previously directed. The burden of financing wars through money creation is borne
by those whose real wealth and real income fall when prices rise. Uniquely, the
4 At present, the Federal Reserve’s use of monetary policy has the same results as the process
described in this report – increases in the money supply increase the amount of real resources
that the government can purchase. The difference between the Federal Reserve’s current
policy and the process described in this report is that current policy is not designed to
maximize the purchasing power of the government. Instead, its current policy aims to
maintain price stability and full employment. Maximizing the purchasing power of the
government would require far too much money creation to maintain these goals. But reaching
these goals may incidentally lead to increases in the money supply that add to the
government’s purchasing power because small increases in the money supply are consistent
with a growing economy which has a small, but positive, rate of inflation.

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CRS-4
burden of financing wars through borrowing from the public is thought to be borne
in part by future generations rather than present generations. The result of borrowing
from the public is lower private investment, and lower private investment leads to a
smaller future economy, and hence lower standards of living in the future.5
Interpreting Results. Unlike science experiments, economic experiments are
not controlled and cannot be repeated. It is impossible to separate out the effects of
a war from the countless other economic events happening simultaneously to get
precise estimates of how any given war affected the economy. The presentation of
data in the tables below is not meant to assume causation. This is especially true in
the case of interest rates. The economic theory that interest rates are higher than they
otherwise would be when the budget is in deficit is not equivalent to the empirical
observation that interest rates are high or low in any given year. For example, interest
rates can rise in any given year because private investment demand rises, monetary
policy is tightened, private individuals change their savings patterns, foreigners find
U.S. assets less attractive, the perceived riskiness of investment increases, or because
the federal budget deficit increases. Furthermore, real (or inflation-adjusted) interest
rates are measured in this report based on actual inflation rates. But they are
determined in part by expected inflation rates. If actual inflation turns out to be much
higher than expected inflation, then real interest rates will be temporarily low. Thus,
it is not unusual to see ex-post negative real interest rates in years of unexpectedly
high inflation, of which there are several examples in the periods discussed below.
In drawing lessons from past conflicts, it should also be stressed that larger wars
require wider ranging government involvement and produce larger economic effects,
as illustrated in Figure 1. The Vietnam Conflict, the Reagan Military Buildup, and the
Desert Storm Operation were not large enough events that they could be thought to
dominate cause and effect in the economy at the time. And to equal the military
outlays (as a percentage of GDP) undertaken at the peak of the Reagan military
buildup, military outlays today would need to more than double from their level in
2001.
5 For more information, see CRS Report RL30520, The National Debt: Who Bears Its
Burden?, by Gail Makinen,.

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CRS-5
Figure 1: Comparing the Size of Conflicts
(Military Outlays at Their Peak as a % of GDP)
Source: Office of Management and Budget, Historical Tables.
World War II
World War II was unique among events considered in this report in that it was
accompanied by fundamental (albeit temporary) changes in the structure of our
market economy. In the face of these measures, any economic comparison between
World War II and other economic events in the post-war period is questionable, and
the predicted economic outcomes could be significantly different. In World War II,
the prices of consumer goods were fixed and controlled on a widespread basis from
1942 to 1945, consumer goods were rationed through the use of purchase coupons,
goods and services available to individuals were purposely kept below salaries to
force a higher private saving rate, private factories were instructed and encouraged
to change their output to war production, resources and credit were directed by the
government toward companies producing war materials, the female participation rate
in the labor force was temporarily raised, and nearly half of gross domestic product
(GDP) was used by the federal government.6
Due to the size of World War II, the government relied on all four methods of
financing. Despite the record size of government as a percentage of GDP, non-
military government expenditures had fallen to less than half their pre-war level by the
end of the war. As can be seen in the table below, which illustrates economic
conditions before, during, and after the war, budget deficits exceeded 30% of GDP
at their peak. The publicly held debt reached 108.6% of GDP in 1946. This would
6 These distortions make economic statistics from the period highly questionable. According
to the Bureau of Economic Analysis, the “residuals” of data that cannot be accounted for
reach one-sixth the size of GDP at one point in World War II.

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CRS-6
have been impossible without government controls over private spending and
investment decisions and the patriotism generated by a major war. Central to this
policy was the decision by the Treasury and Federal Reserve to keep the yield on U.S.
Treasuries artificially low to ease the debt financing burden. (With the desire to keep
inflation low, this policy decision necessitated the use of price controls since it
required rapid money creation.) About one-quarter of the debt financing of World
War II occurred through the war bond program, which sold small-denomination, non-
marketable bonds to private citizens.7 The war effort was large enough to keep the
economy operating far above its sustainable rate for the entirety of the war.
Furthermore, there was a high rate of unemployment before the war began, at 14.6%
in 1940. Thus, the economy probably had idle resources to enlist toward the war
effort, allowing growth to exceed its sustainable rate while those resources became
employed. Since economic growth was so great during the war, the standard
contraction following the war was also large, as the economy adjusted to a decline in
government spending from about 40% of GDP to about 15% of GDP. The
contraction ended in 1948, and left no lasting impact on growth in the 1950s.
To finance the increase in government outlays from 9.8% of GDP in 1940 to
43.6% of GDP in 1943 through higher taxes exclusively would have involved
impossibly large tax increases, with corresponding disincentive effects on work and
saving. Nevertheless, the government did finance a portion of the war effort by
raising taxes. Tax measures during the War included the Revenue Act of 1942, the
Current Tax Payment Act of 1943, the Revenue Act of 1943, and the Individual
Income Tax Act of 1944. The Revenue Act of 1942 included provisions that made
the individual income tax a “mass tax” for the first time, increased the corporate tax,
increased excise taxes, increased the excess profits tax to 90%, and created a 5%
Victory tax which was to be repaid through a post-war tax credit. The Current Tax
Payment Act of 1943 introduced tax withholding which eased the Treasury’s ability
to finance day-to-day expenditures. The Revenue Act of 1943 was meant to alter the
distribution of taxation. It was the first tax bill to be vetoed, and Congress overrode
the veto. The Individual Income Tax Act of 1944 was meant to simplify the income
tax system and it also abolished the Victory Tax. The act lowered tax revenues by an
estimated 0.2% of GDP.8 Tax rates were greatly reduced after the war had ended.
7 See CRS Report RS21046, War Bonds in the Second World War: A Model for a New War
Bond?, James Bickley,.
8 Sidney Ratner, Taxation and Democracy in America, Octagon Books, (New York: 1980),
pp. 515-518; Joe Thorndike, “Wartime Tax Legislation and the Politics of Policymaking,”
Tax Notes, October 25, 2001.

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CRS-7
Economic Indicators in the World War II Era
Year
Military
Tax
Budget
Non-
Real
Inflation
Real
Outlays
Revenue
Deficit
Military
GDP
Rate (Price Corporate
(% of
(% of
(% of
Outlays
Growth
Deflator)
Bond
GDP)
GDP)
GDP)
(% of
Yields
GDP)
1940
1.7%
6.8%
-3.0%
7.2%
8.5%
0.8%
4.1%
1941
5.6%
7.6%
-4.3%
5.6%
13.8%
3.6%
-0.7%
1942
17.8%
10.1%
-14.2%
5.9%
17.8%
7.4%
-6.6%
1943
37.0%
13.3%
-30.3%
5.8%
16.8%
6.9%
-2.2%
1944
37.9%
20.9%
-22.8%
4.7%
11.8%
3.8%
1.9%
1945
37.5%
20.4%
-21.5%
3.0%
3.3%
2.5%
1.0%
1946
19.2%
17.6%
-7.2%
3.8%
-6.2%
7.3%
-5.2%
1947
5.5%
16.4%
1.7%
7.4%
-4.5%
10.4%
-11.2%
Source: Office of Management and Budget, Historical Tables; Bureau of Labor Statistics,
Consumer Price Index; Federal Reserve.
Note: Non-Military Outlays do not include interest payments on the federal debt; real
corporate bond yields are for Moody’s BAA series as recorded by the Federal Reserve less
the consumer price index (CPI); all data are calculated on a fiscal year basis except for
corporate bond yields and economic data in 1940, both of which are calculated on a calendar
year basis.
Korean Conflict
In contrast to World War II, President Truman relied largely on taxation and a
reduction of non-military outlays, rather than borrowing from the public or money
creation, to finance the Korean Conflict. Of course, this turned out to be feasible only
because the Korean Conflict was so much smaller than World War II. Nevertheless,
it is striking how much lower budget deficits and inflation were during this era than
during the Vietnam Conflict and President Reagan’s military buildup, both of which
involved much smaller military expenditures as a percentage of GDP.
Inflation remained low despite the fact that economic growth was kept above its
sustainable rate throughout the war. When high inflation emerged in 1951, the
government again resorted to widespread wage and price controls. It did not
reimplement a rationing system for private consumption of goods and services,
however. A change in Federal Reserve policy in 1951 assured that inflation would be
kept under control. After World War II, the Treasury had adopted the position that
Federal Reserve monetary policy should be directed towards keeping the yield on
Treasury securities stable and artificially low to keep debt financing costs manageable
while limiting the reserves available to banks. In 1951, it became clear that
maintaining this policy would be inflationary, and since inflation remained the Truman
administration’s primary concern, the Treasury and Federal Reserve reached an
“accord” to allow the Fed to focus on maintaining price stability and gradually

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CRS-8
allowing the yields on Treasury securities to become market determined. Typically,
the economy experienced a short recession after the Korean Conflict ended.9
Shortly after the outbreak of the Korean Conflict, the Revenue Act of 1950 was
enacted. It resurrected the income tax rates of World War II and raised taxes by an
estimated 1.3% of GDP. Later in the year, the Excess Profits Tax of 1950 was
enacted. The Revenue Act of 1951 raised individual income and corporate taxes, for
an estimated revenue increase of 1.9% of GDP. The increase in individual and
corporate taxes would have raised more revenue, but the 1951 Act also contained
several narrow-based tax reductions.10
Economic Indicators in the Korean Conflict Era
Year
Military
Tax
Budget
Non-
Real GDP Inflation
Real
Outlays
Revenue
Deficit
Military
Growth Rate (Price Corporate
(% of
(% of
(-)
Outlays
Deflator)
Bond
GDP)
GDP)
(% of
(% of
Yields
GDP)
GDP)
1949
4.8%
14.5%
0.2%
7.8%
2.4%
3.4%
4.6%
1950
5.0%
14.4%
-1.1%
8.8%
2.2%
-1.4%
1.9%
1951
7.3%
16.1%
1.9%
5.4%
11.4%
5.3%
-4.5%
1952
13.2%
19.0%
-0.4%
4.9%
4.6%
3.9%
1.6%
1953
14.1%
18.6%
-1.7%
4.9%
5.0%
1.9%
2.9%
1954
13.0%
18.4%
-0.3%
4.4%
0.0%
1.2%
2.8%
1955
10.8%
16.6%
-0.8%
5.3%
3.7%
0.1%
3.9%
Source: Office of Management and Budget, Historical Tables; Bureau of Labor Statistics,
Consumer Price Index; Federal Reserve.
Note: Non-Military Outlays do not include interest payments on the federal debt; real
corporate bond yields are for Moody’s BAA series as recorded by the Federal Reserve less
the consumer price index (CPI); all data are calculated on a fiscal year basis except for
corporate bond yields which are calculated on a calendar year basis.
Vietnam Conflict
There are no official dates to frame the period of the Vietnam Conflict. This
report considers the conflict to cover the period from 1964, when American soldiers
in Vietnam were increased to 20,000, to 1973, when President Nixon declared an end
9 Craufurd Goodwin, Exhortation and Controls, Brookings Institution, (Washington, DC:
1975), p. 69-93; Milton Friedman and Anna Schwartz, A Monetary History of the United
States, Princeton University Press, (Princeton: 1963), p. 610-636.
10 Robert Willan, Income Taxes: Concise History and Primer, Clairtor’s Publishing Division,
(Baton Rouge: 1994); John Witte, The Politics and Development of the Federal Income Tax,
University of Wisconsin Press, (Madison: 1985)

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CRS-9
to the conflict. In budgetary terms, a buildup did not begin until 1966 and the war
was in decline from 1970 onwards. The military buildup was not as marked as in
other wars because military outlays were already high from the Cold War arms race.
Arguably, fiscal policy in the 1960s and 1970s was not framed in terms of events
in Vietnam; this was done in part purposely due to the domestic controversy
surrounding the Conflict. Unlike World War II and the Korean Conflict, non-military
expenditures were increased throughout the Vietnam era, beginning with the Great
Society programs. Throughout the Conflict, the government attempted to avoid tax
increases, although it did raise taxes between 1968-1970. Thus, borrowing from the
public played a greater part in war financing than it had in the Korean Conflict. There
was no explicit policy during the Vietnam Conflict instructing the Federal Reserve to
keep federal interest costs low, as there was in World War II and at the beginning of
the Korean Conflict. Nevertheless, inflation rose significantly as the Conflict
progressed, although this was probably the result of a belief that the economy could
grow at a faster rate than was actually possible, rather than a desire to use money
creation as a significant source of revenue.
The first tax act of the Vietnam era was a tax reduction, the Revenue Act of
1964, which was implemented to counter a perceived economic slowdown. This Act
embodied many of the proposals made by President Kennedy in 1961 to “get America
moving again.” Its major provisions included a reduction in individual income and
corporate tax rates, and an expansion of the standard deduction. Nevertheless, the
Vietnam Conflict put strains on the budget that ultimately influenced budgetary
decisions. In 1968 and 1969, temporary 10% surcharges were applied to individual
income and corporate taxes, ostensibly to curb inflation. The measure led to the last
budget surplus (1969) until 1998. Later that year, the Tax Reform Act of 1969 was
passed. It was advertised as a measure to reform the tax code and close certain
loopholes, but also had the effect of raising revenue by 0.2% of GDP in 1970. Its
major provisions were the repeal of the investment tax credit (revenue raising), the
restriction of the tax exempt status of foundations (revenue raising), a broadening of
the individual income tax base (revenue raising), and an increase in the income tax’s
standard deduction and personal exemption (revenue reducing). In addition, it
extended the temporary surcharges for the first six months of 1970 at a rate of 5%
(reduced from the previous 10%), raising an additional 0.4% of GDP. The 1971
Revenue Act reduced taxes with the aim of increasing aggregate demand. It restored
the investment tax credit, accelerated planned tax reductions, and increased the
standard deduction. The tax reductions contributed to larger budget deficits in the
following years.11
The combination of rising budget deficits and expansionary monetary policy led
to rapidly rising inflation in the late 1960s and early 1970s. Rather than further
tighten monetary policy or fiscal policy to weaken aggregate demand, President Nixon
responded with the imposition of price controls in four phases from 1971 to 1974.
Under the Nixon program, prices, wages, and profits were controlled for all large
firms. The prices of some commodities, imports and exports, unprocessed
agricultural products, and the wages of low-wage workers were exempted. Later, in
11 Willan, op cit; Witte, op cit.

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CRS-10
phase III, rents were exempted as well. Small firms did not have to comply with
price, profit, or wage controls for some phases. Over the four phases, controls were
meant to be gradually reduced. In phase I, prices and wages were “frozen;” in phase
II, they were “self-administered” which meant that price increases were allowed if
approved by the government; in phase III, “decontrol” began. (The subsequent failure
of inflation to slow in phase III led to tighter controls for some industries in phase IV,
while other industries were decontrolled.) The controls proved to be very unpopular
with the public, as shortages and distortions appeared in different markets.
From 1973, the oil shock and ensuing “stagflation” dominated economic events.
The combination of higher oil prices and the end of price controls, which released
pent up inflationary pressures, led to a high inflation rate throughout the 1970s. By
this point, military expenditures as a percentage of GDP had been significantly
reduced.
Economic Indicators in the Vietnam Era
Year
Military
Tax
Budget
Non-
Real GDP Inflation
Real
Outlays
Revenue
Deficit
Military
Growth Rate (Price Corporate
(% of
(% of
(-)
Outlays
Deflator)
Bond
GDP)
GDP)
(% of
(% of
Yields
GDP)
GDP)
1963
8.9%
17.8%
-0.8%
8.4%
4.1%
1.3%
3.6%
1964
8.5%
17.6%
-0.9%
8.7%
5.7%
1.2%
3.5%
1965
7.4%
17.0%
-0.2%
8.6%
5.4%
1.8%
3.3%
1966
7.7%
17.3%
-0.5%
8.9%
7.3%
2.2%
2.8%
1967
8.8%
18.3%
-1.1%
9.3%
4.5%
3.2%
3.1%
1968
9.4%
17.6%
-2.9%
9.8%
3.0%
3.6%
2.7%
1969
8.7%
19.7%
0.3%
9.3%
4.6%
4.5%
2.3%
1970
8.1%
19.0%
-0.3%
9.8%
1.2%
5.5%
4.4%
1971
7.3%
17.3%
-2.1%
10.7%
1.6%
5.0%
4.2%
1972
6.7%
17.5%
-2.0%
11.5%
4.4%
4.7%
5.0%
1973
5.9%
17.6%
-1.1%
11.6%
6.0%
4.4%
2.0%
1974
5.5%
18.3%
-0.4%
11.7%
2.9%
7.1%
-1.5%
1975
5.5%
17.9%
-3.4%
14.3%
-2.0%
7.5%
1.5%
Source: Office of Management and Budget, Historical Tables; Bureau of Labor Statistics,
Consumer Price Index; Federal Reserve
Note: Non-Military Outlays do not include interest payments on the federal debt; real
corporate bond yields are for Moody’s BAA series as recorded by the Federal Reserve less
the consumer price index (CPI); all data are calculated on a fiscal year basis except for
corporate bond yields which are calculated on a calendar year basis.

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CRS-11
Reagan Military Buildup
Military outlays during the Reagan military buildup were significantly lower as
a percentage of GDP than they were during any of the preceding military conflicts.
Neither tax increases nor money creation were used to finance the buildup. On the
contrary, both taxes and inflation were lowered during this time for reasons unrelated
to the military buildup. Tax cuts and their claimed supply-side effects on economic
growth were one of the major themes of the Reagan era, and the main goal of the
Federal Reserve under Chairman Paul Volcker was to reduce inflation from the
double-digit rates prevalent in the late 1970s. (The Fed accomplished this goal by
1983, but the side effect of the Fed disinflation was the deepest recession since the
Great Depression.) As a result, increased military outlays and tax cuts led to budget
deficits and a reduction in non-military outlays as a percentage of GDP.
The Economic Recovery Tax Act of 1981 was the major tax reduction bill of the
Reagan years. The major provisions were reductions in marginal income tax rates,
individual saving incentives, and more favorable capital depreciation rates. In the
years following the Act, the budget deficit increased from to 2.6% of GDP in 1981
to 4.0% of GDP in 1982 to 6.0% of GDP in 1983. These budget deficits were the
largest budget deficits as a percentage of GDP since World War II. As theory
suggests, the combination of loose fiscal policy and tight monetary policy in the 1980s
led to the highest ex-post real interest rates of any period covered in this report. Since
the United States operated a floating exchange rate in the 1980s, as it does at present,
economists believe that one result of the large budget deficits were the large trade
deficits of the mid-1980s, which were the result of foreign capital being attracted to
U.S. by the high interest rates that budget deficits had caused.12
Efforts were undertaken from 1982 onwards to reduce the budget deficit. In
1982, parts of the Economic Recovery Tax Act of 1981 that had not yet been phased
in were repealed. In 1983, Social Security taxes were increased and benefits reduced.
In 1984, Congress passed the Deficit Reduction Act. In 1985, Congress enacted the
Gramm-Rudman-Hollings Act, which attempted (unsuccessfully) to balance the
budget in 5 years through automatic reductions in expenditures. In 1986, the Tax
Reform Act was passed; it was intended to be revenue neutral. It sought to broaden
the tax base by eliminating deductions and exemptions and lowered marginal tax rates.
It also eliminated the special capital gains tax rate and the investment tax credit,
altered depreciation rules, expanded the Alternative Minimum Tax (AMT) on
individuals and introduced an AMT on corporations. As a percentage of GDP, non-
military outlays were not cut until 1984. While President Reagan favored lower
government spending in general, the size of the budget deficits was thought to be a
central reason for Congress to enact these reductions in outlays. The deficit was not
eliminated until 1998, however. The deficits caused interest payments on the national
debt to rise from 1.9% of GDP in 1980 to 3.1% of GDP in 1985. Military outlays
were not reduced until the end of the Reagan presidency, and the reductions were
later accelerated by the fall of the Soviet Bloc.
12 For more information, see CRS Report 97-985E, Why the Budget Deficit and Trade Deficit
Haven’t Been Moving Together, by Gail Makinen,.

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CRS-12
Economic Indicators in the Reagan Era
Year
Military
Tax
Budget
Non-
Real GDP Inflation
Real
Outlays
Revenue
Deficit
Military
Growth Rate (Price Corporate
(% of
(% of
(-)
Outlays
Deflator)
Bond
GDP)
GDP)
(% of
(% of
Yields
GDP)
GDP)
1980
4.9%
18.9%
-2.7%
14.8%
0.0%
8.9%
0.2%
1981
5.1%
19.6%
-2.6%
14.9%
2.2%
9.7%
5.7%
1982
5.7%
19.1%
-4.0%
14.8%
-1.4%
7.0%
9.9%
1983
6.1%
17.5%
-6.0%
14.8%
2.1%
4.4%
10.4%
1984
5.9%
17.4%
-4.8%
13.4%
7.6%
3.7%
9.9%
1985
6.1%
17.7%
-5.1%
13.7%
4.3%
3.3%
9.1%
1986
6.2%
17.5%
-5.0%
13.2%
3.9%
2.4%
8.5%
1987
6.1%
18.4%
-3.2%
12.5%
2.8%
2.8%
7.0%
1988
5.8%
18.1%
-3.1%
12.4%
4.5%
3.3%
6.7%
1989
5.6%
18.3%
-2.8%
12.5%
3.8%
3.8%
5.4%
1990
5.2%
18.0%
-3.9%
13.4%
2.3%
3.8%
6.0%
Source: Office of Management and Budget, Historical Tables; Bureau of Labor Statistics,
Consumer Price Index; Federal Reserve.
Note: Non-Military Outlays do not include interest payments on the federal debt; real
corporate bond yields are for Moody’s BAA series as recorded by the Federal Reserve less
the consumer price index (CPI); all data are calculated on a fiscal year basis except for
corporate bond yields which are calculated on a calendar year basis.
Desert Storm Operation
The economic and financing issues surrounding the Desert Storm Operation are
unique in this survey in several ways. First, the Desert Storm Operation was the only
military operation considered that did not require any increase in military expenditures
as a percentage of GDP. In fact, it took place during the long reduction in military
spending as a percentage of GDP that accompanied the end of the Cold War. In this
broad sense, there is no reason to consider the economic effects of financing the
buildup. In fact, an economic contraction occurred during Desert Storm, unlike the
typical wartime economic boom. The 1990-1991 recession is not typically attributed
to the war, except for its possible negative effects on confidence. Instead, it is
typically attributed to contractionary monetary policy (undertaken through 1989 to
quell the rising inflation rate), problems in the banking sector, and the spike in oil
prices associated with the Iraqi invasion of Kuwait. It is interesting to note that unlike
previous military conflicts, when the Federal Reserve had tolerated excessive money
creation, during Desert Storm the Federal Reserve sought to stamp out inflationary
pressures that originated before the conflict, even at the risk of recession. After the

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CRS-13
conflict ended, the economy began to expand again – it did not experience a typical
post-war contraction.
The budget deficit rose during the conflict, but it would be difficult to claim that
military spending contributed to the rise in the deficit when overall military spending
was declining during this time. Instead, the rising budget deficit was characterized by
falling tax revenues and rising non-military outlays, both of which can be largely
accounted for by automatic changes in revenues and outlays caused by the economic
slowdown.13 To reduce the widening deficit, the Omnibus Budget Reconciliation Act
of 1990 cut spending and increased taxes. It was estimated that over the following
5 years, 57% of the deficit reduction would come from spending cuts and 29% from
tax increases (14% would come from lower interest payments). Changes to excise
taxes, payroll taxes, and individual income taxes accounted for the bulk of the tax
increases. The revenue raising provisions of the Act were estimated to raise tax
revenues by 0.3% of GDP in 1991. Most of the spending reductions were to come
from reductions in military outlays and Medicare spending.14
Another unique aspect of the financing of the Gulf War was the financial
contributions that the U.S. received from its allies. In effect, foreign governments
financed a large part of the war effort for the United States – contributions from
foreign governments equaled $48 billion, while the overall cost of the war was $61
billion in current dollars.15 In the balance of payments, these contributions
represented a unilateral transfer to the United States, which is recorded as a reduction
in the current account deficit. The exchange value of the dollar was unlikely to have
been significantly affected, however, since a substantial portion of the contributions
came from Saudi Arabia and Kuwait, both of whom have a de facto fixed exchange
rate with the dollar.
13 When adjusted for the effects of the economic slowdown, the structural budget deficit was
equivalent to 2.1% of GDP in 1989, 2.1% of GDP in 1990, and 2.5% of GDP in 1991.
Source: Congressional Budget Office, The Budget and Economic Outlook, (Washington:
January 2001), Table F-1.
14 CRS Report 91-20E, Tax Provisions of the Omnibus Budget Reconciliation Act of 1990,
by David Brumbaugh and Gregg Esenwein,; Congressional Budget Office, Budget and
Economic Outlook, January 1991, “Special Supplement,” Tax Notes, October 29, 1990.
15 CRS Report RS21013, Costs of Major U.S. Wars and Recent U.S. Overseas Military
Operations, by Stephen Daggett and Nina Serafino; Congressional Budget Office, The
Economic and Budget Outlook, (Washington: January 1992), p. 63.

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CRS-14
Economic Indicators in the Desert Storm Era
Year
Military
Tax
Budget
Non-
Real GDP Inflation
Real
Outlays
Revenue
Deficit
Military
Growth Rate (Price Corporate
(% of
(% of
(-)
Outlays
Deflator)
Bond
GDP)
GDP)
(% of
(% of
Yields
GDP)
GDP)
1989
5.6%
18.3%
-2.8%
12.5%
3.8%
3.8%
5.4%
1990
5.2%
18.0%
-3.9%
13.4%
2.3%
3.8%
6.0%
1991
4.6%
17.8%
-4.5%
14.4%
0.0%
3.9%
5.6%
1992
4.8%
17.5%
-4.7%
14.2%
2.2%
2.6%
6.0%
1993
4.4%
17.6%
-3.9%
14.1%
3.0%
2.4%
4.9%
Source: Office of Management and Budget, Historical Tables; Bureau of Labor Statistics,
Consumer Price Index; Federal Reserve.
Note: Non-Military Outlays do not include interest payments on the federal debt; real
corporate bond yields are for Moody’s BAA series as recorded by the Federal Reserve less
the consumer price index (CPI); all data are calculated on a fiscal year basis except for
corporate bond yields which are calculated on a calendar year basis.
Conclusion
The increased government outlays associated with wars can be financed in four
ways: through higher taxes, reductions in other government spending, government
borrowing from the public (the issuance and sale of U.S. Treasury securities to the
public), or money creation. The Desert Storm Operation illustrates that a military
campaign of moderate size can be financed with very little impact on the budget or the
economy. That campaign involved no increase in overall military outlays as a
percentage of GDP. When wars get larger, tax increases almost inevitably become
necessary. Big conflicts typically bring economic booms since borrowing from the
public and money creation expand aggregate demand. “Total wars,” such as World
War II, typically draw on all four financing methods and may even lead to
fundamental shifts away from a market economy.
The choice of how to finance a war is mainly a question of equity, which by its
nature is a political question. (The exceptions are total wars, which involve such large
expenses that virtually any financing choices will lead to considerable efficiency
losses.) Financing through borrowing has been justified by some on the grounds that
future generations benefit from the sacrifice that present generations make by fighting
the war, and should therefore bear some of the cost of the war. Borrowing has also
been justified on “consumption smoothing” grounds – it is better to defray a
temporary expense over time than all at once.
Of the four financing methods, economists tend to reject the money creation
method if it can be avoided. They argue that the “inflation tax” is the most arbitrary
of all taxes because the government cannot democratically specify its incidence. It is

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CRS-15
also a financing method that leads to large efficiency losses quickly because it reduces
the useful functions money serves in a market economy. It also undermines the
effectiveness of monetary policy as a macroeconomic stabilization tool. Economists
also tend to believe that the benefits of widespread price controls are largely illusory.
Even if price controls successfully reduce recorded inflation, they create serious
efficiency and welfare losses, typically lead to shortages, limit individual choice, and
encourage participation in black markets. When removed, price controls have
consistently led to a release of pent up inflation historically.
Total wars by their nature require financing methods that lead to large efficiency
losses. Money creation, increasing taxes, or borrowing from the public on a large
scale could all be opposed on efficiency grounds – it would be difficult to claim that
any one financing method is most efficient. In addition, governments often feel that
the equity rationale makes policies such as rationing necessary, compounding the
overall efficiency loss. Thus, attempting to draw general policy conclusions from the
experience with total war risks comparing apples with oranges. By the same token,
the historically unique conditions suddenly introduced by the global war against
terrorism – including the threat to homeland security with economic repercussions as
yet unclear – suggest that it may be premature to generalize broadly from past
experience until the nature and scope of the conflict becomes clearer

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