To understand the significance of the and wealth elasticities estimated in my 1975 article and reestimated for a variety of samples by George Perkins, it is useful to recall the legal controversy that surrounded education finance in the early 1970's. In the historic and much publicized case of Serrano vs. Priest (1971), the California Supreme Court held that California's system of educational finance violated California's state constitution because local educational outlays were related to local property values. Similar cases were being introduced in the courts of other states and in the U.S. Supreme Court. Perhaps the most commonly discussed legal remedy in cases like Serrano was a plan referred to as power (DPE) by its original advocates, J. E. Coons, W. H. Clune, and S. D. Sugarman in their very influential book (1970). District power equalization is a matching grant formula that makes each percentage point of tax rate levied on the market value of local property produce the same revenue, independent of the actual local tax base. To be more precise, let W, be the tax base (wealth) per pupil in school district i and 6i be the tax rate chosen by school district i. The per pupil tax raised locally would therefore be Ti =61iWi. District power equalization would make the total per pupil revenue of district i proportional to 6i but independent of W, or Ri = 6iW*, where W* is the equivalent tax base implicitly assigned to all school districts by the DPE matching rate formula. The matching rate for district i (min) is the number of state level dollars given to district i for every dollar of revenue that they raise locally; therefore 1 + mi = R/Ti = W*/Wi. The DPE formula is important because it implies that the local price of educational outlays is proportional to wealth. If district i's of buying educational outlays is defined as the amount that the district must produce in local tax revenue per dollar of total spending, the DPE formula implies pi = TIRi = WJ/W*. In terms of the pricewealth elasticity of my earlier paper and Perkins' comment, district power equalization implies v =-1. My reason for estimating and wealth elasticities of demand for local school districts was to answer the following two questions. First, if the courts required the state governments to finance education in a way that eliminated the currently observed association between local wealth and educational outlays, what would be the appropriate matching formula? Second, if the courts mandated the district power equalizing rule, what would be the resulting association between wealth and educational outlays? To make these ideas more precise, I decided to measure the association by the elasticity of per pupil education outlays with respect to per pupil wealth and called this elasticity the degree of wealth neutrality. By applying Theil's famous formula for specification bias, I showed that the wealth neutrality (a) can be written

The very poor performance of the stock market has been one of the major economic puzzles of the 1970's. The value of common stock has fallen significantly in relation to the price of final goods, the replacement value of the capital stock, and the value of pretax equity earnings. This fall in real share prices has raised the cost of capital to firms and has thereby reduced the incentive to invest in plant and equipment. Although no single factor is likely to have been responsible for this unusual performance of share prices, I believe that the sharp rise in during the past fifteen years has been one of the significant causes. Of course, should have no effect on real share values in an economy in which there are no taxes or other imperfections and in which portfolio investors correctly distinguish real and nominal magnitudes.' But the U.S. economy does have substantial taxes that are assessed on the basis of nominal (rather than real) capital income.2 An increase in the rate of raises the effective tax rate on equity earnings relative to the tax rate on other types of investment income. Individuals and financial institutions will therefore hold the existing stock of equity capital only at a lower real price. In Inflation and the Stock Market I presented a very simple model designed to capture the essential feature of this tax nonneutrality and its impact on share prices. The primary purpose of the analysis was to show how the overstatement of taxable profits caused by (because of historic cost depreciation and inventory accounting rules) could lead to lower real share prices even though reduced the real net-of-tax return on debt. This explanation stands in sharp contrast to the conventional view that lowers share prices because the (nominal) yield on debt rises. A second purpose of the analysis was to show how corporate stock could be a good hedge against inflation as long as the rate remained constant while being adversely affected by increases in the expected rate of inflation. And, finally, I wanted to indicate the importance of recognizing separately the roles of tax-exempt institutional investors and taxable individual investors. The analysis was definitely not intended to prove that must cause share prices to decline with existing U.S. tax rules. The model that I used is clearly far too simple in several ways to do more than illustrate a possible line of influence. The model assumes, among other things, that there are no retained earnings, no corporate debt finance, and no individual investment opportunities other than corporate stocks and government bonds.3 But the simplified model has the virtue of tractability and clarity that would be lost by adopting a more complex specification. In their comment, Irwin Friend and Joel Hasbrouck have presented a slightly different model of asset demand in an economy with taxes and inflation. I think that this alternative model is a useful complement to my own analysis. Moreover, as I shall explain in this reply, their model has the same implications as mine about the effect of on share prices. *President, National Bureau of Economic Research, and professor of economics, Harvard University. The study discussed in this note is part of the NBER Study of Capital Formation. The views expressed here are my own and not those of the NBER. 'Franco Modigliani and Richard Cohn have argued that many investors do not correctly evaluate either real profits or the relevant discount rate because they do not distinguish between real and nominal interest rates. 2This includes the use of historic cost depreciation, artificial inventory profits based on FIFO accounting, nominal interest income and expenses, and nominal capital gains. 3These features are included in a later model (see my 1980b article) designed to explain more of the complexities of the tax-inflation interaction.

Economists are now beginning to recognize that an understanding of layoffs is crucial for a proper analysis of unemployment. In manufacturing, about 75 percent of those who are laid off return to their original More generally, among all persons classified as losers, layoffs account for about 50 percent of all unemployment spells. Temporary layoffs are an even larger fraction of cyclical changes in the number of losers. While this group includes some seasonally unemployed, most layoffs are induced by short random or cyclical fluctuations in demand. The conventional model of search unemployment is inappropriate for those and the modern theory of the Phillips curve requires substantial modification because of the size and cyclical variation of unemployment. I In a previous paper (1976), I showed analytically that our current system of unemployment insurance (UI) provides a substantial incentive for increased unemployment.2 The present paper provides micro-economic evidence that UI actually such a powerful effect. The estimates imply that the incentive provided by the current average level of UI benefits is responsible for approximately one-half of unemployment. It is important to note that the current study shows that UI increases the amount of unemployment, but does not deal with the mean per spell. This distinction deserves emphasis because nearly all previous empirical work focused the potential effect of UI duration. This focus is both unfortunate and surprising since UI can actually increase total unemployment while decreasing the mean per spell. While UI increases the of any given spell of unemployment, it may also induce more very short spells of unemployment. This possibility of reduced mean is clear in my 1976 theoretical analysis. An additional practical *Professor of economics, Harvard University. I am grateful to the National Science Foundation for support of this research, to David Ellwood and Joseph Kahan for assistance with the statistical calculations, and to Richard Freeman, Zvi Griliches, Daniel Hamermesh, James Medoff, Melvin Reder, and Jeffrey Sachs for discussions and comments. Earlier versions of this paper were presented at seminars at Chicago, Harvard, and Yale universities. IIn my 1975 paper, pp. 737-42, I discuss the implications of layoffs for the theory of search unemployment, the Phillips curve, and wage inflexibility. Although the standard criterion of unemployment is active seeking within the past four weeks, individuals are officially classified as unemployed without any inquiry about recent job-seeking activity if they state that they are on awaiting recall by their employers. Some of those look for jobs or alternative permanent employment, but the vast majority do return to their original Readers should not be confused by the two quite separate meanings of the term layoff in the Department of Labor's lexicon. In manufacturing establishment data, a is a separation initiated by the employer (not a quit) and may be permanent or In the Current Population Survey (CPS), an individual is if he is not working but has a job to which he is expecting to be recalled by his employer. To emphasize that I am dealing with those layoffs expected to terminate in recall, I use the adjective temporary. Unfortunately, the CPS uses the word in a different and quite confusing way: persons are divided into an indefinite duration group (in which the individual does not have an expected date of recall within thirty days) and a temporary group (when such a date is known). When it is useful to distinguish these groups, I use the terms indefinite duration and fixed duration; in my usage, the term includes both groups. 2My 1976 paper is really an explicit proof of arguments made more informally in my earlier study for the Joint Economic Committee (1973). For a similar development, see Martin Baily.