Chapter 18
ECONOMIC
POLICY
2
Theories of Economic Policy

Many different theories about how the
U.S. economy functions
 So complex, no one actually knows how it works

How policymakers TAX & SPEND, and loosen and
tighten INTEREST RATES, depends on their
beliefs about how the economy functions and
the proper role of the government in the
economy
3
Theories of Economic Policy

Important to understand economic policy in a
market economy
 May be called capitalist economies
 May have a mix of government-owned enterprises
 China claims to have a socialist market economy

What is the government’s role in directing the
economy?
4
We Buy More, & We Borrow More

Globalization results in economic
interdependence among nations

Americans buy many goods and services from
other countries

Foreigners purchase U.S. government securities

So, foreigners lend us money to buy their goods
and services
5
Foreign Holdings of Federal Debt
Budget of the United States
Fiscal Year 2010
6
Laissez-Faire Economics

The ABSCENCE of government control

Economic competition like natural selection – the
strong survive and prosper

ADAM SMITH’S “invisible hand” in
The Wealth of Nations
 Efficient market hypothesis similar concept

Laissez-faire economists would have done
nothing regarding 2008 market crash
7
Economists Getting Data
for Predictions
8
Key Economic Terms
 Economic
 Aggregate demand
depression
 Inflation
 Stagflation
 Business cycles
 Productive capacity
 Gross domestic
product (GDP)
 Fiscal policy
 Monetary policy
9
CPI: Consumer Price Index
 A measure of inflation calculated by
Bureau of Labor Statistics (BLS)
 Based on prices paid for food, clothing, shelter,
transportation, medical services, and other items
needed for daily living
 Not a perfect measure
 Government uses for cost-of-living adjustments
COLA
10
Keynesian Theory
 During Great Depression of 1930s,
John Maynard Keynes
theorized business cycles caused by
imbalances between aggregate demand and
productive capacity
 Demand exceeds capacity price inflation
 Productive capacity exceeds demand output
declines
rising unemployment economic
depression
11
Keynesian Theory

Holds that aggregate demand can be adjusted
through combination of
fiscal policies & monetary policies
 If demand is low, government should spend
more money or cut taxes
 If demand too great, government should spend
less or raise taxes

Most governments have used deficit financing to
combat economic slumps
12
Keynesian Theory

Keynesian economics runs counter to Laissez-Faire
economics

An employment act passed in 1946 established principle of
government involvement in economy
 Also established Council of Economic Advisors (CEA) to
help the President

Many believe Keynesian principles led to “big government”
13
Monetary Policy

Economists may accept Keynesian theory but don’t
see its political utility
 Programs hard to end once begun
 Taxes easier to cut than to raise

For theory to succeed, government must have ability
to begin and end spending quickly and cut and raise
taxes quickly

Instead, monetarists favor small but steady growth in
amount of money in circulation
14
Chairman of the Board
Ben S. Bernanke, appointed chairman of the Federal Reserve Board
February 1, 2006, by President George W. Bush
15
Monetary Policy

Under control of the Federal Reserve System, a
system of banks
 Led by independent board of governors and a
chairperson, all appointed by the president
 Members cannot be removed by president, but
have set terms of 14 years each

System’s ----3 major goals:
1)Controlling inflation
2)Maintaining maximum employment
3)Ensuring moderate interest rates
16
The Federal Reserve System
 The Fed controls the MONEY SUPPLY,
affecting inflation
 Can buy and sell government securities
 Sets target for federal funds rate or discount
rate
 Can change its reserve requirement for member
banks
17
The Federal Reserve
Interest rates should be raised when
economy growing too quickly
 Interest rates should be lowered during
sluggish economy
 Historically, Fed adjust rates to combat
inflation, not to stimulate economic growth

 Does this further interests of wealthy over
those of the poor?
18
The Economy
 Voters hold president responsible for
state of economy
 However, president not completely in
control: Fed controls interest rates and
Congress controls spending
 These restrictions support pluralist model of
democracy
 A strong economy favors incumbent
party (and vice versa)
19
The Chair and the President
Chair of Federal Reserve key economic player
 If president wants a change in monetary
policy, must court the chair

 Former Fed chair Alan Greenspan’s policies
blamed for 2008 financial crisis
 Bush appointed Ben Bernanke in 2006
 Bernanke took bold actions to address situation;
reappointed by President Obama

Historical evidence suggests government
actions can smooth out business cycles
20
Supply-Side Economics
 President Reagan’s answer to stagflation
 Supply-siders want to stimulate
investment through tax cuts for the rich
and less government regulation of
business
 More production of goods
 Increased productivity
 Similar to laissez-faire economics
21
Reaganomics
 Economic Recover Tax Act of 1981
 Reduced individual tax rates
 Cut the marginal tax rate for highest income
group
 President Reagan launched programs to
deregulate business
 Also cut spending to some domestic
programs and increased military
spending
22
How Well Did Reaganomics Work?
 Inflation dropped from over 13 percent in
1981 to three percent by 1983
 Due more to Fed chair Paul Volker’s actions
 Did deregulate business
 Unemployment increased to 9.6 percent
 Did not reduce budget deficit
 Tax revenues saw massive drop
23
Figure 18.1
Budget Deficits and Surpluses over Time
24
Figure 18.1
Budget Deficits and Surpluses over Time
25
Public Policy and the Budget
 Two views on national budget:
 B-O-R-I-N-G vs. exciting script for battlefield
 Initially Congress in charge of budget
 Today, President prepares budget for
Congress to approve
 Budget and Accounting Act of 1921
26
The Nature of the Budget:
Important Terms
 The Budget of the
 Budget outlays
United States
Government
 Fiscal year
 Budget authority
 Receipts
 Deficit
 Public debt
27
The Nature of the Budget
President submits proposed budget for the
next fiscal year to Congress at beginning of
year
 President Obama’s proposed FY 2010-2100
budget

 Budget authority: $3,691 billion
 Budget outlays: $3,834 billion
 Budget receipts: $2,567 billion
 Budget deficit: $1,267 billion
28
Public Debt
 The sum of all unpaid government
deficits
 Feb. 1, 2010, total debt $12.3 trillion
 Public debt owed to outside lenders $7.5
trillion
 Almost 50 percent of which foreign
 Public debt clock:
http://www.brillig.com/debt_clock
29
Preparing the President’s Budget
 Federal agencies begin working on
budget the previous spring
 The Office of Management and Budget
(OMB) oversees process
 Federal budget website:
http://www.gpoaccess.gov/usbudget/
 Agencies submit budgets to OMB in fall
30
Preparing the President’s Budget
OMB reviews and makes recommendations
to president
 Revised guidelines sent back to agencies in
summer
 Agencies prepare budgets to submit in fall
 OMB analysts examine requests and agency
heads lobby presidential advisors
 Proposed budget submitted to Congress

31
The Traditional Procedure for
Passing the Congressional Budget:
The Committee Structure
Tax committees: Ways and Means in House
and Finance Committee in Senate
 Authorization Committees: have jurisdiction
over particular subjects

 House has about 20; Senate about 15

Appropriations committees: in both House
and Senate
 Thirteen distinct appropriations bills supposed
to be enacted to fund nation’s spending
32
The Congressional Budget
 Two-step spending process complex
 Agencies must have both authorization and
appropriation approval to spend money
 Offers many opportunities for lobbying by
special interests – very pluralistic
 Different committees in charge of
revenues and spending
 No one committee in charge of budget as a
whole
33
Three Decades of Budget Reforms
 Budget Impoundment and Control Act of
1974 an effort to make process more
majoritarian
 Created budget committees, timetables,
and the Congressional Budget Office (CBO)
 Annual targets to cut deficit established
in 1980s were not met
34
Three Decades of Budget Reforms
 Budget Enforcement Act (BEA) of 1990
defined two types of spending:
 Mandatory spending for entitlements
 Discretionary spending for expenditures
authorized by annual appropriations
 Act also established pay-as-you-go (pay-
go) restrictions on spending and caps on
discretionary spending
35
Three Decades of Budget Reforms
President George H.W. Bush agreed to
modest tax increases to gain passage of BEA
 Deficit Reduction Act of 1993 helped make
more progress in deficit reduction
 Previous laws paved way for President
Clinton’s Balanced Budget Act of 1997 (BBA)

 Produced budget surplus ahead of schedule

President Obama asked Congress in 2010 to
reinstitute pay-go rules to reduce deficit
36
The End of Budgetary Reform,
2000-Present
 In early 2000s, President Bush and
Republicans in Congress advocated tax
cuts to return surplus to taxpayers
 Congress allowed caps on discretionary
spending and pay requirements to expire
at end of 2002
 Has resulted in deficits
37
Tax Policies
 Revenue side of budget governed by
overall tax policy
 May be changed for many reasons:
 To adjust revenues to meet outlays
 To make tax burden more equitable
 To help control economy by raising or
lowering taxes
38
Tax Policies
 Conflicting philosophies for distributing
cost of government:
 Should citizens be taxed on ability to pay or
benefits received?
 Tax policies also used to advance social
goals or favor certain industries
 So complicated, tax code over 7,000 pages
39
Tax Revenues
 Almost 95 percent of U.S. tax revenues
from three sources:
 Individual income taxes (44 percent)
 Social insurance taxes (36 percent)
 Corporate income taxes (12 percent)
40
Reform
Reform proposals heavily influenced by
interest groups
 President Reagan reduced tax brackets from
14 to two in 1987

 Approached a flat tax
 Reduced progressiveness of tax system

Flat tax violates principle of progressive
taxation
 Progressive taxation allows government to
redistribute wealth and promote economic
equality
41
We Gave at the Bureaucracy
42
Reform
President George H.W. Bush introduced
third tax bracket in 1990
 Clinton created fourth bracket in 1993
 Both of these changes reduced deficit
 President George W. Bush pushed Congress
to pass tax cuts in 2001

 Reduced revenues increased deficits
 Economic downturn, homeland defense, and
military expenses compounded problem
43
Comparing Tax Burdens
 Two ways to look at relative tax burden
 Compare taxes over time
 Compare with rates in other countries
 U.S. rates for a family of four with the
median household income around 20
percent from 1950s to present
 U.S. tax burden not large when
compared to other democratic nations
44
Spending Policies
U.S. FY 2011 budget projects spending over
$3.8 trillion
 Largest amount (20 percent of budget)
targeted for national defense

 From WWII to FY 1993, defense spending #1
 FY 1993 to FY 2009, defense spending #2
Other categories: income security (#3),
Medicare (#4), health (#5), interest on debt
(#6)
 Foreign aid only about one percent of total

45
Figure 18.2
Federal Spending in 2011, by Function
46
Comparing Spending Policies

Comparing relative shares of expenditures
over time shows changes
 Defense spending depends on world situations
Cost of Social Security checks and net
interest payments steadily increasing
 Eliminating affects of price inflation,
comparisons over time show national
spending stays at about 20 percent

47
Figure 18.4
Government Outlays and Receipts
as a Percentage of GDP
48
Incremental Budgeting
 One explanation for increased
government spending: incremental
budgeting
 Agencies submit budgets based on
previous year, plus some new items
 Congress rarely looks at base budget items
 Once program exists, clientele groups lobby
for continuation
49
Earmarks
 Earmarks have increased since early
1990s
 Two places to track earmarks:
 http://earmarks.omb.gov/earmarks-public/
 http://www.washingtonwatch.com/blog/200
9/04/12/catalogue-of-fy-2010-earmarks/
 Opinions on earmarks depend on
viewpoints on role of elected officials
 Representation – earmarks pluralist politics
50
Uncontrollable Spending
Earmarks discretionary outlays
 Most government spending mandatory
outlays and uncontrollable without a change
in the law authorizing the program

 Over 60 percent of 2011 budget basically
uncontrollable
 About 15 percent of budget national defense or
homeland security
 This leaves only around 15 percent for
discretionary spending
51
Public Opinion on Spending
 Most favor spending cuts in the abstract
 When asked about funding specific
programs, most favored keeping existing
funding levels or slight increases
 Especially true for Social Security and
Medicare
 Americans want the benefits but don’t
want to raise taxes to pay for them
52
Taxing, Spending, and
Economic Equality

Promoting economic equality controversial
 Possible only through reductions in economic
freedom though re-distribution of wealth

First income tax used in 1862 to fund Civil War
 That tax repealed in 1871
 Income tax law passed in 1894 ruled
unconstitutional by Supreme Court in 1875
 Sixteenth Amendment (1913) gave national
government power to tax income
53
Government Effects on
Economic Equality
 Do government spending policies have a
measurable effect on income equality?
 Study showed government policies cut
poverty rate in half between 1979 and 2002
 Government payments to individuals
transfer payments
 Do not always go to the poor
54
Fluctuations in Tax Rates
 With progressive taxation, more revenue
taken from rich than from poor
 Progressivity of tax system varied
substantially between 1979 and 2001
 Opponents of progressive taxation
concerned with inequalities
 Richest one percent of taxpayers
contributed 40 percent of all taxes in 2007
55
Tax Inequities
 In some cases, poorer citizens pay higher
percentage of income in taxes than
wealthier citizens
 Warren Buffett on tax rates:
http://www.youtube.com/watch?v=Cu5B-2LoC4s
 Total tax burden combination of
national, state, and local taxes
56
Progressive vs. Regressive Taxes

Not all taxes progressive:
 National income tax: progressive
 National payroll tax: regressive
 Sales tax: regressive

Very low taxes on those whose income
based on capital rather than labor
 Municipal bonds not taxed
 Unearned income not withheld
 Capital gains tax lower than tax on salaries
57
Effects of Taxing and Spending
Policies over Time
 Income gap between the poorest fifth of
American families and richest fifth grew
between 1966 and 2004
 In capitalist system, inequality inevitable
 Study of 18 developed countries shows U.S.
has most unequal distribution of income
58
Figure 18.6
Distribution of Family Income over Time
59
Democracy and Equality

U.S. prizes political equality, but record on
economic equality not as strong
 Wealthiest one percent control 33 percent of
household wealth
 Typical white family’s annual income 1.5 times
that of both blacks and Hispanics

Does pluralist interest group activity distort
government’s efforts to promote equality?
60
Democracy and Equality
Would tax policies change under
majoritarian democracy?
 Series of studies show:

 A majority see major income inequities but
don’t favor heavy taxes on rich
 A majority prefer national sales tax or weekly
lottery; want to pay in increments
Majoritarians believe most Americans don’t
understand national tax system
 We will continue current pluralist approach
to taxation

61
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