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Chapter 18. 2 Theories of Economic Policy  Many different theories about how the U.S. economy functions  So complex, no one actually knows how it works.

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Presentation on theme: "Chapter 18. 2 Theories of Economic Policy  Many different theories about how the U.S. economy functions  So complex, no one actually knows how it works."— Presentation transcript:

1 Chapter 18

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3 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

4 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

5 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

6 Foreign Holdings of Federal Debt Budget of the United States Fiscal Year 2010 6

7 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

8 Economists Getting Data for Predictions 8

9 Key Economic Terms  Economic depression  Inflation  Stagflation  Business cycles  Aggregate demand  Productive capacity  Gross domestic product (GDP)  Fiscal policy  Monetary policy 9

10 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

11 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

12 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

13 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

14 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

15 Chairman of the Board 15 Ben S. Bernanke, appointed chairman of the Federal Reserve Board February 1, 2006, by President George W. Bush

16 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

17 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

18 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

19 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

20 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

21 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

22 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

23 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

24 Figure 18.1 Budget Deficits and Surpluses over Time 24

25 Figure 18.1 Budget Deficits and Surpluses over Time 25

26 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

27 The Nature of the Budget: Important Terms  The Budget of the United States Government  Fiscal year  Budget authority  Budget outlays  Receipts  Deficit  Public debt 27

28 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

29 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: 29

30 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:  Agencies submit budgets to OMB in fall 30

31 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

32 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

33 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

34 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

35 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

36 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

37 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

38 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

39 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

40 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

41 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

42 We Gave at the Bureaucracy 42

43 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

44 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

45 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

46 Figure 18.2 Federal Spending in 2011, by Function 46

47 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

48 Figure 18.4 Government Outlays and Receipts as a Percentage of GDP 48

49 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

50 Earmarks  Earmarks have increased since early 1990s  Two places to track earmarks:  public/ public/  009/04/12/catalogue-of-fy-2010- earmarks/ 009/04/12/catalogue-of-fy-2010- earmarks/  Opinions on earmarks depend on viewpoints on role of elected officials  Representation – earmarks pluralist politics 50

51 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

52 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

53 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

54 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

55 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

56 Tax Inequities  In some cases, poorer citizens pay higher percentage of income in taxes than wealthier citizens  Warren Buffett on tax rates:  Total tax burden combination of national, state, and local taxes 56

57 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

58 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

59 Figure 18.6 Distribution of Family Income over Time 59

60 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

61 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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