1. Chapter 17
ECONOMIC
POLICY

2. Learning Outcomes
17.1 Compare and contrast three theories of market economics: laissez-faire, Keynesian, and supply-side Describe the process by which the national budget is prepared and passed into law and the reforms undertaken by Congress to balance the budget Identify the objectives of tax policies and explain why tax reform is difficult.
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3. Learning Outcomes
17.4 Identify the major areas of government outlays and explain the role of incremental budgeting and uncontrollable spending on the growth of government spending Identify the origins of the income tax, trace the influence of government spending and taxing policies on inequality, and examine these policies from the majoritarian and pluralist perspectives.
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4. Theories of Economic Policy
Laissez-Faire Economics
Absence of government control
Strict advocates maintain government interference with business obstructs workings of the free market
Mainstream economists today favor market principles but recognize that “government can sometimes improve market outcomes”
Efficient market hypothesis has held that financial markets are informally efficient
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5. Theories of Economic Policy
Keynesian Theory
John Maynard Keynes
Business cycles stem from imbalances between aggregate demand and productive capacity
Productive capacity – gross domestic product
Government could stabilize economy by controlling level of aggregate demand
Aggregate demand can be adjusted through fiscal and monetary policies
Low demand: government spend more money or cut taxes
Demand too great: government spend less or raise taxes
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6. Theories of Economic Policy
Keynesian Theory (cont.)
Capitalist countries have widely adopted Keynesian theory in some form
Employment Act in 1946, reflects Keynesian theory
Established government responsibility for economy
Tremendous effect on government economic policy
Council of Economic Advisors (CEA)
Keynes-Hayek: debate in 2012 election
Obama auto industry bailout (Keynes)
Romney “Let Detroit Go Bankrupt” (Hayek)
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7. Dueling Economists on YouTube
This image from a YouTube video portrays British economist John
Maynard Keynes (left) and Austrian economist Friedrich Hayek (right).
Keynes taught at Cambridge University but had enormous influence on
American economics and government. Keynes’s The General Theory
of Employment (1936) advocated deficit spending during economic
downturns to maintain employment. Keynesian theory fell out of favor
in the 1980s, but Presidents Bush and Obama both embraced it to
deal with the 2008 economic collapse. Hayek taught at the University
of Chicago and elsewhere in the United States. His The Road to
Serfdom (1944) argued that government intervention led to socialism
and tyranny. Hayek’s advocacy of free-market capitalism enjoyed
popularity among Republicans in 2012 who objected to the
government bailout of the auto industry. The ten-minute YouTube
video, ‘‘Keynes vs. Hayek: Round Two,’’ reflects their clashing views
from a libertarian perspective. Ironically, Keynes and Hayek were
colleagues at Cambridge briefly during World War II and respected
each other’s work. See Nicholas Wapshott, Keynes Hayek: The Clash
That Defined Modern Economics (New York: W.W. Norton, 2011).
Courtesy Emergent Order
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8. Theories of Economic Policy
Monetary Policy
Monetarists, such as Nobel Laureate Milton Friedman, argue that government can control the economy’s performance simply by controlling the nation’s money supply
Monetary policies are under control of Federal Reserve System in U.S.
Three goals:
Controlling inflation
Maintaining maximum employment
Insuring moderate interest rates
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9. Theories of Economic Policy
Monetary Policy (cont.)
2010 Dodd-Frank financial reform bill granted even greater powers to the Fed to regulate large complex financial firms
Ways the Fed controls money supply
Sells securities, takes money out of circulation, raising interest rate
Buys securities, process in reverse, lowers interest rate
Sets federal funds rate – rate banks charge one another for overnight loans
Less frequently, may change its discount rate
Can change its reserve requirement
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10. Theories of Economic Policy
Monetary Policy (cont.)
Formally, president responsible for state of the economy and voters hold him accountable
President neither determines interest rates (Fed does) nor controls spending (Congress does)
Fed’s activities are essential parts of government’s overall economic policy but lie outside president’s control and in hands of Fed chair
Fed Chair – Critical player in economic affairs
Ben Bernanke – Stretched Fed’s authority during financial crisis of 2008
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11. Theories of Economic Policy
Supply-Side Economics
Stimulate investment through tax cuts and less government regulation of business
Reaganomics
Economic Recover Tax Act of 1981
Tax cuts
Cuts in spending for social programs
Deregulation
Increases in defense spending
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12. Theories of Economic Policy
Supply-Side Economics (cont.)
How Well Did Reaganomics Work?
Worked as expected, except deficit
Inflation dropped:13% in 1981 to 3% by 1983
Due more to Fed chair Paul Volcker’s actions
Deregulated business
Unemployment increased to 9.6%
Didn’t reduce budget deficit
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13. Public Policy and the Budget
Congressional budgeting
Congress in charge of budget until 1921
Today, President prepares budget, Congress approves it
Budget and Accounting Act of 1921
Established Bureau of the Budget (now Office of Management and Budget) to prepare president’s budget to be submitted to Congress each January
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14. Public Policy and the Budget
The Nature of the Budget
Budget of the United States Government – annual plan
Applies to next fiscal year – October 1 to September 30
Defines budget authority and outlays
Receipts – expected tax and revenues
Deficit – difference between receipts and outlays
National debt – sum of all unpaid government deficits
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15. Public Policy and the Budget
Preparing the President’s Budget
The Office of Management and Budget (OMB) oversees process
OMB initiates process in spring, agencies prepare budgets in summer and submit to OMB in fall, analysts review requests, negotiations until budget goes to printer
Proposed budget submitted to Congress
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16. Public Policy and the Budget
Passing the Congressional Budget
The Traditional Procedure
Tax committees
Ways and Means in the House
Finance in the Senate
Authorization committees
Approximately 20 in House; Senate 15
Appropriations committees: House and Senate
More powerful than authorization committees
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17. Public Policy and the Budget
Passing the Congressional Budget (cont’d)
Two serious problems in budgeting process
Spending process is complex
No one is responsible for budget as a whole
Budget committees supervise comprehensive review process aided by Congressional Budget Office (CBO)
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18. Public Policy and the Budget
Passing the Congressional Budget (cont’d)
Congress tried twice to pass Budget Enforcement Act (BEA) of 1990
Defined spending
Mandatory spending
Discretionary spending
Previous laws paved way for Clinton’s Balanced Budget Act of 1997 (BBA)
Led to balanced budget and produced a surplus
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19. Public Policy and the Budget
Passing the Congressional Budget (cont’d)
Congress allowed caps on discretionary spending to expire at end of 2002
Gramm-Rudman-Hollings Balanced Budget and Emergency Deficit Control Act in 1985
Law utter failure, deficit targets eliminated in 1990
Balanced budget amendment (BBA) introduced again in 2011 but failed
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20. Tax Policies Reform Reform proposals influenced by interest groups
Pre-1987 – 14 income brackets
President Reagan reduced to two
Flat tax violates principle of progressive taxation
Progressive taxation allows government to redistribute wealth and promote economic equality
Presidents G.H.W. Bush and Clinton added two more brackets, moved to more progressive tax structure
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21. Tax Policies Reform (cont.)
George W. Bush pushed Congress to pass tax cuts
Reduced revenues increased deficits
Economic downturn, homeland defense, and military expenses compounded problem
Bush’s last budget – over a trillion dollars deficit
Deficit continued to grow under Obama
2012, Obama campaigned to restore 39.6 tax bracket for highest tax bracket
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22. Tax Policies Comparing Tax Burdens
Tax burden on U.S. citizens has decreased since 1950s
Tax burden not large compared to other democratic nations
Almost every democratic nation taxes more heavily than the U.S. does
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23. Federal budget authorities and outlays are organized into about twenty categories, some of which are mainly for bookkeeping purposes. This graph shows expected outlays for each of seventeen substantive functions in President Obama’s FY 2013 budget. The final budget differed somewhat from this distribution because Congress amended some of the president’s spending proposals. The graph makes clear the huge differences among spending categories. Military spending accounts for the largest share of the budget (18.5 percent) and is the largest amount in inflation-adjusted dollars since World War II. About 35 percent of government outlays are
for Social Security and income security—that is, payments to individuals. Health costs (including Medicare) account for almost 25 percent more, and net interest consumes almost 7 percent. This leaves relatively little for transportation, agriculture, justice, science, and energy—matters often regarded as important centers of government activity.
Source: Executive Office of the President, Budget of the United States Government, Fiscal Year 2013: Historical Tables (Washington, D.C.: U.S.
Government Printing Office, 2012), Table 3.1.
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24. This chart plots the percentage of the annual budget devoted to four major expense categories over time. It shows that significant changes have occurred in national spending since During World War II, defense spending consumed more than 80 percent of the national budget. Defense again accounted for most national expenditures during the Cold War of the 1950s. Following the collapse of communism in the 1990s, the military’s share of the budget declined but rose again with the war in Iraq. The major story, however, has been the growth in payments to individuals—for example, in the form of Social Security benefits, Medicare, health care, and various programs that provide a social safety net—including unemployment compensation.
Source: Executive Office of the President, Budget of the United States Government, Fiscal Year 2013:
Historical Tables (Washington, D.C.: U.S. Government Printing Office, 2012), Table 6.1.
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25. Spending Policies Incremental Budgeting…
Agencies submit budgets based on previous year
Congress rarely looks at base budget items
Few agencies ever cut back, spending continually goes up
Earmarks greatly increased until early 1990s
Congress declared moratorium on earmarks after 2010 election
Some members repackaging them as “special funds”
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26. Spending Policies …and Uncontrollable Spending
Earmarks are discretionary outlays
Most government spending is mandatory outlays and uncontrollable without change in law authorizing program
Politics argue against large-scale reductions
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27. Taxing, Spending, and Economic Equality
Government Effects on Economic Equality
Do government spending policies have measurable effect on income inequality?
Government payments to individuals: transfer payments
Don’t always go to poor
Farm program: Wealthiest farmers often receive largest subsidies
Have definite effect on reducing income inequality
National tax policies at all levels have historically favored those with higher incomes and the wealthy
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28. Figure 17.4
In 1913, the Sixteenth Amendment empowered the national government to collect taxes on income. Since then, the government has levied taxes on individual and corporate income and on capital gains realized by individuals and corporations from the sale of assets, such as stocks or real estate. Typically, incomes above certain levels are taxed at higher rates than incomes below those levels. This chart, which lists only the maximum tax rates, shows that these top tax rates have fluctuated wildly over time, from less than 10 percent to more than 90 percent. (They tend to be highest during periods of war.) During the Reagan administration, the maximum individual income tax rate fell to the lowest level since the Coolidge and Hoover administrations in the late 1920s and 1930s. The top
rate increased slightly for 1991, to 31 percent, as a result of a law enacted in 1990, and jumped to 39.6 percent for 1994 under Clinton’s 1993 budget package. The top rate was reduced in stages to 35 percent by Bush’s tax plans in 2001 and 2003.
Source: Wall Street Journal, 18 August 1986, p. 10. Copyright 1986 by Dow Jones & Company, Inc. Reproduced with permission of Dow Jones &
Company, Inc., in the format textbook via Copyright Clearance Center. Additional data from the Tax Policy Center, which reports tax brackets for
individual years at
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29. Taxing, Spending, and Economic Equality
Effects of Taxing and Spending Policies over Time
Poorer citizens pay higher percentage of income in taxes than wealthier citizens
In capitalist system, some degree of inequality is inevitable
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30. FIGURE 17.5 Distribution of Family Income over Time
In 2010, the 20 percent of U.S. families with the highest incomes received over 50 percent of all income, and their share has increased over time. This distribution of income is one of the most unequal among Western nations. At the bottom end of the scale, the poorest 20 percent of families received less than 5 percent of total family income, and their share has decreased over time.
Source: U.S. Census Bureau, ‘‘Income, Poverty, and Health Insurance Coverage in the United States: 2010,’’ Current Population Reports (Washington, D.C.: U.S. Government Printing Office, September
2011), Table A-3.
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31. Taxing, Spending, and Economic Equality
Democracy and Equality
U.S. prizes political equality, but economic equality not as strong
Wealthiest 1% control 35% of nations household wealth
Distribution among ethnic groups alarming
Typical white family’s annual income 1.5 times of blacks and Hispanics
One theory - Pluralist interest group activity distorts government’s efforts to promote equality
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32. Taxing, Spending, and Economic Equality
Democracy and Equality
String of Gallup polls from 1985 to 2008:
Clear majority said distribution of wealth not fair and favor some redistribution – but not through heavy taxes on rich
Favor national sales tax or weekly lottery
Sales tax, flat tax = regressive effect, promoting inequality
Lottery also contributes to wealth inequality
Poor more willing to chance income than rich
Majoritarians argue most Americans don’t understand inequities of national tax system
Economic policy determined through pluralist politics
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