Chapter 18: Economic Policy

Copyright © Houghton Mifflin Company. All rights reserved.18 | 2 Theories of Economic Policy Economic theories explain how market economies work Laissez-Faire Economics –Laissez-faire: absence of government control over the economy –Adam Smith: “the invisible hand”

Copyright © Houghton Mifflin Company. All rights reserved.18 | 3 Theories of Economic Policy Keynesian Economics –Laissez-faire policies cannot do anything about economic depression or raging inflation Economic depression: a period of high unemployment and business failures; a severe, long-lasting downturn in the business cycle Inflation: an economic condition characterized by price increases linked to a decrease in the value of the currency

Copyright © Houghton Mifflin Company. All rights reserved.18 | 4 Theories of Economic Policy Keynesian Economics –Capitalist economies may suffer through many business cycles Business cycles: expansion and contractions of business activity, the first accompanied by inflation and the second by unemployment U.S. has experienced more than 15 business cycles

Copyright © Houghton Mifflin Company. All rights reserved.18 | 5 Theories of Economic Policy Keynesian Economics –Keynes argued that business cycle fluctuations result from imbalances between aggregate demand and productive capacity Aggregate demand: the money available to be spent on goods and services Productive capacity: the total value of goods and services produced when the economy works at full capacity Gross domestic product (GDP): the value of goods and services actually produced

Copyright © Houghton Mifflin Company. All rights reserved.18 | 6 Theories of Economic Policy Keynesian Economics –Keynesian theory: an economic theory that states that the government can stabilize the economy – that is, can smooth business cycles – by controlling the level of aggregate demand, and that the level of aggregate demand can be controlled by means of fiscal and monetary policies Fiscal policies: economic policies that involve government taxing and spending Monetary policies: economic policies that involve control of, and changes in, the money supply –Most capitalist countries have adopted Keynesianism in some form

Copyright © Houghton Mifflin Company. All rights reserved.18 | 7 Theories of Economic Policy Monetary Policy –The political utility of Keynesian fiscal policies is limited –Monetarists: those who argue that government can effectively control the performance of an economy only by controlling the supply of money

Copyright © Houghton Mifflin Company. All rights reserved.18 | 8 Theories of Economic Policy Monetary Policy –Federal Reserve System (“the Fed”): the system of banks that acts as the central bank of the United States and controls major monetary policy Controls the money supply in 3 ways –Selling and buying U.S. government securities –Changing the target for the federal funds rate –Changing the reserve requirement for banks Has historically acted to combat inflation rather than stimulate economic growth

Copyright © Houghton Mifflin Company. All rights reserved.18 | 9 Theories of Economic Policy Supply-Side Economics –Supply-side economics: economic policies aimed at increasing the supply of goods (as opposed to increasing demand), consisting mainly of tax cuts for possible investors and less regulation of business –“Reaganomics”

Copyright © Houghton Mifflin Company. All rights reserved.18 | 10 Public Policy and the Budget Since 1921, the president has been responsible for drafting and submitting the budget to Congress for approval

Copyright © Houghton Mifflin Company. All rights reserved.18 | 11 Public Policy and the Budget The Nature of the Budget –Budget: the annual financial plan that the president is required to submit to Congress at the start of each year –Budget outlays: the amount that government agencies are expected to spend in the fiscal year –Receipts: for a government, the amount expected or obtained in taxes and other revenue –The difference between receipts and outlays is the deficit –Public debt: the accumulated sum of past government borrowing owed to lenders outside the government

Copyright © Houghton Mifflin Company. All rights reserved.18 | 12 Public Policy and the Budget Preparing the President’s Budget –The preparation of the budget is supervised by the Office of Management and Budget (OMB) –President’s budget is the starting point for Congress

Copyright © Houghton Mifflin Company. All rights reserved.18 | 13 Public Policy and the Budget Passing the Congressional Budget –The Traditional Procedure: The Committee Structure 3 types of committees involved in budgeting Does not allow Congress as a whole sufficient control over the budget process –Reforms of the 1970s: The Budget Committee Structure –Lessons of the 1980s: Gramm-Rudman –Reforms of the 1990s: Balanced Budget –Backsliding in the 2000s: Deficits Return

Copyright © Houghton Mifflin Company. All rights reserved.18 | 14 Tax Policies Designed to provide a continuous flow of revenue without requiring new annual legislation –May be used to accomplish many objectives –Major revenue source: individual income taxes (45%)

Copyright © Houghton Mifflin Company. All rights reserved.18 | 15 Tax Policies Tax Reform –The Tax Reform Act of 1986 One of the most sweeping changes in history Eliminated many brackets; approached a flat tax Flat tax violates principle of progressive taxation: a system of taxation whereby the rich pay proportionately higher taxes than the poor Number of tax brackets increased by George H.W. Bush and Bill Clinton

Copyright © Houghton Mifflin Company. All rights reserved.18 | 16 Tax Policies Tax Reform –Changes to law in 2001 and 2003 Increased number of brackets, but changed trigger points Reduced revenue, resulted in deficits

Copyright © Houghton Mifflin Company. All rights reserved.18 | 17 Tax Policies Comparing Tax Burdens –The tax burden has not increased since the 1970s for middle income families in the United States –American tax burden is still low compared with that of other major industrialized democratic nations

Copyright © Houghton Mifflin Company. All rights reserved.18 | 18 Spending Policies FY 2007 budget accounted for $2.8 billion in proposed outlays Incremental Budgeting… –Incremental budgeting: a method of budget making that involves adding new funds (an increment) onto the amount previously budgeted (in last year’s budget) –Earmark: government funds appropriated to be spent for a specific project

Copyright © Houghton Mifflin Company. All rights reserved.18 | 19 Federal Spending in 2007, by Function

Copyright © Houghton Mifflin Company. All rights reserved.18 | 20 Spending Policies … and Uncontrollable Spending –Uncontrollable outlay: a payment that government must make by law –Almost 2/3 of FY 2007 outlays were uncontrollable or relatively uncontrollable

Copyright © Houghton Mifflin Company. All rights reserved.18 | 21 National Government Outlays Over Time

Copyright © Houghton Mifflin Company. All rights reserved.18 | 22 Government Outlays and Receipts as a Percentage of GDP

Copyright © Houghton Mifflin Company. All rights reserved.18 | 23 Taxing, Spending, and Economic Equality Economic equality requires economic freedom to be compromised through redistribution of wealth

Copyright © Houghton Mifflin Company. All rights reserved.18 | 24 Taxing, Spending, and Economic Equality Government Effects on Economic Equality –Transfer payments: a payment by government to an individual, mainly through social security or unemployment insurance –Progressivity of national income tax has varied over time –Combination of national, state, and local taxes may violate progressivity

Copyright © Houghton Mifflin Company. All rights reserved.18 | 25 Taxing, Spending, and Economic Equality Effects of Taxing and Spending Policies Over Time –Between 1966 and 2004, gap in income between rich and poor grew –U.S. has most unequal distribution of income in comparative study of 18 developed countries

Copyright © Houghton Mifflin Company. All rights reserved.18 | 26 Taxing, Spending, and Economic Equality Democracy and Equality –Distribution of wealth is highly unequal Wealthiest 1% of families control 33% of household wealth Distribution between ethnic groups also highly unequal

Copyright © Houghton Mifflin Company. All rights reserved.18 | 27 Taxing, Spending, and Economic Equality Democracy and Equality –Why don’t “the people” share in the nation’s wealth? Little support for increasing income tax More support for regressive taxation: national sales tax, lottery –Most Americans don’t understand the inequalities of the national tax system

Copyright © Houghton Mifflin Company. All rights reserved.18 | 28 Distribution of Family Income over Time