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Chapter 18: Economic Policy 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 | 2 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 | 3 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 | 4 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 | 5 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 | 6 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 | 7 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 | 8 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 | 9 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 | 10 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 | 11 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 | 12 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 | 13 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 | 14 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 | 15 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 | 16 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 | 17 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 | 18 Federal Spending in 2007, by Function Copyright © Houghton Mifflin Company. All rights reserved. 18 | 19 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 | 20 National Government Outlays Over Time Copyright © Houghton Mifflin Company. All rights reserved. 18 | 21 Government Outlays and Receipts as a Percentage of GDP Copyright © Houghton Mifflin Company. All rights reserved. 18 | 22 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 | 23 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 | 24 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 comparative study of 18 developed countries Copyright © Houghton Mifflin Company. All rights reserved. income in 18 | 25 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 | 26 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 | 27 Distribution of Family Income over Time Copyright © Houghton Mifflin Company. All rights reserved. 18 | 28