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Unit 5: Fiscal Policy
Now that you have been introduced to the business cycle, we can begin to understand the role that the
government can play in the economy. During a recession the government generally wants to grow the
economy. During a period of high inflation, the government generally wants to slow the economy
down.
First, we need to know the two types of policies the government can utilize if the economy is
experiencing a recession or high inflation. The two policies are known as fiscal and monetary policy.
Fiscal Policy is the government’s use of taxing and spending.
Monetary Policy is the government’s increasing or decreasing the supply of money in the economy.
In this unit we will focus on fiscal policy.
Government Taxing and Spending
Before we begin looking at policy decisions, it is important that we cover government taxing and
spending.
TAXES
In order for the government to provide services for society, it needs to have money to pay for them. For
the most part this money comes from taxes. Below is a chart that defines several types of taxes. The
numbers are based on 2015 figures.
Type of Tax
Personal Income Tax
Capital Gains Taxes
Definition
A percentage of a person’s income from wages,
interest, etc. is paid to the government. People
pay income taxes to the federal government, most
state governments and some local governments.
Current federal tax rates range from 10% to 39.6%
Here is a link that displays current federal tax.
rates: Forbes.com- tax rates
The current MA state tax rate is 5.15%
A particular type of income tax, capital gains taxes
collect a percentage of the income earned from
investments in stocks and bonds, etc . Current
federal capital gains rates range from 15% to 20%
depending on income. MA state rates reach up to
12%.
FICA- Social Security Taxes
Excise tax
Sales tax
Property Taxes
Estate Taxes
Gift Tax
Corporate Income tax
Customs Duties/Tariffs
A percentage of a person’s wages is taken to help
fund the social security system. Employers have to
match the contributions of their employees.
Wages are taxed up to a certain amount. As of
2015 the maximum amount of income taxed is
$118,500
A tax based on the value of an item like a car, boat,
trailer, etc. This is collected by your local
government. The rate of excise tax on cars in MA
is $25 for each $1000 of assessed value.
A percentage of retail sales purchases is taxed by
many state governments. In MA all goods
excluding food and clothing are taxed at a rate of
6.25%.
A tax based on the value of your home. Cohasset’s
current rate is $12.71 for each $1000 of assessed
value.
Tax on the property of a deceased individual.
There is an exclusion up to $5.34 Million after that
the estate can be taxed up to 40%.
If someone gives a gift worth over $14,000, the
giver of the gift is subject to taxation.
Profits made by companies are also subject to
taxes. Current rates range fro 15% to 35%.
Imported goods may be subject to taxation. The
level of taxation varies by product.
Classifications of Taxes:
The taxes listed above can be classified based on which income group pays a higher percentage of tax.
The 3 classifications are progressive, regressive and proportional.
A progressive tax taxes people with a higher income at a higher percentage rate, while people with
lower incomes pay a lower rate. An example of this is income taxes where the highest income earners
pay 39.6% and lower earners pay 10%.
A regressive tax taxes people with a lower income at a higher rate, while people with higher incomes
pay a lower rate. One example of a regressive tax is a sales tax. Even though the tax is a set rate (6.25%
in MA) , people with lower incomes tend to spend a higher percentage of their income on consumption
(Wealthier people tend to save and invest more) Because of this, lower income people actually pay a
higher percentage of their income toward a sales tax.
A proportional tax taxes all income groups at the same percentage. Property taxes are a good example
of a proportional tax. If a person owns a home worth 350,000 they pay the same percentage as a
person who owns a million dollar home. The person with the million dollar home will pay more money,
but they will pay the same percentage as
Government Spending
Now that we have determined where the money comes from, let’s look at how tax money is spent:
In the United States we have three basic levels of government:
Federal, State and Local (County could be a fourth, but we will leave that out of the discussion at this
time.
Major areas of federal spending include spending on
Defense
Social Security, including retiree benefits and benefits to disabled individuals
Medicare and Medicaid- health insurance for the elderly and people in poverty respectively.
Safety- Net programs provide assistance for people in poverty such as Aid to Families with
Dependent Children (AFDC) better known as welfare
Transportation
Education- money is sent to states, cities and towns for specific programs
Benefits for federal employees- pensions, etc.
Interest on the national debt
Major areas of state spending include:
Medicaid
Health and Human services
Education
Local Aid
Transportation
Public Safety
Major areas of local spending include:
Education
Police
Fire
DPW
Expansionary Policies
Fiscal policy is controlled by the legislative (House and Senate) and executive (President) branches of the
government. Through the creation of legislation these institutions can make more money available to
people during a recession. When people get more money, they tend to spend it, the money multiplies
through the economy and the economy starts to grow. This expansionary type of policy can be done in
two ways. The legislature can choose to increase government spending and/or cut income taxes.
They could pay contractors to build a road, provide funds for cities to hire more teachers, reduce payroll
taxes or simply provide give checks to people who are out of work.
-Once there is an injection of money:
-People tend to increase their spending on goods and services
- Companies begin to see an increased demand for their products
-The companies begin to hire new workers
-The workers now start to spend more money
-The process continues and the GDP of the country begins to increase leading to recovery
Such a policy would increase the aggregate demand in the economy. Because of this, policies that
increase government spending or reduce taxes on individuals so that they can spend more are known as
demand side economics. They are also referred to as Keynesian (named for John Maynard Keynes who
first introduced these ideas during the Great Depression.)
Another expansionary policy is to decrease taxes on businesses and investments. The government
could reduce the taxes that businesses pay the government, or it could reduce the taxes people have to
pay on the investments that they make. Often this approach is referred to as trickle-down economics.
-Once more money is made available to businesses for investments, businesses will begin to
invest the money back into factories, new technologies, etc.
-This will lead to companies supplying more goods and services.
-The increase in supply will lead to lower process which will increase the quantity demanded of
products.
-In order to supply more goods and services the companies will hire more workers
-The workers will now have money, which they will spend.
-The economy begins to improve
This type of policy would increase the aggregate supply in the economy. Because of this, policies that
decrease business taxes or taxes on investments are known as supply side economics.
Contractionary Policies
There may be times when the government might want to slow the growth of the economy to fight
inflation. This type of policy is known as a contractionary policy. Contractionary policies include
decreasing government spending and/or increasing taxes.
-Using such a policy reduces the amount of money that circulates through the economy
-This leads to a decrease in demand for products in the economy
-the decrease in demand leads to a decrease in prices across the economy.
Overall impact of Fiscal Policies
An expansionary Policy
Increases real GDP
Decreases unemployment
Increases prices
A Contractionary Policy
Decreases prices
Decreases GDP
Increases unemployment
At this point we should focus on politics and define the terms liberal and
conservative as they relate to economics.
While both of these approaches are logical, they can lead to heated debates among politicians and
economists.
Conservative
In general, people who consider themselves to be conservative support supply side approaches and
criticize demand side approaches.
In general, conservatives (who tend to be republicans) strive for a reduced role for the
government in the economy (like Adam Smith). They also tend to be supportive of businesses.
Cutting taxes on businesses reduces the role of government interference, while at the same
time, providing more money for businesses to invest in production, which leads to growth in the
economy. Because of this, conservatives tend to favor tax cuts for businesses and investments
during recessionary periods. In general, conservatives tend to favor lower taxes overall.
Conservatives criticize demand side approaches for interfering with the market and because
they believe that government spending only leads to temporary growth. They see such
approaches as an increase in the size of the government, and many conservatives believe that
government can be more of a hindrance to the economy than a benefit. (Again think Smith)
Conservatives also argue that any benefits gained from increased government spending only
lead to short-run, unsustainable growth, with higher price levels. They believe that real growth
in the economy comes from “real variables” like increases in the factors of production and
increasing productivity, not from increases in spending.
Liberal
In general, people who consider themselves to be liberal or progressive support demand side
approaches and criticize supply side approaches.
In general, liberals (who tend to be democrats) believe that the government can be effective if it
intervenes in a market economy, and they tend to be more supportive of increased spending on
social programs designed to assist individuals in lower socio-economic circumstances. Because
of this, liberals tend to favor government spending to provide jobs and increased spending on
social programs during recessionary periods. Liberals are also more likely to support progressive
taxes.
Liberals criticize supply-side ideas based on their effectiveness and concerns regarding economic
equity. First, Keynesians criticize the belief that decreasing taxes on businesses will
automatically lead to economic growth, arguing that businesses may choose to hold onto the
money they receive from tax cuts. They also believe that increasing spending (i.e. demand)
leads more directly toward increased economic output. In addition, liberals criticize the ideas of
trickle-down economics. They challenge the belief that wealth will make its way down to people
on lower rungs of the economic ladder, believing that much of the wealth generated from tax
cuts remains in the hands of the wealthiest members of society.
Overall Criticisms of Using Fiscal Policy
In addition to the opposing views of liberals and conservatives, there is a consensus among
economists that use of fiscal policy can lead to deficits (the government spending more money
than it takes in in tax returns in a given year) and an increase in government debt. Why is this so
bad? Most economists agree that sustained government borrowing to finance deficits can lead
to a decrease in long-term growth in the economy. (Please note that Keynesians would argue
that deficit spending is worth it during a recession) Fiscal policy can also be criticized for taking
a while to implement. Remember these approaches depend on the legislative process. Laws
can take a while to create and to implement. This lag-time can hinder the effectiveness of fiscal
policies.
Despite these limitations, most economists and politicians still consider fiscal policies to be
impactful on the economy, even though they may disagree over the overall level effectiveness
of such policies.
To Sum Up:
-
The government can use fiscal policy to improve economic circumstances.
Fiscal policy includes changing government spending and or the level of taxation
If there is a recession, the government should follow an expansionary policy of increasing
spending and/ or reducing taxes.
If there is high inflation the government should follow a contractionary policy of decreasing
spending and/or increasing taxes.
A Keynesian approach would include increasing government spending and/or decreasing
personal income taxes to spur demand and increase output in the economy.
A Supply- Side approach would include decreasing taxes on businesses and investments to spur
supply and increase output in the economy.
There are political philosophies which often impact peoples’ decisions regarding fiscal policies.
Liberals tend to favor Keynesian ideas and conservatives tend to favor Supply-Side approaches.